The Tax Cuts and Jobs Act added Sec. 461(l) which limits the amount of losses from trades or businesses of non-corporate taxpayers that can be claimed on their tax returns. Taxpayers’ who are “real estate professionals” can no longer deduct excess business losses against other non-business income in the current year without limitation as in the past.
The code defines “excess business loss” as the amount by which the total aggregate deductions for a taxable year of a taxpayer attributable to such trade or businesses (without regards to whether or not such deductions are disallowed) exceed the total gross income and gains from such trade or businesses plus a threshold amount. For 2018, the threshold amount is $250,000 ($500,000 for married taxpayers filing a joint return). These numbers are adjusted annually for inflation and the threshold amount for 2019 is $255,000 and $510,000 respectively. The excess disallowed business loss is treated as a net operating loss carryover to the next year.
The excess business loss calculation factors several aspects of an individual’s real estate business. It combines wages, real estate net income, gains from the sale of business real estate, real estate losses as well as losses from the sale of business real estate. Real estate professionals who operate through partnerships and S Corporations, will take their share of income and losses allocated to them for purposes of this calculation since it is made at the individual level, not the entity level. The excess business loss calculation can also affect a non-real estate professional (a passive investor) in deducting a business loss in the year of disposition since a loss from a passive activity is treated as non-passive in the year of disposition.
For example: Sam is single and is a real estate professional with the following facts. He has wages of $200,000, a net loss from real estate of $1 million from a combination of properties he owns individually and through Limited Liability Company partnerships. He also has $140,000 in capital gains from the sale of business real estate and interest and dividend income of $400,000. Assume Sam has no net operating loss carryforward. Sam will add together the wages and the capital gain resulting in $340,000 of total business income. He will then subtract the $1 million of net real estate losses and arrive at a business loss of $660,000. Adding the new threshold limitation amount of $250,000, Sam’s excess business loss for 2018 is $410,000. Limitation on Business Losses are calculated on new IRS Form 461. Sam can deduct the $250,000 business loss against other non-business income he has earned such as interest, dividends, nonbusiness capital gains and other income, but the $410,000 excess business loss will be a net operating loss carryforward to 2019.
Since Sam did not have a net operating loss carryforward from a tax year before 2018, and had other non-business income of $400,000 (interest and dividend income), Sam would have an adjusted gross income in 2018 of $150,000. If Sam were to claim the standard deduction in 2018 of $12,000, he would have taxable income of $138,000. Without this provision from the Tax Cuts and Jobs Act, Sam would have had a net operating loss for 2018 and would have paid no tax.
The Tax Cuts and Jobs Act eliminated net operating loss carrybacks. All net operating losses incurred from 2018 on must be carried forward. Net operating loss carryforwards incurred after 2017 can be used to offset 80% of modified taxable income, any excess net operating loss will be carried forward. Note that a carryforward of a net operating losses incurred before 2018 can still be used to offset 100% of income in 2018 and later until it is used up. The pre 2018 net operating losses still have a life of 20 years. Post 2017 net operating losses can be carried forward indefinitely.
Assuming the same fact pattern as before, in 2019 Sam’s excess business loss is $405,000 ($660,000 business loss less the floor of $255,000) and he will have taxable income of $132,800 (after the standard deduction which for 2019 is $12,200). Assuming that Sam’s modified taxable income is $132,800, Sam can offset that by 80% of his 2018 net operating loss carryforward. 80% of $132,800 is $106,240 so Sam’s taxable income for 2019 will be $26,560 after the net operating loss carryforward is applied. The unused net operating loss from 2018 of $303,760 ($410,000 less $106,240) plus the 2019 excess business loss of $405,000 will both be carried forward to 2020.
The Excess Business Loss adds another layer of complexity for real estate tax professionals and must be taken into consideration in doing future tax planning or restructuring.
Sandy Klein, CPA, is a partner at Shanholt Glassman Klein Kramer & Co., New York, N.Y.