Taxpayers once invested to create “paper” losses, typically caused by generous tax depreciation deductions. To restrict such losses, the tax law sets out three hurdles that must be cleared before a loss may be claimed.
First, the taxpayer must have “basis” to claim the loss. This is basically the amount of the investment. But the basis may include borrowed money.
Second, the taxpayer must be “at risk” for the investment. This may be narrower than the regular basis, because it includes borrowed money only if the lender can come after the investor if the loan is in default.
The at-risk basis is also computed for each separate investment. The regular basis can be aggregated for all investments within the same entity, such as a partnership.
The big dog in the fight is the passive loss rules. Losses from passive investments can only be offset by income from similar investments, or when the activity that created the losses is disposed of.
The passive loss rules have special provisions for people who spend more than half their time in real estate operations and who also spend more than 750 hours in real estate activities.
The passive loss rules were designed to shut down tax shelters, and they have been very effective. However, it seems there was a need to further limit losses from active-type businesses.
The three limitations discussed above apply in sequence. It is only when the third hurdle, the passive loss one, is cleared, that a loss may be claimed.
The new tax law creates a fourth hurdle. This one applies only to losses that have cleared the first three hurdles. The new hurdle limits annual losses to $250,000, or $500,000 if a joint return is filed.
Sounds like few people will be affected. Surprisingly that is not true. The new hurdle is “scored” as contributing $150 billion in new taxes over the next 10 years.
As with many provisions in the new law, hurdle four is not well defined and its operation across tax years is uncertain. Without any specificity in the statute, tax advisers are suggesting the most optimistic interpretation of the law.
What’s not clear? Hurdle four losses will first be allowed to offset business income. But is W-2 wage income business income? Different tax provisions have different answers to that question. The favorable interpretation is – yes, first offset your W-2 income before applying the limit.
Second, any loss that is limited by hurdle four becomes a net operating loss in the next tax year. Remember it has cleared the first three hurdles, so it makes sense to allow it to carry forward and avoid having to run the gauntlet of the three hurdles again.
But will the $250,000/$500,000 limit apply to the tax year to which the NOL created by the limit applies? The language of the statute suggests no.
So let’s say that in 2018 a married taxpayer has investment income of $5 million, W-2 wages of $1 million, and a business loss of $4 million. Of that loss, $1 million offsets W-2 income, $500,000 is allowed under the limitation, and $2.5 million carries to 2019.
Let’s say 2019 is the same, but now with no 2019 business loss. The $2.5 million NOL may now be fully utilized because the investment income creates positive taxable income to offset.
If this is so, then the loss limit may simply be a one year thing for many taxpayers with positive sources of non-business income. Without non-business income, the NOL would continue to be limited, as it could only eliminate the positive income.
Does this bore you? I hope so because I hate to see people lose more than $500,000 from some business operation in a single year. Hopefully you are not affected.
But the new law rewards winners and penalizes big losers. Oddly, new very generous depreciation writeoffs may create more people who look like losers when they are really winners. Hurdle four may then steal back some of those depreciation benefits.
Jim Hamill is the director of Tax Practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at email@example.com.