Taxpayers Lose when Losses are Lost
Co-Authored by Stan Rose
(A survey of various tax losses and the new and old rules that delay and limit their use)
When a taxpayer generates a loss, it generally either offsets other sources of income and therefore reduces the amount of tax that otherwise would be paid, or may even produce a net loss that in some instances can generate a refund of taxes previously collected. Because use of losses causes the IRS coffers to suffer, a number of restrictions exist in U.S. tax laws that hamper a taxpayer’s ability to convert an actual financial loss into a currently-useable deduction. December’s Tax Cuts and Jobs Act (“TCJA”) rolled out some entirely new restrictions that will impact many people. This seems like an appropriate time to provide a refresher on the various types of tax losses that exist and the numerous old and new limitations that curb their use.
Siloes and Sequences
Not all losses are alike. Some can offset only capital gains, which are taxed at favorable rates, while more potent types can offset “ordinary” income, which is taxed at higher rates. Some are useable only after passing multiple testing gauntlets. Some (but not others) can be carried forward to offset future income, and others are considered personal in nature and once categorized as such simply die on the vine without generating any tax benefit. They may be best understood by viewing them as existing in certain silos, and taking part in one or more sequences. For purposes of this discussion we will place each loss in one of four silos: Passive, ordinary/business, capital, and personal.
Basis and At-Risk Limitations
Basis and at-risk limitations are best viewed as concepts that are addressed before a loss enters one of the silos, because they can apply to various types of income, depending on the type of asset involved or the owner’s relationship to that asset or activity. Basis and at-risk computations are done on an entity-by-entity basis at the individual level.
Deductible losses are reserved for those who have skin in the game. A taxpayer must have truly lost something measurable. This concept exists prominently with owners of flow-through entities (S corporations, partnerships, and LLCs), for whom losses survive the first test in their “deductibility” sequence only if they do not exceed the owner’s “basis.” Basis generally equals the owner’s acquisition cost, plus share of the entity’s income, less share of the entity’s net deductions, less distributions – all on a cumulative basis. If losses exceed basis they are suspended (hung up at this stage in the sequence and temporarily unusable) until more basis is created. Often, this condition cannot exist unless the entity incurs debt. If the entity borrows money directly from an owner, that owner may deduct losses in excess of ownership basis by utilizing basis in that debt, but doing so creates the risk that repayments of that loan (which usually is a tax free event) will generate income for that shareholder. Distributions of cash or property in the absence of sufficient basis may do the same.
Losses cannot exceed the amount that a taxpayer has at risk. Oversimplifying, the concept of “at-risk” is similar to basis. Generally the amount at risk moves up and down for the same components as basis, but this category is broadened to include debt incurred by the entity for which an owner is personally responsible.
Losses reach the “passive loss” stage of the deductibility gauntlet only if they survive the basis/at-risk stage. Passive loss limitations generally are analyzed on a combined basis.
Greatly oversimplifying one of the most voluminous and complex areas of tax law, losses generated from passive activities generally can offset only income generated from other passive activities. Passive losses cannot cross over to be netted with “active” business income, wages, capital gains, retirement income, or investment income. Instead, any net passive losses that remain after combining all passive activity income and losses together are suspended and carried forward to the following year to be netted with that year’s passive income and losses. While this analysis is done on a combined basis, separate entity-by-entity tracking is also needed, because the passive losses related to a particular activity are freed up and immediately usable during the year that the activity is sold or completely abandoned.
A number of very specific rules and case law not covered in this article must be analyzed to determine whether a person’s involvement in an activity is passive or non-passive, but at the core, those terms are somewhat descriptive. A notable exception exists for rental income.
Rental income for most taxpayers is treated as passive per se, although heavy enough involvement can rebut that presumption (using a couple of paths accompanied by even more specific and complex rules). Also, rental income generated by a related party (where landlord and tenant are related through direct or indirect common ownership) is characterized as “self-rental.” Once in that category, income is treated as non-passive, while losses are treated as passive.
Observation: This has been described as the IRS’ “heads I win, tails you lose” rule because treating income as non-passive prevents taxpayers from using that income to free up other passive losses, and treating losses as passive increases the pool of currently-unusable losses. It was created by Congress to prevent manipulation of losses, but unfortunately, it often delays deductions related to perfectly legitimate rental arrangements that were entered into on terms similar to what unrelated parties would negotiate.
Another observation: Note that although income like interest, dividends, and capital gains or losses may “feel” passive (in the sense that one is not working on a shop floor with a steel press to create them), “passive” is a technical term that for tax purposes excludes those types of income. It instead often describes activities that, depending on the taxpayer’s level of involvement, could be either active or passive.
As explained above, after combination of all passive activities, net losses are not immediately useable. They are suspended and carried forward to subsequent years. Net passive income, however, is fully taxable.
The losses described in this “silo” are potent ones, because they offset “ordinary” income, which is taxed at higher rates than its “capital gain” counterpart; and because ordinary income is a wide category, including things like wages and retirement income (offering greater opportunities for the offset to take place). Net business losses also can be carried forward, and historically were sometimes carried back with the use of amended returns to produce refunds. Recent changes in the TCJA have significantly altered the carryover and usage characteristics of business losses.
Net operating losses
Individuals and corporations can generate net operating losses (“NOLs”), which are the result of business deductions exceeding business income. Such losses historically could be carried back for two years and then forward for 20 years, offsetting other income reported in those periods. Carrybacks often produce refunds of tax paid in prior years.
With the creation of the TCJA, a new regime applies, causing NOLs that are generated during years ending after 12/31/17 to be eligible for carryforward for an unlimited number of years, but unable to be carried back at all. Also, only 80% of a year’s income may be offset with an NOL carryforward to that year, even if sufficient NOL exists to wipe out 100% of that year’s income. NOLs that were generated in years ending on 12/31/17 continue to follow the “2 years back, 20 years forward” regime.
Observation: The alternative minimum tax (“AMT”) regime has long used a variant of this “partial use” of NOL system. The TCJA includes new rules that will greatly limit the imposition of AMT, but some of its ghosts will haunt us in this manner.
Another observation: This means that in a profitable year, taxpayers can now expect to pay some amount of tax, regardless of the size of their prior year losses. Until now, other than potentially when AMT applied, taxes were not due until all losses were burned up, and profit existed cumulatively.
NOL usage is sometimes limited if a corporation that has NOLs undergoes ownership changes. Existing corporate NOLs survive ownership changes, but Sec. 382 of the Internal Revenue Code (“IRC”) limits the amount of pre-acquisition NOL that can be used annually under the new ownership. Using its complex rules and many exceptions, the amount of acquired NOL that can be used annually is equal to the value of the company multiplied by the IRS-prescribed long-term tax-exempt rate.
Observation: This change was implemented by Congress years ago because companies were being bought and sold primarily for their NOLs and the resulting tax savings. With the Sec. 382 “speed of use” limits in place, buying a company for its NOL is rendered no more attractive on the tax-savings front than acquiring a tax-exempt bond.
Excess business losses
The concept of excess business losses (“EBLs”) was created by the TCJA, which rolled out an entirely new restriction designed to cap the amount of certain business losses that can be used by individual (non-corporate) taxpayers. This new limitation is imposed only in the year those losses are generated.
Before this restriction (which applies for tax years beginning after 12/31/17), business losses (including those from flow-through activities) could be used in full to offset other income, such as wages or retirement income. Any excess would create an NOL to carry forward to the following year. With this restriction, only $500,000 or $250,000 of net business losses (for married taxpayers filing jointly, and all others, respectively) may be used to offset other income in the year such losses are generated. The excess is branded as an EBL in that year. However, that loss does not vaporize in year #1, but is converted to an NOL as it enters year #2. Once so converted, the metamorphosis is complete: It completely loses its status as an EBL, and therefore is not subject to the same limitation the following year. As an NOL, it enjoys unlimited carryforward potential, but is subject to the new “80% of current income” limit that applies to all NOLs, as described above.
Observation: The effect of this rule is that taxpayers must wait until year #2 to see a business loss offset more than $500,000/$250,000 of non-business income. Like NOLs, it represents Congress’s new intention to provide a break for taxpayers who incurred a loss – but not as big of a break as they may have enjoyed in the past.
Note that it is not yet clear exactly how Sec. 1231 gains and losses (discussed further below) will be treated for purposes of the new EBL limitations. Also, basis, at-risk, and passive loss analysis are all applied before the EBL limitations are applied.
True capital gains and losses
Tax laws applicable to (1) corporations and (2) individuals/trusts handle capital gains and losses very differently.
Corporate tax rules offer no rate differences between capital gains and other types of income, and net capital losses are not allowed. (In other words, capital losses can only offset capital income.) Net capital losses may be carried back 3 years and forward 5 years; if not used by then they permanently are lost.
Individual and trust rules allow up to $3,000 of net capital losses to offset other sources of income annually, and provide favorable rates for net long-term capital gains. (That favorable rate also applies to certain qualifying dividend income, but dividends are not part of the capital gain/loss netting or carryover regimes.) No carryback of net capital losses is allowed, but indefinite carryforwards of net capital losses are allowed.
Other than the favorable little $3,000 “leakage” described above, capital losses stay in their own little silo.
Sec. 1231 gains and losses
IRC Sec. 1231 prescribes a hybrid treatment relatively uncommon in tax rules, allowing gains and losses to essentially move back and forth between capital and ordinary treatment. Earlier we described “self-rental” income as a category that changes its character (between passive and non-passive) whenever such a change would hurt the taxpayer. Gains and losses described in IRC Sec. 1231 can also change character (in this case between ordinary and capital), but generally do so only when it helps the taxpayer – but only up to a point.
Sec. 1231 is described as certain depreciable trade or business property that is held for more than a year. Often, it consists of real estate. If sold at a gain, Sec. 1231 assets are treated as long-term capital gain property, and qualify for the favorable tax rates applicable to long-term capital gains (other than any portion representing “gains” attributable to prior depreciation deductions, which are “recaptured” as ordinary income under Sec. 1250). On the other hand, if sold at a loss, it is treated as an ordinary loss, thereby offsetting income in higher tax brackets (rather than reducing unrelated long-term capital gain income). It truly is the best of both worlds. However, there is a tracking mechanism that dissuades taxpayers from timing sales purely to game the system: Before allowing Sec. 1231 gains to qualify for the long-term capital gain rate, a taxpayer must review the prior 5 years’ tax returns to see if any Sec. 1231 losses were generated. (Recall that Sec. 1231 losses favorably would have offset ordinary, rather than capital, income.) Any current gain up to that amount of prior ordinary loss cannot be treated as long-term gain. It instead must be “recaptured” by being subject to tax at ordinary rates. This is done on a net, rolling 5-year basis, such that any losses must be recaptured only once.
Interestingly, this 5-year lookback requirement exists only when determining how to characterize current year gains, to determine whether to toggle them as long-term capital or ordinary. It never forces a Sec. 1231 loss generated in the current year to be recharacterized as a capital loss.
Observation: In terms of sequence, it seems reasonable to conclude that Sec. 1231 losses will be included as potential excess business losses for purposes of the new TCJA limitation discussed earlier. (Sec. 1231 applies, after all, only to assets used in a trade or business.) Less clear is how Sec. 1231 gains will be treated. 1231 gains and losses can have a dramatic impact on that limitation, and more guidance will be needed from the Treasury Department before these questions can be answered.
Several types of true economic losses do not translate into fully deductible tax losses. It appears that Congress consistently prefers to reward true business and investment-related losses rather than personal losses. Congress also appears of late to be much more inclined to keep the cash it has collected, as evidenced by the new inability following the passage of the TCJA to carry losses backward. The activities listed below primarily are ones that create little or no tax benefit if losses are present, but if profitable, will force open the wallets of the participants.
Casualty losses were seriously hamstrung by the TCJA. Until 2018, certain losses in property value that exceeded 10% of an individual’s adjusted gross income were deductible as an itemized deduction. (Common examples include storm or fire damage.) The new rules that apply beginning in 2018 use similar criteria and math, but narrow the qualifying net losses to include only those that are attributable to federally-declared disaster areas. Losses that fail to meet that criteria may be deducted to the extent that any casualty gains are generated in that same year. If outside of a disaster area, the best an unfortunate taxpayer can do now is break even. A net loss is no longer deductible.
Observation: The TCJA removed or limited several types of itemized deductions, while also increasing the standard deduction. It all depends on the math, but this means that even taxpayers who do qualify under the new, stringent rules are much less likely than before to see their taxes actually change as a result of a casualty loss.
Sale of home
The sale of a personal residence represents another IRS “heads I win, tails you lose” scenario, because generally gains are taxable and losses are not deductible. Several notable exceptions exist.
For property that served as a primary residence (not a “second” home) for 2 out of the most recent 5 years, gains are taxable, but the first $500,000 or $250,000 of such gain may be excluded, depending on whether a joint return or other individual return is filed. If the gain exceeds that amount, the incremental amount is taxed as a capital gain. If sold at a loss, however, no deduction is available, whether current or deferred.
Business use of a home or prior rental of that home can alter the exclusion, character of gain, and loss potential; and some exceptions to the 2-year rule exist as well – all of which involve complex rules that are not covered in this article.
A prior BNN article on hobby losses covers this in much more detail, but the basics can be explained as follows: The same undertaking can represent a hobby for one person and a trade or business for another person. Which category a particular taxpayer belongs in is determined primarily due to the existence of profit as a primary motive. The significance of the categorization is that as a trade or business, net losses (expenses that exceed revenues) may be deducted, subject to many of the rules described above. But as a hobby, rules prevent expenses from exceeding revenue, thereby preventing the creation of net losses. (Revenues have no such cap, and the IRS welcomes – and requires – the reporting of any net hobby income.)
Observation: Some net losses of a trade or business, even if currently not usable, often can be carried over to a subsequent year, as described in earlier sections of this article. No such loss carryover or deferral exists for hobbies, because hobby expenses that exceed hobby revenue simply wither on the vine, and are completely and permanently ignored.
Gambling losses were simultaneously spared, strengthened, and neutered under the TCJA. Gambling winnings historically have been reportable on page 1 of an individual taxpayer’s Form 1040, and this has not changed. Gambling losses historically have been reportable on Sch. A, as an itemized deduction, and that too has not changed. Those reported losses cannot exceed the reported winnings – also unchanged. What has changed is that certain fringe expenses such as travel may now be included as expenses (subject as usual to the cap based in winnings). Also, as noted above, because several other types of itemized deductions no longer exist or are greatly limited beginning in 2018, many taxpayers will utilize the new standard deduction, meaning that their gambling winnings are still reportable, but no incremental reduction in tax will occur as a direct result of reporting the gambling losses and expenses.
Taxpayers generally are correct in thinking that some losses will lower their taxes. However, many different types of losses exist, and there is significant disparity of treatment between the categories, with complex rules applying to them all. Readers who hope to utilize such losses, or who are planning for cash flows related to anticipated tax savings, should become familiar with these various categories, because numerous rules often limit, delay, or completely remove their deductibility.
Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, investment, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.