As New Year Brings New Limitations, What You Should Know About Excess Business Loss

Historically, the real estate industry has benefited from favorable tax laws. The ability to deduct depreciation has created tax-enhanced returns on many real estate investments. However, the Tax Cuts and Jobs Act of 2017 (TCJA) implemented a new limitation, the excess business loss limitation, on the amount of business deductions in excess of gross income for which a taxpayer can claim. For federal income tax purposes, the pain from this limitation was alleviated the past three years. The CARES Act of 2020 enacted a provision suspending the excess business loss limitation for tax years 2018, 2019 and 2020. However, the limitation is coming back into effect for the 2021 tax year.

Background

Prior to the TCJA, individual, trust and estate taxpayers that qualified as real estate professionals, were able to deduct all of their real estate business losses against their other sources of income. If the business losses exceeded the other sources of income, a net operating loss would have been created (certain exceptions existed for estates). This loss could either have been carried back to offset income from prior years or carried forward to future tax years at the election of the taxpayer.

The TCJA limited the deductibility of business losses for individual, trust and estate taxpayers. Beginning with the 2018 tax year, trade or business losses are limited to $500,000 for married couples ($250,000 for single taxpayers). Any “excess business loss” that is not deductible in the current year is carried forward as a net operating loss, which can be used to offset income from a future tax period.

The CARES Act provided a temporary federal exemption from the excess loss limitation as relief from the ongoing COVID-19 pandemic. In addition to the return of this limitation, certain issues need to be addressed at the state level as well.

State taxes

For taxpayers involved in the trade or business of real estate, accelerated depreciation can create substantial taxable losses. Certain qualifying property is eligible for 100 percent bonus depreciation in the year it is first placed in service by the taxpayer. However, the impact depreciation has on the state in which the taxpayer operates needs to be addressed.

 New York’s provision decoupling from federal bonus depreciation is not factored into the determination of the New York excess loss limitation or the allowable net operating loss. This could result in taxable income and a tax liability even if New York adjusted gross income was recalculated to be zero. Careful consideration and planning surrounding New York (or other states with similar regimes) is needed when assessing the benefits of accelerated depreciation. Taxpayers may want to consider making a federal election out of bonus depreciation due to the limitations on losses and depreciate their assets according to its useful life.

It is important to consider the interplay of the loss limitation, accelerated depreciation, and the potential impact on the various states to which a taxpayer has a filing obligation as this is imperative to any successful tax strategy.