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Tax Reform Adds Another Limitation on Real Estate Losses

Tax Reform Adds Another Limitation on Real Estate Losses

Ever since the enactment of the passive loss rules in 1986, real estate businesses have had three hoops to jump through before their losses could be deducted: basis, at-risk and passive loss limitations. While the Tax Cuts and Jobs Act is generally real estate-friendly, Congress effectively added a fourth hurdle by creating the excess business loss limitation.

How does the new provision operate?

For taxpayers other than C corporations, pursuant to Internal Revenue Code Section 469 (IRC §469), any excess business losses of the taxpayer are not allowed. Any disallowed loss is carried over to subsequent years as a net operating loss (“NOL”). An excess business loss is the excess of all trade or business deductions of the taxpayer over the sum of all trade or business gross receipts of the taxpayer plus $250,000 ($500,000 in the case of a joint return). In simpler terms, a married couple can only deduct $500,000 of business losses on their return each year.

The excess business loss limitation applies after the passive loss limitations. Presumably, if a loss is disallowed under the passive activity loss rules, any deductions or income from the passive activity would not be considered in the determination of whether a taxpayer has an excess business loss.

To whom does this apply?

Any individual that operates a sole proprietorship, is a partner in a partnership, or is a shareholder of an S corporation will be subject to this rule. For partners and shareholders, the limitation will apply at the partner or shareholder level, not the entity level.

By default, IRC §469 treats all real estate activities as passive and makes them subject to the passive loss rules. Real estate professionals that meet the qualifications of §469(c)(7)  are considered non-passive. The excess loss limitation applies regardless of whether a taxpayer is a passive or non-passive participant in the activity.

What tax years are affected by this provision?

Like many of the Act’s provisions affecting individual taxpayers, this provision is in place for tax years beginning after December 31, 2017 and before January 1, 2026.

Comprehensive Example

Johnny Rocket files a joint tax return and has an interest in two real estate properties: one is a commercial warehouse owned directly by Johnny; the other is an apartment complex owned through a partnership. Johnny does not qualify as a real estate professional, so the income and losses from these properties is treated as passive. Below are relevant facts for the 2018 financial results:

Property 1:

  • Commercial warehouse
  • $100,000 operating loss in 2018
  • $600,000 in prior year passive losses previously disallowed
  • Activity was disposed during year

Property 2:

  • Apartment complex
  • Johnny owns 25% through a partnership
  • Johnny’s portion of the operating income for 2018 is $50,000
  • No passive loss carryover

Under pre-reform law, Johnny would be able to deduct his entire business loss.

Commercial warehouse operating loss (100,000)
Commercial warehouse passive loss released (600,000)
Apartment complex operating income 50,000
Deductible loss (650,000)

The current loss and passive loss carryovers from the commercial warehouse are non-passive for the year because the activity was fully disposed of. The income from the apartment remains passive. However, since there are no passive losses incurred during the year, Johnny’s net passive income is fully taxable.

Under post-reform law, Johnny’s $650,000 loss is not fully deductible in the current tax year. Johnny has an excess business loss of $150,000 calculated as follows:

Commercial warehouse operating loss (100,000)
Commercial warehouse passive loss released (600,000)
Apartment complex operating income 50,000
Joint threshold 500,000
Excess business loss (150,000)

Johnny can deduct $500,000 of business losses during the year, but $150,000 will carry over to the following year as an NOL. Under the Tax Cuts and Jobs Act, an NOL carryover is generally allowed for a tax year up to the lesser of the carryover amount or 80% of taxable income determined without regard to the deduction for NOLs.

Alternative Example

Assume the same facts as above except that Johnny is a real estate professional and property 1 was not disposed of during the year. Johnny has non-passive losses during the year of $50,000 ($100,000 loss from property 1 offset by $50,000 income from property 2). Since his loss of $50,000 is not in excess of the joint threshold of $500,000 he can deduct the entire loss during the year.

If you have questions on how the excess business loss limitation applies to you, please contact a member of Withum’s Real Estate Services Group.

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