The 2017 Tax Cuts and Jobs Act made several very significant changes. One of the strangest is that a taxpayer can deduct no more than $500,000 of losses from Partnerships, S-Corporations, and rentals ($500,000 married joint, $250,000 single). If a taxpayer has losses greater than that, the losses are suspended and carried forward to the next year. In the next year, the carry forward losses can only offset 80% of the income from that year.
For example: a person has several Partnerships from which he receives K-1’s. Some of the K-1’s report income and some report losses. When all the K-1’s are added together the net number is a $2 million loss. The person can only deduct $500,000 of losses. The other $1.5 million carries forward to the next year. In the next year, the person can only use the loss carryforward to offset up to 80% of the next year’s income.
For people with significant other income such as wages, stock gains or pension income, in prior years the losses from K-1s and rentals could have offset all their other income. The new $500,000 limitation means that they will end up paying tax on their other income in excess of $500,000.
The 80% limitation turns into a problem very fast. A simple example is a person who has $10 million of losses this year and nothing else on his return. He can use $500,000 this year but has nothing to deduct it against. The $500,000 plus the $9.5 million carry to next year. In the next year, the $10 million loss reverses and turns into $10 million of income. The taxpayer has the $10 million loss carryforward. Because of the 80% limitation, the person can only deduct $8 million of the loss carryforward (80% * $10 million of the next year income). Even though the person had zero income and zero cash distributions across two years, he could pay approximately $740,000 of federal tax on $2 million of income.
Any time you have a loss year followed up by income years, you will pay tax on 20% of the income in the income years no matter how large your loss carry forward. The trick to tax planning with this law in effect is to assertively plan your income to avoid big losses and big income years. You want your income to be flat from year to year.
Tax planning would there require that a taxpayer have all their K-1’s in draft form, look at how they interact on their tax return and if there is a large loss in excess of $500,000, revise the k-1’s to defer expenses or accelerate income.
Taxpayers with real estate can do this by having a cost segregation study prepared and then wait until the rest of their returns are finished to see if they want to use the depreciation benefit this year or to delay taking the added depreciation write off till a later year. If you delay the deduction to the later year, you are better off than creating a loss carry forward which would be limited to 80%. Depreciation rules under the new tax law are flexible and in many cases elective. A taxpayer can choose annually whether or not they want to fully deduct eligible purchases in the year placed in service.
Taxpayers need to consider the impact of accelerated depreciation when they shut down or sell a money losing business. When a shut down or sale occurs, all the prior losses flip into income. The big losses in the early year will carry forward and offset only 80% of the shutdown income. In this case, carefully consider whether you can take advantage of the tax rules which often prevent you from taking a loss. For instance accounting methods, passive loss rules, or basis limitation rules.
There are many ways to finesse this if someone is on top of the situation. If you aren’t on top of it, you are could end paying some big, unexpected, and unfair tax bills (unfair in that the taxpayer has a large tax bill but never received any cash).
The IRS has not yet released their rules on how they will look at wages you took from your own business, interest charged to your business, or the sale of business assets. The IRS may or may not take the position that these are business income which are included in computing your net income from businesses. If they count towards business income, then they are included when computing the $500,000 net loss limitation. If not included, then the $500,000 maximum loss will have to be applied to offset them.