Qualified Business Income Deduction

by Greg Yoder

One of the biggest changes to come with the Tax Cut and Jobs Act (TCJA) of 2017 was the addition of Section 199A, or the qualified business income deduction. The stated purpose of this deduction was to provide a lower rate of tax for owners of and investors in certain types of business so that their rates would be closer to corporate rates.

In the simplest possible terms, taxpayers get a deduction for 20% of their qualified business income (QBI). QBI can come from a business that a taxpayer participates in directly (e.g., a Schedule C business or Schedule E rental property) or it can come from various kinds of pass-through entities (partnerships, LLCs, S corporations, REITs, etc.). This deduction is taken separately from and after either itemized deductions or the standard deduction.

Qualified Trade or Business

Because QBI can only be generated by a qualified trade or business, the first step in determining the deduction is determining whether the taxpayer’s business is qualified. In general, a trade or business is a qualified trade or business if it’s based in the U.S. and it is NOT one of the “specified service trade or businesses.” These businesses include:

  • Accounting
  • Actuarial science
  • Athletics
  • Brokerage services
  • Consulting
  • Dealing in securities
  • Financial services
  • Health
  • Investing and investment management
  • Law
  • Performing arts
  • Trading
  • Any trade or business where the principal asset is the reputation or skill of one or more of its employees or owners

While it’s fairly obvious what constitutes some of these businesses (accounting, for example), other categories are defined more broadly or narrowly than you might expect. A health spa, for example, would generally not be considered a health business as defined in the regulations under §199A, so income from a health spa would qualify for the deduction. On the other hand, income from a medical practice (which does meet the regulatory definition of health services) would not qualify for the deduction.

Because being an employee is also specifically excluded by the law from being a qualified trade or business, the wage income of employees is not QBI.

The calculation of QBI for a particular business is beyond the scope of this article, but let’s summarize by saying, “It’s complicated.” Just as an example, businesses that engage in multiple activities may find that some of their activities are qualified but others aren’t. In general, these businesses will need to allocate their income and deductions between qualified and non-qualified businesses. Treasury regulations released this summer provide methods for allocating income and expenses for such entities.

Limits and Exceptions

While the general rule for the QBI deduction is 20% of QBI, there are multiple limits on the amount of the deduction. The first of these is the wage limitation. In general, a qualified business must also generate U.S. wages to generate a deduction. The amount that can be deducted with respect to a particular trade or business is the lesser of a) 20% of the QBI from that business and b) 50% of the W-2 wages paid during the year by that business. A special rule added to favor real estate investors provides that in lieu of the 50% of wages limitation, a business can deduct up to 25% of its wages PLUS 2.5% of the unadjusted basis of its qualified property. That means that a business that pays no wages but uses a large amount of qualified property may still generate a deductible amount.

The deductible amount is determined on a business-by-business basis, and then the amounts are aggregated to determine a taxpayer’s overall QBI deduction. Businesses that generate deductible losses will generate negative QBI, thereby reducing the overall deduction.

There are two principal exceptions to QBI limitations that were added to favor taxpayers with incomes below a certain level. The calculation of these limitations is (wait for it) complicated, but if a married taxpayer filing a joint return has taxable income (before the QBI deduction) of less than $315,000 ($157,500 for other filing statuses), then the taxpayer will typically be able to take a QBI deduction even if he or she has income from a business that doesn’t meet the wage limitation. Similarly, taxpayers with the same level of income will be able to take a deduction for QBI from one of the specified service trades or businesses, even though that business doesn’t meet the definition of a qualified trade or business.

Another limitation provides that the QBI deduction can’t be greater than 20% of the taxable income before the QBI deduction. In making this calculation, any income taxed at long-term capital gains rates can’t be included.

As an example, assume that a taxpayer has adjusted gross income of $400,000, made up of $250K of QBI and $150K of net long-term capital gains. The taxpayer also has itemized deductions of $100,000. In this case, the taxpayer would be entitled to a QBI deduction of $30,000, calculated thusly:

Qualified Business Income 250,000 [A]
Long Term Capital Gains 150,000
Adjusted Gross Income 400,000
Itemized Deductions (100,000)
Taxable Income before QBI Deduction 300,000
Less Long Term Capital Gains (150,000)
Taxable Income before QBI Deduction Net of Long Term Capital Gains 150,000 [B]
QBI Deduction 30,000 20% of lesser of [A] or [B]
Taxable Income 270,000

Of the taxpayer’s $270K taxable income, $150K would be taxed at long term capital gain rates, and the remainder would be taxed at regular graduated income tax rates.

This was — honestly — the simplest example I could come up with. For most taxpayers who can take the deduction, the calculation will be substantially more complicated, and there are plenty of additional complications that I’ve left out of this article.

Notwithstanding the enormous complexities involved in the QBI deduction, it represents a tremendous tax savings opportunity for a select group of taxpayers. If you have questions about whether you qualify for and how much benefit you can expect from this deduction (or any of the many other provisions of the TCJA), please get in touch with us for tax planning. For many taxpayers, there are actions you can take prior to year-end to maximize the deduction — and minimize your taxes.

Tax Planning with the New Corporate Tax Rates and Net Operating Losses

by Steve Braunstein

As we approach the end of 2018, many personal service C-Corporations will have to address the impact of net operating losses in their tax planning strategies, due to the changes enacted by the Tax Cuts and Jobs Act. (“TCJA”)

A net operating loss (“NOL”) is created when deductions for the year are more than income. This can apply to certain business entities, individuals, estates and trusts. Under pre-TCJA law, an NOL for any tax year was generally first carried back two years, and then carried forward 20 years. Taxpayers could elect to forego the carryback.

The TCJA repeals the general two-year NOL carryback. The Act also provides that NOLs may be carried forward indefinitely. This is in effect for NOLs arising in tax years ending after December 31, 2017. This effective date means that NOLs that arose in tax years ending before January 1, 2018, will be subject to the pre-TCJA law.

In past years, many of our small business personal service corporations managed their taxable income to an amount close to break even or a small taxable loss. They did this by paying out bonuses to the owners, because the federal tax rate for personal service corporations was a flat 35%. Beginning in 2018, the corporate tax rate was reduced to a flat 21% for all types of C-Corporations, including personal service corporations. The change in tax rates coupled with the treatment of net operating losses generated after 2018 will likely impact the tax planning strategies for these types of businesses.

For net operating losses generated after 2017, and once the pre- 2018 NOL is utilized in full, a C-Corporation will be limited to using the NOL Deduction in an amount equal to 80% of the taxable income, determined without regard to the NOL deduction. Previously, a C-Corporation could use an NOL to offset 100% of their income.

For example, under pre-TCJA law, if a business generated a loss of $100,000 in 2018 and then had taxable income of $100,000 in 2019 they would have zero taxable income for 2019, because they could net the full 2018 loss with the 2019 income. Under the new law, in the second year when the business generates $100,000 of income, they will only be able to utilize $80,000 of the NOL, resulting in taxable income of $20,000 and the corresponding federal income tax at 21%. The remaining $20,000 will carryforward indefinitely until it is utilized.

With the end of the year quickly approaching, it is important for your personal service C-Corporation to understand the NOL’s they have available and consider when to utilize them, given the current low federal corporate tax rates. The treatment of an NOL is just one of the many TCJA changes that taxpayers will need to consider as they plan to minimize their 2018 tax obligation.

Considerations When Meeting with Your Estate Advisors

by Evelyn Blue, CEP

There have been many changes in the estate tax arena. The following summarizes the most routine items to consider as you meet with your attorneys, financial advisors, and accountants to create and/or update your estate plan. If you have not visited your will and estate plan recently, the recent federal and state legislative changes provide a great opportunity to make this a priority for 2018.

FEDERAL

  • The annual gift tax exclusion has been adjusted for inflation and has increased from $14,000 to $15,000 for 2018.
  • The basic exclusion amount for gift and estate tax has increased from $5.49 million to approximately $11.2 million in 2018. This means each individual can make gifts or reduce their estate amount by this $11.2 million. These provisions will remain in effect until December 31, 2025, unless Congress repeals or amends the current tax legislation. If there is no repeal or amendment, the basic exclusion will sunset after that date and revert back to the law in effect for 2017 with inflation adjustments.

DISTRICT OF COLUMBIA

  • Effective May 2, 2018, estate representatives who are responsible for filing an estate tax return will be required to register for an account, file and submit payment via MyTax.DC.gov. Please see the link to the estate tax brochure here.
  • In the beginning of 2018, the DC estate tax exclusion was equal to the Federal basic exclusion amount which is currently the $11.2 million. However, members of the DC Council joined in a bill to change the DC estate tax exclusion from $11.2 million to $5.6 million for 2018. This DC budget bill must be approved by Congress and is expected to be approved effective October 1, 2018. Assuming the bill becomes a law, a gross estate with a value over $5.6 million in 2018 will have to file an estate tax return. We will update our website when the bill officially is passed.

MARYLAND

  • The Maryland estate tax exclusion has increased to $4 Million for 2018. The Maryland General Assembly met and passed House Bill 308 which limits the estate tax exclusion to $5 million in 2019. In addition, Maryland will recognize portability between spouses in 2019, so a surviving spouse may elect to use, under certain circumstances, any portion of their deceased spouse’s unused Maryland estate tax exemption.

FLORIDA & VIRGINIA

  • Florida and Virginia repealed its estate tax in 2005 and 2007, respectively, and continue to have no state estate tax.

Section 179 and Bonus Depreciation under TCJA

by Maly Sevilla, CPA

The Tax Cuts and Jobs Act (TCJA) changed some of the most used deductions for purchases of qualified property. Code sections 179 and 168(k) (bonus depreciation) allow for the immediate deduction of part or all of the cost of qualified property. The TCJA favorably changes the limits for the deductions allowed under both of these code sections.

The TCJA increased the deduction for bonus depreciation from 50% to 100% and extended the period of phase-out. A 100% first year deduction is allowed for qualified property placed in service after September 27th, 2017 and before January 1st, 2024. The deduction will start phasing out in 2024 going down to 80%, with a decrease of 20% for each year after that, until it phases out completely in 2026.

The TCJA increased the maximum annual section 179 deduction from $500,000 to $1 million. This applies to qualified property placed in service after December 31, 2017. The new law increased the annual phase-out threshold from $2 million to $2.5 million. Thus, the deduction begins to phase out dollar-for-dollar after $2,500,000 is spent on qualified property.

The definition of qualified real property eligible for code section 179 expensing is also expanded by the new law to include the following improvements to nonresidential real property after the date such property was first placed in service: roofs; heating, ventilation, and air-conditioning property; fire protection and alarm systems; and security systems.

Most states decouple from the federal laws that cover the deductions mentioned above. Some states eliminate these deductions all together and opt for a more traditional depreciation deduction. Others, however, allow a portion of these deductions and allow the rest of the cost to be deducted through depreciation deductions. Some states are still deciding what approach they will choose in regards to the TCJA and these deductions.

The TCJA is a sweeping tax act that changed many sections of the law. These changes and the related state conformity should be taken in to consideration when planning for 2018 and beyond. Please contact us to if you have any questions.

The Importance of Reviewing Your Payroll Withholding for 2018

by Elizabeth Dentan, CPA

Based on a new report published by the Government Accountability Office, 30 million Americans are not currently withholding enough federal income tax from their paychecks, according to simulations run by the Treasury Department.

The Tax Cuts and Jobs Act of 2017 (TCJA) revised the tax code, including the elimination of the personal exemption, increasing the standard deduction and changing the tax brackets and rates. As a result, the IRS issued a new withholding table, effective February 2018. This table incorporated these TCJA changes and adjusted withholdings accordingly. Many taxpayers may have noticed an increase in their take home pay earlier this year.

The revised withholding tables are designed to work with the current form W-4 (Employee’s Withholding Allowance Certificate). These tables are designed for taxpayers with straightforward tax profiles, mainly taxpayers with W-2 wages who take the standard deduction. While many taxpayers will experience a decrease in their federal income tax obligation, our experience has shown that a number of taxpayers could end up paying more in tax and with a reduction in federal withholding, these taxpayers could owe tax when they file their 2018 return next spring.

The IRS lists several situations in which taxpayers may want to re-evaluate their situations and complete a new W-4. These situations include:

  • Two income families
  • Taxpayers with two or more jobs
  • Taxpayers with children who claim credits such as the child tax credit
  • Taxpayers who itemize or used to itemize

For those taxpayers who may need to update their W-4, the IRS, through its website https://apps.irs.gov/app/withholdingcalculator offers a withholding calculator which incorporates the tax changes made through the TCJA. To use the calculator, the IRS recommends having your most recent paystub with the year to date withholding on it, and your prior year tax return handy.

We recommend that if you need help determining your withholding or help determining whether you are required to pay estimated taxes, that you contact your tax advisor at Snyder Cohn as the new tax law may significantly impact the calculation of your tax liability.

2018 Nonprofit Tax Matters Update

by Keith Jennings, CPA

A multitude of changes have occurred in the nonprofit industry in 2018. These changes effect both IRS/tax regulations as well as financial statement standards. In this newsletter, we will cover the tax issues.

Tax Cuts and Jobs Act Effect on Nonprofits

You may be surprised to find out that the recently enacted legislation substantially impacted the nonprofit industry. Under the rationale of aligning nonprofits with for-profit organizations with respect to tax law, some of these changes may affect the bottom line of your organization. Here are some of the changes that could affect your organization:

  • Excise tax on nonprofit executive compensation – there will be penalty of 21% on compensation over $1 million.
  • Unrelated business tax on transportation benefits for employees – starting in 2018, if a nonprofit pays commuting/parking benefits, those charges will be considered unrelated business income (UBI) to the nonprofit, and they will have to pay tax on that amount. From what we’ve seen so far in 2018, the response to this has been mixed. Some nonprofits are going to “bite the bullet” and continue to pay the benefit as well as the unrelated business income tax (UBIT). Some other organizations have been increasing staff salaries and then having the staff pay for the parking themselves on an “after-tax” basis. Others are getting rid of this benefit moving forward. One other possible effect of this tax law change going forward could be the potential renegotiating of office leases to include parking in the overall lease agreement. As far as we know, the IRS has not taken a stance on this subject, but stay tuned in the remainder of 2018 for any potential updates on this subject.
  • Other changes to UBIT – if a nonprofit organization has multiple streams of UBI, in prior years the loss from one stream could cover the income from another. Starting in 2018 that will no longer be allowed. Also, starting in 2018 only 80% of UBI will be able to be covered by net operating losses. Prior year’s losses are grandfathered in.

The National Council of Nonprofit’s website is a great resource for nonprofit organizations. They highlighted many of these changes in a great checklist on their site – https://www.councilofnonprofits.org/sites/default/files/documents/tax-law-checklist-nonprofits.pdf.

Disclosure Requirements on Form 990 Schedule B for Certain Organizations

Nonprofit organizations are generally required to disclose on their Form 990 Schedule B each year the names and addresses of donors who contributed over $5,000 during the year. That information must be included in the filing with the IRS, but it is removed for public disclosure on websites such as www.guidestar.org. However, in July 2018 the IRS released Revenue Procedure 2018-38. It stated that starting in calendar year 2018 only 501 c 3 organizations (charities) are required to complete this information. Other types of nonprofit organizations such as 501 c 4 social welfare organizations and 501 c 6 trade associations are no longer required to complete Schedule B. This guideline does not affect private foundations.

The IRS states in the Revenue Procedure that this personally identifiable information is not needed or being used by them. Also, they state that the Schedule increases compliance costs, consumes IRS resources and poses a risk of inadvertent disclosure of private information. However, much like the Supreme Court decision in Citizens United, some citizens and watchdog groups favor stronger public disclosure rules for these types of organizations.

Look for Part II in our next newsletter which will cover financial statement and accounting changes.

Snyder Cohn Named One of 2018 Best Accounting Firms to Work for

Snyder Cohn has been named one of the 2018 Best Accounting Firms to Work for. This makes the fourth time we have achieved this distinction. The annual list of the Best Accounting Firms to Work for was created by Accounting Today and Best Companies Group.

This survey and awards program is designed to identify, recognize and honor the best employers in the accounting industry, benefiting the industry’s economy, workforce and businesses. The list is made up of 100 companies nationwide.

Companies from across the United States entered the two-part survey process to determine the Best Accounting Firms to Work for. The first part consisted of evaluating each nominated Firms from across the United States entered the two-part survey process to determine Accounting Today’s Best Accounting Firms to Work for. The first part consisted of evaluating each nominated company’s workplace policies, practices, philosophy, systems and demographics. This part of the process was worth approximately 25% of the total evaluation. The second part consisted of an employee survey to measure the employee experience. This part of the process was worth approximately 75% of the total evaluation. The combined scores determined the top firms and the final ranking.

“The firms on this list represent the best workplaces in the accounting profession,” said Accounting Today Editor-in-Chief Daniel Hood. “They are outstanding places to build a career.”

We are honored by this recognition and thank our associates for being such a huge part of creating and maintaining an environment we can be proud of!

If you want to be part of an organization like ours, you may employment@snydercohn.com us, as we are always looking for talented entry level and experienced CPAs to be part of our future.

Update: Changes to Parking Benefit and Entertainment Expenses

by Greg Yoder, CPA

The Tax Cuts and Jobs Act – in addition to its more sweeping changes – made a number of small but impactful changes in the sorts of benefits and expenses that business taxpayers can deduct.

Parking Update

The new law contains a deduction disallowance for employer-provided transportation benefits, including parking. Under old law, employers could provide relatively generous parking allowances to employees, and these amounts would be both deductible by the employer and excludable by the employee. The new law maintains the employee exclusion but removes the employer deduction. Alternatively, the employer may deduct the amounts, but then must include them in the employee’s taxable compensation.

There is some ambiguity in the law, and we had hoped that by moving parking benefits to a salary reduction arrangement (SRA), employers would be able to deduct the allowances as compensation while maintaining the exclusion for employees. IRS has clarified that this strategy will NOT be effective: parking-related amounts paid under an SRA will not be deductible by the employer. This leaves employers with two unappealing choices: either report additional taxable compensation to the employee (and get the deduction) or lose the deduction to maintain the employee’s exclusion.

Entertainment Expenses

Under former law, most entertainment expenses were limited to 50% deductibility, provided taxpayers could establish a sufficient business purpose for the expenditures and meet some other requirements and limitations.

The new law eliminates the deduction for most entertainment expenses, including a complete elimination of deduction for entertainment activities and facilities. The change also eliminates any deduction for dues or fees paid to any “social, athletic, or sporting club or organization.” Club dues for business and social clubs continue to be disallowed in full, as under former law.

There are a few exceptions. Most notably, recreational expenses for employees continue to be deductible in full – as they were when other entertainment expenses were limited to 50% deductibility. These expenses won’t be deductible, however, if they primarily benefit highly compensated employees, another requirement that hasn’t changed from former law.

Food and Beverage Expenses

While the entertainment portion of “meals and entertainment” has largely been disallowed, the changes to the meals portion are more complicated. This area has always been one that is ripe for nitpicking, and it hasn’t gotten any simpler under the new law. There’s a mixture of full deductibility, 50% deductibility, and no deductibility at all. But what expenses fall into which category has changed slightly. Some of the changes apply to very narrow groups of taxpayers, but others apply more broadly.

Meals provided to employees for the benefit of the employer (e.g., busy season lunches and dinners for hard-working accountants) were previously deductible in full. Under the new law, these amounts will only be 50% deductible. (Note that meals provided as part of employee recreational/social activities remain deductible in full, raising the possibility that employer-provided meals could be fully deductible as long as the employees are having enough fun. Obviously, this is not an issue for hard-working accountants during tax season, but there may be a gray area in other cases.)

Under former law, expenses for employer-provided eating facilities were entirely deductible because they were considered de minimis fringe benefits. Under the new law, they’re 50% deductible for expenses arising between January 1, 2018 and December 31, 2025. Thereafter, these expenses will be disallowed in full.

As with many other Tax Cut and Jobs Act provisions, the details are more complicated than what we’ve summarized here, and it’s important to get the details right. If you have questions about any of these provisions, please contact us.

New Partnership Audit Rules: Consider a Change

by Dustin Cutlip, CPA

As we make our way through the 2018 tax year much attention is focused on the Tax Cuts & Jobs Act (TCJA) and the impact it will have on individuals and business entities. However, partnerships [including Limited Liability Companies taxed as partnerships] should also be aware of the newly enacted partnership audit rules and how the new rules may impact the language within partnership agreements.

For taxable years beginning after December 31, 2017 the old provisions of the Internal Revenue Code that governed partnership audits, known as the TEFRA procedures, were replaced by a new centralized partnership audit regime. This new regime was created as part of the Bipartisan Act of 2015 [later amended by the Consolidated Appropriations Act of 2018]. These new rules were created largely to help streamline the audit process for large partnerships, but small closely held partnerships are also governed by these new rules. As a result, all partnerships (big and small) should consider taking corrective action.

Entity Level Assessments

Under the new audit rules the assessment and collection of underpaid tax, including interest and penalties, resulting from partnership audits will now be assessed at the partnership level. This is a drastic change from the partner level assessment under the old procedures and will certainly complicate matters for partnerships as they try to match up the economic burden of audit assessments to the corresponding partner(s). This becomes an even bigger challenge when the ownership interest within a partnership changes and partner(s) who would bear economic burden for an audit assessment are no longer partners in the partnership. Given the natural time lag on audit assessments this will be a common issue that partnerships will be faced with in the future. Luckily there are some steps that can be taken to help mitigate the adverse impacts of these new rules.

Elect Out Entirely

Certain partnerships may be eligible to elect out of the entity level assessment entirely and default back to the old partner level assessment under the TEFRA provisions. In order to be eligible for this election a partnership must have 100 or fewer partners and all partners must be either individuals, C or S corporations, the estate of a deceased partner, or a foreign entity that would be treated as a C corporation if it were domestic. This election is not automatic and must be made on a partnerships timely filed federal income tax return. Partnerships should consider adjusting the language in the partnership agreements to address compliance in the area as applicable [e.g. limiting the eligibility of new partners to ones that meet this criteria].

“Push Out” Election

Partnerships may be able to make what is known as a “push out” election which would give the partnership the ability to push out audit adjustments to the partners who ultimately would have faced the economic burden under the old rules [this would include former partners]. Partnerships should consider including appropriate language in the partnership agreements to address the ability to make “push out” elections and obligate partners, both current and former, to indemnify the partnership for their allocable share of the economic burden of audit assessments.

Tax Matters Partner Eliminated

Under the new audit rules the “Tax Matters Partner” is no longer an applicable term and has since been replaced by a “Partnership Representative.” The representative can be any individual, or entity, with substantial presence in the United States and does not have to be a current partner in the partnership. The representative has complete authority to act on behalf of the partnership and the actions of the representative can legally bind all partners. Partners now have no right to receive notice or participate in any audit proceedings, as this is all handled by the partnership representative.

Partnerships should consider updating their partnership agreements to designate an appropriate partnership representative. Partnerships should also consider adding language to the partnership agreement to put restrictions on the powers the representative has (as allowable) in certain cases.

Plan Ahead

All partnerships should be aware of the new partnership audit rules and should analyze and modify partnership agreements accordingly. These new rules are particularly important to consider before a partnership makes any structural or ownership adjustments [transfers, new admissions, and retirements] amongst its current partners in the coming months/years.

If you have any questions on how the new partnership audit rules impact your partnership please contact a member of our team!

How the Tax Law Affects Rental Real Estate Owners

by Billy Litz, CPA

Do you own residential or commercial rental real estate? The Tax Cuts and Jobs Act (TCJA) brings several important changes that owners of rental properties should understand.

In general, rental property owners will enjoy lower ordinary income tax rates and other favorable changes to the tax brackets for 2018 through 2025. In addition, the new tax law retains the existing tax rates for long-term capital gains.

Unchanged Write-Offs

Consistent with prior law, you can still deduct mortgage interest and state and local real estate taxes on rental properties. While the TCJA imposes new limitations on deducting personal residence mortgage interest and state and local taxes (including property taxes on personal residences), those limitations do not apply to rental properties, unless you also use the property for personal purposes. In that case, the new limitations could apply to mortgage interest and real estate taxes that are allocable to your personal use.

In addition, you can still write off all the other standard operating expenses for rental properties. Examples include depreciation, utilities, insurance, repairs and maintenance, yard care and association fees.

Possible Deduction for Pass-Through Entities

For 2018 and beyond, the TCJA establishes a new deduction based on a non-corporate owner’s qualified business income (QBI) from a pass-through business entity — meaning a sole proprietorship, a partnership, or an S corporation. The deduction generally equals 20% of QBI, subject to restrictions that can apply at higher income levels.

While it isn’t entirely clear at this point, the new QBI deduction is apparently available to offset net income from a profitable rental real estate activity that you own through a pass-through entity. The unanswered question is: Does rental real estate activity count as a business for purposes of the QBI deduction? According to one definition, a real property business includes any real property rental, development, redevelopment, construction, reconstruction, acquisition, conversion, operation, management, leasing or brokerage business. Stay tuned as we await more clarity from the IRS.

New Loss Disallowance Rule

If your rental property generates a tax loss — and most properties do, at least during the early years — things get complicated. The passive activity loss (PAL) rules will usually apply, unless you are a materially participating real estate professional.

In general, the PAL rules only allow you to deduct passive losses to the extent you have passive income from other sources, such as positive income from other rental properties or gains from selling them. Passive losses in excess of passive income are suspended until you 1) have sufficient passive income or gains, or 2) sell the property or properties that produced the losses.

To complicate matters further, the TCJA establishes another hurdle for you to pass beyond the PAL rules: For tax years beginning in 2018 through 2025, you can’t deduct an excess business loss in the current year. An excess business loss is the excess of your aggregate business deductions for the tax year over the sum of:

1. Your aggregate business income and gains for the tax year, plus

2. $250,000 or $500,000 if you are a married joint-filer.

The excess business loss is carried over to the following tax year and can be deducted under the rules for net operating loss (NOL) carryforwards.

Important: This new loss deduction rule applies after applying the PAL rules. So, if the PAL rules disallow your rental real estate loss, you don’t get to the new loss limitation rule.

The idea behind this new loss limitation rule is to further restrict the ability of individual taxpayers to use current-year business losses (including losses from rental real estate) to offset income from other sources (such as salary, self-employment income, interest, dividends and capital gains). The practical result is that the taxpayer’s allowable current-year business losses (after considering the PAL rules) can’t offset more than $250,000 of income from such other sources or more than $500,000 for a married joint-filing couple.

    Loss Limitation Rules in the Real World
    Dave is an unmarried individual who owns two strip malls. In 2018, he has $500,000 of allowable deductions and losses from the rental properties (after considering the PAL rules) and only $200,000 of gross income. So he has a $300,000 loss. He has no other business or rental activities.

    Dave’s excess business loss for the year is $50,000 ($300,000 – the $250,000 excess business loss threshold for an unmarried taxpayer). The $50,000 excess business loss must be carried forward to Dave’s 2019 tax year and treated as part of an NOL carryforward to that year. Under the TCJA’s revised NOL rules for 2018 and beyond, Dave can use the NOL carryforward to shelter up to 80% of his taxable income in the carryforward year.

    Important: If Dave’s real estate loss is $250,000 or less, he won’t have an excess business loss, and he would be unaffected by the new loss limitation rule.

Need Help?

The new tax law includes several expanded breaks for real estate owners and one important negative change (the new loss limitation rule). At this point, how to apply the TCJA changes to real-world situations isn’t always clear, based solely on the language of the new law.

In the coming months, the IRS is expected to publish additional guidance on the details and uncertainties. Snyder Cohn will keep you up to date on developments as they become available.