The Tax Cuts and Jobs Act (TCJA) tax reform added an amazing limit on larger business losses that can attack you where it hurts—right in your cash flow. And this new law works in some unusual ways that can tax you even when you have no real income for the year. When you know how this ugly new rule works, you have some planning opportunities to dodge the problem. Over the years, lawmakers have implemented rules that limit your ability to use your business or rental losses against other income sources.
The big three are:
- The “at risk” limitation, which limits your losses to amounts that you have at risk in the activity
- The partnership and S corporation basis limitations, which limit your losses to the extent of your basis in your partnership interest or S corporation stock
- The passive loss limitation, which limits your passive losses to the extent of your passive income unless an exception applies
The TCJA tax reform added Section 461(l) to the tax code, and it applies to individuals (not corporations) for tax years 2018 through 2025. The big picture under this new provision: You can’t use the portion of your business losses deemed by the new law to be an “excess business loss” in the current year. Instead, you’ll treat the excess business loss as if it were a net operating loss (NOL) carryover to the next taxable year.
To determine your excess business loss, follow these three steps:
- Add the net income or loss from all your trade or business activities.
- If step 1 is an overall loss, then compare it to the maximum allowed loss amount: $250,000 (or $500,000 on a joint return).
- The amount by which your overall loss exceeds the maximum allowed loss amount is your new tax law–defined “excess business loss.”
Example. Paul invested $850,000 in a start-up business in 2018 and the business passed through a $750,000 loss to Paul. He has sufficient basis to use the entire loss, and it is not a passive activity. Paul’s wife had 2018 wages of $50,000, and they had other 2018 non-business income of $600,000. Under prior law, Paul’s loss would offset all other income on the tax return and they’d owe no federal income tax. Under the TCJA tax reform that applies to years 2018 through 2025 (assuming the wages are trade or business income):
- Their overall business loss is $700,000 ($750,000 – $50,000).
- The excess business loss is $200,000 ($700,000 overall loss less $500,000).
- $150,000 of income flows through the rest of their tax return.
- They’ll have a $200,000 NOL to carry forward to 2019.
To avoid this ugly rule, you’ll need to keep your overall business loss to no more than $250,000 (or $500,000 joint). Your two big-picture strategies to make this happen are accelerating business income, and delaying business deductions. If one of your businesses will have a loss in excess of the limits, you should start discussing planning opportunities as soon as possible. The longer you wait, the fewer opportunities you will have to limit or, better yet, eliminate the damage.