There’s a provision in the Tax Cuts and Jobs Act (TCJA) tax reform that hurts business start-ups and struggling business owners.
And no one is really talking about it.
This rule prevents you, the business owner, from using all your business losses against non-business income if the losses are too big (as determined by Congress).
We’ll tell you what this rule does, when it applies, the tax hit you’ll take, and whether there’s anything you can do to avoid it (hint, there is).
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 activity1
- The partnership and S corporation basis limitations, which limit your losses to the extent of your basis in your partnership interest or S corporation stock2
- The passive loss limitation, which limits your passive losses to the extent of your passive income unless an exception applies3
Tax Reform’s New Limit
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) carry over to the next taxable year.4
Remember, the TCJA tax reform also made changes to the NOL rules as follows:5
- You can’t carry back your NOL.
- Your NOL carry forward can offset only up to 80 percent of your taxable income in a future year.
New Tax Term—Excess Business Loss—Defined
To determine your excess business loss, follow these three steps:6
- 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.”
If you have an excess business loss, you’ll7
- file Form 461 with your tax return to compute your excess business loss, add the excess business loss back on your tax return as other income with the notation “ELA,” and
- carry forward that amount as an NOL carryforward to the next tax year.
- Tracking Note. You need to track excess business loss NOL carryforwards separately because they reduce Section 199A qualified business income, while regular NOL carryforwards do not.8
Trade or Business?
You’ll definitely include the following in your computation of your excess business loss:
- Schedule C business income or loss
- Schedule E business income or loss
- Schedule F business income or loss
- Income or loss from the sale of business property
You’ll include rental activities that rise to the level of a trade or business. You’ll need to make this determination for Section 199A, as we discuss in New IRS Regs: Does Your Rental Qualify for a 199A Deduction?
There’s a question of whether wages fall into this computation as trade or business income. We think three facts lean toward “yes” at the moment:
- The tax law often refers to the “trade or business of being an employee,” most recently in the proposed Section 199A regulations.
- Line 1 of IRS Form 461 pulls total wages into the computation.9
- Footnote 209 on page 40 of the Joint Committee on Taxation’s General Explanation of Public Law 115-97 (blue book) states that a technical correction may be necessary to exclude wages and salaries from the excess business loss calculation.10
You’ll apply the Section 461(l) loss limitation after all the others, including the passive loss limitation rules.
Therefore, if one of the other loss limitation rules prevents you from using your business loss, then you won’t have to worry about this rule until the other rule releases your loss.
Joan is a single real estate professional who in 2018 had a Schedule E loss of $300,000 and capital gain income of $400,000.
Under prior law, Joan’s loss would offset $300,000 of capital gain income, and the remaining $100,000 of capital gain income would have flowed to the rest of the tax return.
Under the TCJA tax reform that applies for years 2018 through 2025:
- Joan’s overall business loss is $300,000.
- The excess business loss is $50,000 ($300,000 overall loss less $250,000).
- $150,000 of capital gain income flows through the rest of her tax return.
- She has a $50,000 NOL to carry forward to 2019.
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.
Ways to Beat the Ugly Rule
To avoid this 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.
Since we are already past January 1, you can’t do much to accelerate your 2018 business income. But in looking forward to 2019, you have an entire year to increase your business income, including some November and December strategies such as
- increasing your efforts to collect aged receivables,
- offering discounts to collect aged and perhaps all receivables,
- offering discounts for clients to prepay next year’s services,
- accelerating your invoicing schedule, and
- considering factoring receivables (selling them).
As to delaying your business deductions, you do have opportunities when filing your 2018 tax returns, such as
- electing out of bonus depreciation and using straight-line depreciation, and looking closely at placed-in-service dates
- and making sure that assets placed in service in 2019 do not show up as 2018 assets.
If you are facing a large business loss and hope to use that loss to offset all your other income, think again.
Under new code Section 461(l), if your overall business loss exceeds $250,000 (or $500,000 on a joint return), you can’t use the difference in the current year and you have to treat it as a NOL carry forward to the next year.
We see this provision especially impacting real estate investors, real estate professionals, and owners of start-up businesses.
If you think you might have a business loss near the threshold, do a projection of your potential loss amount for the tax year and consider either accelerating your business income or delaying your business deductions.
1 IRC Section 465.
2 IRC Sections 704(d), 1366(d).
3 IRC Section 469.
4 IRC Section 461(l)(2).
5 IRC Sections 172(a)(2), 172(b)(1)(A).
6 IRC Section 461(l)(3).
7 Draft 2018 Form 461 Instructions (September 27, 2018).
8 Prop. Reg. Section 1.199A-3(b)(1)(v).
9 IRS Form 461, Limitation on Business Losses (2018), posted Dec. 28, 2018.