A little noticed provision in the pending tax bill would severely limit the allowable losses of real estate professionals engaged in rental real estate activities. Other taxpayers considered to be ‘active’ in non-rental businesses could also face new limitations on ‘active’ losses, including cash losses and losses that are ‘freed up’ when a passive investment is disposed of.
Under current law, real estate professionals enjoy an exception from the strict “passive loss” rules applicable to most investors in rental real estate. If the taxpayer can demonstrate that he or she works more than 500 hours in his or her rental real estate activities, and also qualifies as a real estate professional based on certain objective tests (providing more than half of their professional services and more than 750 hours in real estate trades or businesses), the taxpayer’s rental real estate losses are not considered passive. The pending House bill, however, would impose a new limitation on active losses, which would include these losses.
The proposed rule would generally apply to losses arising in 2022 and later years. It would only apply to losses, in any taxable year, greater than approximately $250,000 ($500,000 for joint returns) adjusted for inflation. For 2022, the limitation would be $524,000 for joint filers. Losses that were exempted from the passive loss rules, but exceeded these amounts, could not be used against the taxpayer’s wages, salaries or investment income. They could only be used against income or gain from a trade or business, either the business that generated the losses (such as gain from the sale of a real estate investment that had previously generated operating losses) or income or gain from another business. In addition, certain limitations applicable to the use of net operating losses could apply.
It is possible that the drafters of this provision — and many real estate professionals and others who might be affected by it — are unaware of its effect. A much more limited one-year loss deferral rule applies under current law but only to taxable years between 2021 and 2025, and the Administration proposed to extend that beyond 2025 to raise approximately $40 billion over a ten-year period. The House bill would have the more severe effects described above and would raise approximately $160 billion over the same period.
For real estate professionals, with losses that exceed the numerical threshold ($524,000 for joint filers in 2022), the effect is akin to repealing the “real estate professional” exception.
For taxpayers who are active in a non-rental business producing non-passive losses – which, before 2021, could be used against wage, salary or investment income of themselves or their spouses – these new rules would prevent those losses from being used against any income other than business income. Thus, they could not be used against wages, salaries or investment income.
Enactment of the new rule would also mean that a suspended passive loss that was freed-up (under current law) upon the complete disposition of a passive investment would be limited in the same way. Thus, if the freed-up loss exceeded the numerical threshold it could not be used against the taxpayer’s wage, salary or investment income.
The effect in all cases would be comparable to the longstanding rules disallowing the use of capital losses against income from wages, salaries or business income (beyond $3,000 per year). All income would be aggregated if it helped to push the taxpayer into a higher tax bracket – but losses would be put into separate baskets – to prevent a bona fide loss in one basket from reducing income from another basket.
The new separate baskets would effectively consist of wage and salary income, business income and investment income.
Another arguably unforeseen consequence of this rule would apply to high-income wage earners who experienced substantial cash-on-cash losses from an active trade or business they, or their spouse, were engaged in. The computations can be complex, but the following is a somewhat simplified example of how the provision seems intended to work.
If a high-tech executive earned $1.5 million of salary, and used $1.25 million of that salary to cover the cash losses incurred in an active business started by his or her spouse, pre-2021 law would treat the couple as having an income of $250,000 – which would seem accurate to many observers. With current taxes imposed only on their $250,000 of net cash income, starting a business like this might be risky, but it would be possible if they truly believed they would eventually succeed.
For 2021, the $1.25 million cash loss would be limited to $524,000 with the remaining $726,000 a net operating loss in 2022 (subject to some additional limitations on using net operating losses). That could be a substantial hurdle, or bump in the road, but it might be viewed as just another short-term cash flow problem, not a permanent barrier to entrepreneurship.
Under the House bill, the barrier might be much higher. The $726,000 disallowed loss would never be allowed against the salary income of the employed spouse – or any of the couple’s investment income. It could only be used against “business” income or gain.
For a couple with cash income of $250,000 ($1.5 million of wages, less $1.25 million of cash invested in an active business) – and subject to income taxes on $976,000 ($1.5 million less only $524,000 of allowed losses) their income tax bill might be close to $300,000 with only $250,000 of total cash. They could not pay the tax bill even if they had no living expenses at all. Starting a business like this would obviously not be viable.
This may not be a common situation, but the view of entrepreneurship it may imply could have broader implications. The idea that actual cash losses from an active, bona fide business could not be deducted against cash income from salaries or investments seems to be an entirely new approach to the definition of “income” subject to tax.
With all of the attention given to other provisions affecting millions of taxpayers, these provisions, affecting entrepreneurs and real estate professionals, may not have gotten the attention they deserve, and the provisions may not, in fact, be intended to operate in this manner. They do appear headed for enactment, however.
This article was written by Don Susswein and originally appeared on 2021-10-27.
2022 RSM US LLP. All rights reserved.
The information contained herein is general in nature and based on authorities that are subject to change. RSM US LLP guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. RSM US LLP assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein. This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer.
RSM US Alliance provides its members with access to resources of RSM US LLP. RSM US Alliance member firms are separate and independent businesses and legal entities that are responsible for their own acts and omissions, and each are separate and independent from RSM US LLP. RSM US LLP is the U.S. member firm of RSM International, a global network of independent audit, tax, and consulting firms. Members of RSM US Alliance have access to RSM International resources through RSM US LLP but are not member firms of RSM International. Visit rsmus.com/aboutus for more information regarding RSM US LLP and RSM International. The RSM(tm) brandmark is used under license by RSM US LLP. RSM US Alliance products and services are proprietary to RSM US LLP.