Make Sure You Can Deduct Your Carry-Forward Losses

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Taxmaggedon 2018, my new book that will be coming out next month, is full of real life stories of strategies that have worked and some that will need to change with all of the new tax law.

I am frequently asked about loss carry-forwards. Why weren’t they deducted? What has to change to get the deduction? This case was a client who had so many loss carry-forwards that his strategy (or rather lack thereof) was actually costing him money. Here’s what worked pre-2018 and what needs to change with the new law.

First of all, I want to clarify that net operating loss (NOL) occurs with business. Sometimes NOL gets confused with the real estate suspended losses. In the case of real estate, if you have passive real estate losses, those may need to be suspended. If your adjusted gross income is under $100,000, you can only deduct up to $25,000. If your adjusted gross income is over $150,000, you are not allowed to deduct any of those losses. Between $100,000 and $150,000, the amount you can deduct is phased out. Unless you are a real estate professional in the eyes of the IRS, the rest of any real estate loss is suspended. Now, after that rather long explanation, I want to clarify.

That’s not NOL.

Net operating loss is business loss that either came from a Schedule C Sole proprietorship or one of your pass through business entities. In the past, you had a choice of first taking the loss backwards to wipe out high income years and then, if there was carryover, carrying it forward. Now, effective in 2018, you can only carry losses forward.

If you currently have NOL to carry forward, you can continue to do so under the old rules. For new NOL, you can only use the NOL up to 80% of your total income. In other words, even if you have a huge loss that is carrying forward, you still pay tax.

Too Many Losses

I like to do a lot of preparation before consultations with new clients. You’ll get asked a lot of questions about the businesses you have now, what you plan to start, what your income currently is and what you project it to be. Tell me about your dreams and your goals. Tell me about your challenges with those businesses and investments. And then I ask you how I can best help you.

A new client was concerned that he had a lot of carryforward NOL that wasn’t being used. His main questions all revolved about how to use those. He’d read what I, and others, had said about NOL and he wanted to know why he wasn’t getting the deduction.

“That seems strange,” I thought. NOLs are deductible against income.

As I looked at his last tax return, I spotted a few things that I wanted to investigate. Before we even had our consultation, I asked for more information and in this case it meant more years’ worth of tax returns.

The answer was in the past tax returns.

My new client actually had several carryforward losses on his return. He had some suspended real estate losses. These losses likely were not going to change, but we wanted to stop the bleeding so I recommended he stop taking depreciation. Depreciation is a strange type of deduction. You can take it, or not. You can catch it up. You can accelerate it with a cost segregation study. And you can just stop it, after you’ve already started it.

Since depreciation has to be recaptured when you sell and he got no benefit from the additional loss depreciation created, he in effect was exchanging capital gains tax (maximum of 20%) for depreciation recapture tax (25%). Not a smart strategy.

He also had capital loss carryforward. In the case of this type of carryforward, you are limited to the amount of capital gains in that year plus $3,000. Sometimes I see clients with losses of $100,000 or more. Recently, a new client had a loss of $300,000. It would take 100 years to get the tax benefit of that loss. That needed a whole different strategy. He needed to turn ordinary income into capital gains income. Not hard, if you have enough time to plan and are willing to do things a little differently. (For more details on this strategy, please register your book and listen to Insider Tax Strategies, a free bonus as a thank you for your purchase of Taxmaggedon 2018.)

And then we got to the net operating loss. He was absolutely right. He had net operating losses that were carried forward and he was not showing those losses against his other income.

In this case, the issue was that he did not have sufficient basis. There are actually two requirements for net operating losses before you can even consider using those to offset other income. These are:

  • You need to have active participation in the business, and
  • You need to have basis.

Active participation is a pretty low standard, as tax rules goes. It means you have to be active in the business. You could go over the financials with the CFO and talk to the manager a few times a week as way to stay in touch and help focus on what the company can do better. You have active participation!

Basis, though, is a little trickier. There are two types of basis that can qualify. One is equity basis. Equity is comprised of the money you put in the company that isn’t debt. If you make a loan, it’s not equity, it’s a liability for the company. But if you fund it with $10,000, you have $10,000 in equity. Over time, there is income the company will make. Your share of the income increases the basis. If there is company loss, your share of the loss decreases the basis. If you take out a distribution, it decreases the basis.

If the business has a flow through loss to you, you need to tally up the equity basis you have. If you don’t have enough equity basis, you may not be able to take a deduction for the loss.

You do have one more shot, though. You may have enough debt basis. If you have loaned your business money, that adds to the debt basis. In the case of a partnership, or an LLC that has elected to be taxed as a partnership, if you have personally guaranteed partnership debt then it will count as well.

However, in the case of an S Corporation or an LLC that elects to be taxed as an S Corporation, if you personally guarantee the debt, that will not count toward the debt basis.

That’s an important difference to keep in mind.

In this case, my new client didn’t have enough basis. He had a lot of debt, but he had not personally contributed the money and because it was an S Corporation, the fact that he had signed for the debt didn’t count.

Over the next year he personally loaned the money to the corporation so that it could paid off that debt.

The corporation didn’t have enough cash to pay off the debt without getting a loan. This time, though, they got the loan through the owner so he could get basis. That meant he could take advantage of the net operating losses.

The lesson to take away from this real-life story is to first understand what kind of carryforward loss you have and then secondly, figure out what needs to change in order for you take that loss against other income.”

The above excerpt is from Taxmaggedon 2018.

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