When individual taxpayers have losses from flow through entities, the key question is whether or not the individual will have the ability to deduct that loss on their tax return. The Tax Cuts and Jobs Act of 2018 made deducting losses on individual returns more difficult. Prior to 2018, individuals had to pass the following three hurdles to be able to deduct a loss on their individual return:
- Basis limitations
- At risk limitations
- Passive activity loss limitations
Even if you are able to pass all three of these tests, your loss could still be limited. The Tax Cuts and Jobs Act of 2018 created a fourth test, the excess business loss limitation. The CARES Act suspended the excess business loss test for 2020 and 2021, but reintroduced this in 2022. For 2023, individuals can only deduct losses up to $578,000 for a married filing joint return, and $289,000 for a single return. This excess business loss limitation provision was extended to 2028 through the Inflation Reduction Act of 2022.
Below is a chart that illustrates the three hurdles that were in place prior to 2018, along with the fourth hurdle. Additional information regarding each hurdle is provided in the chart.
If you have any questions on these rules and how they affect you, please contact your tax adviser at PeaseBell CPAs, LLC.
- 1. For Partnerships, basis includes a partners share of income or loss from a partnership. This is increased by capital contributions and decreased by distributions. Partnership basis includes a partners share of partnership liabilities. This is increased by a partners share of partnership liabilities assumed by the partner and decreased by partner liabilities assumed by the partnership.
- 2. For S Corporations, basis includes a shareholders share of income or loss from an S Corporation. This is increased by contribuitons and decreased by distributions. This includes shareholder loans made directly to S Corporations. Unlike Partnerships, S Corporation basis does not include liabilities.
- 3. For Partnerships, amounts at risk include contributions (money or property), amounts borrowed if personally liable. This does not include on recourse financing unless qualified nonrecourse financing is secured by real property.
- 4. For S Corporations, amounts at risk include contributions (money or property) and loans made to the S Corporation directly by the shareholder.
- 5. The passive loss rules were designed as anti-tax shelter rules so that passive losses can only offset passive income. Losses form passive activities are generally deferred until disposition of the passive activity. Passive activities are any trade or business in which a taxpayer does not materially participate. Passive activities include most rental real estate activities unless a taxpayer is a real estate professional.
- 6. In order to avoid disallowance of taxable losses, taxpayers can make elections to aggregate activities for at risk purposes. Taxapayers can also make elections to aggregate activities for passive loss purposes.
- 7. The excess loss limitation ($578,000 MFJ or $289,000 Single) is an aggregate of a taxpayers income items from their return (business income, gains, partnership. losses, and all Partnerships and S Corporations that have passed the basis, at-risk, and passive hurdles. If the net of these items produce a loss greater than $578,000 or $289,000, any excess is treated as part of the taxpayer's NOL carryforward and subject to an 80% limitation.
