The constant change in tax law over the last few years continues to makes tax planning a challenging endeavor. One such change involves the Excess Business Loss (EBL) limitation. The EBL limitation applies to noncorporate taxpayers, such as individuals, trusts and estates, and does not allow a “business” loss to exceed $270,000 for single filers or $540,000 for married joint filers for the tax year 2022, indexed annually. The EBL limitation took a temporary hiatus as a result of pandemic-era legislation, but it is back in full force for tax years beginning on or after Jan. 1, 2021.
How Excess Business Loss Works
This limitation is calculated after other limitations for at-risk losses and passive activity losses are applied. Disallowed losses in the current year are carried forward as a net operating loss.
Many rental real estate enterprises incur tax losses because of accelerated depreciation deductions allowed by the tax law. These losses can be significant to an individual and may offset an individual’s income from other sources in that tax year. But before an individual can deduct a loss, several types of limitations must be cleared. These limitations are very complex and must be analyzed at several levels.
First, the amount of any loss is limited to a taxpayer’s basis, which is generally the cost amount that a taxpayer invests in a business asset. The basis may also be increased by a taxpayer’s allocable share of debt. Next, a taxpayer must consider the amount of losses for which the taxpayer is “at-risk.” This generally considers only the allocable share of debt-financed losses for which a taxpayer is personally liable for repayment. Then a taxpayer must consider the passive activity limitation, which limits a taxpayer’s deduction for losses to only those activities in which a taxpayer materially participates. Finally, the EBL limitation is considered after these other three limitations.
To illustrate, consider a single taxpayer who is a real estate professional. The taxpayer that materially participates in a rental real estate activity, which rises to the level of a trade or business. Also, assume that the taxpayer is allocated a business loss of $1 million in the tax year 2022. Further assume the $1 million loss is not subject to a basis, at-risk, or passive activity loss limitation. Finally, consider that the taxpayer has W-2 wages of $750,000 and capital gains from stock sales of $250,000 in the tax year 2022.
At first, a taxpayer might assume their adjusted gross income would be $0 for the tax year, after deducting the $1 million in rental real estate losses. But this is not the case: the taxpayer’s adjusted gross income is actually $730,000. The business loss of $1 million is not fully deductible due to the EBL limitation. For the tax year 2022, a single taxpayer may only deduct $270,000 of the $1 million rental real estate loss. The $270,000 will offset the taxpayer’s other income, and therefore the taxpayer will be subject to tax on $730,000 worth of income. The remaining business loss that is not deductible in 2022 will be carried forward to 2023 as a net operating loss. The amount carried forward is deductible against any source of business income during 2023 (i.e., it is not limited to the real estate sector).
The Origins of Excess Business Loss
The EBL limitation under IRS code section 461(l) is a fairly new concept created by the tax law commonly known as the Tax Cuts and Jobs Act of 2017. In its original form, the limitation applied for tax years 2018 through 2025. But then, the Coronavirus Aid, Relief, and Economic Security (CARES) Act delayed its implementation. As a result, the limitation first took full effect in the 2021 tax year. Although the EBL limitation was scheduled to expire after 2025, the American Rescue Plan Act extended it through 2026.
If these provisions potentially apply to you and you have already filed your 2021 tax return, you should take another look to ensure the limitation was appropriately considered. Taxpayers that filed 2018 and 2019 returns with EBL limitations, which were retroactively repealed for those years under the CARES Act, can file amended returns to fully deduct unlimited business losses. Even though the CARES Act was signed into law on March 27, 2020, some taxpayers did not use its benefits that year, and they can also file amended returns for 2020.
Other Clarifications to Excess Business Loss
In addition to the temporary suspension of the EBL limitation itself, the CARES Act also made other technical corrections to the determination of an EBL applicable for tax years beginning in 2021:
- Employee wages are excluded from gross trade or business income in computing the overall amount of an EBL.
- The EBL limitation is only considered once in the year incurred. Once the loss becomes a net operating loss, it is not subject to further EBL testing in future years.
- Trade or business capital gains are included in the computation of an EBL. Trade or business capital losses are excluded. When calculating the EBL limitation, it is the lesser of 1) capital gain net income from business sources or 2) overall capital gain net income. Therefore, capital losses are not included in this calculation.
Tax laws are becoming more complicated, with changes occurring frequently. State tax jurisdictions may differ in how they conform to this and other federal tax laws. Taxpayers should discuss the impact that the EBL limitation may have with their tax advisors, as each circumstance is different. For more information, contact us.
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