Historically, the real estate industry has benefited from favorable tax laws. The ability to deduct depreciation has created tax-enhanced returns on many real estate investments. However, the Tax Cuts and Jobs Act of 2017 (TCJA) applied a new limitation, the limit on excess business losses, to the amount of business deductions in excess of total income a taxpayer can claim. For federal income tax purposes, the pain has been eased from this limitation for the past three years. The CARES Act of 2020 enacted a provision suspending excess business loss limits for tax years 2018, 2019 and 2020. However, the limitation will come back in effect for tax year 2021.
Prior to the TCJA, individual, trust and real estate taxpayers who qualified as real estate professionals were able to deduct all losses of their real estate business against their other sources of income. If business losses exceed other sources of income, a net operating loss will be generated (certain exceptions exist for real estate). This loss can either be carried forward to offset income from prior years or carried over to future tax years at the taxpayer’s choice.
The TCJA has limited the deductibility of business losses for individual, trust, and estate taxpayers. Starting in the 2018 tax year, business or business losses are limited to $500,000 for married couples ($250,000 for single taxpayers). Any non-deductible “excess business loss” in the current year is carried forward as a net operating loss, which can be used to offset income from a future tax period.
The CARES Act provided a temporary federal exemption from excess loss limits as relief from the ongoing COVID-19 pandemic. In addition to the return of this limitation, some issues need to be addressed at the state level as well.
For taxpayers involved in the trade or business of real estate, accelerated depreciation can result in significant taxable losses. Certain qualifying properties qualify for a 100 percent depreciation bonus in the year in which they are first operated by the taxpayer. However, the effect of depreciation on the state in which the taxpayer is employed must be addressed.
The separation of the New York provision from Federal award amortization is not taken into account in determining the New York excess loss limits or the allowable net operating loss. This may result in taxable income and a tax liability even if New York’s adjusted gross income is recalculated to zero. Careful consideration and planning about New York (or other states with similar systems) are needed when assessing the benefits of accelerated consumption. Taxpayers may wish to consider a federal election by amortizing the bonus due to restrictions on losses and depreciating their assets according to their useful life.
It is important to consider the interaction between loss limits, accelerated depreciation and the potential impact on the different countries a taxpayer is obligated to provide because this is essential to any successful tax strategy.