Why your losses are not always deductible
One of the most frequent questions asked by our clients is why their losses cannot be used to offset their income. “I made money, invested it, lost it and now you are telling me I have to pay tax only on what I made. What about what I lost? Where exactly am I supposed to get the cash to pay these taxes – the sky?” Sound familiar? Well, you are not alone. The tax code is filled with idiosyncrasies that trigger the suspension of losses.
Baskets of Income
One of the primary reasons losses do not always offset income is because the Internal Revenue Code defines different categories of income and specifies how losses can offset gains within and between those categories. For instance, non-corporate taxpayers can deduct capital losses only to the extent of capital gains, plus $3,000 of ordinary income a year. Remaining capital losses are carried forward until the taxpayer has enough capital gain to offset the capital loss or until the taxpayer consumes the loss at a rate of $3,000 per year.
Basis Limitations
In general, losses are only deductible to the extent a taxpayer has basis in an activity. A taxpayer’s basis is generally the amount they invest in the property or activity. If a taxpayer buys a truck for $1000, the basis in the vehicle is $1000. You cannot deduct $1100 when you only pay $1000 for the truck. This principle applies equally to investments in real estate and stocks.
At-Risk Limitation
If a taxpayer has sufficient basis in an asset, they must also overcome the at-risk limitations in order to deduct the loss. I.R.C. §465 limits the amount a taxpayer may deduct to the amount the taxpayer has at risk in an activity. This includes the amount of cash and the value of property contributed to the activity, plus any amounts borrowed for use in the activity for which the taxpayer has a personal liability. The taxpayer is not considered at risk with respect to amounts protected against loss through nonrecourse financing, guarantees, stop-loss agreements, or similar arrangements.
The at-risk rules are designed to prevent taxpayers from offsetting trade, business, or professional income with losses from investments in activities that are largely financed by nonrecourse loans for which they are not personally liable. A common scenario is a taxpayer who invests $100,000 in a partnership that in turn takes out a $900,000 loan and buys a building for $1 million. If the bank makes this loan to the partnership with only the building as collateral, the taxpayer’s risk is limited to the $100,000 they originally invested. If the partnership fails the next day and the building is sold for $800,000, the taxpayer and the bank will each take a loss of $100,000. Because the taxpayer only lost $100,000, they may only deduct up to $100,000 in losses from that activity. So, for continuing activities, taxpayer’s may only deduct losses to the extent they are at risk of losing their own hard earned money.
Passive Activity Limitations
Losses that are not disallowed by the at-risk limitations may still be limited by the passive activity limitations. In general, losses that are from passive activities may not offset nonpassive income (i.e. wages, interest, dividends etc.). I.R.C. §469 lays out a complex set of rules aimed at preventing taxpayers from using losses in activities in which they do not materially participate to offset income from activities in which they do activity participate. In general, the IRS defines two types of passive activities:
- Businesses in which the taxpayer does not materially participate, such as a limited partnership, into which some owners invest but do not participate in the day to day operations; and
- Rentals (no matter what level of participation).
Taxpayers are permitted, however, to deduct up to $25,000 of passive losses in rental real estate activities in which the taxpayer, or the taxpayer’s spouse, have material participation. The $25,000 maximum is phased out between $100,000 and $150,000 in adjusted gross income.
Benjamin R. Podraza, CPA, MST
February 13, 2013