Taxpayers are frequently perplexed by the rules surrounding investment and business losses. Specifically, when such losses may be utilized on their personal income tax return to offset other income.
Limitation on Capital Losses:
The most common type of investment loss is a capital loss, which occurs when a taxpayer sells a capital asset, usually stock, for less than the original purchase price. When a taxpayer’s net capital losses exceed capital gains in a tax year, the capital loss may offset other types of income not to exceed a maximum of $3,000 ($1,500, if married filing separately.) Any unused capital loss remaining, may continued to be utilized in future years up to the same annual limitations. This is commonly referred to as a capital loss carry forward.
Limitations on Business Losses:
Generally, business losses are deductible from taxpayer’s income, and are available to offset ordinary income without restrictions imposed similar to the capital loss limitations. Deductible business losses can be generated through passive investments, privately owned businesses and an operating business managed by others. While most business losses will not be restricted by the capital loss limitation, there are other limitations taxpayers must meet prior to being allowed the full benefit of such losses on a personal level and include:
- The General Basis Limitation
- The At-Risk Limitation
- The Passive Loss Limitation
General Basis Limitation
The first hoop that a taxpayer must jump through is the General Basis Limitation. This limitation suspends a loss to the extent that a partner does not have basis in a partnership interest or a shareholder does not have basis in S Corporation shares and is applied on an entity by entity basis. The limitation is calculated on the last day of the entity’s tax year. The taxpayer’s basis in an entity is the basis of the property contributed to the partnership, plus cash contributions, less distributions, plus the taxpayer’s share of the entity’s liabilities, plus/less the taxpayer’s share of the entity’s income. There are additional rules that control when a shareholder of an S-Corporation can use the entity’s liabilities to increase basis that are beyond the scope of this document.
A taxpayer can utilize the entity’s losses to offset other income until their basis in the entity reaches zero. After losses have fully offset basis, further losses are suspended until the owner’s basis in the entity increases, either by income generation, direct loans, or capital contributions. When the taxpayer’s basis in the entity increases, the taxpayer may then use the remaining losses (to the extent that basis increased.) Losses not utilized will be suspended and available to be carry forwarded indefinitely. However, they do expire upon the death of the taxpayer.
The At-Risk Limitation
The second hoop that taxpayer must jump through is the At-Risk Limitation. This limitation is very similar to the Basis Limitation and is applied on an entity by entity basis. A taxpayer is considered At-Risk to the extent of the cash contributions, plus the basis of contributed property, plus the entity’s liabilities for which they are personally liable . The liabilities are the biggest difference between the Basis Limitation and the At-Risk Limitation. Under the general basis rules, a taxpayer’s basis increases based on their share of the entity’s liabilities, whether or not they are personally liable for the liabilities; however, under the At-Risk rules the taxpayer must be personally liable for the debts. Generally, a taxpayer will be considered personally liable for a debt if they have provided the creditor with a guarantee in the event that the debtor entity defaults on the loan. Additionally, a partner in a partnership can increase their At-Risk amount by providing a loan directly to the partnership. (There are special rules that must be followed with respect to S-Corporations that are beyond the scope of this document.)
A taxpayer can use the entity’s losses against other income until the amount At-Risk reaches zero. At that point, the losses are suspended until the amount At-Risk in the entity increases. When the taxpayer’s At-Risk increases the taxpayer may then use the remaining losses (to the extent that the amount At-Risk increased). Losses suspended under the At-Risk Limitation will carry forward indefinitely. However, they do expire upon the death of the taxpayer.
The Passive Loss Limitation
Even if a taxpayer has sufficient basis, losses may still be limited if the loss is a Passive Loss. A passive loss limitation does not apply on an entity by entity basis, but limits allowable passive losses to the extent that the taxpayer does not have other passive income to offset. These rules usually apply to limited partners, non-managing partners, and non-managing shareholders. This limitation suspends losses generated by entities in which the taxpayer does not materially participate. Material participation is loosely defined as a taxpayers not being involved in the operations of the activity on a regular, continuous, and substantial basis. This is generally defined as participating at least 500 hours on an annual basis. Special rules apply where the facts and circumstances surrounding an activity can reduce this requirement down to 100 hours per year. Additionally, an exception can apply for certain real estate holdings which will allow $25,000 of losses generated by a rental activity to offset other income in lieu of being suspended. Losses suspended under the Passive Loss Limitation may also be carry forwarded indefinitely. However, the limitation disappears and releases unused losses attributed to a passive activity when the taxpayer disposes of the entire interest in an activity.
If the conditions listed above are met or maintained, losses will be reported on Form 1040, and may offset other income to reduce the overall tax burden for the year. If the conditions outlined above are not met, in most cases, the losses are only suspended, and will still be available to be used in future years.