By Jordon Rosen, CPA, MST, AEP®
Year-end planning with losses may seem like a whole lot of work for nothing, but different categories of losses have different hoops you have to jump through, so understanding the rules is key to getting the most out of your losses.
Capital Losses: Capital gains and losses are claimed on Schedule D. First, net short-term and net long-term gains and losses are computed and then they are combined to come up as an overall gain or loss. A net loss is deductible up to $3,000 per year with an unlimited carryover period. A net capital loss carryover from 2016 can be used to offset capital gains recognized in 2017. A net long-term capital gain is better than a short-term capital gain since it taxed at the preferred 15% rate (or 20% if you are in the top tax bracket) as opposed to short-term gains, which are taxed at ordinary rates.
Net Operating Losses: These are losses generated by a trade or business that you actively participate in on a regular and continuous basis. A net operating loss can be carried back 2 years and any unused loss thereafter is carried forward for 20 years until fully used up. An election can be made to forgo the carryback period and just carryforward the loss.
Hobby Losses: The rules are complicated and can be found in IRC Section 183. If deemed a hobby (and not an active trade or business), hoppy expenses can only be deducted to the extent of income and are taken as a miscellaneous itemized deduction subject to the 2% of AGI floor. Several ways to avoid hobby loss classification is to have a business plan, have a budget, maintain a separate business account and run the operation in a business-like manner, among other considerations.
Losses from Partnerships and S Corporations: There are several hurdles to get over before you can deduct losses flowing from these entities. First, you can only deduct losses to the extent you have “basis” in your partnership or S corp. interest. In general, basis is the amount of your investment and additional capital contributions. For partners in a partnership, basis also includes your pro-rata share of partnership liabilities for which you are personally at risk. Shareholders in an S corporation do not get basis in the corporation’s debt, except for loans to the S corporation made directly by the shareholder. If you anticipate a loss for 2017 and see that you won’t have enough basis to deduct the full amount, consider contributing additional capital to the business before the end of the year to create additional basis.
The second hurdle for deducting losses is that you have to have materially participated in the business during the year (this rule also applies to unincorporated businesses). These are the passive activity rules contained in IRC Section 469, which outline the seven requirements for material participation (usually participation of more than 500 during the year will get you there). If you pass the basis test and material participation test, you can deduct the loss on your tax return. If the activity is considered passive, the passive loss can only be used to offset income from other passive activities. Unused passive losses can be carried forward to offset future passive income or ultimately deducted without limit when the activity is disposed of in a taxable transaction.
Rental real estate is passive by definition; however rental losses up to $25,000 may be claimed if you own at least 10% of the property, actively participate in the rental activity (a lower threshold than material participation) and have adjusted gross income less than $150,000.
If you have questions or want further information on the above or other income, retirement or estate planning techniques, please contact Jordon Rosen at firstname.lastname@example.org.