In his science fiction masterpiece, The Time Machine, H.G. Wells wrote: “[i]t is a law of nature we overlook, that intellectual versatility is the compensation for change, danger, and trouble.” Essentially, the line is a less pithy (and, arguably, more nuanced) version of Nietzsche’s “what doesn’t kill you makes you stronger.” And, like all true aphorisms, the poignance of Wells’ observation from the late nineteenth century transcends Time itself. Inarguably, the turmoil engendered by the Virus and the subsequent economic shut-down has given us a world that is replete with “change, danger and trouble”. And, for those select, informed few whose “intellectual versatility” has strengthened amidst the din, a wide portal to economic opportunity has opened.
Brief Background of the “NOL”
“NOL” is an abbreviation for Net Operating Loss. Prior to the Tax Cuts and Jobs Act (“TCJA”) a business that produced an NOL as of year-end could offset up to 100% of its taxable income with that NOL. Moreover, if that loss were greater than the income of the business, the “excess” loss could be carried back and used to offset the prior 2 years of income, beginning with the earlier year first. Additionally, for “pass-through” entities, there was a “cap” on the amount of business loss that could flow through to an individual’s return–$250,000 (single filers) and $500,000 (married filing jointly).
Subsequently, the Tax Cuts and Jobs Act (TCJA) of 2017 limited the tax reduction utility of a business NOL to 80% of the taxable income of the business. Most punitively, under the TCJA, carry-back of any “excess” loss was no longer allowed. As a result, an excess loss in the current tax year could only benefit future tax years.
NOLs under the CARES Act
The Coronavirus Aid, Relief and Economic Security (“CARES”) Act repealed the 80% NOL limitation of the TCJA and returned it to a pre-TCJA level (i.e., 100% of taxable income). The CARES Act also modified the limitations regarding excess loss carry-backs. Specifically, the CARES Act provides that NOLs arising in a taxable year beginning after December 31, 2017, and before January 1, 2021, are allowed as a carry-back to each of the five taxable years preceding the taxable year of such loss. It actually amends (and effectively overrides) the section of the TCJA that prohibited carry-backs (conversely, carry-forwards are still indefinite in duration). Moreover, under the CARES Act, the pre-TCJA “cap” on losses for owners of pass-through entities was eliminated.
How can the above translate to an economic opportunity for a business owner?
Obviously, if the economic shut-down results in a corresponding business shut-down, the business could experience an economic loss. Certainly, the modifications of the CARES Act would enable that business owner to carry back that NOL and use it to reduce prior taxable income. However, real economic losses are not opportunities. Very often, they are tragedies.
A less morose approach is to examine whether available, yet latent, deductions would enable a business owner who is still profitable to simultaneously capitalize on the liberalization of the NOL rules without experiencing an actual economic loss. At Tax Law Solutions, we utilize—and aggregate—a number of different strategies to thread this needle (figuratively) for our clients. The results have been powerful. Interestingly, while a handful of these strategies are esoteric, many others are more widely known and used. However, even with several of the more ubiquitous tax planning techniques among business owners and their tax advisors, there are reoccurring fundamental misconceptions about how they can be employed in the context of the new NOL rules.
Cost Segregation and Self-Rental Rules
An example of a fairly commonplace technique that frequently creates large current year income tax deductions is “cost segregation”. Rather than viewing business real estate as a whole (and depreciating it over either 27.5 or 39 years), cost segregation is the (re)classification of building components as personal property. Using an engineering report to segregate those components from the land and even the building itself, an owner of real estate can increase cash flow by accelerating depreciation deductions that reduce income taxes during the early years of a building’s recovery period. The tax savings are further enhanced if the personal property components also qualify for bonus depreciation under IRC §§168(k) or 179.
While the resultant deduction from a cost segregation study can be significant, many taxpayers misconstrue the effect of that deduction on “active” business income. If the real property from which you generate your cost segregation deduction is classified as a “passive” activity, then the deduction can only be used to offset passive income. For example, if you own rental real estate and you are not classified as a real estate professional[1], all gains and losses from that rental activity are considered non-business passive losses. As such, in that circumstance, you could not utilize a deduction generated by a cost segregation study to count towards a business NOL.
This begs the question—how can a business owner who is not in the real estate business according to the IRS—use a deduction from cost segregation study completed on a rental property that the business owner also owns to capitalize on the opportunity for excess loss carry-backs pursuant to the new NOL rules? Finding that unicorn begins with a search in the “self-rental” field…
By way of reference, the typical self-rental arrangement involves a business owned by an individual renting property from another entity—typically an LLC—owned by the same individual. There are several variations of this—with multiple owners, for example—but the essence of self-rental involves the disaggregation of the operating business from the real estate that serves as the HQ address for the business.
Normally, rental income arrangements, such as leasing real estate to a corporation, produce passive income to the extent of any net rental income received by the lessor (IRC § 469(c)(2)). Passive rental income can be very valuable to some who own real estate, since it can serve to absorb passive losses from other activities. However, the IRS has issued self-rental property regulations that prohibit using net income from the rental of property to offset other passive losses if the property is rented to a business in which the taxpayer materially participates (Treas. Reg. §. 1.469-2(f)(6)).
These rules, converting what would otherwise be passive income into nonpassive income, apply only if the rental activity produces net income. If the rental activity produces a loss, the loss continues to retain its passive character.
For those seeking to offset active business income—and perhaps, ultimately, generate NOLs—the above limitation produces an undesirable result. Fortunately, the ability to recharacterize an otherwise passive loss created in a self-rental arrangement as active can be achieved by successfully “grouping” the rental and the operating businesses together. Specifically, Treasury Regulation §1.469-4 enables you to group your separately owned rental building with your business and treat them as one activity for purposes of the passive loss rules if they constitute an “appropriate economic unit.”
The determination of whether two businesses constitute an “appropriate economic unit” is a multi-factorial one that is purely fact-dependent. Treas. Reg. §1.469-4(c)(2) lists a variety of factors to be considered, such as similarities and differences in the types of businesses, the extent of common control, the extent of common ownership, geographical location, and interdependence between the activities. While the “economic unit” requirement applies to all Treas. Reg. § 1.469-4 activity groupings, the successful grouping of a rental activity with a non-rental activity necessitates meeting an additional requirement under Treas. Reg. § 1.469-4(d). Specifically, the restrictions placed on rental-focused grouping are embodied in Treas. Reg. §1.469-4(d)(1)(I). That Reg. provides that you may not group a rental activity with a business activity unless they constitute an “appropriate economic unit” and either (1) the rental activity is insubstantial in relation to the business activity, or (2) the business activity is insubstantial in relation to the rental activity, or (3) each owner of the business activity has the same proportionate ownership interest in the rental activity.
The proportionate ownership requirement is further clarified in Treas. Reg. §1.469-4(d)(1)(I)(C):
“(C) Each owner of the trade or business activity has the same proportionate ownership interest in the rental activity, in which case the portion of the rental activity that involves the rental of items of property for use in the trade or business activity may be grouped with the trade or business activity.”
Thus, if the above requirements are met, the business that holds the self-rented real estate can successfully be grouped together with an operating business. Consequently, if a cost segregation study on the real estate results in a significant current year’s deduction, that deduction can be used to offset active business income. What’s more, if that deduction, perhaps when coupled with other deductions, can create a business NOL in 2020, that NOL can be used to recapture past wealth already confiscated by the government.
Metaphorically, this affords the contemporary intellectually versatile taxpayer the opportunity to set his Time Machine to 2015 and hit “go”.
If you have any questions or would like to further discuss, please email TLS Support: support@taxlawsolutions.net.
[1] If you have another full-time job that does not involve real estate or “real property”, then you are almost always NOT considered a real estate professional by the IRS.