Summary: The CARES Act brings with it numerous changes in the form of grants, loans, and changes to the tax code. One change that has not gotten as much coverage in real estate circles is how you can use net operating loss from real estate to legally shelter income. If you are a real estate professional or thinking about electing this status in 2020, you are going to want to pay attention because the changes in the law can benefit you significantly.
One benefit from the CARES Act that hasn’t gotten as much coverage is something called the net operating loss (NOL) carry back.
The likely reason for this is that you have to be a real estate professional to fully benefit from the “carry back” portion of the new law.
As we’ve written about in past articles, only a small percentage of people claim real estate professional status (REPS). This is unfortunate because REPS is available to anyone who meets the criteria.
The lack of news coverage about the NOL carry back also means that fewer people will benefit from its potentially massive benefits.
Before we go any further, we have to remind you that we are not accountants or lawyers, so please consult your own tax advisors about the topics covered in this article. It’s also important to note that the contents of the bill are so new that there is very little in terms of guidance on this specific topic so the following information may change as the guidance from the IRS changes.
What is a net operating loss?
The term “net operating loss” refers to financial losses that are generated by your business. This occurs when expenses exceed income.
For real estate investors, this can happen when the expenses from operating your rentals exceed the total rent collected.
With real estate there are numerous ways to generate additional “paper losses,” also known as phantom losses. These are expenses that only exist on paper but don’t actually take money out of your pocket. This is how you can make cashflow on your properties and still show a loss on your tax returns.
For example, you can create large phantom losses using cost segregation/bonus depreciation.
When you have real estate professional status (REPS), you can use these losses to offset your W2 or 1099 income (considered active income). If you don’t have REPS, then these losses are what you’d consider passive losses and cannot be used to offset active income.
When you have REPS and your losses exceed active income for any particular year, then you have NOL that you can use to shelter income in other years.
What is a carry back?
When you use unused NOL to shelter income from previous years, this is what you’d consider a carry back. When you use it to shelter future income, you call it a carry forward.
Let’s look at an example.
Say your spouse makes $300,000 of W2 income. Now let’s assume you have REPS and you generated $500,000 in net operating losses from your rental portfolio.
The $500,000 NOL shelters all $300,000 of your spouse’s income and leaves you with $200,000 in unused NOL.
If you use this NOL to shelter past income by filing an amended return, then you call this a carry back.
If you use this NOL to shelter future income, then you call this a carry forward.
How did the CARES Act impact net operating losses?
The 2017 Tax Cuts and Jobs Act (TCJA) eliminated carry backs (previously you were allowed a 2 year carry back). It also limited carry forwards to sheltering 80% of taxable income (previously you could shelter 100% of taxable income) starting with the 2018 tax year.
The CARES Act brings back NOL carry backs for 5 years and the 100% shelter for carry forwards.
It’s also important to note that the rules are retroactive to the 2018 tax year. So as far as NOL is concerned, it’s as if the TJCA never happened.
Let’s describe this in further detail using the same example we used previously.
Let’s say you generated the $200,000 NOL in 2019.
With TJCA, you could only carry forward and shelter 80% of future taxable income. So if your spouse made $200,000 of W2 income, you could only shelter $160,000 of this income (80% of $200,000) the following year.
With CARES, you can use this loss and go backward in time and shelter 100% of your spouse’s income from prior years!
So let’s say that you didn’t completely shelter your spouse’s income in 2018 and paid taxes on $50,000 of W2 income. Then you would use this $200,000 to offset this $50,000 of income in 2018 and you would still have $150,000 left to apply to 2017 and earlier until you use up all $200,000 of NOL.
Why was this change enacted?
The reason for this change is simply to put money in the pockets of real estate professionals and business owners, NOW.
By allowing you to shelter past income, you don’t have to wait to get this benefit in future years when you carry forward. Instead you can get the benefit immediately when you file your 2019 taxes in July 2020 (if you haven’t heard, the tax deadline was pushed back from April 2020 to July 2020 because of the COVID-19 crisis).
So what does this mean for you?
If you are a real estate professional, this is a huge change in the law because you can get a tax refund this year if you had excess NOL in 2019.
Not only that, the tax law also includes the 2020 tax year. Therefore, you still have time this year to generate as much NOL as possible to apply to past years. You also get a refund when you file your 2020 taxes in April 2021.
If you aren’t a real estate professional, you should consider the benefits of making this election in 2020 and plan accordingly. If you meet criteria this year, you can carry forward 100% of the NOL and shelter future income next year.
There is also a possibility of using the 2020 NOL and carry back in prior years even if you weren’t a real estate professional in prior years, however, we could not find clear guidance on this. [Editor’s note: We have now spoken to several accountants who have told us that 2020 NOL can be carried back even if you weren’t a real estate professional in previous years. As we mentioned before, please check with your own tax advisors instead of relying on the information in this article.]
Starting in 2021, the law reverts back to the old TJCA rules. These eliminate carry backs and only allow you to use 80% of the carry forward instead of 100%.
It’s important to note that these NOL rules have changed numerous times over the last several decades. So it’s likely that in a future recession, they’ll bring back the carry back and the 100% offset. If you missed it this time because you weren’t a real estate professional, you’ll maybe want to be one the next time around.