Net Operating Losses Vs. Passive Activity Losses for Cost Segregation
When the CARES Act temporarily revived five-year Net Operating Loss (NOL) carrybacks and eliminated the 20% haircut, there were many articles written on using them in combination with the fixed “retail glitch” for Qualified Improvement Property (QIP). Often overlooked in these analyses is the role in which the Passive Activity Loss (PAL) rules apply to real estate. This document provides a non-technical summary of provisions related to NOLs and PALs.
Tax Year Beginning
Calculation
Carryback
Carryforward
Before 12/31/2017
NOL = Carryover + Carryback
Two Years
20 Years
After 12/31/2017 & Before 1/1/2021
NOL = Carryover + Carryback
Five Years
Indefinite
After 12/31/2020
NOL = Pre-2018 NOL + Lesser
of:
Post-2017 NOL or 80% of
Taxable Income plus
deductions under §§ 172
(NOL), 199A (QBI), and 250
(GILTI/FDII)
N/A
Indefinite
All years
PAL = PAL Carryover
N/A
Indefinite
The Difference Between NOLs and PALs
In 1986, Congress introduced the Passive Activity Loss rules of Code section 469. These rules basically divide all business income into two categories:
- Nonpassive Income (or loss)
- Passive Income (or loss).
The Passive Activity rules apply to individuals, trusts, estates, personal service corporations, and closely held C corporations . The underlying idea is that taxpayers have different business activities and the income or losses from one activity cannot always be used to offset losses or income from other activities.
This is an important point, because, technically speaking, rental activities are per se passive. In other words, unless an exception applies, all rental activities are assumed to be passive activities. Nonpassive income generally cannot offset passive losses and vice versa. NOLs happen in nonpassive activities. PALs happen in passive activities. An NOL generally cannot offset passive income and a PAL generally cannot offset nonpassive income. But an NOL can apply against nonpassive income, and a PAL can offset passive income.
Example 1:
Consider Mary Moe, who owns and runs a manufacturing company. She also owns two rental houses, a commercial rental property, and a fast-food franchise. The manufacturer (1), each rental property (3), and the fast-food franchise (1) are generally considered separate activities, so Mary has five activities. She personally works at the manufacturing company and hires managers to run the fast-food business and a property management company to handle the rentals. In other words, she only materially participates in the manufacturing activity. It is nonpassive income. The other activities are considered passive.
In Mary’s case, if one rental house has a PAL and the other one generates income, she can offset the rental income with the PAL. If there is still a PAL remaining, it could also offset the passive income from the fast-food business. Any remaining PAL would continue to be carried forward indefinitely until it is absorbed.
Mary's Business
Mary's Activity
Manufacturing
Nonpassive
Rental Properties (houses & commercial)
Passive
Fast-Food Franchise
Passive
Self-Rental Traps
A self-rental is a situation where a taxpayer rents a property to an activity in which they materially participate. Think of an auto dealership. John Joe owns a dealership building in a Property Company (PropCo). He leases it to his franchised, new vehicle automotive dealership operating company (OpCo). Under the self-rental rules, profits from the PropCo are considered nonpassive, but losses are considered passive. The income from the OpCo is nonpassive. If you perform a cost segregation study on the PropCo and it generates a loss, it generally cannot offset the income from the OpCo.
This self-rental trap may be avoidable. For example, if the taxpayer can group the OpCo and PropCo activities, they will be considered a single activity. It depends on the facts and circumstances under a multi-factor test. Not everything can be grouped together. For instance, the rental of personal property and real property generally cannot be grouped together. Another way to avoid the PAL rules is for a taxpayer to be considered a real estate professional.
Example 2:
Recall Mary Moe’s rental commercial building from Example 1. If it is, for example, a strip mall that Mary leases to unrelated third parties, the PAL could offset income from the commercial property. However, if the commercial building is the warehouse she rents to her manufacturing company, Mary may have fallen into the self-rental trap by renting the commercial property to an activity in which they materially participate.
Conclusion
Not all income is equal. If a loss is passive, it can generally only offset other passive income. Turning to cost segregation, in a worst-case scenario the loss from a study may not be fully offset until the property is sold at a gain year down the road. In our experience, this rarely happens, and most taxpayers have sufficient passive income to absorb the loss within five or fewer years. The key takeaway is that while the CARES Act revived NOLs, many taxpayers are still subject to the PAL rules.
- SA Personal Service Company is a corporation the principal activity of which is the performance of personal services and such services are substantially performed by employee-owner.
- A closely held C corporation is a C corporation where more than 50 percent of the value of its outstanding stock is owned, directly or indirectly, by or for not more than 5 individuals.
- Material participation is a technical term that reflects a high-level of engagement with a business activity. The regulations provide several tests to identify it.
- Grouping is a technical term. The general idea is that grouped activities are treated as a single activity.
- Real estate professional is also a technical, which requires an even higher level of engagement in real property trades or businesses than mere material participation.
