By Andrew Gradman
Published at www.gradmantax.com on August 17, 2020. This article is intended for general information only and does not constitute legal advice. Every investment must be evaluated on its specific facts, and every investor should seek tax advice tailored to his or her individual circumstances.
This article describes an incentive to invest in capital-intensive businesses during 2020, arising from the Coronavirus Aid, Relief, and Economic Security (CARES) Act. It explains:
- How investments in capital-intensive businesses can generate accelerated tax losses (i.e. tax losses in excess of actual economic losses);
- How under limited circumstances—broadened by the CARES Act—these accelerated losses can be passed through to the business’s investors, to shelter their other income; and
- How the CARES Act permits the investors to carry back these losses for five years, thus sheltering income previously reported between 2015 and 2019. This carryback treatment is not available for investments made after December 31, 2020.
A. ACCELERATION OF LOSSES FOR TAX PURPOSES
Usually, a taxpayer’s “tax” loss equals his “economic” loss. An exception applies to depreciation—that is, the exhaustion, wear and tear of tangible property. Because it is impractical to require taxpayers to physically measure this sort of loss each year, taxpayers must instead amortize the asset’s purchase cost in a formulaic way over a fixed number of years. The resulting annual deductions rarely correspond to the property’s actual diminution in value during the year.
To encourage investments in capital-intensive businesses, Congress deliberately sets a property’s depreciable life to be shorter than its true expected life. As a result, the business can treat the property as having lost all its value for tax purposes—and thus, can take deductions equal its entire purchase price—even though in reality the property is still in productive use. The desirability of this “accelerated depreciation” reflects the time value of money: The business can use this extra depreciation to avoid paying taxes on income during its early years; conversely, after the asset has been fully depreciated, it will generate no further depreciation, and will fail to shelter the income it generates in its final years.
The degree to which an asset’s depreciation is “accelerated” depends on several factors. In the most extreme cases, the entire deduction can be taken in the year the business first uses the asset. This extreme form of accelerated depreciation is known as “bonus depreciation” or “first-year depreciation.” It is available for qualifying assets placed in service in 2020, 2021, and 2022, then phases out through 2026. First-year depreciation, along with a similar method known as first-year cost expensing, are currently the primary cost recovery vehicle for acquisitions.
B. USE OF ACCELERATED LOSSES BY INVESTORS
If a business generates more deductions than income in a year, the question arises whether the extra deductions can be passed through to its owners, to offset other income not attributable to that business.
The answer will differ for each taxpayer. Here I discuss the five most common factors; additional factors may be relevant to particular taxpayers.
- Ordinary Income or Capital Gains? In general, taxpayers cannot use capital losses to offset ordinary income. See IRC §§ 165(f), 1211. However, the opposite is not true: deductions such as bonus depreciation can be used to offset income regardless of character (i.e., both ordinary income and capital gains), as long as the other constraints below are satisfied. That’s because an individual’s tax liability is based on the lesser of the tax at ordinary rates in IRC 1(a)-(e) or the tax using the capital gains rates in IRC 1(h). Although depreciation does not reduce some items in the second equation (e.g., “net long-term capital gains”), it does reduce the tax due under the first equation.
- Does the taxpayer have sufficient outside basis? If the amount of losses allocated to a partner exceeds his basis in his partnership interest, he can take no further losses until he acquires more basis, by investing in the partnership or paying taxes on partnership income.
- Is the taxpayer “at risk”? To the extent that tangible property is bought with nonrecourse debt, the investor is not “at risk” with respect to the investment. As a result, he is denied a corresponding portion of the pass-through deductions. An exception applies to certain real estate investments.
- Is the investor a passive owner? If the investor is not actively involved in the business, and if the business doesn’t involve certain working interests in oil and gas, the pass-through loss becomes a “passive” loss, meaning he can only apply it to offset “passive income.” Beware: not all passive-feeling income is “passive” for this purpose; it might instead be “portfolio” income. The latter includes these items, if not derived in the ordinary course of a trade or business: interest; dividends; annuities; royalties; gains from the sale of property producing the preceding categories of income (e.g. stocks, bonds, annuities, licenses); and gains from property held for investment outside of a passive activity. Since none of this is passive income, none of it may be sheltered using passive losses.
- Is it an “excess business loss?” Effective 2018, the Tax Cuts and Jobs Act created a new loss limitation: If a business incurred very large losses, those excess losses must be amortized gradually over future years. In many cases, this “excess business loss limitation” made it hard for investors to enjoy the tax benefits of bonus depreciation. However, as part of the CARES Act, the implementation of this rule was delayed until 2021. Thus, this limitation will not affect investments made for the remainder of 2020.
C. CARRYING BACK LOSSES ARISING IN 2020
Until recently, taxpayers could not carry back losses to prior years. Thus, if the taxpayer had no current-year income with which to absorb the pass-through losses, he would have to carry them forward. The CARES Act changes this. It allows NOLs arising in 2018, 2019, or 2020 to be carried back five years, up to 100% of taxable income each year from earliest to latest.
Thus, for a taxpayer who receives a significant loss between now and December 31, 2020 which meets the criteria described above, the question is whether he had any qualifying passive income during any of 2015 to 2019. If so, he can carry back the 2020 loss, leading to a tax refund. The effect (if not the purpose) of this change is to encourage taxpayers to make capital-intensive investments between now and December 31, 2020 which generate accelerated depreciation or similar accelerated losses. Note that years 2015, 2016, and 2017 used the higher, pre-TCJA ordinary tax rates, so carrybacks to these years may be of even greater value.