The last 18 months have been difficult with health, social and financial turmoil appearing to occur on a daily basis. As many look to the future, they are also excited to finalize their 2020 federal personal income tax returns by October 15.e and put 2020 in the rear window. But before signing any personal income tax return for 2020, careful consideration must be given to how best to maximize the benefits of net operating loss (“NOL”). Taxpayers may also consider optimizing the 2018 and 2019 NOLs, given the taxpayer-friendly guidance issued by the IRS in Tax Procedure 2020-24.
Many companies saw the creation of federal NOLs in 2020 due to the fact that the majority of stimulus funds were not taxable, while the associated expenses were still allowed as a deduction. This mismatch in tax treatment, coupled with the negative business impact of COVID in 2020, resulted in more NOLs being reported for the 2020 tax year than normal.
In general, NOLs created in 2018, 2019 and 2020 should be rolled back five years and then carried forward indefinitely. So what’s the problem ? Isn’t it better to postpone the NOL and get the cash refund now rather than wait to postpone the loss to a future taxable year? Like everything in the tax world, it depends. With new 2022 tax laws looming and the possibility of federal personal income tax bills skyrocketing, taking the time to forecast a future benefit of deferring an NOL could result in tax savings. important.
So how do individuals maximize the cash benefits of NOL 2018, 2019 and 2020? Two important questions need to be asked:
1. What is the effective federal owner’s tax rate for deferral years compared to the expected rate for future years?
2. What is the owner’s current cash position? Is the need for money imminent or is there an option to postpone collecting money to maximize the benefits?
Federal Law Changes Regarding Federal NOLs
Significant legislative changes on the use of federal NOLs were included in the Tax Cuts and Employment Act (TCJA) passed in December 2017, and further amended with the passage of the CARES Act in March 2020. Before the TCJA, the general rule provided that a federal NOL could be carried back to the 2 previous tax years and carried over to the next 20 tax years. When the NOL was carried back or forward, it could offset 100% of the declared taxable income.
As part of the TCJA, the NOL rules were changed for any loss that arose in taxable years after December 31, 2017. NOLs generated after that date could be carried forward indefinitely, but carryback was eliminated. . In addition, when losses were carried forward, they could only offset up to 80% of taxable income in that year.
But then came COVID, and with businesses struggling, there was a rush to provide help with stimulus funds and tax breaks. The CARES law allows NOLs generated during civil tax years between 2018 and 2020 to be carried over to the previous five tax years, and then carried over indefinitely. It was a welcome change in law for many taxpayers, and it also introduced the longest NOL deferral period I’ve seen in my life. However, an important nuance about the five-year rollback period is that it must be carried back to the fifth year and then carried over. In other words, you cannot choose the tax year to which the NOL carryback would apply.
For example, suppose Bob created a NOL of $ 500,000 in his flow-through business entity for tax year 2020. Under the CARES amendment, Bob is required to carry forward the loss for five years and apply the loss in tax year 2015. In tax year 2015, Bob’s effective tax rate was 25%. In 2016, Bob’s effective tax rate was 35%. Bob cannot elect to apply the NOL to the 2016 tax year with the highest effective tax rate, but must carry the loss forward to the 2015 tax year. Therefore, assuming the 100% of the loss was used in 2015, the amount of cash benefits Bob receives is only $ 125,000 (500,000 x 25%), compared to $ 175,000 (500,000 x 35%).
Not only must the effective tax rate be reviewed for the deferral years, but the effective tax rate projected in the future must also be taken into account. Incorporating the House Ways and Means Committee’s reconciliation tax bill passed last week, Bob’s individual tax rate in 2022 could increase significantly. Bob’s income tax rate can be as high as 39.6%, he may lose part of his 199A deduction, and his income may be subject to an additional net tax rate of 3.8%.
Now suppose Bob is also a rental real estate professional and owns real estate in various partnerships. Suppose Bob generates taxable income in a normal year, which consists of $ 3,000,000 of rental property income before the application of 199A and $ 100,000 of long-term capital gains income (before the application of 199A). September 13, 2021). Bob’s effective tax rate between 2021 and 2022 could be dramatically different if the House Ways and Means Committee’s reconciliation bill passes.
Under the proposed bill, the top marginal tax rate will drop from 37% to 39.6% for married taxpayers filing jointly with taxable income greater than $ 450,000. In addition, from September 13, 2021, the capital gains tax rate could drop from 20% to 25%. The bill also limits the amount of 199A deductions to $ 500,000 in the case of a joint return and extends the application of the net investment income tax of 3.8% to include the income drawn in the ordinary course of a trade or business if the taxpayer has taxable income of at least $ 500,000. That’s a lot to absorb, but the bottom line is that Bob’s federal income tax payments could increase dramatically. In the simplest example, Bob will see his federal effective tax rate increase by about 6%.
Take-out? Bob may want to avoid using the $ 500,000 NOL that was created in 2020 against the 2015 taxable income, as the 2015 tax year only has an effective tax rate of 25%. . Rather, it should consider deferring it to offset an expected effective tax rate of 40%. The impact on cash flow of the choice to defer only the NOL could generate up to $ 75,000 in additional cash savings ($ 200,000 to $ 125,000).
How can I make sure that my NOL is not carried back, but only carried forward?
Taxpayers are allowed to forgo the entire NOL carryback period, but the election must be made before the due date (including any extensions) to file the taxpayer’s return for the year of imposition of the NOL for which the choice must be in force. If such a choice is made, the NOL can only be postponed. Such a choice is irrevocable and should not be made without consulting your tax advisor.
In Bob’s example, if he has a NOL related to the 2020 tax year and does not want to carry it over to previous years, he must attach a return to his 2020 tax return before the extended due date. of the declaration, on October 15, 2021., waiving the postponement.
Now, some taxpayers may also have created an NOL for the 2018 and 2019 tax years, which was not allowed to carry over under the TCJA. However, the adoption of the CARES law now obliges taxpayers with NOLs created in 2018 and 2019 to carry them back five years. It doesn’t seem fair, does it? As a result, the IRS accepted and published the 2020-24 Tax Procedure, creating a process for taxpayers to waive the five-year deferral period for NOLs created in 2018 and 2019 as well.
Under the 2020-24 tax procedure, an individual taxpayer can choose to waive the five-year deferral period for NOL 2018 and 2019 if the appropriate return is attached to the 2020 tax return, on or before the date term, including extensions. A taxpayer makes the election by attaching a separate return to their 2020 federal income tax return for each of the 2018 or 2019 tax years for which they intend to make the election. The declaration must state that the taxpayer chooses to apply § 172 (b) (3) under Rev. Proc. 2020-24 and include the tax year for which the return applies. Once made, the choice is irrevocable.
It is extremely important that all tax practitioners and taxpayers with NOLs generated in 2018, 2019 or 2020 seriously consider whether they should choose to forgo their federal NOL deferral period. While this decision cannot be made in a vacuum and will require forecasting and modeling, the efforts could create significantly higher cash flows depending on the expected path of federal tax rates over the next four years. The world of taxation continues to become more complex, and this is just one of many more things to consider before filing federal personal income tax returns for 2020.