Losses to be aware of this tax season
While every tax season can be difficult due to evolving compliance standards, tax year 2022 is proving to be a complicated year for filers in high-income tax brackets. Rising interest rates and a higher cost of living have created a unique environment no matter your industry. A key consideration for your 2022 filing efforts should be to acknowledge that every operating loss for your business or capital loss on investments may not lead to a direct deduction on your 1040 the way that you would think. There are various reasons for this, and in most cases it can be attributed to timing or recognition limitations.
Focusing on changes to Section 461(I), the Excess Business Loss Limitation (referred to as EBL) applies to any non-corporate taxpayer, thus affecting individuals, trusts, and even estates in 2022. For any partnerships or S corps, Section 461(I) items only apply at the partner or shareholder level. The EBL directly limits any amount of trade or business deductions that can be used to offset your non-business income.
The equation for Excess Business Loss calculation can be understood as taking your aggregate trade or business deductions, subtracting related income or gains, and adding in your indexed limitation (“threshold”) amount. For 2022, the threshold amounts are $540,000 for those filing MFJ or $270,000 for any other filer. This threshold amount is adjusted annually to recognize inflation.
Keep in mind that there are a few common items that are excluded from EBL calculations when it comes to your deductions. Net Operating Losses (NOL), Section 199A deductions, and capital loss deductions are not considered a part of aggregate deductions. When it comes to calculating your aggregate income, do not recognize employee compensation, and you will need to limit capital gains to the lesser between a) the net capital gain including only gains or losses directly attributable to your trade or business, or b) capital gain net income.
After successfully calculating your EBL Limitation, you are only limited to deducting that amount of loss in 2022. Any amount of excess loss unclaimed (disallowed) in 2022 can be carried forward as an NOL indefinitely in subsequent years. Net Operating Losses may be used to offset up to 80% of the current year's taxable income.
The investment market also appeared to be in a downturn in 2022. It may prove beneficial to speak with your tax advisor regarding how to strategically apply tax-loss harvesting, which requires a keen understanding of wash sales and how they affect capital loss in any year.
According to the IRS’s “wash sale” rule, you cannot sell an investment, realize the loss, and then purchase a substantially similar investment for 30 days before or after the date of the sale. Under general circumstances, the disallowed loss can only be claimed when the new stock is disposed of. It is also important to note that the wash sale applies on a per taxpayer status, and not just per individual investment account. MFJ taxpayers can deduct up to $3,000 ($1,500 for all others) of capital losses against ordinary income, and excess capital losses are carried forward indefinitely to be used in future years.
Tax law is becoming more complicated every year, and each taxpayer’s circumstances are different. Consult with your trusted preparer to determine the impact that the EBL limitation can have on your tax filings for 2022, as well as how to plan accordingly in 2023.