Question

Discuss business deductions for both a Schedule C and Schedule E, adjustments to gross income, and the Passive Loss Limitation Rules.   

Answer 1

Ans-: Let’s Understand deduction first,

Businesses are required to report all of their gross income, and then deduct all of their business expenses from it. The difference is net taxable income. Thus, business expenses work in a way that is similar to deductions.

A deduction is an expense that can be subtracted from an individual or married couple's gross income in order to reduce the amount that is subject to income tax. It is often referred to as an allowable deduction.

For example, if someone earn $100,000 in a year, and make a $20,000  donation to charity during that year, you are eligible to claim a deduction for that donation, reducing your taxable income to $80,000.

Let’s understand Schedule C

The Schedule C tax form is used to report profit or loss from a business. It is a form that sole proprietors (single owners of businesses) must fill out in the United States when filing their annual tax returns. The Schedule C form is designed to let sole proprietors write off as much of their expenses as possible from their tax bill.

Beneficiaries of Schedule C

The Schedule C form benefits both small business owners and the US Internal Revenue Service (IRS). Within the parameters set out by the form, small business owners can deduct a lot of expenses from their tax bill. Expenses such as advertising, commissions, fees, supplies, automotive, utilities, home office, and so on are all tax-deductible. Anything that is deemed by the IRS to be an “ordinary and necessary” business expense can be used as a tax deduction.

Let’s Understand schedule E,

Schedule E is for reporting income or loss from rental real estate, royalties, partnerships, S corporations, estates, trusts, and residual interests in real estate mortgage investment conduits (REMICs).

Adjustment to gross income

Total gross income minus specific deductions

Passive Activity Loss Rules and Limitations

IRS Sec. 469 defines a passive activity as:

1. Any trade or business of the taxpayer in which the taxpayer does not materially participate, and
2. Any rental activity of the taxpayer except as provided under Sec. 469(c)(7).

Due to #2, all rental activities are classified as passive activities. Per IRS Regulations, a loss from a passive activity can only offset income from a passive activity. Losses from passive activities cannot offset earned income.

There are two exceptions that allow taxpayers to use passive losses to offset earned income:

1. The passive loss allowance which allows taxpayers with a Modified Adjusted Gross Income (MAGI) of less than $100,000 to deduct up to $25,000 of passive losses against their other income. This $25,000 deduction is phased out $1 for every $2 that MAGI increases above $100,000. This means that once a taxpayer’s MAGI exceeds $150,000, the passive loss allowance will have been completely phased out.
2. Qualifying as a Real Estate Professional.

Many of us clients earn above $150,000 and do not qualify as real estate professionals. As a result, if their rentals produce passive losses in excess of passive income, the result is a net passive loss for the rental activities. That loss becomes a suspended passive lossand it is carried forward into the future.