Why you cannot rely on the numbers on the 1040 Page One

Actually, this can apply to any of the returns: 1040, 1065, 1120, and 1120S. It is not uncommon for there to be a limit to the amount of expense or loss a taxpayer can apply against taxable income. Some great examples:

• Capital losses are limited to $3,000 on a 1040, no matter how big the loss.
• Rental losses are limited based on the total amount of losses and the overall AGI of the taxpayer.
• Itemized deductions are limited based on the overall AGI of the taxpayer.
• Parts of the home office deduction are not allowed if the deduction will create or increase a loss.

Relying on the numbers on the front page of any tax return, without tracing them to their supporting schedules, can result in miscalculations of recurring cash flow available to pay debt, whether using global- or entity/individual-level cash flow analysis. As important, you can be mislead as to materiality of an income source. A $3,000 loss may not be material. But when you get back to Schedule D Capital Gains you may discover it is a $300,000 loss. For most of our borrowers, that is material.

And specifically related to your question, Jacqueline, the limits on rental losses could actually completely wipe out the losses and result in a zero on the front page of the tax return, Line 17, unless the borrower also has pass-thru entities, trust or estate income coming from Schedule E, Page Two.

Why are rental losses limited?

The next two sections are for those of you who like to know why. If you do not care why, move two subheads down to ‘What to do’.

The congress does not mind an individual or couple who are not high-income having a rental or two and getting a deduction against other taxable income. However, rental income is specifically considered passive, and there is a rule that passive income cannot be used to offset nonpassive (earned or investment) income. This came from a feeling that rich people were unfairly using ‘paper’ losses to shelter real, significant income. Thus the limit.

When are rental losses limited?

If your rental losses are more than $25,000 you may only deduct $25,000 if you do not have passive income against which to offset the losses. And even that amount is reduced if your modified Adjusted Gross Income is $100,000 or more (Married Filing Jointly – MFJ). Once you exceed $150,000 modified Adjusted Gross Income (MFJ), the ability to take the rental losses when not offset by passive income is gone.

What to do for rental cash flow:

For rental cash flow on a 1040, most lenders simply avoid both the bottom line number if looking at all rentals or Line 22 if they are looking at individual rentals. For individual rentals, you have two choices. All line numbers relate to the 2014 returns:

Bottom line approach:

• Start with Line 21 which is the net income or loss without limitations
• Add back depreciation and amortization
• Consider nonrecurring expenses if calculating recurring or projected cash flow
• Add back interest expense
• Treat debt as required by guidelines (Either subtract from rental cash flow or enter on your global debt payment list)

Top down approach:

• Add income on line 3 and 4
• Subtract expenses on Line 20
• Add back depreciation and amortization
• Consider nonrecurring expenses if calculating recurring or projected cash flow
• Add back interest expense
• Treat debt as required by guidelines (Either subtract from rental cash flow or enter on your global debt payment list)

What about newer rentals?

Your borrower may have a rental property that has been purchased since the latest tax return was prepared. Or perhaps it was purchased during that most recent year. You may not feel the tax return gives you sufficient history to count on for your projection. In that case, your guidelines may provide a formula instead. A common formula for residential rentals is 75% of scheduled rents for the cash flow available to pay debt. The 25% not counted allows for some vacancy and some operating costs.

Why watch for the word ‘deductible’?

There are several places in tax returns where the tax line starts with the word ‘deductible’. Besides the rentals, another one many lenders know about is ‘Deductible Meals and Entertainment’. One of the first things you learn is to double that line when you enter it into the borrower expenses if you are entering line-by-line (common with AgLenders for a farming operation). If you started with the bottom line of a business schedule, you likely subtract the deductible meals. This is because, generally, only half is deductible. The business spent twice what they have listed.

The clue is the word deductible. If it was the entire amount of the expense or loss, they would not need to use that word.

More on the cash flow analysis of rental owners

Need to ‘cash flow’ individual borrowers or business loan guarantors when rentals are in the mix? Here is the preview from the online module on rental properties.

1040 Schedule E Rentals Preview from Linda Keith.

See this and other online self-study modules on global tax return analysis for businesses, business owners, the wealthy, complex borrowers and farming operations at Lenders Online Training. The 30-minute-or-less modules are available as a stand-alone self-study mini-course, as part of a full list of modules or as a participant in our virtual training. Check it out.