The $25K Special Loss Allowance - Tax Strategy For AGI Below $100000

Inflation affects everything, from the cost of living to investment returns. Yet, some critical tax deductions and allowances remain stuck in the past, untouched by inflation adjustments. One glaring example is the $25,000 special loss allowance for real estate investors. Despite being established decades ago, this allowance has never been adjusted for inflation. In this post, we'll delve into what the $25K special loss allowance is, how it's currently affecting real estate investors, and why adjusting it for inflation could bring much-needed relief.

Understanding the $25K Special Loss Allowance

The $25,000 special loss allowance, introduced in 1986, was part of the IRS's broader initiative to limit passive loss deductions. This allowance allowed taxpayers with an adjusted gross income (AGI) below $100,000 to offset up to $25,000 of passive real estate losses against non-passive income like W-2 wages. This provision was particularly beneficial for those who didn’t qualify as real estate professionals but still incurred passive losses from their investments.

However, the figure of $25,000 has remained unchanged since 1986. If it were adjusted for inflation using the Consumer Price Index (CPI), that amount would be around $69,675 today. This static threshold significantly diminishes the allowance’s effectiveness in the current economic climate.

For taxpayers who are Married Filing Jointly (MFJ), the income limits to qualify for the $25,000 special loss allowance remain the same as those for individual filers:

1. Adjusted Gross Income (AGI) or Modified Adjusted Gross Income (MAGI) Thresholds:

   • For Married Filing Jointly, to qualify for the full $25,000 special loss allowance, the combined Modified Adjusted Gross Income (MAGI) of both spouses must be $100,000 or less.
   • If your combined MAGI is between $100,000 and $150,000, the special loss allowance begins to phase out. Specifically, for every $2 of combined income above $100,000, the allowable deduction is reduced by $1.
   • If your combined MAGI reaches $150,000 or more, you are no longer eligible for the $25,000 special loss allowance.

2. Phase-Out Calculation Example for Married Filing Jointly:

   • Suppose a married couple filing jointly has a combined MAGI of $130,000. This amount is $30,000 above the $100,000 threshold.
   • The excess amount ($30,000) is divided by 2, resulting in a $15,000 reduction in the special loss allowance.
   • Therefore, the couple would be eligible to deduct only $10,000 ($25,000 - $15,000) against their non-passive income.

3. No Allowance Above $150,000 MAGI for Married Filing Jointly:

   • If the combined MAGI for a married couple filing jointly is $150,000 or more, the $25,000 special loss allowance is completely phased out, and no passive real estate losses can be used to offset non-passive income.

Real-Life Impact: What Would an Inflation Adjustment Mean?

Investor A owns several rental properties and generates passive losses of $70,000 annually. Under the current law, only $25,000 of these losses can be used to offset non-passive income. This limitation results in higher taxable income and a greater tax burden. 

Now, if the $25K special loss allowance were adjusted for inflation to approximately $70,000, Investor A could offset nearly all passive losses against their income, leading to substantial tax savings. This adjustment could free up more capital for reinvestment or personal use, providing a significant financial cushion.

The Broader Case for Inflation Adjustments

The $25,000 special loss allowance isn't the only provision suffering from inflation neglect. Other tax rules, such as the Section 121 home sale exclusion, business gift deductions, and startup cost deductions, have also remained static for years.

• Section 121 Home Sale Exclusion: Currently set at $250,000 for single filers and $500,000 for married couples, this exclusion has not been adjusted since 1997. Adjusting it for inflation would increase these amounts to approximately $477,500 and $955,000, respectively.
• Business Gift Deduction: Set at $25 per recipient since 1954, this deduction would be about $285 today if adjusted for inflation.
• Startup Cost Deduction: Currently capped at $5,000, adjusting for inflation would raise it to about $8,100.

The Dark Side of Inflation Adjustments

It's essential to consider that adjusting thresholds for inflation could have mixed effects. For example, the criteria to qualify as an accredited investor have remained unchanged for decades. If these were adjusted for inflation, the income threshold for a single filer would jump to $634,000, and for a married couple, it would rise to $951,000. The net worth requirement would increase from $1 million to over $3 million, drastically reducing the number of individuals eligible for certain investment opportunities.

While adjusting these allowances and deductions for inflation seems logical, it's not without challenges. For one, increasing these thresholds could reduce government revenue, potentially impacting public services and other budget priorities. Additionally, some lawmakers might resist changes due to concerns over budget deficits or economic implications.