Donald J. Trump’s tax saga illustrates the tax benefits available to people who qualify as “real estate professionals.” This includes anyone who spends over half of their work time (at least 751 hours per year) working as a real estate developer, broker, builder, landlord, or property manager. To understand how Trump managed to turn a $916 million loss into a tax benefit that may have helped him avoid any federal income tax liability for almost two decades requires a little background on a somewhat obscure tax rule.
Under IRS rules, most people can only deduct losses from real estate investments (passive losses) from real estate income (passive income). This is because of a tax law that went into effect in 1986 limiting taxpayers’ ability to deduct losses from real estate investments from other non-real estate income, such as salary from a job. Prior to that time, wealthy investors used real estate tax shelters to create enormous paper tax losses, which they used to offset their other income. The IRS decided to put an end to this type of abuse by capping at $25,000 the amount of real estate investment losses (passive losses) that most taxpayers could deduct in one year. For taxpayers with incomes over $100,000, the $25,000 maximum deduction is phased out, and taxpayers with incomes over $150,000 can't deduct any passive losses at all.
Real estate professionals are not subject to these passive loss restrictions. They can deduct their real estate losses from any income without limit, provided that they “materially participate” in the real estate business. Trump, who undoubtedly qualifies as a real estate professional, appears to have benefitted enormously from this rule. According to the New York Times, copies of state tax returns show that in 1995 he claimed a $916 million net operating loss (NOL). Because of his status as a real estate professional, Trump could have used this $916 million NOL to offset his taxable income from any source, including his television show, licensing his name, and all his other real estate and non-real estate ventures. Under these IRS rules, he could have paid no tax at all for as many as 18 years (under the law in effect at the time, an NOL could be carried forward 15 years and back three years). However, since Trump has not released his full tax returns, no one (other than Trump) knows for sure how much tax he has or hasn’t paid.
While NOLs are common, few individual taxpayers have ever had an NOL as large as Donald Trump’s. In 1995, for example, over 550,000 individual taxpayers used the same tax provision to claim an NOL but the average loss was $97,600. Trump’s NOL amounted to almost 2% of the total NOLs taken by all taxpayers that year.
Just how Donald Trump suffered a stupendous $916 million tax loss is not entirely clear. But it likely stemmed primarily from disastrous real estate investments he made in the early 1990s in Atlantic City casinos and hotels, as well as the Plaza Hotel in New York City. Trump owned these properties through limited liability companies (LLCs) or limited partnerships. Losses (or gains) incurred on property owned by a pass-through entity like an LLC or limited partnership are claimed on the personal returns of the entity’s owners. Thus, Trump’s property investment losses passed though directly from his LLCs and partnerships to his personal tax return. Then, unlike most taxpayers who would only be able to offset those losses against real estate income, Trump could use those losses to offset income from any activity because of his status as a real estate professional.
It appears that everything Trump did was legal. And that may be the most troubling thing about it.