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Module 29Tax Motivated Investments
and Loss Limitations
MenuTax shelter activities
The passive activity limitations
Loss limitations associated with vacation homes
Anatomy of a tax shelter: residential real estate
Anatomy of a tax shelter: low-income housing investment
Tax Shelter Activities: An Introduction
Key Learning Objectives (1)Key Learning Objectives (1)
Definition of a tax shelterDefinition of a tax shelter The goals of a good tax shelterThe goals of a good tax shelter §6111 registration requirements§6111 registration requirements §6707 & §6708 penalties related to registration§6707 & §6708 penalties related to registration
Definition of aTax Shelter
Minimize the tax effects of the income tax Minimize the tax effects of the income tax Generates significant tax losses as a result Generates significant tax losses as a result
of the allowable deductions associated with of the allowable deductions associated with the investmentthe investment
§6111 Registration Requirements
A tax savings to investment cost ratio of A tax savings to investment cost ratio of more than two to one, and more than two to one, and
The offering is (a) treated as a security The offering is (a) treated as a security regulated by law, or (b) exempted from regulated by law, or (b) exempted from regulations but has five or more investors or regulations but has five or more investors or will initially attract investments exceeding will initially attract investments exceeding $250,000$250,000
§6707 and §6708 Registration Penalties
§6707§6707(a) (a) organizer's failure to organizer's failure to register a shelter register a shelter
§6707§6707(b)--failure to furnish(b)--failure to furnish a registration number a registration number
§6708--organizer's failure to retain §6708--organizer's failure to retain list of investors list of investors
The Goals of a Good Tax Shelter
Deferral of taxation Deferral of taxation Conversion of Conversion of
ordinary income ordinary income into capital gaininto capital gain
§6700 and §6701 False Statement Penalties
§6700--organizer furnishes false statements§6700--organizer furnishes false statements §6700--organizer furnishes gross §6700--organizer furnishes gross
overvaluation statementovervaluation statement §6701--aiding and abetting understatement §6701--aiding and abetting understatement
of tax liability of tax liability
Tax Shelter Activities: An Introduction
Key Learning Objectives (2)
The sham transaction doctrine as a weapon The sham transaction doctrine as a weapon against tax sheltersagainst tax shelters
§6700 & §6701 penalties related to false §6700 & §6701 penalties related to false statementsstatements
§7408 injunctive relief§7408 injunctive relief
The Sham Transaction Doctrine
The transaction was entered into primarily The transaction was entered into primarily for tax avoidance andfor tax avoidance and
No economic substance, (no possibility of No economic substance, (no possibility of profit) profit)
§7408 Injunctive Relief
Empowers IRS to seek civil action in Empowers IRS to seek civil action in District Court that would District Court that would enjoinenjoin any person any person from further engaging in conduct subject to from further engaging in conduct subject to §6700 or §6701 §6700 or §6701
Promoters can be shut down much quicker Promoters can be shut down much quicker under this procedure under this procedure
The Passive Activity Limitations: A Closer Look
Key Learning Objectives (1)Key Learning Objectives (1)
The passive activity limitations (PALS)The passive activity limitations (PALS) Identifying an activityIdentifying an activity The active basket and material participationThe active basket and material participation The The portfolioportfolio basket basket Legislative curbs on tax shelters: an overviewLegislative curbs on tax shelters: an overview
Passive Activity Rules
Loss limit rule applies to individuals, estates, trusts, closely held C corporations, and personal service corporations
All items of income or loss classified as ActiveActive Portfolio, orPortfolio, or PassivePassive
General Rule
Passive losses offset only passive income Suspended losses carried forward
Active Basket
Wages and salaries Profit/loss from trade or business in which
taxpayer materially participates Gain/loss from sale of active business assets
Material Participation(Dirty Hands)
Regular Continuous Substantial Extremely complex rules
Portfolio Basket
Interest Dividends Annuities Royalties Gain/loss from sale of portfolio assets
The Passive Activity Limitations: A Closer Look
Key Learning Objectives (2)
The passive basket Applying the passive activity limitations Real estate exceptions to the passive loss
limitations Passive activity credits Disposition of passive activities
Passive Basket
Profit/loss from trade or business IF Taxpayer does not materially participateTaxpayer does not materially participate
Any rental activity, regardless of material participation
Passive Activity LimitationsPAL Rules
Record income/loss for each activity Net all activities If overall net income--report in full If overall loss--report zero net income Disallowed (suspended) losses
Carryover in full to next yearCarryover in full to next year Record by activity Record by activity
Compliance Query: PAL Rules (1)
What is AGI if the taxpayer has$500,000 of salary income and $500,000 of salary income and
Two passive businessesTwo passive businesses
ActivityActivity ActivityActivity
-A--A- -B- -B-
IncomeIncome 50,000 20,000
ExpenseExpense 25,000 30,000
Solution: Compliance Query: PAL Rules (1)
AGI is $515,000 Passive activities net as follows:
Activity Activity Netted
-A- -B-
Income 50,000 20,000 70,000
Expense 25,000 30,000 55,000
Net Inc 25,000 -10,000 15,000*
*When passive net >0,include in AGI
Compliance Query: PAL Rules (2)
What is AGI if the taxpayer has $500,000 of salary income and $500,000 of salary income and Two passive businessesTwo passive businesses
ActivityActivity ActivityActivity
-A--A- -B- -B-
IncomeIncome 50,000 20,000
ExpenseExpense 75,000 5,000
Solution--Compliance Query: AGI is $500,000
Passive activities net as follows:
Activity Activity Netted
-A- -B-
Income 50,000 20,000 70,000
Expense 75,000 5,000 70,000*
Net Inc -25,000 15,000 -0- *Can’t deduct >passive income
Passive Credits
Apply against tax from passive income only
Suspended credits carried forward Use or lose in year of disposition
Disposition of Passive Activities
In the year of dispositionIn the year of disposition In a fully taxable transactionIn a fully taxable transaction Suspended losses may be deducted against Suspended losses may be deducted against
any source of income any source of income
Transfers to Related Parties
Not Not a disposition of a passive activity a disposition of a passive activity
Exception for Qualified Real Estate Professional
>50% of personal services related To real estate trade or business andTo real estate trade or business and
>750 real estate related hours
Exception for Active Rental Real Estate
Up to $25,000 excess loss allowed Reduces active/portfolio incomeReduces active/portfolio income
Phase-out of $25,000 if AGI > 100,000AGI > 100,000 Lose 50¢ for each excess $Lose 50¢ for each excess $
Active participation required
The Active Participation Requirement
Own at least a 10% interestOwn at least a 10% interest By valueBy value
Not be a limited partner andNot be a limited partner and Demonstrate regular, continuous, and Demonstrate regular, continuous, and
substantial involvement substantial involvement
Compliance Query: Active Rental Exception
What is AGI if the taxpayer has $100,000 of salary income and $100,000 of salary income and Two passive businesses (A is active rental)Two passive businesses (A is active rental)
ActivityActivity ActivityActivity
-A--A- -B- -B-
IncomeIncome 50,000 20,000
ExpenseExpense 75,000 5,000
Solution--Compliance Query: AGI is $90,000
Passive activities net as follows:
Activity Activity Netted
-A- -B-Income 50,000 20,000 70,000
Expense 75,000 5,000 70,000*
Net Inc -25,000 15,000 -0-
Excess -10,000 -0-
ARE* -10,000
*ARE = active real estate exception
In Class Exercise: More Active Rental Exception
How does the answer to last Query change?How does the answer to last Query change? Case 1: Case 1:
Activity B is the active real estate rentalActivity B is the active real estate rental Case 2: Case 2:
Salary income is $140,000?Salary income is $140,000? Activity A is the active real estate rentalActivity A is the active real estate rental
Solution--In Class Exercise: More Active Rental Exception
Case 1: AGI = 100,000Case 1: AGI = 100,000 The excess loss is not from active rentalThe excess loss is not from active rental It must be suspendedIt must be suspended
Solution--In Class Exercise: More Active Rental Exception
Case 2: AGI = 135,000Case 2: AGI = 135,000 AGI is over 100,000AGI is over 100,000
Exception must be phased outException must be phased out Lose (140,000-100,000) x .5 of $25,000Lose (140,000-100,000) x .5 of $25,000 Only 5,000 of 25,000 exception remainsOnly 5,000 of 25,000 exception remains
Decedent’s Suspended Losses
Suspended losses are generally allowed on Suspended losses are generally allowed on a decedent's final tax returna decedent's final tax return
Deduction is reduced by any step-up in Deduction is reduced by any step-up in basis to FMVbasis to FMV
Gifts of Activities With Suspended Losses
Transfer by gift not a qualifying dispositionTransfer by gift not a qualifying disposition Losses are not allowable to either the donor Losses are not allowable to either the donor
or doneeor donee Donee’s basis is increased by the suspended Donee’s basis is increased by the suspended
lossloss
Tax Shelters in Residential Real Estate
Limited tax benefits are still available for Limited tax benefits are still available for the small investorthe small investor
Use of leveraging, depreciation, capital Use of leveraging, depreciation, capital gains, benefits of tax losses, positive cash gains, benefits of tax losses, positive cash flowsflows
$25,000 exception for PAL’s $25,000 exception for PAL’s
Loss Limitations Associated With Vacation Homes
Key Learning Objectives (1)Key Learning Objectives (1)
The basic rules of §280AThe basic rules of §280A Rule 1: De minimis rentalsRule 1: De minimis rentals Rule 2: Insignificant personal usageRule 2: Insignificant personal usage Rule 3: Significant personal usageRule 3: Significant personal usage
“Vacation Home”
To determine if rental is a vacation rental To determine if rental is a vacation rental COMPARE days of personal use to days COMPARE days of personal use to days ACTUALLYACTUALLY rented at FMV rented at FMV
Note: OA stands for “otherwise allowable” Note: OA stands for “otherwise allowable” deductions found on Schedule Adeductions found on Schedule A
Vacation Home?
THERE ARE 3 POSSIBLE OUTCOMESTHERE ARE 3 POSSIBLE OUTCOMES Exclude all income and non “otherwise Exclude all income and non “otherwise
allowable” expenses allowable” expenses Rental is a passive activity--see PAL rules Rental is a passive activity--see PAL rules Deduct Deduct
Expenses FOR AGI to zero out rental income Expenses FOR AGI to zero out rental income Excess otherwise allowable deductions FROM Excess otherwise allowable deductions FROM
AGIAGI
De Minimis RentalsDe Minimis RentalsExclude
If rented < 15 daysIf rented < 15 days Exclude all income and non-otherwise Exclude all income and non-otherwise
allowable expensesallowable expenses
Insignificant Personal UsageInsignificant Personal Usage Follow PAL Rules
If personal useIf personal use < 15 days < 15 days OROR < 10% of days rented at FMV < 10% of days rented at FMV
All income and expenses related to the All income and expenses related to the rental are passiverental are passive
Passive actively rules applyPassive actively rules apply Rental exception may be availableRental exception may be available
Significant Personal UsageZero Out AGI
If personal useIf personal use > 14 days > 14 days AND AND > 10% of days rented at FMV> 10% of days rented at FMV
All income is reported for AGIAll income is reported for AGI Expenses related to the rental (including Expenses related to the rental (including
OA's) are deductible FOR AGI but limited to OA's) are deductible FOR AGI but limited to amount of income generated by the rentalamount of income generated by the rental
Excess OA’s are deductible FROM AGIExcess OA’s are deductible FROM AGI
In Class Exercise: Rental or Vacation Home?
Discuss these cases in your groupsDiscuss these cases in your groups
CASECASE -A- -A- -B--B- -C--C- -D- -E--D- -E- RentedRented 300 300 200200 250250 10 75 10 75 UsedUsed 22 21 22 21 22 22 32 14 32 14 CASECASE -F- -F- -G--G- -H--H- -I- -J- -I- -J- RentedRented 100 100 200200 200200 300 300300 300 UsedUsed 13 14 13 14 22 22 29 36 29 36
Solution: In Class Exercise: Rental or Vacation Home?
De minimis rental Case: DCase: D
Insignificant personal usage (PAL) Cases: A, C, E, F, G, ICases: A, C, E, F, G, I
Significant personal usage Cases B, H, JCases B, H, J
Loss Limitations Associated With Vacation Homes
Key Learning Objectives (2)
Special considerations applicable to vacation homes
Expense allocation methods: the IRS vs. the courts
Carryovers of unused deductions
Special Issues
Ordering rule for deductions "Otherwise allowable""Otherwise allowable" Other allowable cash expendituresOther allowable cash expenditures DepreciationDepreciation
Personal use includes Rental < FMV to related party Rental < FMV to related party Donated use to charitable organizationDonated use to charitable organization
Expense Allocation MethodsWhy The Issue?
Total deduction FOR AGI limited to Total deduction FOR AGI limited to income from rent income from rent
Excess OA's can be deducted FROM AGIExcess OA's can be deducted FROM AGI Taxpayer would like to increase percentage Taxpayer would like to increase percentage
of deduction FOR AGI coming from items of deduction FOR AGI coming from items not OAnot OA
Expense Allocation MethodsWhat’s The Denominator?
365 days for interest and tax deductions Per the CourtsPer the Courts
Total number of days actually used for rental or personal usage Per the CodePer the Code Excludes any days the unit was vacantExcludes any days the unit was vacant
In Class Exercise:Expense Allocation Methods
What’s The Difference? Use the following facts to determine the Use the following facts to determine the
deduction for/from AGIdeduction for/from AGI
Rental incomeRental income 5,000 5,000 Interest and taxes Interest and taxes 15,000 15,000 RepairsRepairs 6,000 6,000 Days rented at FMVDays rented at FMV 100 100 Days of personal useDays of personal use 50 50
Solution--In Class Exercise:Expense Allocation Methods
What’s The Difference?Per the CourtsPer the Courts
% = 100 % = 100 ÷ 365 = .274365 = .274
For AGIFor AGI
IncomeIncome 5,0005,000
Less InterestLess Interest 4,1104,110
RepairsRepairs 990 990
Net IncomeNet Income 0 0
From From AGIAGI 15,000 - 4,110 15,000 - 4,110
Per the IRSPer the IRS
% = 100 % = 100 ÷ 150 = .333150 = .333
For AGIFor AGI
IncomeIncome 5,0005,000
Less InterestLess Interest 5,0005,000
RepairsRepairs 0 0
Net IncomeNet Income 0 0
From From AGIAGI 15,000 - 5,000 15,000 - 5,000
Carryovers of Unused Deductions
OA s used in full, either for or from AGI, OA s used in full, either for or from AGI, so no carryover issueso no carryover issue
Depreciation, repairs, etc. carryoverDepreciation, repairs, etc. carryover Cannot be used to create a lossCannot be used to create a loss
Anatomy of a Tax Shelter: Residential Real Estate
Key Learning Objectives (1)Key Learning Objectives (1)
Tax shelters in residential real estateTax shelters in residential real estate Analysis of a typical residential real estate Analysis of a typical residential real estate
investmentinvestment The benefits of leveragingThe benefits of leveraging
Anatomy of a Tax Shelter: Residential Real Estate Key Learning Objectives (2)
Comparing taxable income (loss) with net Comparing taxable income (loss) with net cash flowscash flows
Impact of the passive activity limitationsImpact of the passive activity limitations Incorporating the effects of liquidating the Incorporating the effects of liquidating the
investmentinvestment Summary: the tax advantages of residential Summary: the tax advantages of residential
real estatereal estate
Anatomy of a Tax Shelter: Low-Income Housing Investment
Key Learning Objectives (1)Key Learning Objectives (1)
Investments in low-income housing tax Investments in low-income housing tax credit projectscredit projects
Project description: qualified units and Project description: qualified units and financing termsfinancing terms
Project description: project rents and equity Project description: project rents and equity requirementsrequirements
Anatomy of a Tax Shelter: Low-Income Housing Investment
Key Learning Objectives (2)Key Learning Objectives (2)
Projected cash flowsProjected cash flows Disposition of the project in year 16Disposition of the project in year 16 Assessing the impact of the passive activity Assessing the impact of the passive activity
limitationslimitations