Chapter 7

Deductions:Business/Investment Losses and Passive Activity Losses

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1. Abusive Tax Shelters2. At-Risk Rules3. Determining the Amount at Risk4. Additional Points on At-Risk Rules5. Passive Activity Loss Rules6. Applying the At-Risk and Passive Loss Rules7. Disposing of an Entire Passive Activity Interest8. Inheriting a Passive Activity9. Receiving a Passive Activity as a Gift10. Material Participation

Chapter 7 Exhibits

Chapter 7, Exhibit Contents A

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11. Significant Participation12. 6 Exceptions to Rental Activity Status13. Special $25,000 Allowance14. Real Estate Professionals15. Computing Business Casualty and Theft Losses16. Net Operating Losses—Rules for Individuals17. Hobby Losses18. Home Office Expenses19. Vacation Home Expenses20. Rented for More Than 14 Days

Chapter 7 Exhibits

Chapter 7, Exhibit Contents B

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Tax shelters provided deductions to investors in order to reduce tax liabilities with respect to income from other sources. 

Almost all tax shelters were formed as limited partnerships, which allowed losses to pass through to the individual’s tax return. (A limited partner is not personally liable for the debts of the partnership).

Typical tax shelters once provided high returns without necessarily making a before-tax profit.

Chapter 7, Exhibit 1a

Abusive Tax Shelters

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Example of Pre-1987 Tax Shelter

10 investors form "Pay-No-Tax," a limited partnership.

Each investor contributes $10,000, and the partnership purchases an office building.

The building never exceeds 50% occupancy.

Chapter 7, Exhibit 1b

Abusive Tax Shelters

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Abusive Tax SheltersAt 50% occupancy, the annual cash flows appear as follows:

Description LPEach of the 10 Partners

Rental income $ 70,000 $ 7,000

Operating expenses (40,000) (4,000)

Interest payments (90,000) (9,000)

Negative cash flow (60,000) (6,000)

Depreciation (100,000) (10,000)

Tax loss (160,000) (16,000)

Tax benefit from loss (70% tax bracket from 1965 – 1981) 112,000 11,200

Net cash [($60,000) + $112,000] $52,000 $ 5,200

Annual return on equity ($52,000/$100,000)

52% 52%

Chapter 7, Exhibit 1c

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The partnership had a $160,000 tax loss, which provided $112,000 of tax savings. ($160,000 * 70%)

The partnership only had a $60,000 cash loss.

Compared to the $112,000 tax savings, the partnership actually had a positive cash flow of $52,000.

($112,000 - $60,000)

Chapter 7, Exhibit 1d

Abusive Tax Shelters

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Congress passed the Code Sec. 465 at-risk rules in 1976. However, the at-risk rules did very little to curb abusive tax shelters.

The at-risk rules prevent taxpayers from deducting losses in excess of basis (i.e., amount at-risk).

At-Risk Rules—Background

Chapter 7, Exhibit 2

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Cash investment in an activity

+ Basis of other property invested

+ The activity's borrowings with investor personal guarantees or personal collateral.

+ Income allocation

– Loss allocation

– Withdrawals of cash or other property to investors at FMV

= Amount at risk

Determining the Amount at Risk

Chapter 7, Exhibit 3

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Ordinarily, an investor is not at risk for nonrecourse loans (loans secured by the property purchased, rather than the personal assets of the borrower).

However, Congress permitted “qualified” nonrecourse loans to be treated as “at-risk” if they were secured by their activity's real property.

Generally, nonrecourse secured loans from S & Ls, banks, insurance companies, and federal, state, and local governments are considered to be at-risk.

Additional Points on At-Risk Rules

Chapter 7, Exhibit 4

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Passive Activity Loss Rules

Effective January 1, 1987, passive activity loss rules were enacted, which eliminated most tax shelters.

Generally, passive losses can only offset passive income. Any disallowed losses are treated as a deduction to the activity next year.

Suspended losses can be deducted against passive and nonpassive income upon the fully taxable disposition of the entire interest.

Chapter 7, Exhibit 5a

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The PAL rules generally provide that all income and loss must be placed in one of three categories:

Active – income attributed to direct efforts of the taxpayer (ex. salary, wages and commissions).

Passive – income derived from passive activities. Losses are generally only deductible against passive income.

Portfolio - income from dividends, interest, royalties.

Chapter 7, Exhibit 5b

Passive Activity Loss Rules

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Applying the At-Risk and Passive Loss Rules

1. Determine the amount at-risk for each activity.

2. Determine the gain/loss for each activity for the year.

3. If gain, increase the amount at-risk.

4. If loss, decrease the amount at-risk, but not below zero. Any excess losses are carried over.

Chapter 7, Exhibit 6a

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Applying the At-Risk and Passive Loss Rules

5. Add up passive gains.

6. Add up passive losses (reduce by amounts carried over).

7. Reduce passive gains by passive losses. Include net passive gain in gross income.

8. Any excess passive losses are suspended and can be used in future years to offset passive income

Chapter 7, Exhibit 6b

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Disposing of an Entire Passive Activity Interest

Three rules apply:

1. Losses. Loss on an “entire” disposition of a passive activity and its suspended losses can offset active and portfolio income from all activities.

2. Gains. Gain on an “entire” disposition of a passive activity can be used to offset suspended passive activity losses from other passive activities.

3. Unrelated parties. The disposition must be to an unrelated party (i.e., a party other than half-blood relatives, lineal descendants, ancestors, siblings, and spouses).

Chapter 7, Exhibit 7

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Inheriting a Passive Activity

Three rules apply:

1. Beneficiary's step-up basis. Beneficiary gets a step-up basis at fair market value (FMV) on the date of benefactor's death (or, if elected by executor, FMV six months after the date of death.)

 2. Beneficiary's at-risk amount. The step-up basis becomes “at risk” to the

beneficiary.

3. Decedent's passive loss deduction. In the decedent's final income tax return, suspended losses are deductible to the extent they exceed the “step-up” amount i.e., to the extent they exceed (FMV at date of death - Adjusted basis at date of death). 

Chapter 7, Exhibit 8

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Receiving a Passive Activity as a Gift

Two rules apply:

 

1. Donee basis. Donee does not receive a step-up basis, but the donee assumes the donor's basis (in most cases).

 

2. Donor's suspended losses. The donor's suspended losses are not deductible; instead, they’re added to the donee's basis.

Chapter 7, Exhibit 9

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Material Participation

An activity in which a taxpayer materially participates is not a passive activity.

However, real estate rental activities are generally considered passive regardless of the level of participation.

Material participation requires a taxpayer to be involved in the operations of the activity on a regular, continuous and substantial basis. Must meet 1 of 7 tests.

Chapter 7, Exhibit 10

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Significant Participation

Significant participation requires more than 100 hours of participation.

If total participation in all significant participation activities exceeds 500 hours, then the taxpayer is treated as having materially participated in all such activities.

Chapter 7, Exhibit 11

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6 Exceptions to Rental Activity Status

Generally, any rental activity is considered a passive activity, without regard to material participation. However, if any of the following 6 tests are met, the activity is not considered a rental activity.

1. Under 8-day average rental. Average customer use is 7 days or less (e.g., hotel rooms, movie rentals).

2. 8–30 days average rental plus significant services. Average customer use is 8 to 30 days and “significant” personal services are provided to the customers (e.g., computer leasing, automobile leasing).

3. Over 30-day average rental and extraordinary services. Average customer use is over 30 days and “extraordinary” personal services are provided to customers (e.g., lengthy hospitals stays).

Chapter 7, Exhibit 12a

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4. Insignificant rental. Gross rental income is less than 2% of the lesser of (1) fair market value of the rental asset or (2) the adjusted basis of the rental asset (e.g., renting a small portion of a vast timberland to a farmer)

5. Property is available during defined business hours for nonexclusive use by the general public (e.g., operating a golf course available during prescribed business hours for nonexclusive use).

6. Property is rented to a non-rental activity owned by the lessor.

Chapter 7, Exhibit 12b

6 Exceptions to Rental Activity Status

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Special $25,000 Allowance

An taxpayer may deduct up to $25,000 in rental real estate losses from non-passive income, as long as the taxpayer actively participates and MAGI is less than $100,000.

As long as a taxpayer participates in management decisions, he is considered to be actively participating. Additionally, the taxpayer must own at least a 10% interest in the property and not be a limited partner.

Chapter 7, Exhibit 13a

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The $25,000 allowance is available for all filing statuses. However, for married filing separately (and living apart), the allowance is $12,500. Married individuals who file separately and do not live apart cannot qualify for any of the $25,000 deduction.

There is a phaseout of 50% for every dollar of MAGI over $100,000. The allowance is fully phased-out if MAGI is over $150,000

Chapter 7, Exhibit 13b

Special $25,000 Allowance

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Real Estate Professionals

Over 750 hours a year are devoted to a real estate business, AND

Over 50% of the taxpayer's personal services for the year are devoted to a real estate business, AND

One of the 7 material participation tests is satisfied.

If all 3 of the above tests are met, losses from rental real estate activities will not be subject to passive loss limitations.

 Example: A full-time real estate agent owns and manages a rental house. Any losses from the rental house are nonpassive losses.

Chapter 7, Exhibit 14

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Computing Business Casualty and Theft Losses

If total destruction or theft:

Adjusted Basis

If partial destruction:Lesser of

Adjusted Basis or Decline in Fair Market Value

LessInsurance reimbursement or compensation received

Result: = “Recognized” gain or loss FOR AGI

*Gain is recognized to the extent that insurance reimbursements exceed adjusted basis.

Chapter 7, Exhibit 15

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Net Operating Losses—Rules for Individuals

Carryovers:

NOLs from tax years beginning on or before 8/5/97:

NOLs other than from casualty deductions from tax years beginning after 8/5/97:

NOLs attributable to personal-use casualty and theft losses:

 

3 years back, 15 years forward

 2 years back, 20 years forward 

3 years back, 15 years forward

NOL = Bus. Income - Bus. Exp. - Personal Use Casualty Loss Deductions

Chapter 7, Exhibit 16a

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If carried back: The earliest year’s taxable income is recomputed, and the taxpayer files for a refund with an amended return.

If carried forward: Deduction for AGI in a subsequent year.

Election: May elect to forego carrybacks. This election must be made when the return reporting an NOL is timely made.

Chapter 7, Exhibit 16b

Net Operating Losses—Rules for Individuals

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Hobby Losses

Hobby expenses are deductible only to the extent of hobby income.

The deduction for hobby expenses is a miscellaneous itemized deduction subject to the 2% of AGI floor.

Expenses that are otherwise deductible (such as taxes, interest and casualty losses) are still deductible, regardless of the amount of hobby income. However, such deductions reduce the amount of hobby income available to offset other hobby deductions.

Chapter 7, Exhibit 17

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Home Office Expenses

If a portion of a personal residence is used for business-related activities, expenses allocable to the business-use portion of the home may be deducted.

If a taxpayer is an employee, the home office must be for the convenience of the employer.

Any excess expenses that are not deducted in the current year may be carried forward.

If the taxpayer is an employee, the deduction is a miscellaneous itemized deduction (except for mortgage interest and property taxes, which are fully deductible).

Chapter 7, Exhibit 18

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Vacation Home Expenses

If property is rented for less than 15 days, then home is treated as a personal residence. No rental income or expenses are reported. Regular deductions for personal residences are allowed (mortgage interest, property taxes).

If property is rented for more than 14 days, then the property can be treated as either:

1. Personal residence ( if used excessively for personal purposes)

2. Rental property (not used excessively for personal purposes)

Chapter 7, Exhibit 19

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Rented for More Than 14 Days Excessive personal use is measured by the greater of 14 days

or 10% of rental days. If the taxpayer uses then property for excessive personal

purposes, then the property is considered personal use property. Rental income and expenses are reportable. However, loss deductions are not allowed.

If the taxpayer does not use the property for excessive personal purposes, then the property is considered rental property. Losses can be deducted for AGI (subject to passive activity rules). If the taxpayer actively participates, the $25,000 special allowance applies.

Chapter 7, Exhibit 20