CH 14 Passive Activity Rules

Question 1

The passive activity loss rules do not apply to publicly held corporations.

a. True b. False

Answer 1

a. True

Question 2

A taxpayer who dedicates 400 hours to an activity is presumed to materially participate in that activity.

a. True b. False

Answer 2

b. False

Question 3

If grouped, passive activity limits apply on a group, rather than a per-unit, basis.

a. True b. False

Answer 3

a. True

Question 4

A taxpayer may deduct losses on an investment up to 150% of the taxpayer’s basis in that investment.

a. True b. False

Answer 4

b. False

Question 5

Nonrecourse debt does not increase a taxpayer’s maximum allowable loss for a given investment.

a. True b. False

Answer 5

a. True

Question 6

At-risk limitations are computed separately for each passive activity owned by a taxpayer.

a. True b. False

Answer 6

a. True

Question 7

Excess passive activity losses are deductible against other income.

a. True b. False

Answer 7

b. False

Question 8

If a taxpayer meets one of the six exceptions for rental activities, they do not have to meet the material participation test.

a. True b. False

Answer 8

b. False

Question 9

An individual taxpayer who actively participates in rental real estate activities and meets certain other qualifications may deduct up to $25,000 of losses against non-passive income.

a. True b. False

Answer 9

a. True

Question 10

Active participation is a higher standard than material participation.

a. True b. False

Answer 10

b. False

Question 11

Doug and Carrie are owners in NurseStat, LLC a staffing agency for nurses. They operate the business on a part-time basis. Doug puts in about 20 hours per week and Carrie puts in about 25 hours per week. Although they are married, they file married filing separately.

Which of the following is true?

Only Doug is considered a material participant.

Only Carrie is considered a material participant.

Both Carrie and Doug are considered material participants.

Neither Carrie nor Doug is considered a material participant.

Answer 11

Both Carrie and Doug are considered material participants.

Rationale

For married taxpayers, the participation of both spouses may be combined when calculating the number of hours necessary to meet the material participation tests.

Unlike most other provisions in the IRC, the hours of involvement by the spouse may be used to determine material participation even if the couple files separately for income tax purposes.

They are material participants in the enterprise with 2,340 hours between them.

Question 12

Donny died owning a 15 percent interest in EngraveIt, LLC, a local trophy engraving shop. At his death, his basis in the business was $800,000, and he had suspended losses of $600,000. The fair market value of his interest in the business was $950,000 at the time of his death.

What is Donny’s suspended loss deduction on his final income tax return?

$0.
$150,000.
$450,000.
$600,000.

Answer 12

$450,000.

Rationale

The suspended loss deduction on Donny’s final income tax return is calculated by reducing the suspended loss ($600,000) by the amount of the step-up in basis, or $150,000 ($950,000 - $800,000).

Question 13

Deacon is a 20 percent limited partner in DreamOn, LP a local spa. Deacon invested $105,000 in DreamOn. During DreamOn’s first two years of business the total losses were $300,000 in Year 1 and $200,000 in Year 2.
If the total business loss for the current year is $100,000 what is Deacon’s suspended loss due to at risk rules for the current year?

$0.
$5,000.
$15,000.
$100,000.
Confidence o

Answer 13

15,000.
Rationale

Deacon has $15,000 suspended due to the at-risk rule.

His at-risk amount at the beginning of this year was $5,000 ($105,000 - $60,000 in Year 1 - $40,000 in Year 2).

His allocated loss for Year 3 is $20,000. Therefore, $15,000 will be suspended under the at-risk rules because he only has $5,000 at risk.

Question 14

Maureen is a 12 percent owner in SoccerStart, LLC a coaching service for young soccer players. She is also a 15 percent owner in HandsOn, LLC a successful chain of nail salons. Maureen does not materially participate in either business. Her at-risk and loss/income for the current year is as follows:

• SoccerStart – At-risk = $150,000; Loss of $250,000
• HandsOn – At-risk = $25,000; Income of $100,000

Maureen also has wage income of $50,000 and capital gain income of $20,000. Which of the following statements is true?

The loss suspended because of the at-risk rules is $75,000 and the loss suspended because of the passive loss rules is $75,000.

The loss suspended because of the at-risk rules is $75,000 and the loss suspended because of the passive loss rules is $0.

The loss suspended because of the at-risk rules is $50,000 and the loss suspended because of the passive loss rules is $100,000.

The loss suspended because of the at-risk rules is $100,000 and the loss suspended because of the passive loss rules is $50,000.

Answer 14

The loss suspended because of the at-risk rules is $100,000 and the loss suspended because of the passive loss rules is $50,000.

Rationale

of the $250,000 loss from SoccerStart $100,000 will be suspended because of the at-risk rules (she only has $150,000 at risk) and

$50,000 will be suspended because of the passive loss rules (she only has $100,000 of passive income).

Question 15

Which of the following is true regarding real estate activities?

Real estate activities are always passive.

An individual investor in rental real estate can always consider their real estate activities as active businesses.

Closely held C corporations that participate in real estate activities will always be considered active businesses.

Real estate professionals may be allowed to consider their real estate activities as active in some circumstances.

Answer 15

Real estate professionals may be allowed to consider their real estate activities as active in some circumstances.

Rationale

Real estate activities are generally passive, but exceptions do apply. An individual investor in rental real estate will be subject to the passive income rules; however, some exceptions apply. Closely held C corporations are also eligible if more than 50% of the gross receipts of the corporation are derived from real property trades or businesses in which the corporation materially participates.

Question 16

Norman Jean is a 10 percent owner in HKAccounting, LLC, a review company for the CPA exam. She is also a 20 percent owner in MyPuppy, LLC a rescue organization for dogs. She does not materially participate in either company. Her at-risk and loss/income for the current year is as follows:

• HKAccounting – At-risk = $800,000; Income of $150,000
• MyPuppy – At-risk = $200,000; Loss of $350,000

Norman Jean also has wage income of $75,000. How much of the loss can she write off in the current year?

$150,000.
$200,000.
$225,000.
$350,000.

Answer 16

$150,000.
Rationale

Norman Jean’s actual loss deduction is $150,000. Of the $350,000 loss from MyPuppy, $150,000 will be suspended because of the at-risk rules (she only has $200,000 at risk). Of the $200,000 that is potentially deductible after applying the at-risk rules, $50,000 will be suspended because of the passive loss rules (she only has $150,000 of passive income).

Question 17

Which of the following is not considered passive income?

Annuity payments.
Rental activities.
Real estate activities.
A limited partner’s distributive share of partnership income.

Answer 17

Annuity payments.
Rationale

Annuity payments are portfolio income. Rental and real estate activities are passive income unless an exception applies. A limited partner’s distributive share of partnership income is passive income.

Question 18

Omar is the owner and manager of RUActive Bike Rental, LLC. RUActive rents bicycles to tourists at a resort that helps individuals lose weight. Most customers stay at the resort for two weeks, therefore, most bike rentals are for a period of 12 days. Omar and his spouse are the only two workers at the rental location.

of the following is true for Omar?

The activity is passive because it is a rental activity.

The activity is active because the average rental period is less than 14 days.

The activity is active because the average rental period is 30 days or less and Omar provides significant personal services.

The activity is active because the rental period is inconsequential.

Answer 18

The activity is active because the average rental period is 30 days or less and Omar provides significant personal services.

Rationale

The activity is active because Omar meets one of the rental activity exceptions - the average rental period is 30 days or less and Omar provides significant personal services.

Question 19

Dion is an individual investor in rental real estate. He actively participates in the activity. His AGI is $125,000 for the current year and the rental real estate business had a loss of $30,000.

What is Dion’s available loss against ordinary income assuming he has the required amount at risk?

$0.
$12,500.
$15,000.
$30,000.

Answer 19

$12,500.

Rationale

Individual investors are allowed a loss of $25,000 against ordinary income. However, this amount is phased out between $100,000 - $150,000. Since Dion’s AGI is midway between the two points – he is only entitled to a loss of $12,500 against ordinary income. The rest is suspended under the passive activity rules.

Question 20

Keke owns a 10 percent interest in CreativeWorks, LLP. Keke originally invested $500,000 and has personally taken losses from the partnership of $200,000.

The partnership took out a nonrecourse loan of $800,000.

What is Keke’s at-risk amount?

$300,000.
$500,000.
$1,100,000.
$1,300,000.

Answer 20

$300,000.

Rationale

Keke’s at-risk amount is the amount she invested less the losses she has taken – $300,000 ($500,000 – 200,000).

She does not get to increase her at-risk amount for the nonrecourse debt.

Question 21

Elton is a 20 percent owner in CheerSquad, LLC, a local gym for middle school and high school cheerleaders. The gym provides private coaches to help young cheerleaders learn stunts and improve their overall cheer performance. Elton does not materially participate. Elton contributed $200,000 initially. During the prior years he has been allocated $200,000 in income and $300,000 in losses. After a freak accident during the current year in which one of the cheerleaders was critically injured doing a stunt, the business lost many customers. The business allocated a $150,000 loss to Elton for the current year.

What is Elton’s suspended loss due to at-risk rules?

$0.
$50,000.
$100,000.
$150,000.

Answer 21

$50,000.

Rationale

Elton’s at-risk amount before the current year’s allocation is $200,000 contribution + $200,000 income - $300,000 in losses = $100,000 at risk.

Therefore, he will be able to utilize $100,000 of the current year’s loss against his remaining basis and $50,000 will be suspended due to at-risk rules.

Note that if this is his only activity, all losses otherwise deductible will be suspended under the passive activity rules.

Question 22

Brad, Tom, Katie, and Angelina are partners in MovieMakers, LLC. They all participate in the business to some extent and there are no other employees.
Given the following activities, which of these individuals are clearly material participants?

• Brad has a job outside of the business but does provide about 125 hours a year to help market the business.
• Tom devotes all of his time to the business and generally devotes 60 hours per week to the business.
• Katie has materially participated in the business for the last seven years, however she only dedicated about 50 hours this year because she had a baby in January.
• Angelina devotes very little time to the business and only helps on an as-needed basis. She rarely helps more than two or three hours per month.

Tom only.
Tom and Katie.
Tom and Brad.
Tom, Katie, Brad and Angelina.

Answer 22

Tom and Katie.
Rationale

Tom and Katie both meet one of the seven tests for material participation. It is unlikely that Brad and Angelina meet the “facts and circumstances” test. The seven tests for material participation are:
1. The taxpayer dedicates more than 500 hours of effort to the activity each year.
2. The taxpayer dedicates more than 100 hours to the activity, but no less than anyone else.
3. The taxpayer dedicates more than 100 hours to each of several activities, and more than 500 hour in total for those activities not including any activity for which they are a material participant.
4. The taxpayer is the only person substantially participating in the operation of the activity.
5. The taxpayer has materially participated in the activity for 5 out of the last 10 years.
6. If the activity is a personal service activity, the taxpayer has materially participated in that personal service activity for at least 3 years. A personal service activity includes any trade or business where capital is not a material income producing factor, and professional services (law, accountancy, medicine, engineering, performing arts, and the like).
7. The facts and circumstances surrounding the case indicate that the taxpayer has been regularly, continuously,
and substantially involved in the activity.

Tom meets rule 1 and Katie meets rule 5.

Question 23

Pauline purchased an interest in a publicly traded partnership with a current share of losses of $7,000.
If she also purchased a non-publicly traded partnership with $10,000 of passive income, how much of the passive loss can be used to offset income?

$0.
$3,000.
$5,000.
$7,000.

Answer 23

$0.
Rationale

The answer is zero

. Losses from publicly traded partnerships cannot be offset against income from non-publicly traded partnerships.

Question 24

Chuck and Tito are good friends. They decide to open a sports equipment store together because of their love of the outdoors. They each own 50 percent in SportsCrazy, LLC, which is taxed as a partnership. Chuck manages the business. Tito has a thriving tax practice and therefore does not participate in the operation of the business. Which of the following is true?

Only the income distributed to Chuck is considered passive income.

Only the income distributed to Tito is considered passive income.

The income distributed to both Chuck and Tito is considered passive income.

The income distributed to both Chuck and Tito is considered active income.

Answer 24

Only the income distributed to Tito is considered passive income.

Rationale

The distributive share of the partnership income that Chuck receives will be considered active income since Chuck materially participates in the conduct of SportsCrazy business.

Tito’s distributive share of the partnership income will be treated as passive income/loss since Tito is not materially participating in the conduct of the business activities.

Question 25

Ringo is a 15 percent owner in DesignCreative, LLC, a very successful web developing business. He is also a 15 percent owner in SafeHarbor, LLC, an internet-based virus protection service. Ringo materially participates in DesignCreative, but does not materially participate in SafeHarbor. His at-risk and loss/ income for the current year is as follows:

• DesignCreative – At-risk = $600,000; Income of $250,000
• Safe Harbor – At-risk = $75,000; Loss of $200,000

What amount of loss is suspended because of the passive activity income rules?

$0.
$75,000.
$125,000.
$200,000

Answer 25

$75,000.

Question 26

Arthur is a 10 percent owner in Bubbles, LLC, a local pub that specializes in serving caviar and champagne.

Which of the following will increase his amount at risk?

Arthur takes a cash distribution of income.
Arthur is allocated a business loss.
The business borrows nonrecourse debt.
The business borrows recourse debt.

Answer 26

The business borrows recourse debt.

Rationale

The borrowing of recourse debt will increase Arthur’s at-risk amount. The borrowing of nonrecourse debt typically increases basis in a partnership (or LLC taxed as a partnership), but does not increase the amount at risk. The distribution of income and the allocation of a loss will both decrease his basis and his at-risk amount.
Confidence of your answer

Question 27

In 20x1, Cindy invested $100,000 for a 25% interest in a limited liability company (LLC) involved in an activity in which she is a material participant. The LLC reported losses of $340,000 in 20x1 and $180,000 in 20x2 with Cindy’s share being $85,000 in 20x1 and $45,000 in 20x2.

How much of the losses can Cindy deduct?

A. $0 in 20x1, $0 in 20x2
B. $85,000 in 20x1, $0 in 20x2
C. $85,000 in 20x1, $15,000 in 20x2
D. $85,000 in 20x1, $45,000 in 20x2
E. None of the choices

Answer 27

C. $85,000 in 20x1, $15,000 in 20x2.

Cindy’s losses are not subject to the passive activity loss rules in either year because she is a material participant.

However, the at-risk rules limit her losses to $100,000 over the period ($85,000 in 20x1 and $15,000 in 20x2).

Question 28

Which of the following decreases a taxpayer’s at-risk amount?

A. Cash and the adjusted basis of property contributed to the activity.
B. Amounts borrowed for use in the activity for which the taxpayer is personally liable or has pledged as security property not used in the activity.
C. Taxpayer’s share of amounts borrowed for use in the activity that is qualified nonrecourse financing.
D. Taxpayer’s share of the activity’s income.
E. None of the choices

Answer 28

Solution: The correct answer is E.

Question 29

Sandra acquired a passive activity several years ago. Until 20x1, the activity was profitable. The activity produced losses of $100,000 in 20x1 and $50,000 in 20x2. Sandra had no passive income in 20x1 or 20x2.

How much is her suspended loss from the activity?

A. $90,000 from 20x1 and $50,000 from 20x2
B. $100,000 from 20x1 and $50,000 from 20x2
C. $0 from 20x1 and $0 from 20x2
D. None of the choices

Answer 29

Solution: The correct answer is B.

$100,000 is suspended from 20x1 and $50,000 is suspended from 20x2.

Question 30

Keke owns a 10 percent interest in CreativeWorks, LLP. She originally invested $500,000 and has personally taken losses from the partnership of $200,000. The partnership took out a nonrecourse loan of $800,000. What is Keke’s at-risk amount?

a. $300,000. b. $500,000. c. $1,100,000. d. $1,300,000.

Answer 30

The correct answer is a.

Keke’s at-risk amount is the amount she invested less the losses she has taken – $300,000 ($500,000 – 200,000).

She does not get to increase her at-risk amount for the nonrecourse debt.

Question 31

Elton is a 20 percent owner in CheerSquad, LLC, a local gym for middle school and high school cheerleaders. The gym provides private coaches to help young cheerleaders learn stunts and improve their overall cheer performance. Elton does not materially participate. Elton contributed $200,000 initially. During the prior years he has been allocated $200,000 in income and $300,000 in losses. After a freak accident during the current year in which one of the cheerleaders was critically injured doing a stunt, the business lost many customers. The business allocated a $150,000 loss to Elton for the current year.

What is Elton’s suspended loss due to at-risk rules?

a. $0. b. $50,000. c. $100,000. d. $150,000.

Answer 31

The correct answer is b.

Elton’s at-risk amount before the current year’s allocation is
$200,000 contribution
+ $ 200,000 income
- $ 300,000 in losses
= $ 100,000 at risk.

Therefore, he will be able to utilize $100,000 of the current year’s
loss against his remaining basis and $50,000 will be suspended due to at-risk rules. Note that if this is his
only activity, all losses otherwise deductible will be suspended under the passive activity rules.