Chapter 11 Flashcards
Limitations on “Passive Activity” and “Excess Business” Losses
passive activity
A passive activity may be generally defined as a trade or business in which the taxpayer does not “materially participate.”
Material Participation
A taxpayer will be treated as having material participation in an activity only if the taxpayer is involved in the operations of the activity on a regular, continuous, and substantial basis.
Material Participation
A taxpayer will be treated as having material participation in an activity only if the taxpayer is involved in the operations of the activity on a regular, continuous, and substantial basis.
Closely Held Corporation
A corporation is a “closely held” corporation for purposes of the passive loss limitations if more than 50 percent of the value of its outstanding stock is owned by five or fewer individuals at any time during the last half of the corporation’s taxable year.
Categories of Income
The passive activity rules require that taxpayers classify their income into three general categories:
• portfolio income
• active income
• passive income
Portfolio Income
Portfolio income includes dividends, interest, royalties, income from annuities, and the gain or loss realized from the disposition of property that generates portfolio income for the taxpayer. It would also include gain or loss realized from the disposition of property held for investment, even if the property was not income producing. Portfolio income does not include any income generated in the conduct of a business.
Rental Activities
The general rule for rental activity is that such activity is treated as a passive one regardless of the taxpayer’s participation. However, there is an exception for taxpayers who essentially work full-time in the real property trade or business. If the taxpayer performs more than 750 hours of service during the taxable year in a real property trade or business, and that participation represents more than one-half of the total hours of service provided by the taxpayer for active businesses during the year, then the rental activities for that taxpayer are not automatically treated as passive activities.
The “Active Participation” Exception
Even though rental activities are generally classified as passive, there is an important exception for rental real estate activities known as the “active participation” exception.
To meet the standard of active participation, a taxpayer must own at least a 10 percent interest in the rental real estate and must also actively participate in the rental activity. However, the strict standard of material participation need not be met in order to qualify under the active participation standard.
Qualifying taxpayers may deduct up to $25,000 per year of net losses from the real estate activity against their active or portfolio income if the active participation standard is met. If the taxpayer’s adjusted gross income (AGI) with certain modifications exceeds $100,000, the $25,000 allowance is reduced by 50 percent of the amount by which AGI exceeds $100,000.
Example 1
For 2018, Roger and Regina Retailer, a married couple filing jointly, have $2,000,000 of gross income from non-business sources and $1,400,000 in business losses from their partnership business which is not a passive activity. The Retailers are allowed to deduct $500,000 of the business loss against their $2,000,000 of gross income in 2018. The amount of the excess business loss is $900,000 ($1,400,000 less $500,000). This loss is to be carried forward to tax year 2019.
Example 2
For 2018, Chris, an unmarried individual, owns rental real estate. In 2018, he has a $400,000 allowable loss from his rental properties after considering the PAL rules. However, his excess business loss is $150,000 ($400,000 less $250,000). If Chris has no other business or rental activities, but has $500,000 of gross income from other sources, he can deduct the first $250,000 of his rental loss against his income from other sources. The $150,000 excess business loss is carried forward to Chris’s 2019 tax year and treated as an NOL carryforward for that year. Under the revised NOL rules, Chris can use the NOL carryforward to absorb up to 80% of his taxable income in the carryforward year.
If Chris’s 2018 rental property loss had been $250,000 or less, the entire loss would be deductible since there is no excess business loss.
Example 3
For 2018, John and Jane Smith, a married couple filing jointly have taxable wages of $1,000,000 and a net loss from their business ventures of $1,000,000, of which $250,000 represents a passive loss from rental activities where they are not material participants and $750,000 represents losses from active trades or businesses. The excess business losses will be $250,000 (aggregate deductions from trades or businesses of $750,000 over the sum of $0 aggregate gross income from such trades or business plus $500,000), and these losses are carried forward as an NOL to 2019. The Smiths will also have a passive loss carry-forward of 250,000 and a current year business loss deduction of $500,000. The Smiths will have an adjusted gross income of $500,000 for 2018 (taxable wages of $1,000,000 less $500,000 allowable loss from their active trades or businesses).
Generally, excess losses from a passive activity may not be used to offset nonpassive income for income tax purposes.
True
Under the passive activity loss rules, material participation means involvement in the actual operations of the activity on a regular, continuous, and substantial basis.
True
Under the Tax Cuts and Jobs Act, excess passive losses are not deductible by noncorporate entities in the current taxable year, but may be carried forward to offset income in future tax years.
True
To qualify for the active participation exception to the passive activity loss rules, the taxpayer must own at least 20 percent of the rental real estate, measured by value.
False
The taxpayer must own at least 10 percent of the rental real estate, measured by value.
