Chapter 11 Investor Losses Flashcards
provided
a popular way to avoid or defer taxes, as they could generate deductions and
other benefits to offset income from other sources.
tax shelter
How did people use tax shelters to their advantage.
People used to be able to get really big deductions because there weren’t limitations on tax shelters. Congress changed it a lot so people couldn’t take advantage of it so much.
The first major provision aimed at tax shelters was the
at-risk limitation.
What is the at-risk limitation?
Its objective
is to limit a taxpayer’s deductions to the amount “at risk,” which is the amount
the taxpayer stands to lose if the investment becomes worthless.
So if Bob had income of from salaries of 400,000 and dividends of 15,000 and invested in a company 20,000. The company lost 1 million and Bob shared 40,000 of the losses. How much is his income would he have to report
415,000-20,000 = 395,000
The second major attack on tax shelters came with the passage of the
passive activity
loss rules
What do the passive activity
loss rules do.
These rules are intended to halt an investor’s ability to benefit from
the mismatching of an entity’s expenses and income that often occurs in the early
years of the business.`
ventures where investors
are not involved in the day-to-day operations of the business are generally
referred to as
passive investments or passive activities rather than tax shelters
The passive loss rules require the taxpayer to segregate all income and losses
into three categories:
active, passive, and prtfolio.
In general, the passive loss limits
disallow the deduction of passive losses against
active or portfolio income even
when the taxpayer is at risk to the extent of the loss
In general, passive losses can
only offset
passive income
salary is what active, passive, or portfolio?
Active
dividend is active passive or portfolio?
portfolio
he $20,000 loss allowed under the at-risk rules is disallowed
under the
passive loss rules
The passive loss is disallowed because Bob does not
generate any
passive income that can absorb his passive loss.
Bobs salary and dividends can be used to offset the passive loss of 20,000?
False. his salary
(active income) and dividends (portfolio income) cannot be used to absorb any of the
passive loss
Can bob ever recognize the passive loss?
all is not lost because Bob’s share of the entity’s loss is
suspended; it is carried forward and can be deducted in the future when he has passive
income or sells his interest in the activity.
The at-risk provisions limit the deductibility of losses from what 2 types of activities
business and income producing activities
Under the at-risk rules, a taxpayer’s
deductible loss from an activity for any taxable year is limited to the amount
the taxpayer
has at risk at the end of the taxable year (the amount the taxpayer
could actually lose in the activity).
While the amount at risk generally vacillates over time, the initial amount considered
at risk consists of the following what 2 things:
• The amount of cash and the adjusted basis of property contributed to the activity
by the taxpayer.
• 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.
However,
a taxpayer generally is not considered at risk with respect to borrowed
amounts if either of the following is true:
• The taxpayer is not personally liable for repayment of the debt (e.g., nonrecourse
debt).
• The lender has an interest (other than as a creditor) in the activity.
Active income includes the following:
• Wages, salary, commissions, bonuses, and other payments for services rendered
by the taxpayer.
• Profit from a trade or business in which the taxpayer is a material participant.
• Gain on the sale or other disposition of assets used in an active trade or
business.
• Income from intangible property if the taxpayer’s personal efforts significantly
contributed to the creation of the property.
Portfolio income includes the following
• Interest, dividends, annuities, and royalties not derived in the ordinary course
of a trade or business.
• Gain or loss from the disposition of property that produces portfolio income
or is held for investment purposes.
Section 469 provides that income or loss from the following activities is treated
as passive:
• Any trade or business or income-producing activity in which the taxpayer does
not materially participate.
• Subject to certain exceptions, all rental activities, whether the taxpayer materially
participates or not.
Although the Code defines rental activities as passive activities, several exceptions
allow losses from certain real estate rental activities to offset
nonpassive (active or
portfolio) income.
Losses or expenses generated by passive activities can be deducted only to the extent
of income from all of the taxpayer’s passive activities. Any excess may not be used to
offset income from active sources or portfolio income. Instead, any unused passive
losses are
suspended and carried forward to future years to offset passive income
generated in those years.
When a taxpayer disposes of his or her entire interest in a passive activity, the actual
economic gain or loss from the investment, including any suspended losses, can
finally be determined. As a result, under the passive loss rules, upon a fully taxable
disposition, any overall loss realized from the taxpayer’s activity is recognized and
can be offset against any income?
True
suspended losses
Can be recognized when you sell or dispose of his or her entire interest in a passive activity.
Rex sells an apartment building, a passive activity, with an adjusted basis of $100,000 E X A M P L E 7
for $180,000. In addition, he has suspended losses of $60,000 associated with the
building. What is his total gain and taxable gain
total gain is 80,000 and taxable gain is 20,000
Dean sells an apartment building, a passive activity, with an adjusted basis of $100,000 E X A M P L E 8
for $150,000. In addition, he has current and suspended losses of $60,000 associated
with the building and has no other passive activities. What is his total gain and deductible loss?
total gain is 50,000 and deductible loss is (10,000)
The preceding examples assumed that the taxpayer had an interest in only one passive
activity; as a result, the suspended loss was related exclusively to the activity that
was disposed of. Taxpayers often own interests in more than one activity, however,
and in that case, any suspended losses must be allocated among the activities in
which the taxpayer has an interest. The allocation to an activity is made by
multiplying
the disallowed passive activity loss from all activities by the following fraction:
(Loss from activity)/
(Sum of losses for taxable year from all activities having losses)
Diego has investments in three passive activities with the following income and losses
for 2011:
Activity A ($30,000)
Activity B (20,000)
Activity C 25,000
Net passive loss ($25,000)
Net passive loss allocated to Activity A and B are?
Activity A ($25,000 × $30,000/$50,000) ($15,000) Activity B ($25,000 × $20,000/$50,000) (10,000) Total suspended losses ($25,000)
Sam owes $50,000 of tax, disregarding net passive income, and $80,000 of tax, considering
both net passive and other taxable income (disregarding the credits in both
cases). The amount of tax attributable to the passive income is
30,000
Credits arising from passive activities are limited in much the same way as passive
losses. Passive credits can be utilized only against
regular tax attributable to passive
income,7 which is calculated by comparing the tax on all income (including
passive income) with the tax on income excluding passive income.
Tax credits attributable to passive activities can be carried forward indefinitely
much like suspended passive losses. Unlike passive losses, however, passive credits
are lost forever when
the activity is disposed of in a taxable transaction where loss is
recognized
Alicia sells a passive activity for a gain of $10,000. The activity had suspended losses of $40,000 and suspended credits of $15,000. What happens?
The $10,000 gain is offset by $10,000 of the
suspended losses, and the remaining $30,000 of suspended losses is deductible against
Alicia’s active and portfolio income. The suspended credits are lost forever because the
sale of the activity did not generate any tax.
If a formerly passive activity becomes an active one, suspended losses are allowed to
the extent of
income from the now actie business
If a formerly passive activity becomes an active one, suspended losses are allowed to
the extent of income from the now active business.8 If any of the suspended loss
remains, it continues to be treated as
a loss from a passive activity.
Two tax accountants who earn an aggregate of $200,000 a year in their individual prac- E X A M P L E 1 4
tices agree to work together in a newly formed personal service corporation. Shortly after
its formation, the corporation invests in a passive activity that produces a $200,000 loss
during the year. Because the passive loss rules apply to personal service corporations, the
corporation may or may not deduct the loss?
may not deduct the $200,000 loss against the $200,000 of active income
Determination of whether a corporation is a personal service corporation is based
on rather broad definitions. A personal service corporation is a
C corporation that must meet 2 conditions.
Determination of whether a corporation is a personal service corporation is based
on rather broad definitions. A personal service corporation is a regular (or C) corporation
that meets both of the following conditions
- The principal activity is the performance of personal services.
- Such services are substantially performed by employee-owners.
Generally, personal service corporations include those in the fields of
health, law,
engineering, architecture, accounting, actuarial science, performing arts, and consulting.
A corporation is treated as a personal service corporation if more than 10
percent of the stock (by value) is held by
employee-owners
An employee is
treated as an employee-owner if he or she owns stock on
any day during the taxable
year
A corporation is classified as a closely held corporation if
at any
time during the taxable year more than 50 percent of the value of its outstanding
stock is owned, directly or indirectly, by or for five or fewer individuals. Closely held
C corporations (other than personal service corporations) may use passive losses to
offset active income but not portfolio income.
Silver Corporation, a closely held (non-personal service) C corporation, has $500,000 of
passive losses from a rental activity, $400,000 of active income, and $100,000 of portfolio
income. What is the corporation allowed to do?
The corporation may offset $400,000 of the $500,000 passive loss against
the $400,000 of active business income but may not offset the remainder against the
$100,000 of portfolio income. Thus, $100,000 of the passive loss is suspended
($500,000 passive loss − $400,000 offset against active income).
Application of the passive loss limitations to closely held C corporations prevents
taxpayers from transferring their portfolio investments to such corporations to offset
passive losses against portfolio income.
Section 469 specifies that the following types of activities are to be treated as
passive:
• Any trade or business or income-producing activity in which the taxpayer does
not materially participate.
• Subject to certain exceptions, all rental activities.
See examples 16,17,18 on page 11-11 to read why it’s important to know the identification of an activity
.
in general, a taxpayer can treat one or more trade or business activities or rental
activities as a single activity if those activities form an
appropriate economic unit for measuring gain or loss.
George owns a men’s clothing store and an Internet café in Chicago. He also owns a
men’s clothing store and an Internet café in Milwaukee. Reasonable methods of applying
the facts and circumstances test may result in any of the following groupings: (4 of them)
• All four activities may be grouped into a single activity because of common ownership
and control.
• The clothing stores may be grouped into an activity, and the Internet cafés may
be grouped into a separate activity.
• The Chicago activities may be grouped into an activity, and the Milwaukee activities
may be grouped into a separate activity.
• Each of the four activities may be treated as a separate activity.
Taxpayers should carefully consider all tax factors in deciding
how to group their activities. Once activities have been grouped, they cannot
be regrouped?
they cannot
be regrouped unless the original grouping was clearly inappropriate or there has
been a material change in the facts and circumstances.
The Regulations also grant
the IRS the right to regroup activities when both of the following conditions
exist:
• The taxpayer’s grouping fails to reflect one or more appropriate economic
units.
• One of the primary purposes of the taxpayer’s grouping is to avoid the passive
loss limitations.
Two rules deal specifically with the grouping
of rental activities. These provisions are designed to prevent taxpayers from
grouping rental activities, which are generally passive, with other businesses in a
way that would result in a tax advantage.
First, a rental activity may be grouped with a trade or business activity only if one
activity is insubstantial in relation to the other. That is, the rental activity must be
insubstantial in relation to the trade or business activity, or the trade or business activity
must be insubstantial in relation to the rental activity.
Second, taxpayers generally may not treat an activity involving the rental of
real property and an activity involving the rental of personal property as a single
activity.
What does insubstantial mean?
The Regulations provide
no clear guidelines as to the meaning of “insubstantial”, but the dictionary says lacking strength and solidity: the huts are relatively few and insubstantial | insubstantial evidence.
• not solid or real; imaginary: the flickering light made her face seem insubstantial.
If an individual taxpayer materially participates in a nonrental trade or business activity,
any loss from that activity is treated as an active loss that can offset with
active or portfolio income
If a taxpayer does not materially participate, however, the loss is
treated as a`
passive loss, which can only offset passive income. Therefore, controlling
whether a particular activity is treated as active or passive is an important part
of the tax strategy of a taxpayer who owns an interest in one or more businesses.
material participation can be vague. As enacted, § 469 requires a taxpayer to
participate on a regular, continuous, and substantial basis to be a material participant.
In many situations, however, it is difficult or impossible to gain any assurance that
this nebulous standard is met.
In response to this dilemma, Temporary Regulations18 provide seven tests that
are intended to help taxpayers cope with these issues. Material participation is achieved by meeting all of these tests?
False. It can meet any one of these tests to be considered material participation.
These tests can be divided into the following
three categories:
- Tests based on current participation.
- Tests based on prior participation.
- Test based on facts and circumstances.
What are the 4 tests under tests based on current participation?
- Does the individual participate in the activity for more than 500 hours during
the year? - Does the individual’s participation in the activity for the taxable year constitute substantially
all of the participation in the activity of all individuals (including nonowner
employees) for the year? So if Ned worked only 80 hours he could still meet requirements if he did all the work and had no employees. - Does the individual participate in the activity for more than 100 hours during the year,
and is the individual’s participation in the activity for the year not less than the participation
of any other individual (including nonowner employees) for the year? - Is the activity a significant participation activity for the taxable year, and does the individual’s
aggregate participation in all significant participation activities during the
year exceed 500 hours?
trade or business in which the individual’s
participation exceeds 100 hours during the year.
a significant participation activity
What are the 2 tests based on Prior Participation?
- Did the individual materially participate in the activity for any 5 taxable years (whether
consecutive or not) during the 10 taxable years that immediately precede the taxable
year? - Is the activity a personal service activity, and did the individual materially participate in
the activity for any three preceding taxable years (whether consecutive or not)?
What is the test based on facts and circumstances?
- Based on all of the facts and circumstances, did the individual participate in the activity
on a regular, continuous, and substantial basis during the year?
You can use your wife’s hours in some cases to qualify as a material participant in some cases?
True
a partner whose liability to third-party creditors of
the partnership is limited to the amount the partner has invested in the partnership.
limited partner.
Generally, a limited partner
is not considered a material participant unless he or she qualifies under
Test 1, 5,
or 6 in the preceding list
However, a general partner may qualify as a material participant
by meeting?
any of the 7
is defined as any activity where payments are received principally
for the use of tangible (real or personal) property
rental activity
mportantly, an activity
that is classified as a rental activity is subject to the
passive activity loss rules even if
the taxpayer involved is a material participant.
Sarah owns a fleet of automobiles that are held for rent, and she spends an average E X A M P L E 3 0
of 60 hours a week in the activity. Assuming that her automobile business is classified
as a rental activity, it is automatically subject to
the passive activity rules even though
Sarah spends more than 500 hours a year in its operation.
Dan owns a DVD rental business. Because the average period of customer use is seven
days or less, Dan’s DVD business is treated as a rental activity?
False
The fact that Dan’s DVD business in the previous example is not treated as a
rental activity does not necessarily mean that it is classified as a nonpassive activity.
Instead, the DVD business is treated as a trade or business activity subject to the material
participation standards. If Dan is a material participant, the business is
treated as
active
If he is not a material participant, it is treated as a
passive
Thus, activities covered by any of the following six exceptions provided by the
Temporary Regulations are not automatically treated as nonpassive activities merely
because they would not be classified as rental activities. Instead, the activities are
subject to the material participation tests. What are the 6?
- The average period of customer use of the property is seven days or less.
- The average period of customer use of the property is 30 days or less, and the owner of the
property provides significant personal services. - The owner of the property provides extraordinary personal services. The average period of
customer use is of no consequence in applying this test. - The rental of the property is treated as incidental to a nonrental activity of the taxpayer.
- The taxpayer customarily makes the property available during defined business hours for
nonexclusive use by various customers. - The property is provided for use in an activity conducted by a partnership, S corporation,
or joint venture in which the taxpayer owns an interest.
are services provided by individuals where the
customers’ use of the property is incidental to their receipt of the services. For
example, a patient’s use of a hospital bed is incidental to his or her receipt of medical
services. Another example is the use of a boarding school’s dormitory, which is
incidental to the scholastic services received.
extraordinary personal services
Jack’s adjusted basis in a passive activity is $10,000 at the beginning of 2011. His loss E X A M P L E 3 6
from the activity in 2011 is $4,000. Because Jack has no passive activity income, the
$4,000 cannot be deducted. At year-end, Jack has an adjusted basis and an at-risk
amount of _______ in the activity and a suspended passive loss of ______
6,000; 4,000
The passive loss limits contain two exceptions related to real estate activities. These
exceptions allow all or part of real estate rental losses to offset active or portfolio
income even though the activity otherwise is defined as a passive activity. What are they?
• More than half of the personal services that the taxpayer performs in trades
or businesses are performed in real property trades or businesses in which
the taxpayer materially participates.
• The taxpayer performs more than 750 hours of services in these real property
trades or businesses as a material participant
As discussed earlier, a spouse’s work is taken into consideration in satisfying the
material participation requirement?
True
However, the hours worked by a spouse are not
taken into account when ascertaining whether a taxpayer has worked for more than
750 hours in
real property trades or businesses during a year
If the total deduction and deduction equivalent exceed $25,000, the taxpayer
must allocate the allowance on a pro rata basis, first among the losses (including
real estate rental activity losses suspended in prior years) and then to credits in the
following order:
(1) credits other than rehabilitation and low-income housing credits,
(2) rehabilitation credits, and (3) low-income housing credits
A taxpayer dies with passive activity property having an adjusted basis of $40,000, suspended
losses of $10,000, and a fair market value at the date of the decedent’s death
of $75,000. The increase (i.e., step-up) in basis (see Chapter 13) is
35,000
Is the suspended loss deductible by the beneficiary or or decedent for the previous problem?
No
A taxpayer dies with passive activity property having an adjusted basis of $40,000, suspended
losses of $10,000, and a fair market value at the date of the decedent’s death
of $47,000. Are there suspended losses allowed?
Yes of 3,000 because the step up in basis is only 7,000 and the suspended loss is 10,000 (10,000 - 7,000)
A taxpayer makes a gift of passive activity property having an adjusted basis of E X A M P L E 4 8
$40,000, suspended losses of $10,000, and a fair market value at the date of the gift of
$100,000. The taxpayer cannot deduct the suspended losses in the year of the disposition so what happens?
the suspended losses transfer with the property and are added to the
adjusted basis of the property in the hands of the donee
When a passive activity is transferred by gift, the suspended losses become
permanently
nondeductible to both the donor and the donee.
Stan sells his entire interest in a passive activity for $100,000. His adjusted basis in E X A M P L E 4 9
the property is $60,000. If he uses the installment method, his gross profit ratio is 40%
($40,000/$100,000). If Stan receives a $20,000 down payment, he will recognize a
gain of $8,000 (40% of $20,000). If the activity has a suspended loss of $25,000, Stan
will deduct $5,000 [($8,000 ÷ $40,000) × $25,000] of the suspended loss in the first
year?
True
The deduction for investment interest expense is now limited to
net
investment income for the year.
is gross income from interest, dividends (see below), annuities,
and royalties not derived in the ordinary course of a trade or business
investment income
Investment income is gross income from interest, dividends (see below), annuities,
and royalties not derived in the ordinary course of a trade or business. However,
income from a passive activity and income from a real estate activity in which
the taxpayer actively participates are also included in investment income?
False. They are not included
The following types of income are not included in investment income unless the
taxpayer elects to do so.
• Net capital gain attributable to the disposition of (1) property producing the
types of income just enumerated or (2) property held for investment purposes.
• Qualified dividends that are taxed at the same marginal rate that is applicable
to a net capital gain
Terry incurred $13,000 of interest expense related to her investments during the year. E X A M P L E 5 3
Her investment income included $4,000 of interest, $2,000 of qualified dividends, and a
$5,000 net capital gain on the sale of investment securities. If Terry does not make the
election to include the net capital gain and qualified dividends in investment income,
her investment income for purposes of computing the investment income limitation is
$4,000 (interest income
If she does make the election, her investment income is
$11,000 ($4,000 interest + $2,000 qualified dividends + $5,000 net capital gain).
is the excess of investment income over investment
expenses.
net investment income
Continuing with the facts in the previous example, given that Gina’s current net investment
income is $13,830, her deductible investment interest expense is limited to
$13,830 this year. Therefore, if Gina incurred investment interest of $16,000 this year,
only ______ would be deductible currently
$13,830
The amount of investment interest disallowed is
carried over to future years
