Module 7: Passive Activity and At-Risk Rules

Question 1

Direct Participation Program

Answer 1

An investment that is structured to allow investors to participate directly in the income, deductions and credits of the business. Almost any flow through entity will be referred to as a DPP

Question 2

Two Major Provisions that have Significantly Reduced the Benefit of Tax-Shelter Investments

Answer 2

• at-risk rules; and

- the passive activity loss rules

Question 3

The Tax Code “Passive Activities” (2)

Answer 3

• trade or business activities in which the taxpayer does not materially participate
• rental activities, even if the taxpayer is a material participant, unless the taxpayer is also a real estate professional.

Question 4

Three Forms of Direct Participation Program Partnership Entities

Answer 4

• Limited Partnership
• General Partnership
• Master Limited Partnership

Question 5

Limited Partnership Advantages

Answer 5

• limited liability for a limited partner
• May be quite large or small, with the number of limited partners restricted only by securities registration requirements.

Question 6

Limited Partnership Disadvantages

Answer 6

• lack of liquidity

Question 7

Master Limited Partnership

Answer 7

Limited Partnership in which units are publicly traded on an established stock exchange so they offer the advantage of high liquidity. BUT they are not flow-through entities

Question 8

Special Tax Benefits of Direct Participation Programs

Answer 8

• special allocations
• Accelerated Deductions
• tax credits
• borrowing (debt)

Question 9

DPP Special Allocations Benefits

Answer 9

The benefits that flow through from a partnership entity may be enhanced by the potential, under certain circumstances, for the special allocation of certain items of income, expense, gain or loss.

Question 10

What is a special allocation?

Answer 10

An allocation of one or more items of income, gain, losses, deductions, or credits that depart from the partner’s general profit and loss sharing ratio.

** Certain deductions may be allocated to certain individuals, rather than dividing it among all participants

Question 11

DPP Accelerated Deductions

Answer 11

Produces tax benefits by generating .losses through accelerated deductions and cost recovery.

Question 12

DPP Tax Credits

Answer 12

DPP have traditionally produced tax benefits for investors through the pass through of various tax credits, such as the low-income housing credit and the historic rehabilitation tax credit

Question 13

DPP Borrowing (debt)

Answer 13

By borrowing the funds needed to incur deductible expenses, the program could provide an owner with deductions in excess of the owner’s cash investment.

Question 14

The Passive Activity Loss Rule

Answer 14

Passive Losses may only be deducted against passive income.

Question 15

Who do the passive activity loss rules apply to?

Answer 15

• individuals
• estates
• trusts
• Personal Service Corporations
• Closely held C Corporations (however, not that closely held C corps may offset passive losses against active income but not against portfolio income)

Question 16

At-risk rules

Answer 16

The maximum deductible loss for an investment is limited to the amount that the taxpayer-investor has at risk at the end of the current year. The partner may deduct losses only to the extent of the amount that they have at risk.

Question 17

Calculating the amount that’s at risk

Answer 17

The sum of:

• the money invested
• the adjusted basis of other property contributed to the partnership
• amounts borrowed for use in the activity, but only to the extent that the partners are personally liable for repayment of the debt
• the partner’s share of income, less the partner’s share of losses or withdrawals from the partnership.
• the proportionate share of qualified nonrecourse financing in a real estate activity only

Question 18

Nonrecourse Financing

Answer 18

Debt that is secured by the property, but for which no individual has personal liability

Question 19

Suspended Loss

Answer 19

A tax loss disallowed because of the at-risk rules and may b e used in either the first year in which the at-risk amount is sufficient to absorb the loss, or the year that investment is subsequently sold.

All suspended at-risk losses are lost on the complete disposition of the property unless the loss is allowed only to the extent of an increase in the at-risk amount

Question 20

PAL vs. PIG

Answer 20

PAL - Passive Activity Loss

PIG - Passive Income Gain

Question 21

What happens when a taxpayer disposes of his entire interest in a fully taxable transaction to an unrelated purchaser (not a related party)

Answer 21

Those suspended losses from that activity, including any losses incurred in the year of disposition, are generally deductible in full. It’s used against other passive activities and the unused losses are then classified as non-passive and may be used to offset income from non-passive activities.

Question 22

What constitutes disposition of a taxpayer’s entire interest in a passive activity?

Answer 22

It is a disposition of his interest in all entities that are engaged in the passive activity and, to the extent that the activity is owned in the sole proprietorship form, all of the assets used or created in that activity.

Question 23

Material Participation Rules

Answer 23

• 500+ hour of participation
• Does all of the participation
• 100+ hours and is more than any other participant
• The activity is a significant participation activity
• Taxpayer materially participated in the activity for 5 of the past 10 years
• It’s a personal service activity that the taxpayer materially participated in once in the previous 3 years

Question 24

Publicly Traded Partnership Income Taxability

Answer 24

Any income from a publicly traded partnership is treated as portfolio income

Question 25

Publicly Traded Partnership Loss Taxability

Answer 25

Losses may not be used to offset passive income from any other source. Each publicly traded partnership is treated separately and a net loss from a PTP must be carried forward and used only against the future income from that same partnership

Question 26

Two Types of Limited Partnerships

Answer 26

• PTP and MLP

- Non PTP

Question 27

Losses from Non-PTP’s

Answer 27

May only be used to offset income from another non PTP. However this income does not have to be generated from the same non PTP

Question 28

What makes rental real estate activities active and not passive?

Answer 28

• more than 50% of personal services for the year

- more than 750 hours of work in the real estate activity

Question 29

Real Estate Activity Exception for Small Investors

Answer 29

In meeting several tests, investors may deduct up to $25,000 of rental real estate losses against active portfolio income in any one year.

Question 30

Real Estate Activity Exception for Small Investors Tests

Answer 30

• The small investor must actively participate in the activity
• the small investor must