Module 7 Passive Activity and At-Risk Rules Flashcards
James has suspended losses from a nonpublicly traded partnership of $17,000. In 2023, he has income from a nonpublicly traded partnership of $15,000. What amount of suspended losses, if any, may James deduct in 2023?
A)
$0
B)
$15,000
C)
$2,000
D)
$17,000
b
He may deduct (under the at-risk limitations) his share of the partnership loss to the extent of his investment in the partnership. With a $17,000 loss and only $15,000 in income, James can only deduct $15,000 of the loss.
LO 7.2.2
Which of the following statements regarding passive activity losses is CORRECT?
When determining the amount of suspended loss that may be used against income, the at-risk rules are applied before the passive activity loss rules.
If a loss is not allowed because of the at-risk limitations, the loss is a suspended loss eligible for deduction as a disposition of a passive activity.
A)
Both I and II
B)
I only
C)
II only
D)
Neither I nor II
b
Statement I is correct. Statement II is incorrect. If a loss is not allowed because of the at-risk limitations, the loss is a suspended loss and is not eligible for deduction as a disposition of a passive activity.
LO 7.1.1
Jasper invested $20,000 for a 30% interest in a nonpublicly traded limited partnership. Jasper is not a material participant. The partnership has a loss this year and Jasper’s share is $15,000. This is the only nonpublicly traded limited partnership Jasper owns an interest in, but Jasper did have portfolio income of $9,000 in the same year in addition to his salary of $150,000. How much of the loss can Jasper deduct this year?
A)
$0
B)
$9,000
C)
$15,000
D)
$6,000
a
Because Jasper has no passive income to offset the passive loss, the loss is suspended under the passive activity loss rules.
LO 7.2.2
pon the disposition of a passive activity interest by gift, the suspended losses are
A)
deductible to the extent the losses exceed any increase in the fair market value of the activity.
B)
deductible in full.
C)
completely lost.
D)
added to the basis of the interest.
d
Upon the disposition of a passive activity by gift, the suspended losses are added to the basis of the activity.
LO 7.1.2
Mack owns a vacation home that he plans to rent for 190 days this year. He also plans to live in the house during the year. What is the maximum number of days he can live in the home without jeopardizing the property’s status as a rental property?
A)
95 days
B)
14 days
C)
19 days
D)
140 days
c
Because he will rent the home for 190 days, Mack can use it as a personal residence for up to 19 days (the greater of 14 days or 10% of rental use) without jeopardizing the property’s status as a rental property.
LO 7.2.4
During the current tax year, Jim has $10,000 of passive income from a publicly traded limited partnership. He also has a nonpublicly traded limited partnership that will generate a $10,000 passive loss. How much of this passive loss, if any, is deductible by Jim during the current tax year?
A)
$6,500
B)
$10,000
C)
$1,000
D)
$0
d
Income from a publicly traded limited partnership may not be offset by any other passive losses. Remember that income and losses from nonpublicly traded partnerships may be used to offset each other.
LO 7.2.2
Jim has the following items from four investments:
Passive income from a publicly traded limited partnership $16,000
Passive loss from a publicly traded limited partnership $(8,500)
Passive income from a non-publicly traded limited partnership $13,000
Passive loss from a non-publicly traded limited partnership $(20,000)
What is the total amount of passive losses that may be deducted during the current year?
A)
$20,000
B)
$13,000
C)
$28,500
D)
$29,000
b
The passive loss of $20,000 from the non-publicly traded partnership (non-PTP) is deductible, but it can only offset income from another qualified source, which in this case is the other non-publicly traded partnership. Thus, only $13,000 of the $20,000 is currently deductible. The rest of the losses are suspended. Losses from a publicly traded partnership (PTP) are likewise suspended until the same PTP has income in the future.
LO 7.2.2
Jean leases a house from Nan. The rent is normally $850 per month. Nan accepts reduced monthly rent of $500 per month for the current year in addition to Jean providing repairs to the property. The repairs are worth $2,500 and cost $3,200. How much must Nan include in income due to the house rental?
A)
$8,500
B)
$6,000
C)
$9,200
D)
$10,200
a
The actual rent received of $6,000 plus the fair market value of the services provided, $2,500, are included in income.
LO 7.2.3
Which of the following statements correctly identify the requirements necessary to deduct $25,000 of losses from an active participation real estate program?
The taxpayer must have at least a 10% ownership interest in the property.
The taxpayer’s modified adjusted gross income must not exceed $200,000.
The taxpayer must make the major management decisions related to the property.
The taxpayer’s interest in the property may not be held as a limited partnership interest.
A)
I and III
B)
I, III, and IV
C)
II, III, and IV
D)
II and IV
b
The answer is I, III, and IV. II is false because the phaseout range for the active participation real estate deduction is $100,000 to $150,000.
LO 7.2.1
Your client, Sally, is considering investing in real estate as a way to diversify her investments. She has heard of active participation rental real estate, but is unsure of the requirements that must be met. What can you accurately tell her with respect to active participation rental real estate?
The interest may not be held through a limited partnership.
A deduction-equivalent tax credit of up to $25,000 is available.
The taxpayer must hold a 10% or greater ownership interest.
The taxpayer must make the major management decisions.
A)
III and IV
B)
I and II
C)
I and IV
D)
I, III, and IV
d
The deduction for active participation rental real estate requires that the taxpayer participate in management in a bona fide sense; making the major management decisions. To qualify, the interest may not be held through a limited partnership, and the taxpayer must have at least a 10% or greater ownership interest in the property. The loss is deductible when computing the gross income. Active participation rental real estate generates an above-the-line deduction of up to $25,000 annually, not a credit.
LO 7.2.1
Jane has the following income and losses for the current year:
$1,500 loss from a 30% interest in Laminate Partnership in which she does not materially participate
$500 loss from a .2% limited partnership interest in Venture, a limited partnership
$2,400 loss from a 12% interest in an S corporation in which she manages one of the departments
$32,000 salary as manager with an S corporation
$600 of dividend income from Higher Mutual Fund
What is Jane’s adjusted gross income?
A)
$32,000
B)
$32,600
C)
$30,200
D)
$28,200
c
Jane’s AGI is $30,200. She has $32,600 of income from salary and dividends, and the S corporation loss of $2,400 is deductible because the information provided leads us to the conclusion that she is materially participating in the S corporation: $32,600 - $2,400 = $30,200. The Laminate Partnership and the Venture LP are both passive activities; therefore, the losses would be deductible only against passive income.
LO 7.1.2
Jack operates a cosmetic manufacturing business as an S corporation. In the current year, the business placed in service $33,000 of new property eligible for limited expensing under Section 179. If taxable income before cost recovery is $12,750, the maximum amount that the business can elect this year under Section 179 is
A)
$33,000.
B)
$8,000.
C)
$12,750.
D)
$25,000.
c
The expensing election is limited to taxable income before the expensing election is calculated; therefore, $12,750 is the maximum Jack’s business can elect under Section 179. The remaining amount of $12,250 is carried forward until the income of the business is sufficient to use up the remaining Section 179 expense election.
LO 7.1.2
If the Taylors rented their condo for 300 days last year, how many days could the Taylors have used it personally and still maintained the classification of the condo as primarily a rental use property?
A)
30 days
B)
0 days
C)
14 days
D)
3 days
a
The Taylors could have used the property personally for a total of 30 days (300 rental days × 10%). If rental property is rented at least 15 days a year and is not used for personal use more than the greater of 14 days per year or 10% of the rental days, it is classified as primarily rental use. This treatment permits the Taylors to deduct expenses associated with the rental (not personal) use on Schedule E of IRS Form 1040.
LO 7.2.4
Paula purchased an interest in a master limited partnership (MLP) that produced a loss of $7,000 this year. She also purchased a real estate limited partnership (RELP) that generated $10,000 of passive income this year. How much, if any, of the passive loss from the MLP could be used to offset Paula’s income from the RELP in the current year?
A)
$0
B)
$3,500
C)
$3,000
D)
$7,000
a
The answer is $0. Paula’s losses from the MLP cannot be used to offset income from the RELP. MLP losses may only be used to offset income from the same MLP.
LO 7.2.2
Which one of the following statements is CORRECT regarding the effect of the taxpayer’s death on suspended passive losses?
A)
They are nondeductible up to the amount of the step-up in basis of the activity.
B)
The death of the taxpayer has no effect on the suspended passive losses.
C)
They are completely nondeductible upon the death of the taxpayer.
D)
They are fully deductible upon the death of the taxpayer.
a
They are nondeductible up to the amount of the step-up in basis of the activity.
LO 7.1.2
Which of the following forms of business may be classified as direct participation programs?
General partnership
Limited partnership
S corporation
Closely held C corporation
A)
I, II, and III
B)
I and II
C)
III and IV
D)
IV only
a
The tax advantages provided by direct participation programs are founded upon the principle that most types of business organizations function as tax conduits; therefore, a closely held C corporation cannot qualify as there is no flow through of gains and losses.
LO 7.1.1
Which one of the following best describes the role of a special allocation in a limited partnership?
A)
It requires all items to be distributed pro rata based on a partner’s capital account balance.
B)
It allows an allocation of items of income and expense that is not pro rata.
C)
It establishes the standards for allocating the proceeds of non-routine or “special” items of income.
D)
It allocates management responsibility to the general partners.
b
A special allocation allows an allocation of items in a manner that differs from the “normal” pro rata allocation of deduction, income, credit, etc.
LO 7.1.1
All of the following statements regarding tax deduction limits on passive activity excess losses are correct except
A)
excess passive activity losses are disallowed on the taxpayer’s current tax return and instead are deferred.
B)
excess passive activity losses are fully allowed in the year in which the taxpayer disposes of his entire interest in the passive activity in a taxable transaction.
C)
losses from one nonpublicly traded passive activity may not offset income from another nonpublicly traded passive activity.
D)
excess passive activity losses are the excess of otherwise allowable deductions from the taxpayer’s passive activities over the amount of income from the taxpayer’s passive activities.
c
The taxpayer’s nonpublicly traded passive losses and nonpublicly traded passive income are aggregated for purposes of the limitation so that losses from one nonpublicly traded passive activity may offset income from another nonpublicly traded passive activity.
LO 7.1.2
Erma, age 40, anticipates an adjusted gross income of $177,000 for the current tax year. All her income is attributable to active and portfolio income. She would like to acquire an investment that would reduce her tax liability without exposing her to personal liability. Which one of the following investments is the most appropriate for Erma?
A)
A master limited partnership that will produce passive losses
B)
A historic rehabilitation real estate limited partnership that will produce rehabilitation tax credits
C)
An oil and gas working interest that will produce losses
D)
An “active participation” investment in rental real estate that will produce losses
b
Erma’s AGI is too high to claim the active participation real estate exception. Losses from a master limited partnership can only be deducted against income generated by the same partnership in another tax year. The oil and gas working interest will generate unlimited liability. Thus by process of elimination, the correct answer is historic rehabilitation credit.
LO 7.2.2
You are a CFP® professional and are meeting with your client Brenda to monitor her ongoing financial status. Brenda owns a vacation home in New Mexico. She is now renting the property to others for the entire year except for 10 days during the summer when she and her family used it for their vacation. The gross rental income that Brenda received is $65,000. The expenses for the home for both the rental period and her personal use total $5,000. Brenda would like you to explain how this will change her income tax situation, in particular, how much of the rental expenses are deductible. After reviewing the documents she sent to you prior to the meeting, you have an answer for Brenda. How much of a deduction for rental expenses can Brenda take on her tax return?
A)
$5,000
B)
$4,721
C)
$4,863
D)
$3,411
c
Brenda can deduct the cost of renting the home if she occupies it for the greater of no more than 14 days per year or for 10% of the number of days the property is rented. Because Brenda occupies the house for only 10 days during the year, this test is satisfied. Even though this rental use exception is allowed, the deductible expenses related to the rental of the house are limited. Specifically, she can only deduct a portion of the actual rental expenses, which equals the number of days during the year that the house is rented to others divided by the total number of days that the house is used by either tenants or Brenda. Given 365 days per year, Brenda’s tenants occupy the house all but 10 days, for a total of 355 days. She is allowed to deduct 97.26% (355 days ÷ 365 days) of the $5,000 rental expenses, which equals $4,863.
LO 7.2.4
Natalia, a commissioned salesperson and single taxpayer divorced in 2018, has provided the following information for the current tax year:
Sales commissions $60,000
Keogh contribution $6,000
Alimony paid to Natalia’s former spouse $12,000
Limited partnership passive loss $30,000
Self-employment tax liability $8,478
What is Natalia’s adjusted gross income for the 2023 tax year?
A)
$42,000
B)
$37,761
C)
$33,522
D)
$3,522
b
Total income = $60,000.
Adjustments = $6,000 + $12,000 + ($8,478 ÷ 2) = $22,239.
$60,000 – $22,239 = $37,761.
The passive loss is suspended because Natalia has no passive income to offset.
LO 7.2.2
Which of the following activities is treated as a rental activity under the passive activity rules?
Property rental where average customer use is 6 days
Property rental where average customer use is more than 30 days and no significant services are provided
Property rental where extraordinary services are provided on behalf of the owners
Property rental where the property is customarily made available during defined business hours for the nonexclusive use of customers
A)
II only
B)
II and III
C)
II, III, and IV
D)
I only
a
Only Statement II is treated as a rental activity according to IRS regulations. If a rental is 30 days or less and significant personal services are provided, the activity is a service rather than a rental activity.
LO 7.2.3
Carl, June, and Diane are partners. There is one employee, Mark, who is part-time, working 250 hours per year, primarily in the busy season. Carl works 1,900 hours annually while June works 600 hours and Diane devotes 550 hours in the busy season. Who qualifies as a material participant in the partnership?
A)
Carl and June
B)
Carl, Mark, June, and Diane
C)
Carl only
D)
Carl, June, and Diane
d
Carl, June, and Diane each participate more than 500 hours in the partnership and are considered material participants.
LO 7.2.1
What, if any, is the primary difference in tax treatment between a general partnership and a limited partnership?
A)
Limited partnerships are taxed as corporations, while general partnerships are taxed as partnerships.
B)
The limited partners are treated only as capital investors, whereas the active partners receive both ordinary and capital distributions.
C)
None of these.
D)
The limited partners only receive capital distributions, while the general partners receive only ordinary income distributions.
c
As long as the limited partnership is classified as a partnership (and not a C corporation) for tax purposes, the taxation is no different than it would be if the organization were a general partnership. That is, the partnership issues a K-1 to all of the partners for their distributive share of items of income and loss. Limited partners generally must treat net income or loss from the partnership as passive.
LO 7.1.1
Alex owns a vacation home that he rents, on average, 98 days each year. Alex stays in the home for 6 weeks during the fall every year. Which category does this vacation home fall under?
A)
Primarily personal use
B)
Mixed use
C)
Because Alex stays in the home for 6 weeks in each year, the home is classified as his primary residence
D)
Rental use
b
A vacation home is classified as mixed use if the vacation home is rented for at least 15 days a year and it is also used for personal use for more than the greater of 14 days per year or 10% of the rental days.
LO 7.2.4
Paula purchased an interest in a publicly traded partnership and has experienced a current loss of $7,000. If she purchased a nonpublicly traded partnership with $10,000 of passive income, how much of the passive loss may be used to offset Paula’s income in the current year?
A)
$3,000
B)
$7,000
C)
$0
D)
$10,000
c
The answer is zero. Losses from publicly traded partnerships cannot be offset against income from nonpublicly traded partnerships.
LO 7.2.2
Which of the following is NOT one of the methods by which an S corporation can be terminated?
A)
If it earns more than $10 million in gross receipts in any one year
B)
If gross income for 3 years in a row is of a certain type that exceeds a certain share of total income
C)
When it fails to meet the requirements of a small business corporation
D)
A majority vote of the shareholders
a
The only time that earnings can revoke the S status is when more than 25% of gross receipts for three successive years come from certain types of passive income and the corporation has accumulated earnings and profits from its operations prior to the S election.
LO 7.1.1
Total income = $60,000.
Adjustments = $6,000 + $12,000 + ($8,478 ÷ 2) = $22,239.
$60,000 – $22,239 = $37,761.
The passive loss is suspended because Natalia has no passive income to offset.
LO 7.2.2
a
The benefits that flow through from a partnership entity may be enhanced by the potential, under certain circumstances, “special allocation” of certain items of income, expense, gain, or loss. The passive activity loss rules state that passive losses may only be deducted against passive income (not a tax advantage); there are no partnership basis rules; and the at-risk rules are defined as the maximum deductible loss for an investment limited to the amount that the taxpayer-investor has at risk at the end of the current year. None of the other answers are direct participation programs, which concern business organizations that function as tax conduits.
LO 7.1.1
How can passive activity losses from an ongoing nonpublicly traded partnership, such as a RELP, be deductible from other taxable income?
A)
Passive losses from one partnership can only be offset by passive gains from the same partnership.
B)
Passive losses can only be carried forward against future passive gains.
C)
Passive activity losses are deductible against portfolio gains.
D)
Passive losses can offset passive gains.
d
Generally, passive activity losses can only be used to offset passive activity income. Losses from nonpublicly traded partnerships (non-PTP) can be used to offset gains from other nonpublicly traded partnerships. Losses from master limited partnerships can only offset gains from the same master limited partnership. Losses from a non-PTP may be carried forward, but it is not a requirement. Passive losses cannot be used to offset portfolio income.
LO 7.2.3
Max spends 1,500 hours annually managing the business, usually during their summer and holiday rental seasons, and it is 70% of his business activity for the year. Which of the partners can fully deduct any real estate losses against active and/or portfolio income?
Martha
Max
A)
II only
B)
I only
C)
Neither I nor II
D)
Both I and II
d Both Martha and Max are considered real estate professionals because the activity comprises more than 50% of their personal services and they both participate in more than 750 hours annually. As real estate professionals, the partners may deduct any loss against active and/or portfolio income.
LO 7.2.3
Caleb earns a salary of $190,000. This year, he also received dividends and interest of $60,000. Caleb had previously invested $50,000 to purchase a 15% interest in a passive activity. Operations of the activity this year resulted in a loss of $400,000, of which Caleb’s share is $60,000. How is Caleb’s loss for the current year characterized for income tax purposes?
A)
$50,000 is suspended under the at-risk rules, and $10,000 is suspended under the passive activity loss rules.
B)
$60,000 is suspended under the passive activity loss rules.
C)
$10,000 is suspended under the at-risk rules, and $50,000 is suspended under the passive activity loss rules.
D)
$60,000 is suspended under the at-risk rules.
c
Caleb invested $50,000 in the passive activity which becomes his at-risk amount. Because his share of the loss from the activity is $60,000, Caleb will be allowed to deduct only $50,000, which is his amount at risk. In addition, $10,000 of the loss ($60,000 total – $50,000 deductible under at-risk rules) has been suspended because of the at-risk rules and must be carried forward until Caleb either has $10,000 of income from the passive activity or invests $10,000 in the activity. Caleb has a $50,000 loss after applying the at-risk rules, but he is still not permitted a deduction for the loss because he has no passive income to offset the passive activity loss.
LO 7.1.2
During the current tax year, Paul has the following items from his four investments:
Passive income from a publicly traded limited partnership $15,000
Passive loss from a publicly traded limited partnership $10,000
Passive income from a nonpublicly traded limited partnership $8,000
Passive loss from a nonpublicly traded limited partnership $16,000
What is the total amount, if any, of passive losses that may be deducted during the current year?
A)
$10,000
B)
$8,000
C)
$26,000
D)
$16,000
b
Only passive losses from nonpublicly traded limited partnerships may be offset against income from other nonpublicly traded limited partnerships. Thus, $8,000 of the $16,000 loss may be deducted. The passive loss from a PTP must be held in suspense until that same activity generates income (or until a taxable disposition of the PTP).
LO 7.2.2
Which of the following tax factors may limit the availability of tax benefits from a limited partnership?
I. “Passive loss” rules
II. At-risk rules
III. Alternative minimum tax
A)
I only
B)
III only
C)
I, II, and III
D)
I and II
c
The Tax Reform Act of 1986 has two major provisions that have significantly reduced the benefit of tax-shelter investments: the at-risk rules and the passive activity loss rules limits. The alternative minimum tax is another example of a tax benefit limitation.
LO 7.1.2
Philip, a professor, earned a salary of $140,000 from a university in the current year. He received $35,000 in dividends and interest during the year. In addition, he incurred a loss of $25,000 from an investment in a passive activity. His at-risk amount in the activity at the beginning of the current year was $15,000. What is Philip’s adjusted gross income (AGI) for the current year?
A)
$175,000
B)
$115,000
C)
$160,000
D)
$150,000
PREV
a
Philip’s AGI, after considering the passive investment, is $175,000 ($140,000 active income + $35,000 portfolio income). He cannot offset the passive loss against active or portfolio income. The loss may be deducted only against passive income, which he does not have in the current year.
LO 7.1.2
Which one of the following may enable a direct participation program to provide specific tax advantages to the investors?
A)
Passive activity loss rules
B)
Special allocations
C)
Partnership basis rules
D)
At-risk rules
b
A special allocation is 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. In other words, it may not be necessary to split all of these items pro rata among all of the owners. Certain deductions may be allocated to certain individuals rather than dividing it among all participants.
LO 7.1.1
Jimmy will have an adjusted gross income of $275,000 for the current tax year. He would like to reduce his tax liability without exposing himself to personal liability. Which of the following investments would be appropriate for Jimmy?
An investment in active participation rental real estate
An investment in a newly formed low-income housing limited partnership
An investment in an oil and gas working interest
An investment in a newly formed historic rehabilitation limited partnership
A)
II only
B)
II, III, and IV
C)
III and IV
D)
II and III
a
Jimmy should invest in a newly formed low-income housing limited partnership. Active participation in real estate, historic rehabilitation, and investing in oil and gas are subject to personal liability.
LO 7.2.3
Which of the following rules or doctrines may limit the availability of income tax benefits from a particular investment?
Tax conduit
The substantial economic effect doctrine
The at-risk rule
The passive activity loss rule
A)
I and IV
B)
II, III, and IV
C)
II and III
D)
I and III
b
The substantial economic effect doctrine limits the ability to use special allocations in a partnership. The at-risk rule limits the ability to use leverage by attacking the use of nonrecourse financing. The passive activity loss rule limits the ability to deduct losses from activities in which the taxpayer does not materially participate.
LO 7.1.2
Which of the following statements regarding the at-risk rules and the passive activity loss limits is CORRECT?
The at-risk rules are applied before the passive activity loss rules limits.
If a loss is disallowed in any year because of the at-risk rules, the loss is suspended and taken in the first year that the at-risk amount is of an amount sufficient to absorb the loss.
A)
II only
B)
Neither I nor II
C)
Both I and II
D)
I only
c
The at-risk rules are applied before the limits of the passive activity loss rules. They operate together such that, even if the taxpayer can avoid the restrictions of the at-risk rules, the passive activity loss rules will likely still preclude an income tax loss on an annual basis.
LO 7.1.2
Paul and Mary form an equal partnership to produce hammers for the military. They each have a 50% profit and loss sharing agreement. Paul contributes cash of $50,000 and property with a fair market value of $50,000 and an adjusted basis of $20,000. Mary contributes cash of $25,000 and property with a fair market value of $75,000 and an adjusted basis of $40,000. A bank gives the partnership a recourse loan of $30,000 and a nonrecourse loan of $25,000.
What is the amount of Paul and Mary’s basis in the partnership, respectively?
A)
$127,500 for Paul, $127,500 for Mary
B)
$70,000 for Paul, $65,000 for Mary
C)
$85,000 for Paul, $80,000 for Mary
D)
$97,500 for Paul, $92,500 for Mary
d
The basis of a partnership interest is measured by the amount of cash contributed, increased by the adjusted basis of property contributed, and further increased by the partner’s share of both recourse and nonrecourse financing.
LO 7.1.1
In the current year, George invested $100,000 for a 20% partnership interest in an activity in which he is a material participant. The partnership reported a loss of $400,000 in the current year and a loss of $200,000 in the following year. George’s share of the partnership’s loss was $80,000 in the current year and $40,000 in the following year. How much of the loss from the partnership, if any, can George deduct in the current and following year?
A)
$80,000 in the current year and $40,000 in the following year
B)
$80,000 in the current year and $0 in the following year
C)
$0 in both the current and the following year
D)
$80,000 in the current year and $20,000 in the following year
d
George’s losses are deductible in both years because he is a material participant in the activity. However, the at-risk rules limit his total losses to $100,000. He can carry the remaining $20,000 loss forward until he has increased his basis in the partnership through subsequent partnership allocations or investment in the partnership.
LO 7.1.2
Ron, age 43, and Sandy, age 41, are married with two children, Michael, age 12, and Victoria, age 8, who has been blind since her birth. Ron is an architect and general partner with XYZ partnership. Sandy is self-employed as an attorney and works out of a home office. Her home office is exclusively and regularly used for business and is her principal place of business. Their information for the tax year 2021 is as follows:
Adjusted gross income: $217,300
Itemized deductions (including qualified residential mortgage interest,taxes paid, and charitable contributions): $33,000
Early in the current year, Sandy’s father died. Sandy is the sole beneficiary of her father’s entire estate. The estate is presently in the probate process. Sandy’s mother, Lisa, age 68, has moved in with them but provides her own support. She was married to Sandy’s father when he died earlier this year.
This is Ron’s second marriage. He makes monthly support payments to his former wife and his daughter.
Because both Ron and Sandy are considered to be self-employed, they make quarterly estimated tax payments each year to cover both their income tax and self-employment tax obligations.
Based on the information provided in the case scenario for Ron and Sandy, which of the following statements regarding Ron’s status as a partner with XYZ partnership is CORRECT?
Ron has the right to participate in the management and operation of the business.
Ron has no personal liability for the acts of the partnership or the other partners.
A)
Neither I nor II
B)
I only
C)
Both I and II
D)
II only
b
Statement I is correct. As a general partner, Ron has the right to participate in the management and operation of the business. Statement II is incorrect. As a general partner, Ron has unlimited personal liability for the acts of the partnership and other partners.
LO 7.1.1
Bob passed away during the current year. He had suspended losses from a passive activity of $15,000. Bob’s basis in the partnership was $1,000, and the fair market value at the time of his death was $9,000. Bob originally purchased the partnership interest for $25,000. What amount of passive losses, if any, is deductible on Bob’s final return?
A)
$0
B)
$15,000
C)
$7,000
D)
$1,000
c
The suspended losses are “freed up” only to the extent that the losses exceed the step-up in basis. In this situation, the basis was stepped up by $8,000; subtracted from the $15,000 of losses leaves $7,000 of losses that are freed up
LO 7.1.2
MSC, Inc. is a closely held C corporation that manufactures boilers. The company has been in business for over 45 years. MSC has active income this year of $250,000 and no passive or portfolio income. The company also leases equipment that generates passive losses of $120,000 per year. How much of the passive loss can the company use this year?
A)
$120,000
B)
$0
C)
$25,000
D)
$100,000
a
The company can deduct the entire $120,000 because it is a closely held C corporation that is not a personal service corporation. Passive losses may be used to offset active income, but not portfolio income.
LO 7.1.2
Under the passive activity loss rules, passive losses can be deducted against which of the following?
Active income
Passive income
Portfolio income
A)
I, II, and III
B)
I and III
C)
III only
D)
II only
d
Statement II is correct. Statements I and III are incorrect. Passive losses cannot be deducted against either active income or portfolio income.
LO 7.1.1
Jason and Sarah are accountants and are considering starting a business together. They will both be general partners. Jason and Sarah prefer the partnership form but are concerned about liability issues. Specifically, neither wants to be liable for the acts of the other. Which of the following forms would best suit Jason and Sarah?
A)
General partnership
B)
S corporation
C)
Limited liability partnership
D)
Limited partnership
c
In an LLP, the general partners are not liable for the acts of other partners. In addition, some states will protect the general partners from the claims that arise from obligations of the partnership, but this typically extends only to claims arising out of tort law, not contract law.
LO 7.1.1
Which business entity is never subject to federal income taxation?
A)
Partnership
B)
Individual
C)
C corporation
D)
S corporation
a
Partnerships are never subject to federal income tax. They are pass-through entities. C corporations and individuals are separately taxed, and certain S corporation transactions are taxed at the entity level.
LO 7.1.1
During the current tax year, Meghan expects to have the following items of income:
Distributive share of general partnership self-employment income $25,000
Distributive share of S corporation income $17,000
Sole proprietorship net income $1,500
How much self-employment tax must Meghan pay for the 2023 tax year (round your answer to the nearest dollar)?
A)
$4,974
B)
$3,744
C)
$200
D)
$4,055
b
The partnership and sole proprietorship income are included. The S corp distribution is treated as a dividend not subject to SE tax. ($26,500 x .9235) x .153 = $3,744
LO 7.2.1
ast year, Geoff invested $70,000 for a 25% interest in a partnership in which he was not a material participant. The partnership made a profit last year, of which $19,000 was allocated to Geoff. This year, the partnership suffered a loss and Geoff’s share was $28,000. What is Geoff’s capital at risk in the partnership at the end of the current year?
A)
$61,000
B)
$48,000
C)
$51,000
D)
$38,000
a
At the beginning of this year, Geoff had capital at risk of $89,000 ($70,000 initial investment + $19,000 allocated profit). At the end of the current year, Geoff’s capital at risk is $61,000 ($89,000 beginning capital at risk – $28,000 allocated loss).
LO 7.1.2
How can passive activity losses be deductible from other taxable income?
A)
Passive losses can only be carried forward against future passive gains.
B)
Passive losses can only be offset by passive gains.
C)
Passive losses can offset passive gains, and a phased-out $25,000 deduction ($12,500 for MFS) for rental real estate applies.
D)
Passive activity losses are deductible against portfolio gains.
c
Generally, passive activity losses can only be used to offset passive activity income. An exception for the deduction of passive losses is for rental real estate. A phased-out deduction of $25,000 ($12,500 for MFS) of rental real estate losses is allowed against a taxpayer’s other nonpassive income. If AGI is greater than $100,000 ($50,000 for MFS), however, there is a reduction of 50 cents for each dollar over $100,000 ($50,000 for MFS), which then terminates at $150,000 ($75,000 for MFS) of AGI.
LO 7.1.1
Taxpayers owning certain resources may recover the cost of exhausting that natural resource (cost recovery) using which of the following methods?
Cost depletion
Percentage depletion
Amortization over 15 years
A)
II and III
B)
II only
C)
I and III
D)
I and II
d
Statements I and II are correct. Statement III is incorrect. Amortization is used for Section 197 intangible assets.
Which of the following statements correctly identify the requirements necessary to deduct $25,000 of losses from an active participation real estate program?
The property cannot be used as a vacation home for more than 14 days or 10% of the number of days during the year that the home was rented at a fair rental price, whichever is greater.
The taxpayers can file as MFS.
The taxpayer must make the major management decisions related to the property.
The taxpayer’s interest in the property may not be held as a limited partnership interest.
A)
II, III, and IV
B)
II and IV
C)
I, III, and IV
D)
I and III
c
If the taxpayers file with the MFS status, the deduction is limited to $12,500. All other statements are true.
LO 7.2.3
Which of the following statements regarding material participation is CORRECT?
A)
It only applies to portfolio income and losses.
B)
It usually refers to a taxpayer’s main business.
C)
It is a much less rigorous standard than active participation.
D)
It only applies to real estate and associated rentals.
b
Material participation is a much more rigorous standard than active participation. The statute provides that a taxpayer is materially participating only if he or she is involved in the operations of the business on a regular, continuous, and substantial basis.
LO 7.2.1
Joe has $60,000 in wages, $13,000 in deductions, and $5,000 in passive losses this year. The passive loss did not arise from rental property or real estate. What is Joe’s taxable income this year?
A)
$60,000
B)
$44,000
C)
$48,000
D)
$47,000
d
Joe’s taxable income is $47,000 ($60,000 − $13,000). Passive losses may only offset passive income so his $5,000 loss is not allowed, except for rental and real estate property. Rental and real estate passive losses are allowed up to $25,000 and are subject to the AGI phase out limitations.
LO 7.2.3
Lauren owns a vacation home that she also rents to others during the year. The house was rented to unrelated parties for 11 full weeks during the current year. Lauren used the house 16 days for her vacation during the year. After properly dividing the expenses between rental and personal use, it was determined that a loss was incurred as follows:
Gross rental income $6,400
Less:
Allocated mortgage interest and property taxes ($7,000)
Other allocated expenses ($1,000)
Net rental loss ($1,600)
Which of the following statements regarding the treatment of the rental income and expenses on Lauren’s federal income tax return for the current year is CORRECT?
A)
Because the house was used only 20.8% personally by Lauren, all expenses allocated to personal use may be deducted.
B)
The $7,000 rental portion of mortgage interest and taxes cannot be deducted.
C)
Because Lauren used the house for 16 days, the mortgage interest and property taxes are deductible as a rental expense to the extent of the gross rental income of the property.
D)
A $1,600 loss should be reported.
c
A vacation home can be classified as a personal residence, a rental property, or a mixed-use property. A personal residence is a property that is rented out for less than 15 days per year. Because the beach house was rented for 11 weeks, it will be classified as either a rental property or a mixed-use property. The determination is based on the number of days the taxpayer used the residence for personal use. To qualify as rental property, the personal use cannot exceed the greater of 14 days per year or 10% of rental days. The property was used for personal use for 16 days, so the vacation home will be considered a mixed-use property. Expenses incurred on a mixed-use property must be allocated between rental use and personal use. The rental expenses on a mixed-use property are only deductible to the extent of rental income received (i.e., the taxpayer cannot claim a loss). The expenses not deducted in the current year may be carried forward.
LO 7.2.4
In the current year, Keith had passive losses of $19,000 from a real estate limited partnership purchased in 1985. He also had passive income of $7,000 from an oil and gas limited partnership. Both limited partnerships are not publicly traded.
What is the total amount of passive losses that may be used to offset active, passive, and portfolio income in the current year?
A)
$8,200
B)
$7,000
C)
$1,900
D)
$9,400
b
The passive loss ($19,000) is deductible, but only up to the amount of passive income ($7,000) in the same year; thus, the answer is $7,000.
LO 7.2.2
Which of the following statements regarding the disposition of passive activities with suspended losses is NOT correct?
After using losses to offset gain on the sale of the activity, any remaining losses are still passive losses.
Suspended losses from the activity are first offset against any gain on the sale of the activity.
A)
Both I and II
B)
I only
C)
II only
D)
Neither I nor II
b
Statement II is a correct statement. Statement I is incorrect. After using losses to offset gain on the sale of the activity, any remaining losses are classified as nonpassive losses.
LO 7.1.1
Paul and Mary form an equal partnership to produce hammers for the military. They each have a 50% profit and loss sharing agreement. Paul contributes cash of $50,000 and property with a fair market value of $50,000 and an adjusted basis of $20,000. Mary contributes cash of $25,000 and property with a fair market value of $75,000 and an adjusted basis of $40,000. A bank gives the partnership a recourse loan of $30,000 and a nonrecourse loan of $25,000. What is the amount at-risk for Paul and Mary, respectively?
A)
$70,000 for Paul, $65,000 for Mary
B)
$85,000 for Paul, $80,000 for Mary
C)
$97,500 for Paul, $92,500 for Mary
D)
$127,500 for Paul, $127,500 for Mary
b
The amount at-risk is measured by the amount of cash contributed, increased by the adjusted basis of property contributed, and further increased by the partner’s share of recourse financing only. Nonrecourse financing is included only if it is qualified nonrecourse financing in a real estate activity only.
LO 7.1.2
Which of the following may enable a limited partnership to provide specific tax advantages (subject to certain limits)?
It allows for special allocations.
It is not subject to the at-risk rules.
Its distributions may trigger the alternative minimum tax.
A)
I and II
B)
II and III
C)
I only
D)
I and III
c
The partnership business form allows for special allocations. Partners are still subject to at-risk rules and AMT.
LO 7.2.2
Pam is considering renting out her vacation home in Vail for two weeks during ski season. She lives in the home for approximately two months of the year. She has asked you to explain the income tax consequences.
Which one of the following statements is CORRECT?
A)
The rental income is includible in full in gross income, and the mortgage interest and property tax are 2/52 deductible for AGI.
B)
The rental income is includible in income, but mortgage interest and property taxes allocable to the rental are not deductible for AGI.
C)
The rental income may or may not be includible in income depending on the amount.
D)
The rental income is not includible in income, and the mortgage interest and property taxes are fully deductible as itemized deductions.
d
Rentals for 14 days or fewer (fewer than 15 days) during the year are not required to be included in gross income. However, no rental deductions are allowed either. The mortgage interest and taxes are fully allowed as itemized deductions because the residence test is met.
LO 7.2.4
Ken is a successful attorney with a full-time practice from which he earns a salary of nearly $500,000 a year. Which of the following investments would be appropriate in reducing Ken’s income tax liability?
Investment in an oil and gas working interest
A real estate limited partnership
A rental real estate general partnership in which Ken will not participate
Active participation rental real estate
A)
III only
B)
I, III, and IV
C)
I only
D)
II and III
c
Only a direct interest in oil and gas (the working interest) would generate any tax savings. The other activities would be passive activities and would not meet any deduction exceptions. An investment in an oil and gas working interest is an exception to the passive activity rules. The real estate partnerships are both passive and could only be used if Ken had passive income against which he could offset the losses. The active participation rental real estate is also passive, and Ken does not meet the AGI requirements for the $25,000 exception because his AGI is well in excess of $150,000 (the upper limit of the active participation requirement).
LO 7.1.2
Jimmy will have an adjusted gross income of $275,000 for the current tax year. He would like to reduce his tax liability.
Which of the following investments may reduce Jimmy’s tax liability?
A)
An investment in active participation rental real estate
B)
An investment in a nonpublicly traded limited partnership generating losses
C)
An investment in an oil and gas working interest
D)
An investment in a publicly traded limited partnership generating losses
c
An investment in an oil and gas working interest may reduce Jimmy’s tax liability.
LO 7.1.2
Which of the following business forms may be tax conduits?
General partnership
General partnership
Limited partnership
Publicly traded C corporation
S corporation
A)
II, III, and IV
B)
I and IV
C)
I, II, and IV
D)
I, II, and III
c
General partnerships, limited partnerships, and S corporations may all be tax conduits.
LO 7.1.1
Ron, age 43, and Sandy, age 41, are married with two children, Michael, age 12, and Victoria, age 8, who has been blind since her birth. Ron is an architect and general partner with XYZ partnership. Sandy is self-employed as an attorney and works out of a home office. Her home office is exclusively and regularly used for business, and the home office is her principal place of business. Their information for the tax year 2023 is as follows:
Adjusted gross income: $217,300
Itemized deductions (including qualified residential mortgage interest, taxes paid, and charitable contributions): $33,000
Early in the current year, Sandy’s father died. Sandy is the sole beneficiary of her father’s entire estate. The estate is presently in the probate process. Sandy’s mother, Lisa, age 68, has moved in with them but provides her own support. She was married to Sandy’s father when he died earlier this year.
This is Ron’s second marriage. He makes monthly support payments to his former wife and his daughter.
Because both Ron and Sandy are considered to be self-employed, they make quarterly estimated tax payments each year to cover both their income tax and self-employment tax obligations.
Ron’s investment in his XYZ partnership interest on December 31, 2021, was $12,000. As the result of a serious downturn in business, the partnership calculates Ron’s share of the partnership’s losses for 2023 will be $14,500. How much of this projected 2023 loss, if any, may Ron deduct on his income tax return for 2023?
A)
$0
B)
$14,000
C)
$12,000
D)
$2,500
c
Because this is not a passive activity, he may deduct (under the at-risk limitations) his share of the partnership loss to the extent of his investment in the partnership assuming he has at least that much in other income to offset the loss ($12,000).
LO 7.1.2
How is a shareholder’s share of an S corporation’s income and/or loss reported to the shareholder?
A)
None of these
B)
On the K-1 of Form 1065
C)
On Schedule C of Form 1040
D)
On the K-1 of Form 1120S
d
An S corporation files IRS Form 1120S and also provides each shareholder with a Schedule K-1 form indicating that shareholder’s share of the corporation’s income or loss.
LO 7.1.1
The passive losses of $21,000 are deductible, but only up to the current year’s income ($11,000).
LO 7.1.2
c
In meeting several tests, an individual with active participation in real estate may deduct up to $25,000 of rental real estate losses against active and portfolio income in any one year.
LO 7.2.3
Which of the following statements best describes a tax benefit associated with an active participation rental real estate investment?
A)
Up to $25,000 in losses may be used to offset active or portfolio income for certain taxpayers.
B)
Unlimited losses may be used to offset active or portfolio income of any taxpayer.
C)
The investment will generate portfolio rather than passive income.
D)
The first $25,000 of taxable income from the investment is nontaxable.
a
Active participation rental real estate investment operating losses are deductible against active or portfolio income up to $25,000 per year, assuming the investor’s AGI is $100,000 or less.
LO 7.2.3
In the current year, William has passive losses of $21,000 from an equipment-leasing limited partnership purchased many years ago. He also has passive income of $11,000 from an older real estate limited partnership. Both limited partnerships are not publicly traded. What is the total amount of passive losses that may be used to offset active, passive, and portfolio income in the current year?
A)
$13,000
B)
$21,000
C)
$12,000
D)
$11,000
d
The passive losses of $21,000 are deductible, but only up to the current year’s income ($11,000).
LO 7.1.2
Which of the following statements regarding the rights of a limited partner is CORRECT?
A limited partner has no right to take part in the management of the partnership.
A limited partner is not subject to personal liability for partnership debts.
A)
Neither I nor II
B)
I only
C)
Both I and II
D)
II only
Both of these statements are correct.
LO 7.1.1
All of the following statements regarding tax deduction limits on passive activity excess losses are correct except
A)
excess passive activity losses are fully allowed in the year in which the taxpayer disposes of his or her entire interest in the passive activity in a taxable transaction.
B)
excess passive activity losses are disallowed on the taxpayer’s current tax return, but, instead, are deferred.
C)
losses from one nonpublicly traded passive activity may not offset income from another nonpublicly traded passive activity.
D)
excess passive activity losses are the excess of otherwise allowable deductions from the taxpayer’s passive activities over the amount of income from the taxpayer’s passive activities.
c
The taxpayer’s nonpublicly traded passive losses and nonpublicly traded passive income are aggregated for purposes of the limitation, so that losses from one nonpublicly traded passive activity may offset income from another nonpublicly traded passive activity.
LO 7.2.2
Which one of the following statements is CORRECT with respect to a second, or vacation, home?
A)
If the home is rented for fewer than 15 days, the rental income is taxable, and the rental expenses are deductible.
B)
If the home is rented for fewer than 15 days, the rental income is not taxable.
C)
If the residence test is not met, then any rental income is taxable, but the expenses attributable to the rental are nondeductible.
D)
If the residence test is met, the home mortgage interest is not deductible.
b
If property is rented fewer than 15 days per year, the taxpayer can exclude rental income from gross income, but expenses are nondeductible, except mortgage interest, taxes, and casualty losses (Schedule A).
LO 7.2.4
Which one of the following statements correctly describes the income tax consequences upon the disposition of a passive activity?
A)
The suspended losses are deductible against any income upon the sale of the entire interest.
B)
The suspended losses are deductible in full if more than 50% of the interest in the activity is sold.
C)
If a taxpayer sells 20% of the interest in an activity, then 20% of the suspended losses are deductible against any other income.
D)
The suspended losses are nondeductible.
a
The suspended losses are deductible against any income upon the sale of the entire interest.
LO 7.1.2
Which of the following are requirements for a taxpayer who materially participates in a real property trade or business to be able to deduct any losses from the business?
More than 50% of the individual’s personal services during the tax year are performed in the real property trades or businesses in which the individual materially participates.
More than 10% of the individual’s net assets at the end of the tax year are invested in the real property trades or businesses in which the individual materially participates.
The individual performs more than 750 hours of service in the real property trades or businesses in which the individual materially participates.
A)
I and II
B)
I only
C)
II and III
D)
I and III
d
Options I and III are specific requirements that must be met for a taxpayer to be able to deduct any losses from a real estate trade or business. The amount of the individual’s net assets used in the business is not relevant.
LO 7.2.1
Jim purchased a limited partnership interest many years ago for $50,000. He has $26,000 of suspended losses from the partnership. His basis in the partnership was $15,000 and he recently sold his entire partnership interest for $20,000. Which one of the following statements correctly describes the proper tax treatment of the sale?
A)
There is a $5,000 gain resulting from the sale of the partnership interest, and $11,000 of suspended losses is deductible in full.
B)
There is a $30,000 loss resulting from the sale of the partnership interest, and the $11,000 of suspended losses are deductible in full.
C)
There is a $5,000 gain resulting from the sale of the partnership interest, and the suspended losses are deductible in full.
D)
There is a $30,000 loss resulting from the sale of the partnership interest, and the suspended losses are deductible in full.
c
The gain or loss is the difference between the sale price and the adjusted basis of the partnership interest—$5,000 in this instance. Upon the taxable disposition (typically the sale) of the passive activity, all suspended losses are deductible in full against any other income.
LO 7.1.2
Which of the following taxpayers is subject to the passive activity loss rules?
Individuals
Estates
Trusts
A)
II and III
B)
I only
C)
I, II, and III
D)
I and II
c
All of these taxpayers are subject to the passive activity loss rules.
LO 7.1.1
Willis has an active participation rental real estate activity. Last year, he had losses of $15,000 from the active participation real estate, and his AGI was $225,000. The $15,000 of losses were suspended due to his AGI. In the current year, Willis has an AGI of $90,000 and $6,000 of current losses from his real estate rental activity. What amount of loss may Willis deduct in the current year?
A)
$15,000
B)
$21,000
C)
$6,000
D)
$25,000
b
The suspended losses of $15,000 from a former year plus the current losses of $6,000 equals $21,000.
LO 7.2.3
John is a single taxpayer. He has an annual salary of $88,000 per year. In addition, he
had consulting income of $4,000,
incurred losses of $5,000 from active participation real estate, and
had short-term capital losses of $4,900.
What is John’s total (gross) income for the current tax year?
A)
$87,000
B)
$84,000
C)
$82,100
D)
$86,000
b
The consulting income is included, meaning $84,000 is correct. The rental loss is allowable and used to calculate total income (Schedule E). The short term capital loss is capped at $3,000.
LO 7.2.1
Assume that for each of the next five years, your client, Dan, will have the following:
Active income: $100,000
Investment income: $50,000
Passive income: $0
Passive loss (from nonpublicly traded partnership): $25,000
Dan is considering an investment in a nonpublicly traded partnership that requires a $100,000 initial investment and will generate cash flow (pretax passive income) of $12,500 per year at the end of each year for the next five years. Upon liquidation at the end of the fifth year, Dan will receive a total of $100,000 after taxes. Dan’s after-tax rate of return from other investments is 10% and his combined federal and state marginal tax bracket is 28%.
What is Dan’s net present value on the investment?
A)
$21,977
B)
$9,477
C)
($2,523)
D)
($15,023)
b
This problem requires the calculation of the net present value of the cash flows as compared to the $100,000 initial cash outlay. The net present value of the $12,500 received at the end of each of the first four years is first calculated. The present value of these four payments is $39,623. The calculation of present value of the amount received at the end of year five of $112,500 ($12,500 + $100,000) using a 10% rate yields $69,854. The $69,854 combined with the $39,623 results in a combined present value of all payments of $109,477. Subtracting the initial cash outlay of $100,000 results in a net present value of $9,477. Note that no tax liability would result from the cash flows as they would be “sheltered” by the passive losses.
LO 7.1.1
Which of the following are requirements in order for a taxpayer who materially participates in a real property trade or business to be able to deduct any losses from the business?
More than 50% of the individual’s personal services during the tax year are performed in the real property trades or businesses in which the individual materially participates.
More than 10% of the individual’s net assets at the end of the tax year are invested in the real property trades or businesses in which the individual materially participates.
The individual performs more than 750 hours of service in the real property trades or businesses in which the individual materially participates.
A)
I and II
B)
I only
C)
II and III
D)
I and III
d
Options I and III are specific requirements that must be met in order for a taxpayer to able to deduct any losses from a real estate trade or business. The amount of the individual’s net assets used in the business is not relevant.
LO 7.2.1
Which one of the following best describes the role of a special allocation in a limited partnership?
A)
It allows an allocation of items of income and expense that is not pro rata.
B)
It allocates management responsibility to the general partners.
C)
It establishes the standards for allocating the proceeds of non-routine or “special” items of income.
D)
It requires all items to be distributed pro rata based on a partner’s capital account balance.
a
A special allocation allows an allocation of items in a manner that differs from the “normal” pro rata allocation of deduction, income, credit, etc.
LO 7.1.1
Dwight has an active participation rental real estate activity. In 2022, he had losses of $20,000 from the active participation real estate and his AGI was $140,000. He was allowed to deduct $5,000 of the losses against other income. The remaining $15,000 loss was carried forward into 2023. In 2023, Dwight has an AGI of $90,000 and only $6,000 of current losses from his real estate rental activity. What amount of loss, if any, may Dwight deduct in 2023?
A)
$15,000
B)
$6,000
C)
$21,000
D)
$0
c Dwight is allowed to deduct $21,000 of losses in 2023. The $15,000 carryforward losses are treated as if they occurred in 2023. The $6,000 current losses plus the $15,000 carryover losses total $21,000. This loss would be fully deductible as the AGI is under $100,000.
LO 7.2.1
Paul died recently. At the time of his death, he had $12,000 in suspended losses from a limited partnership, a passive activity. His basis in the limited partnership was zero, and the step-up in basis at death was $10,000. What is the amount of suspended losses that are deductible?
A)
$12,000
B)
$2,000
C)
$0
D)
$10,000
b
The answer is $2,000, the suspended losses ($12,000) minus the basis ($10,000).
LO 7.2.1
The partner’s tax basis in his interest in a partnership
A)
is increased by his share of income reported by the partnership.
B)
remains unchanged unless additional capital is contributed or distributions are made.
C)
remains unchanged until the interest is sold or otherwise disposed.
D)
is decreased if additional capital is contributed.
a
A partner’s tax basis in a partnership interest is affected by items of income or loss, which are passed through to the partner on a proportionate basis. Items of income, as well as capital contributions, increase basis; deductions, as well as distributions, decrease basis.
LO 7.1.1
Patty has a $10,000 passive loss carryforward from Beta limited partnership, which is publicly traded. She also has a $15,000 passive loss carryforward from Alpha limited partnership, which is nonpublicly traded. In the current year, she has $6,000 of income from Beta. She also has $11,000 of income from Gamma LP. Gamma is not publicly traded. What is the total amount of passive losses that Patty may deduct during the current year?
A)
$11,000
B)
$25,000
C)
$6,000
D)
$17,000
d
Of the $10,000 passive loss carryforward from the Beta limited partnership, only $6,000 may be utilized in the current year due to the $6,000 of current year passive income. A total of $11,000 in losses from the Alpha limited partnership may be utilized against the $11,000 of income from the Gamma limited partnership in the current year because both are nonpublicly traded. Thus, the total of passive losses that are allowed for the current year is $17,000.
LO 7.2.2
Which of the following statements regarding limited partnerships is CORRECT?
A limited partner is subject to the passive activity rules when accounting for income and losses from the limited partnership.
The limited partner is liable to the creditors of the partnership only to the extent of that partner’s contributed or promised cash or property.
A)
I only
B)
II only
C)
Both I and II
D)
Neither I nor II
c
Both of these statements are correct.
LO 7.1.1
Which of the following apply to the passive activity loss rules?
Deductible passive losses are limited to the passive gains in other passive activities.
Any unused passive losses may be carried forward against future passive gains.
When the passive activity property is disposed of, any unused passive losses can be deducted against passive gains, portfolio, or active income.
Passive loss rules apply only to real estate transactions.
A)
II, III, and IV
B)
I, II, and III
C)
I and III
D)
II and IV
b
Passive loss rules apply to all passive activities, not just real estate transactions. Passive losses may be deducted against passive gains. If the investor has excess passive losses, the losses are carried forward and may be used in future years to offset future passive gains.
LO 7.1.1
Nathan has a salary of $100,000, dividends of $4,000, and limited partnership income of $10,000. The limited partnership is publicly traded. During January of the current year, Nathan purchased an interest in a nonpublicly traded limited partnership that will generate a $12,000 passive loss during the current tax year. How much of this passive loss, if any, is deductible by Nathan during the current tax year?
A)
$10,000
B)
$12,000
C)
$0
D)
$4,000
c
The general rule is that passive losses are deductible only against passive income. However, passive income from a publicly traded partnership cannot be offset by passive losses arising from any other source. Thus, the passive losses from the new partnership will not be deductible.
LO 7.2.2
Your client, Joe, has active income of $300,000 per year and substantial unused passive losses from a nonpublicly traded limited partnership. He would like to find an investment that would allow him to utilize his passive losses. Which of the following are the most appropriate investments for Joe?
An active participation rental real estate activity generating income
A master limited partnership (MLP) generating income
Certificates of deposit generating portfolio income
A nonpublicly traded limited partnership generating income
A)
I and IV
B)
III and IV
C)
I and II
D)
I, II, and IV
a
Income from active participation rental activities is considered passive income. The nonpublicly traded limited partnership losses may not offset income from a publicly traded partnership (the MLP) or portfolio income.
LO 7.2.2
Which of the following statements concerning the passive activity loss rules is NOT correct?
A)
The $25,000 offset allowance for the small real estate investor is not available to taxpayers whose AGI is $150,000 or more.
B)
Losses from one master limited partnership activity may only offset income from that particular activity; they cannot be used to offset income from any other passive activities.
C)
Losses from passive activities may not offset portfolio or active income except under limited circumstances.
D)
The passive activity loss rules limitation is a permanent disallowance rule.
d
The passive activity loss limitation is not a permanent disallowance rule. When a taxpayer disposes of his entire interest in a fully taxable transaction to an unrelated purchaser (not a related party), his suspended losses from that activity, including any losses incurred in the year of disposition, are generally deductible in full.
LO 7.1.2
When does the alternative minimum tax (AMT) apply to a taxpayer?
A)
When the taxpayer has losses from passive activities or other business functions
B)
Anytime a person is involved in passive activities
C)
When the taxpayer has not withheld or prepaid a sufficient proportion of actual income tax liability
D)
When the AMT calculation results in a tax liability that is greater than that resulting from the regular income tax calculation
d
The AMT is paid when the AMT tax calculation produces a higher amount of tax than the regular tax calculation and the AMT payable is the difference between the two.
LO 7.1.1
Which of the following forms of business could NOT be a direct participation program (tax conduit)?
A)
S corporation
B)
Limited liability company (LLC)
C)
Limited liability partnership (LLP)
D)
Closely held C corporation
d
The tax advantages provided by direct participation programs are founded upon the principle that most types of business organizations function as tax conduits. Therefore, a closely held C corporation cannot qualify, as there is no flow through of gains and losses.
LO 7.1.1
Paul has the following items:
Carryforward of prior year passive loss from:
XYZ limited partnership (publicly traded) $(10,000)
ABC limited partnership (nonpublicly traded) $(6,000)
Current year passive income and loss from:
XYZ limited partnership (publicly traded) $12,000
GHI limited partnership (publicly traded) $(9,000)
JKL limited partnership (nonpublicly traded) $18,000
RST limited partnership (nonpublicly traded) $(14,000)
What is the total amount of passive losses that Paul may deduct during the current year?
A)
$28,000
B)
$18,000
C)
$30,000
D)
$14,000
a
Publicly traded partnership (PTP) income may only be offset by prior year losses from the same partnership. Thus, the $10,000 XYZ carryforward is deductible. Nonpublicly traded income ($18,000) may be offset by current losses ($14,000) or carryforward losses ($6,000) from any nonpublicly traded activities. Thus, the $10,000 XYZ loss and the $18,000 nonpublicly traded loss total $28,000.
LO 7.2.2
To which of the following do the passive activity loss rules apply?
Individuals
C corporations that are not closely held
Closely held C corporations
Estates
A)
I only
B)
I and III
C)
II and IV
D)
I, III, and IV
d
Of the listed choices, option II is the only option to which the passive activity loss rules do not apply. The passive activity loss rules specifically do not apply to C corporations that are not closely held.
LO 7.1.2
John has the following items from four separate investments during the current tax year:
Passive income from a publicly traded limited partnership: $8,000
Passive loss from a publicly traded limited partnership: $10,000
Passive income from a nonpublicly traded limited partnership: $17,000
Passive loss from a nonpublicly traded limited partnership: $9,000
What is the total amount, if any, of passive losses that may be deducted during the current year?
A)
$19,000
B)
$9,000
C)
$17,000
D)
$0
b
Losses from a non-PTP may be deducted up to the amount of income from a non-PTP. In this situation, the passive loss of $9,000 may be deducted in full against the $17,000 of passive income. The income from a PTP may not be offset by passive losses arising from any other source, and the losses from a PTP must be held in suspense until that same partnership generates income.
LO 7.2.2
Your clients, Jane and Mark, are contemplating the purchase of a condominium to use as a rental property. They would manage the property themselves and anticipate that it would generate losses for the first few years, at least. Which of the following statements are CORRECT with respect to active participation rental real estate?
The interest may be held through a limited partnership.
A deduction-equivalent tax credit of up to $25,000 is available.
The taxpayer must hold a 10% or greater ownership interest in the property.
The taxpayer must participate in the management of the property in a bona fide sense.
A)
I, II, and III
B)
III and IV
C)
I and II
D)
II, III, and IV
b
III and IV are the only choices that are correct, by definition. The interest in the property may not, by definition, be held through a limited partnership, and up to $25,000 refers to losses that may be deducted, not credits that may be taken. The deduction-equivalent tax credits mentioned in option II are relevant with respect to low-income housing and historic rehabilitation passive activities.
LO 7.2.3
Which of the following statements regarding passive activity losses is CORRECT?
When determining the amount of suspended loss that may be used against income, the at-risk rules are applied before the passive activity loss rules.
If a loss is not allowed because of the at-risk limitations, the loss is a suspended loss eligible for deduction as a disposition of a passive activity.
A)
Both I and II
B)
Neither I nor II
C)
II only
D)
I only
d
Statement I is correct. Statement II is incorrect. If a loss is not allowed because of the at-risk limitations, the loss is a suspended loss and is not eligible for deduction as a disposition of a passive activity.
LO 7.2.3
Your client has a salary of $80,000, dividends of $20,000, and limited partnership income of $15,000. This year, she invested in an equipment-leasing partnership. Her initial investment included $50,000 cash and a nonrecourse note for $60,000. What is the maximum tax deduction your client may take from this equipment-leasing investment this year?
A)
$15,000
B)
$45,000
C)
$35,000
D)
$50,000
a
Explanation
Passive losses are only deductible against passive income. She has passive income of $15,000 from the limited partnership, thus she could deduct up to $15,000 of passive losses from the equipment-leasing limited partnership.
Bob passed away during the current year. He had suspended losses from a limited partnership activity of $25,000. Bob’s basis in the partnership was $1,000 and the fair market value at the time of his death was $18,000. What amount of passive losses, if any, is deductible on Bob’s final income tax return?
A)
$14,000
B)
$17,000
C)
$0
D)
$8,000
d
The suspended passive losses are “freed up” and deductible only to the extent that the losses exceed the step-up in basis. In this situation, the step-up in basis equals $17,000 (from $1,000 to $18,000). The losses of $25,000 exceed the step-up amount by $8,000.
Jean’s mother dies and leaves her house to Jean this year. The house is valued at $40,000. Jean rents the house to tenants for $1,000 per month following her mother’s death. What amount must Jean include in her annual gross income for this year?
A)
The lesser of the FMV of the house or the amount of rental income she receives
B)
$40,000
C)
The amount of rental income she receives
D)
$40,000 plus the amount of rental income she receives
c Jean receives the house on a tax-free basis because inheritances and gifts are not taxable to the recipient. However, any income generated by the house, such as rental income, is subject to taxation.
LO 7.2.3
A taxpayer invested in a real estate limited partnership several years ago. There is a special allocation in effect in the partnership. He is concerned about the deductibility of the losses that are flowing from the partnership. Which of the following rules or doctrines may limit the availability of income tax benefits from his limited partnership investment?
Direct participation program
Special allocation rules
At-risk rule
Passive activity loss rule
A)
I and IV
B)
I and III
C)
II and III
D)
II, III, and IV
d
Special allocation rules, such as the substantial economic effect doctrine, limit the ability to utilize special allocations in a partnership. The at-risk rule limits the ability to utilize leverage by attacking the use of nonrecourse financing. The passive activity loss rule limits the ability to deduct losses from activities in which the taxpayer does not materially participate. The direct participation program simply refers to a tax conduit.
LO 7.1.2
Cindy has adjusted gross income (AGI) of $350,000. Included in the AGI is passive income of $40,000 and passive losses of $55,000, $40,000 of which she uses to offset the passive income and $15,000 of which is subject to carryforward. Which one of the following activities has the greatest potential for reducing Cindy’s tax liability?
A)
Investing in a real estate partnership in which she will not materially participate that is producing passive losses
B)
None of these options will reduce Cindy’s tax liability
C)
Investing in an oil and gas limited partnership that is generating losses
D)
Investing in “active participation” rental real estate that is producing a loss
b
The active participation deduction is eliminated at $150,000 of AGI. The oil and gas limited partnership and the equipment-leasing limited partnership would produce more passive losses that are nondeductible. Therefore, none of the options are viable.
LO 7.1.2
Which of the following activities are considered passive activities?
A real estate broker spending 1,500 hours on her real estate activities, this being 80% of her personal services for the year
A taxpayer who owns an apartment building using a property management to assist him in managing the property
A taxpayer investing in a real estate limited partnership (RELP)
A taxpayer owning 8% of an inherited condo that is rented to others during the year
A)
II and III
B)
II, III, and IV
C)
I, II, III, and IV
D)
I only
b
Statements II, III, and IV are correct. Only the real estate professional’s activities are not considered passive. In statement IV, the taxpayer owns less than 10% of the activity, so it is considered passive. This taxpayer is barred from using the real estate exception for losses because the taxpayer owns less than 10% of the activity.
LO 7.2.3
With respect to the at-risk rules, qualified nonrecourse financing is a debt
A)
secured by specific real property.
B)
that is convertible into an equity interest.
C)
for which at least one individual is personally liable.
D)
from a loan provided by a related person at “below market” terms.
a
A partner’s share of nonrecourse financing established basis in the partnership, but is not treated as an amount at risk. Remember that nonrecourse financing is debt that is secured by the property, but for which no individual has personal liability.
LO 7.1.2
Lisa and William are married taxpayers who file as married filing separately (MFS) for income tax purposes as it is advantageous for their tax positions; although the couple does live together. Lisa has rental property she inherited from her uncle that will generate a loss this year of $14,000. Lisa meets the active participation standard. Lisa’s AGI is $65,000 and William’s AGI is $80,000. How much is Lisa’s allowed passive activity loss this year?
A)
$5,000
B)
$14,000
C)
$12,500
D)
$0
d
The rental real estate loss allowance is not available to taxpayers who file as MFS and have lived together at any time during the tax year.
LO 7.2.3
On April 1 of the current tax year, Susan sold her principal residence for a total price of $501,000; $301,000 was in cash, with the buyer assuming a $200,000 mortgage on the house. Susan purchased the house 15 years ago for $290,000. She has not made any improvements to the house. To assist in the sale of the residence, she incurred costs of $1,500 for repairs three weeks before the sale occurred. Realtor commissions of $31,000 resulted from the sale. On May 1 of the current tax year, Susan bought a new residence for $260,000.
Assume that Susan is considering renting out her new residence for two weeks (14 days) during the upcoming tax year. However, she is unsure of the income tax consequences. Which one of the following statements is CORRECT?
A)
The rental income is includible in full in gross income.
B)
The rental income is not includible in income.
C)
The rental income may or may not be includible in income, depending on the amount.
D)
The rental income is includible in income, but mortgage interest and property taxes allocable to the rental are deductible for AGI.
b Income from rentals for fewer than 15 days during the year are not required to be included in gross income. However, no deductions attributable solely to the rental are allowed, either. The home mortgage interest and property taxes are still deductible in full as itemized deductions.
LO 7.2.4
Which of the following applies to the at-risk rules, as related to passive loss restrictions for partners?
It is the maximum deductible loss for an investment limited to the amount of risk that the taxpayer has at the end of the current year.
Determining the amount at risk includes the adjusted basis of other property contributed to the partnership.
The inclusion of nonrecourse financing is essentially the only difference between the basis in a partnership and the amount at risk.
A)
II only
B)
I and II
C)
I, II and III
D)
I only
c
In the Tax Code, the at-risk rules are defined as the maximum deductible loss for an investment limited to the amount that the taxpayer-investor has at risk at the end of the current year (i.e., the amount of potential economic loss). A partner may deduct losses only to the extent of the amount that they have “at risk.” The amount at risk equals the sum of the following:
The money invested (except to the extent the money invested was borrowed and was secured only by the investment)
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 (recourse indebtedness)
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
Essentially, the only difference between the amount at risk and the basis in a partnership interest is the treatment of nonrecourse financing.
LO 7.2.3
If a vacation home is rented for 14 days or less during the year, which one of the following statements is CORRECT?
A)
A portion of the rental income may be nontaxable.
B)
The full amount of home mortgage interest is permitted as an itemized deduction.
C)
Repair expenses attributed to the rental activity are deductible.
D)
Typically, only a small amount of cost recovery deductions is allowed for the year.
b
Explanation
If property is rented fewer than 15 days per year, the full amount of home mortgage interest, taxes, and casualty losses are permitted as an itemized deduction (not expenses, though); in addition, rental income can be excluded from gross income.
LO 7.2.4
