Passive Activity and At-Risk Rules

Question 1

What is a direct participation program?

Answer 1

A conduit entity. Simply put, any flow-through entity (limited or general partnership, S Corp, LLC, LLP) is a direct participation program.

Question 2

What are the most common types of partnerships?

Answer 2

Limited - most common and what is referred to today as a tax shelter
General - used seldom because of it unlimited liability for all partners
Master limited - partnerships traded on the stock exchange, many of which are no longer conduits, so not very popular anymore

Question 3

How are passive activities defined?

Answer 3

Activities in which the taxpayer does not actively participate
Rental activities, as long as the owner does not actively participate

Question 4

Every PIG needs a PAL…

Answer 4

Every passive income generator needs a passive activity loss. This means that a taxpayer can only take a passive loss against passive income (vice active or portfolio income)

Question 5

What are the “at risk rules”?

Answer 5

It is the maximum deductible loss for an investment, which is limited to the amount that the taxpayer-investor has at risk at the end of the year. Meaning, the amount deductible is only the amount the taxpayer stands to lose

Question 6

What is a suspended loss?

Answer 6

A loss over and above the at risk amount - a disallowed loss. The loss is suspended until there is sufficient income gain (in future years) or if the taxpayer invests more into the PIG.

Question 7

What is a material participant?

Answer 7

Someone who’s activity would cause their income to be classified “not passive.” This activities:

• 500+ participation hours per year
• More, or all, of the participation is done by this individual
• Material participation took place more than 5 of the past 10 years

Question 8

What is the significance of material participation?

Answer 8

Material participation allows taxpayers to deduct losses because they are no longer limited by passive activity loss rules.

Question 9

What are the loss to income offset rules for publicly and non-publicly traded partnerships?

Answer 9

Losses from one non-publicly traded partnership CAN be used to offset income from another non-publicly traded partnership.

Losses from a PTP CANNOT be used to offset income from another PTP - only the same PTP.

Question 10

What is the real estate professional exception to the passive rental real estate rules? In other words, what qualified material participation in real estate?

Answer 10

More than 50% of personal services AND more than 750 hours of work in the real estate activity per year.

Question 11

What is the more common exception to the rental real estate rules (for those who dabble in rental income)?

Answer 11

The small investor must actively participate in the management of the property AND own at least 10% interest in the property. They can then deduct up to $25,000 against active and portfolio losses.

The $25k is reduced $1 for every $2 phaseout beyond $100k, completely by $150k. Losses can be taken up to the amount of the phaseout-capped deduction.

Question 12

What are the rules for deduction in a mixed use vacation home?

Answer 12

The taxpayer can only deduct up to the rental income - no losses

Question 13

What are the definitions of personal, rental, and mixed use home?

Answer 13

Personal (min rental use): property rented less than 15 days per year

Rental (min personal use): property rented at least 15 days and not personally used for more than 14 days or 10% of rental days

Mixed: property rented at least 15 days and used personally more than 14 days or 10% of rental days per year

Question 14

What is the allowable deduction for a primarily rental property?

Answer 14

Up to $25k deduction with $1 for every $2 reduction after $100K up to $150k

Question 15

What’s the difference between PTP/MLP and non-publicly traded partnerships?

Answer 15

A PTP/MLP is traded on a public exchange

Question 16

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) $70,000 for Paul, $65,000 for Mary
B) $127,500 for Paul, $127,500 for Mary
C) $85,000 for Paul, $80,000 for Mary
D) $97,500 for Paul, $92,500 for Mary

Answer 16

D) $97,500 for Paul, $92,500 for Mary
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.

Question 17

Upon the disposition of a passive activity interest by gift, the suspended losses are

A) added to the basis of the interest.
B) deductible in full.
C) deductible to the extent the losses exceed any increase in the fair market value of the activity.
D) completely lost

Answer 17

A) added to the basis of the interest.

Question 18

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 allocates management responsibility to the general partners.
C) It allows an allocation of items of income and expense that is not pro rata.
D) It establishes the standards for allocating the proceeds of non-routine or “special” items of income.

Answer 18

C) It allows an allocation of items of income and expense that is not pro rata (or not proportionally).

Question 19

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.

Answer 19

They are both correct

Question 20

Which (any) of the following apply to the passive activity loss rules?

a. Deductible passive losses are limited to the passive gains in other passive activities.
b. Any unused passive losses may be carried forward against future passive gains.
c. When the passive activity property is disposed of, any unused passive losses can be deducted against passive gains, portfolio, or active income.
d. Passive loss rules apply only to real estate transactions.

Answer 20

a. Deductible passive losses are limited to the passive gains in other passive activities.
b. Any unused passive losses may be carried forward against future passive gains.
c. When the passive activity property is disposed of, any unused passive losses can be deducted against passive gains, portfolio, or active income.

Question 21

The amount at risk equals the sum of… (5 things)

Answer 21

• The money invested
• The adjusted basis
• Amounts borrowed (to the extent responsible - recourse financing)
• The partners share of income - partners share of losses
• The proportionate share of non-recourse financing in real estate activity only

Question 22

What is non-recourse financing?

Answer 22

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

Question 23

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) $0
B) $2,000
C) $12,000
D) $10,000

Answer 23

The answer is $2,000, the suspended losses ($12,000) minus the basis ($10,000).

Question 24

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.

Answer 24

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.

Question 25

What is the active rental income deduction exception for those MFS living together?

Answer 25

They can’t take the $25,000 in any way, shape, or form

Question 26

After using passive losses to offset gains, what are the remaining losses classified as? (hint - not suspended)

Answer 26

non-passive losses