Passive Activity - Examples Flashcards
Passive Losses - Closely Held C Corporations -
The passive loss rules apply to closely held C corporations but only on a limited basis. A closely held C corporation is a C corporation where five or fewer individuals own more than 50% of the stock at any time during the last half of the corporation’s taxable year. Thus, as applied to a closely held C corporation, the passive loss rules prevent passive activity losses from offsetting portfolio income, which is income from dividends, interest and other investments.
For example, Allen and Beth equally own all of the outstanding stock of Delta. During the current year, Delta generates $15,000 in taxable income from its active business operations. It also earns $10,000 of interest and dividends from investments and reports a $30,000 loss from a passive activity. As Delta is a closely held C corporation, the $15,000 of taxable income from the active business is offset by $15,000 of the passive loss. However, the $10,000 of portfolio income may not be offset. Thus, for the current year, Delta reports $10,000 of taxable income from its portfolio income and has a $15,000 passive loss carryover.
Passive Losses - Publicly Traded Partnerships
In many cases, a publicly traded partnership (PTP) is treated for tax purposes as a corporation. A PTP, for purposes of the passive loss rules, is defined as any partnership where interest in the partnership is either traded on an established securities market or readily available for trading on a secondary market.
If a PTP is treated for tax purposes as a corporation, the passive loss rules generally do not apply. However, if a PTP meets certain gross income requirements it may still be treated as a partnership, causing its items of income, loss, and credit to flow through to the partners. Partners treat losses from a PTP as separate from any other type of income that is passive, active business, or portfolio, as well as separate from any income from other PTPs.
For example, Mark owns interests in partnerships A and B, both of which are PTPs that are treated as partnerships. During the current year, Mark’s share of the income from A is $2,000. Mark’s share of B’s loss is $1,200. B also generated some portfolio income. Mark’s share of B’s portfolio income is $800. The $1,200 loss from B may not offset any of B’s $800 portfolio income. Furthermore, it may not offset any of the $2,000 income from A. The $2,000 income from A is treated as portfolio income. Thus, Mark reports $2,800 portfolio income and has a $1,200 suspended loss from B. In a subsequent year, Mark’s share of any income from B can be offset by the $1,200 of suspended loss that is carried forward.
Partners may deduct suspended losses from PTPs only in the year the partner disposes of his or her interest in the PTP. Partners do not recognize a loss in the year that the PTP itself has a passive activity.
Passive Income and Losses - In general, for any tax year, losses generated in one passive activity may be used to offset income from other passive activities but may not offset either active or portfolio income.
For example, suppose during the year, Kasi, a CPA, reports $100,000 of active business income from his CPA practice. He also owns two passive activities. From activity A, he earned $10,000 of income, and from activity B, he incurred a $15,000 loss. Kasi may use $10,000 of the loss from activity B to offset the $10,000 of income from activity A. However, Kasi may not deduct the $5,000 excess loss from Activity B in the current year, even though he has $100,000 of active business income.
Passive Losses - Carryovers - Passive activity losses that are disallowed as deductions for the year in which they are incurred, are carried over indefinitely and treated as losses allocable to that activity in the following tax years. These losses, known as suspended losses, may offset passive activity income of the subsequent year, but generally may not offset other types of income.
For example, Tammy reports the following income and loss for the year:
Salary $200,000
Loss from activity X ($40,000)
Loss from activity Y ($10,000)
Income from activity Z $30,000
X, Y, and Z are all passive activities. The losses generated in activities X and Y offset the income from activity Z, but none of the salary income is offset. Thus, Tammy has a net passive loss for the year of $20,000 ($40,000 + $10,000 − $30,000), which must be carried over to subsequent years. The amount of the carryover attributable to each activity is as follows:
Activity X: $20,000 x($40,000/$50,000) = $16,000
Activity Y: $20,000 x($10,000/$50,000) = $4,000
Passive Losses - Taxable Disposition of Interest - When a taxpayer disposes of a passive activity to an unrelated third party in a taxable transaction, the economic gain or loss generated by the activity can be computed, and the suspended losses of that activity may be deducted against the taxpayer’s other income
For example, during the current year, Pam realizes $6,000 of taxable income from activity A, $1,000 of loss from activity B, and $8,000 of taxable income from activity C. All three activities are passive activities with regard to Pam. In addition, $30,000 of passive losses from activity C is carried over from prior years. During the current year, Pam sells activity C for a $15,000 taxable gain. Pam reports salary income of $90,000 for the year. Activity C is disposed of in a fully taxable transaction, so, Pam may deduct $2,000 of loss against the salary income, as follows:
Income for the year from C $ 8,000
Gain from the sale of C $15,000
Suspended losses from C ($30,000)
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Total loss from C ($7,000)
Income for the year from A $6,000
Loss for the year from B ($1,000) $5,000
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Pam’s deduction against salary income ($2,000)
Passive Losses - Carryovers from a Former Passive Activity - The determination of whether an activity is passive with respect to a taxpayer is made annually. Thus, an activity that was previously considered passive may not be passive with respect to the taxpayer for the current year. This is called a former passive activity.
For example, Kris owns activity A, which, for the immediately preceding tax year, was considered a passive activity with regard to Kris. $10,000 in losses from activity A were disallowed and carried over to the current year. Due to Kris’ increased involvement in activity A in the current year, it is no longer considered passive with regard to Kris. During the current year, activity A generates a $5,000 loss. And in the same year Kris also has an investment in activity B, a passive activity. Her share of activity B’s income is $7,000. Kris also reports $60,000 in salary. As activity A is not a passive activity for the current year, the $5,000 current year loss is fully deductible against her salary. However, the $10,000 loss carryover from the prior year is deductible only against the $7,000 of income from passive activity B. The $3,000 ($10,000 - $7,000) excess is carried over to the subsequent year.
Note that In the current year, there is only one passive activity (B). The prior year passive suspended loss from A (which was passive last year) can offset current year income of $7,000 in activity B. So the current year, only has one passive activity, B. As far as the previous year, there was only one activity with suspended losses (A). Activity B was only in the current year.
Passive Losses - Credits - Credits generated in a passive activity are also limited and may be used only against the portion of the tax liability that is attributable to passive income. This amount is determined by comparing the tax liability on all income for the year with the tax liability on all income excluding the passive income.
For example, Dale invests in a passive activity. For the year, he must report $10,000 of taxable income from the passive activity. Dale’s share of tax credits generated by the passive activity is $5,000. Assume Dale’s pre-credit tax liability on all income (including the $10,000 from the passive activity) is $25,000, and his pre-credit tax liability on all income excluding the passive activity income is $22,000. He may use only $3,000 ($25,000 - $22,000) of the tax credits generated by the passive activity. The remaining $2,000 of tax credits is carried forward and may be used in a subsequent year against the portion of the tax liability attributable to passive activity income in that year. However, these credits may not offset any portion of the tax liability attributable to non-passive activities.
Real Estate Exceptions - Rental Real Estate Trade or Business -
* More than one-half of the personal services the taxpayer performs in all trades or businesses during the year must be performed in real property trades or businesses in which the taxpayer materially participates.
* The taxpayer must perform more than 750 hours of work during the taxable year in real property trades or businesses in which the taxpayer materially participates.
For example, Anwar and Anya are married and file a joint return. Anwar’s only job is renting and maintaining four large apartment complexes that he owns. Anwar and Anya manage the buildings themselves. During the current year, Anya spent 500 hours keeping records and corresponding with tenants. Anwar spent 700 hours during the year maintaining and repairing the apartments. Even though all of Anya and Anwar’s personal services are connected with a real property trade or business in which they materially participate, this rental activity is considered passive because neither Anwar nor Anya alone spends more than 750 hours doing services related to the rental activity.
Real Estate Exceptions - Limitation on Deduction - Taxpayers must first apply rental real estate losses for active participation against other net passive income for the year. Taxpayers may then deduct these losses against their portfolio or active business income up to $25,000. The $25,000 limit, however, is reduced by 50% of the taxpayer’s adjusted gross income (AGI) in excess of $100,000.
For example, Hal owns over 10% and actively participates in activity A, which is a passive real estate rental activity. Hal’s marginal tax rate is 28% and he has an AGI of less than $100,000. For the year, activity A generates a $20,000 net loss and $10,000 in tax credits (which amounts to $35,714 in deduction equivalent {$10,000/.28}). After deducting the $20,000 net loss against his active business and portfolio income, Hal has a remaining real estate deduction under the limit of $5,000 ($25,000 − $20,000). Thus, Hal may use $1,400 ($5,000 × 0.28) of the credits. The remaining $8,600 ($10,000 − $1,400) of tax credits must be carried over to subsequent years.
If deductions and credits exceeding the $25,000 limit arise from more than one passive activity, they must be allocated between the activities.
Disposition of Passive Activities - Installment sales – suspended losses are recognized based on the ratio of gain recognized in the tax year, relative to the total gain over the life of the installment sale.
For example, a taxpayer sells an interest in a passive activity for $200,000 with an adjusted basis of $120,000. The only amount received in the current year is a down payment of $20,000. Furthermore, the taxpayer had $32,000 of suspended losses at the time of the sale. The gross profit percentage (GPP) for the installment sale is 40% ($80,000 profit divided by $200,000 sales price). Since the taxpayer received the down payment of$20,000, the GPP (40%) dictates that $8,000 must be recognized as a gain. This $8,000 of reported gain in the current tax year represents 10% of the total gain ($80,000) over the life of the installment sale. Therefore 10% ($3,200) of the $32,000 suspended losses will be recognized in the current year.
Inheritance – suspended losses are only deductible to the extent they exceed any step-up in basis. Any excess amounts are deductible on the decedent’s final tax return.
A taxpayer dies with a passive activity with an adjusted basis of $55,000, and a fair market value at the date of death of $65,000.
If the descendent had suspended losses of $12,000, only$2,000 would be deductible on the decedent’s final tax return. ($12,000 suspended losses - $10,000 step-up).
