Tax 5-4, 5, 6, 7 Passive Activity Rules

Question 1

Passive Activity Loss Rules

The passive loss rules limit deductions from a trade or business activity only where a taxpayer does not _____ participate in the activity.

(5-4, 19)

Answer 1

materially

To the extent that an investor is willing and able to meet the standards for material participation, he or she still may use the losses and credits to offset other active income.

Question 2

Passive Activity Loss Rules

Material participation generally is defined as a regular, continuous, and substantial involvement in the activity’s operations. Generally, three factors must be considered.

(5-4, 20)

Answer 2

First, is the activity the taxpayer’s principal trade or business?

Second, what is the taxpayer’s actual day-to-day involvement in the activity?

Third, what is the taxpayer’s knowledge, background, and experience in this or similar activities?

Question 3

Passive Activity Loss Rules

The most common test to determine material participation in a trade or business activity is the _____ hour test. If the taxpayer meaningfully participates for 500 or more hours during the tax year, he or she is deemed to materially participate in the business.

100

500

700

(5-4, 20)

Answer 3

500

Question 4

Passive Activity Loss Rules

List the standards for material participation.

Three factors must be considered:

(5-4, 5, 6, 7, 53)

Answer 4

(1) whether the activity is the taxpayer’s principal trade or business;
(2) the taxpayer’s actual day to-day involvement in the business; and
(3) the taxpayer’s knowledge, experience, and background in this or similar businesses.

Question 5

Passive Activity Loss Rules

The Regulations provide that an individual materially participates in an activity for a tax year if and only if one of the following criteria is met:

(5-4, 5, 6, 7, 53)

Answer 5

(1) The individual participates in the activity for more than 500 hours during the year.
(2) The individual’s participation in the activity for the tax year is substantially all of the participation in it for the year.
(3) The individual participates in the activity for more than 100 hours during the tax year and that participation is not less than that of any other individual for that year.
(4) The activity is a “significant participation activity” for the tax year, and the individual’s aggregate participation in all significant participation activities that year exceeds 500 hours.
(5) The individual materially participated in the activity for any five tax years (whether or not consecutive) during the ten immediately preceding tax years.
(6) The individual materially participated in the activity for any three tax years (whether or not consecutive) preceding the tax year, if the activity is a personal service activity.
(7) The individual meets a facts and circumstances test. The question is whether the taxpayer participated on a regular, continuous, and substantial basis in the activity.

Question 6

Passive Activity Loss Rules

Discuss the tax treatment of income and losses from publicly traded partnerships.

(5-4, 5, 6, 7, 53)

Answer 6

The income from a publicly traded partnership (including MLPs) cannot be offset by passive losses from any other source. The losses from a publicly traded limited partnership are not currently deductible; instead, they must be held in suspense until that same partnership generates income or until there is a disposition of the entire interest in the partnership.

Question 7

Passive Activity Loss Rules

Discuss the rules related to the disposition of a passive activity:

Gift

(5-4, 5, 6, 7, 53)

Answer 7

The suspended losses are added to the basis of the gifted passive activity interest.

Question 8

Passive Activity Loss Rules

Discuss the rules related to the disposition of a passive activity:

Upon death

(5-4, 5, 6, 7, 53)

Answer 8

The suspended losses are deductible only to the extent that the losses exceed the step-up in basis of the passive activity.

Question 9

Passive Activity Loss Rules

Discuss the rules related to active participation in a rental real estate investment

(5-4, 5, 6, 7, 53)

Answer 9

An active participant with under $100,000 in AGI may use up to $25,000 in losses to offset active or portfolio income. This allowance is phased out for taxpayers with AGI between $100,000 and $150,000. The deduction for such losses is suspended for taxpayers with AGI over $150,000. The taxpayer must own at least a 10% interest in the property to be an active participant. Also, ownership of a limited partnership interest does not qualify.

Question 10

Passive Activity Loss Rules

Deborah Rafferty is a successful medical doctor with a full-time private practice and an AGI of $400,000 per year from active income.

Discuss each of the following as an opportunity for Deborah to shelter some of this income.

active participation in rental real estate

(5-4, 5, 6, 7, 53)

Answer 10

A loss from active participation rental real estate would not be deductible because her AGI exceeds the phaseout range of $100,000–$150,000.

Question 11

Passive Activity Loss Rules

Deborah Rafferty is a successful medical doctor with a full-time private practice and an AGI of $400,000 per year from active income.

Discuss each of the following as an opportunity for Deborah to shelter some of this income.

investing in a historic rehabilitation project

(5-4, 5, 6, 7, 53)

Answer 11

The benefit of the deduction-equivalent tax credit is phased out between $200,000 and $250,000 of AGI. Thus, this option would have no current effect on her tax liability.

Question 12

Passive Activity Loss Rules

Deborah Rafferty is a successful medical doctor with a full-time private practice and an AGI of $400,000 per year from active income.

Discuss each of the following as an opportunity for Deborah to shelter some of this income.

investing in a low-income housing project

(5-4, 5, 6, 7, 53)

Answer 12

Assuming that the low-income housing property was placed in service after 1989, this could provide a deduction-equivalent tax credit of up to $25,000, regardless of the AGI. If she is in a 35% MITB, this could save her $8,750 in federal income tax.

Question 13

Passive Activity Loss Rules

Deborah Rafferty is a successful medical doctor with a full-time private practice and an AGI of $400,000 per year from active income.

Discuss each of the following as an opportunity for Deborah to shelter some of this income.

investing in oil and gas working interests

(5-4, 5, 6, 7, 53)

Answer 13

An oil and gas working interest is considered to be not passive. Therefore, the losses would be fully deductible against any other income, regardless of her AGI. However, the form of ownership cannot limit her personal liability, so this type of investment very well could be too risky for her.

Question 14

Passive Activity Loss Rules

Assume that, at the time of a taxpayer’s death, she owned an interest in a limited partnership. At the time of her death, the partnership had an adjusted basis of $15,000, and a fair market value of $45,000. She has suspended losses of $55,000 from the partnership.

What is the amount of suspended losses that may be deducted from the partnership?

(5-4, 5, 6, 7, 53)

Answer 14

The amount that may be deducted is $25,000.

$45,000 FMV
- $15,000 Basis
= $30,000 Step Up

$55,000 Suspended Losses
- $30,000 Step Up
= $25,000 Deduction

The suspended losses are deductible only to the extent that they exceed the step-up in basis of that activity. At the taxpayer’s death, there is a basis step-up of $30,000 (from basis of $15,000 to the fair market value of $45,000). The suspended losses EXCEED the step-up by $25,000. Thus, losses of $25,000 are deductible on the deceased taxpayer’s final return.

Question 15

Passive Activity Loss Rules

Donald has an active participation rental real estate activity. In 2015, he had losses of $30,000 from the active participation real estate, and his AGI was $130,000. He was allowed to deduct $10,000 of the losses against other income. The remaining $20,000 loss carried forward into 2016. In 2016, Donald has an AGI of $95,000, and only $10,000 of current losses from his real estate rental activity. What amount of loss may Donald deduct in 2016?

(5-4, 5, 6, 7, 53)

Answer 15

Donald is allowed to deduct $25,000 of losses in 2016. The $20,000 carry-forward losses are treated as if they occurred in 2016. The $10,000 current losses plus the $20,000 carry-forward losses total $30,000. Of the $30,000 of losses, only $25,000 is allowed to be deducted annually under the active participation rule.

Question 16

Passive Activity Loss Rules

Under the active participation provision, annual losses up to $_ _, _ _ _ may be available to offset income from other sources, including wages, dividends, or interest income.

(5-4, 5, 6, 7)

Answer 16

$25,000 may be available to offset income from other sources, including wages, dividends, or interest income.

To qualify for this exception, an individual must actively participate in the rental of either commercial or residential property. Also, the taxpayer must meet certain adjusted gross income limitations in order to deduct the losses. The key to this exception is that the individual must “actively participate” in the rental operation.

Question 17

Passive Activity Loss Rules

Active participation standard. This active participation standard is of key importance. Active participation is a lower standard than material participation. Active participation merely requires bona fide involvement in the management of the property.

(5-4, 5, 6, 7)

Answer 17

To qualify, a taxpayer must make the major management decisions concerning the operation of the property. Decisions such as defining rental terms, deciding which capital or repair expenditures to make, approving tenants, and collecting rents may qualify an individual for active participation status. A management agent can perform most of the functions, but the taxpayer must make the major management decisions. Ownership of less than a 10% interest or ownership of a limited partnership interest does not qualify.

Question 18

Passive Activity Loss Rules

Adjusted gross income limitation. If the taxpayer’s adjusted gross income is $100,000 or less, the taxpayer may deduct up to $25,000 of losses on an annual basis. If the taxpayer’s adjusted gross income is greater than $100,000 but less than $150,000, the $25,000 loss limitation is phased out (eliminated) on a 2-for-1 basis. That is, for every dollar of AGI in excess of $100,000, the maximum loss allowable is reduced by 50 cents, so that at $150,000 the loss allowance is totally phased out.

(5-4, 5, 6, 7)

Answer 18

For a married taxpayer filing separately who lives apart from his or her spouse for the entire tax year, the maximum loss is $12,500 and the phaseout range is $50,000 to $75,000. This benefit of the loss is not available for a married taxpayer filing separately, unless the spouses lived apart for the entire tax year. For the taxpayer with greater than $150,000 of AGI, the active participation losses are simply treated as passive losses.

Question 19

Passive Activity Loss Rules

For purposes of the passive loss limitation rules, the historic rehabilitation credit is treated as arising from rental real estate activities in which the taxpayer actively participates. In other words, the credit may be used to offset the income tax on up to $25,000 of any income (not $25,000 in tax liability). The effect is a credit that shows up on page 2 of Form 1040. The actual credit amount may be determined by multiplying the amount of the deduction-equivalent tax credit by the marginal tax rate. For example, if the client is in a 28% marginal income tax bracket, and has a full $25,000 rehabilitation deduction-equivalent tax credit, the actual credit—the dollar-for-dollar offset against the tax liability—is $7,000 ($25,000 × 28%).

(5-4, 5, 6, 7)

Answer 19

In addition, the phaseout of this allowance does not begin until the taxpayer’s adjusted gross income exceeds $200,000, and complete phaseout occurs at $250,000. For a married taxpayer filing separately who lives apart from his or her spouse for the entire tax year, the maximum deduction-equivalent tax credit is $12,500 and the phaseout range is $100,000 to $125,000. This benefit of the deduction-equivalent tax credit is not available for a married taxpayer filing separately, unless the spouses lived apart for the entire tax year.

Question 20

Passive Activity Loss Rules

The limitations on passive losses and credits do not apply to a taxpayer who owns a working interest in oil and gas properties. A working interest is an interest where the taxpayer’s form of ownership does not limit his or her personal liability. Losses from an oil and gas working interest are not considered passive. Thus, a taxpayer who owns a working interest individually or as a general partner may continue to use losses and credits from that activity to offset active income even though he or she does not materially participate in operating decisions. These losses may result, in part, from the continued ability of some taxpayers to use percentage depletion, as well as from the ability to expense immediately a portion of the intangible drilling costs.

(5-4, 5, 6, 7)

Answer 20

Note that the limited partners of a limited partnership, or shareholders of an S corporation, do not qualify for this working interest treatment, because those forms of ownership interest do limit their personal liability. Also, the working interest provision does not apply to the ownership of other types of oil and gas interests, such as royalties. The IRS has recently ruled that, in certain situations, income from a working interest is subject to the self-employment tax.

Question 21

Passive Activity Loss Rules

Benefit:
Up to $25,000 annual loss deduction

Restrictions:
Active participation
     10% or greater ownership
     Bona fide involvement
$100,000 to $150,000 AGI phaseout

a. Historic rehabilitation passive activity
b. Oil and gas working interest
c. Real estate professional
d. Active participation rental real estate

(5-4, 5, 6, 7)

Answer 21

Active participation rental real estate

Question 22

Passive Activity Loss Rules

Benefit:
Up to $25,000 deduction-equivalent tax credit

Restrictions:
Phaseout at $200,000 to $250,000 of AGI

a. Historic rehabilitation passive activity
b. Oil and gas working interest
c. Real estate professional
d. Active participation rental real estate

(5-4, 5, 6, 7)

Answer 22

Historic rehabilitation passive activity

Question 23

Passive Activity Loss Rules

Benefit:
Unlimited losses deductible; no AGI limit

Restrictions:
Form of ownership cannot limit personal liability

a. Historic rehabilitation passive activity
b. Oil and gas working interest
c. Real estate professional
d. Active participation rental real estate

(5-4, 5, 6, 7)

Answer 23

Oil and gas working interest

Question 24

Passive Activity Loss Rules

Benefit:
Unlimited losses deductible; no AGI limit

Restrictions:
Half of personal services hours, and 750 hours in real estate activities

a. Historic rehabilitation passive activity
b. Oil and gas working interest
c. Real estate professional
d. Active participation rental real estate

(5-4, 5, 6, 7)

Answer 24

Real estate professional

Question 25

Passive Activity Loss Rules

A _____ activity is defined as any activity that involves the conduct of a trade or business in which the taxpayer does not materially participate.

(5-4, 5, 6, 7, pg 29)

Answer 25

passive

Question 26

Passive Activity Loss Rules

Grouping of Activities: regulations allow the grouping of one or more trade or business activities or rental activities into a single activity if the activities constitute an “appropriate economic unit” for measuring gain or loss under the passive activity loss rules.

The following factors are given the greatest weight in determining whether activities constitute an appropriate economic unit:

(5-4, 5, 6, 7, pg 30)

Answer 26

the similarities and differences in types of business,

the extent of common control,

the extent of common ownership,

the geographical location, and

the interdependencies between or among the activities (for example, the extent to which the activities purchase or sell goods between themselves, involve products or services that are normally provided together, have the same customers, have the same employees, or are accounted for with a single set of books and records).

Question 27

Passive Activity Loss Rules

Grouping of Activities: Taxpayer C has a significant ownership interest in a bakery and a movie theater at a shopping mall in Baltimore and in a bakery and a movie theater in Philadelphia. In this case, reasonable methods of applying the facts and circumstances test may, depending on other relevant facts and circumstances, result in grouping the movie theaters and bakeries into a single activity, into a movie theater activity and a bakery activity, into a Baltimore activity and a Philadelphia activity, or into four separate activities. Once C chooses one of these groupings, however, paragraph (g) of this section requires C…

(5-4, 5, 6, 7, pg 30)

Answer 27

to continue using that grouping in subsequent taxable years unless a material change in the facts and circumstances makes it clearly inappropriate.

Question 28

Treatment of Suspended Losses

Losses from passive activities that were not deductible during the year are suspended and carried forward into the following tax year. Those losses are essentially treated as if they occurred in that (following) tax year.

If the taxpayer’s adjusted gross income is greater than $100,000 but less than $150,000, the $25,000 loss limitation is phased out (eliminated) on a 2-for-1 basis. That is, for every dollar of AGI in excess of $100,000, the maximum loss allowable is reduced by 50 cents.

For example, assume that David has an active participation rental real estate activity. In 2015, he had losses of $25,000 from the active participation real estate, and his AGI was $140,000. He was allowed to deduct…

Answer 28

$40,000 AGI over $100,000
* 0.5
= $20,000 Reduction

$25,000 Losses
- $20,000 Reduction (carried forward)
= $5,000 Deduction in current year

$5,000 of the losses against other income. The remaining $20,000 loss carries forward into 2016. In 2016, David has an AGI of $90,000, and only $5,000 of current losses from his real estate rental activity. David is allowed to deduct $25,000 of losses in 2016. The $20,000 carry-forward losses are treated as if they occurred in 2016. Thus, the $5,000 current loss plus the $20,000 carry-forward losses are all deducted in 2016.

Question 29

Treatment of Suspended Credits

The unused tax credits are carried forward, just like the unused passive activity losses. If there is income tax attributable to passive income in the future years, those carry-forward credits may be used to offset the tax resulting from that passive income.

Answer 29

There is an important difference in the treatment of the carry-forward credits compared to the carry-forward losses. When the activity that generated the credits is disposed of in a taxable transaction (typically a sale) that results in a realized loss, the passive credits carried forward from that activity simply disappear. If the transaction results in a gain, the carry-forward credits may be used to offset the tax attributable to the transaction.

Question 30

Disposition Rules

If the taxpayer dies, the suspended losses are deductible only to the extent that they exceed the step-up in basis of that activity.

Answer 30

For example, assume the taxpayer has an interest in a limited partnership with an adjusted basis of $10,000. (Remember that the basis is reduced by losses that flow through to the taxpayer, even if they were not currently deductible because of the passive activity loss rules.) Its fair market value is $35,000 and there are $45,000 of suspended losses. At the taxpayer’s death, there is a basis step-up of $25,000 (from the adjusted basis of $10,000 to the fair market value of $35,000). The suspended losses exceed the step-up by $20,000. Thus, the $20,000 of losses are deductible on the deceased taxpayer’s final return. If the taxpayer gifts the interest to another party, the suspended passive losses are added to the basis of the gifted interest.

Question 31

Disposition Rules

If the taxpayer gifts the interest to another party, the suspended passive losses are added to the _____ of the gifted interest

Answer 31

basis

Question 32

Passive Activity Loss Rules

Module Check

1. Your client has a deduction-equivalent tax credit of $18,000 from a low-income housing passive activity. The client is in a 33% marginal income tax bracket. What is the amount of the actual credit?

$0

$5,940

$18,000

(LO 5-4)

Answer 32

$5,940

The actual credit, the dollar-for-dollar offset against the tax liability, is $5,940. The credit is available to offset the tax arising on $18,000 of income. In a 33% marginal income tax bracket, the tax would be 33% of $18,000, or $5,940. Thus, the actual credit is $5,940.

Question 33

Passive Activity Loss Rules

Module Check

6. Which of the following describes the phaseout rules as they apply to active participation rental real estate?
   a. The phaseout occurs on a two-for-one basis as the taxpayer’s adjusted gross income increases from $200,000 to $250,000.
   b. The phaseout occurs on a two-for-one basis as the taxpayer’s adjusted gross income increases from $100,000 to $150,000.
   c. The phaseout occurs on a two-for-one basis as the taxpayer’s taxable income increases from $100,000 to $150,000.

(LO 5-5)

Answer 33

b. The phaseout occurs on a two-for-one basis as the taxpayer’s adjusted gross income increases from $100,000 to $150,000.

The correct phaseout of the $25,000 deduction for active participation occurs as adjusted gross income increases from $100,000 to $150,000.

Question 34

Passive Activity Loss Rules

Module Check

7. Which of the following describes a requirement for a taxpayer to be considered a real estate professional under the passive activity rules?
   a. The individual performs more than 750 hours of service during the year in the real property trades or businesses in which the individual materially participates.
   b. More than 75% of the individual’s personal services during the year are performed in the real property trades or businesses in which the individual materially participates.
   c. The individual performs more than 1,000 hours of service during the year in all real property trades or businesses, regardless of the individual’s level of participation.

(LO 5-5)

Answer 34

a. The individual performs more than 750 hours of service during the year in the real property trades or businesses in which the individual materially participates.

One of the requirements to be considered a real estate professional is that the individual must perform more than 750 hours of service during the year in the real property trades or businesses in which the individual materially participates.

The actual requirement is that more than 50% of the individual’s personal services during the year are performed in the real property trades or businesses in which the individual materially participates.

The only actual requirements are the 750 hours of service and 50% of personal services stipulations.

Question 35

Passive Activity Loss Rules

Module Check

8. Which one of the following is a characteristic of the historic rehabilitation tax credit?
   a. The credit may be used to offset up to $25,000 in income tax.
   b. The credit may be used to offset the tax on up to $25,000 of income.
   c. The credit is phased out on adjusted gross income between $100,000 and $150,000.
   d. The credit is phased out on taxable income between $200,000 and $250,000.

(LO 5-5)

Answer 35

b. The credit may be used to offset the tax on up to $25,000 of income.

The credit may correctly be used to offset the tax on up to $25,000 in income.

The credit may not be used to offset $25,000 in income tax; it may offset the tax on up to $25,000 of income.

The credit is phased out on adjusted gross income between $200,000 and $250,000, not between $100,000 and $150,000.”

The credit is phased out on adjusted gross income, not taxable income, between $200,000 and $250,000.

Question 36

Passive Activity Loss Rules

Module Check

9. The low-income housing credit from a passive activity is known as a
   a. qualified tax shelter.
   b. tax benefit for low-income taxpayers and the elderly.
   c. deduction-equivalent tax credit.

(LO 5-4)

Answer 36

c. deduction-equivalent tax credit.

The low-income housing credit is neither a qualified tax shelter nor a tax benefit for those who are elderly or have low income. It is considered to be a deduction-equivalent tax credit because the credit has the same effect as a deduction of up to $25,000.

The low-income housing credit is not a qualified tax shelter. It is considered to be a deduction-equivalent tax credit because the credit has the same effect as a deduction of up to $25,000.

The low-income housing credit is not a tax benefit for low-income taxpayers and the elderly. It is considered to be a deduction-equivalent tax credit because the credit has the same effect as a deduction of up to $25,000.

Question 37

Passive Activity Loss Rules

Module Check

10. Which one of the following accurately states a rule related to publicly traded partnerships?
    a. Losses from publicly traded limited partnerships may be used only to offset income from other publicly traded limited partnerships.
    b. Unused losses from publicly traded limited partnerships may be carried back up to three years to offset prior income from such partnerships.
    c. Unused losses from publicly traded limited partnerships must be carried forward and used only against future income of the same partnership.

(LO 5-4)

Answer 37

c. Unused losses from publicly traded limited partnerships must be carried forward and used only against future income of the same partnership.

Unused losses from publicly traded limited partnerships (PTPs) must be carried forward and used only against future income of the same partnership. Each publicly traded partnership is treated separately; thus the income from a PTP may not be offset by passive losses arising from any other source. In addition, any losses from the PTP must be carried forward, to be used only against future income from the same partnership.

Losses from publicly traded limited partnerships may not be used to offset income from other publicly traded limited partnerships.

Unused losses from publicly traded limited partnerships may not be carried back.

Question 38

Passive Activity Loss Rules

Module Check

11. Which one of the following factors is not considered when grouping activities into an appropriate economic unit?
    a. the extent of common control
    b. geographical location
    c. similarities and differences in types of business
    d. profitability in different types of business

(LO 5-4)

Answer 38

d. profitability in different types of business

Profitability is not one of the factors that should be considered when forming an appropriate economic unit.

The extent of common control is considered to be a factor when forming an appropriate economic unit, as are geographical location and similarities and differences in types of business.

Geographical location is considered to be a factor when forming an appropriate economic unit, as are the extent of common control and the similarities and differences in types of business.

Similarities and differences in types of business are considered to be a factor when forming an appropriate economic unit, as are the extent of common control and geographical location.

Question 39

Passive Activity Loss Rules

Module Check

12. An individual will generally be treated as a material participant in a trade or business activity if
    a. he or she participates less than 100 hours per year in the activity.
    b. he or she participates more than 500 hours annually in the activity.
    c. another individual performs substantially all of the services associated with the business.

(LO 5-5)

Answer 39

b. he or she participates more than 500 hours annually in the activity.

If an individual participates more than 500 hours annually, he or she is deemed to materially participate in the trade or business activity, regardless of any other individual’s participation.

An individual will be deemed to materially participate if he or she has performed more than 100 hours in the trade or business activity during the year, and if this participation is not less than that of any other individual.

If the individual performs substantially all of the services associated with the business, even if it is less than 100 hours, he or she will be deemed to materially participate. If another individual performs substantially all of the services, then the taxpayer likely will not meet the material participation standard.

Question 40

Passive Activity Loss Rules

Module Check

16. A taxpayer in a 33% marginal income tax bracket holds a low-income housing activity through a limited partnership interest. A deduction-equivalent tax credit of $25,000 flows through to the taxpayer. What is the amount of income tax that may be offset by this deduction equivalent tax credit?

$7,250

$8,250

$25,000

(LO 5-5)

Answer 40

$8,250

$25,000
* 33%
= $8,250

The deduction-equivalent tax credit of $25,000 may be used to offset the income tax on up to $25,000 of income. For a taxpayer in a 33% MITB, the credit may offset $8,250 ($25,000 x 33%).

Question 41

Passive Activity Loss Rules

Module Check

17. Which of the following is correct regarding the AGI phaseout for the deduction-equivalent tax credit arising from a low-income housing activity placed in service after 1989?
    a. There is no AGI phaseout.
    b. The phaseout is between $100,000 and $150,000 of AGI.
    c. The phaseout is between $200,000 and $250,000 of AGI.

(LO 5-5)

Answer 41

a. There is no AGI phaseout.

For a low-income housing activity placed in service after 1989, there is no AGI limitation on the use of the deduction-equivalent tax credit.

The phaseout of $100,000 and $150,000 of AGI is for active participation rental real estate. For a low-income housing activity placed in service after 1989, there is no AGI limitation on the use of the deduction-equivalent tax credit.

The phaseout of $200,000 and $250,000 of AGI applies to the historic rehabilitation deduction-equivalent tax credit, or the pre-1990 low-income housing activity. For a low-income housing activity placed in service after 1989, there is no AGI limitation on the use of the deduction-equivalent tax credit.

Question 42

Passive Activity Loss Rules

Module Check

20. David Hill has the following items from four separate investments during the current tax year:

Passive income from a publicly traded limited partnership = $14,000

Passive loss from a publicly traded limited partnership = $10,000

Passive income from a non-publicly traded limited partnership = $16,000

Passive loss from a non-publicly traded limited partnership = $19,000

What is the total amount, if any, of passive losses that may be deducted by David for the current year?

$10,000

$16,000

$26,000

(LO 5-7)

Answer 42

$16,000

None of the $10,000 loss is deductible. Of the $19,000 loss from the non-PTP, only $16,000 may be deducted against the $16,000 income from the non-PTP. The passive loss from a publicly traded partnership (PTP) may only be used to offset future years’ income from that same PTP.

$10,000 is incorrect because The $10,000 passive loss from the publicly traded partnership (PTP) may only be used to offset future years’ income from that same PTP. Thus, none of the $10,000 loss is deductible. Of the $19,000 loss from the non-PTP, only $16,000 may be deducted against the $16,000 income from the non-PTP.

$26,000 is incorrect because The passive income from a publicly traded partnership (PTP) may not be offset by passive losses arising from any other source. The passive loss from a publicly traded partnership (PTP) may only be used to offset future years’ income from that same PTP. Thus, none of the $10,000 loss is deductible. Of the $19,000 loss from the non-PTP, only $16,000 may be deducted against the $16,000 income from the non-PTP.

Question 43

Passive Activity Loss Rules

Module Check

21. Your client, Jolene, has a limited partnership interest with an adjusted basis of $20,000. Its fair market value is $45,000 and there are $52,000 of suspended losses. What amount, if any, of the suspended losses may be deducted upon Jolene’s death?

$0

$27,000

$52,000

(LO 5-7)

Answer 43

$27,000

$45,000 FMV
- $20,000 Basis
= $25,000 Step Up

$52,000 Suspended Losses
- $25,000 Step Up
= $27,000 Deduction

Upon the taxpayer’s death, the suspended losses are deductible to the extent that the losses exceed the step-up in basis of that activity. At the taxpayer’s death, there is a basis step-up of $25,000. The suspended losses exceed the step-up by $27,000. Thus, the $27,000 of losses are deductible on the deceased taxpayer’s final return.

Question 44

Passive Activity Loss Rules

Module Check

25. An oil and gas working interest may be held as
26. an S corporation interest.
27. a general partnership interest.
28. an LLC interest.

(LO 5-5)

Answer 44

3. a general partnership interest.

A general partnership interest may be a working interest, as a working interest is an interest where the taxpayer’s form of ownership does not limit his or her personal liability.

An interest in an S corporation is not an oil and gas working interest. A working interest is an interest where the taxpayer’s form of ownership does not limit his or her personal liability. Shareholders in an S corporation enjoy limited liability.

An LLC interest cannot be an oil and gas working interest. A working interest is an interest where the taxpayer’s form of ownership does not limit his or her personal liability. Members in an LLC enjoy limited liability.

Question 45

Passive Activity Loss Rules

Module Check

26. Paul has owned a small apartment building as a rental property for several years. Over the years, he has accumulated $31,000 of suspended losses from the building. In the current year, Paul sold the building for a gain of $14,000. What amount of suspended passive losses, if any, may Paul deduct in the current year?

$0

$14,000

$17,000

$31,000

(LO 5-7)

Answer 45

$31,000

A taxpayer may deduct the suspended passive activity losses upon the complete disposition of that activity in a taxable transaction. Thus, upon the sale of the entire interest in the activity, the taxpayer may fully deduct the suspended losses of $31,000.

The deduction of the suspended losses is not limited to the gain from the sale of the asset.

Question 46

Passive Activity Loss Rules

Module Check

27. Your client, Vera, recently purchased an interest in a publicly traded limited partnership that will generate an $11,000 passive loss for the current tax year. She also owns an older interest in a non-publicly traded limited partnership that will generate passive income of $6,000 for the current tax year. How much of the passive loss, if any, is deductible by Vera during the current tax year?

$0

$6,000

$11,000

(LO 5-7)

Answer 46

$0

The passive loss from a publicly traded partnership may not be used to offset passive income from any other source. The losses are suspended until that same activity generates income, or until the taxpayer sells the activity. Upon a taxable disposition of the PTP, the suspended losses are “freed up” and are deductible against any other income.

The $11,000 of losses are suspended until that same activity generates income, or until the taxpayer sells the activity.

The losses are not deductible in full.

Question 47

Passive Activity Loss Rules

Module Check

28. Your client, Anthony, owns a small apartment building that will generate a $33,000 loss in the current year. Anthony’s spouse is an architect, and they will have an AGI of approximately $325,000 for the current year. Anthony devotes approximately 800 hours per year to managing the rental activities of the building. In addition, Anthony has a part-time job as an editor for a small equestrian magazine, where he spends approximately 1,200 hours per year.

How much, if any, of the rental loss may Anthony deduct?

$0

$25,000

$33,000

(LO 5-7)

Answer 47

$0

Anthony may not deduct any of the rental loss. He does not qualify for a deduction under the active participation rules, as the AGI exceeds $150,000. He does not qualify as a real estate professional. Although he does devote over 750 hours per year, more than 50% of his personal service hours would need to be performed in the real estate activity. He currently devotes only 40% of his hours to the rental activity.

Question 48

Passive Activity Loss Rules

Module Check

29. The standard used to determine whether a taxpayer is an “active participant” in a real estate rental activity is
30. bona fide involvement in the activity.
31. material participation in the activity.
32. significant participation in the activity.

(LO 5-5)

Answer 48

1. bona fide involvement in the activity.

To be considered an active participant in a rental real estate activity, the taxpayer must exhibit bona fide (good faith) involvement in management decisions.

Active participation is a lower standard than material participation. Active participation merely requires bona fide (good faith) involvement in management decisions.

Significant participation is not relevant in this situation.

Question 49

Passive Activity Loss Rules

Module Check

30. The income from a publicly traded partnership can be offset by
31. passive losses arising from any other source.
32. suspended passive losses arising from that same publicly traded partnership.
33. passive losses from any other publicly traded partnership.

(LO 5-4)

Answer 49

2. suspended passive losses arising from that same publicly traded partnership.

The income from a publicly traded partnership may be offset only by suspended losses arising from the same publicly traded limited partnership.

PTP income may not be offset by passive losses from any other source.

Question 50

Passive Activity Loss Rules

Practice Test 1

17. During January 2010, Juacinto Velasquez purchased an interest in a nonpublicly traded limited partnership that will generate a $10,000 passive loss for the current tax year. He also owns an interest in a publicly traded limited partnership that will generate passive income of $6,000 for the current tax year.

How much of this passive loss, if any, is deductible by Juacinto during the current tax year?

(LO 5-7)

Answer 50

$0

Publicly traded limited partnership income may not be offset by other passive losses. Thus, the $6,000 income is simply taxable in the current year. The $10,000 passive loss is carried forward, and may be used when that same partnership generates income, or is fully deductible upon a taxable disposition of the partnership.

Question 51

Passive Activity Loss Rules

Practice Test 1

22. Sally Franklin has AGI of $300,000. In addition, she currently has passive income of $150,000 and passive losses of $175,000, $150,000 of which she uses to offset the passive income and $25,000 of which is subject to disallowance.

Which one of the following investments has the greatest potential for reducing Sally’s tax liability?

1. “active participation” rental real estate that is producing a loss
2. an equipment leasing limited partnership producing passive losses
3. a limited partnership involved in a historic rehabilitation project that is producing passive losses and credits
   an oil and gas limited partnership that is generating losses
4. an oil and gas limited partnership that is generating losses
5. a low-income housing activity placed in service after 1989 that is producing credits

(LO 5-6)

Answer 51

5. a low-income housing activity placed in service after 1989 that is producing credits

The low-income housing activity placed in service after 1989 is not subject to a limitation based on AGI. Thus, the deduction-equivalent tax credit of up to $25,000 may be available. The oil and gas limited partnership would produce additional passive losses. This cannot be an oil and gas working interest because the form of ownership limits the taxpayer’s personal liability. The historic rehabilitation credit is phased out at $200,000 to $250,000 of AGI.

Question 52

Passive Activity Loss Rules

Practice Test 1

69. Which of the following statements are correct with respect to active participation rental real estate?

I. The interest may be held through a limited partnership.

II. A deduction-equivalent tax credit of up to $25,000 is available.

III. The taxpayer must hold a 10% or greater ownership interest.

IV. The taxpayer must participate in the management of the property in a bona fide sense.

I and II only
II and IV only
III and IV only
I, II, and III only
II, III, and IV only

(LO 5-6)

Answer 52

III and IV only

Active participation real estate requires involvement in a bona fide sense. Also, by definition, the taxpayer must have a 10% or greater ownership interest in the property. Up to a $25,000 loss, not deduction-equivalent tax credit, may be claimed on an annual basis. The interest specifically may not be a limited partnership interest.

Question 53

Passive Activity Loss Rules

Practice Test 2

38. Sally Franklin has AGI of $250,000. In addition, she currently has passive income of $30,000 and passive losses of $48,000, $30,000 of which she uses to offset the passive income and $18,000 of which is suspended.

Which one of the following activities has the greatest potential for reducing Sally’s tax liability?

a. investing in “active participation” rental real estate that is producing a loss
b. investing in an equipment leasing limited partnership that is producing passive losses
c. investing in a newly created limited partnership involved in low-income housing that is producing deduction-equivalent tax credits
d. investing in an oil and gas limited partnership that is generating losses

(LO 5-6)

Answer 53

c. investing in a newly created limited partnership involved in low-income housing that is producing deduction-equivalent tax credits

The low-income housing credit is not subject to an AGI limitation if the low-income property was placed in service after December 31, 1989. Thus, she could use the deduction-equivalent tax credits to offset her tax liability. 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.

Question 54

Passive Activity Loss Rules

Practice Test 2

39. Paul Hall has the following items:

Prior-year passive loss carryforward amounts:

($5,000) from XYZ limited partnership (publicly traded)

($8,000) from ABC limited partnership (nonpublicly traded)

Current-year passive income and loss amounts:

$2,000 from XYZ limited partnership (publicly traded)

($3,000) from GHI limited partnership (publicly traded)

$12,000 from JKL limited partnership (nonpublicly traded)

($14,000) from RST limited partnership (nonpublicly traded)

What is the total amount of passive losses that may be deducted during the current year?

$2,000

$12,000

$14,000

$16,000

$30,000

(LO 5–7)

Answer 54

$14,000

The general rule is that passive losses may only be deducted against passive income. The rules for publicly-traded partnerships is more restrictive—the passive income from a PTP may not be offset by passive losses arising from any other income. In addition, the passive losses from PTPs are not currently deductible—they may only be used to offset future income from that same activity. Of the $5,000 passive loss carryforward from the XYZ limited partnership, only $2,000 may be used in the current year due to the $2,000 of current-year passive income. A total of $12,000 in losses from the RST limited partnership may be used against the $12,000 of income from the JKL limited partnership in the current year because both are nonpublicly traded. Thus, the total of passive losses allowed for the current year is $14,000.

Question 55

40. Brad Wiley has no passive income. During January 1987, Brad purchased an interest in a limited partnership that will generate a $10,000 passive loss during the current tax year.

How much of this passive loss, if any, is deductible by Brad during the current tax year?

$0

$1,000

$2,000

$6,500

$10,000

(LO 5–7)

Answer 55

$0

After 1986, the general rule is that passive losses are only deductible against passive income. In this situation, there is no passive income.

Question 56

Passive Activity Loss Rules

Practice Test 2

73. 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?

I. 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.

II. 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.

III. The individual performs more than 750 hours of service in the real property trades or businesses in which the individual materially participates.

I only

I and II only

I and III only

II and III only

(LO 5–5)

Answer 56

I and III only

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.

Question 57

74. Ken Green 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?

I. investment in an oil and gas working interest

II. a real estate limited partnership

III. a rental real estate general partnership in which Ken will not participate

IV. active participation rental real estate

I only

III only

II and III only

I, III, and IV only

II, III, and IV only

(LO 5–6)

Answer 57

I only

Only a direct interest in oil and gas (the working interest) would generate any tax savings. The other activities would be passive activities and 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 since his AGI is well in excess of $150,000 (the upper limit of the active participation requirement).

Question 58

19. Your client, Joe Gold, 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 one of the following is the most appropriate investment for Joe?

a nonpublicly traded limited partnership generating passive income

a master limited partnership generating income

certificates of deposit generating portfolio income

a portfolio asset that does not generate income but will appreciate in value over time

a publicly traded limited partnership generating income

(LO 5-6)

Answer 58

a nonpublicly traded limited partnership generating passive income

Joe needs a passive income generator. Only the nonpublicly traded limited partnership would qualify. The MLP and the publicly traded partnership would not qualify, as income from a publicly traded partnership cannot be offset by passive losses arising from any other source.

Question 59

Practice Test 1

20. Which one of the following best describes a tax benefit associated with an “active participation” real estate investment?

Losses may be used to offset active or portfolio income.

The first $25,000 of taxable income from the investment is tax-exempt.

Up to $25,000 in losses may be used to offset active or portfolio income.

There are no income limitations associated with this investment.

(LO 5-4)

Answer 59

Up to $25,000 in losses may be used to offset active or portfolio income.

Active participation rental real estate allows for losses of up to $25,000 on an annual basis. The full deduction is only available if the AGI is under $100,000. There is a phaseout between $100,000 and $150,000 of AGI. It is true that the losses may be used to offset active or portfolio income (choice “a.”), but c. is the most complete answer.

Question 60

Practice Test 1

21. Which one of the following best describes the minimum standard for “active participation” in a real estate investment?

The taxpayer must have at least 10% of his or her net worth invested in the real estate.

It must be the taxpayer’s primary trade or business.

The taxpayer must be involved in the management of the property in a bona fide manner.

The standard is identical to the material participation standard.

(LO 5-4)

Answer 60

The taxpayer must be involved in the management of the property in a bona fide manner.

Active participation requires that the taxpayer make the major management decisions; that is, involvement in a bona fide manner. This is a much lower standard than the material participation standard, which requires regular, continuous, and substantial involvement in the activity. The taxpayer must have at least a 10% ownership interest in the rental activity.

Question 61

59. Paul Hall has the following items from four separate investments during the current tax year:

$12,000 passive income from a publicly traded limited partnership

$9,000 passive loss from a publicly traded limited partnership

$14,000 passive income from a non publicly traded limited partnership

$18,000 passive loss from a non publicly traded limited partnership

What is the total amount, if any, of passive losses that may be deducted during the current year?

$0

$14,000

$18,000

$26,000

$27,000

(LO 5-7)

Answer 61

$14,000

The passive loss from a publicly traded partnership (PTP) may only be used to offset future years’ income from that same PTP. Thus, none of the $9,000 loss is deductible. Of the $18,000 loss from the non-PTP, only $14,000 may be deducted against the $14,000 income from the non-PTP.