Unit 10

Question 1

Passive Loss Rules

Answer 1

• Passive losses and credits offset income from taxpayer’s other passive activities.
• Unused passive losses are suspended and carried over to the next tax year.
• At-risk rules are applied before applying passive activity loss rules.

Question 2

Passive Activity Limitation (PAL) Rules

Answer 2

• Introduced in 1986 to limit taxpayers from using losses and credits from passive activities to offset non-passive income.
• Passive activities are those where taxpayer doesn’t have an active role.
• PAL rules prevent excessive “paper losses” from offsetting actual income.

Question 3

PAL Rules prevent what

Answer 3

prevent excessive “paper losses” from offsetting actual income.

Question 4

What is “at risk”

Answer 4

The amount of adjusted basis in a business that an owner has at a particular point in time is known as the taxpayers amount “at-risk”

Question 5

Tax reform act of 1986 classified income into 3 buckets

Answer 5

active, portfolio, and passive

Question 6

Closely held C corporations may use passive losses to

Answer 6

offset active, but not portfolio income.

Question 7

Who do passive activity rules apply to

Answer 7

individuals, trusts, estates, personal service corporations, and closely held C corporations.

Question 8

Section 469 of the IRC specifies that the following types of activities are to be treated as passive:

Answer 8

-Any trade or business or income-producing activity in which the taxpayer does not materially participate
-Subject to certain exceptions, all RENTAL activities

Question 9

Participation for More Than 500 Hours (material participation)

Answer 9

Did the individual participate in the activity for more than 500 hours during the year?

Question 10

Substantially All Participation (material participation)

Answer 10

Does the individual’s participation constitute substantially all of the activity’s participation for the year, including non-owner employees?

Question 11

Participation More Than 100 Hours (material participation)

Answer 11

Did the individual participate in the activity for more than 100 hours during the year, with participation not less than any other individual, including non-owner employees?

Question 12

Significant Participation (martial participation)

Answer 12

Is the activity a significant participation activity for the year, and does the individual’s aggregate participation in all significant activities exceed 500 hours?

Question 13

Five-Year Material Participation

Answer 13

Did the individual materially participate in the activity for any 5 taxable years during the 10 preceding taxable years?

Question 14

Personal Service Activity (material participation)

Answer 14

Is the activity a personal service activity, and did the individual materially participate for any three preceding taxable years?

Question 15

Regular, Continuous, and Substantial Basis (material participation)

Answer 15

Based on all relevant facts and circumstances, did the individual participate in the activity on a regular, continuous, and substantial basis during the year?

Question 16

How many hours is “significant participation”

Answer 16

100 hours

Question 17

Material Participation Standards:

Answer 17

• Measured on an activity-by-activity basis.
• Tax code permits treating multiple trade or rental activities as a single activity if they form an appropriate economic unit for gains or losses measurement.
• IRS sets conditions and guidelines for determining appropriate economic units.

Question 18

Can you treat multiple trade or rental activities as a single activity?

Answer 18

Tax code permits treating multiple trade or rental activities as a single activity if they form an appropriate economic unit for gains or losses measurement.

Question 19

Suppose Dan owns a bowling alley in Boston. He also owns a bakery and a bowling alley in Philadelphia. Here are the possible combinations of activity groupings

Answer 19

He can have four separate activities
-A Boston activity and a Philadelphia activity
-A bowling alley activity and a bakery activity
-A Boston activity, a Philadelphia bakery activity and a Philadelphia bowling alley activity
-A Philadelphia activity, a Boston bakery activity and a Boston bowling alley activity

Question 20

Ramifications of Material Participation and Activity Groupings:

Netting of Passive Gains and Losses:

Answer 20

-If an activity is deemed passive due to not meeting material participation standards, passive losses and gains within that activity can be netted.
-However, if activities are separate and one is actively participated in while the other is passive, netting may not be allowed.

Question 21

Material Participation Activity Groupings Disposition

Answer 21

-If activities are grouped together and one activity within the group is disposed of, suspended losses from that activity cannot be recognized until the entire grouped activity is disposed of.
-This restriction may impact decisions on selling individual components of a grouped activity.

Question 22

Recognition of Passive Income

Answer 22

All passive income must be recognized.

Question 23

Utilization of Passive Losses

Answer 23

-Passive losses are only used to the extent they can be subject to the rules.
-A taxpayer can use a passive loss if they have a passive gain that equals or exceeds the loss.

Question 24

Passive loss example:
Taxpayer has:
Passive interest in an S corporation with income of $20,000.
Passive interest in an unrelated partnership (non-publicly traded) with a loss of $30,000.

Answer 24

Taxpayer can use $20,000 of the $30,000 loss to offset the passive S corporation income.
Remaining $10,000 loss is suspended.

Question 25

Publicly Traded Partnerships (PTPs):
(passive losses)

Answer 25

-Losses from PTPs can only be used against the same partnership.
-Losses from one PTP cannot offset income from another PTP.

Question 26

Recognition of Unused Losses

Answer 26

-Unused losses can be recognized when a taxable disposition is made.
-Unused losses can offset any other type of income (e.g., active or portfolio) when disposed.

Question 27

Suspension of Disallowed Losses:

Answer 27

Disallowed losses are suspended and can only be used in future years.

Question 28

Disallowed losses Specifics for PTPs

Answer 28

-Suspended losses on PTPs can only be used against future passive income from that specific partnership.
-They cannot be used against income from other PTPs or any other passive income sources.

Question 29

Utilization of Suspended Losses sold in a taxable transaction

Answer 29

-When the activity is sold in a taxable transaction, the full amount of suspended losses can be used to offset the gain of the activity.
-If any loss still remains after offsetting the gain, the unused losses can then be used to offset other active or portfolio income.

Question 30

Suspended loss: gift

Answer 30

suspended losses are added to the donee’s basis, and therefore are not deductible by the donor.

Question 31

Suspended loss: nontaxable exchange

Answer 31

taxpayers keep suspended losses and they become deductible when the new property is eventually sold. If the new property has the same activity as the old property, the suspended losses can be used prior to the new property’s disposition.

Question 32

Installment Sales and Recognition of Suspended Losses:

Answer 32

1. Calculation of Recognized Gain:
   
   • The recognized gain in the current tax year is determined by the gross profit percentage (GPP) of the installment sale.
2. Ratio of Gain Recognized:
   
   • The ratio of gain recognized in the tax year to the total gain over the life of the installment sale is calculated.
3. Recognition of Suspended Losses:
   
   • Suspended losses are recognized based on this ratio. For example, if 10% of the total gain is recognized in the current year, then 10% of the suspended losses will also be recognized in that year.

Question 33

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

Answer 33

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.

Question 34

Suspended loss: Sale to a related taxpayer

Answer 34

suspended losses remain as suspended losses to the seller. When the related party sells the property to an unrelated taxpayer, the original seller can then deduct the losses.

Question 35

Suspended loss: Inheritance

Answer 35

In this scenario, the taxpayer’s death results in a step-up in basis for the passive activity. Here’s how the deduction of suspended losses would work:

1. Step-up in Basis: The basis of the passive activity is adjusted to its fair market value at the date of death, which is $65,000.
2. Calculation of Suspended Losses: If the suspended losses exceed the step-up in basis ($65,000), the excess amount is deductible on the taxpayer’s final tax return.

For example, if the suspended losses amount to $70,000, then $5,000 ($70,000 - $65,000) would be deductible on the taxpayer’s final tax return.

Question 36

Suspended losses: divorce

Answer 36

suspended losses are added to the basis of the spouse who receives the property.

Question 37

Suspended losses: Passive activity changed to non-passive activity

Answer 37

suspended losses remain passive losses. However,losses can be used to the extent that the activity has income.

Question 38

To qualify for active participation, a taxpayer must:

Answer 38

Own at least 10% of the property.
Demonstrate substantial involvement in managing the property.

Question 39

Loss recognition rules for active participation in real estate

Answer 39

-Taxpayers who actively participate in real estate can recognize up to a $25,000 loss on their tax return.
- The full $25,000 loss allowance applies if the taxpayer’s modified adjusted gross income (AGI) is less than $100,000.
- If the taxpayer’s modified AGI exceeds $100,000, the $25,000 special loss allowance is reduced:
- The reduction is by 50% of the amount by which the taxpayer’s modified AGI exceeds $100,000 ($50,000 for Married Filing Separately).

Question 40

Modifications to the adjusted gross income (AGI) for the purpose of determining the special loss allowance in real estate

Answer 40

Modified AGI excludes:
- Deduction for ½ of the self-employment (SE) tax.
- Deduction allowed for contributions to IRAs and certain other qualified retirement plans.
- Deduction allowed for interest on student loans.
- Interest income exclusion for Series EE bonds used for higher education expenses.
- Income excluded under an employer’s adoption assistance program.
- Taxable Social Security benefits and certain railroad retirement benefits.
- Passive income or loss in general (as reported on Form 8582).
- Passive loss on rental property because the taxpayer materially participated in the property as a real estate professional.
- Any overall loss from a publicly traded partnership (PTP).

Question 41

Do real estate professionals have the same 25k limitation on passive activity losses?

Answer 41

No the 25k limit is for regular taxpayers

Question 42

Special rules for real estate professionals regarding passive activity rules and loss limitations

Answer 42

Eligible taxpayers include individuals and closely held C corporations who

-Materially participate in real property trades or businesses.
-More than 50% of the individual’s personal services during the tax year are performed in real property trades or businesses in which the taxpayer materially participates.
-The individual spends more than 750 hours of service during the tax year in real property trades or businesses in which the taxpayer materially participates.

Question 43

Differing tax treatment for vacation homes and mixed-use properties in the 8th and 9th tax districts compared to other tax districts:

Answer 43

• In the 8th and 9th tax districts (tax court method), vacation homes and mixed-use properties have different tax treatment compared to other tax districts (the IRS method).
• The focus of the Board’s testing history has been on the rules for mixed-use properties.
• Mixed-use properties, such as vacation homes, involve situations where the taxpayer both rents out the property and uses it personally during the tax year.
• While the calculation methods may differ between tax districts, the testing typically emphasizes understanding the rules governing mixed-use properties rather than the specific calculation methods.

Question 44

Personal Use Property

Answer 44

• Personal use property rented for 14 days or less is not required to report the rental income.
• The taxpayer can only deduct interest and taxes as itemized deductions, provided they own no more than two properties.
• This ruling applies to both the taxpayer’s primary residence and vacation home, allowing them to rent out the properties for short periods without reporting the rental income, and only deducting interest and taxes.

Question 45

Rental Use Property

Answer 45

• Rental use property is determined by the personal use of the property, which must be no more than the greater of 14 days or 10% of the number of days rented at fair rental value.
• All expenses allocated to the rental are allowed as deductions.
• The property can generate passive losses subject to the passive activity rules.

Question 46

Mixed use property

Answer 46

• Mixed-use property occurs when personal use exceeds the greater of 14 days or 10% of the number of days rented at fair rental value.
• Deductions for mixed-use property are limited to the gross rental income.
• Any unused losses from the rental activity are carried forward to future years for potential deduction against future rental income.