343 ACC Chapter 7 Passive Activity Losses
Tax Shelter
-Activity providing deductions and/or credits to an investor which will reduce tax liability
*Ex. One that reduces the taxpayers liability by the tax benefit amount
-Create undesirable consequences such as:
*Declining federal tax revenues
*Diverting investment capital from productive activities to tax avoidance schemes
*Loss of faith in federal tax system
-Were created to encourage investment in certain areas to promote economic growth
-Almost all were formed as limited partnerships b/c they allow losses and credits to be passed
through to the partners individual tax returns
*Limited partner can utilize deductions/credits that flow through from the partnership
-Examples: Equip leasing, real estate, movie productions, farming, cattle breeding etc.
Hurdles in Deducting Losses
1. Basis: Know what you lose and know how to compute that loss using basis
2. Amount At Risk (AAR): Risk of what investor can lose
*Reduced regardless to the extent to which losses are deductible
~Deductible portion is calculated after at-risk rules are applied
*Recourse Loan: Investor can lose it all
~Government could take personal assets if you cant repay debt
~Lender takes recourse actions against person in debt (borrower)
*Nonrecourse Loan: Can only lose what investor original pledged
~Lender cant come after more than what was pledged in time of inability to repay
*Qualified Nonrecourse Loan: For certain ones partner is at risk on real property
~Acquired from person who is actively engaged in the business of lending money
~Acquired from any state, federal, or local gov.
~Exceptions for loans acquired from: related parties, seller of the property, person who
received fee due to taxpayers investment in the property
*Losses reduce the amount at risk
3. Passive Activity Loss (PAL): Loss from a passive activity
*Need passive income to absorb a passive loss
~W/o passive income to absorb loss, the remaining loss carries forward as suspended loss
~Unless you dispose of the activity through a taxable disposition
*Active income can also be used to absorb a loss in certain circumstances
~But not portfolio income
*You must keep track of losses per activity, if you have losses from multiple activities
~If there is not enough income to absorb the losses from all activities, you must compute the
amount of loss each activity will still carry forward
= (Amount of loss from activity / total losses not absorbed) x Income->active/passive
*Passive activity losses remaining after being set against income are allowed a 3000$ maximum
deduction FOR AGI
~Amt of loss exceeding this is carried forward as a suspended loss
Types of Income
-Active Income: Business in which you participate in on a regular basis
*Material participation required
-Passive Income: Activity in which you do not materially participate in
*All rental activity income is passive
~Regardless of whether you materially participate in it or not
*To deduct a passive loss you must have this to put against
-Portfolio it Income: Capital gains, dividend income, interest income, etc.
*Not derived from ordinary course of trade or business
Suspended Losses
-Carried forward indefinitely
-Losses that were unable to be absorbed by income in previous years because losses > income
-Deductible against passive and nonpassive activity income in future years
-Necessary to keep these losses separate for each activity
Step-Up And Step-Down In Basis
-Step-Up: When the Fair Market Value at disposition > Transferors Adjusted Basis
*With this, transferor can deduct the difference between the FMV and the AB
-Step-Down: When the Fair Market Value at disposition < Transferors Adjusted Basis
*Transferor gets no deduction for a step-down in basis
*There is no gain for them to put the loss against so they cant deduct it
Disposition Of A Passive Activity
-If disposed of in a fully taxable transaction:
*Any losses may be recognized by the taxpayer in the yr of disposition
*Losses can offset active and portfolio income
*BUT losses from the sale of passive activities to related parties are usually not deductible
-Excess of the sum of activities below over net income/total gain from passive activities will be
treated as a loss NOT from passive activities (& deductible against nonpassive activity income)
*Any loss from the activity for the tax yr, including suspended losses from previous years
*Any loss realized from the disposition of the activity
-If the passive activity being disposed of is a capital asset, then it cant offset suspended losses at
the time of disposition
*When this happens the suspended loss is treated as an ordinary loss and is considered to be
from a capital asset
Disposition of Passive Asset By Death or Gift
-Death: If interest in a passive activity is transferred b/c of death the deceased can-*Deduct the difference between the step-up in basis and the suspended loss
-Gift: If interest in a passive activity is transferred by gift-*Suspended losses are deductible by donee because its included in their basis
*Suspended losses are added to the recipients basis
*Recipients Basis = Donors Adj. Basis + Amount of Suspended Losses
~Assuming the FMV > Adj. Basis at time of gift
Taxpayers Affected By Passive Losses
-Passive loss limitation applies to:
1. Individuals
2. Estates
3. Trusts
4. Closely held corporations: Limited if its a nonpersonal service C corp, & more than 50% of
stock is owned by 5 or less people
~Able to offset passive losses with net active income, but not portfolio income
~Only one that can deduct passive losses from activity it owns
5. Personal Service Corporations: Prevents taxpayers from sheltering personal service income
~Through incorporating as a personal service corporation
~by acquiring passive activity investments at the corporate level
~C corporations, performs mostly personal service activities, services performed by
employee-owners, & employee-owners own more than 10% of the FMV of the
corporations outstanding stock