ch 7 sol - Answers to Questions Tax Shelters Definition 1...

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Unformatted text preview: Answers to Questions Tax Shelters: Definition 1. A tax shelter is any activity that provides tax write-offs which reduce an investor’s tax liability with regard to income from other sources. Two limitations that apply to deductibility of losses from tax shelters are the at-risk rules (Code Sec. 465) and passive activity rules (Code Sec. 469). Tax Shelters: Usage 2. Tax shelters were popular because of their tax-saving features (i.e., the pass-through of losses and credits) which lowered many upper income investors’ tax liability. Tax shelter activity has been virtually eliminated by the passive activity rules, which were a major component of the Tax Reform Act of 1986. At-Risk Rules: At Risk Defined 3. “At risk” is the amount of investment that an investor would stand to lose if the whole activity in which the investment was made became worthless. At-Risk Rules: Nonrecourse Loans 4. A nonrecourse loan is borrowing without personal liability for repayment. Should the borrower default, the lender merely takes the property purchased (or other collateral) as satisfaction of the debt. The buyer will not be at risk in the case of seller financing because the lender (seller) has an interest in the borrowings. This is true even if the seller is a financial institution. (There is an exception to the at—risk rules for third party lenders of nonrecourse debt on real property.) Passive Losses: General Rule for Deductions 5. The general rule for the deductibility of passive losses is that passive losses can only offset passive income, except for the disposition of an entire interest in a passive activity, from fully taxable transactions and certain pre-enactment activities. Passive Losses: Application of Rules 6. The at-risk rules must be satisfied first, then the passive rules are applied. Both restrict losses from becoming deductions. Passive Losses: Classification of Income 7. Active income is income derived from the direct efforts of the individual, such as wages, salaries, commissions, tips, etc. Passive income is income from passive activities, such as income from the operation of a limited partnership in which an investor is a limited partner. Portfolio income is income from stocks, bonds, annuities, and royalties not derived in the ordinary course of a business. Dividends, interest, and the sale of stocks, bonds, etc., are portfolio income items. Passive Losses: Pre-enactment and Post-enactment Interests 8. For tax years beginning in 1992, no passive activity losses or credits may be deducted against active and portfolio income. Interest in passive activities acquired by the taxpayer on or before October 22, 1986 (the date on which the Tax Reform Act of 1986 was enacted), were eligible for a special deduction and credit phaseout of losses for a five-year period. Passive Losses: Suspended Losses Defined 9. Suspended losses are losses that were incurred during a tax year but were not deductible because of the passive loss restrictions. Suspended losses can offset nonpassive income when a qualified disposition of an entire interest of a passive activity has occurred. They can also offset nonpassive income upon the transfer of a passive activity by reason of death. Passive Losses: Suspended Losses—Transfers on Death 10. Suspended losses are deductible by the decedent when a passive activity is transferred by reason of death to the extent that the excess of the fair market value (stepped-up basis) in the hands of the transferee over the decedent’s adjusted basis is less than the amount of suspended loss. Passive Losses: Suspended Losses—Transfers by Gift 11. Suspended losses from passive activities that are transferred by gift are not deductible. Instead the entire suspended loss is added to the donee’s basis. Passive Losses: Taxpayers Subject to Rules 12. Taxpayers affected by the passive loss rules are individuals, estates, trusts, closely held C corporations, and personal service corporations. Closely held corporations are able to offset passive losses with active income but not portfolio income. Passive Losses: Material Participation Defined 13. Material participation is the involvement of a taxpayer in the operations of an activity on a regular, continuous, and substantial basis. The determination of material participation is important because it may establish whether an activity will be characterized as a passive activity or a nonpassive activity. Passive Losses: Material Participation Tests 14. The seven tests (abbreviated) to establish material participation are applied during the year and are as follows: (1) Participating more than 500 hours. (2) Substantially all of the participation in an activity (regardless of hours). (3) Participating more than 100 hours and more than any other individual. (4) Significant participation with more than 500 hours in all significant participating activities. (5) Material participation in any five taxable years during the 10 preceding taxable years. (6) Material participation in any three taxable years preceding the taxable year for a personal service activity. (7) Regular, continuous, and substantial participation based on facts and circumstances. Passive Losses: Significant Participation 15. Significant participation requires more than 100 hours of participation, but not to the point of satisfying the material participation requirements of the other six tests. If participation in all significant participating activities exceeds 500 hours, then all such activities become material participating activities. Passive Losses: Undertakings and Separate Source of Income Production 16. An undertaking is the smallest portion of a profit-seeking endeavor that can constitute an activity. A “separate Nu...“ A: :mmwm “mannumw nnnuvvn \nlnnh Han nnnrafinnc nFq nrnfihcpplIino pndpnvnr are nnndnnted at the Passive Losses: Rental Operations 17. Both rental and business operations carried on by a taxpayer at the same location are generally treated as two separate activities, unless one undertaking generates more than 80 percent of income over the other. Passive Losses: Real Estate Activities 18. A taxpayer can combine real estate activities in any manner the taxpayer chooses, so long as the IRS is informed of the election. Passive Losses: Nonrental Activities 19. Generally, nonrental activities can be combined in any manner so long as the IRS is notified. Passive Losses: Nonrental Property Tests 20. The six tests (abbreviated) used in determining nonrental property are as follows: (1) Average rental period is seven days or less. (2) Average rental period is 30 days or less with significant personal services provided. (3) Extraordinary personal services are rendered (rental is actually incidental to the receipt of such services). (4) Amount of rental is incidental (less than 2 percent) to the nonrental activity. (5) Rental property is customarily available during defined business hours for nonexclusive use by various customers. (6) Property is rented to a nonrental activity owned by the lessor. Passive Losses: Rental Real Estate Activities—Offset 21. A $25,000 offset is provided taxpayers who rent real estate, who actively participate, and whose modified AGIs are $100,000 or less. There is a phaseout of the $25,000 offset for modified AGIs greater than $100,000 at the rate of $.50 per $1,000 of excess modified income. Individuals and closely held C corporations may treat losses from real estate rental activities after 1993 as losses from activities that are not passive activities if they meet certain requirements. Individuals must spend over one-half of their personal service time during the year materially participating in real property trades or businesses. In addition, they must devote over 750 hours during the year to such activities. Closely held C corporations must derive over half of their gross receipts from real property trades or businesses in which they materially participate. Passive Losses: Rental Real Estate Activities—Active Participation 22. Active participation is the holding of an interest equal to 10 percent or more rental real estate and the making of some management decisions, such as approving tenants, setting rental terms, and approving costs of repairs and maintenance. Passive Losses: Change of Activity Status 23. The suspended losses remain suspended, but can be offset against nonpassive income from the former activity or passive income from other passive activities. Business Casualty Losses: Deductions 24. A loss deduction resulting from the complete destruction of business-use property is figured using the property’s adinsted basis. A loss deduction resulting from the partial destruction of business-use property is figured using Business Casualty Losses: Reimbursements 25. No casualty loss can betaken in the year of loss if a reasonable prospect exists that full reimbursement of the loss from insurance or other source will be received in some future tax year. The casualty loss deduction is limited to the actual expected loss after expected insurance reimbursement. If the actual insurance reimbursement differs from the amount anticipated in past years, the difference can be deducted as a casualty loss deduction in the year the claim is settled. Business Casualty Losses: Business Property Basis Adjustments 26. A business property’s basis will be decreased by the amount of insurance or other recovery received plus the amount deducted. Net Operating Losses: Personal Expenditures 27. No, except for personal casualty and theft losses. A net operating loss deduction was created for the purpose of alleviating the inequitable burden of conducting business operations within arbitrary 12-month periods. Deductible personal expenses were not considered for the NOL deduction, however, because salaries and wages are not generally affected by arbitrary 12-month periods in the same manner as businesses. Net Operating Losses: Carrybacks and CarryfonNards 28. A business incurring a net operating loss in a taxable year can carry the loss back two years and forward twenty years. A business can elect to not carry a net operating loss back but to carry it forward. If an NOL is carried back, it must be carried back to the earliest year (e.g., two years back) first. Home Office Expenses 29. For personal home office expenses to be deductible, a portion of the home must be used exclusively on a regular basis as the principal place of business for any trade or business of the taxpayer; as a place of business which is used by patients, clients, or customers in meeting or dealing with the taxpayer in the normal course of the trade or business; or, in the case of a separate structure which is not attached to the dwelling unit, in connection with the taxpayer’s trade or business. If the taxpayer is an employee, the exclusive use test must be for the convenience of the employer, and not merely for the convenience of the employee. The Taxpayer Relief Act of 1997 expanded the definition of “principal place of business” for tax years beginning after December 31, 1998. Vacation Homes 30. A vacation home can become rental property by lowering the amount of personal use coupled with an intent to rent the property to others at fair rental value. Personal use cannot exceed the greater of 14 days or 10 percent of rental days. Rental property can provide deductions for losses, which are subject to the passive activity rules, while a personal residence (personal-use property) cannot provide deductible losses but can provide deductions for interest and taxes as well as tax-free income if rented less than 15 days. ANSWERS TO PROBLEMS—CHAPTER 7 At-Risk Rules: Amount at Risk 31. Billy Bob will offset the $8,000 in passive income from Partnership A with $8,000 in losses from Partnership B. On January 1, 2012, he is at risk for $18,000 ($10,000 + $8,000) in Partnership A and $10,000 ($22,000 - $12,000) in Partnership B. He has a suspended passive loss for Partnership B of $4,000 ($12,000 - $8,000). He has no loss carryover under the at-risk rules. At-Risk Rules: Amount at Risk 32. Billy Bob would offset the $9,000 in passive income from Partnership A with $9,000 in passive losses from Partnership B. Because he was at risk for only $22,000 in Partnership B, he will have a loss carryover under the at- risk rules for Partnership B of $3,000 ($22,000 - $25,000). His at—risk amount in Partnership B on January 1, 2012, will be zero ($22,000 — $22,000). He will have a suspended passive loss from Partnership B of $13,000 ($22,000 - $9,000). On January 1, 2012, he will be at risk in Partnership A for $19,000 ($10,000 + $9,000). At-Risk Rules: Amount at Risk 33. Ms. Lansing is at risk for $25,000, computed as follows: Cash contributed $15,000 Basis of securities 10,000 Amount at risk m At-Risk Rules: Amount at Risk 34. Ms. Lansing will be at risk for $35,000, computed as follows: Amount at risk (see Problem 33) $25,000 Allocated net income 10,000 Amount at risk ELM After a $5,000 withdrawal, her amount at risk will be $30,000 (withdrawals decrease amount at risk). At-Risk Rules: Amount at Risk 35. Ms. Lansing will be at risk for zero, computed as follows: Amount at risk (see Problem 33) $25,000 Allocated loss, $60,000 (limited to $25,000) 1 25,000 ) Amount at risk $___Q Ms. Lansing will have a $35,000 loss carryover until she becomes at risk. At-Risk Rules: Passive Losses and Suspended Losses 36. a. Amount at risk: Zero Cash contributed $25,000 Less: loss 125,000} $___Q The nonrecourse note for the acquisition of real property was financed by the seller. Thus, the partners are not considered at risk for the note even though it was issued by a financial institution. b. Passive loss deduction: None The amount of passive loss for which Jackson is at risk ($25,000) would be offset by an equal amount of passive income. (In addition, the activity was acquired after 1986.) Jackson would have net passive income of $10,000 ($35,000 - $25,000). 0. Suspended loss: $20,000 . The remaining $20,000 of the allocated loss would be suspended under the at-risk rules. Passive Losses: Deduction and Allocation 37. Ms. Jones experienced a zero deduction and $50,000 suspended loss, computed as follows: Pre-enactment Post-enactment Activities Activities One ($60,000 ) Two $40,000 Three 1 30,000 ) Net m ) M Passive Loss Deduction: Pre-enactment net loss Post-enactment net gain Net pre-enactment loss Amount deductible Suspended Loss: Total suspended loss Allocation One $60,000/$90,000 >< ($50,000) Three $30,000/$90,000 >< ($50,000) Passive Losses: Deduction—Suspended Losses 38. a. Net Loss: Selling price of A-l Less: Basis Realized gain Net income of A-l Total income from A-l Less: Suspended loss ( $60,000 ) M M) $0 ($50,000 ) Suspended Loss $33,333 $ 1 6,667 Net passive loss from A-l (deductible against nonpassive income) 2011 Passive Losses: Pre-enactment Activities A-l $0 13-2 (22,000 ) C-3 D-4 Net M ) b. Passive Loss Deduction: Post-enactment Activities ($5,000 ) (3,000 ) tiw ) $1 5 ,000 lLQQQ $4,000 1_4&O_O $1 8,000 ( 27,000 ELM Lesser of net loss of pre-enactment losses or net loss fiom all passive activities Passive Loss Deduction (ordinary) c. Suspended Losses: Total losses before deduction ( $30,000) Less: Passive loss deduction Suspended Loss QM Allocated Allocation Suspended Loss B-2 $22,000/$30,000 >< $30,000 $22,000 C-3 $ 5,000/$30,000 >< $30,000 $ 5,000 D-4 $ 3,000/$30,000 >< $30,000 $ 3,000 ) ) ( $22,000) Passive Losses: Deduction—Suspended Losses 39. Passive Loss Deduction: None (the losses offset the gains). Suspended Losses: Same as pre-2011 suspended losses (2011 losses were offset by an equal amount of income). Passive Losses: Deduction—Suspended Losses 40. None of the suspended losses are deductible, but Willard will have an increased basis of $65,000: Donor's adjusted basis $25,000 Suspended losses 40,000 Donee's basis m The donee’s basis is determined by adding the suspended losses to the donor’s adjusted basis in the activity. Passive Losses: Real Estate Rental Activities 41. Teri’s AGI would equal $53,000, computed as follows: Flower Shop (not passive activity) $45,000 Dividends from IBM stock 12,000 Interest from AT&T bonds fl,0_00 Total Income $71,000 Less: Rental property loss 1 18,000 ) Adjusted Gross Income ELM Up to $25,000 a year in losses from a rental activity in which the taxpayer actively participates may be used to offset nonpassive income. The hair salon and the laundry are passive activities because Teri did not materially participate in either of them. No deduction for either is allowed against nonpassive income. Passive Losses: Material Participation 42. AZ Airlines is the only activity in which Basemore materially participated because he participated over 500 hours. All other activities are passive activities. He did not, however, materially participate in Ven-Tale, Sadd Books, and Kingdom Autos because their combined total is exactly 500 hours (not more than 500). (MovERent is not an activity in which Basemore significantly participated because his participation in this activity did not exceed 100 hours.) Passive Losses: Rental and Nonrental Operations 43. Because rental and nonrental operations are conducted at the same location and one class of operation (medical) “predominates” over the other, the predominant operation will determine the nature of the undertaking. Accordingly, both operations should be treated as a single undertaking and Dr. Hoplin’s adjusted gross income will be $113,000. If this analysis should fail, then the $25,000 rental real estate loss deduction could be utilized allowing Dr. Hoplin a $12,000 deduction ($12,500 maximum deduction with a modified AGI of $125,000). Passive Losses: Rental Activities 44. Mr. Eichoff’s adjusted gross income is $109,500, computed as follows: AGI before passive losses $122,000 Vacation home loss ( 12,500 ) Partnership loss 0 Adjusted Gross Income M Passive Losses: Material Participation—Suspended Losses 45. Ms. Parker did not materially participate in the movie theater for 2007, 2008, 2009, and 2010, but she did materially participate in 2011. During these four years of operations, the activity experienced a $58,000 loss, which was entirely suspended: Loss Year Loss Phaseout % Deduction Suspended 2007 $21,000 0 $0 $21,000 2008 6,000 0 0 6,000 2009 19,000 0 0 19,000 2010 12,000 0 0 M Total Losses Suspended w Therefore, $24,000 of suspended losses will offset the $24,000 net income from the theater, and the balance ($34,000) will be available to offset future net income from the theater and from other activities that are passive. Portfolio income cannot be offset by the suspended loss. Passive Losses: Rental Real Estate Activities 46. Because Mary Beth does not meet the criteria of (1) devoting more than half of her time to the rental activity as a material participant and (2) participating in the rental activity for more than 750 hours, the loss will be treated as passive. She may deduct the loss only against passive income. If Mary Beth had qualified as an active participant (i.e., made management decisions regarding rental fees, etc.), she might have been able to deduct up to $25,000 of the loss against nonpassive income. Passive Losses: Rental Real Estate Activities 47. Mary Beth now satisfies the criteria of being a material participant in the office building for more than 750 hours. Also, the majority of her time is spent in the real estate business. She may treat the entire rental loss as a business (active) loss, and use it to offset income from her real estate business. Business Casualty and Theft Losses 48. Max Computer Center’s loss deduction for each casualty and theft is: (a) Robbery-Equipment, Theft: Adjusted basis of property $8,000 Less: Insurance reimbursement 7,500 Nonpersonal theft loss deduction _$fl)_0 (b) Fire-Truck, Partial casualty—Lesser of adjusted basis ($4,000) or decline in fair market value ($3,000) $3,000 Less: Insurance reimbursement 3...
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