24211_ch12_final_p001-022

24211_ch12_final_p001-022 - 12 Deductions for Certain...

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Unformatted text preview: 12 Deductions for Certain Investment Expenses and Losses Solutions to Problem Materials DISCUSSION QUESTIONS 12-1 a. Prior to 1986, properly structured investments such as Neptune III provided taxpayers with a legitimate opportunity to save taxes relative to conventional investments. A typical tax shelter produced three basic tax benefits: (1) tax deferral; (2) permanent tax reduction; and (3) conversion of ordinary income into favorable capital gain. Some tax shelters offered all three benefits, while others did not. (See pp. 12-1 through 12-6.) Vehicle. In order to make any tax saving opportunities available to investors, tax shelters must be properly structured. To accomplish this, most tax shelters are organized as limited partnerships in which the investors are limited partners. From a tax perspective, the limited partnership form is the perfect vehicle because it is not a separate taxable entity but rather a conduit. Consequently, all tax benefits derived from the venture flow directly through to the limited partners for their personal use. For example, ordinary losses produced by the partnership flow through to the partners as do tax credits and capital gains. The limited partnership also provides nontax benefits. The limited partnership form provides the investors with a form of limited liability, reducing the risk of their investment. For the most part, the investors, as limited partners, are liable only to the extent of their original investment (although some partnerships require additional contributions beyond the initial contribution). S corporations are sometimes used as tax shelter vehicles since they are also conduit entitles and provide investors with limited liability. Their usage is restricted, however, because the maximum number of investors (i.e., shareholders) cannot exceed 100. Deferral of the Tax. The objective of virtually all tax shelters is to defer the payment of taxes that otherwise would be due currently. This goal is usually accomplished by the creation of initial tax losses that approach, or in many cases, exceed the investor's initial cash investment, particularly with real estate where leverage can be used. For example, Neptune III might be formed by ten investors, each contributing $10,000 for a total of $100,000. The partnership would subsequently borrow $900,000 and use the total $1 million to build the office building. If depreciation in the first year was $150,000, each investor would be entitled to a deduction of $15,000 even though the actual amount invested was only $10,000. By using leverage, a taxpayer could multiply his or her deductions far beyond the amount invested, and especially in cases when nonrecourse debt was used far beyond the amount the investor actually had at risk. The result of this strategy was to produce expenses in the early years of the operation that exceeded income, producing a tax loss. More importantly, under the right circumstances, the investors did not really suffer a loss. The loss was merely artificial since for the most part it was attributable to depreciation, a noncash expenditure (and funds to purchase the assets were borrowed). Moreover, the property was probably not depreciating, but appreciating in value. In any 12-1 12-2 Chapter 12 Deductions for Certain Investment Expenses and Losses b. c. event, these early tax losses enabled the investor to postpone the payment of taxes on other income the investor might have. Of course, assuming the investment was ultimately sold for a gain, any tax savings attributable to depreciation would have to be repaid. In such case, however, the tax would have been successfully deferred, tantamount to an interest free loan from the government. Permanent Tax Benefits. A tax shelter might be able to reduce the tax permanently, not simply defer the tax. Tax shelters offered permanent reduction by making available certain credits to investors. For example, the partnership might rehabilitate a building for use by those with low incomes and take advantage of the rehabilitation credit and the low-income housing credit. Such credits represent a permanent reduction in the tax and generally are not forfeited or recaptured when the property is sold. Favorable Capital Gain. The final benefit to be offered by some tax shelters was the conversion of ordinary income into more favorable capital gain. As the explanation of deferral suggested, sooner or later the tax savings achieved through depreciation today must be paid back tomorrow. In the case of real estate, however, the gain attributable to depreciation historically received favorable long-term capital gain treatment. As a result, taxes saved through depreciation are not fully repaid when the property is sold. For example, assume Neptune constructs the building for $1,000,000 and claims $400,000 of depreciation, producing tax savings for its investors at ordinary tax rates. If Neptune later sells the building for $1,000,000, from an economic view it is essentially no better off than when it originally made the investment. However, from a tax perspective, the investment has produced tax savings. Assuming the $400,000 gain ($1,000,000 $600,000) is long-term capital gain, prior to 1986 only 40 percent of the gain, $160,000, would be taxed due to the long-term capital gain deduction of 60 percent. Congress virtually eliminated the benefits of tax shelters in 1986 by enacting the passive loss rules. Under these rules, all income is classified into three types (1) wages, salaries, and other "active" or nonpassive income; (2) portfolio income (e.g., interest, dividends, and capital gains and losses); and (3) passive income (income from activities in which the taxpayer does not materially participate or from rental activities). Losses from passive activities generally can be deducted only to the extent of income from passive activities. This rule forecloses the opportunity of sheltering salary and investment income with losses from tax shelters. Any losses that cannot be used are suspended and may be deducted against nonpassive income only when the investment is sold. Credits generated from a passive investment are treated in a similar fashion. Credits can be used only to offset tax created by passive income. Any credit not used when the investment is sold is lost, however. (See pp. 12-1 and 12-2.) The enactment of the passive-loss rules has introduced a virtually inscrutable layer to the tax laws. They are incredibly complex as the hundreds of pages of regulations testify. And unfortunately they do not apply simply to investors in traditional tax shelters but to all taxpayers who do not happen to participate materially in a particular activity. Moreover, they make no distinction between true economic losses and artificial losses. Both are made nondeductible, which is an inequitable treatment. In retrospect (hindsight is 20=20), it appears that an at-risk rule with teeth would have been a much better vehicle to prohibit abuses. The at-risk rules generally allow the taxpayer to deduct losses only to the extent the taxpayer is at-risk, that is, the taxpayer has actually suffered a real economic loss or could suffer such loss. Although the current at-risk rules accomplish this, they exempt most real estate deals, and, therefore, are ineffective. If the business is characterized as a passive activity, any losses resulting from operations generally would be deductible only to the extent of passive income. As a practical matter, the losses would not be currently deductible but would be postponed until income was produced or the business was sold. Note that the passive loss rules do not apply to a regular C corporation unless the corporation is closely held or is a personal service corporation. However, the rules do apply to S corporations, partnerships, and sole proprietorships. (See p. 12-9.) An activity is generally considered passive if it is either (1) a rental activity or (2) it is a nonrental activity and the taxpayer does not materially participate. The first determination that must be made is whether the various operations are rental or nonrental in nature. It is unlikely that the ski-shops would be considered a rental activity even if the majority of their gross income is derived from the rental of ski equipment. An activity is not considered a rental activity if the average period of customer use does not exceed seven days. In all likelihood, D's customers probably rent the equipment for no more than a week, and, therefore, the operation would not be considered a rental. Nevertheless, some consideration should be given to the issue, and, if necessary, might require D to maintain records on usage. See the additional discussion in part (c) below. (See pp. 12-14 and 12-16.) 12-2 a. b. Solutions to Problem Materials 12-3 c. d. Assuming the business is considered a nonrental activity, D must determine whether he materially participates in the activity. A taxpayer generally satisfies this requirement if he participates more than 500 hours in the activity during the taxable year. If each shop is considered in isolation and treated as a separate business, this basic test might not be met for a particular shop. From D's perspective, this could be positive if the activity is profitable because it would generate passive income. On the other hand, if a shop had losses, the passive loss rules may work to deny D a deduction unless he has passive income from other sources. D may still be treated as materially participating in each business if each shop is considered a "significant participation activity" (SPA). An individual materially participates if his or her total participation in all SPAs exceeds 500 hours. A SPA is any trade or business in which the taxpayer participates more than 100 hours, but fails the other six tests for material participation. Thus, if D spreads his time among each shop so that he spends more than 100 hours in each and more than 500 overall, he would be deemed to materially participate in each. Note what happens if D's total hours in all SPAs did not exceed 500. In such case, losses would be passive but income would be nonpassive. In applying the material participation tests, D must consider the aggregation rules. Under these rules, several undertakings such as the shops may be aggregated together and treated as one. In such case, D would probably satisfy the material participation test. See the discussion of the aggregation rules below. (See Example 19 and pp. 12-15 and 12-16.) As discussed in part (a) above, one of the first determinations that must be made in applying the passive loss rules is ascertaining whether the activity is a rental or nonrental operation. The distinction is critical because rental activities are generally passive regardless of the taxpayer's participation unless the taxpayer meets the criteria outlined in 469(c)(7). In determining whether D's undertakings are rental or nonrental in nature, there are two important considerations. First, a rental is not necessarily treated as a rental. Special rules treat certain rental operations as nonrental activities for purposes of the passive loss rules. For example, an activity is not a rental if the average customer use of the property does not exceed seven days. This probably would be the case here because most of the rentals are no doubt short-term. (See pp. 12-18 and 12-19.) Virtually all of the important determinations required in applying the passive loss rules require determination of what constitutes an activity. For example, if the taxpayer spends more than 500 hours working in the activity, he or she is deemed to materially participate. The issue that normally must be resolved is whether various endeavors of the taxpayer should be aggregated and treated as one activity or treated as separate activities. To ensure that the taxpayer cannot arbitrarily manipulate his or her participation in an endeavor to create passive income when necessary, the regulations established a broad definition of an activity generally requiring the taxpayer to aggregate certain undertakings. Under the regulations, taxpayers are required to treat one or more trade or business activities or one or more rental activities as a single activity if the activities constitute an appropriate economic unit for measuring gain or loss. Whether two or more activities constitute an appropriate economic unit (AEU) is determined by taking into account all of the relevant facts and circumstances. Five factors are to be given the greatest weight in making the determination. These are: 1. 2. 3. 4. 5. Similarities and differences in types of business The extent of common control The extent of common ownership Geographical location Interdependencies between activities (e.g., they have the same customers or same employees, are accounted for with a single set of books, purchase or sell goods between themselves, involve products or services that are normally provided together) 12-4 Chapter 12 Deductions for Certain Investment Expenses and Losses A taxpayer may use any reasonable method of applying the relevant facts and circumstances. The key ingredient to this rather loose approach is that the taxpayer must be consistent once a particular method of aggregation is selected. Note also that the IRS has the power to regroup activities if the taxpayer's grouping fails to reflect one or more appropriate economic units and one of the primary purposes of the taxpayer's grouping is to circumvent the passive loss rules. (See pp. 12-15 through 12-17). 12-3 The passive loss rules generally apply to individuals, estates, trusts, personal service corporations, and certain closely held C corporations. Partnerships and S corporations are not subject to the limitations; however, their owners, partners, and S shareholders are subject to the special rules. The treatment of Dr. R's activities is examined below. The Sports Institute Inc. This corporation would be considered a personal service corporation (PSC) and as such would be subject to the passive loss rules. A PSC is a corporation where the principal activity is the performance of personal services, and such services are primarily performed by the employee-owners. In addition, employee-owners that perform the services must own more than 10 percent of the stock either directly or indirectly. Dr. R owns 100 percent of The Sports Institute and provides substantially all of the services. As a result, the corporation would be treated as a PSC. PSCs are subject to the passive loss rules to prohibit taxpayers from simply transferring their passive activities to their PSCs or causing their PSCs to purchase tax shelter investments that could be used to shelter the income of the corporation. (See p. 12-13.) The Diner (a partnership). This partnership is not subject to the passive loss rules per se. However, the activities of the partnership flow through to Dr. R and her friend who would be subject to the limitations. (See p. 12-13.) Compatible PCS (a corporation). Although corporations normally are not subject to the passive loss rules, they do apply to closely held corporations. For this purpose, a closely held corporation is one with 5 or fewer individuals owning more than 50 percent of the stock either directly or indirectly. Compatible PCS qualifies as closely held since all of the stock is held by four shareholders. Closely held corporations are subject to the passive loss rules only in a limited manner. These corporations may use any passive losses to offset operating income but not to offset any passive income. This prohibits a taxpayer from incorporating his or her investment portfolio and sheltering the income with tax shelter investments. Note, however, that closely held corporations can use passive losses to offset active income of the business. For this reason, it may be wise for some owners of closely held corporations to transfer their investments that produce passive losses to their corporations in order to use the losses. The conversion of Compatible to an S corporation results in the loss activities flowing through to the individual shareholders. Due to the conversion, any passive losses can be deducted only to the extent of passive income. The potential for offsetting the losses against operating income is eliminated due to the conversion to S status. (See p. 12-13.) Single-family home (rental property). The renting of the home would be treated as a passive activity. Assuming Dr. R actively participates in the rental activity, she may be able to deduct up to $25,000 of losses from the rental annually. However, this opportunity is phased out as Dr. R's income becomes large. The $25,000 allowance is reduced by 50 percent of the excess of A.G.I. over $100,000, and, therefore, is eliminated if A.G.I. (computed without regard to certain items) exceeds $150,000. (See pp. 12-18 and 12-22.) Solutions to Problem Materials 12-5 Limited partnership interest in oil and gas operation. A working interest in certain oil and gas property is not considered a passive activity. (See p. 12-14.) Limited partnership interest in land development activity. Although the partnership is not subject to the passive loss rules per se, the activities flow through to the individual. (See p. 12-13.) 12-4 a. As a general rule, a taxpayer will prefer to characterize any income from an activity as passive. If the income is characterized as passive, it can be used to absorb passive losses, or, from another perspective, can be sheltered by passive losses. (See p. 12-10.) While a taxpayer will normally prefer to characterize income from an activity as passive, such is not the case with losses. Because passive losses are deductible only to the extent of passive income, taxpayers would prefer to treat all losses as nonpassive. In this way, the loss would be fully deductible without limitation, and, therefore, could be used to offset income from other sources. (See p. 12-10.) According to the regulations, the taxpayer is required to aggregate two or more activities as a single activity if the activities constitute an appropriate economic unit for measuring gain or loss. The only real restriction concerns the aggregation of the rental activities and the nonrental activities. The regulations prohibit aggregation of rental and nonrental activities unless either activity is insubstantial to the other. For this reason, a critical first step is determining the nature of each activity, i.e., whether the activity is a rental or nonrental activity. It would appear that the gas station and fast food restaurant are clearly nonrental activities. On the other hand, the rental of the space to the restaurant inside the basketball-soccer facility and the rental of the space to the retail store within the facility would probably be considered rental activities since the space is probably rented for longer than 30 days and there are no extraordinary services provided. The treatment of the basketball-soccer activity is not as clear. The business is renting its playing areas to customers for their use. It would seem that these are short-term rentals since the average time of customer use is probably at most a couple of hours a week. Assuming this is the case, the basketball-soccer facility would be a nonrental activity. Once the activities are characterized, the issue of aggregation must be addressed. The taxpayer has a great deal of flexibility in determining how he might aggregate the different activities. As noted above, taxpayers are required to treat one or more trade or business activities or one or more rental activities as a single activity if the activities constitute an appropriate economic unit for measuring gain or loss. Whether two or more activities constitute an appropriate economic unit (AEU) is determined by taking into account all of the relevant facts and circumstances. Five factors are to be given the greatest weight in making the determination. These are: 1. 2. 3. 4. 5. Similarities and differences in types of business The extent of common control The extent of common ownership Geographical location Interdependencies between activities (e.g., they have the same customers or same employees, are accounted for with a single set of books, purchase or sell goods between themselves, involve products or services that are normally provided together) b. c. 12-6 Chapter 12 Deductions for Certain Investment Expenses and Losses In this case, it would appear that the most logical approach would be to treat each activity separately. D might benefit by this approach if these activities are profitable since he could manage the number of hours in each activity to produce passive income as needed. On the other hand, if any of the activities has a loss and D spends little time related to such activity, it would be to his benefit to aggregate loss activities with income activities. D might be able to take this approach based on the fact that they are all within what appears to be several hundred yards of each other and that there may be some interdependencies between the activities (e.g., they are all accounted for with the same set of books and some employees work in all of the activities). Alternatively, the soccer facility, gas station and food store could be treated as separate activities and the rental activities aggregated and treated as one. Treating the rental activities as one activity would appear to make little difference since rental activities are automatically passive. And, in this situation, the disposition rules appear to be irrelevant since everything is housed under one roof. If the rental income relative to the income of the soccer facility is insubstantial, it seems that the rentals and the facility operation could be treated as one activity. This would appear to be particularly appropriate given that they are all housed in the same building. In this way, any losses from the rentals could be absorbed by the income of the soccer facility. Above all, however, the taxpayer must remember that once he has grouped his activities in a particular manner, he must live with this approach. He must be consistent. The IRS has the power to regroup activities if the taxpayer's grouping fails to reflect one or more appropriate economic units and one of the primary purposes of the taxpayer's grouping is to circumvent the passive loss rules. (See pp. 12-15 through 12-17). Once D has identified the separate activities, the material participation tests must be performed. Assuming D spends time in each of the activities, it may be difficult for him to meet the 500-hour test unless he concentrates on one business rather than another. It is doubtful that he would satisfy either the substantially all test or the more than 100 hours and not-less-than-anyone-else test since all of the businesses have full-time employees that spend more time in that activity than D. More likely than not, each activity may be considered a significant participation activity (i.e., participation is more than 100 hours but less than 500 and fails all of the other material participation tests). In such case, if the total hours in all of the SPAs exceeds 500, D would be deemed to materially participate in each of the activities. However, if the total of SPA hours does not exceed 500, income from each SPA would be nonpassive but losses would be passive. This rule ensures that a taxpayer cannot create passive income by simply spending a little time in various unrelated activities that are profitable. (See Example 28 and p. 12-21.) Note again that with proper planning D could allocate his time to each activity to obtain the desired result. 12-5 a. The method selected by Congress to stop the spread of tax shelters was to limit a taxpayer's deductions from such investments to the extent of income from that or similar investments. Consequently, a taxpayer can circumvent these rules by either converting passive losses to nonpassive losses--a difficult task in the case of the normal investor--or by creating passive income. Authors of the passive loss rules recognized the potential of the latter technique and went to great lengths to prohibit taxpayers from structuring their business activities so that they could create passive income. They were particularly concerned that a narrow definition of an activity would allow taxpayers to generate passive income as they desired simply by dividing their activities into small units and spending little time in those that were profitable. Consequently, the Regulations defined activity in a manner that requires taxpayers to aggregate various endeavors into a single activity. By taking this approach, the material participation test is more easily met and passive income cannot be produced. Under the regulations, taxpayers are required to treat one or more trade or business activities or one or more rental activities as a single activity if the activities constitute an appropriate economic unit for measuring gain or loss. Whether two or more activities constitute an appropriate economic unit (AEU) is determined by taking into account all of the relevant facts and circumstances. Five factors are to be given the greatest weight in making the determination. These are: Solutions to Problem Materials 12-7 1. 2. 3. 4. 5. Similarities and differences in types of business The extent of common control The extent of common ownership Geographical location Interdependencies between activities (e.g., they have the same customers or same employees, are accounted for with a single set of books, purchase or sell goods between themselves, involve products or services that are normally provided together) b. A taxpayer may use any reasonable method of applying the relevant facts and circumstances. The key ingredient to this rather loose approach is that the taxpayer must be consistent once a particular method of aggregation is selected. Note also that the IRS has the power to regroup activities if the taxpayer's grouping fails to reflect one or more appropriate economic units and one of the primary purposes of the taxpayer's grouping is to circumvent the passive loss rules. (See Example 19 and pp. 12-15 through 12-17.) The aggregation rule can be beneficial or detrimental to the taxpayer, depending on the circumstances. Aggregation is beneficial if it enables a taxpayer to combine various undertakings or activities such that the losses of one offset the income of others. Aggregation is also beneficial if it enables the taxpayer to meet the material participation test, which in turn converts a passive loss to a nonpassive loss. On the other hand, the purpose of the aggregation rule is primarily to stifle taxpayers who hoped to create passive income simply by dividing their activities into small units and spending little time in those that were profitable. 12-6 Generally, those endeavors of the taxpayer that are considered rental activities are automatically passive regardless of the taxpayer's participation. In this case, the long-term leasing of the apartment complex would no doubt constitute a rental. Rentals in excess of 30 days are considered "rental" operations unless significant services are performed. For this purpose, services normally offered with rentals of real estate such as repairs, maintenance, security, and the like are not considered significant. Consequently, T's operation is considered a rental and is doomed to passive activity status unless he meets the requirements under 469 (c)(7). (See p. 12-18.) While the losses from most passive activities are deductible only to the extent of passive income, 469 creates a limited exception for rental real estate. Taxpayers having less than $150,000 of A.G.I. may deduct all or a part of the loss. Under this exception, a taxpayer who actively participates in the rental activity may deduct up to $25,000 of losses attributable to the realty. The $25,000 allowance is reduced by 50 percent of the excess of the taxpayer's A.G.I. over $100,000. Any loss not deductible may be carried over to subsequent years and treated as if it occurred in such year. Suspended losses are totally deductible when there is a complete disposition of the property. In this case, T may deduct $25,000 of the loss this year and the remaining $5,000 is carried over to the following year. (See Example 29, and pp. 12-22 and 12-23.) Before reaching a final conclusion that income or loss is passive or nonpassive, the taxpayer must consider the recharacterization rules. The authors of the Regulations were concerned that with a few steps here and there taxpayers could dance around the passive loss rules by creating passive income. Consequently, the Regulations address those cases apparently ripe for abuse. In these situations, what normally would be passive income is recharacterized as nonpassive income. There are six situations when the recharacterization rules operate. These are identified on page 12-24 and listed below: 1. Significant participation activities: Income from significant participation activities that fail to meet the 500-hour test. 2. Rental of nondeductible property: Income from rental activities where less than 30 percent of the basis of the property rented is depreciable (e.g., rental of land). 12-7 12-8 Chapter 12 Deductions for Certain Investment Expenses and Losses 3. 4. 5. 6. Developer sales of rental property: Rental income, including gain on the sale of rental property, if (1) gain on the sale of the property is included during the taxable year; (2) rental of the property commenced less than 24 months before the date of disposition; and (3) the taxpayer performed sufficient services that enhanced the value of the rental property. Self-rented property: Income from rental of property to an activity in which the taxpayer materially participates other than related C corporations. Licensing of intangible property: Royalty income from a pass-through entity that the taxpayer acquired after the entity created the intangible property. Equity-financed lending activity: Income from the trade or business of lending money if certain conditions are satisfied. Credits arising from passive activities can be used to offset any tax generated by passive income. The amount of the credit that can be used is determined by computing the tax attributable to the passive income. A special computation may be required. (See Example 15 and p. 12-13.) Unused credits can be carried forward to the next taxable year and used to offset taxes on future passive income. An important difference between passive credits and passive losses concerns their treatment upon a disposition of the activity. Although unused losses may be used in their entirety upon a complete disposition of the property, credits are allowed only to the extent of any passive income in the year of the sale. In determining passive income, any gain from the sale of the passive activity is considered passive income. If the taxpayer has no passive income in the year of the disposition, any suspended credits attributable to the activity are lost. (See Example 15 and p. 12-13.) 12-8 a. b. 12-9 The IRS reserves the right to regroup a taxpayer's grouping of activities if the taxpayer's grouping fails to reflect one or more appropriate economic units and one of the primary purposes of the taxpayer's grouping is to circumvent the passive loss rules. This appears to be a particularly abusive situation and the IRS would probably group the partnership with the doctors own practices thus eliminating the passive income. (See Reg. 1.469-4 and p. 12-16.) a. The loan proceeds are first allocated to the purchase of the partnership interest. Dr. Z must then look through the partnership entity to see exactly how the assets are used. Since all of the assets of the partnership are used in a passive activity, Dr.'s Z interest will be considered passive interest and combined with other passive activities on Form 8582. (See Example 33 and p. 12-25.) The partnership interest expenses is simply combined with other partnership items in determining whether the partnership has income or loss. If the partnership has a loss, the loss will be treated as passive, effectively treating the interest expenses as passive. (See Example 34 and p. 12-26.) 12-10 b. PROBLEMS 12-11 Taxpayers are required to treat one or more trade or business activities or one or more rental activities as a single activity if the activities constitute an appropriate economic unit for measuring gain or loss. Whether two or more activities constitute an appropriate economic unit (AEU) is determined by taking into account all of the relevant facts and circumstances. Five factors are to be given the greatest weight in making the determination. These are: Solutions to Problem Materials 12-9 1. 2. 3. 4. 5. Similarities and differences in types of business. The extent of common control The extent of common ownership Geographical location. Interdependencies between activities (e.g., they have the same customers or same employees, are accounted for with a single set of books, purchase or sell goods between themselves, involve products or services that are normally provided together) A taxpayer may use any reasonable method of applying the relevant facts and circumstances. The key ingredient to this rather loose approach is that the taxpayer must be consistent once a particular method of aggregation is selected. Note also that the IRS has the power to regroup activities if the taxpayer's grouping fails to reflect one or more appropriate economic units and one of the primary purposes of the taxpayer's grouping is to circumvent the passive loss rules. (See Example 19 and pp. 12-15 and 12-16.) a. b. The taxpayer could treat these as either one activity since they are in the same geographical location or alternatively treat them as separate activities. The regulations prohibit aggregation of rental and nonrental activities unless either activity is insubstantial to the other. In this case, the income from both activities is substantial so each activity would be treated as a separate activity. The taxpayer could treat each store as a separate activity or combine all of the stores since they are in the same location (Denver) or because they are the same type of business. Other groupings could be appropriate, however. The taxpayer would appear to have great flexibility in how he groups the activities. As a practical matter, it seems that it would be easiest to aggregate these in the same manner as the taxpayer maintains his accounting records. Nevertheless, if the taxpayer has passive losses or wants to avoid passive losses, he may wish to consider other arrangements. Possible permutation and combinations include but are not limited to: c. d. Treat each gas station as a separate activity. Treat all of the gas stations as one large activity since they are in the same type of business. Treat each food sale activity in each station as a separate activity and each gas sale activity in each station as a separate activity. Lump all gas sale activities into one activity and all food sale activities into another separate activity. Treat the repair service activity as a separate activity or aggregate it with the gas station's activity in any of the arrangements above. e. Again the taxpayer has a great deal of flexibility. Possible groupings include: Treat each of the liquor stores and the beer distributorship as a separate activity. Treat all of the liquor stores as one activity and the beer distributorship as a separate activity. Treat all of the activities as one activity since they are in the same location and most of the beer distributorship's sales are to the liquor stores. 12-10 Chapter 12 Deductions for Certain Investment Expenses and Losses 12-12 This example is based on an similar one found in the now replaced Temporary Regulations [see Temp. Reg. 1.469-4T(g)(4)(Ex. 3)]. These regulations applied complex tests to determine if certain activities should be aggregated. The recently proposed regulations drastically alter this approach. Taxpayers are now required to treat one or more trade or business activities or one or more rental activities as a single activity if the activities constitute an appropriate economic unit for measuring gain or loss. Whether two or more activities constitute an appropriate economic unit (AEU) is determined by taking into account all of the relevant facts and circumstances. Five factors are to be given the greatest weight in making the determination. These are: 1. 2. 3. 4. 5. Similarities and differences in types of business. The extent of common control. The extent of common ownership. Geographical location. Interdependencies between activities (e.g., they have the same customers or same employees, are accounted for with a single set of books, purchase or sell goods between themselves, involve products or services that are normally provided together) A taxpayer may use any reasonable method of applying the relevant facts and circumstances. The key ingredient to this rather loose approach is that the taxpayer must be consistent once a particular method of aggregation is selected. Note also that the IRS has the power to regroup activities if the taxpayer's grouping fails to reflect one or more appropriate economic units and one of the primary purposes of the taxpayer's grouping is to circumvent the passive loss rules. (See pp. 12-15 and 12-16). In this case, it would appear that the taxpayer has great flexibility in how he groups the activities. While the most obvious approach is to treat each of the businesses as separate activities, there may be some argument that the interdependencies between the three (same employees, providing products and services to each other) would allow aggregation. This approach was not allowed under the temporary regulations and consequently, each activity was considered a separate activity. 12-13 a. A will be able to deduct his share of the loss since he is deemed to participate materially in the activity. According to the facts, A spends at most 416 hours (52 Saturdays 8 hours) participating in the activity. Although he does not meet the general rule (i.e., accumulate more than 500 hours of participation in the activity), he still satisfies the "more than 100 hours and not less than anyone else" test. Specifically, he spends more than 100 hours in the activity and no one else (i.e., B) spends any more time in the activity. (See pp. 12-20 and 12-21.) In this situation, A's material participation works to his advantage since it enables him to deduct the loss. Note that if B spent one more hour than A, under a literal interpretation of the rule, A would not meet the material participation rules since he did not participate more than anyone else. If so, the loss would be passive unless A can use the facts and circumstances to show otherwise. However, if A participates in other activities, he might be treated as materially participating under the significant participation activity (SPA) rules. Under these rules, A materially participates if his total participation in all SPAs exceeds 500 hours. A SPA is defined as a trade or business in which the taxpayer participates more than 100 hours, but fails the other six tests for material participation. The upshot of these rules is that A, and for that matter, B, must maintain records regarding the time they spend participating in the activity. On the other hand, if the business generates income, A's material participation may work to his disadvantage since the income would be active and could not be used to absorb any passive losses that A might have. In such case, A might attempt to fail the material participation test. As noted above, if B spends one more hour than A, then under a literal interpretation of the rule A does not materially participate since he did not participate more than anyone else. If so, any income would be passive. However, the SPA rules might operate to recharacterize the income as active. Under the SPA rules, if the total participation in all SPAs does not exceed 500 hours, the losses are passive but the income is active! (See Example 28 and pp. 12-20 and 12-21.) b. Solutions to Problem Materials 12-11 12-14 It would appear that only E materially participates in the activity. As a general rule, a taxpayer materially participates in an activity if he or she spends more than 500 hours in the activity during the year. For this purpose, participation of a spouse is counted if it is work typically done by owners. In this case, the bookkeeping efforts of E's spouse are not routine and would probably constitute participation. Applying the general rule, it is obvious that none of the three qualify, and, therefore, each must look to the other tests for possible qualification. The second test provides that a taxpayer materially participates if the individual and his or her spouse are the sole participants or their participation represents substantially all of the participation of all individuals who participate. It would appear that none of the three qualify under this test. E and his spouse participate the most in the activities, 80 hours plus the time spent keeping the books. But their participation does not represent substantially all of the participation since C and D together spend 110 hours (70 40). The third test provides that a taxpayer materially participates if he participates for more than 100 hours and no other individual spends more time in the activity. Lumping E and his wife's participation, it appears that they might meet this test since they may spend more than 100 hours and more than either C (70 hours) or D (40 hours). C and D also do not materially participate under the significant participation activity rules, which only apply if a taxpayer spends more than 100 hours in the activity. Although C and D do not meet any of the objective tests, they may still be able to qualify. Under the Regulations, a taxpayer may be treated as materially participating in the activity based on the facts and circumstances. (See pp. 12-20 and 12-21.) a. The treatment of the losses depends on whether F materially participates in the activities. As explained below, F would treat the losses as nonpassive under the significant participation activity rules. A taxpayer is normally treated as materially participating in an activity if he or she spends more than 500 hours in the activity during the year. For this purpose, participation of a spouse is counted if it is work typically done by owners. In this case, it is obvious that F would not satisfy the general rule. Nor would F satisfy the "substantially all of the participation" test or the " more than 100 hours and not-less-than-anyone-else" test. F would fail both of these tests due to the involvement of others in the activities, such as full-time employees. It would appear that F's participation would be governed by the significant participation activity (SPA) rules. Under these rules, F materially participates if his total participation in all SPAs exceeds 500 hours. A SPA is defined as a trade or business in which the taxpayer participates more than 100 hours, but fails the other six tests for material participation. Because F spends 200 hours in the night club and 400 hours in the drugstore and is not considered as materially participating under the other tests, each activity would be considered a SPA. And because F spent more than 500 hours in all SPAs, he is deemed to participate materially. As a result, his share of any losses from the partnerships would be nonpassive and fully deductible. (See Example 28 and pp. 12-20 and 12-21.) Under the SPA rules discussed above, F is deemed to materially participate. Consequently, F treats the income as nonpassive. But what happens if F's total activity in the SPAs does not exceed 500 hours? It would appear, at least at first glance, that both income and losses are treated as passive. This is not the case, however. Under the recharacterization rules, when the 500-hour test is not met, income from each SPA is considered nonpassive (i.e., active), whereas losses are treated as passive. This rule prohibits taxpayers for splitting losses in such a way as to produce passive income that could absorb passive losses. For example, if F expected the drugstore to be profitable and he had large passive losses from other activities, he might (absent the recharacterization rule) take steps to ensure that the drugstore income was passive. He could do this by reducing the hours he worked in the night club to 80 hours. By so doing, he would have one SPA, and the total hours would be less than 500, apparently qualifying it for passive treatment. However, the recharacterization rule prohibits this by treating the income as nonpassive. (See Example 28 and pp. 12-20 and 12-21.) 12-15 b. 12-12 Chapter 12 Deductions for Certain Investment Expenses and Losses 12-16 H would be treated as materially participating under the "prior participation" test, and, therefore, the loss would be nonpassive. Under the prior participation test, an individual is deemed to materially participate if he or she has materially participated in five of the last 10 years. This test prevents taxpayers from moving in and out of passive status as they wish. Because H has no doubt materially participated in the past, he would be deemed to materially participate this year. It is important to note that without this rule H would not materially participate since he did not spend more than 500 hours, provide substantially all of the participation, spend more than 100 hours, or spend more than anyone else. (See pp. 12-20 and 12-21.) 12-17 a. Nonrental activity. An activity is not a rental if the average rental period is seven days or less. (See p. 12-18.) P could deduct any loss from the activity only if he materially participates in the renting of the plane, which appears unlikely. Nonrental activity. An activity is not a rental if the rental period is seven days or less. (See p. 12-18.) Note that because the activity is not considered a rental, the $25,000 loss allowance for rental real estate is not available. The taxpayer should consider renting the property for more than seven days. (See Example 30 and pp. 12-22 and 12-23.) Probably a rental activity. If the average rental period is between eight and 30 days, the activity is a rental unless significant services are provided. According to the Regulations, janitorial services, repairs, trash collection, cleaning of common areas, and security services are ignored in determining whether significant services are performed. The other services (golf, tennis, pool, and masseuse) would only be significant if they represent a large part of the cost of the package relative to the cost of using the property. Because the property qualifies as a rental real estate activity, the taxpayers may be able to utilize the $25,000 exception to deduct all or a portion of any losses arising from the operation. Note that the rental rules create a hardship on taxpayers like S and his wife whose livelihood is derived from long-term rentals. If this activity were characterized as a nonrental activity, the taxpayers would be able to deduct any losses immediately assuming they materially participate in the activity. For this reason, S and his wife might argue that the services are significant in order to convert this to a nonrental activity. (See Examples 23 and 30 and pp. 12-18 and 12-23.) Rental activity. If the average rental period exceeds 30 days, the activity is a rental unless extraordinary services are provided. According to the Regulations, janitorial services, repairs, trash collection, cleaning of common areas, and security services are ignored in determining whether significant services are performed. In this case, the services are not significant so the activity is a rental. Like (c) above, the rental qualifies for the $25,000 exception for rental real estate. (See Examples 23 and 30 and pp. 12-18 and 12-23.) Nonrental activity. If the average rental period exceeds 30 days, the activity is a rental unless extraordinary services are provided. In this case, the owner provides a physician and nursing care that would be considered extraordinary, converting the apparent rental into a nonrental activity. (See Example 24 and p. 12-18.) Nonrental activity. The activity is not a rental activity if the taxpayer customarily makes the property available during defined business hours for the nonexclusive use of various customers. Here, patrons of the health club can use the equipment and other facilities only if they are not being used by other club members. (See p. 12-19.) Nonrental activity. The activity is not a rental activity if the rental of the property is merely incidental to the real purpose for holding the property. In this case, D appears to be holding the property for investment, and the rental income simply helps to defray some of D's costs. The Regulations provide an objective test in this regard. If the rent is less than 2 percent of the property's basis (or value if less), the activity is not a rental. Here the rental represents 2.5 percent ($5,000=$200,000). Although the rental income exceeds the threshold, the rental would still appear incidental. Note that this rule prohibits the creation of passive income. Moreover, under the recharacterization rules (rental of nondepreciable property), rental income is recharacterized as nonpassive unless at least 30 percent of the basis of the property is depreciable. Here, none of the property is depreciable so all of the income would be considered nonpassive. [See Example 26, pp. 12-19 and 12-24, and Temp. Reg. 1.4692T(f)(3)(Example)]. b. c. d. e. f. g. Solutions to Problem Materials 12-13 12-18 a. b. c. d. e. f. Yes, the passive-activity rules apply. Generally, a limited partner in a limited partnership is deemed not to have materially participated in the activity. Consequently, G may deduct the loss when combined with other passive losses, but only to the extent of passive income from all passive activities. For example, if G's passive income had been only $2,000 in this case and his only loss $10,000, he could deduct $2,000. If he had no passive income, the loss would be held in suspension until G has passive income or disposes of his interest in the partnership. (See Example 9, p. 12-9, and 469.) The passive-activity rules should not apply in this case. Since the activity does not involve rental property and G and his wife each spent 300 hours operating the bar, they meet the "more than 500 hours" test of the Treasury's Regulations regarding the material participation requirement. (See p. 12-20.) The passive-activity rules apply in this case because G does not meet any of the following regulatory tests for material participation: (1) "more than 500 hours," (2) "substantially all of the participation," or (3) "more than 100 hours and more than anyone else." Because this is G's only investment, it is impossible for him to qualify as a material participant under the exception that allows aggregation of hours spent in several activities (i.e., the exception for "significant participation activities"). (See Example 28 and pp. 12-20 and 12-21.) The passive activity rules should not apply in this case because G meets the "significant participation in several activities" test. Note that G participates more than 100 hours each in four SPAs and his total participation exceeds 500 hours (i.e., 4 130 520 hours). (See Example 28 and pp. 12-20 and 12-21.) The passive activity rules should not apply in this case. Because the rental income would be considered insubstantial in relation to the non-rental activity, the rental and nonrental operations are aggregated into a single activity. Consequently, the loss on the rental activity offsets the partnership's income from consulting. (See Example 20 and pp. 12-16 and 12-17.) Yes, the passive-activity limitations apply. The corporation can use $4,000 of the loss to offset the corporation's active income. None of the loss may be used to offset the corporation's portfolio income. The passive loss rules do not apply to a regular C corporation unless such C corporation is either (1) a personal service corporation (i.e., one where the principal activity is the performance of personal services and such services are substantially performed by employee-owners who own more than 10% of the stock), or (2) a closely held corporation (i.e., a regular C corporation where five or fewer individuals own more than 50% of the stock). In this case, Try Inc. is a closely held corporation because G is the sole owner. When the rules apply to a closely held corporation, however, the corporation can use the loss to offset active income but not portfolio income (so that an individual with losses cannot avoid the limitation by simply incorporating his or her portfolio). (See Example 16 and pp. 12-13 and 12-14.) The loss has no effect in 2011 due to the passive-activity limitations. M may use the loss from the partnership to offset his other income only if he materially participates in the activity. M must be involved with the activity on a regular, continuous, and substantial basis, or meet one of the regulatory tests to satisfy the material participation requirement. However, M's involvement in the partnership is extremely limited. In effect, he is merely an investor. As a result, M may deduct the loss only to the extent of his other passive income. In this case, he has no passive income so the loss is carried over to be deducted against future passive income. The interest income is not passive income but rather portfolio income, which cannot be reduced by passive losses except in the year of a disposition. (See Example 9 and pp. 12-10 and 12-11.) M can use $12,000 of the $40,000 loss carried over from 2011 to offset his passive income of $12,000 in 2012. (See Example 9 and p. 12-10.) No. The income from M's limited partnership interest is considered passive income. Passive losses are deductible to the extent of passive income from any passive activities. Consequently, he could use $12,000 of the passive loss from 2011 to offset the passive income from the limited partnership. 12-19 a. b. c. 12-14 Chapter 12 Deductions for Certain Investment Expenses and Losses d. M may deduct his unused passive loss from the activity, $28,000 ($40,000 $12,000), against other income in the year he disposes of his interest. The loss first offsets any gain from the sale of the interest. Any remaining loss is then used to offset passive income from other passive activities. Any remaining loss can be used to offset active and portfolio income. In this case, M will use the $28,000 loss to reduce his $40,000 gain from the sale. (See Examples 9 and 10 and pp. 12-9 and 12-10.) 12-20 The taxpayer may deduct $15,000. The balance of the loss, $15,000, is subject to the normal passive-loss rule. The loss is considered passive because it arises from a rental activity. In this case, the activity is treated as a "rental activity" because there are no significant services provided. Although the loss is passive, 469(i) provides an exception to the general rule limiting the deduction of passive losses. Under this provision, the passive-loss limitation does not apply to a taxpayer who actively participates in the rental activity. However, the amount of loss exempt from the rule is limited to $25,000. In addition, the $25,000 exemption is reduced by 50 percent of the excess of the taxpayer's A.G.I. over $100,000. For this purpose, A.G.I. is computed before other passive losses, and the deduction for Individual Retirement Account contributions. In this case, the exception would permit a deduction of $15,000 [$25,000 $10,000 (50% $120,000 $100,000)]. The balance of the $15,000 loss (i.e., that portion not exempt from the general rule of 469) would be treated as a passive loss and could be deducted to the extent of any passive income. (See Example 29 and pp. 12-22 and 12-23.) With respect to the carryover, the question arises as to whether any loss carried over from the rental activity to a subsequent year is eligible for the $25,000 exemption in the later year. For example, assume that in the following year the rental property in this question had zero taxable income. Can the $15,000 loss carryover from the rental property be deducted under the $25,000 exception (since current year losses do not use the $25,000)? The answer to this question is yes according to the Committee Reports for the Conference Report on the Tax Reform Act of 1986. The Report indicates that "losses carried over from a year in which the taxpayer did actively participate but that were not allowed against nonpassive income in such year because they exceed $25,000 (as reduced by the applicable A.G.I. phaseout), are deductible under the $25,000 rule in a subsequent year, but only if the taxpayer is actively participating." Thus, any loss exceeding the $25,000 exception may be carried over and is subject to the $25,000 exception in the subsequent year. Prior to 1994, losses arising from rental real estate activities were automatically passive under 469(c)(2). As such, they could be used only to offset income from other passive activities. New rules established by the Revenue Reconciliation Act of 1993, however, now allow certain taxpayers engaged in real property trades or businesses to treat these activities as nonpassive if certain requirements are satisfied. First, taxpayers must meet the two tests outlined in 489(c)(7)(B), which provide that an individual is eligible for this special treatment if (1) more than one-half of the taxpayer's personal services are performed in real property trades or business in which the taxpayer materially participates and (2) more than 750 hours of such services are performed during the tax year. A real property trade or business, for the purpose of 469(c)(7), is one that develops, redevelops, constructs, reconstructs, acquires, manages, leases, or sells real property. Satisfaction of these two tests is necessary, but not sufficient, to qualify the taxpayer under 469(c)(7). Once these two requirements are met, the taxpayer must determine whether or not he materially participates in the rental real estate activities. Normally this test is applied on a property-by-property basis, although the taxpayer can elect to treat all interests in rental real estate as one activity, whether or not they are an appropriate economic unit under the regulations. Considering the extent to which H and M are involved in the real estate business, they would probably qualify for the passive loss relief provided by 469(c)(7). If so, the partnership losses allocated to them would be considered non passive and therefore deductible from active income. Note, however, that the deduction of these losses may still be limited by the partner's adjusted basis of his partnership interest and by the at-risk rules. (See Example 31 and pp. 12-23 through 12-24.) 12-21 Solutions to Problem Materials 12-15 12-22 a. G is allowed to deduct the passive losses from activities X and Y to the extent of his passive income from Z. In 2011, G is able to use $6,000 of the losses from X and Y to shelter the $6,000 of income produced by Z. The remaining loss is carried forward and treated as if it occurred in the following year. The suspended loss of $4,000 is allocated between the loss activities, X and Y, based on their pro rata contribution to total losses, 70 and 30 percent respectively. The computation and allocation of the suspended loss is shown below. Activity X Y Z Total loss Total Disallowed Loss $(4,000) $(4,000) 2011 $(7,000) (3,000) 6,000 $(4,000) Percentage of Total Loss ($7,000=$10,000) ($3,000=$10,000) Allocable Portion of Loss $(2,800) $(1,200) Activity X Y (See Examples 11 and 12 and pp. 12-10 and 12-11.) The suspended losses for 2012 for X and Y are computed below. Current Net Income (Loss) $ (2,000) (9,000) 1,000 $(10,000) Carryforward From Prior Years $(2,800) (1,200) -- $(4,000) Total Losses $ (4,800) (10,200) -- $(15,000) Activity X Y Z Total 11- The total passive loss disallowed in 2012 is $14,000. The $14,000 disallowed loss is allocated among the activities with total losses (taking into account both current operations and losses suspended from prior years) as follows: Total Disallowed Loss $(14,000) $(14,000) Percentage of Total Loss ($4,800=$15,000) ($10,200=$15,000) Allocable Portion of Loss $(4,480) $(9,520) Activity X Y 12-16 Chapter 12 Deductions for Certain Investment Expenses and Losses b. The sale of the Y activity enables G to deduct all current and suspended losses related to Y. The $4,000 gain is effectively treated as passive income. It first offsets any current and suspended passive losses from Y for the year (i.e., $10,200). The remaining current and suspended loss from Y not absorbed by the gain on the sale, $6,200, ($10,200 $4,000) is first used to offset the net passive income from other passive activities. In this case, there is no net passive income from other activities since Z's income of $1,000 is offset by X's losses of $4,800 ($2,800 $2,000), resulting in a suspended loss for X of $3,800. Consequently, the $6,200 loss of Y can be used to offset other nonpassive or portfolio income. Had the gain not been fully absorbed by passive losses of Y, it is considered passive and could be used to absorb the passive loss of X. This treatment is summarized below. X $(2,800) (2,000) $(4,800) Y $ (1,200) (9,000) $ (10,200) 4,000 $ (6,200) Z -- $1,000 $1,000 Suspended loss Current income (loss) Total Gain on disposition of B Excess loss deducted against other income Z's current income Suspended loss 11- (See Example 13 and pp. 12-9 and 12-12.) 12-23 a. 1,000 $(3,800) b. c. d. Under the recharacterization rules, income that would otherwise be considered passive is treated as nonpassive or active if less than 30 percent of the basis of all of the property is depreciable. In other words, at least 30 percent of the basis must be depreciable, otherwise the recharacterization rules apply. In this case, the improvements represent 25 percent of the basis [$100,000=($300,000 $100,000)], and, therefore, the income from the rental as well as the gain on the sale is recharacterized as nonpassive. [See p. 12-24 and Temp. Reg. 1.469-2T(f)(4)(Example).] Rental income, including gain on the sale of the rental property, is recharacterized as nonpassive (i.e., active) if (1) gain on the sale is included in income during the taxable year; (2) rental of the property commenced less than 24 months before the date of disposition; and (3) the taxpayer performed sufficient services that enhanced the value of the rental property. In this case, all three of these conditions are satisfied: (1) the gain is included this year, (2) rental started less than 24 months prior to the sale, and (3) Q provided sufficient services in that she developed the property. (See p. 12-25.) The rents are recharacterized as nonpassive under the self-rented property rule. According to this rule, income from the rental of property to the activity in which the taxpayer materially participates, other than a related C corporation, is recharacterized as nonpassive. This rule ensures consistent treatment of both the income and expenses related to the rental property. (See p. 12-25.) The income from the travel agency would be recharacterized as active under the special rules for significant participation activities (SPAs), whereas the loss from the office supply store would remain passive. An individual materially participates in a SPA if his or her total participation in all SPAs exceeds 500 hours. A SPA is any trade or business in which the taxpayer participates more than 100 hours, but fails the other six texts for material participation. If total participation in all SPAs does not exceed 500 hours, income is recharacterized as nonpassive, but losses are passive. (See Example 28 and pp. 12-24 and 12-25.) Solutions to Problem Materials 12-17 12-24 There are six situations in which what is normally a rental is to be treated as a nonrental activity. 1. An activity is not a rental activity if the average rental is seven days or less. 2. An activity is not a rental activity if the average rental period is 30 days or less and the owner of the property performs significant services in connection with the rental. 3. An activity is not a rental activity if extraordinary personal services are provided by the owner of the property. 4. An activity is not a rental activity if the rental of property is merely incidental to the nonrental activity. 5. An activity is not a rental activity if the owner customarily makes the property available during defined business hours for the nonexclusive use of various customers. 6. An activity is not a rental activity if the taxpayer owns an interest in a partnership, S corporation, or joint venture to which the property is rented. (See Example 23 and Example 24 and pp. 12-18 and 12-19.) 12-25 a. To determine how the taxpayer's deductions may be limited, the character of the rental property must be determined (i.e., is the rental property to be treated as a residence or as rental property?). Under 280A, the taxpayer is deemed to have used the property as a residence (and deductions are limited under 280A) if his personal use exceeds the greater of 14 days or 10 percent of the number of days actually rented out. In this case, because the taxpayer's personal use, 20 days, exceeds two weeks [the larger of 14 days or four days (10% of 40 rental days)] the property is considered to be the taxpayer's residence. This determination is important for two reasons: (1) the deductions attributable to the property are limited to the rental income; and (2) as a residence, the interest not allocable to the rental activity is deductible as qualified residence interest. In making the allocation of expenses between personal and rental use below, the Bolton case is followed. In this case, interest and taxes were treated as accruing on a daily basis (regardless of actual use) and allocated to the rental use relative to the entire year. In contrast, other expenses were considered a function of use, and thus allocated based on percentage of rental use relative to the combined rental and personal use (which may be less than the entire year). The effect of the Bolton case is to allocate less interest and taxes to rental use, and therefore increase the amount of other deductions, including depreciation, that can be taken when the vacation home is considered a personal residence. It is unclear under current law which approach is correct. As noted in the text, the Committee Reports for the Tax Reform Act of 1986 are contradictory. On the one hand, they say that prior law should be followed (presumably the Bolton case). On the other hand, they state that all expenses should be allocated based on relative use. Interest allocable to rental use: Based on Bolton $3,650 40=365 $400 Based on actual use $3,650 40=(20 40) $2,433 Maintenance allocable to rental use: $900 [40=(20 40)] $600 Depreciation allocable to rental use: $6,000 [40=(20 40)] $4,000 12-18 Chapter 12 Deductions for Certain Investment Expenses and Losses The calculation of the deduction under the gross income limitation of 280A is determined as follows: Total $1,000 3,650 $ 900 $ 6,000 Rental $ 1,000 (400) 600 (600) 0 0 Personal $ 3,250 (itemized deduction) Income Allowed deductions: Interest Limitation Other deductions: Maintenance Limitation Depreciation 300 (nondeductible) 2,000 (nondeductible) b. With respect to the expenses allocable to the rental use, the deductions are limited to the amount of rental income, $1,000. Thus, of the expenses attributable to rental use, S may deduct $400 of interest expense and $600 of maintenance expense for A.G.I. (since they both relate to the production of rents). The remaining interest allocable to personal use is considered qualified residence interest because the unit is treated as a residence (S used the home for more than the greater of 14 days or 10% the number of days rented out). Consequently, all of the $3,250 of interest is deductible as an itemized deduction. The remaining $300 maintenance and $2,000 depreciation, which are allocable to personal use, are not deductible. (See Example 36 and pp. 12-28 through 12-32.) In this situation, S's personal use of 10 days does not exceed the greater of 14 days or 10 percent of the four rental days. Consequently, S's deductions are not subject to the gross income limitation of 280A. The loss potentially deductible--subject to the passive-activity limitations--is $4,920 determined as follows: Interest allocable to rental use: $3,650 40=365 $400 1. Maintenance allocable to rental use: $900 [40=(10 40)] $720 2. Depreciation allocable to rental use: $6,000 [40=(10 40)] $4,800 Total $ 1,000 3,650 900 6,000 Rental $ 1,000 (400) (720) (4,800) ($ 4,920) Personal $3,250 180 1,200 Rental income Expenses: Interest Maintenance Depreciation Loss Solutions to Problem Materials 12-19 c. Under the passive-loss rules, the deductibility of the net loss depends on whether the property is considered a rental activity. Rental of the condominium may or may not be treated as a rental activity, depending on whether significant services are provided in conjunction with the rental. If this is a typical situation where the condominium is placed in a rental pool and maid services are provided (much like a hotel), such services would apparently be considered significant. Therefore, the leasing of the condominium would not be treated as a rental activity. In such case, the rental exception would be unavailable, and the loss could be deducted only to the extent of other passive income. On the other hand, if the taxpayer handled his own rental and provided no maid services or the like, the rental exception would apply. In such case, he could deduct the loss in its entirety because it is less than $25,000. This assumes that the taxpayer's A.G.I. is less than $100,000. If A.G.I. exceeds $100,000, the $25,000 allowance is reduced by 50 percent of the excess. (See Example 37 and pp. 12-28 through 12-33.) The remaining interest expense of $3,250 would not be considered qualified residence interest, as the property is not treated as a residence because it was used less than two weeks. The treatment of the interest is unclear. The taxpayer may be able to deduct the interest as investment interest to the extent of any investment income. Alternatively, the interest may be considered personal interest that is wholly nondeductible. The remainder of the other maintenance and depreciation allocable to personal use would not be deductible. Rental of the condominium for 14 days is considered to be nominal rental (less than 15 days). In this case, all rental income is excluded from gross income and no deduction is allowed for rental expenses. The interest expense may be deducted from A.G.I., if it is qualified residence interest and S itemizes his deductions. (See pp. 12-28 and 12-34 and Review Question 2.) The unit is treated as being used for personal purposes for a calendar day when the owner uses it for any part of such day. [See Proposed Reg. 1.280A-1(e).] But the personal use is disregarded if, on that calendar day, the individual is engaged in repair or maintenance work on the unit on a more or less full-time basis. [See Proposed Reg. 1.280A-1(3)(4).] This condition is satisfied if he works on the unit for the lesser of eight hours or two-thirds of the time that he is present on the premises. In this case, Sunday is clearly a personal use day because S slept in the unit and did not perform any repair work. With respect to Saturday, S worked on repairs for five to six hours, virtually all of the time he was "on the premises" of the unit. In such case, Saturday would not be a personal use day because he worked at least two-thirds of the time present. But, if the IRS interprets "on the premises" liberally and S is treated as having been at the unit since his arrival, he would not have worked the required amount of time, and Saturday would be a personal use day. (See p. 12-29.) Same as (a). Changes by the Tax Equity and Fiscal Responsibility Act of 1982 made it clear that family members accompanying the taxpayer are not required to work on the unit with the taxpayer in order for the day to qualify as a non-personal day. Note that this rule enables the taxpayer's family to enjoy the unit without tainting the day. (See p. 12-29) Under the general rule, T would be subject to the rules applicable when there is substantial owner use because his 31 personal use days in December exceed the greater of 14 days or three days (10% 31 days rented). These rules would limit deductions to the extent of gross income as reduced by otherwise allowable deductions. However, 280A(d) provides that the personal use days will be disregarded if they proceed or follow a qualified rental period--generally a period of at least a year. Because the tenant had been renting the unit for a year prior to her leaving, the personal use by T should be disregarded, and no limitation would be imposed on the deduction. (Note, it is unclear whether the period from February 1 through November 30 during which the apartment was not rented would have any effect on this result.) [See p. 12-33 and 280A(d).] 12-26 a. b. c. 12-20 Chapter 12 Deductions for Certain Investment Expenses and Losses 12-27 a. False. As a general rule, rental activities are considered passive regardless of the taxpayer's participation. However, in 1993, Congress provided relief from the passive loss limitations for those who are truly engaged in the business of rental real estate. Under the so-called real estate professional exception, an individual is eligible to deduct losses from rental real estate if both of the following tests are met. 1. More than 50 percent of all services performed by an individual are performed in real property trades or businesses in which the taxpayer materially participates during the year and 2. The individual performs more than 750 hours of services in real property trades or businesses in which he materially participates. Even if the taxpayer meets these tests, no deduction is allowed unless he satisfies the material participation test for each activity. However, in applying the material participation tests, he is allowed to aggregate his hours in all rental real estate activities. The important concept to grasp is that losses from rental real estate may be deductible even if the taxpayer does not have passive income. (See Example 31 and pp. 12-23 and 12-24.) True. Since D performs more than 50 percent of his services in real property businesses and assuming that the number of hours performed in such businesses exceeds 750 he should be allowed to deduct the losses. It should be emphasized, however, that D must still meet the material participation test for each activity. (See Example 31 and pp. 12-23 and 12-24.) False. As noted above, an individual must perform 750 hours of services in real property businesses to qualify for the real estate professional exception. Even though it might seem that D and his wife together meet the 750-hour requirement, they fail. The exception applies only if one of the spouses separately meets both tests. For example, D must work more than 750 hours to be eligible. Even if D's spouse spent 500 hours working with D (in which case she would materially participate), such hours cannot be aggregated with her husband's for purpose of the 750-hour test. (See p. 12-23.) b. c. 12-28 Partner A's amount at risk on 12/31/2011 is computed as follows: Amount at risk 1/1/2011 contribution Share of $120,000 recourse liability incurred Share of $90,000 repayment of recourse liability Cash distribution of $40,000 Amount at risk 12/31/2011 $100,000 60,000 $160,000 (45,000) (40,000) $ 75,000 The nonrecourse liability incurred by AB Partnership and the repayments of this liability have no effect on partner A's amount at risk. Although A's distributive share of the partnership's taxable loss is $210,000, A's loss deduction under 465 is limited to $75,000. The $75,000 deduction is claimed on A's 2011 tax return but reduces A's amount at risk at the close of 2011. The $135,000 disallowed loss is treated as a deduction incurred in 2011. Partner A's amount at risk on 12/31/2012 is computed as follows: Amount at risk 12/31/2011 Allowable 2011 loss deduction Beginning at-risk balance Share of 2012 taxable income Cash contribution Amount at risk 12/31/2012 $ 75,000 (75,000) ,000 $ 60,000 50,000 $110,000 The $135.000 disallowed loss carryforward from 2011 is allowed as a deduction in 2012 to the extent of $110,000. The remaining $25,000 of disallowed loss deduction is treated as a deduction incurred in 2013. See Example 7 and pp. 12-6 through 12-8. Solutions to Problem Materials 12-21 12-29 The at-risk rules apply to limit the partners' deductions to the amounts they have at risk. a. Each partner's share of the $75,000 loss is $25,000. As a general partner, S is liable for the accounts payable of $20,000. The nonrecourse debt of $30,000 is considered qualified nonrecourse financing since it meets all of the tests: 1. The financing is secured by the real property used in the activity. 2. No person is personally liable for the debt (nonrecourse debt). 3. The amounts are borrowed from a person that is regularly engaged in the lending business (e.g., a commercial lender such as a bank). 4. The lender is not related to the taxpayer. 5. The lender is not the seller of the property or the promoter of the deal (i.e., receives a fee for the taxpayer's investment) or related to the seller or promoter. None of the partners are liable for the nonrecourse debt. Consequently, the nonrecourse debt is normally allocated among the partners according to their interests, $10,000 (1=3 $30,000) to each. Therefore, S's amount at risk is $30,000 ($20,000 $10,000) and, consequently, S can deduct all of the $25,000 subject to the passive loss rules. S's at-risk balance is reduced to $5,000 ($30,000 $25,000). Each of the limited partners have an at-risk amount of $10,000 and can deduct only $10,000 of their $25,000. The remaining $15,000 is carried over to the next year and can be deducted when their at risk amounts increase. b. If the activity was equipment leasing, the nonrecourse debt would not be considered qualified nonrecourse financing since it would not be secured by real property used in the activity. As a result, the debt would not be included in determining the partners' amounts at risk. Consequently, S could still deduct $10,000 of the allocable loss but the other partners could not deduct any of the loss since they have nothing at risk. (See Example 8 and p. 12-8.) ...
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This note was uploaded on 02/05/2012 for the course ACCT 110 taught by Professor Smith during the Spring '11 term at Adrian College.

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