Y07ch7notes411 - Chapter 7 Notes Passive Activity Losses...

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Chapter 7 Notes Passive Activity Losses and Other Losses PART I - PASSIVE ACTIVITY LOSSES I) Introduction – Passive activity rules and the nature of a tax shelter The passive activity rules are simply another manifestation of the general rule that the tax law generally limits investment losses to investment income and the ability to use investment losses to offset other income. The passive activity rules are relatively new (they have only been around since 1986) but they are sweeping in their effect. Before the enactment of the rules, there was a thriving tax shelter industry in the U.S. These were pass-through entities (entities whose income and loss is not taxed at the entity level but is taxed directly to the owners) whose investors were partners of partnerships, or S corporation shareholders, or, in some cases beneficiaries of interests in investment trusts. Before the enactment of the rules, many of these entities passed-through losses to their investors who used the losses to offset other income (at top marginal tax rates) to reduce their tax burdens. The abilities of owners of pass through business and rental entities to use these losses to lower tax burdens placed them in very different positions from investors in regular C corporations who did not receive any personal share of the separate entity’s loss. The ability of the tax shelter investors to use these losses while corporate investors could not was a triumph of substance over form. The tax shelter investors had larger gains upon termination of the pass-through interests (because the pass-through losses reduced their basis in the investment) but these gains were taxed at lower capital gain rates and were less costly in present value terms because this tax was paid further into the future. In addition, corporate sale of appreciated assets pursuant to liquidation generated double taxation – to the corporation on the sale and to the individual on receipt of cash in excess of the basis of the stock. II) The At Risk Rules The old pass-through tax shelters were first attacked by the at risk rules. Losses of investors are limited by three successive hurdles that must be passed in order to deduct losses: 1) Sufficient basis to absorb losses 2) Sufficient amounts “at risk” to absorb losses 3) And since 1986 – the passive activity rules At risk rules Losses limited to amounts at risk which include a) all contributions to the investment (withdrawals reduce basis and amount at risk) b) income recognized from the investment but not withdrawn (losses reduce basis and amount at risk) c) recourse loans (loans for which investor personally liable)
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A determination of basis would include the same items but would also include the investor’s share of nonrecourse loans.
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