Deductions for Certain Investment Expenses

1
Chapter 12

• Deductions for Certain Investment Expenses
  Losses
• Read Examples 1 through 21

2
Passive Activity Losses Credits Limited
Section 469

• The Problem of Tax Shelters

• EXAMPLE OF A TAX SHELTER
• ITC, ACRS, and interest deductions to produce
  early losses, tax reducing credits, plus positive
  cash flow
• equity problems
• economic distortions
• usually no determination of economic gain or loss
  until the end of the project

Tax Responses At risk limitations Investment
interest limitations TRA 86 Passive activity
rules (Sec. 469)
3
General Features of Section 469Passive Activities

• Section 469 applies to individuals, estates,
  trusts, personal service corps., and closely held
  corporations

Classify All Business Activity Into Three Types
Separate nonportfolio businesses on basis of 1.
Ownership 2. Level of TP involvement
4
General Features of Section 469 Basic Tax Aspects

• Losses from passive activities cannot be deducted
  from active or portfolio income.
• Unlimited carryovers of disallowed losses.
• Accumulated (carryover) passive losses are
  deductible from active and/or portfolio income
  without limitation if the activity is completely
  disposed of in a taxable transaction to a
  nonrelated party. Deducted in order against
• Passive gains on the sale
• Current year passive income
• Active/portfolio income

5
General Features of Section 469 Basic Tax
Aspects, cont.

• For closely held corporations, passive losses can
  offset active income, but not portfolio income.
  (Corporations not closely held are not subject to
  passive limitations).
• Tax credits produced from passive activities can
  offset only taxes attributable to passive income,
  with unlimited carryovers of unused credit.
• Separate accounting is required for each active,
  passive, or portfolio activity.

6
Portfolio Income

• Includes income from investments and assets held
  for investment, if not directly connected with an
  active or passive activity.

• EXAMPLES OF PORTFOLIO INCOME
• Most bond interest, dividends and royalty income
• Income on invested working capital assets

7
Passive Income

• Passive Activity defined -- Sec. 469(c) Any
  Activity
• which involves a T/B activity (Sec. 162 or Sec.
  212 - related activities) where the TP does not
  materially participate or
• which involves rentals
• Exceptions
• A passive activity business may also have
  portfolio income
• A working interest (ownership directly or
  through a general P/S) in oil or gas property is
  active, regardless of the TPs level of activity

8
What is an Appropriate Economic Unit?

• Separate accounting is required for each
  appropriate economic unit (activity)
• Problem What is an appropriate economic unit?

EXAMPLE Two brothers own two apartment buildings
and three rental houses, which they operate as a
general partnership. They have a separate
partnership which owns a coin-operated laundry
facility in each apartment building. Which
activities should be aggregated for passive
activity purposes?
9
Appropriate Economic Unit, cont.

• Factors to Consider
• Commonality in types of business
• Extent of common control
• Extent of common ownership
• Geographical location
• Interdependency between activities
• Grouping of activities is done at the entity
  level
• Consistency Requirement Rental and non-rental
  activities may not be grouped unless one activity
  is insubstantial in relation to the other.

10
Participation Levels

• Material Participation (must meet one of 7 tests
  - read pp. 12-13)
• IR Code defined Regular, continuous (for the
  entire tax year), and substantial involvement in
  the activity
• Regulations definition For Material
  Participation , a TP must meet one of seven
  tests. In general, material participation
  requires
• More than 500 hours/year or
• Substantially all of the participation that is
  required to run the business

11
Applying Section 469

• If the sum of all passive activity net loss,
  then apply passive activity rules
• If the sum of all passive activity net gain,
  then the passive activity rules dont apply that
  year
• Unlimited c/o of disallowed losses
• Must allocate c/o between passive activities
• Personal (earned) income always is active.
• An individual can have active (earned) income
  from a passive activity

12
Applying Section 469 Example

• TP has 4 passive business activities
• Activity Gross Inc. Deduct. Net c/o
• 1 500 900 (400) (107)b
• 2 900 450 450 0
• 3 650 1,000 (350) ( 93)b
• 4 100 0 100 0
• Total 2,150 2,350 (200)a (200)
• a. Net loss for year, therefore passive activity
  limits apply
• b. Apportionment of carryover loss to each
  passive activity
• 1) 400/(400350) X (200) (107)
• 2) 350/(400350) X (200) ( 93)

13
Exception to Passive Activity Rules

• Rental property can be either
• A nonrental activity (can be active or passive
  - test of material participation), or
• An active rental activity, or
• A passive rental activity

14
Rented Property that is Part of aNonrental
Activity

• Six situations where rented property is NOT
  considered a rental activity
• 1-7 day rental period, or
• 8-30 day rental period and significant services
  provided, or
• Extraordinary services provideduse of property
  is incidental, or
• Incidental rentals, or
• Property used by an entity in a nonrental activity

15
Active Rental Activities

• Rental property that is part of a rental
  activity
• Unlimited losses from the rental can be deducted
  if the TP meets two tests
• 50 of all personal services during the year must
  be for real property trade or business, and
• The TP performs more than 750 hours in real
  property trades or businesses

16
Passive Rental Activity An Exception to the
Passive Activity Rules

• Individual TPs and estates who actively
  participate in passive rental real estate
  businesses may deduct up to 25,000 losses/year
  from nonpassive income.

This 25,000 allowance is reduced by 50 of the
individuals AGI in excess of 100,000 of
nonpassive income
EXAMPLE AGI 110,000 A maximum of 20,000 may
be deducted against active and portfolio
income. (50)(110,000 - 100,000) 5,000 25,000 -
5,000 20,000
17
Participation Levels Active Participation in
Passive Rental Activities

• TP must have gt 10 ownership interest
• TP must have significant and bona fide
  involvement

Example of Active Participation Approval of
tenants, setting rental terms, approving repairs
and improvements, etc. Use of rental agents does
not defeat active participation
Active participation is less restrictive than
material participation. If material
participation is present, then the rental
business is active.