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Passive Loss Rules
Matthew K. Becker, CPA BDO
Douglas J. Patch, Godfrey & Kahn, S.C.
November 4, 2010
mw5514693
History of Passive Loss
Rules
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Prior to TRA 1986, few limitations were
placed on ability to use deductions from one
activity to offset income from another
activity.
Tax Shelters were designed to generate
large deductions with minimal investment.
TRA 1986 addressed this situation with
many lines of attack: expansion of AMT,
extension of at-risk rules to real estate and
passage of the passive loss rules.
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Effect of Passive Loss Rules
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Loss from passive activities can not
offset active income or portfolio
income.
Exceptions to general rule of
disallowance:
• Dispositions
• Former passive activity rules
• $25,000 Rental/Real Estate Activity Rule
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Effect of Passive Loss Rules
- Dispositions
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Dispose of entire interest in activity in
a fully taxable transaction allows
utilization of suspended losses.
• What is an activity?
• What is a qualifying disposition?
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Effect of Passive Loss Rules
- Dispositions
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Appropriate Economic Unit to
determine “activity.”
Facts and circumstances relevant in
grouping.
Decision made at entity level.
Limitations
• Rental Activity/Non-rental activity
• Real Property Rental/Personal Property
Rental
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Effect of Passive Loss Rules
- Dispositions
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Must dispose of entire interest in
activity
Disposition must be fully taxable
Related Party Rule
Installment sales
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Effect of Passive Loss Rules
– Other Triggering Events
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Activity ceases to be passive
• Not a disposition
• Can use suspended losses to offset
income from the same activity
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$25,000 Rental Real Estate Rule
• Can treat $25,000 as active if active in the
rental
• Otherwise, real estate is per se passive
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Determining Whether an
Activity is Passive
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Trade or Business in which the
Taxpayer does not materially
participate.
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Rental Activity.
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Material Participation
Standard
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Material Participation means
involvement is regular, continuous
and substantial.
Regulations provide Material
Participation standard met if and only
if one of seven tests met.
First six tests are narrowly
quantitative, the seventh is a facts and
circumstances test.
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Material Participation –
Test One
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Taxpayer must participate more than 500
hours
Taxpayer must own activity at time of
services for services to count
Certain hours disregarded:
• Non-owner work done to meet 500 hour test
• Work done in investor capacity unless taxpayer
involved in day-to-day management
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Material Participation –
Test Two
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Met if the taxpayer’s participation
constitutes substantially all of the
participation in the activity.
If test met, does not matter how few
hours taxpayer spends participating in
activity.
Services of non-owners is considered.
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Material Participation –
Test Three
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Met if a taxpayer participates in an activity
for more than 100 hours and his
participation is not less than that of any
other individual during the same year.
Work performed by non-owners is
considered.
Not clear whether number of hours is sole
determinant of who participates more.
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Material Participation –
Test Four
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Met if aggregate participation in all
“significant participation activities” exceeds
500 hours.
A SPA is a non-rental trade or business in
which taxpayer participates for more than
100 hours and none of the other tests are
met.
If fail the 500 hour aggregate test, income
from SPAs is considered active, but loss is
considered passive.
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Material Participation –
Test Five
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If materially participated (based on
other tests) in five of past ten years,
then considered to materially
participate in current year.
Test designed to prevent flip-flops,
i.e., treatment of an activity as
nonpassive when it generates losses
and active when it generates income.
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Material Participation –
Test Six
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Met if participated in a personal service
activity for any three prior taxable years.
Personal service activity means any
business where capital is not a material
income-producing factor including, but not
limited to, health, law, engineering,
architecture, accounting, performing arts or
consulting.
Several cases in the area.
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Material Participation –
Test Seven
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Met if, based on all the facts and circumstances, a
taxpayer establishes regular, continuous and
substantial involvement in the activity.
Regulations specify this test cannot be met if taxpayer
participates in an activity for 100 hours or less.
Management services are disregarded unless: (1) no
other individual is compensated for providing
management services and (2) no other individual
performs a greater number of management hours.
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Material Participation –
Other Considerations
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Distinction between investors and
entrepreneurs
Treatment of limited partners
Material Participation by legal entities
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Definition of Rental Activity
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A rental activity is an activity where
payments are for the use of tangible
property.
Exception One: Average customer use
period of seven days or less.
Exception Two: Average use of 30 days or
less and significant personal services.
Exception Three: Extraordinary personal
services.
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Definition of Rental Activity,
cont.
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Exception Four: Rentals incident to
nonrental activities of taxpayer.
Exception Five: Property customarily made
available for nonexclusive use by various
customers.
Exception Six: Property rented to a pass
through entity or joint venture in which the
taxpayer owns an interest.
Exception Seven: Rental of taxpayer’s
residence.
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Real Estate Operators
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Taxpayers who qualify as real estate
operators must treat their rental activities as
nonpassive upon a showing of material
participation.
Definition of real estate operator:
• Closely held C corporation with more than
50% of gross receipts from real property.
• Individuals who perform more than 50% of
services in a real property trade or business AND
more than 750 hours in real property trades or
businesses in which he materially participates.
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Real Estate Operators
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Must group all real estate activities
together as a whole or treat
separately.
Must still meet one of the seven
activity tests for trade or business to
be considered active.
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Net Income from
Nonshelterable Passive
Activities (“NOPAs”)
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Six situations in which net gain, but
not net loss, from a passive activity is
treated as nonpassive.
Can use suspended loss from NOPA
to offset income from the NOPA.
NOPA #1: Significant Participation
Passive Activities
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NOPAs, cont.
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NOPA #2: Rental of Nondepreciable
Property.
NOPA #3: Equity-Financed Lending
Activity.
NOPA #4: Property Rented Incidental
to Development Activity
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NOPAs, cont.
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NOPA #5: Property Rented to a
Nonpassive Activity of the Taxpayer.
NOPA #6: Certain Royalties
Received Through a Pass Through
Entity.
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Self-Charged Interest Rule
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Interest income is portfolio income
generally not available to offset loss
from a passive activity.
Self-charged interest rule allows offset
of interest expense of debtor passive
activity attributable to loan from
owner.
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Self Charged Interest
Example
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X owns 50%; Y owns 50% of LLC.
LLC conducts per se passive rental
activity.
X loans $1,000,000 to LLC at 10%
interest rate.
X can treat $50,000 of interest income
as passive income.
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Self Charged Interest
Example, Cont.
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What if $1,000,000 were contributed
as preferred equity with a 10% priority
return?
• Economics between X and Y would be
the same
• Entire special allocation is passive
income and could be offset with passive
loss.
• Must take care to avoid having the special
allocation treated as a guaranteed
payment.
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Rev. Proc 2010-13
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Requires taxpayers to report their
groupings and regroupings of
activities.
Also requires reporting additions of
activities to current groupings.
Effective for tax years beginning on or
after January 25, 2010.
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Reporting Requirements –
New Groupings
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The taxpayer must file a statement
identifying the activities.
Statement must be attached to the
original return for the first taxable year
in which two or more activities are
grouped.
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Reporting Requirements –
Existing Groupings
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No disclosure is required for existing
groupings that are unchanged.
Statement must be attached to the tax
return in any year that an activity is
added to an existing group.
When adding an activity, the entire
group must be disclosed.
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Regrouping Activities
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Regrouping is required for groups that
are clearly inappropriate or have a
material change in facts and
circumstances.
Failing to regroup inappropriate
activities will cause each activity to be
treated separately.
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Special Rules –
Partnerships and S-Corps
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Partnerships and S Corporations must
report groupings to partners and
shareholders.
Grouping is reported by separately
stating income and loss for each
group on attachments to the entity’s
Schedule K-1.
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Reporting Requirements –
Partners and Shareholders
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Partners and shareholders are generally
not required to report groupings
disclosed by the entity.
Separate disclosure is required if the
partner or shareholder:
• Groups together activities that the entity does not
group together,
• Groups entity activities with activities conducted
directly by partner or shareholder, and/or
• Groups entity activities with activities conducted
through other passive entities.
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Partners & Shareholders
Example – Grouping Partnerships
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Assume the taxpayer holds a partnership
interest in a grocery distributor as well as
a partnership interest in a separate entity
that owns the warehouse rented to the
distributor.
Assume both partnerships are under
common control and that the warehouse
is rented predominantly to the distributor.
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Partners & Shareholders
Example – Grouping Partnerships cont.
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Each partnership attaches a statement
of activity to the partner’s K-1.
The taxpayer may elect to group these
activities into a single activity.
If grouped, the taxpayer’s material
participation is measured by testing both
activities together as one activity.
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Partners & Shareholders
Example – Grouping at Entity Level
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Assume the same facts as the previous
example except that the distributor
activity and the warehouse activity are
part of one partnership.
Further assume that the partnership
chooses to group the activities.
Assume the taxpayer materially
participates in the distribution activity but
not the warehouse activity.
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Partners & Shareholders
Example – Grouping at Entity Level cont.
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The activities must remain grouped on
the partner’s return.
If the taxpayer’s material participation in
the distributor activity is not enough to
make him a material participant in the
entire economic unit, both activities
become passive.
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Grouping Factors
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Any reasonable method can be used to
group activities.
Grouped activities must constitute
appropriate economic units.
• Similarities and differences in types of trades or
businesses.
• The extent of common control and/or ownership.
• Geographical location.
• Interdependencies between or among the activities.
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Grouping Factors
cont.
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Business interdependencies can arise
from:
• Having the same customers,
• Having the same employees, and/or
• Having a single set of books or records.
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Interdependencies among activities can
also arise when:
• Activities purchase or sell goods to each other, or
• Products or services are normally provided together.
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Grouping Factors
cont.
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Taxpayers may not combine or separate
activities each tax year.
Regrouping is only allowed in
circumstances where the initial grouping
was:
• “clearly inappropriate or there has been a material
change in the facts and circumstances that makes the
original grouping inappropriate.”
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Commissioner can regroup a taxpayer’s
activities when clearly inappropriate.
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Grouping Factors
Example – Appropriate Economic Unit
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Taxpayer owns a bakery and a movie theater in
a mall located in Chicago, IL.
He also owns a bakery and a movie theater in a
mall located in Houston, TX.
Depending on other circumstances, the
taxpayer may:
•
•
•
•
Group all the activities into a single activity,
Group them as a movie theater activity and a bakery activity,
Group them as a Chicago activity and a Houston activity, or
Treat them as four separate activities.
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Benefits of Grouping
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Taxpayers can potentially combine
passive rental activities with profitable
active trade or business activities.
Activities can only be combined if the
activities constitute an appropriate
economic unit and:
• The rental activity is insubstantial in relation to the
trade or business activity,
• The trade or business activity is insubstantial in
relation to the rental activity, or
• They have the same proportionate ownership.
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Benefits of Grouping
Example – Proportionate Ownership
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Husband is the sole owner of an S corporation
that conducts a grocery store trade or business
activity.
Wife is the sole owner of an S Corporation that
owns and rents out a building.
Part of the Wife’s building is rented to the
Husband’s grocery store.
Both activities are reported on a joint tax return.
The activities can be combined as if the grocery
store S Corporation owned the portion of the
rented building used by the grocery store.
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Regrouping Activities
Example – Material Change
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Assume the same facts as the previous
example except that the grocery store
business was moved to an unrelated
location.
The rental property is now rented to an
unrelated party.
A material change in facts and
circumstances has occurred and the
activities must be regrouped separately.
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Suspended Losses –
General Rules
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Losses can generally be suspended for
two reasons:
• Passive activity loss rules
• At-Risk Basis Rules
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Passive losses can only offset passive
income.
Passive losses are carried forward until
used or activity is disposed.
All losses are limited to amount investor
has “at risk”.
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Suspended Losses –
Combined Passive Activities
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Total losses from combined passive
activities are allocated among each
separate activity.
The ratable portion of each separate
activity’s deductions that are
suspended are determined as follows:
Total suspended
losses
x
Each activity's passive activity deduction
Sum of all passive activity deductions
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Suspended Losses
Example – Allocation
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Assume these are treated as a single
passive activity with the following results:
Last Year
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Movie
Theater
Bakery
Total
Gross Income
20,000
60,000
80,000
Deductions
(40,000)
(60,000)
(100,000)
Net Income (Loss)
(20,000)
-
(20,000)
The loss would be allocated as follows:
$20,000
x
$20,000
x
$40,000
$100,000
$60,000
$100,000
=
$8,000
Bakery
=
$12,000
Movie
Theater
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Suspended Losses –
Example – Allocation (cont.)
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Assume that the taxpayer disposed of
the movie theater the next year.
The taxpayer can elect to treat the movie
theater as a separate activity in the year
disposed.
The $12,000 suspended loss would be
deductible in full to offset non-passive
income upon disposition.
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At-Risk Basis
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In general, limits losses to what the
taxpayer actually has “at risk”.
At-risk losses are suspended until the
taxpayer increases at-risk basis
through income or contributions.
Suspended at-risk losses are subject
to the passive loss rules in the year in
which the loss is allowed.
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At-Risk Basis
Example – Suspended Losses (Year 1)
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Assume the taxpayer purchased an interest in a
passive activity with the following transactions
in Year 1.
Movie Theater
Initial Investment
Gross Income
Deductions
Net Income (Loss)
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Year 1
15,000
20,000
(40,000)
(20,000)
The taxpayer has a $15,000 suspended loss
due to the passive activity rules and a $5,000
suspended loss due to the at-risk rules.
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At-Risk Basis
Example – Suspended Losses (Year 2)
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Assume the taxpayer became a material participant
during the next year and the following occurred.
Movie Theater
Contribution
Gross Income
Deductions
Net Income (Loss)
●
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Year 1
15,000
20,000
(40,000)
(20,000)
Year 2
20,000
30,000
(40,000)
(10,000)
The taxpayer now has at-risk basis to take the
current-year loss and the prior year suspended loss.
The prior year suspended at-risk loss becomes a nonpassive loss.
The prior year passive loss is carried forward.
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Q&A
Thank you!
Matthew K. Becker, CPA
BDO
Tel: (616) 802-3413
[email protected]
Douglas J. Patch
Godfrey & Kahn, S.C.
Tel: (414) 287-9324
[email protected]
5514693.ppt
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