Transcript Deductions: Business/Investment Losses and Passive

CCH Federal Taxation
Basic Principles
Chapter 7
Deductions:
Business/Investment Losses
and Passive Activity Losses
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Chapter 7 Exhibits
1.
2.
3.
4.
5.
6.
7.
8.
9.
Abusive Tax Shelters
At-Risk Rules
Passive Activity Loss Rules
Disposing of Entire Passive Activity
Interest
Inheriting a Passive Activity
Receiving a Passive Activity as a Gift
Rental Activities
Grouping Passive with Nonpassive
Activities
Grouping Personal and Real Property
Rentals
Chapter 7, Exhibit Contents
10. Limited Rental Period
11. Insignificant Rentals
12. Non-Exclusive Use During Defined
Business Hours
13. Real Estate Professionals
14. Special $25,000 Allowance Under
Code Sec. 469(i)
15. Rental Real Estate
16. Casualty and Theft Losses
17. Net Operating Losses—Rules for
Individuals
18. Net Operating Losses for
Individuals–Example
CCH Federal Taxation Basic Principles
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Abusive Tax Shelters
Before 1987, a 50% or higher return on equity by high-income taxpayers
was not unusual given that
 tax rates were high (e.g., the top tax rate from 1965 to 1981 was
70%) and
 depreciation allowances were generous (e.g., 1981–1983 depreciation
on office buildings could be computed using a 15-year
life and the 175% declining-balance method; today, it is 39 years
with the straight-line method).
Typical tax shelters once provided high returns without necessarily making
a before-tax profit.
Chapter 7, Exhibit 1a
CCH Federal Taxation Basic Principles
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Abusive Tax Shelters
Example Before–1987 Tax Shelter
 10 investors form "Pay-No-Tax," a limited partnership (LP), and
each contributes $10,000.
 The LP obtains a $900,000 nonrecourse loan from Easy Money
S & L (a federally insured loan) and builds a "Class C" office
building. Note: “nonrecourse” means the S & L would have no
claims against the investors personally in the event of default. The
S & L’s only avenue would be to foreclose on the property.
 The building never exceeds 50% occupancy.
Chapter 7, Exhibit 1b
CCH Federal Taxation Basic Principles
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Abusive Tax Shelters
At 50% occupancy, the annual cash flows appear as follows:
Description
(a)
Rental income
(b)
LP
Each of the
10
Partners
$ 70,000
$ 7,000
Operating expenses
(40,000)
(4,000)
(c)
Interest payments
(90,000)
(9,000)
(d) = (a) – (b) – ( c)
Negative cash flow
(60,000)
(6,000)
(e)
Depreciation
(100,000)
(10,000)
(f) = (d) – (e)
Tax loss
(160,000)
(16,000)
(g) = (f) x 70%
Tax benefit from loss (70% tax
bracket from 1965 – 1981)
112,000
11,200
(h) = (d) + (g)
Net cash [($60,000) + $112,000]
$52,000
$ 5,200
(i) = (h)  equity
Annual return on equity
Chapter 7, Exhibit 1c
CCH Federal Taxation Basic Principles
52%
52%
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Abusive Tax Shelters
 Congress passed the Code Sec. 465 at-risk rules in
1976. However, the at-risk rules did very little to
curb abusive tax shelters.
 Effective January 1, 1987, the Code Sec. 469
passive activity loss rules were enacted, virtually
eliminating most tax shelters.
Chapter 7, Exhibit 1d
CCH Federal Taxation Basic Principles
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At-Risk Rules
The at-risk rules prevent taxpayers from deducting losses in
excess of basis (i.e., amounts at-risk).
Cash investment in an activity
+
Basis of other invested property in the activity
+
+
The activity's borrowings with investor personal guarantees or
personal collateral. (Nonrecourse loans are also deemed “atrisk” if from “qualified” lenders.)
Income allocation
–
Loss allocation, to the extent it “jumps hurdle 1”
–
Distributions of cash or other property to investors at FMV
Chapter 7, Exhibit 2a
CCH Federal Taxation Basic Principles
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At-Risk Rules
Qualified Nonrecourse Loans. Congress took the “bite” out
of the at-risk rules by permitting “qualified” nonrecourse
loans to be treated as “at-risk” under Code Sec. 465(b)(6) if
they were secured by their activity's property. Generally,
nonrecourse secured loans from S & Ls, banks, insurance
companies, and federal, state, and local governments are
considered to be at-risk.
Chapter 7, Exhibit 2b
CCH Federal Taxation Basic Principles
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At-Risk Rules
Penalties for Abusive Tax Shelters. In 1982, Congress
passed a law penalizing abusive tax shelters. The IRS,
however, had difficulty detecting abusive tax shelters since
they were often buried in complex partnership agreements.
Chapter 7, Exhibit 2c
CCH Federal Taxation Basic Principles
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Passive Activity Loss Rules
The PAL rules generally provide that all income and loss must be placed in
one of three categories:
 Active (losses are fully deductible to the extent of basis)

Passive (losses are deductible only against passive income, with some
exceptions)

Portfolio (dividends, interest, royalties, etc.; interest expense is
limited to net investment income)
Chapter 7, Exhibit 3a
CCH Federal Taxation Basic Principles
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Passive Activity Loss Rules
Effect of PAL Rules. The PAL rules eliminated most tax
shelters effective January 1, 1987. Values that had been
artificially inflated due to tax benefits plummeted, and the
real estate industry and S & Ls collapsed during the next six
years. Taxpayers paid hundreds of billions of dollars to
replace federally insured deposits loaned out by the S & L’s
and other institutions.
Chapter 7, Exhibit 3b
CCH Federal Taxation Basic Principles
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Disposing of an Entire Passive
Activity Interest
Three rules apply:
1. Losses. Loss on an “entire” disposition of a passive activity and its
suspended losses can offset active and portfolio income from all
activities.
2. Gains. Gain on an “entire” disposition of a passive activity can be used
to offset suspended passive activity losses from other passive activities.
3. Unrelated parties. The disposition must be to an unrelated party (i.e., a
party other than half-blood relatives, lineal descendants, ancestral
descendants, siblings, and spouses).
Chapter 7, Exhibit 4
CCH Federal Taxation Basic Principles
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Inheriting a Passive Activity
Four rules apply:
1. Beneficiary's step-up basis. Beneficiary gets a step-up basis at fair market value
(FMV) on the date of benefactor's death (or, if elected by executor, FMV six months
after the date of death.)
2. Beneficiary's at-risk amount. The step-up basis becomes “at risk” to the beneficiary.
3. Decedent's passive loss deduction. In the decedent's final income tax return,
suspended losses are deductible to the extent they exceed the “step-up” amount [i.e., to
the extent they exceed (FMV at date of death - Adjusted Basis at date of death)].
4. No effect on beneficiary's basis. The beneficiary's step-up basis is not reduced by the
decedent's passive loss deduction.
Chapter 7, Exhibit 5
CCH Federal Taxation Basic Principles
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Receiving a Passive Activity as a Gift
Two rules apply:
1. Donee basis. Donee does not receive a step-up basis, but the
donee assumes the donor's basis (in most cases).
2. Donor's suspended losses. The donor's suspended losses are not
deductible; instead, they’re added to the donee's basis.
Chapter 7, Exhibit 6
CCH Federal Taxation Basic Principles
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Rental Activities
Generally, rental activities are deemed to be passive without regard to material
participation. However, under the following situations, rental activities may receive
“active” loss treatment. (Note that in each situation, the taxpayer must still satisfy any
one of the seven material participation requirements.)







Chapter 7, Exhibit 7
Grouping passive with nonpassive activities
Grouping personal and real property rentals
Limited rental periods
Insignificant rentals
Nonexclusive use during defined business hours
Real estate professionals
Special $25,000 allowance under Code Sec. 469(i)
CCH Federal Taxation Basic Principles
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Grouping Passive with Nonpassive
Activities
A passive rental activity may be grouped with an active nonrental activity
if the following two rules apply:
1.
They are part of the same economic unit, i.e.,
 control is common
 ownership is common,
 geographic location is the same,
 activities are interdependent, and
 types of businesses are similar.
Chapter 7, Exhibit 8a
CCH Federal Taxation Basic Principles
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Grouping Passive with Nonpassive
Activities
2. The rental revenue is  20% of the total revenue from both
activities (e.g., subleasing a small portion of an inventorystorage warehouse). (Prop. Reg. §1.469-4(d).)
However, note that a disposition of merely the passive activity in
this case does not qualify as the “disposition of an entire interest.”
Chapter 7, Exhibit 8b
CCH Federal Taxation Basic Principles
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Grouping Personal and Real Property
Rentals
The rental of personal property may be grouped with the
rental of real property if the personal property is rented
in connection with the real property (e.g., coin- operated
washing machines in an apartment building.) (Prop. Reg.
§1.469-4(e).)
Chapter 7, Exhibit 9
CCH Federal Taxation Basic Principles
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Limited Rental Period
Under 8-day average rental. Average customer use is
7 days or less (e.g., hotel rooms, movie rentals).
Chapter 7, Exhibit 10a
CCH Federal Taxation Basic Principles
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Limited Rental Period
8–30 days average rental plus significant services.
Average customer use is 8 to 30 days and “significant”
personal services are provided to the customers (e.g.,
computer leasing, automobile leasing).
Chapter 7, Exhibit 10b
CCH Federal Taxation Basic Principles
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Limited Rental Period
Over 30-day average rental and extraordinary
services. Average customer use is over 30 days
and “extraordinary” personal services are provided
to customers (e.g., lengthy hospitals stays).
Chapter 7, Exhibit 10c
CCH Federal Taxation Basic Principles
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Insignificant Rentals
Gross rental income is less than 2% of the
lesser of (1) fair market value of the rental
asset or (2) the adjusted basis of the rental
asset (e.g., renting a small portion of a vast
timberland to a farmer)
Chapter 7, Exhibit 11
CCH Federal Taxation Basic Principles
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Nonexclusive Use During
Defined Business Hours
Property is available during defined
business hours for nonexclusive use by the
general public (e.g., operating a golf
course available during prescribed business
hours for nonexclusive use).
Chapter 7, Exhibit 12
CCH Federal Taxation Basic Principles
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Real Estate Professionals
 Over 750 hours a year are devoted to a real estate business,
AND
 Over 50% of the taxpayer's personal services for the year are
devoted to a real estate business, AND
 One of the 7 material participation tests is satisfied.
Example: A full-time real estate agent owns and manages a
rental house. Any losses from the rental house are
nonpassive losses.
Chapter 7, Exhibit 13
CCH Federal Taxation Basic Principles
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Special $25,000 Allowance Under
Code Sec. 469(i)
Up to $25,000 of losses from rental real estate
activities may be deductible against nonpassive
income. This $25,000 allowance is available for all
filing statuses except married filing separately (the
allowance is $12,500 if married filing separately and
living apart).
Chapter 7, Exhibit 14a
CCH Federal Taxation Basic Principles
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Special $25,000 Allowance Under
Code Sec. 469(i)
The criteria for this special allowance are as follows:
1. AGI, ignoring passive activity loss limitations, must be less than $150,000 when
adjusted as follows:
+ IRA deduction
+ Passive activity loss in excess of passive activity income
– Social Security benefits that are includible (i.e., taxable)
2. The taxpayer must provide “active” participation (i.e., making “some” of the
management decisions). Material participation is not required.
3. The taxpayer must own at least 10% of the passive activity.
4. 50 cents of the special allowance is phased out for every $1 the adjusted AGI is
over $100,000.
Chapter 7, Exhibit 14b
CCH Federal Taxation Basic Principles
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Special $25,000 Allowance Under
Code Sec. 469(i)
Example: Passive Activity Loss Deductions
Fred has shown you the following tax
information and asks for your advice:
Wages . . . . . . . . . . . . . . . . . . . . . . . . .
Taxable Social Security benefits . . . .
Passive activity income (PAI) . . . . . .
Passive activity losses (PAL) . . . . . . .
IRA deduction . . . . . . . . . . . . . . . . . .
How much of the passive activity losses are
deductible?
How much are suspended?
Chapter 7, Exhibit 14c
CCH Federal Taxation Basic Principles
$ 140,000
10,000
50,000
(180,000)
3,000
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Special $25,000 Allowance Under
Code Sec. 469(i)
Computation of adjusted AGI:
+
+
–
=
Chapter 7, Exhibit 14d
AGI, ignoring PAL limitations
($140,000 + $10,000 +$50,000 - $180,000 - $3,000)
IRA deduction
PALs in excess of PAI, ($180,000 - $50,000)
Taxable Social Security benefits
Adjusted AGI
CCH Federal Taxation Basic Principles
$ 17,000
3,000
130,000
10,000
$140,000
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Special $25,000 Allowance Under
Code Sec. 469(i)
Computation of deductible and suspended PALs:
(a)
PALs deductible due to offset with passive activity income
$ 50,000
(b)
PALs in excess of passive activity income ($180,000 $50,000)
130,000
(c)
Excess PAL allowance before phaseout
25,000
(d)
Phaseout amount (($140,000 - $100,000) x 50%)
20,000
(e) = (c ) – (d) Allowance after phaseout ($25,000 - $20,000)
(f) = Lesser PAL deduction under Code Sec. 469(i) (i.e., the “adjusted
of: (b) or (e) AGI” rules)
5,000
5,000
(g) = (a) + (f) Total PALs that are deductible ($50,000 + $5,000)
$ 55,000
(h) = (b) – (f) PALs that are suspended to future years ($130,000 - $5,000)
$125,000
Chapter 7, Exhibit 14e
CCH Federal Taxation Basic Principles
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Rental Real Estate
Category
Classification
1
Personal use,
but rental
income and
expenses are
reportable. Loss
deductions are
not allowed.
Chapter 7, Exhibit 15a
Rental Days
> 14 days
Personal Days
Greater than
the greater of
 14 days or
 10% of the
rental days
CCH Federal Taxation Basic Principles
Tax Treatment
Same as hobby and home
office expense rules, that
is :
 100% of taxes, interest
and casualty loss (subject
to 10% AGI floor) are
deductible on Schedule A.
 Out-of-pocket expenses
and depreciation may not
create a loss.
 Any portions deductible
are prorated and treated as
miscellaneous itemized
deductions (subject to the
2% AGI floor).
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Rental Real Estate
Category
2
Classification
Rental Days
Personal use,
but rental
income and
expenses are
not reportable.
< 14 days
Chapter 7, Exhibit 15b
Personal Days
N/A
CCH Federal Taxation Basic Principles
Tax Treatment
None (except taxes,
interest, and casualty loss
deductions are fully
deductible).
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Rental Real Estate
Category
3
Classification
Rental Days
Business-use
> 14 days
/PAL rules do
not apply.
Rental income
and expenses
are reportable.
Loss
deductions are
unlimited.
Chapter 7, Exhibit 15c
Personal-Use Days Tax Treatment
Less than or equal  Losses are fully
to the greater of
deductible, provided
that the taxpayer has
sufficient basis.
 14 days or
 10% of the rental  Any mortgage
interest not allocable to
days
the rental activity
becomes nondeductible
and, one of the
consumer interest.
special exceptions  Unallocable taxes are
previously
still deductible.
discussed provides
active treatment.
CCH Federal Taxation Basic Principles
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Casualty and Theft Losses
Computing Casualty Loss Deductions
Explanation of abbreviations:
 “Basis” = Cost minus accumulated depreciation (if any).
““ means “reduce” or “reduced.”
 FMV = fair market value.
 “IP” refers to insurance proceeds.
Gain or Loss from Casualty:
(Personal-Use):
(Business-Use):
Reimbursements, less:
Reimbursements, less:
If total destruction:
Lower of basis or FMV
Basis
If partial destruction:
Lower of Basis or FMV
Lower of Basis or  FMV
If theft:
Lower of basis or FMV
Basis
Result:
= “Realized” gain or loss
= “Recognized” gain or loss
Nature of the
Casualty:
Chapter 7, Exhibit 16a
CCH Federal Taxation Basic Principles
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Casualty and Theft Losses
If a personal use gain:
= “Tentative” casualty gain.
Do not  by $100 per event
If a personal use loss:
Reduce by $100 per event to get:
“tentative” casualty loss.
Chapter 7, Exhibit 16b
CCH Federal Taxation Basic Principles
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Casualty and Theft Losses
If all personal use
The result is a net
tentative gains and losses casualty gain that gets
net to a GAIN:
capital gains treatment.
If all tentative gains and
losses net to a LOSS:
Chapter 7, Exhibit 16c
 by 10% AGI (applied once
to all events’ combined net
loss.) Any loss remaining is
deductible “from” AGI
CCH Federal Taxation Basic Principles
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Casualty and Theft Losses
Personal Use
Business Use
Type of deduction
“From” AGI
“For” AGI
Type of gain
Capital (Ch. 12)
Sec 1231 (Ch. 12)
Chapter 7, Exhibit 16d
CCH Federal Taxation Basic Principles
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Casualty and Theft Losses
Type of Casualty
Adjusted basis after casualty:
Complete destruction:
N/A (No basis if asset is completely destroyed!)
Partial destruction
+ Basis immediately BEFORE partial destruction
- Insurance proceeds
- Deductible casualty loss (if any)
+ Casualty gain (if any)
= Basis immediately AFTER partial destruction
Theft
N/A (No basis if asset is gone!)
Special Rule for Partial Destruction: If  FMV < IP < Basis, then no gain or loss is
reported. [Refer to Chapter 7 problem 48(b)].
Chapter 7, Exhibit 16e
CCH Federal Taxation Basic Principles
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Net Operating Losses—Rules for Individuals
Definition of NOL
Carryovers:
NOLs from tax years beginning on or
before 8/5/97:
NOLs other than from casualty deductions
from tax years beginning after 8/5/97:
NOLs attributable to personal-use
casualty losses:
Chapter 7, Exhibit 17a
[Bus. Inc. - Bus. Exp. - Personal Use
Casualty Loss Deductions]
3 years back, 15 years forward
2 years back, 20 years forward
3 years back, 15 years forward
CCH Federal Taxation Basic Principles
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Net Operating Losses—Rules for Individuals
Definition of NOL
[Bus. Inc. - Bus. Exp. - Personal Use
Casualty Loss Deductions]
If carried back:
The earliest year’s TI is recomputed, &
TP files for a refund with an amended
return. Reg. §1.172-5(b)(1)
If carried forward:
Deduction for AGI in a subsequent year.
Election:
May elect to forego carrybacks. This
election must be made when the return
reporting an NOL is timely made. Code
Sec. 172(b)(3)
Chapter 7, Exhibit 17b
CCH Federal Taxation Basic Principles
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Net Operating Losses—Rules for Individuals
Definition of NOL
[Bus. Inc. - Bus. Exp. - Personal Use Casualty Loss Deductions]
Calculation
TI (a negative amount)
+ NOL Carryovers
+ Alimony
+ IRA contributions
+ Net nonbusiness capital losses
+ Standard or itemized deductions, (except personal casualty.
deductions are not added back!)
+ Personal exemptions
– Interest income
– Dividend income
– Net nonbusiness capital gains
– Other nonbusiness income (except wages are not subtracted!)
= Net Operating Loss
(Code Sec. 172(c), (d), Reg. §1.172-3)
Chapter 7, Exhibit 17c
CCH Federal Taxation Basic Principles
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Net Operating Losses—Rules for Individuals
Definition of NOL
[Bus. Inc. - Bus. Exp. - Personal Use Casualty Loss
Deductions]
How much of an NOL
can be used to offset
prior year taxable
income?
The amount of an NOL that can be carried back to a prior
year is limited to modified taxable income (“MTI”). MTI
is computed as follows:
+ Taxable income per prior-year return
+ Personal & dependency exemptions per prior-year
return;
+ Excess capital losses per prior-yr. return;
+ Adjustment to itemized deductions claimed in prior year
that were based on and limited by AGI. This adjustment is
necessitated by the capital loss adjustment above, which
results in increased AGI. Charitable deductions MUST
NOT be adjusted.
= Modified taxable income (“MTI”)
(Reg. §1.172-5)
Chapter 7, Exhibit 17d
CCH Federal Taxation Basic Principles
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Net Operating Losses—Rules for Individuals
Definition of NOL
[Bus. Inc. - Bus. Exp. - Personal Use Casualty Loss
Deductions]
How is the tax refund After NOLs are used to offset prior-year MTI, taxes are
determined?
recomputed based on MTI less the NOL. The tax refund is
the difference between
(a) Taxes per the prior-year return, and
(b) The recomputed tax for the prior year.
Chapter 7, Exhibit 17e
CCH Federal Taxation Basic Principles
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Net Operating Losses for Individuals
Example
FACTS:
1. Fred’s sole proprietorship had $100,000 sales and $135,000
expenses for the current year, plus a $(30,000) NOL carryover from
18 years ago.
2. Fred also had the following income and expenses in the current year:
 $1,000 interest income on a savings account
 $32,000 wages
 $1,500 long-term capital gain on the sale of business property
 $(10,000) short-term capital loss on the sale of stock
 $9,000 long-term capital gain on the sale of a painting held for
investment
 $(6,000) alimony payments
QUESTION: Compute Fred’s NOL, assuming that he does not itemize.
Chapter 7, Exhibit 18a
CCH Federal Taxation Basic Principles
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Net Operating Losses for Individuals
Example
First step: Compute taxable income (a negative amount):
Bus. Loss
$(35,000) $100,000 – $135,000 = $(35,000)
–
NOL Carryover
(30,000)
+
Interest income
1,000
+
Wages
+
LTCG (bus. prop.)
–
STCL (non-bus.)
(1,000) $9,000 – $10,000 = $(1,000)
–
Alimony payments
(6,000)
–
Standard deduction
(4,700)
–
Personal exemption
(3,000)
=
Taxable income
Chapter 7, Exhibit 18b
32,000
1,500
(45,200)
CCH Federal Taxation Basic Principles
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Net Operating Losses for Individuals
Example
Second step: Purge taxable income of the NOL carry forward and nonbusiness items.
(Do not purge personal use casualty losses, if any; there were none in this problem):
Back-End Approach:
TI
Front-End Approach:
$(45,200)
–
+
NOL carryover
30,000
–
Interest income
(1,000)
Bus. Loss
+ Wages
+ LTCG (bus. prop.)
+
STCL (non-business)
1,000
+
Alimony payments
6,000
+
Standard deduction
4,700
+
Personal exemption
3,000
=
Net operating loss
Chapter 7, Exhibit 18c
(1,500) = Net oper. loss
CCH Federal Taxation Basic Principles
$(35,000)
32,000
1,500
(1,500)
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