Transcript Chapter 10Limitations on the Deductibility of Partnership

Chapter 10
Limitations on the Deductibility
of Partnership Losses
Three Deductibility Limitations
 The deductibility of partnership losses passed
through to a partner is subject to three separate
limitations:



First, the loss may not exceed the partner’s tax basis in the
partnership interest-§704(d)
Second, any losses surviving the tax basis limit are subject to
the at-risk limitation- §465
Finally, losses may be disallowed under the passive loss
limitations - §469
Disallowed Losses Are Carried Forward
 Carryforwards Under §704(d):
Loss passed through to a partner in excess of tax basis is
carried forward indefinitely until the partner obtains
additional basis sufficient to allow the deduction
 Carryforward losses unused as of the date of any sale or
disposition of the partnership interest are lost (because
they did not reduce the basis of the interest, and therefore
any gain/loss from the sale is already reduced/increased
by the amount of the carryforward)

Do not carry over to the transferee
 Do not explicitly offset the gain or increase the loss recognized

Disallowed Losses Are Carried Forward (Cont.)
 Carryforwards Under §465
 Losses disallowed under the at-risk rules are carried forward
indefinitely just as are those denied under tax basis limitation
 A partner’s tax basis in her partnership interest is reduced by
losses even if they are disallowed under the at-risk rules
 When a partner sells her interest in the partnership, losses
carried forward under the at-risk limitation are deductible in
full regardless of the amount of gain or loss recognized by the
partner/member on the transaction
Disallowed Losses Are Carried Forward (Cont.)
 Carryforwards Under §469
 For individuals, losses from passive activities are only
deductible to the extent of income from other passive activities
 Losses disallowed under the passive loss limitations are
carried forward indefinitely until the partnership has sufficient
passive income from other sources to absorb the carryforward
 If the partner completely disposes of the partnership interest,
any passive loss carryforward is deductible in full in the year of
disposition
At-Risk Rules of §465
 Under §465, a taxpayer may not claim deductions for
losses in excess of the amount that the taxpayer
actually has “at risk” with respect to the activity
generating the losses

§465 applies to individuals and closely held corporations only
At-Risk Rules of §465 (Cont.)
 A taxpayer’s amount at risk is computed in the same
manner as is tax basis except that it excludes
nonqualified nonrecourse debt

A qualified nonrecourse debt is one which:
Is borrowed for the activity of holding real property (very broadly
defined), and is secured by that property
 Is borrowed from a lender who is in the business of lending money
and who has no interest in the activity for which the money is
borrowed, other than as a creditor
 Is not convertible into stock or other securities

Passive Loss Limitations of §469
 General
 Deductions for net losses (income minus losses) from “passive”
activities are not allowed



Passive loss is loss realized from rental activities and loss
“allocated” to nonparticipatory partners (i.e., limited partners) in
partnership activities
Disallowed losses are carried forward and can be deducted
only against net passive income in future years or when the
taxpayer fully disposes of the interest in the passive activity
The passive loss limitation is applied after application of the
at-risk loss limitation
Classification of Income Under §469
 General
 Passive activity income includes all income from passive
activities, including gain from disposition of an interest in a
passive activity or from disposition of property used in a
passive activity
Taxpayers to Whom §469 Applies
 The passive loss rules apply only to individuals,
certain trusts and estates, personal service
corporations and closely-held corporations

Unlike individuals, closely held corporations are allowed to
deduct net passive losses against active income and offset the
tax attributable to net active income with passive activity
credits

However, closely held corporations cannot offset portfolio income
with net passive losses
Passive Activities Defined
 Definition: A passive activity is one in which the
taxpayer does not “materially participate” during the
taxable year
 Most rental activities are deemed to be passive
regardless of the taxpayer’s level of participation

A significant exception: for taxpayers who are engaged
primarily in the real estate business
Passive Activities Defined (Cont.)
 Regular, continuous, and substantial
 Material participation definition: involvement, by the taxpayer
or his/her spouse, which is “regular, continuous and
substantial”
A limited partner cannot satisfy the material participation
requirement
 Most taxpayers prefer to rely on one of the more reliable “safe
harbor” definitions that follow, rather than this subjective
definition

Passive Activities Defined (Cont.)
 Rental Activities
 §469 automatically classifies most rental activities as passive
activities, regardless of the taxpayer’s level of participation
For this purpose, a rental activity is one involving the long-term
rental of property and for which the taxpayer does not provide
substantial additional services
 Short term rental activities where substantial personal services in
connection with the rental are required (e.g. operation of hotel) do
not constitute a passive activity

Passive Activities Defined (Cont.)
 Real Estate Professionals
 Taxpayers in the “real property business” are not subject to the
passive loss restrictions
 A taxpayer is in the real property business if he/she:
Spends more than half of his/her time in real property businesses
in which he/she materially participates; and
 Performs more than 750 hours of services during the taxable year
in real property trades or businesses in which he or she materially
participates

Passive Activities Defined (Cont.)
 Exemption for Real Estate Rental Activities in which
Taxpayer “Actively” Participates

For taxpayers who “actively participate in the management of
rental property, the first $25,000 of net losses generated by
such property are exempted from Code Sec. 469
First, the losses are still passive losses, while not subject to the
passive loss limitations
 Second, the exemption applies only if the taxpayer “actively”
participates in management of the property

Passive Activities Defined (Cont.)
 Exemption for Real Estate Rental Activities in which
Taxpayer “Actively” Participates (Cont.)

Active participation requires the following:
The taxpayer must have at least a 10% interest in the rental activity
 The taxpayer must not own the interest as a limited partner, and
 The taxpayer must participate in the activity in a significant and
bona fide manner (participate in management decisions)

Activities That Are Not Passive Activities
 Five categories of trade or business activities are not
treated as passive activities





Trade or business activities in which the taxpayer materially
participated for the tax year
A working interest in an oil or gas well held by the taxpayer
directly or through an entity that does not limit liability
Rental of a vacation home
Trading activities involving personal property traded for the
account of those who own interests in the activity
Rental real estate activities of real estate professionals