Tax Shelter Problem

1
Tax Shelter Problem

• Large deductions for depreciation, etc. which
  offset ordinary income (50 rates)
• Gains treated as capital gains and taxed at lower
  rates (28)

2
Congressional Response

• 1976 - At risk rules
• 1986
• Passive activity loss rules
• Lower ordinary tax rates for individuals
• Eliminated preferential capital gains rates

3
The At-Risk Limitation

• An investors deductible loss from an activity
  for any taxable year is limited to the amount the
  taxpayer has at-risk at the end of the taxable
  year
• An investors at-risk amount fluctuates over time

4
Initial Amount at Risk

• Cash and property contributed by the investor
• Amounts borrowed for use in the activity for
  which the taxpayer is personally liable
• Adjusted basis of property pledged as security
  that is not used in the activity

5
Adjustments to Amount at Risk

• Increases
• Investors share of income of the activity
• Investors share of recourse debt incurred by the
  activity
• Additional investments in the activity
• Decreases
• Investors share of loss of the activity
• Reduction of investors share of recourse debt of
  the activity
• Investors withdrawals from the activity

6
Real Estate Exception

• Qualified nonrecourse financing on real estate
  activities
• Nonrecourse financing has no effect on the
  investors at-risk amount for non-real-estate
  activities

7
Passive Loss Limits

• Three baskets of income/loss
• Active - Wages, salary, profit from a trade or
  business in which the taxpayer is a material
  participant
• Portfolio - Interest, dividends, annuities and
  royalties not derived in the ordinary course of a
  trade or business, gain or loss from the
  disposition of property that produces portfolio
  income or is held for investment purposes
• Passive

8
Passive income or loss

• Any trade or business or income-producing
  activity in which the taxpayer does not
  materially participate
• Subject to certain exceptions, all rental
  activities, whether the taxpayer materially
  participates or not

9
Suspended Passive Losses

• Passive losses that are not deductible in the
  year incurred are suspended
• Suspended passive losses may be carried forward
  and used to offset
• Passive income in future years
• Passive income and other types of income in the
  year of disposition of the passive activity

10
Passive Loss Limits Examples

• Example Joe has active income of 60,000 and a
  passive loss of 20,000 in 2008
• Tax treatment the 20,000 passive loss is not
  deductible in 2008 and is suspended
• Example (Contd) Joe has active income of
  70,000 and passive income of 25,000 in 2009
• Tax treatment the 20,000 suspended passive
  loss from 2008 is deductible in 2009 (assuming
  the at-risk rules do not limit the deduction)
• Thus, 5,000 of passive income is recognized in
  2009

11
Passive Loss Allocation Example

• Example Taxpayer has 3 passive activities,
  which produced income (losses) as follows
• Activity A (40,000)
• Activity B ( 10,000)
• Activity C 20,000
• Total (30,000)
• Activity A
• (40,000/50,000) x 30,000 24,000
• Activity B
• (10,000/50,000) x 30,000 6,000
• Total loss allocated 30,000

12
Passive Activity Credits

• Omit this topic

13
Taxpayers Subject to the Passive Loss Rules

• Individuals
• Estates
• Trusts
• Personal service corporations
• The principal activity is the performance of
  personal services substantially performed by
  owner-employees
• Closely held C corporations
• Any time during the taxable year, gt 50 of the
  value of its outstanding stock is owned, directly
  or indirectly, by or for not more than five
  individuals

14
Material Participation

• A trade or business is treated as
• Active if the taxpayer is a material participant
• Passive if the taxpayer is not a material
  participant
• Tests to determine whether a taxpayer is a
  material participant can be divided into three
  categories
• Tests based on current participation
• Tests based on prior participation
• Tests based on facts and circumstances

15
Tests Based on Current Participation

• Individual participates more than 500 hours
  during the year
• Individuals participation constitutes
  substantially all of the participation in the
  activity of all individuals (including nonowner
  employees)
• Individual participates for more than 100 hours
  and such participation is not less than the
  participation of any other individual (including
  nonowner employees)
• Individuals total participation in all
  significant participation activities exceeds 500
  hours

16
Tests Based on Past Participation

• Individual materially participated in the
  activity for any 5 taxable years during the 10
  taxable years that immediately precede the
  current taxable year
• Individual materially participated in a personal
  service activity for any three preceding taxable
  years (whether consecutive or not)

17
Rental Activities Defined

• A rental activity is any activity where payments
  are received principally for the use of tangible
  (real or personal) property
• General rulerental activities are automatically
  treated as passive activities, even if the
  taxpayer is a material participant

18
Rental Activities Exceptions

• Certain activities involving rentals of real and
  personal property are not treated as rental
  activities
• Such activities will be treated as active if the
  taxpayer is a material participant
• The Regulations provide six exceptions under
  which rental activities are not automatically
  treated as passive activities

19
Real Estate Professional Exception

• To qualify for nonpassive treatment the taxpayer
  must satisfy both of the following requirements
• More than half of the personal services that the
  taxpayer performs are performed in real property
  trades or businesses in which the taxpayer
  materially participates
• The taxpayer performs more than 750 hours of
  services in these real property trades or
  businesses as a material participant

20
Small Landlord Exception

• An exception exists for up to 25,000 in loss
  where the taxpayer
• Actively participates (makes management decisions
  in a significant and bona fide sense) in the real
  estate rental activity
• Owns 10 percent or more (in value) of all
  interests in the activity during the entire
  taxable year (or shorter period during which the
  taxpayer held an interest in the activity)
• The potential 25,000 deduction is reduced by 50
  of the amount by which the taxpayers AGI exceeds
  100,000.

21
Interaction of At-Risk and Passive Activity Limits

• The passive loss rules are applied after
  application of the at-risk rules
• Example Taxpayer has 10,000 at risk in his only
  passive activity which generates a 15,000 loss
  in the current year.
• 5,000 of the 15,000 loss is suspended under the
  at-risk rules
• 10,000 of the loss is suspended under the
  passive loss rules