Module 29 Tax Motivated Investments and Loss Limitations

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Module 29Tax Motivated Investments and Loss
Limitations
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Menu

• Tax shelter activities
• The passive activity limitations
• Loss limitations associated with vacation homes
• Anatomy of a tax shelter residential real estate
• Anatomy of a tax shelter low-income housing
  investment

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Tax Shelter Activities An Introduction

• Key Learning Objectives (1)
• Definition of a tax shelter
• The goals of a good tax shelter
• 6111 registration requirements
• 6707 6708 penalties related to registration

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Definition of aTax Shelter

• Minimize the tax effects of the income tax
• Generates significant tax losses as a result of
  the allowable deductions associated with the
  investment

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6111 Registration Requirements

• A tax savings to investment cost ratio of more
  than two to one, and
• The offering is (a) treated as a security
  regulated by law, or (b) exempted from
  regulations but has five or more investors or
  will initially attract investments exceeding
  250,000

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6707 and 6708 Registration Penalties

• 6707(a) organizer's failure to
  register a shelter
• 6707(b)--failure to furnish a
  registration number
• 6708--organizer's failure to retain list of
  investors

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The Goals of a Good Tax Shelter

• Deferral of taxation
• Conversion of
• ordinary income into capital gain

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6700 and 6701 False Statement Penalties

• 6700--organizer furnishes false statements
• 6700--organizer furnishes gross overvaluation
  statement
• 6701--aiding and abetting understatement of tax
  liability

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Tax Shelter Activities An Introduction

• Key Learning Objectives (2)
• The sham transaction doctrine as a weapon against
  tax shelters
• 6700 6701 penalties related to false
  statements
• 7408 injunctive relief

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The Sham Transaction Doctrine

• The transaction was entered into primarily for
  tax avoidance and
• No economic substance, (no possibility of profit)
  

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7408 Injunctive Relief

• Empowers IRS to seek civil action in District
  Court that would enjoin any person from further
  engaging in conduct subject to 6700 or 6701
• Promoters can be shut down much quicker under
  this procedure

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The Passive Activity Limitations A Closer Look

• Key Learning Objectives (1)
• The passive activity limitations (PALS)
• Identifying an activity
• The active basket and material participation
• The portfolio basket
• Legislative curbs on tax shelters an overview

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Passive Activity Rules

• Loss limit rule applies to individuals, estates,
  trusts, closely held C corporations, and personal
  service corporations
• All items of income or loss classified as
• Active
• Portfolio, or
• Passive

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General Rule

• Passive losses offset only passive income
• Suspended losses carried forward

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Active Basket

• Wages and salaries
• Profit/loss from trade or business in which
  taxpayer materially participates
• Gain/loss from sale of active business assets

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Material Participation(Dirty Hands)

• Regular
• Continuous
• Substantial
• Extremely complex rules

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Portfolio Basket

• Interest
• Dividends
• Annuities
• Royalties
• Gain/loss from sale of portfolio assets

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The Passive Activity Limitations A Closer Look

• Key Learning Objectives (2)
• The passive basket
• Applying the passive activity limitations
• Real estate exceptions to the passive loss
  limitations
• Passive activity credits
• Disposition of passive activities

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Passive Basket

• Profit/loss from trade or business IF
• Taxpayer does not materially participate
• Any rental activity, regardless of material
  participation

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Passive Activity LimitationsPAL Rules

• Record income/loss for each activity
• Net all activities
• If overall net income--report in full
• If overall loss--report zero net income
• Disallowed (suspended) losses
• Carryover in full to next year
• Record by activity

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Compliance Query PAL Rules (1)

• What is AGI if the taxpayer has
• 500,000 of salary income and
• Two passive businesses
• Activity Activity
• -A- -B-
• Income 50,000 20,000
• Expense 25,000 30,000

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Solution Compliance Query PAL Rules (1)AGI
is 515,000

• Passive activities net as follows
• Activity Activity Netted
• -A- -B-
• Income 50,000 20,000 70,000
• Expense 25,000 30,000 55,000
• Net Inc 25,000 -10,000 15,000
• When passive net gt0,include in AGI

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Compliance Query PAL Rules (2)

• What is AGI if the taxpayer has
• 500,000 of salary income and
• Two passive businesses
• Activity Activity
• -A- -B-
• Income 50,000 20,000
• Expense 75,000 5,000

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Solution--Compliance Query AGI is 500,000

• Passive activities net as follows
• Activity Activity Netted
• -A- -B-
• Income 50,000 20,000 70,000
• Expense 75,000 5,000 70,000
• Net Inc -25,000 15,000 -0-
• Cant deduct gtpassive income

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Passive Credits

• Apply against tax from passive income only
• Suspended credits carried forward
• Use or lose in year of disposition

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Disposition of Passive Activities

• In the year of disposition
• In a fully taxable transaction
• Suspended losses may be deducted against any
  source of income

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Transfers to Related Parties

• Not a disposition of a passive activity

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Exception for Qualified Real Estate Professional

• gt50 of personal services related
• To real estate trade or business and
• gt750 real estate related hours

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Exception for Active Rental Real Estate

• Up to 25,000 excess loss allowed
• Reduces active/portfolio income
• Phase-out of 25,000 if
• AGI gt 100,000
• Lose 50 for each excess
• Active participation required

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The Active Participation Requirement

• Own at least a 10 interest
• By value
• Not be a limited partner and
• Demonstrate regular, continuous, and substantial
  involvement

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Compliance Query Active Rental Exception

• What is AGI if the taxpayer has
• 100,000 of salary income and
• Two passive businesses (A is active rental)
• Activity Activity
• -A- -B-
• Income 50,000 20,000
• Expense 75,000 5,000

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Solution--Compliance Query AGI is 90,000

• Passive activities net as follows
• Activity Activity Netted
• -A- -B-
• Income 50,000 20,000 70,000
• Expense 75,000 5,000 70,000
• Net Inc -25,000 15,000 -0-
• Excess -10,000 -0-
• ARE -10,000
• ARE active real estate exception

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In Class Exercise More Active Rental Exception

• How does the answer to last Query change?
• Case 1
• Activity B is the active real estate rental
• Case 2
• Salary income is 140,000?
• Activity A is the active real estate rental

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Solution--In Class Exercise More Active Rental
Exception

• Case 1 AGI 100,000
• The excess loss is not from active rental
• It must be suspended

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Solution--In Class Exercise More Active Rental
Exception

• Case 2 AGI 135,000
• AGI is over 100,000
• Exception must be phased out
• Lose (140,000-100,000) x .5 of 25,000
• Only 5,000 of 25,000 exception remains

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Decedents Suspended Losses

• Suspended losses are generally allowed on a
  decedent's final tax return
• Deduction is reduced by any step-up in basis to
  FMV

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Gifts of Activities With Suspended Losses

• Transfer by gift not a qualifying disposition
• Losses are not allowable to either the donor or
  donee
• Donees basis is increased by the suspended loss

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Tax Shelters in Residential Real Estate

• Limited tax benefits are still available for the
  small investor
• Use of leveraging, depreciation, capital gains,
  benefits of tax losses, positive cash flows
• 25,000 exception for PALs

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Loss Limitations Associated With Vacation Homes

• Key Learning Objectives (1)
• The basic rules of 280A
• Rule 1 De minimis rentals
• Rule 2 Insignificant personal usage
• Rule 3 Significant personal usage

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Vacation Home

• To determine if rental is a vacation rental
  COMPARE days of personal use to days ACTUALLY
  rented at FMV
• Note OA stands for otherwise allowable
  deductions found on Schedule A

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Vacation Home?

• THERE ARE 3 POSSIBLE OUTCOMES
• Exclude all income and non otherwise allowable
  expenses
• Rental is a passive activity--see PAL rules
• Deduct
• Expenses FOR AGI to zero out rental income
• Excess otherwise allowable deductions FROM AGI

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De Minimis RentalsExclude

• If rented lt 15 days
• Exclude all income and non-otherwise allowable
  expenses

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Insignificant Personal Usage Follow PAL Rules

• If personal use
• lt 15 days OR
• lt 10 of days rented at FMV
• All income and expenses related to the rental are
  passive
• Passive actively rules apply
• Rental exception may be available

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Significant Personal UsageZero Out AGI

• If personal use
• gt 14 days AND
• gt 10 of days rented at FMV
• All income is reported for AGI
• Expenses related to the rental (including OA's)
  are deductible FOR AGI but limited to amount of
  income generated by the rental
• Excess OAs are deductible FROM AGI

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In Class Exercise Rental or Vacation Home?

• Discuss these cases in your groups
• CASE -A- -B- -C- -D- -E-
• Rented 300 200 250 10 75
• Used 22 21 22 32 14
• CASE -F- -G- -H- -I- -J-
• Rented 100 200 200 300 300
• Used 13 14 22 29 36

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Solution In Class Exercise Rental or Vacation
Home?

• De minimis rental
• Case D
• Insignificant personal usage (PAL)
• Cases A, C, E, F, G, I
• Significant personal usage
• Cases B, H, J

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Loss Limitations Associated With Vacation Homes

• Key Learning Objectives (2)
• Special considerations applicable to vacation
  homes
• Expense allocation methods the IRS vs. the
  courts
• Carryovers of unused deductions

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Special Issues

• Ordering rule for deductions
• "Otherwise allowable"
• Other allowable cash expenditures
• Depreciation
• Personal use includes
• Rental lt FMV to related party
• Donated use to charitable organization

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Expense Allocation MethodsWhy The Issue?

• Total deduction FOR AGI limited to income from
  rent
• Excess OA's can be deducted FROM AGI
• Taxpayer would like to increase percentage of
  deduction FOR AGI coming from items not OA

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Expense Allocation MethodsWhats The Denominator?

• 365 days for interest and tax deductions
• Per the Courts
• Total number of days actually used for rental or
  personal usage
• Per the Code
• Excludes any days the unit was vacant

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In Class ExerciseExpense Allocation
MethodsWhats The Difference?

• Use the following facts to determine the
  deduction for/from AGI
• Rental income 5,000
• Interest and taxes 15,000
• Repairs 6,000
• Days rented at FMV 100
• Days of personal use 50

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Solution--In Class ExerciseExpense Allocation
MethodsWhats The Difference?

• Per the Courts
• 100 365 .274
• For AGI
• Income 5,000
• Less Interest 4,110
• Repairs 990
• Net Income 0
• From AGI 15,000 - 4,110

• Per the IRS
• 100 150 .333
• For AGI
• Income 5,000
• Less Interest 5,000
• Repairs 0
• Net Income 0
• From AGI 15,000 - 5,000

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Carryovers of Unused Deductions

• OA s used in full, either for or from AGI, so no
  carryover issue
• Depreciation, repairs, etc. carryover
• Cannot be used to create a loss

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Anatomy of a Tax Shelter Residential Real Estate

• Key Learning Objectives (1)
• Tax shelters in residential real estate
• Analysis of a typical residential real estate
  investment
• The benefits of leveraging

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Anatomy of a Tax Shelter Residential Real Estate

• Key Learning Objectives (2)
• Comparing taxable income (loss) with net cash
  flows
• Impact of the passive activity limitations
• Incorporating the effects of liquidating the
  investment
• Summary the tax advantages of residential real
  estate

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Anatomy of a Tax Shelter Low-Income Housing
Investment

• Key Learning Objectives (1)
• Investments in low-income housing tax credit
  projects
• Project description qualified units and
  financing terms
• Project description project rents and equity
  requirements

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Anatomy of a Tax Shelter Low-Income Housing
Investment

• Key Learning Objectives (2)
• Projected cash flows
• Disposition of the project in year 16
• Assessing the impact of the passive activity
  limitations