B.A.P. B. = Basis A. = At-Risk P. = Passive

Practitioners MUST be familiar with each of these 3 items separately. B.A.P. Practitioners MUST be familiar with each of these 3 items separately.

B.A.P. In my experience, it is the interaction of these 3 items that causes problems for practitioners. Accordingly, we will now go over a few rules and then look at an example that will clarify this interaction.

B.A.P.

Basis At-risk Passive

BASIS/AT-RISK/PASSIVE Remember, your homework is NOT complete until ALL 3 have been done!! Think of 3 flour sifters.

This B.A.P. thing…. Is going to be really annoying Should be shortened to only 2 letters Will make taxes great again…and fun Makes me want to sell yogurt instead

PASSIVE ACTIVITY Road Map The “Room of Doom” The six exceptions The “OK Corral” The 7 tests The 3 police officers

BASIS – Regular (1120S & 1065) Partner/member can have a disparity between INSIDE and OUTSIDE basis. Can an S Corp shareholder?

S Corp…..“Direct Debt” only BASIS – Debt (1120S & 1065) S Corp…..“Direct Debt” only Ptp/LLC…All debt gets allocated (much more broad than S Corp)

Recourse Debt BASIS – Debt (1065) Allocated to whoever bears the “economic risk of loss”. “No Value Liquidation” approach.

Non-Recourse Debt BASIS – Debt (1065) Generally, allocated based on profit & loss ratios. If PCBIG is present, then must allocate via Reg. 1.752-3(a) 3-tier process.

AT-RISK TIP: The major difference between outside basis (the “B” basis) and at-risk basis (the “A” basis) is the treatment of…. nonrecourse loans.

Qualified Nonrecourse Financing AT-RISK Nonrecourse loans increase “B” basis but not “A” basis. There is one exception… Qualified Nonrecourse Financing

AT-RISK A QNRF history lesson: REAL ESTATE LOBBY 101

AT-RISK A history lesson: TAX SHELTERS 101

AT-RISK Basically, only 2 situations where a shareholder, partner, or member may have plenty of “B” basis but not enough “A” basis.

AT-RISK Situation #1: IRC 465(b)(3) Not “at-risk” for amounts borrowed from a person (or someone related to this person pursuant to IRC 267) having an interest in the activity other than as a creditor.

AT-RISK NOT AT RISK Situation #1: Example 1 Mike, a shareholder, puts in $50,000 for his initial stock. He borrowed it from Bob, the other shareholder. NOT AT RISK

(because Bob’s aunt is not “related” per IRC 267) AT-RISK Situation #1: Example 2 Same as example 1, except Mike borrows the money from Bob’s aunt. OK…AT RISK (because Bob’s aunt is not “related” per IRC 267)

AT-RISK NOT AT RISK Situation #1: Example 3 Same as example 1, except Mike borrows the money from Bob’s mom. NOT AT RISK

AT-RISK AT RISK! Situation #1: Example 4 Same as example 1, except Mike borrows the money from his dad. AT RISK!

AT-RISK Situation #2: IRC 465(B)(4) Not “at-risk” for amounts protected against loss through nonrecourse borrowing, guarantees, stop loss agreements, or other similar things.

AT-RISK Exception to #2: IRC 465(B)(6) This code section is the EXCEPTION to IRC 465(b)(4), on previous slide, and says that QNRF will give “at-risk” basis.

AT-RISK ONE LAST WARNING: Be ever on the alert for “RECAPTURE” events.

PASSIVE ACTIVITY RULES ROOM OF DOOM IRC 469(c)(2) dictates that all rental activities are tainted, automatically, as “passive”.

PASSIVE ACTIVITY RULES ROOM OF DOOM There are ONLY 2 places where we can find exceptions to this rule. IRC 469(c)(7)…..REP rules Temp. Reg. 1.469-1T(e)(3)(ii)…. The famous six exceptions.

PASSIVE ACTIVITY RULES ROOM OF DOOM IRC 469(c)(7)…..REP rules

PASSIVE ACTIVITY RULES ROOM OF DOOM The six exceptions: Avg. period of use 7 days or less. (vacation condo, motel)

PASSIVE ACTIVITY RULES ROOM OF DOOM The six exceptions: Avg. period of use 30 days or less and significant personal services provided. (dude ranch)

PASSIVE ACTIVITY RULES ROOM OF DOOM The six exceptions: Extraordinary personal services provided. (hospital, boarding school dorm)

PASSIVE ACTIVITY RULES ROOM OF DOOM The six exceptions: Rental of the prop. incidental to a non-rental activity of taxpayer. (PPC has great example)

PASSIVE ACTIVITY RULES ROOM OF DOOM The six exceptions: Taxpayer makes the property available during defined hours for nonexclusive use. (golf course)

PASSIVE ACTIVITY RULES ROOM OF DOOM The six exceptions: Taxpayer, as an owner, provides the property for use in an activity which is not a rental activity. (Letter Ruling 9722007)

PASSIVE ACTIVITY RULES THE OK CORRAL This is the room you either START in (if you are NOT a rental activity) or MOVE to (if you started in the Room of Doom and meet one of the 6 exceptions).

PASSIVE ACTIVITY RULES THE OK CORRAL Here, you must pass ONE of the 7 tests to rise to the level of “material participation”. Temp. Reg. 1.469-5T

PASSIVE ACTIVITY RULES THE OK CORRAL – 7 tests More than 500 hours Substantially all participation, including that of non-owners. More than 100 hours and more than anyone else.

PASSIVE ACTIVITY RULES THE OK CORRAL – 7 tests Significant participation activity (see example 4 in the temp. reg.) Prior year material participation (the 5 out of 10 look-back rule)

PASSIVE ACTIVITY RULES THE OK CORRAL – 7 tests Personal service activity test. Look-back to ANY 3 prior years for service businesses. Facts and circumstances! Good luck with this one!

PASSIVE ACTIVITY RULES THE 3 COPS These are commonly referred to as the “recharacterization” rules.

PASSIVE ACTIVITY RULES THE 3 COPS These rules will only come into play when there is INCOME (now, that’s a switch!) that a taxpayer would LIKE to be shown as passive.

PASSIVE ACTIVITY RULES THE 3 COPS These rules will result in passive income being re-characterized as non-passive.

PASSIVE ACTIVITY RULES THE 3 COPS Self-rental rule Reg. 1.469-2(f)(6) Ground rents rule Reg. 1.469-2T(f)(3) Property rented that is incidental to a development activity Reg. 1.469-2(f)(5)

Regarding the “3 cops”… They are really outlaws They do mean things to nice taxpayers They will make taxes great again…and lots of fun Makes me want to sell yogurt instead

BASIS/AT-RISK/PASSIVE Time to put this all together in a skit!!

BASIS/AT-RISK/PASSIVE Setup for skit Mike and Gary form an LLC to make widgets. Each puts in $10,000. Mike had to borrow $4,000 of his $10,000 from Gary. Mike’s K-1 shows an $11,000 loss on line 1. Mike does NOT materially participate.

BASIS/AT-RISK/PASSIVE Setup for skit…continued Mike, obviously, wants to DEDUCT the entire $11,000 loss and is devastated when you tell him that he cannot do that. Then he says he is going to abandon his interest in the business next year.

BASIS/AT-RISK/PASSIVE Setup for skit…continued You tell him not to worry, and go over IRC 469(g)(1) with him explaining that he will be able to deduct that loss once he “disposes” of his entire interest in the activity.

BASIS/AT-RISK/PASSIVE

BASIS/AT-RISK/PASSIVE $11,000 - $1,000 = $10,000 on to “A” B

BASIS/AT-RISK/PASSIVE $10,000 - $4,000 = $6,000 on to “P” A

BASIS/AT-RISK/PASSIVE = $0 able to deduct! $6,000 - $6,000 $6,000 P P

BASIS/AT-RISK/PASSIVE $1,000 $4,000 $6,000 B A P Now, after closing the Company, what do we do with the $$ left hanging on each of the hula hoops?

BASIS/AT-RISK/PASSIVE $1,000 This $1,000 is a BASIS limitation, so it goes away! Don’t be confused…it is NOT a passive limitation. B

BASIS/AT-RISK/PASSIVE This $4,000 is an AT-RISK limitation, so what will happen here depends on Gary! $4,000 A Option 1: Gary forgives this. Result? At-risk basis does NOT increase, so it goes away! Option 2: Mike pays Gary. Result? At-risk basis increases, so Mike gets a deduction. Again, this is NOT a passive limitation….it’s an at-risk limitation.

BASIS/AT-RISK/PASSIVE $6,000 This $6,000 is a passive activity suspended loss and will automatically flow out to Mike once the activity is disposed of. P

Bad news for limited partners! SOME ADDITIONAL INFORMATION: PASSIVE ACTIVITY RULES THE OK CORRAL – No ltd Partners IRC 469(h)(2)…ltd partners are PASSIVE. Bad news for limited partners!

THE OK CORRAL – No ltd Partners SOME ADDITIONAL INFORMATION: PASSIVE ACTIVITY RULES THE OK CORRAL – No ltd Partners Temp. Reg. 1.469-5T(e)(2) to the rescue! Limited partners CAN avail themselves of tests #1 (500 hrs), #5 and #6 (the look- back rules).

THE OK CORRAL – LLC members?? SOME ADDITIONAL INFORMATION: PASSIVE ACTIVITY RULES THE OK CORRAL – LLC members?? IRS position LLC members…same as Ltd partners. Tax court says “BAD IRS”! Garnett v. Comm., 132 TC No. 19 (6/30/09)