© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Individual Income Taxes 1 Chapter 11 Investor Losses

2 The Big Picture (slide 1 of 3) Trudy and Jim Reswick want to enhance their financial security –They are willing to borrow money to make an appropriate investment. Currently, Trudy and Jim’s sole source of income is their salaries, totaling $100,000. Their most significant asset is their personal residence –Fair market value is $500,000 with a mortgage of $350,000.

3 The Big Picture (slide 2 of 3) Their broker suggests that they borrow $100,000 at 8% and use the proceeds to make one of the following investments: –A high-growth, low-yield portfolio of marketable securities. The portfolio’s value is expected to grow 10% each year. –An interest in a limited partnership that owns and operates orange groves in Florida. Tax losses of $25,000 expected in each of the next 5 years, after which profits are expected. The broker predicts an annual 10% return over the 10-year period. –An interest in a local limited partnership that owns and rents apartments to college students. Losses of $25,000 per year expected for 5 years, after which profits would follow. An average annual total return of 10% over a 10-year period.

4 The Big Picture (slide 3 of 3) Trudy and Jim want to choose the alternative that produces the best after-tax return over a 10-year planning horizon. They are aware, however, that tax restrictions may limit the advantages of some of these investment options. In this connection, evaluate each option. –Read the chapter and formulate your response.

5 Passive Loss Rules (slide 1 of 2) Require income and losses to be separated into three categories: –Active –Portfolio –Passive Generally, disallow the deduction of passive losses against active or portfolio income

6 Passive Loss Rules (slide 2 of 2) In general, passive losses can only offset passive income Passive losses are also subject to the at-risk rules –Designed to prevent taxpayers from deducting losses in excess of their economic investment in an activity

7 At-Risk Limits (slide 1 of 4) At-risk defined –The amount of a taxpayer’s economic investment in an activity Amount of cash and adjusted basis of property contributed to the activity plus amounts borrowed for which taxpayer is personally liable (recourse debt)

8 At-Risk Limits (slide 2 of 4) At-risk defined –At-risk amount does not include nonrecourse debt unless the activity involves real estate For real estate activities, qualified nonrecourse debt is included in determining at-risk limitation

9 At-Risk Limits (slide 3 of 4) At-risk limitation –Can deduct losses from activity only to extent taxpayer is at-risk –Any losses disallowed due to at-risk limitation are carried forward until at-risk amount is increased –Previously allowed losses must be recaptured to the extent the at-risk amount is reduced below zero –At-risk limitations must be computed for each activity of the taxpayer separately

10 At-Risk Limits (slide 4 of 4) Interaction of at-risk rules with passive loss rules –At-risk limitation is applied FIRST to each activity to determine maximum amount of loss allowed for year –THEN, passive loss limitation applied to ALL losses from ALL passive activities to determine actual amount of loss deductible for year

11 Calculation of At-Risk Amount Increases to a taxpayer’s at-risk amount: – Cash and the adjusted basis of property contributed to the activity –Amounts borrowed for use in the activity for which the taxpayer is personally liable or has pledged as security property not used in the activity –Taxpayer’s share of amounts borrowed for use in the activity that are qualified nonrecourse financing –Taxpayer’s share of the activity’s income Decreases to a taxpayer’s at-risk amount: –Withdrawals from the activity –Taxpayer’s share of the activity’s loss –Taxpayer’s share of any reductions of debt for which recourse against the taxpayer exists or reductions of qualified nonrecourse debt

12 Passive Loss Limits (slide 1 of 8) Active income –Wages, salary, and other payments for services rendered –Profit from trade or business activity in which taxpayer materially participates –Gain from sale or disposition of assets used in an active trade or business –Income from intangible property created by taxpayer

13 Passive Loss Limits (slide 2 of 8) Portfolio income –Interest, dividends, annuities, and certain royalties not derived in the ordinary course of business –Gains/losses from disposition of assets that produce portfolio income or held for investment

14 Passive Loss Limits (slide 3 of 8) Passive losses defined –Losses from trade or business activities in which taxpayer does not materially participate, and –Certain rental activities

15 Passive Loss Limits (slide 4 of 8) Limitations on passive losses –Generally, passive losses can only offset passive income, i.e., they cannot reduce active or portfolio income –Disallowed losses are suspended and carried forward Suspended losses must be allocated to specific activities

16 Passive Loss Limits (slide 5 of 8) Suspended losses are deductible in year related activity is disposed of in a fully taxable transaction

17 Passive Loss Limits (slide 6 of 8) Example - Roy sells an apartment building, a passive activity, with an adjusted basis of $200,000 for $360,000. In addition, he has suspended losses of $120,000 associated with the building. His total gain, and his taxable gain, are calculated as follows: Net sales price $ 360,000 Less: Adjusted basis (200,000) Total gain$ 160,000 Less: Suspended losses (120,000) Taxable gain (passive) $ 40,000

18 Passive Loss Limits (slide 7 of 8) Passive credits –Credits from passive activities are subject to loss limitation –Utilize passive credits to the extent of tax attributable to passive income –Credits disallowed are suspended and carried forward similar to losses Suspended credits can be used to offset tax from disposition of activity but any credits left after activity is disposed of are lost forever

19 Passive Loss Limits (slide 8 of 8) Taxpayers subject to rules –Individuals, estates, trusts, personal service corporations –Closely-held corporations Can deduct passive losses against active income –S Corp and partnership passive losses flow through to owners and limits applied at the owner level

20 Passive Loss Issues Passive losses are losses from trade or business activities in which taxpayer does not materially participate and certain rental activities What constitutes an activity? What is “material participation"? When is an activity a rental activity?

21 Identification of Activities (slide 1 of 2) Taxpayers with complex business operations must determine if segments of their business are separate activities or entire business is treated as a single activity

22 Identification of Activities (slide 2 of 2) Regs allow grouping multiple trade or businesses if they form an appropriate economic unit for measuring gain or loss –Once activities are grouped, can’t regroup unless: Original groups were clearly inappropriate, or Material change in circumstances

23 Special Grouping Rules for Rental Activities Designed to prevent grouping of rental activities (generally passive) with other businesses in a way that would result in a tax advantage –A rental activity may be grouped with a trade or business activity only if one activity is insubstantial in relation to the other –Taxpayers generally may not treat an activity involving the rental of real property and an activity involving the rental of personal property as a single activity

24 Material Participation Tests (slide 1 of 8) An activity is treated as active rather than passive (thus, not subject to the passive loss limits) if taxpayer meets one of 7 material participation tests Participation is generally defined as work performed by an owner

25 Material Participation Tests (slide 2 of 8) Test 1 –Taxpayer participates in the activity more than 500 hours during the year

26 Material Participation Tests (slide 3 of 8) Test 2 –Taxpayer’s participation in the activity is substantially all of the participation in the activity of all individuals for the year

27 Material Participation Tests (slide 4 of 8) Test 3 –Taxpayer participates in the activity more than 100 hours during the year and not less than the participation of any other individual in the activity

28 Material Participation Tests (slide 5 of 8) Test 4 –Taxpayer’s participation in the activity is significant and taxpayer’s aggregate participation in all significant participation activities during the year exceeds 500 hours –Significant participation is more than 100 hours

29 Material Participation Tests (slide 6 of 8) Test 5 –Taxpayer materially participated in the activity for any 5 years during the last 10 year period

30 Material Participation Tests (slide 7 of 8) Test 6 –The activity is a personal service activity in which the taxpayer materially participated for any 3 preceding years

31 Material Participation Tests (slide 8 of 8) Test 7 –Based on the facts and circumstances, taxpayer participated in the activity on a regular, continuous, and substantial basis Regular, continuous, and substantial are not specifically defined in the Regulations

32 Participation Defined Participation generally includes any work done by an individual in an activity that he or she owns –Does not include work if of a type not customarily done by owners and if one of its principal purposes is to avoid the disallowance of passive losses or credits –Work done in an individual’s capacity as an investor is not counted in applying the material participation tests –Participation by an owner’s spouse counts as participation by the owner

33 Rental Activities (slide 1 of 7) Rental of tangible (real or personal) property is automatically passive activity unless it meets one of the 6 exceptions (Regs) If exception applies, activity is subject to the material participation tests

34 Rental Activities (slide 2 of 7) Exception 1 –The average period of customer use of the property is 7 days or less

35 Rental Activities (slide 3 of 7) Exception 2 –The average period of customer use of the property is 30 days or less, and the taxpayer provides significant personal services Significant services are only services performed by individuals

36 Rental Activities (slide 4 of 7) Exception 3 –Taxpayer provides extraordinary personal services –Average period of customer use is of no consequence Extraordinary personal services occur when the customer’s use of the property is incidental to the services provided

37 Rental Activities (slide 5 of 7) Exception 4 –Rental of the property is incidental to a nonrental activity of the taxpayer Temp Regs provide that the following rentals are not passive activities: –Property held primarily for investment –Property used in a trade or business –Lodging rented for the convenience of an employer

38 Rental Activities (slide 6 of 7) Exception 5 –Taxpayer customarily makes the property available during business hours for nonexclusive use by customers

39 Rental Activities (slide 7 of 7) Exception 6 –Property is provided for use in an activity conducted by a partnership, S corporation, or joint venture in which taxpayer owns an interest

40 Interaction of At-Risk and Passive Loss Limits Passive loss rules are applied after the at-risk rules –Losses not allowed under the at-risk rules are suspended under the at-risk rules, not the passive loss rules –Basis is reduced by deductions even if not currently usable due to passive loss rules

41 The Big Picture - Example 40 Interaction of At-Risk and Passive Activity Limits Return to the facts of The Big Picture on p If the Reswicks invest in the orange grove limited partnership, the at-risk rules would not limit the deductibility of the $25,000 losses until after year 4. –The at-risk basis is reduced from $100,000 by $25,000 over each of the first 4 years of the investment. –However, the passive loss rules prohibit deductions for the losses in the first 4 years of the investment (assuming no passive income from other sources). Therefore, based on the facts provided, none of the suspended losses would be deductible until year 6 when the orange grove is expected to begin producing profits.

42 Real Estate Passive Loss Limits (slide 1 of 4) Generally, losses from rental real estate are treated like other passive losses There are two significant exceptions to the general rule

43 Real Estate Passive Loss Limits (slide 2 of 4) Exception 1: Real estate professionals –Rental real estate losses are not treated as passive if the following requirements are met: Taxpayer performs more than half of his/her personal services in real property businesses in which the taxpayer materially participates, and Taxpayer performs more than 750 hours of services in these real property businesses as a material participant

44 Real Estate Passive Loss Limits (slide 3 of 4) Exception 2: Real estate rental activities –Taxpayer can deduct up to $25,000 of losses on real estate rental activities against active or portfolio income –Benefit is reduced by 50% of taxpayer’s AGI in excess of $100,000

45 Real Estate Passive Loss Limits (slide 4 of 4) Exception 2: Real estate rental activities –To qualify for this exception the taxpayer must: Actively participate in rental activity, and Own at least 10% of all interests in activity –Active participation defined: Requires only participation in making management decisions in a significant and bona fide sense

46 The Big Picture - Example 42 Real Estate Rental Activities Return to the facts of The Big Picture on p If the Reswicks invest in the apartment rental limited partnership, their $25,000 loss would be deductible under the real estate rental activities exception. –This assumes they actively participate and own at least a 10% interest in the partnership. The loss will be deductible in each of the first 4 years of their investment before exhausting their at-risk basis, even if they do not have passive income from other sources.

47 Suspended Losses Losses can be suspended due to the passive loss limits or the at-risk limits Losses suspended due to at-risk limitations are investment specific, thus no allocation of suspended losses is necessary Suspended at-risk and passive losses can be carried forward indefinitely

48 Disposition of Passive Interests (slide 1 of 3) Disposition at death: suspended loss deductible on decedent’s final tax return to extent of excess over any step-up in basis Disposition by gift: suspended loss increases donee’s basis in property

49 Disposition of Passive Interests (slide 2 of 3) Disposition by installment sale: portion of suspended loss deductible is same as percentage of total gain recognized in year

50 Disposition of Passive Interests (slide 3 of 3) Nontaxable exchange: if activities involved are same, suspended losses can be deducted against income from acquired activity –Otherwise, suspended loss generally deductible in year new activity disposed of in taxable transaction

Investment Interest (slide 1 of 5) Definition: interest on loans whose proceeds are used to purchase investment property, e.g., stock, bonds, land Deduction of investment interest expense is limited to net investment income

Investment Interest (slide 2 of 5) Net investment income: –Investment income less investment expenses

Investment Interest (slide 3 of 5) Investment income: –Gross income from interest, dividends, annuities, and royalties not derived from business –Net capital gains and qualified dividends are treated as investment income only if elected Amount elected as investment income is not eligible for the 15%/0% rates that otherwise apply to net capital gain and qualifying dividends

Investment Interest (slide 4 of 5) Investment expenses: –All expenses (other than interest) directly related to investment income that are allowed as a deduction –Application of 2% of AGI floor for some investment expenses must be considered in computing amount of net investment income

Investment Interest (slide 5 of 5) Investment interest disallowed in current year due to limitation is carried forward to future years until ultimately used –Deductibility subject to net investment income limitation in carryover years

56 The Big Picture - Example 52 Investment Interest Expense Limit Return to the facts of The Big Picture on p If the Reswicks invest in the high growth, low-yield portfolio of marketable securities –Most of the investment return will consist of appreciation Not taxed until the securities are sold. –Relatively little of the return will consist of currently taxable interest and dividend income. Assume that the interest and dividend income for the year from these securities equals $500 and that all of it is treated as investment income. –If investment interest expense on the $100,000 loan is $8,000 The deduction for the investment interest expense is limited to the $500 of net investment income.

57 Refocus On The Big Picture (slide 1 of 4) The objective for most investors should be to maximize after-tax wealth from among investment alternatives. –This requires an understanding of the relevant tax restrictions that apply to certain expenses and losses arising from various investment choices. The after-tax returns from the 3 alternatives under consideration may be affected by the at-risk, passive activity, and investment interest limitations.

58 Refocus On The Big Picture (slide 2 of 4) The high-growth, low-yield portfolio is expected to generate very little if any current dividend income (i.e., net investment income). –If the broker’s prediction is correct, the market value of the securities will grow by approximately 10% a year. –However, the annual $8,000 interest expense on the debt incurred to purchase the securities may not be deductible as investment interest due to the lack of net investment income. Unless investment income is generated from this or some other source, the interest will not be deductible until the securities are sold. –To the extent the interest is deducted as investment interest, the gain on the portfolio’s sale will not be subject to preferential capital gains rates. As a result, the net after-tax return will be impaired because of the investment interest limitation.

59 Refocus On The Big Picture (slide 3 of 4) The returns from the other two investments are reduced by the at-risk & passive loss rules as well as the investment interest limit. The projected 10% return is apparently contingent on being able to use the tax losses as they arise.

60 Refocus On The Big Picture (slide 4 of 4) These benefits will be deferred because the at-risk and passive activity loss rules delay the timing of the deductions. –For example, with the orange grove investment, none of the passive losses are deductible until year 6 when passive income is generated. –In the real estate rental venture, however, Jim and Trudy could deduct the $25,000 passive loss under the rental real estate exception. The at-risk rules would limit any additional losses in year 5 to the at-risk amount. Since the at-risk and passive loss rules limit the tax losses flowing to the Reswicks, the after-tax return will not be nearly as high as their broker predicts.

© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 61 If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact: Dr. Donald R. Trippeer, CPA SUNY Oneonta