1. Module 29 Tax Motivated Investments and Loss Limitations

2. 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

3. Tax Shelter Activities: An Introduction Key Learning Objectives (1) n Definition of a tax shelter n The goals of a good tax shelter n §6111 registration requirements n §6707 & §6708 penalties related to registration

4. Definition of a Tax Shelter n Minimize the tax effects of the income tax n Generates significant tax losses as a result of the allowable deductions associated with the investment

5. §6111 Registration Requirements n A tax savings to investment cost ratio of more than two to one, and n 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

6. §6707 and §6708 Registration Penalties n §6707 (a) organizer's failure to register a shelter n §6707 (b)--failure to furnish a registration number n §6708--organizer's failure to retain list of investors

7. The Goals of a Good Tax Shelter n Deferral of taxation n Conversion of ordinary income into capital gain

8. §6700 and §6701 False Statement Penalties n §6700--organizer furnishes false statements n §6700--organizer furnishes gross overvaluation statement n §6701--aiding and abetting understatement of tax liability

9. Tax Shelter Activities: An Introduction Key Learning Objectives (2) n The sham transaction doctrine as a weapon against tax shelters n §6700 & §6701 penalties related to false statements n §7408 injunctive relief

10. The Sham Transaction Doctrine n The transaction was entered into primarily for tax avoidance and n No economic substance, (no possibility of profit)

11. §7408 Injunctive Relief n Empowers IRS to seek civil action in District Court that would enjoin any person from further engaging in conduct subject to §6700 or §6701 n Promoters can be shut down much quicker under this procedure

12. The Passive Activity Limitations: A Closer Look Key Learning Objectives (1) n The passive activity limitations (PALS) n Identifying an activity n The active basket and material participation n The portfolio basket n Legislative curbs on tax shelters: an overview

13. Passive Activity Rules n n Loss limit rule applies to individuals, estates, trusts, closely held C corporations, and personal service corporations n n All items of income or loss classified as u Active u Portfolio, or u Passive

14. General Rule n n Passive losses offset only passive income n n Suspended losses carried forward

15. Active Basket n n Wages and salaries n n Profit/loss from trade or business in which taxpayer materially participates n n Gain/loss from sale of active business assets

16. Material Participation (Dirty Hands) n n Regular n n Continuous n n Substantial n n Extremely complex rules

17. Portfolio Basket n n Interest n n Dividends n n Annuities n n Royalties n n Gain/loss from sale of portfolio assets

18. The Passive Activity Limitations: A Closer Look Key Learning Objectives (2) The passive basket n n Applying the passive activity limitations n n Real estate exceptions to the passive loss limitations n n Passive activity credits n n Disposition of passive activities

19. Passive Basket n n Profit/loss from trade or business IF u Taxpayer does not materially participate n n Any rental activity, regardless of material participation

20. Passive Activity Limitations PAL Rules n n Record income/loss for each activity n n Net all activities n n If overall net income--report in full n n If overall loss--report zero net income n n Disallowed (suspended) losses u Carryover in full to next year u Record by activity

21. Compliance Query: PAL Rules (1) What is AGI if the taxpayer has $500,000 of salary income and Two passive businesses ActivityActivity -A- -B- -A- -B- Income Income 50,000 20,000 Expense Expense 25,000 30,000

22. Solution: Compliance Query: PAL Rules (1) AGI is $515,000 Passive activities net as follows: ActivityActivity 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 >0,include in AGI

23. Compliance Query: PAL Rules (2) What is AGI if the taxpayer has u $500,000 of salary income and u Two passive businesses ActivityActivity -A- -B- -A- -B- Income Income 50,000 20,000 Expense Expense 75,000 5,000

24. Solution--Compliance Query: AGI is $500,000 Passive activities net as follows: ActivityActivityNetted -A- -B- Income 50,000 20,000 70,000 Expense 75,000 5,000 70,000* Net Inc-25,000 15,000 -0- *Can’t deduct >passive income

25. Passive Credits n n Apply against tax from passive income only n n Suspended credits carried forward n n Use or lose in year of disposition

26. Disposition of Passive Activities n In the year of disposition n In a fully taxable transaction n Suspended losses may be deducted against any source of income

27. Transfers to Related Parties n Not a disposition of a passive activity

28. Exception for Qualified Real Estate Professional n n >50% of personal services related u To real estate trade or business and n n >750 real estate related hours

29. Exception for Active Rental Real Estate n n Up to $25,000 excess loss allowed u Reduces active/portfolio income n n Phase-out of $25,000 if u AGI > 100,000 u Lose 50¢ for each excess $ n n Active participation required

30. The Active Participation Requirement n Own at least a 10% interest u By value n Not be a limited partner and n Demonstrate regular, continuous, and substantial involvement

31. Compliance Query: Active Rental Exception What is AGI if the taxpayer has u $100,000 of salary income and u Two passive businesses (A is active rental) ActivityActivity -A- -B- -A- -B- Income Income 50,000 20,000 Expense Expense 75,000 5,000

32. Solution--Compliance Query: AGI is $90,000 Passive activities net as follows: ActivityActivityNetted -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

33. In Class Exercise: More Active Rental Exception n How does the answer to last Query change? n Case 1: u Activity B is the active real estate rental n Case 2: u Salary income is $140,000? u Activity A is the active real estate rental

34. Solution--In Class Exercise: More Active Rental Exception Case 1: AGI = 100,000 n The excess loss is not from active rental n It must be suspended

35. Solution--In Class Exercise: More Active Rental Exception Case 2: AGI = 135,000 n AGI is over 100,000 u Exception must be phased out n Lose (140,000-100,000) x.5 of $25,000 n Only 5,000 of 25,000 exception remains

36. Decedent’s Suspended Losses n Suspended losses are generally allowed on a decedent's final tax return n Deduction is reduced by any step-up in basis to FMV

37. Gifts of Activities With Suspended Losses n Transfer by gift not a qualifying disposition n Losses are not allowable to either the donor or donee n Donee’s basis is increased by the suspended loss

38. Tax Shelters in Residential Real Estate n Limited tax benefits are still available for the small investor n Use of leveraging, depreciation, capital gains, benefits of tax losses, positive cash flows n $25,000 exception for PAL’s

39. Loss Limitations Associated With Vacation Homes Key Learning Objectives (1) n The basic rules of §280A n Rule 1: De minimis rentals n Rule 2: Insignificant personal usage n Rule 3: Significant personal usage

40. “Vacation Home” n To determine if rental is a vacation rental COMPARE days of personal use to days ACTUALLY rented at FMV n Note: OA stands for “otherwise allowable” deductions found on Schedule A

41. Vacation Home? THERE ARE 3 POSSIBLE OUTCOMES n Exclude all income and non “otherwise allowable” expenses n Rental is a passive activity--see PAL rules n Deduct u Expenses FOR AGI to zero out rental income u Excess otherwise allowable deductions FROM AGI

42. De Minimis Rentals De Minimis Rentals Exclude n If rented < 15 days n Exclude all income and non-otherwise allowable expenses

43. Insignificant Personal Usage Insignificant Personal Usage Follow PAL Rules n If personal use u < 15 days OR u < 10% of days rented at FMV n All income and expenses related to the rental are passive n Passive actively rules apply n Rental exception may be available

44. Significant Personal Usage Zero Out AGI n If personal use u > 14 days AND u > 10% of days rented at FMV n All income is reported for AGI n Expenses related to the rental (including OA's) are deductible FOR AGI but limited to amount of income generated by the rental n Excess OA’s are deductible FROM AGI

45. In Class Exercise: Rental or Vacation Home? n Discuss these cases in your groups n CASE -A--B--C--D- -E- n Rented 300200250 10 75 n Used 22 21 22 32 14 n CASE -F--G--H--I- -J- n Rented 100200200300 300 n Used 13 14 22 29 36

46. Solution: In Class Exercise: Rental or Vacation Home? n n De minimis rental u Case: D n n Insignificant personal usage (PAL) u Cases: A, C, E, F, G, I n n Significant personal usage u Cases B, H, J

47. Loss Limitations Associated With Vacation Homes Key Learning Objectives (2) n n Special considerations applicable to vacation homes n n Expense allocation methods: the IRS vs. the courts n n Carryovers of unused deductions

48. Special Issues n n Ordering rule for deductions u "Otherwise allowable" u Other allowable cash expenditures u Depreciation n n Personal use includes u Rental < FMV to related party u Donated use to charitable organization

49. Expense Allocation Methods Why The Issue? n Total deduction FOR AGI limited to income from rent n Excess OA's can be deducted FROM AGI n Taxpayer would like to increase percentage of deduction FOR AGI coming from items not OA

50. Expense Allocation Methods What’s The Denominator? n n 365 days for interest and tax deductions u Per the Courts n n Total number of days actually used for rental or personal usage u Per the Code u Excludes any days the unit was vacant

51. In Class Exercise: Expense Allocation Methods What’s The Difference? n Use the following facts to determine the deduction for/from AGI n Rental income 5,000 n Interest and taxes 15,000 n Repairs 6,000 n Days rented at FMV 100 n Days of personal use 50

52. Solution--In Class Exercise: Expense Allocation Methods What’s The Difference ? Per the Courts % = 100 365 =.274 % = 100 ÷ 365 =.274 For AGI Income5,000 Less Interest4,110 Repairs 990 Repairs 990 Net Income 0 From AGI 15,000 - 4,110 Per the IRS % = 100 150 =.333 % = 100 ÷ 150 =.333 For AGI Income5,000 Less Interest5,000 Repairs 0 Repairs 0 Net Income 0 From AGI 15,000 - 5,000

53. Carryovers of Unused Deductions n OA s used in full, either for or from AGI, so no carryover issue n Depreciation, repairs, etc. carryover n Cannot be used to create a loss

54. Anatomy of a Tax Shelter: Residential Real Estate Key Learning Objectives (1) n Tax shelters in residential real estate n Analysis of a typical residential real estate investment n The benefits of leveraging

55. Anatomy of a Tax Shelter: Residential Real Estate Key Learning Objectives (2) n Comparing taxable income (loss) with net cash flows n Impact of the passive activity limitations n Incorporating the effects of liquidating the investment n Summary: the tax advantages of residential real estate

56. Anatomy of a Tax Shelter: Low- Income Housing Investment Key Learning Objectives (1) n Investments in low-income housing tax credit projects n Project description: qualified units and financing terms n Project description: project rents and equity requirements

57. Anatomy of a Tax Shelter: Low- Income Housing Investment Key Learning Objectives (2) n Projected cash flows n Disposition of the project in year 16 n Assessing the impact of the passive activity limitations