Individual Income Taxes C11-1 Chapter 11 Investor Losses Copyright ©2009 Cengage Learning...

C11-C11-11Individual Income TaxesIndividual Income TaxesIndividual Income TaxesIndividual Income Taxes

Chapter 11Chapter 11

Investor LossesInvestor Losses

Copyright ©2009 Cengage Learning

Individual Income Taxes


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

• 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




• 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

• 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


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)

• 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)




• 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

• 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




• 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

• 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




• 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

• 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


Calculation of At-Risk AmountCalculation 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

• 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

• 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


Passive Loss Limits(slide 1 of 7)


• 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

• 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




• 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

• 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




• Passive losses defined– Losses from trade or business activities in

which taxpayer does not materially participate, and

– Certain rental activities

• Passive losses defined– Losses from trade or business activities in

which taxpayer does not materially participate, and

– Certain rental activities




• 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

• 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




• Suspended losses are deductible in year related activity is disposed of in a fully taxable transaction

• Suspended losses are deductible in year related activity is disposed of in a fully taxable transaction




• 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

• 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




• 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

• 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


Passive Loss IssuesPassive 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?

• 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?


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

• Taxpayers with complex business operations must determine if segments of their business are separate activities or entire business is treated as a single activity




• 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

• 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


Special Grouping Rules for Rental Activities

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

• 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


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

• 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




• Test 1– Taxpayer participates in the activity more than

500 hours during the year


500 hours during the year




• Test 2– Taxpayer’s participation in the activity is

substantially all of the participation in the activity of all individuals for the year


substantially all of the participation in the activity of all individuals for the year





100 hours during the year and not less than the participation of any other individual in the activity


100 hours during the year and not less than the participation of any other individual in the activity





significant and taxpayer’s aggregate participation in all significant participation activities during the year exceeds 500 hours

– Significant participation is more than 100 hours


significant and taxpayer’s aggregate participation in all significant participation activities during the year exceeds 500 hours

– Significant participation is more than 100 hours




• Test 5– Taxpayer materially participated in the activity

for any 5 years during the last 10 year period

• Test 5– Taxpayer materially participated in the activity

for any 5 years during the last 10 year period




• Test 6– The activity is a personal service activity in

which the taxpayer materially participated for any 3 preceding years

• Test 6– The activity is a personal service activity in

which the taxpayer materially participated for any 3 preceding years




• 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

• 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


Participation DefinedParticipation 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

• 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


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

• 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




• Exception 1– The average period of customer use of the

property is 7 days or less


property is 7 days or less





property is 30 days or less, and the taxpayer provides significant personal services

• Significant services are only services performed by individuals


property is 30 days or less, and the taxpayer provides significant personal services

• Significant services are only services performed by individuals




• 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

• 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




• 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

• 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




• Exception 5– Taxpayer customarily makes the property

available during business hours for nonexclusive use by customers

• Exception 5– Taxpayer customarily makes the property

available during business hours for nonexclusive use by customers




• 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

• 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


Interaction of At-Risk and Passive Loss Limits

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

• 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


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

• Generally, losses from rental real estate are treated like other passive losses

• There are two significant exceptions to the general rule




• 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

• 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




• Exception 2: Rental real estate 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

• Exception 2: Rental real estate 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




• Exception 2: Rental real estate 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

• Exception 2: Rental real estate 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


Suspended LossesSuspended 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

• 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


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

• 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




• Disposition by installment sale: portion of suspended loss deductible is same as percentage of total gain recognized in year

• Disposition by installment sale: portion of suspended loss deductible is same as percentage of total gain recognized in year




• 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

• 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

Individual Income TaxesIndividual Income TaxesIndividual Income TaxesIndividual Income Taxes

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

• 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




• Net investment income:– Investment income less investment expenses

• Net investment income:– Investment income less investment expenses




• 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 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 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 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 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

• 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


If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact:

Dr. Donald R. Trippeer, CPA [email protected]

SUNY Oneonta

If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact:

Dr. Donald R. Trippeer, CPA [email protected]

SUNY Oneonta

Individual Income Taxes C11-1 Chapter 11 Investor Losses Copyright ©2009 Cengage Learning...

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Transcript of Individual Income Taxes C11-1 Chapter 11 Investor Losses Copyright ©2009 Cengage Learning...