1. © 2016 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. 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. 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 are 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. 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. 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. 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. 7 At-Risk Limits (slide 1 of 4) At-risk defined –The amount of a taxpayer’s economic investment in an activity The amount of cash and adjusted basis of property contributed to the activity, plus Amounts borrowed for use in the activity for which taxpayer is personally liable (recourse debt) or has pledged as security property not used in the activity

8. 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 financing is included in determining at-risk limitation

9. 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. 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. 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. 12 The Big Picture - Example 2 At-risk Limits (slide 1 of 2) Return to the facts of The Big Picture on p. 11-1. In 2015, the Reswicks invest $40,000 in an oil partnership –Assume that the Reswicks’ interest in the partnership is subject to the at-risk limits but is not subject to the passive loss limits.

13. 13 The Big Picture - Example 2 At-risk Limits (slide 2 of 2) Return to the facts of The Big Picture on p. 11-1. Because the Reswicks have only $40,000 of capital at risk, they cannot deduct more than $40,000 against their other income. –They must reduce their at-risk amount to zero ($40,000 at-risk amount − $40,000 loss deducted). –The nondeductible loss of $20,000 can be carried over to 2016. ($60,000 loss generated − $40,000 loss allowed)

14. 14 The Big Picture - Example 3 Carryover Losses - At-risk Limits Return to the facts of Example 2. In 2016, the Reswicks have taxable income of $15,000 from the oil partnership and invest an additional $10,000 in the venture. –Their at-risk amount is now $25,000 ($0 beginning balance + $15,000 taxable income + $10,000 additional investment). –This enables them to deduct the carryover loss and requires them to reduce their at-risk amount to $5,000 ($25,000 at-risk amount − $20,000 carryover loss allowed).

15. 15 Passive Loss Limits – Classification and Impact (slide 1 of 4) The passive loss rules require taxpayers to classify their income and losses into one of the following 3 categories –Active, –Passive, or –Portfolio Then the rules limit the extent to which losses in the passive category can be used to offset income in the other categories

16. 16 Passive Loss Limits – Classification and Impact (slide 2 of 4) 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

17. 17 Passive Loss Limits – Classification and Impact (slide 3 of 4) 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

18. 18 Passive Loss Limits – Classification and Impact (slide 4 of 4) Passive activity defined –Any trade or business or income-producing activity in which the taxpayer does not materially participate –Subject to certain exceptions, all rental activities, whether the taxpayer materially participates or not

19. 19 Passive Loss Limits – General Impact 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

20. 20 The Big Picture - Example 4 Passive Loss Limits (slide 1 of 2) Return to the facts of The Big Picture on p. 11-1. In addition to their salaries of $100,000 from full-time jobs, assume that: –The Reswicks receive $12,000 in dividends and interest from various portfolio investments. –They decide to invest $100,000 in the orange grove limited partnership, which produces a $25,000 loss for the Reswicks this year.

21. 21 The Big Picture - Example 4 Passive Loss Limits (slide 2 of 2) Return to the facts of The Big Picture on p. 11-1. Because their at-risk basis in the partnership is $100,000, the current $25,000 loss is not limited by the at-risk rules. However, the loss is a passive loss. –It is not deductible against their other income. –The loss is suspended and carried over to the future. The suspended loss –Can be offset against other future passive income, or –Will be allowed when they eventually dispose of the passive activity.

22. 22 Passive Loss Limits – General Impact Suspended losses are deductible in year related activity is disposed of in a fully taxable transaction

23. 23 Passive Loss Limits – General Impact Suspended losses are deductible in year related activity is disposed of in a fully taxable transaction

24. 24 Passive Loss Limits - 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

25. 25 Passive Credits Credits from passive activities are subject to the 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

26. 26 Passive Credits Credits from passive activities are subject to the 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

27. 27 Passive Activity Changes to Active If a formerly passive activity becomes an active one –Suspended losses are allowed to the extent of income from the now active business Any remaining suspended loss continues to be treated as a loss from a passive activity –Can be deducted from passive income, or –Carried over to the next tax year and deducted to the extent of income from the now active business in the succeeding year(s)

28. 28 Taxpayers Subject To Passive Loss Limits Passive loss rules apply to –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

29. 29 Taxpayers Subject To Passive Loss Limits Passive loss rules apply to –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

30. 30 Passive Loss Issues Passive losses are losses from trade or business activities in which the taxpayer does not materially participate and certain rental activities What constitutes an activity? What is material participation? When is an activity a rental activity?

31. 31 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

32. 32 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

33. 33 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

34. 34 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

35. 35 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

36. 36 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

37. 37 Material Participation Tests (slide 2 of 8) Test 1 –Taxpayer participates in the activity more than 500 hours during the year

38. 38 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

39. 39 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

40. 40 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

41. 41 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

42. 42 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

43. 43 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

44. 44 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

45. 45 Rental Activities Rental of tangible (real or personal) property is automatically passive activity unless it meets one of the exceptions –Temporary Regulations provide exceptions for certain situations where activities involving rentals of real and personal property are not to be treated as rental activities If exception applies, activity is subject to the material participation tests

46. 46 Rental Activities Rental of tangible (real or personal) property is automatically passive activity unless it meets one of the exceptions –Temporary Regulations provide exceptions for certain situations where activities involving rentals of real and personal property are not to be treated as rental activities If exception applies, activity is subject to the material participation tests

47. 47 Administrative Guidance Administrative Guidance. Although enacted in 1986, some of the passive loss rules have yet to be completely formulated. At present, only a portion of the planned Regulations relating to passive losses have been finalized.  Reg §1.469-2T (Passive activity loss), Reg §1.469-3T (Passive activity credit), and Reg §1.469-4T (Definition of activity) were all issued at least two decades ago and have still not been finalized.

48. 48 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

49. 49 The Big Picture - Example 29 Interaction Of At-risk And Passive Activity Limits Return to the facts of The Big Picture on p. 11-1. 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.

50. 50 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

51. 51 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

52. 52 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

53. 53 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

54. 54 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

55. 55 The Big Picture - Example 31 Real Estate Rental Activities Return to the facts of The Big Picture on p. 11-1. 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.

56. 56 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

57. 57 Disposition of Passive Interests (slide 1 of 2) 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

58. 58 Disposition of Passive Interests (slide 2 of 2) Disposition by installment sale: portion of suspended loss deductible is same as percentage of total gain recognized in year

59. 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

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

61. Investment Interest (slide 3 of 5) Investment income: –Gross income from interest, certain 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 preferential rates that otherwise apply to net capital gain and qualifying dividends

62. 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

63. 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

64. Other Investment Losses Other types of investment losses that individual taxpayers may face include the following: –a.Sale of securities held as investments for less than basis yield capital losses. –b.Securities held as an investment that become worthless produce capital losses. –c.Losses on small business stock. –d.Losses on rental of vacation homes. –e. Hobby losses.

65. Other Investment Losses Other types of investment losses that individual taxpayers may face include the following: –a.Sale of securities held as investments for less than basis yield capital losses. –b.Securities held as an investment that become worthless produce capital losses. –c.Losses on small business stock. –d.Losses on rental of vacation homes. –e. Hobby losses.

66. 66 The Big Picture - Example 39 Investment Interest Expense Limit Return to the facts of The Big Picture on p. 11-1. 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.

67. 67 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.

68. 68 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 any capital gain from the portfolio’s sale is treated as investment income, the gain 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.

69. 69 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.

70. 70 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.

71. © 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 71 If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact: Dr. Donald R. Trippeer, CPA trippedr@oneonta.edu SUNY Oneonta