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

2. C11-2 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

3. Individual Income Taxes C11-3 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 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

4. Individual Income Taxes C11-4 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)

5. Individual Income Taxes C11-5 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 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

6. Individual Income Taxes C11-6 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 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

7. Individual Income Taxes C11-7 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 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

8. Individual Income Taxes C11-8 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 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

9. Individual Income Taxes C11-9 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

10. Individual Income Taxes C11-10 Passive Loss Limits (slide 2 of 7) 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

11. Individual Income Taxes C11-11 Passive Loss Limits (slide 3 of 7) 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

12. Individual Income Taxes C11-12 Passive Loss Limits (slide 4 of 7) 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

13. Individual Income Taxes C11-13 Passive Loss Limits (slide 5 of 7) Suspended losses are deductible in year related activity is disposed of in a fully taxable transaction

14. Individual Income Taxes C11-14 Passive Loss Limits (slide 6 of 7) 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

15. Individual Income Taxes C11-15 Passive Loss Limits (slide 7 of 7) 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

16. Individual Income Taxes C11-16 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? 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?

17. Individual Income Taxes C11-17 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

18. Individual Income Taxes C11-18 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 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

19. Individual Income Taxes C11-19 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

20. Individual Income Taxes C11-20 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

21. Individual Income Taxes C11-21 Material Participation Tests (slide 2 of 8) Test 1 –Taxpayer participates in the activity more than 500 hours during the year Test 1 –Taxpayer participates in the activity more than 500 hours during the year

22. Individual Income Taxes C11-22 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 Test 2 –Taxpayer’s participation in the activity is substantially all of the participation in the activity of all individuals for the year

23. Individual Income Taxes C11-23 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 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

24. Individual Income Taxes C11-24 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 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

25. Individual Income Taxes C11-25 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 Test 5 –Taxpayer materially participated in the activity for any 5 years during the last 10 year period

26. Individual Income Taxes C11-26 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 Test 6 –The activity is a personal service activity in which the taxpayer materially participated for any 3 preceding years

27. Individual Income Taxes C11-27 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 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

28. Individual Income Taxes C11-28 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 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

29. Individual Income Taxes C11-29 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

30. Individual Income Taxes C11-30 Rental Activities (slide 2 of 7) Exception 1 –The average period of customer use of the property is 7 days or less Exception 1 –The average period of customer use of the property is 7 days or less

31. Individual Income Taxes C11-31 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 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

32. Individual Income Taxes C11-32 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 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

33. Individual Income Taxes C11-33 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 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

34. Individual Income Taxes C11-34 Rental Activities (slide 6 of 7) 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

35. Individual Income Taxes C11-35 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 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

36. Individual Income Taxes C11-36 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

37. Individual Income Taxes C11-37 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

38. Individual Income Taxes C11-38 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 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

39. Individual Income Taxes C11-39 Real Estate Passive Loss Limits (slide 3 of 4) 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

40. Individual Income Taxes C11-40 Real Estate Passive Loss Limits (slide 4 of 4) 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

41. Individual Income Taxes C11-41 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 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

42. Individual Income Taxes C11-42 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

43. Individual Income Taxes C11-43 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

44. Individual Income Taxes C11-44 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 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

45. Individual 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

46. Individual Income Taxes Investment Interest (slide 2 of 5) Net investment income: –Investment income less investment expenses Net investment income: –Investment income less investment expenses

47. Individual Income Taxes 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 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

48. Individual Income Taxes 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 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

49. Individual Income Taxes 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 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

50. Individual Income Taxes C11-50 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 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