Chapter 10 Limitations on the Deductibility of Partnership Losses

Three Deductibility Limitations The deductibility of partnership losses passed through to a partner is subject to three separate limitations:  First, the loss may not exceed the partner’s tax basis in the partnership interest-§704(d)  Second, any losses surviving the tax basis limit are subject to the at-risk limitation- §465  Finally, losses may be disallowed under the passive loss limitations - §469

Disallowed Losses Are Carried Forward Carryforwards Under §704(d):  Loss passed through to a partner in excess of tax basis is carried forward indefinitely until the partner obtains additional basis sufficient to allow the deduction  Carryforward losses unused as of the date of any sale or disposition of the partnership interest are lost (because they did not reduce the basis of the interest, and therefore any gain/loss from the sale is already reduced/increased by the amount of the carryforward)  Do not carry over to the transferee  Do not explicitly offset the gain or increase the loss recognized

Disallowed Losses Are Carried Forward (Cont.) Carryforwards Under §465  Losses disallowed under the at-risk rules are carried forward indefinitely just as are those denied under tax basis limitation  A partner’s tax basis in her partnership interest is reduced by losses even if they are disallowed under the at-risk rules  When a partner sells her interest in the partnership, losses carried forward under the at-risk limitation are deductible in full regardless of the amount of gain or loss recognized by the partner/member on the transaction

Disallowed Losses Are Carried Forward (Cont.) Carryforwards Under §469  For individuals, losses from passive activities are only deductible to the extent of income from other passive activities  Losses disallowed under the passive loss limitations are carried forward indefinitely until the partnership has sufficient passive income from other sources to absorb the carryforward  If the partner completely disposes of the partnership interest, any passive loss carryforward is deductible in full in the year of disposition

At-Risk Rules of §465 Under §465, a taxpayer may not claim deductions for losses in excess of the amount that the taxpayer actually has “at risk” with respect to the activity generating the losses  §465 applies to individuals and closely held corporations only

At-Risk Rules of §465 (Cont.) A taxpayer’s amount at risk is computed in the same manner as is tax basis except that it excludes nonqualified nonrecourse debt  A qualified nonrecourse debt is one which:  Is borrowed for the activity of holding real property (very broadly defined), and is secured by that property  Is borrowed from a lender who is in the business of lending money and who has no interest in the activity for which the money is borrowed, other than as a creditor  Is not convertible into stock or other securities

Passive Loss Limitations of §469 General  Deductions for net losses (income minus losses) from “passive” activities are not allowed  Passive loss is loss realized from rental activities and loss “allocated” to nonparticipatory partners (i.e., limited partners) in partnership activities  Disallowed losses are carried forward and can be deducted only against net passive income in future years or when the taxpayer fully disposes of the interest in the passive activity  The passive loss limitation is applied after application of the at-risk loss limitation

Classification of Income Under §469 General  Passive activity income includes all income from passive activities, including gain from disposition of an interest in a passive activity or from disposition of property used in a passive activity

Taxpayers to Whom §469 Applies The passive loss rules apply only to individuals, certain trusts and estates, personal service corporations and closely-held corporations  Unlike individuals, closely held corporations are allowed to deduct net passive losses against active income and offset the tax attributable to net active income with passive activity credits  However, closely held corporations cannot offset portfolio income with net passive losses

Passive Activities Defined Definition: A passive activity is one in which the taxpayer does not “materially participate” during the taxable year Most rental activities are deemed to be passive regardless of the taxpayer’s level of participation  A significant exception: for taxpayers who are engaged primarily in the real estate business

Passive Activities Defined (Cont.) Regular, continuous, and substantial  Material participation definition: involvement, by the taxpayer or his/her spouse, which is “regular, continuous and substantial”  A limited partner cannot satisfy the material participation requirement  Most taxpayers prefer to rely on one of the more reliable “safe harbor” definitions that follow, rather than this subjective definition

Passive Activities Defined (Cont.) Rental Activities  §469 automatically classifies most rental activities as passive activities, regardless of the taxpayer’s level of participation  For this purpose, a rental activity is one involving the long-term rental of property and for which the taxpayer does not provide substantial additional services  Short term rental activities where substantial personal services in connection with the rental are required (e.g. operation of hotel) do not constitute a passive activity

Passive Activities Defined (Cont.) Real Estate Professionals  Taxpayers in the “real property business” are not subject to the passive loss restrictions  A taxpayer is in the real property business if he/she:  Spends more than half of his/her time in real property businesses in which he/she materially participates; and  Performs more than 750 hours of services during the taxable year in real property trades or businesses in which he or she materially participates

Passive Activities Defined (Cont.) Exemption for Real Estate Rental Activities in which Taxpayer “Actively” Participates  For taxpayers who “actively participate in the management of rental property, the first $25,000 of net losses generated by such property are exempted from Code Sec. 469  First, the losses are still passive losses, while not subject to the passive loss limitations  Second, the exemption applies only if the taxpayer “actively” participates in management of the property

Passive Activities Defined (Cont.) Exemption for Real Estate Rental Activities in which Taxpayer “Actively” Participates (Cont.)  Active participation requires the following:  The taxpayer must have at least a 10% interest in the rental activity  The taxpayer must not own the interest as a limited partner, and  The taxpayer must participate in the activity in a significant and bona fide manner (participate in management decisions)

Activities That Are Not Passive Activities Five categories of trade or business activities are not treated as passive activities  Trade or business activities in which the taxpayer materially participated for the tax year  A working interest in an oil or gas well held by the taxpayer directly or through an entity that does not limit liability  Rental of a vacation home  Trading activities involving personal property traded for the account of those who own interests in the activity  Rental real estate activities of real estate professionals