Bryant - Course 4. Tax Planning. 10. Passive Activity

Question 1

What is the definition of passive activity?

Answer 1

The term passive activity includes rental activities or any trade or business in which the taxpayer does not materially participate.

The definition of passive activity is based on two critical elements:
* Identification of what constitutes an activity, and
* Determination of whether the taxpayer has materially participated in that activity.

Question 2

What is known as the amount of adjusted basis in a business that an owner has at a particular point in time?

Answer 2

The amount of adjusted basis in a business that an owner has at a particular point in time is known as the amount at-risk. The adjusted basis is the amount at-risk, and it is an amount that changes frequently. Contributions, pass-through of income, and certain debt obligations will serve to increase the owner’s amount at-risk, while distributions, pass-through of losses, and certain debt repaid by the business entity will decrease the owner’s amount at-risk.

Question 3

An owner cannot have any loss passed through to their personal return (via form K-1) unless their amount at-risk is at least equal to or greater than the loss.
* True
* False

Answer 3

The term owner is used as a generic term to describe a partner, shareholder, or member. An owner cannot have any loss passed through to their personal return (via form K-1) unless their amount at-risk is at least equal to or greater than the loss. To the extent that a particular pass-through of a loss exceeds the available amount at-risk, the loss will be “suspended” and will not be available to use, until such time that the amount at-risk increases enough to use that suspended loss.

Question 4

Passive Activity & At-Risk Rules Example:

Prior to applying this year’s Form K-1 pass-through loss of $15,000 from an S-corporation, Bob Williams has an amount at-risk of $12,000. The at-risk rules will allow $12,000 of the $15,000 loss to pass-through, but $3,000 will be suspended. This allowable loss of $12,000 will then bring Bob’s amount at-risk to zero. If next year, Bob Williams has pass-through income of $5,000, then his amount at-risk will increase to $5,000 (from zero). Now his suspended loss of $3,000 will be allowed to pass-through, thus reducing his final amount at-risk after the second year to $2,000.

Question 5

Identification of an Activity

Answer 5

Identifying whether an activity is either passive or active is critical for several reasons. Whether a taxpayer materially participates in an activity is determined separately for each activity. Suspended losses of a passive activity are carried over from year to year and are deductible when the taxpayer’s ownership of that activity is completely terminated. Therefore, the taxpayer should keep separate losses and credits associated with each particular activity. In some instances, taxpayers may deduct up to $25,000 of passive losses from rental real estate activities. Thus, taxpayers should not combine losses from passive business and rental real estate activities into one activity. Each separate passive activity should be treated separately.

The way taxpayers combine or separate operations into activities can significantly impact the deductibility of losses that are generated. Taxpayers may treat one or more activities as a single activity only if they constitute an “appropriate economic unit.” Although this determination is made by examining all the relevant facts and circumstances, the following factors are given the greatest weight:

Similarities and differences in the types of business
* The extent of common control
* The extent of common ownership
* The geographical location, and
* Any interdependencies between the operations (that is, the extent to which they purchase or sell goods between the activities, have the same customers, or are accounted for with a single set of books).

Not all of these factors are necessary for a taxpayer to treat more than one operation as a single activity. Furthermore, a taxpayer may use any reasonable method of applying the relevant facts and circumstances in grouping the activities.

Question 6

Grouping of Operations Example:

Carla owns a bakery and a movie theater in each of two different shopping malls, one located in Baltimore and the other in Philadelphia. Depending on other relevant facts and circumstances, a reasonable grouping of the operations may result in any of the following:
* One activity involving all four operations
* Two activities: a bakery activity and a theater activity
* Two activities: a Baltimore activity and a Philadelphia activity
* Four activities

Answer 6

Under the Treasury Regulations, taxpayers have some degree of flexibility in determining how different business operations are grouped into activities. However, once the activities are established, taxpayers must be consistent in grouping their activities in subsequent years unless material changes in the facts and circumstances clearly make the groupings inappropriate.

In identifying separate activities, taxpayers generally may not group rental operations with a trade or business operations. However, a combination is allowed if either the rental operation is insubstantial in relation to the business operation or vice versa. Unfortunately, the Treasury Regulations do not give any guidance with regard to what is insubstantial. Furthermore, because of the special rules, real estate rental activities may not be combined with rental activities involving personal property.

Question 7

Two business operations conducted at separate locations can never be combined into the same activity.
* False
* True

Answer 7

False.
Taxpayers may treat one or more activities as a single activity only if they constitute an appropriate economic unit. Once the activities are established, taxpayers must be consistent in grouping their activities in subsequent years unless material changes in the facts and circumstances clearly make the groupings inappropriate.

Question 8

According to the Treasury Regulations, taxpayers materially participate in an activity if they meet at least one of the following tests:

Answer 8

• The individual participates in the activity for more than 500 hours during the year.
• The individual’s participation in the activity for the year constitutes substantially all of the participation in the activity by all individuals, including individuals who do not own any interest in the activity.
• The individual participates in the activity for more than 100 hours during the year, and that participation is more than any other individual’s participation for the year (including participation by individuals who do not own any interest in the activity).
• The individual participates in “significant participation activities” for an aggregate of more than 500 hours during the year and over 100 hours in each activity.
• The individual participated in the activity in any non-consecutive five years during the immediately preceding ten taxable years.
• The individual participated in the activity for any three years preceding the year in question, and the activity is a personal service activity.
• The individual participates in the activity on a regular, continuous, and substantial basis during the year.

Question 9

Rather than attempt to memorize all seven standards for materially participation, the key things to remember are:

Answer 9

• More than 500 hours of participation
• More than 100 hours and the most of any participant

Question 10

Describe material participation as it relates to Limited Partnerships

Answer 10

A limited partner has limited liability for his or her investment in the partnership only if the partner has no active involvement. Thus, the material participation test is not met and the limited partner’s investment is generally considered passive.

However, a limited partner can meet the material participation test if the individual meets either the 500-hour test or the prior year tests. It is rare for a limited partner to meet the material participation test because limited partners are generally not involved in the operation of the business. Thus, most income and deductions from limited partnerships are considered passive.

Question 11

Define working interest, in terms of passive activity

Answer 11

One of the exceptions to the passive loss rules is a working interest in an oil or gas property. A working interest is an interest that is responsible for the cost of the development or operation of the oil and gas property. This type of interest in an oil and gas property is not considered a passive activity as long as the taxpayer’s liability in the interest is not limited. Thus, even though a taxpayer may not materially participate in the activity, the passive loss rules do not apply. The rules do not apply even if the taxpayer holds the interest through an entity such as a partnership.

Question 12

Identification of an activity is done first by __ ____??____ __.

Answer 12

Identification of an activity is done first by grouping activities together and then categorizing them into either active or passive based on factors such as the material participation of taxpayers in a particular activity.

Question 13

Material participation defines the participation level for a particular activity undertaken by taxpayers. The base of material participation rests on either __ ____??____ __ or the __ ____??____ __.

Answer 13

Material participation defines the participation level for a particular activity undertaken by taxpayers. The base of material participation rests on either the number of hours spent on the activity or the participation of the taxpayer in the prior years.

Question 14

Limited partners are most likely passive in the activities of a limited partnership, as they do not meet the __ ____??____ __.

Answer 14

Limited partners are most likely passive in the activities of a limited partnership, as they do not meet the material participation test. Income and deductions from limited partnerships are also considered passive.

Question 15

__ ____??____ __ deals with the type of interest that is responsible for the cost of development or operation of an oil and gas property. This activity is not considered passive even though a taxpayer does not materially participate in the activity and passive loss rules also are not applicable to them.

Answer 15

Working interest deals with the type of interest that is responsible for the cost of development or operation of an oil and gas property. This activity is not considered passive even though a taxpayer does not materially participate in the activity and passive loss rules also are not applicable to them.

Question 16

Material participation by a taxpayer in an activity is satisfied if the individual participates in the activity for more than 500 hours during the year.
* False
* True

Answer 16

True

Taxpayers materially participate in an activity if they meet one in a list of tests pursuant to the Treasury Regulations, which includes participation in the activity for more than 500 hours during the year.

Question 17

Which of the following is NOT a test for material participation?
* Individual participates in the activity for more than 500 hours during the year.
* A limited partner with less than 100 hours of participation.
* Individual participates in “significant participation activities” for an aggregate of more than 500 hours during the year and over 100 hours in each activity.
* Individual participated in the activity in any non–consecutive five years during the immediately preceding ten taxable years.

Answer 17

A limited partner with less than 100 hours of participation.

All of the options except for a limited partner with less than 100 hours of participation qualify for material participation. For a limited partner, the liability for his or her investment in the partnership is limited. It is also assumed that there is no active involvement. Thus, the material participation test is not met and the limited partner’s investment is generally considered passive.

Question 18

In which type of business can an activity be considered non-passive as well as passive, and loss rules be inapplicable?
* Real estate property
* Oil and gas property
* Rental activities
* Engineering activities

Answer 18

Oil and gas property

A working interest is an interest in the development or operation of an oil and gas property. This type of interest in an oil and gas property is not a passive activity, as long as the taxpayer’s liability in the interest is not limited. Thus, even though a taxpayer may not materially participate in the activity, the passive loss rules do not apply.

Question 19

Why did Congress enact IRC Section 469 on passive losses?

Answer 19

In the past, taxpayers were able to reduce their income tax liability on income from a business or investment activity with deductions, losses, and credits arising in another activity by investing in tax shelters. Many of these tax shelters were simply passive investments because they did not require the taxpayer’s involvement or participation.

In many cases, tax shelters had no real economic substance other than the creation of deductions and credits that enabled taxpayers to reduce and sometimes eliminate the income tax liability from their other business activities. In an effort to prevent these perceived and real abuses, Congress enacted IRC Section 469, which restricts the current use of losses and credits that arise in rental activities as well as activities in which the taxpayer does not materially participate. These activities are described as passive activities.

Question 20

Closely Held C Corporation Taxation Example:

Allie and Beth equally own all of the outstanding stock of Delta. During the current year, Delta generates $15,000 in taxable income from its active business operations. It also earns $10,000 of interest and dividends from investments and reports a $30,000 loss from a passive activity. As Delta is a closely held C corporation, the $15,000 of taxable income from the active business is offset by $15,000 of the passive loss. However, the $10,000 of portfolio income may not be offset. Thus, for the current year, Delta reports $10,000 of taxable income from its portfolio income and has a $15,000 passive loss carryover.

Answer 20

The passive loss rules apply to closely held C corporations, but only on a limited basis. A closely held C corporation is a C corporation where five or fewer individuals own more than 50% of the stock at any time during the last half of the corporation’s taxable year. Thus, as applied to a closely held C corporation, the passive loss rules prevent passive activity losses from offsetting portfolio income, which is income from dividends, interest, and other investments. However, a closely held C corporation’s passive losses may offset its income from active business operations.

Question 21

What are the passive losses rules for a Personal Service Corporation?

Answer 21

A personal service corporation (PSC) is a regular C corporation whose principal activity is the performance of personal services that are substantially performed by owner-employees. However, a corporation is not a PSC unless owner-employees own more than 10% of the value of the stock. The passive loss rules apply to a personal service corporation. If a corporation is both a PSC and a closely held C corporation, the more restrictive rules for PSCs apply. Thus, passive losses of a PSC may not offset the PSC’s active business income or portfolio income.

Question 22

A corporation is not a personal service corporation (PSC) unless owner-employees own more than __ ____??____ __ of the value of the stock.
* 10%
* 15%
* 25%
* 50%

Answer 22

10%

A corporation is not a PSC unless owner-employees own more than 10% of the value of the stock.

Question 23

What are the special rules in determining whether closely held C corporations or personal service corporations (PSCs) materially participate in an activity?

Answer 23

These corporations materially participate in an activity only if one or more shareholders who own more than 50% in value of the outstanding stock materially participate in the activity.

In addition, a closely held C corporation (other than a PSC) materially participates in an activity if it meets all of the following tests with regard to an activity:
* A substantial portion of the services of at least one full-time employee is in the active management of the activity.
* A substantial portion of the services of at least three full-time non-owner employees is directly related to the activity.
* The Section 162 business deductions of the activity exceed 15% of the activity’s gross income for the period.

Question 24

What are the passive losses rules for a publicly traded partnership (PTP)?

Answer 24

In many cases, a publicly traded partnership (PTP) is treated for tax purposes as a corporation. A PTP, for purposes of the passive loss rules, is defined as any partnership where interest in the partnership is either traded on an established securities market or readily available for trading on a secondary market.

If a PTP is treated for tax purposes as a corporation, the passive loss rules generally do not apply. However, if a PTP meets certain gross income requirements it may still be treated as a partnership, causing its items of income, loss, and credit to flow through to the partners. Partners treat losses from a PTP as separate from any other type of income that is passive, active business, or portfolio, as well as separate from any income from other PTPs.

Question 25

Publicly Traded Partnership (PTP) Example:

Mark owns interests in partnerships A and B, both of which are PTPs that are treated as partnerships. During the current year, Mark’s share of the income from A is $2,000. Mark’s share of B’s loss is $1,200. B also generated some portfolio income. Mark’s share of B’s portfolio income is $800. The $1,200 loss from B may not offset any of B’s $800 portfolio income. Furthermore, it may not offset any of the $2,000 income from A. The $2,000 income from A is treated as portfolio income. Thus, Mark reports $2,800 of portfolio income and has a $1,200 suspended loss from B. In a subsequent year, Mark’s share of any income from B can be offset by the $1,200 of suspended loss that is carried forward.

Answer 25

Partners can only carry these losses forward and offset them against income generated by that particular PTP in a subsequent year. Furthermore, the loss may not offset any portfolio income that the PTP might generate. Any net income from PTPs is treated as portfolio income.

Partners may deduct suspended losses from PTPs only in the year the partner disposes of his or her interest in the PTP. Partners do not recognize a loss in the year that the PTP itself has a passive activity.

Question 26

Joe Jones has the following passive activity for the current year:
($5,000) loss from ABC, a publicly traded partnership
$7,000 income from DEF, a publicly traded partnership
($10,000) loss from CHI, a private interest in a limited partnership
$8,000 income from Solar Winds, a private interest in an S-Corporation
How much of the losses will be suspended and carried over?
* $7,000
* $3,000
* $5,000
* $10,000

Answer 26

$7,000

$7,000 of losses must be suspended [($5,000) from ABC & ($2,000) from CHI].

Question 27

Section 469 requires taxpayers to classify their income into what three categories?

Answer 27

Section 469 requires taxpayers to classify their income into three categories:
* active income (e.g., wages, salaries, and active business income),
* portfolio (i.e., investment) income, and
* passive income.

Question 28

What is included in Portfolio income?

Answer 28

Portfolio income includes dividends, interest, annuities, and royalties (and allocable expenses and interest expenses) that are not derived in the ordinary course of a trade or business. Gains and losses on property that produces these types of income also are included in portfolio income if the disposition of the property does not occur in the ordinary course of business. Portfolio income becomes part of net investment income, which is used in computing the deduction limit for investment interest expense.

Question 29

Passive Income and Losses - Duration Calculation Example:

During the year, Kasi, a CPA, reports $100,000 of active business income from his CPA practice. He also owns two passive activities. From activity A, he earned $10,000 of income, and from activity B, he incurred a $15,000 loss. Kasi may use $10,000 of the loss from activity B to offset the $10,000 of income from activity A. However, Kasi may not deduct the $5,000 excess loss from Activity B in the current year, even though he has $100,000 of active business income.

Answer 29

Taxpayers compute income and loss in the passive category separately for each passive activity in which they have invested. In general, for any tax year, losses generated in one passive activity may be used to offset income from other passive activities, but may not offset either active or portfolio income.

Question 30

Carryover Example:

Tammy reports the following income and loss for the year:
* Salary $200,000
* Loss from activity X ($40,000)
* Loss from activity Y ($10,000)
* Income from activity Z $30,000

X, Y, and Z are all passive activities. The losses generated in activities X and Y offset the income from activity Z, but none of the salary income is offset. Thus, Tammy has a net passive loss for the year of $20,000 ($40,000 + $10,000 - $30,000), which must be carried over to subsequent years.

The amount of the carryover attributable to each activity is as follows:
* Activity X: $20,000 x ($40,000 ÷ $50,000) = $16,000
* Activity Y: $20,000 x ($10,000 ÷ $50,000) = $4,000

Answer 30

Passive activity losses that are disallowed as deductions for the year in which they are incurred are carried over indefinitely and treated as losses allocable to that activity in the following tax years. These losses, known as suspended losses, may offset passive activity income of the subsequent year, but generally may not offset other types of income. If a taxpayer has invested in several passive activities, and for the year some of the activities generate income while others generate losses, the loss carried over for each loss activity is a pro-rata portion of the total passive loss for the year.

Question 31

Passive activity losses that are disallowed as deductions for the year in which they are incurred and then are carried over indefinitely & treated as losses allocable to that activity in the following tax years are called __ ____??____ __ or carryovers.
* suspended losses
* credits
* deductions
* withholdings

Answer 31

suspended losses

Suspended losses may offset passive activity income of the subsequent year, but generally may not offset other types of income.

Question 32

Disposition of Interest Example:

During the current year, Pam realizes $6,000 of taxable income from activity A, $1,000 of loss from activity B, and $8,000 of taxable income from activity C. All three activities are passive activities with regard to Pam. In addition, $30,000 of passive losses from activity C has been carried over from prior years. During the current year, Pam sells activity C for a $15,000 taxable gain. Pam reports salary income of $90,000 for the year. Activity C is disposed of in a fully taxable transaction, so, Pam may deduct $2,000 of loss against the salary income, as follows:

Income for the year from C $8,000
Gain from the sale of C 15,000
Suspended losses from C (30,000)
———-
Total loss from C ($7,000)
Income for the year from A $6,000
Loss for the year from B (1,000) 5,000
———-
Pam’s deduction against salary income ($2,000)

Answer 32

When a taxpayer disposes of a passive activity to an unrelated third party in a taxable transaction, the economic gain or loss generated by the activity can be computed, and the suspended losses of that activity may be deducted against the taxpayer’s other income. However, the amount of the total net economic loss from the asset that is disposed of must first offset any passive income from other passive activities.

If the taxpayer sells the passive activity to a related party, the suspended loss is not deductible until the related party sells the activity to a non-related person.

Although the death of a taxpayer is not a taxable disposition of the asset, some of the suspended losses may be deducted when a taxpayer dies. The amount of the deduction allowed is the amount by which the suspended losses exceed the increase in the basis of the property. These losses generally are deducted on the decedent’s final income tax return. Any suspended losses up to the amount of the increase in basis are lost.

In general, the suspended losses of a passive activity become deductible only when the taxpayer completely disposes of his or her interest in the activity. However, in Treasury Regulation 1.469-4(g) the government has stated that taxpayers may treat the disposition of a substantial part of an activity as the disposition of a separate activity. This treatment is only available, however, if the taxpayer can establish with reasonable certainty the amount of income, deductions, credits, and suspended losses and credits that are allocable to that part of the activity.

Question 33

Former Passive Activity Example:

Kris owns activity A, which, for the immediately preceding tax year, was considered a passive activity with regard to Kris. $10,000 in losses from activity A were disallowed and carried over to the current year. Due to Kris’ increased involvement in activity A in the current year, it is no longer considered a passive activity. During the current year, activity A generates a $5,000 loss. In addition, this year, Kris also has an investment in activity B, a passive activity. Her share of activity B’s income is $7,000. Kris also reports $60,000 in salary. As activity A is not a passive activity for the current year, the $5,000 current year loss is fully deductible against her salary. However, the $10,000 loss carryover from the prior year is deductible only against the $7,000 of income from passive activity B. The $3,000 ($10,000 - $7,000) excess is carried over to the subsequent year.

Answer 33

The determination of whether an activity is passive with respect to a taxpayer is made annually. Thus, an activity that was previously considered passive may not be passive with respect to the taxpayer for the current year. This is called a former passive activity. Any loss carryover from a former passive activity is deductible against the current year’s income of that activity even though the activity is not a passive activity in the current year. However, any suspended loss in excess of the activity’s income for the year is still subject to carryover limitations. Since the activity is no longer passive for the year, the current year’s loss is deductible against active business income.

Question 34

Bess owns activity X, which produced a $15,000 passive loss last year. Her only income last year was wages of $20,000.
Bess is a material participant in activity X this year when it produces a $10,000 loss. This year, her wages are $30,000. She also has passive income from activity Y of $8,000 this year.
What is Bess’s total passive activity loss carryover to next year?
* $17,000
* $2,000
* $7,000
* $0

Answer 34

$7,000

The $15,000 of passive activity losses from last year is offset by $8,000 of passive income from activity Y this year. This leaves $7,000 to be carried over to next year. The $10,000 of loss from activity X is not passive this year since Bess is now a material participant.

Question 35

Credits Example:

Dale invests in a passive activity. For the year, he must report $10,000 of taxable income from the passive activity. Dale’s share of tax credits generated by the passive activity is $5,000. Assume Dale’s pre-credit tax liability on all income (including the $10,000 from the passive activity) is $25,000, and his pre-credit tax liability on all income excluding the passive activity income is $22,000. He may use only $3,000 ($25,000 - $22,000) of the tax credits generated by the passive activity. The remaining $2,000 of tax credits is carried forward and may be used in a subsequent year against the portion of the tax liability attributable to passive activity income in that year. However, these credits may not offset any portion of the tax liability attributable to non-passive activities.

Answer 35

Credits generated in a passive activity are also limited and may be used only against the portion of the tax liability that is attributable to passive income. This amount is determined by comparing the tax liability on all income for the year with the tax liability on all income excluding the passive income.

Question 36

In general, losses from passive activities may offset portfolio income.
* False
* True

Answer 36

False

Taxpayers need to calculate income and loss in the passive activity separately for each passive activity in which they are invested. For any tax year, losses generated in one passive activity may be used to offset income from other passive activities, but may not offset either active or portfolio income. Carryover passive losses may offset passive activity income in the subsequent year, but generally may not offset other types of income.

Question 37

Dan died during the current year. He owned passive activity property with a FMV of $40,000 and a basis of $36,000. $12,000 of suspended losses were attributable to the property.
How much of the suspended loss is deductible on Dan’s final income tax return?
* $0
* $4,000
* $8,000
* $12,000

Answer 37

$8,000

($40,000 - $36,000) is an increase in basis; $4,000 of suspended losses are lost. $12,000 - $4,000 = $8,000

Question 38

In the current year, Alice reports:
a salary of $150,000
income of $20,000 from activity X
losses of $35,000 from activity Y
losses $15,000 from activity Z
All three activities are passive with respect to Alice and are purchased during the current year.
What is the amount of loss that must be carried over with respect to all of these activities?
* $21,000
* $9,000
* $30,000
* $12,000

Answer 38

$30,000

Net passive loss = $30,000
Loss attributable to activity Y = $21,000
Loss attributable to activity Z = $9,000

Salary $150,000
Income from activity X $20,000
Loss from activity Y ($35,000)
Loss from activity Z ($15,000)

Thus,
Net passive loss = $30,000
Carryover for activity Y = (30,000 x 35,000)/50,000 = $21,000
Carryover for activity Z = (30,000 x 15,000)/50,000 = $ 9,000

Question 39

Joe Buckner has the following current-year passive income and loss amounts:
$8,000 income from ABC limited partnership (publicly traded)
($4,000) loss from CHI limited partnership (publicly traded)
$13,000 income from JKL limited partnership (nonpublicly traded)
($16,000) loss from RST limited partnership (nonpublicly traded)
What is the total amount of passive losses that may be deducted during the current year?
* ($4,000)
* ($13,000)
* ($16,000)
* ($20,000)

Answer 39

($13,000)

The $8,000 income from ABC, since it is publicly traded (a PTP), must be reported and the only loss that could ever be used to defray this income is a loss from that same partnership, i.e. a suspended loss carried over from last year. The $4,000 loss from CHI, also a PTP, must be suspended and cannot be used.

The only loss that can be used is $13,000 of the $16,000 loss from RST. This will serve to reduce the $13,000 income from JKL down to zero.

The remaining $3,000 loss from RST that can’t be used will be suspended and carried over to next year.

Question 40

Describe Real Estate Exceptions

Answer 40

In general, rental activities are considered passive activities. However, the passive activity rules do not apply to certain taxpayers that are involved in real property trades or businesses. Instead, these activities are treated as active businesses. A real property trade or business involves the development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokering of real property.

This exception applies to taxpayers if both of the following requirements are met:
* More than one-half of the personal services the taxpayer performs in all trades or businesses during the year must be performed in real property trades or businesses in which the taxpayer materially participates.
* The taxpayer must perform more than 750 hours of work during the taxable year in real property trades or businesses in which the taxpayer materially participates.

In meeting these tests, personal services a taxpayer renders in his or her capacity as an employee are not treated as performed in real property trades or businesses unless the employee owns at least 5% of the employer. Furthermore, for married taxpayers filing a joint return, the exception applies only if one of the spouses separately meets both requirements. The time spent in the activity by both spouses is not used to determine whether or not the material participation test is met.

Question 41

When can a taxpayer still may deduct up to $25,000 of annual losses from these passive rental real estate activities against other income?
List 2 requirements to meet this exception.

Answer 41

Many rental real estate activities are not considered rental real estate businesses and are therefore subject to the passive loss rules.

However, if an individual taxpayer meets specific requirements, the taxpayer still may deduct up to $25,000 of annual losses from these passive rental real estate activities against other income.

In order to meet this exception, an individual must do both of the following:
* Actively participate in the activity, and
* Own at least 10% of the value of the activity for the entire tax year.

Question 42

Define Active Participation

Answer 42

A taxpayer can achieve active participation, as opposed to material participation, without regular, continuous, and material involvement in the activity and without meeting any of the material participation tests. However, the taxpayer still must participate in the making of management decisions or arranging for others to provide services in a significant and bona fide sense. This includes approving new tenants, deciding on rental terms, approving expenditures, and other similar decisions.

Active participation may be achieved even if the taxpayer hires a rental agent and others provide the services. In general, a limited partner is not able to participate actively in any activity of a limited partnership.

Question 43

What’s special about Rehabilitation, Revitalization, and Low Income Housing Credits?

Answer 43

Tax credits earned from real estate due to historic rehabilitation, business revitalization, or low-income housing may be used to reduce active and portfolio income up to an amount equal to a $25,000 deduction, even if the taxpayer does not actively participate. These activities, which would otherwise be subject to the passive loss rules, get special treatment to encourage investment in these areas.

Question 44

What is the Limitation on Deduction?

Answer 44

Taxpayers must first apply rental real estate losses for active participation against other net passive income for the year. Taxpayers may then deduct these losses against their portfolio or active business income up to $25,000. The $25,000 limit, however, is reduced by 50% of the taxpayer’s adjusted gross income (AGI) in excess of $100,000. For this purpose, AGI is determined without regard to any passive activity loss or to any loss allowable to taxpayers who materially participate in real property trades or businesses such as real estate development. So, if a taxpayer has AGI of $150,000 or more, all of the rental real estate losses must be suspended and carried over with the taxpayer’s other passive losses.

For historic rehabilitation credits, the phase-out begins at $200,000 of AGI rather than $100,000. Therefore, the taxpayer loses the benefit of the deduction completely if his or her AGI exceeds $250,000.

There is no phase-out for business revitalization or low-income housing credits.

Question 45

Active Participation Example:

Hal owns over 10% and actively participates in activity A, which is a passive real estate rental activity. Hal’s marginal tax rate is 24% and he has an AGI of less than $100,000. For the year, activity A generates a $20,000 net loss and $10,000 in tax credits (which amounts to $41,667 in deduction equivalent ($10,000/0.24). After deducting the $20,000 net loss against his active business and portfolio income, Hal has a remaining real estate deduction under the limit of $5,000 ($25,000 - $20,000). Thus, Hal may use $1,200 ($5,000 x 0.24) of the credits. The remaining $8,800 ($10,000 - $1,200) of tax credits must be carried over to subsequent years.

Answer 45

The $25,000 limit applies to the sum of both deductions and credits. In order to properly apply the limit, taxpayers must convert the credits into deduction equivalents. A deduction equivalent is an amount that, if taken as a deduction, would reduce the tax liability by an amount equal to the credits. The amount of the deduction equivalents can be computed by dividing the amount of the credit by the taxpayer’s marginal tax rate. If the sum of the deductions and the deduction equivalents exceeds the $25,000 limit, the deductions are used first.

If deductions and credits exceeding the $25,000 limit arise from more than one passive activity, they must be allocated between the activities.

Question 46

Vacation Home Rules and Mixed-use Properties

Define Personal-use property, Rental use property, and Mixed-use property

Answer 46

• Personal-use property is rented for 14 days or less. Income does not have to be reported. This applies to both the taxpayer’s primary residence and to the vacation home. The only expenses allowed as itemized deductions are mortgage interest and property taxes. These deductions are limited to the primary residence as well as one vacation/mixed-use property.
• Rental use property is determined by the personal use of the property for no more than the greater of 14 days or 10% of the number of days rented at fair rental value. All expenses allocated to the rental are allowed, and the property can produce passive losses subject to the passive activity rules.
• Mixed-use property is the result of personal use exceeding the greater of 14 days or 10% of the number of days rented at fair rental value. Deductions are limited to gross rental income, and any unused losses are carried forward to future years.

Question 47

Section Three Summary

The conduct of the trade or business of rental and real estate property does not come under passive activity loss rules. In addition, there are certain real estate rental activities that may allow for the deduction of up to $25,000 against other income even though the activities are passive. There are limitations on the deductions that can be made on the rental real estate losses against other income for the year.

Answer 47

In this lesson, we have covered the following:
* The rental real estate trade or business: The passive activity loss rules do not apply. In fact, activity in a rental real estate business is considered active when it involves development, redevelopment, construction, acquisition, conversion, rental, operation, management, leasing, or brokering of real property. This exception is applicable if taxpayers meet some requirements.
* Other rental real estate activities include active participation in real estate rental activity, rehabilitation, and revitalization, and provide low-income housing credits that allow up to $25,000 of deductions against other income. There are limitations on the use of such deductions depending on the taxpayer’s adjusted gross income (AGI).

Question 48

Module Summary

Material participation in the operations of a business has become a major concern for the IRS and for taxpayers. The IRS asks questions about material participation to categorize businesses as either active or passive. In 1986, the Passive Activity Limitation (PAL) rules were introduced to limit taxpayers from using losses and credits from sources that did not require an active role by the taxpayer. So, when you invest in real estate or you own limited partnership interests, the tax loss limitation rules apply to these passive activities.

The key concepts to remember are:

Answer 48

• At-Risk Rules: Any pass-through loss can only be used to the extent that a taxpayer has a sufficient amount at-risk (basis). These rules are applied prior to the passive activity rules, and only amounts that pass the at-risk rules are then subject to the passive activity rules.
• Passive Activity Definition: Any trade or business activity in which the taxpayer does not materially participate. Includes all rental activities except for certain rental real estate activities and exceptions contained in regulations. Does not include working interests in oil and gas property.
• Passive Losses: Passive losses are deductible against passive income, but not against active or portfolio income. Disallowed losses are carried over to subsequent years (suspended losses). Losses must be accounted for separately by activity.
• Real Estate Exceptions: Individuals may deduct losses up to $25,000 against active and portfolio income if they actively participate in the activity. This is a lesser standard than material participation, but the taxpayer must still participate in management decisions or arrange for others to provide services. The deduction phases out at a 50% rate for AGI in excess of $100,000. Rehabilitation, revitalization, and low-income housing credits state that $25,000 in deductions can be taken for rehabilitation, revitalization, and low-income housing credits generated by real estate ownership even if the taxpayer does not actively participate in the enterprise. The deduction for rehabilitation credits phases out at a 50% rate for AGI in excess of $200,000. There is no phase-out for revitalization and low-income housing credit amounts.

Question 49

Passive losses of a personal service corporation (PSC) may NOT offset
I. the PSC’s active business income
II. portfolio income
* Both I and II
* II only
* I only
* Neither I nor II

Answer 49

Both I and II

The passive losses of a PSC may not offset the PSC’s active business income or portfolio income.

Question 50

A __ ____??____ __ is a partnership where interest in the partnership is either traded on an established securities market or readily available for trading on a secondary market.
* Publicly traded partnership (PTP)
* Personal service corporation (PSC)
* Closely held C corporation
* Specified service trade or business (SSTB)

Answer 50

Publicly traded partnership (PTP)

A publicly traded partnership (PTP), for purposes of the passive loss rules, is defined as any partnership where interest in the partnership is either traded on an established securities market or readily available for trading on a secondary market.

Question 51

The passive loss limitation rules apply to (select all that apply):
* Any personal service corporation
* Individuals, estates, and trusts
* Certain publicly traded partnerships
* Any closely held C corporation

Answer 51

The passive loss limitation rules apply to:
* Any personal service corporation
* Individuals, estates, and trusts
* Certain publicly traded partnerships
* Any closely held C corporation

Each of these entities is subject to passive loss rules.

Question 52

Active participants in a real estate business may be eligible to deduct up to __ ____??____ __ of passive losses that can be used to offset passive, portfolio, or active business income.
* $50,000
* $10,000
* $20,000
* $25,000

Answer 52

$25,000

Taxpayers must first apply rental real estate losses for active participation against other net passive income for the year. Taxpayers may then deduct these losses against their portfolio or active business income up to $25,000.

Question 53

Identify the categories of income according to IRC Section 469 (select all that apply).
* adjusted gross income
* portfolio income
* passive income
* gross income
* active income

Answer 53

portfolio income
passive income
active income

IRC Section 469 requires taxpayers to classify their income into three categories:
* active income (e.g., wages, salaries, and active business income),
* portfolio (i.e., investment) income, and
* passive income.

Question 54

One of the exceptions to the passive loss rules is __ ____??____ __.
* involvement in a closely held C corp
* a trade or business that manages rental operations
* a personal service corporation
* a working interest in an oil or gas property

Answer 54

a working interest in an oil or gas property

One of the exceptions to the passive loss rules is a working interest in an oil or gas property.

A working interest is an interest that is responsible for the cost of the development or operation of the oil and gas property.

Question 55

Publicly traded partnerships (PTPs) are able to carry losses forward and use them to offset __ ____??____ __.
* passive income from any source
* net income from the PTP
* income generated by any other PTP
* income generated by that specific PTP

Answer 55

income generated by that specific PTP

In many cases, a publicly traded partnership (PTP) is treated for tax purposes as a corporation. A PTP, for purposes of the passive loss rules, is defined as any partnership where interest in the partnership is either traded on an established securities market or readily available for trading on a secondary market.

Question 56

Each of the following is a test to determine material participation EXCEPT:
* The individual participated in the activity in any non-consecutive five years during the immediately preceding ten taxable years.
* The individual participates in the activity for more than 750 hours during the year.
* The individual’s participation in the activity for the year constitutes substantially all of the participation in the activity by all individuals.
* The individual participates in the activity on a regular, continuous, and substantial basis during the year.

Answer 56

The individual participates in the activity for more than 750 hours during the year.

One of the material participation requirements states that the individual participates in the activity for more than 500 hours during the year, not 750.

Question 57

A closely held C corporation is a C corporation where five or fewer individuals own more than __ ____??____ __ of the stock at any time during the last half of the corporation’s taxable year.
* 25%
* 50%
* 80%
* 75%

Answer 57

50%

A closely held C corporation is a C corporation where five or fewer individuals own more than 50% of the stock at any time during the last half of the corporation’s taxable year.

Question 58

Losses generated in one passive activity may be used to offset income from __ ____??____ __.
* portfolio income
* other passive activities
* income derived from all sources
* active income sources

Answer 58

other passive activities

Taxpayers compute income and loss in the passive category separately for each passive activity in which they have invested. In general, for any tax year, losses generated in one passive activity may be used to offset income from other passive activities, but may not offset either active or portfolio income.