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1

Joel just purchased an interest in a partnership. As a limited partner, he will not participate in management decisions of the partnership. Which of the following statements regarding the tax implications of this arrangement is CORRECT?

I. Joel must take into consideration the at-risk rules.
II. Joel is subject to the passive activity loss rules.

I & II

Joel will be subject to both the at-risk rules and the passive activity loss rules when determining the deductibility of any losses on the rental activity.

2

Janet has carryover losses of $25,000 from a RELP. Her AGI is $200,000 in the current year. She still owns her interest in the RELP. What can Janet do to use her RELP losses against her other income in the current year?

I. Sell her entire interest in the RELP to an unrelated party.
II. Buy an MLP that generates income.

I only.

Losses from a non-publicly traded partnership may only offset income from another non-publicly traded partnership. Her only option is to attempt to sell her entire interest in the RELP to an unrelated party.

3

Which of the following statements regarding the full or partial sale of a passive activity interest in a particular parcel of real estate is or are CORRECT?

I. Suspended amounts and credits cannot be used when there is a partial sale.
II. Suspended amounts and credits may only be used to offset income for the current passive activity.

I only.

Only a full sale of a passive activity allows the taxpayer to deduct any suspended losses against passive or portfolio income. The losses must first be applied against income or gain from the passive activity, second, against income from all passive activities, and third, against all other income or gain. Regarding a partial disposition, no suspended losses or credits may be used until the entire activity is sold or disposed of.

4

Joseph, age 54 and single, earns a salary of $190,000 working for a manufacturing company. He is an avid saver and over the years has amassed an investment portfolio of $2 million. He expects the portfolio to appreciate in value at an average rate of 8% per year. Last year, he received dividends and interest from the portfolio of $40,000. After speaking with a financial planner, Joseph decided to invest $50,000 of his portfolio to purchase a 15% interest in a passive activity. Operations of the activity have now resulted in a loss of $400,000, of which Joseph’s share is $60,000. How is Joseph’s loss for the current year characterized for income tax purposes?

A. $60,000 is suspended under the passive activity loss rules.
B. $60,000 is suspended under the at-risk rules.
C. $10,000 is suspended under the at-risk rules, and $50,000 is suspended under the passive activity loss rules.
D. $50,000 is suspended under the at-risk rules, and $10,000 is suspended under the passive activity loss rules.

C.

The at-risk rules must be applied before the passive loss rules. Joseph invested $50,000 in the passive activity. Therefore, his at-risk amount is $50,000. Because his share of the loss from the activity is $60,000, Joseph will be allowed to deduct only $50,000, his amount at risk. In addition, $10,000 of the loss ($60,000 total less $50,000 deductible under at-risk rules) has been suspended because of the at-risk rules and must be carried forward. Even though Joseph has a $50,000 loss after applying the at-risk rules, he is still not permitted a deduction for the loss because he has no passive income. Through application of both rules, the entire loss of $60,000 is suspended for the current tax year.

5

In the current year, Bob invested $50,000 for a 20% interest in a partnership in which he was a material participant. The partnership incurred a loss, and Bob’s share was $75,000. Which of the following statements regarding Bob’s investment is NOT correct?

A. Because Bob has only $50,000 of capital at risk, he can never deduct more than $50,000 against his other income.
B. Bob’s nondeductible loss of $25,000 may be carried forward and used when the at-risk rules permit the claiming of such amount.
C. If Bob has taxable income of $30,000 from the partnership in the following year (and no other transactions that affect his at-risk amount), he can use all of the $25,000 loss carried forward from this year.
D. Bob’s $75,000 loss is nondeductible in the current year and in the following year under the passive activity loss rules.

A.

The correct analysis of the tax treatment of Bob’s income is that he is limited to a $50,000 deduction against his other income because that is his at-risk amount. The remaining $25,000 is a loss carryforward. If he has taxable income of $25,000 or more in subsequent years, then Bob’s disallowed loss may be taken. The at-risk rules are applied before the passive activity rules.

6

Paula purchased an interest in an MLP with a current loss of $7,000. If she purchased a RELP with $10,000 of passive income generated this year, how much, if any, of the passive loss from the MLP could be used to offset Paula’s income in the current year?

A. $0 B. $3,000 C. $7,000 D. $10,000

A.

Losses from MLPs cannot be used to offset income from RELPs in any given year. MLP losses may only be used to offset income from the same MLP.

7

Carter, an unmarried individual, had an AGI of $180,000 in the current year before any other above-the-line deductions. He incurred a loss of $30,000 from rental real estate in which he actively participated. What amount of loss, if any, may be used in the current year as an offset against Carter’s active or portfolio income?

A. $0 B. $12,500 C. $25,000 D. $30,000

A.

An exception to passive loss limits regarding rental real estate allows a small investor to deduct annually up to $25,000 of losses against other income. However, this annual deduction is reduced by 50% of the taxpayer’s AGI in excess of $100,000. Thus, the deduction is entirely phased out at $150,000 of AGI. Carter’s AGI is more than this, so he cannot deduct any of his $30,000 loss.

8

Which of the following rules or doctrines may limit the availability of income tax benefits from a particular investment?

I. Tax conduit
II. The substantial economic effect doctrine
III. The at-risk rule
IV. The passive activity loss rule

II, III, & IV

The substantial economic effect doctrine limits the ability to use special allocations in a partnership. The at-risk rule limits the ability to use leverage by attacking the use of nonrecourse financing. The passive activity loss rule limits the ability to deduct losses from activities in which the taxpayer does not materially participate.

9

Which of the following is NOT one of the methods by which an S corporation can be terminated?

A) When it fails to meet the requirements of a small business corporation
B) If gross income for 3 years in a row is of a certain type that exceeds a certain share of total income
C) If it earns more than $10 million in gross receipts in any one year
D) A majority vote of the shareholders

C.

The only time that earnings can revoke the S status is when more than 25% of gross receipts for three successive years come from certain types of passive income and the corporation has accumulated earnings and profits from its operations prior to the S election.

10

Which of the following may enable a direct participation program to provide specific tax advantages to the investors?

A) Passive activity loss rules
B) Special allocations
C) Partnership basis rules
D) At-risk rules

B.

The benefits that flow through from a partnership entity may be enhanced by the potential, under certain circumstances, "special allocation" of certain items of income, expense, gain, or loss. The passive activity loss rules state that passive losses may only be deducted against passive income (not a tax advantage); there are no partnership basis rules; and the at-risk rules are defined as the maximum deductible loss for an investment limited to the amount that the taxpayer-investor has at risk at the end of the current year. None of the other answers are direct participation programs, which concern business organizations that function as tax conduits.

11

Jasper invested $20,000 for a 30% interest in a nonpublicly traded limited partnership. Jasper is not a material participant. The partnership has a loss this year and Jasper's share is $15,000. This is the only nonpublicly traded limited partnership Jasper owns an interest in, but Jasper did have portfolio income of $9,000 in the same year in addition to his salary of $150,000. How much of the loss can Jasper deduct this year?

A) $6,000
B) $15,000
C) $0
D) $9,000

C.

Because Jasper has no passive income to offset the passive loss, the loss is suspended under the passive activity loss rules.

12

Upon the disposition of a passive activity interest by gift, the suspended losses are

A) completely lost.
B) added to the basis of the interest.
C) deductible to the extent the losses exceed any increase in the fair market value of the activity.
D) deductible in full.

B.

Upon the disposition of a passive activity by gift, the suspended losses are added to the basis of the activity.

13

Study Note:

A vacation home can be classified as a personal residence, a rental property, or a mixed-use property. A personal residence is a property that is rented out for less than 15 days per year. Because the beach house was rented for 11 weeks, it will be classified as either a rental property or a mixed-use property. The determination is based on the number of days the taxpayer used the residence for personal use. To qualify as rental property, the personal use cannot exceed the greater of 14 days per year or 10% of rental days. The property was used for personal use for 16 days, so the vacation home will be considered a mixed-use property. Expenses incurred on a mixed-use property must be allocated between rental use and personal use. The rental expenses on a mixed-use property are only deductible to the extent of rental income received (i.e., the taxpayer cannot claim a loss). The expenses not deducted in the current year may be carried forward.

14

Which of the following statements correctly identify the requirements necessary to deduct $25,000 of losses from an active participation real estate program?

I. The property cannot be used as a vacation home for more than 14 days or 10% of the number of days during the year that the home was rented at a fair rental price., whichever is greater
II. The taxpayers can file as MFS.
III. The taxpayer must make the major management decisions related to the property.
IV. The taxpayer's interest in the property may not be held as a limited partnership interest.

I, III, & IV

If the taxpayers file with the MFS status, the deduction is limited to $12,500. All other statements are true.

15

In the current year, Keith had passive losses of $19,000 from a real estate limited partnership purchased in 1985. He also had passive income of $7,000 from an oil and gas limited partnership. Both limited partnerships are not publicly traded.

What is the total amount of passive losses that may be used to offset active, passive, and portfolio income in the current year?

A) $7,000
B) $9,400
C) $8,200
D) $1,900

A.

The passive loss ($19,000) is deductible, but only up to the amount of passive income ($7,000) in the same year; thus, the answer is $7,000.

16

Which one of the following is CORRECT regarding an active participation rental real estate activity?

A) A deduction of up to $25,000 is available annually.
B) A cumulative deduction-equivalent tax credit of up to $25,000 is available over the life of the activity.
C) A cumulative deduction of up to $25,000 is available over the life of the activity.
D) A deduction-equivalent tax credit of up to $25,000 is available.

A.

In meeting several tests, an individual with active participation in real estate may deduct up to $25,000 of rental real estate losses against active and portfolio income in any one year.

17

You are a CFP® professional and are meeting with your client Brenda to monitor her ongoing financial status. Brenda owns a vacation home in New Mexico. She is now renting the property to others for the entire year except for 10 days during the summer when she and her family used it for their vacation. The gross rental income that Brenda received is $65,000. The expenses for the home for both the rental period and her personal use total $5,000. Brenda would like you to explain how this will change her income tax situation, in particular, how much of the rental expenses are deductible. After reviewing the documents she sent to you prior to the meeting, you have an answer for Brenda. How much of a deduction for rental expenses can Brenda take on her tax return?

A) $3,411
B) $4,721
C) $5,000
D) $4,863

D.

Brenda can deduct the cost of renting the home if she occupies it for the greater of no more than 14 days per year or for 10% of the number of days the property is rented. Because Brenda occupies the house for only 10 days during the year, this test is satisfied. Even though this rental use exception is allowed, the deductible expenses related to the rental of the house are limited. Specifically, she can only deduct a portion of the actual rental expenses, which equals the number of days during the year that the house is rented to others divided by the total number of days that the house is used by either tenants or Brenda. Given 365 days per year, Brenda's tenants occupy the house all but 10 days, for a total of 355 days. She is allowed to deduct 97.26% (355 days ÷ 365 days) of the $5,000 rental expenses, which equals $4,863.

18

Erma, age 40, anticipates an adjusted gross income of $177,000 for the current tax year. All her income is attributable to active and portfolio income. She would like to acquire an investment that would reduce her tax liability without exposing her to personal liability. Which one of the following investments is the most appropriate for Erma?

A) An "active participation" investment in rental real estate that will produce losses
B) A master limited partnership that will produce passive losses
C) A historic rehabilitation real estate limited partnership that will produce rehabilitation tax credits
D) An oil and gas working interest that will produce losses

C.

Erma's AGI is too high to claim the active participation real estate exception. Losses from a master limited partnership can only be deducted against income generated by the same partnership in another tax year. The oil and gas working interest will generate unlimited liability. Thus by process of elimination, the correct answer is historic rehabilitation credit.

19

MSC, Inc. is a closely held C corporation that manufactures boilers. The company has been in business for over 45 years. MSC has active income this year of $250,000 and no passive or portfolio income. The company also leases equipment that generates passive losses of $120,000 per year. How much of the passive loss can the company use this year?

A) $100,000
B) $0
C) $25,000
D) $120,000

D.

The company can deduct the entire $120,000 because it is a closely held C corporation that is not a personal service corporation. Passive losses may be used to offset active income, but not portfolio income.

20

Philip, a professor, earned a salary of $140,000 from a university in the current year. He received $35,000 in dividends and interest during the year. In addition, he incurred a loss of $25,000 from an investment in a passive activity. His at-risk amount in the activity at the beginning of the current year was $15,000. What is Philip's adjusted gross income (AGI) for the current year?

A) $115,000
B) $150,000
C) $175,000
D) $160,000

C.

Philip's AGI, after considering the passive investment, is $175,000 ($140,000 active income + $35,000 portfolio income). He cannot offset the passive loss against active or portfolio income. The loss may be deducted only against passive income, which he does not have in the current year.

21

Which of the following forms of business may be classified as direct participation programs?

I. General partnership
II. Limited partnership
III. S corporation
IV. Closely held C corporation

I, II, & III

The tax advantages provided by direct participation programs are founded upon the principle that most types of business organizations function as tax conduits; therefore, a closely held C corporation cannot qualify as there is no flow through of gains and losses.

22

Which one of the following best describes the role of a special allocation in a limited partnership?

A) It allows an allocation of items of income and expense that is not pro rata.
B) It requires all items to be distributed pro rata based on a partner’s capital account balance.
C) It establishes the standards for allocating the proceeds of non-routine or "special" items of income.
D) It allocates management responsibility to the general partners.

A.

A special allocation allows an allocation of items in a manner that differs from the "normal" pro rata allocation of deduction, income, credit, etc.

23

The partner's tax basis in his interest in a partnership

A) remains unchanged unless additional capital is contributed or distributions are made.
B) is increased by his share of income reported by the partnership.
C) is decreased if additional capital is contributed.
D) remains unchanged until the interest is sold or otherwise disposed.

B.

A partner's tax basis in a partnership interest is affected by items of income or loss, which are passed through to the partner on a proportionate basis. Items of income, as well as capital contributions, increase basis; deductions, as well as distributions, decrease basis.

24

Which of the following statements regarding limited partnerships is CORRECT?

I. A limited partner is subject to the passive activity rules when accounting for income and losses from the limited partnership.

II. The limited partner is liable to the creditors of the partnership only to the extent of that partner's contributed or promised cash or property.

Both statements are correct

25

To which of the following do the passive activity loss rules apply?

I. Individuals
II. C corporations that are not closely held
III. Closely held C corporations
IV. Estates

I, III, & IV

Of the listed choices, option II is the only option to which the passive activity loss rules do not apply. The passive activity loss rules specifically do not apply to C corporations that are not closely held.

26

Bob passed away during the current year. He had suspended losses from a limited partnership activity of $25,000. Bob's basis in the partnership was $1,000 and the fair market value at the time of his death was $18,000. What amount of passive losses, if any, is deductible on Bob's final income tax return?

A) $0
B) $17,000
C) $14,000
D) $8,000

D.

The suspended passive losses are "freed up" and deductible only to the extent that the losses exceed the step-up in basis. In this situation, the step-up in basis equals $17,000 (from $1,000 to $18,000). The losses of $25,000 exceed the step-up amount by $8,000.

27

Cindy has adjusted gross income (AGI) of $350,000. Included in the AGI is passive income of $40,000 and passive losses of $55,000, $40,000 of which she uses to offset the passive income and $15,000 of which is subject to carryforward. Which one of the following activities has the greatest potential for reducing Cindy's tax liability?

A) None of these options will reduce Cindy's tax liability
B) Investing in an oil and gas limited partnership that is generating losses
C) Investing in "active participation" rental real estate that is producing a loss
D) Investing in a real estate partnership in which she will not materially participate that is producing passive losses

A.

The active participation deduction is eliminated at $150,000 of AGI. The oil and gas limited partnership and the equipment-leasing limited partnership would produce more passive losses that are nondeductible. Therefore, none of the options are viable.

28

Patty has a $10,000 passive loss carryforward from Beta limited partnership, which is publicly traded. She also has a $15,000 passive loss carryforward from Alpha limited partnership, which is nonpublicly traded. In the current year, she has $6,000 of income from Beta. She also has $11,000 of income from Gamma LP. Gamma is not publicly traded. What is the total amount of passive losses that Patty may deduct during the current year?

A) $17,000
B) $25,000
C) $11,000
D) $6,000

A.

Of the $10,000 passive loss carryforward from the Beta limited partnership, only $6,000 may be utilized in the current year due to the $6,000 of current year passive income. A total of $11,000 in losses from the Alpha limited partnership may be utilized against the $11,000 of income from the Gamma limited partnership in the current year because both are nonpublicly traded. Thus, the total of passive losses that are allowed for the current year is $17,000.

29

Nathan has a salary of $100,000, dividends of $4,000, and limited partnership income of $10,000. The limited partnership is publicly traded. During January of the current year, Nathan purchased an interest in a non-publicly traded limited partnership that will generate a $12,000 passive loss during the current tax year. How much of this passive loss, if any, is deductible by Nathan during the current tax year?

A) $4,000
B) $0
C) $12,000
D) $10,000

B.

The general rule is that passive losses are deductible only against passive income. However, passive income from a publicly traded partnership cannot be offset by passive losses arising from any other source. Thus, the passive losses from the new partnership will not be deductible.

30

Paul has the following items:

Carryforward of prior year passive loss from:

XYZ limited partnership (publicly traded) $(10,000)
ABC limited partnership (nonpublicly traded) $(6,000)

Current year passive income and loss from:

XYZ limited partnership (publicly traded) $12,000
GHI limited partnership (publicly traded) $(9,000)
JKL limited partnership (nonpublicly traded) $18,000
RST limited partnership (nonpublicly traded) $(14,000)

What is the total amount of passive losses that Paul may deduct during the current year?

$28,000

Publicly traded partnership (PTP) income may only be offset by prior year losses from the same partnership. Thus, the $10,000 XYZ carryforward is deductible. Nonpublicly traded income ($18,000) may be offset by current losses ($14,000) or carryforward losses ($6,000) from any nonpublicly traded activities. Thus, the $10,000 XYZ loss and the $18,000 nonpublicly traded loss total $28,000.

31

Which of the following statements regarding passive activity losses is CORRECT?

I. When determining the amount of suspended loss that may be used against income, the at-risk rules are applied before the passive activity loss rules.
II. If a loss is not allowed because of the at-risk limitations, the loss is a suspended loss eligible for deduction as a disposition of a passive activity.

I only

Statement I is correct. Statement II is incorrect. If a loss is not allowed because of the at-risk limitations, the loss is a suspended loss and is not eligible for deduction as a disposition of a passive activity.

32

Lisa and William are married taxpayers who file as married filing separately (MFS) for income tax purposes as it is advantageous for their tax positions; although the couple does live together. Lisa has rental property she inherited from her uncle that will generate a loss this year of $14,000. Lisa meets the active participation standard. Lisa's AGI is $65,000 and William's AGI is $80,000. How much is Lisa's allowed passive activity loss this year?

A) $14,000
B) $5,000
C) $12,500
D) $0

D.

The rental real estate loss allowance is not available to taxpayers who file as MFS and have lived together at any time during the tax year.

33

If a vacation home is rented for 14 days or less during the year, which one of the following statements is CORRECT?

A) Repair expenses attributed to the rental activity are deductible.
B) Typically, only a small amount of cost recovery deductions is allowed for the year.
C) The full amount of home mortgage interest is permitted as an itemized deduction.
D) A portion of the rental income may be nontaxable.

C.

If property is rented fewer than 15 days per year, the full amount of home mortgage interest, taxes, and casualty losses are permitted as an itemized deduction (not expenses, though); in addition, rental income can be excluded from gross income.