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Loss & Deduction Limits Chapter 2 Pages 43-93 Chapter Contents P. 43 Loss Limit Framework Hobby & Vacation Loss Limits Basis & At-Risk Rules Passive Activity Limits NOL’s Loss Limits & C Corporations No law changes to these issues Loss Limit Framework P.44 At Risk

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loss deduction limits

Loss & Deduction Limits

Chapter 2

Pages 43-93

chapter contents p 43
Chapter Contents P. 43
  • Loss Limit Framework
  • Hobby & Vacation Loss Limits
  • Basis & At-Risk Rules
  • Passive Activity Limits
  • NOL’s
  • Loss Limits & C Corporations

No law changes to these issues

loss limit framework p 44
Loss Limit Framework P.44

At

Risk

Investment interest limit

PAL

Limit

Basis

Limits

Hobby & vacation home,

Related party limits

Capt. Loss limit

Loss

Deduction

first base p 45
First Base P. 45
  • Hobby Loss Rules
  • Vacation Loss Rules
  • Related Party Limits

Out at First Base!

safe at first p 44
Safe at First? P. 44

Losses generated from:

  • Partnerships
  • S-Corps
  • LLC

Subject to Basis Limits

second base p 45
Second Base P. 45

At Risk limitations

third base p 45
Third Base P. 45

Passive Activity Losses

(PAL’s)

heading for home p 45
Heading for Home! P.45

Capital Loss Limits

Last Hurdle

hobby loss p 46
Hobby Loss P.46
  • IRC 183 – and related regulations can disallow a loss for a lack of “Profit Motive”
profit motive p 46
Profit Motive P.46

Profit motive is generally presumed when:

  • Profit in three of last five years
  • Two of seven years for horses
  • One in ten years for beekeeping?
statute of limitations p 46
Statute of Limitations P.46
  • A taxpayer can elect to extend the Statute of Limitations to postpone the application of the test for the presumption until the fourth year (6 yrs for horses)
profit motive indicators p 46
Profit Motive Indicators P. 46

Treas. Reg. 1.183-2

Nine Indicators

They are Subjective

nine factors p 47
Nine Factors P.47
  • Manner in which the taxpayer carries on the activity
  • Expertise of the taxpayer
  • Time & Effort
  • Expected appreciation of assets
nine factors p 4715
Nine Factors P.47

6. Success of the taxpayer in carrying on other similar or dissimilar activities

7. Occasional Profits

8. Financial status of the taxpayer

9. Personal Pleasure

loss limits p 47
Loss Limits P.47
  • Some Expenses may be deductible
  • Expenses are separated in layers/tiers
  • All of the income is reportable
first tier p 47
First Tier P. 47

Deductions allowable under another code section

  • Itemized Deductions
tier two p 47
Tier Two P.47
  • Deductions other than depreciation

(If they would be allowed in a for profit activity)

IRC 162 “Trade or Business Expenses”

tier three deductions p 47
Tier Three Deductions P.47
  • Depreciation to extent of income
example 2 1 p 48
Example 2.1 P. 48

Facts

Leon owns a yacht

Occasionally rents out

Total Income $14,000

Total Expenses $16,000 (allocated)

What deductions can he claim & where?

income analysis p 48
Income Analysis P.48

Rental Income $14,000

Tier 1 deductions -0-

Tier 2 deductions: (13,500)

Remaining Income $500

Tier 3 deductions

Depreciation ($2,500) 500

Depreciation Carryover $2,000

various court cases p 49
Various Court Cases P. 49
  • The IRS has been winning most of the cases taken to court
  • At least act like you are trying to make a profit
  • Business Plan
  • Keep Records
  • Education (in the activity)
vacation homes p 49
Vacation Homes P.49
  • IRC 280 covers Disallowance of certain expenses in connection with business use of home, rental of a vacation home
14 day rule p 50
14 Day Rule P. 50
  • For residences rented for 14 days or less (annually) the rental income is not included in taxable income
14 day rule p 5026
14 Day Rule P. 50

No expenses relating to that income is deductible

non personal use test p 50
Non Personal Use Test P. 50

Vacation Home vs. Rental Property

A rental meets the non personal use test if owner use is 14 days or less

or

If personal use is 10% or less of rented days

personal use tests p 50
Personal Use Tests P. 50
  • Use by an owner
  • Use by member of owner’s family
  • Use under an exchange agreement
  • Use for less than FMV
what s the difference p 51
What’s the Difference ? P. 51

Vacation Home

  • Allocate deductions
  • No deductions in excess of income

Rental Activity

  • No allocation
  • Excess deduction over income
  • Passive activity limitations
ordering limits p 51
Ordering Limits P. 51
  • Like the hobby loss rules, Vacation Homes & Rental Activity with personal use have an ordering of expenses
allocation formula s p 51
Allocation Formula(s) P. 51
  • Allocate general expenses not specific to any particular day’s use

Per IRC

  • General Rule: allocate on the basis of the days used …

Tax Court & Ninth Circuit Court of Appeals

  • Interest & Taxes: allocated on the basis of total days in the year…
example 2 5 p 52
Example 2.5 P. 52

Facts

Allen used his vacation home for 20 days

Rented for 180 days

Exceeds 14 day & 10% limits

(vacation home limits apply)

second base
Second Base

Basis & At-Risk Limitations

s corporation basis p 54
S-Corporation Basis P. 54

Basis in stock

Plus

Certain Debt

allocations among s h s p 54
Allocations among S/H’s P. 54

General Rule – allocations of income & loss

Based on a per-share, per-day weighted

average.

For all S/H who held any shares on any day

Not the same for partnerships (partnership agreement)

basis @ acquisition p 55
Basis @ Acquisition P. 55

Various ways to acquire stock & basis

  • IRC 351 incorporation –substituted basis

(equal to basis in property given to corp.)

2. Purchased stock

(basis equal cost)

3 Stock received as a gift

(pre 1977 = owners basis + gift tax paid up to FMV)

basis @ acquisition p 5539
Basis @ Acquisition P. 55

4. Received as compensation

(imputed cost or gross income reported)

5. Received through an estate (FMV at death)

example 2 6 p 56
Example 2.6 P.56
  • Jeanne inherits 1/3 stock of Jayco
  • Jayco is a cash basis S-Corporation
  • FMV @ death was $100,000
  • $45,000 of A/R

What is Jeanne basis in the stock?

(assume pre 8-20-96)

example 2 6 p 5641
Example 2.6 P.56

$ FMV @ date of death = basis ($100,000)

If Jay died after 8-20-96?

$100,000 – $15,000 = $85,000 – FMV @ date of death = basis

yearly adjustments p 56
Yearly Adjustments P.56
  • Allocated portion of S-Corp. income (+)
  • Allocated portion of S-Corp. losses (-)

(prorated based on ownership % stock per-day, per-share)

where to report p 56
Where to Report P.56

Where to report the items of income or loss or deduction? (From K-1)

  • Ordinary Income Schedule E
  • Ordinary Loss Schedule E
  • Capital Gains or Losses Schedule D
  • Charitable Contributions Schedule A
  • Tax Exempt Income Page 1
example 2 8 p 57
Example 2.8 P.57
  • Zoeco is an S-Corporation
  • One S/H (all year)
  • 1/1/03 basis was $110,000
  • Ordinary loss $60,000
  • Distribution of $70,000
  • No accumulated E&P (retained earnings)

What is the effect of the earnings & distribution?

example 2 8 p 5745
Example 2.8 P.57

Basis @ 1/1/03 $110,000

+ Ordinary Income -0-

  • Current Year Distributions (70,000)

Adjusted Basis before 2003 loss $40,000

2003 Ordinary Loss $60,000

Limited to 40,000 40,000

Carry Forward to 2004 $20,000

s corp debt basis p 58
S- Corp. Debt basis P.58

+ Basis for a direct loan (guarantee is no good)

- Adjustments to debt basis if losses exceed stock basis (reduced by excess loss)

example 2 9 p 58
Example 2.9 P.58

Bigtime Inc. – S. Corporation

2003 Ordinary Losses ($100,000)

2004 Ordinary Income 140,000

Sole S/H Stock Basis 60,000

Debt Basis 50,000

How does S/H adjust her basis?

basis for partners or llc members p 60
Basis for Partners or LLC Members P. 60

Acquisition of Interest

  • By Contribution of Property

(no gain or loss to partner)

  • Partner’s basis in Partnership interest is basis of property contributed

(outsider basis)

It is a substitute basis… property for interest

example 2 12 p 61
Example 2.12 P.61
  • Partnership PW, LLC
  • Phil & Wayne contributed $44,000 (cash)
  • Admit Linda – contributes asset FMV $44,000 (her basis is $32,000)
  • Each member is a 1/3 S/H
  • What is their respective Capital Account
  • What are their respective Basis
effect of liabilities on basis p 61
Effect of Liabilities on Basis P.61
  • Tax Law –apportions partnership’s liabilities among the partners
  • A change to partnership ownership could result in a basis adjustment
effect of liabilities p 61
Effect of Liabilities P.61

Increase in liability = Contribution of Cash

( increases basis)

liability decrease = Cash Distribution

decrease in basis (not below zero)

determination of member liability p 61
Determination of Member Liability P.61

Determining Factors

Recourse Debt

or

Non-Recourse Debt

recourse debt p 61
Recourse Debt P.61
  • Economic Risk – by any partner or member
  • Each partner’s share of recourse debt is his economic risk of loss
  • Risk of Loss is based by the partner’s obligation on an immediate hypothetical constructive liquidation.
factors p 62
Factors P. 62
  • Any obligations outside the partnership agreement (guarantees, indemnifications, reimbursement agreements…)directly to creditors or other partners
  • Obligations to the Partnership (imposed the partnership agreement)
  • Payment Obligations
example 2 13 p 63
Example 2.13 P.63

Same facts as Ex. 2.12

Partnership acquires building for $50,000 cash

& borrows $350,000

All 3 ptrs. guarantee the loan (Joint & severally)

What is the allocation among the partners?

outside basis p 63
Outside Basis P. 63

Phil “capital” $44,000

Loan 116,666 $160,666

Wayne “capital” 44,000

Loan 116,667 160,667

Linda “capital” 32,000

Loan 116,667148,667

Total $470,000

increases in basis p 64
Increases in Basis P. 64

For Partnerships

  • Taxable Income of the partnership
  • Tax-exempt income of the partnership
  • Purchases of an asset using debt
  • Contributions of property or cash
decreases in basis p 64
Decreases in Basis P. 64
  • Deductible expenses or losses of the partnership
  • Non-deductible expenses of the partnership
  • Partnership assets used to pay partnership liabilities
  • Distribution of cash or property to a partner
at risk rules p 65
At Risk Rules P.65
  • Deductions & losses from any activity are subject to At-Risk limitations
  • Any losses in excess of the At-Risk amount are suspended and carried forward only
who is covered by these rules p 65
Who is covered by these rules? P.65
  • Individuals
  • Estates
  • Trusts
  • Certain Closely held corporations
definition at risk p 65
Definition “At Risk” P. 65
  • Monies contributed
  • All debts (personally liable)
  • FMV of Pledged property (as security for the repayment of debt)
example 2 14 p 66
Example 2.14 P.66
  • Teresa acquires $100,000 in stock in TRS (S-Corp.)
  • Invests $10,000 of her own monies
  • Borrows $90,000 from TRS
  • What is her Basis?
  • What is her At-Risk?
additional rules after 1996 p 66
Additional Rules after 1996 P.66
  • A non-recourse loan can give a taxpayer an amount at-risk (real estate)
  • Only if it is a “qualified non-recourse financing” (loan must be secured by the real property & by a commercial lender)
increases at risk p 66
Increases At-Risk P. 66
  • Contributions of cash
  • Contributions of property
  • Share of income from activity
  • Change loan from non-recourse to recourse loan
  • Gains recognized on disposition of taxpayer’s interest in the activity
decreases to at risk p 66
Decreases to At-Risk P. 66
  • Withdrawal of cash
  • Withdrawal of property
  • Investor’s share of losses
  • Recourse to non-recourse financing

(at-risk cannot be reduced below zero)

passive activity losses p 67
Passive Activity Losses P. 67
  • In 1986 the Tax Reform Act included new section IRC 469
  • This had the affect of reducing or eliminating millions of dollars in real estate losses and help set it motion the decline of real estate values in second homes & condos
passive activity losses p 6770
Passive Activity Losses P. 67

Two Tests

  • The taxpayer has income from the same or another activity subject to the passive loss rules

or

2. The taxpayer disposes of his or her entire interest in the activity in a fully taxable disposition to an unrelated party

who is effected by irc 469 p 68
Who is effected by IRC 469? P.68
  • Individuals
  • Estates
  • Trusts (except grantor)
  • Personal service corporations
  • Closely held corporations
new terms under irc 469 p 68
New Terms under IRC 469 P. 68

Material Participation

Must be involved in the operation of the trade or business on a Regular, Continuousand Substantial basis

new terms under irc 469 p 6873
New Terms under IRC 469 P. 68

What is an Activity?

Activity ≠ Entity

An activity is within an entity

What about multiple activities within an entity ?

passive activity p 68
Passive Activity P. 68
  • Any rental activity

or

  • An activity where the taxpayer does not materially participate
carryforward of pal p 69
Carryforward of PAL P.69
  • Suspended losses & credits are carried forward

(losses & deductions allowed in full upon disposition of entire interest)

(not credits)

multiple pal carryforwards p 69
Multiple PAL Carryforwards P.69
  • Multiple rentals
  • Limited partner in a baseball team
  • Charter boat activity

(no material participation)

Which suspended losses are used first?

example 2 17 p 69
Example 2.17 P.69
  • AJ owns interests in three passive activities (A,B & C)
  • Two of the three activities has a loss
  • The total of the losses exceeds the gains

What is the allocation for the excess losses?

character of losses p 70
Character Of Losses P. 70

Figure 2.17

Within the individual losses for each activity the loss is comprised of separate characters of losses

Each part retains its character

rental activities p 71
Rental Activities P. 71

Rental Activities are always Passive!!

(of course there are a few exception)

Three General Tests

general tests p 71
General Tests P.71

Customer Use

1. Use of 7 days or less

(hotels, tool rentals, car rentals) not passive

  • Between 7 and 30 days use

(rent unless significant personal services)

  • More than 30 days use

(generally rent unless extraordinary personal services) hospitals, boarding schools…

deductible loss limits p 73
Deductible Loss Limits P. 73

Rental Real Estate

$25,000 of passive losses allowed

if

Taxpayer is a natural person or estate

and

The Taxpayer actively participates

special rule often missed p 74
Special Rule (often missed) P.74

Manual filed returns

Married Taxpayers Filing Separate

  • Live together at any time – no deduction
  • Line apart all year - $12,500 limit

(missed by the IRS as well)

active vs material participation p 74
Active vs Material Participation P.74
  • Material – Regular, continuous & substantial
  • Active- Decision making or hiring others to manage (repairs, securing tenants, determining rent…)
netting rental real estate ex 2 24 p 75
Netting Rental Real Estate Ex. 2.24 P.75
  • Charles has two real estate rentals
  • He activity participates in both rentals
  • He has non rental passive income
  • All acquired prior to 1986 law change
  • Charles qualifies for $25,000 allowance

How does he allocate his income & losses?

figure 2 18 p 75
Figure 2.18 P. 75

ActivityIncome/(Loss)

“A” Real Estate $20,000

“B” Real Estate (30,000)

“C” LLP (non real estate) (15,000)

What would Charles like to do?

What is Charles required to do?

example 2 24 p 75
Example 2.24 P. 75

Activity A $15,000

Activity C (15,000) net to $-0-

Remaining

Activity A $ 5,000

Activity B ($30,000)

Net Loss $25,000 claimed on Schedule E

No unused losses!!

example 2 24 p 7588
Example 2.24 P. 75

What the Regs. Require Charles to do!

Activity “A” $20,000

Activity “B” (30,000)

Net loss ($10,000) from rental activity

Deductible 10,000

Activity “C” no deduction allowed and

$15,000 loss is Suspended

real estate professionals p 75
Real Estate Professionals P. 75

Trade or Business

Non-Rental Activity

Non-Passive

Needs to meet Material Participation test

self rental rule p 79
Self Rental Rule P. 79
  • Dr. Z owns a medical practice which is (incorporated)
  • He owns the building that houses the practice & rents to the practice
  • Any Net Loss = Passive
  • Any Net Income = Active
material participation p 75
Material Participation P. 75

More than > half of personal services performed in Real Estate

and

> 750 hours in Real Estate business for year

material participation p 76
Material Participation P. 76

Specific Rules

Involved in the operation of the activity on a:

Regular, continuous & substantial basis

and

Meeting any one of seven tests

participation tests p 76
Participation Tests P. 76

(pass any one test)

  • Participation exceeds 500 hours
  • Sole Participant
  • More than 100 hrs. & no one spends more time
  • Significant Participation: Multiple Activities combined

continued…

seven tests p 75
Seven Tests P. 75

5. Material Participation for 5 of last 10 yrs.

6. Material Participation in Personal Service Activity for 3 years

7. Facts and circumstances

(pass any one test)

disposition of an interest in a passive activity p 80
Disposition of an Interest in a Passive Activity P. 80

Entire Interest – releases suspended losses

(all years & losses revert to active losses)

Includes all losses on disposition of interest

(not considered passive – capital)

related party transactions p 81
Related Party Transactions P. 81
  • Not considered a disposition
  • Does not trigger suspended losses
  • May be used to offset passive income
passive to active p 81
Passive to Active P. 81

When a previous passive activity becomes active, what happens to any suspended losses?

installment sale of entire interest p 82
Installment Sale of Entire Interest P. 82
  • This is a fully taxable transaction – triggers suspended losses
  • It is pro-rated based on the ratio of gain on the sale
net operating losses p 83
Net Operating Losses P. 83

Heading for Home

Final Hurdle for claiming a loss

Getting a tax benefit

What happens if there is no taxable income in which to offset our loss?

carry backs forwards p 83
Carry Backs & Forwards P. 83
  • Prior to 8-6-97- carryback 3 yrs & carryforward 15 years (19 yrs to get tax benefit)
  • After 8-5-97 – Carryback 2 years & carryforward 20 yrs (23 yrs)
  • 2002 Act – Extends carryback to 5 years

(for tax yrs ending in 2001 or 2002)

nol s a planning opportunity
NOL’s a Planning Opportunity
  • Carryforward vs Carryback ?

That is the question

  • Quick refund vs. future benefits

(time value of money)

(Interest on refunds from carrybacks)

2. Prior tax rates vs. expected tax rates

nol nold computation p 84
NOL & NOLD Computation P.84
  • How do you know if you have an NOL
  • Negative Taxable Income?

Only if from business losses

nol nold computation p 84103
NOL & NOLD Computation P.84

Excess of deductions over income modified to obtain the taxpayer’s true business loss

Start with Business Income

W-2 Salaries & Wages

Rents

Commissions

Farm Income

non business losses p 84
Non Business Losses P.84
  • Non Business deductions are allowed to the extent of non business income
  • Capital Gains – (2 netting rules)

Allows Either

nonbusiness deduction

or

capital losses

example 2 36 p 84
Example 2.36 P.84

Duncan Williams

Negative AGI of $64,000

What is his NOL

duncan williams p 85
Schedule C income

Schedule C deductions

Interest income (non business)

LTCG (business)

LTCL (non-business)

LTCL (non-business)

AGI

$140,000

(210,000)

7,000

1,000

3,000

(5,000)

($64,000)

Duncan Williams P. 85
slide107
Line 1

Line 2a (Schedule A)

Line 2b (exemptions)

Line 2c (2a + 2b)

Line 3 (line 1 – 2c)

Line 4 (exemptions)

Line 5 (non bus. CL)

Line 6 (non bus. CG)

Line 7 (CG – CL)

Line 9 (non. bus. deductions)

Line 10 & 11(non. bus. Income

Line 12

Line 25 (is line 7)

$(64,000)

+ 13,000

+ 3,050

= $16,050

(80,050)

3,050

+ 5,000

+ 3,000

+ 2,000

= 9,000

-7,000

2,000

2,000

nol absorption p 86
NOL Absorption P.86
  • NOL Amount absorbed = Modified Taxable Income (with several adjustments)
  • Net capital loss deduction for the intervening year is added back
  • Small business stock exclusion added back
  • Various AGI based adjs. added back
nol absorption p 86 87
NOL Absorption P.86-87
  • What if the NOL exceeds the modified taxable income?
example 2 37 p 87
Example 2.37 P.87

Duncan Williams (the same)

2001 - $50,000 of taxable income

No net capital losses

No small business stock

Personal exemption $2,900

Modified taxable income $52,900

NOL to 2002 is $20,000

2002 taxable income $40,000

tax benefit of an nol p 88
Tax Benefit of an NOL P.88

Show me the money!

Form 1045 Application for Tentative Refund

AKA Quickie Refund

“Tentative Refund?”

special rules p 89
Special Rules P. 89
  • What happens if in the loss year the return is MFJ and subsequent years are MFS or another status?
c corporation losses p 89
“C” Corporation Losses P. 89

Not as complex as S-Corporations, Partnership, or Individuals

But, not completely without its problems

corporation basis issues p 91
Corporation Basis Issues P. 91

Investments in Partnerships

  • No Basis – no loss ( same as individuals)

Otherwise no limitations

at risk rules p 91
At-Risk Rules P. 91

Applies to closely held C corporations

material participation p 91
Material Participation P. 91

A “C” Corporation meets the test if:

One or more S/H’s owning more than 50% of the outstanding stock of the corporation materially participation in the activity

qualified business standard p 91
Qualified Business Standard P. 91

Meeting the Standards

1. For the 12 month period ending on the last day of the tax year, at least one full-time employee of the corporation spent substantially all of his work hours in active management of the activity

qualified business standard p 91120
Qualified Business Standard P. 91
  • During the same time period, substantially all of the work of at least three full-time non-owner employees was directly related to the activity and
  • The corporation’s business deductions attributable to the activity exceed 15% of its gross income from the activity for the taxable year.
emerging issue p 92
Emerging Issue P.92

Loss Limits after a Change in Ownership

The IRS has the ability to disallow losses after a change in 50% or more on the stock ownership if the principal purpose of the change was to allow the new owner the benefit of a deduction or credit identified with the acquired corporation

the limitation p 92
The Limitation P. 92

Multiply the value of the company at the time ownership by: the long-term tax-exempt rate

(at the time of ownership change)

FMV of loss corp. X LT tax-exempt interest rate

conclusions p 93
Conclusions P. 93

There are a Ton of limits on claiming losses & deductions

But

In most cases, they can be navigated with a little bit of effort & a good tax program