IRC §469 – Passive ActivitiesPart 3 PAGI, PAD, PAI, PAL !
PAL General Rule • Loss from passive activity is only usable against income from a passive activity • Individuals can’t use PAL against active or portfolio income • Sometimes, what seems to be PAGI will be treated as not PAGI (recharacterization rules) • §469(i) - • Special rule for dispositions – generally, an activity’s PAL is “triggered” upon taxable disposition of the activity.
PAL, PAGI, PAD and relevance • §469(d)(1) – PAL = excess of aggregate losses from all passive activities for the year, over aggregate income from all passive activities for the year. • So some netting involved, but must track PAL per activity so know how much suspended PAL might be triggered if activity disposed of • PAGI - an item of gross income if and only if such income is from a passive activity • PAD - if and only if such deduction— • “(i) Arises (within the meaning of paragraph (d)(8) of this section) in connection with the conduct of an activity that is a passive activity for the taxable year; or • (ii) Is treated as a deduction from an activity under §1.469-1T(f)(4) for the taxable year.” • More details in -2 and -2T regs • Special rules for gains from dispositions, portfolio and personal service income • Ordering rules relevant if the loss is also subject to passthrough basis limitations, 465 and capital loss limitations (discussed later) • Calculations on Form 8582
PAL • §1.469-2T(b) • Generally, excess of passive activity deductions for the year over passive activity gross income for the year • Different definition used for closely-held corporation • -1T(g) • PAL = excess of PAD over (PAGI + “net active income”) • Basically just can’t use PAD against portfolio income (but see -1T(g) for details (not necessary for BUS 225K)
What is PAGI? 1.469-2T(c) • Gross income from a passive activity • Not portfolio income • Unless derived in ordinary course of the trade or business, such as interest earned by a bank • Not income from personal services • PAGI “does not include compensation paid to or on behalf of an individual for personal services performed or to be performed by such individual at any time”
Portfolio income PLR 201005016 • S corp earned interest on construction loan proceeds it received • Held: the interest income is portfolio income • Not derived in the ordinary course of a trade or business • No exception for interest arising from working capital • Starting in 2013, 3.8% Medicare tax on unearned income of high income individuals and trusts starts (§1411) • Will approach of the 469 regs be used to define unearned or net investment income?
PAGI Questions • Partnership owns one rental property. Had CODI in 2010 of $40,000. Is it PAGI? • Your client owns an apartment building and is required to keep security deposits in separate account. Earns $1,000 of interest income each year. • Q – Portfolio or rental income? • Client earns royalties from business of licensing movie rights? Q – Portfolio or trade/business income?
More PAGI Questions • Positive §481(a) adjustment • Income from a covenant not to compete • Gross income or gain allocable to business or rental use of a dwelling unit for any year in which §280A(c)(5) applies
PAGI – disposition gain rules • General rule -2T(c)(2) – “Treatment of gain. Except as otherwise provided in the regulations under section 469, any gain recognized upon the sale, exchange, or other disposition (a “disposition”) of an interest in property used in an activity at the time of the disposition or of an interest in an activity held through a partnership or S corporation is treated in the following manner: • (1) The gain is treated as gross income from such activity for the taxable year or years in which it is recognized; • (2) If the activity is a passive activity of the taxpayer for the taxable year of the disposition, the gain is treated as passive activity gross income for the taxable year or years in which it is recognized; and • (3) If the activity is not a passive activity of the taxpayer for the taxable year of the disposition, the gain is treated as not from a passive activity.” • Interest in p/s and S corp stock are not property used in a PA
Classification of disposition gain - 1 • §1.469-2T(c) and -2(c) • 12-month lookback rule – if property used in more than one activity in 12 months preceding disposition, gain characterized and allocated among the activities on a reasonable basis
Classification of disposition gain - 2 • §1.469-2T(c) and -2(c) • Substantially appreciated property rule – prop is SA if its FMV > 120% of its adjusted basis. If SA property previously used in a nonpassive activity, gain is NOT treated as passive unless property was used in a PA for either 20% of time it was held, or during the entire 24-month period ending on disposition date.
Disposition Question • T sells office building which he held for 3 years. During 12 months prior to sale, T used building 7 months as rental and 5 months in his business. • Q - How to treat T’s gain?
Disposition Question • Anne acquires building on 1/1/97 and uses it until 3/31/08 in a business activity in which Anne materially participates. On 4/1/08, Anne leases the building to Bob and on 12/31/09, sells it for $500,000. Adjusted basis = $200,000. • Q – nature of disposition gain? • Q – is the building “substantially appreciated?”
Income recharacterization rules -2T(f) and -2(f) SET 1 • Rules preventing conversion of active business income into PAGI: • SPA rule (f)(2) • Rental of self-developed property* (f)(5) • Self-rented property rule* (f)(6) (self rental rule) * applies on property by property basis
Income recharacterization rules -2T(f) and -2(f) SET 2 • Rules preventing conversion of portfolio income into PAGI • Rental of non-depreciable property (f)(8) • Equity-financed lending activities (f)(4) • Passthrough entities licensing intangible property* (f)(7) * applies on property by property basis
Authority for income recharacterization rules • Regulatory authority Congress gave to IRS at §469(l) • Preserve intent of §469 • Leg history: “to protect underlying purpose of the passive loss provision, i.e., preventing the sheltering of positive income sources through the use of tax losses derived from passive business activities.” • Without such rules, taxpayers would be encouraged to: • Change participation levels • Convert investment activities to passive
SPA -2T(f)(2) • SPA – same definition as under -5T MP test • If PAGI from all SPAs > PAD from such activities, net passive activity income treated as nonpassive activity income • EX – T has 3 SPAs and aggregate hours are 400 • SPA MP test not met, so passive • If generate income, treated as non-passive • IF t/p met the SPA MP test, the recharacterization rule would not apply (would not be subject to §469)
SPA Example • 2008 • SPA $1,000 income • Rental $1,000 loss • Result: report $1,000 active income and c/f $1,000 PAL • 2009 • SPA $1,000 loss • Rental $1,000 loss • Result: both losses are PALs and c/f
Rental of self-developed property (f)(5) • Net rental activity income not treated as PAI if, • Any gain from disposition of property is included in income for the TY • Property was rented out for less than 12 months prior to its disposition, and • T materially or significantly participated in the value enhancement of the property
Self-rented property rule (f)(6) (self rental rule) • Rental income from an item of property rented to a T or B in which T materially participates is treated as NOT from a PA • EX – Al, a lawyer, rents office space to the law p/s in which he is a MP. If the rental activity generates income, it will not be PAI
Self-rental rule upheld by courts • Krukowski, 89 AFTR 2d 2002-827, 279 F.3d 547 (7th Cir. 2002) • Congress gave broad grant of authority to IRS in §469(l) • The rule “comports with Congress’s goal of eliminating tax shelters.” • Congress referred to example of situation to be addressed by IRS as including related property leases which reduce active business income and create passive income.
Rental of nondepreciable property (f)(8) • Net passive activity income from activity of renting property is not treated as PAI if the unadjusted basis of the depreciable property is less than 30% of the unadjusted basis of all property rented in the activity. • EX – rental of a parking lot where avg period of customer use > 30 days. If unadjusted basis is: • Land $80,000 • Pavement $20,000 The rule will apply if rental generates income because unadjusted basis of depreciable property ($20,000) is less than 30% of the unadjusted basis of all property rented in the activity ($100,000)
Equity-financed lending activities (f)(4) • Purpose – to prevent individuals, partnerships and S corps from becoming lenders in order to generate PAI when it would otherwise be portfolio income • “Equity-financed lending activity” – • (1) involves T or B of lending money; and • (2) avg outstanding balance of liabilities (deposits) incurred for the TY does not exceed 80% of avg outstanding balance of the interest-bearing assets (loans) held in the activity for the year
Passthrough entities licensing intangible property (f)(7) • If T acquired interest after substantial development was completed, the royalty income is not PAI, but is recharacterized as portfolio income unless an exception is met: • 1) expenditures reasonably incurred by development entity for TY with or within T’s TY wrt development or marketing of such property, exceed 50% of the gross royalties from licensing such property; or • 2) T’s share of development or marketing expenditure for all TYs of entity beg with TY of entity in which T acquired interest and ending with TY of entity ending with or within T’s current TY exceeds 25% of FMV of T’s interest in such property at time T acquired interest in the entity.
Question 1 • George is a lawyer in a law p/s and rents office space to the p/s. What is the effect to George?
Question 2 • Wilma owns: • Video rental store 200 hours income • Rental real estate 50 hours loss • Acctg p/s 2,000 hours income • Software consult 250 hours loss What is character of each activity – passive or active?
Question 3 • Barbara is evaluating 3 different rental properties to acquire: • Farm with 5,000 acres of land. The farmhouse would be rented out and the land rented out for cattle grazing. Barbara considers retiring there in about 10 years. • Apartment building with 50 units. • Mini-mall that she would construct, rent out for a few years and sell at a profit and use the money for retirement. • Which is the better investment. B has 3 partnership interests that all produce PALs.
Passive activity deduction • Define per 1.469-2T(d) • NOT PADs: • Portfolio expenses • Nonpassive activity interest expense • Loss from disposition of property producing portfolio income • Triggered loss under §469(g) • State, local, foreign income taxes • Misc. itemized deductions • Charitable contribution deduction • NOL or Capital loss c/f • Casualty or theft loss if not of type that recur regularly in the conduct of the activity (EX – shoplifting in a store) • Negative §481(a) adj if attributable to passive activity • Loss from dispositions of PA • Also consider 12-month lookback rule
PAL • Once know the excess of PAD over PAGI (the “PAL”) you allocate it to loss activities using the allocation rules • When a PAL carries forward, it must always be attached to an activity • -1T(f)(2) • Form 8582 and worksheets
Self-charged rule • TRA86 Blue Book page 233 – 234 • §1.469-7 • Only applies to interest (although legislative history implied could be broader) • Addresses issues where same debt produces portfolio income and PAD • EX – lending transaction between individual and his partnership
Self-charged example Partnership AB A B AB operates a rental activity A loaned $50K to AB at 10% interest So, A receives $5K portfolio income and has $2.5K interest expense on his K-1 Under self-charged rule, A can treat $2.5K of his interest income as PAGI rather than as portfolio income (see example at 1.469-7(h)) 50% 50%
Spouses filing joint return -1T(j) • Treat as 1 t/p for 469 purposes • Exceptions at -2T(j)(2) • If stop filing MFJ • PADs and PACs allocable to individual’s activities for TY must be determined by taking into account items of deduction and credit attributable to individual’s interest in PAs for immediately preceding TY • Participation rule -5T(f)(3)
Publicly-traded partnerships - 1 • Special rule at §469(k) • Added by Revenue Act of 1987, but effective as if added by TRA86 • Definition: “any partnership if— • (A) interests in such partnership are traded on an established securities market, or • (B) interests in such partnership are readily tradable on a secondary market (or the substantial equivalent thereof).”
Publicly-traded partnerships - 2 • §469 applies separately for items for each PTP • Can’t offset loss of a PTP against anything other than income of a PTP (but not its portfolio income) • §469(i) doesn’t apply to PTP’s rental activities • §469(g) only applies to PTP if partner sells his entire interest in the PTP • Special reporting on Form 8582
Disposition of interest in passthrough entity • §1.469-2T(e)(3) • If sell p/s interest – allocate among the passive activities, businesses and investments of the partnership as if the p/s had sold its assets • P/S may report the information on its K-1 to help the selling partner • Details and examples in regs
Intro to carryover of PAL and PAC • §1.469-1(f)(4) • For any activity for which any deductions or credits are disallowed under §469, disallowed loss or credit is allocated among T’s activitys for succeeding TY in a manner that reasonably reflects extent to which each activity continues the loss activity AND the disallowed loss or credit allocated to an activity is treated as a deduction or credit from the activity for the succeeding TY
EX - continued • $21,000 PAL is disallowed • Allocated ratably to the activities that produced losses for the year • A: $21,000 x $9,000/$25,000 = $7,500 • B: $21,000 x $16,000/$25,000 = $13,440 • These are the PALs that carryforward attached to an activity • Reported (and computed) using Form 8582