Passive Loss Rules Matthew K. Becker, CPA BDO Douglas J. Patch, Godfrey & Kahn, S.C. November 4, 2010 mw5514693.

Passive Loss Rules

Matthew K. Becker, CPA BDO

Douglas J. Patch, Godfrey & Kahn, S.C.

November 4, 2010

mw5514693

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History of Passive Loss Rules● Prior to TRA 1986, few limitations were

placed on ability to use deductions from one activity to offset income from another activity.

● Tax Shelters were designed to generate large deductions with minimal investment.

● TRA 1986 addressed this situation with many lines of attack: expansion of AMT, extension of at-risk rules to real estate and passage of the passive loss rules.

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Effect of Passive Loss Rules

● Loss from passive activities can not offset active income or portfolio income.

● Exceptions to general rule of disallowance:

• Dispositions• Former passive activity rules• $25,000 Rental/Real Estate Activity Rule

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Effect of Passive Loss Rules - Dispositions

● Dispose of entire interest in activity in a fully taxable transaction allows utilization of suspended losses.

• What is an activity?• What is a qualifying disposition?

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Effect of Passive Loss Rules - Dispositions● Appropriate Economic Unit to

determine “activity.”● Facts and circumstances relevant in

grouping.● Decision made at entity level.● Limitations

• Rental Activity/Non-rental activity• Real Property Rental/Personal Property

Rental

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Effect of Passive Loss Rules - Dispositions

● Must dispose of entire interest in activity

● Disposition must be fully taxable● Related Party Rule● Installment sales

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Effect of Passive Loss Rules – Other Triggering Events

● Activity ceases to be passive• Not a disposition• Can use suspended losses to offset

income from the same activity

● $25,000 Rental Real Estate Rule• Can treat $25,000 as active if active in the

rental• Otherwise, real estate is per se passive

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Determining Whether an Activity is Passive

● Trade or Business in which the Taxpayer does not materially participate.

● Rental Activity.

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Material Participation Standard● Material Participation means

involvement is regular, continuous and substantial.

● Regulations provide Material Participation standard met if and only if one of seven tests met.

● First six tests are narrowly quantitative, the seventh is a facts and circumstances test.

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Material Participation – Test One● Taxpayer must participate more than 500

hours● Taxpayer must own activity at time of

services for services to count● Certain hours disregarded:

• Non-owner work done to meet 500 hour test• Work done in investor capacity unless taxpayer

involved in day-to-day management

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Material Participation – Test Two

● Met if the taxpayer’s participation constitutes substantially all of the participation in the activity.

● If test met, does not matter how few hours taxpayer spends participating in activity.

● Services of non-owners is considered.

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Material Participation – Test Three● Met if a taxpayer participates in an activity

for more than 100 hours and his participation is not less than that of any other individual during the same year.

● Work performed by non-owners is considered.

● Not clear whether number of hours is sole determinant of who participates more.

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Material Participation – Test Four● Met if aggregate participation in all

“significant participation activities” exceeds 500 hours.

● A SPA is a non-rental trade or business in which taxpayer participates for more than 100 hours and none of the other tests are met.

● If fail the 500 hour aggregate test, income from SPAs is considered active, but loss is considered passive.

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Material Participation – Test Five

● If materially participated (based on other tests) in five of past ten years, then considered to materially participate in current year.

● Test designed to prevent flip-flops, i.e., treatment of an activity as nonpassive when it generates losses and active when it generates income.

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Material Participation – Test Six● Met if participated in a personal service

activity for any three prior taxable years.● Personal service activity means any

business where capital is not a material income-producing factor including, but not limited to, health, law, engineering, architecture, accounting, performing arts or consulting.

● Several cases in the area.

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Material Participation – Test Seven● Met if, based on all the facts and circumstances, a

taxpayer establishes regular, continuous and substantial involvement in the activity.

● Regulations specify this test cannot be met if taxpayer participates in an activity for 100 hours or less.

● Management services are disregarded unless: (1) no other individual is compensated for providing management services and (2) no other individual performs a greater number of management hours.

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Material Participation – Other Considerations

● Distinction between investors and entrepreneurs

● Treatment of limited partners● Material Participation by legal entities

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Definition of Rental Activity

● A rental activity is an activity where payments are for the use of tangible property.

● Exception One: Average customer use period of seven days or less.

● Exception Two: Average use of 30 days or less and significant personal services.

● Exception Three: Extraordinary personal services.

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Definition of Rental Activity, cont.

● Exception Four: Rentals incident to nonrental activities of taxpayer.

● Exception Five: Property customarily made available for nonexclusive use by various customers.

● Exception Six: Property rented to a pass through entity or joint venture in which the taxpayer owns an interest.

● Exception Seven: Rental of taxpayer’s residence.

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Real Estate Operators

● Taxpayers who qualify as real estate operators must treat their rental activities as nonpassive upon a showing of material participation.

● Definition of real estate operator:• Closely held C corporation with more than

50% of gross receipts from real property.• Individuals who perform more than 50% of

services in a real property trade or business AND more than 750 hours in real property trades or businesses in which he materially participates.

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Real Estate Operators

● Must group all real estate activities together as a whole or treat separately.

● Must still meet one of the seven activity tests for trade or business to be considered active.

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Net Income from Nonshelterable Passive Activities (“NOPAs”)

● Six situations in which net gain, but not net loss, from a passive activity is treated as nonpassive.

● Can use suspended loss from NOPA to offset income from the NOPA.

● NOPA #1: Significant Participation Passive Activities

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NOPAs, cont.

● NOPA #2: Rental of Nondepreciable Property.

● NOPA #3: Equity-Financed Lending Activity.

● NOPA #4: Property Rented Incidental to Development Activity

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NOPAs, cont.

● NOPA #5: Property Rented to a Nonpassive Activity of the Taxpayer.

● NOPA #6: Certain Royalties Received Through a Pass Through Entity.

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Self-Charged Interest Rule

● Interest income is portfolio income generally not available to offset loss from a passive activity.

● Self-charged interest rule allows offset of interest expense of debtor passive activity attributable to loan from owner.

Self Charged Interest Example

● X owns 50%; Y owns 50% of LLC.● LLC conducts per se passive rental

activity.● X loans $1,000,000 to LLC at 10%

interest rate.● X can treat $50,000 of interest income

as passive income.

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Self Charged Interest Example, Cont.

● What if $1,000,000 were contributed as preferred equity with a 10% priority return?

• Economics between X and Y would be the same

• Entire special allocation is passive income and could be offset with passive loss.

• Must take care to avoid having the special allocation treated as a guaranteed payment.

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Rev. Proc 2010-13

● Requires taxpayers to report their groupings and regroupings of activities.

● Also requires reporting additions of activities to current groupings.

● Effective for tax years beginning on or after January 25, 2010.

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Reporting Requirements – New Groupings

● The taxpayer must file a statement identifying the activities.

● Statement must be attached to the original return for the first taxable year in which two or more activities are grouped.

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Reporting Requirements – Existing Groupings

● No disclosure is required for existing groupings that are unchanged.

● Statement must be attached to the tax return in any year that an activity is added to an existing group.

● When adding an activity, the entire group must be disclosed.

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Regrouping Activities

● Regrouping is required for groups that are clearly inappropriate or have a material change in facts and circumstances.

● Failing to regroup inappropriate activities will cause each activity to be treated separately.

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Special Rules –Partnerships and S-Corps

● Partnerships and S Corporations must report groupings to partners and shareholders.

● Grouping is reported by separately stating income and loss for each group on attachments to the entity’s Schedule K-1.

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Reporting Requirements – Partners and Shareholders

● Partners and shareholders are generally not required to report groupings disclosed by the entity.

● Separate disclosure is required if the partner or shareholder:• Groups together activities that the entity does not group

together,• Groups entity activities with activities conducted directly

by partner or shareholder, and/or• Groups entity activities with activities conducted

through other passive entities.

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Partners & ShareholdersExample – Grouping Partnerships

● Assume the taxpayer holds a partnership interest in a grocery distributor as well as a partnership interest in a separate entity that owns the warehouse rented to the distributor.

● Assume both partnerships are under common control and that the warehouse is rented predominantly to the distributor.

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Partners & ShareholdersExample – Grouping Partnerships cont.

● Each partnership attaches a statement of activity to the partner’s K-1.

● The taxpayer may elect to group these activities into a single activity.

● If grouped, the taxpayer’s material participation is measured by testing both activities together as one activity.

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Partners & ShareholdersExample – Grouping at Entity Level

● Assume the same facts as the previous example except that the distributor activity and the warehouse activity are part of one partnership.

● Further assume that the partnership chooses to group the activities.

● Assume the taxpayer materially participates in the distribution activity but not the warehouse activity.

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Partners & ShareholdersExample – Grouping at Entity Level cont.

● The activities must remain grouped on the partner’s return.

● If the taxpayer’s material participation in the distributor activity is not enough to make him a material participant in the entire economic unit, both activities become passive.

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Grouping Factors

● Any reasonable method can be used to group activities.

● Grouped activities must constitute appropriate economic units.• Similarities and differences in types of trades or

businesses.• The extent of common control and/or ownership.• Geographical location.• Interdependencies between or among the activities.

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Grouping Factors cont.

● Business interdependencies can arise from:• Having the same customers,• Having the same employees, and/or• Having a single set of books or records.

● Interdependencies among activities can also arise when:• Activities purchase or sell goods to each other, or• Products or services are normally provided together.

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Grouping Factorscont.

● Taxpayers may not combine or separate activities each tax year.

● Regrouping is only allowed in circumstances where the initial grouping was:• “clearly inappropriate or there has been a material

change in the facts and circumstances that makes the original grouping inappropriate.”

● Commissioner can regroup a taxpayer’s activities when clearly inappropriate.

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Grouping FactorsExample – Appropriate Economic Unit

● Taxpayer owns a bakery and a movie theater in a mall located in Chicago, IL.

● He also owns a bakery and a movie theater in a mall located in Houston, TX.

● Depending on other circumstances, the taxpayer may:• Group all the activities into a single activity,

• Group them as a movie theater activity and a bakery activity,

• Group them as a Chicago activity and a Houston activity, or

• Treat them as four separate activities.

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Benefits of Grouping

● Taxpayers can potentially combine passive rental activities with profitable active trade or business activities.

● Activities can only be combined if the activities constitute an appropriate economic unit and:• The rental activity is insubstantial in relation to the trade

or business activity,

• The trade or business activity is insubstantial in relation to the rental activity, or

• They have the same proportionate ownership.

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Benefits of GroupingExample – Proportionate Ownership

● Husband is the sole owner of an S corporation that conducts a grocery store trade or business activity.

● Wife is the sole owner of an S Corporation that owns and rents out a building.

● Part of the Wife’s building is rented to the Husband’s grocery store.

● Both activities are reported on a joint tax return.● The activities can be combined as if the grocery

store S Corporation owned the portion of the rented building used by the grocery store.

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Regrouping ActivitiesExample – Material Change

● Assume the same facts as the previous example except that the grocery store business was moved to an unrelated location.

● The rental property is now rented to an unrelated party.

● A material change in facts and circumstances has occurred and the activities must be regrouped separately.

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Suspended Losses – General Rules

● Losses can generally be suspended for two reasons:• Passive activity loss rules• At-Risk Basis Rules

● Passive losses can only offset passive income.

● Passive losses are carried forward until used or activity is disposed.

● All losses are limited to amount investor has “at risk”.

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Suspended Losses – Combined Passive Activities

● Total losses from combined passive activities are allocated among each separate activity.

● The ratable portion of each separate activity’s deductions that are suspended are determined as follows:

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Total suspended losses

xEach activity's passive activity deduction

Sum of all passive activity deductions

Suspended LossesExample – Allocation

● Assume these are treated as a single passive activity with the following results:

● The loss would be allocated as follows:

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Last Year BakeryMovie

Theater TotalGross Income 20,000 60,000 80,000 Deductions (40,000) (60,000) (100,000)

Net Income (Loss) (20,000) - (20,000)

$20,000 x$40,000

= $8,000 Bakery$100,000

$20,000 x$60,000

= $12,000 Movie

Theater$100,000

Suspended Losses – Example – Allocation (cont.)

● Assume that the taxpayer disposed of the movie theater the next year.

● The taxpayer can elect to treat the movie theater as a separate activity in the year disposed.

● The $12,000 suspended loss would be deductible in full to offset non-passive income upon disposition.

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At-Risk Basis

● In general, limits losses to what the taxpayer actually has “at risk”.

● At-risk losses are suspended until the taxpayer increases at-risk basis through income or contributions.

● Suspended at-risk losses are subject to the passive loss rules in the year in which the loss is allowed.

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At-Risk BasisExample – Suspended Losses (Year 1)

● Assume the taxpayer purchased an interest in a passive activity with the following transactions in Year 1.

● The taxpayer has a $15,000 suspended loss due to the passive activity rules and a $5,000 suspended loss due to the at-risk rules.

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Movie Theater Year 1Initial Investment 15,000

Gross Income 20,000Deductions (40,000)Net Income (Loss) (20,000)

At-Risk BasisExample – Suspended Losses (Year 2)

● Assume the taxpayer became a material participant during the next year and the following occurred.

● The taxpayer now has at-risk basis to take the current-year loss and the prior year suspended loss.

● The prior year suspended at-risk loss becomes a non-passive loss.

● The prior year passive loss is carried forward.

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Movie Theater Year 1 Year 2Contribution 15,000 20,000

Gross Income 20,000 30,000 Deductions (40,000) (40,000)Net Income (Loss) (20,000) (10,000)

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Q & A

Thank you!

Matthew K. Becker, CPABDOTel: (616) [email protected]

Douglas J. PatchGodfrey & Kahn, S.C.Tel: (414) [email protected]

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