Chapter 11
Investor Losses
Individual Income Taxes
© 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
1
The Big Picture (slide 1 of 3)
• Trudy and Jim Reswick want to enhance their
financial security
– They are willing to borrow money to make an
appropriate investment.
• Currently, Trudy and Jim’s sole source of
income is their salaries, totaling $100,000.
• Their most significant asset is their personal
residence
– Fair market value is $500,000 with a mortgage of
$350,000.
2
The Big Picture (slide 2 of 3)
• Their broker suggests that they borrow $100,000 at 8% and
use the proceeds to make one of the following investments:
– A high-growth, low-yield portfolio of marketable securities.
• The portfolio’s value is expected to grow 10% each year.
– An interest in a limited partnership that owns and operates orange
groves in Florida.
• Tax losses of $25,000 are expected in each of the next 5 years, after which
profits are expected.
• The broker predicts an annual 10% return over the 10-year period.
– An interest in a local limited partnership that owns and rents apartments
to college students.
• Losses of $25,000 per year expected for 5 years, after which profits would
follow.
• An average annual total return of 10% over a 10-year period.
3
The Big Picture (slide 3 of 3)
• Trudy and Jim want to choose the alternative
that produces the best after-tax return over a
10-year planning horizon.
• They are aware, however, that tax restrictions
may limit the advantages of some of these
investment options.
• In this connection, evaluate each option.
– Read the chapter and formulate your response.
4
Passive Loss Rules
(slide 1 of 2)
• Require income and losses to be separated into
three categories:
– Active
– Portfolio
– Passive
• Generally, disallow the deduction of passive
losses against active or portfolio income
5
Passive Loss Rules
(slide 2 of 2)
• In general, passive losses can only offset
passive income
• Passive losses are also subject to the at-risk
rules
– Designed to prevent taxpayers from deducting
losses in excess of their economic investment in an
activity
6
At-Risk Limits
(slide 1 of 4)
• At-risk defined
– The amount of a taxpayer’s economic investment
in an activity
• The amount of cash and adjusted basis of property
contributed to the activity, plus
• Amounts borrowed for use in the activity for which
taxpayer is personally liable (recourse debt) or has
pledged as security property not used in the activity
7
At-Risk Limits
(slide 2 of 4)
• At-risk defined
– At-risk amount does not include nonrecourse debt
unless the activity involves real estate
• For real estate activities, qualified nonrecourse
financing is included in determining at-risk limitation
8
At-Risk Limits
(slide 3 of 4)
• At-risk limitation
– Can deduct losses from activity only to extent
taxpayer is at-risk
– Any losses disallowed due to at-risk limitation are
carried forward until at-risk amount is increased
– Previously allowed losses must be recaptured to
the extent the at-risk amount is reduced below zero
– At-risk limitations must be computed for each
activity of the taxpayer separately
9
At-Risk Limits
(slide 4 of 4)
• Interaction of at-risk rules with passive loss
rules
– At-risk limitation is applied FIRST to each activity
to determine maximum amount of loss allowed for
year
– THEN, passive loss limitation applied to ALL
losses from ALL passive activities to determine
actual amount of loss deductible for year
10
Calculation of At-Risk Amount
• Increases to a taxpayer’s at-risk
amount:
– Cash and the adjusted basis of
property contributed to the
activity
– Amounts borrowed for use in the
activity for which the taxpayer is
personally liable or has pledged
as security property not used in
the activity
– Taxpayer’s share of amounts
borrowed for use in the activity
that are qualified nonrecourse
financing
– Taxpayer’s share of the activity’s
income
• Decreases to a taxpayer’s at-risk
amount:
– Withdrawals from the activity
– Taxpayer’s share of the activity’s
loss
– Taxpayer’s share of any
reductions of debt for which
recourse against the taxpayer
exists or reductions of qualified
nonrecourse debt
11
The Big Picture - Example 2
At-risk Limits (slide 1 of 2)
• Return to the facts of The Big Picture on p. 11-1.
• In 2015, the Reswicks invest $40,000 in an oil
partnership
– Assume that the Reswicks’ interest in the
partnership is subject to the at-risk limits but is not
subject to the passive loss limits.
12
The Big Picture - Example 2
At-risk Limits (slide 2 of 2)
• Return to the facts of The Big Picture on p. 11-1.
• Because the Reswicks have only $40,000 of
capital at risk, they cannot deduct more than
$40,000 against their other income.
– They must reduce their at-risk amount to zero
• ($40,000 at-risk amount − $40,000 loss deducted).
– The nondeductible loss of $20,000 can be carried
over to 2016.
• ($60,000 loss generated − $40,000 loss allowed)
13
The Big Picture - Example 3
Carryover Losses - At-risk Limits
• Return to the facts of Example 2.
• In 2016, the Reswicks have taxable income of
$15,000 from the oil partnership and invest an
additional $10,000 in the venture.
– Their at-risk amount is now $25,000
• ($0 beginning balance + $15,000 taxable income + $10,000
additional investment).
– This enables them to deduct the carryover loss and requires
them to reduce their at-risk amount to $5,000
• ($25,000 at-risk amount − $20,000 carryover loss allowed).
14
Passive Loss Limits – Classification and Impact
(slide 1 of 4)
• The passive loss rules require taxpayers to
classify their income and losses into one of the
following 3 categories
– Active,
– Passive, or
– Portfolio
• Then the rules limit the extent to which losses
in the passive category can be used to offset
income in the other categories
15
Passive Loss Limits – Classification and Impact
(slide 2 of 4)
• Active income
– Wages, salary, and other payments for services
rendered
– Profit from trade or business activity in which
taxpayer materially participates
– Gain from sale or disposition of assets used in an
active trade or business
– Income from intangible property created by
taxpayer
16
Passive Loss Limits – Classification and Impact
(slide 3 of 4)
• Portfolio income
– Interest, dividends, annuities, and certain royalties
not derived in the ordinary course of business
– Gains/losses from disposition of assets that
produce portfolio income or held for investment
17
Passive Loss Limits – Classification and Impact
(slide 4 of 4)
• Passive activity defined
– Any trade or business or income-producing
activity in which the taxpayer does not materially
participate
– Subject to certain exceptions, all rental activities,
whether the taxpayer materially participates or not
18
Passive Loss Limits – General Impact
• Limitations on passive losses
– Generally, passive losses can only offset passive
income, i.e., they cannot reduce active or portfolio
income
– Disallowed losses are suspended and carried
forward
• Suspended losses must be allocated to specific activities
19
The Big Picture - Example 4
Passive Loss Limits (slide 1 of 2)
• Return to the facts of The Big Picture on p. 11-1.
• In addition to their salaries of $100,000 from
full-time jobs, assume that:
– The Reswicks receive $12,000 in dividends and
interest from various portfolio investments.
– They decide to invest $100,000 in the orange
grove limited partnership, which produces a
$25,000 loss for the Reswicks this year.
20
The Big Picture - Example 4
Passive Loss Limits (slide 2 of 2)
• Return to the facts of The Big Picture on p. 11-1.
• Because their at-risk basis in the partnership is
$100,000, the current $25,000 loss is not limited by
the at-risk rules.
• However, the loss is a passive loss.
– It is not deductible against their other income.
– The loss is suspended and carried over to the future.
• The suspended loss
– Can be offset against other future passive income, or
– Will be allowed when they eventually dispose of the
passive activity.
21
Passive Loss Limits – General Impact
• Suspended losses are deductible in year related
activity is disposed of in a fully taxable
transaction
22
Passive Loss Limits – General Impact
• Suspended losses are deductible in year related
activity is disposed of in a fully taxable
transaction
23
Passive Loss Limits - Example
• Roy sells an apartment building, a passive activity, with an
adjusted basis of $200,000 for $360,000. In addition, he has
suspended losses of $120,000 associated with the building.
• His total gain, and his taxable gain, are calculated as follows:
Net sales price
Less: Adjusted basis
Total gain
Less: Suspended losses
Taxable gain (passive)
$ 360,000
(200,000)
$ 160,000
(120,000)
$ 40,000
24
Passive Credits
• Credits from passive activities are subject to
the loss limitation
– Utilize passive credits to the extent of tax
attributable to passive income
– Credits disallowed are suspended and carried
forward similar to losses
• Suspended credits can be used to offset tax from
disposition of activity but any credits left after activity
is disposed of are lost forever
25
Passive Credits
• Credits from passive activities are subject to
the loss limitation
– Utilize passive credits to the extent of tax
attributable to passive income
– Credits disallowed are suspended and carried
forward similar to losses
• Suspended credits can be used to offset tax from
disposition of activity but any credits left after activity
is disposed of are lost forever
26
Passive Activity Changes to Active
• If a formerly passive activity becomes an
active one
– Suspended losses are allowed to the extent of
income from the now active business
• Any remaining suspended loss continues to be treated as
a loss from a passive activity
– Can be deducted from passive income, or
– Carried over to the next tax year and deducted to the extent of
income from the now active business in the succeeding year(s)
27
Taxpayers Subject To Passive Loss Limits
• Passive loss rules apply to
– Individuals, estates, trusts, personal service
corporations
– Closely-held corporations
• Can deduct passive losses against active income
– S Corp and partnership passive losses flow through
to owners and limits applied at the owner level
28
Taxpayers Subject To Passive Loss Limits
• Passive loss rules apply to
– Individuals, estates, trusts, personal service
corporations
– Closely-held corporations
• Can deduct passive losses against active income
– S Corp and partnership passive losses flow through
to owners and limits applied at the owner level
29
Passive Loss Issues
• Passive losses are losses from trade or business
activities in which the taxpayer does not
materially participate and certain rental
activities
• What constitutes an activity?
• What is material participation?
• When is an activity a rental activity?
30
Identification of Activities
(slide 1 of 2)
• Taxpayers with complex business operations
must determine if segments of their business
are separate activities or entire business is
treated as a single activity
31
Identification of Activities
(slide 2 of 2)
• Regs allow grouping multiple trade or
businesses if they form an appropriate
economic unit for measuring gain or loss
– Once activities are grouped, can’t regroup unless:
• Original groups were clearly inappropriate, or
• Material change in circumstances
32
Identification of Activities
(slide 2 of 2)
• Regs allow grouping multiple trade or
businesses if they form an appropriate
economic unit for measuring gain or loss
– Once activities are grouped, can’t regroup unless:
• Original groups were clearly inappropriate, or
• Material change in circumstances
33
Special Grouping Rules
for Rental Activities
• Designed to prevent grouping of rental activities
(generally passive) with other businesses in a way
that would result in a tax advantage
– A rental activity may be grouped with a trade or business
activity only if one activity is insubstantial in relation to the
other
– Taxpayers generally may not treat an activity involving the
rental of real property and an activity involving the rental
of personal property as a single activity
34
Material Participation Tests
(slide 1 of 8)
• An activity is treated as active rather than
passive (thus, not subject to the passive loss
limits) if taxpayer meets one of 7 material
participation tests
35
Material Participation Tests
(slide 1 of 8)
• An activity is treated as active rather than
passive (thus, not subject to the passive loss
limits) if taxpayer meets one of 7 material
participation tests
36
Material Participation Tests
(slide 2 of 8)
• Test 1
– Taxpayer participates in the activity more than 500
hours during the year
37
Material Participation Tests
(slide 3 of 8)
• Test 2
– Taxpayer’s participation in the activity is
substantially all of the participation in the activity
of all individuals for the year
38
Material Participation Tests
(slide 4 of 8)
• Test 3
– Taxpayer participates in the activity more than 100
hours during the year and not less than the
participation of any other individual in the activity
39
Material Participation Tests
(slide 5 of 8)
• Test 4
– Taxpayer’s participation in the activity is
significant and taxpayer’s aggregate participation
in all significant participation activities during the
year exceeds 500 hours
– Significant participation is more than 100 hours
40
Material Participation Tests
(slide 6 of 8)
• Test 5
– Taxpayer materially participated in the activity for
any 5 years during the last 10 year period
41
Material Participation Tests
(slide 7 of 8)
• Test 6
– The activity is a personal service activity in which
the taxpayer materially participated for any 3
preceding years
42
Material Participation Tests
(slide 8 of 8)
• Test 7
– Based on the facts and circumstances, taxpayer
participated in the activity on a regular,
continuous, and substantial basis
• Regular, continuous, and substantial are not specifically
defined in the Regulations
43
Participation Defined
• Participation generally includes any work done by an
individual in an activity that he or she owns
– Does not include work if of a type not customarily done by
owners and if one of its principal purposes is to avoid the
disallowance of passive losses or credits
– Work done in an individual’s capacity as an investor is not
counted in applying the material participation tests
– Participation by an owner’s spouse counts as participation
by the owner
44
Rental Activities
• Rental of tangible (real or personal) property is
automatically passive activity unless it meets
one of the exceptions
– Temporary Regulations provide exceptions for
certain situations where activities involving rentals
of real and personal property are not to be treated
as rental activities
• If exception applies, activity is subject to the material
participation tests
45
Rental Activities
• Rental of tangible (real or personal) property is
automatically passive activity unless it meets
one of the exceptions
– Temporary Regulations provide exceptions for
certain situations where activities involving rentals
of real and personal property are not to be treated
as rental activities
• If exception applies, activity is subject to the material
participation tests
46
Administrative Guidance
•Administrative Guidance. Although enacted in 1986,
some of the passive loss rules have yet to be completely
formulated. At present, only a portion of the planned
Regulations relating to passive losses have been
finalized.
Reg §1.469-2T (Passive activity loss), Reg §1.469-3T
(Passive activity credit), and Reg §1.469-4T (Definition
of activity) were all issued at least two decades ago and
have still not been finalized.
47
Interaction of At-Risk and Passive
Loss Limits
• Passive loss rules are applied after the at-risk
rules
– Losses not allowed under the at-risk rules are
suspended under the at-risk rules, not the passive
loss rules
– Basis is reduced by deductions even if not
currently usable due to passive loss rules
48
The Big Picture - Example 29
Interaction Of At-risk
And Passive Activity Limits
• Return to the facts of The Big Picture on p. 11-1.
• If the Reswicks invest in the orange grove limited partnership,
the at-risk rules would not limit the deductibility of the
$25,000 losses until after year 4.
– The at-risk basis is reduced from $100,000 by $25,000 over each of the
first 4 years of the investment.
– However, the passive loss rules prohibit deductions for the losses in the
first 4 years of the investment (assuming no passive income from other
sources).
• Therefore, based on the facts provided, none of the suspended
losses would be deductible until year 6 when the orange grove
is expected to begin producing profits.
49
Real Estate Passive Loss Limits
(slide 1 of 4)
• Generally, losses from rental real estate are
treated like other passive losses
• There are two significant exceptions to the
general rule
50
Real Estate Passive Loss Limits
(slide 2 of 4)
• Exception 1: Real estate professionals
– Rental real estate losses are not treated as passive
if the following requirements are met:
• Taxpayer performs more than half of his/her personal
services in real property businesses in which the
taxpayer materially participates, and
• Taxpayer performs more than 750 hours of services in
these real property businesses as a material participant
51
Real Estate Passive Loss Limits
(slide 2 of 4)
• Exception 1: Real estate professionals
– Rental real estate losses are not treated as passive
if the following requirements are met:
• Taxpayer performs more than half of his/her personal
services in real property businesses in which the
taxpayer materially participates, and
• Taxpayer performs more than 750 hours of services in
these real property businesses as a material participant
52
Real Estate Passive Loss Limits
(slide 3 of 4)
• Exception 2: Real estate rental activities
– Taxpayer can deduct up to $25,000 of losses on
real estate rental activities against active or
portfolio income
– Benefit is reduced by 50% of taxpayer’s AGI in
excess of $100,000
53
Real Estate Passive Loss Limits
(slide 4 of 4)
• Exception 2: Real estate rental activities
– To qualify for this exception the taxpayer must:
• Actively participate in rental activity, and
• Own at least 10% of all interests in activity
– Active participation defined:
• Requires only participation in making management
decisions in a significant and bona fide sense
54
The Big Picture - Example 31
Real Estate Rental Activities
• Return to the facts of The Big Picture on p. 11-1.
• If the Reswicks invest in the apartment rental limited
partnership, their $25,000 loss would be deductible
under the real estate rental activities exception.
– This assumes they actively participate and own at least a
10% interest in the partnership.
• The loss will be deductible in each of the first 4 years
of their investment before exhausting their at-risk
basis, even if they do not have passive income from
other sources.
55
Suspended Losses
• Losses can be suspended due to the passive
loss limits or the at-risk limits
• Losses suspended due to at-risk limitations are
investment specific, thus no allocation of
suspended losses is necessary
• Suspended at-risk and passive losses can be
carried forward indefinitely
56
Disposition of Passive Interests
(slide 1 of 2)
• Disposition at death: suspended loss deductible
on decedent’s final tax return to extent of
excess over any step-up in basis
• Disposition by gift: suspended loss increases
donee’s basis in property
57
Disposition of Passive Interests
(slide 2 of 2)
• Disposition by installment sale: portion of
suspended loss deductible is same as
percentage of total gain recognized in year
58
Investment Interest
(slide 1 of 5)
• Definition: interest on loans whose proceeds
are used to purchase investment property, e.g.,
stock, bonds, land
• Deduction of investment interest expense is
limited to net investment income
Investment Interest
(slide 2 of 5)
• Net investment income:
– Investment income less investment expenses
Investment Interest
(slide 3 of 5)
• Investment income:
– Gross income from interest, certain dividends,
annuities, and royalties not derived from business
– Net capital gains and qualified dividends are
treated as investment income only if elected
• Amount elected as investment income is not eligible for
the preferential rates that otherwise apply to net capital
gain and qualifying dividends
Investment Interest
(slide 4 of 5)
• Investment expenses:
– All expenses (other than interest) directly related
to investment income that are allowed as a
deduction
– Application of 2% of AGI floor for some
investment expenses must be considered in
computing amount of net investment income
Investment Interest
(slide 5 of 5)
• Investment interest disallowed in current year
due to limitation is carried forward to future
years until ultimately used
– Deductibility subject to net investment income
limitation in carryover years
Other Investment Losses
• Other types of investment losses that
individual taxpayers may face include the
following:
– a.
Sale of securities held as investments for
less than basis yield capital losses.
– b.
– c.
– d.
– e.
Securities held as an investment that
become worthless produce capital losses.
Losses on small business stock.
Losses on rental of vacation homes.
Hobby losses.
Other Investment Losses
• Other types of investment losses that
individual taxpayers may face include the
following:
– a.
Sale of securities held as investments for
less than basis yield capital losses.
– b.
– c.
– d.
– e.
Securities held as an investment that
become worthless produce capital losses.
Losses on small business stock.
Losses on rental of vacation homes.
Hobby losses.
The Big Picture - Example 39
Investment Interest Expense Limit
• Return to the facts of The Big Picture on p. 11-1.
• If the Reswicks invest in the high growth, low-yield portfolio
of marketable securities
– Most of the investment return will consist of appreciation
• Not taxed until the securities are sold.
– Relatively little of the return will consist of currently taxable interest
and dividend income.
• Assume that the interest and dividend income for the year
from these securities equals $500 and that all of it is treated as
investment income.
– If investment interest expense on the $100,000 loan is $8,000
• The deduction for the investment interest expense is limited to the $500 of
net investment income.
66
Refocus On The Big Picture (slide 1 of 4)
• The objective for most investors should be to
maximize after-tax wealth from among investment
alternatives.
– This requires an understanding of the relevant tax
restrictions that apply to certain expenses and losses arising
from various investment choices.
• The after-tax returns from the 3 alternatives under
consideration may be affected by the at-risk, passive
activity, and investment interest limitations.
67
Refocus On The Big Picture (slide 2 of 4)
• The high-growth, low-yield portfolio is expected to generate
very little if any current dividend income (i.e., net investment
income).
– If the broker’s prediction is correct, the market value of the securities
will grow by approximately 10% a year.
– However, the annual $8,000 interest expense on the debt incurred to
purchase the securities may not be deductible as investment interest due
to the lack of net investment income.
•
Unless investment income is generated from this or some
other source, the interest will not be deductible until the
securities are sold.
– To the extent any capital gain from the portfolio’s sale is treated as
investment income, the gain will not be subject to preferential capital
gains rates
– As a result, the net after-tax return will be impaired because of the
investment interest limitation.
68
Refocus On The Big Picture (slide 3 of 4)
• The returns from the other two
investments are reduced by the at-risk &
passive loss rules as well as the
investment interest limit.
• The projected 10% return is apparently
contingent on being able to use the tax
losses as they arise.
69
Refocus On The Big Picture (slide 4 of 4)
• These benefits will be deferred because the at-risk
and passive activity loss rules delay the timing of the
deductions.
– For example, with the orange grove investment, none of the
passive losses are deductible until year 6 when passive
income is generated.
– In the real estate rental venture, however, Jim and Trudy
could deduct the $25,000 passive loss under the rental real
estate exception.
• The at-risk rules would limit any additional losses in year 5 to the
at-risk amount.
• Since the at-risk and passive loss rules limit the tax
losses flowing to the Reswicks, the after-tax return
will not be nearly as high as their broker predicts.
70
If you have any comments or suggestions concerning this
PowerPoint Presentation for South-Western Federal
Taxation, please contact:
Dr. Donald R. Trippeer, CPA
trippedr@oneonta.edu
SUNY Oneonta
© 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
71