CHAPTER 5
LOSSES AND LOSS LIMITATIONS
SOLUTIONS TO PROBLEM MATERIALS
PROBLEM MATERIAL
1.
Willis, Davis, Raabe, Kaplan, and Engle, CPAs
50 Kellogg Boulevard
St. Paul, Minnesota 55164
January 29, 1998
Loon Finance Company
100 Tyler Lane
Erie, Pennsylvania 16563
This letter is to inform you of the possibility of taking a bad debt deduction of $8,000.
Your loan to Scott is a business bad debt; therefore, you are allowed to take a bad debt deduction for partial worthlessness. You also may be able to take a bad debt deduction in the year when there has been a final settlement on the debt if you collect less than currently expected. Alternatively, if you deduct any amount as a bad debt this year and subsequently collect on the debt, you may recognize income in the year the bad debt is collected.
Should you need more information or need to clarify anything, please contact me.
Sincerely,
John J. Jones, CPA
Partner
TAX FILE MEMORANDUM
Date: January 29, 1998
From: John J. Jones
Subject: Bad Debt Deduction
Loon Finance Company’s $20,000 loan to Scott is a business bad debt. Therefore, a bad debt deduction is allowed for partial worthlessness of $8,000 (i.e., Scott has filed for bankruptcy and Loon has been notified that the most it can expect to receive is 60 cents on the dollar). Loon will be able to claim a bad debt deduction in the year when a final settlement has been reached with respect to the loan.
pp. 5-3 and 5-4
3.
|
Salary |
|
|
$75,000 |
|
§ 1244 ordinary loss (limited to $50,000) |
|
|
(50,000) |
|
Long-term capital gain |
|
$19,000 |
|
|
Long-term capital loss |
$21,000 |
|
|
|
Excess § 1244 loss ($71,000 - $50,000) |
|
|
|
|
Worthless security* |
2,500 |
(23,500) |
|
|
Net long-term capital loss |
|
($4,500) |
|
|
Capital loss limitation |
|
|
(3,000) |
|
Adjusted gross income |
|
|
$22,000 |
|
Less: Standard deduction |
|
|
(4,250) |
|
Personal exemption |
|
|
(2,700) |
|
Taxable Income |
|
|
15,050 |
*The security is considered to be worthless on the last day of the tax year. Therefore, the loss is long-term.
pp. 5-5 to 5-7
4. Sell all of the stock in the current year:
Current year’s AGI
|
Salary |
|
$80,000 |
|
Ordinary loss (§ 1244 limit) |
|
(50,000) |
|
Long-term capital gain |
$8,000 |
|
|
Long-term capital loss |
(30,000) |
|
|
($80,000 - $50,000) |
||
|
Long-term capital loss (limit) |
|
(3,000) |
|
AGI |
|
$27,000 |
Next year’s AGI
|
Salary |
$90,000 |
|
|
Long-term capital gain |
$10,000 |
|
|
Long-term capital loss carryover |
(19,000) |
|
|
($30,000 - $11,000) |
||
|
Long-term capital loss (limit) |
(3,000) |
|
|
AGI |
$87,000 |
|
|
Total |
$114,000 |
Total AGI
|
Current year |
$27,000 |
|
Next year |
87,000 |
|
Total |
$114,000 |
Sell half of the stock this year and half next year:
Current year’s AGI |
|
|
Salary |
$80,000 |
|
Ordinary loss (§ 1244 stock) |
(40,000) |
|
Long-term capital gain |
8,000 |
|
AGI |
$48,000 |
|
|
|
|
Next year’s AGI |
|
|
Salary |
$90,000 |
|
Ordinary loss (§ 1244 stock) |
(40,000) |
|
Long-term capital gain |
10,000 |
|
AGI |
$60,000 |
|
|
|
|
Total AGI |
|
|
Current year |
$48,000 |
|
Next year |
60,000 |
|
Total |
$108,000 |
Mary’s combined AGI for the two years is lower if she sells half of her § 1244 stock this year and half next year. p. 5-6
5. Under Reg. § 1.165-8(a)(2), a theft loss is deductible in the year of the discovery of the theft. If, in the year of discovery, there exists a claim for reimbursement, the loss is not deductible until the claim is settled or there is no longer a reasonable expectation of recovery. Since Helen's losses are all nonbusiness losses, the statutory $100 floor is deducted from the amount of the loss. The deductible amounts in 1998 and 1999 are as follows.
1998: Lower of
Decline in Casualty
Value or Insurance Loss
Decline in Adjusted Adjusted Reim- Deduc-
Item Value Basis Basis bursement tion
|
Silver |
$16,500 |
$12,000 |
$12,000 |
$2,800 |
$9,200 |
|
Stereo |
6,200 |
8,400 |
6,200 |
5,600 |
600 |
|
TV |
560 |
840 |
560 |
490 |
70 |
|
Totals |
|
|
$18,760 |
$8,890 |
$9,870 |
|
Less: Statutory floor (one casualty ) |
(100 ) |
||||
|
Total 1998 casualty loss amount |
$9,770 |
||||
|
10%-of-AGI floor ($20,000 X 10%) |
(2,000) |
||||
|
Total 1998 casualty loss deduction |
$7,770 |
||||
1999: Since the damage to the furniture is an act of vandalism, it is regarded as a casualty loss. Assuming that the repair bill is a reasonable estimate of the decline in the value of the furniture, the deductible loss is determined as follows.
|
Damage to furniture: |
|
|
Lower of adjusted basis ($1,400) or repair bill ($1,550) |
$1,400 |
|
Less: Insurance reimbursement |
( 280) |
|
Total 1999 loss |
$1,120 |
|
Less: Statutory floor (same casualty) |
-0- |
|
Total 1999 casualty loss amount |
$1,120 |
|
10%-of-AGI floor ($500 X 10%) |
( 50 ) |
|
Total 1999 casualty loss deduction |
$1070 |
Since the claim on the furniture was unresolved as of December 31, 1998, the related loss deduction cannot be claimed on the 1998 return. However, Reg. § 1.165-7(b)(4)(ii) provides that the $100 statutory floor be applied against the entire loss from a casualty. Since the $100 floor was applied to the 1998 loss related to this same casualty, the 1999 deduction is not subject to a second $100 statutory floor. However, the 10%-of-AGI floor does apply for 1999. pp. 5-7 to 5-12
6. Home ($300,000 - $175,000) - $100,000 = $25,000 loss
Antique clock ($2,000 - $1,500) = $500 gain
Antique table ($3,000 - $3,000) = $0
Antique organ ($20,000 - $15,000) = $5,000 gain
|
Casualty loss ($25,000 - $100 floor) |
$24,900 |
|
Less: Casualty gain ($5,000 + $500) |
(5,500) |
|
Excess of casualty loss over gain |
$19,400 |
|
Less: 10% of AGI floor ($80,000 X 10%) |
(8,000) |
|
Casualty loss deduction from AGI |
$11,400 |
|
|
|
pp. 7-7 to 7-12
7. The loss is a business loss. Therefore, for the farm building and the farm equipment that were completely destroyed, the adjusted basis is used in calculating the amount of the casualty loss. For the barn that was damaged, the lower of the adjusted basis or the decline in value is used in calculating the amount of the casualty.
|
Building ($80,000 - $60,000) |
$20,000 |
|
Equipment ($40,000 - $25,000) |
15,000 |
|
Barn ($30,000 - $25,000) |
5,000 |
|
Total loss |
$40,000 |
|
|
|
Because the President declared the area a disaster area, Grackle could claim the loss on last year's return or on the current year's tax return.
If Grackle applies the loss to the prior year, the benefit of the loss will be at a tax rate of 25% to 34%. If the loss is applied to the current year, the benefit will be at a tax rate of 39% and thus, provides a larger tax savings.
Grackle should include the loss on the current year's tax return, since the tax savings are greater.
pp. 5-7 to 5-11
8. The tax issues for Toucan Corporation are as follows.
pp. 5-7 to 5-11
9.
Willis, Davis, Raabe, Kaplan, and Engle, CPAs
50 Kellogg Boulevard
St. Paul, Minnesota 55164
January 26, 1998
Snipe Industries
450 Colonel’s Way
Warrensburg, MO 64093
Gentlemen:
This letter is to inform you of the tax consequences of filing a claim versus not filing a claim with your insurance company for reimbursement for damages to the car driven by Sam Smith.
Because the claim is being made by a company and not an individual, you may deduct the casualty loss in full even if no claim for insurance is filed. Thus, your plan will work. The full $7,000 loss is deductible. Note that the result would have been different if the casualty loss were claimed by an individual. In such a circumstance, because the car was insured, the amount of the tax deduction would be determined as if a claim had been filed with the insurance company and the reimbursement was received. Consequently, the deduction would have been zero.
The benefit of filing the claim, absent any tax consequences, is an expected cash inflow of $6,000 from the insurance company, while the tax savings from the casualty loss deduction if no claim is made is $2,380 (assuming a 34% tax rate). Thus, the expected cost of policy cancellation should be at least $3,620 ($6,000 - $2,380) to justify not filing a claim.
Should you need more information or need to clarify anything, please contact me.
Sincerely,
John J. Jones, CPA
Partner
pp. 5-7 to 5-11
10. Sam should be advised to file the insurance claim. Whether or not he files the claim, the tax consequences would be the same. The amount of tax deduction is determined as if a claim had been filed with the insurance company and the reimbursement was received. Consequently, regardless of whether a claim is filed, the tax deduction from the casualty is, at most, $900, computed as follows.
|
Damage measured by decline in FMV ($19,000 - $12,000) |
$7,000 |
|
Less deemed insurance reimbursement ($7,000 - $1,000) |
(6,000) |
|
Loss from accident |
$1,000 |
|
Less $100 floor |
( 100) |
|
Loss before application of 10% of AGI floor |
$ 900 |
If Sam’s AGI is greater than $9,000, the casualty loss deduction will be zero.
p. 5-10
11. The at-risk rules limit Fred’s deductions. He can deduct $35,000 in 1998, and his at-risk amount will be reduced to $15,000 ($50,000 original investment - $35,000 deducted). He will be limited to a $15,000 deduction in 1999 unless he increases his amount at-risk. For example, if Fred invests an additional $10,000 in 1999, his at-risk amount would be $25,000 ($15,000 balance + $10,000 additional investment), and he would be able to deduct the entire $25,000 loss in 1999. Fred’s share of the partnership losses is not subject to the passive loss restrictions because Fred’s interest is not a passive activity. Examples 22
12. Willis, Davis, Raabe, Kaplan, and Engle, CPAs
50 Kellogg Boulevard
St. Paul, Minnesota 55164
February 5, 1998
Mr. Bill Parker
54 Oak Drive
St. Paul, MN 55162
Dear Mr. Parker:
This letter is in response to your inquiry regarding the tax treatment of losses that you could expect this year and next year from an investment in Best Choice Partnership. As I understand the facts, you would invest $60,000 in the partnership with the expectation that your share of the partnership losses in the current and succeeding years would be $40,000 and $25,000, respectively.
Even though your investment would not be subject to the passive activity limitations, the amount of the deduction that you may claim in any one year is subject to the at-risk rules. Essentially, these rules provide that your deductions are limited to the amount that you have invested in the venture or the amount that you could lose if the investment were to be unsuccessful. Consequently, in your case, the initial amount that you would have at risk would be $60,000. Therefore, you would be able to deduct $40,000 in the current year, which would cause your at-risk basis to be lowered to $20,000 ($60,000 - $40,000). Because your at-risk basis at the end of next year would be only $20,000, your share of subsequent partnership losses that would be deductible would be limited to $20,000. The amount not deducted under this scenario ($5,000) would be deductible later when your at-risk basis increased, for example by additional investments you may make in the partnership or because of income generated by the partnership.
If you have additional questions or need further clarification, please call me.
Sincerely,
John J. Jones, CPA
pp. 5-17 and 5-18
13. Application of the at-risk rules:
Application of the passive activity rules:
What is the interaction between the at-risk rules and the passive activity rules in determining the current treatment of losses flowing from the investment?
14. Based on the following, Alternative 2's benefit exceeds Alternative 1's by $1,196 ($34,317 - $33,121), primarily because of the flow of the benefits and the effect of the at-risk rules on those benefits.
Alternative 1
|
|
|
Tax cost/ |
After-tax |
8% PV |
Present |
|
|
Income |
benefit |
benefit |
factor |
value |
|
Yr. 1 |
($15,000) |
$ 4,200 |
$ 4,200 |
0.92593 |
$ 3,889 |
|
|
Yr. 2 |
(15,000) |
2,800 1 |
|
2,800 |
0.85734 |
2,401 |
|
Yr. 3 |
45,000 |
(11,200) 2 |
|
33,800 |
0.79383 |
26,831 |
|
Total present value |
|
|
|
$33,121 |
|
|
Alternative 2
|
|
|
Tax cost/ |
After-tax |
8% PV |
Present |
||
|
|
Income |
benefit |
benefit |
factor |
value |
||
|
Yr. 1 |
($30,000) |
$7,0003 |
$ 7,000 |
0.92593 |
$ 6,482 |
||
|
Yr. 2 |
20,000 |
(4,200) 4 |
15,800 |
0.85734 |
13,546 |
||
|
Yr. 3 |
25,000 |
|
18,000 |
0.79383 |
14,289 |
||
|
|
|
|
|
|
|
||
|
Total present value |
|
|
|
|
$34,317 |
||
1
Because of the at-risk rules, Carmen's tax deduction in year 2 is limited to her remaining at-risk basis of $10,000. The $5,000 loss that is not deductible in year 2 is suspended until her at-risk basis increases. Therefore, her tax benefit from the deduction is $2,800 ($10,000 X 28%).
2
Carmen's $45,000 share of income increases her at-risk basis and provides the opportunity to claim the $5,000 suspended loss from the previous year. Therefore, her taxable income for year 3 from this investment is $40,000 ($45,000 - $5,000) and the tax is $11,200 ($40,000 X 28%).
3
Because of the at-risk rules, Carmen's tax deduction in year 1 is limited to her at-risk basis of $25,000. The $5,000 loss that is not deductible in year 1 is suspended until her at-risk basis increases. Therefore, her tax benefit from the deduction is $7,000 ($25,000 X 28%).
4
Carmen's $20,000 share of income increases her at-risk basis and provides the opportunity to claim the $5,000 suspended loss from the previous year. Therefore, her taxable income from this investment in year 2 is $15,000 ($20,000 - $5,000) and the tax due is $4,200 ($15,000 X 28%).
pp. 4-17 and 4-18
15. In 1998, Kay cannot deduct any of the passive loss. The $35,000 loss is suspended and carried forward to 1999. The 1999 income of $15,000 is reduced by $15,000 of the suspended passive loss from 1998. After deducting $15,000 of the passive loss in 1999, $20,000 of the 1998 passive loss remains suspended. pp. 5-18 to 5-22
16. Based on the following, Option A's benefit exceeds Option B's benefit by $1,080 ($14,226 - $13,146), primarily because of the flow of the benefits and the effect of the passive activity loss rules on those benefits.
Option A
|
|
|
Tax cost/ |
After-tax |
8% PV |
Present |
|
|
Income |
benefit |
benefit |
factor |
value |
|
Yr. 1 |
$8,000 |
($2,480) |
$5,520 |
0.92593 |
$ 5,111 |
|
Yr. 2 |
8,000 |
(2,480) |
5,520 |
0.85734 |
4,733 |
|
Yr. 3 |
8,000 |
(2,480) |
5,520 |
0.79383 |
4,382 |
|
Total present value |
|
|
|
|
$14,226 |
Option B
|
|
|
Tax cost/ |
After-tax |
8% PV |
Present |
|
|
Income |
benefit |
benefit |
factor |
value |
|
Yr. 1 |
($8,000) |
$ -0- |
$ -0- |
0.92593 |
$ -0- |
|
Yr. 2 |
(2,000) |
-0- |
-0- |
0.85734 |
-0- |
|
Yr. 3 |
24,000 1 |
(7,440) |
16,560 |
0.79383 |
13,146 |
|
Total present value |
|
|
|
|
$13,146 |
1
The $10,000 of suspended passive losses from years 1 and 2 would offset the $34,000 income of year 3 producing net income from this alternative of $24,000 for the year.pp. 5-18 to 5-22
17. Last year, Leanne could deduct nothing against nonpassive income, and was required to allocate the $40,000 net loss among the three loss activities.
Income (loss):
|
Activity A $60,000 |
|
|
Activity B |
(30,000) |
|
Activity C |
(30,000) |
|
Activity D |
(40,000 ) |
|
Net passive loss |
($40000) |
|
|
|
Net passive loss allocated to:
|
Activity B (30/100 X $40 |
($12,000) |
|
Activity C (30/100 X $40000) |
(12,000) |
|
Activity D (40/100 X $40000) |
(16,000) |
|
Total suspended losses |
($40,000 ) |
In the current year, Leanne has a net gain of $20,000 from the sale of Activity D. She can offset the $16,000 suspended loss from the activity and the current year's loss of $1,000 from the activity against the $20,000 gain. In addition, the remaining net gain of $3,000 ($20,000 - $16,000 - $1,000) from the sale may be used to absorb passive losses from other activities.
pp. 5-20, 5-21 and Examples 26 and 27
18. a.
|
Net sales price |
$100,000 |
|
Less: Adjusted basis |
( 35,000) |
|
Total gain |
$ 65,000 |
|
Less: Suspended losses |
( 40,000) |
|
Taxable gain (passive) |
$ 25,000 |
b.
|
Net sales price |
$100,000 |
|
Less: Adjusted basis |
( 75,000) |
|
Total gain |
$ 25,000 |
|
Less: Suspended losses |
( 40,000) |
|
Deductible loss |
($ 15,000) |
c.
|
Net sales price |
$100,000 |
|
Less: Adjusted basis |
( 75,000) |
|
Total gain |
$ 25,000 |
|
Less: Suspended losses |
( 40,000) |
|
Deductible loss |
($ 15,000) |
|
|
|
The suspended passive losses are fully deductible. The suspended credits are lost forever because the sale of the activity did not generate any tax.
Example 29
19. A personal service corporation cannot offset passive losses against active or portfolio income. Brown’s income is $560,000 ($500,000 active income + $60,000 dividend income). Example 31 and related discussion
20. a. A personal service corporation is not allowed to offset passive losses against ordinary income. Therefore, White's taxable income based on the facts given is $436,000 ($400,000 income from operations + $36,000 portfolio income). Example 31
b. A closely held, non-personal service corporation is allowed to offset passive losses against active income, but not against portfolio income. Therefore, White's taxable income based on the facts given is $396,000 ($400,000 income from operations - $40,000 passive loss + $36,000 portfolio income). Example 32
21. A closely held, non-personal service corporation can offset passive losses against active income, but not against portfolio income. Green's income is $60,000 ($50,000 active income + $60,000 dividend income - $50,000 passive loss deducted to extent of active income). Green will have a suspended passive loss of $30,000 ($80,000 - $50,000 used). Example 32
22. If Eleanor can incur an additional 21 hours in the grocery store activity, she will have participated more than 500 hours in all of her significant participation activities. Consequently, she would be considered a material participant in the ventures and the losses expected would be deductible against her active and portfolio income. Example 38
23. Willis, Davis, Raabe, Kaplan, and Engle, CPAs
50 Kellogg Boulevard
St. Paul, Minnesota 55164
December 5, 1998
Mr. Greg Reynolds
66 Hanover Street
Cincinnati, OH 45230
Dear Mr. Reynolds:
This letter is in response to your inquiry regarding the various strategies that are available concerning your movie theater and drugstore ventures in Cincinnati, Indianapolis, and Louisville. As you know, the basic issue relates to how the stores should be grouped or reported under the passive activity rules so as to maximize the tax benefit to you.
Based on the projections that you have provided for the year, the $400,000 salary from your radio show is active income, and all profits and losses from the movie theater and drugstores will be passive (assuming your participation in these activities does not change). As a result, you would have a net passive loss of $55,000 ($89,000 loss + $41,000 loss + $15,000 loss - $56,000 profit - $34,000 profit) that would be suspended and not available to offset your salary. To mitigate this result, three options are presented below for your consideration.
Option 1 is based on the significant participation activity rule. If all of the businesses are treated as separate activities, you would not be considered a material participant, even under the significant participation activity rule. Under the significant participation activity rule, the drugstores would be considered significant participation activities, but the movie theaters would not. However, even with the drugstores, you do not expect total participation to exceed the 500 hours threshold (140 + 170 + 180 = 490). Therefore, if you could participate 11 more hours in any of the drugstore businesses, they would be treated as active and you could offset the $145,000 net loss from the drugstores against your salary. Further, if you do not change your participation in the movie theaters, their combined $90,000 of income will be reported as passive income. This characterization as passive could be helpful if you acquire additional passive businesses in the future that produce passive losses.
Under option 2, both the movie theater and drugstore businesses could be combined as a "single activity" based on common ownership. Because you have participated more than 500 hours in the five businesses, the net loss of $55,000 would be considered active which could be used to offset your radio talk show salary.
Option 3 would combine the drugstores as one activity based on product while the theaters would be treated as a separate activity based on product. As with option 1, if you could participate 11 more hours in any of the drugstore businesses, they would be treated as active and you could offset the net loss of $145,000 ($89,000 + $41,000 + $15,000) against your salary. Also, you could treat the theaters as a single business and the net income would be passive, which could be helpful in the future if other passive ventures would be acquired.
Other grouping possibilities exist, such as a grouping by location, but they do not appear to produce any tax advantages in your situation.
Greg, before making a decision on the above options, you should consider what is likely to happen in the future. For example, what is the likely profit and loss pattern of the existing businesses for the future? Will you acquire additional businesses? If so, what types of businesses are likely to be acquired, and how will the new businesses fit into the grouping method that you adopt? Will you dispose of any of the existing businesses in the near future, and what impact will that have on the current grouping decisions?
You will need to consider carefully all tax factors in deciding how to group your activities. This is because once activities have been grouped, they cannot be regrouped unless the original grouping was clearly inappropriate or there has been a material change in facts and circumstances.
Of course, our firm will be happy to assist you further in any way we can concerning the choices you face. If we can answer or clarify any questions you may have, please call me.
Sincerely,
John J. Jones, CPA
Partner
pp. 5-25 to 5-27
24. · The amount of Rene’s at-risk basis in the hardware business and whether the losses flowing from the entity are limited by the at-risk rules.
25. Lee's share of ABC's loss in 1998 is $80,000 ($400,000 X .20 ownership interest), and the entire loss is suspended under the passive loss rules. His share of the passive income in 1999 is $40,000 ($200,000 income X .20 ownership interest). His at-risk amount is $80,000 ($120,000 - $80,000 passive loss in 1998 + $40,000 share of income in 1999). He may deduct $40,000 of his $80,000 suspended loss against the passive income in 1999. This leaves a $40,000 suspended loss at the end of 1999. Examples 49 to 51
26. The at-risk limits disallow $10,000 of the deduction ($40,000 loss - $30,000 at risk). Ken is not a material participant, so the remaining $30,000 is disallowed by the passive loss rules. Examples 49 to 51
27. Fran is a material participant, so the passive loss limits do not apply. The at-risk rules limit Fran's prior year deduction to $40,000, the amount she is at risk. This reduces her at-risk amount to $0 ($40,000 at-risk amount - $40,000 deduction). The remaining $10,000 is suspended under the at-risk limits. The current income increases Fran's at-risk amount to $30,000 ($0 beginning balance + $30,000 income). This will enable her to deduct the $10,000 loss from last year that was suspended under the at-risk limits. Her at-risk amount at the end of the current year is $20,000 ($30,000 - $10,000 deduction for the prior year loss). pp. 5-17 and 5-18
28. a. If Soong is not a material participant, $45,000 of his $60,000 loss is reclassified as a passive loss and disallowed under the passive loss limits. The remaining $15,000 is disallowed by the at-risk limits. Therefore, Soong's AGI is $218,000 ($200,000 salary + $18,000 portfolio income).
b. If Soong is a material participant, $45,000 of his $60,000 loss is deductible as an active loss. The remaining $15,000 is disallowed by the at-risk limits. Therefore, Soong's AGI is $173,000 ($200,000 salary + $18,000 portfolio income - $45,000 active loss).
Examples 49 to 51
29. The fundamental issue is how can the time that Alan devotes to his business best be allocated across the various businesses in order to minimize the negative impact of the material participation rules as set out in the Regulations. Related to this issue are several related points that need to be identified and resolved.
30. If losses were limited only by the at-risk rules, Sam would be able to deduct the following amounts in 1996 and 1997.
|
Year |
Loss |
Allowed* |
Disallowed |
|
1997 |
$40,000 |
$30,000 |
$10,000 |
|
1998 |
30,000 |
-0- |
30,000 |
*Allowed under the at-risk rules, reclassified as passive losses subject to passive loss limitations.
However, the losses are limited by the passive loss rules as follows.
|
Year |
Passive |
Deductible |
Suspended |
|
1997 |
$30,000 |
-0- |
$30,000 |
|
1998 |
-0- |
-0- |
-0- |
In 1999, the $50,000 income increases Sam's at-risk amount to $50,000 so he is allowed to deduct the $40,000 of disallowed losses in 1999. The $50,000 is passive income which can be offset by $50,000 of suspended losses, leaving a suspended loss of $20,000. At the end of 1999, Sam has no unused losses under the at-risk rules, $20,000 of suspended passive losses and a $10,000 adjusted basis in the activity ($30,000 adjusted basis on 1/1/96 - $40,000 loss in 1997 - $30,000 loss in 1998 + $50,000 income in 1999). Examples 22 and 49 to 51
31. Willis, Davis, Raabe, Kaplan, and Engle, CPAs
50 Kellogg Boulevard
St. Paul, Minnesota 55164
March 5, 1998
Mr. Joe Cook
125 Hill Street
Charleston, WV 25311
Dear Mr. Cook:
This letter is in response to your inquiry regarding the $50,000 loss you incurred this year in conjunction with your investment in the apartment building, which I have assumed is not low-income housing given that it is located in an exclusive part of the city. As I understand your situation, you anticipate that your current AGI, exclusive of the loss flowing from the rental real estate activity, will be $140,000 and you wish to determine whether the loss is either partially or fully deductible.
As you are aware, the apartment rental activity is considered a passive activity, and, in general, is subject to the passive activity rules. However, because you are an active participant in the investment, you will be able to deduct $5,000 under a special exception to the passive activity rules. More specifically, the law allows losses of up to $25,000 from certain rental real estate activities to be deducted each year. However, if a taxpayer's AGI exceeds $100,000, the amount deductible in the current year is reduced by 50% of every dollar of AGI over $100,000. Once a taxpayer's AGI exceeds $150,000, no current loss deduction is allowed. Because your AGI is expected to be $140,000, the maximum allowable loss of $25,000 is reduced as follows: [$25,000 (maximum allowable) - .50($140,000 AGI - $100,000)]. Therefore, your AGI would be $135,000 after the allowable $5,000 loss ($140,000 - $5,000). The remaining $45,000 loss that would not be deductible in the current year is suspended under the passive loss rules and would be available in future years.
If you do not actively participate in the management and operations of the apartment building next year, any loss generated will be deductible only against passive income from other projects that you may have. Assuming you have no passive income, next year’s loss will not be deductible until (1) you receive passive income from the apartment or another source or (2) you dispose of the apartment.
Joe, if you have any additional questions or would like further clarification of this matter, please call me.
Sincerely,
John J. Jones, CPA
pp. 5-33 and 5-36
32. Donald does not satisfy both requirements of the provision available to certain real estate professionals which allows nonpassive treatment for the losses from real estate activities. Of the 2,300 hours Donald worked during the current year, only 1,100 hours, or less than half, involved real estate trades or businesses in which he materially participated. Therefore, his real estate rental activities are passive activities.
However, the 600 hours Donald devoted to his real estate development business satisfies the 500 hour material participation requirement. Therefore, the $18,000 loss is fully deductible.
Under the rental real estate exception, Donald can deduct $25,000 of his $26,000 real estate rental losses. The remaining $1,000 of losses are suspended passive losses.
pp. 5-34 to 5-36
33. Willis, Davis, Raabe, Kaplan, and Engle, CPAs
50 Kellogg Boulevard
St. Paul, Minnesota 55164
September 15, 1998
Scott Myers
603 Pittsfield Dr.
Champaign, IL 61821
Dear Scott,
Based on our discussion, I understand that you are attempting to qualify under the special rules for real estate professionals as a material participant in order to deduct against your nonpassive income any losses generated by this rental activity. Consequently, you should document a sufficient number of hours so that you will meet the material participation standard.
Your activities appear to date to be within the bounds of the tax law as it is written, but you also appear to be stretching its limits. You need to be careful to avoid any appearance of or taking any actual fraudulent actions on you or your wife’s part. Essentially, the issue is whether the participation hours generated are of substance or merely of form. Another issue is whether one of the principal purposes of the tasks being performed is to avoid the disallowance of passive losses or credits.
Should you need more information or need me to clarify anything, please call.
Sincerely,
Jake Smith, CPA
34. Roger is a material participant in the tax practice but not in the real estate development activity, which causes the real estate development to be classified as passive. Further, the apartment leasing operation is a passive activity because it is a rental activity and it does not qualify for the real estate rental exception given the taxpayers’ level of income. Therefore, the income from the tax practice may not be offset by either the losses from the real estate development business or the apartment leasing operation.
Roger does not qualify for the exception for real estate professionals because he has not spent more than half of his personal services in real estate trades or businesses in which he materially participates. He has not been a material participant in the real estate development activity (i.e., he has not spent more than 500 hours in the activity); therefore, the resulting loss is treated as a passive loss. Further, he does not qualify for the limited $25,000 exception available for rental real estate activities for the apartment leasing operation because his joint income tax return will show AGI in excess of $150,000.
pp. 5-33, 5-34, and Example 53
35. Gene is considered a material participant in the tax practice but not in the apartment leasing operation. However, because he actively participates in the real estate rental activity and owns at least 10% in the activity, $25,000 of the $30,000 loss is deductible in the current year against his tax practice income. The remaining $5,000 loss from the rental activity is suspended as a passive activity loss. pp. 5-33 and 5-34
36. As Ted’s income tax preparer, you need to learn more of the facts surrounding the nature of his involvement in the rental real estate activity and the management consulting business. As a general rule, rental activities are passive activities without regard to the taxpayer’s level of participation. However, if the taxpayer meets the requirements applicable to real estate professionals, then the activity shall be treated as active, and not as a passive activity [§ 469(c)(7)].
In Ted’s situation, he prefers to have the income from the rental real estate classified as passive in order to be able to use the $40,000 passive loss. If the general rule characterizing rental property applies, he will obtain the passive classification he desires. However, if his management consulting business is a real property trade or business in which he materially participates, and along with the rental real estate business, he spends more than half of his personal services in these ventures, then both the management consulting and rental real estate businesses will be treated as active. Another issue is whether the hours devoted to supporting the sports program will be considered in determining the activity’s classification. In this case, Ted would not be able to offset the $40,000 passive loss against the rental real estate income because of its active classification. Alternatively, if the management consulting business is not a real estate business and if Ted spends more than 50% of his personal services in the rental real estate business, then the rental real estate business would be treated as an active activity rather than a passive activity. Again, this would then prevent Ted from obtaining the desire result.
In the event you learn that the rental real estate venture should be treated as active because of one of the reasons above but Ted still desires passive classification, you should not accept the engagement.
37. Ida can utilize $20,000 of losses and $1,400 of credits as follows.
|
Income (Loss): |
|
|
Activity A |
($12,000) |
|
|
|
|
|
Activity B |
|
(18,000) |
|
|
|
|
Activity C |
|
10,000 |
|
Net loss |
|
|
|
|
($20,000) |
|
Utilized loss |
|
|
|
|
20,000 |
|
Suspended loss |
|
|
|
$ -0- |
|
|
Utilized credit |
|
|
|
$ 1,400 |
|
|
Suspended credit |
|
|
|
$ 700 |
|
After deducting the loss of $20,000, Ida has available a deduction equivalent of $5,000 [$25,000 (maximum loss allowed) - $20,000 (utilized loss)]. Then the maximum amount of credits Ida may claim is $1,400 [$5,000 (deduction equivalent) x .28 (marginal tax bracket)] that is allocated to Activity A. Examples 55 and 56
38.
|
Rental loss |
($105,000) |
|
Rental income |
25,000 |
|
Other passive income |
32,000 |
|
Net passive rental loss |
( $ 48,000) |
|
Deductible against other income |
25,000 |
|
Suspended rental loss |
($ 23,000) |
Example 54
39.
Hoffman, Smith, and Willis, CPAs
5101 Madison Road
Cincinnati, OH 45227
February 2, 1998
Mr. George Johnson
100 Apple Lane
St. Paul, Minnesota 55123
Dear Mr. Johnson:
This letter is in response to your request concerning whether you can claim a casualty loss for the damage your automobile sustained when it fell through the ice as you were watching an iceboat race.
Based on our research, we believe that the event constitutes a casualty and as such, you are entitled to claim a casualty loss for the damage to your car.
Should you need more information or need further clarification on any matter, do not hesitate to contact me.
Sincerely yours,
John J. Jones, CPA
Partner
TAX FILE MEMORANDUM
January 29, 1998
FROM: John J. Jones
SUBJECT: George Johnson’s Casualty Loss
Today I talked with George Johnson concerning an incident involving his car. Several weeks ago, George parked his car on a lake while he was watching an iceboat race. During the race, the ice beneath his car unexpectedly gave way, and the car sank to the bottom of the lake. George wants to know whether he will be entitled to claim a casualty loss for the damage to his car.
The facts of George’s case are similar to Rev. Rul. 69-88, 1969-1 C.B. 58. In the ruling, the taxpayer’s automobile was parked on the ice while he was ice fishing. A casualty loss was allowed for the purpose of claiming a deduction under § 165.
Based on this ruling, I have advised George that he will be entitled to claim a casualty loss for the damage to his car.
40
. Real estate rental activities are generally treated as passive activities under § 469(c)(2). However, Bill participates for more than 750 hours as a real estate professional. Therefore, the apartment building is not a passive activity based on the exception of § 469(c)(7). The small engine repair shop is a passive activity because Bill does not meet the material participation conditions of § 469(h) or the terms of the relevant Regulations. Bill does not meet the 500-hour material participation requirement for the repair shop or any other test for material participation.
Specifically, under § 469(c)(7) the apartment rental venture is given active treatment rather than passive treatment because Bill satisfies the following requirements.
Bill’s investment in the repair shop is not given active treatment because he is not considered to materially participate in its operation. The Regulations providing guidance on the meaning of the term "material participation" [Temp. Reg. § 1.469-5T(a)] include seven tests, one of which must be met for a taxpayer to be considered a material participant. Bill clearly does not meet the more-than-500-hour threshold of Temp. Reg. § 1.469-5T(a)(1); however, under Temp. Reg. § 1.469-5T(a)(4), if the activity is a significant participation activity and all of the taxpayer’s aggregate participation in all significant participation activities exceed 500 hours, each such activity is considered active. Thus, if both the repair shop and the apartment complex activities are significant participation activities, the repair shop (and the apartment complex) activity would be considered active under this Regulation.
Unfortunately for Bill, while the repair shop business is considered a significant participation activity (i.e., he participates for more than 100 hours in a trade or business) and he does not otherwise qualify as a material participant [Temp. Reg. § 1.469-5T(c)], the apartment complex activity is not a significant participation activity. Temp. Reg. § 1.469-5T(c)(1)(i) requires a significant participation activity to be a trade or business within the meaning of Reg. § 1.469-1T(e)(2). In sum, trade or business activities are such activities, other than rental activities, that are trades or business activities within the meaning of Reg. § 1.469-4(b)(1) [Reg. § 1.469-1(e)(2)]. Therefore, because the rental activity cannot be a significant participation activity, the 500-hour threshold test for all significant participation activities is not met. As a result, the repair shop business is treated as a passive activity rather than one that is active.
41.
Willis, Davis, Raabe, Kaplan, and Engle, CPAs
50 Kellogg Boulevard
St. Paul, Minnesota 55164
April 10, 1998
Mr. Bill Johnson
30 Brookfield Drive
Hampton, VA 23666
Dear Mr. Johnson:
This letter is in response to your inquiry concerning whether you should aggregate your three rental real estate properties and treat them as one activity or whether they should each be treated as a separate activity. In our discussions, you have shared the following relevant information with us:
Suspended Expected Current
Property Passive Losses Year’s Income/(Loss)
|
A |
None |
$25,000 |
|
B |
($20,000) |
$15,000 |
|
C |
($40,000) |
($15,000) |
Even though you qualify to treat the current year’s operating results as nonpassive activities under the § 469(c)(7) real estate professional exception, Reg. § 1.469-9(e) provides that these activities are treated as former passive activities if they carry previously suspended losses. This means under § 469(f)(1) that previously disallowed losses from an activity can only offset income from that activity and not from other activities. The only way to utilize losses from one activity against other income is if the activity is sold. However, as you are aware, you may receive some relief from this constraint if you elect under Reg. § 1.469-9(g) to treat the three properties as one activity for purposes of the passive loss rules rather than three separate activities.
If you choose to make the election and treat the three properties as one activity, the result for the current year follows.
|
Property A income |
$25,000 |
|
Property B income |
15,000 |
|
Property C loss |
(15,000) |
|
Income before use of suspended losses |
$25,000 |
|
Less: Use of suspended losses |
(25,000) |
|
Current amount taxed |
$ 0 |
Suspended losses carried over to future years
($60,000 - $25,000) = $35,000
If you choose not to make the election and each property is treated as a separate activity, the result for the current year follows.
|
Property B income |
$15,000 |
|
|
Less: Use of suspended |
|
|
|
loss from Property B |
(15,000) |
|
|
Net income from Property B |
|
$ 0 |
|
Property A income |
|
25,000 |
|
Property C loss |
|
(15,000) |
|
Current amount taxed |
|
|
|
(treated as nonpassive income) |
|
$10,000 |
|
|
|
|
The $10,000 taxable amount is treated as nonpassive because you qualify as a real estate professional who materially participates in real property trades or businesses.
Suspended losses carried over to future years
|
Property B ($20,000 – $15,000) |
$5,000 |
|
Property C |
40,000 |
|
Total suspended losses |
$45,000 |
As can be seen from the above analysis, if the properties are treated as one activity, all of the suspended losses are available to offset income from other rental properties aggregated in the activity. As a result, you will not recognize any income from your real estate ventures in the current year. Alternatively, without the election, the suspended losses from one activity cannot offset the income from other rental real estate activities in which you materially participate, and you will recognize $10,000 of income. Therefore, based on your particular facts, it would appear that in the current year you would benefit by making the aggregation election.
A disadvantage of making the election (which is binding unless your situation materially changes (Reg. § 1.469-9(g)) is that if you later sell either Property B or C and a significant suspended loss associated with that property has not been absorbed as of the time of the sale, the suspended loss will not be released at the time of the sale unless the property represents "substantially all" of the aggregated activity (Reg. § 1.469-4(g)). In contrast, if the election had not been made, any remaining suspended loss could be fully utilized in the year of the disposition.
As with many elections available within the context of the tax law, tradeoffs are involved which can affect various taxpayers differently, depending on their unique set of facts. If, given your particular situation, you need further help in sorting out your options or you need more information, do not hesitate to contact us.
Sincerely,
Sally P. Thomas, CPA
Partner