1. Income Tax Fundamentals 2010 edition Gerald E. Whittenburg Martha Altus-Buller 2010 Cengage Learning
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8. 2010 Cengage Learning Example The Prebena family owns a ski condo in Alta, UT; in the current year personal use = 25 days and rental use = 50 days. Data pertaining to the rental follows; what amounts will be reported on Schedules E and A for the current year? Rental income $10,000 Taxes $ 1,500 Interest $ 3,000 Utilities $ 2,000 Insurance $ 1,500 Snow removal $ 2,500 Depreciation $12,000 Solution Step 1: Personal use is > 14 days or 10% of rental (5 days); therefore, does exceed the greater number and this is dual use property Step 2: Taxes/interest = $4,500 x 50/75 = $3,000 deduction on E Step 3: Other expenses = $6,000 x 50/75 = $4,000 deduction on E Step 4: Depreciation = $12,000 x 50/75 = $8,000 but limited to $3,000 (remaining income) because dual use property can’t create a loss Step 5: = What amount goes to Schedule A? ($ 4,500 taxes/interest – $3,000 rental = $1,500 ) Step 6: = What is the loss carry forward? $ 8,000 – 3,000 = $5,000
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39. 2010 Cengage Learning Example Bobbi Jo is single and owns one rental duplex that showed a loss of $20,000. Her modified AGI before the loss is $118,000. What amount of the rental loss can be claimed?
40. 2010 Cengage Learning Example Bobbi Jo is single and owns one rental duplex that showed a loss of $20,000. Her modified AGI before the loss is $118,000. What amount of the rental loss can be claimed? Solution Step 1 Modified AGI exceeds $100,000 (therefore, $25,000 allowable loss may be reduced) Step 2 $118,000 - $100,000 = $18,000 excess, $25,000 - ($18,000 x 50%) = $16,000 Only $16,000 of the rental loss can be deducted
Rents Amounts received or accrued as rents in payment for the use of property must be included in gross income. As a general rule, the payment by a lessee of any expenses of a lessor is additional rental income of the lessor ( Reg. §1.61-8(c) Consideration received by the lessor for cancellation of a lease is in substitution for rental payments and, thus, not a return of capital. Any reduction in the value of property due to cancellation of a lease is a deductible loss only when fixed by a closed transaction. Expenses attributable to property held for the production of rents or royalties are deductible in computing “adjusted gross income.”
Vacation Homes Special rules limit the amount of rental expense deductions that may be taken by an individual on a residence that is rented out for part of the year and used for personal purposes during other parts of the year. A vacation home becomes a personal residence when its owner uses it excessively for personal purposes. Excessive personal use is measured by the greater of 14 days or 10% of the number of rental days. That is, if the owner personally uses the residence more than the greater of (1) 14 days or (2) 10% of the rental days, then the dwelling will be a personal residence and rental losses are not deductible. If rental expenses exceed rental income, then regular expenses, interest and taxes, are deducted first. Other rental expenses (operating expenses are deductible to the extent of rental income. If a residence is rented out during the year for more than 14 days, then the property will either be a personal residence (personal use property) or rental property ( which could provide a deductible loss subject to the passive loss rules).
If a personal residence is rented out for less than 15 days during the year, any rental income received is excluded from gross income and no rental expense deductions are allowed. However regular expense deductions attributable to all personal residences, such as interest and taxes are still deductible
The at-risk rules and the passive activity loss limitations are designed to prevent taxpayers from claiming deductions generated by abusive tax shelters that do not reflect economic reality. Nonetheless, the presence of these rules does not guarantee that taxpayers will never claim improper deductions associated with their trades or businesses and investment ventures. A study by the IRS of 577 taxpayers revealed that wealthy individuals and big corporations recently claimed over $16 billion of improper deductions from abusive tax shelters. Of those involved in the study, 400 were individual taxpayers whose activities were clearly subject to the at-risk and passive loss rules. Whether their improper deductions were due to statutory flaws or ignorance of the law is subject to debate. While some taxpayers overstate deductions, many other taxpayers do not claim all of the deductions to which they are entitled. Among the deductions most commonly unclaimed are those related to home office expenses, job search costs, and charitable contributions. Apparently, many taxpayers fail to claim these deductions out of fear or ignorance or possibly because they lack the records needed for substantiation. Ideally, each taxpayer should take advantage of every legitimate deduction available, but only to the extent allowed by law. Unfortunately, many taxpayers end up claiming greater or lesser tax deductions than appropriate
Under Section 469 all income is placed into three categories: 1. Passive Activities 2. Active Income (Salary) 3. Portfolio Income Losses and credits from passive activities can only offset passive income. They cannot offset the other two categories. Passive loss limitations prevent taxpayers with large amounts of active income from sheltering that income through investing in passive activities (e.g., a doctor cannot use passive farm losses to offset his earned income). Example T is a physician who earns $400,000 from his practice in 1994. In January, he acquired a passive activity that produced a loss of $150,000. The loss is classified as passive and cannot be used to offset the active income from his medical practice.
The at-risk provisions limit the deductibility of losses from a business or income-producing activity to the taxpayer’s actual economic investment in the activity . a. The at-risk provisions apply to individuals and closely held corporations . b. Generally, these provisions prevent the possibility of write-offs that are a multiple of the taxpayer’s investment in the tax shelter. c. Under prior law, multiple write-offs were made possible primarily through the use of nonrecourse debt to acquire tax shelter assets (see Example 1 in the text for an illustration). d. Nonrecourse debt is debt for which the borrower is not personally liable (e.g., a mortgage on real estate acquired by a partnership without the assumption of any liability for the mortgage by the partnership or any of the partners, with the acquired property pledged as collateral for the loan). 5. The taxpayer’s at-risk amount includes cash plus the adjusted basis of property contributed to the activity plus borrowed amounts for which the taxpayer has personal liability or has pledged as security property not used in the activity. In addition, the at-risk amount includes the taxpayer’s share of amounts borrowed for use in the activity that is qualified nonrecourse
The amount at risk is increased by the taxpayer’s share of income and is decreased by the taxpayer’s share of losses and withdrawals from the activity. Example 2 : Assume the same facts as in Example 1. Ed’s share of the partnership’s income for 2007 was $25,000, and he withdrew $10,000 from the partnership during the year. His at-risk amount at the end of 2007 is $85,000 ($70,000 beginning amount + $25,000 income – $10,000 withdrawal). Example 3 : Assume the same facts as in Examples 1 and 2 and that Ed’s share of the Teal Partnership’s loss for 2008 is $100,000. Because of the at-risk limitations, Ed can only deduct $85,000 (his at-risk amount), and his ending at-risk amount is reduced to zero. The remaining $15,000 of loss is suspended under the at-risk rules. Form 6198 is used to compute the at-risk amount. Any losses disallowed for any given taxable year may be deducted in the first succeeding year in which the at-risk rules do not prevent the deduction.
SUSPENDED LOSSES Unused passive losses are carried over and used to offset future passive income or deducted against active or portfolio income when a taxpayer disposes of the activity in a fully taxable transaction. Keeping suspended losses for each activity separate is necessary in order to determine the amount of an activity's deductible portion of suspended loss whenever an event qualifying for the deduction occurs (e.g. a fully taxable disposition). TAX PLANNING CONSIDERATION A taxpayer with passive losses should consider acquiring an activity that generates passive income in order to utilize the passive losses. Example J who has active income of $200,000, owns a passive activity that produces a $90,000 loss for the year. J cannot offset the loss against active income. Upon the advice of his CPA, J acquires a passive activity that produces income of $100,000 for the year. J can now utilize the passive loss by offsetting it against the passive income.
The treatment of losses from nonrental trade or business activities depends on whether the taxpayer is a material participant . a. If a taxpayer materially participates in a nonrental trade or business activity, any loss from that activity will be treated as an active loss that can be offset against all types of income. b. If a taxpayer does not materially participate, the loss will be treated as a passive loss that can only be offset against passive income (subject to a limited exception for certain real estate rental activities, discussed in items 37 and 38 in these lecture notes). 28. From a planning perspective , taxpayers will benefit from having profitable activities classified as passive and loss activities classified as active. a. If a taxpayer has any passive losses, such losses can only be used if the taxpayer has passive income. b. Active losses can be offset against all types of income, and are not subject to the passive loss limitations.
Under Section 469 all income is placed into three categories: 1. Passive Activities 2. Active Income (Salary) 3. Portfolio Income Losses and credits from passive activities can only offset passive income. They cannot offset the other two categories. Passive loss limitations prevent taxpayers with large amounts of active income from sheltering that income through investing in passive activities (e.g., a doctor cannot use passive farm losses to offset his earned income). Example T is a physician who earns $400,000 from his practice in 1994. In January, he acquired a passive activity that produced a loss of $150,000. The loss is classified as passive and cannot be used to offset the active income from his medical practice.
RENTAL ACTIVITIES The code generally specifies that rental activities are to be treated as passive and defines a rental activity as any activity where payments are received principally for the use of tangible property. The temporary regulations contain specific rules for determining whether a rental activity is to be treated as a passive activity. An activity that is treated as a nonrental activity under any of the following six exceptions will not automatically be classified as passive. The average period of customer use for such property is seven days or less. The average period of customer use for such property is 30 days or less, and significant personal services are proved by the owner of the property. Extraordinary personal services are provided without regard to the average period of customer use. ( Example The use of a hospital's boarding facilities) The rental of such property is treated as incidental to a nonrental activity of the taxpayer. The taxpayer customarily makes the property available during defined business hours for nonexclusive use by various customers. Example Golf course for particular hours. The taxpayer provides property for use in an activity conducted by a partnership, S corporation or joint venture in which the taxpayer owns an interest, but the activity is not a rental activity. . Example A partner in a law firm provides the use of expensive audio equipment for the purpose of analyzing a case.
RENTAL REAL ESTATE ACTIVITIES An individual is allowed to avoid the passive loss limitations for all rental real estate activities in which the individual actively participates. A $25,000 offset against nonpassive income can be attained if the taxpayer's modified adjusted gross income (AGI computed without regard to any passive activity loss, taxable social security benefits, or deductions for IRA contributions) is $100,000 or less. (Sec. 469(i)). The offset is before AGI. Example A Taxpayer owns 3 rentals and had modified taxable income of $77,500 for the year. The combined loss of the rental houses was $28,000. He was an active participant in the management of the rentals. The taxpayer qualifies for the $25,000 offset and will be able to reduce passive income by that amount. The remaining $3,000 loss will become a suspended loss and will be allocated among all properties experiencing a loss.
Bad Debts: Business v. nonbusiness bad debts.-- Nonbusiness bad debts are deductible by taxpayers other than corporations only as short-term capital losses ( Code Sec. 166(d) ), are subject to the limitations on deductions for capital losses, and are reported on Schedule D (Form 1040). In addition, an S corporation that has a nonbusiness bad debt must separately state the debt as a short-term capital loss ( Rev. Rul. 93-36 , 1993-1 CB 187; No deduction may be claimed for a partially worthless nonbusiness bad debt
Special rules apply to taxpayers who want to withdraw amounts from their regular IRAs and roll the funds over to a Roth IRA. If a taxpayer meets certain requirements, an amount in a regular IRA can be converted to an amount in a Roth IRA pursuant to one of three methods. First, an amount can be contributed (rolled over) to a Roth IRA within 60 days after the distribution from a regular IRA. Second, the amount in a regular IRA can be transferred in a trustee-to-trustee transfer from the trustee of the regular IRA to the trustee of the Roth IRA. Finally, an amount in a regular IRA can be transferred to a Roth IRA that is maintained by the same trustee. For purposes of the third method, redesignating a regular IRA as a Roth IRA is treated as a transfer of the entire account balance from a regular IRA to a Roth IRA.
In 2010, a much-anticipated change in Roth individual retirement account (IRA) conversion rules will take effect. Beginning in 2010, the $100,000 adjusted gross income (AGI) limit that has prevented individuals from converting from a traditional IRA to a Roth IRA will disappear, and all individuals will be able to do so without any income or filing status limits. Practitioners can send or email the following letter to their clients to inform them about the opportunity to convert a traditional IRA to a Roth IRA in 2010 and thereafter.
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