Vol 01 chapter 11 2015

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Individual Income Taxes
1
Chapter 11
Investor Losses

2
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.

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.

4
• 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.

5
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

6
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

7
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

8
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

9
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

10
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

11
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

12
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 2014, the Reswicks invest $40,000 in an oil
partnership
– By using nonrecourse loans, the partnership spends
$60,000 on deductible intangible drilling costs
applicable to their interest.
– Assume that the Reswicks’ interest in the
partnership is subject to the at-risk limits but is not
subject to the passive loss limits.

13
At-risk Limits (slide 2 of 2)
• 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 2015.
• ($60,000 loss generated − $40,000 loss allowed)

14
Carryover Losses - At-risk Limits
• Return to the facts of Example 2.
• In 2015, 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).

15
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

16
(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

17
(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

18
(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

19
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

20
Passive Loss Limits (slide 1 of 2)
• 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.

21
Passive Loss Limits (slide 2 of 2)
• 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.

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 $ 360,000
Less: Adjusted basis (200,000)
Total gain $ 160,000
Less: Suspended losses (120,000)
Taxable gain (passive) $ 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 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)

26
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

27
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?

28
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

29
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

30
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

31
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

32
(slide 2 of 8)
• Test 1
– Taxpayer participates in the activity more than 500
hours during the year

33
(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

34
(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

35
(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

36
(slide 6 of 8)
• Test 5
– Taxpayer materially participated in the activity for
any 5 years during the last 10 year period

37
(slide 7 of 8)
• Test 6
– The activity is a personal service activity in which
the taxpayer materially participated for any 3
preceding years

38
(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

39
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

40
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

41
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

42
Interaction Of At-risk
And Passive Activity Limits
• 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.

43
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

44
(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

45
(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

46
(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

47
Real Estate Rental Activities
• 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.

48
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

49
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

50
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

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

56
Investment Interest Expense Limit
• 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.

57
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.

58
• 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.

59
• 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.

60
• 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.

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
61
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

Vol 01 chapter 11 2015

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