105

Chapter 7 Deductions: Business/Investment Losses and Passive Activity Losses

SUMMARY OF CHAPTER
Deductions are allowed for losses from unprotable investment-related activities, dispositions of certain assets, and unprotable business operations. Generally, deductible losses from a business, property held for production of income, or investment property are deductible for adjusted gross income. Losses derived from personal-use property, if deductible, are usually deductible from adjusted gross income as an itemized deduction. This chapter deals with losses originating from business operations and certain investment-related activities.

Tax Shelters and At-Risk Rules

7001 Tax Shelters A tax shelter is an activity providing deductions and/or credits to an investor which will reduce tax liability with respect to income from other sources. Investments in tax shelters have been restricted by the at-risk rules and the passive activity rules. Essentially all limited partnership investments, rental properties, and businesses in which an owner does not materially participate have been affected. 7125 At-Risk Rules The at-risk rules disallow losses that are in excess of an investors amount at risk. In a general sense, at risk is the amount of investment that an investor could possibly lose. An investor is not at risk for nonrecourse borrowings, stop-loss arrangements, no-loss guarantees, or borrowings in which the lender has an interest (as in seller nancing).

Passive Activity Loss Rules

7201 Application of Rules The at-risk rules must rst be satised, then the passive activity loss rules apply. A passive loss can then be used in the following ways: offset passive income, offset other income (under certain conditions), and/or become suspended. Passive income and losses are before AGI items. 7205 Classication of Income Because of the passive activity rules, income is required to be classied as active, passive, or portfolio income. Ordinarily, active income is attributable to the direct efforts of the taxpayer, such as salary, commissions, wages, etc. Passive income is income derived from a passive activity. Portfolio income is interest, dividends, annuities, and royalties not derived in the ordinary course of a trade or business. 7211 Disallowance of Passive Losses and Credits For tax years beginning in 1991, no passive activity losses or credits may be deducted against active and portfolio income. Interests in passive activities acquired by the taxpayer on or before October 22, 1986 (the date on which the Tax Reform Act of 1986 was enacted), were eligible for a special deduction and credit phaseout of losses for a ve-year period. 7215 Suspended Losses Generally, any loss or credit from a passive activity which is disallowed by the passive loss rules is treated as a deduction or credit allocable to such activity in the next taxable year. Suspended losses can become deductible

2009 CCH. All Rights Reserved.

Chapter 7

106

CCH Federal TaxationBasic Principles

against future income from passive activities or against nonpassive income upon the fully taxable disposition of an entire interest. Suspended losses must be kept separately for each passive activity to determine the amount of the activitys deductible portion. 7225 Disposition of a Passive Activity If a passive activity is disposed of in a fully taxable transaction, any losses (including suspended losses from prior years) may be recognized by the taxpayer in that such losses can offset active and portfolio income (nonpassive income). 7231 Taxpayers Affected by Passive Losses The passive loss limitations apply to individuals, estates, trusts, closely held corporations, and personal service corporations. Partnerships and S corporations are not included in this list. 7235 Material Participation A passive activity is dened as any activity which involves the conduct of a trade or business, and in which the taxpayer does not materially participate. Also included in the denition are rental activities, without regard to the extent of the taxpayer participation. Material participation requires a taxpayer to be involved in the operations of the activity on a regular, continuous, and substantial basis. Special rules apply to signicant participation and limited partners. 7261 Identifying an Activity Determining the scope of a particular activity is important for identifying whether a taxpayer has two or more separate activities or one activity with two or more undertakings. This distinction is vital when material participation is involved and upon disposition of the activity. 7273 Rental Activities An activity is a rental activity if during the year (1) tangible property held in connection with the activity is used by customers or is held for use by customers and (2) gross income attributable to the conduct of the activity represents amounts paid principally for the use of the property. Generally, any rental activity is a passive activity, without regard to material participation. 7281 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 taxpayers modied adjusted gross income (AGI computed without regard to any passive activity loss, taxable Social Security benets, or deductions for IRA contributions) is $100,000 or less. The offset is before AGI. Effective for tax years after 1993, individuals and closely held C corporations may treat losses on rental real estate activities in which the taxpayer materially participates as losses from nonpassive activities. Individuals must materially participate for over 750 hours in real property trade or business activities during the year. Also, over one-half of the individuals personal service activities during the year must be devoted to real property trade or businesses. Closely held C corporations must realize over 50 percent of their gross revenue from the conduct of real property trade or businesses. 7287 Change of Activity Status Under the passive activity rules, it is quite possible for an activity to change from passive to nonpassive. A passive activity could become a former passive activity if (1) the taxpayer qualies as a material participant or (2) the activity no longer qualies as a trade or business or rental activity. Generally, the passive loss rules do not apply to a former passive activity.

Chapter 7

2009 CCH. All Rights Reserved.

Instructors Manual

107

Business and Investment Losses

7301 Business Casualty and Theft Losses Generally, all casualty and theft losses are deductible if incurred in a trade or business or in connection with an investment with the exception of losses caused by a taxpayers willful act of negligence. Casualty losses usually are losses from re, storm, or other catastrophe. Theft losses are losses arising from robbery, embezzlement, or larceny. 7331 Net Operating Losses (NOLs) In order to alleviate the arbitrariness of a 12-month accounting period, the net operating loss deduction allows a business to offset tax losses against taxable income over a longer period of time which normally would include an entire business cycle of up and down periods. Thus, a business which has a net operating loss in one taxable year can carry the loss back to offset taxable income in the two preceding tax years or carry the loss forward to offset future taxable income for up to 20 years. 7345 Hobby Losses Hobby losses are generally deductible only to the extent of income produced by the activity. Expenses incurred that are otherwise deductible without regard to the existence of a business or prot motive (taxes, interest, casualty losses, etc.) are deductible regardless of the amount of hobby income. However, such deductions reduce the amount of hobby income available to offset other hobby deductions. Other hobby expenses are deductible in an amount equal to the excess of hobby income over deductions otherwise allowable with regard to prot motive. 7351 Home Ofce Expenses For personal home ofce expenses to be deductible, a portion of a personal residence must be used exclusively on a regular basis (1) as the principal place of business for any trade or business of the taxpayer, (2) as a place of business which is used by patients, clients, or customers, and (3) in the case of a separate structure which is not attached to the dwelling unit, in connection with the taxpayers trade or business. If the taxpayer is an employee, the exclusive use test must be for the convenience of the employer and not merely for the convenience of the employee. The Taxpayer Relief Act of 1997 expanded the denition of principal place of business for tax years beginning after December 31, 1998. 7371 Vacation Home Expenses Special rules limit the amount of rental expenses deductions that may be taken by an individual taxpayer (investor) on a residence that is rented out for part of a year and used for personal purposes during other parts of the year. If a personal residence is rented out less than 15 days during the year, any rental income received is excluded from gross income and no rental expense deductions are allowed. If a residence is rented out during the year for more than 14 days, then the property will either be a personal residence or rental property (which could provide a deductible loss subject to the passive loss rules).

ANSWER TO KEYSTONE PROBLEMCHAPTER 7

(7371.) Kims taxable income for 2009 is a ($41,450) loss, and her net operating loss deduction is $33,600, computed as follows: Income Salary Dividends Business loss Business casualty Passive loss deduction Adjusted Gross Income $15,400 1,500 $35,000 ( 72,000 ) ( 37,000 ) ( 12,000 ) 0 ( $32,100 )

2009 CCH. All Rights Reserved.

Chapter 7

108

CCH Federal TaxationBasic Principles

Less: Standard deduction ( 5,700 Personal exemption ( 3,650 Taxable Income ( $41,450 Net Operating Loss Deduction Taxable Income ( $41,450 Add: Personal exemption 3,650 Nonbusiness expenses in excess of nonbusiness income: Standard deduction $5,700 Dividends ( 1,500 ) 4,200 Net Operating Loss Deduction ( $33,600

) ) ) )

ANSWERS TO QUESTIONSCHAPTER 7
Topical List of Questions
1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23. 24. 25. Tax Shelters: Denition (7001, 7125, and 7201) Tax Shelters: Usage (7001) At-Risk Rules: At Risk Dened (7125) At-Risk Rules: Nonrecourse Loans (7125) Passive Losses: General Rule for Deductions (7201) Passive Losses: Application of Rules (7201) Passive Losses: Classication of Income (7205) Passive Losses: Pre-enactment and Post-enactment Interests (7211) Passive Losses: Suspended Losses Dened (7215) Passive Losses: Suspended LossesTransfers on Death (7225) Passive Losses: Suspended LossesTransfers by Gift (7225) Passive Losses: Taxpayers Subject to Rules (7231) Passive Losses: Material Participation Dened (7235) Passive Losses: Material Participation Tests (7235) Passive Losses: Signicant Participation (7235) Passive Losses: Undertakings and Separate Source of Income Production (7261) Passive Losses: Rental Operations (7273) Passive Losses: Real Estate Activities (7261) Passive Losses: Nonrental Activities (7261) Passive Losses: Nonrental Property Tests (7273) Passive Losses: Rental Real Estate ActivitiesOffset (7281) Passive Losses: Rental Real Estate ActivitiesActive Participation (7281) Passive Losses: Change of Activity Status (7287) Business Casualty Losses: Deductions (7301) Business Casualty Losses: Reimbursements (7301)

Chapter 7

2009 CCH. All Rights Reserved.

Instructors Manual

109

26. 27. 28. 29. 30.

Business Casualty Losses: Business Property Basis Adjustments (7301) Net Operating Losses: Personal Expenditures (7331) Net Operating Losses: Carrybacks and Carryforwards (7331) Home Ofce Expenses (7351) Vacation Homes (7371)

Answers to Questions
Tax Shelters: Denition 1. A tax shelter is any activity that provides tax write-offs which reduce an investors tax liability with regard to income from other sources. Two limitations that apply to deductibility of losses from tax shelters are the at-risk rules (Code Sec. 465) and passive activity rules (Code Sec. 469). Tax Shelters: Usage 2. Tax shelters were popular because of their tax-saving features (i.e., the pass-through of losses and credits) which lowered many upper income investors tax liability. Tax shelter activity has been virtually eliminated by the passive activity rules, which were a major component of the Tax Reform Act of 1986. At-Risk Rules: At Risk Dened 3. At risk is the amount of investment that an investor would stand to lose if the whole activity in which the investment was made became worthless. At-Risk Rules: Nonrecourse Loans 4. A nonrecourse loan is borrowing without personal liability for repayment. Should the borrower default, the lender merely takes the property purchased (or other collateral) as satisfaction of the debt. The buyer will not be at risk in the case of seller nancing because the lender (seller) has an interest in the borrowings. This is true even if the seller is a nancial institution. (There is an exception to the at-risk rules for third party lenders of nonrecourse debt on real property.) Passive Losses: General Rule for Deductions 5. The general rule for the deductibility of passive losses is that passive losses can only offset passive income, except for the disposition of an entire interest in a passive activity, from fully taxable transactions and certain pre-enactment activities. Passive Losses: Application of Rules 6. The at-risk rules must be satised rst, then the passive rules are applied. Both restrict losses from becoming deductions. Passive Losses: Classication of Income 7. Active income is income derived from the direct efforts of the individual, such as wages, salaries, commissions, tips, etc. Passive income is income from passive activities, such as income from the operation of a limited partnership in which an investor is a limited partner. Portfolio income is income from stocks, bonds, annuities, and royalties not derived in the ordinary course of a business. Dividends, interest, and the sale of stocks, bonds, etc., are portfolio income items. Passive Losses: Pre-enactment and Post-enactment Interests 8. For tax years beginning in 1992, no passive activity losses or credits may be deducted against active and portfolio income. Interest in passive activities acquired by the taxpayer on or before October 22, 1986 (the date on which the Tax Reform Act of 1986 was enacted), were eligible for a special deduction and credit phaseout of losses for a ve-year period.

2009 CCH. All Rights Reserved.

Chapter 7

110

CCH Federal TaxationBasic Principles

Passive Losses: Suspended Losses Dened 9. Suspended losses are losses that were incurred during a tax year but were not deductible because of the passive loss restrictions. Suspended losses can offset nonpassive income when a qualied disposition of an entire interest of a passive activity has occurred. They can also offset nonpassive income upon the transfer of a passive activity by reason of death. Passive Losses: Suspended LossesTransfers on Death 10. Suspended losses are deductible by the decedent when a passive activity is transferred by reason of death to the extent that the excess of the fair market value (stepped-up basis) in the hands of the transferee over the decedents adjusted basis is less than the amount of suspended loss. Passive Losses: Suspended LossesTransfers by Gift 11. Suspended losses from passive activities that are transferred by gift are not deductible. Instead the entire suspended loss is added to the donees basis. Passive Losses: Taxpayers Subject to Rules 12. Taxpayers affected by the passive loss rules are individuals, estates, trusts, closely held C corporations, and personal service corporations. Closely held corporations are able to offset passive losses with active income but not portfolio income. Passive Losses: Material Participation Dened 13. Material participation is the involvement of a taxpayer in the operations of an activity on a regular, continuous, and substantial basis. The determination of material participation is important because it may establish whether an activity will be characterized as a passive activity or a nonpassive activity. Passive Losses: Material Participation Tests 14. The seven tests (abbreviated) to establish material participation are applied during the year and are as follows: (1) Participating more than 500 hours. (2) Substantially all of the participation in an activity (regardless of hours). (3) Participating more than 100 hours and more than any other individual. (4) Signicant participation with more than 500 hours in all signicant participating activities. (5) Material participation in any ve taxable years during the 10 preceding taxable years. (6) Material participation in any three taxable years preceding the taxable year for a personal service activity. (7) Regular, continuous, and substantial participation based on facts and circumstances. Passive Losses: Signicant Participation 15. Signicant participation requires more than 100 hours of participation, but not to the point of satisfying the material participation requirements of the other six tests. If participation in all signicant participating activities exceeds 500 hours, then all such activities become material participating activities. Passive Losses: Undertakings and Separate Source of Income Production 16. An undertaking is the smallest portion of a prot-seeking endeavor that can constitute an activity. A separate source of income production occurs when the operations of a prot-seeking endeavor are conducted at the same location and are owned by the same person and the income producing operations (rather than support operations) are conducted at such location. This is meaningful in determining whether there are one or two separate activities being carried on by a taxpayer.

Chapter 7

2009 CCH. All Rights Reserved.

Instructors Manual

111

Passive Losses: Rental Operations 17. Both rental and business operations carried on by a taxpayer at the same location are generally treated as two separate activities, unless one undertaking generates more than 80 percent of income over the other. Passive Losses: Real Estate Activities 18. A taxpayer can combine real estate activities in any manner the taxpayer chooses, so long as the IRS is informed of the election. Passive Losses: Nonrental Activities 19. Generally, nonrental activities can be combined in any manner so long as the IRS is notied. Passive Losses: Nonrental Property Tests 20. The six tests (abbreviated) used in determining nonrental property are as follows: (1) Average rental period is seven days or less. (2) Average rental period is 30 days or less with signicant personal services provided. (3) Extraordinary personal services are rendered (rental is actually incidental to the receipt of such services). (4) Amount of rental is incidental (less than 2 percent) to the nonrental activity. (5) Rental property is customarily available during dened business hours for nonexclusive use by various customers. (6) Property is rented to a nonrental activity owned by the lessor. Passive Losses: Rental Real Estate ActivitiesOffset 21. A $25,000 offset is provided taxpayers who rent real estate, who actively participate, and whose modied AGIs are $100,000 or less. There is a phaseout of the $25,000 offset for modied AGIs greater than $100,000 at the rate of $.50 per $1,000 of excess modied income. Individuals and closely held C corporations may treat losses from real estate rental activities after 1993 as losses from activities that are not passive activities if they meet certain requirements. Individuals must spend over one-half of their personal service time during the year materially participating in real property trades or businesses. In addition, they must devote over 750 hours during the year to such activities. Closely held C corporations must derive over half of their gross receipts from real property trades or businesses in which they materially participate. Passive Losses: Rental Real Estate ActivitiesActive Participation 22. Active participation is the holding of an interest equal to 10 percent or more rental real estate and the making of some management decisions, such as approving tenants, setting rental terms, and approving costs of repairs and maintenance. Passive Losses: Change of Activity Status 23. The suspended losses remain suspended, but can be offset against nonpassive income from the former activity or passive income from other passive activities. Business Casualty Losses: Deductions 24. A loss deduction resulting from the complete destruction of business-use property is gured using the propertys adjusted basis. A loss deduction resulting from the partial destruction of business-use property is gured using the lesser of (1) adjusted basis or (2) decline in fair market value (FMV before less FMV after).

2009 CCH. All Rights Reserved.

Chapter 7

112

CCH Federal TaxationBasic Principles

Business Casualty Losses: Reimbursements 25. No casualty loss can be taken in the year of loss if a reasonable prospect exists that full reimbursement of the loss from insurance or other source will be received in some future tax year. The casualty loss deduction is limited to the actual expected loss after expected insurance reimbursement. If the actual insurance reimbursement differs from the amount anticipated in past years, the difference can be deducted as a casualty loss deduction in the year the claim is settled. Business Casualty Losses: Business Property Basis Adjustments 26. A business propertys basis will be decreased by the amount of insurance or other recovery received plus the amount deducted. Net Operating Losses: Personal Expenditures 27. No, except for personal casualty and theft losses. A net operating loss deduction was created for the purpose of alleviating the inequitable burden of conducting business operations within arbitrary 12-month periods. Deductible personal expenses were not considered for the NOL deduction, however, because salaries and wages are not generally affected by arbitrary 12-month periods in the same manner as businesses. Net Operating Losses: Carrybacks and Carryforwards 28. A business incurring a net operating loss in a taxable year can carry the loss back two years and forward twenty years. A business can elect to not carry a net operating loss back but to carry it forward. If an NOL is carried back, it must be carried back to the earliest year (e.g., two years back) rst. Home Ofce Expenses 29. For personal home ofce expenses to be deductible, a portion of the home must be used exclusively on a regular basis as the principal place of business for any trade or business of the taxpayer; as a place of business which is used by patients, clients, or customers in meeting or dealing with the taxpayer in the normal course of the trade or business; or, in the case of a separate structure which is not attached to the dwelling unit, in connection with the taxpayers trade or business. If the taxpayer is an employee, the exclusive use test must be for the convenience of the employer, and not merely for the convenience of the employee. The Taxpayer Relief Act of 1997 expanded the denition of principal place of business for tax years beginning after December 31, 1998. Vacation Homes 30. A vacation home can become rental property by lowering the amount of personal use coupled with an intent to rent the property to others at fair rental value. Personal use cannot exceed the greater of 14 days or 10 percent of rental days. Rental property can provide deductions for losses, which are subject to the passive activity rules, while a personal residence (personal-use property) cannot provide deductible losses but can provide deductions for interest and taxes as well as tax-free income if rented less than 15 days.

ANSWERS TO PROBLEMSCHAPTER 7
Topical List of Problems
31. 32. 33. 34. 35. 36. At-Risk Rules: Amount at Risk (7201 and 7215) At-Risk Rules: Amount at Risk (7201 and 7215) At-Risk Rules: Amount at Risk (7125) At-Risk Rules: Amount at Risk (7125) At-Risk Rules: Amount at Risk (7125) At-Risk Rules: Passive Losses and Suspended Losses (7125 and 7215)

Chapter 7

2009 CCH. All Rights Reserved.

Instructors Manual

113

37. 38. 39. 40. 41. 42. 43. 44. 45. 46. 47. 48. 49. 50. 51. 52. 53. 54. 55. 56. 57. 58. 59. 60. 61. 62.

Passive Losses: Deduction and Allocation (7215) Passive Losses: DeductionSuspended Losses (7215) Passive Losses: DeductionSuspended Losses (7215) Passive Losses: DeductionSuspended Losses (7225) Passive Losses: Real Estate Rental Activities (7281) Passive Losses: Material Participation (7235) Passive Losses: Rental and Nonrental Operations (7261 and 7281) Passive Losses: Rental Activities (7371) Passive Losses: Material ParticipationSuspended Losses (7215 and 7235) Passive Losses: Rental Real Estate Activities (7235 and 7281) Passive Losses: Rental Real Estate Activities (7235) Business Casualty and Theft Losses (7301) Net Operating Losses: Computation (7331) Net Operating Losses: Computation (7331) Home Ofce Expenses: Computation (7351) Vacation Home Expenses: Deduction (7371) Vacation Home Expenses: Allocation (7371) Multiple ChoicePassive Activities (7235) Multiple ChoiceBusiness Casualty Losses (7301) Multiple ChoiceHome Ofce Expenses Deduction (7351) Multiple ChoiceNet Operating Losses (7331) Multiple ChoiceVacation Home Expenses (7371) Manufacturers Deduction (7375) Comprehensive ProblemPassive Losses and Rental Property Activities (7281 and 7215) Comprehensive ProblemNet Operating Losses (7331) Research ProblemVacation Home Expenses: Conversion to Rental Property

Answers to Problems
At-Risk Rules: Amount at Risk 31. Billy Bob will offset the $8,000 in passive income from Partnership A with $8,000 in losses from Partnership B. On January 1, 2010, he is at risk for $18,000 ($10,000 + $8,000) in Partnership A and $10,000 ($22,000 $12,000) in Partnership B. He has a suspended passive loss for Partnership B of $4,000 ($12,000 $8,000). He has no loss carryover under the at-risk rules. At-Risk Rules: Amount at Risk 32. Billy Bob would offset the $9,000 in passive income from Partnership A with $9,000 in passive losses from Partnership B. Because he was at risk for only $22,000 in Partnership B, he will have a loss carryover under the at-risk rules for Partnership B of $3,000 ($22,000 $25,000). His at-risk amount in Partnership B on January 1, 2010, will be zero ($22,000 $22,000). He will have a suspended passive loss from Partnership B of $13,000 ($22,000 $9,000). On January 1, 2010, he will be at risk in Partnership A for $19,000 ($10,000 + $9,000).

2009 CCH. All Rights Reserved.

Chapter 7

114

CCH Federal TaxationBasic Principles

At-Risk Rules: Amount at Risk 33. Ms. Lansing is at risk for $25,000, computed as follows: Cash contributed Basis of securities Amount at risk $15,000 10,000 $25,000

At-Risk Rules: Amount at Risk 34. Ms. Lansing will be at risk for $35,000, computed as follows: Amount at risk (see Problem 33) Allocated net income Amount at risk $25,000 10,000 $35,000

After a $5,000 withdrawal, her amount at risk will be $30,000 (withdrawals decrease amount at risk). At-Risk Rules: Amount at Risk 35. Ms. Lansing will be at risk for zero, computed as follows: Amount at risk (see Problem 33) Allocated loss, $60,000 (limited to $25,000) Amount at risk $25,000 ( 25,000 ) $0

Ms. Lansing will have a $35,000 loss carryover until she becomes at risk. At-Risk Rules: Passive Losses and Suspended Losses 36. a. Amount at risk: Cash contributed $25,000

The nonrecourse note for the acquisition of real property was nanced by the seller. Thus, the partners are not considered at risk for the note even though it was issued by a nancial institution. b. Passive loss deduction: None The amount of passive loss for which Jackson is at risk ($25,000) would be offset by an equal amount of passive income. (In addition, the activity was acquired after 1986.) Jackson would have net passive income of $10,000 ($35,000 $25,000). c. Suspended loss: None The remaining $20,000 of the allocated loss would be carried over under the at-risk rules. Passive Losses: Deduction and Allocation 37. Ms. Jones experienced a zero deduction and $50,000 suspended loss, computed as follows: Pre-enactment Activities ( $60,000 ) Post-enactment Activities $40,000 ( 30,000 ) $10,000

One Two Three Net

( $60,000 )

Chapter 7

2009 CCH. All Rights Reserved.

Instructors Manual

115

Passive Loss Deduction: Pre-enactment net loss Post-enactment net gain Net pre-enactment loss Amount deductible Suspended Loss: Total suspended loss Allocation $60,000/$90,000 ($50,000) $30,000/$90,000 ($50,000)

( $60,000 ) 10,000 ( $50,000 ) $0 ( $50,000 ) Suspended Loss $33,333 $16,667

One Three

Passive Losses: DeductionSuspended Losses 38. a. Net Loss: Selling price of A-1 Less: Basis Realized gain Net income of A-1 Total income from A-1 Less: Suspended loss Net passive loss from A-1 (deductible against nonpassive income) 2009 Passive Losses: Pre-enactment Activities $0 ( 22,000 ) Post-enactment Activities $15,000 11,000 $4,000 14,000 $18,000 ( 27,000 ) $( 9,000 )

A-1 B-2 C-3 D-4 Net b. Passive Loss Deduction:

( $22,000 )

( $5,000 ) ( 3,000 ) ( $8,000 )

Lesser of net loss of pre-enactment losses or net loss from all passive activities Passive Loss Deduction (ordinary) c. Suspended Losses: Total losses before deduction Less: Passive loss deduction Suspended Loss ( $30,000 ) 0 ( $30,000 )

( $22,000 ) $0

2009 CCH. All Rights Reserved.

Chapter 7

116

CCH Federal TaxationBasic Principles

B-2 C-3 D-4

Allocated Allocation Suspended Loss $22,000/$30,000 $30,000 $22,000 $ 5,000/$30,000 $30,000 $ 5,000 $ 3,000/$30,000 $30,000 $ 3,000

Passive Losses: DeductionSuspended Losses 39. Passive Loss Deduction: None (the losses offset the gains). Suspended Losses: Same as pre-2009 suspended losses (2009 losses were offset by an equal amount of income). Passive Losses: DeductionSuspended Losses 40. None of the suspended losses are deductible, but Willard will have an increased basis of $65,000: Donor's adjusted basis Suspended losses Donee's basis $25,000 40,000 $65,000

The donees basis is determined by adding the suspended losses to the donors adjusted basis in the activity. Passive Losses: Real Estate Rental Activities 41. Teris AGI would equal $53,000, computed as follows: Flower Shop (not passive activity) Dividends from IBM stock Interest from AT&T bonds Total Income Less: Rental property loss Adjusted Gross Income $45,000 12,000 14,000 $71,000 ( 18,000 ) $53,000

Up to $25,000 a year in losses from a rental activity in which the taxpayer actively participates may be used to offset nonpassive income. The hair salon and the laundry are passive activities because Teri did not materially participate in either of them. No deduction for either is allowed against nonpassive income. Passive Losses: Material Participation 42. AZ Airlines is the only activity in which Basemore materially participated because he participated over 500 hours. All other activities are passive activities. He did not, however, materially participate in Ven-Tale, Sadd Books, and Kingdom Autos because their combined total is exactly 500 hours (not more than 500). (MovERent is not an activity in which Basemore signicantly participated because his participation in this activity did not exceed 100 hours.) Passive Losses: Rental and Nonrental Operations 43. Because rental and nonrental operations are conducted at the same location and one class of operation (medical) predominates over the other, the predominant operation will determine the nature of the undertaking. Accordingly, both operations should be treated as a single undertaking and Dr. Hoplins adjusted gross income will be $113,000. If this analysis should fail, then the $25,000 rental real estate loss deduction could be utilized allowing Dr. Hoplin a $12,000 deduction ($12,500 maximum deduction with a modied AGI of $125,000).

Chapter 7

2009 CCH. All Rights Reserved.

Instructors Manual

117

Passive Losses: Rental Activities 44. Mr. Eichoffs adjusted gross income is $109,500, computed as follows: AGI before passive losses Vacation home loss Partnership loss Adjusted Gross Income $122,000 ( 12,500 ) 0 $109,500

Passive Losses: Material ParticipationSuspended Losses 45. Ms. Parker did not materially participate in the movie theater for 2005, 2006, 2007, and 2008, but she did materially participate in 2009. During these four years of operations, the activity experienced a $58,000 loss, which was entirely suspended: Year Loss Phaseout % 2005 $21,000 0 2006 6,000 0 2007 19,000 0 2008 12,000 0 Total Losses Suspended Deduction $0 0 0 0 Loss Suspended $21,000 6,000 19,000 12,000 $58,000

Therefore, $24,000 of suspended losses will offset the $24,000 net income from the theater, and the balance ($34,000) will be available to offset future net income from the theater and from other activities that are passive. Portfolio income cannot be offset by the suspended loss. Passive Losses: Rental Real Estate Activities 46. Because Mary Beth does not meet the criteria of (1) devoting more than half of her time to the rental activity as a material participant and (2) participating in the rental activity for more than 750 hours, the loss will be treated as passive. She may deduct the loss only against passive income. If Mary Beth had qualied as an active participant (i.e., made management decisions regarding rental fees, etc.), she might have been able to deduct up to $25,000 of the loss against nonpassive income. Passive Losses: Rental Real Estate Activities 47. Mary Beth now satises the criteria of being a material participant in the ofce building for more than 750 hours. Also, the majority of her time is spent in the real estate business. She may treat the entire rental loss as a business (active) loss, and use it to offset income from her real estate business. Business Casualty and Theft Losses 48. Max Computer Centers loss deduction for each casualty and theft is: (a) Robbery-Equipment, Theft Adjusted basis of property Less: Insurance reimbursement Nonpersonal theft loss deduction (b) Fire-Truck, Partial casualtyLesser of adjusted basis ($4,000) or decline in fair market value ($3,000) Less: Insurance reimbursement Nonpersonal casualty loss deduction $8,000 7,500 $500 $3,000 3,500 0

2009 CCH. All Rights Reserved.

Chapter 7

118

CCH Federal TaxationBasic Principles

No loss occurs because the insurance reimbursement is less than the basis. (c) Fire-Equipment, Complete casualty Adjusted basis of property Less: Insurance reimbursement Nonpersonal casualty loss deduction Net Operating Losses: Computation

$9,000 6,000 $3,000

49. Marys 2009 business net operating loss is $19,850, computed as follows: Loss shown on return Add back: Personal exemption Nonbusiness deductions ($3,000) nonbusiness income ($2,000) Net Operating Loss Net Operating Losses: Computation 50. Ralphs 2009 business net operating loss is $11,850, computed as follows: Loss shown on return Add back: Personal exemption Nonbusiness deductions ($12,000) nonbusiness income ($10,000) Net Operating Loss Home Ofce Expenses: Computation 51. a. Jane Masons home ofce deduction for 2009 is $1,360, computed as follows: Home expenses Portion of home used for home ofce Home ofce deduction $17,000 8 % $1,360 ( $17,500 ) 3,650 2,000 ( $11,850 ) ( $24,500 ) 3,650 1,000 ( $19,850 )

b. Janes home ofce deduction is limited to $1,000, the income derived from the business activities carried on at home reduced by all related tax deductions other than the business use of home deduction. Expenses normally allowable as deductions to all taxpayers (real estate taxes and interest on home mortgage) are deducted rst. Other expenses are deductible to the extent of the remaining balance of income. Any excess expenses are not deductible but could be carried forward. ($1,000 gross income less $880 interest and taxes allocation less $120 limited allocation of other home ofce expenses equals $1,000 home ofce deduction.) Vacation Home Expenses: Deductions 52. a. If a vacation home 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. Regular expense deductions which are available to all individual taxpayers on personal residences, such as mortgage interest payments, property taxes, and casualty losses, are deductible as itemized deductions. Based on these facts, no rental expense deduction is allowed to Joan on her 2009 tax return. b. If an individual uses a vacation home for personal purposes for more than the greater of 14 days or 10 percent of rental days, rental expense deductions are limited to any rental income received from the property. Since Joan used the vacation home for more than 14 days or 10 percent of rental days, her rental expense deduction is limited to $1,500, computed as follows:

Chapter 7

2009 CCH. All Rights Reserved.

Instructors Manual

119

Rental income Less: Mortgage interest payments and property taxes ($10,000 30 rental days/365 days a year) Balance available for operating expenses and depreciation Less: Utilities expenses ($4,000 30 rental days/50 total use days = $2,400 but limited to available balance) Balance available for depreciation Depreciation Net rental loss deduction

$1,500 822 $678

678 $0 0 $0

c. If an individual does not use a vacation home for more than 14 days or 10 percent of rental days, then all rental expenses are deductible for AGI (subject to the passive activity rules). Joans rental expense deduction is $15,500, computed as follows: Mortgage interest payments and property taxes ($10,000 230 rental days/365 days a year) Utilities expenses ($4,000 230 rental days/250 total use days) Depreciation ($6,000 230 rental days/250 total use days) Total rental expense deduction $6,300 3,680 5,520 $15,500

The rental expense deduction ($15,500) in excess of rental income ($9,000) is subject to limitations placed on the deductibility of excess rental expense deductions. Vacation Home Expenses: Allocation 53. The IRS prefers to allocate normal expenses allowable to all taxpayers based on total usage of the residence. Joans rental expense deduction using this allocation formula is $18,400, computed as follows: Mortgage interest payments and property taxes ($10,000 230 rental days/250 total use days) Utilities expenses ($4,000 230 rental days/250 total use days) Depreciation ($6,000 230 rental days/250 total use days) Total rental expense deductions Multiple ChoicePassive Activities 54. d. Material participation in a small-tool rental business (averaging three days use) does not qualify as a passive activity. Multiple ChoiceBusiness Casualty Losses 55. b. The basis of the warehouse is decreased by $200,000 after the casualty. Multiple ChoiceHome Ofce Expenses Deduction 56. b. Employee with an ofce on the employers premises would be the least likely to qualify for a home ofce deduction. Multiple ChoiceNet Operating Losses 57. d. Net operating losses can be increased by personal casualty losses, business casualty losses, and unreimbursed employee business expenses. $9,200 3,680 5,520 $18,400

2009 CCH. All Rights Reserved.

Chapter 7

120

CCH Federal TaxationBasic Principles

Multiple ChoiceVacation Home Expenses 58. a. All allocated vacation home (used 16 days and rented out 190 days) expenses are deductible (subject to the passive loss rules). Manufacturers Deduction 59. a. Manufacturers deduction is $43,200 b. [6% 720,000 (the lesser of $800,000 or $720,000)]. c. $720,000 $43,200 = $676,800 Johns AGI. Comprehensive ProblemPassive Losses and Rental Property Activities 60. Filing jointly gives a tax liability of $9,550 on a taxable income of $68,700. Income Harvey's salary Betty's salary Dividends Interest For AGI deductions: Passive activity loss Rental property loss Harvey's business loss Adjusted gross income From AGI deductions: Standard deduction (standard > itemized) Personal exemptions (3 $3,650) Taxable income Tax liability (tax rate schedules) *Rental loss deduction: Modied AGI ($125,000 $14,300) Less: $100,000 Excess Phaseout rate Nondeductible portion Offset Less: Nondeductible portion Rental offset Joint Return $45,000.00 62,000.00 11,000.00 7,000.00 0.00 ( 19,650.00 )* ( 14,300.00 ) $91,050.00 11,400.00 10,950.00 $68,700.00 $9,550.00 $110,700.00 100,000.00 $10,700.00 50 % $5,350.00 $25,000.00 5,350.00 $19,650.00

Comprehensive ProblemNet Operating Losses 61. The $150,000 net operating loss deduction would result in a savings of $40,577 on Michaels 2009 tax return. Business revenue Less: Business deductions Business income Less: Net operating loss deduction Adjusted business income $600,000 410,000 $190,000 150,000 $40,000

Chapter 7

2009 CCH. All Rights Reserved.

Instructors Manual

121

Less: Personal exemption Standard deduction Taxable income 2009 tax liability (tax rate schedules) Taxable income without NOL ($30,650 + $150,000) 2009 tax liability without net operating loss Tax effect of net operating loss on tax liability Note: This ignores any phaseout of personal exemption.

$3,650 5,700

9,350 $30,650 $4,180 $180,650 $44,757 $40,577

Research ProblemVacation Home Expenses: Conversion to Rental Property 62. Code Sec. 280ASpecial rules limit the amount of rental expense deductions that may be taken by an individual taxpayer (investor) on a residence that is rented out for part of a year and used for personal purposes during other parts of the year. Under Code Sec. 280A(g) 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. Code Sec. 469Rental properties will be subject to the passive loss rules under this section of the Code. However, if the taxpayers have modied AGI of $100,000 or less, then $25,000 of net rental loss can be deducted each year against nonpassive income. Reg. 1.165-9(b)The regulation provides that the loss basis will be the lower of fair market value or adjusted basis on the date of conversion. As referenced from this regulation, Reg. 1.167(g)-1 further provides that the loss basis (lower of FMV or adjusted basis on conversion date) will be the basis used in computing depreciation on the converted property. A.B. WoodTaxpayers will have the burden of establishing a new basis for converted property; failure to do so may disallow any loss deduction. E.G. McKinneyTaxpayers who rent out a vacation home, which does not qualify as rental property (because of excess personal use), cannot deduct more than the gross rentals received, but are able to use 365 days as the denominator in computing the amount of interest and taxes that are otherwise deductible. Similar to D.D. Bolton, 77 TC 104, CCH Dec. 38,705, affd (CA-9 1982) 82-2 USTC 9699, 694 F.2d 556. T.B. JeffersonProperty that is to be converted to income-producing status must be offered for rent at fair rentalas shown by the actions (intent) of the ownerin order for expenses to become deductible, including depreciation. L.M. McAuleyBefore a loss resulting from a sale can be recognized, however, the converted property must have actually been rented.

2009 CCH. All Rights Reserved.

Chapter 7