Archive for Passive Activity
In November 2011 the IRS issued proposed regulations (REG-109369-10) that would redefine “interest in a limited partnership as a limited partner” for purposes of determining material participation under the Sec. 469 passive loss rules.
What that means in plain terms is that historically under Sec. 469(h)(2), losses from an interest in a limited partnership have been treated as passive losses because essentially no limited partner in a limited partnership is treated as materially participating in the management of the investment.
With these proposed regulations, the IRS is more narrowly defining when a partner’s interest will be treated as a limited partnership interest for purposes of the passive activity rules which I believe to be good. Under the proposed regulations, an interest in an entity will be treated as an interest in a limited partnership under Sec. 469(h)(2) if:
The entity is classified as a partnership for federal tax purposes; and
The holder of the interest does not have rights to manage the entity at all times during the entity’s tax year under the law of the jurisdiction in which the entity was organized and under the entity’s governing agreement. Rights to manage include the power to bind the entity.
The IRS emphasizes that these rules are provided solely for purposes of the passive activity rules and not for any other provision that makes a distinction between a general partner and a limited partner. The IRS requested the change evidently because under the Revised Uniform Limited Partnership Act of 1985, many states have adopted laws that allow limited partners to participate in the management and control of the partnership without losing their limited liability. In addition, under state LLC laws, LLC members do not lose their limited liability by management participation in the LLC’s business. Nevertheless, the IRS has historically treated members of LLCs as limited partners for purposes of this rule. Various courts have disagreed with the IRS and have allowed LLC members to be treated as general partners and therefore allowed them to prove material participation under the passive loss rules.
Comments on the proposed changes are due Feb. 27, 2012. The regulations would apply to tax years beginning on or after the date of their publication in the Federal Register.
A foreclosure on rental property technically involves the sale of the property back to the lender. Form 1099-A Acquisition or Abandonment of Secured Property reports that the lender has repossessed or foreclosed on the property. Box 2 is the amount of the outstanding mortgage debt, and box 4 is the fair market value of the property. If the value of the foreclosed property exceeds the amount of outstanding debt, the debt is considered fully satisfied because the value of the property exceeds the outstanding debt meaning that there would be no debt to cancel after the lender acquires the property.
However if the lender also cancels debt associated with the transaction, there may be income to report from the cancellation of debt on IRS Form 1099-C.
When a foreclosed property is ‘sold’ back to the lender the gain or loss on that transaction is realized by the property owner or taxpayer. The gain or loss is the difference between the amount realized when the property is sold and the taxpayer’s adjusted basis or cost in purchasing and upgrading the property. IRS Publication 551 Basis of Assets is a good source of information on how the basis in the property might be increased or decreased during ownership.
The realized amount is contingent on whether the debt is recourse debt or non-recourse debt. If the debt is non-recourse debt the lender essentially cannot claim assets of the debtor if the secured property does not fully satisfy the outstanding debt. If the debt is recourse debt the lender essentially claims assets of the debtor when the secured property does not fully satisfy the outstanding debt. When the foreclosure involves recourse debt the amount realized is the smaller of the outstanding debt immediately before the foreclosure reduced by any amount of recourse debt for which the taxpayer was liable, or the fair market value of the property.
It is important to remember that Sec. 1245 property in the rental unit may be subject to depreciation recapture which is taxed as ordinary income and also that Sec. 1250 property does not necessarily require depreciation recapture particularly if the straight-line method is used. Sec. 1231 basically says that if the property is foreclosed or ‘sold’ at a loss, the loss is categorized as an ordinary loss not a capital loss.
The sale of the property is reported on IRS Form 4797 Sales of Business Property. The sale of the building is reported in Part I of Form 4797 if sold at a loss and in Part III if sold at a gain. Report the sale of the land separately in Part I, whether sold at a gain or loss. Any non-recaptured Sec. 1250 gain is entered in Part III of Schedule D Form 1040 Capital Gains and Losses.
Also commonly referred to as 197 Intangibles, the following costs must be amortized (deducted as an expense) over 15 years (180 months) starting with the later of (a) the month the intangibles were acquired or (b) the month the trade or business or activity engaged in for the production of income begins:
Going concern value;
Workforce in place;
Business books and records, operating systems, or any other information base;
A patent, copyright, formula, process, design, pattern, know-how, format, or similar item;
A customer-based intangible (e.g., composition of market or market share);
A supplier-based intangible;
A license, permit, or other right granted by a governmental unit;
A covenant not to compete entered into in connection with the acquisition of a business; and
A franchise, trademark, or trade name (including renewals).
A longer period may apply to section 197 intangibles leased under a lease agreement entered into after March 12, 2004, to a tax-exempt organization, governmental unit, or foreign person or entity (other than a partnership). See section 197(f)(10).
A section 197 intangible is treated as depreciable property used in your trade or business. When you dispose of a section 197 intangible, any gain on the disposition, up to the amount of allowable amortization, is recaptured as ordinary income. If multiple section 197 intangibles are disposed of in a single transaction or a series of related transactions, calculate the recapture as if all of the section 197 intangibles were a single asset. This does not apply to section 197 intangibles disposed of for which the fair market value exceeds the adjusted basis. In some cases based on the exit strategy of your investment and how the investment fits into your portfolio you may be best served from an overall tax strategy to NOT amortize particularly considering the amortization expense is recaptured as ordinary income when the investment is disposed.
For those of you that are partial owners of a tenants in common (TIC) real estate investment take care to discuss the amortization of intangible as well as start up expenses with someone that has gone through the whole cycle before from a tax perspective the benefits and drawbacks of electing to amortize.
A qualifying real estate professional may deduct rental real estate losses for each rental in which he/she materially participates provided 3 tests are passed:
More than one half of the taxpayer’s personal services must be in real property business. ‘Real property’ trade or business activity includes: development, construction, acquisition, conversion, rental, management, leasing, and brokerage. Examples, a real estate agent is considered to be in the real property trade or business but a construction sub-contractor is not.
Taxpayer must work more than 750 hours annually in the ‘real property business. A rental activity is considered to be in the ‘real property business’ but the taxpayer must materially participate in the activity for time to be counted.
Taxpayer must materially participate in each separate rental real estate activity unless a written election was filed with an original return to treat all real estate rentals as one single activity. Once this election is filed it binds all future years. Be sure to keep a copy of the election in your permanant tax file.
One spouse alone must satisfy both tests one and two above. Spouses cannot divide the tests amongst themselves.
Even if the taxpayer is a real estate professional rental losses are passive and are reported on Form 8582 unless taxpayer materially participated in the rental activity
Not grouping related activities as one activity
Treating equipment leasing as non-passive by placing the revenue from such on Schedule ‘C’ or Schedule K-1 line 3. Rentals are passive even if the taxpayer materially participated
Deduct rental real estate losses when AGI is more than $150,000. The $25,000 Passive Activity Loss Limitation offset is phased out when modified adjusted gross income exceeds $150,000
Real estate professional has 10+ rentals listed all as non-passive.
Schedule ‘E’ net income is reported on Form 8582 as property leased to taxpayer’s corporation or partnership. Self rented property income is not passive
Reg 1.469-4(d) prohibits grouping a rental activity and a business unless each activity is owned in identical percentage and property is leased to the business. A rental can never be grouped with a ‘C’ corp.
There are two distinct issues to evaluate when disposing of a passive asset:
Is the disposition considered to be a qualifying disposition under reg 1.469 making the losses deductible?
Is the gain on the sale truly passive income and entered on IRS form 8582 triggering deductibility of unrelated passive losses?
Current and suspended losses are deducted in a ‘qualified disposition’ if:
The disposition is in its entirety.
The disposition is to an unrelated party.
The transaction with buyer is fully taxable.
A ‘related party’ for tax purposes is:
* Mother or Father
* Son or Daughter
* Partnership or Corporation that taxpayer owned more than 50%
A disposition of an asset is considered not fully taxable if it is:
* Converted to personal use.
* Given as a gift or charitable contribution
* A like/kind exchange of real estate
* An installment sale
* In bankruptcy
Upon death of a taxpayer his/her suspended losses in an activity are allowed only to the extent losses exceed transferee’s basis.
If taxpayer materially participates in the operations of an activity that he/she owns, income is not passive and should not be reported on IRS form 8582.
If after applying current and suspended losses against the net gain on the disposition of the activity, neither loss nor gain goes on form 8582. Losses generally go on schedule ‘E’ and gains go on IRS form 4797 and or Schedule ‘D’ of the 1040
If the current year non-passive activity triggers deductibility of prior year suspended passive activity losses, IRC 469(f) permits a prior year passive loss to offset current year income from the same activity, even though that income might be non-passive in the current year. While net income or gain on sale is non-passive, it may be used to trigger prior year passive losses (or credits) from the same rental or business activity. Stated differently, non-passive income cannot offset any passive loss except a prior passive loss from the same activity. What the law does makes inherent common sense. It permits a netting of prior year passive losses against income from the same business (or rental). Note: interest income, dividends, royalties, annuities and gains on stocks and bonds will virtually always be non-passive and cannot be used to trigger former passive losses.
Common scenarios where prior year losses are triggered due to the former passive activity rule:
· Self-rented property produces net income in current year and is treated as non-passive under Reg. 1.469-2(f)(6). In prior years, there were losses from the same activity, which were passive under IRC 469(c).
· TP materially participates in the current year in a business, but did not materially participate in prior years. Material participation means meeting the 500-hour test in Reg. 1.469-5T(a) or one of the other tests.
· TP is a real estate professional and elected to group his rentals. When he/she sells even one property, since the rentals are all considered a single activity, gain from that rental will trigger deductibility of prior year losses from any of the rentals.
· There is gain on sale of a rental activity, but not a fully taxable transaction. While all losses are not triggered as the transaction fails the qualifying disposition requirement of IRC 469(g), prior year suspended losses are triggered to the extent of net income reported and taxed in the current year.
A former passive activity is any activity that was a passive activity in a prior tax year, but is not a passive activity in the current tax year. A prior year un-allowed loss from a former passive activity is allowed to the extent of the current year income from the activity.
If current year net income from the activity is less than the prior year un-allowed loss, enter the prior year un-allowed loss and any current year net income from the activity on Form 8582 and the applicable worksheets.
If current year net income from the activity is greater than or equal to the prior year un-allowed loss from the activity, report the income and loss on the forms and schedules you would normally use; do not enter the amounts on Form 8582.
If the activity has a net loss for the current year, enter the prior year un-allowed loss (but not the current year loss) on Form 8582 and the applicable worksheets.
This new IRS Revenue Procedure is hugely important. Beginning in tax years after 1/24/2010 the IRS is requiring a written statement to accompany the tax return that lists how passive investment activities are grouped. The statement must include your name, address, employer ID #, and/or social security #, and it must state clearly ‘grouped activities are an appropriate economic unit.’ This statement is only required once in the initial year of the grouping. But the statement must be kept with a copy of your tax return. This rule applies to IRS forms 1040, 1041, 1065, 1120S. Basically taxpayers avoid passive loss limitations by grouping business or rentals as one activity. Reg 1.469-4 allows for related businesses or rentals to form a single activity.
If several business entities form a single activity it is easier as an owner to materially participate. It is easier to work over 500 hours in a tax year among several entities if they are grouped together. If each entity is a separate activity, you may not have enough hours to materially participate in each. Grouping may mean that you escape passive loss limitations. Interestingly enough you only need one or two interdependency factors to demonstrate proper grouping. If there are no interdependencies found however the activities cannot be grouped.
When you might want to group activities:
If you have related businesses where one has losses
When you have a business and related rental real estate (only if both investments are owned in identical percentage or are insubstantial)
If you have a business and related equipment lease such as an airplane (only if both investments are owned in identical percentage or are insubstantial)
If you have several condo units in the same complex
When you might not want to group activities:
If you have a business with passive income and you do not materially participate
IF you have a business that is expected to be profitable in the near future.
If you have a business and rental real estate if the rental real estate has net income. Remember self rented income is always non-passive.
If you have a business with suspended losses and net income not anticipated.
John R. Dundon, EA – 720-234-1177 – firstname.lastname@example.org – http://prep.1040.com/jd/ – DEFEND YOURSELF AGAINST THE IRS - Enrolled with the United States Department of Treasury to Practice before the IRS – Enrolled Agent # 85353. Under contract with the IRS as a Certified Individual Taxpayer Identification Number (ITIN) Acceptance Agent – I am a Federally Authorized Tax Practitioner (USC 31 Section 330 + IRC 7525a.3.A) regulated under US Treasury Cir. 230.
Material participation is regular, consistent and substantial personal involvement in operations. It is required in businesses, farms, rental real estate owned by real estate professionals, most vacation rentals, hotels, motels, and B&B’s, etc.. Basically most anything reported on IRS form K-1 Line 1 for partnership or ‘S’ Corp businesses should evaluate material participation issues.
For the most part if a tax payer is ‘materially participating’ in an investment activity then losses are allowed in full. The investment is not passive. If you are not ‘materially participating’ in an investment activity then the investment is considered passive and losses are reported as passive activity losses on IRS form 8582. On this form no losses are deductible without passive income.
If you are a limited partner in an investment you are considered to have materially participated if you meet one of the following criteria:
You (or your spouse) worked more than 500 hours through out the course of the year in the business.
You ‘materially participated’ in the business for 5 of the last 10 years.
If a personal service activity you materially participated for any 3 prior years.
Additionally if you are an LLC managing member you are considered to have materially participated if you met any one of the above criteria or:
You or your spouse performed ‘most’ of the work.
You worked more than 100 hours but no one else worked more than you.
You have several passive business activities in which you claim to materially participate between 100-500 hours each, and the total participation exceeds 500 hours. (not applicable to rentals)
Facts and circumstances indicate that you materially participated, for example you did not hire a ‘manager’.