Homework

Chapter 7

Deductions: Business/Investment Losses and Passive Activity Losses

OBJECTIVES

After completing  Chapter 7 , you should be able to:

1. Determine the amount and classification of losses originating from business operations.

2. Ascertain the amount and classification of losses from investment-related activities.

3. Understand tax shelters and the rationale for at-risk rules.

4. Achieve a thorough understanding of the intricacies of the passive activity rules.

5. Identify and determine the amount of allowable business and theft losses.

6. Calculate the amount of a net operating loss and determine the amounts to be carried forward.

7. Understand the allowable home office expenses and determine the limitation on the deduction for such losses.

8. Achieve an understanding of the vacation home rental rules and the limitation on such losses.

OVERVIEW

Deductions are provided in the Code for losses resulting from unprofitable investment-related activities, dispositions of certain assets, and unprofitable business operations. In each of these cases certain limitations or adjustments may apply, thus limiting the amount of deductible loss. Generally, deductible losses from a business, property held for production of income, or investment property are deductible for adjusted gross income.

This chapter deals with losses originating from business operations and certain investment-related activities. Tax shelters, at-risk rules, passive activity rules, business casualty and theft losses, net operating losses, hobby losses, home office expenses, and vacation homes are among the topics addressed. Losses resulting from the sale of capital assets (e.g., stocks and bonds) and business-use assets (Code Sec. 1231) are discussed in  Chapter 12 .

Tax Shelters and At-Risk Rules

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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. Prior to the Tax Reform Act of 1986, tax shelters played an unreasonably influential role in the financial planning of many individuals. A Treasury study revealed that in 1983, 21 percent of tax returns reporting total positive income greater than $250,000 paid taxes equaling 10 percent or less of total positive income (which is composed of salary, interest, dividends, and income from profitable businesses and investments). S. Rept. No. 313, 99th Cong., 2d Sess. (1986), p. 714.

Congress recognized the undesirable consequences that tax shelters created, which included declining federal tax revenues, diverting investment capital from productive activities to tax avoidance schemes, and perhaps most importantly, the loss of faith in the federal tax system. The Senate Finance Committee went so far as to say: “Extensive shelter activity contributes to public concerns that the tax system is unfair and to the belief that tax is paid only by the naive and unsophisticated.” The reason Congress had allowed tax shelters to exist in the first place was to encourage investment in certain areas in order to promote economic growth.

EXAMPLE 7.1

Arthur Johnson, a corporate executive, had income of $275,000 during 1983 (before passive loss rules). He took advantage of the tax laws (legally) by purchasing a shopping center in January 1983. The price was $500,000. He paid $25,000 down and financed the balance over 20 years. Rental income averaged $3,500 a month, while payment on the $475,000 note was $6,000 a month. Maintenance, taxes, and repairs averaged $1,500 a month. Initially, it appears that Mr. Johnson was losing $4,000 a month ($3,500 – $6,000 – $1,500) during his first year of ownership ($48,000 a year). But after considering his tax bracket (50 percent) and depreciation (12 percent for 1983), his net cash flow actually increased by $5,000 for the year because of preferential tax rules:

Net Cash Flow Before Tax Benefit	$(48,000)
Depreciation (12% × $500,000)	(60,000)
Principal Payment Adjustment *	2,000
Net Deductible Loss	$(106,000)
Times Tax Bracket	× .50
Tax Benefit	$53,000
Net Cash Flow Before Tax Benefit	(48,000)
Net Cash Flow	$5,000
*  $2,000 of the note payments were applied to principal (i.e., not deductible), all other monthly expenses were deductible.

Notice that the tax benefit in the preceding example was treated as an immediate cash inflow. It simply reduced the taxpayer’s tax liability by the tax benefit amount, which, essentially, represented taxes that would have been paid on income from other sources, such as salary, dividends, interest, etc. When coupled with the possibility that the property could increase in value, this was a popular form of investment and an easy concept for tax shelter salesmen to sell. However, most such investments never provided a net cash flow as illustrated in the example.

Practically all tax shelters were formed as limited partnerships. Limited partnerships were used because they allowed losses and credits to be passed through to the partners’ individual tax returns. A limited partner is a partner who is not personally liable for the debts of the partnership. More importantly, a limited partner can utilize deductions and/or credits that “flow through” from the partnership. Some examples of the activities tax shelter limited partnerships engaged in included equipment leasing, real estate, oil and gas, movie productions, cattle breeding, cattle feeding, and farming. Even though most tax shelters never made a profit, thousands of taxpayers bought into them for the sole purpose of avoiding income taxes. Thus, genuine economic value was rarely considered in making an investment decision to acquire an interest in a tax shelter activity.

The Tax Reform Act of 1986 significantly impacted such investment decisions with the passage of the passive activity rules. Code Sec. 469. Essentially all limited partnership investments, rental properties, and businesses in which an owner does not materially participate have been affected. The general rule is that losses arising from a passive activity are not deductible, except against income from a passive activity. The unused portion of the loss, however, is not lost but is suspended (i.e., carried over) until offset by passive income in a future tax year or until the entire activity is disposed of in a fully taxable transaction.

EXAMPLE 7.2

Assume the same facts as in the preceding example, except that if Arthur Johnson purchased the shopping center in 2020, his investment would fall under the passive activity rules, which would allow no deduction (i.e., no tax benefit) for the loss in 2020. The entire disallowed loss would become a suspended loss until passive income is later received or he appropriately disposes of the rental property. For instance, if in 2021 the shopping center yields $25,000 in income, then the loss from 2020 would be used to offset the income and any unused balance of suspended loss would be carried over to 2022.

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AT-RISK RULES

Prior to the 1986 Act, Congress made a rather weak attempt to curb tax shelter abuse by enacting the at-risk provisions (Code Sec. 465) in 1976. The at-risk rules disallow losses that are in excess of an investor’s amount at risk. In a general sense, at risk is the amount of investment that an investor could possibly lose. The rules apply to individuals as well as closely held corporations. An investor’s amount at risk is computed as follows:

Cash invested
+	Adjusted basis of other property invested
+	Borrowings for which investor is personally liable
+	Borrowings for which investor has pledged collateral
+	Allocated portion of income
–	Allocated portion of losses
–	Withdrawals
=	Amount at risk

The formula does not indicate to what extent the allocated losses are deductible for tax purposes, because the amount at risk is reduced (but not below zero) regardless of the extent to which the losses are deductible. The deductible portion of any possible losses is calculated after applying the at-risk rules.

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 financing). Code Sec. 465. A nonrecourse loan is a loan that is secured by the property purchased, rather than the personal assets of the borrower (i.e., the borrower is not personally liable). A recourse loan, on the other hand, is one where the borrower is personally liable for repayment.

EXAMPLE 7.3

Betty Smith gave $10,000 cash, pledged $10,000 for security of a partnership loan, and gave a computer with an adjusted basis of $5,000 for her interest in a limited partnership. Her amount at risk is $25,000. The activity allocated a $40,000 loss (passive loss) to her. Only $25,000 (the amount at risk) of the $40,000 loss can be used to offset income from other passive activities during the year. Since she is not at risk for the remaining $15,000, it is carried over into a future tax year until she becomes at risk, which would then free up this amount to be offset against passive income.

EXAMPLE 7.4

Assume Betty Smith gave $10,000 cash and signed a nonrecourse note for property that the limited partnership was acquiring. Ms. Smith would only be at risk for her $10,000 cash investment, and, consequently, only $10,000 of the $40,000 could be used to offset income from other passive activities. The remaining $30,000 is carried over until she becomes at risk.

Generally, taxpayers are not considered at risk with regard to nonrecourse loans. However, a partner is considered to be at risk for certain qualified nonrecourse loans on real property. A qualified nonrecourse loan is one acquired from:

1. a person who is actively and regularly engaged in the business of lending money, or

2. any federal, state, or local government (including loans guaranteed by such governments) (Code Sec. 465(b)(6)(B))

An exception to this rule applies for loans acquired from:

1. Related parties,

2. The seller of the property, or

3. A person who receives a fee due to the taxpayer’s investment in the property.

A partner would not be at risk for such loans. Code Sec. 49(a)(1)(D)(iv).

Because losses reduce the amount at risk, such losses usually may be recaptured if the investor’s amount at risk is less than zero at the close of a taxable year. Code Sec. 465(e). Thus, when an individual’s amount at risk drops below zero, the taxpayer will include in gross income the amount of the excess. A drop in at risk, for example, can occur when a debt arrangement is changed from recourse to nonrecourse.

TAX BLUNDER

Lynn R. and Wade L. Moser et al., the taxpayers, entered into a leveraged computer leasing transaction with Finalco Inc. Finalco entered into leases with end-users, purchased the equipment, financed the purchase with a lending institution, and then resold the equipment in a sale and leaseback transaction to Lease Pro Inc., a company engaged in the purchase, sale, and leasing of computer equipment. The taxpayers then purchased the equipment from Lease Pro and leased it back to Finalco. The fixed monthly rental payment that Finalco owed to the taxpayers was the same amount as the monthly installments that the taxpayers owed to Lease Pro that, in term, was identical to the monthly installments Lease Pro owed to Finalco. As a result, in making payments, no cash was exchanged because the amount owed by each group equaled the amount each group was due. From 1981 to 1983, the taxpayers reported net losses totaling $300,937. However, these losses were disallowed because the court held that the taxpayers were not at risk under Code Sec. 465(b)(4). That is, this section suspends at-risk treatment where a transaction is structured, by whatever technique, to remove any realistic possibility that the taxpayer will suffer an economic loss if the transaction turns out to be unprofitable. W.L. Moser, 90-2 USTC ¶50,498, 914 F.2d 1040 (CA-8 1990). Whenever the circular nature of the taxpayers’ obligations effectively shields the taxpayers from economic loss, Code Sec. 465(b)(4) will hold that the taxpayers are not at risk for any portion of the notes underlying the transaction.

Passive Activity Loss Rules

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APPLICATION OF RULES

The at-risk rules are still in effect and are applied before passive loss restrictions. Once the at-risk rules are satisfied, 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.

EXAMPLE 7.5

Bob McKeown contributed $35,000 cash and signed a $15,000 nonrecourse note to invest in Limited Partnership A (LPA). He is at risk for $35,000 in the partnership. Bob is also at risk for $50,000 in Limited Partnership B (LPB). Both activities are considered to be passive activities. During the year, LPA experienced a loss and allocated to him his portion of the loss, $65,000. LPB had a better year and allocated $25,000 of income to Bob. Because Bob is at risk for only $35,000 for LPA, only $35,000 of the $65,000 loss is considered as a passive loss. As a result, $25,000 of the $35,000 passive loss from LPA can be used to offset the $25,000 of passive income (before AGI) from LPB. Ten thousand dollars ($35,000 – $25,000) of the passive loss from LPA is suspended under the passive loss rules. At the end of the year, Bob’s amount at risk for LPA will be zero ($35,000 – $35,000). The remaining $30,000 ($65,000 – $35,000) loss from LPA is carried over under the at-risk rules until Bob increases his amount at risk in LPA. Once Bob satisfies the at-risk rules, this amount will become a passive loss and may be used to offset future passive gains. Bob will be at risk for $75,000 ($50,000 + $25,000) for LPB at the end of the year.

Partnership	Initial Amount At Risk	Allocated Gain (Loss)	Loss Passive Income (Loss)	Carryover Under At-Risk Rules	Suspended Passive Loss	Ending Amount At Risk
A	$35,000	($65,000)	($35,000)	($30,000)	($10,000)	$0
B	$50,000	$25,000	$25,000	—	—	$75,000

If Bob had received $45,000 of passive income from LPB (instead of $25,000), his results would be different. He could offset the passive income with $35,000 of passive losses from LPA, resulting in $10,000 of net passive income, and have no suspended passive loss. His amount at risk for LPA is still zero and he still has a loss carryover under the at-risk rules of $30,000. His ending amount at risk for LPB would be $95,000 ($50,000 + $45,000).

Partnership	Initial Amount At Risk	Allocated Gain (Loss)	Passive Income (Loss)	Loss Carryover Under At-Risk Rules	Suspended Passive Loss	Ending Amount At Risk
A	$35,000	($65,000)	($35,000)	($30,000)	$0	$0
B	$50,000	$45,000	$45,000	—	—	$95,000

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CLASSIFICATION OF INCOME

Because of the passive activity rules, income is required to be classified as active, passive, or portfolio. 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. The gain from the sale of property that produces portfolio income (e.g., stocks and bonds) is also classified as portfolio income. Code Sec. 469(e). The reason for the classification is to keep separate the types of income that passive losses can offset. As previously mentioned, passive losses can only offset passive income and cannot be used as a deduction against active or portfolio income (except in certain instances). Similarly, tax credits from passive activities can only offset taxes incurred from passive income.

Portfolio income received by a limited partnership and allocated to the partners is not passive income, and the partners cannot offset the portfolio income by passive losses from this partnership or any other passive activity. Thus, limited partnerships that receive portfolio income and experience net income (or loss) from operations must separately allocate income (loss) generated from operations and portfolio income to its partners.

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DISALLOWANCE OF PASSIVE LOSSES AND CREDITS

For tax years after 1990, 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 five-year period. Code Sec. 469(m)(2). Thus, after 1990, passive losses in excess of passive gains are not deductible and must be carried forward.

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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. Code Sec. 469(b). Suspended losses can become deductible against future income from passive activities or against nonpassive income upon the fully taxable disposition of an entire interest. Keeping suspended losses for each passive 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).

EXAMPLE 7.6

Linda Helmsly owned the following passive activities during 2020 (all were acquired after 1986, and she was at risk for all losses):

Activity	Income/(Loss)	Suspended (Loss) *
ABC	$35,000	$0
XYZ	(45,000)	(20,000)
BBD	(60,000)	(80,000)
	$(70,000)
*  Suspended losses from previous years.

The amount of net loss experienced in 2020, $70,000, is not deductible but is suspended. It must be allocated, however, between all activities showing a loss for the year (XYZ and BBD):

Activity	Allocation	Suspended (Loss)	Total Suspended (Loss)
ABC	N/A	$ 0	$ 0
XYZ	$45,000/$105,000 × $70,000	(30,000)	(50,000)
BBD	$60,000/$105,000 × $70,000	(40,000)	(120,000)
APPLICATION OF THE AT-RISK AND PASSIVE LOSS RULES
Step 1.	Determine the amount at risk for each passive activity (before considering gain or loss for that year).
Step 2.	Determine whether each passive activity results in a gain or loss for the tax year.
Step 3.	If an activity results in a gain:
	(a)	Increase the amount at risk for that activity.
	(b)	Treat gain as passive gain.
Step 4.	If an activity results in a loss:
	(a)	Reduce the amount at risk for that activity (but not below zero) by the amount of the loss.
	(b)	Any excess losses are carried over under the at-risk rules.
	(c)	Treat losses (except for amounts carried over) as passive losses.
Step 5.	Add up all passive gains.
Step 6.	Add up all passive losses.
Step 7.	Reduce passive gains (but not below zero) by passive losses and any passive loss credits. Include any net passive gain in gross income.
Step 8.	Carry over excess passive losses as suspended passive losses.
	(a)	If more than one activity results in a passive loss, allocate suspended passive losses between the activities in proportion to the amount of their passive losses.
	(b)	In future tax years, use suspended passive losses to offset passive income.

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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 the year of disposition to the extent of $259,000 for 2020 (or $518,000 in the case of a joint return). The losses that exceed these amounts will be added to the taxpayer’s net operating loss. Such losses can offset active and portfolio income (nonpassive income). However, losses from the sale of passive activities to related parties generally are not deductible. See  Chapter 10 .

The excess of the sum of Items 1 + 2 over 3 will be treated as a loss which is not from a passive activity (i.e., deductible against nonpassive income):

1. Any loss from the activity for the tax year, including suspended losses from prior years, plus

2. Any loss realized from the disposition of the activity, over

3. Net income or gain from all passive activities (determined without regard to losses from the disposition or losses from the activity). Code Sec. 469(g)(1).

Passive activity interests that are capital assets and are appropriately disposed of are subject to the capital asset rules for losses (Code Sec. 1211) after applying the passive loss rules. See  Chapter 12 . A limited partnership interest held as an investment is a capital asset.

EXAMPLE 7.7

Rob Williams had gross income of $125,000 in 2020 and owned the following passive activities during the year:

Activity	Gain/(Loss)	Suspended (Loss)
ZZZ	$15,000	$(50,000)
XXX	(10,000)	(28,000)
YYY	(22,500)	(45,000)

All activities were acquired after 1986, and Rob was at risk for all losses. He sold his entire interest in ZZZ in a fully taxable transaction. ZZZ was a limited partnership in which Rob was a limited partner. He acquired the limited partnership interest in 1987. The selling price was $22,000, while his basis in the interest was $55,000. The result is computed as follows:

Selling price	$22,000
Adjusted basis	(55,000)
Realized loss	$(33,000)

The $50,000 of suspended losses will first offset the $15,000 gain from ZZZ, and the balance ($35,000) will be deductible against active and portfolio income. The $33,000 realized loss resulting from the sale of the limited partnership interest will become a long-term capital loss.

Death, Gift, and Other Transfers

If an interest in a passive activity is transferred by reason of death, suspended losses are deductible on a decedent’s income tax return to the extent that the excess of the stepped-up basis in the hands of the transferee over the decedent’s adjusted basis is less than the amount of suspended loss.

EXAMPLE 7.8

Zeb McFarland died and left a passive activity to his nephew. Zeb’s basis in the activity was $25,000, while the nephew’s basis was “stepped up” to $40,000. Suspended losses amounted to $21,000. The amount of passive loss deduction that can offset nonpassive income is $6,000, the $21,000 suspended loss minus the $15,000 step-up in basis.

If an interest in a passive activity is transferred by gift, the suspended losses are not deductible but are added to the recipient’s basis.

EXAMPLE 7.9

Jennie Franklin gave her daughter a limited partnership interest in a real estate activity. Suspended losses amounted to $20,000. The mother’s adjusted basis at the time of the gift was $30,000. The daughter’s basis would be the mother’s adjusted basis plus the amount of suspended losses, or $50,000 (assuming fair market value was greater than $30,000).

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TAXPAYERS AFFECTED BY PASSIVE LOSSES

The passive loss limitations apply to individuals, estates, trusts, closely held corporations, and personal service corporations. Code Sec. 469(a)(2). This list describes taxpayers that would otherwise be entitled to the tax benefits of losses or credits from a passive activity. Partnerships and S corporations are not included. Limitations on losses or credits from activities operated by these entities are passed through and applied at the level of the partners and shareholders, respectively.

Personal Service Corporations

The application of the passive activity loss rules to personal service corporations is intended to prevent taxpayers from sheltering personal service income simply by incorporating as a personal service corporation and acquiring passive activity investments at the corporate level. In general, a corporation is a personal service corporation if (1) it is a C corporation, (2) its principal activity is the performance of personal services, (3) the services are substantially performed by employee-owners, and (4) such employee-owners own more than 10 percent of the fair market value of the corporation’s outstanding stock. Whether these qualifications are satisfied is determined during a testing period for the tax year, which is generally the corporation’s prior tax year. Temp. Reg. §1.469-1T(g)(2).

Closely Held Corporations

A closely held corporation’s losses and credits from a passive activity may be limited if (1) it is a C corporation that is not a personal service corporation, and (2) more than 50 percent of its stock is owned directly or indirectly by (or for) not more than five individuals. Noting the distinction between taxpayers is worthwhile because closely held corporations are able to offset passive losses with net active income, but not portfolio income. Code Sec. 469(e)(2). Consequently, a closely held corporation is the only entity affected by the passive loss rules that can deduct losses from a passive activity that it owns.

EXAMPLE 7.10

Jasper Corporation, a closely held corporation, generated $150,000 of income from operations during the year. It also received passive losses of $200,000 and interest of $30,000. (Jasper Corporation was fully at risk for the amount of loss.) The corporation’s taxable income is $30,000 because it can offset passive losses with active income, but not with portfolio income. The remaining $50,000 of passive losses will become suspended.

Oil and Gas Working Interests

A working interest which a taxpayer holds in oil and gas properties is not subject to the passive activity rules. Code Sec. 469(c)(3). The working interest cannot be held through any entity that limits the taxpayer’s liability (e.g., limited partnership interest or stock in a corporation). A working interest is a working or operating mineral interest in any tract or parcel of land. Temp. Reg. §1.469-1T(e)(4)(iv).

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MATERIAL PARTICIPATION

A passive activity is defined as “any activity which involves the conduct of a trade or business, and in which the taxpayer does not materially participate.” Code Sec. 469(c)(1). Also included in the definition are rental activities, without regard to the extent of taxpayer participation. Temp. Reg. §1.469-1T(e)(1)(ii). As a consequence, trade or business activities in which a taxpayer does materially participate are not passive activities. Nevertheless, rental of real estate properties is generally classified as a passive activity regardless of the level of participation.

“Material participation” requires a taxpayer to be involved in the operations of the activity on a regular, continuous, and substantial basis. Code Sec. 469(h)(1). When making this rule, Congress was aware that many taxpayers would accumulate suspended losses from tax shelter investments as a result of the passive loss rules. Moreover, some of these taxpayers might own profitable businesses that could be turned into passive activities (which would then be used to offset passive losses). The change from an active business to a passive activity could possibly be achieved by lowering a taxpayer’s level of participation in the active business. The result of such maneuvering would impede the overall effectiveness of the passive loss provisions. Material participation, then, was devised to include virtually all “passive” business owners but at the same time exclude certain “active” business owners from being brought into the passive loss arena.

On the other hand, a business in which an individual materially participates is not a passive activity. Therefore, if the business experiences a loss, the loss will be deductible against all other types of income (passive, active, and/or portfolio) without regard to the passive loss restrictions. Additional guidance in making the determination as to who qualifies as a material participant is provided under the regulations by furnishing seven tests. Temp. Reg. §1.469-5T(a). Thus, an individual will be treated as materially participating in an activity for the tax year if any of the following tests apply:

Test 1.	The individual participates in the activity for more than 500 hours during the tax year.
Test 2.	The individual’s participation in the activity constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners) for the tax year.
Test 3.	The individual participates in the activity for more than 100 hours during the tax year, and such individual’s participation for the tax year is not less than the participation in the activity of any other individual (including nonowners) for the tax year.
Test 4.	The activity is a “significant participation” activity for the tax year, and the individual’s aggregate participation in all significant participation activities during such year exceeds 500 hours (see below).
Test 5.	The individual materially participated in the activity for any five tax years, whether or not consecutive, during the 10 tax years that immediately preceded the tax year.
Test 6.	The activity is a personal service activity and the individual materially participated in the activity for any three tax years, whether or not consecutive, preceding the tax year.
Test 7.	Based on all of the facts and circumstances, the individual participates in the activity on a regular, continuous, and substantial basis during the tax year.

Also note that in determining whether a taxpayer materially participates, the participation of a taxpayer’s spouse will be taken into account. Code Sec. 469(h)(5).

Significant Participation

An individual is treated as significantly participating in an activity for a tax year if and only if the individual participates in the activity for more than 100 hours during the year. A significant participating activity is a trade or business in which an individual significantly participates, but not to the extent of material participation as determined by the other six tests. Temp. Reg. §1.469-5T(c). In other words, an individual may have ownership interests in several businesses, but participates infrequently (less than material participation in each). If the hours of participation for each activity exceed 100, and the total number of hours in all such businesses exceeds 500, then the individual is treated as materially participating in all such businesses.

EXAMPLE 7.11

David Jones owns an interest in six businesses. His level of participation is as follows:

Activity	Hours
A	100
B	125
C	90
D	135
E	140
F	100
Total	690

David is not a material participant in any one of the activities above. In addition, he is not significantly participating in activities A, C, and F (not more than 100 hours of participation in each). The aggregate amount of participation in the significant participating activities is 400 hours from activities B, D, and E. Therefore, David is not treated as materially participating under Test 4, and all activities fall under the passive loss rules.

 

EXAMPLE 7.12

Assume the same facts as in  Example 7.11 , except that activity C had 105 hours of participation. Because the number of participation hours is in excess of 100, activity C is a significant participation activity. This brings the aggregate number of hours in significant participating activities to 505. David would now be considered to be a material participant, and therefore only activities A and F would fall under the passive loss rules.

Limited Partners

Limited partners, by the very nature of their relationship to the partnership, are not considered to be material participants. As a general rule, limited partners are not involved in the day-to-day management of partnership affairs. However, if limited partners participate in the activity, they may become material participants in the partnership if one of the following applies:

1. The limited partner holds a general partnership interest at all times during the partnership’s tax year ending with or within the individual’s tax year (or the portion of the partnership’s tax year during which the individual—directly or indirectly—owns such limited partnership interest).

2. The limited partner participates more than 500 hours (Test 1).

3. The limited partner participates for any five years during the 10 tax years immediately preceding the tax year at issue (Test 5).

4. For a personal service activity, the limited partner materially participated in the activity for any three years preceding the year at issue (Test 6). Temp. Reg. §1.469-5T(e).

Participation Standard

The Internal Revenue Service considers an individual to be participating when any work is done by such individual in connection with an activity in which the individual owns an interest at the time the work is done. Individuals are not considered as participating in the following situations:

1. Work not customarily done by an owner if one of the principal purposes for the work is to avoid the disallowance of any loss or credit from such activity under the passive loss rules.

2. Work done in the individual’s capacity as an investor (such as studying and reviewing financial statements of the activity, preparing or compiling summaries or analyses of the finances or operations of the activity for the individual’s own use, and monitoring the finances or operations in a nonmanagerial role). Temp. Reg. §1.469-5T(f).

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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 having two or more undertakings. Two situations in which this determination is vital occur when material participation is involved and upon disposition of the activity. For example, if an owner is involved in an activity that has two separate and distinct undertakings, such as rental property and retail sales, then a determination must be made as to whether the two undertakings will be treated as one activity or two activities. If the sales/rental business is treated as one activity, then the individual will only have to satisfy the material participation rules for one activity. A disposition of one of the undertakings, however, will not qualify as a “disposition of an entire interest” for purposes of recognizing a loss against nonpassive income. But if the sales/rental business is treated as two separate activities, then the material participation requirements must be met for each separate activity. In addition, because each undertaking is a separate activity, a disposition of an entire interest is allowed if one of the undertakings (now an activity) is sold.

Proposed Regulations were issued in 1992 which provide guidance for grouping a taxpayer’s trade or business activities and rental activities under the passive activity rules. The regulations define trade or business activities as activities that:

1. Involve the conduct of a trade or business (within the meaning of Code Sec. 162);

2. Are conducted in anticipation of the commencement of a trade or business; or

3. Involve research or experimental expenditures that are deductible under Code Sec. 174 (or would be deductible if the taxpayer adopted the method described in Code Sec. 174(a)). Prop. Reg. §1.469-4(b)(1).

 

Rental activities are defined as activities constituting rental activities within the meaning of Temporary Regulation §1.469-1T(e)(3). They are discussed in detail in the next section of this chapter.

Under the Regulations, a taxpayer may treat one or more trade or business activities or rental activities as a single activity. To qualify for such treatment, the activities must constitute an appropriate economic unit for determining gain or loss for purposes of Code Sec. 469.

A facts and circumstances approach is used to determine whether or not various activities may be treated as a single activity. Any reasonable method of applying the relevant facts and circumstances may be used for this purpose. Certain factors are considered the most important in determining whether separate activities constitute an appropriate economic unit. However, not all factors need be present. They are:

1. Similarities and differences in types of businesses;

2. The extent of common control;

3. The extent of common ownership;

4. Geographical location; and

5. Interdependence between activities.

Interdependence between activities may exist if firms buy or sell goods to one another, have customers in common, provide products or services together, share employees, or are accounted for on the same set of books and records. Reg. §1.469-4(c)(1) and (2).

EXAMPLE 7.13

Ernie operates a bookstore and a restaurant in a shopping mall in Atlanta and a bookstore and a restaurant in Miami. Depending upon how Ernie applies the facts and circumstances test, he may end up with one to four activities for purposes of the passive activity rules. Both bookstores and restaurants could be grouped into one activity. Alternatively, he may have two separate activities, one constituting the bookstores and one constituting the restaurants. He may also have an Atlanta activity and a Miami activity. Finally, he may treat each business as a separate activity. Reg. §1.469-4(c)(3)

EXAMPLE 7.14

Ted owns a large retail business. He is the sole proprietor of a firm that provides bookkeeping services to businesses. The retail business is the primary client of the bookkeeping firm. Because the two activities are under common control, Ted could treat the retail activity and the bookkeeping activity as a single activity. Reg. §1.469-4(c)(3).

The Regulations generally prohibit the grouping of rental activities with nonrental trade or business activities. However, such groupings are permissible if the income generated by one activity is insubstantial in relation to the income generated by the other activity. No guidance is provided in the Proposed Regulations on the meaning of the word “insubstantial” in this context. Reg. §1.469-4(d). But prior temporary regulations indicate that an activity providing 20 percent or less of the total revenue of two activities may be considered insubstantial.

Two separate rental activities, one involving personal property and the other involving real property, may not be grouped into one activity. An exception to this rule arises when personal property is rented in connection with real property. Reg. §1.469-4(e).

Limited partners in partnerships are generally prohibited from grouping the limited partnership activity with other activities. However, such groupings are permitted with other activities in which the taxpayer is a limited partner and which carry on the same type of business. If the taxpayer is not a limited partner in the second activity, the grouping may still be achieved by applying the facts and circumstances test. Reg. §1.469-4(f)(1) and (2).

Activities that have been grouped under any of the above criteria may not be regrouped in subsequent taxable years unless it can be demonstrated that the original grouping was clearly inappropriate. Alternatively, a material change in the facts and circumstances (such as a change in ownership) may occur that would justify a regrouping of activities. Reg. §1.469-4(g).

The Commissioner has the authority to regroup a taxpayer’s activities. This will occur if the grouping does not result in appropriate economic units under the facts and circumstances test and one of the primary purposes of the taxpayer’s grouping is to avoid the passive loss rules. Reg. §1.469-4(h).

EXAMPLE 7.15

Bob and three friends each own separate retail businesses, and they invested in limited partnerships years ago that generate annual passive losses. Bob and his friends acquire limited partner interests in a partnership created to provide janitorial services to their respective retail businesses. The janitorial service is run by a general partner selected by Bob and the others. The janitorial service is set up to insure that it generates a profit. The four limited partners plan to treat the janitorial service as a separate activity and use losses from their other limited partnership to offset the net profit from the janitorial service.

Applying the facts and circumstances test, each partner’s interest in the janitorial service and the partner’s respective business would constitute one appropriate economic activity, rather than two. In addition, it is obvious that the partners created the janitorial service and treated it as a separate activity in order to circumvent the passive loss rules. Hence, the Commissioner would likely require the partners to treat their respective interests in the janitorial service and their individual businesses as one activity instead of two. Penalties may also be levied against them under Code Sec. 6662. Reg. §1.469-4(h).

Activities carried on by a partnership or S corporation are first grouped by the partnership or S corporation by applying these rules. After the activities are grouped by the partnership or corporation, the individual partner or shareholder then groups the activities with other activities, as appropriate, in which the partner or shareholder is personally involved. Reg. §1.469-4(j).

Under certain circumstances, a taxpayer who disposes of a substantial part of an activity during a taxable year may treat the part disposed of as a separate activity. To do so, the taxpayer must establish the following with reasonable certainty:

1. The amount of disallowed deductions and credits carried over from prior years that are allocable to that part of the activity for the taxable year; and

2. The amount of gross income and any other deductions and credits allocable to that part of the activity for the taxable year. Reg. §1.469-4(k).

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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. Temp. Reg. §1.469-1T(e)(3). Generally, any rental activity is a passive activity, without regard to material participation. Code Sec. 469(c)(2) and (4).

The following tests and examples are exceptions to rental activity status (i.e., if any test is met, then the activity is not a rental activity);

1. The average period of customer use for rental property is seven days or less.

EXAMPLE 7.16

George Lee owns a home video movie rental store. The average period of customer use is two days. The store is not a rental activity.

2. The average period of customer use is 30 days or less, and significant personal services are provided by or on behalf of the owner in connection with making the property available for use by customers. Significant personal services include services performed by individuals. In making the determination, factors such as the frequency with which the service is provided, type and amount of labor required, and the value of the services relative to the amount charged for the use of property will be weighed.

EXAMPLE 7.17

Monica Sellers owns a computer leasing service. The average period of customer use is more than seven days but less than 30 days. Pursuant to the lease agreements, skilled technicians and programming consultants employed by her maintain and service malfunctioning equipment as well as implement programs for no additional charge. The value of the maintenance, repair, and implementation services exceeds 50 percent of the amount charged for the use of the equipment. Significant personal services are provided and the activity is not a passive activity.

3. Extraordinary personal services are provided by or on behalf of the owner in connection with making the property available for use by customers. Extraordinary personal services are services provided to customers so that use of the property is actually incidental to the receipt of such services.

EXAMPLE 7.18

The use of a hospital’s boarding facilities generally is incidental to the receipt of personal services provided by the hospital’s medical staff. The hospital’s boarding operations are not rental activities.

4. The rental of such property is treated as incidental to a nonrental activity of the taxpayer.

EXAMPLE 7.19

Bob Townson owns 3,000 acres of unimproved land for the principal purpose of realizing gain from appreciation. In order to defray the cost of carrying the land, he leases it to a rancher who allows cattle to graze on it. If the gross rental income is less than 2 percent of the lesser of the land’s fair market value or the adjusted basis (incidental to the nonrental activity), then the land is not a rental activity. Assuming that the land is worth $600,000 and his adjusted basis is $450,000, the rent must be less than $9,000 (2% × $450,000) in order for it to be incidental.

5. The taxpayer customarily makes the property available during defined business hours for nonexclusive use by various customers.

EXAMPLE 7.20

Operating a golf course that is available during prescribed business hours for nonexclusive use by various golfers is not a rental activity.

6. 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. Temp. Reg. §1.469-1T(e)(3)(B)(ii).

EXAMPLE 7.21

Patricia Bowers is a partner in a law firm. She provides to the firm the use of expensive, sophisticated audio equipment for the purpose of analyzing a case. The equipment is unloaded in the firm’s office and used for a specified period of time for a fee. The law firm is not engaged in a rental activity. None of her fees from the audio equipment will be considered as income from a rental activity.

PLANNING POINTER

Even though an activity is not classified as a rental activity, it may still fall into passive activity status if the material participation requirements are not met.

 

¶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 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. Code Sec. 469(i). The offset is before AGI.

EXAMPLE 7.22

Alex Alexander owned three rental houses and had modified AGI 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 rental properties. Alex qualifies for the $25,000 offset and will be able to reduce nonpassive income by that amount. The remaining $3,000 loss will become a suspended loss and will be allocated among all properties experiencing a loss.

Active participation, as opposed to material participation, need not be regular, continuous, and substantial. Active participation by an individual can include making some of the management decisions (such as approving prospective tenants, setting the terms of rental arrangements, and approving the costs of repairs or capital improvements). An outside property management firm, then, can be hired to provide appropriate management services on a day-to-day basis without jeopardizing active participation status. In addition, a taxpayer must hold a 10 percent or more interest in the property at all times during the year to be an active participant. Generally, a limited partner does not actively participate in a rental real estate activity that is owned through an interest in a limited partnership. As in the case of material participation, the participation of a taxpayer’s spouse will be taken into account in determining whether the taxpayer actively participated.

Single individuals and married taxpayers filing jointly can qualify for the maximum $25,000 amount. Married individuals who live apart from their spouses at all times during the year can qualify for $12,500 each. Married individuals who do not live apart for the entire year and file separately cannot qualify for any part of the $25,000 offset.

The maximum level of modified AGI is $100,000 in qualifying for the full $25,000 ($12,500 for qualified married individuals filing separately) deduction. However, when modified AGI exceeds $100,000, the excess is subject to a phaseout of the full offset: For every dollar of modified AGI in excess of $100,000, the $25,000 ($12,500) offset is reduced by 50 cents (or 50 percent of the excess). Thus, the $25,000 offset is fully phased out at a modified AGI of $150,000.

EXAMPLE 7.23

Ron Reingold owned two rental properties during the year and actively participated in the management of the properties. His modified AGI was $140,000. Ron’s loss from the rental activities is $10,000. Ron is entitled to a $5,000 offset. Ron’s deduction is limited to the $5,000 offset, and the remaining $5,000 becomes a suspended loss, figured as follows:

Modified AGI	$140,000
Maximum level allowed	(100,000)
Excess	$40,000
Excess	$40,000
Times reduction %	× .50
Offset reduction	$20,000
Maximum offset	$25,000
Offset reduction	(20,000)
Offset after phaseout	$5,000

Revenue Reconciliation Act of 1993 Changes to Benefit Real Estate Professionals

Additional relief was provided by the Revenue Reconciliation Act of 1993 for individuals and closely held C corporations that materially participate in rental real estate activities. After 1993, provided certain requirements are met, losses and credits from rental real estate activities will not be subject to the passive loss limitations. These requirements are designed to demonstrate that the taxpayer is a material participant in the activity, and commits a minimum amount of time, on an annual basis, to the activity.

Individuals are eligible if:

1. more than one-half of the personal services performed in trades or businesses by the taxpayer during such taxable year are performed in real property trades or businesses in which the taxpayer materially participates, and

2. such taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates.

For closely held C corporations to qualify:

1. The corporation must materially participate in rental real estate activities; and

2. The corporation must derive more than 50 percent of its gross receipts for the taxable year from such activities.

The criteria for determining material participation are the same as under previous law. Furthermore, as under prior law, a limited partner in a limited partnership is generally not considered to be a material participant in the partnership.

These changes in the law were intended to benefit real estate professionals, those who commit the majority of their time to performing real estate activities. Thus, the average passive investor in such activities will not qualify for relief under these provisions.

However, a couple filing jointly could benefit from the new rules if at least one spouse satisfies the requirements. For example, one spouse may work as a real estate broker or as a real estate leasing agent and the other spouse could own rental property. Losses incurred on the rental property may be treated as losses from an activity in which the taxpayer materially participates (i.e., not as passive losses) if the real estate broker spouse satisfies the requirements.

EXAMPLE 7.24

During 2020, Beth Miller materially participated in the following personal service activities: 800 hours as a personal estate planner, 450 hours in rental real estate activities, and 600 hours as a real estate broker. Beth devoted more than one-half of her personal services to real property trades or businesses, and her material participation in those real estate activities exceeded 750 hours. Hence, any loss incurred by Beth in either real estate activity will not be subject to the passive loss rules. She will be able to offset any losses from either real estate activity against active or portfolio income.

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CHANGE OF ACTIVITY STATUS

Under the passive activity rules, it is quite possible for an activity to change from passive to nonpassive. For example, an individual may not materially participate in a business for a previous tax year, but in later years may become a material participant. Thus, while the taxpayer was not a material participant, the business was a passive activity. Then when the taxpayer becomes a material participant, circumstances would appear to terminate the application of passive activity rules. A passive activity could become a “former passive activity” if any of the following apply:

1. The taxpayer qualifies as a material participant.

2. The activity no longer qualifies as a trade or business or rental activity.

EXAMPLE 7.25

Fred Manson’s real estate activities consisted of five rental properties located on a 25-acre tract. For each rental property, an acre was carved out of the larger tract and was sold last year, leaving Fred with 20 acres of unproductive land. His real estate activities no longer qualify as a rental activity for the current year and, therefore, will be characterized as a former passive activity.

Generally, the passive loss rules do not apply to a former passive activity, except for the former passive activity’s suspended losses. A former passive activity’s suspended losses will continue to be suspended, but can be offset against (1) passive income from other passive activities or (2) nonpassive income from the former passive activity. Code Sec. 469(f).

EXAMPLE 7.26

Sally Dennison was not a material participant for the past few years in SSS, a partnership. The partnership was engaged in the business of selling, constructing, maintaining, and repairing fireplaces, fireplace equipment, and chimneys. Sally became a partner in the business during 2011, and her share of allocated losses for 2011–2019 was $55,000. Because she owned no other passive activities, the $55,000 was a suspended loss. In 2020, she became a material participant, and SSS significantly improved its operating position. Her share of the net income amounted to $29,500 for the year, which is now characterized as nonpassive income. The $55,000 suspended loss will offset the $29,500 of nonpassive income from SSS, while the remaining $25,500 continues to be suspended.

Business and Investment Losses

¶7301

BUSINESS CASUALTY AND THEFT LOSSES

Business and investment casualty losses which receive similar tax treatment are discussed in this section. Personal casualty losses are reviewed in greater detail at  ¶8501 .

The following losses can be deducted by an individual taxpayer (Code Sec. 165(c)):

1. Losses incurred in a trade or business;

2. Losses incurred in any transaction entered into for profit though not connected with a trade or business; or

3. Losses of property not connected with a trade or business, if such losses arise from fire, storm, shipwreck, or other casualty, or from theft in a federally-declared disaster area, or to the extent of casualty gains.

Casualty losses usually are losses from fire, storm, or other catastrophe. Theft losses are losses arising from robbery, embezzlement, or larceny. Reg. §1.165-8(d). 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 taxpayer’s willful act or willful negligence. Reg. §1.165-7(a)(3)(i).

Proper Year of Deduction

A casualty loss is normally deductible in the year it occurs. If a casualty loss is incurred in an area designated as a disaster area by the President of the United States, the taxpayer can elect to deduct the casualty loss in the tax year preceding the year of the loss. The intent behind permitting a taxpayer to deduct a disaster area casualty loss in the tax year preceding the loss is to lessen the immediate tax burden on the taxpayer and, thereby, lessen the financial burden related to the casualty loss.

EXAMPLE 7.27

Greenwood Paper Co. incurred a casualty loss of $10,000 in 2020. The $10,000 loss is normally deductible on Greenwood’s 2020 income tax return. Because the casualty occurred in an area designated as a disaster area by the President of the United States, Greenwood may elect to deduct the casualty loss on its 2019 tax return. If the 2019 tax return was already filed, an amended return would be filed for 2019 to claim a tax refund.

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. Reg. §1.165-1(d)(2)(i). The casualty loss deduction is limited to the actual expected loss after expected insurance reimbursement. If the actual insurance reimbursement is less than the amount anticipated in past tax years, the difference can be deducted as a casualty loss deduction in the year the claim is settled.

A theft loss is different from a casualty loss in that a theft loss is deductible in the year the theft is discovered (which may not necessarily be the same as the year of theft). As with casualty losses, a theft loss deduction is limited to the actual expected loss after expected reimbursement. If the reimbursement is less than the amount anticipated in past tax years, the difference can be deducted in the year the claim is settled.

Computation of Deduction

A deduction resulting from the partial destruction of business property is limited to the lesser of the following:

1. The adjusted basis of the casualty property, or

2. The decline in fair market value of the casualty property.

Any insurance or other form of compensation will reduce the amount deductible. If such property is completely destroyed or stolen, the deductible loss is the adjusted basis of the property less any reimbursement (regardless of decline in the fair market value).

As a general rule, if reimbursement is less than the property’s adjusted basis, then no gain can be realized. If reimbursement is less than adjusted basis but more than the amount of loss (computed using decline in FMV), then a taxpayer experiences neither a gain nor a loss.

EXAMPLE 7.28

The following casualty and theft losses occurred at Turnkey Construction Company during 2020:

		Fair Market Value
Event	Adjusted Basis	Before Casualty	After Casualty	Insurance Reimburse
1. Stolen Equip.	$12,000	$6,000	$ 0	$6,000
2. Fire—Bldg.	$77,000	$95,000	$45,000	$35,000
3. Wreck—Truck	$21,000	$18,500	$10,000	$10,000

The loss deduction for each casualty and theft is figured as follows:

1. Stolen equipment (theft loss—treated the same way as complete casualty loss)

Adjusted basis	$12,000
Less: Insurance	6,000
Theft loss deduction	$6,000

2. Fire in building (partial business casualty—lesser of adjusted basis or decline in fair market value)

Decline in FMV	$50,000
Less: Insurance	35,000
Casualty loss deduction	$15,000

3. Wrecked truck (partial business casualty with insurance proceeds greater than amount of loss)

Decline in FMV	$8,500
Less: Insurance	10,000
Net	$(1,500)

The net amount of $1,500 is not a realized gain because the property’s adjusted basis was $21,000 (the formula used to compute realized gain is insurance proceeds less adjusted basis, which would provide a $11,000 loss). On the other hand, the difference between the property’s adjusted basis and insurance proceeds ($11,000 loss) is not a deductible loss because a partial casualty loss deduction requires the lesser of adjusted basis or decline in FMV in determining the amount of loss. Thus, a partial casualty where insurance proceeds are greater than the amount of loss yields neither a gain nor a loss (because the property’s adjusted basis is greater than the insurance proceeds).

In some instances, however, a casualty or theft may result in a taxpayer realizing a gain. This could occur when the insurance coverage, which is normally based on fair market value, exceeds the cost basis of the property (i.e., insurance proceeds less adjusted basis equals realized gain).

Basis Adjustment

Whenever a taxpayer has a partial or complete casualty, the following items will reduce the property’s adjusted basis if there was no gain realized:

1. Amount of reimbursement

2. Amount of deductible loss

EXAMPLE 7.29

Jack Caldwell’s business office was partially destroyed by a tornado. His adjusted basis in the building was $210,000, and the decline in FMV was $150,000. Insurance proceeds amounted to $100,000. Mr. Caldwell’s adjusted basis in the property is computed as follows:

Decline in FMV	$150,000
Less: Insurance	100,000
Deductible loss	$50,000
Adjusted basis before casualty	$210,000
Less: Insurance	100,000
Less: Deductible loss	50,000
Adjusted basis after casualty	$60,000

In determining a casualty property’s decline in value, appraisals establishing the property’s fair market value before the casualty as well as after the casualty are important evidence for defending the amount of a casualty loss deduction. The cost of repairs to restore the casualty property to its condition before the casualty may also be sufficient evidence to indicate the amount of the loss deduction. Reg. §1.165-1(d)(2)(ii).

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NET OPERATING LOSSES (NOLS)

Prior to the Taxpayer Relief Act of 1997, a business that had a net operating loss in one taxable year could carry the loss back to offset taxable income in the three preceding tax years or carry the loss forward to offset future taxable income for up to 15 years. Code Sec. 172.

For tax years beginning after August 5, 1997 and ending before January 1, 2018, the NOL carryback period was shortened to two years, and the NOL carryforward period was extended to 20 years. (Special carryback rules existed in relation to: (1) real estate investment trusts that did not receive carrybacks; (2) specified liability losses that were subject to a ten-year carryback; (3) excess interest losses that did not receive carrybacks; (4) farming losses that could be carried back for five years; and (5) corporate capital losses that were not affected by the changes.)

Further, the three-year carryback period was retained for the portion of the NOL that relates to casualty and theft losses of individual taxpayers and to NOLs that were attributable to Presidentially declared disasters and were incurred by taxpayers engaged in farming or by a small business (gross receipts of $5 million or less for a three-tax-year period).

Further, a five-year NOL carryback period applied for qualified disaster losses (Code Sec. 172(b)(1)(J), as added by the Emergency Economic Stabilization Act of 2008 (P.L. 110-343)). Also, a farming loss could be carried back for five years (Code Sec. 172(b)(1)(G) and (i)), and it did not include a qualified disaster loss.

However, for years ending after December 31, 2017, the NOL carryforward period is indefinite. The carryback period has been repealed except for certain farming losses (permitted a 2-year carryback). Also, the NOL deduction for a year is limited to 80% of taxable income for tax years beginning after December 31, 2017. Corporations may want to carefully plan when purchasing assets because the 80 percent limitation and bonus depreciation may both apply leading to an NOL creation or increase which is limited by the 80 percent limitation. Additionally, corporations, unlike individuals, do not have to make the capital gains and losses or nonbusiness expenses adjustments since these items are not permitted in calculating corporate taxable income. Moreover, the full dividends received deduction is allowed in determining the corporation’s NOL. However, a similarity does exist between individuals and corporations because the NOL deduction for each year is considered separately. Keep in mind the NOLs from other tax years are not included in the NOL calculation for the current year.

EXAMPLE 7.30

Able Box Company has a net operating loss of $50,000 in 2020. The loss cannot be carried back to offset previous taxable income. The 2020 net operating loss can be carried forward indefinitely to offset future taxable income.

EXAMPLE 7.31

In 2020, Southern Corporation has $250,000 of gross income from operating expenses of $350,000. The corporation had dividends from a 25-percent owned domestic corporation totaling $40,000. The corporation has a net operating loss for the year of $90,000, computed as follows:

Gross Income
Operations	$250,000
Dividends	40,000
Total Gross income		$290,000
Expenses from operations	$350,000
Dividends-received deduction ($40,000 × 65%)	26,000
Total deductions		376,000
Net operating loss		$86,000
Southern corporation may carry the $86,000 NOL forward indefinitely.

EXAMPLE 7.32

Assume the same facts as in Example 7.32. Additionally, Southern Corporation has taxable income of $50,000 in 2021. Southern is permitted to use the NOL from 2020 to offset $40,000 ($50,000 x 80%) of 2021 taxable income, resulting in 2021 taxable income of $10,000. Southern will carry forward the remaining NOL of $46,000 ($86,000-$40,000) to 2022.

The objective of the net operating loss deduction is to increase tax fairness regarding the taxation of business income. A 12-month tax accounting period is an arbitrary period of time to tax business enterprises. Business affairs cannot be arranged into arbitrary 12-month periods. 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 future taxable income.

The net operating loss deduction is available only for losses connected with a trade or business. An excess of nonbusiness and personal deductions over nonbusiness and personal income, with the exception of personal casualty and theft losses, is not eligible for NOL treatment. Personal casualty and theft losses, however, are considered to be business losses for purposes of computing the net operating loss deduction.

Carryforward Procedures

A business incurring a net operating loss in a taxable year can carry the loss forward indefinitely. The net loss shown on a taxpayer’s return usually requires adjustment in several ways before becoming a net operating loss.

Computation of Net Operating Loss

The term “net operating loss” is defined as the “excess of deductions over gross income.” Code Sec. 172(c). This excess of deductions over gross income is subject to modifications which limit the net operating loss to only business losses. Prior to the Tax Cuts and Jobs Act, a loss reported on a tax return by an individual taxpayer with business income is modified in the following ways in order to determine a net operating loss deduction:

Taxable Income/Loss
+	Any NOL deduction from another year
+	Nonbusiness capital losses exceeding nonbusiness capital gains
+	Nonbusiness deductions in excess of nonbusiness income
=	Net operating loss

Nonbusiness deductions included all itemized deductions (less personal casualty and theft losses incurred in a federally-declared disaster area) plus self-employed retirement plan contributions. Nonbusiness income is all income not derived from a trade or business, such as dividends, interest, and nonbusiness capital gains. Salary and wages are considered to be trade or business income for purposes of computing an NOL.

EXAMPLE 7.33

Larry Watkins owns and operates a pizza parlor. In 2017 (prior to Tax Cuts and Jobs Act), Larry had the following income and deductions listed on his individual tax return.

Business income		$45,000
Salary from second job		15,000
Interest		5,000
Dividends		2,000
Long-term capital gain (LTCG)		1,000	$68,000
Less:
Business deductions		$70,000
Itemized deductions (included $10,000 personal casualty loss incurred in a federally-declared disaster area)		19,000	89,000
Taxable income			($21,000)

Larry’s net operating loss for 2017 is computed as follows:

Taxable income (negative amount)			($21,000)
Add:
Nonbusiness deductions in excess of nonbusiness income:
Itemized deductions	$19,000
Less: Personal casualty loss incurred in a federally-declared disaster area	10,000
Nonbusiness deductions		$9,000
Less: Nonbusiness income
Interest	5,000
Dividends	2,000
LTCG	1,000	8,000
			1,000
Net operating loss deduction			($20,000)

If only the “business-related” items were considered, then the NOL could be figured as follows:

Business income	$45,000
Salary from second job	15,000
Total business income		$60,000
Business deductions	$70,000
Personal casualty loss incurred in a federally-declared disaster area	10,000
Total business deductions		$80,000
Net operating loss deduction		($20,000)

However, the Tax Cuts and Jobs Act has introduced new excess business loss limitations. Naturally, this new limitation only applies to noncorporate taxpayers, such as individuals, trusts, and estates. A single taxpayer is limited to $259,000 ($518,000 for a married filing jointly return) for excess business losses. To calculate excess business losses, total all of the business deductions and subtract out the total gross income and gains arising from the taxpayer’s trade or businesses as well as the corresponding limitation amount ($259,000 for a non-joint return, $518,000 for a joint return). Any remaining losses will be treated as a net operating loss and can be carried over indefinitely.

EXAMPLE 7.34

A single taxpayer has dividends of $400,000, loss from an S corporation of $600,000, and $150,000 of partnership income. The taxpayer actively participated in both trade or businesses.

Step 1:	Combine income and loss from trade or businesses as an active participant ($150,000-$600,000)	($450,000)
Step 2:	Choose the greater of applicable loss limitation amount or step 1 (number less negative) The applicable loss limitation amount is $259,000 for non-joint filers and $518,000 for joint return filers	($259,000)
Step 3:	Nonbusiness income plus greater of loss limitation or step 1 ($400,000-$259,000)	$141,000
Step 4:	If Step 2 is less than Step 1, the taxpayer does not have a NOL. If Step 2 is greater than Step 1, NOL available to be carried forward indefinitely equals step 1 minus limitation amount ($450,000-$259,000)	($191,000)

The taxpayer has net positive income of $141,000 ($400,000-$259,000) and has an NOL carryover of $191,000.

Recomputation of Tax Liability in Carryforward Year

After the net operating loss is computed for the tax year in which the loss is incurred, the loss is then carried forward indefinitely.

¶7345

HOBBY LOSSES

Special rules apply to expenses and losses incurred in pursuing an activity not engaged in for profit. Under Code Sec. 183, expenses that are otherwise deductible under the Code without regard to the existence of a business or profit motive (taxes, interest, casualty losses, etc.) are still deductible regardless of the amount of hobby income. Other expenses such as operating expenses and depreciation are not deductible from 2018-2025.

In determining whether an activity is engaged in for profit, reference is made to objective standards, taking into account the facts and circumstances of each case. Although a reasonable expectation of profit is not required, the circumstances should indicate that the taxpayer entered into, or continued, the activity with the objective of making a profit.

Among the factors considered in determining whether activities are engaged in for profit are (Reg. §1.183-2(b)):

1. The taxpayer’s history of income or losses with respect to the activity.

2. The amount of occasional profits, if any, which are earned.

3. The cause of the losses.

4. The success of the taxpayer in carrying on other similar or dissimilar activities.

5. The financial status of the taxpayer.

6. The time and effort expended by the taxpayer in carrying on the activity.

7. The expertise of the taxpayer or advisors.

8. The manner in which the taxpayer carries on the activity.

9. Expectation of profit by the taxpayer.

10. Expectation that assets used in the activity may appreciate in value.

11. Elements of personal pleasure or recreation.

If any activity is not engaged in for profit, deductions are allowable only to the following extent (Reg. §1.183-1(b)(1)):

Amounts deductible without regard to whether the activity giving rise to such amounts was engaged in for profit are allowable in full. Examples of these expenses include interest under Code Sec. 163 and realty taxes under Code Sec. 164, and personal casualty losses under Code Sec. 165.

EXAMPLE 7.35

Gene Allison operates a fishing boat during three months of the year and is not engaged in this activity for profit. He used the boat for his own personal use for one month and leased it to another person for two months. He has income from such operations of $3,000, taxes of $1,400, utilities of $900, maintenance expenses of $600, and depreciation of $1,200. His deductions are limited to $1,400.

The $1,400 is itemized as part of the taxes deduction.

If profit results from the activity in three out of five consecutive years ending with the tax year in question, a rebuttable presumption is created that an activity was not engaged in as a hobby. This permits the taxpayer to avoid the restrictions on the deduction of hobby losses. In the case of horse racing, breeding, and showing, a rebuttable presumption is created if profit results from the activity in two out of seven consecutive years.

A taxpayer may elect to delay a determination as to whether the presumption applies until the close of the fourth (or sixth, in the case of horse racing, breeding, or showing) tax year after the tax year in which the taxpayer first engages in the activity. A taxpayer is required to execute a waiver of the statute of limitations in order to make the election.

PLANNING POINTER

Remember the eleven factors from the regulations can work either for or against the taxpayer(s). For example, in Budin v. Comm. (T.C. Memo 1994-185), the taxpayers were engaged in horse breeding, training, and jumping activities. Significant losses were incurred by the taxpayers during the years in question. The court noted that Elbert and Shirley Budin did not conduct their horse activity in a business like manner. Specifically, the Budin’s avowed purpose was horse breeding; however, they had acquired geldings, which were incapable of breeding. Therefore, the true spirit of the regulations must be adhered to for tax purposes.

¶7351

HOME OFFICE EXPENSES

If a taxpayer uses a portion of a personal residence for business-related activities, expenses allocable to the portion of the home used for business purposes may qualify as a tax deduction. For personal home expenses to be tax deductible, however, a portion of the home must be used exclusively on a regular basis as:

1. The principal place of business for any trade or business of the taxpayer;

2. A place of business which is used by patients, clients, or customers in meeting or dealing with the taxpayer in the normal course of a trade or business; or

3. In the case of a separate structure which is not attached to the dwelling unit, in connection with the taxpayer’s trade or business (Code Sec. 280A(c)).

 

For tax years beginning after December 31, 1998, the Taxpayer Relief Act of 1997 expands the definition of a “principal place of business.” A home office qualifies as a taxpayer’s principal place of business under the Act if:

1. The office is used by the taxpayer to conduct administrative or management activities of the taxpayer’s trade or business; and

2. There is no other fixed location of the trade or business where the taxpayer conducts substantial administrative or management activities of the trade or business.

The exclusive use test means that if the portion of the home used for business activities is also used for personal (nonbusiness) activities, then no deduction will be allowed. An exception to the exclusive use test applies when personal residences are used to provide day care services for children, handicapped individuals, and elderly persons. The day care facility exception applies only if the taxpayer has applied for, been granted, or is exempt from having a license, certification, registration, or approval under applicable state law. Personal family use of the day care facilities is acceptable but, in determining the allowable deduction, expenses allocable to the personal use time are not deductible. Code Sec. 280A(c). The regular basis test means that the portion of the home used for business purposes must be used for business on a regular basis, not occasionally. Employees are not allowed a home-office deduction.

EXAMPLE 7.36

Roger Blaine, a physician, uses a portion of his personal home as his principal medical office on an exclusive and regular basis. Expenses related to the portion of the home used for business purposes are deductible on Roger’s tax return. If Roger occasionally meets patients in the family living room, which is also used regularly for family activities, then none of the expenses allocable to the living room are deductible since the room is not used exclusively and on a regular basis for business.

PLANNING POINTER

Exclusive use of a portion of a home for business purposes is required to qualify for a business use of home deduction. Exclusive use for business purposes does not require, however, that the portion of the home used for business purposes be physically separated from the remainder of the home. A specified space within a room can qualify for the deduction as long as the exclusive use test is met. G. Weightman, 42 TCM 104, CCH Dec. 37,986(M), T.C. Memo. 1981-301.

Typical expenses deductible for a portion of a personal home used for business activities are heating, water, electricity, maintenance and repairs, depreciation, real estate taxes, and interest on a home mortgage. The portion of these expenses allocated to the business use of the home usually is based on the square feet used for business in relation to the total square feet available in the home. In no instance can the deduction for the business use of a home exceed the gross income derived from the business activities carried on at home and from the amount of income generated from rental activity of the home reduced by all related tax deductions other than the business use of home deduction. If the expenses of the business use of the home exceed the gross income derived from the business activity less related deductions, expenses normally allowable as deductions to all taxpayers (such as real estate taxes and interest on a home mortgage loan) are deducted first. If any income remains, other expenses are then deducted to the extent of the remaining income, with depreciation taken last.

Any excess expenses that are not deductible in the current year can be carried forward to offset income from the same home office business activities in succeeding years. Code Sec. 280A(c). Also, for any home office deduction related to work as an employee, the deduction is not allowed (except for mortgage interest and property taxes, which are fully deductible).

EXAMPLE 7.37

Esther Simcox, a self-employed management consultant, maintains an office in her home on an exclusive and regular basis. The business office space accounts for one-fifth of the total space in her home. In 2020, Esther had gross income of $25,000 from her consulting business. Deductions related to her management consulting income, other than the business use of home deduction, amounted to $5,000. During 2020, Esther incurs the following home expenses:

Real estate taxes	$3,600
Interest on mortgage loan	4,200
Tax deductions normally allowable to all taxpayers		$7,800
Maintenance on home	$1,200
Utilities (water, electricity, gas, sewer)	2,500
Other expenses (repairs, maid service, etc.)	3,000
Operating expenses		6,700
Total depreciation (straight-line)		2,500
Total		$17,000

Esther’s home office deduction for 2020 is $3,400, determined by taking the $17,000 of home expenses times 1/5, the portion of the home used for business purposes. If Esther’s gross income from the consulting business less related deductions, other than the business use of home deduction, amounted to only $2,000 in 2020, then the business use of home deduction is limited to $2,000. In calculating the business use of home deduction, tax deductions normally allowable to all taxpayers are deducted first.

Impact of Revenue Procedure 2013-13(1/15/13)

The IRS announced a simplified, optional method of claiming a home office deduction. Specifically, the new optional deduction is limited to $1,500 per year based on $5 per square foot for up to 300 square feet. Taxpayers using this new option will not be able to depreciate the portion of their home used in their trade or business. However, they can still claim allowable mortgage interest, real estate taxes, and casualty losses on their home as itemized deductions on Schedule A of Form 1040.

Comparison to Example 7.37-Above. Assume that the above office space of one-fifth amounted to 300 square feet. Under Rev. Proc. 2013-13, the deduction for the qualified business use of her home is $1,500 (300 sq.ft. × $5). Esther can deduct the real estate taxes and mortgage interest on her Schedule A and the business expenses of $5,000 on Schedule C. But she cannot deduct the depreciation of $2,500. It appears that taxpayers with large deductions should first figure the deductions out under the old method ($3,400) and then compare that figure to the new method’s maximum of $1,500. Also, it should be noted that the home office deduction goes on Form 8829 and is then carried to Schedule C. In contrast, deductions that are itemized are not worth as much as Schedule C deductions. Also, since the taxpayer did not take any depreciation on her home, then her basis is higher and less gain will be reported under Sec. 1231. Naturally, these considerations are just some of the variables to gauge with the client before adopting this new procedure when filing tax returns.

¶7371

VACATION HOME EXPENSES

Special 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. Code Sec. 280A. 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. 280A(g). However, regular expense deductions attributable to all personal residences (such as mortgage interest, property taxes, and personal casualty losses) are still available. 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).

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 percent 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 percent of 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 (mortgage interest, property taxes, and casualty losses) are deducted first. (Any remaining regular expenses are deductible as itemized deductions.) Other rental expense deductions (maintenance, repairs, depreciation, etc.) are limited to the remaining amount of rental income (after it is reduced by the amount of regular expenses that were deducted first).

EXAMPLE 7.38

Joel Harris owned a condo in a resort area. During the year, he personally used it for 17 days, and it was rented for 100 days. Because he used the condo for more than either 14 days or 10 percent of rental days (10 days), the vacation home will be treated as a personal residence and losses will not be allowed.

However, if an individual rents out a vacation home for more than 14 days and does not use it excessively for personal purposes, then it will be treated as rental property. That is, if the taxpayer does not use it for personal purposes for the greater of 14 days or 10 percent of rental days, then losses are allowed to be deducted for AGI (subject to the passive activity rules). If an individual actively participates in the rental real estate activity, then up to $25,000 of losses can be used to offset nonpassive income.

EXAMPLE 7.39

John Henderson owns a vacation home in Palm Springs. His expenses related to the home during the year are as follows:

Mortgage interest and taxes	$20,000
Utilities, maintenance, and repairs	5,000
Depreciation	15,000
Total expenses	$40,000

Assume Mr. Henderson rents out the home for less than 15 days during the year and uses it personally for more than 14 days. He receives rental income of $4,000. None of the rental income is reported on his income tax return, and no rental expenses are deductible on his tax return. The mortgage interest and taxes of $20,000, however, are allowable.

In determining rental expense deductions, the allocation formulas used to compute rental expenses differ depending on the type of expense being allocated and interpretation of the tax law by the Tax Court and the IRS. For regular expenses allowable to all taxpayers, the Tax Court allocation formula is based on a full year (365 days). D.D. Bolton, 82-2 USTC ¶9699, 694 F.2d 556 (CA-9 1982). The IRS prefers to allocate regular expenses based on total usage of the residence. For other expenses, the allocation formula is based on total usage of the residence.

EXAMPLE 7.40

Assume Mr. Henderson rents out the vacation home for 25 days during the year and receives rental income of $10,000. He uses the dwelling for personal purposes for 30 days during the year. Under these assumptions, the rental income of $10,000 is included in his income because he rented the home out for more than 14 days. The dwelling will be treated as a personal residence because he used it for personal purposes for the greater of (1) 14 days, or (2) 10 percent of the rental days. The rental expense deductions are computed using both the IRS method and the Tax Court method as follows:

	Tax Court	IRS
Rental income	$10,000	$10,000
Less: Mortgage interest payments and property taxes
($20,000 × 25 rental days/365 days a year)	1,370
($20,000 × 25 rental days/55 total use days)		9,091
Less: Utility expenses, maintenance, and repair expenses, etc.
($5,000 × 25 rental days/55 total use days)	2,272
($5,000 × 25 rental days/55 total use days, but limited to $909—cannot create a loss)		909
Amount remaining for depreciation	$6,358	$0
Less: Depreciation
($15,000 × 25 rental days/55 total use days = $6,818, but limited to $6,358)	6,358	0
Net Rental Loss	$0	$0

EXAMPLE 7.41

Assume Mr. Henderson rents out the home for 25 days during the year and receives rental income of $10,000. He uses the home for personal purposes for seven days during the year. Under these assumptions, all rental income is recognized on his income tax return since the dwelling was rented out for more than 14 days. Because the residence will be treated as rental property (personal use was less than 14 days or 10 percent of rental days), losses are allowed. His rental income and rental expenses are computed as follows:

	Tax Court	IRS
Rental income	$10,000	$10,000
Less: Mortgage interest and property taxes
($20,000 × 25 rental days/365 days a year)	1,370
($20,000 × 25 rental days/32 total use days)		15,625
Less: Utility expenses, maintenance, and repair expenses, etc.
($5,000 × 25 rental days/32 total use days)	3,906	3,906
Income or loss before depreciation	$4,724	($9,531)
Less: Depreciation
($15,000 × 25 rental days/32 total use days)	11,718	11,718
Net Rental Loss	($6,994)	($21,249)

Under either the Tax Court or the IRS approach, the loss is less than the $25,000 loss allowed for rental property in which there is active participation. In this case, the remainder of the mortgage interest is not deductible because the vacation home is not considered a second residence. Therefore, the IRS approach is more favorable to the taxpayer.

Personal use days of a vacation home by an owner generally include the following: days of personal use by the owner or by a member of the owner’s family including spouse, ancestors, lineal descendants, children, brothers, and sisters; and days of use under an arrangement to exchange one residence for another for a period of time; and days of use by any individual if not rented at a fair rental. Code Sec. 280A(d)(2)(A). Time spent at a vacation home by an owner while making repairs usually does not count as days of personal use if at least two-thirds of each day, up to eight hours a day, is spent making repairs.

KEYSTONE PROBLEM

Kim Boles, single and 38 years old, owned the following passive activities during 2020:

Activity	2020 Gain/(Loss)	Acquired
XYZ	($10,000)	10/05/87
LMN	($12,500)	06/22/88
TUV	$11,000	09/01/89

She was the sole proprietor of a small business that had gross revenues of $35,000 and expenses of $72,000. She participated in the business 2,000 hours. The business had a computer stolen from its office. The computer’s basis was $12,000, and its fair market value was $7,500 at the time of the theft. The amount of the theft is not included in expenses as stated above.

Kim also owned a condo in Vail, Colorado. She used it 17 days for personal purposes and rented it 150 days. Gross rentals were $1,300, while all expenses other than interest and taxes were $1,700. Interest and taxes amounted to $6,500.

Kim received $15,400 salary from a part-time job, received $1,500 in dividends, and had total itemized deductions of $3,000. Compute Kim’s taxable income for 2020 and any other tax consequences that are appropriate under the IRS method.

SUMMARY

· Deductions arising from tax shelters are subject to the at-risk rules and the passive activity rules. The at-risk provisions are structured to deny taxpayers from deducting losses in excess of their actual economic investment in the endeavor. In general, deductions or expenses incurred by passive activities can only be deducted against passive income, and any unused passive losses are suspended and carried forward to future years to offset passive income in those years.

· Net operating losses from business endeavors may be carried forward indefinitely.

· Hobby losses require that expenses can only be deducted up to the amount of interest, realty taxes, and personal causalty losses.

· Business casualty or theft losses are the lesser of the decline in fair market value or the adjusted basis, but will equal adjusted basis when the property is totally destroyed.

· Losses from ownership of a vacation home may be deductible if the home qualifies as rental property. The excessive use test is used in making the rental property determination (i.e., the greater of 14 days or 10 percent of the rental days). Once a home is determined to be rental, the losses are subject to the passive loss rules.

PROBLEMS

Darian Basemore owned an interest in five businesses in 2020. His level of participation and percentage of ownership in each enterprise is as follows:

Activity	Hours of Participation	Ownership Percentage
Ven-Tale	180	22%
MovERent	88	17
AZ Airlines	950	33
Sadd Books	135	12
Kingdom Autos	185	25

46. In which activity, if any, will Darian be considered a material participant?

· Max Computer Center incurred the following casualty and theft losses in 2020:

Event
a.	=	Robbery-Equip.
b.	=	Fire-Truck
c.	=	Fire-Equip.

·

·	Fair Market Value
Event	Adjusted Basis	Before Casualty	After Casualty	Insurance Reimburse
a.	$8,000	$9,000	$0	$7,500
b.	$4,000	$5,000	$2,000	$3,500
c.	$9,000	$6,000	$0	$6,000

· 52. Compute the casualty and theft loss for each item listed.