Maximizing Investor Losses

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It has a shot of the tax firm and a welcome message. There is a button to start labeled “Enter.”

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Wade and Carmen inside the accounting firm, in a conference room.

Wade: Hi, Carmen. Great job in resolving the issues from last week with Jonathan Dixon.

As long as Jonathan uses over-the-counter holistic medicine and procedures not prescribed by his doctor, unfortunately, the medical expenses will not be deductible. Jonathan will be able to maximize his deductions by increasing his charitable contributions, especially considering that he is in a high tax bracket.

Carmen: He will also be able to increase his charitable deductions by either contributing cash or capital gain property. Although he cannot contribute more than fifty percent of his adjustable gross income, he can make cash and non-cash contributions.

Wade: We can also advise him to contribute capital gain property, although there is a thirty percent maximum contribution to tax-exempt organizations.

Carmen: Instead of trying to increase his spending for non-deductible medical expenses, he should increase his charitable contributions to reduce his tax liability.

Wade: Exactly! All right, Carmen, let’s get started with our work for this week, where our focus will be on Investor Losses.

Carmen: I’m ready to get started!

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Wade and Carmen in his office

Wade: Jonathan Dixon called and said that he found more documents that might help reduce his tax liability. I’ll set up the meeting for this afternoon.

Carmen: All right! Thanks, Wade!

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Wade, Carmen and Jonathan Dixon in the conference room.

Wade: Jonathan, welcome back. I’m going to sit back and let you two get to work.

Jonathon Dixon: Thanks, Wade.

Carmen, I forgot to bring my other tax documents with me the last time I was here.

I own several rental properties that are managed by a management company, but I’m considering managing them myself, if it will help.

I also have substantial investments and I’m considering selling some of them this year to invest in a closely held corporation.

How would you recommend that I handle these issues?

Carmen: That's what we're here for, Mr. Dixon. Let me think about this, and I’ll get back to you.

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Key Chapter provisions

Title: Investor Losses

Introduction: Investors who sustain losses from passive business activity can reduce their tax liability. However, passive losses require the taxpayer to separate all income and losses into three categories known as active, passive, and portfolio. Active income is typically from wages, while portfolio income is from dividends and interest. Passive income is from activities where business owners are not involved in the day-to-day operations. In general, passive loss rules disallow deductions for passive losses against active or portfolio income.

Tab 1: The at-risk provisions limit the deductibility of losses from business and income-producing activities to the amount of cash and the adjusted basis of property, plus amounts borrowed for use in the activity.

Tab 2: When losses cannot be used during the tax year, they can be carried over to subsequent years to offset against passive income.

Tab 3: If a taxpayer materially participates in a non-rental trade or business activity, a loss from the activity is treated as an active loss that can be offset against active or portfolio income.

Tab 4: The rental of real estate is an exception to the passive loss rule. If a taxpayer materially participates in a real estate trade or business, losses are not treated as passive. However, the taxpayer must materially participate and perform more than seven hundred and fifty hours of service.

Tab 5: A corporation is classified as a closely-held corporation if more than fifty percent of the value of outstanding stock is owned directly or indirectly by five or fewer individuals.

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From the information provided, under what circumstances would passive losses be deductible?

1. Since Mr. Dixon is currently not spending any time managing his real estate properties, then no passive losses can be deducted from active income.

2. If Mr. Dixon would manage the properties and spend more than seven hundred fifty hours, then the passive losses could offset by active income.

3. Investing in the closely-held company would also allow any passive losses to offset active income but not portfolio income.

4. In order for participation in real estate to qualify as the exception, the taxpayer must materially participate in the activity by performing more than one half of personal service in real estate AND perform more than seven hundred and fifty hours of service in real property trades.

Carmen: If Mr. Dixon materially participates in his rental activities, he will be able to deduct up to twenty-five-thousand dollars from real estate activities from active or portfolio income. As it stands now, since his property manager spends time managing his properties, he can only offset passive losses against other passive income.

If there are excess losses, they must be suspended or carried over to future years when enough passive income is generated to absorb the losses.

Investing in the closely-held corporation is also a good idea since any losses can offset his active income.

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Carmen and Wade in Wade's office

Wade: Carmen, I agree with your advice to Jonathon. Let’s review a draft of his tax return and determine what other tax planning strategies we can develop to minimize his tax liability.

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Carmen, Jonathan Dixon, and Wade in the conference room

Carmen: Hey Mr. Dixon, we have a draft of your tax return for review.

We recommend that you consider managing the rental properties yourself instead of using the property manager. In doing so, you can increase your hours to satisfy the requirement of material participation. The benefit is that you can deduct up to twenty-five-thousand dollars against your active or portfolio income.

Also, we do suggest that you invest in the closely-held corporation to decrease your income for future losses because those losses can offset active income but not portfolio income.

Please review the draft of the return, and if there are no changes, we are ready to file the changes.

Jonathon Dixon: Thanks, Carmen. I’m glad that I consulted with you regarding the real estate activity. I could certainly benefit from the passive losses since I will be renovating several properties this year.

Carmen: You’re very welcome! Let me know if there is anything else you need.

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Wade in his office

Wade: Well, it's approaching the end of the day. We have reviewed the complexities of investor losses and the restrictions on utilizing losses to offset active income. I recommend that you continue to review the contents of Publication Seventeen to prepare for our next topic next week, which will be Tax Credits and Payments.

By the way, don’t forget to participate in this week’s discussion questions.

I’ll see you next week!