FP514 Module 7

Question 1

fyi

Passive Activities
Two kinds of passive activities:
Trade or business activities in which taxpayer does not materially
participate
Rental activities even if taxpayer is material participant
Unless taxpayer is also real estate professional

Question 2

fyi

Tax-Shelter Investments
 Intended to defer or eliminate investor’s taxes
 Sometimes generate tax losses in excess of
taxpayer income

Two major provisions that have reduced the tax benefits (think of as 2 gates rental losses must pass thru)
At-risk rules - how much could you actually lose
* 1st gate - only deduct losses up to what you can lose (ie…cash & property & recourse debt(loan))
* if don’t get past this gate..don’t ever get to next gate

Passive activity loss limits - What kind of income can this loss offset?(ie..can the at risk expenses be offset by passive income)
* 2nd gate - if u don’t materially participate, losses can offset wages, interest, and portfolio income.

** At-risk rules are applied before passive activity loss rules (because, if you don’t have passive expenses, there is not reason to see if you have passive income)
Disallowed losses suspended
Taken in first year at-risk amount is sufficient to absorb the loss or the
investment is sold.
 If investment is sold
loss is allowed only to extent of an increase in at-risk amount.
otherwise, all suspended at-risk losses are lost upon the complete
disposition of property.

EXAMPLE: Application of at-risk rules In the current year, Tyler invested $60,000 for a 20% interest in a partnership in which he was a material participant. The partnership entity incurred a loss, and Tyler’s proportional share was $95,000. However, Tyler has only $60,000 of capital at risk, so he cannot deduct more than $60,000 against his other income. Tyler’s nondeductible loss of $35,000 may be carried over and used later when either Tyler has $35,000 of income from the partnership in a future tax year (and he has no other transactions that would affect his at-risk amount) or he invests $35,000 more into the partnership.

Question 3

fyi

Oil and Gas Working Interest
* lossed are not passive
* Does NOT limit taxpayers liability
* no participation is required
* lossed are deductible w/o limits

Question 4

fyi

Passive Activity Loss Rules
Passive losses may only be deducted against passive
income
Not deductible against active income or portfolio income

Question 5

fyi

Passive Activity Loss Rules - limit when you can use losses APPLY TO:
 individuals
 estates
 trusts
 personal service corporations (PSCs)
 closely held C corporations
 oil and gas activity working (not royalty) interests not a
passive activity

Material participation - If answer is yes, taxpayer is material participant and activity is not passive.
Does taxpayer:
 complete more than 500 hours of participation during the year?
 participate in the activity, which constitutes substantially all the
participation of all individuals (including individuals who are not owners)
for the year?
 participate for more than 100 hours, and is this amount equal to or more
than any other participant?

Question 6

fyi

Material Participation in Real Estate
Lose deductible if:

1 - more than 50% of hours are
devoted to real property
trades or businesses with
material participation, and

2 - more than 750 hours are
in real property trades or
businesses with material
participation

Question 7

fyi

• Direct participation program - a flow thru entity (conduit) passing directly to owners. (ie..Partnerships, LLC, S corp’s). Pass thru income doesnt have to be passive.
  
  • No C corps have pass thru income because the corp pays its own tax.
• Passive activity loss - apply to ind, trust, estates, closely held C corps)

Question 8

fyi

Material Participation in Trade or Business
Meets one of seven tests under regulations
 500 hours per year of participation—most common test
 100 hours and no one participates more
 Facts and circumstances test
 Regular continuous, and substantial involvement
What is taxpayer’s knowledge, background, and experience

Question 9

fyi

Publicly Traded Partnerships

• Losses are not deductible against other passive income.**
   Losses are held in suspense until SAME activity generates
  income.
   Income cannot be offset by passive losses arising from any
  other source.

Question 10

fyi

Two types of limited partnerships:
Publicly traded partnership (PTP), also known as a master limited
partnership (MLP)
Nonpubliclytraded or privately offered limited partnership

TEST TIP
Losses from one non-publicly traded partnership can be used to offset income from another non-publicly traded partnership. Losses from a PTP cannot be used to offset income from other partnerships. Losses from a PTP may only be used to offset income from the same PTP in subsequent years. In essence, PTP income is treated as portfolio income

A PTP/MLP is traded on established securities exchange.
 Income cannot be used to offset losses from:
nonpubliclytraded partnerships
other publicly traded partnerships

Question 11

fyi

Exception for Rental Estate Activities
Rental real estate activities are inherently passive.
Exception (when income is NOT passive)
Losses not passive for real estate professional if real
estate activities are more than 50% of professional’s
personal services for year
Professional puts in more than 750 hours of work in real
estate activity (p/t realtors can still use as passive income)

Exception for small investors
Homeowner who converts home into rental
Small investors may deduct up to $25,000 of rental real
estate losses against active or portfolio income in any one
year after meeting tests.

Exception for Rental Estate Activities
Tests:
Must actively participate in activity
Active participation is a lesser standard than material participation
Requires only participation in management decisions regarding the
property

Must own at least 10% in value of all interests in the activity during the
taxable year

Question 12

fyi

Exception for Rental Estate Activities
*$25,000 deduction
Reduced by $1 for every $2 of AGI > $100,000
Phased out completely at AGI of $150,000
AGI limit pertains to both MFJ and single (S) filing statuses
 If MFS filers lived apart for entire tax year, the allowance is
$12,500
Subject to AGI phaseout threshold that begins at $50,000

Question 13

Rental Estate Activities Exception –Question
Carter, an unmarried individual, had an AGI of $180,000 in the
current year before any other above-the-line deductions. He
incurred a loss of $30,000 from rental real estate in which he
actively participated. What amount of loss, if any, may be used in
the current year as an offset against Carter’s active or portfolio
income?
A. $0
B. $12,500
C. $25,000
D. $30,000

Answer 13

a

An exception to passive loss limits regarding rental real estate allows a small investor (e.g., Carter) to
deduct annually up to $25,000 of losses against other income. However, this annual deduction is
reduced by 50% of the taxpayer’s AGI in excess of $100,000. Therefore, the deduction is entirely
phased out at $150,000 of AGI. Carter’s AGI is more than this, so he cannot deduct any of his
$30,000 loss.

Question 14

Vacation Home Rentals/Rental Property
Tax consequences depend on the relative time the
home is rented (for income purposes) versus the
amount of time the home is personally used.
Personal use
Property is rented for fewer than 15 days per year.
All rent (without limit) generated during this time is excluded from the taxpayer’s income

Primarily rental use
Property is rented at least 15 days per year and is not used for personal use more than the greater of 14 days per year or 10% of the rental days.
The taxpayer can deduct expenses associated with the rental use on Schedule E of IRS Form 1040.
Allows for possible deduction of rental losses up to $25,000

Mixed (personal and rental) use
Vacation home is rented for at least 15 days per year and is also used for personal use more than the greater of 14 days per year or 10% of the rental days.
Rental expenses deductible only to extent of rental income
No possibility of $25,000 ordinary loss against income
Rental income and expenses are reported on Schedule E.

Question 15

Rental Property –Question
Chris owns a vacation home that he plans to rent for 190 days this year. He also plans to use the home for personal use. What is the maximum number of days he can live in the home without jeopardizing the property’s status as primarily for rental use?
A. 14 days
B. 19 days
C. 95 days
D. 190 days

Answer 15

b

Because Chris will rent his vacation home for 190 days, he can use the home as a personal residence for up to 19 days (the greater of 14 days or 10% of rental use) without jeopardizing its status as primarily for rental use

Question 16

Which one of the following statements is CORRECT regarding the effect of the taxpayer’s death on suspended passive losses?

A)
They are nondeductible up to the amount of the step-up in basis of the activity.

B)
They are fully deductible upon the death of the taxpayer.I

C)
They are completely nondeductible upon the death of the taxpayer.

D)
The death of the taxpayer has no effect on the suspended passive losses.

Answer 16

A

Question 17

Willis has an active participation rental real estate activity. Last year, he had losses of $15,000 from the active participation real estate, and his AGI was $225,000. The $15,000 of losses were suspended due to his AGI. In the current year, Willis has an AGI of $90,000 and $6,000 of current losses from his real estate rental activity. What amount of loss may Willis deduct in the current year?

A)
$6,000

B)
$25,000

C)
$15,000

D)
$21,000

Answer 17

D

Question 18

Sally Franklin has AGI of $300,000. In addition, she currently has passive income of $150,000 and passive losses of $175,000—$150,000 of which she uses to offset the passive income and $25,000 of which is subject to disallowance.

Which one of these investments has the greatest potential for reducing Sally’s tax liability?

A)
“Active participation” rental real estate that is producing a loss

B)
A working interest in an oil and gas general partnership

C)
A limited partnership involved in a historic rehabilitation project that is producing passive losses and credits

D)
An equipment-leasing limited partnership producing passive losses

Answer 18

b

Explanation
A working interest in an oil and gas partnership can provide unlimited loss deductions against other income. Congress considers this socially desirable to encourage investment in the industry. The caveat is investors in these instruments must also assume unlimited liability. Therefore, a working interest must be a general partnership rather than a limited partnership. The other answer choices cannot offset passive income.

LO 7.1.2

Question 19

Jason and Sarah are accountants and are considering starting a business together. They will both be general partners. Jason and Sarah prefer the partnership form but are concerned about liability issues. Specifically, neither wants to be liable for the acts of the other. Which of the following forms would best suit Jason and Sarah?

A)
Limited partnership

B)
Limited liability partnership

C)
General partnership

D)
S corporation

Answer 19

b

Explanation
In an LLP, the general partners are not liable for the acts of other partners. In addition, some states will protect the general partners from the claims that arise from obligations of the partnership, but this typically extends only to claims arising out of tort law, not contract law.

LO 7.1.1

Question 20

Which of the following tax factors may limit the availability of tax benefits from a limited partnership?

I. “Passive loss” rules

II. At-risk rules

III. Alternative minimum tax

A)
I, II, and III

B)
III only

C)
I only

D)
I and II

Answer 20

A

The Tax Reform Act of 1986 has two major provisions that have significantly reduced the benefit of tax-shelter investments: the at-risk rules and the passive activity loss rules limits. The alternative minimum tax is another example of a tax benefit limitation.

LO 7.1.2

Question 21

Your client, Sally, is considering investing in real estate as a way to diversify her investments. She has heard of active participation rental real estate, but is unsure of the requirements that must be met. What can you accurately tell her with respect to active participation rental real estate?

i The interest may not be held through a limited partnership.
ii A deduction-equivalent tax credit of up to $25,000 is available.
iii The taxpayer must hold a 10% or greater ownership interest.
iv The taxpayer must make the major management decisions.

Answer 21

a

Explanation
The deduction for active participation rental real estate requires that the taxpayer participate in management in a bona fide sense; making the major management decisions. To qualify, the interest may not be held through a limited partnership, and the taxpayer must have at least a 10% or greater ownership interest in the property. The loss is deductible when computing the gross income. Active participation rental real estate generates an above-the-line deduction of up to $25,000 annually, not a credit.

Question 22

Which of the following is NOT one of the methods by which an S corporation can be terminated?

A)
A majority vote of the shareholders

B)
If gross income for 3 years in a row is of a certain type that exceeds a certain share of total income

C)
When it fails to meet the requirements of a small business corporation

D)
If it earns more than $10 million in gross receipts in any one year

Answer 22

d

Explanation
The only time that earnings can revoke the S status is when more than 25% of gross receipts for three successive years come from certain types of passive income and the corporation has accumulated earnings and profits from its operations prior to the S election.

LO 7.1.1

Question 23

Bob passed away during the current year. He had suspended losses from a passive activity of $15,000. Bob’s basis in the partnership was $1,000, and the fair market value at the time of his death was $9,000. Bob originally purchased the partnership interest for $25,000. What amount of passive losses, if any, is deductible on Bob’s final return?

A)
$0

B)
$7,000

C)
$1,000

D)
$15,000

Answer 23

b

Explanation
The suspended losses are “freed up” only to the extent that the losses exceed the step-up in basis. In this situation, the basis was stepped up by $8,000; subtracted from the $15,000 of losses leaves $7,000 of losses that are freed up

LO 7.1.2

Question 24

Upon the disposition of a passive activity interest by gift, the suspended losses are

A)
completely lost.

B)
deductible in full.

C)
added to the basis of the interest.

D)
deductible to the extent the losses exceed any increase in the fair market value of the activity

Answer 24

c

Explanation
Upon the disposition of a passive activity by gift, the suspended losses are added to the basis of the activity.

LO 7.1.2

Question 25

Which of the following rules or doctrines may limit the availability of income tax benefits from a particular investment? Tax conduit The substantial economic effect doctrine The at-risk rule The passive activity loss rule A) I and IV B) II, III, and IV C) I and III D) II and III

Answer 25

b Explanation The substantial economic effect doctrine limits the ability to use special allocations in a partnership. The at-risk rule limits the ability to use leverage by attacking the use of nonrecourse financing. The passive activity loss rule limits the ability to deduct losses from activities in which the taxpayer does not materially participate.

Question 26

MSC, Inc. is a closely held C corporation that manufactures boilers. The company has been in business for over 45 years. MSC has active income this year of $250,000 and no passive or portfolio income. The company also leases equipment that generates passive losses of $120,000 per year. How much of the passive loss can the company use this year? A) $0 B) $120,000 C) $100,000 D) $25,000 LO 7.1.2 Pre

Answer 26

b Explanation The company can deduct the entire $120,000 because it is a closely held C corporation that is not a personal service corporation. Passive losses may be used to offset active income, but not portfolio income. LO 7.1.2

Question 27

Which of the following business forms may be tax conduits? General partnership General partnership Limited partnership Publicly traded C corporation S corporation A) I and IV B) II, III, and IV C) I, II, and IV D) I, II, and III

Answer 27

c Conduit means pass thru (passes income thru to owner and not taxed as an entity)

Question 28

Which of the following may enable a direct participation program to provide specific tax advantages to the investors? A) Special allocations B) At-risk rules C) Partnership basis rules D) Passive activity loss rules

Answer 28

a The benefits that flow through from a partnership entity may be enhanced by the potential, under certain circumstances, "special allocation" of certain items of income, expense, gain, or loss. The passive activity loss rules state that passive losses may only be deducted against passive income (not a tax advantage); there are no partnership basis rules; and the at-risk rules are defined as the maximum deductible loss for an investment limited to the amount that the taxpayer-investor has at risk at the end of the current year. None of the other answers are direct participation programs, which concern business organizations that function as tax conduits. LO 7.1.1

Question 29

Which one of the following best describes the role of a special allocation in a limited partnership? A) It allows an allocation of items of income and expense that is not pro rata. B) It establishes the standards for allocating the proceeds of non-routine or "special" items of income. C) It requires all items to be distributed pro rata based on a partner’s capital account balance. D) It allocates management responsibility to the general partners.

Answer 29

a Explanation A special allocation allows an allocation of items in a manner that differs from the "normal" pro rata allocation of deduction, income, losses, credit, etc. **

Question 30

The partner's tax basis in his interest in a partnership A) remains unchanged unless additional capital is contributed or distributions are made. B) is decreased if additional capital is contributed. C) remains unchanged until the interest is sold or otherwise disposed. D) is increased by his share of income reported by the partnership.

Answer 30

d

Question 31

Which of the following forms of business could NOT be a direct participation program (tax conduit)? A) Limited liability partnership (LLP) B) S corporation I C) Limited liability company (LLC) D) Closely held C corporation

Answer 31

d * Closely held C corpt do not allow pass thru income so it doesn't act as a tax conduit.

Question 32

Which of the following statements concerning the passive activity loss rules is NOT correct? A) The $25,000 offset allowance for the small real estate investor is not available to taxpayers whose AGI is $150,000 or more. B) The passive activity loss rules limitation is a permanent disallowance rule. C) Losses from one master limited partnership activity may only offset income from that particular activity; they cannot be used to offset income from any other passive activities. D) Losses from passive activities may not offset portfolio or active income except under limited circumstances.

Answer 32

b year by year

Question 33

Bob passed away during the current year. He had suspended losses from a limited partnership activity of $25,000. Bob's basis in the partnership was $1,000 and the fair market value at the time of his death was $18,000. What amount of passive losses, if any, is deductible on Bob's final income tax return? A) $8,000 Correct Answer B) $14,000 C) $17,000 D) $0

Answer 33

A The suspended passive losses are "freed up" and deductible only to the extent that the losses exceed the step-up in basis. In this situation, the step-up in basis equals $17,000 (from $1,000 to $18,000). The losses of $25,000 exceed the step-up amount by $8,000.

Question 34

Paul has the following items: Carryforward of prior year passive loss from: XYZ limited partnership (publicly traded) $(10,000) ABC limited partnership (nonpublicly traded) $(6,000) Current year passive income and loss from: XYZ limited partnership (publicly traded) $12,000 GHI limited partnership (publicly traded) $(9,000) JKL limited partnership (nonpublicly traded) $18,000 RST limited partnership (nonpublicly traded) $(14,000) What is the total amount of passive losses that Paul may deduct during the current year? A) $28,000 B) $18,000 C) $14,000 D) $30,000

Answer 34

A Explanation Publicly traded partnership (PTP) income may only be offset by prior year losses from the same partnership. Thus, the $10,000 XYZ carryforward is deductible. Nonpublicly traded income ($18,000) may be offset by current losses ($14,000) or carryforward losses ($6,000) from any nonpublicly traded activities. Thus, the $10,000 XYZ loss and the $18,000 nonpublicly traded loss total $28,000. LO 7.2.2

Question 35

John has the following items from four separate investments during the current tax year: Passive income from a publicly traded limited partnership: $8,000 Passive loss from a publicly traded limited partnership: $10,000 Passive income from a nonpublicly traded limited partnership: $17,000 Passive loss from a nonpublicly traded limited partnership: $9,000 What is the total amount, if any, of passive losses that may be deducted during the current year? A) $0 B) $19,000 C) $9,000 D) $17,000

Answer 35

C * they didnt specifically mention the PTP's were the same.

Question 36

Your clients, Jane and Mark, are contemplating the purchase of a condominium to use as a rental property. They would manage the property themselves and anticipate that it would generate losses for the first few years, at least. Which of the following statements are CORRECT with respect to active participation rental real estate? The interest may be held through a limited partnership. A deduction-equivalent tax credit of up to $25,000 is available. The taxpayer must hold a 10% or greater ownership interest in the property. The taxpayer must participate in the management of the property in a bona fide sense. A) I, II, and III B) II, III, and IV C) I and II D) III and IV

Answer 36

D Explanation III and IV are the only choices that are correct, by definition. The interest in the property may not, by definition, be held through a limited partnership, and up to $25,000 refers to losses that may be deducted, not credits that may be taken. The deduction-equivalent tax credits mentioned in option II are relevant with respect to low-income housing and historic rehabilitation passive activities.

Question 37

Which of the following statements regarding passive activity losses is CORRECT? When determining the amount of suspended loss that may be used against income, the at-risk rules are applied before the passive activity loss rules. If a loss is not allowed because of the at-risk limitations, the loss is a suspended loss eligible for deduction as a disposition of a passive activity. A) I only B) Neither I nor II C) Both I and II D) II only

Answer 37

A Explanation Statement I is correct. Statement II is incorrect. If a loss is not allowed because of the at-risk limitations, the loss is a suspended loss and is not eligible for deduction as a disposition of a passive activity.

Question 38

Which of the following applies to the at-risk rules, as related to passive loss restrictions for partners? It is the maximum deductible loss for an investment limited to the amount of risk that the taxpayer has at the end of the current year. Determining the amount at risk includes the adjusted basis of other property contributed to the partnership. The inclusion of nonrecourse financing is essentially the only difference between the basis in a partnership and the amount at risk. A) II only B) I, II and III C) I only D) I and II

Answer 38

B Explanation In the Tax Code, the at-risk rules are defined as the maximum deductible loss for an investment limited to the amount that the taxpayer-investor has at risk at the end of the current year (i.e., the amount of potential economic loss). A partner may deduct losses only to the extent of the amount that they have "at risk." The amount at risk equals the sum of the following: The money invested (except to the extent the money invested was borrowed and was secured only by the investment) The adjusted basis of other property contributed to the partnership Amounts borrowed for use in the activity, but only to the extent that the partners are personally liable for repayment of the debt (recourse indebtedness) The partner's share of income, less the partner's share of losses or withdrawals from the partnership The proportionate share of qualified nonrecourse financing in a real estate activity ONLY Essentially, the only difference between the amount at risk and the basis in a partnership interest is the treatment of nonrecourse financing. LO 7.2.3

Question 39

If a vacation home is rented for 14 days or less during the year, which one of the following statements is CORRECT? A) Typically, only a small amount of cost recovery deductions is allowed for the year. B) The full amount of home mortgage interest is permitted as an itemized deduction. C) Repair expenses attributed to the rental activity are deductible. D) A portion of the rental income may be nontaxable.

Answer 39

B Explanation If property is rented fewer than 15 days per year, the full amount of home mortgage interest, taxes, and casualty losses are permitted as an itemized deduction (not expenses, though); in addition, rental income can be excluded from gross income.