Passive Activity Loss Rules: Strategies for Pass- Throughs to - - PowerPoint PPT Presentation

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Passive Activity Loss Rules: Strategies for Pass- Throughs to Maximize Deductions

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Leveraging Federal Guidance and Rulings to Establish Material Participation

A Live 110-Minute Teleconference/Webinar with Interactive Q&A

Today's panel features: Steven Schneider, Director, Tax Group, Tax Goulston & Storrs, Washington, D.C. Carolyn R. Turnbull, Director of Tax, Moore Stephens Tiller, Atlanta N l B k P t P t hi T h i l T P ti L d G t Th t W hi t D C

A Live 110-Minute Teleconference/Webinar with Interactive Q&A

Noel Brock, Partner, Partnership Technical Tax Practice Leader, Grant Thornton, Washington, D.C.

Thursday, June 24, 2010 The conference begins at: The conference begins at: 1 pm Eastern 12 pm Central 11 am Mountain 10 am Pacific 10 am Pacific

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Passive Activity Loss Rules: Strategies For Pass Throughs Strategies For Pass-Throughs To Maximize Deductions W bi Webinar

June 24, 2010

Steven Schneider, Goulston & Storrs sschneider@goulstonstorrs.com Carolyn Turnbull, Moore Stephens Tiller cturnbull@mstiller.com Noel Brock, Grant Thornton noel.brock@gt.com

Today’s Program

Relevance Of Passive Activity Loss Rules Slides 6-8 (Steven Schneider) Passive Activity Loss Rules Under The IRC Slides 9-41 (Carolyn Turnbull Steven Schneider Noel Brock) (Carolyn Turnbull, Steven Schneider, Noel Brock) Special Impacts On Real Estate Professionals Slides 42-52 (Carolyn Turnbull) Recent Passive Activity Loss Developments Slides 53-69 (Carolyn Turnbull) i d l i i lid Best Practices And Tax Planning Tips Slides 70-71 (Carolyn Turnbull, Steven Schneider, Noel Brock)

5

Relevance Of Passive A ti it L R l Activity Loss Rules

Steven Schneider, Goulston & Storrs Steven Schneider, Goulston & Storrs

Introduction To Passive Activity Rules



Relevance under new Sect. 1411 3.8% Medicare tax

St ti i 2013 3 8% M di t t i t t

–

Starting in 2013, a 3.8% Medicare tax on net investment income from trade or business that is (a) not a §469 passive activity, and (b) trading in financial instruments or commodities commodities



Recent problems with audits of real estate professionals

7

Introduction To Passive Activity Rules



Issues with IRS recharacterizing income and losses

–

The IRS has special rules to recharacterize passive income to non-passive income and non-passive income to non-passive income and non-passive losses to passive losses.

 Examples

– Self-charged rent – Self-charged interest – Special rules for certain dispositions

8

Passive Activity Loss R l U d Th IRC Rules Under The IRC

Carolyn Turnbull, Moore Stephens Tiller Steven Schneider, Goulston & Storrs Steven Schneider, Goulston & Storrs Noel Brock, Grant Thornton

General Rules: IRC §469

Passive activity loss and credit disallowed

A t l d d t i ti it l tili



A taxpayer may only deduct a passive activity loss or utilize a passive activity credit against the taxpayer’s passive activity income for any given taxable year.

–

Any passive activity loss or credit which is disallowed for a taxable year is carried forward and treated as a credit or deduction allocable to the passive activity in the following taxable year. S d d l d dit f ti it ll d i f ll

–

Suspended losses and credits from an activity are allowed in full upon a taxable disposition of the activity.

–

If any passive losses are not deductible in any given year, the amount of the suspended losses from each passive activity is 10 amount of the suspended losses from each passive activity is determined on a pro rata basis.

General Rules: IRC §469 (Cont.)

Taxpayers to whom the passive activity rules apply



The passive activity limitations apply to the following taxpayers:

–

An individual, estate or trust;

–

A closely held C corporation; and

–

A personal service corporation

11

General Rules: IRC §469 (Cont.)

Publicly traded partnerships

The passive loss rules are applied separately with respect to each



The passive loss rules are applied separately with respect to each publicly traded partnership. Each partner in a publicly traded partnership treats loss (if any) from the partnership as separate from income and loss from any other publicly traded partnership, and also as separate y p y p p p from any income or loss from passive activities.

–

Net income from publicly traded partnerships

–

Net losses and credits attributable to the interest in the publicly traded partnership



Treatment of suspended losses and credits

–

Disposition of a publicly traded partnership (or an activity in a publicly traded partnership)

12

partnership)

–

Non-application of the publicly traded partnership separate entity rule to the low-income housing credit or the rehabilitation credit

General Rules: IRC §469 (Cont.)

Calculation of the passive activity loss and passive activity credit y



A taxpayer’s passive activity loss for a particular taxable year is equal to the amount (if any) by which:

–

The taxpayer’s aggregate loss from all passive activities for the taxable year exceeds exceeds

–

The aggregate income from all passive activities for the year



A taxpayer’s passive activity credit for a particular taxable year is equal to the amount by which: y

–

The sum of all of the taxpayer’s credits from all passive activities allowable for the taxable year under



Subpart D of part IV of subchapter A of the Internal Revenue Code, or



Subpart B (other than §27(a)) of such part IV) exceeds

13



Subpart B (other than §27(a)) of such part IV) exceeds

–

The taxpayer’s regular tax liability for the taxable year which is allocable to all passive activities

General Rules: IRC §469 (Cont.)

Allocation of passive activity loss and credit

A taxpayer's passive activity loss $25 000 offset for rental real A taxpayer s passive activity loss, $25,000 offset for rental real estate and passive activity credit are allocated to all activities, and within activities, on a pro rata basis as provided under regulations. regulations.

14

General Rules: IRC §469 (Cont.)

Definition of passive activity G l l General rule

A i ti it i ti it :



A passive activity is any activity:

–

Which involves the conduct of a trade or business, ,

–

And in which the taxpayer does not materially participate 15

General Rules: IRC §469 (Cont.)

Definition of passive activity Trade or business activities Trade or business activities



Trade or business activities are activities that:

–

Involve the conduct of a trade or business (within the meaning of §162) §162),

–

Are conducted in anticipation of the commencement of a trade or business, or

–

Involve research or experimentation expenditures that are deductible under §174 (or would be deductible if the taxpayer adopted the under §174 (or would be deductible if the taxpayer adopted the method described in §174(a))



Trade or business activities do not include:

–

Rental activities, or A ti iti th t t t d d §1 469 1T( )(3)( i)(B) i id t l 16

–

Activities that are treated under §1.469-1T(e)(3)(vi)(B) as incidental to an activity of holding property for investment

General Rules: IRC §469 (Cont.)

Definition of passive activity

Exclusions Exclusions



Working interests in oil and gas property



Activity of trading personal property for the account of owners of interests in the activity (without regard to whether such activity is a trade interests in the activity (without regard to whether such activity is a trade

• r business activity)



Compensation for personal services



Portfolio income

Interest and dividends

–

Interest and dividends

–

Gain on sale of stocks and bonds

–

Gain on sale of investment property



Income from leased land and land held for investment I f t t d t ti it i hi h th t 17



Income from property rented to an activity in which the taxpayer materially participates.



Lottery winnings

General Rules: IRC §469 (Cont.)

$25,000 offset for real estate activities



Under §469(i), an individual may offset up to $25,000 of income that is not treated as passive under the passive loss rules, with losses and credits from rental real estate activities with respect to hi h th i di id l ti l ti i t which the individual actively participates.

–

A taxpayer may also use low-income housing credits as a part of the

• verall $25,000 amount, regardless of whether the individual actively

participates in the rental real estate activity to which such credits participates in the rental real estate activity to which such credits relate. 18

General Rules: IRC §469 (Cont.)

$25,000 offset for real estate activities (Cont.)



Phase-out of exemption

–

$25,000 amount is reduced, but not below zero, by 50% of the amount by which the taxpayer’s AGI exceeds $100,000. p y $ ,

–

For married individuals filing a separate return, the $25,000 amount is reduced to $12,500, and the AGI amount is reduced to $50,000.



The $25,000 amount is reduced to zero for married individuals filing a separate return who do not live apart at all times during the taxable year. p p g y

–

The phase-out does not apply to low-income housing credits.

–

Where any portion of a passive activity credit is attributable to the rehabilitation credit, "$200,000" is substituted for the "$100,000" adjusted gross income

• limitation. (In the case of a married individual filing a separate return,

19

( g p , "$100,000" is substituted for the "$50,000" limitation.)

Material Participation

General rule



A taxpayer materially participates in an activity only if the taxpayer is involved in the operations of the activity on a:

–

Regular

–

Continuous, and

–

Substantial basis



The individual’s involvement must relate to the operations of the activity.



An individual is most likely to have materially participated in an

20

activity where involvement in the activity is the taxpayer’s principal business.

Material Participation (Cont.)

Material participation tests of temp. Reg. §1.469-5T



Under temp Reg §1 469 5T a taxpayer is considered to materially



Under temp. Reg. §1.469-5T, a taxpayer is considered to materially participate in an activity if he satisfies any one of the following seven tests:

1. 500-hours test. The taxpayer (or spouse) participates in the activity for more than 500 hours during the tax year. 2 S b t ti ll ll t t Th t ’ ti i ti tit t b t ti ll ll 2. Substantially all test. The taxpayer’s participation constitutes substantially all

• f the participation in the activity of all individuals (including non-owners) for the

tax year. 3. 100 hours and nobody works harder test. The taxpayer’s participation in the activity for more than 100 hours during the tax year and his participation is not activity for more than 100 hours during the tax year, and his participation is not less than the participation of any other person.

 The activity is a significant participation activity for the tax year, and his aggregate

participation in all significant participation activities during the year exceeds 500 hours.

–

A significant participation activity is one in which the taxpayer has more than 100 hours of participation during the tax year but fails to satisfy any other test for material participation

21

participation during the tax year but fails to satisfy any other test for material participation.

 He materially participated in the activity for any five of the 10 tax years immediately

preceding the tax year in question.

Material Participation (Cont.)

Material participation tests of temp. Reg. §1.469-5T (Cont ) (Cont.)

4.

Significant participation activity/500-hours test. The

4.

Significant participation activity/500 hours test. The activity is a significant participation activity for the tax year, and the taxpayer’s aggregate participation in all significant participation activities during the year exceeds 500 hours.

• A significant participation activity is one in which the taxpayer has more

than 100 hours of participation during the tax year but fails to satisfy any

• ther test for material participation.

5

5 out of 10 years test. The taxpayer materially participated in

22

5.

5 out of 10 years test. The taxpayer materially participated in the activity for any five of the 10 tax years immediately preceding the tax year in question.

Material Participation (Cont.)

Material participation tests of temp. Reg. §1.469-5T (Cont.) ( )

6. Personal services activity and 3-years test. The activity is a personal service activity, and the taxpayer materially participated in the activity for any three tax years preceding the tax year in question.

• A personal service activity is one that involves the performance of personal services

in the fields of health law engineering architecture accounting actuarial science in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting or any other trade or business in which capital is not a material income-producing factor. 7. Facts and circumstances. Based on all facts and circumstances, the taxpayer participates in the activity on a regular, continuous and substantial basis during the tax year year.



Participation-satisfying standards not contained in §469 are not taken into account.



To satisfy the facts and circumstances test, the taxpayer must participate in the activity for more than 100 hours during the year.



A taxpayer's management services are not taken into account unless no other

23



A taxpayer s management services are not taken into account unless no other person is compensated for management services, and no other individual performs management services exceeding the hourly total of such services performed by the taxpayer.

Material Participation (Cont.)

Participation



General rule Any work done by an individual (without regard to the



General rule. Any work done by an individual (without regard to the capacity in which the individual does the work) in connection with an activity in which the individual owns an interest at the time the work is done is treated as participation in the activity.



Exceptions



Exceptions

–

Certain work not customarily done by owners



A principal purpose of the work must be to avoid the §469 passive activity limitations.

–

Participation as an investor



Work done by an individual in the individual’s capacity as an investor is not treated as participation in the activity, unless the individual is directly involved in the day-to- day management or operations of the activity. 

Participation by an individual’s spouse is treated as participation by the 24



Participation by an individual s spouse is treated as participation by the individual (regardless of whether the spouse owns an interest in the activity or the spouses file a joint return for the taxable year).

Material Participation (Cont.)

Material participation by entities subject to the passive loss rules passive loss rules



Estate or trust is treated as materially participating in an activity (or as actively participating in a rental real estate activity) if an executor or fiduciary, in his capacity as such, so participates.

–

In the case of a grantor trust, material participation is determined at the grantor, rather than the entity, level.



Interests held through pass-through entities

–

Material participation is determined at the shareholder’s or general partner’s level in the case of a taxpayer who holds an interest in an 25 p p y activity through an S corporation or a general partnership.

Material Participation (Cont.)

Material participation by entities subject to the passive loss rules (Cont ) passive loss rules (Cont.)



Interests in limited partnerships

–

Under §469(h)(2), except as provided in the regulations, a taxpayer cannot materially participate in a passive activity held through a limited partnership materially participate in a passive activity held through a limited partnership interest.



This rule also applies to limited partnership interests which the taxpayer indirectly possesses through a tiered entity arrangement.



When a taxpayer possesses both a limited partnership interest and e a a paye possesses bo a ed pa e s p e es a d another type of interest (e.g., a general partnership interest) with respect to an activity, the taxpayer is conclusively presumed not to materially participate with respect to the limited partnership interest.

–

Whether the taxpayer materially participates with respect to other interests in th ti it i d t i d b i i th di f t d

26

the activity is determined by examining the surrounding facts and circumstances.

Material Participation (Cont.)

Material participation by entities subject to the passive loss rules (Cont.) p ( )

Treatment of limited partners under temp. Reg. §1.456-5T(e)



General rule. An individual is not treated as materially participating in any activity of a limited partnership for purposes of applying §469 and any activity of a limited partnership for purposes of applying §469 and the regulations thereunder to:

–

The individual’s share of any income, gain, loss, deduction or credit from such activity that is attributable to a limited partnership interest in the partnership; and p p

–

Any gain or loss from such activity recognized upon a sale or exchange of such an interest



Exceptions: Any activity in which the individual would be treated as materially participating for the taxable year under paragraphs (a)(1), (5), 27 materially participating for the taxable year under paragraphs (a)(1), (5),

• r (6) of temp. Reg. §1.469-5T if the individual were not a limited partner

for such taxable year.

Material Participation (Cont.)

Material participation by entities subject to the passive loss rules (Cont ) passive loss rules (Cont.)

Limited partnership interest defined (temp. Reg. 1.469-5T(e)(3)



Exception Limited partner holding general partnership interest



• Exception. Limited partner holding general partnership interest

–

A partnership interest of an individual shall not be treated as a limited partnership interest for the individual’s taxable year if the individual is a general partner in the partnership at all times during individual is a general partner in the partnership at all times during the partnership’s taxable year ending with or within the individual’s taxable year (or portion of the partnership’s taxable year) during which the individual (directly or indirectly) owns such limited 28 partnership interest.

Material Participation (Cont.)

Material participation by entities subject to the passive loss rules (Cont.) p ( )

Material participation for closely held and personal service corporations



A closely held corporation or a personal service corporation



A closely held corporation or a personal service corporation materially participates in an activity if and only if

–

One or more shareholders holding stock representing more than 50% (by value) of the outstanding stock of such corporation t i ll ti i t i th ti it materially participate in the activity, or

–

For a closely-held C corporation which is not a personal service corporation, the requirements of §465(c)(7)(C) (without regard to clause (iv) (re: excluded businesses) and taking into account §465( )(7)(D) ( lifi d t t i t hi )) 29 §465(c)(7)(D) (re: qualified corporate partner in a partnership)) are met with respect to the activity

Material Participation (Cont.)

Material participation by entities subject to the passive loss rules (Cont.) p ( )

Material participation for closely held and personal service corporations



Closely held corporation not a personal service corporation (temp. Reg.



Closely held corporation not a personal service corporation (temp. Reg. §1.469-1T(g)(3)(i)(B))

–

The §465(c)(7)(C) standard is generally satisfied if:



For the prior 12-month period, the corporation has at least one fulltime employee of the corporation substantially all of whose services are employee of the corporation, substantially all of whose services are related to the active management of the activity;



During the same period, the corporation has at least three fulltime non-

• wner employees who provide sufficient services which are directly

related to the activity; and

30



The amount of the taxpayer's business deductions attributable to the activity exceeded 15% of gross income from the business for the taxable year.

Material Participation (Cont.)

Material participation by entities subject to the passive loss rules (Cont.) p ( )

Significant participation for closely held and personal service corporations

A ti it f l l h ld ti l i



An activity of a closely held corporation or a personal service corporation is treated as a significant participation activity if and

• nly if:

–

The corporation is not treated as materially participating in the The corporation is not treated as materially participating in the activity for the taxable year, and

–

One or more individuals, each of whom are treated as significantly participating in such activity, directly or indirectly (in the aggregate) hold more than 50% (by value) of the outstanding stock of such 31 hold more than 50% (by value) of the outstanding stock of such corporation

Material Participation (Cont.)

Material participation by entities subject to the passive loss rules (Cont.) p ( )

Participation of an individual in a closely held or personal service corporation (temp. Reg. §1.469-1T(g)(3)(ii))



The rules of temp Reg §1 465 5T generally apply in determining



The rules of temp. Reg. §1.465-5T generally apply in determining whether an individual materially or significantly participates in the activities of a corporation, except:

–

All activities of the corporation are treated as activities in which the individual holds an interest in determining whether the individual participates (within the holds an interest in determining whether the individual participates (within the meaning of temp. Reg. §1.469-5T(f)) in an activity of the corporation; and

–

The individual’s participation in all activities other than activities of the corporation are disregarded in determining whether the individual’s participation in an activity of the corporation is treated as material ti i ti d t R §1 469 5T( )(4) ( l ti t t i l

32

participation under temp. Reg. §1.469-5T(a)(4) (relating to material participation in significant participation activities)

Material Participation (Cont.)

Material participation by entities subject to the passive loss rules (Cont.) p ( )

Participation of an individual in a closely held or personal service corporation (temp. Reg. §1.469-1T(g)(3)(ii))



The rules of temp Reg §1 465 5T generally apply in determining



The rules of temp. Reg. §1.465-5T generally apply in determining whether an individual materially or significantly participates in the activities of a corporation, except:

–

All activities of the corporation are treated as activities in which the individual holds an interest in determining whether the individual participates (within the holds an interest in determining whether the individual participates (within the meaning of temp. Reg. §1.469-5T(f)) in an activity of the corporation, and

–

The individual’s participation in all activities other than activities of the corporation are disregarded in determining whether the individual’s participation in an activity of the corporation is treated as material ti i ti d t R §1 469 5T( )(4) ( l ti t t i l

33

participation under temp. Reg. §1.469-5T(a)(4) (relating to material participation in significant participation activities)

Special Material Participation Rule F Li i d P For Limited Partners

• Sect. 469(h)(2) presumptively treats losses from certain limited

partnership interests as passive. – “Interests in limited partnerships. Except as provided in regulations, no interest in a limited partnership as a limited partner shall be treated as an interest with respect to which a taxpayer materially participates ” materially participates.

• Limited partners may rebut the statutory presumption and prove

material participation, but they are limited to three of the seven regulatory material participation tests outlined previously. Temp. g y p p p y p

• Treas. Reg. § 1.469-5T(e)(1) and (2)

– Participation in the activity for more than 500 hours during the tax year – Materially participate in the activity for any five of the last 10 tax years – Materially participate in a personal service activity for any three prior tax years

34 34

prior tax years

Special Material Participation Rule Special Material Participation Rule For Limited Partners (Cont.)

• The regulations define two categories of limited partnership interests:
• The regulations define two categories of limited partnership interests:

– Those designated as limited partnership interests in the limited partnership agreement or the certificate of limited partnership – Those for which the liability of the holder of such interest is Those for which the liability of the holder of such interest is limited under state law (in the state where organized) to a determinable fixed amount

• Temp. Treas. Reg. § 1.469-5T(e)(3)
• General partner exception: A partnership interest of an individual shall

not be treated as a limited partnership interest for the individual’s taxable year, if the individual is a general partner in the partnership at all times during the partnership’s taxable year ending with or within all times during the partnership s taxable year ending with or within the individual’s taxable year. Temp. Treas. Reg. § 1.469-5T(e)(3)

35 35

Garnett V Commissioner 132 T C No Garnett V. Commissioner, 132 T.C. No. 19 (June 30, 2009)

• Taxpayer held interests in limited liability companies (LLCs), limited

liability partnerships (LLPs) and tenancies in common (TICs). The LLCs and LLPs generated losses, and taxpayer used to offset other

• rdinary income on taxpayer’s individual income tax return. IRS

asserted that taxpayer failed to satisfy the material participation requirements of Sect. 469.

• Issue: Whether the taxpayer’s interests in LLCs and LLPs should be

considered interests in limited partnerships “as a limited partner,” so as to be treated presumptively passive under the special rule of Sect. 469(h)(2)

36 36

Garnett v Commissioner 132 T C No Garnett v. Commissioner, 132 T.C. No. 19 (June 30, 2009) [Cont.]

T IRS Taxpayer arguments

• Sect. 469(h)(2) is inapplicable

because: IRS arguments

• Sect. 469(h)(2) is applicable because:
• Taxpayer’s interests in the LLCs
• No interest in any the companies

was a “limited partnership interest,” as that term is used in the code. State l h i “li i d and LLPs satisfy the definition of “limited partnership interest,” in the temporary regulations law governs what is a “limited partnership interest in a limited partnership T i id d l

• Taxpayer is not properly

considered a general partner

• Taxpayer is considered a general

partner (not a limited partner)

37 37

Garnett v Commissioner 132 T C No Garnett v. Commissioner, 132 T.C. No. 19 (June 30, 2009) [Cont.]

H ldi

• Holding

– The temporary regulations do allow for entities other than state law limited partnerships to be treated as “limited partnerships” under S 469(h)(2)

• Sect. 469(h)(2).

– Sect. 469(h)(2) does not apply, because interests in LLPs and LLCs are properly considered general partner interests and thus, h l i f h l i li the general partner exception of the temporary regulations applies. – The decision turned on the fact that members of LLCs and partners in LLPs are not restricted as to their participation under state law.

38 38

Thompson v U S No 06-211 Ct Fed Thompson v. U.S., No. 06-211 Ct. Fed.

• Cl. (July 20, 2009)
• Taxpayer held interests in LLCs that generated losses that taxpayer

used to offset items of ordinary income on taxpayer’s individual income tax return. The parties stipulated that if the member interest is a li i d hi i h h i l limited partnership interest, then the taxpayer cannot material participation in the LLC. The parties also stipulated that if the member interest is not a limited partnership interest, then the taxpayer can demonstrate material participation demonstrate material participation.

• Issue: Whether these interests should be treated as presumptively

passive under Sect. 469(h)(2), such that the losses flowing from the LLCs could be used to offset only passive income (not ordinary LLCs could be used to offset only passive income (not ordinary income)

39 39

Thompson v U S No 06-211 Ct Fed Thompson v. U.S., No. 06-211 Ct. Fed.

• Cl. (July 20, 2009) [Cont.]
• The Thompson court’s holding is broader than the holding in Garnett.

In addition to holding the taxpayer to be a general partner, the Court of F d l Cl i h ld h i i ibl f i i LLC Federal Claims held that it is not possible for an interest in an LLC to be properly treated as an “interest in a limited partnership as a limited partner.”

40 40

IRS Response

• On March [8], 2010 the IRS announced its acquiescence in result only

in James R. Thompson v. U.S.

41 41

Special Impacts On Real E t t P f i l Estate Professionals

Carolyn Turnbull, Moore Stephens Tiller Carolyn Turnbull, Moore Stephens Tiller

S i l R l F T I R l Special Rules For Taxpayers In Real Property Business: IRC §469(c)(7)



The passive loss limitations do not apply to any rental real estate activity of a taxpayer who is in the real property business. activity of a taxpayer who is in the real property business.

–

Generally, each interest of the taxpayer in rental real estate is treated as a separate activity.

A taxpayer may elect to treat all interests in rental real estate as



A taxpayer may elect to treat all interests in rental real estate as

• ne activity.



The term “real property trade or business” means any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing or brokerage trade or business.

43

Special Rules For Taxpayers In Real Property Business: IRC §469(c)(7) (Cont.)



A taxpayer is in the real property business for this purpose if:

More than one half of the personal services performed in trades or

–

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 for businesses in which the taxpayer materially participates (under the general material participation y p p ( g p p rules), and

–

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



Where spouses file a joint return, the above two requirements are satisfied if and only if either spouse separately satisfies the

44

requirements.

Special Rules For Taxpayers In Real Property Business: IRC §469(c)(7) (Cont.)

Rental activities



General rule. A passive activity includes any rental activity. A ti it i t l ti it f t if



An activity is a rental activity for a tax year if:

–

Tangible property held in connection with the activity is used by customers, or held for use by customers; and

–

The gross income from the activity represents amounts paid,

• r to be paid, principally for the use of such property.

45

Special Rules For Taxpayers In Real Property Business: IRC §469(c)(7) (Cont.)

Rental activities (Cont.)

E ti (R §1 469 1T( )(3)(ii))



Exceptions (Reg. §1.469-1T(e)(3)(ii))

–

Average period of customer use is seven days or fewer.

–

Average period of customer use is 30 days or fewer, and significant personal services are provided personal services are provided.

–

Extraordinary personal services are provided (even if the average period of customer use is greater than 30 days).

–

Rentals are incidental to non-rental activities.

–

Property is made available to customers during defined hours of business for their non-exclusive use.

–

Property is provided to a joint venture, partnership or S corporation in which the taxpayer holds an interest; and the property is provided 46 in which the taxpayer holds an interest; and the property is provided in the taxpayer’s capacity as an owner of such an interest rather than rented to the joint venture, partnership or S corporation.

Special Rules For Taxpayers In Real Property Business: IRC §469(c)(7) (Cont.)

Closely held C corporations



A closely held C corporation is in the real property trade or business if for the year in question, more than 50% of the gross receipts of the corporation are derived from real property trades

• r businesses in which the corporation materially participates.



Personal services performed as an employee are not performed in real property trades or businesses unless the services are p p y performed by a 5% owner in the employer.

47

Special Rules For Taxpayers In Real Property Business: IRC §469(c)(7) (Cont.)

Suspended losses



According to the House Committee Report on the Revenue Reconciliation Act of 1993, a suspended loss from a rental real property activity that is treated as not passive because of these new rules is classified as a loss from a former passive activity. Thus, the deduction for the suspended loss is limited to income from the activity and is not allowed to offset other income. Any i i d d l ll d i f ll h th remaining suspended losses are allowed in full when the taxpayer disposes of the activity in a fully taxable transaction with an unrelated party.

48

Special Rules For Taxpayers In Real Property Business: IRC §469(c)(7) (Cont.)

Summary of steps for identifying whether a taxpayer qualifies as a real estate professional under IRC §469(c)(7)



Identify the taxpayer’s (or taxpayers’ in the case of married taxpayers) real property trades or businesses



Divide the real property trades or businesses into rental real estate activities and other real estate activities

–

Pay special attention to identify rental activities that are not treated as rental activities under Reg. §1.469-1T(e)(3)(ii). These activities should not be grouped with the taxpayer’s rental real estate activities, for purposes of determining whether the taxpayer materially participates in his/her rental real estate activities. Make sure that the election to treat all of the taxpayer’s rental real estate activities as a

–

Make sure that the election to treat all of the taxpayer s rental real estate activities as a single rental real estate activity has been properly made under Reg. §1.469-9(g)

–

Identify which of the “other real estate activities” the taxpayer has grouped together



Calculate whether the taxpayer separately materially participates in his/her rental real estate activities and other real estate activities

49

activities and other real estate activities

–

The taxpayer can include participation by his/her spouse regardless of whether or not the taxpayer and spouse file a joint return

Special Rules For Taxpayers In Real Property Business: IRC §469(c)(7) (Cont.)

Summary of steps for identifying whether a taxpayer qualifies as a real estate professional under IRC §469(c)(7) (Cont.) p § ( )( ) ( )



Determine whether the taxpayer meets the participation tests under §469(c)(7)(B)

–

Calculate the number of hours that the taxpayer who wishes to be classified

–

Calculate the number of hours that the taxpayer who wishes to be classified as a real estate professional participated in total in the real estate activities during the year

–

Calculate the number of hours that the taxpayer who wishes to be classified as a real estate professional participated in total in his/her non real estate as a real estate professional participated in total in his/her non-real estate related activities during the year

–

Determine whether the taxpayer satisfies the “more-than-one-half” and “more than 750 hours” participation tests under §469(c)(7)(B)

50



The taxpayer may not include participation by his/her spouse in determining whether he/she satisfies these two tests.

Special Rules For Taxpayers In Real Property Business: IRC §469(c)(7) (Cont.)

Example

A and B are married. A, a CPA, retired from his accounting firm during 2009 and wishes to be classified as a real estate professional for 2009. A and B individually own three apartment buildings and a condo held primarily for rental to third parties. A and B both actively manage the rental of their apartment buildings and the condo. A also owns property that he has subdivided and i h ldi f l t thi d ti is holding for sale to third parties. The number of hours that A and B participated in each of the activities during 2009 is shown in the table following.

51

g g

Special Rules For Taxpayers In Real Property Business: IRC §469(c)(7) (Cont.)

Example

Assumptions

• A and B have properly elected to treat their rental real estate activities as a single activity.
• A and B have properly treated the condo and the real estate development activities as a single activity.

52

• A’s and B’s hours of participation in the real estate activities are all includible in determining whether A and

B materially participate in the rental real estate and other real estate activities. Conclusion

• A qualifies to be treated as a real estate professional for 2009.

R t P i A ti it Recent Passive Activity Loss Developments and p Other Guidance

Carolyn Turnbull, Moore Stephens Tiller Carolyn Turnbull, Moore Stephens Tiller

Rules For Grouping Activities

General rules

A i t i it



Appropriate economic unit

–

One or more trade or business activities or rental activities may be treated as a single activity they constitute an appropriate economic unit for the measurement of gain or loss for purposes of §469 unit for the measurement of gain or loss for purposes of §469.



Facts and circumstances test

–

Taxpayers may use any reasonable method for grouping activities. Following factors are given the greatest weight:

–

Following factors are given the greatest weight:



Similarities and differences in types of trades or businesses



Extent of common control



Geographical location 54



Geographical location



Interdependence between or among the activities

Rules For Grouping Activities (Cont.)

Limitations on grouping activities



Grouping rental activities with other trade or business activities

–

Exceptions



Rental activity is insubstantial in relation to the trade or business activity T d b i ti it i i b t ti l i l ti t th t l ti it



Trade or business activity is insubstantial in relation to the rental activity



Each owner of the trade or business activity has the same proportionate

• wnership interest in the rental activity



Grouping real property rentals and personal property rentals



Grouping real property rentals and personal property rentals

–

Exceptions



Personal property provided in connection with the real property



Real property provided in connection with the personal property

55

Rules For Grouping Activities (Cont.)

Limitations on grouping activities (Cont.)



Activities of limited partners and limited entrepreneurs

–

Applies to activities described in §465(c)(1)

–

Exception Exception



A taxpayer that owns an interest as a limited partner or limited entrepreneur in an activity described in §465(c)(1) may group that activity with another activity in the same business if the grouping constitutes an appropriate economic unit under Reg §1 469 4(c) appropriate economic unit under Reg. §1.469-4(c).

–

A limited entrepreneur is a person who:



Has in interest in an enterprise other than as a limited partner, and



Does not actively participate in the management of such enterprise

56



Does not actively participate in the management of such enterprise

Rules For Grouping Activities (Cont.)

Limitations on grouping activities (Cont.)



Activities conducted through §469 entities

–

• Sect. 469 entity includes:



A C corporation subject to §469 A S ti



An S corporation



A partnership

–

A §469 entity must group its activities under the rules in Reg. §1.469-4. §

–

Once the §469 entity groups its activities, a shareholder or partner may group those activities:



With each other,



With activities conducted directly by the shareholder or partner and

57



With activities conducted directly by the shareholder or partner, and



With other activities conducted through other §469 entities

Rules For Grouping Activities (Cont.)

Limitations on grouping activities (Cont.)



Activities conducted through §469 entities

–

A shareholder or partner may not treat activities group together by a §469 entity as separate activities. § y p

–

Special rule for activities conducted by C corporations



A taxpayer may group an activity conducted by a C corporation subject to §469 with another activity of the taxpayer, but only for purposes of determining whether the taxpayer materially or significantly participates in determining whether the taxpayer materially or significantly participates in the other activity.



Other activities identified by the commissioner

58

Other activities identified by the commissioner

Rules For Grouping Activities (Cont.)

Disclosure and consistency requirements (Reg §1 469 4(e)) (Reg. §1.469-4(e))



Prohibition on regrouping activities

–

General rule

–

General rule



Once a taxpayer has grouped activities, the taxpayer may not regroup those activities in subsequent years.

–

Exception



A taxpayer must regroup activities and comply with the commissioner’s disclosure requirements if:

–

The taxpayer determines that the taxpayer’s original grouping was clearly inappropriate, or

59

pp p

–

A material change in the facts and circumstances has occurred that makes the

• riginal grouping clearly inappropriate

Rules For Grouping Activities (Cont.)

Grouping by Commissioner to prevent tax avoidance (Reg §1 469 4(f)) (Reg. §1.469-4(f))



The commissioner may regroup a taxpayer’s activities if:

–

Any of the activities resulting from the taxpayer’s grouping is not an

–

Any of the activities resulting from the taxpayer s grouping is not an appropriate economic unit, and

–

A principal purpose of the taxpayer’s grouping (or failure to regroup) is to circumvent the principal purpose of §469 60

Taxpayer Activity Groupings For Purposes Taxpayer Activity Groupings For Purposes Of Passive Loss Limitations – Recent Development p

• Rev. Proc. 2010-13

B k d



Background



• Rev. Proc. 2010-13 requires a taxpayer to disclose with its
• riginal income tax return information related to:

–

New activity groupings,

–

The addition of a new activity to an existing activity grouping, and

–

Any regroupings for which the taxpayer determined that the original grouping was clearly inappropriate or there was a material change in facts and circumstances that has made the original grouping clearly inappropriate



Relief for untimely disclosures is not available under Reg

61



Relief for untimely disclosures is not available under Reg. §301.9100-1(d)(2).

Taxpayer Activity Groupings For Purposes Taxpayer Activity Groupings For Purposes Of Passive Loss Limitations – Recent Development

• Rev. Proc. 2010-13 (Cont.)



Special rules for groupings by partnerships and S corporations



Special rules for groupings by partnerships and S corporations

–

Partnerships and S corporations are not subject to the disclosure requirements described above.



Instead, partnerships and S corporations must comply with the disclosure p p p p y instructions for grouping activities provided for on Form 1065 and Form 1120S.

–

The partner or shareholder is not required to make a separate disclosure of the groupings disclosed by the entity unless the partner h h ld

• r shareholder:



Groups together any of the activities that the entity does not group together



Groups the entity’s activities with activities conducted directly by the h h ld

62

partner or shareholder



Groups the entity’s activities with activities conducted through other §469 entities

Taxpayer Activity Groupings For Purposes Taxpayer Activity Groupings For Purposes Of Passive Loss Limitations – Recent Development p

• Rev. Proc. 2010-13 (Cont.)

Th lt f f ili t t h th ti iti h b



The penalty for failing to report whether activities have been group as a single activity in accordance with this revenue procedure is that each trade or business activity or rental activity will be treated as a separate activity for purposes of §469.

–

Relief is available if the taxpayer has filed all affected income tax returns consistent with the claimed grouping of activities and makes the required disclosure on the income tax return for the year in which the failure to disclose is first discovered by the taxpayer.

–

Taxpayer must have reasonable cause for failing to disclose the groupings if the failure is first discovered by the IRS.

–

Commissioner may regroup taxpayer’s activities if the taxpayer’s grouping is not an appropriate economic unit and a principal 63 grouping is not an appropriate economic unit, and a principal purpose of the taxpayer’s grouping (or failure to group under §1.469- 4(e)) is to circumvent the purposes of §469.

Taxpayer Activity Groupings For Purposes Taxpayer Activity Groupings For Purposes Of Passive Loss Limitations – Recent Development p

• Rev. Proc. 2010-13 (Cont.)



Effective date: Taxable years beginning on or after Jan. 25, 2010



Reporting for pre-existing groupings is required only upon a change in the groupings.

64

Taxpayer Activity Groupings For Purposes Taxpayer Activity Groupings For Purposes Of Passive Loss Limitations – Planning Ideas When You Might Want to Group



Related businesses, especially if losses



Business and related rental real estate

– Only allowed if owned in identical percentage or one is

insignificant in relation to the other insignificant in relation to the other.



Business and related equipment leasing activity

65

– Only allowed if owned in identical percentage or one is

insignificant in relation to the other.

Taxpayer Activity Groupings For Purposes Taxpayer Activity Groupings For Purposes Of Passive Loss Limitations – Planning Ideas

When You Might Not Want to Group



Business with net income (PIG), if no material participation



Note: You can still group activities with losses, but IRS may re- g p , y group including the income activity if abusive



Business and rental if rental has net income



Business and rental, if rental has net income

66

IRS P i L A dit T h i IRS Passive Loss Audit Technique Guide



Contains an overview chapter as well as chapters on the following topics:

–

Rental losses

–

Passive income

–

Material participation

–

Dispositions

–

Entity issues

–

Interaction with other Internal Revenue Code sections

–

Activities (grouping rules), and

–

Credits 67

IRS P i L A dit T h i IRS Passive Loss Audit Technique Guide (Cont.)



Each chapter includes:

–

A brief discussion of the relevant issues b e d scuss o

• e e e a

ssues

–

Tips to IRS examination agents on how to identify issues during audit

–

A list of examination techniques

–

A list of documents the examining agent should request from the taxpayer, and

–

The supporting law for the IRS’ identification of the issues

C t Th IRS’ P i L A dit T h i G id l t



Caveat: The IRS’ Passive Loss Audit Technique Guide was last updated in 2005. Some of the chapters are out-of-date (e.g., the discussion of the treatment of LLC members in Chapter 6).

68

State Issues Surrounding IRC §469



Taxpayers must pay close attention to the treatment of passive income and losses in any state that they are required to file in.

–

California has not adopted the special rules for real estate professionals under §469(c)(7). All rental activities are treated as passive activities.

–

The computation of an individual’s net income for Illinois purposes The computation of an individual s net income for Illinois purposes begins with the individual’s federal AGI for the year. An individual may not adjust the federal AGI for passive losses and carryovers not reported on the federal return for such year.

–

In most states passive activity losses of a non-resident individual

–

In most states, passive activity losses of a non resident individual are allowed only if they are derived from or connected with sources with that state (e.g., see NY Tax Law §631(b)(4).).



Special rules may apply for determining whether the sale of an interest in an entity, such as a partnership or S corporation, is sourced to that state

69

a e y, suc as a pa e s p o S co po a o , s sou ced o a s a e (e.g., see NY Tax Law §631(b)(1)(A)(1)).

Best Practices And Tax Pl i Ti Planning Tips

Carolyn Turnbull, Moore Stephens Tiller Steven Schneider, Goulston & Storrs Steven Schneider, Goulston & Storrs Noel Brock, Grant Thornton

St t i F P Th h T Strategies For Pass-Throughs To Maximize Deductions

Circular 230 Disclosure These materials are intended for internal discussion purposes

• nly. To ensure compliance with requirements imposed by the

IRS, we inform you that any U.S. tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or any other state or local law, or (ii) promoting marketing or recommending to another party any promoting, marketing or recommending to another party any transaction or matter addressed herein.

71