Limitations on Losses At Risk Rules -

1
Limitations on LossesAt Risk Rules -
465Passive Activity Losses - 469

2
Our Objectives

• Understand tax shelters and rational for
• at-risk rules
• passive loss rules
• Achieve thorough understanding of the intricacies
  of passive activity rules

3
Tax Shelters

• Activity providing deductions/credits that
  reduces tax liability from other sources of
  income
• Prior to 1986 - unreasonably influenced
  financial planning
• 1983 study
• 21 of returns w/ income gt 250,000
• paid taxes of less than 10 of income

4
Tax Shelters

• Extensive shelter activity contributes to
  public concerns that the tax system is unfair and
  to the belief that tax is paid only by the naïve
  and unsophisticated
• Senate Finance Committee

5
An Example

• J , a corporate executive, had income of
  275,000 during 1983. He purchased a shopping
  center in Jan. 1983 for 500,000, paying 25,000
  down financed the balance over 25 years.
  Rental income averaged 3,500 a month, while
  payment on the 475,000 note was 6,000/month.
  Maintenance, taxes and repairs averaged
  1,500/month.
• It appears that J is losing 4,000/month
  (3,500 -6,000 - 1,500) during the first year
  or 48,000/year. But considering his tax bracket
  (50) and depreciation (12 for 1983) his net
  cash flow is a positive 5,000.

6
Net Cash Flow

• Net Cash Flow Before Tax Benefit
  48,000
• Depreciation (12 x 500,000) -
  60,000
• Principal Payment Adjustment
  2,000
• Net Deductible Loss
  106,000
• Times Marginal Tax Rate
  x50
• Tax Benefit
  53,000
• Negative Cash Flow before taxes
  48,000
• Positive Net Cash Flow
  5,000
• 2,000 of the note payments were applied to
  principal (not deductible), all other monthly
  expenses were deductible

7
Form of Tax Shelters

• Formed as limited partnerships
• Flow-thru entity
• Popular tax shelters
• Equipment leasing
• Real estate
• Cattle breeding and feeding
• Farming
• Oil and gas
• Movie productions

8

• Existing At Risk Rules
• 1986 Acts Passive Activity Rules
• Death of the Tax Shelters

9
At Risk Rules -- 469

• 1976 - 1st attempt to curb tax shelters
• Disallow losses in excess of amount at risk
  (amount that could be lost)
• Apply to individuals and closely held
  corporations
• Not at risk for
• Nonrecourse loans (secured only by the purchased
  property vs. where borrower is personally liable)
• Stop loss arrangements
• No loss guarantees
• Loans which lender has an interest (as in seller
  financing)

10
At Risk Amount

• Cash Invested
• Adjd basis of other property invested
• Recourse loans (personally liable)
• Loans with pledged collateral (up to FMV of
  collateral)
• Income
• - Losses
• - Withdrawals
• Amount at risk

11
Disallowed losses

• Carryover until
• At risk or
• Dispose of the activity

12
Real Estate Exception

• With qualified nonrecourse financing
• Commercial lender or govt. lender
• Qualified person
• Non-convertible debt
• (no seller or promoter lenders)

13
Real Estate Exception

• At risk for qualified nonrecourse loans on real
  property
• A qualified loan
• Acquired from a person actively and regularly
  engaged in the business of lending money or
• Any federal, state, or local government
• Exception to the R.E. Exception
• Loans from related parties or
• Loans from a person who receives a fee due to
  taxpayers investment in the property

14
Recaptured Losses

• If at risk amount goes below zero
• Previous deducted losses are recaptured (create
  gains)
• The amount of at risk (below zero) is included in
  income
• Generally occurs when loan status changes from
  recourse to nonrecourse

15
Exercise

• Smith put up 10,000 cash, pledged 10,000 for
  security of a partnership loan, and gave
  equipment with an adjusted basis of 5,000 and
  FMV of 8,000 for her interest in a limited
  partnership. What is her amount at risk?

16
Answer

• Her at risk amount is 25,000

17
Exercise

• Now, what if Smith was allocated a 40,000
  loss from the partnership?
• How much can she use to offset income from
  her other passive activities?

18
Answer

• Only 25,000 (the amount at risk) of the
  40,000 loss can be used to offset income from
  other passive activities.
• Since she is not at risk for the
  remaining 15,000, it is carried over into a
  future year until she becomes at risk or the
  activity is disposed of.

19
Exercise

• Assume Smith gave 10,000 cash and signed
  a nonrecourse note for property that the limited
  partnership was acquiring.
• How much would she be at risk?

20
Answer

• Smith would only be at risk for her 10,000
  investment, and so only 10,000 of the 40,000
  loss could be used to offset income from other
  passive activities. The remaining 30,000 is
  carried over until she becomes at risk.

21
Passive Activity Loss Limits

• Section 469

22
3 Category Classification
Passive
Portfolio
Active

• Wages
• Salary
• Bonuses
• Active T/B
• Income from
• intangible
• property
• from personal
• effort

• Interest
• Dividends
• Annuities
• Royalties
• non-
• business
• G/L from
• portfolio
• property

• Activity which
• does not
• materially
• participate
• All rental
• activities
• (subject to
• exceptions)

23
General Impact

• Passive deductions only against passive income
• Excess Carried forward against passive income
• Suspended losses - used when entire activity
  disposed of

24
Exercise

• Kyle earned 75,000 from wages. He also
  received 5,000 in dividends, and interest from
  various portfolio investments, and his share of a
  passive loss from a partnership interest was
  30,000. How much of the 30,000 loss can he
  deduct this year?
• (Assuming it is not subject to the at
  risk rules and he has enough basis in the
  partnership)

25
Solution

• The passive loss cant be deducted this year
• Suspended and carried forward to future years to
  offset PIGs
• No future passive income
• Then offset the loss against other types of
  income
• When he eventually disposes of the passive
  activity

26
Impact of Suspended Losses

• Upon fully taxable disposition
• Loss realized from the activity recognized
• Can be offset against any income
• Fully taxable
• Sale of property to unrelated 3rd party
• Gain on sale passive
• 1st offset by suspended losses from that activity

27
Exercise

• Red sells a building with an adjusted basis of
  1,000,000 for 1,800,000. He has a suspended
  loss of 600,000 from the building. What results?

Sales Price 1,800,000 -
Adj. Basis - 1,000,000
Gain 800,000 - Suspended
losses -600,0000 Taxable gain
(passive) 200,000
28
Loss Situations

• If the current and suspended losses of the
  passive activity gt gain realized or if the sale
  results in a loss, the amount of
• Any loss from the activity in excess of passive
  income
• Is treated as non-passive loss

29
Exercise

• D sells a building with adj. basis of
  1,000,000 for 1,500,000. He also has current
  and suspended losses of 600,000 associated with
  the building and has no other passive activities.
  

Sales Price 1,500,000 - Adj. Basis
1,000,000 Gain
500,000 - Suspended loss 600,000 Deductible
loss 100,000
The 100,000 deductible loss is offset
against Ds active and portfolio income
30
Carryovers of Suspended Losses

• Suspended losses must be allocated among
  taxpayers passive activities
• Suspended losses are carried over indefinitely
• Offset in future against any PAL from related
  activity 469(d)(2)

Loss from Activity Sum of losses for
year from all activities having losses
Disallowed Loss
X
31
Exercise
Activity X
(300,000) Activity Y
(200,000) Activity Z
250,000
Net Passive Loss
(250,000)
How are these losses allocated to each activity?
Allocated to
.
Activity
X (250,000 x 300,000/500,000)
150,000 Activity Y (250,000 x 200,000/500,000
) 100,000 Total suspended losses
(c/o) (250,000)
32
Exercise
Assume the same fact as before except this is the
next year and Activity X produces 100,000
of income. How is Activity Xs suspended loss of
150,000 from the previous year used?
100,000 of income is offset against the income
from the activity. If Activity X is sold early
next year, then the remaining 50,000 suspended
loss is used in determining the taxable gain or
loss.
33
Passive Credits - 469(d)(2)

• Use only against regular tax from passive income
• Passive credits may not be used if
• Have a net loss from passive activities for the
  year
• AMT applies that year

34
Example

• T owes 500,000 of tax, disregarding net
  passive income, and 800,000 of tax, considering
  both net passive and other taxable income
  (disregarding credits in both cases). The amount
  of tax attributable to passive income is
• Tax due (before cr.s) including net passive
  income 800,000
• Less Tax due (before cr.s) w/o including net
  income - 500,000
• Tax attributable to passive income
  300,000
• T may claim a maximum of 300,000 of
  passive activity credits the excess credits are
  carried over

35
Carry over of Passive Credits

• Carried over indefinitely
• But lost forever when activity is disposed of in
  a taxable loss transaction
• Must have sufficient tax on passive income upon
  disposition to absorb credits

36
Exercise

• X sells a passive activity for a gain of
  100,000. The activity had suspended losses of
  400,000 and suspended credits of 150,000. What
  happens?
• 100,000 gain is offset by 100,000 of suspended
  losses - the remaining 300,000 of suspended
  losses are deductible against active and
  portfolio income.
• The suspended credits -- lost forever -- the
  sale did not generate any tax. True even if X
  has positive taxable income or is subject to AMT

37
Exercise

• What if X had realized a 1,000,000 gain on
  the sale of the passive activity? What happens
  to the suspended credits?
• They are used to the extent of regular tax
  attributable to the net passive income
• Gain on sale
  1,000,000
• Less Suspended losses (400,000)
• Taxable gain
  600,000
• If the tax from the gain of 600,00 is
  150,000 or more, the entire 150,000 of
  suspended credits may be used. If tax from the
  gain is less than 150,000, the excess of
  suspended credit of the tax from the gain is lost
  forever.

38
Taxpayers Subject to PAL Rules469(a)

• Individuals
• Estates
• Trusts
• Personal Service Corporations
• Closely Held C Corporations
• Applied at Owner Level of S Corporations and
  Partnerships

39
Personal Service Corporation

• Principal activity - personal services,
• Health, law, engineering architecture,
  accounting, actuarial science, performing arts
  and consulting
• Personal services are substantially performed by
  employee owners
• More than 10 of stock value held by
  employee-owner
• Employee-owner --
• Employee and shareholder on any day of the year
• Do no have to occur on same day

40
Closely Held C Corporation

• More than 50 of outstanding stock value owned by
  or for not more than 5 or fewer individuals
• May offset passive losses against active income
• Not against portfolio income
• Prevents using portfolio income to offset PAL in
  closely held corporations

41
Exercise

• R Corporation, (a manufacturing company
  owned solely by Jon Jay) has 250,000 of passive
  losses, 200,000 of active income, and 50,000 of
  interest income. What results?
• R may offset 200,000 of the 250,000
  passive loss against the 200,000 active income.
  It may not offset the remainder against the
  50,000 of interest (portfolio) income. 50,000
  of the PAL is suspended.

42
Definition of Passive Activities

• Trade or business or
• Income producing property
• Does not materially participate
• All rental activities (exceptions)

43
Important Issues

• What constitutes an activity?
• What is meant by material participation?
• When is an activity a rental activity?

44
Activity Identification

• 1st Step
• What is a separate activity?
• Necessary to determine whether income or loss is
  passive or active

45
Example

• T owns a business with two separate divisions
• Division 1 has net income of 50,000
• Division 2 has a net loss of 30,000.
• T participates in 1 for 750 hours and in 2
  for 50 hours
• If he is allowed to treatment them as a single
  activity, he can offset the 30,000 loss against
  the 50,000 income
• If not, he will not be considered to materially
  participate in Division 2 and it will be a PAL
  and can not be offset against active income

46
Example

• T has a business with 2 divisions
• Has a loss of 100,000 in division 1
• Has a loss of 50,000 in division 2
• T sells division 1 at end of year
• If they are separate activities - he can deduct
  the 100,000 loss
• If they are not separate activities - he still
  has a suspended loss on division 1 along with
  the loss on division 2

47
Reg. 1.469-4

• Activity appropriate economic unit for
  measuring gain or loss
• Using all relevant facts circumstances
• May use any reasonable method in applying facts
  and circumstances

48
Factors Used - Reg. 1.469-4

• Similarities and differences in types of business
  
• Extent of common control
• Extent of common ownership
• Geographical location
• Interdependencies

49
Regulation Example Reg. 1.469-4(f)

• T owns a mens clothing store and a video game
  parlor in Chicago. He also owns a mens clothing
  store in and a video game parlor in Milwaukee.
• All 4 may be grouped into a single activity
• Clothing stores may be one activity and video
  store may be another activity
• Chicago stores may be grouped as one activity and
  the Milwaukee stores another
• Each may be a separate activity

50
Regulation Example Reg. 1.469-4(f)

• T is a partner in a business that sells snack
  items to drugstores. He also is a partner in a
  partnership that owns and operates a warehouse.
  Both partnerships, are under common control and
  are located in the same industrial park. The
  predominate part of the warehouse business is
  warehousing items for the snack business, and it
  is the only warehousing business in which T is
  involved.
• T should treat the snack business and the
  warehousing business as a single activity

51
Regrouping Activities

• Once activities have been grouped
• Cannot be regrouped unless original grouping was
• clearly inappropriate or
• a material change in facts circumstances
• Must disclose any regrouping to IRS
• IRS has right to regroup if
• Groups fail to reflect appropriate economic units
• One of the primary purposes of grouping is to
  avoid PAL limits

52
Regulation Example Reg. 1.469-4(f)

• A, B, C, D, and E are physicians who operate
  their own separate practices. Each owns
  interests in PAL activities, so they devise a
  plan to set up a PIG. They form PIG partnership
  to acquire and operate X-ray equipment, and each
  receives a limited partnership interest. They
  select an unrelated 3rd party to operate the
  X-ray business and none of the limited partners
  participates in the activity. The services
  provided by the partnership are provided to the
  doctors who own the limited partnership interests
  and fees are set to assure a profit for PIG.
  Each doctor treats his medical practice and his
  interest in the partnership as separate
  activities and offsets losses from passive
  investments against the passive income from the
  partnership. IRS will regroup this into a single
  activity for each doctor.

53
Rental Activity Grouping

• May be grouped with a T/B activity only if one
  activity is insubstantial in relation to the
  other
• May generally not treat activity involving rental
  of real property and activity involving rental of
  personal property as a single activity

54
Exercise

• CPA firm owns a building in Tulsa, where they
  conduct their CPA practice. They also rent space
  on the street level of the building to several
  retail business. 95 of their revenue is
  generated by the CPA practice and 5 from the
  rental activity. May they combine the two
  activities if the rental generates a loss?
• It is probably considered insubstantial
  and could be grouped with the accounting practice.

55
Material Participation

• Participate on a regular, continuous, and
  substantial basis????
• Regulations -- 7 tests
• Tests based on
• current participation
• prior participation
• facts and circumstances

56
Current Participation Tests

• More than 500 hours?
• More than 100 hours and not less than any other
  individual?
• Participation constitute substantially all of the
  participation in the activity?
• A significant participation activity
  (participation gt 100 hours) and total
  participation in all significant participation
  activities gt 500 hours?

57
Prior Participation Tests

• Materially participate in the activity for any 5
  years (consecutive or not) during the last 10
  years immediately preceding the current year
• A personal service activity and materially
  participated in any of the 3 preceding years
  (consecutive or not)

58
Facts and Circumstances

• Based on all the facts and circumstances, did
  taxpayer materially participate in activity on a
  regular, continuous, and substantial basis during
  the year?

59
PARTICIPATION

• Work by an individual in an activity that he/she
  owns
• Does not include work if
• type not customarily done by owners
• principal purpose is to avoid PAL rules
• done in capacity of investor
• Participation by spouse counts as owners
  participation

60
Participation?

• Tim and Jill divorced in late November of this of
  this year.
• Tim then married Sue on December 30.
• Sue was Tims secretary and all three worked on
  Tims Xmas tree farm business, which had a
  rather large loss this year.
• All three have worked 170 hours each this year on
  the tree farm.
• This will only qualify as an active activity if
  Tim can use both Jills and Sues work time to
  get them up to the 500 hours needed.
• Tim and Sue will file a joint return this year.
  What do you think?

61
Limited Partners

• Generally not considered to materially
  participate
• Unless he/she qualifies
• under
• Test 1 --- (500 hrs)
• Test 5 --- (5 of the last 10 years)
• Test 6 --- (Personal service any 3 years)

62
Rental Activities

• General rule -- rental activities passive
• Any activity - payments are received principally
  for use of tangible (real or personal) property
  ( 469(j)(8)
• Reg. 1.469-1T(e)(3)(vi) ----
• 6 Exceptions (not automatically passive)

63
Exercise

• T owns an office building that is a rental
  activity for T and he spends 2000 hours this year
  in its operation. The building is a rental
  activity.
• Is it automatically subject to passive activity
  rules, even if he works at this on a full time
  basis?
• Yes, as long as it is not subject to one of the
  exceptions of Reg. 469-1T(e)(3)(ii)

64
6 Rental Activity Exceptions

• Average period of customer use for the property -
  7 days or less
• Average period of customer use is 30 days or less
  owner of property provides significant personal
  services
• Owner provides extraordinary personal services
• Rental is treated as incidental to a nonrental
  activity
• Property is customarily available during business
  hours for nonexclusive use by customers
• Property is provided for use in an activity
  conducted by a partnership, S corp, or joint
  venture which taxpayer owns an interest

65
2 -- Significant Personal Services

• Personal services - only services by individuals
• Significant - Facts Circumstances
• Frequency of services
• Type amount of labor required
• Value of services relative to rental charges
• Facts Circumstances

66
Exercise

• T owns photocopying equipment and leases it to
  customers. The average period of customer use is
  25 days. T has skilled technicians employed to
  maintain the equipment for no additional charge.
  Service calls occur 3 time per week on average
  and require substantial labor. The value of
  maintenance services exceed 50 of rental fees
  charged for use of the equipment.
• Do you think that this will be considered
  significant personal services by the IRS?

67
Solution

• According to Reg. 1.469-(e)(3)(viii),
  Example 1 and 2,
• This would be considered significant
  but not extraordinary services.

68
3 -- Extraordinary Personal Services

• Customers use of property is merely incidental
  to their receipt of services
• Examples
• Patients use of hospital bed incidental to his
  receipt of medical services
• Use of a schools dormitory incidental to the
  academic services received

69
4 -- Incidental to a Nonrental Activity

• Property held primarily for investment
• Principal purpose of holding property is the
  expectation of a gain from appreciation and gross
  rent income lt2 of the lesser of
• The unadjusted basis or
• FMV of the property
• Property used in a trade or business
• Must have been used in business during the year
  or at least 2 of the 5 preceding years
• 2 test also applies

70
Exercise

• T invest in vacant land for purpose of
  realizing a profit on its appreciation. He
  leases the land during the period it is held.
  The lands adjusted basis is 250,000 and the FMV
  is 260,000. The lease payments are 4,000 per
  year. Would this be considered a rental
  activity?
• No, because the gross rent income is less
  than 2 of 250,000.

71
4 -- Incidental to a Nonrental Activity

• Property held for sale to customers
• Lodging rented for convenience of employer
• Partner who rents property to a partnership that
  is used in partnerships trade or business

72
At-Risk and Passive Activity Limits

• Basis limits first
• At-risk rules second
• Passive loss rules applied after at-risk rules
• Note, basis is reduced even if deductions are not
  currently usable because of PAL rules

73
Summary of Loss Limit Hurdles
Basis
465
469
At Risk
PAL
74
Exercise

• Ts adjusted basis and at-risk amount in a
  passive activity is 100,000 at the beginning of
  1997. Her loss from the activity in 1997 is
  40,000. Jack has no passive income in 1997.
  What is the tax result?
• T cannot deduct the 40,000 loss (no PIG) Her
  adjusted basis and at-risk about is 60,000 and
  she has suspended PAL of 40,000

75
Transaction Adj. Basis At-risk Amt Deduct
Suspended

100,000
100,000 0 0 Year
1997 (40,000 PAL) - 40,000 -40,000
0 (40,000)PAL
60,000 60,000
76
Exercise - Continued

• Assume T has a loss of 90,000 in 1998. T
  has no passive income. What tax result?
• Now , the 90,000 exceeds the at-risk amount
  amount (60,000) by 30,000. The 30,000 loss is
  disallowed by the at-risk rules. T has no
  passive income, so the remaining 60,000 is
  suspender under PAL rules. So at year end she
  has a 30,000 loss suspended under the at-risk
  rules, 100,000 of suspended passive losses, and
  an adjusted basis and at risk amount of 0

77
Transaction Adj. Basis At-risk Amt Deduct
Suspended

100,000
100,000 0 0 Year
1997 (40,000 PAL) - 40,000 -40,000
0 (40,000)PAL
60,000 60,000
Year 1998 (90,000 PAL) -60,000
-60,000 0 (100,000) PAL
0 0
0 (30,000) AR
78
Exercise - Continued

• Assume T realized 10,000 of passive
  income in 1999. What tax results?
• The 10,000 income increases her at-risk amount
  to 10,000 so 10,000 (of the unused 30,000
  loss) is reclassified as passive loss and the
  10,000 income is offset by 10,000 of suspended
  passive losses
• 20,000 (30,000 - 10,000) of unused losses
  under at-risk rules
• 100,000 of (reclassified) suspended passive
  losses (100,000 10,000 of reclassified
  unused at-risk losses less 10,000 of passive
  losses offset)
• 0 at-risk amount and 0 adjusted basis

79
Transaction Adj. Basis At-risk Amt Deduct
Suspended

100,000
100,000 0 0 Year
1997 (40,000 PAL) - 40,000 -40,000
0 (40,000)PAL
60,000 60,000
Year 1998 (90,000 PAL) -60,000
-60,000 0 (100,000) PAL
0 0
0 (30,000) AR
Year 1999 10,000 PIG 10,000
10,000 10,000 (100,000) PAL
-10,000 -10,000
(20,000) AR
0 0
80
Exercise - Continued

• In 2000, T has no gain or loss. She
  contributed 50,000 to the activity. What tax
  result?
• The 50,000 increases the at-risk amount, so the
  20,000 of losses suspended under the at-risk
  rules is reclassified as passive.
• T gets no passive loss deduction in 2,000
• At year end,
• she has no suspended losses under the at-risk
  rules,
• 120,000 of suspended passive losses (100K
  20K reclassified at-risk losses),and
• 30,000 Adjusted basis and at-risk amount
  (50,000 - 20,000 of reclassified losses)

81
Year 2000 Contributed 50,000
50,000 0 (120,000)PAL 50,000
- 20,000 - 20,000
0 AR
30,000 30,000
82
Real Estate Exceptions (2)

• Material
• Participation
• in Real Property
• Trade or
• Business

Rental Real Estate Activities
83
Material Participation in Real Property Trade or
Business

• Not passive if
• gt 50 trade or business personal services in real
  estate
• gt 750 hours of services in real estate business

84
Exercise

• T performed personal service activities
• 800 hrs as a CPA
• 500 hrs in real estate development business
• 400 hrs in real estate rental activities
• Are Ts losses subject to PAL rules?

No, more than 50 of his personal services were
devoted to real estate businesses and
his material participation in those real
estate exceeded 750 hours
85
Rental Real Estate Activities

• Deduct up to 25,000 of losses
• Reduce by 50 of AGI above 100,000
• Must actively participate in real estate rental
  activity
• participates in bon fide management decisions
• Own 10 or more of the activity

86
The 25,000 Deduction

• 1st net all active participation rental losses
  and gains
• Deduct up to 25,000
• Both deductions and credits (in deduction
  equivalents)
• Example
• 5,000 credits and 28 tax bracket deduction
  equivalent of 17,875 (5,000/.28)
• Any excess is treated as a passive loss

87
Exercise

• T has 85,000 of AGI before any rental real
  estate activities. He has 90,000 of losses from
  Rental Real Estate Activity 1 and 30,000 of
  income from Rental Real Estate Activity 2. He
  also has passive income from another activity of
  38,000. What is the tax result?

The net rental loss of 60,000 is offset against
the 38,000 of passive income. This leaves
22,000 to deduct against other income.
88
Exercise

• T is an active participant in a real estate
  rental activity that has 8,000 of income,
  26,000 deductions, and 1,500 of credits. T is
  in a 28 tax bracket. What tax results?

1st - offset PAL against income (8,000 -
26,000 Net passive loss of 18,000
--- Note that he has 7,000 left 2nd - Compute
credit equivalent of the 7,000 (7,000
x .28 1960) So -- he can use all of the 1,500
credit
89
Disposition of Passive Interest

• General Rule - Use all suspended losses and
  credits upon a taxable disposition
• Exceptions and special rules for nontaxable and
  certain other dispositions

90
Disposition at Death

• Deduct suspended losses to the extent they exceed
  the step up in basis (if any)
• Suspended losses are lost to the extent of basis
  increase
• Report allowed losses on final return

91
Exercise

• T dies with passive property having an adjusted
  basis of 400,000, suspended losses of 100,000
  and a FMV at death of 750,000. How much of the
  100,000 suspended loss is deductible?

None -- The 100,000 suspended loss is lost
because it does not exceed the step-up in basis
(350,000)
92
Exercise

• T dies with passive activity property having an
  adjusted basis of 400,000, suspended losses of
  100,000, and a fair market value of 470,000.
  How much can be deducted?

Since the step-up is only 70,000 (470,000 -
400,000) --- 70,000 of loss is lost. 30,000
of deduction would be allowed the decedent on
his final return.
93
Installment Sale of a Passive Activity

• Triggers recognition of suspended losses
• Losses allowed in each year gain is recognized
• In ratio of recognized gain to total realized gain

94
Exercise -- Installment Sale

• T sold her entire interest in a passive
  activity for 10,000. Her adjusted basis in the
  property was 6,000. She received a down payment
  of 2,000 and she had a suspended loss of 2,500.
  What tax results?

• Gross profit ratio 40 (4,000/10,000)
• Recognized gain of 800 (40 x 2,000)
• Deduct 500 of suspended loss in first year
• (800/4,000 x 2,500)

95
Passive Activity Changes to Activity

• Suspended losses allowed to extent of income from
  now active business
• Remaining suspended loss continues to be treated
  as passive
• Exception to the rule
• The working interest exception for oil and gas
  wells

96
Nontaxable Exchange of a Passive Activity

• Suspended loss remains with the taxpayer
• Generally, deductible when the acquired property
  is sold
• If activity of old and new property are the same
  -- suspended losses can be used