CERTIFIED FINANCIAL PLANNER CERTIFICATION PROFESSIONAL EDUCATION PROGRAM Income Tax Planning

CERTIFIED FINANCIAL PLANNER CERTIFICATION PROFESSIONAL EDUCATION PROGRAMIncome Tax Planning Module 5Passive Activity Losses & Related Topics

Learning Objectives 5–1: Identify legal forms or structures a direct participation program may use and the tax and nontax considerations in selecting a form. 5–2: Identify tax mechanisms that enable direct participation programs to provide specific tax advantages. 5–3: Identify factors that may limit the availability of federal income tax benefits from a direct participation program. 5–4: Identify rules, deductions, or benefits related to a direct participation program. 5–5: Identify requirements that must be met to qualify for a special tax benefit available from a direct participation program. 5–6: Evaluate a situation to select the most appropriate direct participation program, if any. 5–7: Analyze a situation to calculate the allowable deductions under the passive activity loss rules. 5–8: Identify rules related to a vacation, or second, residence. 5–9: Analyze a situation to calculate the allowable deductions under the vacation home rules.

Questions to Get Us Warmed Up

Direct Participation Programs (DPP) DPP is simply a conduit entity. Advantages Disadvantages

Direct Participation Programs (DPP) Advantages Disadvantages

Tax Mechanisms

Tax-Advantaged Investment Factors Limiting Effectiveness of a Tax-Advantaged Investment • Limitation on Losses and Credits from Passive Activities: Limits a taxpayer’s ability to use losses or credits to reduce the tax due on active or portfolio income • Substantial Economic Effect: Limits the use of special allocations • At-Risk Rules: Limit the use of leverage—not as risk for nonrecourse financing—generally • Alternative Minimum Tax (AMT): Limits a taxpayer’s ability to reduce overall tax liability by imposing a tax on alternative minimum taxable income, which includes preference items and adjustments

Factors to Consider • Need for Liquidity: Many direct participation programs lack liquidity; Master limited partnerships are an exception • Need to Preserve Capital: Many direct participation programs involve significant risk • Unused Passive Losses: need passive income generators (PIGs): Direct participation programs that generate passive income are most suitable for those who have unused passive losses • Low Marginal Income Tax Bracket: Clients in a low income tax bracket derive the least advantage from tax-advantaged investments • Alternative Minimum Tax Problems: Investment in direct participation programs may cause even greater alternative minimum tax problems

Passive Activities • Trade or business activity without material participation (or) • All rental activities except: • Hotel/motels • Rental activities with significant services provided • Short-term rentals of property (DVDs, tuxedos, etc.) • Material participation in real property trades or businesses • Active participation in rental real estate

Material Participation • 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, experience?

PAL Exceptions/Opportunities Active Participation in Rental Real Estate • Requires “bona fide” involvement • $25,000 of losses allowed annually • $100,000 to $150,000 AGI phaseout of losses • 10% or greater ownership interest in the activity • Not a limited partnership interest • Not available if MFS, unless lived apart for entire year

PAL Exceptions/Opportunities Historic Rehabilitation Programs • $25,000 deduction-equivalent tax credit • May offset tax due on up to $25,000 of other income • $200,000 to $250,000 AGI phaseout

PAL Exceptions/Opportunities Low-Income Housing Activity • $25,000 deduction-equivalent tax credit • May offset tax due on up to $25,000 of other income • $200,000 to $250,000 AGI phaseout if property placed in service prior to 1990 • No AGI limit if property placed in service after 1989

PAL Exceptions/Opportunities Ownership of Oil and Gas Working Interest • Losses are deemed to be not passive. • The form of ownership cannot limit taxpayer’s personal liability. • No participation is required. • Losses are deductible without limit and without respect to taxpayer’s AGI. Investments that Generate Passive Income • Passive income may be offset by passive losses. • Taxpayers with otherwise unused passive losses may receive passive income essentially tax free.

Requirements to Qualify for Special Tax Benefits Closely Held C Corporation • If not a personal service corporation, passive losses may be used to offset active income, but not portfolio income. Qualified Nonrecourse Financing • secured by the real property • no one is personally liable • not convertible into equity • provided either by: • an unrelated entity in the business of lending money, or • a related person on commercially reasonable terms

Material Participation in Real Estate Losses deductible if • more than 50% of hours are devoted to real property trades or businesses with material participation • more than 750 hours are in real property trades or businesses with material participation

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.

Disposition Rules Sale/Exchange • All losses are ‘freed up’ and deductible in full against other income if disposition of “substantially all.” Death • Losses are deductible to the extent that the losses exceed step-up in basis of activity. Gift • Losses are added to basis of gifted activity.

Vacation Home Rules Residence Test • if met, no losses allowed • deduction allowed to extent income exceeds interest and taxes Infrequent Rentals (14 days or less), Frequent Personal Use • rental income not reported • interest and taxes allowed as itemized deductions • no other rental deductions

Vacation Home Rules Frequent Rentals (more than 14 days) Infrequent Personal Use • losses allowed • property tax attributable to personal use is itemized deduction • mortgage interest attributable to personal use is treated as investment interest expense

Vacation Home Rules Frequent Rentals (more than 14 days) Frequent Personal Use • no loss allowed • excess deductions are carried forward • interest and property taxes attributable to personal use are allowed as itemized deductions

Review Question 1 Which one of the following is a disadvantage of the limited partnership form of doing business? • The limited partner has no voice in management. • Interests are excessively liquid, creating volatile swings in value. • The number of limited partners is restricted to 100.

Review Question 2 A special allocation typically results in • the partner in the lowest tax bracket receiving more deductions. • an allocation of gains and losses based upon the ownership percentage of the partner. • an allocation of income and deductions that differs from the partner’s share of bottom-line profits and losses.

Review Question 3 Which one of the following is not an item used in determining the amount a partner has at risk? • the adjusted basis of property contributed to the partnership • amounts borrowed for use in the activity for which the partner is personally liable for repayment • amounts borrowed for use in the activity that were secured only by the investment

Review Question 4 Qualified nonrecourse financing is financing • that is convertible into an equity interest. • for which the partners are personally liable. • that is secured by the real property.

Review Question 5 The passive activity loss rules apply to • personal service corporations only. • closely held C corporations only. • individuals only. • personal service corporations, closely held C corporations, and individuals.

Review Question 6 Which of the following describes a requirement for a taxpayer to be considered a real estate professional under the passive activity rules? • The individual performs more than 750 hours of service during the year in the real property trades or businesses in which the individual materially participates. • More than 75% of the individual’s personal services during the year are performed in the real property trades or businesses in which the individual materially participates. • The individual performs more than 1,000 hours of service during the year in all real property trades or businesses, regardless of the individual’s level of participation.

Review Question 7 Which one of the following is a characteristic of the historic rehabilitation tax credit? • The credit may be used to offset up to $25,000 in income tax. • The credit may be used to offset the tax on up to $25,000 in income. • The credit is phased out on adjusted gross income between $100,000 and $150,000. • The credit is phased out on taxable income between $200,000 and $250,000.

Review Question 8 Which one of the following is a characteristic of the rules related to publicly traded partnerships? • Losses from publicly traded limited partnerships may be used only to offset income from other publicly traded limited partnerships. • Unused losses from publicly traded limited partnerships may be carried back up to three years to offset prior income from such partnerships. • Unused losses from publicly traded limited partnerships must be carried forward and used only against future income of the same partnership.

Review Question 9 An individual will generally be treated as a material participant in an activity if • he or she participates less than 100 hours in the activity. • he or she participates more than 500 hours in the activity. • another individual performs substantially all of the services associated with the business.

Review Question 10 Which one of the following statements is true regarding a vacation home (second residence)? • Net income from the rental of a vacation home is considered to be passive. • Expenses are allocated between personal and rental use if the unit is rented out fewer than 15 days per year. • Personal use of the residence does not include a day on which the taxpayer engages in repairs of the unit on a full-time basis.

Review Question 11 Which one of the following describes the treatment of a vacation home that is frequently rented and infrequently used by the owner? • Deductions are permitted for all of the maintenance and operating expenses, as long as personal use does not exceed 14 days. • Deductible rental expenses are not limited to gross rental income. • Unused mortgage interest and property taxes may be carried over to the subsequent year and used against future income from the rental activity.

Review Question 12 Which one of the following statements is correct as it applies to a vacation home with frequent personal use and frequent rentals? • Any excess deductions attributable to rental use may be carried forward and applied against future rental income. • the tax court method of allocation allocates mortgage interest and property taxes based upon a comparison of the number of days that the property is rented at fair value to the total number of days the property is used during the year. • Deductions allocable to rental use are not limited to gross income.

Review Question 13 Your client, Marian Powers, has substantial unused passive losses from a nonpublicly traded limited partnership. She would like to find an investment that would allow her to utilize her passive losses. Which one of the following is the most appropriate investment for Marian? • a master limited partnership generating income • certificates of deposit generating portfolio income • a publicly traded limited partnership generating income • a nonpublicly traded partnership generating income, in which Marian will not materially participate

Review Question 14 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 the following activities, if any, has the greatest potential for reducing Sally’s tax liability? • investing in “active participation” rental real estate that is producing a loss • investing in a low income housing activity placed in service after 1989 that is producing deduction-equivalent credits • investing in a limited partnership involved in a historic rehabilitation project that is producing passive losses and credits • investing in an oil and gas limited partnership that is generating losses

Review Question 15 Paul Hall has the following items from the current year: What is the total amount, if any, of passive losses that may be deducted during the current year? • $0 • $13,000 • $23,000 • $29,000 • $30,000

Review Question 16 Which of the following statements are correct with respect to active participation rental real estate? • The interest may not 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. • The taxpayer must participate in the management of the property in a bona fide sense. • I and II only • I and IV only • III and IV only • I, II, and III only • I, III, and IV only

CERTIFIED FINANCIAL PLANNER CERTIFICATION PROFESSIONAL EDUCATION PROGRAMIncome Tax Planning Module 5End of Slides

CERTIFIED FINANCIAL PLANNER CERTIFICATION PROFESSIONAL EDUCATION PROGRAM Income Tax Planning