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Module 29 Tax Motivated Investments and Loss Limitations

Module 29 Tax Motivated Investments and Loss Limitations

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Module 29 Tax Motivated Investments and Loss Limitations

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  1. Module 29Tax Motivated Investments and Loss Limitations

  2. Menu Tax shelter activities The passive activity limitations Loss limitations associated with vacation homes Anatomy of a tax shelter: residential real estate Anatomy of a tax shelter: low-income housing investment

  3. Tax Shelter Activities: An Introduction Key Learning Objectives (1) • Definition of a tax shelter • The goals of a good tax shelter • §6111 registration requirements • §6707 & §6708 penalties related to registration

  4. Definition of aTax Shelter • Minimize the tax effects of the income tax • Generates significant tax losses as a result of the allowable deductions associated with the investment

  5. §6111 Registration Requirements • A tax savings to investment cost ratio of more than two to one, and • The offering is (a) treated as a security regulated by law, or (b) exempted from regulations but has five or more investors or will initially attract investments exceeding $250,000

  6. §6707 and §6708 Registration Penalties • §6707(a) organizer's failure to register a shelter • §6707(b)--failure to furnish a registration number • §6708--organizer's failure to retain list of investors

  7. The Goals of a Good Tax Shelter • Deferral of taxation • Conversion of ordinary income into capital gain

  8. §6700 and §6701 False Statement Penalties • §6700--organizer furnishes false statements • §6700--organizer furnishes gross overvaluation statement • §6701--aiding and abetting understatement of tax liability

  9. Tax Shelter Activities: An Introduction Key Learning Objectives (2) • The sham transaction doctrine as a weapon against tax shelters • §6700 & §6701 penalties related to false statements • §7408 injunctive relief

  10. The Sham Transaction Doctrine • The transaction was entered into primarily for tax avoidance and • No economic substance, (no possibility of profit)

  11. §7408 Injunctive Relief • Empowers IRS to seek civil action in District Court that would enjoin any person from further engaging in conduct subject to §6700 or §6701 • Promoters can be shut down much quicker under this procedure

  12. The Passive Activity Limitations: A Closer Look Key Learning Objectives (1) • The passive activity limitations (PALS) • Identifying an activity • The active basket and material participation • The portfolio basket • Legislative curbs on tax shelters: an overview

  13. Passive Activity Rules • Loss limit rule applies to individuals, estates, trusts, closely held C corporations, and personal service corporations • All items of income or loss classified as • Active • Portfolio, or • Passive

  14. General Rule • Passive losses offset only passive income • Suspended losses carried forward

  15. Active Basket • Wages and salaries • Profit/loss from trade or business in which taxpayer materially participates • Gain/loss from sale of active business assets

  16. Material Participation(Dirty Hands) • Regular • Continuous • Substantial • Extremely complex rules

  17. Portfolio Basket • Interest • Dividends • Annuities • Royalties • Gain/loss from sale of portfolio assets

  18. The Passive Activity Limitations: A Closer Look Key Learning Objectives (2) The passive basket • Applying the passive activity limitations • Real estate exceptions to the passive loss limitations • Passive activity credits • Disposition of passive activities

  19. Passive Basket • Profit/loss from trade or business IF • Taxpayer does not materially participate • Any rental activity, regardless of material participation

  20. Passive Activity LimitationsPAL Rules • Record income/loss for each activity • Net all activities • If overall net income--report in full • If overall loss--report zero net income • Disallowed (suspended) losses • Carryover in full to next year • Record by activity

  21. Compliance Query: PAL Rules (1) What is AGI if the taxpayer has $500,000 of salary income and Two passive businesses Activity Activity -A- -B- Income 50,000 20,000 Expense 25,000 30,000

  22. Solution: Compliance Query: PAL Rules (1)AGI is $515,000 Passive activities net as follows: Activity Activity Netted -A- -B- Income 50,000 20,000 70,000 Expense 25,000 30,000 55,000 Net Inc 25,000 -10,000 15,000* *When passive net >0,include in AGI

  23. Compliance Query: PAL Rules (2) What is AGI if the taxpayer has • $500,000 of salary income and • Two passive businesses Activity Activity -A- -B- Income 50,000 20,000 Expense 75,000 5,000

  24. Solution--Compliance Query: AGI is $500,000 Passive activities net as follows: Activity Activity Netted -A- -B- Income 50,000 20,000 70,000 Expense 75,000 5,000 70,000* Net Inc -25,000 15,000 -0- *Can’t deduct >passive income

  25. Passive Credits • Apply against tax from passive income only • Suspended credits carried forward • Use or lose in year of disposition

  26. Disposition of Passive Activities • In the year of disposition • In a fully taxable transaction • Suspended losses may be deducted against any source of income

  27. Transfers to Related Parties • Not a disposition of a passive activity

  28. Exception for Qualified Real Estate Professional • >50% of personal services related • To real estate trade or business and • >750 real estate related hours

  29. Exception for Active Rental Real Estate • Up to $25,000 excess loss allowed • Reduces active/portfolio income • Phase-out of $25,000 if • AGI > 100,000 • Lose 50¢ for each excess $ • Active participation required

  30. The Active Participation Requirement • Own at least a 10% interest • By value • Not be a limited partner and • Demonstrate regular, continuous, and substantial involvement

  31. Compliance Query: Active Rental Exception What is AGI if the taxpayer has • $100,000 of salary income and • Two passive businesses (A is active rental) Activity Activity -A- -B- Income 50,000 20,000 Expense 75,000 5,000

  32. Solution--Compliance Query: AGI is $90,000 Passive activities net as follows: Activity Activity Netted -A- -B- Income 50,000 20,000 70,000 Expense 75,000 5,000 70,000* Net Inc -25,000 15,000 -0- Excess -10,000 -0- ARE* -10,000 *ARE = active real estate exception

  33. In Class Exercise: More Active Rental Exception • How does the answer to last Query change? • Case 1: • Activity B is the active real estate rental • Case 2: • Salary income is $140,000? • Activity A is the active real estate rental

  34. Solution--In Class Exercise: More Active Rental Exception Case 1: AGI = 100,000 • The excess loss is not from active rental • It must be suspended

  35. Solution--In Class Exercise: More Active Rental Exception Case 2: AGI = 135,000 • AGI is over 100,000 • Exception must be phased out • Lose (140,000-100,000) x .5 of $25,000 • Only 5,000 of 25,000 exception remains

  36. Decedent’s Suspended Losses • Suspended losses are generally allowed on a decedent's final tax return • Deduction is reduced by any step-up in basis to FMV

  37. Gifts of Activities With Suspended Losses • Transfer by gift not a qualifying disposition • Losses are not allowable to either the donor or donee • Donee’s basis is increased by the suspended loss

  38. Tax Shelters in Residential Real Estate • Limited tax benefits are still available for the small investor • Use of leveraging, depreciation, capital gains, benefits of tax losses, positive cash flows • $25,000 exception for PAL’s

  39. Loss Limitations Associated With Vacation Homes Key Learning Objectives (1) • The basic rules of §280A • Rule 1: De minimis rentals • Rule 2: Insignificant personal usage • Rule 3: Significant personal usage

  40. “Vacation Home” • To determine if rental is a vacation rental COMPARE days of personal use to days ACTUALLY rented at FMV • Note: OA stands for “otherwise allowable” deductions found on Schedule A

  41. Vacation Home? THERE ARE 3 POSSIBLE OUTCOMES • Exclude all income and non “otherwise allowable” expenses • Rental is a passive activity--see PAL rules • Deduct • Expenses FOR AGI to zero out rental income • Excess otherwise allowable deductions FROM AGI

  42. De Minimis RentalsExclude • If rented < 15 days • Exclude all income and non-otherwise allowable expenses

  43. Insignificant Personal UsageFollow PAL Rules • If personal use • < 15 days OR • < 10% of days rented at FMV • All income and expenses related to the rental are passive • Passive actively rules apply • Rental exception may be available

  44. Significant Personal UsageZero Out AGI • If personal use • > 14 days AND • > 10% of days rented at FMV • All income is reported for AGI • Expenses related to the rental (including OA's) are deductible FOR AGI but limited to amount of income generated by the rental • Excess OA’s are deductible FROM AGI

  45. In Class Exercise: Rental or Vacation Home? • Discuss these cases in your groups • CASE -A- -B- -C- -D- -E- • Rented 300 200 250 10 75 • Used 22 21 22 32 14 • CASE -F- -G- -H- -I- -J- • Rented 100 200 200 300 300 • Used 13 14 22 29 36

  46. Solution: In Class Exercise: Rental or Vacation Home? • De minimis rental • Case: D • Insignificant personal usage (PAL) • Cases: A, C, E, F, G, I • Significant personal usage • Cases B, H, J

  47. Loss Limitations Associated With Vacation Homes Key Learning Objectives (2) • Special considerations applicable to vacation homes • Expense allocation methods: the IRS vs. the courts • Carryovers of unused deductions

  48. Special Issues • Ordering rule for deductions • "Otherwise allowable" • Other allowable cash expenditures • Depreciation • Personal use includes • Rental < FMV to related party • Donated use to charitable organization

  49. Expense Allocation MethodsWhy The Issue? • Total deduction FOR AGI limited to income from rent • Excess OA's can be deducted FROM AGI • Taxpayer would like to increase percentage of deduction FOR AGI coming from items not OA

  50. Expense Allocation MethodsWhat’s The Denominator? • 365 days for interest and tax deductions • Per the Courts • Total number of days actually used for rental or personal usage • Per the Code • Excludes any days the unit was vacant