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Module 29 Tax Motivated Investments and Loss Limitations

Module 29 Tax Motivated Investments and Loss Limitations. 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.

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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

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