Chapter 10 Limitations on the Deductibility of Partnership Losses

1. Chapter 10Limitations on the Deductibility ofPartnership Losses

2. Three Deductibility Limitations • The deductibility of partnership losses passed through to a partner is subject to three separate limitations: • First, the loss may not exceed the partner’s tax basis in the partnership interest-§704(d) • Second, any losses surviving the tax basis limit are subject to the at-risk limitation- §465 • Finally, losses may be disallowed under the passive loss limitations - §469

3. Disallowed Losses Are Carried Forward • Carryforwards Under §704(d): • Loss passed through to a partner in excess of tax basis is carried forward indefinitely until the partner obtains additional basis sufficient to allow the deduction • Carryforward losses unused as of the date of any sale or disposition of the partnership interest are lost (because they did not reduce the basis of the interest, and therefore any gain/loss from the sale is already reduced/increased by the amount of the carryforward) • Do not carry over to the transferee • Do not explicitly offset the gain or increase the loss recognized

4. Disallowed Losses Are Carried Forward (Cont.) • Carryforwards Under §465 • Losses disallowed under the at-risk rules are carried forward indefinitely just as are those denied under tax basis limitation • A partner’s tax basis in her partnership interest is reduced by losses even if they are disallowed under the at-risk rules

5. Disallowed Losses Are Carried Forward (Cont.) • Carryforwards Under §465 • When a partner sells her interest in the partnership, losses carried forward under the at-risk limitation are deductible in full regardless of the amount of gain or loss recognized by the partner/member on the transaction • Losses carried forward under the tax basis limitation are not deductible on sale of a partnership interest

6. Disallowed Losses Are Carried Forward (Cont.) • Carryforwards Under §469 • For individuals, losses from passive activities are only deductible to the extent of income from other passive activities • Losses disallowed under the passive loss limitations are carried forward indefinitely until the partnership has sufficient passive income from other sources to absorb the carryforward

7. Disallowed Losses Are Carried Forward (Cont.) • Carryforwards Under §469 • If the partner completely disposes of the partnership interest, any passive loss carryforward is deductible in full in the year of disposition

8. The Basis Limitations under §704(d) • Losses Cannot Exceed Tax Basis • A partner cannot deduct partnership losses that exceed the tax basis of the partnership interest • Accounting for Debt • A partner’s risk of loss in a partnership interest includes not only direct investment made in the partnership interest, but also includes debt which the partner is obligated to pay in future

9. The Basis Limitations under §704(d) (Cont. ) • Nonrecourse Debt • Definition: debt for which the borrower has no individual responsibility to repay the lender, and for which the lender solely looks to the property serving as collateral for the debt in the event of default • If the loan is a legitimate economic liability, it will be included in the borrower’s tax basis for the property • A nonrecourse debt is considered legitimate if it was borrowed from an unrelated lender, or if the borrower can demonstrate that the FMV the property exceeded the principal balance of the loan at the time the loan was made

10. At-Risk Rules of §465 • Under §465, a taxpayer may not claim deductions for losses in excess of the amount that the taxpayer actually has “at risk” with respect to the activity generating the losses • §465 applies to individuals and closely held corporations only

11. At-Risk Rules of §465 (Cont.) • A taxpayer’s amount at risk is computed in the same manner as is tax basis except that it excludes nonqualified nonrecourse debt • A qualified nonrecourse debt is one which: • Is borrowed for the activity of holding real property (very broadly defined), and is secured by that property • Is borrowed from a lender who is in the business of lending money and who has no interest in the activity for which the money is borrowed, other than as a creditor • Is not convertible into stock or other securities

12. Passive Loss Limitations of §469 • General • Deductions for net losses (income minus losses) from “passive” activities are not allowed • Passive loss is loss realized from rental activities and loss “allocated” to nonparticipatory partners (i.e., limited partners) in partnership activities • Disallowed losses are carried forward and can be deducted only against net passive income in future years or when the taxpayer fully disposes of the interest in the passive activity

13. Passive Loss Limitations of §469 (Cont.) • The passive loss limitation is applied after application of the at-risk loss limitation

14. Classification of Income Under §469 • General • Passive activity income includes all income from passive activities, including gain from disposition of an interest in a passive activity or from disposition of property used in a passive activity

15. Classification of Income Under §469 (Cont.) • Gain from Sale of an Interest in a Partnership • If the partnership was engaged in a passive activity, any gain or loss recognized on the sale or disposition of the partner’s interest in the entity will be classified as passive gain or loss

16. Classification of Income Under §469 (Cont.) • Gain from Sale of an Interest in a Partnership • If the partnership is engaged in more than one activity (e.g., a passive activity and a portfolio activity) in one entity, the gain or loss must be allocated between the activities based on the relative gain or loss which would have been recognized if the entity had sold its entire interest in each of its activities just prior to the partner’s disposition of the partnership interest

17. Taxpayers to Whom §469 Applies • The passive loss rules apply only to individuals, certain trusts and estates, personal service corporations and closely-held corporations • Unlike individuals, closely held corporations are allowed to deduct net passive losses against active income and offset the tax attributable to net active income with passive activity credits • However, closely held corporations cannot offset portfolio income with net passive losses

18. Passive Activities Defined • Definition: A passive activity is one in which the taxpayer does not “materially participate” during the taxable year • Most rental activities are deemed to be passive regardless of the taxpayer’s level of participation • A significant exception: for taxpayers who are engaged primarily in the real estate business

19. Passive Activities Defined (Cont.) • Limited Partners • Limited partners generally are not treated as material participants • However, if the limited partner (or LLC member treated as a limited partner) satisfies the requirements of tests (1), (5), or (6) above, the partner can be treated as a material participant

20. Passive Activities Defined (Cont.) • Rental Activities • §469 automatically classifies most rental activities as passive activities, regardless of the taxpayer’s level of participation • For this purpose, a rental activity is one involving the long-term rental of property and for which the taxpayer does not provide substantial additional services • Short term rental activities where substantial personal services in connection with the rental are required (e.g. operation of hotel) do not constitute a passive activity

21. Passive Activities Defined (Cont.) • Rental Activities • Exceptions to passive treatment: • The average period of customer use of the property is seven days or less (e.g., hotels, motels, short-term equipment or vehicle rentals, etc.) • The average period of customer use of the property is 30 days or less and significant personal services are provided with the rentals • Extraordinary personal services are provided by or on behalf of the owner(s) of the property in making such property available for customer use

22. Passive Activities Defined (Cont.) • The rental is incidental to a non-rental activity • The rental property is customarily made available during defined business hours for nonexclusive use by various customers (e.g., health clubs) • The property is provided for use in a non-rental activity in the owner’s capacity as an owner of an interest in a partnership, S corporation, or joint venture conducting that activity

23. Passive Activities Defined (Cont.) • Real Estate Professionals • Taxpayers in the “real property business” are not subject to the passive loss restrictions • A taxpayer is in the real property business if he/she: • Spends more than half of his/her time in real property businesses in which he/she materially participates; and • Performs more than 750 hours of services during the taxable year in real property trades or businesses in which he or she materially participates

24. Passive Activities Defined (Cont.) • Exemption for Real Estate Rental Activities in which Taxpayer “Actively” Participates • For taxpayers who “actively participate in the management of rental property, the first $25,000 of net losses generated by such property are exempted from Code Sec. 469 • First, the losses are still passive losses, while not subject to the passive loss limitations • Second, the exemption applies only if the taxpayer “actively” participates in management of the property

25. Passive Activities Defined (Cont.) • Exemption for Real Estate Rental Activities in which Taxpayer “Actively” Participates (Cont.) • Active participation requires the following: • The taxpayer must have at least a 10% interest in the rental activity • The taxpayer must not own the interest as a limited partner, and • The taxpayer must participate in the activity in a significant and bona fide manner (participate in management decisions)

26. Passive Activities Defined (Cont.) • Exemption for Real Estate Rental Activities in which Taxpayer “Actively” Participates (Cont.) • The exemption amount is reduced by 50 cents for each dollar that the taxpayer’s “modified AGI” exceeds $100,000 • Modified AGI is regular AGI, computed without regard to various items, including taxable social security, deductible IRA contributions, passive activity income or loss, and one-half of self-employment taxes

27. Activities That Are Not Passive Activities • Five categories of trade or business activities are not treated as passive activities • Trade or business activities in which the taxpayer materially participated for the tax year • A working interest in an oil or gas well held by the taxpayer directly or through an entity that does not limit liability • Rental of a vacation home

28. Activities That Are Not Passive Activities (Cont.) • Five categories of trade or business activities are not treated as passive activities (Cont.) • Trading activities involving personal property traded for the account of those who own interests in the activity • Rental real estate activities of real estate professionals

29. Operating Rules • Calculation and Use of Carryforwards • First, total all income from passive activities • Then, total all losses from passive activities • If the total loss exceeds the total income, the taxpayer has a net passive loss, which is disallowed unless subject to the rules related to the taxpayer’s active participation rental activities

30. Operating Rules (Cont.) • Calculation and Use of Carryforwards • The taxpayer then allocates the disallowed passive loss back to the passive activities which generated the loss (based on the relative amounts of the losses they generated) • These losses carry forward indefinitely, and can be deducted if the taxpayer either earns net passive income in a subsequent year or disposes of the entire interest in the passive activity to which the loss has been allocated

31. Operating Rules (Cont.) • Calculation and Use of Carryforwards • Under §469, the loss carryforward from a disposed activity is applied against passive income from other passive activities first, and any excess loss is then characterized as loss from non-passive activities • However, passive loss carryovers from other passive activities are applied against passive income from such activities before application of the carryover from the disposed activity. This tends to leave more of the loss from the disposed activity to be treated as non-passive.