TAX SHELTER
Taxpayer would intentionally invest in an activity that was designed to produce losses to avoid or defer taxes
AT-RISK LIMITS
1. Losses are deductible when at-risk amount is positive. Any disallowed losses are deductible when at-risk
amount become positive
2. The at-risk amounts are increased when the partnership increases its recourse debts and are decreased
when reducing its debt.
However, a taxpayer generally is not considered at risk if:
The taxpayer is not personally liable for repayment of the debt (nonrecourse debt), or
The lender has an interest in the activity
In 2018, Fred invested $50,000 in a general partnership. Fred’s interest is not considered to be a passive activity.
If his share of the partnership losses is $35,000 in 2018 and $25,000 in 2019, how much can he deduct in each
year
2018:35,000 (at-risk amount reduced to 15,000)
2019: 15,000 (10,000 is carryover)
Continue with the facts of the previous example. In 2020, the Fred have taxable income of $15,000 from the oil
partnership and invest an additional $10,000 in the venture.
The at-risk amount increased to 15,000+10,000=25,000.
This enable him to deduct the carryover loss of 10,000 and reduce the at-risk amount to 15,000.
PASSIVE ACTIVITY LOSS LIMITS
1. Losses are deductible when there is passive activity income.
Any excess passive activity loss suspended to future years to offset passive activity income.
2. Dispose of passive activity
All suspended passive activity losses become deductible, which can offset:
1. Net passive activity income or gains (if any), and
2. active or portfolio income
3. A closely held, personal service corporation, trusts, individuals, estates are subject to this rule.
4. The allocation to an activity
Active income includes:
Wages, salary, commissions, bonuses
Profit from a trade or business in which the taxpayer is a material participant
Gain on the sale of assets in trade or business.
Income from intangible property if the taxpayer’s personal efforts is significant
Portfolio income includes:
Interest, dividends, annuities, and royalties not derived in the ordinary course of a trade or business.
Gain or loss from the disposition of property that produces income or is held for investment purposes
Passive activity income or loss include:
Any trade or business or income-producing activity that the taxpayer does not materially participate.
all rental activities
Kay acquired an interest in a partnership in which she is not a material participant. Kay’s basis in her
partnership interest at the beginning of 2018 is $40,000. Kay’s partnership loss is $35,000 in 2018, and
partnership income is $15,000 in 2019. How much may Kay deduct in 2018 and 2019?
2018: 0 (no passive activity income)
2019: 15,000 (20,000 remaining suspended)
Mike earns $200,000 from his law practice and receives $45,000 in dividends and interest during the year. In
addition, he incurs a loss of $50,000 from an investment in a passive activity acquired three years ago. What is
Mike’s net income for the current year after considering the passive investment?
Net income is 245,000 (active and portfolio income)
50,000 is not deductible because there is no passive activity income
Sarah has investments in four passive activity partnerships. Last year the income and losses were as follows:
Activity Income (Loss)
A $ 30,000
B (30,000)
C (15,000)
D (5,000)
In the current year, she sold her interest in Activity D for a $10,000 gain. Activity D, which had been profitable
until last year, had a current loss of $1,500. How will the sale of Activity D affect Sarah’s taxable income in the
current year?
Last year
Net passive activity loss=30,000-30,000-15,000-5000=-20,000
Net passive activity loss of 20,000 allocated to
B:20,000*30/50=12,000
C:20,000*15/50=6,000
D:20,000*5/50=2,000
She can offset the 2000 suspended loss and current year’s loss against the 10,000 gain. In addition, the
remaining net gain 65,000 (10,000-2,000-1500) may be used to absorb other passive activity losses.
Leon sells his interest in a passive activity for $100,000. Determine the tax effect
a. Adjusted basis in this investment is $35,000. Losses from prior years that were not deductible due to the
passive activity loss restrictions total $40,000 (suspended losses).
Total gain=100,000-35,000=65,000
Less suspended losses (40,000)
Taxable gain=25,000
b. Adjusted basis in this investment is $75,000. Losses from prior years that were not deductible due to the
passive activity loss restrictions total $40,000.
Total gain=100,000-75,000=25,000
Less suspended losses (40,000)
Deductible loss (15,000)
Rules for Determining Passive Activities
1. A first step is to determine what constitutes an “activity.
the following five factors are important:
-Types of businesses
-Extent of common control
-Extent of common ownership
-Locations
-Interdependencies.
2. Once activities have been grouped, they cannot be regrouped
3. Two rules deal specifically with the grouping of rental activities:
First, a rental activity may be grouped with a trade or business activity only if one activity is insubstantial in
relation to the other.
Second, taxpayers generally may not treat an activity involving the rental of real/personal property as a single
activity
Material Participation
1. If an individual taxpayer materially participates in a nonrental activity, any loss is treated as an active loss
2. If a taxpayer does not materially participate, the loss is treated as a passive activity loss
3. If an activity is generating gains, you may want it to be classified as passive so that you can offset other
passive losses against it.
If an is generating losses, you may want it to be classified as active so that you can avoid the limitations on
the deductibility of passive losses.
4. A taxpayer need participate on a regular, continuous, and substantial basis to be a material participant.
5. Material participation is achieved by meeting any one of the tests:
Rental Activities Defined
1. Most rental activities are passive activities, regardless material participants.
2. A person who rents property for seven days or less is generally required to provide significant services to the
customer. Providing these services supports a conclusion that the person is engaged in a service business rather
than a rental business.
Special Passive Activity Rules for Real Estate Activities
1. nonpassive treatment for real estate professionals.
-More than half of the personal services that the taxpayer performs are in real property trades
-The taxpayer performs more than 750 hours of services in these real property trades or businesses
2. The second exception allows individuals to deduct up to $25,000 of losses from real estate rental activities
against active and portfolio
To qualify for the $25,000 exception, a taxpayer must meet both of the following requirements:
-Actively participate in the real estate rental activity, and
-Own 10 percent or more of all interests in the activity during the entire taxable year
The potential annual 25,000 deduction is reduced if the taxpayer’s AGI is in excess of 100,000.
Jiu has $105,000 of losses from a real estate rental activity in which she actively participates. She has other
rental income of $25,000 and other passive activity income of $32,000. Her AGI before considering these items
of income and loss is $95,000. How much rental loss can Jiu deduct against active and portfolio income
(ignoring the at-risk rules)? Does she have any suspended losses to carryover?
Rental losses are first offset by passive activity income: 105000-25000-32000=48000. Then, it is reduced by
25,000. Therefore, the suspended rental loss is 23000
Interaction of the At-Risk and Passive Activity Loss Limits
The determination of whether a loss is suspended under the passive activity loss rules is made after application
of the at-risk rules.
Further, a taxpayer’s at-risk basis is reduced by the losses even if the deductions are not currently usable
because of the passive activity loss rules.
Jack’s adjusted basis in a passive activity is $10,000 at the beginning of 2018. His loss from the activity in 2018
is $4,000.
Under At-risk: 4000 is deductible
Under passive loss. the $4,000 cannot be deducted (no passive income)
At year-end, Jack has at-risk amount reduced to $6,000
a suspended loss under passive rule of $4,000.
Jack then has a loss of $9,000 in 2019.
Under at-risk: he can reduce 6,000, so $3,000 suspended loss under at-risk rules.
Jack has no passive activity income, so $6,000 suspended loss under passive activity rules.
At year-end, he has:
A $3,000 loss suspended under the at-risk rules.
$10,000 of suspended passive activity losses ($4,000 from 2018 and $6,000 from 2019).
An adjusted basis and an at-risk amount in the activity of zero.
Jack then realizes $1,000 of passive activity income in 2020.
The $1,000 increases both at-risk amount, and positive activity income.
Under At-risk: The at-risk amount is reduced to 0 because is offset by 1000 of 3000 suspended loss under at-
risk. Therefore, suspended loss under at-risk is 2000
The suspended loss under passive loss is still 10,000 because 1)1000 of 3000 suspended loss under at-risk
reclassified as passive loss. 2)1000 passive income is offset by 1000 passive loss
At the end of 2020, Jack has:
No taxable passive activity income.
$2,000 suspended losses under the at-risk rules.
$10,000 of (reclassified) suspended passive activity losses (10,000+1000-1000)
an at-risk amount in the activity of zero
In 2021, Jack has no gain or loss. He contributes $5,000 more to the passive activity.
Under at-risk: 5000 increase at-risk amount, then is offset by 2000 suspended loss under at-risk.
5000 has no effect on passive income. However, 2000 was reclassified as passive loss. Therefore, passive loss is
12,000.
At year end:
No suspended loss under at-risk
120000 suspended loss under passive loss
At risk amount is 3000.
Lee acquired a 20% interest in the BlueSky Partnership for $60,000. The partnership was profitable through
2018, and Lee’s amount at risk in the partnership interest was $120,000 at the beginning of 2019. BlueSky
incurred a loss of $400,000 in 2019 and reported income of $200,000 in 2020. Assuming that Lee is not a
material participant, how much of his loss from BlueSky Partnership is deductible in 2019and 2020? Consider
the at-risk and passive activity loss rules
Loss in 2019 is 400,000*0.2=80,000. The entire loss is suspended under passive activity loss rules because he
has no passive activity income.
Passive activity income in 2020 is 200,000*0.2=40,000.
The at-risk amount is 120,000+400,000-80,000=80,000.
The suspended loss in 2020=40,000-80,000=40,000 (offset by passive activity income)
Five years ago Gerald invested $150,000 in a passive activity, his sole investment venture. On January 1, 2018,
his amount at risk in the activity was $30,000. His shares of the income and losses were as follows:
Year
Income (Loss)
2018 ($40,000)
2019 (30,000)
2020 50,000
Gerald holds no suspended at-risk or passive activity losses at the beginning of 2018. How much can Gerald
deduct in 2018 and 2019? What is his taxable income from the activity in 2020? Consider the at-risk rules as
well as the passive activity loss rules.
2018: Under at-risk rule, he can deduct 30,000, the remaining 10,000 is suspended loss under at-risk.
Since there is not passive income, the 30,000 is not deductible, so, 30,000 is suspended loss under passive
loss
The amount at risk is 0
2019: Under at-risk rule, nothing can be deducted. Therefore, 30,000 is suspended loss under at-risk.
2020: 50,000 both increase at-risk amount and passive income:
Under at-risk: 50,000 is offset by 40,000 total suspended loss under at-risk rule. Therefore, the amount at risk is
reduced to 10,000
Under passive loss rule: the 40,000 suspended loss at-risk actually reclassified as passive loss. Therefore, total
passive loss=30,000+40,000-50,000=20,000