module 29 tax motivated investments and loss limitations

Module 29Tax Motivated Investments

and Loss Limitations

MenuTax 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

Tax Shelter Activities: An Introduction

Key Learning Objectives (1)Key Learning Objectives (1)

Definition of a tax shelterDefinition of a tax shelter The goals of a good tax shelterThe goals of a good tax shelter §6111 registration requirements§6111 registration requirements §6707 & §6708 penalties related to registration§6707 & §6708 penalties related to registration

Definition of aTax Shelter

Minimize the tax effects of the income tax Minimize the tax effects of the income tax Generates significant tax losses as a result Generates significant tax losses as a result

of the allowable deductions associated with of the allowable deductions associated with the investmentthe investment

§6111 Registration Requirements

A tax savings to investment cost ratio of A tax savings to investment cost ratio of more than two to one, and more than two to one, and

The offering is (a) treated as a security The offering is (a) treated as a security regulated by law, or (b) exempted from regulated by law, or (b) exempted from regulations but has five or more investors or regulations but has five or more investors or will initially attract investments exceeding will initially attract investments exceeding $250,000$250,000

§6707 and §6708 Registration Penalties

§6707§6707(a) (a) organizer's failure to organizer's failure to register a shelter register a shelter

§6707§6707(b)--failure to furnish(b)--failure to furnish a registration number a registration number

§6708--organizer's failure to retain §6708--organizer's failure to retain list of investors list of investors

The Goals of a Good Tax Shelter

Deferral of taxation Deferral of taxation Conversion of Conversion of

ordinary income ordinary income into capital gaininto capital gain

§6700 and §6701 False Statement Penalties

§6700--organizer furnishes false statements§6700--organizer furnishes false statements §6700--organizer furnishes gross §6700--organizer furnishes gross

overvaluation statementovervaluation statement §6701--aiding and abetting understatement §6701--aiding and abetting understatement

of tax liability of tax liability

Tax Shelter Activities: An Introduction

Key Learning Objectives (2)

The sham transaction doctrine as a weapon The sham transaction doctrine as a weapon against tax sheltersagainst tax shelters

§6700 & §6701 penalties related to false §6700 & §6701 penalties related to false statementsstatements

§7408 injunctive relief§7408 injunctive relief

The Sham Transaction Doctrine

The transaction was entered into primarily The transaction was entered into primarily for tax avoidance andfor tax avoidance and

No economic substance, (no possibility of No economic substance, (no possibility of profit) profit)

§7408 Injunctive Relief

Empowers IRS to seek civil action in Empowers IRS to seek civil action in District Court that would District Court that would enjoinenjoin any person any person from further engaging in conduct subject to from further engaging in conduct subject to §6700 or §6701 §6700 or §6701

Promoters can be shut down much quicker Promoters can be shut down much quicker under this procedure under this procedure

The Passive Activity Limitations: A Closer Look


The passive activity limitations (PALS)The passive activity limitations (PALS) Identifying an activityIdentifying an activity The active basket and material participationThe active basket and material participation The The portfolioportfolio basket basket Legislative curbs on tax shelters: an overviewLegislative curbs on tax shelters: an overview

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 ActiveActive Portfolio, orPortfolio, or PassivePassive

General Rule

Passive losses offset only passive income Suspended losses carried forward

Active Basket

Wages and salaries Profit/loss from trade or business in which

taxpayer materially participates Gain/loss from sale of active business assets

Material Participation(Dirty Hands)

Regular Continuous Substantial Extremely complex rules

Portfolio Basket

Interest Dividends Annuities Royalties Gain/loss from sale of portfolio assets

The Passive Activity Limitations: A Closer Look


The passive basket Applying the passive activity limitations Real estate exceptions to the passive loss

limitations Passive activity credits Disposition of passive activities

Passive Basket

Profit/loss from trade or business IF Taxpayer does not materially participateTaxpayer does not materially participate

Any rental activity, regardless of material participation

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 yearCarryover in full to next year Record by activity Record by activity

Compliance Query: PAL Rules (1)

What is AGI if the taxpayer has$500,000 of salary income and $500,000 of salary income and

Two passive businessesTwo passive businesses

ActivityActivity ActivityActivity

-A--A- -B- -B-

IncomeIncome 50,000 20,000

ExpenseExpense 25,000 30,000

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

Compliance Query: PAL Rules (2)

What is AGI if the taxpayer has $500,000 of salary income and $500,000 of salary income and Two passive businessesTwo passive businesses


-A--A- -B- -B-



Solution--Compliance Query: AGI is $500,000

Passive activities net as follows:


-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

Passive Credits

Apply against tax from passive income only

Suspended credits carried forward Use or lose in year of disposition

Disposition of Passive Activities

In the year of dispositionIn the year of disposition In a fully taxable transactionIn a fully taxable transaction Suspended losses may be deducted against Suspended losses may be deducted against

any source of income any source of income

Transfers to Related Parties

Not Not a disposition of a passive activity a disposition of a passive activity

Exception for Qualified Real Estate Professional

>50% of personal services related To real estate trade or business andTo real estate trade or business and

>750 real estate related hours

Exception for Active Rental Real Estate

Up to $25,000 excess loss allowed Reduces active/portfolio incomeReduces active/portfolio income

Phase-out of $25,000 if AGI > 100,000AGI > 100,000 Lose 50¢ for each excess $Lose 50¢ for each excess $

Active participation required

The Active Participation Requirement

Own at least a 10% interestOwn at least a 10% interest By valueBy value

Not be a limited partner andNot be a limited partner and Demonstrate regular, continuous, and Demonstrate regular, continuous, and

substantial involvement substantial involvement

Compliance Query: Active Rental Exception

What is AGI if the taxpayer has $100,000 of salary income and $100,000 of salary income and Two passive businesses (A is active rental)Two passive businesses (A is active rental)


-A--A- -B- -B-



Solution--Compliance Query: AGI is $90,000

Passive activities net as follows:


-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

In Class Exercise: More Active Rental Exception

How does the answer to last Query change?How does the answer to last Query change? Case 1: Case 1:

Activity B is the active real estate rentalActivity B is the active real estate rental Case 2: Case 2:

Salary income is $140,000?Salary income is $140,000? Activity A is the active real estate rentalActivity A is the active real estate rental

Solution--In Class Exercise: More Active Rental Exception

Case 1: AGI = 100,000Case 1: AGI = 100,000 The excess loss is not from active rentalThe excess loss is not from active rental It must be suspendedIt must be suspended

Solution--In Class Exercise: More Active Rental Exception

Case 2: AGI = 135,000Case 2: AGI = 135,000 AGI is over 100,000AGI is over 100,000

Exception must be phased outException must be phased out Lose (140,000-100,000) x .5 of $25,000Lose (140,000-100,000) x .5 of $25,000 Only 5,000 of 25,000 exception remainsOnly 5,000 of 25,000 exception remains

Decedent’s Suspended Losses

Suspended losses are generally allowed on Suspended losses are generally allowed on a decedent's final tax returna decedent's final tax return

Deduction is reduced by any step-up in Deduction is reduced by any step-up in basis to FMVbasis to FMV

Gifts of Activities With Suspended Losses

Transfer by gift not a qualifying dispositionTransfer by gift not a qualifying disposition Losses are not allowable to either the donor Losses are not allowable to either the donor

or doneeor donee Donee’s basis is increased by the suspended Donee’s basis is increased by the suspended

lossloss

Tax Shelters in Residential Real Estate

Limited tax benefits are still available for Limited tax benefits are still available for the small investorthe small investor

Use of leveraging, depreciation, capital Use of leveraging, depreciation, capital gains, benefits of tax losses, positive cash gains, benefits of tax losses, positive cash flowsflows

$25,000 exception for PAL’s $25,000 exception for PAL’s

Loss Limitations Associated With Vacation Homes


The basic rules of §280AThe basic rules of §280A Rule 1: De minimis rentalsRule 1: De minimis rentals Rule 2: Insignificant personal usageRule 2: Insignificant personal usage Rule 3: Significant personal usageRule 3: Significant personal usage

“Vacation Home”

To determine if rental is a vacation rental To determine if rental is a vacation rental COMPARE days of personal use to days COMPARE days of personal use to days ACTUALLYACTUALLY rented at FMV rented at FMV

Note: OA stands for “otherwise allowable” Note: OA stands for “otherwise allowable” deductions found on Schedule Adeductions found on Schedule A

Vacation Home?

THERE ARE 3 POSSIBLE OUTCOMESTHERE ARE 3 POSSIBLE OUTCOMES Exclude all income and non “otherwise Exclude all income and non “otherwise

allowable” expenses allowable” expenses Rental is a passive activity--see PAL rules Rental is a passive activity--see PAL rules Deduct Deduct

Expenses FOR AGI to zero out rental income Expenses FOR AGI to zero out rental income Excess otherwise allowable deductions FROM Excess otherwise allowable deductions FROM

AGIAGI

De Minimis RentalsDe Minimis RentalsExclude

If rented < 15 daysIf rented < 15 days Exclude all income and non-otherwise Exclude all income and non-otherwise

allowable expensesallowable expenses

Insignificant Personal UsageInsignificant Personal Usage Follow PAL Rules

If personal useIf personal use < 15 days < 15 days OROR < 10% of days rented at FMV < 10% of days rented at FMV

All income and expenses related to the All income and expenses related to the rental are passiverental are passive

Passive actively rules applyPassive actively rules apply Rental exception may be availableRental exception may be available

Significant Personal UsageZero Out AGI

If personal useIf personal use > 14 days > 14 days AND AND > 10% of days rented at FMV> 10% of days rented at FMV

All income is reported for AGIAll income is reported for AGI Expenses related to the rental (including Expenses related to the rental (including

OA's) are deductible FOR AGI but limited to OA's) are deductible FOR AGI but limited to amount of income generated by the rentalamount of income generated by the rental

Excess OA’s are deductible FROM AGIExcess OA’s are deductible FROM AGI

In Class Exercise: Rental or Vacation Home?

Discuss these cases in your groupsDiscuss these cases in your groups

CASECASE -A- -A- -B--B- -C--C- -D- -E--D- -E- RentedRented 300 300 200200 250250 10 75 10 75 UsedUsed 22 21 22 21 22 22 32 14 32 14 CASECASE -F- -F- -G--G- -H--H- -I- -J- -I- -J- RentedRented 100 100 200200 200200 300 300300 300 UsedUsed 13 14 13 14 22 22 29 36 29 36

Solution: In Class Exercise: Rental or Vacation Home?

De minimis rental Case: DCase: D

Insignificant personal usage (PAL) Cases: A, C, E, F, G, ICases: A, C, E, F, G, I

Significant personal usage Cases B, H, JCases B, H, J

Loss Limitations Associated With Vacation Homes


Special considerations applicable to vacation homes

Expense allocation methods: the IRS vs. the courts

Carryovers of unused deductions

Special Issues

Ordering rule for deductions "Otherwise allowable""Otherwise allowable" Other allowable cash expendituresOther allowable cash expenditures DepreciationDepreciation

Personal use includes Rental < FMV to related party Rental < FMV to related party Donated use to charitable organizationDonated use to charitable organization

Expense Allocation MethodsWhy The Issue?

Total deduction FOR AGI limited to Total deduction FOR AGI limited to income from rent income from rent

Excess OA's can be deducted FROM AGIExcess OA's can be deducted FROM AGI Taxpayer would like to increase percentage Taxpayer would like to increase percentage

of deduction FOR AGI coming from items of deduction FOR AGI coming from items not OAnot OA

Expense Allocation MethodsWhat’s The Denominator?

365 days for interest and tax deductions Per the CourtsPer the Courts

Total number of days actually used for rental or personal usage Per the CodePer the Code Excludes any days the unit was vacantExcludes any days the unit was vacant

In Class Exercise:Expense Allocation Methods

What’s The Difference? Use the following facts to determine the Use the following facts to determine the

deduction for/from AGIdeduction for/from AGI

Rental incomeRental income 5,000 5,000 Interest and taxes Interest and taxes 15,000 15,000 RepairsRepairs 6,000 6,000 Days rented at FMVDays rented at FMV 100 100 Days of personal useDays of personal use 50 50

Solution--In Class Exercise:Expense Allocation Methods

What’s The Difference?Per the CourtsPer the Courts

% = 100 % = 100 ÷ 365 = .274365 = .274

For AGIFor AGI

IncomeIncome 5,0005,000

Less InterestLess Interest 4,1104,110

RepairsRepairs 990 990

Net IncomeNet Income 0 0

From From AGIAGI 15,000 - 4,110 15,000 - 4,110

Per the IRSPer the IRS

% = 100 % = 100 ÷ 150 = .333150 = .333

For AGIFor AGI

IncomeIncome 5,0005,000

Less InterestLess Interest 5,0005,000

RepairsRepairs 0 0

Net IncomeNet Income 0 0

From From AGIAGI 15,000 - 5,000 15,000 - 5,000

Carryovers of Unused Deductions

OA s used in full, either for or from AGI, OA s used in full, either for or from AGI, so no carryover issueso no carryover issue

Depreciation, repairs, etc. carryoverDepreciation, repairs, etc. carryover Cannot be used to create a lossCannot be used to create a loss

Anatomy of a Tax Shelter: Residential Real Estate


Tax shelters in residential real estateTax shelters in residential real estate Analysis of a typical residential real estate Analysis of a typical residential real estate

investmentinvestment The benefits of leveragingThe benefits of leveraging

Anatomy of a Tax Shelter: Residential Real Estate Key Learning Objectives (2)

Comparing taxable income (loss) with net Comparing taxable income (loss) with net cash flowscash flows

Impact of the passive activity limitationsImpact of the passive activity limitations Incorporating the effects of liquidating the Incorporating the effects of liquidating the

investmentinvestment Summary: the tax advantages of residential Summary: the tax advantages of residential

real estatereal estate

Anatomy of a Tax Shelter: Low-Income Housing Investment


Investments in low-income housing tax Investments in low-income housing tax credit projectscredit projects

Project description: qualified units and Project description: qualified units and financing termsfinancing terms

Project description: project rents and equity Project description: project rents and equity requirementsrequirements

Anatomy of a Tax Shelter: Low-Income Housing Investment


Projected cash flowsProjected cash flows Disposition of the project in year 16Disposition of the project in year 16 Assessing the impact of the passive activity Assessing the impact of the passive activity

limitationslimitations

module 29 tax motivated investments and loss limitations

Documents