Passive Activity Loss Rules:
Strategies for Pass-Throughs Leveraging Latest Federal Guidance and Rulings to Establish Material Participation
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THURSDAY, FEBRUARY 28, 2013
Presenting a live 110-minute teleconference with interactive Q&A
Robert S. Barnett, Partner, Capell Barnett Matalon & Schoenfeld, Jericho, N.Y.
Carolyn Turnbull, Tax Director, McGladrey, Orlando, Fla.
Bryan Rimmke, Tax Manager, Ernst & Young, Washington, D.C.
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Passive Activity Loss Rules: Strategies for Pass-Throughs Seminar
Robert Barnett, Capell Barnett Matalon &
Feb. 28, 2013
Bryan Rimmke, Ernst & Young
Carolyn Turnbull, McGladrey
Schoenfeld
Today’s Program
Overview Of Key Passive Activity Loss Concepts
[Bryan Rimmke]
General Problems Related To Grouping
[Bryan Rimmke]
Issues With The Real Estate Professional Designation
[Robert Barnett]
Issues Arising With The New 3.8% Tax
[Carolyn Turnbull]
Slide 64 – Slide 89
Slide 8 - Slide 22
Slide 23 – Slide 35
Slide 36 – Slide 63
Notice
ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY
THE SPEAKERS’ FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY
OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT
MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR
RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.
You (and your employees, representatives, or agents) may disclose to any and all persons,
without limitation, the tax treatment or tax structure, or both, of any transaction
described in the associated materials we provide to you, including, but not limited to,
any tax opinions, memoranda, or other tax analyses contained in those materials.
The information contained herein is of a general nature and based on authorities that are
subject to change. Applicability of the information to specific situations should be
determined through consultation with your tax adviser.
7
Passive Activity Limitations Slide 9
Circular 230
► Any U.S. tax advice contained herein was not intended or written to
be used, and cannot be used, for the purpose of avoiding penalties
that may be imposed under the Internal Revenue Code or applicable
state or local tax law provisions.
► These slides are for educational purposes only and are not intended,
and should not be relied upon, as accounting advice.
Passive Activity Limitations Slide 10
Objectives For This Section
► Define passive activity
► Apply the material participation rules
► Identify activity groupings
Passive Activity Limitations Slide 12
Taxpayers Subject To Passive Activity Limitations
► The passive activity limitations apply to:
► Individuals (including partners and S corporation shareholders)
► Estates and trusts
► Closely held C corporations
► Personal service corporations
► The passive activity limitations do not apply to:
► Partnerships and S corporations
► C corporations that are not closely held or personal service
corporations
Passive Activity Limitations Slide 13
Passive Activity
► A passive activity includes:
► A trade or business activity in which the taxpayer does not
materially participate, and
► Any rental activity except
► Certain rental real estate activities of a qualifying real estate
professional
Passive Activity Limitations Slide 14
Passive Activity (Cont.)
► Losses from a passive activity generally are deductible currently only
against passive income.
► Excess passive losses are suspended.
► Cannot be carried back but can be carried forward indefinitely
► Exception for a fully taxable disposition of all, or substantially all, of
the taxpayer’s interest in the activity to an unrelated transferee
► Similar rules apply to credits from a passive activity.
► Passive credits are generally allowed only to the extent of federal
income tax otherwise payable on net passive income.
Passive Activity Limitations Slide 15
Passive Activity (Cont.)
► Net income from a passive activity is generally treated as passive
income.
► Exceptions under recharacterization rules, e.g.:
► Rental of non-depreciable property
► Property rented for use in a non-passive activity
► Property rented incidental to development activity
Passive Activity Limitations Slide 16
Non-Passive Activity
► A non-passive activity is a trade or business activity in which the
taxpayer materially participates.
► Includes certain rental real estate activities of a qualifying real
estate professional
► Losses from a non-passive activity are not limited by the passive
activity limitations.
► Thus, non-passive losses are deductible currently subject to tax
basis, at-risk and other loss limitations.
Passive Activity Limitations Slide 17
Non-Passive Activity (Cont.)
► Portfolio income and deductions
► Portfolio income and deductions are generally not treated as from
a passive activity.
► Investment interest expense is subject to limitation under
§163(d).
► Investment expenses are subject to the 2% floor.
► I.e., such expenses are deductible only to the extent in
excess of 2% of AGI.
Passive Activity Limitations Slide 19
Material Participation Tests
► Material participation requires satisfying at least one of the following seven
tests:
► Participation in the activity exceeds 500 hours during the year.
► No pro ration for activity begun or terminated during the year
► Participation constitutes substantially all of the participation in the activity
of all individuals, including non-owners.
► Participation exceeds 100 hours and is at least as much as the
participation of any other individual, including non-owners.
► The activity is a “significant participation” activity, and total participation in
all “significant participation” activities exceeds 500 hours.
► A significant participation activity is an activity in which:
► Taxpayer’s participation exceeds 100 hours, and
► Taxpayer does not materially participate under any of the other
tests.
Passive Activity Limitations Slide 20
Material Participation Tests (Cont.)
► Other tests for material participation
► Taxpayer materially participated in any five of the prior 10 years.
► Activity is a “personal service activity,” and taxpayer materially
participated in any three years in the past.
► Based on all the facts and circumstances, taxpayer participates on
a “regular, continuous and substantial basis.”
► Managerial activities do not count unless:
► No other person who acts in a managerial capacity receives
compensation, and
► No other person spends more time than the taxpayer
performing managerial services.
► Participation must exceed 100 hours.
Passive Activity Limitations Slide 21
Material Participation Of Limited Partners
► Limited partners may achieve material participation only under the
following three of the seven tests:
► Participation of more than 500 hours
► Material participation in any five of prior 10 years
► Material participation in a personal service activity in any three
prior years
► LLC members – not addressed in regulations
► Case law favorable in not treating LLC members as limited
partners
► Court decisions in Gregg, Garnett, Thompson, Newell
► Proposed regulations look to rights to participate in management.
Passive Activity Limitations Slide 22
Material Participation: Special Rules
► Participation includes time spent by taxpayer’s spouse.
► Even if the spouse does not own an interest in the activity
► Even if taxpayer and spouse do not file a joint return
► Participation excluded
► Work not of a type customarily done by an owner if a principal purpose of
such work is to avoid disallowance under §469
► Unless the individual is directly involved in the day-to-day management or
operations, participation as an investor:
► Studying and reviewing financial statements or operations reports
► Preparing or compiling summaries or analyses of the finances or
operations for the individual’s own use, and
► Monitoring finances or operations in a non-managerial capacity
Passive Activity Limitations Slide 25
Grouping Activities
► Material participation is tested at the activity level.
► Can include activities conducted through partnerships and S
corporations, closely held and personal service C corporations
► Activity can be a trade or business activity or rental activity.
► A “trade or business activity” is an activity:
► Other than a rental activity
► Not incidental to an activity of holding property for investment, and
► Either:
► Involves the conduct of a trade or business under §162,
► Is conducted in anticipation of commencing a trade or business, or
► Involves research or experimental expenditures that are or would
be deductible under §174
Passive Activity Limitations Slide 27
Grouping Activities (Cont.)
► Taxpayers may aggregate multiple activities into a single activity or
fragment a single activity into multiple activities.
► Activity grouping must be an “appropriate economic unit.”
► Based on the facts and circumstances
► Regulations list five factors:
► Similarities and differences in types of trades or businesses
► Extent of common control
► Extent of common ownership
► Geographical location
► Inter-dependencies between or among the activities
Passive Activity Limitations Slide 28
Grouping Rental Activities
► Rental and trade or business activities generally cannot be
aggregated unless an “appropriate economic unit,” and:
► Rental activity is “insubstantial” in relation to trade or business
activity.
► Trade or business activity is “insubstantial” in relation to rental
activity.
► Identical ownership (permits aggregation only of the portion of the
rental to the trade or business activity)
► Real property and personal property rental activity cannot be
aggregated except rental of:
► Personal property provided in connection with real property, and
► Real property provided in connection with personal property
Passive Activity Limitations Slide 29
Grouping Activities (Cont.)
► Activity grouping is determined first at the pass-through entity level.
► Partners and S shareholders may aggregate other activities at the
owner level, but may not fragment a single activity at the pass-
through entity level into separate activities at the owner level.
► Limited partners and limited entrepreneurs may not aggregate
§465(c)(1) activities with any other activities.
► Motion picture films and video tapes
► Farming
► Leasing §1245 property
► Oil and gas resources
► Geothermal deposits
Passive Activity Limitations Slide 30
Grouping Activities: Consistency And Disclosure
► Once an activity grouping is adopted, it cannot be changed by the
taxpayer in a subsequent year unless:
► The original grouping was “clearly inappropriate,”
► The facts and circumstances have changed materially to make it
clearly inappropriate.
► New groupings and changes to old groupings must be reported on the
individual’s tax return.
► Rev. Proc. 2010-13, generally effective in 2011
► Anti-abuse rule: IRS can regroup if:
► Taxpayer’s grouping is not an appropriate economic unit, and
► A principal purpose of the grouping (or failure to regroup) is to
circumvent the underlying purposes of §469.
Passive Activity Limitations Slide 31
Grouping Activities: Rev. Proc. 2010-13
► The revenue procedure requires taxpayers to report certain changes
to the taxpayers groupings on their annual tax return.
► The disclosure is required in the following situations:
► New groupings
► Addition of new activities to existing groupings
► Regroupings
► Partnerships and S corporations are not subject to the disclosure
regime; instead, they must comply with disclosure instructions
provided for on Form 1065 and Form 1120S, respectively.
► The revenue procedure provides various rules in the event a taxpayer
fails to report.
Passive Activity Limitations Slide 33
Planning
► Material participation and non-passive treatment are not always
beneficial.
► Passive treatment is generally beneficial for activity with net
income.
► Beware recharacterization rules
► Non-passive treatment is generally beneficial for activity with net
losses.
Passive Activity Limitations Slide 34
Planning (Cont.)
► To achieve or avoid material participation, consider activity groupings that
may be permissible.
► E.g., perhaps a loss activity with no material participation can be
aggregated with another activity with material participation.
► Thus, loss activity is non-passive.
► Alternatively, perhaps a net income activity with material participation can
be fragmented into multiple activities with no material participation.
► Thus, net income activity is passive.
► Beware consistency rule
► Is new activity grouping precluded by prior year activity groupings?
► Will new activity grouping continue to be beneficial in future years?
Passive Activity Limitations Slide 35
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► Views expressed in this presentation are not necessarily those of Ernst & Young LLP.
Disclaimer
ISSUES WITH THE REAL ESTATE PROFESSIONAL DESIGNATION
Robert Barnett, Capell Barnett Matalon & Schoenfeld
Recent IRS Activity
• Hoskins, TCM 2013-36
• Hudzik, TC Sum. Op. 2013-4
• Kutney, TC Sum. Op. 2012-120
• Fitch, TCM 2012-358
• Harnett, 110 AFTR 2d 2012-6628
• Chambers, TC Sum. Op. 2012-91
• Jafarpour, TCM 2012-165
• Iovine, TC Sum. Op. 2012-32
• Manalo, TC Sum. Op. 2012-30
• Yano, TCM 2012-101
• Iverson, TCM 2012-19
37
Real Estate Professionals
• May treat rental real estate losses as non-passive
• §469(c)(7)(B)
• May use passive losses to offset active income – subject to material participation
requirements
• Employee must be more than a 5% owner.
39 39
Two Tests
• 1) More than one-half of the personal services performed in trades or businesses
by the taxpayer during such taxable year are performed in real property trades or
businesses in which the taxpayer materially participates, and
• 2) Such taxpayer performs more than 750 hours of services during the taxable
year in real property trades or business in which the taxpayer materially
participates.
The taxpayer must still materially participate in the activity, or that activity
is considered passive.
40
Real Property Trades Or Businesses
• Development, construction and reconstruction
• Acquisition and conversion
• Rental and leasing
• Operation and management
• Brokerage
41
Example
• Employee (not an owner) of a construction company
• Works 1,000 hours
• Works in his rental property 600 hours
• What about if he works 751 hours in rental property?
• Fails test!
• Must own at least 5%
42
750-Hour Test
• Do not count hours for 750-hour test unless materially participate
– Each real estate activity is treated separately.
– Consider aggregation election
– Must materially participate in each activity
– IRC does not require 750 hours for each activity.
43
Material Participation
• Regular, continuous and substantial
• Seven tests: Treas. Reg.
1.469-5T
• More than 500 hours is favorite
• Participation is substantially all of the participation in it by all individuals.
• Participates for more than 100 hours and not less than that of any other
individual
44
How Do You Prove Participation?
• Regs – any reasonable means
• Calendars, appointment books, logs
• Contemporaneous daily logs are not required if other reasonable means exist to
establish material participation.
• Participation as an investor requires day-to-day management or operation of the
activity.
45
Married
• Can count participation by spouse to meet material participation only
• Even if do not file joint return!
46
Miller v. Commissioner TC Memo 2011-219
• Two property losses not passive in 2005 and 2006
• Four property losses were passive.
• No penalty imposed
• H worked as a tugboat pilot
47
Miller v. Commissioner (Cont.)
• H had a contractor’s license.
• Kitchen remodeling, siding, decks, fences, etc.
• Wife – leases, advertising, research, bidding
• H – contemporaneous time sheets for contracting work but not
administrative work such as planning, ordering
• H rental maintenance and repair
48
Miller v. Commissioner (Cont.)
• Burden of proof – for a deduction
• Deficiency notice presumed correct
• Burden may shift to Commissioner, if certain conditions satisfied - §7491
• Petitioner did not claim that the burden was shifted.
49
Miller v. Commissioner (Cont.)
• Prove participation – by any reasonable means
• Not “ballpark estimate”
• Look at performance of both spouses, for material participation
• H performed more than 750 hours as a contractor and on rental properties.
• H performed more time on real estate than as a tugboat pilot.
50
Miller v. Commissioner (Cont.)
• Contemporaneous work logs, but
• Failed to aggregate
• Seven tests reviewed by the court
• Reasonable cause and good faith – no penalties
51
Rental Activities
• Treas. Reg. §1.469-1T(e)(3) – amounts received for use of tangible
property
• Except if average period of customer use is seven days or fewer
• Increased to 30 days or fewer if significant personal services are provided
by or on behalf of the owner (special rule for extraordinary personal
services)
• Except if the rental is “incidental to a nonrental activity of the
taxpayer”
52
Bailey v. Comm’r TC Summary Opinion 2011-22
• B&B inn having several buildings
• One property was rented for short term – average period of customer use
under 8 days
• Not counted for 750-hour test of real estate professional
53
Separate Activity
• Each interest in rental real estate is treated as a separate activity – subject to
the material participation requirements.
• Unless aggregation election
• Treat ALL rental realty as single activity
• Election makes it easier to meet the material participation requirement.
55
Anjum Shiekh TCM 2010-126
• Taxpayer had several rental properties.
• Claimed he was a real estate professional
• Required material participation for each activity
• IRS said he failed the material participation test for one property.
• Failed to present evidence of hours worked - use contemporaneous log
56
Schedule E
• Is not sufficient to constitute aggregation
• Need formal election and notice
• Net leases more troublesome
57
To Elect Or Not To Elect
• Do not make if have passive income from real estate and passive losses
from other activities, because you want to keep the income passive
• Do not include property to be sold
58
Election To Aggregate All
Rental Real Estate Interests
• Treasury Reg. §1.469-9(g)(3)
• Statement with return
• Taxpayer X, SSN 123-45-6789, is a qualifying taxpayer and hereby elects
pursuant to IRC §469(c)(7)(A) to treat ALL interests in rental real estate as
one activity.
59
Late Election
• Prior to Rev. Proc. 2011-34, PLRs 201126026 and 200728016 allowed taxpayers
to make late aggregation elections.
– Treasury Reg. §301.9100-3
• Acted reasonably and promptly
• Good faith – no prejudice to government
• Reasonable cause for failure
• Such as reliance on professional
60
Rev. Proc. 2011-34, 2011-24 IRB 875
• Allow late election
• Attach statement
• Filed consistently and timely
• Amend last filed return
• Identify year desired for election
61
Election Is Irrevocable
• Applies to all future years
• Unless a material change in circumstances
• Make the election if it results in utilization of losses that would otherwise be
suspended
62
The “Band-Aid”
This tax season:
• Consider utilizing Rev. Proc. 2011-34
• Consider all group possibilities
• Run the projections
• Don’t lose credibility; maintain records
• Watch Schedule E closely
63
New IRC
1411, 3.8% Surtax On Net
Investment Income
Background
Sect. 1411(a) imposes a 3.8% tax on the lesser of an individual’s:
- Net investment income, or
- The excess (if any) of –
• Modified adjusted gross income (MAGI) over
• A threshold amount.
Threshold amount
- $250,000 for taxpayers filing a joint return or surviving spouses
- $125,000 for married taxpayers filing separately
- $200,000 for other taxpayers
66
New IRC
1411, 3.8% Surtax On Net
Investment Income (Cont.)
Background (Cont.)
For estates and trusts,
1411(a)(2) imposes a 3.8% tax on
the lesser of:
- Undistributed net investment income, or
- The excess (if any) of –
• Adjusted gross income, over
• The dollar amount at which the highest tax bracket in
which
1(e) begins for the year.
68
New IRC
1411, 3.8% Surtax On Net
Investment Income (Cont.)
Background (Cont.)
Sec. 1411(c) defines “net investment income” as the excess (if any) of:
- The sum of:
• Gross income from interest, dividends, annuities, royalties and rents, other than such income which is derived in the ordinary course of a trade or business (emphasis added) described in
1411(c)(2);
• Other gross income derived from a trade or business described in 1411(c)(2); and
• Net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property other than property held in a trade or business not described in
1411(c)(2);
over
- The deductions allowed by Subtitle A of the Internal Revenue Code that are properly allocable to such gross income or net gain.
A trade or business is described in
1411(c)(2) if the trade or business is:
- A passive activity with respect to the taxpayer, or
- A trade or business of trading in financial instruments or commodities.
69
New IRC
1411, 3.8% Surtax On Net
Investment Income (Cont.)
Background (Cont.)
Disposition of an interest in an S corporation or partnership
(pass-though entity)
- Sect. 1411 (c)(4) provides that gain (or loss) from the
disposition of an interest in a pass-through entity is taken
into account under
1411(c)(1)(A)(iii) only to the extent of
the net gain (or net loss) that would be so taken into
account by the transferor, if all property of the pass-
through entity were sold for FMV immediately before the
disposition of such interest.
Sect. 1411(c)(6) provides that
1411 does not include any
item taken into account in determining self-employment
income.
70
Proposed
1411 Regulations, REG-
130507-11, Issued Dec. 5, 2012
Net Investment Income
Public hearing is scheduled for April 2, 2013.
Proposed regulations are generally scheduled to take effect
for tax years beginning after Dec. 3, 2013.
72
Proposed Reg.
1.1411-4, Net
Investment Income (NII)
Net Investment Income
NII includes gross income from rents, dividends, annuities,
royalties, rents, substitute interest payments and substitute
dividend payments, except to the extent derived in the ordinary
course of a trade or business.
- Level for determining whether gross income is derived in the
ordinary course of a trade or business
• Made at the individual level when the individual, estate,
or trust owns or engages in a trade or business directly
or indirectly through a disregarded entity (DE)
• Made at the entity level when the individual, estate or
trust owns or engages in a trade or business through
one or more pass-through entities
73
Proposed Reg.
1.1411-4, Net
Investment Income (NII), Cont.
Net Investment Income (Cont.)
Items of NII in
1411(c)(1)(A)(i) and Prop. Reg.
1.1411-4(a)(1)(i) that are portfolio income will, by definition, be included in
1411 because these portfolio items are not
derived in the ordinary course of a trade or business.
Self-charged interest, which is treated as passive income under Reg.
1.469-7, is subject to the surtax under
1411(c)(1)(A)(i).
Self-charged rent will be subject to the surtax under 1411(c)(1)(A)(i), if the gross rents are from an activity
described in Reg.
1.469-2(f)(6) that is not derived in the ordinary course of a trade or business.
Interest on working capital will generally be subject to the surtax under
1411(c)(1)(A)(i).
74
Proposed Reg.
1.1411-4, Net
Investment Income (NII), Cont.
Computation Of Net Gain
Net gain under
1411(c)(1)(A)(iii) does not include gain or loss
attributable to property (other than property from the investment of
working capital) held in a trade or business from other than a
passive activity.
- General rule
• A partnership interest or S corporation stock is not property
held in a trade or business.
- Level for determining whether net gain is attributable to property
held in a trade or business
• Made at the individual level if individual, estate or trust
owns or engages in trade or business, directly or indirectly,
through a DE
• Made at the entity level if individual, estate or trust owns an
interest through one or more pass-through entities 75
Proposed Reg.
1.1411-4, Net
Investment Income (NII), Cont.
Properly Allocable Deductions
Proposed Reg.
1.1411-4(f) provides that, unless specifically stated otherwise, only properly allocable deductions described in paragraph (f) may be taken into account in determining net investment income. These deductions include:
- Deductions allocable to gross income from rents and royalties under
62(a)(4)
- Deductions allocable to passive activities described in proposed Reg.
1.1411-5
- Investment interest expense (as defined in
163(d)(3))
- Investment expenses (as defined in
163(d)(4)(C))
- Taxes imposed under
164(a)(3)
76
Proposed Reg.
1.1411-4, Net
Investment Income (NII), Cont.
Properly Allocable Deductions (Cont.)
Except to the extent allowed under Chap. 1 (e.g., carryover of
excess investment interest expense), current-year deductions
in excess of NII may not offset NII in another year.
NOL carryovers and carrybacks are not deductible in
computing NII.
Itemized deductions may be allocated to NII only to the extent
they exceed the 2% floor on miscellaneous itemized
deductions and the overall limitation on itemized deductions.
Deductions allowed under proposed Reg.
1.1411-4(f) do not
include losses described in
165.
- Such losses are deductible only in determining net gain
under
1411(c)(1)(A)(iii).
77
Proposed Reg.
1.1411-5, Trades Or Businesses
To Which The
1411 Tax Applies
Provides that the
1411 tax applies to a trade or business
that is a passive activity
- Whether an activity is a trade or business is determined
under
162.
- Whether a trade or business is a passive activity is
determined under
469.
Sect. 469(c)(1) provides that a passive activity involves the
conduct of a trade or business activity in which the taxpayer
does not materially participate.
78
Proposed Reg.
1.1411-5, Trades Or Businesses
To Which The
1411 Tax Applies, (Cont.)
Note that under Reg.
1.469-4(b)(1), trade or business
activities are activities, other than rental activities (emphasis
added) or activities that are treated under Reg.
1.469-
1T(e)(3)(vi)(B) as incidental to an activity of holding property
for investment, that:
- (i) Involve the conduct of a trade or business (within the
meaning of Sect. 162),
- (ii) Are conducted in anticipation of the commencement of
a trade or business, or
- (iii) Involve research or experimental expenditures that
are deductible under
174 (or would be deductible if the
taxpayer adopted the method described in
174(a)).
• The proposed
1411 regulations do not appear to
follow subparagraphs (ii) and (iii), above.
79
Proposed Reg.
1.1411-5, Trades Or Businesses
To Which The
1411 Tax Applies, (Cont.)
To be engaged in a trade or business, the taxpayer must be
involved in the activity with continuity and regularity, and the
taxpayer’s primary purpose for engaging in the activity must be
for income or profit. (Groetzinger, Sup. Ct. 1987)
The rental of even a single property may constitute a trade or
business, under various provisions of the Code.
- Hazard (TC 1946) (1939 IRC
117)
- Post (TC 1956) (1939 IRC
117)
- Gilford (2d Cir. 1953) (1939 IRC
117)
- Schwarcz (TC 1955) (1939 IRC
122)
- Elek (TC 1958) (1939 IRC
122)
- Fegan (TC 1979) (
482)
- Pinchot (2d Cir. 1940) (1926 IRC
302)
- Flint (Sup. Ct. 1911)
80
Proposed Reg.
1.1411-5, Trades Or Businesses
To Which The
1411 Tax Applies, (Cont.)
Sect. 469(c)(2) provides that rental activities are automatically
deemed to be passive, for purposes of the passive activity
rules.
Sect. 468(j)(8) defines the term “rental activity” to mean any
activity in which payments are principally for the use of
tangible property.
- See Reg.
1.469-1T(d)(3)(ii) for certain exceptions
Sect. 469(c)(7) provides an exception for real estate rental
activities conducted by certain real estate professionals.
- This exception provides that the qualified rental real
estate activity is not per se passive.
- Note that a qualified real estate professional must still
materially participate in his real estate rental activities to
have this exception to the passive loss rules apply.
81
Proposed Reg.
1.1411-5, Trades Or Businesses
To Which The
1411 Tax Applies, (Cont.)
The proposed regulations generally follow the taxpayer’s grouping
rules to determine whether a taxpayer materially participates in a
trade or business activity, for purposes of
1411.
- Proposed Reg.
1.469-11(b)(3)(iv)(A) would allow an individual,
estate or trust to regroup its activities, without regard to the
manner in which the activities were grouped in the preceding
taxable year, in the first taxable year beginning after Dec. 31,
2013 in which
1411 would apply to such taxpayer.
A proper grouping under Reg.
1.469-4(d)(1) (grouping rental
activities with other trade or business activities) will not convert
gross income from rents into other gross income derived from a
trade or business described in Prop. Reg.
1.1411-5(a)(1).
- Gross income from the rental activity must derived in the
ordinary course of a trade or business under
162 in order to
escape taxation under
1411.
82
Proposed Reg.
1.1411-5, Trades Or Businesses
To Which The
1411 Tax Applies, (Cont.)
Example 1: Rental Activity
A, an unmarried individual, rents a commercial building to B for
$50,000 in Year 1. A’s rental activity does not involve the conduct
of a
162 trade or business, but under
469(c)(2), A’s rental
activity is a passive activity. Because the rental activity does not
satisfy the trade or business requirement of proposed Reg. 1.1411-5(b)(1)(i), A’s rental income of $50,000 will not constitute
NII under
1411(c)(1)(A)(i). A’s rental income of $50,000 will still
constitute gross income from rents within the meaning of 1411(c)(1)(A)(i), however, because this provision does not
require a trade or business.
83
Proposed Reg.
1.1411-5, Trades Or Businesses
To Which The
1411 Tax Applies, (Cont.)
Example 2: Application Of Grouping Rules Under
469
In Year 1, A, an unmarried individual, owns an interest in PRS, which is a
partnership for federal income tax purposes. PRS is engaged in two
activities, X and Y, which constitute trades or businesses (within the
meaning of
162), neither of which constitute trading in financial
instruments or commodities. Pursuant to Reg.
1.469-4, A has properly
grouped X and Y (the grouped activity). A participates in X for more than
500 hours during Year 1 and would be treated as materially participating
in the activity, within the meaning of Reg.
1.469-5T(a)(1). A only
participates in Y for 50 hours during Year 1 and, but for the grouping of
the two activities together, would not be treated as materially
participating in Y within the meaning of Reg.
1.469-5T(a). Pursuant to 1.469-4 and 1.469-5T(a)(1), however, A materially participates in the
grouped activity, and therefore for purposes of proposed Reg.
1.1411-
5(b)(1)(ii), neither X nor Y is a passive activity with respect to A.
Accordingly, with respect to A, neither X nor Y is a trade or business
described in proposed Reg.
1.1411-5(b)(1).
84
Proposed Reg.
1.1411-5, Trades Or Businesses
To Which The
1411 Tax Applies, (Cont.)
Example 3: Application Of The Rental Activity Exceptions
B, an unmarried individual, is a partner in PRS, which is engaged in an
equipment leasing activity. The average period of customer use of the
equipment is seven days or fewer (and therefore meets the exception in
Reg.
1.469-1T(e)(3)(ii)(A)). B materially participates in the equipment
leasing activity (within the meaning of Reg.
1.469-5T(a)). The
equipment leasing activity constitutes a trade or business within the
meaning of
162.
In Year 1, B has modified adjusted gross income (as defined in proposed
Reg.
1.1411-2(c)) of $300,000, all of which is derived from PRS. All of
the income from PRS is derived in the ordinary course of the equipment
leasing activity, and all of PRS’ property is held in the equipment leasing
activity. Of B’s allocable share of income from PRS, $275,000 constitutes
gross income from rents (within the meaning of proposed Reg.
1.1411-
4(a)(1)(i)).
85
Proposed Reg.
1.1411-5, Trades Or Businesses
To Which The
1411 Tax Applies, (Cont.)
Example 3: Application Of The Rental Activity Exceptions (Cont.)
While $275,000 of the gross income from the equipment leasing activity meets
the definition of rents in proposed Reg.
1.1411-4(a)(i), the activity meets one
of the exceptions to rental activity in Reg.
1.469-1T(e)(3)(ii), and B materially
participates in the activity. Therefore, the trade or business is not a passive
activity with respect to B for purposes of proposed Reg.
1.1411-5(b)(1)(ii),
and because the rents are derived in the ordinary courses of a trade or
business, the ordinary course of a trade or business exception in proposed
Reg.
1.1411-4(b) applies, which means that the rents are not subject to
proposed Reg.
1.1411-4(a)(1)(i). Furthermore, because the equipment
leasing trade or business is not a trade or business described in proposed
Reg.
1.1411-5(a)(1) or (a)(2), the $25,000 of other gross income is not
subject to proposed Reg.
1.1411-4(a)(1)(ii). Finally, gain or loss from the sale
of the property held in the equipment leasing activity will not be subject to
proposed Reg.
1.1411-4(a)(1)(iii), because although it is attributable to a
trade or business, it is not a trade or business to which the
1411 tax applies.
87
Proposed Reg.
1.1411-5, Trades Or Businesses
To Which The
1411 Tax Applies, (Cont.)
Example 4: Application Of
469 And Other Gross Income
Under Proposed Reg.
1.1411-4(a)(1)(ii)
Use the same facts as Example 3, except that B does not materially
participate in the equipment leasing trade or business, and therefore the trade
or business is a passive activity with respect to B for purposes of proposed
Reg.
1.1411-5(b)(1)(ii). Accordingly, the $275,0000 of gross income from
rents is subject to proposed Reg.
1.1411-4(a)(i), because the rents are
derived from a trade or business described in proposed Reg.
1.1411-5(a)(1)
(that is, the ordinary course of a trade or business exception in proposed Reg. 1.1411-4(b) is inapplicable). Furthermore, the $25,000 of other gross income
from the equipment leasing trade or business is subject to proposed Reg. 1.1411-4(a)(1)(ii), because that income is derived from a trade or business
described in proposed Reg.
1.1411-5(a)(1). Finally, gain or loss from the sale
of the property used in the equipment leasing trade or business is subject to
proposed Reg.
1.1411-4(a)(1)(iii), because the trade or business is a passive
activity with respect to B.
88
Proposed Reg.
1.1411-5, Trades Or Businesses
To Which The
1411 Tax Applies, (Cont.)
Example 5: Application Of The Portfolio Income Rule And
469
C, an unmarried individual, is a partner in PRS, a partnership engaged in a trade or
business (within the meaning of
162) that does not involve a rental activity. C does not
materially participate in PRS within the meaning of Reg.
1.469-5T(a), and therefore
the trade or business of PRS is a passive activity with respect to C for purposes of
Prop. Reg.
1.1411-5(a)(1). C’s $500,000 allocable share of PRS’ income consists of
$450,000 of gross income from a trade or business and $50,000 of gross income from
dividends and interest (within the meaning of proposed Reg.
1.1411-4(a)(1)(i)) that is
not derived in the ordinary course of the trade or business of PRS. Thus, under 469(e)(1)(A)(i)(1) and the regulations thereunder, C’s allocable share of gross income
from dividends and interest consists of portfolio income. Therefore, C’s $500,000
allocable share of PRS’ income is subject to
1411. C’s $50,000 allocable share of
PRS’ income from dividends and interest is subject to proposed Reg.
1.1411-4(a)(1)(i),
because the share is gross income from interest and dividends that is not derived in the
ordinary course of a trade or business (that is, the ordinary course of a trade or
business exception of proposed Reg.
1.1411-4(b) is inapplicable). C’s $450,000
allocable share of PRS’ income is subject to proposed Reg.
1.1411-4(a)(1)(ii),
because it is gross income from a trade or business that is a passive activity.
89