Presenting a live 110 minute teleconference with interactive Q&A Passive Activity Loss Rules: Strategies for Pass Throughs to Maximize Deductions Leveraging Latest Federal Guidance and Rulings to Establish Material Participation WEDNESDAY, MAY 25, 2011 1pm Eastern 12pm Central 11am Mountain 10am Pacific Today s faculty features: Sarah Staudenraus, Partner, Pass-Throughs and Special Industries Group, KPMG, Washington, D.C. Sandra Hernandez, Managing Director, WTAS, Los Angeles Jeanne Sullivan, Director, National Pass-Throughs Group, KPMG, Washington, D.C. For this program, attendees must listen to the audio over the telephone. Please refer to the instructions emailed to the registrant for the dial-in information. Attendees can still view the presentation slides online. If you have any questions, please contact Customer Service at1-800-926-7926 ext. 10.
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Strategies for Pass Throughs h to Maximize i Deductions Seminar May 25, 2011 Sarah Staudenraus, KPMG sarahstaudenraus@kpmg.com Jeanne Sullivan, KPMG jsullivan@kpmg.com Sandra Hernandez, WTAS LLC sandra.y.hernandez@wtascom
Today s Program Overview Of Passive Activity Loss Rules Re: Partners [Sarah Staudenraus, Jeanne Sullivan and Sandra Hernandez] Slide 7 Slide 33 Exceptions And Nuances In Sect. 469 [Sarah Staudenraus, Jeanne Sullivan and Sandra Hernandez] Slide 34 Slide 48 Reporting Requirements And The Latest Rev. Proc. [Sarah Staudenraus, Jeanne Sullivan and Sandra Hernandez] Slide 49 Slide 54
Sarah Staudenraus, KPMG Jeanne Sullivan, KPMG Sandra Hernandez, WTAS LLC OVERVIEW OF PASSIVE ACTIVITY LOSS RULES RE: PARTNERS
Notice ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY THE PRESENTERS 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. 8
Dated Material THE MATERIAL CONTAINED IN THESE COURSE MATERIALS IS CURRENT AS OF THE DATE PRODUCED. THE MATERIALS HAVE NOT BEEN AND WILL NOT BE UPDATED TO INCORPORATE ANY TECHNICAL CHANGES TO THE CONTENT OR TO REFLECT ANY MODIFICATIONS TO A TAX SERVICE OFFERED SINCE THE PRODUCTION DATE. 9
Partner Loss Limitations: Significance Losses are subject to the following limitations: Partnership basis rules (Sect. 704(d)) At-risk rules (Sect. 465) Passive activity loss rules (Sect. 469) A taxpayer can never deduct more losses than the amount that flows through from the prior limit. 10
Partner Loss Limitations: Overview I. Basis limitations under Sect. 704(d) A. Limits a partner s deduction of partnership losses to outside adjusted tax basis B. Does not limit the allocation of losses II. At-risk limitations under Sect. 465 A. Limits losses from an activity to amount at-risk B. Partnership may have more than one activity III. Passive activity loss limitations under Sect. 469 A. Limits losses from passive activities to passive income from all sources 11
Loss Limitation Ordering Rule: Example Partner s outside basis in partnership interest $ 50,000 Partner s at-risk Limitation $ 35,000 Partner s share of partnership p losses (passive) $ (60,000) Partner s passive income (other sources) $ 25,000 Partner can deduct $(25,000) of passive loss on return calculated as follows: Loss Suspended Allowable Allowed 704(d) $(60,000) $(10,000) $(50,000) 465 $(50,000) $(15,000) $(35,000) 469 $(35,000) $(10,000) $(25,000) (25,000) 12
Overview I. Sect. 469 disallows a passive activity loss for the year, with one exception: A. Certain taxpayers may deduct up to $(25,000) passive activity loss for rental real estate activities. II. A passive activity loss is the amount by which the aggregate losses from all passive activities exceed aggregate g income from all passive activities. A. The purpose of Sect. 469 is to prevent taxpayers from using losses from passive activities to offset salary and investment income. B. The limitation is applied by each partner, not at the partnership level. 13
Types Of Income I. Sect. 469 divides income into three categories: II. 1. Active - Income from activities in which the taxpayer materially participates, including activities in which wages or salaries are earned 2. Portfolio Investment income such as annuities, royalties, interest, dividend, capital gains/losses, guaranteed payments for interest on capital 3. Passive - Income from activities in which the taxpayer does not materially participate Net income from each category is subject to tax. III. Net loss from passive activities is generally not currently deductible. A. Rental real estate allowance exception B. Oil and gas activity exception C. Suspended losses deductible on fully taxable disposition 14
What Is Non Passive Income? I. The following income is not considered d passive: A. Portfolio (investment) income B. Gain or loss from investment property C. Income from intangibles created by taxpayer D. Personal service income E. Income from a covenant not to compete F. Tax refunds G. Recharacterized income H. Activity of trading personal property for the accounts of owners of the activity 15
Suspended d Loss Carryovers I. Sect. 469 allows the deduction d of losses from passive activities iti to the extent of aggregate income from passive activities in the year. II. The excess aggregate loss (the passive activity loss ) is disallowed and carried forward. A. No limit on the carryforward B. Carried forward losses are treated as incurred in the following year. C. Suspended losses become non-passive on disposition of the activity. 16
Who Is Subject To Sect. 469? I. Individuals II. Estates and trusts III. Closely held C corporations A. Special rules: Passive losses may offset active income but not portfolio income. IV. Personal service corporations V. Partnerships and S corporations are not subject to Sect. 469 loss limitations. A. However, partners and shareholders may be subject to the rules with respect to their distributive share of partnership income/losses. 17
What Is A Passive Activity? i I. Any trade or business in which the taxpayer does not materially participate II. Most rental activities A. Special definition of rental B. For real estate professionals, a rental real estate activity in which taxpayer does not materially participate. 18
What Is A Rental Activity? i I. Rental activities iti for Sect. 469 do not include the following activities: 1. Short-term rentals where the average use is 7 days or less 2. Rentals where the average use is 30 days or less, and there are significant personal services 3. Rentals that involve extraordinary personal services (rental incident to services) 4. Incidental rentals 5. Non-exclusive use by customer 6. Property provided to flow-through entities 19
What Is An Activity? i I. Generally, an activity it is one or more business undertakings. A. Several business undertakings that together form an appropriate economic unit may constitute an activity, or B. A segregated g business undertaking may itself constitute t an activity. II. Determined based on all facts and circumstances III. Grouping is subject to certain parameters. 20
Why Is It Important To Define The Activity? I. Level of participation i determined d for each activity it A. It may be easier to meet material participation standard if separate undertakings are combined. II. Suspended loss is allowed upon the disposition of all or a substantial portion of an activity. A. May be easier to free up losses, if separate undertakings have not been combined as one activity III. Passive loss and credit carryovers are tracked separately for each activity. 21
Limitations On Grouping Activities I. Sect. 469 entities (partnerships, closely held C corp, S corp) II. 22 A. Must perform the first grouping of the entity s activities B. Taxpayers cannot treat activities grouped together by the Sect. 469 entity as separate, but may group that activity with other activities of the taxpayer. Taxpayers cannot group: A. Rental activities with other trade or business activities (with some exceptions) B. Real property rentals with personal property rentals (with some exceptions) C. Activities of limited partners and limited entrepreneurs (applies to motion pictures, farming, leasing, oil and gas, geothermal deposits)
Grouping Consistency Requirement I. Taxpayer may not regroup activities in subsequent years, unless the original grouping was clearly inappropriate or there has been a material change in facts. II. Commissioner may regroup if taxpayer s groupings fail to reflect appropriate economic units, and primary purpose was to circumvent Sect. 469. 23
Does Taxpayer Materially Participate? I. There are seven tests t for material participation i for nonlimited partners. 1. Taxpayer participated i t more than 500 hours 2. Taxpayer participation was substantially all of the hours 3. Participation was >100 hours and more than anyone else 4. Taxpayer s participation in significant participation activities exceeded 500 hours 5. Nickel and dime test (materially participated 5 of last 10 years) 6. Personal service activity (any 3 years) 7. Facts and circumstances test (and > 100 hours) 24
What Does It Mean To Participate? i I. Regular, continuous and substantial ti involvement II. Generally, any work in an activity done by an individual who owns an interest t in the activity it A. Includes spouse s participation III. Exceptions A. Work not customarily done by owners if principal purpose is avoidance of Sect. 469 B. Work done as an investor, unless involved in daily operations 25
Participation By Limited Partners I. Limited partners determine material participation using three of the tests. 1. Taxpayer participated more than 500 hours 2. Nickel and dime test (materially participated 5 of last 10 years) 3. Personal service activity (any 3 years) II. If limited partner also owns a general partner interest, then limited partner is treated as a general partner. III. What about LLC members? See Garnett, 132 T.C. 368 (2009); Thompson, 87 Fed. Cl. 728 (2009); Newell, TC Memo. 2010-23 26
Passive Activity Loss Limitations: Impact I. Passive losses are only deductible d against passive income. II. If there is an aggregate passive loss, then each passive loss is carried forward indefinitely. it III. $25,000 exception for active participation in rental real estate A. Phases out for income over $100,000 IV. Unused suspended losses are deductible upon a complete disposition in a taxable transaction. 27
Recharacterization i Of Net Income I. Gains from formerly non-passive activities II. Rental of non-depreciable propertyp III. Equity-financed lending activity IV. Licensing intangible property V. Incidental-to-development t d l t VI. Rentals to a related non-passive activity VII.Significant participation p activities (SPAs) 28
Significant ifi Participation i i Activities i i I. Taxpayer participates more than 100 hours (but less than 500 hours) in each of several trade or business activities, and total participation in such activities exceeds 500 hours. II. If passive gross income from all significant participation activities exceeds passive activity deductions from all such activities, a portion of the net passive income is treated as non-passive. 29
State Conformity? I. Taxpayers and preparers p must consider potential non- conformity to federal rules in any state in which they are required to file. II. Do not assume federal = state 30
State Conformity? (Cont.) I. How do states conform to IRC 469? A. General conformity to IRC 1. No mention of passive activity losses in statutes or regulations B. Specific conformity to IRC 469 C. Conformity with exceptions to IRC 469 31
State Conformity? (Cont.) I. Some states have their own version of passive activity loss rules (e.g., New Jersey and Pennsylvania). A. Classify income into various categories or baskets B. Losses from one category cannot offset another category 32
State Conformity? (Cont.) I. Additional issues to consider A. Resident vs. non-resident 1. Most states will allow a passive activity loss of a nonresident only if they are derived from or connected with sources within the state. B. Different filing status for state purposes 1. Is the loss clearly attributable to one spouse? 33
Sarah Staudenraus, KPMG Jeanne Sullivan, KPMG Sandra Hernandez, WTAS LLC EXCEPTIONS AND NUANCES IN SECT. 469
Effect On Medicare Contribution Tax (MCT) I. Beginning in 2013, a tax of 3.8% will apply to net investment income of individuals, estates and trusts (MCT). II. Net investment income includes: Portfolio-type income + Income from passive activities as defined in Sect. 469 + Income from the trade or business of trading in financial instruments or commodities 35
Consider The Medicare Contribution Tax Grouping under Sect. 469 will affect whether trade or business activities are: Active (and excluded from the MCT), or Passive (and included for the MCT). Further, net passive losses will not reduce non-passive net investment income for purposes of the MCT. 36
Real Estate Professional Exception I. If a taxpayer qualifies as a real estate professional : A. Rental activities are not per se passive and A. The taxpayer can elect to group all rental activities as a single activity, for purposes of qualifying as materially participating in the rental activity. The election applies for all years in which the taxpayer is a real estate professional. 37
What Is A Real Estate Professional? I. Two-pronged test (each prong having sub-tests): 1. More than half of personal services performed in trades or businesses 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 in real property trades or businesses in which the taxpayer materially participates. 38
Real Property Trades Or Businesses I. Real property trade or business: Any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing or brokerage trade or business A. What is a rental? Treas. Reg. Sect. 1.469-1T(e)(3)(ii) B. Closely held C corp is in a real property trade or business if more than 50% of gross receipts are derived from real property trades or businesses in which the corporation materially participates. C. Services performed by an employee are not performed in real property trades or businesses unless performed by a 5% owner in the employer. 39
Real Estate Professional I. Recent cases on real estate professionals: Todd D. Bailey Jr., et ux. v. Commissioner, T.C. Summ. Op. 2011-22); Bosque v. Commissioner, T.C. Memo 2011-79 A. The taxpayer (without counting spouse s hours) must materially participate in real estate trades or businesses for the required number of hours. B. If the real estate trade or business is rental, it must qualify as a rental activity (real estate rented for more than 7 days on average), and the taxpayer must establish material participation in the rental activity. C. An activity of leasing real estate for 7 days or less on average is not treated as a real estate trade or business, for this purpose. p 40
Self Charged Interest Rules I. If a taxpayer lends money to a partnership or S corp in which the taxpayer owns an interest, or vice versa, the taxpayer will have interest income and expense related to the loan. If the proceeds of the loan are used in a passive activity, there could be a mismatch between the passive deductions d generated and the portfolio interest t income from the loan. These are self-charged interest deductions that the regulations intend to allow to offset. The regulations also apply to guaranteed payments for the use of capital under Sect. 707(c). II. The regulations recharacterize the applicable percentage of the interest t income and/or the interest t expense as arising i from a passive activity. A. See Treas. Reg. Sect. 1.469-7 for calculations and examples 41
Self Charged Interest Rules: Example A $5,000 Interest Income $2,500 Interest Expense Loan PRS I. A lends money to a partnership (PRS) in which A owns a 50% interest. II. PRS pays A $5,000 interest and allocates $2,500 to A as an interest expense deduction allocable to a passive activity in Year 1. III. A s applicable percentage of the interest income is 50%, and $2,500 of A s interest income is recharacterized as income from a passive activity. IV. The balance of the interest income is portfolio income. 42
Former Passive Activities i i I. Losses from former passive activities may offset only income from the (now active) activity. The remaining suspended loss is allowed if the taxpayer disposes of the activity in a fully taxable transaction to an unrelated person. A. According to the House Committee Report, Revenue Reconciliation Act of 1993, if a taxpayer has a suspended passive loss (e.g. from rental activities) and qualifies as a real estate professional, then the suspended loss is treated as a loss from a former passive activity. B. Other situations include: 1. Contribution of the passive activity to a corporation 2. Closely held C corp no longer subject to Sect. 469 43
Oh Other Special Rules I. Closely-held l ld C corporations A. Passive activity deductions can offset net active income. B. Any excess passive activity loss is suspended at the C corp level. C. Material participation: One or more shareholders holding more than 50% by value of stock must materially participate in the corporation s activity. 1. See also Sect. 465(c)(7)(C) for non-personal service corporations 44
Oh Other Special Rules (Cont.) I. Oil and gas interests t A. A working interest in an oil and gas property, which the taxpayer holds directly or through an entity that does not limit liability, is not a passive activity. II. Publicly traded partnerships (PTPs) A. Passive loss rules apply separately to each interest in a PTP (e.g., PTP losses can only offset income from such PTP). B. A complete disposition is a disposition of the entire interest in partnership. 45
Disposition Of Passive Activity By Sale Or Exchange Type Of Disposition General Treatment Fully taxable disposition with an Suspended losses are deductible. unrelated party Fullytaxable disposition with a Losses remain suspended until the activity is related party acquired by an unrelated party. Disposition in a non recognition transaction In general, suspended losses attach to the replacement activity. Installment sale Suspended losses recognized in same ratio as gain is recognized Partial disposition, fully taxable, Generally losses remain suspended. If unrelated party disposition is substantially all of activity, a portion of losses may be deductible. Death of taxpayer py Suspended losses in excess of the basis step up, if any, are deductible in the final year. 46
Disposition Of Passive Activity By Sale Or Exchange (Cont.) Type Of Disposition Gift Divorce Distribution by trustor estate General Treatment Suspended losses are eliminated for the donor, but added to the basis donee takes in property. Suspended losses are eliminated for the forfeiting spouse, but are added to the basis recipient spouse takes in property. Suspended losses not deductible by estate/trust. Basis of activity is increased by suspended losses immediately before distribution. 47
State Conformity Nuances I. In California, IRC 469(c)(7) does not apply (CTRC 17561). A. The election to aggregate rental real estate holdings is not available. B. All rental activities are treated as passive. II. Passive activity loss limitations can affect state modifications. A. In Maine, depreciation adjustments are limited in the same ratio limited for federal 48
Sarah Staudenraus, KPMG Jeanne Sullivan, KPMG Sandra Hernandez, WTAS LLC REPORTING REQUIREMENTS AND THE LATEST REV. PROC.
Passive Activity Loss Grouping: Rev. Proc. 2010 13 Grouping Disclosures I. Individuals: id For tax years beginning i on or after Jan. 25, 2010, Rev. Proc. 2010-13 requires written annual return disclosures: 1. In the first year in which two or more passive activities are grouped as a single activity 2. In a year in which a passive activity is added to the grouping 3. In a year in which the taxpayer determines that the original grouping was clearly inappropriate or there has been a material change in the facts and circumstances that t makes the original i grouping clearly inappropriate. II. However, a partner or S corporation shareholder need not make any additional disclosures unless the partner/shareholder groups the Sect. 469 entity s activities that were not grouped by the entity, or groups an activity of the Sect. 469 entity with other activities conducted directly (or indirectly through other Sect. 469 entities). 50
Passive Activity Loss Grouping: Rev. Proc. 2010 13 Grouping Disclosures (Cont.) I. Sect. 469 entities: Annual activity grouping disclosures required in accordance with the instructions for forms 1065 and 1120(S) II. Forms require separate activity reporting: 17 items required for each activity III. Does reporting net income/loss on Schedule K, Line 1 amount to a grouping or not? 51
Passive Activity Loss Grouping: Rev. Proc. 2010 13 Grouping (Cont.) I. Grandfather rule for individual taxpayer groupings prior to the effective date of Rev. Proc. 2010-13 need not be disclosed unless the individual taxpayer: A. Adds a new passive activity to the group, B. Determines that the original grouping was clearly inappropriate, or C. Determines there has been a material change to the facts and circumstances that makes the original grouping clearly inappropriate. II. Grandfather rule does not appear to be applicable to partnership disclosures. 52
Passive Activity Loss Grouping: Rev. Proc. 2010 13 Grouping (Cont.) I. If a taxpayer fails to disclose a grouping that is required to be disclosed under Rev. Proc. 2010-13, then each trade or business will be treated as a separate activity (unless the IRS regroups under anti-avoidance rule of Treas. Reg. Sect. 1.469-4(f)). A. Does this rule also apply to partnerships? 53
State Reporting I. In California, as IRC 469(c)(7) does not apply, rental real estate holdings can not be aggregated and must be separately tracked. II. Taxpayer aggregating multi-state properties A. Issues upon disposition III. State ramifications are not always identical to federal. 54