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Chapter 17: Passive activities and at-risk rules.

WHAT IS IT?

The passive activities and at-risk rules provide hurdles that taxpayers must overcome in order for certain losses to offset other sources of income in a given year. The at-risk rules are applied after the basis limitation provisions that are discussed further in Chapter 20. If a taxpayer's loss passes the basis and at-risk limitation tests, the passive activity rules are applied. The at-risk rules focus on the taxpayer's investment (risk) in the venture, while the passive rules focus on the nature of the taxpayer's involvement in the venture. Losses may be suspended (i.e., can't be utilized in the current year but are not lost and may be used at a future date) at any or all of these levels.

Taxpayers often invest substantial amounts of money into ventures without being aware of the potential tax impact of these limitations. If a taxpayer expects losses from an investment to automatically offset their other sources of income, they may be in for a bad surprise.

This situation comes up very often with an investment in real estate. Since the depreciation on a property often outpaces the amortized principal in the early years, a property may throw off a positive cash flow but report a taxable loss. That taxable loss must meet the tests of each of the three limitation rules before the taxpayer can claim any of the loss as an offset to their taxable income.

INTRODUCTION TO THE AT-RISK LIMITATION RULES

The at-risk limitation rules were added to the Internal Revenue Code with the Tax Reform Act of 1976. Prior to the addition of these rules, taxpayers were allowed to deduct losses from investment activities to the extent of their basis, which is determined by adding the taxpayer's:

1. actual cash investment,

2. adjustments from the results of operations,

3. liabilities the taxpayer is obligated to pay (recourse), and

4. costs financed through nonrecourse loans that the taxpayer will not be obligated to pay personally.

The enactment of the at-risk rules was the first major attempt by Congress to deal with the growing number of tax shelters. Tax shelters were a popular way for investors to take advantage of their ability to deduct losses up to their basis in the investment. The taxpayer's basis, however, was often increased by liabilities that the investor would never be called upon to pay in the event the business failed.

Initially, the at-risk rules were applied only to investments in five activities that were perceived to be the most abusive tax shelters. The five original activities subject to the at-risk limitation rules were: (1)

1. farming,

2. exploring for or exploiting oil and gas resources,

3. holding, producing, or distributing motion picture films or videotapes,

4. equipment leasing, and

5. exploring for or exploiting geothermal deposits.

In 1978, the at-risk limitation rules were extended to all other investment activities except real estate. Finally, in 1986, the at-risk rules added real estate activities to the scope of activities covered by IRC Section 465. (2) The at-risk rules continue to apply under today's law and cover all investment activities.

INTRODUCTION TO THE PASSIVE ACTIVITY LOSS LIMITATION RULES

In a further effort to curb perceived abuses with the growing use of tax shelters, Congress enacted the passive activity loss (PAL) rules with the Tax Reform Act of 1986. At the time, tax shelters were being marketed to investors with the purpose of generating losses to offset high-income taxpayers' salaries and wages. Back in 1986, the highest marginal tax rate was 50%, so a great deal of tax savings was at stake.

Although the number of abusive tax shelters may have been reduced, in part, by these rules, they have cast a much wider net and many taxpayers who have not invested in tax shelters still have to deal with the PAL limitations each year when they file their tax return. The PAL rules are contained in IRC Section 469 and the corresponding regulations.

The PAL rules apply to any individual, estate, trust, certain closely held C corporations, and personal service corporations. (3) A passive activity can be practically any business or rental activity owned by a taxpayer directly or held by a taxpayer in a flow-through entity such as a partnership, limited liability company, or S corporation.

TAX IMPLICATIONS

At-Risk Rules

The at-risk limitations are applied to individual taxpayers and closely held corporations. Closely held corporations are defined as one having five or fewer shareholders owning more than 50% of the corporation's stock during the last half of the tax year. (4) For flow-through entities, such as partnerships, certain limited liability companies, and S corporations, these limitations are applied at the individual partner, member, or shareholder level.

The at-risk rules limit deductions for borrowing that attempt to be characterized as "at-risk" for tax purposes when there is no actual economic risk to the investor. For instance, assume Georgia wants to purchase a $100,000 interest in an oil drilling venture. She intends to invest $20,000 of her own funds while borrowing the $80,000 balance. The bank providing the loan to Georgia has agreed to make a "nonrecourse" loan to her. In other words, the bank will rely solely on the value of the property as its collateral for the debt. In the event Georgia cannot repay the loan, the bank cannot look to Georgia's other assets to cover the unpaid balance. Since the most Georgia can lose on her investment is $20,000 in cash, her deductions will be limited to that $20,000 (plus the amount of income generated from the investment).

The amount at-risk for a given activity is the combined total amount of money and the adjusted basis of other property contributed with respect to the activity and amounts borrowed with respect to the activity. (5) However, in order for an individual to be treated as at-risk for amounts borrowed by the entity owning the activity, the individual must be personally liable for the repayment of the borrowed amounts or pledge property outside the investment as security. (6) The courts have interpreted this to mean that the individual must have the ultimate liability for the repayment of the debt.

The at-risk rules cover essentially all investment activities (except for real estate acquired before 1987). With respect to real estate subject to the at-risk rules, "qualified nonrecourse financing" is treated as an additional amount at-risk. Qualified nonrecourse financing is any debt incurred that:

1. Is borrowed for the holding of real property;

2. Is borrowed from a "qualified person" (one in the business of lending money, such as a bank or savings and loan institution) or represents a loan from any federal, state, or local government or instrumentality thereof, or is guaranteed by any federal, state, or local government,

3. Holds no person personally liable for repayment, and

4. Is not convertible debt. (7)

An investor is considered at-risk to the extent of:

1. Cash invested, plus

2. The basis of property invested, plus

3. Amounts borrowed for use in the investment that are secured by the investor's assets (other than the property used in the investment activity), plus

4. Amounts borrowed to the extent the investor is personally liable for its repayment, plus

When the investment is made in partnership form--

1. The investor-partner's undistributed share of partnership income, plus

2. The investor-partner's proportionate share of partnership debt, to the extent he is personally liable for its repayment.

An investor is not considered "at-risk" with respect to nonrecourse debt (other than qualified nonrecourse financing, see above) used to finance the activity, or to finance the acquisition of property used in the activity, or with respect to any other arrangement for the compensation or reimbursement of any economic loss. For example, if Georgia is able to obtain commercial insurance against the risk that the oil drilling fund will not return her original $20,000 cash investment, she would not even be considered "at-risk" on that amount.

If a taxpayer does not have sufficient amounts at-risk in a given activity, the deductibility of the losses from that activity are limited to the amount at-risk. Any excess losses are carried forward to future years and may be utilized to offset future income from the activity or be deducted when the taxpayer adds amounts to the activity for which the taxpayer is deemed to be at-risk.

A taxpayer who previously deducted losses from an activity based upon amounts that were at-risk in a prior year may be required to recapture those losses if the amount that a taxpayer has at-risk falls in a future year. (8) This can happen if the taxpayer used a certain amount of liabilities as an amount at-risk to deduct losses to the full extent of the amount at-risk. If the subsequent principal repayments of the liability reduce the amount at-risk below zero, they would need to be recaptured in that year.

Taxpayers with losses from activities with amounts not at-risk are required by the IRS to complete and file with their tax return Form 6198, At Risk Limitations. (9)

Passive Activity Rules

In general, losses from passive activities are deductible in a given year to the extent the passive activity income exceeds the losses from passive activities. Passive activity losses in excess of passive activity income are suspended. Suspended passive activity losses are carried forward indefinitely to future years to offset future income from passive activities. PALs may not be used to offset other nonpassive income such as salaries, investment income, or capital gains. However, passive losses from one activity can generally be offset with passive income from a different activity.

Credits from passive activities are also disallowed unless there is net passive income in a given year. Like PALs, these credits are carried forward indefinitely to future years. There is no carryback provision for either PALs or passive activity credits.

Suspended losses, but not credits, may be utilized in the year in which an activity is completely or substantially disposed.

The IRS requires that taxpayers with passive activities complete and file with their tax return Form 8582, Passive Activity Loss Limitations. If credits from passive activities are being reported by a taxpayer in any year, Form 8582-CR, Passive Activity Credit Limitations should be used.

DETERMINING THE "ACTIVITY"

As you can see from the short introduction above, both the at-risk and passive loss rules use the term "activity." Unfortunately, what an activity is for purposes of the at-risk rules does not necessarily carry over to the PAL rules.

At-Risk Activities

The definition of an activity for the purposes of the at-risk limitation rules begins with the five original activities defined under IRC Section 465(c)(1). Each of the original five activities must be treated as a separate activity. (10) This has been interpreted to mean that any project that is covered under one of these activities must be accounted for separately under the at-risk rules. The only exception is for the leasing of tangible personal property by a partnership or S corporation. All leased assets placed in service in a single tax year are treated as a single activity. (11)

For activities other than the five original activities under IRC Section 465(c)(1), if the activities constitute a single trade or business, all the activities of that trade or business are aggregated if: (12)

1. the taxpayer actively participates in the management of the trade or business, or

2. the trade or business is carried on by a partnership or S corporation, and 65% or more of the losses for the tax year are allocable to persons who actively participate in the management of the trade or business.

The determination of an activity for purposes of the at-risk rules is very important since the losses of one activity that are limited by the at-risk rules may not be deducted using available at-risk amounts in another activity.

Passive Activities

A passive activity is (1) any activity that involves the conduct of a trade or business in which the taxpayer does not "materially participate" or (2) any rental activity. (13)

Since the definition of a "passive activity" includes the term "activity," one would expect to find a definition of "activity" somewhere. Unfortunately, taxpayers are not so lucky. An activity is based on a case by case "facts and circumstances" evaluation. The IRS has allowed any "reasonable method" to determine whether one or more trade or business activities constitute an appropriate "economic unit." Therefore, one or more trade or business activities may be aggregated to represent an economic unit.

In order to aggregate activities for the purpose of determining an appropriate economic unit, taxpayers must evaluate: (14)

1. the similarities and differences in types of business,

2. the extent of common control and ownership,

3. geographic location, and

4. interdependencies between or among the activities.

For example, taxpayers are generally allowed to aggregate activities in the same line of business into one activity without considering geographic location if the activities are commonly controlled by the same owners.

Example: A taxpayer owns an ice cream store and a shoe store in Pittsburgh, and an ice cream store and a shoe store in a Philadelphia shopping mall. There are four different possible combinations of the activities:

1. one activity aggregating all four businesses,

2. two separate activities--a Pittsburgh activity and a Philadelphia activity,

3. two separate activities--an ice cream store activity and a shoe store activity, or

4. four separate activities--one for each business.

Certain activities may not be aggregated. A rental activity that leases real property may not be aggregated with a rental activity that leases personal property, unless the rentals are provided together. (15) Also, a rental activity may not be aggregated with a trade or business activity unless the combination of the two activities represent an appropriate economic unit and: (16)

1. the rental activity is "insubstantial" in relation to the trade or business activity,

2. the business activity is "insubstantial" in relation to the rental activity, or

3. each owner of the trade or business activity has the same proportionate ownership in the rental activity.

Although "insubstantial" is not defined in the current regulations, prior temporary regulations accepted up to 20% of the total gross receipts of the combined activities to be considered insubstantial. However, this test is not valid under current rules which favor a stricter facts and circumstances test. The Service can challenge groupings in which the receipts of one are well below the 20% level.

Example: A owns a building in which he operates a card store. The card store has two rental spaces. Gross receipts from the rental spaces are 15% of the total receipts of the combined activities. The rental activity may be insubstantial in relation to the combined activity, so the rental activity and business activity may possibly be aggregated based on other subjective facts.

What is critically important is that the taxpayer group activities in the first year the activities are reported if the taxpayer wants to be able to group them at any point in the future. The regulations specifically exclude the ability to use the grouping rules solely to avoid a PAL problem. (17) Currently, the regulations only state that disclosure of the groupings must be made to the IRS, but no specific form of the disclosure has been issued.

Married couples are considered as one taxpayer when applying the aggregation rules. Therefore, if B owns a rental property and B's spouse, C, owns a retail store, the rental property and retail store may be aggregated into one activity for the application of the PAL rules.

An activity is the unit of measurement for the PAL rules. Once the activity is determined, several tests are applied to determine whether the taxpayer's participation in the activity is passive or nonpassive. These tests include:

1. material participation (defined below),

2. active participation for rental real estate, and

3. when suspended losses of passive activities become available upon the complete disposition of an activity.

Once an activity group is created, the taxpayer may not change the groupings unless the combination of the activities is clearly inappropriate or a material change has occurred from when the initial aggregation was made. If the aggregation is broken, disclosure must be made to the IRS. (18)

The IRS may regroup a taxpayer's activities if: (19)

1. the taxpayer's aggregation fail to reflect one or more appropriate economic units, and

2. one of the primary purposes of the taxpayer's grouping is to circumvent the PAL rules.

Since an aggregated group of activities is considered as one activity for the application of the PAL rules, suspended losses are only deductible upon the complete disposition of the aggregated activity. This provision suggests that the taxpayer should group activities in the smallest possible units unless the goal of the aggregated activities is to obtain a level of material participation.

QUESTIONS AND ANSWERS

At-Risk Limitations

Question--Do guarantees by a taxpayer of a partnership's debt increase the amount at-risk?

Answer--A guarantee of partnership debt does not increase the guarantor partner's amount at-risk unless the partner is actually required to make payments to the creditor. (20) The guarantor must have no right of action against any other party should payment be required under the terms of the guarantees.

Question--How are suspended at-risk losses carried forward?

Answer--If the at-risk rules prevent a taxpayer from deducting the full amount of a loss, the losses may be carried forward indefinitely. The losses may then be used to offset income in a future year from the same activity or when the taxpayer increases the amount at-risk in the activity. If the taxpayer recognizes a gain on the disposition of the activity, the gain could be offset by the suspended losses. However, unlike the passive rules, there is no automatic "freeing-up" of the losses on disposition.

Losses that are limited retain their character from year-to-year. That is, if a long-term capital loss is limited, the carryover will continue to be a long-term capital loss to be used when sufficient at-risk basis is generated. There are many instances where a taxpayer may have more than one type of loss limited by the at-risk rules. Although there is no formal ordering rule for deducting losses subject to the at-risk rules, the instructions to Form 6198 require a pro rata share of each type of loss limited by the at-risk rules be carried forward. Note that there was an ordering rule established by a proposed regulation in 1979.21 However, the regulation has never been finalized. In fact, the instructions to Form 6198 contradict the proposed regulation.

passive activity Loss limitations

Question--How does a taxpayer's participation in an activity impact the application of the PAL rules?

Answer--A taxpayer's participation determines whether the activity is treated as a passive activity or a nonpassive activity. To be a nonpassive activity, the taxpayer must "materially" participate in the activity.

Question--What is "material" participation?

Answer--Material participation is defined as a taxpayer's participation on a regular, continuous, and substantial basis. (22) The regulations under IRC Section 469 provide seven tests for material participation. A taxpayer that meets any one of the seven tests is deemed to be a material participant for that year. The tests must be applied on an annual basis to each activity of a taxpayer.

If a taxpayer materially participates in an activity that generates a loss in a given year, the loss may be used in that year to offset passive, portfolio, or nonpassive income. If a taxpayer is deemed not to be a material participant, any losses are generally treated as passive and are not deductible against any other source of income except income from other passive activities.

The seven tests for material participation are: (23)

1. The taxpayer participates in the activity for more than 500 hours during the year.

2. The taxpayer's participation in the activity constitutes substantially all of the participation by all individuals in the activity, including nonowners.

3. The taxpayer's participation is more than 100 hours during the year, and no other individual, including nonowners, participates more hours than the taxpayer.

4. The activity is a significant participation activity (the taxpayer participates more than 100 hours during the year) and the taxpayer's annual participation in all significant participation activities is more than 500 hours.

5. The taxpayer materially participated in the activity for any five tax years during the 10 immediately preceding tax years.

6. If the activity is a personal service activity (one in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any other trade or business in which capital is not a material income-producing factor), the taxpayer materially participated in the activity for any three tax years preceding the current year.

7. Based on all the facts and circumstances, the taxpayer participates on a regular, continuous and substantial basis during the year. (24)

There is reciprocity to the application of the material participation tests. If a taxpayer's spouse materially participates in an activity, the taxpayer is also considered to materially participate. In addition, participation of both spouses is combined to determine if the material participation tests are met regardless of whether a joint return is filed.

A close reading of the above tests show that the focus is on the quantity of hours, not the quality of the work performed. Any work performed by the taxpayer is considered participation for the purpose of these tests--unless (1) the work is not customarily done by the owner of an activity and (2) avoidance of PAL rules is a principal purpose.

Taxpayers must be able to substantiate their participation by reasonable means according to Treas. Reg. 1.469-5T(f)(4). Under examination, the Internal Revenue Service tends to focus on contemporaneous documentation of hours spent in an activity in order to determine the level of participation. However, contemporaneous documentation is not required if the taxpayer can reasonably establish their participation by other means. Auditors will consider it difficult for someone who earns a salary reported on a Form W-2 to also have enough time to also spend 500 hours in a separate activity.

Taxpayers commonly use calendars, appointment books, phone records, e-mail logs, and automobile mileage logs to help support the level of participation. Some types of work do not count towards the required number of hours, including:

(1) Investor-type activities (unless the taxpayer is involved in the day-to-day management or operations), such as:

* Studying or reviewing financial statements or reports.

* Preparing or compiling summaries or analyses for the individual's own use.

* Monitoring finances or operations in a non-managerial capacity

(2) Work not customarily done by an owner. This is asserted where the work is normally assigned to an employee, but was done by an owner in order to avoid the disallowance of losses under Section 469.

(3) Services not integral to operations. The most common example of this limitation is travel time.

Question--Can a limited partner materially participate?

Answer--A limited partner cannot materially participate in an activity unless: (25)

1. the limited partner is also a general partner,

2. the limited partner participates more than 500 hours in the activity,

3. the limited partner materially participated for any five of the ten preceding years, or

4. the activity is a personal service activity and the limited partner participated for any three preceding years.

Note that limited liability company members are currently treated by IRS auditors as limited partners for the purpose of applying the material participation rules. However, as of this edition, no formal guidance has been issued by the IRS.

Question--How are the PAL rules applied to different types of income?

Answer--Income from a passive activity is divided into passive income and portfolio income. Portfolio income includes interest, dividends, and investment capital gains or losses and is fully reportable by a taxpayer without the application of the PAL rules. This split between passive and portfolio income is not found in most other areas of the tax law such as in the case of foreign income categorization in which most types of portfolio income are considered passive. Congress realized that such a split was necessary in the case of the passive rules to prevent taxpayers from creating passive (portfolio) investment companies whose income could be shielded by other types of passive income.

Passive losses are aggregated and applied against passive income in a given year. If the passive losses exceed the passive income for the year, the excess losses are allocated to the loss activities and are carried forward indefinitely.

Losses from publicly traded partnerships (PTPs) may only be used against income from that specific partnership. No grouping of PTPs is permitted, even if they operate in the same industry, such as oil and gas. As a result, losses from PTPs generally accumulate over time. Unless the PTP passes income through to the investors, a PTP may need to be disposed of in order to release the suspended losses and be used to offset other income.

Question--How are rental real estate activities treated under the PAL rules?

Answer--A rental real estate activity with active participation is separately categorized under the PAL rules. Up to $25,000 of losses from such activities (which are limited to those activities of natural persons) with active participation may be used to offset other nonpassive income. (26) This special loss allowance begins to be phased-out for joint filers with modified adjusted gross income (MAGI) over $100,000. The allowance is reduced 50 cents for every dollar of MAGI over $100,000.27 Therefore, the special loss allowance is fully phased-out for married taxpayers in excess of $150,000.

Active participation is determined separately from material participation. In order to be considered an active participant, a taxpayer must make management decisions, such as approving tenants or setting policies, or arrange or perform other services, such as making repairs. (28) In addition, an active participant must be a 10% owner of the activity, by value, not including interests as a limited partner. (29)

Certain rental real estate activities are not considered as such under the PAL rules. These include rentals in which: (30)

1. the average period of use is seven days or less (e.g. a motel),

2. the average period of use is 30 days or less and significant personal services are provided (e.g. a hotel),

3. extraordinary personal services are provided,

4. rentals are incidental to nonrental activity,

5. the property is available for nonexclusive use (e.g. a golf course), or

6. the property is provided for use in a related entity with a nonrental activity.

Example--Roger owns a vacation property in New Jersey and rents it to individuals and families for an average of less than seven days (see #1 above). As a result, the property is not automatically treated as a passive activity because it is not classified as a real estate activity. If Roger meets one or more of the material participation tests, the income or loss from the rental of the vacation property will not be treated as passive. Any loss from the rental will be fully deductible against his ordinary income.

Note, however, that since the activity is not treated as a rental real estate activity, the special loss allowance described above is not available. Therefore, if Roger is not able to substantiate his material participation in the property, the loss would be passive with no offset from the special loss allowance. Ordinarily, this will occur in situations where the owner of the property uses a management company for the day-to-day rental operations. Since most of the material participation tests are based on hours devoted to the activity, the delegation of the management of the property will make it difficult, if not impossible, for a taxpayer to materially participate in such an activity.

Question--When do suspended losses for an activity become fully deductible?

Answer--Suspended losses of a passive activity become fully deductible in a complete, fully taxable disposition of the activity to an unrelated party. (31) The activity may also be considered as fully disposed if "substantially all" of the assets held by the activity are disposed. A discontinuation of operations or the retaining of the underlying assets is insufficient to be treated as a disposition.

Current year income or loss is then combined with the suspended losses of the activity. If the activity has a net loss in the year of disposition, the loss is treated as nonpassive if it exceeds income and gains from other passive activities. If the activity has net income in the year of disposition, the income is treated as passive and may be used to offset losses from other passive activities.

Question--What happens to suspended losses when there is not a complete, fully taxable disposition?

Answer--If an activity is disposed in a nontaxable or tax-deferred event, the suspended losses remain suspended and attach to the newly acquired property.

If an activity is sold through the use of an installment sale, the suspended loss is recognized each year in the same percentage as the gain on the sale. (32)

For dispositions of passive activities by gift, suspended losses are added to the donee's basis of the property. However, if the passive activity is subsequently sold at a loss by the donee, the basis for the loss is the lessor of the donee's basis including the suspended PAL or the fair market value on the date of the gift. (33) The result is that it may be better to dispose of the activity through a taxable transaction rather than by gift.

If a taxpayer dies with suspended PAL losses, the losses may be deducted on the decedent's final income tax return after being reduced by any step-up in the basis of the passive activity property. (34)

Question--Can net income from a self-rented property offset passive losses?

Answer--No. A taxpayer may not use net income from a property to offset other passive losses if the property is rented for use in a trade or business in which the taxpayer materially participates. Any income from self-rented property is treated as nonpassive. However, if the self-rented property generates a net loss, the loss is treated as passive. (35) Self-rentals, therefore, represent an area in which appropriately grouping the activities may be effective. It is critical, however, that such grouping occur on the initial return reporting the activities. Retroactive groupings will not be allowed by the Service.

Question--What are the special aggregation rules available to real estate professionals?

Answer--Real estate professionals treat otherwise passive rental real estate activities as nonpassive. (36) This provision, which was introduced in the early-1990s, gives such professionals the ability to convert passive losses that would otherwise be suspended into nonpassive losses that can be used to offset other sources of income.

In order to benefit from this provision, a real estate professional must make an election to treat all rental real estate activities as a single activity. (37) The taxpayer must materially participate in the combined real estate activities and:

1. more than 50% of the personal services performed by the taxpayer are performed in real property trade or businesses in which the taxpayer materially participates, and

2. the taxpayer must perform more than 750 hours in real property trade or businesses. (38)

A real property trade or business is one that involves real estate in one of the following activities: (39)

1. development,

2. redevelopment,

3. construction,

4. reconstruction,

5. acquisition,

6. conversion,

7. rental,

8. operation,

9. management,

10. leasing, or

11. brokerage.

By making the affirmative election to combine rental real estate activities, the taxpayer treats all rental real estate interests as a single activity, including those held as a limited partner. Material participation is then determined for the activity as a whole. Absent this election, all rental activities are treated as separate activities and the taxpayer may be saddled with large suspended losses. Once the election to combine the rental real estate activities is made, it is irrevocable unless the facts and circumstances of the taxpayer materially change.

Question--How are losses from former passive activities handled?

Answer--Situations occur in which a taxpayer owns an activity that is properly classified as passive and, at some point in the future, the taxpayer is deemed to materially participate in the activity. Any suspended losses of the activity from the years in which the taxpayer treated the activity as passive are first deducted to the extent the taxpayer recognizes income form the same activity. Any remaining suspended losses from the former passive activity are treated as a normal PAL carryforward and may be used to offset passive income from other activities.

Question--Are there any specific rules for investments in hedge funds?

Answer--Certain taxpayers invest in partnerships that are not treated as a passive activity even though the taxpayer does not materially participate or invested as limited partner. Many hedge fund or other partnership Schedule K-1s report that the income or loss from the activity is neither passive nor portfolio under Treasury Regulation section 1.469-2T(d)(2). A partnership interest carrying this footnote on its Schedule K-1 is identifying the partnership as one that trades in stocks, bonds and securities for its own account (and those of its partners). Losses from such an activity should not be treated as being from a passive activity and, therefore, be deducted in full. Likewise, the income from such an activity cannot be used to offset other passive activity losses.

CHAPTER ENDNOTES

(1.) IRC Sec. 465(c)(1).

(2.) IRC Sec. 465(c)(3).

(3.) IRC Sec. 469(a)(2).

(4.) IRC Sec. 465(a)(1).

(5.) IRC Sec. 465(b)(1).

(6.) IRC Sec. 465(b)(2).

(7.) IRC Sec. 465(b)(6).

(8.) IRC Sec. 465(e).

(9.) IRS Ann. 84-14, 1984-6 IRB 22.

(10.) IRC Sec. 465(c)(2).

(11.) IRC Sec. 465(c)(2)(B)(i).

(12.) IRC Sec. 465(c)(3)(B).

(13.) IRC Secs. 469(c)(1), 469(c)(2).

(14.) Treas. Reg. [section] 1.469-4.

(15.) Treas. Reg. [section] 1.469-4(d)(2).

(16.) Treas. Reg. [section] 1.469-4(d)(1).

(17.) Treas. Reg. [section] 1.469-4.

(18.) Treas. Reg. [section] 1.469-4(e)(1).

(19.) Treas. Reg. [section] 1.469-4(f).

(20.) Prop. Treas. Reg. [section] 1.465-6(d).

(21.) Prop. Treas. Reg. [section] 1.465-38.

(22.) IRC Sec. 469(h).

(23.) Temp. Treas. Reg. [section] 1.469-5T(a).

(24.) Treas. Reg. [section] 1.469-5; Temp. Treas. Reg. [section] 1.469-5T(a).

(25.) Temp. Treas. Reg. [section] 1.469-5T(e).

(26.) IRC Sec. 469(i).

(27.) IRC Sec. 469(i)(3)(A).

(28.) Committee Report P.L. 99-514 (1986).

(29.) IRC Sec. 469(i)(6).

(30.) Treas. Reg. [section] 1.469-1T(e)(3).

(31.) IRC Sec. 469(g).

(32.) IRC Sec. 469(g)(3).

(33.) IRC Sec. 469(j)(6).

(34.) IRC Sec. 469(g)(2).

(35.) Treas. Reg. [section] 1.469-2(f)(6).

(36.) IRC Sec. 469(c)(7)(A).

(37.) Treas. Reg. [section] 1.469-9(g)(1).

(38.) IRC Sec. 469(c)(7)(B).

(39.) IRC Sec. 469(c)(7)(C).
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Publication:Tools & Techniques of Income Tax Planning, 3rd ed.
Date:Jan 1, 2009
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