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Passive activity loss allocations; careful planning can reduce the adverse impact of Sec. 469.

The Tax Reform Act of 1986 (TRA) introduced taxpayers to the Sec. 469 passive activity loss (PAL) rules. These rules were designed to deal with the problem of tax shelters, a problem that Congress believed was undermining the integrity of the tax system. Sec. 469 quickly established itself as one of the most complicated and far-reaching sections of the Code. Other tax provisions may rival the passive activity rules in complexity, but few of the more intricate provisions can match the breadth of a section that touches virtually every trade or business in which an owner does not materially participate.

The complexity that characterizes the passive activity provisions arises from two sources. First, there are the problems of delineating the scope of each of a taxpayer's activities and classifying each activity as passive or nonpassive. This task is complicated to a considerable extent by the Treasury's attempts to structure the Sec. 469 regulations in a manner that will thwart all taxpayer efforts to increase passive income of decrease passive losses. Second, there are the computational problems. Special allowances must be computed, losses must be allowed and suspended, and the suspended amounts must be allocated among and within activities.

This articl will focus on the second of these problems, the passive loss allowance, suspension and allocation procedures; explore the workings of these procedures and, in the process, reveal a number of planning opportunities; and expose inconsistencies between the intra-activity allocation procedure described in the regulations and the allocation procedure embodied in the form on which lossesl from passive activities are reported.

The Basic Loss Suspension Process

The passive loss rules are built around a simple idea: deductions from passive activities are allowed only to the extent of the income from passive activities. Unallowed deductions are "suspended" and are treated as passive activity deductions in the following year. Before exploring this idea more fully, however, some terms must be precisely defined in order to understand the passive activity rules.

Five terms must be distinguished: current, suspended, dispositional, overall and collective. An activity produces "current income" if the gross income produced by the activity in the current year exceeds the deductions associated with the activity in the current year (disregarding any suspended losses carried from prior years and any gains and losses from disposition of the taxpayer's entire interest in the activity). An activity produces "current loss" if the deductions associated with the activity exceed the gross income from the activity in the current year (again disregarding prior year suspended losses, and gains and losses from disposition). Current income or loss usually arises from the operation of an activity and from the disposition of property used in an activity, although it can also arise from such sources as a partial dispositional of an interest in an activity. The "suspended loss" associated with an activity is the amount of dissalowed loss resulting from application of the passive loss rules. As Sec. 469(b) states, this loss "shall be treated as a deduction ... allocable to such activity in the next taxable year." The term "dispositinal gain or loss" refers to the gain or loss realized when a taxpayers completely disposes of an interest in a passive activity in a fully taxable sale or exchange. The term "overall income or loss" refers to the sum of the current income or loss, the suspended loss from the prior year (if any) and the dispositional gain or loss (if any). An activity will be said to be "loss-producing" if it produces an overall loss and "income-producing" if it produces overall income. Finally, the term "collective income or loss" refers to the sum of the overall income and loss from all passive activities or to the sum of the overall income and loss from a designated group of activities.

Sec. 469 (d) (1) defines a "passive activity loss" as the amount (if any) by which --the aggregate losses from all passive activities for the tax year (including suspended losses) exceed --the aggregate income from all passive activities for such year. Equivalently, the PAL can be defined as the collective loss, if any, from all passive activities. This definition of the passive activity loss leads to a very precise statement of the basic passive loss disallowance rule in Sec. 469(a): the passive activity loss for the tax year will not be allowed. Unfortunately, this definition can also lead to some confusion because the phrase "passive activity loss" is often used to refer to the loss from a single loss-producing passive activity. (In fact, Sec. 469(g) used this phrase in exactly this fashion before it was amended by the Technical and Miscellaneous Revenue Act of 1988.) To reduce ambiguity, this article will avoid such usage. Example 1. Taxpayer T with taxable income of $100,000 from nonpassive sources has an interest in exactly three passive activities, A, B and C. There are no dispositions during the year. Current income (loss), prior year suspended losses and overall income (loss) associated with these activities in year 1 are as follows.

[TABULAR DATA OMITTED]

The sum of the overall losses from loss-producing passive activities equals $20,000, the combination of an overall loss of $4,000 from B and $16,000 from C. The sum of the overall income from income-producing passive activities equals $15,000, the overall income from A. The passive activity loss, $5,000, equals the collective loss from all passive activities, which equals the sum of the overall income and loss from all passive activities. Applying the basic passive loss disallowance rule, all of the overall income from A will be recognized, while $15,000 of the $20,000 of overall losses from B and C will be allowed. The remaining $5,000 of losses from B and C will be suspended and carried forward to be combined with current income and loss in the next year. Taxable income will be $100,000.

Interactivity Suspended Loss Allocations

Once the total amount of loss to be suspended during the current year has been computed, this loss must be translated into a suspended loss for each activity. Sec. 469(j)(4) states that "[t]he passive activity loss . . . shall be allocated to activities, and within activities, on a pro rata basis. . . ." Temp. Regs. Sec. 1.469-1T(f)(2)(i)(A) further specifies that the passive activity loss is to be apportioned only among loss-producing activities. Perhaps the easiest way to allocate the PAL is to compute the loss suspension percentage (designated as "S" in the following formula), which represents the portion of the losses from loss-producing activities that will be suspended.

S = The passive activity loss / Sum of the overall losses from loss-producing passive activities

Since the passive activity loss is allocated on a pro rata basis, S also represents the percentage of the overall loss associated with each loss-producing activity that will be suspended.

Alternatively, the allowed loss for each loss-producing activity can be computed using the loss allowance percentage, A, which measures the portion of the losses from loss-producing passive activities that will be allowed.

A = Sum of the overall income from income-producing passive activities / Sum of the overall losses from loss-producing passive activities

Note: A = 1 - S.

Example 2: For taxpayer T from Example 1, the loss suspension and allowance percentages are calculated in the following manner.

S = $(5,000) (the PAL) / $(4,000) (overall loss from B) + $(16,000) (overall loss from C) / = $(5,000) / $(20,000) / = 0.25

A = $15,000 (overall income from A) / $(4,000) (overall loss from B) + $(16,000) (overall loss from C / = $15,000 / $(20,000) / = 0.75

Thus, 25% of the overall loss from each loss-producing passive activity will be suspended and the remaining 75% will be allowed.

[TABULAR DATA OMITTED]

Dispositions

The key passive activity disposition rule of Sec. 469(1)(A) states that current and suspended losses from an activity will be recognized when a taxpayer disposes of his entire interest in the activity in a fully taxable sale or exchange. Losses are allowed on disposition because Sec. 469 was designed to disallow fictional losses, not true economic losses. If an artificial loss occurs during the years in which a taxpayer owns an activity, the loss will be offset by an equal artificial gain on disposition. Thus, on disposition, it is possible to determine the scope of the true economic loss. This economic loss is to be allowed.

The Treasury has not yet issued regulations relating to passive activity dispositions, but the probable Treasury interpretation of Sec. 469(g)(1)(A) can be inferred from three sources: the instructions to Form 8582, Passive Activity Loss Limitations; the instructions to Form 8582-CR, Passive Activity Credit Limitations; and Publication 925, Passive Activity and At-Rish Rules. Using the terminology introduced above, the probable Treasury interpretation can be summarized as follows. If the disposed activity produces an overall gain in the year of disposition, all gains and losses associated with the activity remain passive. If the disposed activity produces an overall loss in the year of disposition, an amount of loss equal to the overall loss from the disposed activity less the collective income, if any, from activities that have not been disposed, is reclassified as nonpassive. [1] See Example 3 on page 309.

Planning Opportunities

Several tax planning alternatives are available that focus on years in which activities are disposed at an overall loss and years in which passive activities collectively produce income. By selectively shifting items of passive gross income and deduction into and out of these years, a taxpayer can lessen the impact of the passive activity limitations. In the absence of special years such as these, shifting will not affect tax liability.

* Disposition-at-a-loss year

A disposition-at-a-loss year occurs when (1) a passive activity is disposed and it produces an overall loss in the year of disposition, and (2) retained passive activities produce a collective loss in the disposition year. Under such circumstances, the overall loss from the disposed activity will be reclassified as nonpassive and, subject to such further restrictions as the capital loss limitations, the reclassified loss will be subtracted from taxable income. The following planning alternative will increase the overall loss from a disposed activity in the disposition year and thus reduce tax liability in that year, but will not alter tax liability in the years preceding disposition. Planning: Shift income produced by the disposed activity from the disposition year to the years preceding disposition year to the years preceding disposition by shifting items of gross income produced by the disposed activity from the disposition year to the years preceding disposition, or by shifting deductions produced by the disposed activity from the years preceding disposition to the disposition year. Stop shifting if passive activities begin to produce collective income in the years preceding disposition. (2) The two situations in Example 4, below, illustrate the logic behind this principle. Example 4: Activity D. is disposed at an overall loss in year 2.

* Situation 1: D produced overall income in year 1. The proposed shifts will increase the overall income from D in year 1 and increase the overall loss from D in year 2 by the same amount. However, year 1 tax liability will not rise because the extra income will be offset by losses from other passive activities, losses that would have been suspended had these shifts not occurred.

* Situation 2: D produced overall loss in year 1. The proposed shifts will decrease the overall loss from D in year 1 and increase the current or dispositional loss from D in year 2 by a like amount. The decrease of the overall year 1 loss will also reduce the suspended loss from D carried from year 1 to year 2. However, the reduction of the carryforward loss will be less than the increase of the current or dispositional loss in year 2; as a result, the overall loss produced by D in year 2 will increase.

In both situations the proposed shifts will increase the overall loss produced by D in year 2 and thus reduce year 2 tax liability without altering year 1 tax liability. However, the analysis also indicates that a given shift will have a larger effect on taxable income in year 2 when D produces overall income in year 1 because there will be no carry-forward reduction under such circumstances. [3]

The tax benefits of a given shift will be larger when the loss suspension percentage is small and when the disposed activity produces a small portion of the collective loss produced by all loss-producing activities in the year preceding disposition. See Example 5 on page 310.

An additional planning opportunity is available if the disposed activity produces losses in the year preceding disposition. Planning: Shift income produced by retained activities from the years preceding disposition to the disposition year by shifting items of gross income produced by retained activities from the years preceding disposition to the disposition year or by shifting deductions produced by retained activities from the disposition year to the years preceding disposition. Stop shifting if retained passive activities begin to produce collective income in the disposition year.

Example 6: Activity D is disposed at an overall loss in year 2; activity R is retained.

* Situation 1: R produced overall income in year 1. The proposed shifts will increase the PAL in year 1 and thus increase the year 1 loss suspension ratio (S).

* Situation 2: R produced overall loss in year 1. The proposed shifts will increase the PAL in year 1 and increase the sum of the year 1 losses from loss-producing activities by a like amount. Since the denominator of S exceeds the numerator, the result will be an increase of the year 1 loss suspension ratio, although S will not rise as much as it would have if the numerator alone had increased.

In both cases, the increase of S will boost the amount of loss from D that is suspended in year 1 and the extra suspended loss will be carried to year 2 where it will increase the overall loss from D. Since the loss from D is allowed in year 2, tax liability will decline. As the analysis indicates, an income shift of a given size will have a larger effect on taxable income when R produces overall income in year 1.

The tax benefits of a given shift will be larger when the loss suspension percentage is small and when the disposed activity produces a large portion of the collective loss produced by all loss-producing activities in the year preceding disposition. See Example 7 on page 311..

If the disposed activity produces overall income in the year of disposition, these income-shifting strategies will not alter tax liability. Thus, a taxpayer who uses these planning devices in the mistaken anticipation of a disposition at a loss will not be hurt by his actions.

* Gain year

A gain year--a year in which passive activities produce collective income--might result from the sale of an entire interest in an activity or from the sale of property used in an activity. Alternatively, it might result from a good operational year. No matter what the cause, if a gain year is followed by years in which passive activities produce a collective loss, the following planning device can be employed to minimize the tax liability associated with the gain.

Planning: Shift income from the gain year to subsequent years by shifting items of gross income from the gain year to subsequent years or by shifting deductions from postgain years to the gain year.

Both strategies will shift some or all of the collective income produced in the gain year to years in which it will be sheltered by passive losses. The shifted items of gross income and deduction may be associated with any activity, not just an activity that produces a gain. Since gain years often result from the sale of property, the installment method offers obvious gain-deferral possibilities. Note that there is no advantage in shifting losses from pregain years to the gain year; such losses, if recognized earlier, would be carried forward to the gain year as suspended losses anyway.

These planning alternatives presented all indicate that deduction shifting can reduce tax liability. Depreciation elections are one of the principal means by which a taxpayer can control the timing of deductions. The cost of residential rental property, for example, can be recovered over 27.5 years or over 40 years. However, electing a lengthy recovery period or a slow depreciation method is usually ill-advised. It is generally advantageous to recognize deductions early and, if necessary, carry them forward to gain years as suspended losses. A lengthy recovery period or a slower depreciation method would be advisable only if the taxpayer anticipated that the activity would be disposed at a loss.

These planning strategies are summarized in the table on page 312.

The Special Allowance

for Active Rental Realty

Sec. 469(c)(2) and (j)(8) together state that rental activities in which the rental payments are "principally for the use of tangible property" are passive. As a result, loss deductions from most rental activities are limited by the passive loss rules. Sec. 469(i) creates an exception by establishing a special allowance that permits a taxpayer to deduct up to $25,000 of losses from active participation rental real estate activities (APRRAs). A taxpayer is said to actively participate in a rental realty activity if he participates in management decisions relating to the activity in a significant and bona fide sense. APRRA losses that are suspended by the passive activity rules retain their APRRA character in subsequent years and are deductible under the special allowance provisions, but only if the taxpayer actively participates in the activity in subsequent years. (4) Related special allowance provisions potentially permit taxpayers to use certain credits from passive activities that would otherwise be suspended by the passive activity rules. The designated credits are the rehabilitation and the low-income housing credits, as well as credits produced by APRRAs.

Sec. 469(i)(3)(A) establishes a cap for the special APRRA loss allowance. The cap begins at $25,000 and is reduced 50 cents for each $1 that modified AGI exceeds $100,000. Thus, the $25,000 allowance is eliminated entirely when modified AGI reaches $150,000. Modified AGI is defined as AGI,

--excluding any passive activity loss;

--excluding all social security and railroad retirement income (i.e., excluding amounts that are included in AGI under Sec. 86);

--including Veterans' Administration benefits and other tax-exempt income sources listed in Sec. 135; and

--including qualified retirement contributions, such as individual retirement accounts (IRAs), that are deductible under Sec. 219. (5)

The Code says nothing more about the computation of the special allowance. Sec. 469(j)(4) gives the Treasury broad authority to issue regulations in this area but regulations have not yet been issued. However, the instructions for Form 8582, in combination with Form 8582 itself, permit one to infer the basics of the Treasury interpretation.

The Treasury has apparently decided that the special allowance should equal the minimum of (the absolute value of)

--the modified AGI cap;

--the PAL; or

--the "APRRA PAL"--the collective loss from all

APRRAs considered in isolation.

The restriction that the special allowance not exceed the PAL is designed to maximize the allowance available for the designated credits that qualify for the special allowance. The limitation that the special allowance not exceed the APRRA PAL, which derives from the TRA Conference Report, (6) forces taxpayers to offset APRRA losses with APRRA income before using the special allowance, thus insuring that the special allowance does not "free" APRRA income to absorb non-APRRA losses.

Example 8: Taxpayer X with modified AGI of $130,000 and taxable income of $100,000 from nonpassive sources has an interest in five passive activities. R1, R2 and R3 are APRRAs; P1 and P2 are not. Overall income (loss) from these activities is as follows.
 Overall
 income
 Activity (loss)
 P1 $(10,000)
 P2 5,000
 R1 5,000
 R2 (12,000)
 R3 (8,000)
 Total $(20,000)


If none of these activities were APRRAs, $10,000 of the losses from the loss-producing passive activites would be allowed and $20,000 would be suspended. Taxable income would be $100,000.

However, since R1, R2 and R3 are APRRAs, X can use the special allowance, which equals the lesser of

--the modified AGI cap, $10,000 [$25,000 - (0.5 x ($130,000 - $100,000))];

--the PAL, $20,000; or

--the APRRA PAL, $15,000.

Thus, the special allowance equals $10,000, the modified AGI cap. Of the $20,000 of APRRA losses, $10,000 are allowed and the remaining $10,000 carry forwared, retaining their APRRA character. Taxable income is $90,000.

A taxpayer who is using the special allowance and is limited by the restriction that the special allowance cannot exceed the APRRA PAL may be able to reduce his tax liability with a few simple planning strategies, each designed to increase the size of the APRRA PAL.

* Avoid active participation in income-producing APRRAs.

* Accelerate the recognition of APRRA deductions.

* Delay the recognition of items of APRRA gross income.

Note: These planning alternatives will not reduce tax liability if the taxpayer is also using the special allowance to allow APRRA credits, rehabilitation credits or low-income housing credits and some of these credits are being suspended. Under such circumstances, these planning alternatives will increase allowed APRRA losses, but will reduce allowed credits by an exactly offsetting amount.

Example 9: Assume the same facts as in Example 8, except that X's modified AGI is $110,000 rather than $130,000. Taxable income from nonpassive sources continues to be $100,000. The modified AGI cap is $20,000 and the APRRA PAL is $15,000; thus, the special allowance is $15,000. Taxable income is $85,000. If X avoids actice participation in activity R1, the APRRA PAL will rise to $20,000 and the special allowance will also rise to $20,000. Taxable income will fall to $80,000.

A taxpayer who is using the APRRA special allowance should also keep the allowance in mind when acquiring new passive activities. Such a taxpayer may find that newly acquired income-producing APRRAs are taxed less favorable than are passive investments that are not APRRAs.

Example 10: Taxpayer X from Example 8 acquires an APRRA that produces overall income of $10,000. The new activity will cause the PAL to decline to $10,000 while the APRRA PAL declines to $5,000. Thus the special allowance will also decline to $5,000. Taxable income will be $95,000, which is $5,000 more than the taxable income in Example 8.

Supposed instead that X acquires a passive activity that is not an APRRA. This activity also produces overall income of $10,000. The new activity will cause the PAL to decline to $10,000, but the APRRA PAL will not decline, so the special allowance will remain equal to $10,000. Taxable income will continue to be $90,000.

Interactivity Suspended Loss

Allocations With Active Rental Realty

The Treasury has not yet issued regulations describing the interactivity allocation of suspended losses for taxpayers who qualify for the APRRA special allowance. The only guidance currently available is found in Firm 8582 and in the accompanying instructions and worksheets. (7) Form 8582 prescribes a three-step interactivity suspended loss allocation procedure when a taxpayer has an interest in one or more APRRAs. This allocation procedure requires the taxpayer to first segregate passive activities into two categories: APRRAs and all "other" passive activities. The three-step allocation procedure then works as follows.

Step 1: The first step focuses on the overall losses from the loss-producing APRRAs in isolation. Compute the special allowance and preliminarily allow losses from loss-producing APRRAs to the extent of this allowance. If there is more than one loss-producing APRRA, the special allowance is allocated proportionately among the loss-producing APRRAs. When an allocation is required, the computations can be most easily performed by first computing the "step 1" loss allowance percentage: [A.sub.1] = The special allowance / Sum of the losses from all loss-producing APRRAs

A portion ([A.sup.1]) of the overall loss from each loss-producing APRRA is then preliminarily allowed while the remainder is preliminarily suspended and carried to step 2 of the allocation procedure. Note that [A.sup.1] will never exceed 1 because of the manner in which the special allowance is computed.

Step 2: The second step focuses on the preliminarily suspended APRRA losses from step 1 in combination with the overall income from income-producing APRRAs and the overall income and losses from all other passive activities. The income items in this assortment will be referred to as "step 2 gains" while the loss items will be referred to as "step 2 losses." The excess of the step 2 losses over the step 2 gains will be termed the step 2 PAL.

Next, perform a conventional passive loss allowance and allowacation computation, akin to the performed earlier, using the step 2 gains and losses, allowing step 2 losses to the extent of the step 2 gains. The easiest way to perform this computation is to compute the step 2 allowance and suspension percentages, [A.sub.2] and [S.sub.2]:

[A.sub.2]=Sum of the step 2 gains / Sum of the step 2 losses

[S.sub.2]=The step 2 PAL / Sum of the step 2 losses

A portion [(A.sub.2)] of each of the step 2 losses will then be allowed and a portion [(S.sub.2)] will be suspended. Step 3: In the final step, combine the allowed losses from steps 1 and 2.

See Example 11 on page 314.

The passive activity planning principles presented earlier, which focus on disposition-at-a-loss years and gain years, also apply to taxpayers who are using the APRRA special allowance. In fact, the benefits of these planning alternatives will be enhanced if the taxpayer's modified AGI is between $100,000 and $150,000, because these alternatives will decrease modified AGI and increase the APRRA special allowance.

Intra-activity Suspended Loss Allocations

The emphasis thus far has been on the overall passive income or loss associated with each activity. This overall income or loss is, of course, equal to the sum of the current income or loss, the prior year suspended loss and the dispositional gain or loss. These components of overall income or loss will often include elements that are subject to special tax treatment, such as capital losses and Sec. 1231 losses. Whenever a suspended overall loss for a given passive activity contains components subject to special tax treatment, the suspended overall loss must be translated into suspended ordinary loss, suspended Sec. 1231 loss, suspended capital loss, etc. Sec. 469(j)(4) states that this intra-activity loss allocation should be done on a pro rata basis, but otherwise leaves the translation rules to the Treasury. The Treasury has provided guidance in two places: Temp. Regs. Sec. 1.469-1T(f)(2)(ii) and Form 8582. Interestingly, the guidance provided by these two sources is contradictory.

* Temp. Regs. Sec. 1.469-1T(f)(2)(ii)

allocation procedure

Temp. Regs. Sec. 1.469-1T(f)(2)(ii) proposes the following rules for translating allowed overall gains and losses into allowed items for gross income and allowed deductions. If an activity produced overall income, all items of gross income and all deductions associated with the activity are recognized. If an activity produces an overall loss, all items of gross income associated with the activity are recognized and a pro rata share of each deduction is allowed. The sum of the allowed deductions must be such that gross income from the activity less allowed deductions equals to the allowed loss. The sum of the disallowed deductions will equal the suspended loss. See Example 12 on page 315.

Once the overall amount of suspended deductions for a given loss-producing activity has been determined, a pro rata share of each of the components of the overall disallowed amount must be suspended. The easiest way to suspended the deductions for a given activity X is to first compute the deduction suspension percentage for the activity, which equals the portion of the activity X deductions that are to be disallowed.

[S.sub.DX]=Disallowed loss from X / Sum of the deductions from X

A portion, [S.sub.DX], of each deduction associated with the activity is then disallowed. This percentage is not to be confused with the loss suspension percentage computed earlier. Also note that this percentage generally will have a different value for each activity. Alternatively, the deduction allowance percentage for the activity can be computed under the following formula, which equals the portion of the deductions from X that will be allowed.

[A.sub.DX]=Gross income from X + allowed loss from X / Sum of the deductions from X

Note: [A.sub.DX] = 1 - [S.sub.DX.]

See Example 13 on page 317.

Form 8582 allocation procedure

Form 8582, in combination with its worksheets and instructions, proposes the following procedure for recognizing the gross income and deductions from a passive activity. Segregate the gross income items and the deductions associated with the activity by tax schedule, or, in the case of Schedule (Form 1040), Capital Gains and Losses, and Form 4797, Sales of Business Property, by part of schedule. Thus, for example, all items found on Schedule (Form 1040), Profit or Loss From Business, are grouped together, all items found on Part I of Schedule D are grouped together and all items found on Schedule E (Form 1040), Supplemental Income and Loss, are grouped together. Next, compute the net gain or loss of each of these groups.

1. If the items in a given group produce net income, i.e., if the components of the activity that are reported on a given schedule produce a net gain when considered in isolation on that schedule, recognize the net income from the activity reported on that schedule.

2. If the items in a given group produce a net loss, i.e., if the components of the activity that are reported on a given schedule produce a net loss when considered in isolation on that schedule, suspended a pro rata share of that net loss.

The easiest way to implement the pro rata suspension rule for a given activity X is first to compute the group-loss suspension percentage:

[S.sub.GX] = Disallowed loss from X / Sum of the net losses for all loss-producing groups in X

Next, multiply the net loss for each loss-producing group by this percentage to determine the portion of the group loss that is to be suspended. This percentage is not to be confused with the loss suspension percentage or the deduction suspension percentage. Also note that this percentage generally will be different for different activities. See Example 14 on page 318.

This analysis shows that the Form 8582 allocation procedure is guided principally by a desire to harmonize the suspension process with existing forms and schedules, not by a desire to allocate the suspended loss form a given activity in the pro rata fashion that Sec. 469(j)(4) suggests.

Comparison of the procedures

In order to understand the differences between the intra-activity loss allocation procedures outlines in the regulations and in Form 8582, it is useful to distinguish two types of group losses -- single transaction losses (such as capital losses and Sec. 1231 losses) and operational losses (such as losses that appear on Schedule C.). A single transaction loss will equal the deduction associated with that loss while (the absolute value of) an operational loss will be less than the deductions associated with that loss. If follows that the intra-activity allocation procedure in Temp. Regs. Sec. 1,469-1T(f), which allocates an activity's suspended loss in proportion to the activity's deductions, will allocate relatively more suspended loss to operations than will the Form 8582 procedure, which allocates an activity's suspended loss in proportion to an activity's group losses. Stated another way, the Temp. Regs. Sec. 1.4691T(f) procedure will allow a larger portion of a single transaction loss and smaller portion of an operational loss than will the procedure in Form 8582. A comparison of Examples 13 and 14 reveals that the Temp. Regs. Sec. 1.469-1T(f) produces a 47% larger allowed capital loss in the current year than does the Form 8582 procedure. In subsequent years the capital loss allowed by the Form 8582 procedure will be larger.

This contradiction between a regulation and an IRS form puts taxpayers and tax prepares in an interesting position. Sec. 6011(a) requires taxpayers to "make a return or statement according to the forms and regulations prescribed by the Secretary," yet the courts have repeatedly rejected taxpayers arguments that rely on statements contained in IRS forms and publications. In McGuire, the Tax Court wrote: "Petitioners claim they were misled by instructions on the Internal Revenue Service form. Even if petitioners were misled by such instructions, the result is not changed. We must apply the law as enacted by Congress. Our decision must be based upon the statute and the authoritative regulations, and not upon the informal publications of the Internal Revenue Services." (8)

Despite the fact that tax liability should be computed in accord with Temp. Regs. Sec. 1.469-1T(f), there is no question that most returns will continue to be prepared in accord with Form 8582. This is, in part, a consequence of the widespread use of computerized tax preparation programs, virtually all of which use allocation algorithms based on Form 8582. In many cases, the continued use of Form 8582 is of little consequence; it often yields the same tax liability as Temp. Regs. Sec. 1.469-1T(f). However, the two procedures will yield different tax liabilities if (1) the taxpayers has suspended capital losses from passive activities and is subject to the capital loss limitation of Sec. 1211 or (2) the taxpayer has suspended Sec. 1231 losses from passive activities, the taxpayer is in the 31% tax bracket and the taxpayer is subject to Sec. 1231(c)(1) lookback recapture. (9) Under such circumstances, which procedure will yield lower tax liability? A complete answer, of course, requires a detailed projection of the taxpayer's tax position over the next few years; however, a couple of rules of thumb can provide some guidance in the following situations.

* If the taxpayer has suspended capital losses from passive activities and is subject to the capital loss limitation in the current year, the Form 8582 procedure will probably yield a lower tax liability; a switch to the Temp. Regs. Sec. 1.469-1T(f) procedure will reduce ordinary losses, increase the size of the capital loss carryforward and increase current year tax liability. If the taxpayer is not subject to the capital loss limitation this year, but is likely to be subject to it in subsequent years, the Temp. Regs. Sec. 1.469-1T(f) procedure will probably yield a lower future tax liability.

* If a taxpayer in the 31% tax bracket with suspended Sec. 1231 losses from passive activities is subject to lookback recapture in the current year, but is not likely to be subject to lookback recapture in subsequent years, the Temp. Regs. Sec. 1.469-1T(f) procedure will probably yield a lower tax liability; a switch to the Form 8582 procedure will reduce the passive Sec. 1231 loss allowed in the current year and increase lookback recapture. If the taxpayer is not subject to lookback recapture this year, but is likely to be subject to it in subsequent years, a switch from the Temp. Regs. Sec. 1.469.-1T(f) procedure to the Form 8582 procedure will not change current tax liability but will probably yield a lower future tax liability.

Conclusion

The passive loss rules of Sec. 469, which were added to the Code by the Tax Reform Act of 1986, were the cornerstone of a broad and largely successful attack on tax shelters, an attack that included the expansion of the alternative minimum tax, the repeal of the capital gains deduction for individuals and the extension of the at-risk rules to real estate. A thorough study of the passive loss suspension and allocation rules as well as the principal passive activity disposition rule shows that careful planning can reduce the adverse impact of Sec. 469.

(1) There is some controversy over how Sec. 469(g) should be interpreted. This author ha argued that gains on disposition should not be counted in the determination of the loss under Sec. 469(g)(1)(A). Sec. Allen, "Fixing the Passive Activity Loss Rules," 50 Tax Notes 1419 (3/25/91). For an opposing point of view, see Grace, "PAL Disposition Rule Imperfect, But Not Fatally Flawed," 51 Tax Notes 651 (5/6/91).

(2) This planning alternative (and the alternatives presented below) assumes that the taxpayer faces substantially the same marginal tax rate in the years under consideration. Significant swings in the marginal tax rate could change the results.

(3) If the disposed activity produces overall income in the year before disposition, regulations to be issued under Sec. 469(g)(l)(C) could reduce or eliminate the tax saving created by this planning alternative. Sec. 469(g)(1(C) is targeted at activities that produced overall income during the years before disposition and then produce a loss on disposition. It gives the Treasury the authority to issue regulations that could reduce or eliminate the amount of loss classified as nonpassive on disposition under such circumstances.

(4) H. Rep. No. 99-841, 99th Cong., 2d Sess. II-141, n. (1986).

(5) Sec. 469(i)(3)(E).

(6) H. Rep. No. 99-841, note 4, at II-141.

(7) In Ann. 89-142, IRB 1989-47, 18, the IRS announced that it had changed the absurdly complex APRRA special allowance allocation procedure embodied in the 1987 and 1988 editions of Worksheet 3 Form 8582 to conform to Temp. Regs. Sec. 1.469-1T(f)(2). Curiously, it is not possible to infer an allocation procedure from the cryptic description contained in this subsection of the regulations. It is quite accurate to say that, at this time, Worksheet 3 Form 8582 is the law.

(8) Michael A. McGuire, TC Memo 1983-261, at 83-1067.

(9) The Revenue Reconciliation Act of 1990, which caps the capital gains tax rate at 28% (Sec. 1(h), amended by Act Section 11101(c)), has restored significance to Sec. 1231(c)(1) recapture.
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Author:Allen, Stephen D.
Publication:The Tax Adviser
Date:May 1, 1992
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