Small Business Taxes & ManagementTM--Copyright 2014, A/N Group, Inc.
Passive Activity Losses
It sounded like a great deal when your brother-in-law told you about buying a home in Florida to rent out. The tenant would pay your mortgage and you'd get a tax deduction for the anticipated losses. Things didn't pan out as planned. The property has been rented, on average, only 10 months a year and the expenses have been far more than projected. But the worst part came when your accountant said you couldn't deduct the losses because your adjusted gross income was over $150,000. (The law provides that up to $25,000 of rental losses from an activity in which the taxpayer "actively" participates can be used to offset ordinary income. That benefit is phased out when your AGI exceeds $100,000.) The passive losses aren't lost but are carried forward indefinitely until they can be used. (See below.) That may be small comfort for someone with several rental properties as the overall loss can be significant.
A similar situation can occur with respect to an investment in a partnership, LLC, or S corporation where you don't materially participate. For example, you partnered with your daughter in an LLC she started. You've got a 50% interest in the losses, but except for some occasional business advice you don't participate in the activity. You can't deduct those losses. Moreover, there's no $25,000 exception as there is with rental real estate.
Note. Renting property to your nonpassive business does not produce passive income. For example, Fred and Sue own a free-standing warehouse in their own name. They rent the entire building to Madison Tools, Inc. an S corporation in which they have a 75% interest and in which they materially participate.
For a discussion of material participation, go to Material Participation.
Utilizing Passive Losses
There are several ways, other than the $25,000 exception for rental real estate, to use passive losses.
The first, and most obvious, is to generate offsetting passive income. That can happen when the rental (or other property with passive losses) produces passive income. That doesn't have to be the same property.
Example 1--Fred and Sue have rented a lakefront home for several years with losses for each of the years. Because of the AGI limitation, the losses have accumulated to $60,000. In 2014 they rent the property for the full year producing a modest profit of $6,500. They can offset the $6,500 of profit by the same amount of the accumulated passive losses. They will carry forward the remaining $53,500 in losses to 2015.
Passive losses of any type can be used against passive income. For example, assume the facts are the same as in Example 1, but Fred invests, but does not materially participate, in his daughter's business which produces $10,000 of passive income. The income can be offset by $10,000 of accumulated passive losses.
You may be able to create passive income by failing to materially participate in an activity. For example, Fred has a 20% interest in an LLC. The business is profitable and Fred materially participates so it's not a passive activity. If Fred no longer materially participates in the business the profits will be passive. Caution. The IRS could challenge the position and one of the material participation tests is that you materially participated in the activity for any 5 (whether or not consecutive) of the 10 immediately preceding tax years. Get good advice if you're thinking of using this technique.
Not all rentals produce passive income. Certain passive activities with income don't create passive activity income. They include:
The second way to utilize the losses is to dispose of your entire interest in the activity. The simplest situation is if you sell a single rental property. For example, before renting the house in 2014, Fred and Sue sell the lake property. While the sale results in a loss, they can now use the entire $60,000 of carryforward losses to offset ordinary income.
In order to avail yourself of this option, you can't sell the property to a related party. And you must sell your entire interest. If Fred and Sue take back a note for the property, they'll pick up the carryforward losses as the note is paid off, not all in one year. Another option is to sell property used in a passive activity that will generate income. For example, you own several rental properties. Some would generate a capital gain if sold. The income generated from the sale could be used to utilize passive losses even if the losses were generated by a different property.
Tax Tip--It's not unusual to have significant accumulated passive losses. Using them all in one year may lower your income enough to bring you down one or more tax brackets. That could mean the losses won't produce the most tax benefits. Taking back a note could spread and maximize the benefits. There are a number of factors to consider before using this approach.If you give away your interest in a passive activity, the unused passive activity losses allocable to the interest cannot be deducted in any tax year. Instead, the basis of the transferred interest must be increased by the amount of these losses.
If a passive activity interest is transferred because the owner dies, unused passive activity losses are allowed (to a certain extent) as a deduction against the decedent's income in the year of death. The losses are allowed only to the extent they exceed the amount by which the transferee's basis in the passive activity has been increased under the rules for determining the basis of property acquired from a decedent.
You should be aware that any discussion about passive activities frequently involves the issue of grouping activities. How you group activities can be important to show material participation. For example, if your auto body shop activity is grouped with your distribution of auto parts, you need only show material participation in one to make the two a nonpassive activity. But then selling one activity isn't considered disposing of your entire interest. And you may not be totally free to group activities. Again, get good advice.
In a recent Chief Counsel Advice Memorandum (LR 201415002) the issue was whether a foreclosure on real property subject to recourse debt comprising a taxpayer's entire interest in a passive (or former passive) activity qualifies as a fully taxable disposition for purposes of Sec. 469(g)(1)(A) if the foreclosure triggers cancellation of indebtedness (COD) income that is excluded from gross income under Sec. 108(a)(1)(B).
The IRS held that a foreclosure in the situation described above is a fully taxable transaction for purposes of Secs. 1001 and 469(g)(1)(A). It doesn't matter that any COD income from the cancellation of the recourse debt is excluded under Sec. 108(a)(1)(B) (the insolvency exception). In addition, the losses are not reduced by any excluded COD income under Sec. 108(b)(2)(F). Normally, a taxpayer who excludes some COD income as a result of the insolvency rule, must reduce tax attributes by a like amount. For example, normally the taxpayer would reduce any passive activity losses or credits by the amount of the income excluded. That wasn't the case here.
Here's the example from the memorandum. In 2010 Fred purchased a strip center for $1 million, financing the entire amount with a recourse mortgage of $1 million. The rental activity is passive and the real property constitutes Fred's entire interest in the passive activity. He has no other passive activities. From 2010 through 2013 the property accumulates $100,000 of losses that are suspended and carried forward to 2014. In 2014 Fred defaults on the debt and the lender foreclosures the mortgage. At the time of foreclosure the fair market value of the property was $825,000. Fred's adjusted basis in the property was $800,000; the balance on the loan was $900,000. In addition, Fred is insolvent with liabilities exceeding assets by $200,000 at the time of foreclosure. The lender cancels the remaining $75,000 debt after foreclosure ($900,000 outstanding debt - $825,000 fair market value). Fred has a $25,000 gain on the foreclosure ($825,000 FMV - $800,000 adjusted basis) and $75,000 of COD income ($900,000 debt - $825,000 FMV) that is excludable from gross income because he is insolvent by $200,000.
This ruling creates some interesting opportunities for taxpayers with properties underwater. While Chief Counsel Advice may not be used or cited as precedent, the holding would appear to stand up if challenged.
Utilizing these losses, particularly in situations where it's unlikely the losses can be used against passive income in the near future, can be tricky. Get good advice before proceeding with any course of action.
Copyright 2014 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. Articles in this publication are not intended to be used, and cannot be used, for the purpose of avoiding accuracy-related penalties that may be imposed on a taxpayer. The information is not necessarily a complete summary of all materials on the subject. Copyright is not claimed on material from U.S. Government sources.--ISSN 1089-1536
--Last Update 04/30/14