CHAPTER 10

LIMITATIONS ON THE DEDUCTIBILITY OFPARTNERSHIP LOSSES

THREE DEDUCTIBILITY LIMITATIONS

The deductibility of partnership losses passed through to a partner is subject to three separate limitations: First, the loss may not exceed the partner’s tax

basis in the partnership interest-§704(d) Second, any losses surviving the tax basis limit

are subject to the at-risk limitation- §465 Finally, losses may be disallowed under the

passive loss limitations - §469

DISALLOWED LOSSES ARE CARRIED FORWARD

Carryforwards Under §704(d): Loss passed through to a partner in excess of

tax basis is carried forward indefinitely until the partner obtains additional basis sufficient to allow the deduction

Carryforward losses unused as of the date of any sale or disposition of the partnership interest are lost (because they did not reduce the basis of the interest, and therefore any gain/loss from the sale is already reduced/increased by the amount of the carryforward) Do not carry over to the transferee Do not explicitly offset the gain or increase the loss

recognized

DISALLOWED LOSSES ARE CARRIED FORWARD (CONT.)

Carryforwards Under §465 Losses disallowed under the at-risk rules are

carried forward indefinitely just as are those denied under tax basis limitation

A partner’s tax basis in her partnership interest is reduced by losses even if they are disallowed under the at-risk rules

DISALLOWED LOSSES ARE CARRIED FORWARD (CONT.)

Carryforwards Under §465 When a partner sells her interest in the

partnership, losses carried forward under the at-risk limitation are deductible in full regardless of the amount of gain or loss recognized by the partner/member on the transaction Losses carried forward under the tax basis limitation

are not deductible on sale of a partnership interest

DISALLOWED LOSSES ARE CARRIED FORWARD (CONT.)

Carryforwards Under §469 For individuals, losses from passive activities are

only deductible to the extent of income from other passive activities

Losses disallowed under the passive loss limitations are carried forward indefinitely until the partnership has sufficient passive income from other sources to absorb the carryforward

DISALLOWED LOSSES ARE CARRIED FORWARD (CONT.)

Carryforwards Under §469 If the partner completely disposes of the

partnership interest, any passive loss carryforward is deductible in full in the year of disposition

THE BASIS LIMITATIONS UNDER §704(D)

Losses Cannot Exceed Tax Basis A partner cannot deduct partnership losses that

exceed the tax basis of the partnership interest

• Accounting for Debt A partner’s risk of loss in a partnership interest

includes not only direct investment made in the partnership interest, but also includes debt which the partner is obligated to pay in future

THE BASIS LIMITATIONS UNDER §704(D) (CONT. )

Nonrecourse DebtDefinition: debt for which the borrower has

no individual responsibility to repay the lender, and for which the lender solely looks to the property serving as collateral for the debt in the event of default

If the loan is a legitimate economic liability, it will be included in the borrower’s tax basis for the property A nonrecourse debt is considered legitimate if it was

borrowed from an unrelated lender, or if the borrower can demonstrate that the FMV the property exceeded the principal balance of the loan at the time the loan was made

AT-RISK RULES OF §465

Under §465, a taxpayer may not claim deductions for losses in excess of the amount that the taxpayer actually has “at risk” with respect to the activity generating the losses §465 applies to individuals and closely held

corporations only

AT-RISK RULES OF §465 (CONT.)

A taxpayer’s amount at risk is computed in the same manner as is tax basis except that it excludes nonqualified nonrecourse debt A qualified nonrecourse debt is one which:

Is borrowed for the activity of holding real property (very broadly defined), and is secured by that property

Is borrowed from a lender who is in the business of lending money and who has no interest in the activity for which the money is borrowed, other than as a creditor

Is not convertible into stock or other securities

PASSIVE LOSS LIMITATIONS OF §469

General Deductions for net losses (income minus losses)

from “passive” activities are not allowed Passive loss is loss realized from rental activities and

loss “allocated” to nonparticipatory partners (i.e., limited partners) in partnership activities

Disallowed losses are carried forward and can be deducted only against net passive income in future years or when the taxpayer fully disposes of the interest in the passive activity

PASSIVE LOSS LIMITATIONS OF §469 (CONT.)

The passive loss limitation is applied after application of the at-risk loss limitation

CLASSIFICATION OF INCOME UNDER §469

General Passive activity income includes all income from

passive activities, including gain from disposition of an interest in a passive activity or from disposition of property used in a passive activity

CLASSIFICATION OF INCOME UNDER §469 (CONT.)

Gain from Sale of an Interest in a Partnership If the partnership was engaged in a passive

activity, any gain or loss recognized on the sale or disposition of the partner’s interest in the entity will be classified as passive gain or loss

CLASSIFICATION OF INCOME UNDER §469 (CONT.)

Gain from Sale of an Interest in a Partnership If the partnership is engaged in more than one

activity (e.g., a passive activity and a portfolio activity) in one entity, the gain or loss must be allocated between the activities based on the relative gain or loss which would have been recognized if the entity had sold its entire interest in each of its activities just prior to the partner’s disposition of the partnership interest

TAXPAYERS TO WHOM §469 APPLIES

The passive loss rules apply only to individuals, certain trusts and estates, personal service corporations and closely-held corporations Unlike individuals, closely held corporations are

allowed to deduct net passive losses against active income and offset the tax attributable to net active income with passive activity credits However, closely held corporations cannot offset

portfolio income with net passive losses

PASSIVE ACTIVITIES DEFINED

Definition: A passive activity is one in which the taxpayer does not “materially participate” during the taxable year

Most rental activities are deemed to be passive regardless of the taxpayer’s level of participation A significant exception: for taxpayers who are

engaged primarily in the real estate business

PASSIVE ACTIVITIES DEFINED (CONT.)

Limited Partners Limited partners generally are not treated as

material participants However, if the limited partner (or LLC member

treated as a limited partner) satisfies the requirements of tests (1), (5), or (6) above, the partner can be treated as a material participant

PASSIVE ACTIVITIES DEFINED (CONT.)

Rental Activities §469 automatically classifies most rental

activities as passive activities, regardless of the taxpayer’s level of participation For this purpose, a rental activity is one involving the

long-term rental of property and for which the taxpayer does not provide substantial additional services

Short term rental activities where substantial personal services in connection with the rental are required (e.g. operation of hotel) do not constitute a passive activity

PASSIVE ACTIVITIES DEFINED (CONT.)

Rental Activities Exceptions to passive treatment:

1. The average period of customer use of the property is seven days or less (e.g., hotels, motels, short-term equipment or vehicle rentals, etc.)

2. The average period of customer use of the property is 30 days or less and significant personal services are provided with the rentals

3. Extraordinary personal services are provided by or on behalf of the owner(s) of the property in making such property available for customer use

PASSIVE ACTIVITIES DEFINED (CONT.)

4. The rental is incidental to a non-rental activity5. The rental property is customarily made available

during defined business hours for nonexclusive use by various customers (e.g., health clubs)

6. The property is provided for use in a non-rental activity in the owner’s capacity as an owner of an interest in a partnership, S corporation, or joint venture conducting that activity

PASSIVE ACTIVITIES DEFINED (CONT.)

Real Estate Professionals Taxpayers in the “real property business” are not

subject to the passive loss restrictions A taxpayer is in the real property business if

he/she: Spends more than half of his/her time in real property

businesses in which he/she materially participates; and Performs more than 750 hours of services during the

taxable year in real property trades or businesses in which he or she materially participates

PASSIVE ACTIVITIES DEFINED (CONT.)

Exemption for Real Estate Rental Activities in which Taxpayer “Actively” Participates For taxpayers who “actively participate in the

management of rental property, the first $25,000 of net losses generated by such property are exempted from Code Sec. 469 First, the losses are still passive losses, while not

subject to the passive loss limitations Second, the exemption applies only if the taxpayer

“actively” participates in management of the property

PASSIVE ACTIVITIES DEFINED (CONT.)

Exemption for Real Estate Rental Activities in which Taxpayer “Actively” Participates (Cont.) Active participation requires the following:

The taxpayer must have at least a 10% interest in the rental activity

The taxpayer must not own the interest as a limited partner, and

The taxpayer must participate in the activity in a significant and bona fide manner (participate in management decisions)

PASSIVE ACTIVITIES DEFINED (CONT.)

Exemption for Real Estate Rental Activities in which Taxpayer “Actively” Participates (Cont.) The exemption amount is reduced by 50 cents

for each dollar that the taxpayer’s “modified AGI” exceeds $100,000

Modified AGI is regular AGI, computed without regard to various items, including taxable social security, deductible IRA contributions, passive activity income or loss, and one-half of self-employment taxes

ACTIVITIES THAT ARE NOT PASSIVE ACTIVITIES

Five categories of trade or business activities are not treated as passive activities Trade or business activities in which the taxpayer

materially participated for the tax year A working interest in an oil or gas well held by

the taxpayer directly or through an entity that does not limit liability

Rental of a vacation home

ACTIVITIES THAT ARE NOT PASSIVE ACTIVITIES (CONT.)

Five categories of trade or business activities are not treated as passive activities (Cont.) Trading activities involving personal property

traded for the account of those who own interests in the activity

Rental real estate activities of real estate professionals

OPERATING RULES

Calculation and Use of Carryforwards First, total all income from passive activities Then, total all losses from passive activities If the total loss exceeds the total income, the

taxpayer has a net passive loss, which is disallowed unless subject to the rules related to the taxpayer’s active participation rental activities

OPERATING RULES (CONT.)

Calculation and Use of Carryforwards The taxpayer then allocates the disallowed

passive loss back to the passive activities which generated the loss (based on the relative amounts of the losses they generated)

These losses carry forward indefinitely, and can be deducted if the taxpayer either earns net passive income in a subsequent year or disposes of the entire interest in the passive activity to which the loss has been allocated

OPERATING RULES (CONT.)

Calculation and Use of Carryforwards Under §469, the loss carryforward from a

disposed activity is applied against passive income from other passive activities first, and any excess loss is then characterized as loss from non-passive activities However, passive loss carryovers from other passive

activities are applied against passive income from such activities before application of the carryover from the disposed activity. This tends to leave more of the loss from the disposed activity to be treated as non-passive.