passive and real estate activities

If you are an owner of a trade or business in which you do not materially participate, the passive activity rules can limit your ability to deduct losses. And, if you hold rental real estate investments, the losses are passive even if you materially participate, unless you qualify as a real estate professional. Beginning in 2013, income from passive activities including rental real estate may also be subject to the 3.8% Medicare Contribution Tax. EisnerAmper 2014 personal tax guide 52 This very favorable result is due to the fact that the suspended losses This veryfavorableresultisdueto thefactthatsuspendedlosses As anexample,assumeyouhavesuspendedpassivelossesof year. You dispose of the activity in 2013 and realize a capital gain qualifies asparticipation. activities. Moreover, there are specificrulesasto whatkindofwork activity,on aparticular especiallywhen they inseveral participate Taxpayers should keep detailed records as to the time they spend passive loss rulesandlimitations. these losses forward to thefollowing year, subject to the same losses that you cannot deduct in the current year, you can carry when you completely disposeoftheactivity. Ifyou have passive have income from otherpassive activitiesto offset thelosses, or Passive activity losses are deductibleonlyto theextent thatyou ƒ ƒ ƒ ƒ the passive activity limitationrules,are if: to inabusiness materially activity, participate andthereby avoid Thematerially participate. mostcommon ways you are deemed A passive loss is aloss from abusiness activity in which you do not WHAT AREPASSIVE LOSSES? well asreceivingtheproceedsfrom thesale. $300,000 fromanactivitythatyouhaveheldformorethanone In fact,youmayactuallyreduceyourtaxesdespitethegain. If you have suspended passive activity losses, you may be able to of $340,000.Youwouldactually savefederaltaxesof$50,800as reduce your ordinary income at a 39.6% rate, whereas the long-term reduce yourordinaryincomeata39.6% rate,whereasthelong-term dispose ofapassiveactivityatgainandnothavetopayanytaxes. tax tip ƒ ƒ ƒ ƒ 14 ties, totaling more than500hours peryear inallsuchactivities. You work more than100hours peryear ineachofseveral activi less than any otherperson, includingnon-owners, or You work more than100hours peryear intheactivity andnot tion intheactivity, Your constitutes participation substantiallyalloftheparticipa year, You more participate than500hours intheactivity duringthe RELEASE SUSPENDEDORDINARY LOSSES USE PASSIVE ACTIVITY CAPITAL GAINSTO - - participation to meetoneofthetests listedparticipation above, ifpossible, so For anactivity thatisgenerating losses, consider increasing your Increase your in loss activities participation trap discussed inTax Tip 15. illustrates. Butyou mustalsobeaware ofthephantom income realize a gain on the sale, you can still save taxes as Tax Tip 14 the disposition(subject to capitalloss limitations). Even ifyou fully deductiblewhentheactivity issold—includingany loss on through a bona fide sale to an unrelated party. The losses become Sell any passive activity withcurrent orsuspendedpassive losses Dispose oftheactivity losses: can doto convert thedisallowed losses into tax-saving deductible losses that are subject to a disallowance, there are things that you If you fail the material tests participation and you have passive CONVERT PASSIVE LOSSES as passive losses, allowing you to deducttheminfull. real estate professional, your real estate losses are no longer treated meet thereal estate professional test (discussed below). Ifyou are a If you are engaged inreal estate activities,increase your hours to or businesses Increase thehours you inreal participate property trades in thatyear. you willnotbesubjectto apassive loss limitationfor theactivity Tax intheamountof$1,520(3.8% of$40,000,whichisthediffer The tax savings would bereduced bythe3.8% Medicare Contribution The suspendedlosswouldthereforereduceyourtaxby$118,800 (39.6% of$300,000)butthecapitalgainwouldonlyincreaseyour tax by $68,000 (20% of $340,000). If you have a net capital loss carryover thatyoumightnotbeabletoutilize,yoursavingswould capital gainfromthesalewouldbetaxedatnomorethan20%. giving youthefulltaxbenefitof loss(butareducedcarryover). loss). ence betweenthe $340,000 capitalgainand$300,000ordinary even begreatersincethegaincouldoffsetbycarryoverloss, - 14 demonstrates,thiscanactually beataxsavingsopportunity. would haveanordinarylosstooffset thisincome.AsTaxTip When identifyingyour netpassive losses, take into account the IDENTIFY YOUR ACTUAL PASSIVE LOSSES the income isnotfullyoffset by passive losses. the additional3.8%Medicare Contribution Tax to theextent that losses from otherunrelated passive activities.This may result in to you whichcanbeoffset until you utilize allofyour passive you in.This willnotmaterially participate creates passive income Consider investing in an income-producing trade or business that Invest inincome-producing passive activities to the extent thattheincome isnotfullyoffset by passive losses. This may result intheadditional3.8%Medicare Contribution Tax sure thatyou are notstillconsidered active undertheothertests. can usetheincome to offset your passive losses. However, make if feasible. Therefore, the activity may become passive and you non-passive income, limityour to less than500hours, participation For anactivity thatyou inthatisgenerating materially participate Decrease your inincome participation activities losses: should consider taking the following steps to utilize your passive into “material activities participation” as discussed above, you If you have passive losses from activitiesthatyou cannotconvert UTILIZE YOUR PASSIVE LOSSES ƒ following: Phantom incometotheextentof yournegativecapitalcanalso tax tip Income in excess of your net proceeds can be triggered upon the Income inexcessofyournetproceedscanbetriggereduponthe than youractualinvestmentintheproperty.Thisissometimes the extentyourprioryear’spassive lossesweresuspended,you occur ifyoudisposeofyourinterest inthepass-throughactiv or receivedcashdistributionsinprioryearsthatweregreater on indebtedness. Therefore,youmayhavedeductedlossesand/ ity, eveniftheunderlyingproperty remainsunsold.However,to referred toasnegativecapital. disposition of real estate. This results from prior deductions based ƒ 15 that onlygenerate portfolio income, suchascapitalgains, Investment and trading partnerships, S corporations and LLCs INCOME TRAP THE PHANTOM

- business, andthustheseactivitieswould beconsidered passive. of anLLC are presumed inthe to notbematerially participating Generally, limited ofanLLPandnon-managingmembers partners (LLP (LLC LOSSES FROM LIMITEDLIABILITYCOMPANIES ƒ ƒ not intheAMT. forward to offset your regular taxinfuture years whenyou are credits are limited becauseof theAMT, you cancarrythecredits your taxes infuture years. Ifyou have netpassive income butthe disallowed credits are carriedforward and can be used to offset passive activity income. Ifyou have anetoverall passive loss, the both regular taxandAMT to theextent of your taxattributableto Tax credit aswell asthelow income housingcredit canoffset AMT. For post-2007 investments, boththequalifiedRehabilitation to your net passive income, and cannot be used to reduce your credits are limited to theamountofyour regular taxattributable However, for properties placed into service prior to 2008, these low-income housingcredits, canreduce your regular taxliability. Tax credits from passive activities, such as rehabilitation and PASSIVE ACTIVITY CREDITS ticipation ofthemember. must beexamined to ascertainthe nature andextent ofthepar intheseactivities. Rather,participation the facts and circumstances are notlimited for partners purposesofdetermining theirmaterial the IRSdoesnotconcur, recent caseshave heldthatsuchmembers partnership interests alsoapplyto members ofanLLC. Although The have courts addressed whethertherulesthatapplyto limited partnership interest. person can avoid thepassive loss ruleswithrespect to thelimited andageneralas bothalimited partner partner. Inthiscase,such tion where anindividualholds aninterest inalimited partnership There isanexception to thepresumption ofnomaterial participa ƒ ƒ activity cannotoffset thepassive losses from theactivity. Portfolio income, such as interest and dividends, from a passive deduction, subjectto thesamedisallowance rules. in apassive activity istreated asanadditionalpassive activity Interest expense onmoney borrowed to fundyour investment cannot offset your passive losses. intheactivity.not participate Therefore, theinvestment income interest anddividends,are notpassive activities,even ifyou do s s ) ) &LIMITEDLIABILITYPARTNERSHIPS - -

passive and real estate activities 53 EisnerAmper 2014 personal tax guide 54 ƒ limitations. To qualify, you mustannually: estate losses in full since you are not subject to the passive loss If you are areal estate professional, you candeductrental real REAL ESTATE PROFESSIONAL RULES completely phasedout whenAGI reaches $150,000. the amount by which the taxpayer’s AGI exceeds $100,000. It is This special allowance is reduced, but not below zero, by 50% of each year ifyou actively inarental participate real estate activity. A separate rule allows you to deduct up to $25,000 of losses the gain on thesale of real estate properties, as discussed below. estate professional ornot,there are ways you candefer thetaxfrom as areal estate professional. Regardless ofwhetheryou are areal Real estate activitiesare passive by definition,unless you qualify REAL ESTATE ACTIVITIES installment salemethod,youwilldefer$290,000offederaltaxtofutureyearsasthemortgageispaiddownbybuyer. before theendofyearandreceiveamortgagefrombuyerforbalance,withfirstpaymentdueinJanuary2014.Byusing ($2,000,000 lessthecostof$600,000plusaccumulateddepreciation$400,000).Youwillreceivea20%downpayment$400,000 improvements). Atthetimeofsale,youhadaccumulateddepreciation$400,000.Thereforeyourtaxablecapitalgainis$1,800,000 In 2013,yousellanonresidentialbuildingfor$2,000,000,netofclosingcosts,which you boughtin1998 for $600,000(includingsubsequent tax tip ƒ 16 erty trades orbusinesses inwhich you materiallyand participate, Perform more than50%ofyour personal services inreal prop and relatedinterestnetinvestmentincome. Note: years’ installmentsareexpectedtoincrease. deductions onrealpropertya“firstinfirstout”(FIFO)method.Also,thismethodmaynotbeadvantageouswhenthetaxratesoffuture Caution: of 90%.Thegrossprofitratioisthetaxablegain$1,800,000dividedbytotalproceeds$2,000,000. The taxablegainusingtheinstallmentsalemethodiscomputedbymultiplyingdownpaymentof$400,000grossprofitratio Deferred tax Federal taxcostthisyear Taxable gaininyearofsale

The 3.8%MedicareContributionTaxonnetinvestmentincome,whichisnotreflectedintheaboveillustration,mayapplytogain

You aresubjecttoataxrateof25%ontheportiongainthatisattributablepreviousnon-accelerateddepreciation THE INSTALLMENT SALE METHOD DEFER YOUR GAINUSING Full paymentincurrentyear

- consents to itsrevocation. Once theelectionismade,itcontinuesparticipation. unless theIRS their real estate rental activitiesfor purposesofdetermining material real estate professional test, ataxpayer can electto aggregate allof increase your hours ofservice to meetthetests. For purposesof the Tax Tip: participate. gains, from rental real estate activitiesinwhichthey materially Contribution Tax onnet investment income, includingcapital Real estate professionals are notsubjectto the3.8%Medicare sidered to intherental materially participate activity. for rent mightbe a real estate professional butmight not becon example, areal estate broker whoowns oneortwo apartments activity inorder for thatactivity to beconsidered nonpassive. For In addition,you intherental mustmaterially participate real estate ƒ ƒ $ 1,800,000 Have more than750 hours ofservice inthesebusinesses. 380,000 If you fail eithertest andyou have real estate losses, tryto Installment salemethod $ 360,000 290,000 90,000 - when you have expiring losses, orstate tax considerations). ing inalike-kind exchange ifataxable event isthebetter approach (e.g., Note: like-kind exchange. est. Also, thesale ofyour principalresidence doesnotqualifyfor a other securitiesandintangible assets inter suchasapartnership Caution: replacement property within45days the sale. after exchanges. These rulesincludearequirement thatyou identifythe investment purposes,specificandcomplex rulesgovern like-kind as permitting an exchange of land for a building if both are held for of like-kind property allows for amountofflexibility, acertain such and canyieldsubstantialtaxbenefits.Even though thedefinition Like-kind exchanges typically are usedwhen sellingreal estate sell theproperty thatyou receive intheexchange. exchange rulegives you to theopportunity defer taxes untilyou cash orotherbootreceived (such asunlike property). The like-kind gain atthe timeoftheexchange, except upto theamountofany a like-kind (same nature orcharacter), you donotrealize taxable If you exchange investment orbusiness property for property of LIKE-KIND EXCHANGES deferred tax(assessed asanadditionaltax)willapply. own at December 31 exceeds $5 million, an interest charge on the However, if the face amount of all installment receivables you interest if the entity does not elect out of the installment method. you owned theproperty through anentity inwhich you holdan when received. You canusetheinstallmentsalemethodeven if or loans.The interest payments are taxable asordinary income be entitled to interest payments on the seller-financed mortgages if interest isnotstated onthedeferred payments. You may also future years willalsobelong-term except for theinterest element thatissoldhadalong-termerty holdingperiod,thegain reported in retains thesamecharacter aswhenitwas sold.Therefore, ifprop by afullyear (see Tax Tip 16).The gain you report infuture years next year, you candeferofthesalesprice thetaxonthatportion receive principalpayments. By simplydeferring onepayment until The installmentmethodallows you to report gain onlyasyou can defer muchofthetaxto future years. to report the gain onthe installment sale method. By doing so, you more payments theyear after ofthesalesothatyou are eligible plating asaleofreal estate, consider agreeing to receive oneor gain onthesaleofreal estate for future years. Ifyou are contem An installmentsalecanbeavery tax-efficient methodto defer a INSTALLMENT SALE REPORTING BENEFITS Like-kind exchange reporting isnotelective. Consider notengag Like-kind exchanges do not apply to thesaleof stocks, bonds, - - - -

passive and real estate activities 55