passive and real estate activities

If you are an owner of a 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. Income from passive activities including rental real estate may also be subject to the 3.8% Medicare Contribution Tax on net investment income. This very favorableresult isdueto thefactthatsuspended very This January 1, 2018), whereas2018), 1, thelong-termfromgain capital the sale January As anexample,assumeyouhavesuspendedpassivelossesof $340,000. You wouldactuallysave federal taxes of $43,000 aswell from$300,000 an activity that you haveheldfor more than one work qualifiesasparticipation. activities. Moreover, there are specificrulesastowhatkindof activity, inseveral on aparticular participate they when especially Taxpayers shouldkeepdetailedrecords astothetimetheyspend passive lossrulesandlimitations. to the following year,these losses forward subject to the same the currentcannot deduct in that you losses year, can carry you when youcompletelydisposeof theactivity. Ifyouhavepassive have income from otherpassiveactivitiestooffset the losses,or Passiveareactivity losses deductibleonlytotheextentthatyou •  •  • •  the passiveactivitylimitationrules,are if: inabusinessactivity,to materiallyparticipate andthereby avoid The most common ways youare deemed materially participate. A passivelossisafrom abusinessactivityinwhichyoudonot as receiving theproceeds from thesale. year. You disposeofand realize theactivity in 2018 acapitalgainof WHAT ARE PASSIVE LOSSES? In fact,youmayactuallyreduce yourtaxesdespitethegain. you maybeableto activity losses, passive If youhavesuspended losses reduce your at a 37% rate (beginning on incomeata37%rate(beginning reducelosses ordinary your dispose of activity atagainandnothaveto a passive pay anytaxes. tax tip  activities. activities, totalingmore peryearinallsuch than500hours You work more peryear ineach of than100hours several or includingnon-owners, less thananyotherperson, You work more peryearinthe activity andnot than 100hours in theactivity, Your constitutessubstantiallyallof theparticipation participation the year, You more intheactivityduring than500hours participate 14 RELEASE SUSPENDED ORDINARY LOSSES USE PASSIVE ACTIVITY CAPITAL GAINS TO participation tomeet oneof thetests listed above,if possible,so participation For an activity that is generating losses, consider increasing your Increase your inlossactivities participation trap discussedinTax Tip15. illustrates. But you must also be aware of the phantom income realize againonthesale, youcanstillsavetaxesasTax Tip14 the disposition(subjecttocapitallosslimitations).Evenifyou fully deductiblewhentheactivityissold—includinganylosson through a bona fide sale to an unrelated party. The losses become Sell anypassiveactivitywithcurrent orsuspendedpassivelosses Dispose of theactivity deductible losses: the disallowed losses into tax-saving you can do to convert thatarelosses there subjecttoadisallowance, are that things passive have you and tests participation material the fail If you treated aspassivelosses,allowingyoutodeducttheminfull. are areal estateprofessional, yourreal estatelossesare nolonger to meet the real estate professional test (discussed below). If you areIf you inreal engaged increase activities, estate yourhours or businesses trades Increase you participate thehours inreal in thatyear. you will not be subject to a passive loss limitation for the activity CONVERT PASSIVE LOSSES The tax savings wouldbereduced by the 3.8% Medicare Contribu $340,000). If you have a net capital loss carryover thatyoumight If youhaveanetcapitallosscarryover $340,000). tion Tax intheamount ofof(3.8% $1,520 which isthe dif $40,000, therefore reduce(37% of your tax by $111,000 but the $300,000), would betaxedatnomore than20%.Thesuspendedlosswould ference between the $340,000 and $300,000 ordinary ferenceordinary capital gain and$300,000 between the $340,000 benefit of theloss(buta reduced carryover). even begreaterwould savings not beabletoutilize,your sincethe capital gain would only increasewould only capital gain of(20% tax by$68,000 your loss). gain could be offset by the carryover loss, giving you the full tax full the you giving loss, carryover the by offset be could gain - -

passive and real estate activities 57 EisnerAmper 2018 personal tax guide 58 14 demonstrates,thiscanactually beataxsavingsopportunity. the incomeisnotfullyoffset bypassivelosses. the additional 3.8% Medicare Contribution Tax to the extent that losses from otherunrelatedmay resultactivities. This passive in to youwhichcanbeoffset utilizeallof untilyou yourpassive in.Thiscreates passiveincome you will notmaterially participate Consider investinginanincome-producing tradeorbusinessthat Invest inincome-producing passive activities atallinthe current year.even ifyoudonotparticipate inthe current year,will be deemed to be materially participating intheactivityforfiveoutof you thelasttenyears, participating by passive losses. If you or yourspouse have been materially Contribution Tax to the extent that the income is not fully offset the othertests.ThismayresultMedicare3.8% intheadditional However, makesure thatyouare notstillconsidered activeunder passive and you can use the income to offset your passive losses. if feasible. Therefore,than 500hours, the activity may become to less generating non-passive income, limit yourparticipation thatis For anactivity inwhich youmaterially participate Decrease your inincomeactivities participation losses: should considertakingthefollowingstepstoutilizeyourpassive activitiesasdiscussedabove,you into “materialparticipation” If youhavepassivelossesfrom activitiesthatyou cannot convert sometimes referred toasnegativecapital. the extent your prior year’s passivelosseswerethe extent your prior year’s suspended, you the dispositionof real estate.Thisresults from priordeductions tax tip Phantom income to the extent of your negativecapitalcan also would have an ordinary loss to offset this income. As Tip As Tax income. this offset to loss ordinary an have would were greater than youractualinvestmentintheproperty. Thisis based onindebtedness.Therefore, youmayhavededucted Income inexcessof yournetproceeds canbetriggered upon UTILIZE YOUR PASSIVE LOSSES even if the underlying property remains unsold.However,even if the underlying property to ofoccur ifyoudispose your in the pass-through activity, losses and/orreceived that cashdistributionsinprioryears 15 INCOME TRAP THE PHANTOM

•  •  • following: take intoaccountthe losses, net passive your When identifying ordinary income. ordinary to offset allcategoriesof income,includingearned incomeor real estate activitiesare notconsidered passiveandare available the taxpayerisareal estateprofessional, thelossesderivedfrom activities inwhichtheyare notmateriallyinvolved.However, if fromtaxpayers using losses incurred from income-producing at theindividualtaxpayerlevel.Thepassivelossrulesprevent income could notoffsetloss passive earned incomeorordinary a flow-throughif ataxpayerhas fromloss activity, apassive the Under thepassiveactivitylossrulescontainedinIRCSec.469, Limitation onLossesfor Taxpayers OtherThan Corporations of themember.participation naturethe of extent and the toascertain be examined must intheseactivities.Rather,participation thefactsandcircumstances of forpurposes determining theirmaterial not limitedpartners the IRSdoesnotconcur, are caseshaveheldthatsuchmembers of tomembers apply also LLC. an partnership Although haveaddressed whethertherulesthatapplytolimited The courts interest. passive lossruleswithrespect tothelimitedpartnership and ageneralpartner. canavoidthe Inthiscase,suchperson asbothalimitedpartner holds aninterest inalimitedpartnership presumption where of anindividual nomaterialparticipation would beconsidered passive.There isanexceptiontothe and thustheseactivities inthebusiness, materially participating Generally, of anLLPare presumed limitedpartners tonotbe IDENTIFY YOUR ACTUAL PASSIVE LOSSES LIABILITY PARTNERSHIPS COMPANIES LOSSES FROM LIMITED LIABILITY activity cannotoffset thepassivelossesfrom theactivity. Portfolio interest as such income, from dividends, and passive a deduction, subjecttothesamedisallowancerules. in apassiveactivityis treated asan additional passive activity Interest expense on money borrowed to fund your investment income cannotoffset yourpassivelosses. intheactivity.do notparticipate Therefore, theinvestment interest anddividends, are notpassiveactivities,evenifyou income, suchascapital gains, that onlygenerate portfolio ScorporationsandLLCs Investment andtradingpartnerships, ( “LLC s ” ) AND LIMITED ( “LLP s ” ) low-income housing credits, can reduce your regular tax liability. Tax credits from rehabilitation as such activities, passive and taxpayer willneedtofollowtheordering rulesperIRCSec.172. year. the When applyingtheNOLdeductioninsubsequentyears, of to80% deduction NOL taxable taxableincomeforagiven to be indefinite andlimits the amended the NOL carryforward in accordancethe following years with IRC Sec. 172. The Act has tothetaxpayerin amounts are treated asanNOLcarryforward 2025. December31, Any residualand thislimitationexpires after year,The thresholdevery for inflation amounts willbeadjusted married taxpayerfilingjointlyor$250,000forallothertaxpayers. gain forthetaxableyearplusathreshold amountof $500,000for trade orbusinessoverthesumof aggregate gross incomeor aggregate deductionsof thetaxpayerattributabletohisorher 31, 2017.TheActdefinesanexcessbusinesslossastheof December after beginning limitation, effective for taxableyears other than C corporations, called an “excess business loss” businesslossfromadditional limitationonataxpayer’s entities The Tax Cuts andJobsAct amends andaddsto IRC Sec. 461 an ispaiddownbythebuyer.the installmentsalemethod,youwilldefer$290,000of federaltaxtofuture asthemortgage years before of 2018.Byusing the endof from paymentduein thebuyerforbalance,withfirst the yearandreceiveJanuary amortgage ($2,000,000 lessthecostof $600,000plustheaccumulateddepreciation of $400,000).You willreceive a20%downpaymentof $400,000 improvements). At thetimeof thesale,youhadaccumulateddepreciation of $400,000.Therefore yourtaxablecapitalgainis$1,800,000 In 2017,yousellanonresidential buildingfor$2,000,000,netof closingcosts,whichyouboughtin1998for$600,000(includingsubsequent tax tip PASSIVE ACTIVITY CREDITS 16 gain andrelated interest. Note: future installmentsare years’ expectedtoincrease. out”(“FIFO”)method.Also,thismethodmaynotbeadvantageouswhenthetaxrates infirst ona“first deductions onreal of property Caution: ratio of 90%.Thegross profit ratioisthetaxablegain of $1,800,000dividedbythetotalproceeds of $2,000,000. The taxablegainusingtheinstallmentsalemethodiscomputedbymultiplyingdownpaymento Deferred tax Federal taxcostthisyear Taxable gaininyearofsale The 3.8%Medicare ContributionTax onnetinvestmentincome,whichisnotreflected intheaboveillustration,mayapplyto You are of subjecttoataxrateof thegainthat isattributabletoprevious 25%ontheportion non-accelerateddepreciation THE INSTALLMENT SALE METHOD DEFER YOUR GAIN USING Full paymentincurrentyear activity. specialallowanceisreduced, This butnotbelowzero, by a rental in real estate participate actively if you each year losses below. Aseparateruleallowsyoutodeductup$25,000 of from the gainonsaleof asdiscussed real estateproperties, estate professional or not,there are ways youcandefer the tax reala as estate professional. Regardless of arewhether you reala Real estateactivitiesareyou qualify passivebydefinition,unless you are notintheAMT. tooffsetcredits yourregular forward taxinfuture when years but thecredits are limitedbecauseof theAMT, the youcancarry offset your taxesinfuture Ifyouhavenetpassiveincome years. andcanbeusedtothe disallowedcredits are carriedforward loss, passive activityincome.Ifyouhaveanetoverall to passive both regularAMT totheextentoftax and tax attributable your Tax credit aswellthelow-incomehousingcredit canoffset AMT. For post-2007 investments, both the qualified Rehabilitation income, andcannotbeusedtoreduceto yournetpassive your credits are limited to the amount of yourregular tax attributable However, priorto2008,these placedintoservice forproperties REAL ESTATE ACTIVITIES $ 1,800,000 380,000 f $400,000bythegross profit Installment salemethod $ 360,000 290,000 90,000

passive and real estate activities 59 EisnerAmper 2018 personal tax guide 60 The installment method allows you to report gain only asyou The installmentmethodallows youtoreport doing so,youcandefermuchof thetaxtofuture years. thegainoninstallmentsalemethod.By eligible toreport theyear ofone ormore thesalesothatyouare paymentsafter contemplating asale of real estate, consider agreeing to receive a gainonthesaleof real estate forfuture Ifyouare years. tax-efficient method todefer An installmentsalecanbeavery it continuesunlesstheIRSconsentstoitsrevocation. of determining material participation. Once the election is made, to aggregate all of their real estate rental activities for purposes purposes of the real estate professional test, a taxpayer can elect to losses, increasetry your hours ofto meet service the tests. For Observation: participate. gains, from rental real estateactivitiesinwhichtheymaterially TaxContribution capital including investment income, onnet Real estateprofessionals are notsubjecttothe3.8%Medicare the taxpayer. by spouse inatradeorbusinessistreated asworkperformed byataxpayer’s testthough,workperformed participation separately satisfies both requirements. In regards to the material requirements are satisfied if, and only if, at least one of thespouses In thecaseof ajointreturn, thereal estateprofessional intherental activity.considered tomateriallyparticipate for rent might be areal estate professional but might not be example, a real estate broker who owns oneortwo apartments activity inorder forthatactivitytobeconsidered nonpassive.For intherental real estate In addition,youmustmateriallyparticipate •  •  limitations. To qualify, youmustannually: in fullsinceyouareestate losses loss notsubjecttothepassive If youare areal estate professional, youcan deduct rental real It iscompletelyphasedoutwhenAGI reaches $150,000. 50% of AGI theamountbywhichtaxpayer’s exceeds$100,000. INSTALLMENT SALE REPORTING BENEFITS REAL ESTATE PROFESSIONAL RULES Have more than 750 hours of service inthesebusinesses. Have more of than750hours service and participate, trades or businesses inwhich you materiallyproperty Perform in real more than 50%of services your personal

If you fail either test and you have real estate real have you and test either fail you If recognized immediately. Furthermore, when the deferred gain on is 751 or 1250, 1245, sections IRC under income recapture any Caution: on thedeferred tax(assessedasanadditional tax)willapply. interestan million, exceeds $5 own atDecember31 you charge method. However, ifthefaceamountof allinstallmentreceivables hold aninterest notelectoutof iftheentitydoes theinstallment through anentity in which you even ifyouownedthe whenreceived. You canusetheinstallmentsalemethod or loans. The interest payments aremortgages taxable asordinary You mayalsobeentitledtointerest paymentsonseller-financed interest element if interest is not stated on the deferred payments. in future will also be long-termreported exceptyears for the that is sold had a long-term holding period, the gain if property retainsyears the same character as when it was sold.Therefore, price byafullyear(seeTax infuture Tip16).Thegainyoureport until next year, of thesales youcandeferthetaxonthat portion receive principal payments. By simply deferring one payment holding the funds within 45 days after thesale. holding thefundswithin45days after with the qualified intermediary the replacement property identify cannot directly receive anycashorotherconsideration andmust like-kind exchanges. Theserulesincludea requirement that you govern complexrules and specific purposes, forinvestment held such aspermitting anexchangeof landforabuildingifbothare amount of flexibility,of allowsforacertain like-kindproperty and can yield substantial tax benefits. Even though the definition Like-kind exchangestypicallyare usedwhensellingreal estate thatyoureceive intheexchange. property to defer taxes until yousell the rule gives you the opportunity Thelike-kindexchange boot receivedas unlikeproperty). (such of the exchange, except up to the amountof any cashorother nature orcharacter),youdonotrealize taxablegainatthetime of forproperty alike-kind(same If youexchangereal property of gain. resale. Personal will no longer be allowed adeferral property notheldprimarilyfor to onlyrealDecember 2017, 31, property limits thedeferralof gainonlike-kindexchangescompletedafter collectibles.TheTaxfurniture, boatsandart CutsandJobsAct property.personal Personal can include vehicles, property intangible and tangible included that forassets exchanges Previously, IRCSec.1031 allowed deferralof gainonlike-kind uponthe receipt first ofis reported principal payments. gain 1250 unrecapturedsection the 20%), of rate tax (maximum gain capital regular and 25%) of rate tax (maximum gain 1250 the sale of real estate is attributable to both unrecaptured section LIKE - KIND EXCHANGES Even if no payments are received in the year of sale, of year the in received are payments no if Even Your a positioninwhich your specific fact pattern must support 12-month periodthatthedwellingunitisrented atafairrental. (2) your own personal useof(2) yourownpersonal the dwellingunitcannotexceed vacation property orsecond home was infact held for rental,vacation property vacation home, rent it out for asubstantial period of time and sible foryoutodoalike-kindexchangeifturn avacation and reported as rental or investment property,and reported the better your to rental property areto rental tricky, property Itispos butcanbeworthwhile. tax-deferred exchangetreatment. Themore rental, investment, the greater ofofor 10% 14days thenumberofthe during days this safeharbor, youmusthaveheldtherelinquished property home,youare notallowedto to beanewsecondorprimary ittoan that realconverted then youhave a business, estate as then exchangeitforotherreal estateandconducttherental of tax tip Like-kind exchanges for vacation homes that are converted Like-kind exchanges for vacation homes that are converted which includes a safe harbor rule under which it said it would not for atleast24monthsandineachof thetwo12-monthperiods position will be to support tax-deferred exchangetreatment. position willbetosupport washeld,treatedmore you cansubstantiatethattheproperty and held for rental or investment. The was converted property wasacquired inthe1031 beginning withthedateproperty residence, theexclusionwillnotapplyduringfive-yearperiod residence exclusion. If you acquire inthe like-kind property home andtake advantage of the $500,000primary primary foranother,property ittoyour youcannotimmediately convert of forpurposes property In order alike-kindexchange. tomeet move inimmediately. In2008theIRSissuedRev. Proc. 2008-16, home intoarental property.your Forexample,ifyoustopusing In addition, after successfully swapping one vacation/investment successfullyswappingonevacation/investment In addition,after or business use activity, the stronger the facts will be that the asyourprincipal exchange andlaterattempttosellthatproperty challenge whether areplacement dwelling qualifiedasinvestment intended swappedforis if theproperty In addition, conversion. sucha thetimingandfactsmustsupport exchange. Ofcourse, investment, orbusinessuseandwouldtherefore for qualify you must theexchange: rent(1) thedwelling immediately after investment property. couldallowforalike-kind conversion This like-kind exchange. unit to another person forafairrentalunit toanotherperson or more; for14days and 17 FOR VACATION HOMES LIKE - KIND EXCHANGES

-

For taxable years beginning after December31,2017andbefore beginningafter For taxableyears their regular taxableincome. individual incometaxrate,dependingontheirbracket,to law,was requiredtaxpayer generally anindividual their toapply investment andnon-investmentrelated activities.Underpre-Act the taxtreatment of incomefrom pass-through entitiesforboth The Tax CutsandJobsAct of 2017 makes significant changesto considerations). better approach (e.g., when you have expiring losses, or state tax not engaginginalike-kindexchangeiftaxableeventisthe Note: a like-kindexchange. Caution: limitation test”). The 20%deduction islimited to the greater of may stilldeductthe20%butare subjecttoacap (the“wage above thisincome thatare engagedinnon-specified businesses maydeductthe20%.Taxpayers businesses specified service Taxpayers below this income threshold that are engaged innon- and $207,500. earning between $157,500 and $415,000, andforindividualfilers withtaxableincomebetween$315,000 outforjointfilers phases businesses,notedabove,thededuction For specifiedservice of itsemployeesorowners. reputation the is orbusiness trade such of orskill ormore one where tradeorbusiness or any of asset theprincipal services, brokerage consulting, athletics, financial services, arts, performing in thefieldsof health,law,services accounting, actuarial science, than architecture ofthe performance involving orengineering) asanytradeor business(other or businessisdefined,inpart, tradeorbusiness.”a “specified service trade Aspecifiedservice below, if is not allowed the QBI deduction is earnedthe 20% from whose taxable income isabove theFor limits taxpayers mentioned to thetaxpayer. include reasonable compensationorguaranteedpaymentsmade commodities gainsandforeign currency gains.QBIdoesnot interest income,short-term capitalgains,long-term capitalgains, income (e.g.,dividendsotherthanREITdividends),investment is defined asalldomestic businessincome other than investment income. QBI dividends and qualified publicly traded partnership qualifiedREIT The 20%deductionisalsoallowedforataxpayer’s S corporation or sole proprietorship.LLC taxed as a partnership, income (“QBI”)fromdomestic qualifiedbusiness apartnership, 2026,theActallowsadeductionof 1, 20%ofJanuary ataxpayer’s PASS Like-kind exchange reporting is not elective. Consider elective. not is reporting exchange Like-kind - THROUGH TAX TREATMENT

The sale of yourprincipalresidence for does notqualify

passive and real estate activities 61 EisnerAmper 2018 personal tax guide 62 depreciation deductions. be available.Seethechapteronbusinessownerissuesand investments underIRCSec.179.Bonusdepreciation mayalso with the ability to immediately write off new the cost of certain willreceive owners anewtaxadvantage Some property owners. 1,2018impacting real estate business law beginningJanuary The Taxto tax changes Act alsomakesadditional CutsandJobs is allowedasadeductiontotaxableincome. AGI computing in allowed not is deduction 20% The instead but as anemployee. of(defined above)orthetradebusiness services performing tradeorbusiness any businessotherthanaspecifiedservice is tradeorbusiness Aqualified ADS). under periods recovery without regardSec. 168 applicable lists (which Sec. 168(g) toIRC under IRC period that would apply to the property recovery ofthe lastday that dateor(2) thelastfullyearinapplicable andendingonthelaterof after the datetenyears (1) in service placed isfirst is theperiodbeginningon date the property year. depreciable The respect periodwith property toqualified period forwhichhasnotendedbefore thecloseof thetaxable qualified businessincome (land isnot included) the depreciable a “qualified trade or business” and used inthe production of subjectto depreciation under IRC Sec. 167, held byproperty isgenerallydefinedastangible this purpose,qualifiedproperty of acquisition, allqualifiedproperty.immediately after basis, For to thequalifiedtradeorbusinessplus2.5%of theunadjusted or business or (b) the sum of 25% of the W-2 wages with respect (a) 50%of theW-2wagespaidwithrespect tothequalifiedtrade account thelongerdepreciation schedulesiftheyelecttouse will needtotakeinto owners interior improvements. Property forresidentialyears rental property, forqualified and20years periodsof fornon-residential 40years property,recovery 30 interest limit must depreciate underslightly longer real property opting to use the real owners estate exception to the property The current depreciation rulesforreal estate continues.However, the entitylevel. debt. Theinterest limit, andthereal estateelection,appliesat The newinterestand appliestoexisting limitis effective in 2018 manner asprovided by the IRS and,once made, is irrevocable. the passiveactivityrules.Theelectionismadeatatime andina tradeorbusinessasdefinedunder the limitationanyreal property Specifically,tax rules. theelectioncanbemadetoexcludefrom maydesireowners to elect out of the new interest disallowance issues anddepreciation deductions),butinvestmentproperty expense (as explained more fully in the chapter on business owner cancontinuetodeductnetinterest owners Investment property asset, suchasanytypeof rental property. taxes associated with abusiness owner can deduct property toremaincontinue Accordingly, deductible. rental a property business, or in an activity related to the production of income, onatradeor State andlocaltaxespaidinrespect tocarrying the real estateexceptiontotheinterest limit.