1. Chapter 7
Deductions:
Business/Investment Losses
and Passive Activity Losses
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2. Chapter 7 Exhibits
1. Abusive Tax Shelters
2. At-Risk Rules
3. Determining the Amount at Risk
4. Additional Points on At-Risk Rules
5. Passive Activity Loss Rules
6. Applying the At-Risk and Passive Loss Rules
7. Disposing of an Entire Passive Activity Interest
8. Inheriting a Passive Activity
9. Receiving a Passive Activity as a Gift
10. Material Participation
Chapter 7, Exhibit Contents A CCH Federal Taxation Basic Principles 2 of 31

3. Chapter 7 Exhibits
11. Significant Participation
12. 6 Exceptions to Rental Activity Status
13. Special $25,000 Allowance
14. Real Estate Professionals
15. Computing Business Casualty and Theft Losses
16. Net Operating Losses—Rules for Individuals
17. Hobby Losses
18. Home Office Expenses
19. Vacation Home Expenses
20. Rented for More Than 14 Days
Chapter 7, Exhibit Contents B CCH Federal Taxation Basic Principles 3 of 31

4. Abusive Tax Shelters
 Tax shelters provided deductions to investors in order to
reduce tax liabilities with respect to income from other
sources.
 Almost all tax shelters were formed as limited partnerships,
which allowed losses to pass through to the individual’s tax
return. (A limited partner is not personally liable for the debts
of the partnership).
 Typical tax shelters once provided high returns without
necessarily making a before-tax profit.
Chapter 7, Exhibit 1a CCH Federal Taxation Basic Principles 4 of 31

5. Abusive Tax Shelters
Example of Pre-1987 Tax Shelter
 10 investors form "Pay-No-Tax," a limited partnership.
 Each investor contributes $10,000, and the partnership
purchases an office building.
 The building never exceeds 50% occupancy.
Chapter 7, Exhibit 1b CCH Federal Taxation Basic Principles 5 of 31

6. Abusive Tax Shelters
At 50% occupancy, the annual cash flows appear as follows:
Each of the 10 Partners
Description LP
Rental income $ 70,000 $ 7,000
Operating expenses (40,000) (4,000)
Interest payments (90,000) (9,000)
Negative cash flow (60,000) (6,000)
Depreciation (100,000) (10,000)
Tax loss (160,000) (16,000)
Tax benefit from loss (70% tax bracket
from 1965 – 1981) 112,000 11,200
Net cash [($60,000) + $112,000] $52,000 $ 5,200
Annual return on equity 52% 52%
($52,000/$100,000)
Chapter 7, Exhibit 1c CCH Federal Taxation Basic Principles 6 of 31

7. Abusive Tax Shelters
 The partnership had a $160,000 tax loss, which provided
$112,000 of tax savings. ($160,000 * 70%)
 The partnership only had a $60,000 cash loss.
 Compared to the $112,000 tax savings, the partnership
actually had a positive cash flow of $52,000.
($112,000 - $60,000)
Chapter 7, Exhibit 1d CCH Federal Taxation Basic Principles 7 of 31

8. At-Risk Rules—Background
 Congress passed the Code Sec. 465 at-risk rules in 1976.
However, the at-risk rules did very little to curb abusive tax
shelters.
 The at-risk rules prevent taxpayers from deducting losses in
excess of basis (i.e., amount at-risk).
Chapter 7, Exhibit 2 CCH Federal Taxation Basic Principles 8 of 31

9. Determining the Amount at Risk
Cash investment in an activity
+ Basis of other property invested
+ The activity's borrowings with investor personal guarantees or
personal collateral.
+ Income allocation
– Loss allocation
– Withdrawals of cash or other property to investors at FMV
= Amount at risk
Chapter 7, Exhibit 3 CCH Federal Taxation Basic Principles 9 of 31

10. Additional Points on At-Risk Rules
 Ordinarily, an investor is not at risk for nonrecourse loans
(loans secured by the property purchased, rather than the
personal assets of the borrower).
 However, Congress permitted “qualified” nonrecourse loans
to be treated as “at-risk” if they were secured by their activity's
real property.
 Generally, nonrecourse secured loans from S & Ls, banks,
insurance companies, and federal, state, and local governments
are considered to be at-risk.
Chapter 7, Exhibit 4 CCH Federal Taxation Basic Principles 10 of 31

11. Passive Activity Loss Rules
 Effective January 1, 1987, passive activity loss rules were
enacted, which eliminated most tax shelters.
 Generally, passive losses can only offset passive income. Any
disallowed losses are treated as a deduction to the activity
next year.
 Suspended losses can be deducted against passive and
nonpassive income upon the fully taxable disposition of the
entire interest.
Chapter 7, Exhibit 5a CCH Federal Taxation Basic Principles 11 of 31

12. Passive Activity Loss Rules
The PAL rules generally provide that all income and loss must be
placed in one of three categories:
 Active – income attributed to direct efforts of the taxpayer
(ex. salary, wages and commissions).
 Passive – income derived from passive activities. Losses are
generally only deductible against passive income.
 Portfolio - income from dividends, interest, royalties.
Chapter 7, Exhibit 5b CCH Federal Taxation Basic Principles 12 of 31

13. Applying the At-Risk and Passive Loss Rules
1. Determine the amount at-risk for each activity.
2. Determine the gain/loss for each activity for the year.
3. If gain, increase the amount at-risk.
4. If loss, decrease the amount at-risk, but not below zero.
Any excess losses are carried over.
Chapter 7, Exhibit 6a CCH Federal Taxation Basic Principles 13 of 31

14. Applying the At-Risk and Passive Loss Rules
5. Add up passive gains.
6. Add up passive losses (reduce by amounts carried over).
7. Reduce passive gains by passive losses. Include net passive
gain in gross income.
8. Any excess passive losses are suspended and can be used in
future years to offset passive income
Chapter 7, Exhibit 6b CCH Federal Taxation Basic Principles 14 of 31

15. Disposing of an Entire Passive
Activity Interest
Three rules apply:
1. Losses. Loss on an “entire” disposition of a passive activity and its
suspended losses can offset active and portfolio income from all
activities.
2. Gains. Gain on an “entire” disposition of a passive activity can be used
to offset suspended passive activity losses from other passive activities.
3. Unrelated parties. The disposition must be to an unrelated party (i.e., a
party other than half-blood relatives, lineal descendants, ancestors,
siblings, and spouses).
Chapter 7, Exhibit 7 CCH Federal Taxation Basic Principles 15 of 31

16. Inheriting a Passive Activity
Three rules apply:
1. Beneficiary's step-up basis. Beneficiary gets a step-up basis at fair
market value (FMV) on the date of benefactor's death (or, if elected by
executor, FMV six months after the date of death.)
2. Beneficiary's at-risk amount. The step-up basis becomes “at risk” to the
beneficiary.
3. Decedent's passive loss deduction. In the decedent's final income tax
return, suspended losses are deductible to the extent they exceed the
“step-up” amount i.e., to the extent they exceed (FMV at date of
death - Adjusted basis at date of death).
Chapter 7, Exhibit 8 CCH Federal Taxation Basic Principles 16 of 31

17. Receiving a Passive Activity as a Gift
Two rules apply:
1. Donee basis. Donee does not receive a step-up basis, but
the donee assumes the donor's basis (in most cases).
2. Donor's suspended losses. The donor's suspended losses
are not deductible; instead, they’re added to the donee's
basis.
Chapter 7, Exhibit 9 CCH Federal Taxation Basic Principles 17 of 31

18. Material Participation
 An activity in which a taxpayer materially participates is not a
passive activity.
 However, real estate rental activities are generally considered
passive regardless of the level of participation.
 Material participation requires a taxpayer to be involved in
the operations of the activity on a regular, continuous and
substantial basis. Must meet 1 of 7 tests.
Chapter 7, Exhibit 10 CCH Federal Taxation Basic Principles 18 of 31

19. Significant Participation
 Significant participation requires more than 100 hours of
participation.
 If total participation in all significant participation activities
exceeds 500 hours, then the taxpayer is treated as having
materially participated in all such activities.
Chapter 7, Exhibit 11 CCH Federal Taxation Basic Principles 19 of 31

20. 6 Exceptions to Rental Activity Status
 Generally, any rental activity is considered a passive activity, without
regard to material participation. However, if any of the following 6 tests
are met, the activity is not considered a rental activity.
1. Under 8-day average rental. Average customer use is 7 days or less (e.g.,
hotel rooms, movie rentals).
2. 8–30 days average rental plus significant services. Average customer use is
8 to 30 days and “significant” personal services are provided to the
customers (e.g., computer leasing, automobile leasing).
3. Over 30-day average rental and extraordinary services. Average customer
use is over 30 days and “extraordinary” personal services are provided to
customers (e.g., lengthy hospitals stays).
Chapter 7, Exhibit 12a CCH Federal Taxation Basic Principles 20 of 31

21. 6 Exceptions to Rental Activity Status
4. Insignificant rental. Gross rental income is less than 2% of the lesser
of (1) fair market value of the rental asset or (2) the adjusted basis of
the rental asset (e.g., renting a small portion of a vast timberland to a
farmer)
5. Property is available during defined business hours for nonexclusive
use by the general public (e.g., operating a golf course available
during prescribed business hours for nonexclusive use).
6. Property is rented to a non-rental activity owned by the lessor.
Chapter 7, Exhibit 12b CCH Federal Taxation Basic Principles 21 of 31

22. Special $25,000 Allowance
 An taxpayer may deduct up to $25,000 in rental real estate
losses from non-passive income, as long as the taxpayer
actively participates and MAGI is less than $100,000.
 As long as a taxpayer participates in management decisions,
he is considered to be actively participating. Additionally, the
taxpayer must own at least a 10% interest in the property and
not be a limited partner.
Chapter 7, Exhibit 13a CCH Federal Taxation Basic Principles 22 of 31

23. Special $25,000 Allowance
 The $25,000 allowance is available for all filing statuses.
However, for married filing separately (and living apart), the
allowance is $12,500. Married individuals who file separately
and do not live apart cannot qualify for any of the $25,000
deduction.
 There is a phaseout of 50% for every dollar of MAGI over
$100,000. The allowance is fully phased-out if MAGI is over
$150,000
Chapter 7, Exhibit 13b CCH Federal Taxation Basic Principles 23 of 31

24. Real Estate Professionals
 Over 750 hours a year are devoted to a real estate business, AND
 Over 50% of the taxpayer's personal services for the year are devoted to
a real estate business, AND
 One of the 7 material participation tests is satisfied.
If all 3 of the above tests are met, losses from rental real estate
activities will not be subject to passive loss limitations.
Example: A full-time real estate agent owns and manages a rental
house. Any losses from the rental house are nonpassive losses.
Chapter 7, Exhibit 14 CCH Federal Taxation Basic Principles 24 of 31

25. Computing Business Casualty and Theft Losses
If total destruction
Adjusted Basis
or theft:
Lesser of
If partial destruction:
Adjusted Basis or Decline in Fair Market Value
Insurance reimbursement or compensation
Less
received
Result: = “Recognized” gain or loss FOR AGI
*Gain is recognized to the extent that insurance reimbursements exceed adjusted basis.
Chapter 7, Exhibit 15 CCH Federal Taxation Basic Principles 25 of 31

26. Net Operating Losses—Rules for Individuals
NOL = Bus. Income - Bus. Exp. - Personal Use Casualty Loss Deductions
Carryovers:
NOLs from tax years beginning on or 3 years back, 15 years forward
before 8/5/97:
NOLs other than from casualty deductions 2 years back, 20 years forward
from tax years beginning after 8/5/97:
NOLs attributable to personal-use casualty 3 years back, 15 years forward
and theft losses:
Chapter 7, Exhibit 16a CCH Federal Taxation Basic Principles 26 of 31

27. Net Operating Losses—Rules for Individuals
If carried back: The earliest year’s taxable income is recomputed,
and the taxpayer files for a refund with an
amended return.
If carried forward: Deduction for AGI in a subsequent year.
Election: May elect to forego carrybacks. This election
must be made when the return reporting an NOL
is timely made.
Chapter 7, Exhibit 16b CCH Federal Taxation Basic Principles 27 of 31

28. Hobby Losses
 Hobby expenses are deductible only to the extent of hobby
income.
 The deduction for hobby expenses is a miscellaneous
itemized deduction subject to the 2% of AGI floor.
 Expenses that are otherwise deductible (such as taxes,
interest and casualty losses) are still deductible, regardless of
the amount of hobby income. However, such deductions
reduce the amount of hobby income available to offset other
hobby deductions.
Chapter 7, Exhibit 17 CCH Federal Taxation Basic Principles 28 of 31

29. Home Office Expenses
 If a portion of a personal residence is used for business-
related activities, expenses allocable to the business-use
portion of the home may be deducted.
 If a taxpayer is an employee, the home office must be for the
convenience of the employer.
 Any excess expenses that are not deducted in the current
year may be carried forward.
 If the taxpayer is an employee, the deduction is a
miscellaneous itemized deduction (except for mortgage
interest and property taxes, which are fully deductible).
Chapter 7, Exhibit 18 CCH Federal Taxation Basic Principles 29 of 31

30. Vacation Home Expenses
 If property is rented for less than 15 days, then home is
treated as a personal residence. No rental income or expenses
are reported. Regular deductions for personal residences are
allowed (mortgage interest, property taxes).
 If property is rented for more than 14 days, then the
property can be treated as either:
1. Personal residence ( if used excessively for personal
purposes)
2. Rental property (not used excessively for personal
purposes)
Chapter 7, Exhibit 19 CCH Federal Taxation Basic Principles 30 of 31

31. Rented for More Than 14 Days
 Excessive personal use is measured by the greater of 14 days
or 10% of rental days.
 If the taxpayer uses then property for excessive personal
purposes, then the property is considered personal use
property. Rental income and expenses are reportable.
However, loss deductions are not allowed.
 If the taxpayer does not use the property for excessive
personal purposes, then the property is considered rental
property. Losses can be deducted for AGI (subject to passive
activity rules). If the taxpayer actively participates, the
$25,000 special allowance applies.
Chapter 7, Exhibit 20 CCH Federal Taxation Basic Principles 31 of 31