Passive Activity Loss Exception Applies to Real Estate Agent - Essay Example

?Passive Loss A tax-paying individual can generally reduce their losses by deducting passive activity losses from their passive activity income, and until such time that they use it, will enable them to carry any exceeding loss into the forthcoming years. For instance, John F. Kerry, who is an owner of two properties for rent incurred a $25, 000 loss in one property in 2008, while incurring another $40,000 taxable income from the other property. What he can do in order to report a $15, 000 of passive income is net the results from the two properties which would would reflect on his tax return for the year. Passive activity Trade and rental activities are the two kinds of passive activities. In trade or business activities, the taxpayer does not take part in a material sense throughout the duration of the year, while in rental activities, it is regardless of the taxpayer's material participation unless he or she is into real estate by profession. Deducting passive loss from a taxpayer can only extend to their passive income. According to Section 469(c)(2), any rental activity is under the classification of passive activities unless the taxpayer will materially participate in a real property trade or business during the year as well as performing personal services exceeding 750 hours. Any excess of the 750 hours corresponds to more than 50% of the personal services that the taxpayer has carried throughout all trades or businesses. An activity may also be considered non-passive if it is under a lease entered into after Feb. 18, 1988, and in which the taxpayer is renting property to a trade or business wherein the taxpayer has material participation. Taxpayers are entitled to as much as $25,000 passive losses deduction from a rental real estate activity if he or she owns at least a 10% interest and has active participation in the activity. The availability of the sum total of the $25,000 limit is dependent on whether the adjusted gross income (AGI) is less than $100,000, though even this has gone through a gradual phasing out as the AGI increased to $150,000. (Internal Revenue Code) Of late, the Tax Court ruled in favor of the IRS in two cases, without any real relation, on the same day which involved the passive loss regulations for rental activities. Due to the taxpayer's inability to establish his activities qualification as a real property trade or business which should fall under the exception of 469(c)(7) of the Internal Revenue Code, the court ascertained that the taxpayer's rental activity was passive. On the latter case, the court determined under the "self-rental" rule of Treasury Regulation that a taxpayer's rental activity was not passive. (Reichert, 2008) Another example is the case of Carolyn Fenderson who owns 10 rental housing units, coming up with an aggregated loss of $57, 906. She filed an amended 2002 tax return way back in 2005, which included the lists of the rental income and deductions on Schedule C. She has an AGI exceeding $150, 000 and is without other passive incomes. In order to deduce the $57,906 loss, treating the activity as a non-passive real property trade or business was a necessity. After scrutinizing her calendar records, the Tax Court only accepted 759 hours out of the 1,062 hours of personal service for the rental activity she was claiming, against the 780 hours on her other job as a software sales account manager, thereby failing the 50% test for the activity Gregory Farris had a 50% interest in a partnership, renting three buildings in 1985 to his law firm which he also had a partnership with. After the execution of a new lease in 1990, another was brought forth in 1992 due to the incorporation of the law firm because of the destruction of the original document. After Farris acquired sole ownership of the rental property, a new lease was once again brought forth in 2000. In the years 2000, 2001 and 2002, Farris' claim is such that the net passive income from the property were $34,839, $46,168, and $48,391, thus enabling him to deduct equal passive losses. The IRS prohibited the loss deductions. Asserting his lack of passive income against which to offset them, since the self-rental rule redefined the rental income as non-passive. Farris contended in the Tax Court that the lease which was in effect on 2000 to 2002 was a mere continuation of the 1985 lease. If it will be accepted by the court, this would entitle him to exempting the income from being redefined as non-passive. However, the Tax Court stated that the lease could not be a continuation as the parties of the 2000 lease does not include the original parties of the 1985 lease. Any endeavor to regard the law corporation as to be a continuation of the terminated law partnership would be at odds with the federal income tax laws and the state laws. The two cases is an illustration of how classifying an activity as passive or non-passive can be ambiguous. When taxpayers have financial gain from activities that are passive, another activity incurring a loss needs to be passive in order to get a current deduction. On the otherhand, when taxpayers have no other passive income, an activity with a loss has to be non-passive to acquire a current deduction. (Reichert, 2008) Phase-out Rule The maximum special allowance of $25,000. For married individuals, it will be $12,500 give n that they are filling separate returns and living apart at all times during the year. They will received a reduction of 50% from the amount of their modified adjusted gross income that is more than $100,000, making it $50, 000 if you are married but filing separately. In general, if the modified adjusted gross income is $150,000 or more, or $75,000 or more if you are married but filing separately, you will not be able to use the special allowance. Example B. Bryan Parker is the owner of one rental property and in charge of making managerial decisions. This property rendered a $20,000 loss in 2008 and his AGI in that year was $140,000. This AGI is equivalent to 80% through the $100,000–$150,000 phaseout range, so he can take off only 20% of the $25,000 maximum which will only be equivalent to $5,000. If he can deduct $5,000 of his $20,000 loss, he can’t deduct the remaining $15, 000 right away, but he can move it forward to the forthcoming years as a suspended passive loss. Example C. In 2010, John was not married and was also not a real estate professional. His salary for 2010 was $120,000 and incurred a $31,000 loss from his rental real estate activities in which he was actively participating which will make his modified adjusted gross income $120,000. He can deduct only $15,000 of his passive activity loss when he files for his 2010 return and must carry over the remaining $16,000 passive activity loss to 2011. He figured his deductions and carryovers as follows: AGI $120,000 Amount not subject to phaseout (100,000) Amount subject to phaseout rule $20,000 X 50 % X50% Required reduction to special Allowance $10,000 Maximum special allowance $25,000 Required reduction (10,000) Passive loss from rental real estate $31,000 Adjusted special allowance $15,000 Special allowance 15,000 Carry Forward Amount $16,000 Exceptions to the Phaseout Rules As compared to rental real estate activities, there is a higher phaseout range which applies to rehabilitation investment credits. The phaseout of the $25,000 special allowance for those credits begin when their modified adjusted gross income goes over $200,000 or $100,000 to married individuals who are filing separate returns and living separately at all times during the year. (IRS, 2010) PASSIVE ACTIVITY LOSS EXCEPTION APPLIES TO REAL ESTATE AGENT The Tax Court in Agarwal, TC Summary Opinion 2009-29, has held that a wedded couple may deduct losses related to their rental activity due to the wife's being in a real property trade or business, which entails that they were not covered in the Section 469 for passive activity loss limitations. As of 2001 and 2002, the taxpayer husband was working as a full-time engineer while the taxpayer wife was working as a full time real estate agent in a real estate brokerage firm though she was not yet licensed broken during those times. The taxpayer wife was working with the brokerage firm under an "Independent Contractor Agreement (Between Broker and Associate Licensee)", entailing that she was an independent contractor and not employed by the firm, per se. The contract did require the taxpayer to make sales, exchanges, leases, rent properties as well as solicit additional listings and clients. Put together, both taxpayers played out more or less 170 hours managing the "Wanda Property" and another 170 hours managing the "Mohave Property" in the years 2001 and 2002. There was no involvement of any other individual with regards to managing the rental properties. In those same years, the taxpayer wife played out a total of 1, 400 and 1, 600 hours, as she managed the couple's rental properties and selling real estate. In 2001, she reported commissions of $13,912 as gross receipts on the couple's Schedule C, Profit or Loss from Business, and total expenses of $14,084. For 2002, she reported commissions of $14, 119 as gross receipts and total expenses of $13,401 (Practical Tax Strategies. 2009) Filing for the total net loss of $40, 104 which they attributed to their rental activities for the year 2001, the couple reported the total income from rents as $36, 367 and total expense or losses as amounting to $76, 471 on their Schedule E. For 2002, they reported total income from rents as $45, b521 and total expenses as $65, 177 in order to get a net loss of $19, 656. The IRS, however, did not accept the couple's Schedule E losses for each year. First and foremost, passive losses are only permitted as far as they are qualified for the special allowance for rental real estate as well as the transitional phase-in rule. Secondly, their losses were in excess of their passive income, special allowance, and the phase-in rule. Section 469 generally forbids passive activity losses. A passive activity is defined as "any trade or business or an activity engaged in for the production of income in which the taxpayer does not materially participate." A passive activity loss, on the otherhand is defined as the excess of the aggregate losses over the aggregate income from all passive activities. Material participation means that "the taxpayer is involved in the activity's operations on a regular, continuous, and substantial basis." (IRS) Section 469(c)(2) indicates that the general rule in which rental activity is being handled is through treating each activity as a per se passive activity, regardless of the taxpayer's lack or presence of material participation. On the otherhand, under Section 469(c)(7), rental activities of a qualifying taxpayer in the field of real property trade or business are not treated as a per se activity under Section 469(c)(2). Rather, the qualifying taxpayer's rental activities are treated as a trade or business, falling under the category which takes into consideration the participation of the spouse of the taxpayer and will then be subject to the material participation requirements. A taxpayer, however, may qualify for the exemption rule of the real property trade or business if: 1. More than half of the personal services the taxpayer performs in trades or businesses within the tax year are executed in real property trades or businesses wherein the taxpayer has material participation. 2. The taxpayer was able to render more than 750 hours of services during the tax year in real property trades or business in which he had materially participated. A "real property trade or business" is defined as "any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business." (IRS) At trial, the taxpayers reasoned that real estate agents should be considered real estate professionals due to their engagement in a real property brokerage business. The IRS's response in turn is such that the taxpayer's spouse was a licensed real estate agent, not a licensed broker. (Practical Tax Strategies. 2009) Under the law of the state of California, she could not be engaged in a brokerage trade or business. Consequently, the IRS asserted that she was not involved in a real property trade or business as defined by Section 469(c)(7)(C). (Internal Revenue Code) According to the Tax Court, the word "brokerage" was not defined in Section 469, and thus, by applying the principles of statutory construction, the Tax Court determined that the use of the term must be in its "ordinary and usual sense." After using the definitions given in the Webster's Third New International Dictionary, the court's conclusion is that for the intents of Section 469, the "business" of a real estate broker should then entail the inclusion of but not limited to the following: 1. Selling, exchanging, purchasing, renting, or leasing real property. 2. Offering to do those activities. 2. Negotiating the terms of a real estate contract. 3. Listing of real property for sale, lease, or exchange. 4. Procuring prospective sellers, purchasers, lessor, or lessees. Dispose of an Active to Release Suspend Passive Loss The passive activity loss (PAL) guidelines were initially enacted as a solution to address abusive tax shelters and also for the purposes of restricting taxpayers' capacity to cut down their tax obligations through the utilization of loss deductions or credits. In numerous cases, any amount of loss incurred from passive activities which exceeds income from passive activities in a particular year can not be deducted and must be carried forward to following tax years or until such time that the activity is disposed of in a taxable transaction. PALs that have not been used are suspended and carried forward to future years until the taxpayer (1) gets rid of the specific activity that incurred him the losses, (2) brings forth net passive activity income in the case of a personal service corporation (PSC), or (3) and in the case of closely held corporations, generates net passive activity income or net active income (CHC). In general, a disposition happens if the taxpayer will let go of all interests in the activity in a fully taxable dealings to unrelated parties. Example D: A, Inc., is a PSC owning two passive activities, the first one being a leased office building and the other being a book unit. The building lease activity has no existing suspended losses with a income of $10,000 annual income for the current year. The book unit on the otherhand incurred $50,000 in suspended losses and a current-year loss of$10,000. The owner has always treated the activities as two separate activities and has earned an active income of$100,000 in the current year. After coming up with the decision to cut his losses with the book unit due to its lack of profitability, he planned to sell most of the assets involving the book unit activity on the 30th of December of the current year. The assets that he is planning to sell have a fair market value (FMV) amounting to $20,000 and a basis of $5,000. He is also planning to keep the book unit's office equipment in its active business operations instead of selling it. That office equipment in particular has an FMV amounting $1,000 and a basis of $500. Question is, will he be able to use the $50,000 of suspended losses from the book unit in the current year? Assuming that he will dispose of practically all of the book unit activity in the current year, he must be capable of correctly accounting for the gross income, deductions, and credits that are allocatable to that activity for the current tax year which would result to his capability to offset the $10,000 income from the building rental, the $15,000 profit from the selling the book unit, and $35,000 of its active income with the $50,000 suspended loss, as well as the $10,000 current-year loss from the book unit activity. (Ellentuck, 2008) References: Reichert, Charles J, CPA. 2008. Passive or Non-passive Activity-IRS Wins Either Way. Journal of Accountancy. ProQuest. pg. 74 Internal Revenue Service. Publication 925. Passive Activity and At-Risk Rules. For Use on Preparing 2010 Returns. Department of Treasury, Internal Revenue Service. Practical Tax Strategies. 2009. Passive Activity Loss Exception Applies to Real Estate Agent. pg. 301 Ellentuck, Albert B, Esq. 2008. Disposing of an Activity to Release Suspended Passive Losses. The Tax Adviser. ProQuest. pg. 317 Read More