1

PASSIVE ACTIVITY LOSSES

Rental and business losses disallowed.

NET INVESTMENT INCOME 3.8% tax on investment income, including passive income.

Overview of passive activity rules Page 2

Material participation 3

Vacation homes, condos, hotels 4

Common Mistakes 5

Disclosure statements & elections 10

Net investment income 13

Avoiding the 3.8% tax 15

By

Lucy H. Clark, EA JP – Independent Tax Consultant Former IRS Technical Advisor with the National Office

117 Goddard Road, PO Box 498

Rindge, New Hampshire 03461-0498 603-899-6315

lucy@clarktaxes.com 9/18/2014

2

OVERVIEW: PASSIVE ACTIVITY LOSSES (PAL) Form 8582, IRS 469, Reg. 1.469

Concerns Rentals: Are rental losses deductible?

Is the property rental real estate and modified AGI is more than $150,000? .

Is taxpayer (TP) a real estate pro, and did he materially participate in the rental activity?

Does activity fall out of the rental definition and is as a business subject to material participation? Businesses: Is a business loss from Sch. C, Sch. F, K-1 line 1 (1065 or 1120S) deductible?

Income: Should income be treated as passive income, which is entered on Form 8582 and thereby triggers deductibility of passive losses?

Basic tax law IRC 469 & Reg. 1.469, Form 8582, Pub. 925

Passive losses are deductible only to the extent of passive income. Unused passive losses are carried forward indefinitely or until there is a qualifying disposition. Limitations apply to individuals, investors in 1065s & 1120S, personal service corps, trusts & estates. Rentals (equipment leasing & rental real estate) are passive, whether or not TP materially participated.

Rental real estate gets a $25,000 special allowance if modified AGI is less than $100,000.

Rentals of a real estate pro are excepted from the passive loss limitations if TP materially participated in each of the rentals.

Business losses are passive if TP did not materially participate.

TP materially participated if and only if he meets 1 of 7 tests in Reg.1.469-5T(a) for the year.

What is passive income?

Net income from a rental activity (except land, or a rental to a business where TP works).

Net income from a business activity in which TP does not materially participate.

Gain on sale of an asset used in a passive activity.

What are the activity (grouping) rules? Reg. 1.469-4, Revenue Procedure 2010-13

Related business may be grouped as a single activity. Requires statement with return in first year. Makes it easier to meet 500 hour test for material participation).

Rentals may be grouped with a business if insubstantial or owned in same percentage. If not, no grouping allowed.

A rental activity may never be grouped with C corporation.

What activities are excepted from the passive loss limitations? Traders in stocks and bonds Reg. 1.469-1T(e)(6)

Oil and gas if TP has a working interest (simply means his liability is not limited) IRC 469(c)(3)

Rental real estate if § 280A(c)(5) applies (i.e. if personal use more than 14 days, loss limited by 280A)

Rental real estate of a real estate professional if he materially participated in each rental All current and carryover losses on a qualifying disposition

Deduction exceptions (not limited by passive activity rules)

Charitable contributions Reg. 1.469-2T(d)(2)(viii)

Foreign tax credit IRC 469(d)(2)(A)(ii)

New markets tax credit Questions to ask the client

Which activities are related, i.e. form an economic unit?

Have they always been treated as nonpassive in the past?

Where is the activity located?

Is the activity a rental activity? How long does each customer use the property?

Who manages the activity?

What services did you or your spouse perform for each business for the year? Hours? What records do you have to support your services and hours worked? Reg. 1.469-5T(f)(4)

More info at www.irs.gov: Publication 925; Form 8582 & Instructions; MSSP Guide: Passive Activity Losses Training 3149-115.

3

MATERIAL PARTICIPATION

Consider: Has business been grouped with a related activity as a single activity? Reg. 1.469-4 Material participation required: Did the taxpayer and/or spouse materially participate in …

A business or farming activity? Sch. C or F

A partnership or S corporation business (K-1 line 1)?

A vacation rental, condo rental, beach cottage, B&B, etc.

If TP is a real estate professional, did he materially participate in each rental? What might alert me to a material participation issue?

The taxpayer (TP) lives a long distance from the activity.

TP has a time consuming job or other nonpassive activities (check nonpassive column on back of Sch. E)

Low ownership percentage or limited partnership interest.

No salary or guaranteed payment for services in connection with an 1120S or 1065.

There is someone else who handles day-to-day operations. Basic tax law IRC 469(h), Reg. 1.469-5T(a), Reg. 1.469-5T(f) Passive losses are deductible only up to passive income. Loss is passive if TP does not materially participate. Managerial authority does not equate to material participation. TP materially participated only if he meets one of 7 hourly tests in Reg. 1.469-5T(a). TP must prove he materially participates in each separate tax year.

Exceptions: 1. Traders in stocks & bonds (Reg. 1.469-1T(e)(6)); oil & gas, if liability is not limited (IRC 469(c));

2. All current & carryover losses on disposition to an unrelated party in a fully taxable transaction. What are the 7 tests? Both spouses’ hours count. Must meet one test for the year. Reg. Sec. 1.469-5T(a)

1. Did TP and/or spouse work more than 500 hours a year in the business? 2. Did TP do most of the work? 3. Did TP work more than l00 hours and no one worked more hours? 4. Did TP have several passive business activities in which he worked between 100-500 hours each, and total hours are more than 500 hours? Test is not applicable for rentals or limited partners. 5. Did TP materially participate in activity for any 5 of the last l0 years? 6. Did TP materially participate in a personal service activity for any 3 prior years? Personal service activity =health, law, engineering, architecture, accounting, actuarial science, performing arts & consulting.

7. Do facts and circumstances indicate TP materially participated? Test cannot be used unless TP worked more than 100

hours for the year. Also does not apply if (1) anybody was paid in connection with managing the activity; or (2) if any person spent more hours than TP managing the activity.

Notes: (1) Limited partner can use only tests 1, 5 or 6. (2) Work of one spouse is attributed to the other; if one spouse materially participates, so does the other. (3) Managing member of an LLC can use any of the seven tests. Recordkeeping requirements Reg. 1.469-5T(f)(4)

Services performed and hours attributable to those services. TP must provide these, not IRS Agent!

Appointment books and calendars to support hours claimed. Or narrative with services and hrs.

Contemporaneous records are not required if services and hours are reasonable. Hours which do not count “IRS-proof” your time records!

Hours before TP actually owned the activity. Reg. 1.469-5(f)(1)

Reading reports, preparing budgets, phone calls, visits to monitor operations, preparing 1040, organizing records & other investor-type time unless TP is directly involved daily. Reg. 1.469-5T(f)(2)(B)(ii)

Work not customarily done by owner and purpose is to avoid PAL limits. Reg. 1.469-5T(f)(2)(B)(i)

Travel time (analogous to personal commute). Thomas E. Truskowsky, T.C. Summary Opinion 2003-130

Work which may be attributable to another tax year. Reg. 1.469-5T(a)

Work done by an employee, subcontractor, relative, POA, or other person.

4

VACATION RENTALS, CONDOS, B&Bs, HOTELS

Concerns

Are losses currently deductible?

Does the taxpayer (TP) meet any of the 7 tests in Reg. 1.469-5T(a) for material participation?

What might alert me to a passive loss issue?

The condo/B&B/hotel/motel/vacation rental is located a significant distance from the taxpayer’s home.

There are commissions or management fees associated with the activity.

The taxpayer has a full-time job unrelated to the activity (check W-2). Basic tax law Reg. 1.469-1T(e)(3)(ii) (A)&(B) If either of the following apply for the year, the activity is not deemed a rental, and gets no $25,000 offset.

Average customer use is 7 days or less for the year or

Average customer use is 30 days or less and significant personal services are provided (maid). If either of the above apply for the year, the activity is treated as a business. TP must prove he materially participated for each separate tax year. If he materially participated, losses are fully deductible. If not, losses are not deductible in the absence of passive income. If neither of the above use rules apply, the activity generally is a rental. Note: If either of the above apply, the activity is not rental real estate for purposes of the real estate professional exception to the passive loss rules under IRC 469(c)(7).

Average customer use = Days rented for the year divided by number of rental periods. What is material participation? Reg. 1.469-5T(a) Managerial authority does not equate to material participation. Reg. 1.469-5T(a) provides that the taxpayer materially participates if and only if he meets one of 7 tests. With on-site management, the taxpayer may not meet any of the tests, and thus is passive: 1. The taxpayer and spouse worked 500 hours during the year on the condo. 2. TP did most of the work (clearly inapplicable if there is on-site management). 3. TP did 100 hours of work and no one did more. With a full-time front desk staff, TP will not meet this test. Also,

it is TP’s burden to provide hours worked by management & others.

4. TP worked 100-500 hours on the condo and when combined with other passive businesses, the sum of hours exceeds 500 hours for the year. This test generally is not applicable, as TP must have other businesses in which he does not materially participate.

5. TP materially participated any 5 of the last 10 years. 6. The activity is a personal service activity and TP materially participated any prior 3 years. Condos

are not personal service activities. Test is not applicable. 7. TP materially participated under all the facts and circumstances. Test cannot be used if anyone is

paid compensation in connection with management. Test also requires more than 100 hours. Questions to ask

Where is the property located?

What is the average rental period? On average, how long was property rented to each tenant?

Who handles the day-to-day operations of the property?

What services do you perform? Hours you worked during the year? Recordkeeping requirements Reg. 1.469-5T(f)(4)

Services performed and hours attributable to those services for the year.

Documentation need not be contemporaneous as long as it is reasonable.

5

COMMON MISTAKES With PASSIVE LOSSES

THE BIGGEST MISTAKE OF ALL: Forgetting the passive activity rules! Passive activity losses are generally deductible only to the extent of passive income. What’s the problem? Passive income is relatively rare. Thus many passive activity losses are not fully deductible in the current year. Furthermore, while rental real estate receives a $25,000 special allowance, that offset is fully phased out when modified adjusted gross income exceeds $150,000. Thus no rental loss is deductible. Passive loss limitations apply to:

All rentals, whether equipment leasing or rental real estate – whether owned personally, via a partnership, S corporation, personal service corporation, or trust. A rental activity is passive – whether or not the taxpayer materially participates! See IRC 469(c)(2)&(4). Material participation is irrelevant! Exception: rental real estate of a real estate professional if he materially participated in the rental activity (IRC 469(c)(7) and Reg. Sec. 1.469-9(e)(1).

If the taxpayer does not materially participate, trade or business losses are generally nondeductible! Applies to all businesses whether conducted as a:

Sch. C sole proprietorship Sch. F farm Partnership, i.e. K-1 line 1 loss S corporation, i.e. K-1 line 1 loss Trust Personal service corporation – passive loss rules apply in full to all PSCs.

All losses in the nonpassive column on the back of Sch. E may send an IRS examiner’s antenna up! SOME FLAWED THINKING ON MATERIAL PARTICIPATION … First, the material participation rules generally do not apply to equipment leases or rental real estate (except rentals of a real estate professional). They applies to trades or businesses, i.e. Sch. C, Sch. F, K-1 line 1. Sometimes a taxpayer believes that he exercises managerial authority; thus he must materially participate. That is a seriously flawed argument. Material participation is based on meeting hourly tests. Furthermore, one of the tests must be met in each separate tax year. The fact that the taxpayer materially participated last year does not necessarily mean he materially participates in the current year. Reg. 1.469-5T(a) holds that the taxpayer materially participates if and only if he meets one of the following tests:

Did the taxpayer and/or spouse work more than 500 hours a year in the business?

Did the taxpayer perform most of the work?

Did the taxpayer work more than l00 hours and no one worked more hours?

Did taxpayer have several passive business activities in which he participates between 100-500 hours each, and the total participation exceeds 500 hours? Test is not applicable to rentals or for a limited partner.

Did taxpayer materially participate in activity for any 5 of the last l0 years?

Did the taxpayer materially participate in a personal service activity for any 3 prior years? Personal service activity =health, law, engineering, architecture, accounting, actuarial science, performing arts and consulting.

Do facts and circumstances indicate the taxpayer is materially participating? Test does not apply unless taxpayer worked more than 100 hours a year. Furthermore, it does not apply if (1) any person received compensation in connection with managing the activity; or (2) if any person spent more hours than taxpayer managing the activity.

To prove he meets one of the tests, Reg. 1.469-5T(f)(4) requires the taxpayer to provide services performed and hours attributable to those services based on reasonable means. A narrative without hours attributable to the services claimed does not meet the recordkeeping requirements.

6

AND SOME ERRONEOUS THINKING ON RECORDS TO PROVE MATERIAL PARTICIPATION: Taxpayers sometimes give an IRS examiner a general summary of activities in the form of a narrative or letter - and expect that will be sufficient to prove material participation. Reg. 1.469-5T(f)(4) does permit a narrative. However, a general narrative or summary without services performed and hours specifically allocable to those services does not meet the recordkeeping requirements of Reg. 1.469-5T(f)(4). Reg. 1.469-5T(f)(4) requires an identification of services performed and hours attributable to those services. Other items which may be indicators of material participation, but do not specifically meet the recordkeeping rules, i.e. services performed and hours attributable to those services:

The taxpayer’s oral testimony

Affidavits or statements from employees, business partners, or others Suggestion: A simple method for recordkeeping is to maintain a calendar with the services performed each day and the hours for those services. THE NEXT BIG MISTAKE: Relying on tax software to properly compute the passive loss limitation! Form 8582 for the passive loss limitation is absolutely no fun to fill out – especially by hand! It is tedious and has seven complex worksheets – which are a reflection of complicated regulations! Thank goodness for tax software! Most tax software does a good job with the passive loss limitations. However, there are several common situations where tax programs may prepare Form 8582 incorrectly, i.e. the preparer may need to override the program in order to get a correct result. In each of the following situations, there is an exception to a general rule:

K-1 line 1 from a trading partnership: Even if the taxpayer is limited partner, net loss (or income) from a partnership which trades in stocks, bonds and other securities is completely excepted from the passive loss rules. Neither losses nor income should be on Form 8582. Stated differently, a limited partner’s K-1 Box 1 losses are non-passive, i.e. fully deductible! Needless to say, this is a major exception to the passive loss limitations. Some tax software programs enter any limited partnership interest onto Form 8582, and the return preparer will need to override the program. See Reg. 1.469-1T(e)(6).

Oil and gas activity when the taxpayer is a general partner in a partnership or owns his interest via a joint venture: Oil and gas activities are excepted from the passive loss limitations, if the taxpayer has a so-called “working interest”, which simply means he holds his interest in the activity through an entity that does not limit his liability. See IRC 469(c)(3) and Reg. 1.469-1T(e)(4)(v). If the taxpayer holds his oil and gas interest as a general partner or if the activity is a joint venture, even though he may not materially participate under any of the tests in Reg. Sec. 1.469-5T(a), his losses or income are not subject to the passive loss limitations. Stated differently, if the entity shell does not limit liability, oil and gas losses are fully deductible, regardless of TP’s level of participation. However, there is a tax trap. If in any subsequent year, the activity generates net income, that income is always non-passive. See IRC 469(c)(3)(B).

Income from self-rented property: Rental income generally is passive income and may be used to offset unrelated passive losses. However, there is a commonly seen exception to this rule: net income from a building or equipment leased to the taxpayer’s partnership or corporation where he works (materially participates). If there is net income from so-called self-rented property, that income is not passive income and does not belong on Form 8582. See Final Reg. 1.469-2(f)(6). Some computer systems place all Sch. E net income onto Form 8582, including rental income from self-rented property.

Income from leased land: Similar to self-rented property, the regulations say, “Au contraire, mon frere!” Net income is reportable, but the income is not passive income, and may not be used on Form 8582 to trigger otherwise nondeductible passive activity losses. See Reg. 1.469-2T(f)(3). Same rule applies to leased land which is sold; net gain is nonpassive. Examples: leased farm land; leased land for cell towers; leased land for mobile home parks; leased land for a billboard.

Royalties: Royalties are clearly defined as nonpassive under IRC 469(e)(1). However, like self-rented property and leased land, the income is reflected on Sch. E. While income on the face of Sch. E is

7

generally passive income, royalties, self-rented property, and leased land are all nonpassive. Some programs enter all net income from the face of Sch. E, including royalties, onto Form 8582. The return preparer must override the program to remove this type of income from Form 8582. There is a highly restrictive exception in Reg. 1.469-2T(c)(3)(i)(A) and Reg. 1.469-2T(c)(7)(1) which permits royalties to be treated as passive income. As a practical matter, in over 13 years the PAL Technical Advisor, I only once saw a taxpayer which met this exception.

Publicly traded partnerships: (also known as master limited partnerships - MLP): If the partnership is a publicly traded partnership (PTP), § 469 (k) provides that the PAL limitations must be applied separately to items from each PTP. A loss from a PTP can only be offset by income from the same PTP. Result: income and losses from PTPs are not reported on Form 8582, but must be figured separately. Furthermore, the $25,000 special allowance does not apply to a PTP’s rental real estate losses. From the K-1, you can easily identify whether the partnership is a publicly traded partnership. Part I, block D will be checked indicating the entity is a publicly traded partnership.

Rentals grouped with business: If rental real estate or equipment leasing have been properly grouped with a business in which the taxpayer materially participates, the losses do not belong on Form 8582. The preparer may need to override his tax software program!

ANOTHER SERIOUS ERROR: Not considering the grouping rules. If the taxpayer splinters his business into several different entities or there are several business locations, the “activity” rules in Reg. 1.469-4 should always be considered, as grouping related business entities as a single activity may permit losses that otherwise might not be deductible. IRC 469(h) requires material participation in an “activity”. An activity is not necessarily an entity. An activity is the economic business unit, conceivably comprised of Sch. C or F, partnerships, S corporations, and closely held corporation or personal service corporations. Example: real estate developers often splinter every new project into a new partnership or S corporation. The fact that entities are related does not necessarily mean they have been grouped. The taxpayer can decide to treated related entities as separate and distinct activities. Or the taxpayer can group certain related entities as one single activity. See Reg. 1.469-4 and Revenue Procedure 2010-13. Suggestions:

If related entities have been grouped as a single activity under Reg. 1.469-4, be sure documentation regarding the grouping decision is maintained in the tax workpapers.

Add a statement to the tax return indicating, which entities have been treated as a single activity, i.e. an economic unit, under Reg. 1.469-4. Statement is required by Revenue Procedure 2010-13. .

Retain a copy of the full return with an initial year grouping statement in the “Permanent File”.

If return is audited by IRS, advise Agent immediately of any grouping.

Even though disclosure is required only in the initial year or when there is an addition to the group, you might want to disclose every year. It could prevent an IRS audit!

A few reminders:

The time for a grouping decision is in the initial year an activity appears on the tax return.

The time for grouping is when the taxpayer first reflects an entity on his tax return. Material participation is in “an activity”. Thus the taxpayer must know what his activity is when the return is filed in order to determine if the losses are properly deductible. Revenue Procedure 2010-13 requires a written statement attached to the return.

A rental generally cannot be grouped with a business. Exceptions: A rental can be grouped if (1) insubstantial or (2) owned in identical percentages with the business and leased back to the business.

As a practical matter, grouping is generally done at the individual investor level. However, it is possible for a partnership or S corporation which has ownership in several undertakings to group.

Any grouping decision should be clearly documented and a record of that grouping saved.

The time for grouping is not on audit! Important: If rental real estate or equipment leasing have been properly grouped with a business in which the taxpayer materially participates, the losses do not belong on Form 8582. The preparer may need to override his tax software program! Via grouping, the losses escape the passive loss limitations, and the income escapes the 3.8% net investment income surtax under § 1411.

8

ANOTHER GROUPING ISSUE: Not grouping a real estate professional’s rentals as a single activity. There is a serious misconception that if the taxpayer is a real estate professional (an owner of a construction company, for example), his rental real estate interests are completely excepted from the passive loss limitations. To the contrary, Reg. 1.469-9(e)(1) explicitly holds that a real estate professional’s rental remains passive unless he materially participates in the rental activity. In other words, the rental losses are generally nondeductible … unless the taxpayer materially participated in the rental activity. Managerial authority does not equate to material participation. Reg. 1.469-5T(a) holds that the taxpayer materially participates if and only if he meets one of seven tests, the most common being the 500-hour test. If an election to group rentals as a single activity is made, the taxpayer may be able to meet the 500 hour test for the year via counting time worked in all the rentals that he owns. To make the election to group rental real estate as one single activity, Reg. 1.469-9(g)(3) requires a statement attached to an original return:

1. A declaration that the taxpayer is a qualifying taxpayer, i.e. spends more than half his

personal services on real property businesses and works more than 750 hours in real property businesses AND

2. Is electing to treat all his rental interests as a single activity pursuant to IRC 469(c)(7)(A). Completing the real estate professional line on Sch. E line 43 is not an election to group rentals. There are pros and cons to making the election, but the election helps most taxpayers. If the taxpayer failed to make the election on a timely filed return, there are a some possibilities. First, Proposed Reg. 301.9100-2(b) permits an automatic six-month extension from the due date of the return (excluding extensions) to make elections whose due dates are on the due date of the return. The taxpayer must file an amended return and attached the appropriate form or statement for the election. The amended return must be filed within six months from the due date of the return and sent to the same address that the filing to make the election would have been sent to had the filing been time made. Secondly, Proposed Reg. 301.9100-3 permits a taxpayer to make a late election to treat all his rentals as a single rental real estate activity. § 9100 is a relief provision that permits taxpayers to file late elections even when the statute requires a timely election with the return. There have been a number of PLRs in which a late election to group rentals was permitted. The taxpayer must prove that he acted in reasonably and in good faith. Neither an examiner nor appeals has authority to grant 9100 relief. A “user fee” is required when the taxpayer files a Private Letter Ruling. The user fee can run anywhere from a few hundred dollars to several thousand dollars. See Revenue Procedure 2010-8 (2010-1 I.R.B.) for the amounts of user fees. Rules for PLRs are in Revenue Procedure 2010-1. Lastly, Revenue Procedure 2011-34 permits a late election in certain circumstances, even on audit! AND ANOTHER IMPORTANT CONSIDERATION: Whether what appears to be a rental activity falls outside the rental definition and is treated as a business. Example: many vacation rentals. What the taxpayer may call a “rental” may, for purposes of the passive loss limitations, be treated as a business under the passive activity rules. Reg. 1.469-1T(e)(3)(ii) contains several exceptions to the rental definition which are discussed below. These types of activities are generally treated as businesses and the taxpayer must prove he materially participated before losses are deductible. It is important to make this determination because rentals are automatically passive whether or not the taxpayer materially participates. Furthermore, rental real estate is permitted a special allowance of up to $25,000. In contrast a business activity loss is not deductible if the taxpayer does not materially participate (in the absence of passive income). If the taxpayer does materially participate in a business, his losses are generally fully deductible, assuming he has basis and is at-risk.

9

Determining what is and is not a rental is also important in considering the real estate professional exception. If the activity is a vacation condo or hotel, it is not a rental under the passive loss rules. The real estate professional relief is not applicable – and the activity cannot be part of the election to group rental real estate. Activities which fall outside the rental definition under Reg. 1.469-1T(e)(3)(ii):

The average customer use is 7 days or less. Examples: many vacation condos or vacation homes, charter boats, B&Bs.

The average customer use is 30 days or less and significant personal services are provided. Examples: hotels, motels.

Extraordinary personal services are provided in connection with making the property available. Examples: hospitals, nursing homes, boarding schools. Services are extraordinary only if the use by customers of the property is incidental to the services. See Reg. 1.469-1T(e)(3)(C). Revenue Ruling 2005-64 generally holds that if a pilot is provided with an aircraft, extraordinary personal services are provided, and thus the activity is treated as a business.

The rental is incidental to a non-rental activity. The principal purpose is realizing gain from appreciation and gross income is less than 2% of the unadjusted basis or FMV. See Reg. 1.469-1T(e)(3) (vi) (B). The rental would also be deemed incidental if the property was used in a business in which the taxpayer had an ownership interest and gross rents are less than 2% of the unadjusted basis or FMV. But possible § 183, not for profit issue.

The rental is incidental. Gross income is less than 2% of the unadjusted basis or FMV, and the property was used in a business in which the taxpayer owns an interest. Reg. 1.469-1T(e)(3) (vi) (C).

The property is available during business hours for nonexclusive use by customers. Examples: health spa, golf course.

The taxpayer provides the property for use in an activity that is conducted by a 1065 or 1120S. Example: Property is contributed to an S corporation or partnership. Provided means contributed; it does not mean rented to a business. See Reg. 1.469-1T(e)(3)(vii). For this exception to apply (1) the rental must be to a partnership, S corporation or joint venture (not to a C corporation); the taxpayer must have an ownership interest in the 1065 or 1120S that is leasing the property; and (3) the property must have been contributed to the entity.

AND FINALLY, A FEW FREE COMMENTS ON § 280A PERSONAL USE! If a living facility is used personally, there must be an allocation of expenses between business and personal use. A living facility has cooking, toilet and sleeping accommodations. A living facility includes: house apt; condo; mobile home; boat; motor home. Personal use includes: owners; family (except primary residence); any day rented at less than fair rental value; non-work days. Expenses allocated to personal use: interest – second home on Sch. A; real estate taxes – Sch. A; other expenses – nondeductible. If personal use is more than 14 days or 10%, then business expenses are limited to income. Excess expenses may be carried over to indefinitely to future years against operating income. The 280A limitation applies to individuals, partnerships, and S corporations.

10

DISCLOSURE STATEMENT GROUPING OF BUSINESSES AND/OR RENTALS

Attach to an original return. Required for any new grouping beginning 2011. Modify as needed.

The taxpayer has grouped the following trade or business or rental activities as a single activity under the provisions of Treasury Regulation 1.469-4 and Revenue Procedure 2010-13:

Name, Address, Employer Identification Number or SSN

Name, Address, Employer Identification Number or SSN

Name, Address, Employer Identification Number or SSN We declare that the above grouped activities constitute an appropriate economic unit for the measurement of gain or loss for purposes of section 469, i.e. the passive activity rules. Reminders: (1) A rental can be grouped with a business only if it is insubstantial or owned in identical percentage to the business. A rental can never be grouped with a C corporation. (2) The above disclosure statement does not constitute an election by a real estate professional to group rental real estate as a single activity. See page 12 for the real estate professional election.

DISCLOSURE STATEMENT

ADDITION OF A NEW ACTIVITY TO AN EXISTING GROUPING Attach to an original return. Required for any addition to an existing grouping beginning 2011.

The following new trade or business or rental has been added to an existing grouping within the taxable year:

Name, Address, Employer Identification Number or SSN The existing grouping consists of the following trade or businesses or rental activities:

Name, Address, Employer Identification Number or SSN

Name, Address, Employer Identification Number or SSN

Name, Address, Employer Identification Number or SSN We declare that the above grouped activities, which now includes the new activity, constitute an appropriate economic unit for the measurement of gain or loss for purposes of section 469, i.e. the passive activity rules.

DISCLOSURE STATEMENT

REGROUPING OF BUSINESSES AND/OR RENTALS UNDER REG. 1.469-4(e)(2) Attach to an original return. Required for any change to a grouping beginning 2011.

The taxpayer has regrouped the following trade or business or rental activities under the provisions of Treasury Regulation 1.469-4(e)(2):

Name, Address, Employer Identification Number or SSN

Name, Address, Employer Identification Number or SSN

Name, Address, Employer Identification Number or SSN We declare that the above regrouped activities constitute an appropriate economic unit for the measurement of gain or loss for purposes of section 469, i.e. the passive activity rules.

OR We declare that the above regrouped activities are each separate and distinct activities under section 469, i.e. the passive activity rules. Explanation of reason for regrouping: There must be an explanation of why the taxpayer’s original grouping was determined to be clearly inappropriate or the nature of the material change in the facts and circumstances that makes the original grouping clearly inappropriate.

11

DISCLOSURE OF GROUPING BY PARTNERSHIP OR S CORP

If a partnership or S corporation has grouped trade or business or rental activities, in the initial year, there must be a disclosure reported to the investors as an attachment to each Schedule K-1). Modify as needed.

The partnership or S corporation has grouped the following trade or business or rental activities as a single activity under the provisions of Treasury Regulation 1.469-4 and Revenue Procedure 2010-13:

Name, Address, Employer Identification Number or SSN

Name, Address, Employer Identification Number or SSN

Name, Address, Employer Identification Number or SSN The partnership or S corporation declares that the above grouped activities constitute an appropriate economic unit for the measurement of gain or loss for purposes of section 469, i.e. the passive activity rules.

SUPPLEMENTAL INFORMATION

PRE-EXISTING GROUPING UNDER REG. SEC. 1.469-4 Attach to an original return. Disclosure of a grouping which existed prior to 2011 is not required. However, disclosure documents the grouping

and could avoid future questions.

Joe D. Taxpayer has a pre-existing grouping, which forms an appropriate economic unit, i.e. a single activity, under Reg. Sec. 1.469-4, comprised of the following activities:

Name, Address, Employer Identification Number or SSN

Name, Address, Employer Identification Number or SSN

Name, Address, Employer Identification Number or SSN We declare that the above grouped activities constitute an appropriate economic unit for the measurement of gain or loss for purposes of section 469, i.e. the passive activity rules.

DISCLOSURE STATEMENT REGROUPING OF BUSINESSES AND/OR RENTALS UNDER REG. 1.1411 - FRESH START

Attach to an original return. Required for any change to a grouping due to net investment income beginning 2013.

The taxpayer has regrouped the following trade or business or rental activities under the provisions of Treasury Regulation 1.469-4(e)(2) and the fresh start provision in Final Regulation 1.1411:

Name, Address, Employer Identification Number or SSN

Name, Address, Employer Identification Number or SSN

Name, Address, Employer Identification Number or SSN We declare that the above regrouped activities constitute an appropriate economic unit for the measurement of gain or loss for purposes of section 469, i.e. the passive activity rules. Explanation of reason for regrouping: Final Regulation 1.1411 permits a re-grouping in the first year the taxpayer has net investment income and meets the threshold amounts. As evidenced by the tax return, the taxpayer has interest, dividend and other net investment income. Furthermore, the taxpayer exceeds the $250,000 applicable threshold for married filing joint returns and $200,000 for all other returns. There must be an explanation of why the taxpayer is re-grouping. Notes:

Signatures are not required with the above Disclosure Statements as they will be attached to an original signed tax return.

Returns with initial year disclosure statements should be kept in a Permanent file! IRS does not maintain indefinite copies of these returns.

12

REAL ESTATE PROFESSIONAL ELECTION IRC 469(c)(7)(A) and Reg. Sec. 1.469-9(g)

Modify as needed. Attach to an original return. Required to group rentals. No need to list each individual rental. Election governs year filed and all future years.

The taxpayer declares (1) that he is a qualifying real estate professional for the tax year and (2) that he is making the election under Internal Revenue Code § 469(c)(7)(A) to group all rental real estate interests, whether held personally or via flow-through entities, as a single activity. Note: Election does not need to be made annually, but a copy of the return with the election should be maintained in a Permanent File. Unlike the election for grouping businesses under Reg. 1.469-4, you do not need to list each individual rental real estate activity.

FILED PURSUANT TO REV. PROC. 2011-34

RELIEF FOR LATE ELECTION UNDER REG. 1.469-9(g) TAX YEAR ______ (Modify as needed. Attach to Form 1040X, amended return. Election governs year for which it is filed and all future years. Mail to Service

Center where original return was filed. Keep copy of amended return with election in Permanent File. )

The taxpayer declares (1) that he is a qualifying real estate professional for the tax year and (2) that he is making the election under Internal Revenue Code § 469(c)(7)(A) to group all rental real estate interests, whether held personally or via flow-through entities, as a single activity. The reason for the failure to timely file the election grouping all rentals as a single activity is:

Examples:

The taxpayer believes an election was filed in a prior year, possibly in 1995, but the return with the election cannot be located. Thus, for absolute clarity and certainty, this election is being made and will be maintained in a “permanent file” henceforth.

Both the taxpayer and the return preparer were of the opinion that an election was filed, but it cannot be located. Thus, this election is being made.

The taxpayer, who is not a tax professional, was unaware of the election at the time of the return filing.

Through an inadvertent oversight, the return preparer did not discuss the possibility of the election with the taxpayer at the time of the filing of the original return.

The taxpayer intended to make the election at the time of the filing of the return, but through what appears to be a clerical oversight, no election was attached to the original return.

The taxpayer intended to make the election, but was of the erroneous opinion that merely completing line 43 of Sch. E, Reconciliation for real estate professionals, constituted an election.

The taxpayer meets all the requirements of Rev Proc 2011-34 in order to file a late § 1.469-9(g) election:

(1) The taxpayer failed to make the election solely because he failed to file the election with his original return as required by Reg. Sec. 1.469-9(g)(3).

(2) The taxpayer has filed consistently with the election. All rentals have been treated as non-passive for the year of the election as they were deemed a single activity and the taxpayer materially participated in the grouped rental activity. Subsequent year filings have also been treated consistent with the election.

(3) The taxpayer timely filed returns affected by the election, i.e. they were filed by the due date, the properly extended due date, or within six months after the due date, excluding extensions, as provided for in § 301.9100.

(4) The taxpayer has reasonable cause, as discussed above, for the failure to timely file the election grouping his rentals.

Under penalties of perjury I (we) declare that I (we) have examined this election, including accompanying documents, and, to the best of my (our) knowledge and belief, the election contains all the relevant facts relating to the election, and such facts are true, correct, and complete. ___________________________ Signature of Taxpayer(s)

SUPPLEMENTAL INFORMATION

REAL ESTATE PROFESSIONAL ELECTION - IRC 469(c)(7)(A) (Use to document election when it has been lost or destroyed or TP is unsure. Modify as needed.)

The taxpayer, John D. Realtor, properly filed an election with an original return in a prior year. The election governs all future years. However, as a copy of the return with the election cannot be currently located, he is once again filing a return with the election, simply to verify its validity. The taxpayer declares (1) that he is a qualifying real estate professional for the tax year and (2) that he is making the election under IRC § 469(c)(7)(A) to group all rental real estate interests as a single activity.

13

3.8% TAX ON NET INVESTMENT INCOME Form 8960 & Instructions

Basic tax law IRC 1411; Final Reg. 1411 For high income taxpayers, beginning 1/1/2013, 3.8% additional tax on the lesser of:

Net investment income or

Modified adjusted gross income less the applicable threshold ($250,000 if MFJ).

Applies only to US citizens and residents, estates and trusts. Not applicable to nonresident aliens.

Net investment income (NII) is: Reg. 1.1411-4

Interest (except tax exempt), ordinary dividends, royalties, and non-qualified annuities Net rental income (except self-rental or a rental which has been grouped with a business under Reg. 1.469-4) Reg. 1.1411-4(g)(6)

Capital gains in excess of capital losses. Capital loss limitation of $3000 can offset other NII. Net gain on the sale of C corporation stock. Net income from passive businesses. Reg 1.1411-5 If TP doesn’t materially participate, net income from Sch. C or F; or K-

1 line income 1 from a partnership or S corporation is NII. Net gain on sale of assets by a passive activity Net gain from the sale of partnership or S corporation if TP is passive. Net income or net gain from the sale of leased land. Reg. 1.469-2T(f)(3) Position is in § 1411 Preamble Income and gains from a business, which is a trader in financial instruments and commodities. Gain on sale of second home. Kiddie tax on your return (with some adjustment).

Investment income is reduced by deductions allocable to income/ gain. Any loss from an NII activity can offset other NII income! Income is offset by net losses to determine net investment income.

Modified adjusted gross income = AGI, unless TP has foreign earned income.

Individual threshold Married filing joint $250,000; MFS $125,000; All others $200,000 Reg1.1411-2(c)

Thresholds are not adjusted for inflation. No proration of the threshold amounts for most short periods (example: death).

Example: Single TP: wages - $180,000 & interest income - $25,000. AGI=$205,000. Threshold= $200,000. MAGI of $205,000 less

$200,000 threshold = $5,000. TP owes an additional tax of $190 (3.8% of $5000).

Estate & trust threshold: A mere $12,150!

Reduces net investment income Properly allocable deductions $3000 capital loss limitation All current and carryover passive losses allowed due to a disposition of a passive activity Form 4797 losses allowed on disposition of a passive activity Casualty loss attributable to passive activity Investment interest expense; Investment advisory fees State taxes attributable to NII Not investment income:

Wages; self-employment income (Sch. C, Sch. F, guaranteed payment) Social Security, IRA, 401k, 403(b), 408, 457 distributions §162 business in which TP materially participated Property or equipment rented to a business where TP works Reg. 1.1411-4(g)(6); Reg. 1.469-2(f)(6) Rental real estate or equipment lease grouped with a partnership or S corporation Reg. 1.1411-4(g)(6); Reg. 1.469- 4 Non-taxables: §121 exclusion, §1031 exchange, §351 transfer, §721 transfer etc. If it is not in AGI, it is not investment income.

Business income is not investment income if all of the following are met:

It is an active § 162 trade or business, and income is from the ordinary course of the business,

Activity is not a passive activity to the taxpayer under § 469, and

It is not trading in financial instruments or commodities. Passive activity = Rental real estate; equipment leasing; or a business if TP does not materially participate. Determined based on use in current year. No look-back rule to determine passive. No definition of “ trade or business” in nearly 70,000 pages of Code and Regulations!

14

Other rules

Gain from the sale of business assets is not investment income if all of the above tests are met.

Separately stated interest, dividend, capital gains, and other portfolio income from a partnership or S corp is not income derived from the ordinary course of a business and thus is investment income.

NOL carryover does not reduce net investment income (but passive loss carryover reduces passive income).

Gain on sale of a partnership interest or S corp stock is investment income unless the entity is engaged in a business and TP materially participated (generally – see regs for complex rules).

Fresh start for passive activity groupings Reg. 1.469- 11(b)(3(iv) & Reg. 1.469-4; Rev Proc 2010-13

TP may regroup related activities in 2013 or 2014 or in the first year he has AGI more than the threshold and has investment income. Grouping related entities may turn some activities from being passive to non-passive.

TP must disclose the regrouping in writing on his original tax return.

Consider grouping rental with a related business. Turns income non-passive; no NII. Reg. 1.1411-4(g)(6)

No regrouping for rental real estate activities of a real estate professional. Rental income of a real estate professional Reg. 1.1411-4(g)(7); IRC 469(c)(7)

Rental income of a RE Pro may be excepted from net investment income.

If TP worked 500 hours in a separate or grouped rental activity, rentals will be excepted from NII.

Or, if TP worked 500 hours in any 5 of the last 10 years in the rentals, they are excepted from NII. Also, rentals of a dealer that are part of the dealing business are excepted from NII.

Estates and Trusts Reg. 1.1411-3, Form 8960 & Instructions

The 3.8% surtax on net investment income also applies to estates and trusts (simple and complex). AGI tShreshold to apply tax only $12,150! Nothing in § 469 (passive activities) or Final 1.1411 as to how material participation is determined. The passive activity rules apply to estates and trusts. IRC 469(a)(2) But no regs have been written on material participation for an estate or trust. The 7 tests for material participation apply to individuals, not to estates and trusts. However, in the

absence of any regulations, it makes sense to use them as an administrative proxy. IRS informally advises that it is the executor or trustee who must materially participate. Note: IRS lost the sole Court case on this issue: Mattie K. Carter Trust v. United States, N.D. ex., No. 4:02-CV-154-A, 4/11/03

Material participation in a trust was permitted via an employee/beneficiary’s participation. District Court; not precedent setting. In the absence of express guidance in tax law, the taxpayer may use any reasonable method. Note: IRS had held a trust could not be a real estate pro; however, in Frank Aragona Trust 142 T.C. No 9 (full tax court case and citable), trustees were individuals, and because 3 of 6 trustees worked on the trusts’ real estate, the trust was a real estate professional. Watch for future regulations on trusts and § 469!

More Info: www.irs.gov In the Search box: type in net investment income FAQ (many good Q&As) Disclaimer: The above information and the suggestions below are based on my best understanding of very long and complex regulations under § 1.1411. The information above merely summarizes the rules. There remain some unanswered questions and gray areas, and the regulations may need to be researched. Chief Counsel's Office is currently considering promulgating regulations on trusts and passive activities. Lucy Clark 9/1/14

15

AVOID 3.8% MEDICARE TAX Mid-year tax planning could be important for a high wealth taxpayer! GROUP BUSINESSES: Group related businesses under Reg. 1.469-4. There is a one-time fresh start under final Reg 1411. Written disclosure is required under Rev. Proc 2010-13. If grouped activity is non-passive, then income escapes investment income categorization. Caution: TP may need the passive income to trigger otherwise nondeductible passive losses. Note: it is only net passive income which becomes investment income, i.e. the net of rental income and losses AND the net of passive income from businesses and passive businesses losses, and, of course, interest and dividend and other portfolio income . Reminder: Rentals that are grouped with businesses under Reg. 1.469-4(d) are not passive for either § 469 or § 1411,i.e. they are not subject to the passive activity rules or the 3.8% surtax, assuming the taxpayer materially participates in the grouped business activity. GROUP A BUSINESS AND RELATED RENTAL: By grouping, the rental activity is effectively deemed part of the business. Thus, if the taxpayer materially participates in the grouped activity, income or losses from the rental are non-passive. A rental can be grouped with a business only if owned in identical percentages or if insubstantial to the business. See Reg. 1.469- 4(d). KEEP INCOME BELOW $250,000 FOR MFJ ($200,000 FOR SINGLES): Increase business deductions or itemized deductions. Structure a stock or bond sale over two years. On sale of asset, do installment sale.

SHORT-TERM LEASE IN YEARS OF SALE: In year of sale of a rental, lease the property 7 days or less on average. Reg. 1.469-1T(e)(3)(ii)(A) treats an activity where the average rental period is 7 days or less as a business, not a rental activity. The passive activity rules always look to the current year to determine of the character of the activity. If the activity is a business in which TP materially participates (example: does most of work), gain is not investment income. There is no lookback rule for passive activities. The activity may have been a rental in prior years, but in the current year is treated as a trade or business. SALE OF RENTAL – CONSIDER § 351 OR § 721 TRANSFER TO NON-PASSIVE BUSINESS: With a rental property which TP plans to sell, consider a § 351 exchange to a corporation; or tax free exchange to a partnership business. Then use the property in the business activity. If TP materially participates, gain on ultimate sale will be non-passive. Nontaxable transactions do not enter into net investment income. LIKEKIND EXCHANGE: On sale of a rental property, consider a § 1031 likekind exchange; then buy asset for use in non-passive business, i.e. business where TP works. INSTALLMENT SALE: If TP is near the threshold amount, consider an installment sale of property over two or more years to keep income below the threshold. STRUCTURE INCOME OVER TWO YEARS: If TP is near the threshold amount, and there are wages or other income, take it over two years to stay below the threshold. Similarly, if TP plans to sell stocks or bonds at a gain and is near the threshold amount, structure the sale over two years. Or sell some stocks and bonds with losses that can offset the gains. DELAY IRA WITHDRAWAL OR STRUCTURE OVER TWO YEARS: If the taxpayer is considering a withdrawal from a traditional IRA and the amount is beyond the RMD, consider taking the funds over two or more years. Two years does not mean two full tax years. A portion could be taken out on December 30 of one year and January 2 the next year, a mere four days later. NOLs VS PASSIVE LOSS CARRYOVERS: Scrutinize NOLs and business losses, and properly categorize them. An NOL carryover loss cannot offset net investment income, but a passive loss carryover on Form 8582 can offset passive income, thereby reducing net investment income. Similarly, you may not have given much thought as to whether an activity was passive in the past. However, if there is the potential for passive income from one source, another source generating a passive loss can absorb the income, thereby reducing the net investment income. FIXED OR VARIABLE ANNUITIES: Shift income in CDs to fixed annuities. Interest income is not reportable till income is taken out. It is also possible to do § 1034 exchange when annuity matures, so interest income continues to accrue without being taxable. Your client could also invest in a variable annuity.

16

MAX OUT 401K OR 403(b), SEP, IRA CONTRIBUTIONS: Contributing to a tax-deferred retirement plan lowers AGI and taxable income. For 2014, a taxpayer can contribute as much as $17,500; if the taxpayer is 50 or over, he can contributed as much as $23,000. These amounts apply to each spouse. For a SEP-IRA, the taxpayer can contributed up to 20% of net self-employment income up to a maximum of $52,000. SHIFT INCOME GENERATING ASSETS TO A MINOR CHILD: Shift income generating assets (up to $200,000 of investment income) to a child and avoid the 3.8% tax on that amount. Note: Even though the youngster is in a seemingly low tax bracket, the so-called kiddie tax under IRC § 1(g) applies. Thus the majority of the income will be taxed at the parents’ highest marginal tax bracket, but this strategy will avoid the 3.8% Medicare surtax. Caution: shifting assets could impact the child when applying for scholarships for college. Additionally, if assets are valued at more than $14,000, a gift tax return may need to be filed.

CONSIDER WHETHER TP MAY BE A REAL ESTATE PROFESSIONAL: Taxpayers in the past who had lots of rental income probably didn’t care whether they were characterized as a real estate professional. However, now if they are a real estate professional under IRC 469(c)(7) and can exceed the 500 hour threshold for rentals, now they can avoid the 3.8% surtax under § 1411.

MUNICIPAL BONDS: Invest in munis. Tax exempt interest is not subject to the 3.8% surtax. However, consider state taxes. Some states tax interest on municipals.

FILE SEPARATELY: In some cases, filing separately could minimize the tax on net investment income. Any views or opinions expressed in this handout are solely those of the author, and not those of any associated company or organization. Circular 230 Disclaimer: To the extent this handout contains advice relating to a federal tax issue, it is not intended or written to be used for (1) avoiding penalties imposed under the Internal Revenue Code, or (2) promoting or marketing to another party any transaction or matter addressed in this handout.