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:: Partnership - Audit Technique Guide - Chapter 5 - Loss Limitations (12-2002)   Chapter 5 - Table of Contents Introduction    Issue:  Basis Limitations         Examination Techniques        Supporting Law         Resources          Issue:  At-Risk Limitations         At-Risk Computation         Examination Techniques        Supporting Law         Resources          Issue:  Limitations On Related Partner And Non-Partner Transactions  Related Partners         Loss Disallowance         Related Non-partners         Examination Techniques        Supporting Law         Resources          Issue:  Automatic Adjustments Due to Passive Loss Limitations     Examination Techniques  Supporting Law         Resources          Issue:  Equipment, Airplane and Other Leases      Examination Techniques        Supporting Law         Resources          Issue:  Rental Real Estate Losses        Examination Techniques        Supporting Law         Issue:  Real Estate Professionals        Examination Techniques        Supporting Law         Issue:  Material Participation         Examination Techniques        Supporting Law         Issue:  Self-Rented Property          Examination Techniques        Supporting Law    back to the top INTRODUCTION A partner must meet several loss limitation requirements, before a loss is allowed.  The loss limitation tiers must be met in the following order: Does the partner have adequate basis in its partnership interest to deduct losses? Does the partner have adequate amounts at-risk in its partnership to deduct losses? Is the partnership activity a rental real estate activity or an equipment leasing activity?  If so, partner losses are presumptively passive, that is, nondeductible in the absence of passive income.  (But see IRC section 469(c)(7)) If the partnership activity is a trade or business, does the partner materially participate under the passive activity rules? If a partner does not meet any one of the loss limitation tiers, the losses are suspended at that level.  They will remain at that tier until the losses can meet the requirements.  The losses will then be carried forward to the next level in the same manner until the losses will eventually be allowed. There are exceptions to general loss limitation rules relating to transactions between a partnership and its partners under IRC section 707(b). back to the top ISSUE:  BASIS LIMITATIONS The first tier that must be considered is the basis limitation.  This test must be met before at-risk and passive limitations apply.  The partner must have sufficient outside basis at the end of the partnership tax year in its partnership interest to deduct losses.  The partner’s outside basis is not allowed to fall below zero.  IRC section 705(a)(2) and IRC section 733.  Therefore, if current year losses for the year exceed the partner’s outside basis, the losses will be suspended.  These losses will be carried forward to subsequent years until the partner’s basis is increased to allow the losses.   If the partnership interest is sold, any unused losses disappear and cannot be used to offset any gain on the disposition. IRC section 704(d).  There are two basic ways to increase basis: Cash and the adjusted basis of property contributed (including the partner’s share of partnership liabilities) Partner’s share of partnership income (taxable and tax exempt) There are two basic ways to decrease basis, but not below zero: Distributions from the partnership of cash and the adjusted basis of property distributed (including the partner’s decreased share of partnership liabilities) Partner’s share of partnership losses (whether or not deductible for taxes) The outside basis determines how much of the basis may be reduced by distributions before recognizing a gain.  If the partner is distributed cash in excess of its basis, there will be a gain recognized. The outside basis also determines how much of the basis may be reduced by losses flowing from the partnership.  If there are more losses flowing through the partnership to the partner than there is basis in the partner’s interest, then instead of a gain recognized, the losses exceed the outside basis are suspended until the partner has basis to claim these losses in a subsequent year. Kingbay v. Commissioner, 46 T.C. 147. Distributions reduce basis first and the partner’s allocable share of ordinary losses are considered second.  Revenue Ruling 66-94, 1966-1 C.B. 166.  The ordering of these rules is important because the distributions are recovered through basis first so there potentially will be no gain recognized.  Then losses are considered.  If the losses would make the basis fall below zero they are suspended, but are not lost forever.  See Chapter III for basis ordering rules. Examination Techniques The examination techniques used should serve, in the end, to answer the following: Do the partner’s current year cash distributions exceed the partner’s outside basis?  If so, then the taxpayer must report a gain for the excess distribution.  (Remember debt relief is considered a deemed cash distribution.) Did the partner receive a property distribution?  If so, did the property’s adjusted basis in the partnership’s hands reduce the partner’s basis?  Was the property’s adjusted basis more than the adjusted basis in the partnership interest?  If it was, then the basis in the partnership is now zero.  No losses will be allowed.  They will be suspended. Does the partner have sufficient basis to deduct the  partner’s share of partnership losses?  If not, then the losses must be suspended indefinitely until the basis is increased. back to the top Issue Identification Request the partner’s outside basis calculation, if losses are present on the partnership return. Request the partner’s related returns to review losses actually taken on the returns. Review the partnership return to see if there were negative capital accounts at the end of last year and current losses on this return.  If so, there may be a possibility that several of the partners’ outside bases are zero.  This may be of greater concern if this is the final year of the partnership. Review the suspended loss computation for accuracy. Review any cash or property distributions to any of the partners. Documents to Request Prior and subsequent year returns Outside basis computation Suspended loss computation Partnership books and records Partnership agreement Interview Questions Were there any cash or property distributions to any of the partners during the year? How many years has the partnership operated with losses? Supporting Law IRC, Subchapter K:     Section 704    Section 705    Section 733 Supporting regulation and specific regulations cited above. Kingbay v. Commissioner 46 T.C. 147 – Deductions of partnership loss by limited partners is allowed only to the extent of the adjusted bases of their interests in the partnership at the end of the partnership year in which a loss occurred.  Their adjusted basis in the current year was determined to be zero because of reduction by partners’ distributive share of the partnership losses. Revenue Ruling 66-94, 1966-1 C.B. 166 – This ruling determines that distributions are taken into consideration before losses in computing a partner’s adjusted basis in the partnership interest under IRC section 704(a). Resources RIA U.S. Tax Reporter – Income Taxes CCH Standard Federal Tax Reporter Practitioners Publishing Co. back to the top ISSUE:  AT-RISK LIMITATIONS The second tier that must be considered is the at-risk limitations.  At-risk rules are covered under IRC section 465 and are not part of Subchapter K.   These rules apply to individuals and closely held corporations.  It reflects the amount a partner is at-risk in the partnership activity.  It is essentially the amount of cash that a partner would be out-of-pocket for if the partnership ceased business.  The at-risk limitations operate somewhat in the same way as basis limitations.  The at-risk amount cannot fall below zero.  If there are losses in excess of the amount that a partner is at-risk, then these losses are suspended and carried forward until such time the partner increases his or her amount at-risk.  These suspended losses can be carried forward indefinitely.  Contrary to the basis rules under IRC section 704(d), suspended losses may be used to offset any gain on the sale of a partnership interest.  Prop. Treas. Reg. section 1.465-66.  If withdrawals, distributions, or loan repayments are made that reduce the amount of at-risk below zero, the partner usually recognizes income.  At-risk is computed at year end. Originally when the at-risk rules were enacted in 1976, the activities they applied to were: Farming Exploring for or exploiting oil and gas resources Holding, producing, or distributing motion picture films or videotapes Equipment leasing Exploring for or exploiting geothermal deposits. These activities were originally chosen because Congress thought most tax shelters would fall within these categories.  At-risk rules were created to deter the creation of tax shelters.  The law has been broadened to include all activities.  The at-risk rules are usually applied on an activity-by-activity basis; however, they can be aggregated together. Do not confuse the at-risk aggregation rules with the aggregation rules for passive activities.  They are different.  The original five activities are all to be considered separate activities except for equipment leasing.  Any other activity including equipment leasing can be grouped together to apply the at-risk rules, if either of the following requirements can be met: Taxpayer actively participates in the management of the trade or business, or Trade or business is carried on by a partnership or S Corporation and 65 percent or more of the losses for the tax year are allocable to persons who actively participate in the management of the trade or business. When activities are aggregated together, it is more likely that the amounts at-risk will not fall below zero.  For example, all contributions or recourse loans are accounted for as one activity whether they were specifically for a particular activity or not. At-Risk Computation + Cash invested + Loans which are recourse to general partners + Loans in which a partner is personally liable for repayment, such as a guarantee on a non-recourse debt with no reimbursements, or the partner must have pledged his or her own property (other than the property used in the activity) as security for the repayment (only to extent of the net FMV in the partner’s interest in the pledged property).  This applies to limited and general partners.  Callahan v. Commissioner, 98 T.C. 276 (1992) + Direct loans by partners except if the activity is one of the original five activities.  (See discussion below) + A/B of any property contributed to the partnership + Partner’s share of income (taxable and tax exempt) and gain on a disposition of a partnership interest + Qualified Non-recourse Debt – Real Property  - Repayments on loans for which a partner is at-risk  - Distributions to a partner of cash or adjusted basis of other property  - Partner’s share of losses and capital losses = At-risk for the partner Under normal circumstances all non-recourse loans are omitted from the computation because partners are not considered at-risk for these type of loans.  They do not bear any risk of loss.  They will have no cash-out-of pocket if the loan defaults.  The creditor is the one at-risk.  Qualified non-recourse financing is an exception to this rule. IRC section 465(b)(6) and Treas. Reg. sections 1.465-27(a). Qualified non-recourse financing is debt that is secured by real property and other property that is incidental to holding the real property.  It must meet the following requirements to be included in the amount at-risk. Funds are loaned for the real property Funds are loaned from a “qualified person,” or a federal, state, or local government entity No person is personally liable on the loan (If it is a real estate partnership, the partnership may be liable on the debt and not cause this requirement to fail).  Treas. Reg. section 1.465-27(b)(3) Loan is not convertible to a partnership interest.  Be aware that this feature automatically taints the loan as not being a qualified non-recourse loan.  Make sure that the third party lender does not have an option agreement to convert the loan into an equity interest in the partnership at a later date. A “qualified person” for these purposes is any person who is actively and regularly engaged in the business of making loans such as a commercial lending institution.  In most circumstances it cannot be a related person, a person that is the seller or related to the seller of the real property, or a person who receives a fee with respect to the investment in the property such as a real estate broker or a related person.  A “qualified person” may be a related party if they meet the following requirements: Related person is actively and regularly engaged in the business of making loans Loan is commercially reasonable which means: Note is written, unconditional promise to pay a sum certain on demand on a specific date Interest rate on the note cannot be above or below market rate and cannot be contingent on profits Loan must be substantially the same terms as an arms-length loan between unrelated parties.   Related party loans are not included in the amounts at-risk such as family members or controlled corporations who have an interest in the activity.  IRC section 465(b)(3)(A).  Remember that when applying IRC section 267(b) and IRC section 707(b)(1) that for the at-risk rule 50 percent should be replaced with 10 percent.  IRC section 465(b)(3)(C). Losses can be used partially in the current year and then the remainder will be suspended and carried forward.   Taxpayers must follow an ordering rule to deduct the losses in the current year.  Proposed Treas. Reg. sections 1.465-38. Capital losses IRC section 1231 losses All other losses and deductions except Tax preference items under IRC section 57 Tax Preference items under IRC section 57 The losses retain their character when carried over in the subsequent year and will follow this same ordering rule. Taxpayers who have losses from at-risk activities must file a Form 6198. back to the top Examination Techniques The examination techniques used should serve, in the end, to answer the following: Does the partner have sufficient amount at-risk to allow losses?  Review the at-risk computation. Does the partnership have non-recourse debt that is potentially being included in the partner’s at-risk amount? Does the partner have any relief of debt that may result in the at-risk amount falling below zero? Does the partner aggregate activities to allow recourse debt from another activity to increase at-risk in all other activities?  Are the management requirements met? Does the partnership have qualified non-recourse financing?  Does the financing meet all of the requirements? Are there any related party loans?  These will probably not be included in the at-risk computation. Are there suspended losses from prior years?  Is the character of these losses being carried forward intact? Issue Identification If it appears there is potential non-recourse debt included in the amount at-risk, then request the at-risk computation to determine if the partners have sufficient at-risk amounts. Request the debt instruments to determine what type of loans are on the books and on the tax return.  If it is qualified non-recourse debt, make sure that the requirements have been met to be qualified?  Determine if there are any related party loans. Request a list of the groupings of the activities that have been aggregated.  Also, request what trade or business is carried on within the activities.  Does the partner meet the management requirements? Request a list of the suspended losses and their character? Request the recourse loan documents to review for any changes in the economic at-risk of loss with the partners in the last 3 years.  If any partner is relieved of recourse liabilities, then this will reduce the amount at-risk.  The partner may have already taken losses against this recourse debt.  If the relief of debt results in the at-risk amount falling below zero, then income will be recognized for recapture of this amount. Documents to Request Prior and Subsequent year partnership tax returns Debt Instruments At-risk computation Aggregation of activities Trade or businesses involved with the aggregated activities Duties of the partners within the aggregated activities Related party loans Suspended loss computation Interview Questions What type of loans are represented on the tax return? Are any of the loans recourse and qualified non-recourse loans? Has there been a change in the debt instruments in the last 3 years? Did the partner aggregate the activities?  What management duties do the partners have? Do the partners have at-risk computations available? Are there any related party loans? Are there any suspended losses from prior years? Supporting Law IRC, Subchapter K: Section 707 IRC section 465 IRC section 267 Supporting regulation and specific regulations cited above. Callahan v. Commissioner, 98 T.C. 276 (1992) – The limited partners were required if called upon by the general partners to pay three times the amount of cash contributions.  The limited partners had the discretion, by written notice, to elect out of the overcall provisions.  It was determined that the limited partners were not at-risk for this amount because the partners’ obligations were contingent and illusory. Resources RIA U.S. Tax Reporter – Income Tax CCH Standard Federal Tax Reporter Tax Management Portfolio Practitioners Publishing Co. back to the top ISSUE:  LIMITATIONS ON RELATED PARTNER AND NON-PARTNER TRANSACTIONS Related Partners IRC section 707(a) states that certain transactions between partners and partnerships are treated as if between the partnership and non-partners. IRC section 707(b) limits the general rule set forth in IRC section 707(a) in two ways: Loss Disallowance IRC section 707(b)(1)(A) states that no losses will be recognized on a sale or exchange of property between a partner and the partnership if the partner owns  greater than 50  percent of the capital or profits in the partnership either directly or indirectly. IRC section 707(b)(1)(B) states that no losses will be recognized on a sale or exchange of property between two partnerships if the same persons own greater than 50 percent of the capital or profits of both partnerships either directly or indirectly. For example, if property is sold by a greater than 50 percent partner to the partnership, there would be a realized, but not recognized, loss by the partner.  If the partnership later disposes of the property at a gain, the unrecognized loss will offset the partnership gain on the asset.  However, without a special IRC section 704(b) allocation, all partners will partake in the benefit of the unrecognized loss offset. Capital Gain Disallowance IRC section 707(b)(2)(A) states that any gain is ordinary income, if property which is not a capital asset in the transferee’s hands, is sold at a gain between a partnership and a partner who owns greater than 50 percent of the capital and profits of the partnership either directly or indirectly. IRC section 707(b)(2)(B) states that any gain is ordinary income, if property which is not a capital asset in the transferee’s hands, is sold at a gain between two partnerships in which greater than 50 percent of the capital or profits is owned by the same persons directly or indirectly. Constructive ownership rules are determined by applying IRC section 267(c) IRC section 707(b)(3) and Treas. Reg. section 1.707-1(b)(3). Related Non-partners Losses on sales between related non-partners are not governed by IRC section 707(b).  IRC section 267 rules relating to loss on sales between related taxpayers applies to these transactions.   If any one of the relationships exist under IRC section 267(b), losses are disallowed between the partnership and the other person who is not a partner.  This is true even if the non-partner is a spouse of a partner and regardless of the percentage of capital or profits interest that the partner may own. For example, if a partner owns 5 percent of the capital and profits of a partnership and the partnership sold property to the partner’s spouse at a loss, that partner’s 5 percent share of the partnership loss would be disallowed.  If, on the other hand, the partnership had sold property to the 5 percent partner, the loss would be allowed because the partner is less than 50 percent partner under Treas. Reg. section 1.267(b)-1(b)(1)(ii). If this same 5 percent partner’s spouse sold property to the partnership for a loss, the entire loss would be disallowed under Treas. Reg. section 1.267(b)-1(b)(1)(ii). Gains on sales between non-partners and partnerships are not governed by IRC section 707(b) or IRC section 1239.  Therefore, gain on a sale of depreciable property by the 5 percent partner’s spouse will result in capital gain instead of ordinary income. back to the top Examination Techniques The examination techniques used should serve, in the end, to answer the following: Are there any sale or exchange transactions between the partnership and any greater than 50 percent partners.  If there are any that result in a recognized loss, then the loss should be disallowed. Are there any sale or exchange transactions between the partnership and any related party to a partner?  If there are any that result in a recognized loss, then the loss should be disallowed. Are there any sale or exchange transactions between the partnership and the partners that result in a gain?  If there are any that result in a recognized capital gain, then review the transaction to see if the asset in the transferee hands was a capital asset.  If it was not, then the capital gain should be recharacterized to ordinary income. Issue Identification Review the partnership agreement to determine which partners own greater than 50 percent of the capital or profits of the partnership. Request all documents for any exchanges between the partnership and the partners.  Review for losses on the exchange if the partner owns greater than 50 percent of the capital or profits.  Review for potential capital gain treatment by a greater than 50 percent partner. Request all documents for any exchanges between the partnership and a related party of any of the partners.  Review for losses on the exchange.  Losses are disallowed. Documents to Request Partnership agreement Prior and subsequent year partnership returns Related party tax returns Exchange documents between the partnership and the partners and related parties. Asset documentation for prior characterization of the asset exchanged. Interview Questions Were there any sale and exchange transactions during the year between the partnership and any partner? Were there any sale and exchange transactions during the year between the partnership and a related party of any partner? Supporting Law IRC, Subchapter K:  Section 707 IRC section 267 IRC section 1239 Supporting regulation and specific regulations cited above. Resources RIA U.S. Tax Reporter – Income Taxes CCH Standard Federal Tax Reporter Federal Taxation of Partnerships and Partners, William S. McKee, William F. Nelson, and Robert L. Whitmire, Warren, Gorham & Lamont back to the top ISSUE:  AUTOMATIC ADJUSTMENTS DUE TO PASSIVE LOSS LIMITATIONS When processing flow through items, any adjustment which increases the partner’s modified AGI over $100,000 could result in an automatic adjustment, if not outright disallowance, of the partner’s rental real estate losses.  Under IRC section 469(i), a $25,000 offset for rental real estate losses is permitted if the taxpayer actively participates in the activity.  However, the  $25,000 offset is phased out at the rate of 50 cents for every dollar modified AGI exceeds $100,000.  When the partner’s modified AGI is greater than $150,000 no rental loss is permitted (unless the taxpayer has passive income, which is relatively rare).  Modified AGI is simply AGI computed without any passive loss or passive income (plus several minor modifiers which are not commonly seen).  For more information, see the Passive Activity Loss Guide, Chapter 2. Examination Techniques The examination techniques should serve, in the end, to answer the following: Review each partner’s return for adjustments which will push AGI over $150,000.  If there is any loss on Schedule E line 24, there is a potential automatic adjustment. If AGI is over $150,000, in most cases, modified AGI is also greater than $150,000.  In other words, there is generally no need to compute modified AGI.  Furthermore, if the partner’s modified AGI exceeds $150,000, there is no need to compute Form 8582.  In the absence of passive income, rental losses are simply disallowed. For the report, simply make a statement to the following effect:  Since the taxpayer's modified adjusted gross income as defined in IRC section 469(i) exceeds $150,000, no loss is allowable in the current year.  Losses must be carried forward to the next year and entered on Form 8582 line 1c.  Issue Identification If there is a Form 8582 attached to the return, check lines 1a and 2a to see if there is any remaining passive income (rare).  In some cases, Form 8582 is not filed.  However, passive income would be reflected on Schedule E line 22 or on the back of Schedule E in the passive income column. Also verify that the taxpayer is not a real estate professional via review of Schedule E line 42.  If there is an entry on line 42, the taxpayer may not be subject to the passive loss limitations.  See discussion of the real estate professional rules below. Documents to Request Partners’ Forms 1040. Interview Questions None.  The adjustment is computational, similar to the medical adjustment. Supporting Law IRC section 469(i)(2) Up to $25,000 in rental real estate losses of an individual may be deducted if the individual actively participates in the activity. IRC section 469(i)(3) The $25,000 offset is phased out at the rate of 50 cents for every dollar of modified AGI in excess of $100,000. Resources Passive Activity Losses, MSSP Audit Guide, Chapter 2 MSSP Bulletin Board, Passive Loss Library Lucy H. Clark, Passive Activity Issue Specialist (National), 603-433-0723 Federal Taxation of Partnerships and Partners, William S. McKee, William F. Nelson, and Robert L. Whitmire, Warren, Gorham & Lamont back to the top ISSUE:  EQUIPMENT, AIRPLANE AND OTHER LEASES Rentals are passive activities, regardless of the taxpayer’s level of participation.  Losses from a partnership which leases equipment, airplanes, computers, office furniture, vehicles and other personal property are generally not deductible by the partners – even if leased back to an entity where the partner works.  It does not matter whether the partner materially participates or not.  Equipment leasing losses are generally nondeductible in the absence of passive income.  Thus, if an airplane, for example, is leased all year long to an entity, no loss is deductible in the absence of passive income. Short-term rentals (7 days or less) fall outside the definition of a rental activity and are treated like a business, subject to the material participation standard.  However, if the lessee has a recurring right to use the property, then it is deemed a true rental.  No standard applies for rentals of equipment.  Losses are simply not deductible in the absence of passive income.  They go on Form 8582 line 2b and are suspended until such time as the partner has passive income or an entire disposition. Examination Techniques The examination techniques should serve, in the end, to answer the following: Passive rental losses should be entered on Form 8582 line 2b.  As a general rule, they should not be reflected on Schedule E in the non passive column, which completely avoids the passive loss limitations.  Many taxpayers and representatives are unaware that equipment leasing activities are subject to the passive loss limitations. If the partnership itself is a leasing activity, all partner losses have a passive taint. In some cases, partnerships which conduct a business segregate equipment, furniture and fixtures and/or vehicles into a separate entity.  That property is then leased back to the partnership.  As a general rule, losses from the entity leasing the property to the partnership are passive.  Thus, the investors should be entering those losses on Form 8582 line 2b. Many taxpayers assume if they materially participate in the leasing activity, rental losses escape the passive taint.  However, IRC section 469(c)(2) and (4) explicitly hold that rentals are passive, regardless of whether the taxpayer materially participates. Issue Identification Peruse Blocks A, B and C of Form 1065 for indicators that the partnership activity is leasing activity. Review partners’ Forms 1040 for equipment leasing losses erroneously entered on Schedule E in the non-passive column.  Equipment leasing activities should not be in the non-passive column.  They should be reflected on Form 8582 line 2b and are deductible in the passive column only if there is sufficient passive income against which to offset the losses. Documents to Request Lease covering the years under examination.  If there is no lease, explain the terms of the oral agreements. Interview Questions Ask at the initial interview if the partnership itself is a leasing activity or if it leases property from another partnership or S corporation. Explain how the leasing activity works and identify the customers. Does the lessee have a recurring right to use the property? Explain who the equipment is leased to and for what period(s) of time. Explain what services, if any, the taxpayer provides with the equipment. back to the top Supporting Law IRC section 469(a) and (d) ─ Passive losses are deductible only to extent of passive income. IRC section 469(c)(2) and (4) ─ A rental or leasing activity is passive regardless of whether the taxpayer materially participates. IRC section 469(j)(8) and Treas. Reg. section 1.469-1T(e)(3)(i) ─ A rental is any activity where payments are principally for the use of tangible property. Treas. Reg. section 1.469-1T(e)(3)(ii)(A) ─ Activity falls outside rental definition if average customer use is 7 days or less.  If the average customer use is 7 days or less, it is treated like a business, subject to material participation (IRC section 469(h) and Treas. Reg. section 1.469-5T(a)). Treas. Reg. section 1.469-1(e)(3)(iii)  Final Reg. ─ Each period during which a customer has a recurring right to use the property is a separate period.  For example if the property is used only a few hours at a time, but the lessee has a recurring right to use the property all year, the period of customer use is a year.  It will be treated as a rental activity (passive regardless of participation), not a business, subject to material participation.  Review the lease. Treas. Reg. section 1.469-1T(e)(3)(ii)(C) ─ Activity falls outside the rental definition and is treated like a business if taxpayer provides extraordinary personal services, that is, the rental is incidental to services provided. Treas. Reg. section 1.469-1T(e)(3)(ii)(F) ─ Property falls outside rental definition if provided for use in a partnership, S corporation or joint venture.  Note that there is no exception for property provided to a C corporation.  Also note that Treas. Reg. section 1.469-1T(e)(3)(vii) indicates that providing means contributing the property to a partnership or S corporation. Treas. Reg. section 1.469-4(d)(1)(i) ─ General rule: rentals may not be grouped with businesses. Treas. Reg. section 1.469-4(d)(1)(i)(A) and(C)  Exception: rental can be grouped with business if insubstantial or owned in exact same percentage as business. Treas. Reg. section 1.469-4(d)(5)(ii) ─ No grouping of a rental with a C corporation ever.  Rentals can be grouped with a C corporation only to determine material or significant participation.  Both standards apply to businesses, not to rentals.  IRC section 469(c)(1)(B) and Treas. Reg. section 1.469-5T(c)(1)(i). Resources Passive Activity Losses, MSSP Audit Guide, Chapter 2 MSSP Bulletin Board, Passive Loss Library Lucy H. Clark, Passive Activity Issue Specialist (National), 603-433-0723 Federal Taxation of Partnerships and Partners, William S. McKee, William F. Nelson, and Robert L. Whitmire, Warren, Gorham & Lamont back to the top ISSUE:  RENTAL REAL ESTATE LOSSES Rental real estate is a passive activity – unless the partner is a real estate professional.  Issues on real estate professionals are discussed in the next segment.  For partners who are not real estate professionals, no rental losses may be deducted if the taxpayer’s modified AGI exceeds $150,000.  Furthermore, the $25,000 offset is not available to either limited partners or partners who own less than 10 percent of the partnership. Examination Techniques The examination techniques should serve, in the end, to answer the following: If the partnership conducts a rental real estate activity, scrutinize each partner’s Form 1040 return for the following: Is there an entry in box 42 of Schedule E indicating he or she is a real estate professional?  If so, losses will be deductible in the non-passive column, if he or she materially participates in the rental activity conducted by the partnership.  Material participation means he or she performed more than 500 hours during the year or did most of the work or met one of the other tests in Treas. Reg. section 1.469-5T.  If the partner does not materially participate, losses remain passive (Treas. Reg. section 1.469-9(e) and should be entered on Form 8582 line 1b or 2b.  Thus, they will be deductible only to the extent of passive income on Form 8582 line 10.  See chapters 2 and 3 of the Passive Activity Losses Reference Guide (Training #3149-115, TPDS No. 83479V Note:  The guide will probably be revised shortly; thus, these numbers may change). If the taxpayer is not a real estate professional (Schedule E line 42 is blank): Have partnership losses been entered in the non-passive column of Schedule E in error?  Rental real estate is a passive activity under IRC section 469(c).  Thus losses belong on Form 8582 line 1a, if the taxpayer actively participates, or line 2b, if not active.  Form 8582 limits total rental losses to $25,000 and reduces the $25,000 special allowance to zero, when modified AGI exceeds $150,000. Have limited partner’s or those who own less than 10 percent of the partnership entered losses on Form 8582 line 1b, thereby giving himself the benefit of the $25,000 offset in error?   Since a limited partner or anyone who owns less than 10 percent cannot be active, losses go on line 2b.   Losses on Form 8582 line 2b are deductible only if there is passive income (which is relatively rare). Issue Identification Peruse Blocks A, B and C of Form 1065 for indicators that the partnership activity is rental real estate.  Needless to say, if Form 8825 is attached to the 1065, you are probably dealing with rental real estate.  If so, check Schedules K-1 for each partner to ascertain who is a limited partner or who owns less the 10 percent. back to the top Documents to Request Copies of each partner’s Form 1040. Interview Questions If it is not clear from the return, ask if the partnership conducts a rental real estate activity? Ask what the level of involvement is for each partner.  Active participation is a liberal standard, requiring only management decisions in a bona fide sense.  However, as stated above limited partners and those with less than 10 percent ownership interest cannot be active. Supporting Law IRC section 469(c)(2) ─ Rentals are passive activities. IRC section 469(a) and (d) ─ Passive losses are deductible only to extent of passive income. IRC section 469(c)(2) and (4) ─ A rental (or leasing) activity is passive regardless of whether the taxpayer materially participates.  Exception:  real estate professionals under IRC section 469(c)(7). IRC section 469(c)(7) ─ Rental real estate of a qualifying real estate professional is excepted from the passive loss limitations if the taxpayer materially participates in the rental.  The taxpayer must rise to all the following tests:  (1) more than half his personal services must be in real property business and rental real estate; (2) he or she must spend more than 750 hours on real property businesses and real estate rentals during the year; and (3) he or she must materially participate in each separate real estate rental for losses to be fully deductible. IRC section 469(i) ─ Exception for rental real estate up to $25,000 if MAGI less than $100,000.  Note no exception for any other kind of rental. IRC section 469(i)(3)(E) ─ Modified adjusted gross income (MAGI) for Form 8582 line 6 is determined by computing AGI without any passive loss (excess passive losses after netting with passive income), any rental losses (whether or not allowed by IRC section 469(c)(7)), IRA/SEP, taxable social security or one-half of self-employment tax. IRC section 469(i)(6)(A) ─ The taxpayer is not active if his ownership interest is less than 10 percent.  Losses go on F8582 line 2b (not line 1b); thus the taxpayer receives no $25,000 offset. IRC section 469(i)(6)(C) ─ The taxpayer is not active if he is a limited partner. Losses go on F8582 line 2b (not line 1b); thus the taxpayer receives no $25,000 offset. back to the top ISSUE:  REAL ESTATE PROFESSIONALS If a partner spends the majority of his or her time on real property businesses or rentals and more than 750 hours during the year, his or her rental real estate activities are no longer presumptively passive.  Instead, they are treated like a business.  If the taxpayer materially participates, losses are no longer subject to the passive loss rules.  Many taxpayers incorrectly assume if they work in a real property business, rental losses are no longer subject to the passive loss limitations.  The material participation requirement is ignored. If the partner owns 50 percent or more of the partnership, each rental in a partnership is deemed a separate activity.  Thus, the partner must rise to material participation (work more than 500 hours during the year, perform most of the work or meet one of the other tests in Treas. Reg. section 1.469-5T(a)) for each separate rental activity. While few taxpayers do it, a timely election can be made to group rentals as a single activity, making it easier to rise to the material participation test.  See Treas. Reg. section 1.469-9(g). Examination Techniques The examination techniques should serve, in the end, to answer the following: On review the partner’s Form 1040, note whether he/she and his/her spouse have full-time jobs and other non-passive activities.  Note where the rentals are located in proximity to the taxpayer’s residence.  Ask who performs most of the work on the rentals, husband or wife.  Inquire what partner services the partner performs with his/her rentals. Because partnerships are not required to take passive losses or credits into account for their taxable year, the passive loss limitation is not a partnership item for TEFRA entities.  There is no need to open the Form 1065, if it is already not open.  The resolution of the issue of whether a partner is subject to the passive loss limitation is not a partnership item.  Whether the passive loss limitations apply to a partner has no effect on any item on the partnership's books and records.   For open TEFRA entities, the passive loss issue should be treated as an affected item. Issue Identification Scrutinize each rental property on Form 8825 and on Schedule E.  The following are indictors that the partner does not materially participate: • Commissions • Management fees • Large labor or wages • Rental property is located a long distance from the partner’s residence • The taxpayer is a limited partner. Documents to Request Partner’s Form 1040. Copy of an election to group rentals as a single activity under Treas. Reg. section 1.469-9(g) and the return with which it was made.  Most taxpayers have not elected to group.  Those that did, generally made the election with their 1995 Form 1040. If the partnership grouped its rentals under the provisions of Treas. Reg. section 1.469-4(d)(5), a copy of the tax workpapers or any other documentation indicating rentals were grouped. Services and hours performed by the taxpayer. back to the top Interview Questions Who monitors the rental?  Who collects the rent?  Who does the repairs? Does the partnership pay anyone to manage the rental or handle rents, problems, etc.? Do you have a real estate agent or manager?  Ask for each rental property.  Check Schedule E properties for large commissions or management fees.  Also check for large labor expense - possibly a hired contractor spent more time than the taxpayer.  If there is paid management, it is a strong indicator taxpayer did not materially participate. Does a relative or friend manage/monitor the property for free? Does a tenant receive free/reduced rent for managing the rentals – or for caring for the properties?  This is common practice with large apartment buildings. Supporting Law IRC section 469(c)(7) ─ Rental real estate losses are non-passive if the taxpayer spends more than half his or her services and more than 750 hours on real property businesses and materially participates in his or her rentals.   IRC section 469(c)(7)(A)(ii) and Treas. Reg. section 1.469-9(e)(3) ─ Each rental is a separate activity unless taxpayer elected to group under Treas. Reg. section 1.469-9(g) (not seen often).  Thus, even if taxpayer is a real estate professional, he or she still must meet material participation (Treas. Reg. section 1.469-5T(a)) for each separate rental before losses will be fully deductible. Treas. Reg. section 1.469-9(e) ─ If taxpayer is a real estate professional, he or she still must materially participate in each separate rental before losses are non-passive.  If the taxpayer does not materially participate, losses remain passive.   Treas. Reg. section 1.469-9(g) ─ The taxpayer must file a timely written election to group all rentals as a single activity.   Treas. Reg. section 1.469-9(h)(2) ─ Each rental in a partnership is a single interest in rental real estate if taxpayer owns 50 percent or more of the entity.  The taxpayer may elect to treat all rental real estate interests as a single activity. Treas. Reg. section 1.469-5T(a) ─ Tests to be applied to determine whether taxpayer materially participates, that is, whether losses are or are not deductible. back to the top ISSUE:  MATERIAL PARTICIPATION In order to deduct losses from a partnership that conducts a business, the partner must prove that he or she works on a regular, continuous and substantial basis in the operations of the activity.  There are seven tests for material participation in Treas. Reg. section 1.469-5T(a), the most common being the 500-hour test.  See Chapter 3 of the Passive Activity Loss Guide. The following hours are not counted in the hourly computations for material participation: investor-type activities (reading reports, monitoring as a non-manger, etc.) and work not customarily done by an owner if the purpose is to avoid the passive loss limitations.  Treas. Reg. section 1.469-5T(f)(2). Examination Techniques The examination techniques should serve, in the end, to answer the following: At the initial interview, ask what services each partner performs for the partnership.  Inquire how often each partner is at the partnership business location. Look for guaranteed payments or wages as an indicator that the partner does work on a regular basis in the partnership. When perusing the partners’ Forms 1040, look for losses in the non-passive column.  If losses are entered in the non-passive column, the taxpayer is indicating that he materially participates in the activity, that is, works on a regular, continuous and substantial basis in operations. Issue Identification The following items on a partner’s Schedule K-1 are possible indicators that he or she does not materially participate in the partnership’s business: • Limited partnership interest • Low ownership interest • Partnership is a significant distance from the partner’s residence back to the top Documents to Request From partners who do not appear to work regularly in the partnership, ask them to document services performed and hours attributable to those services for the year under examination. Ask if the partnership activity has been grouped with a related business under the “activity” rules in Treas. Reg. section 1.469-4. Request the partnership agreement with portions highlighted which address who manages the entity or any other item which may address the partners’ participation. Interview Questions What services does the taxpayer perform and how many hours? What records does taxpayer have to substantiate hours worked? Is taxpayer directly involved in day-to-day management? Is there an on-site manager/supervisor/foreman? Does taxpayer have signatory authority on checks? Does taxpayer have authority to borrow money?  Hire/fire personnel? Is work being performed by taxpayer required or necessary to the activity? Is taxpayer compensated for participation?  If not, why? Supporting Law IRC section 469(c)(1) ─ Passive activity is a business in which the taxpayer does not materially participate. IRC section 469(h) ─ A taxpayer materially participates only if he is involved in the operations of an activity on a regular, continuous, and substantial basis. Treas. Reg. section 1.469-5T(a) ─ Taxpayer materially participates if and only if he or she meets one of 7 tests.  Most common:  Does he or she work 500 hours in the activity in the year under exam? Treas. Reg. section 1.469-5T(f)(4) ─ Reasonable means for proving hours requires (1) an identification of services provided and (2) hours spent performing those services during the year based on appointment books, calendars, narrative summaries. back to the top ISSUE:  SELF-RENTED PROPERTY Passive losses are deductible only to the extent of passive income.  Thus, it is important to scrutinize income on a partner’s Form 8582 carefully.  While the income is always reportable, if it is removed from Form 8582 as it does not constitute passive income, generally an adjustment to passive losses results. It is common practice for many entities to hold their buildings (and