Loading summary
Transcript1 lines
- [00:00]
Matt Foreman
Foreign welcome to the 13th episode of How Tax Works. I'm Matt Foreman. In this episode, I'll be talking about passive activity, loss and credit limitations under Section 469 of the Internal Revenue Code. How Tax Works is meant for informational and entertainment purposes only. This may be attorney advertising and it is not legal advice. Please hire your own attorney. How Tax Works is intended to help listeners navigate the intricacies and complexities of tax law, regulations, case law, and guidance to demystify how taxes shape the financial and business choices that we all make. Before we get started, a few administrative items. New episodes every two weeks, roughly, you know, holidays and such. We'll move them back and forth a little. But the next episode, two weeks, we're going to talk about the at risk limitation rules under 465. If you have any questions, comments, or constructive criticism, you can email me at my FRB email address, which you can find via your favorite search engine. So what are we talking about? Right, if you Forgot the last 20 seconds, we're talking about section 469 of the internal Revenue Code, Passive activity, losses and credits. Limited, or really they're not limited? Limited is kind of a wrong word here. It's really suspended. You know, just for context, I'm doing this first off in reverse order. I really should do 465 first because under the ordinary rules, ordering rules, which I'll talk about later, it actually comes first. But this, this one, I think a. I think 469, the passive activity loss rules are more interesting. And I talked about it from part two of the episode last time with two weeks ago about. So we're run capital partners, so I thought there was a bit of a lead in. So even if I'm doing it in reverse order, whatever, it's fine. It doesn't matter. This is free. I can do whatever I want. So I think that's. That's really important. First off, you know, when I talk about this, there's a couple things to keep in mind. One, you know, the losses, you know, or they use the word limited, what it really means is susp. And two, this is both losses and it's tax credits as well. They're lumped into one basket. A lot of things that have problem with one or the other or whatever are both. So that's not a big deal. But I'm basically going to talk about losses. Losses. I'll talk about credits, but anytime it's losses, it's also credits. So before 1986. Right. The Tax Reform act of 1986. Pretty famous bill, right? You could offset income from your active trade or business from a W2A K1 with passive losses. So so as a result, what people did was they would invest in really just bad investments, frankly. I mean, they may have been good businesses, but investments that made no economic sense because they were able to throw off all these losses which they would take. Right? So someone would invest in a business, they get a whole bunch of capital for a period of time that was cheaper than taking on debt or other investors. Those people would take the losses and then they would just kind of disappear after they took their losses. Right? They'd get their money back or something like that. So you know, Congress was looking to raise revenue as they were lowering rates and this is one of the many things they did. So again, Tax Reform act of 1986. So the current rule as it has been for, for nearly 40 years now is that passive losses can only offset passive income. Active losses can offset passive income or active gains. So that's really important. The way this mechanism is effectuated is that what it does is it creates three baskets of income. There's active income in which the taxpayer must materially participate. There's passive income trader business exists, but the taxpayer does not materially participate in that trade or business. And Third, there's portfolio income 46091 interest, dividends, gain or loss from the sale or exchange of investment property. I'm not really going to talk about portfolio income here. I don't really think it's that necessary to have this discussion. And I think it's more important to focus on, you know, the passive activity loss rules instead of, you know, portfolio income. I, I should note that there's a really interesting set of rules dealing with portfolio income that largely comes from hedge funds and other things like that. So that, you know, it's really intended. People think oh, it's active or passive, active or passive. They actually kind of kick portfolio and come out so that you can't say, oh, portfolio income is actually passive. Right. For 469 purposes. It's its own special one portfolio which behaves more like an active. It's not quite active but more like that. It tends to be things that only really create. Portfolio income is only really income. There aren't really portfolio losses in the same manner anyway. So what is passive? Right? And the first thing is if it's categorized as passive, it is a perpetual carry forward forever, right? The whole time under 469B, it's not like a 20 year carry forward or some other period of time. It's forever, it's no matter what. So I think that that's really important, that it's forever. Two, you know, it can be used if passive income comes along, right? So if you carry forward, even if there's passive income, you can use the passive income to offset passive losses. One thing I actually see a lot is people who own real estate that does kick off passive losses. What they do sometimes is they will buy real estate after someone, you know is done depreciating it. Maybe they're active in the business. They buy it from someone because they, what they want is they want a piece of property that they're not really depreciating as much or as fast. They're not going to do a cost seg or anything like that. And the idea behind it is actually that they want the passive income to offset the passive losses, right? They just want to start using them up. And that's fine. Those tend to generate cash flow, so it's fine. It all comes up at the 1040 at the individual level. So I think it's really important. And you could also use passive income if you sell your ownership, the, your entire ownership, the entire interest in, in a taxable transaction, can't do 1031, 1033, 721, et cetera, et cetera. So if you're doing a taxable transaction under 4, 1669G, you can use that passive income to offset because that's it. Because basically you sell it and then that's it, right? It frees up, it's no longer passive. So it then just kind of comes in and it can be used as if it's active income. So even if you don't use all the passive losses, you sell at a loss, an overall loss, right? Not a net loss, but whatever. One of the really interesting things this came up, and I've been thinking about it a bunch lately, is the idea that it's actually better than a net operating loss, right? Because for, for two reasons. One, NOL is limited by 80% federally, and states often limit NOL usage as well. Some say you can't use nol, you can use only small portion, et cetera, you know, passive activity losses. First off, most states follow very, very consistently. And secondly, and I think this is actually possibly more important point is because it's suspended, right? You can just use the whole thing immediately. So passive activity losses are not necessarily a bad thing if used properly or if in a specific situation. So I think that that's really important. So now we're going to move on. I think it's really the technicals. This is probably why you're tuning in here, right. Is what is material participation? It's described in 469H. There are a lot of regulations that really dig into it. There are fundamental questions as to whether the seven tests. I'll get to a second. Whether whether the Treasury Department and the IRS has authority to do it, especially now that Chevron deference is gone. Some of these don't really make sense, but I'm not sure they're bad. I'm not sure they're wrong. And I think for the most part they're helpful. I think otherwise you're basically looking at facts and circumstances and 750 hours. So by going into the regulations, it actually lowers the hours, it gives you more possibility. So I think that's really helpful. So the code itself only really says to participate, you must participate on a regular, continuous and substantial basis. Right. So that's pretty easy, right? What does that mean? No one knows. It's, you know, it's sort of like, you know, it's something, you know, and you see, so to speak. So there's seven tests that the Treasury Department put out. They're in temporary regulations. They have not been finalized. I never totally understood why. I'm sure someone could give me a reason as to why. But there's seven different tests. You only need to get one test. That's really important for me. Right. Or for, for the taxpayer. Right. You only need to get one. You only need to get all seven. So the first one is the individual participates in the activity for more than 500 hours during the tax year. You know, a lot of people say, you know, 10 hours a week. Right. You know, it's a little less than, that'd be 520. But go on vacation, Ms. A week at nine, one week, whatever, you're over 500, then you then, then that's it. As material participation, you're golden. The second one, the individual's participation constitutes substantially all of the activities for all of the individuals, including owners and non owners for the tax year. Okay? So this one's really important because there are businesses where you can be profitable, where you spend 50 hours a year, right. Let's say you have rental real estate, you have an extremely long term tenant, okay. And you, you know, one once a month, you email them, you do this, you're only gonna hit 30, 40, 60 hours maybe. But that's all, that's all the time anyone spends, you know, that's fine. That's enough. Substantially all. I don't, I don't really define substantially all. I always say 80%, but that's important. By the way, these are all under 1469.5t predominantly TA. And then 1, 2, 3 kind of goes through it. I think that's a really important one to go through. I should note I'm gonna go back up a little bit in the first one, the 500 hours. And this is, this is the case. It aggregates the time spent by married couple as if they're a single taxpayer. So if that, that gives you sort of two ways to look at it. One, if both of you spend 250 and one half hours, you're at 501 together, you're good. If one of you spends 501, then you group in together. So what happens a lot is people, especially in real estate, which I'll get into in a moment, you know, one of the two spouses will spend all of their time on it, but you know, they'll work apart. It's really a part time job. They're doing other things. Maybe they have two jobs, but they'll hit the 600 hours. The other spouse will also own real estate or similar business. The effect of that is that both of them, once one materially participates, they both do because you're adding the hours together. So I think that's really important. The third one is that the individual participates for more than again, individual, you know, it's married couple spends more than 100 hours during the tax year and is not less than any other individual participant. Right. So more than a hundred hours, very easy math. We can all do that kind of math, basic algebra. And not less than any other individual participant. Which means you are more than every single other individual participant. So again this is, this is the business that doesn't take a lot of time to run. The way I describe this is again, I'm going to go to rental real estate a lot. It's a really common one. They own it. The owner spends 130 hours a year. Okay, so, so they're spending, you know, very minimal time. But the most time that anyone else spends is a plumber's there for five hours and you know, the real estate agent contacts them twice a year. That six hours or whatever it is probably more. Six is probably too high. And that's all you really need, Right? You just need to hit the a hundred hours and be more than ever than any other individual. And I think that's really, that's really important. And it's not every other individual participant. It's every other individual participants, their hours, their specific hours, not combined. The fourth one is that the taxpayer spends at least a hundred hours in each of a variety of different activities. And together the individual's participation in the larger group of activities exceeds 500 hours. Okay, so, you know, this one's kind of clunky, right? There's a lot going on here. The most important point that I think is here is that the activities that are grouped do not actually have to be similar. They give an example using a restaurant and a shoe store, right? So what they're saying is if you have a whole bunch of passive activities, but you spend a lot of time on all of them together, even if you're not otherwise grouping them, then you're fine. Okay, Then you've hit the 500 and you're over 500 total. And that's really the idea it's sort of looking at. Okay, well, you know, geez, you know, it's kind of a mix of the first one and the third one, which is more than 500 hours and more than a hundred hours on that specific activity. But you might not be more than any other individual person on it. So again, that's why they went with like the shoe store and the restaurant. I think that's a really important one. The next one, the fifth one, is the individual materially participated in this activity for at least five of the past 10 years, though not necessarily consecutively. This one has no statutory authority for it whatsoever. Look, it's super taxpayer friendly, I call it, you know, if someone gets sick or. I use it a lot, if someone used to be active in it, right? So let's say you're in a business, you're active in it for five years, then you go do something else. Well, guess what? You get five more years of being active. That's really important. Or you can kick in for a couple years, in and out, rotate back and forth, et cetera, or you just have a year where you really don't hit the 500 hours, you don't hit something else. So that one's pretty easy. The next one, the six, the activity is a personal service activity and the individual materially participated in at least the three years preceding the current tax year, though not necessarily consecutively. All right, so two, two, two requirements, I will break that down. One is it is a personal service activity, and two, material participation at least three years preceding the current tax year. Okay, so at some point you did it for Three years and it's a personal service activity, you still get the benefit. I've never really understood this one. Again, similar to the previous one, no statutory authority whatsoever. So I don't totally get it. But I don't think this is one anyone's going to really challenge, you know, now that Chevron deference is gone, because it can only be taxpayer friendly. I suppose theoretically the IRS could challenge their own regulations, although A, the government doesn't do that. Generally they have, but they generally don't. And B, perhaps more importantly, can you imagine saying, don't look at the man behind the curtain. Right. You know, don't, don't worry about that. The final one is a facts and circumstances test says, you know, the, based on the facts and circumstances, the individual individual participates in the activity on a regular, continuous and substantial basis during the tax year. I got to be honest, I hate using this one. Hate, hate, hate, because it's telling you that you don't meet any of the other ones. But don't worry about that waving you off. Oh, it's fine. I still do it. You know, if that were an audit fact pattern and I'm dealing with a couple of these audits right now, I would tell the taxpayer to consider paying, have a real conversation with them about that because I think that's an important one to say. Well, that's a, that is a last case scenario. So I think that's, that's an important one. So I think at this point we're about, about halfway through, maybe a little more. Let's, let's just take a quick break. Be back in just a moment with some musical interlude. So we're back. So the question is what activities qualify for the hour count or the activities that qualify, et cetera. Right. So it's really, it's really what ones don't is more the question. Right. Activities as an investor, generally not. So reviewing an operating agreement, that's probably as an investor, that's not as someone running a business. Maybe, but it depends. Right. Activities as a limited partner. So Soroban Capital Partners. Right. Soron Capital Partners is all about limited partners. If you're saying you're a limited partner for purposes of the payroll tax, congratulations. You, you are probably passive for the purposes of the passive activity loss limitation rules, totally distinct from net investment income tax, different rules, but that's going to be problematic. The key is that the activities that qualify are ones that are someone who is active in the business does. So you could review an operating agreement as part of it. You could you know, hire a fire. You could look at finances, things like that. Love, they love people who are reviewing, you know, balance sheets and other financial documents. That's. That's a really, really, really good one. And I think that's important. So you know we're going to talk about rental activities. I know I've talked about a lot. But rental activities are per se passive. 469h There is an exception for people in the real property business. 469c 7 cat b so if more than one half of the taxpayer's personal services are in a real property trade or business in which the taxpayer materially participates then and more than 750 hours so it kicks it up a little. Your real property business, you are no longer per se passive. Right. So it's a little more, you know, not a huge issue. Usually it kicks down to 750 I'm sorry to 500 because of the first tests in the regs. And that's really fine. And I always say, you know, look, I said this before, if one spouse is active, both are active. So I had a conversation with someone who's. Whose spouse? He was a real estate broker. He spent 800 to a thousand. I don't think it was a full time job. There were a couple in their 50s, you know, starting to wind down. She'd been a teacher for a while. Sort of shifted over. I think she was. Frankly I think she retired and was bored and I'm sorry she was still working. He was a real estate broker and. And he was bored. Started being a real estate broker. Eight hundred a thousand hours wasn't. You know I won't say it wasn't working too hard but I think it was something to do. It earned money. He enjoyed talking to people. He missed interacting. Teachers tend to like interacting with people. So it gave him that wasn't a huge amount of hours but he's well over the 7:50. You know, easy to mate to show that it's what he did. He held himself out there, et cetera, et cetera. He probably could have even if he didn't hit the 500 cop probably could have met made the facts and circumstances. So she held a number. An amount of real estate that came in. It was inherited real estate. She owned it directly through a trust. But it was, it was, it went up to her. I believe it was technically a grantor trust at that point or it functioned like one. It, it went up to him. It went up to her and that's fine. Right? He hit the hours. It's no longer passive. So that's really important. Have a couple kind of ancillary issues. Wasn't totally sure where to put them in. Want to talk about grouping and ordering grouping. So must be a single economic unit to determine that is a facts and circumstances test. The treasury regs. Not temporary, they're their final regs. Treasury Reg. 1.4694. C2. There are a number of factors in the regulations. There's five that I think A are the best and B, the IRS tends to give the most weight. The first is the similarities and differences in types of the trader business. So, you know, look, they're looking to see is this an economic unit? Right, Good question. Under the facts and circumstances, are they really one economic unit? Look, if you have six businesses and they're all rental real estate or you're, you know, managing sort of at a high level, a number of restaurants or something like that, that's it. But again, if you're trying to group to get to the 500 hours or you're trying to group different activities to get them all there, right? And you have two totally different activities, that's, that's problematic. If they're more similar, you know, that's going to really be a much better fact pattern. The next two, extent of common control and the extent of common ownership. Right? So if you own like 10% and the other 90 and both of them are totally different, they're, you know, there's sort of a, let's say, presumption that they're not controlled, they're not owned by the same people. But if you have three partners who all go in together on everything, well, that's, that's a good fact pattern. You know, that's saying, well, maybe they're more similar businesses. Maybe they're really one economic unit because you're going in with your partners. Right? That's the idea. Geographical location, especially proximity. Proximity is a great factor. If you have two businesses and one's in New York and one's is in Washington state. Not, not a great fact pattern. That's when you have to overcome, right. There's presumptions there, but it's one you can overcome. And the final one is interdependence between and among the activities themselves. How much are they related? Are they two totally different activities? You know, even if they have different PLs and they have different LLCs and they're, you know, or as corporations, right. Same idea. How does that work? How do they go through that? And I think that's really Important to know, you know, how much are they interdependent and how much are they dependent. And even if they're not dependent. Right. But they're similar businesses. Again, this goes back to them. There's a lot of interplay between the different ones. You have similar businesses and you're sort of trying to replicate it again and again and again. That's going to show that there is one. A single economic unit. You're just kind of adding into it. Adding into it. And I think that's really important. Once you're grouped, you cannot ungroup or regroup unless the grouping was inappropriate in the first place or there is a material change in the facts and circumstances. Right. So this is a lot like the 199 cap. A group, big same ideas in general. If you're going to group, you know, there's an amount of risk that goes along with it. The IRS generally does not like grouping unless it's fairly obvious. I think for, you know, obvious reasons not, not to use a pun there, they'll never shy away. But I think that's one you have to think about and really plan out with the tax pro to. To get right. Finally, we're going to talk about the ordering rules. So the ordering rules are not, you know, order like taking an order. Right. They're the order in which you consider different ways that the ability to take a deduction or credit are limited. Right. So there's really four that plug into this. One is available basis. You have to have outside basis. Huge limiting factor for S Corporations because there's not outside basis. So you can't sometimes pass out losses even if there's debt on the inside that allows for more asset value. Generally not a problem. Partnerships. And if it is, well, you have other issues. Right. You're throwing in cash or you just have other problems. Right. Two is at risk, section 465. So two weeks, we'll talk about that one. Unless you're listening to these back to back. So enjoy. The third one is the passive activity loss and credit limitation rules. 469. So this one. So. And finally there's the excess business losses under 461L. Only for another. I think it's two more years. I think it's 24, 25. Basically $250,000 single or filing separately, $500,000 jointly index for inflation. So it's already higher than that. And the idea is that if you have a business loss over a certain amount, it's limited. What they didn't want is people who have a lot of passive income or active income or whatever. If you just have a huge amount of a business that lost a lot of money, you can't offset all of your income. Sort of similar to the net operating loss limitation. So the way the ordering rules function is first you see if the basis limits if the basis doesn't limit you go to at risk at risk limits then you're done. Right. If it does not limit you go to passive activity loss rules. That doesn't limit you go to excess business loss. If there's no limit on any of those, congratulations, you can now you can. You can take the loss so that that's a positive So I hope you enjoyed it. That was the third teeth episode of How Tax works. I hope you learned something. Hope you enjoyed it. I'll be back in two weeks 14th episode if I can count right. And I'll be talking about the 465 at risk limitations. Right. And now for the best song of all time.