CHAPTER 13
END OF CHAPTER PROBLEMS
Discussion Questions
1. Discuss the at risk concept and how it applies to the deductibility of investment losses.
Answer:
A taxpayer shall be considered at risk for an activity for the amount of money and the adjusted basis of other property contributed by the taxpayer to the activity, and amounts borrowed in relation to the activity. At-risks rules and passive activity loss rules work together to limit the deductibility of losses from activities where the taxpayer does not materially participate in the business or losses from activities where no economic loss is actually suffered.
2. What amounts are considered at-risk when making the determination of a deductible loss?
Answer:
The initial at-risk amount is the money plus the adjusted basis of property contributed to the activity. The at-risk amount also includes certain amounts borrowed in connection with the activity. This amount is increased each tax year by income/gain items and any additional contributions of money or property. The at-risk amount is decreased each tax year by loss items and distributions of money or property. Factors that either increase or decrease the at-risk amount are taken into account prior to determining the amount of allowed loss items.
3. What are the differences between recourse, nonrecourse, and qualified nonrecourse liabilities? Which liabilities are considered at-risk?
Answer:
A recourse liability exists when the taxpayer is personally liable for the debt. A taxpayer’s share of recourse debt is considered an amount at-risk. Recourse debt is not included in the at-risk amount if the amounts are borrowed from any person (or entity) who has an interest in the activity or someone who is related to any person who has an interest in the activity, but the related party lender would get the at-risk increase. Nonrecourse debts are loans where no individual is personally liable for the debt. Since no one is personally liable, a taxpayer’s share of nonrecourse liabilities does not increase at-risk amounts. Qualified nonrecourse debt applies to taxpayers involved in the activity of holding real property (real estate). Taxpayers are deemed to be at-risk for their share of such amounts. Qualified nonrecourse financing is any debt that is borrowed by the taxpayer with respect to the activity of holding real property, borrowed from a qualified person or government, no person is personally liable for repayment, and is not convertible debt.
4. What is a passive activity? What types of activities are automatically considered passive?
Answer:
Passive activity refers to any activity which involves the conduct of any trade or business, and in which the taxpayer does not materially participate. Passive activity also includes almost all rental activity.
5. Discuss the concept of material participation. To be considered a material participant, what tests must the taxpayer satisfy?
Answer:
Material participation by the taxpayer is defined as participation in the activity on a regular, continuous, and substantial basis.
6. When a loss is disallowed under the passive activity loss rules, what happens to that loss in future years?
Answer:
Losses that are disallowed is carried over indefinitely until the taxpayer has passive income or until he or she disposes of the activity.
7. Discuss the rules concerning the $25,000 loss offset for rental activities. Why are $25,000 in losses allowed for some taxpayers?
Answer:
In order to qualify for the $25,000 offset, a taxpayer must actively participate in the rental activity. The loss is allowed against ordinary income for lower income taxpayers. Once the income of a taxpayer exceeds $100,000, the available loss is reduced 50 cents for every dollar of income over $100,000.
8. What are the differences between material participation, active participation, and significant participation?
Answer:
The activity is a significant participation activity if participation is greater than 100 hours. Active participation is defined as any interest in any rental real estate activity for any period if such interest (including any interest of the spouse of the individual) is greater than 10 percent of all interest in such activity. Material participation is defined as any participation in an activity on a regular, continuous, and substantial basis.
9. When a passive activity is sold or otherwise disposed, what happens to any suspended losses from that activity?
Answer:
When a taxpayer disposes of a passive activity, suspended passive losses from past years are allowed and any excess passive losses can be used to offset non-passive income.
10. When must Form 6198 and Form 8582 be filed? Does the taxpayer file more than one From 6198 or Form 8582?
Answer:
When an activity is at-risk, a Form 6198 is filed for each at-risk activity. Form 8582 relates to passive activity losses. Only one Form 8582 is filed regardless of the number of passive activities with losses.
11. How do the passive loss rules and the at-risk rules work in conjunction to limit losses?
Answer:
The goal of the passive activity loss (PAL) rules was to eliminate tax losses created from activities that were not the taxpayer’s primary source of income. The PAL rules supplement the At-Risk rules. The loss must first be allowed under the At-Risk rules and then must pass through the PAL rules in order to ultimately be deducted on the tax return.
12. Discuss the AMT formula and how it relates to the regular income tax. Include in your discussion factors that cause AMT to be assessed.
Answer:
The AMT is calculated by using regular taxable income and then adjusting for tax preference items and other adjustments. The AMTI (Alternative Minimum Taxable Income) = regular taxable income + personal/dependency exemptions and standard deduction (if the taxpayer does not itemize) +/- adjustment items + tax preference items. From AMTI, subtract the AMT exemption amount to equal the alternative minimum tax base. Multiply this number by a 26% or 28% tax rate, and then subtract the regular tax to get the AMT.
13. What AMT adjustment items are likely to affect all taxpayers that itemize their deductions? Give examples.
Answer:
For medical expenses, the AGI floor increases from 7.5% to 10% for AMT. Mortgage interest is only allowed for AMT if the interest is to build, buy, or substantially improve the taxpayer’s residence. Any itemized deduction for taxes or miscellaneous itemized deductions are disallowed in entirety for AMT purposes.
14. Are medical expenses treated differently for AMT purposes than for regular tax purposes? If so, explain?
Answer:
The AGI floor for medical expenses is increased from 7.5% of AGI to 10% of AGI for AMT.
15. Are the depreciation lives the same for AMT purposes as for regular tax purposes? If not, how are the lives determined for AMT?
Answer:
For regular depreciation, the life of the asset is determined under the general depreciation system (GDS). For AMT purposes, the life of the asset is determined under the alternative depreciation system (ADS).
16. Discuss the tax basis calculation adjustment. Why is the gain or loss on the sale of depreciable assets different for AMT purposes than for regular tax purposes?
Answer:
Since different depreciation methods are used for AMT verses regular tax purposes, then the adjusted basis for the different taxes have to be different. The adjusted basis is different, then the resulting gain or loss on disposal must be different. Typically, since AMT depreciation is more conservative, the AMT basis will be larger which will result in a smaller gain or larger loss.
Multiple Choice
17. Which of the following increase(s) a taxpayer's at-risk amount?
a. Cash and the adjusted basis of property contributed to the activity.
b. Borrowed amounts used in the activity for which the taxpayer is personally liable for.
c. Income from the activity.
d. All of the above.
Answer: d
18. Which of the following decreases a taxpayer's at-risk amount?
a. Cash contributions.
b. Property contributions.
c. Release of liabilities.
d. Income items.
Answer: c
19. In 2006, Kirsten invested $20,000 for a 10% partnership interest (not a passive activity). The partnership has losses of $150,000 in 2006 and $250,000 in 2007. Kirsten’s share of the partnership’s losses is $15,000 in 2006 and $25,000 in 2007. How much of the losses from the partnership can Kirsten deduct?
a. $0 in 2006 and $0 in 2007.
b. $15,000 in 2006 and $5,000 in 2007.
c. $15,000 in 2006 and $25,000 in 2007.
d. $20,000 in 2006 and $0 in 2007.
Answer: b
20. Leonard invests $10,000 cash in an equipment leasing activity for a 15% share in the business. The 85% owner is Rebecca who contributes $10,000 and borrows $75,000 to put in the business. Only Rebecca is liable for repayment of the loan. The partnership incurs a loss of $125,000 during the year. What amount of the loss is deductible currently by Leonard and Rebecca (ignore passive loss rules)?
a. $0 by Leonard and $0 by Rebecca.
b. $10,000 by Leonard and $85,000 by Rebecca.
c. $18,750 by Leonard and $106,250 by Rebecca.
d. $21,250 by Leonard and $73,750 by Rebecca.
Answer: b
21. Myer owns a 20% interest in a partnership (not involved in real estate) in which his at-risk amount was $50,000 at the beginning of the year. During the year, he receives a $40,000 distribution from the partnership. The partnership produces a $160,000 loss during the year. What is Myer’s deductible loss for the year (ignore passive loss rules)?
a. $0.
b. $10,000.
c. $32,000.
d. $50,000.
Answer: b
22. Alcott invested $20,000 for a 25% interest in a partnership (not a passive activity) on January 1, 2006. The partnership borrowed $100,000 (with full recourse to the partners) on January 15, 2006 to cover short-term cash flow requirements. During the year, the partnership generated a $60,000 loss. By December 31, 2006, the partnership had paid off $20,000 of the loan. What is Alcott’s at-risk amount on January 1, 2007?
a. $20,000.
b. $25,000.
c. $40,000.
d. $45,000.
Answer: b
23. Dudley and his Uncle Edgar each invested $70,000 cash in the D&E Partnership and each received a 50% interest in the partnership. To finance his investment in the partnership, Dudley borrowed $30,000 on a full recourse basis from his partner, Uncle Edgar. Which of the following statements is correct?
a. Dudley’s at-risk amount in his partnership interest is $40,000.
b. Uncle Edgar’s at-risk amount in his partnership interest is $70,000.
c. Dudley’s at-risk amount in his partnership interest is $70,000.
d. Uncle Edgar’s at-risk amount in his partnership interest is $40,000.
Answer: a
24. Which of the following would be considered a passive activity?
a. A limited partnership interest in which the taxpayer materially participates.
b. Most rental real estate activities.
c. A trade or business in which the taxpayer does not materially participate.
d. All of the above.
Answer: d
25. Sylvester, an accountant, owns a mail order business in which he participates. He has one employee who works part-time in the business. Which of the following statements is incorrect?
a. If Sylvester participates for 600 hours and the employee participates for 1,000 hours during the year, Sylvester qualifies as a material participant.
b. If Sylvester participates for 120 hours and the employee participates for 120 hours during the year, Sylvester does not qualify as a material participant.
c. If Sylvester participates for 500 hours and the employee participates for 520 hours during the year, Sylvester does not qualify as a material participant.
d. If Sylvester participates for 95 hours and the employee participates for 5 hours during the year, Sylvester probably qualifies as a material participant.
Answer: a
26. Janel owns five small businesses. Each business has its own manager and employees. Janel spends the following number of hours this year working in the various businesses: business A, 130 hours; business B, 160 hours; business C, 110 hours; business D, 120 hours; business E, 100 hours. Which of the following statements is correct?
a. Businesses A, B, C, D, and E are all significant participation activities.
b. Businesses A, B, C, and D are all significant participation activities.
c. Janel is considered a material participant in Businesses A, B, C, and D.
d. Both b. and d. are correct.
Answer: d
27. Samuel is a CPA and earns $75,000 from his practice in the current year. He also has an ownership interest in three passive activities. In the current tax year, the activities had the following income and loss:
Partnership A $ 20,000
Partnership B $ (16,000)
Partnership C $ (12,000)
What is Samuel’s adjusted gross income for the current year?
a. $67,000.
b. $72,000.
c. $75,000
d. $95,000.
Answer: c
28. Nathaniel has AGI (before any rental loss) of $65,000. He also owns several rental properties in which he actively participates. The rental properties produced a $30,000 loss in the current year. Nathaniel also has $5,000 of income from a limited partnership interest. How much, if any, of the rental loss can he deduct in the current year?
a. $0.
b. 5,000.
c. $25,000.
d. $30,000.
Answer: d
29. Basil has $130,000 AGI (before any rental loss). He also owns several rental properties in which he actively participates. The rental properties produced a $30,000 loss in the current year. Basil also has $5,000 of income from a limited partnership interest. How much, if any, of the rental loss can Basil deduct in the current year?
a. $0.
b. $5,000.
c. $15,000.
d. $25,000.
Answer: c
30. Raymond sells his entire interest in a rental property in which he actively participated at a gain of $18,000. The activity has a current year loss of $5,500 and $18,500 in prior year suspended losses. During the year, Raymond has $55,000 in salary. What is Raymond’s AGI for the year?
a. $49,000.
b. $55,000.
c. $67,500.
d. $73,000.
Answer: a
31. Jacob is single with no dependents. During 2006, he has $48,000 of taxable income. He also has $28,000 of positive AMT adjustments and $12,000 of tax preferences. Jacob does not itemize his deductions but takes the standard deduction. Calculate his AMTI.
a. $88,000.
b. $91,300.
c. $93,150.
d. $96,450.
Answer: d
32. Which of the following itemized deductions is not allowed for AMT?
a. Medical expenses.
b. Taxes.
c. Charitable contributions.
d. Interest on loan to purchase principal residence.
Answer: b
33. Which of the following statements is correct with regard to the medical expense deduction?
a. Medical expenses are not deductible for AMT.
b. The medical expense deduction is increased for AMT.
c. The medical expense deduction is decreased for AMT.
d. Certain medical expenses that are deductible for regular tax purposes are not deductible for AMT.