Chapter 7

Deductions: Business/Investment Losses and Passive Activity Losses

(Revised11-04-2015)

[Not in text order!]

Recurring Themes in Chapter:

  • Expenses can’t exceed Income (that is, no losses allowed)
  • Deductions are taken in a specific order.

Hobby Losses

  • Hobby losses were introduced in Chapter 6.
  • Activities not carried on with the intention of making a profit.
  • Often there is a substantial element of personal enjoyment.
  • A lack of profit motive means the activity is a hobby.
  • No profit in 3 of 5 years indicates a hobby, not a business.
  • Horse racing/breeding/showing needs only 2 of seven years.
  • The taxpayer may still show by evidence that a profit motive exists.

Hobby (Loss) rules

  • Deductions for an activity not carried on for profit cannot exceed hobby income:
  • Hobby expenses are itemized deductions.
  • Interest and taxes are deducted first.
  • All other expenses are miscellaneous itemized deductions subject to the 2% of AGI floor.
  • Factors Indicating Hobby v. Business:

-History of profits and losses

-Amount of occasional profits

-Success of similar business

-Financial status of the taxpayer

-Time and effort spent on activity

-Expertise of taxpayer and advisers

-Professional manner in which the activity is carried out

-Element of personal pleasure

-Expectation asset will increase in value

Home Office Deductions (O-I-H)

  • A portion of the home which is used for business (not investment) activities.
  • Must separate business and personal elements, using “some reasonable allocation method”:

Allocate mutual expenses (utilities, interest, depreciable basis, cleaning, etc.) on basis of either:

(a) Number of rooms in the O-I-H / total house rooms,

or

(b) Number of square feet in the O-I-H/ total square feet in the house.

  • Limit on O-I-H expenses (Sec 280A)
  • Deductions can't exceed income from home office
  • Any excess may be carried over to future years.
  • For Qualifying O-I-H, Office must be used exclusively and regularly (that means 100.00%) as:

(1)The principal place of business for any trade or business of taxpayer, including a place used for the administrative or Mgt. Activities for any trade or business if there is no other FIXED location used for those activities.

(2)A place of business used by clients in normal course of business, or

(3)A separate structure not attached to taxpayer's dwelling unit.

  • If an employee, O-I-H must also be used for the convenience of the employer.
  • Day care providers do not have to maintain exclusive use, but must allocate space costs by:

Totalhours per week of day care provided

Total hours in the week (168)

  • O-I-H deductions must be taken in a certain order:

(1) Items deductible w/o regard to home office use,(Interest & taxes).

(2) Other business expenses not related to the home office (supplies, etc.).

(3) Item’s that reduce basis (depreciation) and other items that would be non-deductible if not an O-I-H (% of insurance utilities, etc.).

For Example:

Gross income from O-I-H $15,000

Business Expenses:

non-O-I-H expenses$9,000

% of interest 4,000

% of taxes 1,000

share of depreciation 1,500

% of utilities 1,000

Total Expenses $16,500

Calculation Example of Office-In-Home deduction:

Gross income$15,000

Less:Type (1) expenses:

Interest$4,000

Taxes 1,000 (5,000)

Amount remaining$10,000

Less:Type (2) expenses:

Non O-I-H expenses (9,000)

Limit on O-I-H expenses$ 1,000

Deductible O-I-H expenses ( 1,000)

Home office income $ -0-__

Carryover to next year:

Total O-I-H expenses (depreciation & insurance)$2,500

Less:O-I-H expenses allowed(1,000)

Carryover$1,500

(MUCH) Simplified Home office Method:

Rather than allocating any expenses ahome office deduction may be computed by:

  • Number of square feet in home office time $5/sq feet.

Maximum square feet allowable is 300 sq feet.

  • Still subject to income limitations.

“Vacation” Rental Homes

  • Property sometimes rented out and sometimes used by the owner for personal use.
  • Expenses include interest, taxes, insurance, condo fees, depreciation, repairs, amortization, maintenance, etc.
  • Common expenses must be allocated between rental and personal use.
  • Rental of Vacation home/Principal Residence:

(a) If Rental period is less than 15 days:May exclude all income.

(b) If Personal use is no more than the greater of (1) 14 days or (2) 10% of rental period

-Ignore personal use.

-Subject to passive activity rules on limiting deduction of

losses.

(c) If personal use is more than the greater of (1) 14 days or (2) 10% of rental period, then:

Business deductions cannot exceed rental income, and Expenses must be deducted in the following order:

  • FIRST:
  • Deduct Interest, taxes & casualty losses (since these are deductible whether or not the property is rented) allocable to business use.
  • NEXT:
  • Deduct operating expenses (other than depreciation) allocable to business use.
  • LAST:
  • Deduct depreciation ("items that affect basis") allocable to business use.

Allocation Ratio:

Total Days Rented = Business Use %

Total Days Used[1]

Example:

Business use160 days66.67%

Personal use 80 days33.33%

Total240 days 100.00 %

Rental income = $6,800

Expenses:(Sch.A)

Total(SchE)Itemized

DescriptionAmountRental %Deduction

Interest & taxes$4,500$3,000$1,500

Repairs & Mntce 1,800 1,200 -0-

Rental Comm 1,000 1,000 -0-

Depreciation 5,400 3,600 -0-_

Totals $12,700$8,800$1,500

Computation of allowable deductions:

Rental income:$6,800

Less:

Interest & Taxes(3,000)

Net 3,800

Less:

Operating expenses(2,200) (Repairs + Commissions)

Limit on depreciation1,600

Less:

Allowable depreciation (1,600)

Net rental income $ -0-

Total Business deduction$8,800

Allowed deductions (6,800)

Unused deductions$2,000) (depreciation)

At Risk Rules

  • A Taxpayer may not deduct losses to the extent the taxpayer is not "at risk" in an activity at the end of the tax year. “At risk” includes the amount of cash and property contributed to the entity, and the amount of debt for which the taxpayer is personally liable.
  • May include “qualified non-recourse financing” on real estate if the loan is acquired from a non-related party normally in the business of lending money.
  • The “At Risk” amount is increased for the share of profits, and decreased for the share of losses.
  • Losses not used because of “At Risk” rules may be deductible in the future if the at risk amount increases.
  • These rules apply beforeany Passive Activity Rules.

Passive Activity Losses

Passive Activities include all Investment activities in which the taxpayer doesnot “materially participate” – this Includes all rental activitiesunlessthe taxpayer or spouse are “real estate professionals”.

  • To qualify for Material Participationthe taxpayer must (only need to meet one):
  1. Spend more than 500 hours a year on the activity.
  2. Taxpayer’s activities are virtually all of the participation for the activity.
  3. Spend more than 100 hours a year, and that is more than anyone else.
  4. Activity is significant participation activity and the participation in all such activities exceeds 500 hours a year.
  5. Taxpayer materially participated for 5 tax years out of previous 10.
  6. Activity is a personal service activity and taxpayer materially participated at least three years, or
  7. Based on all the facts and circumstances, the individual participates on a substantial, regular and continuous basis during the year.
  • Losses from “passive activities” may only offset income from passive activities. This led to the rise of so-called Passive Income Generators (PIGS).
  • Losses in excess of income will be “suspended” and carried forward until such time as there is income from passive activities or the activity is disposed of in a fully taxable transaction.
  • The taxpayer may deduct up to $25,000 per year in losses from rental real estate provide the taxpayer "actively participates" in the management of the activity. The $25,000 deduction is phased out between $100,000 and $150,000 of AGI (50% of the excess over $100,000).

Business Casualty and Theft Losses

Deductible losses Include:

  • Losses incurred in a trade or business.
  • Losses incurred in any transaction entered into for profit, though not connected with trade or business.
  • Casualty losses.
  • The loss is equal to the expected loss after reimbursement.
  • Qualifying losses are deductible in year the loss is sustained, however, embezzlement losses are deductible in year discovered.

Net Operating Losses (NOL’s)

  • Usually indicated when the AGI is negative.

Simple NOL Computation:

Business income

+ Salaries

-Business Deductions

-Casualty losses

= Net Operating Loss

  • NOL’s are carried back two years and forward 20 years.
  • The taxpayer may elect to carry the NOL forward only, and forego the carryback period. This avoids having to amend the tax return for past years; but where is the loss most valuable?
  • Individuals seldom have Net Operating Losses.

1

[1]This is formula adopted by the IRS.