Investor Losses

March 13, 2024

8691 / Who is subject to the at risk rules? Do the at-risk rules apply to partnerships and S corporations?

<div class="Section1">Generally, the at-risk rules apply to individuals, estates, trusts, and certain closely-held C corporations.<a href="#_ftn1" name="_ftnref1">1</a> A C corporation is considered to be closely-held, and thus subject to the at risk rules, if more than 50 percent of its stock is owned, directly or indirectly, by five or fewer individuals.<a href="#_ftn2" name="_ftnref2">2</a>In the case of pass-through entities (such as partnerships and S corporations), the at-risk rules will apply at the individual taxpayer level (e.g., to the partner or S corporation shareholder), rather than directly to the entity itself. <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.IRC § 465(a); IRS Pub. 925, supra. <a href="#_ftnref2" name="_ftn2">2</a>.IRC § 465(a), 542(a)(2). </div></div>

March 13, 2024

8696 / To which taxpayers do the passive rules apply?

<div class="Section1">IRC Section 469, which governs the treatment of passive losses, applies to individual taxpayers, estates and trusts. Closely-held C corporations and personal service corporations are also subject to the passive loss rules in an attempt to prevent taxpayers from creating these entities solely to avoid the passive loss rules (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8695">8695</a>).<a href="#_ftn1" name="_ftnref1">1</a> <hr> Planning Point: Even though the passive activity rules do not apply to grantor trusts, partnerships, and S corporations directly, they do apply to the owners of these entities (i.e., they are applied at the individual level, rather than the entity level).<a href="#_ftn2" name="_ftnref2">2</a> <hr> The passive loss rules apply to S corporations and partnerships indirectly, because income and losses flow through the entity to apply at the individual taxpayer level (e.g., to the S corporation’s shareholders or partnership’s partners). See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8967">8967</a> and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8930">8930</a> for a detailed discussion of the pass-through rules applicable to S corporations and partnerships, respectively. <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.IRC § 469(a)(2). <a href="#_ftnref2" name="_ftn2">2</a>.Temp. Treas. Reg. § 1.469-1T(b); IRS Pub. 925. </div></div>

March 13, 2024

8706 / What is the result if a taxpayer has interest expenses that exceed net investment income for the tax year?

<div class="Section1">If a taxpayer has interest expenses that exceed his or her net investment income for the year, those expenses are considered excess interest and the deduction is disallowed. However, disallowed interest expenses from one year can be carried forward to the succeeding tax year.<a href="#_ftn1" name="_ftnref1">1</a>A taxpayer’s investment interest expenses that are disallowed because of the investment income limitation in one year will be treated as investment interest paid or accrued in the succeeding tax year.<a href="#_ftn2" name="_ftnref2">2</a> The IRS has issued guidance that provides it will not limit the carryover of a taxpayer’s disallowed investment interest to a succeeding tax year to the taxpayer’s taxable income for the tax year in which the interest is paid or accrued.<a href="#_ftn3" name="_ftnref3">3</a> Prior to the issuance of this guidance, several federal courts had held that no taxable income limitation existed on the amount of disallowed investment interest that could be carried over.<a href="#_ftn4" name="_ftnref4">4</a> <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.IRC § 163(d)(2). <a href="#_ftnref2" name="_ftn2">2</a>.IRC § 163(d)(2). <a href="#_ftnref3" name="_ftn3">3</a>.Rev. Rul. 95-16, 1995-1 CB 9. <a href="#_ftnref4" name="_ftn4">4</a>.See, for example, Sharp v. U.S., 94-1 USTC 50,001. </div></div>

March 13, 2024

8690 / To what types of investment activities do the “at risk” rules apply?

<div class="Section1">The “at risk” rules apply to each of the following activities when engaged in by an individual (including partners and S corporation shareholders, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8691">8691</a>) as a trade or business or for the production of income: (1) holding, producing, or distributing motion picture films or video tapes; (2) farming (including raising, shearing, feeding, caring for, training, or management of animals); (3) leasing of depreciable personal property (and certain other “IRC Section 1245” property); (4) exploring for, or exploiting, oil and gas reserves; (5) exploring, or exploiting, geothermal deposits; (6) holding real property.<a href="#_ftn1" name="_ftnref1">1</a> <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.IRC §§ 465(c); 464(e). </div></div>

March 13, 2024

8689 / What are the “at risk” rules with respect to investor losses?

<div class="Section1"> The at risk rules are a group of provisions in the IRC and regulations that limit the current deductibility of “losses” generated by tax shelters (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8687">8687</a>) and certain other activities to the amount that the taxpayer actually has “at risk” (i.e., in the economic sense) in the tax shelter. “Loss” for purposes of the at risk rules means the excess of allowable deductions for the tax year (including depreciation or amortization allowed or allowable and disregarding the at risk limits) over the taxpayer’s income from the activity for the tax year.<a href="#_ftn1" name="_ftnref1">1</a>Historically, the primary targets of the at risk rules have been limited partners and the nonrecourse financing of a limited partner’s investment in the tax shelter (which was once common in tax shelters, see the example in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8687">8687</a> for an illustration). Despite this, the rules also apply to certain corporations and general partners in both limited and general partnerships and to non-leveraged risk-limiting devices (e.g., guaranteed repurchase agreements) designed to generate tax deductions in excess of the amount for which the investor actually bears a risk of loss in a shelter.<a href="#_ftn2" name="_ftnref2">2</a> Other at risk provisions of the IRC limit the availability of the investment tax credit with respect to property acquired for purposes of the tax shelters or other activities.<a href="#_ftn3" name="_ftnref3">3</a> <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.IRC § 465(d); IRS Pub. 925, Passive Activity and At-Risk Rules (2022). <a href="#_ftnref2" name="_ftn2">2</a>.See Sen. Rep. 94-938, 1976-3 CB (vol. 3) 57 at 83. <a href="#_ftnref3" name="_ftn3">3</a>.IRC §§ 49(a)(1), 49(a)(2). </div></div>

March 13, 2024

8694 / What rules apply for determining whether a taxpayer has amounts “at risk” when the taxpayer receives qualified nonrecourse financing with respect to the purchase of real property?

<div class="Section1"> An investor in real estate (excluding mineral property) is considered at risk with respect to nonrecourse financing if: (a) no person is personally liable for repayment (except to the extent provided in regulations); (b) the financing is secured by real property used in the activity; (c) the financing is borrowed with respect to the activity of holding real property; (d) the financing is not convertible debt, and either (1) the financing is borrowed from a “qualified person” or represents a loan from any federal, state, or local government or instrumentality thereof, or is guaranteed by any federal, state, or local government, or (2) the financing is borrowed from a related person upon commercially reasonable terms that are substantially the same terms as loans involving unrelated persons.<a href="#_ftn1" name="_ftnref1">1</a> A “qualified person” is one who is actively and regularly engaged in the business of lending money and who is not (1) related in certain ways to the investor, (2) the one from whom the taxpayer acquired the property (or related to such a person), or (3) a person who receives a fee with respect to the lessor’s investment in the real estate (or related to such a person).<a href="#_ftn2" name="_ftnref2">2</a> In the case of a partnership, a partner’s share of qualified nonrecourse financing of the partnership is determined on the basis of the partner’s share of such liabilities incurred in connection with the financing.<a href="#_ftn3" name="_ftnref3">3</a> <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.IRC § 465(b)(6). <a href="#_ftnref2" name="_ftn2">2</a>.IRC §§ 465(b)(6)(D)(i), 49(a)(1)(D)(iv). <a href="#_ftnref3" name="_ftn3">3</a>.IRC § 465(b)(6)(C). </div></div>

March 13, 2024

8703 / How do the passive loss rules interact with the at-risk rules?

<div class="Section1">When determining whether a loss deduction will be allowed, the taxpayer must first apply the at risk rules. If a deduction is disallowed in one year under the at risk rules (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8689">8689</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8694">8694</a>), it generally cannot be deducted as a loss under the passive activity rules.<a href="#_ftn1" name="_ftnref1">1</a> Therefore, the loss will be suspended under the at risk rules, and can be carried forward to the succeeding tax year if the taxpayer has sufficient amounts “at risk” in that later tax year.<div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.Temp. Treas. Reg. § 1.469T(d)(6)(i). </div></div>

March 13, 2024

8701 / How are the passive activities of publicly-traded partnerships treated under the passive loss rules?

<div class="Section1">Special restrictions apply to publicly traded partnerships under the passive loss rules. A publicly traded partnership is a partnership that is traded on an established securities market or is readily tradable on a secondary market (or the substantial equivalent thereof).<a href="#_ftn1" name="_ftnref1">1</a>The rules are applied separately to items attributable to a publicly traded partnership, meaning that income, losses, and credits attributable to the partnership may not be aggregated with other income, losses, and credits of the taxpayer-partner for purposes of the passive loss rules.<a href="#_ftn2" name="_ftnref2">2</a> Net passive loss from a publicly traded partnership will be treated as passive, while net passive income from a publicly traded partnership is to be treated as investment income.<a href="#_ftn3" name="_ftnref3">3</a> Generally, net passive loss from a publicly traded partnership is carried forward until the partner has additional passive income from the partnership or the partner disposes of the partnership interest. Also, the $25,000 rental real estate exemption (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8700">8700</a>) is available with respect to a publicly traded partnership only in connection with the low-income housing credit and the rehabilitation investment credit. Further, a taxpayer will not be treated as having disposed of the taxpayer’s entire interest in an activity of a publicly-traded partnership until the taxpayer has disposed of the entire interest in the partnership. It would seem that if a publicly traded partnership is taxed as a corporation, the partnership is not a taxpayer subject to the passive loss rules.<a href="#_ftn4" name="_ftnref4">4</a> <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.IRC § 469(k). <a href="#_ftnref2" name="_ftn2">2</a>.IRC § 469(k)(1). <a href="#_ftnref3" name="_ftn3">3</a>.Notice 88-75, 1988 CB 386. <a href="#_ftnref4" name="_ftn4">4</a>.See IRC § 469(a). </div></div>

March 13, 2024

8688 / What is an abusive tax shelter?

<div class="Section1"> While Congress has recognized that the loss of revenue is an acceptable side effect of special tax provisions designed to encourage taxpayers to make certain types of “tax shelter” investments that yield tax benefits, losses from tax shelters often produce little or no benefit to society, or produce tax benefits that are exaggerated beyond those intended. These cases are called “abusive tax shelters,” and are described by the IRS in Publication 550 as follows: “Abusive tax shelters are marketing schemes involving artificial transactions with little or no economic reality. They often make use of unrealistic allocations, inflated appraisals, losses in connection with nonrecourse loans, mismatching of income and deductions, financing techniques that do not conform to standard commercial business practices, or mischaracterization of the substance of the transaction. Despite appearances to the contrary, the taxpayer generally risks little. Abusive tax shelters commonly involve package deals designed from the start to generate losses, deductions, or credits that will be far more than present or future investment. Or, they may promise investors from the start that future inflated appraisals will enable them, for example, to reap charitable contribution deductions based on those appraisals. They are commonly marketed in terms of the ratio of tax deductions allegedly available to each dollar invested. This ratio (or “write-off”) is frequently said to be several times greater than one-to-one.”<a href="#_ftn1" name="_ftnref1">1</a> The IRS has taken steps to combat abusive tax shelters and transactions. A comprehensive strategy is in place to: <ul> <li>Identify and deter promoters of abusive tax transactions through audits, summons enforcement and targeted litigation;</li> <li>Keep the public advised by publishing guidance on transactions and shelters that are determined to be abusive;</li> <li>Promote disclosure by those who market and participate in abusive transactions; and</li> <li>Develop and implement alternative methods for resolving abusive transactions claimed by taxpayers.</li> </ul> <hr> Planning Point: An investment that is considered a tax shelter is subject to restrictions, including the requirement that it be disclosed and registered. The regulations require taxpayers to disclose certain reportable transactions involving abusive tax shelters in which they participate. These transactions include transactions that are the same as, or substantially similar to, a transaction specifically identified by the IRS or state tax agency as a tax avoidance transaction (a so-called “listed transaction”).<a href="#_ftn2" name="_ftnref2">2</a> <hr> <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.IRS Publication 550, Investment Income and Expenses (2022). <a href="#_ftnref2" name="_ftn2">2</a>.IRC §§ 6707A(c)(2) and 6664(d)(2)(A); Treas. Reg. § 1.6011-4. </div></div>

March 13, 2024

8693 / What rules apply in determining a taxpayer’s amount “at risk” when the taxpayer has borrowed the funds that have contributed to the activity?

<div class="Section1">In general, if an individual borrows the money contributed to an activity (or, in the case of a limited partnership, the money with which the interest is purchased), the individual is “at risk” only to the extent the individual is personally liable to repay such amounts, or to the extent property is pledged that is not otherwise used in the activity as security for the loan.<a href="#_ftn1" name="_ftnref1">1</a>If the individual borrowed funds to purchase the property contributed to the activity, the individual is “at risk” with respect to such property only to the extent that the individual would have been “at risk” had the borrowed funds themselves been contributed instead of the purchased property.<a href="#_ftn2" name="_ftnref2">2</a> If an individual is personally liable for amounts borrowed in the conduct of the activity, the individual is “at risk” to the extent of such amounts even if property used in the activity is also pledged as security for such amounts.<a href="#_ftn3" name="_ftnref3">3</a> The fact that the partnership or other partners are in the chain of liability does not reduce the amount a partner is “at risk” if the partner bears ultimate responsibility.<a href="#_ftn4" name="_ftnref4">4</a> If the individual is initially personally liable for the borrowed amounts (i.e., as in recourse liabilities), but after the occurrence of some event or lapse of a period of time the liability will become nonrecourse, the individual is considered “at risk” during the period of recourse liability if both of the following are true: (a) the borrowing arrangement was motivated primarily for business reasons and not tax avoidance; and (b) the arrangement is consistent with the normal commercial practice of financing the activity for which the money was borrowed.<a href="#_ftn5" name="_ftnref5">5</a> If amounts are borrowed for use in the activity and the individual is not personally liable for repaying those amounts, but the individual pledges property that is not used in the activity as security for repayment, the individual is “at risk” only to the extent that the amount of the liability does not exceed the fair market value of the pledged property. If the fair market value of the security changes after the loan is made, the taxpayer must redetermine the amount at risk using the new fair market value.<a href="#_ftn6" name="_ftnref6">6</a> Property cannot be treated as security if such property itself is financed (directly or indirectly) by loans secured with property contributed to the activity.<a href="#_ftn7" name="_ftnref7">7</a> Even if an individual is personally liable or has pledged security for borrowed funds, borrowed amounts cannot (unless it is eventually provided in future regulations) be considered at risk (1) if they are borrowed from a person who has an interest (other than as a creditor) in the activity, or (2) if they are borrowed from a person who is related to another person (other than the taxpayer) having an interest in the activity.<a href="#_ftn8" name="_ftnref8">8</a> For this purpose, a “related” person includes the following: (1) members of a family (i.e., an individual and brothers, sisters, spouse, ancestors, and lineal descendants); (2) a partnership and any partner owning, directly or indirectly, 10 percent of the capital or profits interests in such partnership; (3) two partnerships in which the same persons own, directly or indirectly, more than 10 percent of the capital or profits interest; (4) an individual and a corporation in which such individual owns, directly or indirectly, more than 10 percent in value of the outstanding stock; (5) two corporations that are members of the same controlled group; (6) a grantor and a fiduciary of the same trust; (7) fiduciaries of trusts that have a common grantor; (8) a fiduciary of a trust and the beneficiaries of that trust, or beneficiaries of another trust if both trusts have the same grantor; (9) a fiduciary of a trust and a corporation if more than 10 percent in value of outstanding stock is owned, directly or indirectly, by the trust or by the grantor of the trust; (10) a person and a tax-exempt organization controlled by such person or family of such person; (11) a corporation and a partnership in which the same person owns a more-than-10 percent interest (by value of stock in the case of the corporation and by capital or profits interest in the case of the partnership); (12) two or more S corporations if more than 10 percent of the stock (by value) of each is owned by the same person; (13) an S corporation and a C corporation if more than 10 percent of the stock (by value) is owned by the same person; and (14) an executor of an estate and a beneficiary of such estate (except in the case of a sale or exchange in satisfaction of a pecuniary bequest).<a href="#_ftn9" name="_ftnref9">9</a> <hr> Planning Point: Money borrowed to finance a contribution to an activity cannot increase the amount at risk by the contribution and by the amount borrowed to finance the contribution. The amount at risk may be increased only once.<a href="#_ftn10" name="_ftnref10">10</a> <hr> See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8694">8694</a> for the rules that apply when a taxpayer has obtained “qualified” nonrecourse financing with respect to an activity involving real property. <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.Treas. Reg. § 1.4650; Prop. Treas. Reg. §§ 1.465-6, 1.4655. <a href="#_ftnref2" name="_ftn2">2</a>.See Prop. Treas. Reg. § 1.4653. <a href="#_ftnref3" name="_ftn3">3</a>.See Let. Rul. 7927007. <a href="#_ftnref4" name="_ftn4">4</a>.Pritchett v. Comm., 87 USTC ¶ 9517 (9th Cir. 1987). <a href="#_ftnref5" name="_ftn5">5</a>.Prop. Treas. Reg. § 1.465-5. See Rev. Rul. 82-123, 1982-1 CB 82; Rev. Rul. 8183, 1981 CB 115. <a href="#_ftnref6" name="_ftn6">6</a>.Prop. Treas. Reg. § 1.4655(a). <a href="#_ftnref7" name="_ftn7">7</a>.IRC § 465(b)(2). <a href="#_ftnref8" name="_ftn8">8</a>.IRC § 465(b)(3). <a href="#_ftnref9" name="_ftn9">9</a>.IRC §§ 465(b)(3)(C), 267(b), 707(b)(1). <a href="#_ftnref10" name="_ftn10">10</a>. IRS Publication 925, Passive Activity and At-Risk Rules (2019). </div></div>