Deduction Of Interest And Expenses

March 13, 2024

8050 / Are expenses paid for the production of tax-exempt income deductible?

<div class="Section1"> Any expense that would otherwise be deductible under any Internal Revenue Code section is not deductible if it is allocable to tax-exempt income other than tax-exempt interest.<a href="#_ftn1" name="_ftnref1">1</a> Expenses allocable to tax-exempt interest may be deductible if they are trade or business expenses, taxes, or depreciation, but the same expenses allocable to tax-exempt income other than interest are not deductible. If an expense is allocable to both nonexempt income and exempt income, a reasonable proportion, determined in the light of all the facts and circumstances, is allocated to each.<a href="#_ftn2" name="_ftnref2">2</a> Legal fees incurred to collect Social Security benefits have been held deductible only to the extent that they were allocable to the portion of benefits that were includable in the taxpayer’s gross income.<a href="#_ftn3" name="_ftnref3">3</a> In the absence of evidence showing a more reasonable basis for allocation, the expense has been allocated between taxable and tax-exempt income in the proportion that each bears to the total taxable and nontaxable income in the year.<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 § 265(a)(1). <a href="#_ftnref2" name="_ftn2">2</a>. Treas. Reg. § 1.265-1(c). <a href="#_ftnref3" name="_ftn3">3</a>. Rev. Rul. 87-102, 1987 CB 78. <a href="#_ftnref4" name="_ftn4">4</a>. Jamison v. Comm., 8 TC 173 (1947); Ellis v. Comm., 6 TCM 662 (1947); Mallinckrodt v. Comm., 2 TC 1128 (1943), acq., Rev. Rul. 59-32, 1959-1 CB 245, as clarified by Rev. Rul. 637, 1963-1 CB 57. </div></div>

March 13, 2024

8035 / What is the “ninety-day rule” that may apply in determining whether mortgage interest may be deducted?

<div class="Section1"> Editor’s Note: The 2017 tax reform legislation changed the rules governing the treatment of mortgage interest, home equity indebtedness interest and interest on debts to secure refinancing. See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8034">8034</a> for details. In order to be incurred to acquire, construct, or substantially improve a residence, a debt must (a) be traceable under the tracing rules of Temporary Treasury Regulation Section 1.163-8T to the purchase of a qualified residence, or (b) qualify under one of two 90-day rules.<a href="#_ftn1" name="_ftnref1">1</a> The 90-day rule with respect to acquiring a residence provides that expenditures to acquire the residence within 90 days before or after the date the debt is incurred can be treated as incurred to acquire the residence. The 90-day rule with respect to constructing or substantially improving a residence is somewhat more complex. A debt incurred before the residence or improvement is complete may be treated as incurred to construct or substantially improve a residence to the extent of expenditures (to construct or improve the residence) made no more than 24 months prior to the date the debt is incurred. If the debt is incurred no later than 90 days after the residence is complete, it may be treated as incurred to construct or substantially improve a residence to the extent of expenditures (to construct or improve the residence) made during the following period: beginning 24 months before the residence or improvement is complete, and ending on the date the debt is incurred. Guidelines state that a determination of whether a residence or an improvement is complete depends upon all the facts and circumstances.<a href="#_ftn2" name="_ftnref2">2</a> <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>. Notice 88-74, 1988 CB 385. <a href="#_ftnref2" name="_ftn2">2</a>. Notice 88-74, 1988 CB 385. </div></div>

March 13, 2024

8037 / Can a taxpayer deduct mortgage interest overcharges that are later reimbursed?

March 13, 2024

8047 / Is interest paid on amounts borrowed to purchase or carry market discount bonds deductible for bonds issued before July 19, 1984 and acquired before May 1, 1993?

<div class="Section1"> If a market discount bond was issued before July 19, 1984 and acquired on the market after that date but before May 1, 1993, the taxpayer generally will not be required to treat any part of the gain on disposition that is attributable to market discount as interest income (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7645">7645</a>). However, if deferred interest expense on such a bond is deducted on disposition, an equal amount of any gain on the disposition must be treated as interest income.<a href="#_ftn1" name="_ftnref1">1</a> Similarly, if the bond is disposed of in a nonrecognition transaction, an interest characterization rule will apply at the time gain is recognized and the deferred interest expense is deducted by the transferee.<a href="#_ftn2" name="_ftnref2">2</a> If amounts are borrowed or indebtedness is continued to purchase or carry bonds that were issued and acquired on or before July 18, 1984 at a market discount, the interest expense paid in the year is not disallowed simply because market discount is not recognized until disposition of the bond. Furthermore, when gain attributable to the market discount is recognized it is treated as capital gain (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="702">702</a> for the treatment of capital gain). <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>. IRC § 1277(d), prior to repeal by OBRA ’93. <a href="#_ftnref2" name="_ftn2">2</a>. See General Explanation–TRA ’84, p. 98. </div></div>

March 13, 2024

8036 / How does refinancing of a taxpayer’s mortgage debt impact the taxpayer’s mortgage interest deduction?

<div class="Section1"> Editor’s Note: The 2017 tax reform legislation changed the rules governing the treatment of mortgage interest, home equity indebtedness interest and interest on debts to secure refinancing. See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8034">8034</a> for details. Refinancing of a debt that was incurred to acquire, construct, or substantially improve a residence will be treated in the same manner as the first debt, to the extent that the proceeds are used to refinance the first debt. (The tracing rules found in Temporary Treasury Regulation Section 1.163-8T are used to determine how the proceeds are used. See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8043">8043</a>.) If a taxpayer uses part of the loan proceeds to refinance an existing debt and the remaining proceeds for other purposes, the debt may qualify as acquisition indebtedness to the extent of the refinancing. The remaining debt may qualify as home equity indebtedness, up to the applicable limits. Under the 2017 tax reform legislation, debt amounts that are related to a refinancing will be treated as though incurred on the date that the original debt was incurred, provided that any additional amounts of debt incurred as a result of the refinancing do not exceed the amount of the refinanced debt. However, this exception does not apply if the refinancing occurs after the expiration of the term of the original debt. Further, it does not apply if the original debt was not amortized over its term, the expiration of the term of the first refinancing of the debt or, if earlier, the date which is 30 years after the date of the first refinancing.<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 § 163(h)(3)(F)(iii). </div></div>

March 13, 2024

8038 / How is mortgage interest debt that is incurred to acquire the interest of a taxpayer’s spouse or former spouse pursuant to a divorce treated?

<div class="Section1"> Editor’s Note: The 2017 Tax Act changed the rules governing the treatment of mortgage interest, home equity indebtedness interest and interest on debts to secure refinancing. See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8034">8034</a> for details. Regulations will provide that a debt incurred to acquire the interest of a spouse or former spouse pursuant to a divorce or legal separation will be treated as debt incurred to acquire a residence (for purposes of the definition of acquisition indebtedness in IRC Section 163) without regard to the treatment the transaction would otherwise receive under IRC Section 1041 (regarding transfers incident to divorce).<a href="#_ftn1" name="_ftnref1">1</a> <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>. Notice 88-74, 1988 CB 385. See also Let. Rul. 8928010. </div></div>

March 13, 2024

8042 / How is the investment interest deduction coordinated with the passive loss rules?

<div class="Section1"> The investment interest limitation is coordinated with the passive loss rules (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8010">8010</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8021">8021</a>), so that interest and income subject to the passive loss rules are not taken into consideration under the investment interest limitation.<a href="#_ftn1" name="_ftnref1">1</a> Interest expense incurred to purchase an interest in a passive activity is allocated to that passive activity and is not investment interest.<a href="#_ftn2" name="_ftnref2">2</a> (Very generally, a passive activity is any activity that involves the conduct of a trade or business in which the taxpayer does not materially participate and any rental activity.)<a href="#_ftn3" name="_ftnref3">3</a> However, portfolio income of a passive activity and expense (including interest expense) allocable to it is considered investment income and expense, not passive income and expense.<a href="#_ftn4" name="_ftnref4">4</a> Temporary regulations provide that, for purposes of the investment interest and passive loss rules, interest expense is generally allocated on the basis of the use of the proceeds of the underlying debt (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8043">8043</a>). <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>. IRC §§ 163(d), 469. <a href="#_ftnref2" name="_ftn2">2</a>. Temp. Treas. Reg. § 1.163-8T(a)(4)(B). <a href="#_ftnref3" name="_ftn3">3</a>. IRC § 469. <a href="#_ftnref4" name="_ftn4">4</a>. IRC § 469(e)(1). </div></div>

March 13, 2024

8046 / Is interest paid on amounts borrowed to purchase or carry market discount bonds deductible for bonds issued after July 18, 1984, and bonds issued before July 19, 1984 and acquired after April 30, 1993?

<div class="Section1"> If amounts are borrowed or indebtedness is continued in order to purchase or carry a bond issued after July 18, 1984 at a market discount, or a bond issued before July 19, 1984 and purchased on the market at a discount after April 30, 1993, the interest expense is deductible to the extent that stated interest (or original issue discount) paid or accrued on it is includable in income for the year. (For the income tax treatment of market discount upon disposition of such bonds, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7645">7645</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7648">7648</a>.) If interest expense exceeds that amount, it will be deductible to the extent that it exceeds the market discount allocable to the days on which the bond was held during the tax year. Interest expense that is allocable to the market discount accruing in the year is not currently deductible; the deduction is deferred.<a href="#_ftn1" name="_ftnref1">1</a> Amounts so disallowed in one year may be deductible in a later year in which includable interest on the obligation is greater than the interest expense for that year. Generally, the taxpayer may elect, on a bond by bond basis, to deduct an amount of previously disallowed interest expense up to the difference.<a href="#_ftn2" name="_ftnref2">2</a> Any deferred interest expense not previously deducted under that election becomes deductible in the year in which the bond is sold or redeemed. If the bond is disposed of in a transaction in which part or all of the gain is not recognized (e.g., a gift), the deferred interest is allowed as a deduction at that time only to the extent that gain is recognized. (See, e.g., Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7646">7646</a> with respect to gain that is recognized on a gift.) To the extent deferred interest expense is not allowed as a deduction upon the disposition of the bond in such a nonrecognition transaction, the disallowed interest expense will be treated as disallowed interest expense of the transferee of transferred basis property, or the transferor who receives exchanged basis property in the transaction.<a href="#_ftn3" name="_ftnref3">3</a> (Transferred basis property is property having a basis determined in whole or in part by the basis of the transferor.<a href="#_ftn4" name="_ftnref4">4</a> Exchanged basis property is property having a basis determined in whole or in part by other property held at any time by the person for whom the basis is being determined.)<a href="#_ftn5" name="_ftnref5">5</a> Thus, in the case of a market discount bond that is transferred basis property (a gift, for example), the transferee will be entitled to deduct the previously disallowed interest expense as if it were his own. On the other hand, interest expense allocable to market discount is currently deductible, not deferred, if the taxpayer has elected to treat the market discount as current income as it accrues under either the straight line or constant interest rate method.<a href="#_ftn6" name="_ftnref6">6</a> This election is discussed in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7644">7644</a>.Unless the interest expense on borrowing is greater than the sum of (1) interest income on the bond that would be includable in gross income in the absence of the election plus (2) the amount of market discount accruing over the days the bond was held in the year, the election will merely result in a wash; in other words, the deduction and the included interest will offset each other. Whether amounts are borrowed or loans continued in order to purchase or carry market discount bonds depends on the taxpayer’s purpose for borrowing. In determining the individual’s purpose, the IRS will, presumably, apply the same principles applied in determining if indebtedness is incurred or continued to purchase or carry tax-exempt bonds (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8044">8044</a>). Noncapitalized expenses incurred in short sales of securities are treated as interest expenses subject to the deferred deduction rules if the proceeds of the short sales are used to purchase or carry a market discount bond.<a href="#_ftn7" name="_ftnref7">7</a> During the time the deduction of interest is deferred because it is on indebtedness incurred or continued to purchase or carry market discount bonds (or is an expense of a short sale the proceeds of which are used to purchase or carry market discount bonds), the interest (or short sale) expense is not counted as interest expense for other purposes (for example, in disallowing interest on amounts borrowed to buy tax-exempt bonds). <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>. IRC § 1277. <a href="#_ftnref2" name="_ftn2">2</a>. IRC § 1277(b)(1)(A). <a href="#_ftnref3" name="_ftn3">3</a>. IRC § 1277(b)(2). <a href="#_ftnref4" name="_ftn4">4</a>. IRC § 7701(a)(43). <a href="#_ftnref5" name="_ftn5">5</a>. IRC § 7701(a)(44). <a href="#_ftnref6" name="_ftn6">6</a>. IRC § 1278(b). <a href="#_ftnref7" name="_ftn7">7</a>. IRC § 1277(c). See General Explanation–TRA ’84, p. 98. </div></div>

March 13, 2024

8048 / Is student loan interest deductible?

<div class="Section1"> An above-the-line deduction (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="715">715</a>) is available to lower and middle income taxpayers for interest paid on a qualified education loan (i.e., college loans – see below) subject to certain limitations.<a href="#_ftn1" name="_ftnref1">1</a> The 2017 tax reform legislation did not change the rules governing the deductibility of student loan interest. However, the Act does provide that income resulting from the discharge of student loan debt because of the death or permanent and total disability of the borrower is not included in taxable income.<a href="#_ftn2" name="_ftnref2">2</a> This provision is effective for loans that are discharged after December 31, 2017. The amount of the deduction is limited to a maximum of $2,500.<a href="#_ftn3" name="_ftnref3">3</a> The deduction is phased out ratably for taxpayers with modified adjusted gross income (MAGI–see below) between $100,000 and $130,000 (married filing jointly) or $50,000 and $65,000 (single).<a href="#_ftn4" name="_ftnref4">4</a> The $50,000 and the $100,000 amounts are adjusted for inflation (as rounded to the next lowest multiple of $5,000).<a href="#_ftn5" name="_ftnref5">5</a> In 2024, the indexed levels are $165,000-$195,000 (married filing jointly) and $80,000-$95,000 (single filers).<a href="#_ftn6" name="_ftnref6">6</a> For 2023, the indexed levels are $155,000-$185,000 (married filers) and $75,000-$95,000 (single filers). The phaseout is accomplished by reducing the otherwise deductible amount by the ratio that the taxpayer’s MAGI over the applicable limit bears to $15,000 ($30,000 for a couple filing jointly) (the deduction cannot be reduced below zero). Example: In 2024, Mr. and Mrs. Green paid $900 in interest on a student loan that otherwise qualifies for the deduction under the statutory requirements described below. The Greens’ MAGI in 2024 was $165,000. The ratio that their MAGI in excess of $155,000 [$165,000 – $155,000 = $10,000] bears to $30,000 is one to three; consequently, the amount otherwise deductible is reduced by one-third, to $600 [$900 – (⅓ × $900) = $600]. Modified adjusted gross income is the taxpayer’s adjusted gross income as determined before the deduction for qualified tuition and related expenses<a href="#_ftn7" name="_ftnref7">7</a> (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8054">8054</a>) and the exclusions for income derived from certain foreign sources or sources within United States possessions,<a href="#_ftn8" name="_ftnref8">8</a> and after the inclusion of any taxable Social Security benefits,<a href="#_ftn9" name="_ftnref9">9</a> any deductible IRA contributions,<a href="#_ftn10" name="_ftnref10">10</a> adjustments for passive activity losses or credits<a href="#_ftn11" name="_ftnref11">11</a> (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8010">8010</a>), the exclusion for savings bond interest used for education expenses<a href="#_ftn12" name="_ftnref12">12</a> (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7686">7686</a>), and the exclusion for certain adoption expenses.<a href="#_ftn13" name="_ftnref13">13</a> Eligibility. The individual claiming the deduction must be legally obligated to make the interest payments under the terms of the loan.<a href="#_ftn14" name="_ftnref14">14</a> Despite this, if a third party who is not legally obligated to make a payment of interest on a qualified education loan makes an interest payment on behalf of a taxpayer who is legally obligated to make the payment, that taxpayer is treated as receiving the payment from the third party and, in turn, paying the interest.<a href="#_ftn15" name="_ftnref15">15</a> Note, however, that the CARES Act provides that student loan interest paid by an employer after March 27, 2020 and before January 1, 2021 is excluded from income. Interest paid by an employer is not deductible.<a href="#_ftn16" name="_ftnref16">16</a> The deduction may not be taken: (1) by an individual who may be claimed as a dependent on another’s tax return; (2) if the expense can be claimed as a deduction elsewhere on the return; or (3) by married taxpayers filing separate returns.<a href="#_ftn17" name="_ftnref17">17</a> No deduction is allowed for which an exclusion is allowed under IRC Section 127 to the taxpayer because of a qualified payment made by the taxpayer’s employer under the 2020 CARES Act. A qualified education loan is any indebtedness incurred by the taxpayer solely to pay qualified higher education expenses (see below) that are: (1) incurred on behalf of the taxpayer, a spouse, or a dependent at the time the indebtedness was incurred; (2) paid or incurred within a reasonable period of time (see below) before or after the indebtedness was incurred, and (3) attributable to education furnished in an academic period during which the recipient was an eligible student (see below).<a href="#_ftn18" name="_ftnref18">18</a> The determination of whether qualified higher education expenses are paid or incurred within a “reasonable period of time” generally is made based on all the relevant facts and circumstances. However, qualified higher education expenses are treated as paid or incurred within a reasonable period of time before or after the taxpayer incurs the indebtedness if: (1) the expenses are paid with the proceeds of education loans that are part of a federal postsecondary education loan program; or (2) the expenses relate to a particular academic period and the loan proceeds used to pay the expenses are disbursed within a period that begins 90 days prior to the start of the academic period and ends 90 days after the end of that academic period.<a href="#_ftn19" name="_ftnref19">19</a> The term qualified education loan does not include indebtedness owed to certain related persons. In addition, a loan from a qualified plan – including an IRC Section 403(b) plan or from a life insurance or annuity contract held by such a plan – is not a qualified education loan.<a href="#_ftn20" name="_ftnref20">20</a> A loan does not have to be issued or guaranteed under a federal postsecondary education loan program to be a qualified education loan.<a href="#_ftn21" name="_ftnref21">21</a> A qualified education loan includes indebtedness incurred solely to refinance a qualified education loan. A qualified education loan includes a single, consolidated indebtedness incurred solely to refinance two or more qualified education loans of a borrower.<a href="#_ftn22" name="_ftnref22">22</a> Qualified higher education expenses means the cost of attendance at an eligible education institution (see below) reduced by the sum of: (1) the amounts excluded from gross income under IRC Section 127 (employer educational assistance programs), IRC Section 135 (income from U.S. Savings bonds used to pay for higher education expenses – see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7686">7686</a>), IRC Section 529 (distributions from qualified tuition programs – see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="689">689</a>), or IRC Section 530 (distributions from a Coverdell Education Savings Account, formerly known as an Education IRA – see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="681">681</a>) by reason of such expenses; (2) the amount of any excludable scholarship, allowance or payments (other than a gift, bequest, devise or inheritance) received by an individual for expenses attributable to enrollment; and (3) certain educational assistance allowances provided to veterans or members of the armed forces.<a href="#_ftn23" name="_ftnref23">23</a> An eligible education institution generally includes any accredited postsecondary institution (i.e., college, university, or vocational school) offering an educational program for which it awards a bachelor’s degree or a two-year degree, as well as those that conduct an internship or residency program leading to a degree or certificate awarded by an institute of higher learning, a hospital, or a health care facility that offers postgraduate training. The term also includes those institutions offering at least a one-year program that trains students for gainful employment in a recognized profession.<a href="#_ftn24" name="_ftnref24">24</a> An eligible student means any student who is enrolled in a degree, certificate, or other program leading to a recognized credential at an eligible education institution, and who is carrying at least half of a normal full-time work load in the course of study.<a href="#_ftn25" name="_ftnref25">25</a> Interest. Amounts paid on a qualified education loan are deductible if the amounts are interest for federal income tax purposes. Interest includes qualified stated interest and original issue discount, which generally includes capitalized interest (i.e., any accrued and unpaid interest on a qualified education loan that, in accordance with the terms of the loan, is added by the lender to the outstanding principal balance of the loan).<a href="#_ftn26" name="_ftnref26">26</a> The Preamble to the final regulations states: “generally, fees such as loan origination fees or late fees are interest if the fees represent a charge for the use or forbearance of money. Therefore, if the fees represent compensation to the lender for the cost of specific services performed in connection with the borrower’s account, the fees are not interest for federal income tax purposes.<a href="#_ftn27" name="_ftnref27">27</a> The Tax Court found that certain fees, including insurance fees, were similar to payments for services rendered and not deductible as interest.”<a href="#_ftn28" name="_ftnref28">28</a> In general, a payment is treated first as a payment of interest to the extent of the interest that has accrued and remains unpaid as of the date the payment is due, and second as a payment of principal.<a href="#_ftn29" name="_ftnref29">29</a> The 60-month limit on the student loan interest deduction was permanently repealed under PPA 2006. Reporting requirements. Certain reporting requirements must be met by a payee who receives interest totaling $600 or more with respect to a single payor on one or more covered student loans. Generally, the payee must file Form 1098-E (Student Loan Interest Statement) with respect to that interest, and provide the payor with the same information. For the final regulations relating to the information reporting requirements for payments of interest on qualified education loans (including the filing of information returns in an electronic format in lieu of a paper format), see Treasury Regulation Sections 1.6050S-3, 1.6050S-4.<a href="#_ftn30" name="_ftnref30">30</a> <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>. IRC § 221(a). <a href="#_ftnref2" name="_ftn2">2</a>. IRC § 108(f)(5). <a href="#_ftnref3" name="_ftn3">3</a>. IRC § 221(b)(1); Treas. Reg. § 1.221-1(c). <a href="#_ftnref4" name="_ftn4">4</a>. IRC § 221(b)(2); Treas. Reg. § 1.221-1(d)(1). <a href="#_ftnref5" name="_ftn5">5</a>. IRC § 221(f); Treas. Reg. § 1.221-1(d)(3). <a href="#_ftnref6" name="_ftn6">6</a>. Rev. Proc. 2023-34. <a href="#_ftnref7" name="_ftn7">7</a>. IRC § 222. <a href="#_ftnref8" name="_ftn8">8</a>. IRC §§ 911, 931, 933. <a href="#_ftnref9" name="_ftn9">9</a>. IRC § 86. <a href="#_ftnref10" name="_ftn10">10</a>. IRC § 219. <a href="#_ftnref11" name="_ftn11">11</a>. IRC § 469. <a href="#_ftnref12" name="_ftn12">12</a>. IRC § 135. <a href="#_ftnref13" name="_ftn13">13</a>. IRC §§ 137; Treas. Reg. § 1.221-1(d)(2). <a href="#_ftnref14" name="_ftn14">14</a>. Treas. Reg. § 1.221-1(b)(1). <a href="#_ftnref15" name="_ftn15">15</a>. Treas. Reg. § 1.221-1(b)(4)(i). See, e.g., Treas. Reg. § 1.221-1(b)(4)(ii), Example 1 (payment by employer) and Example 2 (payment by parent). <a href="#_ftnref16" name="_ftn16">16</a>. CARES Act § 2206. <a href="#_ftnref17" name="_ftn17">17</a>. IRC §§ 221(e), 221(c); Treas. Reg. §§1.221-1(b)(2), 1.221-1(b)(3); 1.221-1(g)(2). <a href="#_ftnref18" name="_ftn18">18</a>. IRC § 221(d)(1); Treas. Reg. § 1.221-1(e)(3)(i). <a href="#_ftnref19" name="_ftn19">19</a>. Treas. Reg. § 1.221-1(e)(3)(ii). <a href="#_ftnref20" name="_ftn20">20</a>. IRC § 221(d)(1); Treas. Reg. § 1.221-1(e)(3)(iii). <a href="#_ftnref21" name="_ftn21">21</a>. Treas. Reg. § 1.221-1(e)(3)(iv). <a href="#_ftnref22" name="_ftn22">22</a>. Treas. Reg. § 1.221-1(e)(3)(v). <a href="#_ftnref23" name="_ftn23">23</a>. IRC § 221(d)(2); Treas. Reg. § 1.221-1(e)(2). <a href="#_ftnref24" name="_ftn24">24</a>. IRC §§ 221(d)(2), 25A(f)(2); Treas. Reg. § 1.221-1(e)(1). <a href="#_ftnref25" name="_ftn25">25</a>. IRC §§ 221(d)(3), 25A(b)(3). <a href="#_ftnref26" name="_ftn26">26</a>. Treas. Reg. § 1.221-1(f)(1). <a href="#_ftnref27" name="_ftn27">27</a>. See Rev. Rul. 69-188, 1969-1 CB 54, amplified by Rev. Rul. 69-582, 1969 CB 29; see also, e.g., Trivett v. Comm., TC Memo 1977-161, aff’d on other grounds, 611 F.2d 655 (6th Cir. 1979). <a href="#_ftnref28" name="_ftn28">28</a>. Preamble, TD 9125, 68 Fed. Reg. 25489, 25490 (May 7, 2004). <a href="#_ftnref29" name="_ftn29">29</a>. Treas. Reg. § 1.221-1(f)(3). <a href="#_ftnref30" name="_ftn30">30</a>. See Treas. Reg. §§ 1.6050S-3, 1.6050S-4. </div></div>

March 13, 2024

8016 / How is an activity defined for purposes of the passive loss rules?

<div class="Section1"> Regulations allow taxpayers to use a facts-and-circumstances approach to define one or more trade or business activities as a single activity if the activities constitute an appropriate economic unit for purposes of IRC Section 469. (In the case of a limited partnership interest in an electing large partnership, all passive loss limitation activities of the partnership are treated as a single passive activity. See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="7733">7733</a>.) Relevant factors to consider include: (1) similarities and differences in types of businesses; (2) the extent of common control; (3) the extent of common ownership; (4) geographical location; and (5) interdependencies between the activities. There may be more than one reasonable method for grouping activities.<a href="#_ftn1" name="_ftnref1">1</a> Rental activities may not be grouped with trade or business activities unless either the rental activity is insubstantial in relation to the trade or business activity or vice versa, or ownership interests in the trade and business activity are held in the same proportion as ownership interests in the rental activity.<a href="#_ftn2" name="_ftnref2">2</a> An activity involving the rental of real property and an activity involving the rental of personal property may not be treated as a single activity (unless the personal property is provided in connection with the real property or vice versa).<a href="#_ftn3" name="_ftnref3">3</a> For activities conducted through partnerships, S corporations, or C corporations subject to the passive loss rules, the entity must first group its activities under the above rules. Individual partners and shareholders may then group those activities with others conducted directly by the individual taxpayer or with activities conducted through other partnerships, S corporations, or C corporations subject to the passive loss rules, under the same rules. However, a shareholder or partner may not treat activities grouped by an entity as separate activities.<a href="#_ftn4" name="_ftnref4">4</a> Example: Taxpayer B, an individual, is a partner in a business that sells non-food items to grocery stores (partnership L). B also is a partner in a partnership that owns and operates a trucking business (partnership Q). The two partnerships are under common control. The predominant portion of Q’s business is transporting goods for L, and Q is the only trucking business in which B is involved. Under this section, B appropriately treats L’s wholesale activity and Q’s trucking activity as a single activity. A taxpayer involved as a limited partner or limited entrepreneur in certain activities (generally, holding, producing, or distributing motion picture films or videotapes; farming; equipment leasing; or exploring for, or exploiting oil and gas resources or geothermal resources) may group that activity with another activity only if the two activities are in the same type of business and the grouping is appropriate under the facts-and-circumstances test above.<a href="#_ftn5" name="_ftnref5">5</a> Once a taxpayer has grouped individual activities under the rules above, he or she may not regroup them in subsequent taxable years unless the original grouping was clearly inappropriate or there is a material change in facts and circumstances making the original grouping clearly inappropriate.<a href="#_ftn6" name="_ftnref6">6</a> The IRS may regroup a taxpayer’s activities if any of the activities resulting from the taxpayer’s grouping is not an appropriate economic unit and a principal purpose of the taxpayer’s grouping (or failure to regroup) is to circumvent the underlying purpose of IRC Section 469.<a href="#_ftn7" name="_ftnref7">7</a> Example: Taxpayers D, E, F, G, and H are doctors who operate separate medical practices. D invested in a tax shelter several years ago that generates passive losses and the other doctors intend to invest in real estate that will generate passive losses. The taxpayers form a partnership to engage in the trade or business of acquiring and operating X-ray equipment. In exchange for equipment contributed to the partnership, the taxpayers receive limited partnership interests. The partnership is managed by a general partner selected by the taxpayers; the taxpayers do not materially participate in its operations. Substantially all of the partnership’s services are provided to the taxpayers or their patients, roughly in proportion to the doctors’ interests in the partnership. Fees for the partnership’s services are set at a level equal to the amounts that would be charged if the partnership were dealing with the taxpayers at arm’s length and are expected to assure the partnership a profit. The taxpayers treat the partnership’s services as a separate activity from their medical practices and offset the income generated by the partnership against their passive losses. For each of the taxpayers, the taxpayer’s own medical practice and the services provided by the partnership constitute an appropriate economic unit, but the services provided by the partnership do not separately constitute an appropriate economic unit. Moreover, a principal purpose of treating the medical practices and the partnership’s services as separate activities is to circumvent the underlying purposes of Section 469. Accordingly, the IRS may require the taxpayers to treat their medical practices and their interests in the partnership as a single activity, regardless of whether the separate medical practices are conducted through C corporations subject to Section 469, S corporations, partnerships, or sole proprietorships. Additionally, the IRS may assert penalties under IRC section 6662 against the taxpayers in appropriate circumstances.<a href="#_ftn8" name="_ftnref8">8</a> A taxpayer who disposes of substantially all of an activity may treat the disposed interest as a separate activity, but only if the taxpayer can establish with reasonable certainty both (1) the amount of deductions and credits allocable to that part of the activity for that taxable year under IRC Section 469 and (2) the amount of gross income and any other deductions and credits allocable to that part of the activity for the taxable year.<a href="#_ftn9" name="_ftnref9">9</a> In general, for the first taxable year ending after May 10, 1992, taxpayers that are not in compliance with the activity grouping rules of Treasury Regulation Section 1.469-4 must regroup their activities under those rules without regard to how the activities were previously grouped. Further, regrouping is permissible for the first taxable year ending after May 10, 1992, even if the taxpayer is already in compliance with the activity grouping rules of Treasury Regulation Section 1.469-4.<a href="#_ftn10" name="_ftnref10">10</a> For special rules relating to rental real estate in which a taxpayer materially participates, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8021">8021</a>. <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>. Treas. Reg. § 1.469-4(c). <a href="#_ftnref2" name="_ftn2">2</a>. Treas. Reg. § 1.469-4(d)(1). <a href="#_ftnref3" name="_ftn3">3</a>. Treas. Reg. § 1.469-4(d)(2). <a href="#_ftnref4" name="_ftn4">4</a>. Treas. Reg. § 1.469-4(d)(5). <a href="#_ftnref5" name="_ftn5">5</a>. Treas. Reg. § 1.469-4(d)(3). <a href="#_ftnref6" name="_ftn6">6</a>. Treas. Reg. § 1.469-4(e). <a href="#_ftnref7" name="_ftn7">7</a>. Treas. Reg. § 1.469-4(f). <a href="#_ftnref8" name="_ftn8">8</a>. Treas. Reg. § 1.469-4(f)(2). <a href="#_ftnref9" name="_ftn9">9</a>. Treas. Reg. § 1.469-4(g). <a href="#_ftnref10" name="_ftn10">10</a>. Treas. Reg. § 1.469-11(a)(1), Treas. Reg. § 1.469-11(b)(3)(ii). </div></div>