 Hello and welcome to this session. This is Professor Farhad in which we will discuss passive activity loss limits and at-risk limits. To understand the passive activity loss rules and the at-risk limitation it's very important to put those into a historical context. Why did they come into place? We'll have to go back to the 1980s specifically before 1986 when tax shelters were a common thing. Also in the 1980s interest rate was high in contrast to now and we had something called acres accelerated cost recovery system it's a depreciation method and it's called acres for a reason it's accelerated. Now 1986 going forward we started to use makers and this is what you learn about now modified accelerated modified it's slowed down the depreciation early on so giving this background here's what was happening back in the mid-80s you have people that are generating w2 income or business income and here's what they would do for example you will take a doctor a lawyer and another doctor just for the sake of illustration well they will do they will decide to buy a strip mall and rent it out and each individual for the sake of illustration will invest 30 000 in equity so on overall they contributed 90 000 90 k altogether then they borrowed 910 000 therefore they have a business of a million dollar they started the business and they deduct now they're gonna rent this place and they are going to deduct depreciation because we have acres early on it's gonna have a lot of depreciation and the interest on the loan between the depreciation on the interest they're gonna be generating losses from those losses they will go ahead and reduce their w2 income income from other activities so basically what they were doing they were buying deductions and this is basically a form of a tax shelter another example in year one ryan earned the salary of 350 000 as the ceo of farhad company in a dividend income of 12 000 he also made an investment of 35 000 for a 10 ownership interest and a partnership for year one the partnership reported a loss of 740 000 now ryan's share of the loss is 74 000 what would happen under those circumstances if there are no loss limitation what is the effect of this partnership loss on ryan's income tax return well ryan would realize a 74 000 times the tax rate in one year only now let's assume for the sake of illustration the tax rate is 25 percent so if we take 74 000 times 0.25 he would realize 18 500 in tax savings in one year from this partnership because there is no limitation to combat those abuses what the government did they introduced the at risk limit rule and you are limited also to your tax basis limitation simply put you are your your deduction will be limited to the amount at risk and we'll talk about what that is shortly it's the amount that you are at risk of losing and or your tax basis what are your tax basis usually the at risk and the tax basis are the same but the at risk limit might exclude will exclude certain non-request liabilities which we'll talk about those shortly also the government introduced the passive activity loss rule which segregate your income into three buckets so your income now will have to be either classified as active passive or portfolio income now we need to discuss those three buckets but before we discuss those three income buckets i would like to make an announcement about my company farhat lectures dot com farhat accounting lectures is a supplemental educational tool that's going to help you with your cpa exam preparation as well as your accounting courses my cpa material is aligned with your cpr view course such as becker roger wiley gleam miles my accounting courses are aligned with your accounting courses broken down by chapter and topics my resources consist of lectures multiple choice questions true false questions as well as exercises go ahead start your free trial today no obligation no credit card required so here are the three buckets the first one is active income what's considered active income from the word active it means you are working for it an income that's generated by the taxpayer through active engagement in a specific activity think about what you do on a day to day basis that's your active income the most common example will be a w2 salary and wages it could be guarantee payments it could be business income from activities in which the taxpayer materially participate and this is important it's a business but the taxpayer materially participate now what does materially materially participate mean we're going to have a whole session discussing but simply put it means the taxpayer is actively engage in the activity on a on a regular and continuous basis and we'll talk about this later don't worry about this portfolio income it's basically investment income it will include capital gains interest income dividend income annuity income royalty income basically those are portfolio or investment income passive income passive income is is an income from any trade or income producing activity hold on it sounds like this one here in which the taxpayer does not materially participate and notice the here not materially materially participate so if that doctor and lawyer that we talked about early on did not did not run the business did not rental that shopping center made the decision was there on regular basis invested certain amount of hours which will talk about all the details later then they cannot take this loss against this income that's it so passive losses are separate than active income separate than portfolio income also it's worth noting that any working interest in an oil or gas property in which the form of ownership does not limit the owner's liabilities also excluded just FYI know it in case you have a CPA question about this now let's talk about the tax basis limitation simply put we have to know where is the basis this tax basis limit the amount of the loss that a partner an s an s shareholder or an LLC member can pass to to its individual income tax so I you are limited to your tax basis what is your tax basis how much you basically invested in the company what's your capital that's basically what a what a basis is in fact the deduction of the loss is limited to the taxpayer initial investment in a flow through entity adjusted for items such as income deduction distribution and that as appropriate now bear in mind we will be discussing in greater details tax basis because different entities will have slightly different tax basis like a partnership will be a little different than an s corporation but for now we could have a general idea about how to compute tax basis as a general idea we compute tax basis through the amount of cash and adjusted basis of property contributed simply put if you invested in a company if you invested money your basis your capital is starting to accumulate if you contributed property the adjusted basis of your property is added any amount then the amount borrowed by the entity for which the taxpayer notice I highlighted in yellow personally liable or has pledged a property that's not used in the business so you pledged a property as a security to get a loan and it's not used in the business well guess what if that's the case it gets added to your basis and if it gets added to your basis it allow you to deduct you remember the the losses against it amount of non recourse liability non recourse liability including qualified non recourse liability that are borrowed for the use in the activities what is non recourse what is recourse and non recourse recourse liabilities is when the own the lender the lender can come back and take your personal property home vehicle a personal boat whatever you have they have a recourse against you non recourse liabilities that's it you borrow the money if something happened too bad the lender cannot take away anything from you so amount of non recourse liabilities including qualified non recourse liabilities that are borrowed for the use in the activity that's added now just make a note of this remember this we're going to discuss it later on also any share of the activities income add to your basis any share of the loss is reduced reduce your basis and obviously if you withdraw money it's the opposite of contributing money it's going to reduce your basis so you need to know what increases your basis what increases your basis because remember your losses are limited to your basis so this is an idea about your basis also your losses are limited to your at risk limit at risk limit is the second limitation that applies to the deduction it's the amount of the taxpayer economic investment in the activity okay in other words it represents the economic risk to which the taxpayer is exposed how much are you exposed at to compute the at risk amount well it's very easy we'll take the tax basis less his share or her share of the entity's non recourse liabilities remember I kept emphasizing this non recourse I said amount of non recourse because when you compute the at risk amount you will take out that non non recourse because it does not it it's less notice it's your tax basis less your share of non recourse liability it's also important to emphasize that recourse liabilities increase your tax basis we already saw this and increase your at risk basis so make sure you differentiate between recourse and non recourse recourse because they can come after you they have a recourse against you then it should be considered at risk because you are risking your personal asset you are risking your personal wealth therefore you are at risk however non recourse liabilities again i'm repeating this more than once increases your basis not your at risk amount so make sure you know this also there's an exception an exception applied to the non recourse liability that are secured by real property or qualified non recourse liability which increases the tax basis as well at at risk basis of the taxpayer so if it's a qualified non recourse you should be good to go and what's a qualified non recourse liabilities that are secured by real property if that's the case it's a qualified non recourse because they can take the property how to compute the at risk basis again very similar will start by the amount of cash and the adjusted basis of the property contributed to the activity amount borrowed for the use in the activity for which the taxpayer is personally liable or has pledged as a security a property not used in the activity that's also increases your at risk basis amount borrowed for the use in the activity that are qualified non recourse only qualified that means there's it's against real property it's against notice here what we said it's against secured by real property also any income will increase the at risk amount any share of income and any share of loss would reduce the at risk amount obviously also of the if the taxpayer would draw money from the activity it's going to reduce the basis so what's the difference between the at risk and the basis is the non recourse liability now a loss and access of the taxpayer at risk basis is suspended until the at risk basis is reinstated how would it be reinstated you will either contribute more money to the to the business contributed to property you have to borrow money in which you are personally liable or the business will generate more income it can it can be caro it can be carried forward indefinitely when the taxpayer disposed get rid of this of his or her ownership any suspended loss due to the at risk limitation can be deducted from the gain realized from the sale of the interest so you can deduct this if there's any gain on that sale on that sale of the business let's look at an example to illustrate the concept and keep it simple for now at the beginning of the current year peter invested 32 000 for a 50 ownership in pj partnership the partnership reported income of 50 000 for year end and distributed 2000 to each partner determine peter's at risk basis by the end of the year well the solution will be look something like this the initial investment of 32 peter's share of the partnership income of 25 000 minus the withdrawal of 20 000 so at risk amount is 55 000 now it's important to note here that this is a simple example and peter's tax basis equal to his at risk basis because partnership has neither a recourse nor a non-recourse we don't care about recourse but we worry about non-recourse we don't have to worry about this so we're keeping it simple what should you do now go to far hat lectures and work mcq's through false that's going to help you understand this topic further now i'm going to be talking a little bit more about passive activity income passive activity losses what constitute material participation so just keep going keep working with this you need to understand it so you will succeed whether in your course or cpa exam good luck study hard and stay safe