 Hello and welcome to this session. This is Professor Farhad in which we will discuss passive activity loss limits passive activity loss limit falls under the umbrella of investor losses so if the investor incur losses, how much of those losses can we deduct now in order to understand the passive activity loss We have to understand what is called at risk limits for investors in the prior session We did cover the at risk limit. It's basically what is what is the money? What is the capital? What is the wealth that is exposed for an investor and that's the amount that the investor can deduct So first we have to determine how much are you at risk at and we did determine this in the prior session Basically what cash you you invested in the business any property you contributed any loans You took out and you're personally liable so on and so forth So first we have to determine are you at risk? So do you have basically money on the line money at risk if that's the case? Yes, you might have losses that you can deduct the next thing We have to figure out is is your activity passive or active? Why do we have to do that? Also if you remember from the prior session the IRS looks at your income Bucket your income in three buckets put them in three buckets Active income portfolio income and passive income. We need to understand what is active income versus Passive income. Well, what is active income? Well, active income is income that's generated by the taxpayer through the active engagement in a specific activity Like what we talked about this in the prior session, but let's do it again Salaries and wages you are earning you are actively earning your money Guarantees payment business income from activities in which the taxpayer materially participate and we're gonna spend a little bit more time in this session Defining what materially participate is simply put Just to keep it simple. Let's assume you own a farm and you work on that farm Guess what? You're the owner of the business and you actively cultivate the land plant the land so the land so on and so forth So you are active Okay, now we could also have a portfolio income and this is when your money is working for you Investment income capital gains interest income dividend income annuity and royalty Basically, your money is working for you in form of investment. That's fine, too. It's called portfolio income Now we also have what we called passive income Also, it's an income from trade business or income producing activity So notice just like active income through active engagement in specific activity in a trade in which the taxpayer does not materially Participate, let's go back to my farm example. Let's assume I own a farm, but you know what I never visit that farm I don't plant any fruit or vegetables Or cloud the land or anything like this I just I invest my money and someone else takes care of it and at the end of the year They will send me a statement. Let's assume I own 20% They will allocate 20% of the profit or the loss to my account. So what am I here? I am a passive I am a passive investor here. I don't participate. So my income is passive not active now Why do we have to know about this passive income? Well Passive income can be used as a tax shelter simply put if you remember the story I told you back in the 80s real estate rental business Assumed to be passive because what was happening is this many people with high income with a lot of w2 income or Active business income what they would do they will buy real estate property and they would rent it out and as a result They will generate losses, but they were not actively participating. So simply put the IRS says you cannot take your losses From a passive activity and offset your income your active income So when we talk about passive income, we always assume that real estate rental business is assume It's a passive and there are two exception will talk about those two exceptions later Now if you have a schedule C if you have a business like a schedule C business You you could be passive or active if you have an S if you're if you are a shareholder in an S corporation a Partner you can be passive or active. So it depends but Rental real estate is considered always Passive so passive is if a taxpayer does not work on a regular Continuous and substantial basis in the business remember I own the farm, but I don't I don't know anything about that form I don't know anything about the farming business. Well, guess what? I am I have a passive income here if there's any income and passive loss for that matter so If I don't do so in the business the losses are considered to be passive. What does that mean? Well, if the losses are passive, they are generally not deductible in the absence of passive income So I have passive losses. That's a great. I can only I Can only offset them against passive income So I have to have a passive income in order to use my passive losses now again if you remember in the prior session I gave you this example. I'm gonna show you the picture real quick Remember, I told you we have two doctors and a lawyer and what did they do for they purchased a shopping center And they rented out and they generate losses. So that's why Rental business especially real estate rental is always assumed to be passive Unless you have two exceptions. We'll talk about those later But what is in general a passive activity? And this is what we need to focus on because if we know what if we can define what a passive activity is Then we know what a passive income or passive loss for that matter Before we define passive activity, I have an announcement about my company farhat lectures comm Farhat accounting lectures is a supplemental educational tool That's gonna help you with your CPA exam preparation as well as your accounting courses My CPA material is aligned with your CPA review 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 through false questions as well as exercises Go ahead start your free trial today. No obligation. No credit card required So do we have a passive activity? So is this a passive activity to determine whether we have a passive activity or not? We have to address three questions and the first one is what is an activity? What constitute an activity? What is the taxpayers material participation? And remember I told you we're gonna talk more about material participation and that later is now soon and the third thing And when is an activity a rental activity simply put if it's a rental activity What do we have to do and that's gonna be an easy answer here with the two exceptions Starting with the first of the three questions Identification of an activity well under the treasury regulation Which is the IRS follow an activity is defined as one or more trade or business activities or rental activities that form an Appropriate economic unit for the purpose of measuring the taxpayers gain the losses simply put some sort of a business unit Where you are measuring your gain or losses. It could be more than one. It could be one You can combine them so on and so forth. So when you're identifying an activity or Group or group and of various activities together all the relevant factors and circumstances can be considered So you could have one unit or multiple unit grouped together or separate? Once activities are grouped and you're gonna see why that's important Erie grouping generally is not allowed unless the original grouping was clearly Inappropriate or the fact or the circumstances have materially changed So if you group two or three business together and told them this I'm gonna consider this one unit Then you change your mind. You have to justify it or if you have them separate Then you change your mind. You're gonna have to justify it So it's allowed that you have to justify it, but let's look at some examples to illustrate the importance of grouping Grouping the business unit. Let's assume Maggie owns a business with two separate units X and Y Maggie but materially participated in managing X but does not get involved in Y. So simply put material We're gonna see what materially participate is but for now just in other words. She runs the business on a day-to-day basis She makes all the decisions She hire fire make pricing decisions so on and so forth for the current year The X the unit acts a generated income of a hundred thousand. This is where Maggie Participates while unit Y Reported a net loss. Why because Maggie does not participate. She's she's silent in that unit if Maggie treats X and Y Units as component of the same activity then she can lose she can use the loss reported in Y Which is 37,000 to offset the income generated an X So if they are one unit, we would report them together. We net them out. They're considered one unit However, if Maggie is not allowed or it doesn't make any business sense or just it clearly They're not related to treat the two unit as a single activity Then here's what's gonna happen Maggie will have a hundred thousand of active income because remember for unit X Maggie is Materially participating and a passive loss of 430 save them from unit Y What can we do with this passive loss of 37,000 nothing for this year? We have to wait until we have a passive income to offset the loss Therefore we'll carry it for future year Maria owns a vape store and a restaurant in Maryland I don't recommend vape stores, but that doesn't matter. That's what she wants to do She also on a vape store and restaurant in Boston and deciding how to group her activities Any of the following alternative could be reasonable. How can she do it? Well, she can say I'm gonna group all four activities together And she'll the sole owner. So this is grouping based on the owner's identity or She can group the activities in Maryland together and the activities in Boston together And she's gonna say I want to group them based on geographical areas or she can group them The vape stores together and Restaurants together based on the type of activities or she can treat each unit or each activity as a separate stand-alone activity again, it makes a difference whether Whether you have each one is treated as passive or active when it comes to netting So that's why you have to be careful. Am I grouped them together? Am I not? Which one is active which one is not so you have to be very careful in how you group them But the point is you do have that flexibility Let's talk about material participation and that's important Here's what's gonna happen The IRS basically state that a taxpayer is considered to be actively participating in an activity if he or she Meets one of the following seven material participation tests You only have to meet one and you're gonna see at the end You could meet anyone and we're gonna see what does that mean in a moment the taxpayer participate in the activity more than 500 hours during the year so you can if you can show you participate in the activity actively participate more than 500 hours, you are considered to be active. You're done To the taxpayer participation in the activity is substantially all the participation in the activity of all individuals for the year Well, sometimes you might have a small business and you're by yourself and you don't spend 500 hours But basically, you're the only person that spend hours in that business whether those 50 or 500 you spend all the hours now You are considered active because no one else in that business then you are active who else is running the business if you are not Right, you are active The taxpayer participate in the activity for more than 100 hours during the year and not less Then the participation of any other individual in the activity So you spend more than 100 and not less and no one is above you So you're basically running the show therefore you are considered to have active participation The tax the taxpayers participation in the activity is significant And the taxpayer aggregate participation in all participation activity during the year exceeds 500 hours And the significant participation is more than 100 so you so 100 hours you're doing heavy duty and a total of 500 Five the taxpayer materially participated in the activity for any five years during the last 10 year period So simply put in the last 10 you've been you are considered to be materially participate materially participating Therefore you assume to have active role The activity is a personal service activity in which the taxpayer materially participated for any preceding three years personal service lawyers Architect accountant and if you are materially participating for any of the three preceding years You are still running the show. You are an active business owner Seven and look at seven And this is what I was talking about at the beginning based on fact and circumstances The taxpayer participated in the activity on a regular continuous and substantial basis Now when we say base based on fact and circumstances because the irs can nothing of every possible scenario So they thought of this scenario as definitely you're an active But you can always argue that I am active based on the fact and the circumstances and you have to prove that Because regular continuous and substantial is not defined actually in the regulation So that's why you can argue as long as you can prove to them that you are active then You are active now bear in mind investor type of work does not count So if you're obtaining a loan raising money meeting with potential investors creditor Reviewing financial reports financial statements for the purpose of investing in the business Then those are called investor type work and those hours does not count Let's look at an example during the current year john cpa earned the net income of 450 000 for a miss cpa practice additionally John owned an interest in activities b and d in which he does not materially participate He incurred the loss of 20 000 from b and a net income of 15 000 from d Now john if he put an additional 50 hours In activity d it will be treated as a active business active income it will be treated as materially participating Let's see to determine if john's attempt to meet the material participation standard for d It's important to understand the tax is so the tax consequences. So let's see if that's a good idea Without the material participation both activities are treated as passive And guess what the loss in b Maybe offset the gain in d. So simply put if they are both if they are both if they are both Passive we can take 15 plus a 20 negative 20 plus 15 and we were able to offset Offset remove this and we still have 5000 but we're able to remove 5000 of net income however If john materially participate in d and d becomes an active business Then we have a net income that's going to be report and well a net income or revenue or profit or income of 15 000 and a loss Not there's nothing we can do with it because this becomes passive This this is is passive and this the 15 000 is active This becomes taxable And there's nothing we can do with this passive loss. So it's in john's best interests Given the circumstances not to turn d into an active business because if you do then you cannot You cannot use the 20 000 of losses. That's what we're trying to say here Another example jane an attorney owns a restaurant that reported a net loss in the current year That's fine restaurant reported a net loss during the year jane worked 450 hours in managing the restaurant And 20 hours in doing genitalial activities her husband julian participated 80 hours in the activities relating relating To more related to marketing and sales Okay, so let's see if jane is an active participant and how do we count those hours? Assuming that activities were not performed to avoid any disallowance of passive activity losses jane qualifies But let's see how she qualifies in the restaurant She's gonna count her hours and her husband's hour simply put you can count your hours and your husband's hour together Now you're saying hold on a second That's 5 30 that should be right because she also put 20 hours doing genitalial activities Here we're gonna have to kind of think about you have to be managing Actively participating making decision Just rack and up hours will not count. So doing genitalial activities will not count Now what counts and what not counts? Obviously, it's not clear cut But the point is if it's not managing doing doing major amount of the work making major decision Then it's not managing the business. It's not actively participating It's important to know that genitalial activities are not included in the activity This is just adding up hours not allowed. For example, also, let's assume jane wants to cut the grass Mode the lawn outside the restaurant that does not count that does not count The third the three of three is the rental activity and this is easy subject to two exceptions Which we'll talk about all rental activities are automatically considered passive activities because rental activities is what brought Brought all of us into this lesson because rental activities were being abused in the 80s I talked about this in the prior session where people were buying rental property generating losses from high interest and depreciation and offsetting those offsetting the losses Upsetting their taking the losses and offsetting their active income So we have two exceptions. We have to talk about from rental activities the mom and pop exception in the real-estate professional starting with the mom and pop under the mom and pop exception the taxpayer is allowed to deduct up to 25 000 Of net losses from rental real-estate activities and any access loss is carried Forward as a suspended passive activity loss for a future year The deduction amount is reduced by 50 of the taxpayers agi in access of 100 000 and the deduction is completely eliminated at 150 so simply put Up if you make up to 100 000 if you have agi of 100 000 really it's it's a modified agi But no one cares about the m if your agi is less than 100 000 you can deduct up to 25 000 Once your agi exceeded 100 000 your 25 000 will start to go down Until you reach 150 once you reach 150 in agi the government says you're making too much money You cannot use those losses. You cannot use those losses A taxpayer who's actively engaged in a in a rental real-estate activity and owns at least 10 of the activity is eligible. So you have to own 10 of the activity to be eligible 10 of the Property and most of these properties are owned 100 by the mom and the pop Usually what this happened like for example, I'm I'm planning on selling my home now buying a new home I'm waiting for the real-estate market to slow down a little So what I'm going to do if the real-estate market slowed down more than a little a lot I'm not going to sell my house. I'm going to keep my house rented out by the new home So I will be a mom and pop exception. I just I'm just because of my I bought a second home I don't want to sell my current home because the market went down the market doesn't have to go down I may just keep the home as a second business as a as a second Source of income. It's a lot of headache, but this is the point. So these these people mom and pop They own 100% usually of the business usually And the active management require an active participation here You don't need material participation, but an active active participation and making Decisions in a significant and bona fide sense in what sense you are making decision to run the business Like what type of a major decision do you make as a landlord? Well, approving tenants deciding on the rental terms approving cap approving capital or repair expenditure also How much to charge if you're making those decisions? Well, it doesn't have to be, you know It doesn't have to be 500 hours. It doesn't have to be anything as long as you're making those decisions And you meet the other qualification Guess what you qualify? Not you qualify in case you have losses You can use up to 25 000 of losses against your active income The second exception you have to be a real considered a real estate professional Who are the real estate professional an individual who provide more than 50 His or her personal services in real estate business So basically provide More than half of their time in this business and at least that amount to 750 hours in real estate property business Now you are considered a real estate professional And his or her income is treated as an active income. What does that mean? If it's active income That's good because if you have active losses, you can if you have active losses You can deduct the active losses against other active income. Now you are your activity is considered active like basically It's active income because that you are in the business of real estate. Therefore any income any losses They are treated as active now the spouse participation are not taken into account When evaluating whether the taxpayer work more than 750 So just be aware of this in case they added the spouse's hours for to be considered They are not considered. You cannot use the spouse's hour Versus if you go back here just the reason I'm showing you this is I want to Show you the difference between the two spouses here under Jane her Her and her husband hours were counted. So just be aware of this under the real estate professional Not at all you are counted separately, but here you combine them for this purpose for the material participation Let's go back and finish the real estate professional Also personal services performed as an employee are not treated as performed in real Real property trade or business unless the employee owns at least five percent of the business So if you acted as an employee, let's assume you are running, you know, you're running the credit of the individuals of the tenant I don't know. You are mowing the lawn. It doesn't matter what you are doing If that doesn't count unless you own five percent of the business because if you don't own the business And if you are working in the real estate business, but you don't have any ownership Then you're an employee. You cannot be considered a real estate professional and notice the threshold is pretty low You only have to own five percent for those activities for those activities to be counted toward your 750 hours Let's take a look at a few examples We have mario has an aji before any consideration of rental property of 120 000 He has a loss from a rental activity in which he actively participate In addition, he has a passive income of 15 000 from another rental property So what is the amount of rental activity loss that mario is allowed to deduct in the current year? Well, let's take a look First his aji is below 150 So we're going to assume that yeah, we're below 150. Therefore he qualifies for 25 000, which is good Let's see what we're going to do first mario can offset the 15 000 of rental loss against the passive income because they are both Considered passive. So we'll have a remaining passive loss of 60 000. So basically what we did We took the 15 000 of income plus Minus the rental losses of 75 you are left with 60 000. What can we do with the 60 000? Remember mario is in the 120 000 aji range So mario is actively engaged in real act in rental activity. Therefore, he's eligible for the mom and pop exception Which allows up to 25 000 of passive losses from rental activities against other income That's the good news and the good news more is he can deduct it But the allowance of 25 000 is reduced by half Have the access of aji over 100 000. So what's going to happen? We look at the aji in access of 100 000, which is 20 000 and you can you will take half of that, which is 10 000 As a result, so as a result, I'm sorry You will be reduced by 10 000 as a result if we have 25 000 Reduce it by 10 you are left with 15 Or you can another way to look at this is if this is the range the range is from 100 to 150 And you are 20 20 000 into the range So 20 000 that the whole range just kind of The whole range is 50 000. This is where you start to lose the whole range is 50 000 your 20 Over 50 inside the range. So you're 40 percent inside the range as you go move inside the range You would lose your you would lose your you will start to lose so of the 25 000 What what's going to happen is you're only going to keep 60 percent of it. Well, let's see what's 25 000 times 60 percent 25 000 Whoops, too many zeros times 0.6 That's 15 000 therefore you qualify for 15 000 Or you can take the amount over aji divided by two and that's the amount not allowed and you can deduct it from the 25 Either or will be good. Just understand you are 40 percent Into the aji range the range started at 100 000. So how much can mario deduct? Well, total how much had he deducted total of 30 000 the first 15 000 Went against the 75. So we have 75 000 and losses We used 15 000 immediately against the income were left with 60 then for the remaining 60 were able to take another 15 We just computed this 25 000 times 60 percent a total of 30 000 Now we need to know what would what would we have to do if we go from a passive activity to a active activity So basically we had a passive activity or go back to my farming example Now I decided to be a farmer. Okay when a passive activity changes to an active activity suspended losses From the years in which the activity was passive may be deducted against the income from the newly becoming An active activity now any losses suspended now I can use them Any remaining suspended losses is carried forward to offset future income From the formerly passive activity or income from the from other passive activity So the good news is you don't lose them if you change if I decided to go back and be a farmer now I just want to leave my job and be an active farmer rather than just own shares in a farm Then that will be the case. Let's look at an example over the previous three years Lisa has owned an interest in a single passive activity At the beginning of the current year when Lisa's total suspended passive losses amounted to 50 000 She increased her hours of participation and she became a material participant in the activity That's fine. She has 50 000 of losses Lisa's share of the current year's income from the activity is 30 000. Well, guess what now? I'm gonna use those suspended losses And offset all my income of 30 000 and what happened to the remaining 20 000 Maybe carried forward to offset future income Future income from this activity or income from other passive activities So really it's a good thing if you decided to go from passive to active and you have suspended losses That's not a bad idea. What should you do now? Go to far hat lectures and work mcqs and true false to help you understand this concept better This is considered challenging for many students cpa candidate as well as accounting students Read your book use your material Good luck study hard and stay safe