In 2013, wealthy taxpayers experienced significantly higher tax rates as well as phased-out deductions due to the American Tax Relief Act of 2012 and the Affordable Care Act. Many high net worth clients were dismayed to learn that their federal marginal tax rate went from a high of 35% in 2012 to as much as 45% in 2013 after taking into account the impact of phase-outs, the Medicare surtax and the net investment income tax on portfolio and passive income.
Federal capital gain rates have also increased from 15% to 20% for taxpayers in the top bracket, which is a 33% rate increase, but still favorable compared to the marginal rate on ordinary income. One of the best long-term tax strategies has been to invest in a business or real estate, have losses pass through in the initial years of ownership, and then have a sale event where loss recapture and appreciation are taxed at capital gain rates. If an owner is considered an active participant in the business, the early stage losses are deductible against ordinary income.
Clients who have a tolerance for risk and are looking for tax savings through alternative investments including direct investments in small businesses and real estate, or through participation in a private equity or hedge fund, should thoroughly review with their tax advisor the IRS rules tha allow realization tax benefits from losses passed through from these investments. The following discussion describes the key aspects as to when losses are deductible.
A direct investment in a business or real estate is most often made through a pass-through entity. A business interest is often held in an S corporation and real estate is often held in a limited liability company which is taxed as a partnership. Loss allocations to an owner/investor can be limited as follows:
- The owner/investor must have basis in his ownership interest in the entity in order to be able to claim his share of any loss.
- The owner/investor must have sufficient at-risk basis (capital invested and/or debt deemed to be held with recourse to the owner) in order to be able to claim any loss.
The loss must be classified as non-passive or the owner/investor must have other passive income to offset a passive loss for any year except for the year of disposition of the entity that produces the loss.
The third requirement generally is the biggest hurdle for the owner/investor. With few exceptions, an activity involving conduct of trade or business is deemed to be a passive activity if the investor/ owner does not materially participate.
Rental activities are generally subject to an automatic passive classification, except for qualifying real estate professionals and certain active-participation real estate rental activities. Exceptions include working interests in oil and gas property which are deemed active; and trading in personal property is deemed non-passive.
Material participation is determined annually with seven separate tests used to measure material participation. Satisfying any one of the seven will result in non-passive status for the activity for the year in question. A taxpayer is considered to be materially participating in an activity if any one of the following tests are satisfied:
- Participation for more than 500 hours.
- Participation constitutes substantially all of the participation in the activity of all individuals (including non-owners) for the tax year.
- Participates in the activity for more than 100 hours during the tax year, and his participation is not less than the participation of any other person.
- The activity is a significant participation activity for the tax year, and his aggregate participation in all significant participation activities during the year exceeds 500 hours. A significant participation activity is one in which the taxpayer has more than 100 hours of participation during the tax year but fails to satisfy any other test for material participation.
- Materially participated in the activity for any five tax years of the 10 tax years immediately preceding the tax year in question. The five tax years need not be consecutive.
- Materially participated in any three preceding years if the activity is a defined personal service activity. A personal service activity is one that involves the performance of personal services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any other trade or business in which capital is not a material income-producing factor.
- Participates regularly, continuously and substantially, taking into account all facts and circumstances.
There are some services of the owner/investor that are disregarded in applying these material participation tests. Services performed as an investor, such as reviewing the performance of the entity, is not considered unless the owner/investor is also involved in the daily management of the business.
For an investor/owner it may be advantageous to group several different entities into a single activity in order to satisfy one of the tests. The IRS regulations state that activities can be aggregated when they constitute an appropriate economic unit. Although the investor/owner may use any reasonable method for the grouping, the following factors are given greatest weight in determining whether several activities can be combined: similarities and differences in types of businesses; the extent of common control; the extent of common ownership; geographical location; and interdependencies between the activities.
As noted above, rental activities generally default to passive classification. For an owner of rental property with adjusted gross income less than $150,000, a limited amount of losses from the real estate rental activities will be treated as non-passive each year. Assuming the investor/owner performs services such as securing tenant rentals and approving capital improvements, up to $25,000 of losses will be treated as non-passive.
Code Sec. 469 allows an owner/investor who has more substantial participation in real estate activities to be considered a real estate professional. If the owner/investor performs more than one-half of his personal services in a real property trade or business and also performs more than 750 hours of personal services in real property trade or business activities, then real estate rental activities are not subject to automatic passive classification. A real property trade or business is any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business. Services performed by an employee are not treated as performed in real property trades or businesses, unless the employee is a 5-percent owner.
For real estate professionals there is a different method of aggregation of real estate rental activities). The real estate professionals may elect to treat all of the taxpayer’s interests in rental real estate as a single activity. Combining all rental activities will generally make it easier to meet the material participation standard.
Meeting the material participation tests under IRC sec. 469 requires significant involvement on the part of the owner/ investor. The underlying rules and regulations are complex and anyone who is considering an investment that will require their active involvement should consult their tax adviser and review these provisions carefully.