The end of the year is approaching and your new tax client, Maxine, has begun to

Question

The end of the year is approaching and your new tax client, Maxine, has begun to focus on ways of minimizing her 2015 income tax liability. Several years ago she purchased an investment in Teal Limited Partnership, which is subject to the "at risk" and the "passive activity loss" rules. Last year Maxine sold different investment that was subject to these rules and that had produced large amounts of passive income each year. Maxine believes that her investment in Teal has good long-term economic prospects. However, it has been generating tax losses for several years in a row. In fact, when she was discussing the last year's income tax return with her prior tax accountant, he said that unless "things change" with respect to her investments, she would not be able to deduct losses from Teal this year. Your posting will be an explanation to Maxine on the following:

a. What was her prior tax accountant referring to in his comment?

b. You learn that Maxine's current "at risk" basis in her Teal investment is $1,000 and that her share of the current loss is expected to be $13,000. Based on these facts, how will her current year loss be treated?

c. After reviewing her situation, Maxine's financial advisor suggested that she invest at least an additional $12,000 in Teal to ensure a full loss deduction in the current year. How do you react to his suggestion?

d. What other suggestions would you make to Maxine for her to consider as she attempts to maximize her current year deductible losses.

e. Finally, the "at risk" rules did not exist prior to 1987. Prior to that all investment losses were deductible. What do you think about the current "at risk" and 'passive activity loss" rules (besides the fact that they are complicated)? Should taxpayers be allowed to write off investment losses beyond their investment basis?

Explanation / Answer

Answer: a)

Maxine's accountant was referring to the impact of the at risk and passive activity loss rules on the deductablility of the loss from Teal investment. The at- risk rules are designed to prevent taxpayers from deducting losses in excess of the actual economic investment in the activity. The passive loss rules prevent taxpayers from deducting passive losses in excess of the passive income. In Maxine's current situation, she apparently has no other investments that produce passive income (i.e., she previously sold such an interest).

Answer: b)

Maxine's current at- risk amount is $1000, and she has no other investment activity that produces passive income. Therefore, Maxine's current year deduction is limited by both at- risk and passive loss rules. The $13000 loss reduces the at- risk basis to $0 and $12000 of the balance is suspended. The $1000 loss not limited by at- risk rules also is suspended under that passive loss rules because Maxine does not have any passive income. Therefore, none of the $13000 loss can be deducted.

Answer: c)

The financial advisor's suggestion is faulty.By marking an additional $12000 investment in Teal,the at- risk basis is increased to $13000($1000+$12000). this avoids any suspension of the loss under at- risk rules. However, because Maxine has no passive income, the entire $13000 loss is suspended under the passive loss rules.

Answer: d)

Maxine has two basic choice. One choice involves two steps, the first being to make an additional $12000 investment in Teal as suggested by her financial advisor. In addition, she should purchase an interest in a new investment that is expected to produce passive income of atleast $13000 annually. Under this alternative, the additional investment in Teal ensures that the at- risk rules will not limit the deduction, while the investment in a new passive activity will generate passive income against which the $13000 loss may be offset.

Maxine's second option is to consider selling her interest in Teal. The sale of interest will not be restricted by the at- risk rules, and the final economic gain or loss from her investment will be recognized for tax purposes. If the entire interest is sold, the passive loss rules will not restrict the deductability of the final year's loss.

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