Advanced Individual Income Tax

Accounting 811: Spring, 1998

Week 6: Costs of Income and Limits on Losses

1. Costs of Profit-Seeking: Sec. 212

Structure parallels 162: Origin as response to Higgins case (p. 419)

Higgins: Issue: are securities portfolio mgmgt costs a 162 deduction?

Also in the case: concept of allocation of joint expenses

Response: Sec. 212 enacted to cover exepnses of income seeking non-business

Somewhat poorly defined area: covers, but not quite equal to "investment"

Proximity of the expense to the profit?: Surasky

Reviews Sec. 212 language and Regs. 1.212-1(d):

"genuinely incurred w/in reasonable biz judgment in effort to produce income: "speculative" not the determining factor

IRS Response: Acquiesced w/ reservation

Note that CG got a break, but cost of getting it fully deductible. Arbitrage?

The "Origin of the Claim": Fleischman

Representative Divorce case following Gilmore

Issue: Are the fees paid an attorney on a lawsuit to invalidate a prenuptual agreement deductible under Sec. 212?

Gilmore case: look to origin of the claim, rather than effect on Y producing property

Fees to negotiate or collect alimony are deductible: alimony is Y.

Fees to defend aren't deductible: avoiding an expense isn't "income"

Note on Gilmore: Capitalize costs to defend ownership

Personal use or Held for Income? Lowry

Issue When and how does residential property become Y producing?

I.e. personal use (262) vs 212 deductions: maintainance

"Reasonable expectation of profit" makes maintenance deductible

Multi-factor test: see. p. 451 for list

Holding for value increase is holding for production of future Y under the Regs.1.212-1(b)

2. Loss limitations: in general: Sec. 165

Analysis: reason for concern: Tax Sheltering

Losses from manipulating recognition

Losses from manipulating timing

Losses within the family group

Losses from essentially personal expenses

Sec. 165 allows deduction

What’s a loss?

expense not specifically matched with any income?

Trade/Biz, transactions for profit, casualty

So not sales of personal use property
Note lack of symmetry: personal use gains are taxed

Other restrictions on deducting losses:

If capital, only vs CGains (3K other Y): (More in 3 weeks)

problem of recognition manipulation
Also led to 1091 "wash sale" rule
Also led to "anti-straddle" rules, Secs. 1092 and 1256

3. Gambling losses

Gambling Y is taxable: other Y

Losses limited to current year's gambling income

misc itemized not subject to 2% limit
no carryforward

Example:

Suppose 100K income, 500K winning bets, 500K losing
What result (per law?)
600 AGI, (600-120 *3% =14,400 of itemizeds lost)

4. Bad Debts: Sec. 166

Business vs. Nonbusiness

Ordinary vs. ST capital loss treatment

Requirement of total worthlessness

Limit on cash method: deduction can’t exceed basis

Suppose it’s not your debt?: 6672 EG

5. Sec. 267 Related party loss transaction rules

also accounting method mismatch

accrual corporation with controlling cash employee

no deduction til related party takes into income'

loss on related party sale

obvious abuse potential

rule: loss disallowance and basis/ tax cost carryover

Indirect sales: McWilliams v. CIR, p. 891

related party definitions:

    family, 50% sh, 2 50% corps. trusts and owners

attribution rules:

      family here is Spouse, B, S, Ancest, descend
      through entities (c-c-p-) to individual owners
also corporations under shared ownership

Strings of attribution rules in Code

267 / 707(b)
318
1563
414(m)

each extensively cross referenced, with lots of tiny modifications

6. Sec. 183: Hobbies

where activity produces income, and expenses

Reporting procedure

Report the Y: other Y
limit the deductions: unlike proprietorship businesses
similar to gambling losses

"tiers" of deductions

deductions that don't depend on profit: prop tax, casualty

if income left, then use other deductions up to income

1st those affecting cash, then depreciation

no shelter against other income, except tx, cas.

Note similar tiering w/ home office and vacation homes

how determine "for profit"

weak objective test : profit 3/5 years. extend limitations

strong subjective test: regs. 9 factors

7. Vacation Homes and Home Offices: Sec. 280A

Tiering:

always deduct tx, casualty

    and interest if its a "second residence"

    question is whether other expenses create sheltering loss

What property does it apply to:

"Residence", "used for personal purposes"

use by self, family, co-owner results in "residence" (defined term)
broader than usual idea of "vacation home"

Distinguish incidental rentals and year round landlording

If 14 days or less, exclude income and don't allocate expenses

If not used by Tp and rented to another at FMV, deduct all expenses: Sched E
not personal if T there less than 14 days
still a q of passive losses

280A limits loss in intermediate area

    question how to prorate vacancy time

Example

used 2 mos, rented 2 mos, vacant 8 mos
income 2,000; i and tx 3,000, utes 1,000, dep 3,000
q is proration of i and tx to vacancy.

Home office aspects

The "principal place of business" test

used for residence and place of biz
regular and exclusive, principal place of biz

Soliman case p. 519

"relative importance" of the places

where the goods and services are delivered
Amount of time spent (no fixed test)

Note eff. 12/31/98 there is a legislative fix

SEC. 932. CLARIFICATION OF TREATMENT OF HOME OFFICE USE FOR ADMINISTRATIVE AND MANAGEMENT ACTIVITIES.

(a) IN GENERAL.—Paragraph (1) of section 280A(c) is amended by adding at the end the following new sentence: ‘‘For purposes of subparagraph (A), the term ‘principal place of business’ includes a place of business which is used by the taxpayer for the administrative or management activities of any trade or business of the taxpayer if there is no other fixed location of such trade or business where the taxpayer conducts substantial administrative or management activities of such trade or business.’’.

8. Passive Activity Losses

Another 1986 complication

How a leveraged deferral tax shelter worked

Creation of current noncash losses to offset other income

eg. invest 100, borrow 900, depreciate: deductions exceed cash in

      will reverse in future (Y exceeds cash in, due to loan payoff)

but people are short-term: don't understand
and it was terrible for compliance

How Sec. 469 shuts down tax shelters

If there is a "Passive Activity"

Then match loss with income type
defer excess passive activity losses
use only against PA income

Mechanics

Classify the activity

      # of hours (over 500, under 100, in-between, or rental

Sum the results of "passives

if net income, tax it

if loss, carry forward indefinitely
deferred losses are allocated among the loss activities

Relief rules

Disposition

can deduct c/f for a specific activity when disposed of

means tracking must be activity by activity: causes complications on calculations

Small Landlord Loophole

     Qualifications: "active mgmt", own 10%, not Ltd ptr.

     Effect: 1st 25K loss (total: not per property) passes thru

     pass thru itself phases out: 100K to 150K

           for $2 in Y, $1 deduction lost

Real Estate Professionals

if over 750 hours in RE

can use rental RE losses vs nonrental RE income

Build Date 3/9/98 'Gwailo