South-Western Federal Taxation 2013

Comprehensive Hoffman 36th Edition Solutions

Manual

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South-Western Federal Taxation 2013 Comprehensive Hoffman 36th Edition Solutions Manual

CHAPTER 11

INVESTOR LOSSES

SOLUTIONS TO PROBLEM MATERIALS

Status: Q/P
Question/ Learning Present in Prior
Problem Objective Topic Edition Edition

1 LO 1 Purpose and general impact of at-risk New

limits and passive loss rules
2 LO 2 At-risk amount New
3 LO 2 Changes in at-risk amount Unchanged 3
4 LO 2, 3 At-risk and passive loss limits Unchanged 4
5 LO 3 Descriptions of active, portfolio, and Unchanged 5
passive income
6 LO 3 Preference as to active or passive New
classification
7 LO 3 Preference as to active or passive Unchanged 7
classification
8 LO 3 Disposition of passive activity New
9 LO 3 Disposition of passive activity Unchanged 9
10 LO 3 Taxpayers subject to passive loss rules Unchanged 10
11 LO 3 Corporate passive activity loss deduction New
12 LO 4 Appropriate economic unit Unchanged 12
13 LO 4 Nature of passive activity Unchanged 13
14 LO 4 IRS regrouping of passive activities New
15 LO 5 Material participation significance Unchanged 15
16 LO 5 The 500-hour standard for material Unchanged 16
participation
17 LO 5 Passive or active loss determination Unchanged 17
18 LO 5, 11 Material participation determination Modified 18
19 LO 2, 3, 5 At-risk and passive loss limits; material Unchanged 19
participation status
20 LO 5 Work that qualifies for material Unchanged 20
participation standard
21 LO 5 Application of passive loss rules: hobby Unchanged 21
versus trade or business

11-1

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11-2 2013 Comprehensive Volume/Solutions Manual

Status: Q/P
Question/ Learning Present in Prior
Problem Objective Topic Edition Edition

22 LO 5 Limited partnership interest and material Unchanged 22

participation standard
23 LO 6 Significant personal services New
24 LO 4, 5, 6 Passive activity definition Unchanged 24
25 LO 5, 6, 8 Rental business: active versus passive Unchanged 25
26 LO 8 Real estate professional classification Modified 26
27 LO 2, 3, 4, Application of at-risk and passive loss New
5, 6, 7 rules
28 LO 3, 4, 5 Classification of businesses and Unchanged 28
application of at-risk and passive
activity loss rules
29 LO 5, 8 Determination of passive activity status New
30 LO 8 Real estate activity exceptions Unchanged 30
31 LO 5, 8 Differences between material and active Unchanged 31
participation
32 LO 8, 11 Treatment of rental property Unchanged 32
33 LO 2 At-risk rules Unchanged 33
34 LO 2 At-risk rules Unchanged 34
35 LO 2, 11 At-risk rules Modified 35
*36 LO 1, 3 Treatment of suspended losses Unchanged 36
37 LO 1, 3 Passive activity loss rules: general Unchanged 37
application
38 LO 3 Passive activity loss rules: general New
application
39 LO 3, 11 Passive activity loss rules: general Unchanged 39
application
40 LO 3 Passive activity loss rules: general Unchanged 40
application
*41 LO 3, 11 Sale of passive activity and suspended Unchanged 41
losses
42 LO 3 Sale of passive activity and suspended Modified 42
losses
*43 LO 3 Sale of passive activity and suspended Unchanged 43
losses
44 LO 3 Passive losses of personal service New
corporation
45 LO 3 Passive losses of corporations Unchanged 45
*46 LO 2, 3, 7, Interaction of at-risk and passive loss rules Unchanged 47
11
*47 LO 6 Character of property: held as investment New
property or rental property
48 LO 2, 3, 7, Interaction of at-risk and passive loss rules Unchanged 48
11
49 LO 2, 3, 7 Interaction of at-risk and passive loss rules Unchanged 49
50 LO 2, 3, 5, Interaction of at-risk and passive loss rules New
7
51 LO 2, 3, 5, Interaction of at-risk and passive loss rules Unchanged 51
7
52 LO 2, 3, 7 Passive loss deduction amounts Unchanged 52
 Investor Losses 11-3

Status: Q/P
Question/ Learning Present in Prior
Problem Objective Topic Edition Edition

53 LO 3, 8 Rental loss: nonactive participation Unchanged 54

54 LO 3, 8 Spousal participation in real estate New
activities
55 LO 3, 8, Joint or separate return: real estate rental Modified 55
11 exception
*56 LO 3, 8, Real estate rental exception Modified 56
11
57 LO 3, 8 Real estate rental exception Unchanged 57
*58 LO 3, 8 Passive activity loss allowed, suspended Unchanged 58
losses and credits
*59 LO 8 Real estate rental loss deduction Unchanged 59
*60 LO 9 Death and suspended losses New
61 LO 9 Gift of a passive activity Unchanged 61
*62 LO 9 Installment sale of passive activity Unchanged 62
63 LO 10, 11 Investment interest expense: net Modified 63
investment income
64 LO 10 Investment interest expense Unchanged 64

*The solution to this problem is available on a transparency master.

Status: Q/P
Research Present in Prior
Problem Topic Edition Edition

1 Offsetting rent income by passive losses New

2 Passive activity: amount of deductible loss Unchanged 2
3 Internet activity New
11-4 2013 Comprehensive Volume/Solutions Manual

CHECK FIGURES

33. Deduction limited to $20,000. 48.b. None of loss is deducted.

34. $40,000 loss deduction in current 48.c. $13,000 suspended under the passive
year; $20,000 loss deduction next. loss rules.
35. Total present value of Alternative 1 49. In 2013, may deduct $40,000 against
$56,185; total present value of passive income.
Alternative 2 $57,762. 50. $40,000 deductible in current year.
36. $16,000 of suspended losses. 51.a. AGI of $218,000.
37. 2011 $0; 2012 $25,000. 51.b. AGI of $173,000.
38. $245,000. 52. No loss deductible in 2011 or 2012.
39. Total present value of Option A 53. AGI of $120,000.
$14,843; total present value of 54. $25,000 of the rental loss is
Option B $21,987. deductible.
40. AGI of $140,000. 55. Should file jointly.
41. Defer sale until next year. 56. $9,320 net positive cash flow before
42. Net gain of $6,500 can be used to mortgage payments.
absorb passive losses from other 57. $25,000 deductible.
activities. 58. Use $20,000 of losses and $1,400 of
43.a. Taxable gain (passive) $25,000. credits.
43.b. Deductible loss $15,000. 59. Suspended loss $23,000.
43.c. Deductible loss $15,000. 60. $6,000.
44. $100,000 passive loss not 61. Nina loses suspended losses; son adds
deductible. suspended losses to basis.
45.a. Taxable income $268,000. 62. Gain $40,000; deductible suspended
45.b. Taxable income $208,000. losses $4,800.
46. Invest in Rocky Road Excursions. 63. Deduct either $7,500 or $25,500.
47. Rent should be at least $2,000. 64.a. $9,500.
48.a. At-risk and passive loss rules. 64.b. Carry forward to subsequent years.
 Investor Losses 11-5

DISCUSSION QUESTIONS
1. The tax benefits associated with tax shelter investments are reduced by the at-risk provisions
and the passive loss rules. The at-risk provisions apply to individuals and closely held
corporations. Under these rules, a taxpayer’s deductible loss from an activity for any taxable
year is limited to the amount the taxpayer has at risk at the end of the taxable year. The
passive loss rules apply to individuals, estates, trusts, personal service corporations, and
closely held C corporations. They provide that losses and expenses generated by passive
activities can be deducted only to the extent of income from all of the taxpayer’s passive
activities. With both sets of rules, losses that are disallowed in the current year may be
carried forward to future years where they may provide a tax benefit. pp. 11-2, 11-3, 11-7,
and 11-10

2. Ken is at risk for the $200,000 of cash invested plus his $75,000 share of the recourse debt.
Thus, his at-risk amount is $275,000. pp. 11-4 and 11-5

3. A taxpayer’s at-risk amount is increased by the following items:

• The amount of cash and the adjusted basis of property contributed to the activity.

• Amounts borrowed for use in the activity for which the taxpayer is personally liable or
has pledged as security property not used in the activity.
• Taxpayer’s share of amounts borrowed for use in the activity that is qualified
nonrecourse financing.
• Taxpayer’s share of the activity’s income.
A taxpayer’s at-risk amount is decreased by the following items:
• The amount of cash and the adjusted basis of property withdrawn from the activity (i.e.,
withdrawals).
• The taxpayer’s share of losses from the activity.
• Reductions of amounts borrowed for use in the activity for which the taxpayer is
personally liable or reductions in qualified nonrecourse debt.
If a taxpayer is facing disallowances of deductions because of the at-risk limitation, it is
possible to increase the amount at risk by investing additional funds or property or having the
business increase recourse or qualified nonrecourse debt.
pp. 11-4, 11-5, and Concept Summary 11.1
4. Dick can deduct only $16,000 currently because that is all he has at risk. Assuming further
he is not a material participant, this deduction will be suspended under the passive loss rules
in the absence of passive income from other investments. If his at-risk amount increases in
the future, he will then be able to deduct the remainder (i.e., $8,000), again subject to the
passive activity limitations. pp. 11-4, 11-5, and 11-19
5. Active income includes the following:
• Wages, salary, commissions, bonuses, and other payments for services rendered by the
taxpayer.
11-6 2013 Comprehensive Volume/Solutions Manual

• Profit from a trade or business in which the taxpayer is a material participant.

• Gain on the sale or other disposition of assets used in an active trade or business.
• Income from intangible property if the taxpayer’s personal efforts significantly
contributed to the creation of the property.
Portfolio income includes the following:
• Interest, dividends, annuities, and royalties not derived in the ordinary course of a trade
or business.
• Gain or loss from the disposition of property that produces portfolio income or is held for
investment purposes.
Passive income is generally income arising from the following activities:
• Any trade or business or income-producing activity in which the taxpayer does not
materially participate.
• Subject to certain exceptions, any rental activity, whether the taxpayer materially
participates or not.
pp. 11-6 and 11-7
6. Carlos would prefer to have the loss activity classified as active. An active loss can offset
income from any of the three categories of income: active, passive, and portfolio. If an
activity is classified as passive, a loss from that activity can offset only passive income.
pp. 11-6 and 11-7
7. Kim would generally prefer to have the activity classified as passive. Passive income can be
offset by passive losses, active losses, and portfolio losses. Active income can be offset only
by active and portfolio losses. pp. 11-6 and 11-7
8. The losses not previously deducted will be allowed when Pamela disposes of the activity.
pp. 11-7 and 11-8
9. The losses not previously deducted are allowed when Lucile disposes of the activity.
pp. 11-6 to 11-9
10. The Code specifically states that the passive loss rules apply to individuals, closely held C
corporations, and personal service corporations. However, in the case of closely held
corporations, passive losses can be used to offset active income. For the flow-through
entities, such as partnerships and S corporations, the passive loss rules apply at the partner
and shareholder levels, not at the entity level. pp. 11-9 and 11-10
11. The loss is not deductible if Silver Corporation is a personal service corporation. However, the
loss is deductible against active income if Silver Corporation is a closely held C corporation
that is not a personal service corporation. pp. 11-9 and 11-10
12. The following five factors are relevant in determining whether activities constitute an
appropriate economic unit. It is not necessary to meet all of these conditions in order to treat
more than one activity as a single activity.
 Investor Losses 11-7

• Similarities and differences in types of business conducted in the various trade or

business or rental activities.
• The extent of common control over the various activities.
• The extent of common ownership of the activities.
• Geographical location of the different units.
• Interdependencies among the activities.
Example 19
13. The question of what constitutes a passive activity is complicated when an activity has
several parts. Is each part to be counted as a separate activity or as a component of a single
activity? Regulations have been issued to provide guidelines for determining what constitutes
an activity. See Examples 16 to 20 for illustrations of these guidelines.
14. The IRS may regroup activities when both of the following conditions exist.
• The taxpayer’s grouping fails to reflect one or more appropriate economic units.
• One of the primary purposes of the taxpayer’s grouping is to avoid the passive loss
limitations.
p. 11-12
15. The term material participation is significant from the taxpayer’s perspective because losses
from a nonrental activity in which the taxpayer materially participates can offset active and
portfolio income. Material participation is determined by the level of participation of the
taxpayer in the activity. The underlying theory is that a high enough level of participation
indicates that the taxpayer has an interest in the activity other than as an investment. The
taxpayer who materially participates in the activity has both an economic interest in the
activity and an interest in the activity as an ongoing source of livelihood. p. 11-13
16. The more-than-500-hour standard for material participation was adopted for two reasons.
First, few investors in traditional tax shelters devote more than 500 hours a year to such
investments. Second, the IRS believes that income from an activity in which the taxpayer
participates for more than 500 hours a year should not be treated as passive. p. 11-14
17. Doug is entitled to an ordinary loss deduction for each activity if significant participation
occurs and his aggregate participation in all such activities exceeds 500 hours during the
year. A significant participation activity is one in which the taxpayer’s participation exceeds
100 hours. Thus, Doug is entitled to an ordinary loss deduction if his participation in the
activity exceeds 100 hours and the aggregate participation in all four activities exceeds 500
hours. Example 25 and related discussion
18. John is entitled to treat the loss as active if his participation constitutes substantially all of the
participation in the activity of individuals (including nonowner employees) for the year. If
John is the only individual who participates in the activity, he would be entitled to an active
loss deduction. Example 23 and related discussion
19. • The amount of Rita’s at-risk basis in the hardware business and whether the losses
flowing from the entity are limited by the at-risk rules.
11-8 2013 Comprehensive Volume/Solutions Manual

• Whether the profits and losses from the public accounting firm are classified as passive or
active.
• Whether Rita is a material participant in the hardware business.
• Whether Rita is subject to the passive loss rules.
pp. 11-3, 11-4, and 11-13 to 11-16
20. As a general rule, participation includes work done by an individual in an activity that he or
she owns. Such participation includes supervising employees, selling goods, providing
services to customers, and any other activity associated with the day-to-day operations of a
business. However, participation does not include work of a type not customarily done by
owners if one of the principal purposes of such work is to avoid the disallowance of losses or
credits. In addition, participation does not include activities of the owner which are really
investor types of activities. Investment activities include examination of financial statements
in a non-managerial capacity. Example 29 and related discussion
21. The issues related to Sylvia’s pottery venture include the following:
• Is the venture profitable or has it produced losses?

• Is the pottery venture a hobby (subject to the hobby loss rules) or is it a trade or business?
Chapter 6

• If the pottery venture is not a hobby, is Sylvia’s participation sufficient to escape the
passive activity rules? p. 11-13

• If the business produces gains, is it preferable for them to be treated as passive or active?
p. 11-6

• Does she have any suspended losses that could be used to offset any passive income from
the venture? pp. 11-6 and 11-7

22. Generally, a limited partner is not considered a material participant, but Sean may be
a material participant if he qualifies under Test 1, 5, or 6. p. 11-15

23. A rental activity will not automatically be treated as a passive activity if the period of
customer use is 30 days or less and the owners provide significant personal services. In
determining whether personal services are significant, relevant facts and circumstances
include the frequency with which services are provided, the type and amount of labor
required, and the value of such services relative to the amount charged for the use of the
property. In order to be a significant personal service, it must be performed by individuals.
p. 11-18

24. The Code defines the following activities as passive:

• Any trade or business or income-producing activity in which the taxpayer does not
materially participate.

• Subject to certain exceptions, all rental activities, whether the taxpayer materially
participates or not.
Reg. § 1.469-4 provides rules that are used to delineate what constitutes an activity for
purposes of the passive loss limitations. Temp. Reg. § 1.469-5T(a) provides guidelines for
 Investor Losses 11-9

determining what constitutes material participation. In addition, Temp. Reg. § 1.469-1T(e)(3)

describes various rental activities that are not treated as rental activities for purposes of
classifying the activities as passive.

pp. 11-10, 11-11, 11-17 and 11-18

25. The average rental period for the DVD business is seven days or less; thus, the business is
not treated as a rental activity. Laura is a material participant with respect to the DVD
business, so it is active. Real estate rental operations are passive, unless the taxpayer
participates more than 750 hours as a real estate professional and that participation
constitutes more than half of her personal services for the year. pp. 11-18, 11-20, 11-21, and
Examples 31 and 41

26. If Caroline is a real estate professional who performs more than 750 hours of service in the
real estate rental activity as a material participant and that participation constitutes more than
half of her personal services for the year, she can treat the entire $65,000 as nonpassive.
p. 11-21 and Example 41
27. Application of the at-risk rules:

• What is their at-risk basis and does it include their share of the entity-level borrowing?

• What amount of the partnership’s loss will David and Debbie be able to deduct in the
current year and what amount (if any) will be suspended because of the at-risk rules?

Application of the passive activity rules:

• Whether the investment is a passive activity or whether David and Debbie are treated as
material participants in the venture.

• If the passive activity rules apply, what amount may be deducted in the current year and
what amount is suspended under the passive loss rules for future use?

What is the interaction between the at-risk rules and the passive activity rules in determining
the current treatment of losses flowing from the investment?

pp. 11-3, 11-4, 11-13, 11-14, and 11-19

28. Whether the at-risk rules apply. If so, is Charles’s at-risk basis sufficient to absorb such
losses? pp. 11-3 to 11-5

• How will these investments be grouped as activities (e.g., aggregating all businesses as
one retail activity, treating them as three separate activities, or categorizing each location
as a separate activity)? pp. 11-10 to 11-12

• Will Charles’s involvement in any one or more of the activities be sufficient to support
the classification of these businesses as active? pp. 11-13 to 11-16

• Will the mountain bike and ski rental shops be classified as rental activities or will they
qualify for one of the exceptions involving rentals of personal property that are not
treated as rental activities? pp. 11-17 to 11-19
• Assuming the passive activity rules apply, what is the best combination of grouping the
ventures as one or more activities? pp. 11-10 to 11-12
11-10 2013 Comprehensive Volume/Solutions Manual

• What is Charles’s willingness to stay with these investments for an extended period of
time without selling them? pp. 11-3 to 11-5 and 11-11 to 11-20

29. The dress shop is a passive activity because Elizabeth does not meet the 500-hour material
participation requirement. The significant participation activities provision cannot be relied
on to classify the dress shop as active in these circumstances because the apartment complex
activity cannot be considered. As to the apartment building, real estate rental activities are
generally treated as passive activities. However, Elizabeth participates for more than 750
hours as a real estate professional and meets the associated requirements. Therefore, the
apartment building is not treated as a passive activity. See Temp. Reg. § 1.469-5T(c),
pp. 11-14 to 11-16, 11-20, and 11-21

30. Brad might be allowed to deduct up to $25,000 of the passive loss from the townhouse
complex against active or portfolio income. To qualify for the deduction under the real estate
rental exception, Brad must actively participate in the activity and own 10% or more of all
interests in the activity for the entire taxable year.
Even if Brad qualifies for the real estate rental exception, the potential $25,000 deduction
will be reduced if his AGI exceeds $100,000. The reduction is equal to 50% of AGI in excess
of $100,000. The deduction will be phased out completely if AGI reaches $150,000.

Brad also could deduct the loss if he works more than 750 hours as a material participant in
connection with the townhouse complex and qualifies as a real estate professional.
pp. 11-20 to 11-22
31. In a nonrental trade or business, “material” participation is required to avoid the passive loss
limitations. It is determined based on the facts of each case. In this regard, pertinent
questions include:
• Is the activity the taxpayer’s principal trade or business?
• Does the taxpayer have knowledge and expertise relevant to conducting the activity?
Temporary Regulations provide seven tests that are intended to help taxpayers cope with
these issues.
“Active” participation, however, refers to the real estate rental activity exception. It requires
that the taxpayer participate in a significant and bona fide way in management decisions.
Examples include such acts as approving new tenants, deciding rental terms, and authorizing
capital or repair expenditures.
pp. 11-13 and 11-22
32. The issues related to Robert’s rental property include the following:
• Is the rental property treated as a passive activity? pp. 11-17 and 11-18
• Does Robert have passive income from other sources to absorb the passive loss from the
rental activity? p. 11-7
• Can Robert take advantage of the $25,000 exception available for real estate rental
activities? Is he an active participant? pp. 11-22 and 11-23
 Investor Losses 11-11

• What will be the impact of any suspended passive losses on the tax treatment of a future
sale of the rental property? pp. 11-7 and 11-8

PROBLEMS
33. The passive loss limitations do not apply to Lionel because he is a material participant in
a partnership that is engaged in a nonrental activity. However, the at-risk limitations apply to
restrict his deduction. As Lionel’s initial at-risk amount is $20,000, the cost of his
investment, his deduction is limited to $20,000. The excess $5,000 nondeductible loss is
suspended and available for use in the future at such time when Lionel’s at-risk amount
increases. pp. 11-3 to 11-6
34. Hoffman, Maloney, Raabe, and Young, CPAs
5191 Natorp Boulevard
Mason, OH 45040
February 3, 2012
Mr. Bill Parker
54 Oak Drive
St. Paul, MN 55164
Dear Mr. Parker:
This letter is in response to your inquiry regarding the tax treatment of losses that you could
expect this year and next year from an investment in Best Choice Partnership. As I
understand the facts, you would invest $60,000 in the partnership with the expectation that
your share of the partnership losses in the current and succeeding years would be $40,000
and $25,000, respectively.

Even though your investment would not be subject to the passive activity limitations, the
amount of the deduction that you may claim in any one year is subject to the at-risk rules.
Essentially, these rules provide that your deductions are limited to the amount that you have
invested in the venture or the amount that you could lose if the investment were to be
unsuccessful. Consequently, in your case, the initial amount that you would have at risk
would be $60,000. Therefore, you would be able to deduct $40,000 in the current year, which
would cause your at-risk basis to be reduced to $20,000 ($60,000 – $40,000). Because your
at-risk basis at the end of next year would be only $20,000, your share of the partnership loss
that would be deductible would be limited to $20,000. The amount not deducted under this
scenario would be deductible later when your at-risk basis increases, for example, by
additional investments you may make in the partnership or because of income generated by
the partnership.
If you have additional questions or need further clarification, please call me.
Sincerely,
John J. Jones, CPA
Examples 4 and 5

35. Based on the following, Alternative 2’s benefit exceeds Alternative 1’s by $1,577 ($57,762 –
$56,185), primarily because of the flow of the benefits and the effect of the at-risk rules on
those benefits.
11-12 2013 Comprehensive Volume/Solutions Manual

Alternative 1
Tax cost/ After-tax 6% PV Present
Income benefit benefit factor value

Year 1 ($20,000) $ 5,000 $ 5,000 0.9434 $ 4,717

Year 2 (28,000) 5,000 1 5,000 0.8900 4,450
Year 3 72,000 (16,000)2 56,000 0.8396 47,018
Total present value $56,185

Alternative 2
Tax cost/ After-tax 6% PV Present
Income benefit benefit factor value

Year 1 ($48,000) $10,000 3 $10,000 0.9434 $ 9,434

Year 2 32,000 (6,000)4 26,000 0.8900 23,140
Year 3 40,000 (10,000) 30,000 0.8396 25,188
Total present value $57,762
1 Because of the at-risk rules, Heather’s tax deduction in year 2 is limited to her
remaining at-risk basis of $20,000. The $8,000 loss that is not deductible in year 2 is
suspended until her at-risk basis increases. Therefore, her tax benefit from the
deduction is $5,000 ($20,000 × 25%).

2 Heather’s $72,000 share of income increases her at-risk basis and provides the
opportunity to claim the $8,000 suspended loss from the previous year. Therefore, her
taxable income for year 3 from this investment is $64,000 ($72,000 – $8,000) and the
tax cost is $16,000 ($64,000 × 25%).

3 Because of the at-risk rules, Heather’s tax deduction in year 1 is limited to her at-risk
basis of $40,000. The $8,000 loss that is not deductible in year 1 is suspended until her
at-risk basis increases. Therefore, her tax benefit from the deduction is $10,000
($40,000 × 25%).

4 Heather’s $32,000 share of income increases her at-risk basis and provides the
opportunity to claim the $8,000 suspended loss from the previous year. Therefore, her
taxable income from this investment in year 2 is $24,000 ($32,000 – $8,000) and the tax
cost is $6,000 ($24,000 × 25%).
pp. 11-4 to 11-6

36. Hazel cannot deduct any of the losses because she has no passive income. Her suspended
losses at the end of the current year are $16,000 ($10,000 loss from Activity A + $6,000 loss
from Activity B). The suspended losses are carried forward for use in future years when
passive income is generated or the activities are disposed of. pp. 11-7 to 11-9

37. In 2011, Gene cannot deduct any of the passive loss. The $45,000 loss is suspended and
carried forward to 2012 where it offsets the income of $25,000. After 2012, $20,000 of the
2011 passive loss remains suspended. The at-risk rules do not limit the deductible amount
because the at-risk basis exceeds the loss. Examples 3 and 6

38. Mike cannot deduct the passive loss against active or portfolio income. Therefore, his net
income after considering the passive investment is $245,000 ($200,000 active income +
$45,000 portfolio income). Example 6
 Investor Losses 11-13

39. Option B’s benefit exceeds Option A’s by $7,144 ($21,987 – $14,843), primarily because of
the flow of the benefit and the ability to benefit from the passive loss deductions in years 1
and 2.

Option A
Tax cost/ After-tax 8% PV Present
Income benefit benefit factor value

Year 1 $8,000 ($2,240) $5,760 0.92593 $ 5,333

Year 2 8,000 (2,240) 5,760 0.85734 4,938
Year 3 8,000 (2,240) 5,760 0.79383 4,572
Total present value $14,843

Option B
Tax cost/ After-tax 8% PV Present
Income benefit benefit factor value
Year 1 ($ 8,000) $ 2,240 $2,240 0.92593 $ 2,074
Year 2 (2,000) 560 560 0.85734 480
Year 3 34,000 (9,520) 24,480 0.79383 19,433
Total present value $21,987
pp. 11-7 and 11-8

40. The $50,000 loss is suspended under the passive loss rules because Ray is not a material
participant. AGI is $140,000. Example 6

41. If Activity A is sold in the current year, the following results:

Gain from Activity A $100,000

Less: Suspended losses from Activity B
($35,000 + $35,000 + $5,000) (75,000)
Taxable gain $ 25,000
Federal income tax (at 28%) $ 7,000

In addition, the $19,000 loss (and the corresponding tax benefit of $5,320) from Activity B
expected to be incurred next year would be suspended until passive income is generated. The
prospects of gaining the use of the tax benefit at this time are nil.

If Activity A is sold next year, the following results:

Gain from Activity A $94,000
Less: Suspended losses from Activity B
($35,000 + $35,000 + $5,000 + $19,000) (94,000)
Taxable gain $ –0–
Tax (at 28%) $ –0–

Therefore, by deferring the sale until next year, Larry is able to avoid the current payment of
a $7,000 Federal tax liability. In addition, the expected gain from the sale can be offset by all
of the suspended passive loss from Activity B (including the expected $19,000 loss from next
year). By deferring the sale, Larry’s short-term cash flow increases by $1,000.
11-14 2013 Comprehensive Volume/Solutions Manual

Reduced sales price ($6,000)

Reduced Federal income tax 7,000
Increase in cash flow $1,000
Examples 6, 8, and 56
42. Last year, Sarah could deduct nothing against nonpassive income and was required to
allocate the $20,000 net loss among the three loss activities.
Income (loss):
Activity A $30,000
Activity B (30,000)
Activity C (15,000)
Activity D (5,000)
Net passive loss ($20,000)
Net passive loss allocated to:
Activity B (30/50 × $20,000) ($12,000)
Activity C (15/50 × $20,000) (6,000)
Activity D (5/50 × $20,000) (2,000)
Total suspended losses ($20,000)
In the current year, Sarah has a net gain of $10,000 from the sale of Activity D. She can
offset the $2,000 suspended loss from the activity and the current year’s loss of $1,500 from
the activity against the $10,000 gain. In addition, the remaining net gain of $6,500 ($10,000 –
$2,000 – $1,500) from the sale may be used to absorb passive losses from the other activities.
pp. 11-7, 11-8, and Examples 9 and 10
43. a. Net sales price $ 100,000
Less: Adjusted basis (35,000)
Total gain $ 65,000
Less: Suspended losses (40,000)
Taxable gain (passive) $ 25,000
Example 7
b. Net sales price $ 100,000
Less: Adjusted basis (75,000)
Total gain $ 25,000
Less: Suspended losses (40,000)
Deductible loss ($ 15,000)
Example 8
c. Net sales price $ 100,000
Less: Adjusted basis (75,000)
Total gain $ 25,000
Less: Suspended losses (40,000)
Deductible loss ($ 15,000)

The suspended passive losses are fully deductible. The suspended credits are lost forever
because the sale of the activity did not generate any tax.
Examples 8 and 12
 Investor Losses 11-15

44. The passive loss limitations apply to personal service corporations. Therefore, the $100,000
of passive losses may not be used in the current year to offset any of Ash’s other income.
Instead, the amount is suspended for use in the future when Ash generates passive income or
disposes of the passive activity. Example 14
45. a. A personal service corporation is not allowed to offset passive losses against active or
portfolio income. Therefore, Orange’s taxable income is $268,000 ($250,000 income
from operations + $18,000 portfolio income). Example 14
b. A closely held, non-personal service corporation is allowed to offset passive losses
against active income, but not against portfolio income. Therefore, Orange’s taxable
income is $208,000 ($250,000 income from operations – $60,000 passive loss +
$18,000 portfolio income). Example 15

46. Hoffman, Maloney, Raabe, and Young, CPAs

5191 Natorp Boulevard
Mason, OH 45040
January 23, 2013
Ms. Kristin Graf
123 Baskerville Mill Road
Jamison, PA 18929

Dear Kristin:

This letter is in response to your request for assistance in analyzing the tax consequences
from two investment alternatives. One alternative is to make an additional investment of
$10,000 in Rocky Road Excursions. Here you have an at-risk basis of $0, suspended losses
under the at-risk rules of $7,000, and suspended passive losses of $1,000. If this investment
is made, your share of the projected profits for this year would increase from $1,000 to
$8,000. The other choice is to invest $10,000 as a limited partner in the Ragged Mountain
Winery. This would produce passive income of $9,000 this year. The following analysis is
based on these facts.

Invest $10,000 in Rocky Road Excursions:

Expected profit from investment $8,000

Beginning at-risk basis $ –0–
Increase to at-risk basis due to profit 8,000
Increase to at-risk basis due to investment 10,000
$18,000
Use of loss suspended by at-risk rules (7,000)
Ending at-risk basis $11,000

Beginning suspended passive loss ($ 1,000)

Reclassified suspended passive loss (7,000)
Use of suspended passive losses—revised (8,000)
Current taxable income $ –0–

Current tax liability $ –0–

11-16 2013 Comprehensive Volume/Solutions Manual

Invest $10,000 in Ragged Mountain Winery:

Expected profit from investment—Ragged Mountain Winery $9,000
Expected profit from investment—Rocky Road Excursions 1,000
Use of suspended passive losses from Rocky Road Excursions
($1,000 reclassified suspended loss under the at-risk rules +
$1,000 suspended passive loss) (2,000)
Current taxable income $8,000
Current tax liability ($8,000  28%) $2,240

As you can see, the tax effects of the two options vary significantly due to the interplay of the
at-risk and the passive activity loss rules. This analysis should help you make a more
informed investment decision. If you need any further explanation, please contact me.
Sincerely,
Libba Eanes, CPA
Partner
Examples 36 to 39
47. Fred owns a passive activity that currently produces an annual $2,800 loss that is not
deductible because of the absence of passive income. Upon renting the land, Fred hopes to
have the rent income classified as passive income. As a result, the $2,800 loss could be
deducted up to the amount of the rent income. Therefore, a key consideration is setting the
rent at a level so as to ensure that it will be treated as passive income. For the rent income to
be treated as income from a passive activity, the rent charge must be at least 2% of the
property’s unadjusted basis. Consequently, the rent income should be at least $2,000
($100,000 × 2%). If Fred sets the rent at any amount less than $2,000, the entire receipt will
be treated as income that is not from a passive activity. In such a case, the $2,800 passive
loss could not be deducted and would be suspended. Example 32
48. a. Maxine’s accountant was referring to the impact of the at-risk and passive activity
loss rules on the deductibility of the loss from the 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 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).
b. Maxine’s current at-risk amount is $1,000, and she has no other investment activity
that produces passive income. Therefore, Maxine’s current year deduction is limited
by both the at-risk and passive loss rules. The $13,000 loss reduces the at-risk basis to
$0, and the $12,000 balance of the loss is suspended. However, the $1,000 loss not
limited by the at-risk rules is suspended under the passive loss rules because Maxine
does not have any passive income. Therefore, none of the $13,000 loss can be
deducted.
c. The financial adviser’s suggestion is faulty. By making an additional $12,000
investment in Teal, the at-risk basis is increased to $13,000 ($1,000 + $12,000). This
avoids any suspension of the loss under the at-risk rules. However, because Maxine
has no passive income, the entire $13,000 loss is suspended under the passive loss
rules.
 Investor Losses 11-17

d. Maxine has two basic choices. One choice involves two steps, the first being to make
the additional $12,000 investment in Teal as suggested by her financial adviser. In
addition, she should purchase an interest in a new investment that is expected to
produce passive income of at least $13,000 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 $13,000 loss may be offset. Maxine’s second option is to
consider selling her interest in Teal. The sale of the 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 deductibility of the final year’s loss.
pp. 11-7, 11-19, and 11-20
49. Lee’s share of BlueSky’s loss in 2012 is $80,000 ($400,000 × 20%), and the entire loss is
suspended under the passive loss rules. His share of the passive income in 2013 is $40,000
($200,000 × 20%). His at-risk amount is $80,000 ($120,000 – $80,000 passive loss in 2012
+ $40,000 share of income in 2013). In 2013, he may deduct $40,000 of his $80,000
suspended loss against the passive income. This leaves a $40,000 suspended loss at the end
of 2013. Examples 36 to 39
50. Grace is allowed a $40,000 deduction. Because her at-risk basis is only $40,000, of the
$50,000 loss $10,000 is suspended. The available $40,000 loss is not subject to the passive
activity loss rules because she was a material participant. As the loss is treated as an active
loss, Grace’s income for tax purposes is $100,000 ($140,000 – $40,000). Examples 21 and
36 to 39
51. a. If Jonathan is not a material participant, $45,000 of his $60,000 loss ($300,000 loss
× 20% interest) is reclassified as a passive loss and disallowed under the passive loss
limits. The remaining $15,000 is disallowed by the at-risk limits. Therefore,
Jonathan’s AGI is $218,000 ($200,000 salary + 18,000 portfolio income).
b. If Jonathan is a material participant, $45,000 of his $60,000 loss is deductible as an
active loss. The remaining $15,000 is disallowed by the at-risk limits. Therefore,
Jonathan’s AGI is $173,000 ($200,000 salary + $18,000 portfolio income – $45,000
active loss).
Examples 37 to 39
52. If losses were limited only by the at-risk rules, Gerald would be able to deduct the following
amounts in 2011 and 2012.
Year Loss Allowed* Disallowed
2011 $40,000 $30,000 $10,000
2012 30,000 –0– 30,000
* Allowed under the at-risk rules, reclassified as a passive loss subject to the passive loss
limitations.
However, the losses also are limited by the passive loss rules as follows:
Year Passive Deductible Suspended
2011 $30,000 $–0– $30,000
2012 –0– –0– –0–
11-18 2013 Comprehensive Volume/Solutions Manual

In 2013, the $50,000 income increases Gerald’s at-risk amount to $50,000, enabling him to
deduct the $40,000 of disallowed losses. The $50,000 is passive income that can be offset by
$50,000 of suspended losses, leaving a suspended loss of $20,000. At the end of 2013,
Gerald has no unused losses under the at-risk rules, $20,000 of suspended passive losses, and
a $10,000 adjusted basis in the activity [$30,000 (adjusted basis on 1/1/2011) – $40,000 (loss
in 2011) – $30,000 (loss in 2012) + $50,000 (income in 2013)]. Examples 4, 5, and 37 to 39
53. The activity is a passive activity and Rachel is not an active participant. Therefore, no
deduction is allowed under the real estate rental exception. The $35,000 loss is suspended
under the passive loss rules, and Rachel’s AGI is $120,000. pp. 11-22 and 11-23
54. Maria’s and Juan’s hours of participation can be aggregated for purposes of the 500-hour test
for material participation. Thus, Maria qualifies as a material participant in her real estate
development business (320 hours + 250 hours = 570 hours) and the $18,000 loss is active. In
the case of the rental loss, Maria’s and Juan’s hours of participation cannot be aggregated for
purposes of the real estate professionals exception. Therefore, the more than 750-hour
requirement of such exception is not satisfied (i.e., Maria has worked only 720 hours (320
hours + 400 hours) in her real property trades or businesses) and the $26,000 rental loss is
passive. However, of the $26,000 real estate rental passive loss generated, $25,000 can be
deducted under the exception for real estate rental property. pp. 11-20 to 11-22
55. Bonnie and Jake are much better off filing jointly (a tax liability based on the 2012 rate
schedules of $3,222 compared to $5,656). The decrease in medical deductions [($8,500
– $2,006) versus ($8,500 – $3,525)] is more than offset by the fact that they lose their rental
loss deduction if they file separately because they live together.
Bonnie Jake Joint
Income:
Salaries $42,500 $26,000 $68,500
Interest income 750 750 1,500
Rental loss (–0–) (–0–) (23,000)
AGI $43,250 $26,750 $47,000
Itemized deductions:
Medical expenses $ –0– $ 8,500 $ 8,500
Less: 7.5% of AGI –0– (2,006) (3,525)
All other 9,000 3,400 12,400
Total itemized deductions ($ 9,000) ($ 9,894) ($17,375)
Personal exemptions (3,800) (3,800) (7,600)
Taxable income $30,450 $13,056 $22,025
Tax (rounded) $ 4,133 $ 1,523 $ 2,434
Tax filing separately:
Bonnie’s tax $ 4,133
Jake’s tax 1,523
$ 5,656
Tax filing jointly (2,434)
Tax savings filing jointly $ 3,222
p. 11-22
56. The incremental tax impact of renting the property would be that Mary and Charles would
have a $1,000 deductible loss [$22,000 – ($4,000 + $9,000 + $10,000)]. The total deductible
 Investor Losses 11-19

loss, including the real estate tax and interest expenses, would be $9,000 ($1,000 + $8,000).
The real estate tax and interest expenses would be deductible whether or not Mary and
Charles convert the cottage to rental status. Even though the rental cottage would be
considered a passive activity, it would qualify for the real estate rental exception. This allows
taxpayers to deduct up to $25,000 per year against active and portfolio income. Therefore,
converting the property to rental status would produce an incremental $1,000 tax deduction
and a tax benefit of $320 ($1,000 × 32%). The cash flow position before the mortgage
payments would be:

Rent income $22,000

Tax benefit from passive loss deduction 320
Less:
Rental commissions (4,000)
Maintenance expenses (9,000)
Net positive cash flow before mortgage payments $ 9,320

Under the facts given, the cash flow from renting the cottage would not be sufficient to cover
the $12,000 mortgage payment. Nonetheless, other relevant factors might be considered that
could lead Mary and Charles to decide to rent the cottage. Chapter 6 and pp. 11-22 and 11-23

57. Gene is considered a material participant in the tax practice but not in the apartment leasing
operation. However, because he actively participates in the real estate rental activity and
owns at least 10%, $25,000 of the $30,000 loss is deductible in the current year against his
tax practice income. The remaining $5,000 loss from the rental activity is suspended as
a passive activity loss. pp. 11-22 and 11-23

58. Ida can utilize $20,000 of losses and $1,400 of credits as follows because of the real estate
rental activity exception:

Income (Loss): Activity A ($12,000)

Activity B (18,000)
Activity C 10,000
Net loss ($20,000)
Utilized loss 20,000
Suspended loss $ –0–

Utilized credit $ 1,400

Suspended credit $ 700

After deducting the loss of $20,000, Ida has available a deduction equivalent of $5,000
[$25,000 (maximum loss allowed) – $20,000 (utilized loss)]. Therefore, the maximum
amount of credits Ida may claim is $1,400 [$5,000 (deduction equivalent) × 28% (marginal
tax bracket)]. Examples 44 and 45

59. Rental loss ($105,000)

Rental income 25,000
Other passive income 32,000
Net passive rental loss ($ 48,000)
Deductible against other income 25,000
Suspended rental loss ($ 23,000)
Example 43
11-20 2013 Comprehensive Volume/Solutions Manual

60. On Francine’s final income tax return, a deduction of $6,000 is allowed, determined as
follows:

FMV of property at death $170,000

Adjusted basis of property (160,000)
Increase (step-up) in basis $ 10,000

Suspended loss ($ 16,000)

Increase (step-up) in basis 10,000
Suspended loss allowable on Francine’s final income tax return ($ 6,000)

Example 47

61. Nina loses the suspended losses of $25,000 and they are added to the basis of the property
given to her son. She may or may not have to pay gift taxes, depending on circumstances
not stated in the problem.
In 2011, Nina’s son has a passive activity with an adjusted basis of at least $125,000
[$100,000 (Nina’s basis) + $25,000 (Nina’s suspended losses) + part of Nina’s gift taxes
paid, if any]. In 2012, the son reports income of $12,000 (which can be offset by other
passive losses, if any). He cannot offset any of Nina’s $25,000 of suspended losses.

Example 48

62. In the current year, Tonya has a gain of $40,000 and can deduct $4,800 of suspended losses
as follows:

Sale price $150,000

Adjusted basis (50,000)
Total gain $100,000

Proceeds received this year $ 60,000

Gross profit ratio ($100,000/$150,000) × 2/3
Gain recognized this year $ 40,000

Suspended losses $ 12,000

Ratio of gain recognized to total gain ($40,000/$100,000) × 40%
Current deductible loss $ 4,800
Example 49

63. Hoffman, Maloney, Raabe, and Young, CPAs

5191 Natorp Boulevard
Mason, OH 45040

February 26, 2013

Ms. Kathleen Tweardy

11934 Briarpatch Drive
Midlothian, VA 23113
Dear Ms. Tweardy:
 Investor Losses 11-21

In our recent meeting, you asked me to determine the amount of your investment interest
deduction for 2012. The amount of the deduction depends on choices made regarding the
treatment of the capital gain on the sale of securities and the qualified dividends.
The deduction for investment interest is limited to the amount of investment income reported.
If you choose not to treat the capital gain and qualified dividends as investment income for
purposes of the investment interest expense limitation, your deduction will be $7,500.
However, if you elect to treat these items as investment income, the deduction becomes
$25,500 ($7,500 interest + $6,000 qualified dividends + $12,000 capital gain).

The maximum rate applicable to the capital gain and qualified dividends is 15%, while other
income may be subject to rates as high as 35%. If treated as investment income, the $12,000
capital gain and $6,000 of qualified dividends will not qualify for the beneficial tax rate of
15%. Therefore, you must decide between the tax benefit of an additional deduction of
$18,000 ($6,000 + $12,000) versus the benefit of the applicable reduced rates.
Due to the complexities of the capital gain provisions, we will need to meet again to obtain
additional information that is relevant to the election available. Please call me at (510) 555-
1234 to schedule an appointment. Thank you for consulting with my firm on this matter and
we look forward to serving you in the future.
Sincerely,
Julie Morgan, CPA
Partner
pp. 11-26 and 11-27
64. a. Helen’s investment interest deduction is limited to net investment income computed
as follows:
Income from investments $10,000
Less: Investment expenses* (500)
Net investment income $ 9,500
*Because Helen has no other miscellaneous itemized deductions, the deductible
investment expenses are the smaller of (1) $2,000, the amount of investment
expenses included in the total of miscellaneous itemized deductions subject to the
2%-of-AGI floor, or (2) $500, the amount of miscellaneous expenses deductible
after the 2%-of-AGI floor is applied [$2,000 – $1,500 (2% of $75,000)].
Helen’s investment interest expense deduction in 2012 is limited to $9,500, the
amount of net investment income. The balance of $1,500 is disallowed in 2012.

Total investment interest expense $11,000

Less: Net investment income (9,500)
Investment interest disallowed in 2012 $ 1,500

b. The $1,500 of investment interest disallowed is carried over and becomes investment
interest expense in the subsequent year (subject to the net investment income
limitation). Helen could increase her investment interest deduction by electing to treat
the LTCG as investment income. The amount so elected will not qualify for the
beneficial tax treatment available for net capital gains.
pp. 11-27 and 11-28
South-Western Federal Taxation 2013 Comprehensive Hoffman 36th Edition Solutions Manual

11-22 2013 Comprehensive Volume/Solutions Manual

Proposed solutions to the Research Problems and the Appendix E Tax Return Problems are
found at the Instructor Companion Site for the textbook (www.cengage.com/taxation/swft).
Previously, these items were a part of the Instructor’s Guide for the text, but now they are available
online at this site as free-standing documents, as well as on the Instructor’s Resource CD.

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