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Passive Activity Loss ATG - Exhibit 7.1: Investment Income And Investment Interest Expense

Publication Date - December, 2004

NOTE: This guide is current through the publication date. Since changes may have occurred after the publication date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the publication date.


Table of Contents / Exhibit 7.2
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Exhibit 7.1: Investment Income And Investment Interest Expense

LAW: Under IRC § 163(d) interest on debt on property held for investment is limited to net investment income. Investment income is only income defined in IRC § 469(e)(1), i.e. generally portfolio income.  Additionally, it is reduced by investment expenses.  It is not business income (other than working interests in oil and gas and traders in stocks and bonds) nor rental income.  Furthermore, after 1992 investment income generally does not include long-term capital gains from the sale of investment property unless the taxpayer elects to forego the lower capital gains rate.   Also see Reg. § 1.163-8T on interest tracing and Notices 89-35, 88-37 and 88-20 relating to passive activity interest.

INVESTMENT INCOME:

Investment income includes interest, dividends, royalties, annuities, short-term capital gains, and long-term capital gains (if election on line 4e).

_____ Verify via review of Schedule K-1s, Form 1099-Misc., etc. that Form 4952 line 4 (investment income) does not include business income or rental income. Whether the business or rental is on Schedule C/E, Form 4797 or a flow through from a partnership, S Corporation or trust, income generally is not investment income.  If investment income on Form 4952 is also on the back of Schedule E in the non-passive column, it is strong indicator that the taxpayer erroneously used ordinary business income as investment income.  Investment income is portfolio income as defined in IRC § 469(e)(1) (interest, dividends, royalties, annuities, short-term capital gains, and long-term capital gains if election on Form 4952 line 4e to tax at ordinary rates.

Reminder:  Investment interest is deductible only up to investment income.

LAND:  Income from leased land is also treated as investment income (Reg. § 1.469-2(f)(10) and § 1.469-2T(f)(3))  This income goes on Form 4952, but should not be on Form 8582 line 1a as it is non-passive under Reg. §1.469-2T(f)(3).

PTPs:  Net income from PTPs (also known as master limited partnerships) is investment income.  See Notice 88-75.

_____ Verify income on line 4a does not include capital gains from the disposition of business property (Schedule D flowing from Form 4797) nor income from a business, whether in the form of a sole proprietorship, partnership or S Corporation nor distributions from mutual funds.  Verify that investment income is only interest, dividends, annuities, royalties, and short-term capital gains, etc.  Beginning with the 1993 tax year, if capital gains are included in investment income on line 4, that income must be taxed at ordinary income rates.  Taxpayer loses the benefit of the lower capital gain  rate for capital gains on Schedule D.  The amount on Form 4952 line 4e should also be on Schedule D line 22 reducing the amount available for the lower capital gain rate.  Furthermore, capital gains on Form 4952 line 4e should be gains from stocks, bonds or other securities.  Capital gains from the sale of any business asset or interest in a rental property are not investment income.  If gain flows from Form 4797, it should not be on Form 4952.

_____ Verify that line 4 of Form 4952 does not include capital gains from rentals nor any other passive activity.  Since gain on disposition of rentals is passive income, it cannot be used as investment income.  See Reg. § 1.163(d) & 1.469-2T(c).

_____ Verify that line 4b does not contain any income that was reflected on Form 4797.  The Form 4797 is for the sale of business assets.  The Form 4952 reflects income from investments. 

_____ Verify that investment income has been reduced by losses from working interests in oil and gas activities (Schedule C or E).  IRC § 163(d)(1) provides that investment interest shall not exceed net investment income.  The IRC 163(d)(5)(A)(ii) provides that property held for investment includes a business which is not a passive activity and taxpayer does not materially participate.  A working interest in oil and gas fits this criteria IRC § 469(c)(3).

_____ Verify that investment income has been reduced by losses from partnership and S Corporations that trade in stocks and bonds and other securities on the owner’s account.  Check for Schedule E non-passive losses from Form 1065s with names such as XXX Equities, XXX Mutual Funds, XXX Investors – all of which are generally traders in stocks and bonds.  While those losses are excepted from the passive loss limitations under Reg. § 1.469-1T(e)(6) the losses are nothing more than investment expenses that reduce investment income.  The IRC § 163(d)(5)(A)(ii) provide that property held for investment includes a business that is not passive and in which the taxpayer does not materially participate.  Traders in stocks and bonds fall into the investment interest rules because IRC § 163(d)(5)(A)(ii) defines property  held for investment as any interest in  a business which is not a passive activity and in which the taxpayer does not materially participate.  Trading is a business.  It is not a passive activity under Reg. § 1.469-1T(e)(6).   Most limited partners do not materially participate.  In other words, traders fit squarely within the definition in IRC § 163(d)(5)(A)(ii).   The IRC § 163(d) repeatedly uses the term net investment income.  Investment income and losses must always be netted  to determine the amount of net investment income.  Furthermore, IRC § 163(d)(4) (A) explains that the term net investment income means the excess of investment income over investment expenses.

_____ Verify that income reflected on line 4 of Form 4952 has been reported on Schedule B, D or E.  The Form 4952 is a computational form only, limiting the amount of investment interest deductible as an itemized deduction on Schedule A.  It does not report income.

_____ Verify via review of Schedule K-1s, Form 1099-Misc., etc. that income Form 4952 line 4 does not include any passive income, i.e. income that would properly belong on Form 8582.   Passive income is income from a rental activity or from a business in which the taxpayer does not materially participate.

_____ Verify that only income recharacterized under Reg. § 1.469-2T(f)(3) (land), (4) or (7) has been used as investment income.  See Reg. § 1.469-2T(f)(10).  Income from self-rented property, for example, which is recharacterized under Reg. § 1.469-2T(f)(6) is not investment income.

_____ Verify that income has been reduced by investment expenses (costs directly connected with production of investment income).  Also verify that investment expenses have not been deducted on Schedule C.

_____ Verify that investment income on Form 4952 has not also been entered on Form 8582 lines 1a or 3a as passive income.  Investment income is never passive income, and passive income is not  investment income.  The same type of income should never be entered on both Form 4952 and Form 8582.  IRC § 163(d)(4)(D)

_____ Verify that self-charged interest income from loans to related parties on Form 8582 lines 1a or 3a (which has been recharacterized as passive income under the provisions of Reg. 1.469-7) has NOT also been entered on Form 4952 as investment income, erroneously triggering deductions for investment interest expense. The IRC § 163(d)(4)(D) specifically states that investment income does not include any income taken into account in computing passive losses.  Since investment interest expense is deductible only up to investment income, removing self-charged interest income from F4952 will result in automatic adjustments to investment interest expense. 

_____ Verify that capital losses including loss carryovers have been used to reduce capital gains.  

_____ Via review of Schedule D line 22, verify that ordinary rates (versus lower capital gain rates) were used for any amount of Form 4952 line 4e.  In other words, the amount elected as investment income is subtracted on Schedule D from the amount which receives the preferential capital gains rate (20/10 percent).  Instead it is taxed as ordinary income, i.e. potentially as high as 39.6 percent.

INVESTMENT INTEREST EXPENSE

_____ Tie Schedule K-1s and Form 1099-Misc. substantiating interest Form 4952, line 1.

_____ Verify via loan documents, etc., that interest expense is for monies borrowed to buy investments that produce interest, dividends, royalties or annuities.  It is not interest expense to purchase a business or rental property.  See § 163(d) and § 469(e)(1).  Investment interest expense is NOT interest to purchase an "investment" in a partnership or S Corporation.  If entity is a rental, interest goes on Form 8582 line 1b or 3b. If the taxpayer does not materially participate (work on a regular basis-IRC § 469(h), Reg. § 1.469-5T(a)) in the entity, interest expense goes on Form 8582 line 3b.  If the taxpayer materially participates in business, interest is deductible on back of Schedule E.

_____ Verify via review of Schedule K-1s that the taxpayer has not included any interest expense from a rental property or other passive activity  (partnership, S Corporation or business without material participation - regular, continuous and substantial).  Interest from passive activities is reflected on   Form 8582, but is not reflected on Form 4952.  Even interest on a loan to purchase stock in a passive activity carries a passive taint under the tracing rules and should be entered on Form 8582 lines 1b or 2b (not on F4952).  Notices 89-35, 88-37, 88-20.  Under the interest tracing rules in Reg. § 1.163-8T, interest allocable to a passive activity remains passive even in years after disposition of the activity.  It is not investment interest because it is allocated to a passive activity expenditure.  See Reg. § 1.469-2T(d)(3) and § 1.163-8T(a)(4)(B) & (b)(4).

_____ Verify that the taxpayer has not included tax exempt interest (IRC § 265(a)(2) Ex. municipal bond interest) nor any interest that should be capitalized, such as construction interest subject to

 IRC § 263A.

ADJUSTMENT: Remove incorrect expense or income from Form 4952 and recalculate.  Remove passive interest or income from Form 4952 and enter on Form 8582, PAL Limitation, and recalculate Form 8582.  If there is no passive income, the taxpayer will receive no current tax benefit from his passive interest.  It will be carried forward to subsequent years until he has passive income.  If passive income was erroneously entered on Form 4952, verify that it has been properly reported on Schedule E or elsewhere.  Make any other adjustments based upon your examination and recalculate Form 4952.


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