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Passive loss rules spice up Illinois senate race

September 30, 2010

In Delaware, they're talking witchcraft. In Louisiana, a candidate is linked to hookers. But Illinois really has an exciting issue: passive losses!

As all tax geeks know, the Section 469 passive loss rules were enacted to shut down the mass-marketed limited partnerships of the early 1980s by allowing individuals to deduct net business losses only if they "materially participate" in an "activity." Otherwise the losses can only be used against other "passive" income, or when the activity is sold.

The Chicago Tribune reports that Illinios Senate Candidate Alexi Giannoulias was able to take a $2.7 million loss in 2009 on a controversial politically-connected bank he ran, and which failed earlier this year. The paper reported that while Mr. Giannoulias didn't work in the bank in 2009, he worked there at least 500 hours per year from 2002 through 2006.

This led blogger Ed Morrissey to ponder:

The issue isn’t tax evasion or fraud. Apparently, the deduction is legitimate if Giannoulias worked at the bank in 2006, although it’s not clear exactly how working more than 500 hours for Broadway in 2006 gets someone off the hook for that much in taxes. That goes far beyond my paltry experience in tax law, and unless someone shows this analysis by the Chicago Tribune as faulty, I’ll assume that they have the legal implications correct.

The tax law measures "material participation" based on how much time you spend on an activity (See Reg. Sec. 1.469-5T). The most common benchmark is 500 hours; if you work in an activity that much in a year, any income and losses are non-passive. Another rule treats you as materially participating in any year if you materially participated in five of the prior ten years. That allows a retiring partner or S corporation owner to be non-passive for five years after retirement. This is the rule that Mr. Giannoulias is invoking.

While it may seem convenient that he managed to get to 500 hours in 2006 after he said he left behind "day-to-day" involvement in the bank in 2005, getting him his fifth year of material participation, it was likely only a one-year acceleration of his loss. When the FDIC siezed the bank in April 2010, he probably would have triggered his losses anyway via a complete disposition of the activity.

For a more complete discussion of the material participation rules, read on.

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The regulations say you achieve "material participation" in non-real estate activities for a tax year if:

-You participate at least 500 hours; or
-You participate at least 100 hours and at least 500 hours in that and other "100 hour" activities; or
-You participate at least 100 hours and more than anybody else, or
-You are the only participant; or
-You materially participated in five of the past ten years )or in any three years for a service activity).

There is also a "facts and circumstances" test, but don't count on it.

A special rule apples to real estate. If you are not a "real estate professional," losses are normally passive no matter what, unless you provide "extraordinary" personal services.

If you are a "real estate" professional," you can apply the normal material participation rules to determine whether you have a passive activity. To be a real estate professional, you have to spend at least half your working hours - not less than 750 hours annually - in "real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade."

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The biggest problem that you see in the cases in this area is proving the amount of time that was spent. The term "ballpark guestimate" is constantly used by the courts to charachterize the time records that people come up with after the fact.

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