Getting 'Down and Dirty' With a PIG
As the end of the year rapidly approaches, some of your well-heeled clients may be looking to get down into the slop. Specifically, they may want to invest in a PIG—short for Passive Income Generator—to absorb some of their suspended losses from other passive activities. This strategy is a twist on the classic tax shelters that investors used to pursue near the end of the year.
Here's the basic premise: Prior to the Reagan administration, astute investors would sink money into tax shelter deals like cattle breeding or equipment leasing so they could show losses in the early years of these limited partnerships. As a result, the losses could be used to offset highly taxed income from other investments and business activities. Eventually, Congress clamped down on tax shelters marketed by zealous syndicators by enacting the passive activity loss (PAL) rules in 1986.
Under the PAL rules, an investor is generally only allowed to use losses from passive activities to offset income from other passive activities received during the year. Any excess loss must be suspended indefinitely. Therefore, the losses generated by tax shelters now provide a limited tax benefit to investors in the upper tax brackets.
Seven Tests for Material Participation
The IRS says you are a material participant in a trade or business activity for a tax year if you satisfy any of the following seven tests.
- You participated in the activity for more than 500 hours.
- Your participation was substantially all the participation in the activity of all individuals for the tax year, including the participation of individuals who did not own any interest in the activity.
- You participated in the activity for more than 100 hours during the tax year, and you participated at least as much as any other individual (including individuals who did not own any interest in the activity) for the year.
- The activity is a significant participation activity, and you participated in all significant participation activities for more than 500 hours. A significant participation activity is any trade or business activity in which you participated for more than 100 hours during the year and in which you did not materially participate under any of the material participation tests, other than this test.
- You materially participated in the activity for any five (whether or not consecutive) of the 10 immediately preceding tax years.
- The activity is a personal service activity in which you materially participated for any three (whether or not consecutive) preceding tax years. An activity is a personal service activity if it involves the performance of personal services in the fields of health (including veterinary services), law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any other trade or business in which capital is not a material income-producing factor.
- Based on all the facts and circumstances, you participated in the activity on a regular, continuous, and substantial basis during the year.
For this purpose, a "passive activity" is defined as any kind of trade or business in which you do not "materially participate," although there are a number of special rules to contend with. As an example, a rental real estate activity is automatically treated as a passive activity unless your level of participation qualifies you as a real estate professional.
However, if you actively participate in the rental activity—you do much more than just rubber-stamp tenants—you may be entitled to an offset of up to $25,000 of losses. This offset is phased out for an AGI between $100,000 and $150,000. In addition, you can avoid the PAL rules if you have a "working interest" in an oil and gas deal.
Otherwise, other investments where you sit on the sidelines are treated as passive activities, unless you manage to pass one of the seven material participation tests established by IRS regulations (see sidebar). But all is not lost.
It didn't take long for clever syndicators and promoters to flip the PAL rules on their head. Instead of deals designed to generate losses in the formative years of a limited partnership, a PIG is set up to start churning out income right away. Thus, you can use the PIG income to soak up any losses incurred earlier in the year and any suspended losses. In effect, the income is tax-free up to the total amount of the losses.
PIGS are now marketed much like tax shelters used to be. The offerings may include certain real estate and oil and gas partnerships. As with other investments, you should investigate other relevant aspects of the deal, weighing all the financials and the outfit's track record. Assuming the offering still makes sense from both an economic and tax perspective, your clients can reap tax benefits from finding a PIG in a poke.