Question

CASE STUDY PROBLEM I:1-50
Rick Cabela, a high-income client, has contacted you for advice regarding two new proposed business ventures and other tax planning ideas. Rick already operates a highly successful consulting business that earns approximately $2,000,000 net after expenses, and he reports this amount on his personal income tax return. Below are the details: • Rick is considering the purchase of several apartment buildings for rental purposes. He believes the apartments would generate a tax loss of approximately $100,000 in each of the first three years, then operate profitably thereafter. Rick would like to use the tax losses for the first three years to reduce his personal income taxes.
• Rick is also considering an investment in a blueberry farm. He intends to purchase some farmland and turn it into a blueberry farm. The costs in the first year would be the land, equipment, blueberry plants, and labor to develop the farm. In years 2–4, labor costs and maintenance would be the primary financial outlays. No revenue would be earned until year 5 when Rick believes the farm will be very profitable, generating net profits of approximately $100,000 per year. With the substantial cash outlays in the first four years and very little revenue, Rick believes the tax losses would reduce his personal income taxes. Assume the farm is a valid business and Rick materially participates in the activity of the farm.
• Because of his high income, Rick’s income tax liability is very high. He read in a financial journal that the contribution of appreciated stock to a charitable organization is a good idea for tax purposes. He has some stock in Apple Co. for which he paid $10,000 several years ago, and the shares are now worth $200,000.

For each of the situations above, what are the principal tax issues that Rick should consider?

Answer 1

Answer:

•           The apartment buildings constitute a rental activity and are subject to the passive activity rules of Section 469 of the Internal Revenue Code. Since Rick's adjusted gross income (AGI) is greater than $150,000 before the loss, he would be unable to currently deduct the losses on his personal income tax return. Therefore, the $100,000 of losses in each of the first three years would not be deductible. However, the losses would be considered as suspended passive losses and would be available as a deduction against the rental income in future years.

•           The blueberry farm, while requiring a substantial cash outlay, would not result in as much a loss as Rick believes. The reason is that most of the cash outlays must be capitalized and, if allowed, depreciated over several years rather than deducted currently. The land would not be depreciated at all. Both the equipment and blueberry plants must be capitalized and depreciated. So, while he may not get as much of a current deduction, he still would be able to claim the deductions in future years when the farm begins generating revenue.

•           Rick is correct about using appreciated stock as a charitable contribution. If he gave his entire amount of stock to charitable organizations, he would receive a $200,000 charitable deduction in the year of the contribution. He would not be required to recognize any of the appreciation as income on his tax return. See Section 170 of the Internal Revenue Code for details.