Common use of Income or Loss Clause in Contracts

Income or Loss. The 1986 Act distinguishes between income from a "passive" activity and portfolio income. A passive activity includes (1) trade or business activities in which the taxpayer does not materially participate, and (2) rental activities where payments are primarily for the use of tangible property. In general, losses generated by a passive activity will only be allowed to offset income from a passive activity. Portfolio income generally includes interest, dividends, royalty or annuity income and gain from sales of portfolio assets, for example, property held for investment. Portfolio income is not treated as passive income and must be accounted for separately. Portfolio income is reduced by deductible expenses (other than interest) that are clearly and directly allocable to such income. Properly allocable interest expenses also reduces portfolio income. With regard to interest, the Treasury has issued Temporary Regulations which adopt a tracing rule. Interest attributable to indebtedness which is used to purchase an interest in a passive activity will be regarded as passive and subject to the passive loss rules. Thus, if a Limited Partner borrowed all or a portion of the funds used to purchase his Unit(s), interest paid on such borrowing could be used to offset income attributable to a passive activity. The distinction between passive income and portfolio income thus has a material effect on the Partnership and the Limited Partners. If the Partnership is engaged in a passive activity, any income from the Partnership is deemed "passive income" which is available to be offset by any other passive losses which the Limited Partner has from other sources. Portfolio income cannot be offset by such passive losses. Specifically, passive losses from the Partnership net of taxable income from the Partnership may be used to offset passive income from other sources, with any unused losses carried over into the next tax year, where they are available to offset passive income from the Partnership and other sources. In the year that the Unit is disposed of, or the Partnership is dissolved, any unused passive loss is available to offset any gain upon the disposition or dissolution, as the case may be, then to offset any passive income from other sources and, finally, to offset ordinary income. The Treasury has promulgated certain Temporary Regulations which provide that the lesser of the Partnership's net passive income or the Partnership's equity financed interest income shall be treated as not from a passive activity. Such income is in turn treated as interest income, or in other words, portfolio income. The Partnership's equity financed interest income is that portion of its net interest income derived by excluding interest income allocable to liabilities incurred in the activity. It is determined by multiplying net interest income by a fraction whose numerator is the excess of the average outstanding balance for the year of interest bearing assets less the average outstanding balance for the year of the liabilities incurred in the activity and whose denominator is the average outstanding balance for the year of the interest bearing assets held in the activity. Net interest income is the gross interest income less expenses from the activity reasonably allocable to the gross interest income. The Partnership does not currently anticipate that it will have significant liabilities incurred in connection with its lending activities. Accordingly, its equity financed interest income should equal its net passive income and such amount should be treated as portfolio income. To the extent that the Partnership does incur liabilities, it would require a portion of income between passive and portfolio income. The treatment of the Partnership's equity financed interest income as portfolio income is premised upon the Partnership being engaged in a trade or business. Whether the Partnership is engaged in the trade or business of lending money will depend on the facts and circumstances. Such facts and circumstances include the manner in which the Partnership conducts its affairs and the nature of its dealings with borrowers and other third parties and the number of loans made by the Partnership in any one year. For example, the courts have held that a person who makes one or two loans in a year is not engaged in a trade or business even though that person made many loans in preceding years. Similarly, making up to five loans did not constitute a trade or business. On the other hand, the making of twenty loans was deemed to be a trade or business. It is not possible under the circumstances to determine whether the Partnership will be deemed to be engaged in a trade or business. The Partnership may also make payments to Limited Partners under its Guaranteed Payment for Offering Period. The Guaranteed Payment for Offering Period is likely to constitute a guaranteed payment as provided under Section 707(c). As such, these payments should be considered interest payments treated as portfolio income.