Special Tax Situations

Several tax rules apply to specific situations that CFP professionals commonly encounter. These include the kiddie tax for children with investment income, estimated tax payment requirements, passive activity loss limitations, at-risk rules, and hobby loss provisions.

Kiddie Tax

The kiddie tax is designed to prevent parents from shifting investment income to their children to take advantage of the children's lower tax brackets. Under these rules, a child's unearned income above a threshold is taxed at the parent's marginal tax rate.

Who Is Subject to the Kiddie Tax?

The kiddie tax applies to a child who:

• Is under age 19 at the end of the tax year, OR
• Is a full-time student under age 24 at the end of the tax year
• Has at least one living parent
• Does not file a joint return with a spouse
• Has unearned income above the threshold

Exception: The kiddie tax does NOT apply if the child provides more than half of their own support from earned income.

2025 Kiddie Tax Thresholds

CFP Exam Tip: Remember the formula: First $1,350 tax-free, second $1,350 at child's rate, and anything over $2,700 at parent's rate.

What Counts as Unearned Income?

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Standard Deduction for Dependents

A dependent claimed on another taxpayer's return has a limited standard deduction. This rule prevents dependents from using a full standard deduction to shelter significant unearned income.

2025 Dependent Standard Deduction

The standard deduction for a dependent is the greater of:

• $1,350, OR
• Earned income + $450 (but not more than the regular standard deduction of $15,000 for 2025)

Examples

Example 1 - Child with Only Unearned Income:

• 12-year-old has $2,000 of dividend income, no earned income
• Standard deduction = Greater of $1,350 OR ($0 + $450) = $1,350
• Taxable income = $2,000 - $1,350 = $650 (taxed at child's rate since under $1,350)

Example 2 - Child with Earned and Unearned Income:

• 17-year-old has $5,000 wages + $1,000 interest
• Standard deduction = Greater of $1,350 OR ($5,000 + $450) = $5,450
• Taxable income = $6,000 - $5,450 = $550

Example 3 - Child with High Earned Income:

• 16-year-old has $20,000 wages from summer job + $500 interest
• Standard deduction = Greater of $1,350 OR ($20,000 + $450) = $20,450, BUT capped at $15,000
• Taxable income = $20,500 - $15,000 = $5,500 (taxed at child's rate)

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Estimated Tax Payments

Taxpayers who do not have sufficient tax withholding must make quarterly estimated tax payments to avoid underpayment penalties. This commonly applies to self-employed individuals, investors, retirees, and high-income earners.

2025 Quarterly Due Dates

Special Rule: If you file your tax return and pay the full balance by February 2 of the following year, you can skip the January 15 payment.

Safe Harbor Rules

To avoid underpayment penalties, taxpayers must meet ONE of the following safe harbors:

CFP Exam Tip: The 110% rule for high-income taxpayers is frequently tested. If a client's prior year AGI exceeded $150,000, they must pay 110% of last year's tax (not just 100%) to use the prior-year safe harbor.

Underpayment Penalty

The penalty rate is the federal short-term rate plus 3 percentage points, compounded daily. For 2025, this rate is approximately 8% annually.

W-2 Withholding Advantage: Withholding from wages is treated as paid evenly throughout the year, regardless of when it actually occurs. Increasing withholding in December is treated as if payments were made quarterly all year.

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Passive Activity Loss Rules

Passive activity loss (PAL) rules prevent taxpayers from using losses from passive activities to offset active or portfolio income. Losses are "suspended" and carried forward.

Three Categories of Income

Key Rule: Passive losses can only offset passive income. They cannot offset active or portfolio income.

Material Participation Tests

A taxpayer materially participates if they meet ANY ONE of these tests:

1. 500+ hours in the activity during the year
2. 100+ hours AND more than any other individual
3. Substantially all participation in the activity
4. Significant participation (100+ hours) in multiple activities totaling 500+ hours
5. Materially participated in 5 of the prior 10 years
6. Personal service activity with participation in any 3 prior years
7. Regular, continuous, and substantial participation (facts and circumstances)

Rental Real Estate Special Rule

Rental activities are automatically considered passive, even with material participation. However, there is a special allowance:

$25,000 Rental Loss Allowance:

• Taxpayers who actively participate in rental real estate can deduct up to $25,000 of rental losses against non-passive income
• This allowance phases out by $1 for every $2 that AGI exceeds $100,000
• The allowance is completely eliminated at $150,000 AGI

Active Participation (less stringent than material participation):

• Make management decisions (approve tenants, repairs, terms)
• Own at least 10% of the property

Example: A taxpayer with $130,000 AGI and $25,000 of rental losses:

• Phase-out: ($130,000 - $100,000) x 50% = $15,000 reduction
• Available allowance: $25,000 - $15,000 = $10,000 deductible
• Remaining $15,000 is suspended

Real Estate Professionals Exception

A real estate professional can treat rental real estate as non-passive if:

1. More than 50% of personal services are in real estate trades or businesses
2. More than 750 hours in real estate activities
3. Materially participates in each rental activity

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At-Risk Rules

The at-risk rules limit loss deductions to the amount the taxpayer has "at risk" in an activity. This prevents deducting losses that exceed economic exposure.

Amount At Risk Includes:

• Cash invested
• Adjusted basis of property contributed
• Amounts borrowed for which taxpayer is personally liable
• Amounts borrowed secured by property (other than property used in the activity)

Amount NOT At Risk:

• Nonrecourse financing (not personally liable)
• Amounts protected by guarantees, insurance, or stop-loss agreements
• Amounts borrowed from persons with an interest in the activity

Ordering Rule: At-risk rules are applied before passive activity loss rules.

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Hobby Loss Rules

The hobby loss rules prevent taxpayers from using losses from activities not engaged in for profit to offset other income.

Profit Motive Test

An activity is presumed to be a hobby (not for profit) if it does not show a profit in 3 of the last 5 tax years (2 of 7 years for horse breeding/racing).

If presumed a hobby, the IRS may challenge the activity, but the taxpayer can still prove profit motive based on facts and circumstances:

• Time and effort devoted
• Expertise of taxpayer or advisors
• Expectation of asset appreciation
• Success in similar activities
• History of income or losses
• Financial status of taxpayer
• Elements of personal pleasure

Tax Treatment Under TCJA (2018-2025)

Under the Tax Cuts and Jobs Act:

• Hobby income is fully taxable as ordinary income
• Hobby expenses are NOT deductible at all (previously limited to miscellaneous itemized deductions subject to 2% AGI floor)

Example: A taxpayer has a horse breeding activity with $30,000 income and $45,000 expenses. If classified as a hobby:

• Taxable income: $30,000 (fully taxable)
• Deductible expenses: $0
• Net effect: Pay tax on $30,000 despite losing $15,000

Planning Tip: If an activity is genuinely for profit but hasn't shown profit in 3 of 5 years, the taxpayer can elect under Section 183(e) to postpone the IRS determination until the end of the 5-year (or 7-year) period.