©2007 Prentice Hall, Inc.

LOSSES AND BAD DEBTS (1 of 2) Transactions that may result in losses Classifying the losses on the taxpayer’s tax return Passive losses Casualty and theft losses Bad debts ©2007 Prentice Hall, Inc.

LOSSES AND BAD DEBTS (2 of 2) Net operating losses Tax planning considerations Compliance and procedural considerations ©2007 Prentice Hall, Inc.

Transactions that May Result in Losses (1 of 2) Sale of exchange of property Selling costs Deducted in year incurred for inventory Reduction of amount realized for non-inventory Expropriated, seized, or confiscated property Not a casualty or theft Treated as sale or exchange ©2007 Prentice Hall, Inc.

Transactions that May Result in Losses (2 of 2) Abandoned property Ordinary loss if business or investment property Nondeductible if personal property Worthless securities Securities must be completely worthless Capital loss on last day of tax year Demolition of property Add cost of demolition to basis of land ©2007 Prentice Hall, Inc.

Classifying the Losses on the Taxpayer’s Tax Return Ordinary vs. capital loss §1244 stock Disallowance possibilities ©2007 Prentice Hall, Inc.

Ordinary vs. Capital Loss Dependent on type of property involved and type of transaction involved §1231 property Includes real property or depreciable property used in a trade or business and held for more than one year ©2007 Prentice Hall, Inc.

§1244 Stock Losses on §1244 stock treated as ordinary rather than capital loss $50K limitation or $100K if filing MFJ Qualification as §1244 stock ≤ 50% of gross receipts from passive sources during prior 5 tax years, AND Contributions to capital and paid-in surplus ≤ $1M at time of issue ©2007 Prentice Hall, Inc.

Disallowance Possibilities Transfers of property to controlled corporation in exchange for stock Property sold to certain related parties Wash sales Losses limited because losses exceed amount for which taxpayer is at risk ©2007 Prentice Hall, Inc.

Passive Losses Computation of passive losses & credits Carryovers Definition of a passive activity Taxpayers subject to passive loss rules Publicly traded partnerships Rental real estate trade or business Other rental real estate activities ©2007 Prentice Hall, Inc.

Computation of Passive Losses and Credits Income classified into three categories Active income E.g., wages, salaries, active business income Portfolio income (investment income) E.g., interest, dividends, royalties Passive income Net income/loss calculated separately for each activity Passive losses can only offset passive income ©2007 Prentice Hall, Inc.

Carryovers Suspended losses Disallowed passive losses that are carried forward indefinitely Taxable disposition of interest in passive activity Suspended losses from activity used to reduce gain on disposition after losses used to offset current passive income ©2007 Prentice Hall, Inc.

Definition of a Passive Activity (1 of 2) Any rental activity Any trade, business, or investment activity in which taxpayer does not materially participate Interest in limited partnerships is passive activity because limited partners not legally barred from participating in management of ptrshp ©2007 Prentice Hall, Inc.

Definition of a Passive Activity (2 of 2) Material participation tests Only need to meet one test Participate > 500 hrs in activity Participation constitutes substantially all participation in activity by all individuals Participate > 100 hrs in activity and participation more than all other individuals Sum of participation in all passive-type activities > 500 hrs Material participation in 5 of last 10 years ©2007 Prentice Hall, Inc.

Taxpayers Subject to Passive Loss Rules Applies to individuals, estates, trusts, closely-held C Corporations, PSCs, and certain publicly traded partnerships Applies to owners of partnerships and S Corporations ©2007 Prentice Hall, Inc.

Publicly Traded Partnerships Any partnership if partnership interests traded on primary or secondary markets If corporate tax provisions apply to PTP, passive rules do not apply If partnership tax provisions apply to PTP, passive loss rules apply at partner level ©2007 Prentice Hall, Inc.

Rental Real Estate Trade or Business Passive activity rules do not apply to real estate professionals who materially participate in real estate trade or business activities if > 50% of personal services performed in real property trades or businesses AND Taxpayer performs > 750 hrs in real property trades or businesses ©2007 Prentice Hall, Inc.

Other Rental Real Estate Activities Taxpayers actively participating in rental real estate activities with AGIs not in excess of $100K May deduct $25K of such rental real estate losses against portfolio and active income See Topic Review I8-2 ©2007 Prentice Hall, Inc.

Casualty and Theft Losses (1 of 2) Casualty defined Theft defined Deductible amount of casualty loss Limitations on personal-use property Netting casualty gains and losses on personal-use property ©2007 Prentice Hall, Inc.

Casualty and Theft Losses (2 of 2) Casualty gains and losses attributable to business and investment property When losses are deductible ©2007 Prentice Hall, Inc.

Casualty Defined A casualty loss results from an identifiable event that was sudden, unexpected, or unusual Qualifying casualties include fire, flood, hurricane, tornado, and hail ©2007 Prentice Hall, Inc.

Theft Defined Generally, criminal intent and violation of state law required to meet definition of theft Includes larceny, embezzlement, robbery, blackmail, extortion, and ransom ©2007 Prentice Hall, Inc.

Deductible Amount of Casualty Loss Generally decline in FMV due to casualty For partial destruction loss is lesser of decline in FMV or adjusted basis Total destruction of business or investment property amount of loss is adjusted basis ©2007 Prentice Hall, Inc.

Limitations on Personal-Use Property Two limitations Losses sustained in each separate casualty reduced by $100, AND Total amount of all net casualty losses reduced by 10 % of taxpayer’s AGI ©2007 Prentice Hall, Inc.

Netting Casualty Gains and Losses on Personal Use Property Losses reduced by insurance reimbursement Casualty losses must be netted against casualty gains prior to applying 10% of AGI limitation Net casualty subject to 10% limitation ©2007 Prentice Hall, Inc.

Casualty Gains & Losses Attributable to Business and Investment Property Net casualty loss on business property or investment property used to generate rents or royalties is a for AGI deduction Losses on other investment property are miscellaneous itemized deductions NOT subject to 2% of AGI floor ©2007 Prentice Hall, Inc.

When Losses Are Deductible Generally deduct losses in year in which taxpayer sustains loss Theft loss deductible when discovered If insurance reimbursement expected, loss deductible in year reimb. received Disaster losses may be deducted in year prior to year sustained ©2007 Prentice Hall, Inc.

Bad Debts (1 of 2) Bona fide debtor-creditor relationship Taxpayer S basis in the debt Debt must be worthless Nonbusiness bad debts Business bad debts ©2007 Prentice Hall, Inc.

Bad Debts (2 of 2) Recovery of bad debts Income in year of recovery to extent benefit received from loss Deposits in insolvent financial institutions ©2007 Prentice Hall, Inc.

Bona Fide Debtor-Creditor Relationship (1 of 2) Related parties Facts and circumstances test Existence of written obligation to repay Establishment of repayment schedule Reasonableness of interest rate Likelihood that unrelated party would have made loan ©2007 Prentice Hall, Inc.

Bona Fide Debtor-Creditor Relationship (2 of 2) Third party debt Guarantor becomes creditor if she must satisfy debt for third party ©2007 Prentice Hall, Inc.

Taxpayer’s Basis in the Debt Creditor must have basis in debt Generally, basis is amount loaned May be income recognized for performing services to debtor ©2007 Prentice Hall, Inc.

Debt Must Be Worthless Must prove worthlessness to deduct bad debt Legal action not required ©2007 Prentice Hall, Inc.

Nonbusiness Bad Debts Definition Tax treatment Any debt other than A debt created or acquired in connection to, or results from a trade or business Tax treatment Short-term capital loss in year debt becomes totally worthless No loss for partial worthlessness ©2007 Prentice Hall, Inc.

Business Bad Debts Provides ordinary loss deduction Generally must use specific write-off method ©2007 Prentice Hall, Inc.

Net Operating Losses Computing the net operating loss for individuals Carryback and carryover periods Recomputation of taxable income in the carryover year ©2007 Prentice Hall, Inc.

Computing the Net Operating Loss for Individuals Taxable loss + NOL deductions + Capital loss deduction See p. I8-30 for specific rules + Personal exemptions + Excess of nonbusiness deductions over nonbusiness income = Personal Net Operating Loss ©2007 Prentice Hall, Inc.

Carryback And Carryover Periods Carryback 2 years Begin with oldest year first Then carryforward 20 years In chronological order May elect to forgo carryback period Losses from multiple years Use up earliest loss first ©2007 Prentice Hall, Inc.

Recomputation Of Taxable Income In The Carryover Year NOL is a for AGI deduction because it is attributable to taxpayer’s trade or business NOL carried to other years determined in same manner as original NOL computation ©2007 Prentice Hall, Inc.

Tax Planning Considerations (1 of 2) Taxpayers should document their determination that a particular debt is worthless Documentation of fair market value is important to support a casualty loss ©2007 Prentice Hall, Inc.

Tax Planning Considerations (2 of 2) Taxpayer should consider forgoing NOL carryback to only carry forward if higher marginal rate is expected in future or carryback would jeopardize tax credits ©2007 Prentice Hall, Inc.

Compliance and Procedural Considerations Casualty losses If reporting loss in previous year file amended return if return already filed on Form 1040X Net Operating Losses File 1040X or Form 1045 for quick refund Worthless Securities Report on Part I of Schedule D ©2007 Prentice Hall, Inc.

©2007 Prentice Hall, Inc.