Chapter 8 Losses and Bad Debts

Learning Objectives Identify transactions that may result in losses Determine the proper classification for losses Calculate the suspended loss from passive activities Identify what constitutes a passive activity loss

Learning Objectives Determine when a taxpayer has materially participated in a passive activity Identify and calculate the deduction for a casualty or theft loss Compute the deduction for a bad debt Compute a net operating loss deduction

Transactions That May Result In Losses Sale or exchange of property Expropriation, seizure, or confiscation of property Abandonment of property Worthless securities Demolition of property

Classifying The Loss On A Taxpayer’s Return Ordinary vs. Capital loss Disallowance possibilities

Ordinary Vs. Capital Loss Dependent on type of property involved and type of transaction involved Losses on qualifying Sec stock are treated as ordinary rather than capital loss($50,000 limitation or $100,000 if filing MFJ)

Qualification as Sec Stock Must be issued and owned by an individual or partnership Corporation must be domestic Stock must be issued for cash or property, not services

Qualification as Sec Stock Corporation must not have derived > 50% of gross receipts from passive income sources during the immediately preceding 5 tax years, and At the time stock is issued, the amount of money and property contributed to both capital and paid- in surplus may not exceed $1 million

Disallowance Possibilities Transfers of property to a controlled corporation in exchange for stock Property sold to certain related parties Wash sales Losses limited because the losses exceed the amount for which the taxpayer is at risk.

Passive Losses Computation of passive losses and credits Carryovers Definition of passive activity

Passive Losses Taxpayers subject to passive loss rules Publicly traded partnerships Rental real estate trade or business Other rental real estate activities

Passive Activity Includes any rental activity and any trade, business, or investment activity in which the taxpayer does not materially participate Investments in limited partnerships generate passive losses due to the legal restrictions on limited partners’ involvement in the management of the partnership

Applies to individuals, estates, trusts, closely-held C Corporations, Personal Service Corporations, and certain publicly traded partnerships While not applied to partnerships and S Corporations directly, applies to owners Taxpayers Subject To Passive Loss Rules

Passive Losses Types of income – Active: wages, salaries, business – Portfolio: dividends, interest, annuities, royalties – Passive: rental, trade, business or investment General rule: passive losses can only be used to offset passive income

Passive Losses: Exceptions Real estate professionals who materially participate in real estate trade or business activities Taxpayers actively participating in rental real estate activities with AGIs not in excess of $100,000 may deduct $25,000 of such rental real estate losses against portfolio and active income

Casualty & Theft Losses What is a casualty What is a theft Deductible amount of casualty loss

Casualty A casualty loss results from an identifiable event that was sudden, unexpected, or unusual Qualifying casualties include fire, flood, hurricane, tornado, hail, and cyclone

Theft Generally, criminal intent and violation of a state law are required to meet the definition of theft Includes larceny, embezzlement, robbery, blackmail, extortion, and ransom

Casualty & Theft Losses Limitations on personal use property – Subject to two limitations: the losses sustained in each separate casualty are reduced by $100, and the total amount of all net casualty losses is reduced by 10 % of the taxpayer’s AGI – Netting casualty gains and losses on personal use property

Casualty & Theft Losses Casualty gains and losses attributable to business and investment property When losses are deductible

Bad Debts Bona fide debtor- creditor relationship Taxpayer must have basis in the debt Debt must be worthless Non-business bad debts

Bad Debts Business bad debts Accounting for the business bad debts Recovery of bad debts Deposits in insolvent financial institutions

Net Operating Loss Involves business income and deductions only and will increase an NOL(Net Operating Loss) Computing the NOL Carryback and carryover periods Recomputation of taxable income in the carryover year

Tax Planning Considerations Taxpayers should document their determination that a particular debt is worthless Documentation of fair market value is important to support a casualty loss Taxpayer should consider forgoing NOL carryback to only carry forward if a higher marginal rate is expected in the future or a carryback would jeopardize tax credits

Compliance and Procedural Considerations Net Operating Loss Worthless Securities