1. Losses - Deductions and Limitations
Chapter 7
Losses - Deductions and Limitations
Kevin Murphy
Mark Higgins
©2007 South-Western

2. Definition of Losses
Annual (Activity) Losses result when an entity’s deductions for the period exceed its income
Transaction Losses result from the disposition of an asset

3. the disposition of an asset because of the capital recovery concept.
Concept Review
Losses may result from
the disposition of an asset because
of the capital recovery concept.

4. Concept Review
Most of the classification rules for deductions also apply to losses, because losses also result when deductions exceed income.

5. The deductibility of losses is a matter of
Concept Review
The deductibility of losses is a matter of
legislative grace and is based on the
ability-to-pay concept.

6. General Scheme for Treatment of Losses
Figure 7-1
Realized loss
Annual loss
Transaction loss
Trade or
business
loss
Trade or
business
loss
Investment-
related
loss
Personal
use
loss
Passive
Activity
Capital
loss
limitations
Loss allowed
or loss
deduction
suspended
Ordinary
loss
Non-
deductible
NOL
deduction

7. Annual Losses: Net Operating Loss
Incurred in trade or business operations
Caused by business expenses
May not be caused by investment or personal expenses
Treatment
No tax in year NOL occurs
Carry-back 5 years
May elect to carry-back only 2 years
Carry-forward unused NOL 20 years
May elect to forego carry-back

8. Annual Losses: Tax Shelter Losses
Tax shelters are activities designed to minimize the effect of tax on wealth accumulation.
Dominant business purpose is lacking
Primary motivation is tax reduction
Are often vehicles for tax law abuse

9. Tax Shelter Losses At-Risk Rules
At-Risk Rules disallow the deduction of artificial losses
Loss deduction limited to amounts actually “at-risk”
To determine amounts actually at-risk, take the amount of cash or other assets contributed and
Add debts for which taxpayer is responsible
Adjust for share of income (loss) from the activity
Reduce by amount of withdrawals

10. Tax Shelter Losses Passive Activity Loss
A passive activity is any trade or business in which the taxpayer does not materially participate.
Passive Activity Loss Rules disallow the deduction of passive activity losses from other forms of income

11. Passive Activity Loss Definition
Three classifications for activities:
Portfolio income: unearned income derived from holding investments
Active income: earned income
Passive income: earned or unearned income from a trade or business in which a taxpayer does not materially participate

12. Passive Activity Loss Taxpayers subject to the limitations:
All non-corporate taxable entities
Conduit entity passive losses flow-through to owners
Taxpayers not subject to the limitations:
Publicly held corporations
PAL can offset active and portfolio income
Closely held corporations
PAL can offset active income, but not portfolio

13. Passive Activity Loss General Rules for Limitations
Passive activity losses must be netted against passive activity income
Net passive losses are not deductible
Net passive gains are reported with other income

14. Passive Activity Loss Exception for Rental Real Estate
By definition, all rental activities and limited partnership interests are passive
But, taxpayers who materially participate in rental real estate business are allowed to offset any losses against other active or portfolio income

15. Passive Activity Loss Exception for Rental Real Estate
And, taxpayers who are active participants in rental real estate business may offset a portion of losses
Must own at least 10% interest in the activity
Must have significant and bona fide involvement

16. Active Participants in Real Estate
Active Participation Exception permits up to $25,000 of rental real estate loss to be deducted annually
Deduction amount is reduced by $0.50 for each dollar of AGI over $100,000.
For AGI over $150,000, no allowed loss deduction remains.

17. Passive Activity Loss Disposition of Passive Activities
Excess (suspended) losses must be accounted for in the year of disposition
Disposition by sale frees the suspended loss to offset income of any other activity
First, offsets other passive income
Second, offsets gain from disposal
Third, any remaining PAL offsets ordinary income

18. Disposition of Passive Activities
Disposition upon death leaves the passive activity in the decedent’s estate
Passive activity with unrealized gain
Beneficiary takes passive activity with stepped-up basis
Released excess loss is deductible against other income, but
Any unrealized gain on activity decreases amount of suspended loss to release
Passive activity with unrealized loss
No suspended loss is released

19. Transaction Losses
Transaction losses result from the disposition of business, investment or personal-use assets.

20. Transaction Losses: Trade or Business Losses
Business casualty and theft losses result from damage caused by a sudden, unexpected and/or unusual event
For property fully destroyed, deduct the adjusted basis less insurance recovery
For property partially destroyed, deduct the lesser of the property’s adjusted basis, or the decline in the property’s value

21. Transaction Losses: Investment-Related Losses
Net capital losses result from netting short-term and long-term capital gains and losses
Individual taxpayers may deduct only $3,000 annually
Corporate taxpayers may not deduct any net capital loss
Carry-back for 3 years, then forward for 5

22. Transaction Losses: Investment-Related Losses
Losses on Small Business Stock may be deducted up to $50,000 per person ($100,000 per married couple) per year
Small business = a corporation with capitalization of less than $1 million
Stock must have been bought directly from corporation
Excess over $50,000 ($100,000) is netted with other capital gains and losses

23. Transaction Losses: Investment-Related Losses
Losses on Related Party Sales are disallowed because they generally fail the arm’s length transaction concept
Loss is carried forward with the property
Gain from later sale may be offset by deferred loss
Loss cannot be created or increased by using the deferred loss

24. Transaction Losses: Investment-Related Losses
Wash Sale losses are disallowed because the sale violates the substance-over-form doctrine
A wash sale occurs when a security is sold at a loss, and during +/- 30 days of the sale the seller buys substantially identical securities
Disallowed loss amount is added to the basis of the replacement security

25. Transaction Losses: Personal Use Losses
Losses from the disposition of personal use assets are generally not deductible
Exception exists for personal casualty and theft losses

26. Transaction Losses: Personal Casualty and Theft Losses
Loss is the lesser of
The property’s adjusted basis, or
The decline in the value of the property (repair cost)
Loss is reduced by
Insurance proceeds received,
$100 per event (Administrative convenience), and
10% of AGI per year

27. End of Chapter 7