1. 8-1 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

2. 8-2 LOSSES AND BAD DEBTS (1 of 2)  Transactions that may result in losses  Classifying losses on the taxpayer’s tax return  Passive losses  Casualty and theft losses  Bad debts ©2011 Pearson Education, Inc. Publishing as Prentice Hall

3. 8-3 LOSSES AND BAD DEBTS (2 of 2)  Net operating losses  Tax planning considerations  Compliance and procedural considerations ©2011 Pearson Education, Inc. Publishing as Prentice Hall

4. 8-4 Transactions that May Result in Losses (1 of 3)  Sale of exchange of property  Amount realized includes liability transferred to buyer  Exception if property transferred is an individual’s qualified residence  No gain on transfer AND no discharge of indebtedness income  Selling costs  Deducted in year incurred for inventory  Reduction of amt realized for non-inventory ©2011 Pearson Education, Inc. Publishing as Prentice Hall

5. 8-5 Transactions that May Result in Losses (2 of 3)  Expropriated, seized, or confiscated property  If not a casualty or theft  Treated as sale or exchange  Abandoned property  Ordinary loss if business or investment property  Nondeductible if personal property ©2011 Pearson Education, Inc. Publishing as Prentice Hall

6. 8-6 Transactions that May Result in Losses (3 of 3)  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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

7. 8-7 Classifying the Losses on the Taxpayer’s Tax Return  Ordinary vs. capital loss  §1244 stock  Disallowance possibilities ©2011 Pearson Education, Inc. Publishing as Prentice Hall

8. 8-8 Ordinary vs. Capital Loss  Dependent on type of property involved and type of transaction involved  §1231 property  Net §1231 loss is an ordinary loss  Includes real property or depreciable property used in a trade or business and held for more than one year ©2011 Pearson Education, Inc. Publishing as Prentice Hall

9. 8-9 §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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

10. 8-10 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

11. 8-11 Passive Losses  Computation of passive losses & credits  Carryovers  Definition of a passive activity  Taxpayers subject to passive loss rules  Real estate business  Other rental real estate activities ©2011 Pearson Education, Inc. Publishing as Prentice Hall

12. 8-12 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

13. 8-13 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

14. 8-14 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 legally barred from participating in management of ptrshp ©2011 Pearson Education, Inc. Publishing as Prentice Hall

15. 8-15 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

16. 8-16 Taxpayers Subject to Passive Loss Rules (1 of 2)  Applies to individuals, estates, trusts, closely-held C Corporations, PSCs, and certain publicly traded partnerships  Applies to owners of partnerships and S Corporations  PSCs  Passive loss limits apply in their entirety to a PSC ©2011 Pearson Education, Inc. Publishing as Prentice Hall

17. 8-17 Taxpayers Subject to Passive Loss Rules (2 of 2)  Publicly traded partnerships (PTP)  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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

18. 8-18 Real Estate 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

19. 8-19 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 2 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

20. 8-20 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

21. 8-21 Casualty and Theft Losses (2 of 2)  Casualty gains and losses attributable to business and investment property  Timing of casualty loss deduction ©2011 Pearson Education, Inc. Publishing as Prentice Hall

22. 8-22 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

23. 8-23 Theft Defined  Generally, criminal intent and violation of state law required to meet definition of theft  Includes larceny, embezzlement, robbery, blackmail, extortion, and ransom ©2011 Pearson Education, Inc. Publishing as Prentice Hall

24. 8-24 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

25. 8-25 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

26. 8-26 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

27. 8-27 Casualty Gains & Losses Attributable to Business & 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  If property held <1yr, treat as ordinary ©2011 Pearson Education, Inc. Publishing as Prentice Hall

28. 8-28 Timing of Casualty Loss Deduction  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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

29. 8-29 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

30. 8-30 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

31. 8-31 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

32. 8-32 Bona Fide Debtor-Creditor Relationship (2 of 2)  Third party debt  Guarantor becomes creditor if she must satisfy debt for third party ©2011 Pearson Education, Inc. Publishing as Prentice Hall

33. 8-33 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

34. 8-34 Debt Must Be Worthless  Must prove worthlessness to deduct bad debt  Legal action not required ©2011 Pearson Education, Inc. Publishing as Prentice Hall

35. 8-35 Nonbusiness Bad Debts  Definition  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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

36. 8-36 Business Bad Debts  Provides ordinary loss deduction  Generally must use specific write-off method ©2011 Pearson Education, Inc. Publishing as Prentice Hall

37. 8-37 Net Operating Losses  Computing the net operating loss for individuals  Carryback and carryover periods  Recomputation of taxable income in the carryover year ©2011 Pearson Education, Inc. Publishing as Prentice Hall

38. 8-38 Computing the Net Operating Loss for Individuals Taxable loss + NOL deductions + Capital loss deduction (See Example 40 for specific rules) + Personal exemptions + Excess of nonbusiness deductions over nonbusiness income = Personal Net Operating Loss ©2011 Pearson Education, Inc. Publishing as Prentice Hall

39. 8-39 Carryback and Carryover Periods (1 of 2)  Carryback 2 years  Begin with oldest year first  Taxpayers may elect to carryback NOLs 3, 4, or 5 years if incurred in 2008 or 2009 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

40. 8-40 Carryback and Carryover Periods (2 of 2)  After carryback, NOLs carried forward 20 years  In chronological order  May elect to forgo carryback period  Losses from multiple years  Use up earliest loss first ©2011 Pearson Education, Inc. Publishing as Prentice Hall

41. 8-41 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

42. 8-42 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

43. 8-43 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

44. 8-44 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 ©2011 Pearson Education, Inc. Publishing as Prentice Hall

45. Comments or questions about PowerPoint Slides? Contact Dr. Richard Newmark at University of Northern Colorado’s Kenneth W. Monfort College of Business richard.newmark@PhDuh.com 8-45 ©2011 Pearson Education, Inc. Publishing as Prentice Hall