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Chapter 7 Losses - Deductions and Limitations ©2006 South-Western Kevin Murphy Mark Higgins Kevin Murphy Mark Higgins.

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Presentation on theme: "Chapter 7 Losses - Deductions and Limitations ©2006 South-Western Kevin Murphy Mark Higgins Kevin Murphy Mark Higgins."— Presentation transcript:

1 Chapter 7 Losses - Deductions and Limitations ©2006 South-Western Kevin Murphy Mark Higgins Kevin Murphy Mark Higgins

2 Transparency 7 -2 © 2006 South-Western Definition of Losses vAnnual (Activity) Losses result when an entity’s deductions for the period exceed its income vTransaction Losses result from the disposition of an asset

3 Transparency 7 -3 © 2006 South-Western Losses may result from the disposition of an asset because of the capital recovery concept. Concept Review

4 Transparency 7 -4 © 2006 South-Western Concept Review Most of the classification rules for deductions also apply to losses, because losses also result when deductions exceed income.

5 Transparency 7 -5 © 2006 South-Western Concept Review The deductibility of losses is a matter of legislative grace and is based on the ability-to-pay concept.

6 Transparency 7 -6 © 2006 South-Western Realized loss Annual lossTransaction loss Trade or business loss Trade or business loss Passive Activity NOL deduction Loss allowed or loss deduction suspended Ordinary loss Capital loss limitations Non- deductible Investment- related loss Personal use loss Figure 7-1 General Scheme for Treatment of Losses

7 Transparency 7 -7 © 2006 South-Western Annual Losses: Net Operating Loss vIncurred in trade or business operations FCaused by business expenses FMay not be caused by investment or personal expenses vTreatment FNo tax in year NOL occurs FCarry-back 5 years VMay elect to carry-back only 2 years FCarry-forward unused NOL 20 years VMay elect to forego carry-back

8 Transparency 7 -8 © 2006 South-Western Annual Losses: Tax Shelter Losses vDominant business purpose is lacking vPrimary motivation is tax reduction vAre often vehicles for tax law abuse Tax shelters are activities designed to minimize the effect of tax on wealth accumulation.

9 Transparency 7 -9 © 2006 South-Western Tax Shelter Losses At-Risk Rules vAt-Risk Rules disallow the deduction of artificial losses FLoss deduction limited to amounts actually “at- risk” FTo determine amounts actually at-risk, take the amount of cash or other assets contributed and VAdd debts for which taxpayer is responsible VAdjust for share of income (loss) from the activity VReduce by amount of withdrawals

10 Transparency 7 -10 © 2006 South-Western Tax Shelter Losses Passive Activity Loss vPassive Activity Loss Rules disallow the deduction of passive activity losses from other forms of income A passive activity is any trade or business in which the taxpayer does not materially participate.

11 Transparency 7 -11 © 2006 South-Western Passive Activity Loss Definition Three classifications for activities: vPortfolio income: unearned income derived from holding investments vActive income: earned income vPassive income: earned or unearned income from a trade or business in which a taxpayer does not materially participate

12 Transparency 7 -12 © 2006 South-Western Passive Activity Loss vTaxpayers subject to the limitations: FAll non-corporate taxable entities FConduit entity passive losses flow-through to owners vTaxpayers not subject to the limitations: FPublicly held corporations VPAL can offset active and portfolio income FClosely held corporations VPAL can offset active income, but not portfolio

13 Transparency 7 -13 © 2006 South-Western Passive Activity Loss General Rules for Limitations vPassive activity losses must be netted against passive activity income FNet passive losses are not deductible FNet passive gains are reported with other income

14 Transparency 7 -14 © 2006 South-Western Passive Activity Loss Exception for Rental Real Estate vBy definition, all rental activities and limited partnership interests are passive vBut, taxpayers who materially participate in rental real estate business are allowed to offset any losses against other active or portfolio income

15 Transparency 7 -15 © 2006 South-Western Passive Activity Loss Exception for Rental Real Estate vAnd, taxpayers who are active participants in rental real estate business may offset a portion of losses FMust own at least 10% interest in the activity FMust have significant and bona fide involvement

16 Transparency 7 -16 © 2006 South-Western Active Participants in Real Estate vActive Participation Exception permits up to $25,000 of rental real estate loss to be deducted annually FDeduction amount is reduced by $0.50 for each dollar of AGI over $100,000. FFor AGI over $150,000, no allowed loss deduction remains.

17 Transparency 7 -17 © 2006 South-Western Passive Activity Loss Disposition of Passive Activities vExcess (suspended) losses must be accounted for in the year of disposition vDisposition by sale frees the suspended loss to offset income of any other activity FFirst, offsets other passive income FSecond, offsets gain from disposal FThird, any remaining PAL offsets ordinary income

18 Transparency 7 -18 © 2006 South-Western Disposition of Passive Activities vDisposition upon death leaves the passive activity in the decedent’s estate FPassive activity with unrealized gain VBeneficiary takes passive activity with stepped- up basis VReleased excess loss is deductible against other income, but VAny unrealized gain on activity decreases amount of suspended loss to release FPassive activity with unrealized loss VNo suspended loss is released

19 Transparency 7 -19 © 2006 South-Western Transaction Losses Transaction losses result from the disposition of business, investment or personal-use assets.

20 Transparency 7 -20 © 2006 South-Western Transaction Losses: Trade or Business Losses vBusiness casualty and theft losses result from damage caused by a sudden, unexpected and/or unusual event FFor property fully destroyed, deduct the adjusted basis less insurance recovery FFor property partially destroyed, deduct the lesser of the property’s adjusted basis, or the decline in the property’s value

21 Transparency 7 -21 © 2006 South-Western Transaction Losses: Investment-Related Losses vNet capital losses result from netting short-term and long-term capital gains and losses FIndividual taxpayers may deduct only $3,000 annually FCorporate taxpayers may not deduct any net capital loss VCarry-back for 3 years, then forward for 5

22 Transparency 7 -22 © 2006 South-Western Transaction Losses: Investment-Related Losses vLosses on Small Business Stock may be deducted up to $50,000 per person ($100,000 per married couple) per year FSmall business = a corporation with capitalization of less than $1 million FStock must have been bought directly from corporation FExcess over $50,000 ($100,000) is netted with other capital gains and losses

23 Transparency 7 -23 © 2006 South-Western Transaction Losses: Investment-Related Losses vLosses on Related Party Sales are disallowed because they generally fail the arm’s length transaction concept FLoss is carried forward with the property VGain from later sale may be offset by deferred loss VLoss cannot be created or increased by using the deferred loss

24 Transparency 7 -24 © 2006 South-Western Transaction Losses: Investment-Related Losses vWash Sale losses are disallowed because the sale violates the substance-over-form doctrine FA wash sale occurs when a security is sold at a loss, and during +/- 30 days of the sale the seller buys substantially identical securities FDisallowed loss amount is added to the basis of the replacement security

25 Transparency 7 -25 © 2006 South-Western Transaction Losses: Personal Use Losses vLosses from the disposition of personal use assets are generally not deductible vException exists for personal casualty and theft losses

26 Transparency 7 -26 © 2006 South-Western Transaction Losses: Personal Casualty and Theft Losses vLoss is the lesser of FThe property’s adjusted basis, or FThe decline in the value of the property (repair cost) vLoss is reduced by FInsurance proceeds received, F$100 per event (Administrative convenience), and F10% of AGI per year

27 Transparency 7 -27 © 2006 South-Western End of Chapter 7

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