1. 8-1 ©2008 Prentice Hall, Inc.

2. 8-2 ©2008 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

3. 8-3 ©2008 Prentice Hall, Inc. LOSSES AND BAD DEBTS (2 of 2)  Net operating losses  Tax planning considerations  Compliance and procedural considerations

4. 8-4 ©2008 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  If not a casualty or theft  Treated as sale or exchange

5. 8-5 ©2008 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

6. 8-6 ©2008 Prentice Hall, Inc. Classifying the Losses on the Taxpayer’s Tax Return  Ordinary vs. capital loss  §1244 stock  Disallowance possibilities

7. 8-7 ©2008 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

8. 8-8 ©2008 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

9. 8-9 ©2008 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

10. 8-10 ©2008 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

11. 8-11 ©2008 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

12. 8-12 ©2008 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

13. 8-13 ©2008 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

14. 8-14 ©2008 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

15. 8-15 ©2008 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

16. 8-16 ©2008 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

17. 8-17 ©2008 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

18. 8-18 ©2008 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

19. 8-19 ©2008 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

20. 8-20 ©2008 Prentice Hall, Inc. Casualty and Theft Losses (2 of 2)  Casualty gains and losses attributable to business and investment property  When losses are deductible

21. 8-21 ©2008 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

22. 8-22 ©2008 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

23. 8-23 ©2008 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

24. 8-24 ©2008 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

25. 8-25 ©2008 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

26. 8-26 ©2008 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

27. 8-27 ©2008 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

28. 8-28 ©2008 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

29. 8-29 ©2008 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

30. 8-30 ©2008 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

31. 8-31 ©2008 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

32. 8-32 ©2008 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

33. 8-33 ©2008 Prentice Hall, Inc. Debt Must Be Worthless  Must prove worthlessness to deduct bad debt  Legal action not required

34. 8-34 ©2008 Prentice Hall, Inc. 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

35. 8-35 ©2008 Prentice Hall, Inc. Business Bad Debts  Provides ordinary loss deduction  Generally must use specific write-off method

36. 8-36 ©2008 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

37. 8-37 ©2008 Prentice Hall, Inc. Computing the Net Operating Loss for Individuals Taxable loss + NOL deductions + Capital loss deduction See example I8-40 for specific rules + Personal exemptions + Excess of nonbusiness deductions over nonbusiness income = Personal Net Operating Loss

38. 8-38 ©2008 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

39. 8-39 ©2008 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

40. 8-40 ©2008 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

41. 8-41 ©2008 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

42. 8-42 ©2008 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

43. 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 8-43 ©2008 Prentice Hall, Inc.