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

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

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

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

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

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

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 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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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