© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Chapter 7 Losses – Deductions and Limitations Murphy & Higgins Concepts in Federal Taxation, 2012 edition

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Concept Review  Losses may result from the disposition of an asset because of the capital recovery concept  Most of the classification rules for deductions also apply to losses, because losses also result when deductions exceed income  The deductibility of losses is a matter of legislative grace and is based on the ability-to-pay concept

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. General Scheme for Treatment of Losses 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

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Annual Losses: Net Operating Losses  Annual loss incurred in a trade or business in which the taxpayer materially participates  It results from an excess of allowable deductions over income for the accounting period  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 2 years Carry-forward unused NOL 20 years  May elect to forego carry-back

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Annual Losses: Tax Shelters  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

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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,  Start with the amount of cash or other assets contributed  Add debts for which taxpayer is responsible  Adjust for share of income (loss) from the activity  Reduce by amount of withdrawals

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Tax Shelter Losses: Passive Activity Loss  Passive activity: 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  Two basic tests for material participation Individual (including the individual’s spouse) participates in the activity for more than 500 hours per year Taxpayer spends more than 100 hours a year in the activity, and the time spent in the activity is more hours than any other owner or non- owner spends on the activity (known as the 100-hour test)  Remaining five tests are : Rental Activities Limited Partnership Interests Working Interest in Oil and Gas Low-Income Housing Projects Real Estate Professional Exception

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Passive Activity Loss: Classifications  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

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Passive Activity Loss: Limitations  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  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

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Passive Activity Loss: Exceptions  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 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  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

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Passive Activity Loss: Disposition of Passive Activities  Loss Activities 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 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 Disposition By Gift  Excess (suspended) losses must be accounted for in the year of disposition

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Transaction Losses: Trade or Business Losses  Transaction losses Result from the disposition of business, investment or personal- use assets Allowance of deductions for losses follows the same line of reasoning as for the allowance of deductions  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

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Transaction Losses: Investment-Related Losses (slide 1 of 2)  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 of net capital loss annually  Corporate taxpayers may not deduct any net capital loss  Carry-back for 3 years, then forward for 5 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

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Transaction Losses: Investment-Related Losses (slide 1 of 2)  Losses on Related Party Sales: 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  Wash Sale losses: 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

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Transaction Losses: Personal Use, Personal Casualty & Theft Losses  Personal use losses Losses from the disposition of personal use assets are generally not deductible Exception exists for personal casualty and theft losses  Personal casualty and theft losses Loss is the lesser of  Property’s adjusted basis, or  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