Losses and Loss Limitations

Losses and Loss Limitations
Chapter 6 Losses and Loss Limitations

The Big Picture (slide 1 of 3)
Robyn is nearing the end of a year that she would like to forget. Several years ago she loaned a friend $25,000 to enable him to start a business. The friend had made scheduled payments of $7,000 ($1,000 of this was interest) when he unexpectedly died in January. At the time of his death, he was insolvent. Robyn’s attempts to collect on the debt were fruitless. Last year Robyn invested $60,000 in the stock of a company started by her brother. The company declared bankruptcy in May of this year. Robyn is notified by the bankruptcy trustee that she can expect to receive nothing from the company. 2

Robyn has owned and operated a bookstore as a sole proprietorship for the past 10 years. The bookstore previously has produced annual profits of about $75,000. Due to a chain bookstore opening down the street, Robyn’s bookstore sustained a net loss of $180,000 this year. In September, a tornado caused a large oak tree to blow over onto Robyn’s house. The cost of removing the tree and making repairs was $32,000. Robyn received a check for $25,000 from her insurance company in final settlement of the claim. Her adjusted basis for the house was $280,000. 3

Robyn invested $20,000 for a 10% interest in a limited partnership that owns and operates orange groves in Florida. Due to a hard freeze that damaged much of the fruit, the partnership lost $200,000 and allocated $20,000 of ordinary loss to Robyn. Robyn comes to you for tax advice and would like to know the tax ramifications of each of the transactions listed above. Read the chapter and formulate your response. 4

Bad Debts If an account receivable arising from credit sale of goods or services becomes worthless A bad debt deduction is permitted only if income arising from creation of the receivable was previously included in income No deduction is allowed if taxpayer is on the cash basis since no income is reported until the cash has been collected 5

Business Bad Debts (slide 1 of 4)
Specific charge-off method must be used Exception: Reserve method is allowed for some financial institutions Deduct as ordinary loss in the year when debt is partially or wholly worthless

If a business bad debt previously deducted as partially worthless becomes totally worthless in a future year Only the remainder not previously deducted can be deducted in the future year

In the case of total worthlessness, deduction is allowed for entire amount in the year the debt becomes worthless Deductible amount depends on basis in bad debt If debt arose from sale of services or products and the face amount was previously included in income That amount is deductible If the taxpayer purchased the debt Deduction is equal to amount paid for debt instrument

If a receivable has been written off The collection of the receivable in a later tax year may result in income being recognized Income will result if the deduction yielded a tax benefit in the year it was taken

Nonbusiness Bad Debts (slide 1 of 2)
Debt unrelated to the taxpayer’s trade or business Deduct as short-term capital loss in year amount of worthlessness is known with certainty No deduction is allowed for partial worthlessness of a nonbusiness bad debt

Nonbusiness Bad Debts (slide 2 of 2)
Related party (individuals) bad debts are generally suspect and may be treated as gifts Regulations state that a bona fide debt arises from a debtor-creditor relationship based on a valid and enforceable obligation to pay a fixed or determinable sum of money Thus, individual circumstances must be examined to determine whether advances between related parties are gifts or loans

Classification of Bad Debts
Individuals will generally have nonbusiness bad debts unless: In the business of loaning money, or Bad debt is associated with the individual’s trade or business Determination is made either at the time the debt was created or when it became worthless

The Big Picture - Example 4 Nonbusiness Bad Debts
Return to the facts of The Big Picture on p. 6-2. Robyn loaned her friend, Jamil, $25,000. Jamil used the money to start a business, which subsequently failed. When Jamil died after having made principal payments of $6,000 on the loan, he was insolvent. Even though the proceeds of the loan were used in a business, the loan is a nonbusiness bad debt The business was Jamil’s, not Robyn’s. 13

Worthless Securities (slide 1 of 2)
Loss on worthless securities is deductible in the year they become completely worthless These losses are capital losses deemed to have occurred on the last day of the year in which the securities became worthless Capital losses may be of limited benefit due to the $3,000 capital loss limitation

Worthless Securities (slide 2 of 2)
Example of worthless securities On December 1, 2010, Sally purchased stock for $10,000. The stock became worthless on June 1, Sally’s loss is treated as having occurred on December 31, The result is a long-term capital loss.

The Big Picture - Example 7 Worthless Securities (slide 1 of 2)
Return to the facts of The Big Picture on p. 6-2. Robyn, a calendar year taxpayer, owned stock in Owl Corporation. She acquired the stock on October 1, 2010 Cost was $60,000. On May 31, 2011, the stock became worthless as the company declared bankruptcy. The stock is deemed to have become worthless as of December 31, 2011 Robyn has a long-term capital loss 16

The Big Picture - Example 7 Worthless Securities (slide 2 of 2)
Alternatively, if the stock is § 1244 small business stock (see below). She has a $50,000 ordinary loss and a $10,000 long-term capital loss. 17

Bad Debt Deductions Summary

Section 1244 Stock (slide 1 of 3)
Sale or worthlessness of § 1244 stock results in ordinary loss rather than capital loss for individuals Ordinary loss treatment (per year) is limited to $50,000 ($100,000 for MFJ taxpayers) Loss in excess of per year limit is treated as capital loss

Section 1244 loss treatment is limited to stock owned by original purchaser who acquired the stock from the corporation Corporation must meet certain requirements for stock to qualify Major requirement is limit of $1 million of capital contributions Section 1244 does not apply to gains

Example of § 1244 loss In 2008, Sam purchases from XYZ Corp. stock costing $150,000. (Total XYZ stock outstanding is $800,000.) In 2011, Sam sells the stock for $65,000. Sam, a single taxpayer, has the following tax consequences: $50,000 ordinary loss $35,000 long-term capital loss

Definition of Casualty & Theft (C & T)
Losses or damages to the taxpayer’s property that arise from fire, storm, shipwreck, or other casualty or theft Loss is from event that is identifiable, damaging to taxpayer’s property, and sudden, unexpected, and unusual in nature Events not treated as casualties include losses from disease and insect damage

Definition of Theft Theft includes robbery, burglary, embezzlement, etc. Does not include misplaced items

When Casualty & Theft Is Deductible
Casualties: year in which loss is sustained Exception: If declared “disaster area” by President, can elect to deduct loss in year prior to year of occurrence Thefts: year in which loss is discovered

The Big Picture - Example 13 Disaster Area Losses
Return to the facts of The Big Picture on p. 6-2. On September 28, 2011, Robyn’s personal residence was damaged when a tornado caused an oak tree to fall onto the house. The amount of her uninsured loss was $7,000. Because of the extent of the damage in the area, the President of the United States designated the area a disaster area. Because Robyn’s loss is a disaster area loss, Robyn has 2 options. She may elect to file an amended return for 2010 and take the loss in that year. The amount of the loss will be reduced first by $100 and then by 10% of her 2010 AGI. Alternatively, she may take the loss on her 2011 income tax return. The amount of the loss will be reduced first by $100 and then by 10% of her 2011 AGI. 25

Effect of Claim for Reimbursement
If reasonable prospect of full recovery: No casualty loss is permitted Deduct in year of settlement any amount not reimbursed If only partial recovery is expected, deduct in year of loss any amount not covered Remainder is deducted in year claim is settled

Amount of C&T Deduction
Amount of loss and its deductibility depends on whether: Loss is from nonpersonal (business or production of income) or personal property Loss is partial or complete

Amount of Nonpersonal C&T Losses
Theft or complete casualty (FMV after = 0) Adjusted basis in property less insurance proceeds Partial casualty Lesser of decline in value or adjusted basis in property, less insurance proceeds

C&T Examples Business and production of income losses (no insurance proceeds received) Adjusted FMV FMV Item Basis Before After Loss A , , , ,000 B , , , ,000 C , , ,000

Nonpersonal C&T Losses
Losses on business, rental, and royalty properties Deduction will be for AGI Not subject to the $100 per event and the 10% of AGI limitation Losses not connected with business, rental, and royalty properties Deduction will be from AGI Example - theft of a security Theft losses of investment property are not subject to the 2% of AGI floor on certain miscellaneous itemized deductions

Nonpersonal C&T Gains Depending on the property, gain can be ordinary or capital Amount of nonpersonal gains Insurance proceeds less adjusted basis in property

Personal C&T Gains and Losses (slide 1 of 4)
Casualty and theft losses attributable to personal use property are subject to the $100 per event and the 10% of AGI limitations These losses are itemized deductions, but they are not subject to the 2% of AGI floor Amount of personal C&T losses Lesser of decline in value or adjusted basis in property, less insurance proceeds Insurance proceeds may result in gain recognition on certain casualty and thefts

If a taxpayer has both personal casualty and theft gains as well as losses, a special set of rules applies A personal casualty gain is the recognized gain from a casualty or theft of personal use property A personal casualty loss for this purpose is a casualty or theft loss of personal use property after the application of the $100 floor Taxpayer must first net (offset) the personal casualty gains and personal casualty losses Tax treatment depends on the results of this netting process

If netting personal casualty gains and losses results in a net gain Treat as gains and losses from the sale of capital assets Short term or long term, depending on holding period Personal casualty and theft gains and losses are not netted with the gains and losses on business and income-producing property

If netting personal casualty gains and losses results in a net loss All gains and losses are treated as ordinary items The gains—and the losses to the extent of gains—are treated as ordinary income and ordinary loss in computing AGI Losses in excess of gains are deducted as itemized deductions to the extent the losses exceed 10% of AGI

Example of C&T Limitation (slide 1 of 2)
Karen (AGI = $40,000) has the following C&T in 2011 (amounts are lesser of decline in value or adjusted basis): 1. Car stolen ($6,000) with camera inside ($500) Earthquake damage: house ($2,000), furniture ($1,000)

Example of C&T Limitation (slide 2 of 2)
Example of C&T limitation (cont’d) Karen has no insurance coverage for either loss: 1. $6,000 + $500 = $6,500 – $100 = $6,400 2. $2,000 + $1,000 = $3,000 – $100 = $2,900 Karen’s deductible C&T loss is $5,300 [$6,400 + $2,900 – (10% $40,000)]

Net Operating Losses (slide 1 of 4)
NOLs from any one year can be offset against taxable income of other years The NOL provision is intended as a form of relief for business income and losses Only losses from trade or business operations, casualty and theft losses, or losses from foreign government confiscations can create a NOL

No nonbusiness (personal) losses or deductions may be used in computing NOL Exception: personal casualty and theft losses

Carryover period Must carryback to 2 prior years, then carryforward to 20 future years May make an irrevocable election to just carryforward When there are NOLs from two or more years, use on a FIFO basis 3 year carryback is available for: Individuals with NOL from casualty or thefts Small businesses with NOLs from Presidentially declared disasters 5-year carryback period and a 20-year carryover period are allowed for a farming loss

Example of NOL carryovers Ken has a NOL for 2011 Ken must carryover his NOL in the following order: Carryback to 2009 and 2010, then carryforward to 2012, 2012, ..., 2031 Ken can elect to just carryforward his NOL Carryover would be to 2012, 2013, ..., 2031

Passive Loss Rules (slide 1 of 2)
Require income and losses to be separated into three categories: Active Portfolio Passive Generally, disallow the deduction of passive losses against active or portfolio income 42

Passive Loss Rules (slide 2 of 2)
In general, passive losses can only offset passive income Passive losses are also subject to the at-risk rules Designed to prevent taxpayers from deducting losses in excess of their economic investment in an activity 43

At-Risk Limits (slide 1 of 4)
At-risk defined The amount of a taxpayer’s economic investment in an activity Amount of cash and adjusted basis of property contributed to the activity plus amounts borrowed for which taxpayer is personally liable (recourse debt) 44

At-risk defined At-risk amount does not include nonrecourse debt unless the activity involves real estate For real estate activities, qualified nonrecourse debt is included in determining at-risk limitation 45

At-risk limitation Can deduct losses from activity only to extent taxpayer is at-risk Any losses disallowed due to at-risk limitation are carried forward until at-risk amount is increased Previously allowed losses must be recaptured to the extent the at-risk amount is reduced below zero At-risk limitations must be computed for each activity of the taxpayer separately 46

Interaction of at-risk rules with passive loss rules At-risk limitation is applied FIRST to each activity to determine maximum amount of loss allowed for year THEN, passive loss limitation applied to ALL losses from ALL passive activities to determine actual amount of loss deductible for year 47

Calculation of At-Risk Amount
Increases to a taxpayer’s at-risk amount: Cash and the adjusted basis of property contributed to the activity Amounts borrowed for use in the activity for which the taxpayer is personally liable or has pledged as security property not used in the activity Taxpayer’s share of amounts borrowed for use in the activity that are qualified nonrecourse financing Taxpayer’s share of the activity’s income Decreases to a taxpayer’s at-risk amount: Withdrawals from the activity Taxpayer’s share of the activity’s loss Taxpayer’s share of any reductions of debt for which recourse against the taxpayer exists or reductions of qualified nonrecourse debt 48

Passive Loss Limits (slide 1 of 8)
Active income Wages, salary, and other payments for services rendered Profit from trade or business activity in which taxpayer materially participates Gain from sale or disposition of assets used in an active trade or business Income from intangible property created by taxpayer 49

Portfolio income Interest, dividends, annuities, and certain royalties not derived in the ordinary course of business Gains/losses from disposition of assets that produce portfolio income or held for investment 50

Passive losses defined Losses from trade or business activities in which taxpayer does not materially participate, and Certain rental activities 51

Limitations on passive losses Generally, passive losses can only offset passive income, i.e., they cannot reduce active or portfolio income Disallowed losses are suspended and carried forward Suspended losses must be allocated to specific activities 52

Suspended losses are deductible in year related activity is disposed of in a fully taxable transaction 53

Example - Roy sells an apartment building, a passive activity, with an adjusted basis of $200,000 for $360,000. In addition, he has suspended losses of $120,000 associated with the building. His total gain, and his taxable gain, are calculated as follows: Net sales price $ 360,000 Less: Adjusted basis (200,000) Total gain $ 160,000 Less: Suspended losses (120,000) Taxable gain (passive) $ 40,000 54

Passive credits Credits from passive activities are subject to loss limitation Utilize passive credits to the extent of tax attributable to passive income Credits disallowed are suspended and carried forward similar to losses Suspended credits can be used to offset tax from disposition of activity but any credits left after activity is disposed of are lost forever 55

Taxpayers subject to rules Individuals, estates, trusts, personal service corporations Closely-held corporations Can deduct passive losses against active income S Corp and partnership passive losses flow through to owners and limits applied at the owner level 56

Passive Loss Issues Passive losses are losses from trade or business activities in which taxpayer does not materially participate and certain rental activities What constitutes an activity? What is “material participation"? When is an activity a rental activity? 57

Identification of Activities (slide 1 of 2)
Taxpayers with complex business operations must determine if segments of their business are separate activities or entire business is treated as a single activity 58

Identification of Activities (slide 2 of 2)
Regs allow grouping multiple trade or businesses if they form an appropriate economic unit for measuring gain or loss Once activities are grouped, can’t regroup unless: Original groups were clearly inappropriate, or Material change in circumstances 59

Material Participation Tests (slide 1 of 8)
An activity is treated as active rather than passive (thus, not subject to the passive loss limits) if taxpayer meets one of 7 material participation tests Participation is generally defined as work performed by an owner 60

Taxpayer participates in the activity more than 500 hours during the year 61

Taxpayer’s participation in the activity is substantially all of the participation in the activity of all individuals for the year 62

Taxpayer participates in the activity more than 100 hours during the year and not less than the participation of any other individual in the activity 63

Taxpayer’s participation in the activity is significant and taxpayer’s aggregate participation in all significant participation activities during the year exceeds 500 hours Significant participation is more than 100 hours 64

Taxpayer materially participated in the activity for any 5 years during the last 10 year period 65

The activity is a personal service activity in which the taxpayer materially participated for any 3 preceding years 66

Based on the facts and circumstances, taxpayer participated in the activity on a regular, continuous, and substantial basis Regular, continuous, and substantial are not specifically defined in the Regulations 67

Participation Defined
Participation generally includes any work done by an individual in an activity that he or she owns Does not include work if of a type not customarily done by owners and if one of its principal purposes is to avoid the disallowance of passive losses or credits Work done in an individual’s capacity as an investor is not counted in applying the material participation tests Participation by an owner’s spouse counts as participation by the owner 68

Rental Activities Rental of tangible (real or personal) property is automatically passive activity unless it meets one of the 6 exceptions (Regs) If exception applies, activity is subject to the material participation tests 69

Interaction of At-Risk and Passive Loss Limits
Passive loss rules are applied after the at-risk rules Losses not allowed under the at-risk rules are suspended under the at-risk rules, not the passive loss rules Basis is reduced by deductions even if not currently usable due to passive loss rules 70

Real Estate Passive Loss Limits (slide 1 of 4)
Generally, losses from rental real estate are treated like other passive losses There are two significant exceptions to the general rule 71

Exception 1: Real estate professionals Rental real estate losses are not treated as passive if the following requirements are met: Taxpayer performs more than half of his/her personal services in real property businesses in which the taxpayer materially participates, and Taxpayer performs more than 750 hours of services in these real property businesses as a material participant 72

Exception 2: Real estate rental activities Taxpayer can deduct up to $25,000 of losses on real estate rental activities against active or portfolio income Benefit is reduced by 50% of taxpayer’s AGI in excess of $100,000 73

Exception 2: Real estate rental activities To qualify for this exception the taxpayer must: Actively participate in rental activity, and Own at least 10% of all interests in activity Active participation defined: Requires only participation in making management decisions in a significant and bona fide sense 74

Suspended Losses Losses can be suspended due to the passive loss limits or the at-risk limits Losses suspended due to at-risk limitations are investment specific, thus no allocation of suspended losses is necessary Suspended at-risk and passive losses can be carried forward indefinitely 75

Disposition of Passive Interests
Disposition at death: suspended loss deductible on decedent’s final tax return to extent of excess over any step-up in basis Disposition by gift: suspended loss increases donee’s basis in property 76

Refocus On The Big Picture (slide 1 of 3)
Robyn can receive tax benefits associated with her unfortunate occurrences during the current tax year. Bad Debt It appears that Robyn’s loan to her friend was a bona fide debt. The amount of the deduction is the unpaid principal balance of $19,000 ($25,000 - $6,000). Since the bad debt is a nonbusiness bad debt, it is classified as a short-term capital loss. Loss from stock investment If Robyn purchased the stock directly from the company, the stock may qualify as small business stock under § 1244. If this is the case, the first $50,000 of the loss is an ordinary loss, and the remaining $10,000 loss is treated as a long-term capital loss. If the stock is not § 1244 stock, the entire $60,000 loss is treated as a long-term capital loss 77

Loss from Bookstore The $180,000 loss from the bookstore is reported on Schedule C of Form 1040. It is an ordinary loss, and it qualifies for NOL treatment. Robyn can carry the $180,000 net loss back and offset it against the net income of the bookstore for the past two years. Any amount not offset can be carried forward for the next 20 years. The carryback will produce a claim for a tax refund. Casualty Loss The loss on the damage to Robyn’s personal residence is a personal casualty loss. Using the cost of repairs method, the amount of the casualty loss is $7,000 ($32,000 - $25,000). This amount must be reduced by $100 and 10% of AGI. 78

Passive activity loss. The $20,000 loss on the limited partnership is not deductible currently due to the passive loss limitation. However, the loss can be carried forward and utilized in the future to offset any passive income generated from the venture. What If? What if instead of operating orange groves the partnership owns and rents apartments to college students and Robyn actively participates in the venture? In this case, Robyn may qualify for a $20,000 ordinary loss deduction under the rental real estate exception. 79

Dr. Donald R. Trippeer, CPA
If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact: Dr. Donald R. Trippeer, CPA SUNY Oneonta

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