1. Chapter 7. Losses-Deductions and Limits-2013 T13F-Chp-07-1-Losses-Deductions and Limits-2013

2. Part 1. Introduction Part 2. Annual Losses. Trade or Business,
Part 1. Introduction Part 2. Annual Losses Trade or Business, Rental Activities Part 3. Losses, Loss Carryovers NOL, Tax Shelters (Passive Losses) Part 4. Trade or Business Losses Operating losses, Business casualty or theft losses Part 5. Investment related losses Capital losses (individuals and corp), Small business stock, Related party losses, Wash sales Part 6. Losses on Personal use items (Casualties)

4. Definition of Losses
Annual (Activity) Losses result when an entity’s deductions for the period exceed its income
Transaction Losses result from disposition of an asset

5. General Scheme for Treatment of Losses
Figure 7-1
Realized loss
Annual loss
Transaction loss
Trade or
business
loss
Trade or
business
loss
Investment-
related
loss
Personal
use
loss
Passive
Activity
Capital
loss
limitations
Loss allowed
or loss
deduction
suspended
Ordinary
loss
Non-
deductible
NOL
deduction

8. Annual Losses: Net Operating Loss
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 (But consider 2009 law)
Carry-forward unused NOL 20 years
May elect to forego carry-back

10. Annual Losses: Tax Shelter Losses
Tax shelters are 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

12. Study the information given on the building on the preceding page
Study the information given on the building on the preceding page. Assume the owner only pays interest on the mortgage.
What is gain or loss on sale of the building, if it is sold on 1-1-Yr2, for $500,000?
What happens to the taxable loss from Yr 1?
We will also consider what happens if the value of the building declines over the period of ownership.
You can lose from operations and from selling the property for less than basis.

15. Assume Taxpayer owns the building for exactly 4 years and in each year the income statement looks like the one on the preceding slide.
After 4 years (12-31-Yr-4), Taxpayer sells the building for $350,000.
Taxpayer has been paying interest only.
What is the gain or loss on the building?
What happens to 4 years of losses?

22. 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, take the amount of cash or other assets contributed and
Add debts for which taxpayer is responsible
Adjust for share of income (loss) from the activity
Reduce by amount of withdrawals

23. Tax Shelter Losses Passive Activity Loss
A passive activity is 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

24. Types of Income and Losses
Active: salary and wages of an employee and income earned from a business in which the owner/recipient materially participates
Portfolio: interest and dividends
Passive: tax shelter income, income passed through to limited partners, and income from other businesses in which owner/recipient does not materially participate

25. Passive Activity Loss 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

26. Passive Activity Loss 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

27. Passive Activity Loss Exception for 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

28. Passive Activity Loss Disposition of Passive Activities
Excess (suspended) losses must be accounted for in the year of disposition
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

29. Disposition of Passive Activities
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

30. General Loss Limitation
If a partner’s share of losses exceeds the partner’s basis
Partner can only deduct losses to the extent of basis
Excess losses are carried forward (indefinitely) to future years until there is sufficient basis against which to deduct the unused losses

31. Material Participation
Current activity level
500 hours or more participation in year
Participation is substantially all the activity by all persons
At least 100 hours and no one else participates more
At least 100 hours in more than one activity and aggregate of activities exceeds 500 hours

32. Material Participation
Prior activity level
Materially participated in 5 of preceding 10 years
Materially participated in 3 prior years in personal service activity

33. Rental Real Estate Relief
Taxpayers can qualify for up to $25,000 deduction for rental real estate losses
Taxpayer must own at least 10% and actively participate in management
Set rents, qualify renters, approve repairs
Deduction phases out for AGIs between $100,000 and $150,000

34. Bud is single & received wages of $140,000 from IBM in 2013
Bud is single & received wages of $140,000 from IBM in Bud is a 50% partner in a partnership engaged in a rental real estate activity w/ $60,000 loss for the partnership. Bud was an active participant in the rental real estate activity. He had no other income.
How much of the partnership rental loss may Bud deduct on his 2013 income tax return? (Sec. 469(i))
a. $0 b. $5,000 c. $15,000 d. $25,000

37. Real Property Business Exception
Taxpayers must spend more than half their time in real property businesses in which they materially participate and time spent equals or exceeds 750 hours

38. A taxpayer has this income (losses) for the current year: Active Income $43, Portfolio Income $29,000 Passive Income $(27,000) What is the taxpayers taxable income (loss) if:

39. T/P is single individual & passive income is not from rental
T/P is single individual & passive income is not from rental? An individual cannot deduct passive losses against active or portfolio income. The individual taxpayer has taxable income of $72,000 ($43, $29,000) and a suspended loss of $27,000.

40. T/P is a single individual and the passive income results from a rental activity for which the taxpayer fails to qualify as a real estate professional? Individual - active participant in a rental real estate activity - is allowed to deduct up to $25,000 of losses from rental activities against active and portfolio income. The taxable income is $47,000 ($43, $29, $25,000).

41. T/P is single and the passive income results from a rental activity for which the taxpayer qualifies as a real estate professional? An individual who qualifies as real estate professional can deduct all losses from the activity against active and portfolio income. The taxable income is $45,000 ($43, $29, $27,000).

42. Laura owns a commercial office building
Laura owns a commercial office building. She spends more than 500 hours a year managing the building. She also spends 1,700 hours working in her own real estate development firm.

43. Laura qualifies as a real estate professional
Laura qualifies as a real estate professional. She spends more than 50% of her personal service time in a real property trade or business, the amount of time spent in the real property trade or business is greater than 750 hours, and she materially participates in the rental activity (i.e., spends greater than 500 hours managing the rental activity). Because she qualifies as a real estate professional, office building is not passive activity.

44. Assume the same facts as in preceding slide, except that Laura hires a full-time manager for the commercial office building. She spends 75 hours meeting with the manager and reviewing the operations.   The office building is a passive activity. Because Laura does not spend more than 500 hours managing the rental property, she does not qualify as a real estate professional.

46. Transaction Losses
Transaction losses result from the disposition of business, investment or personal-use assets.

47. Transaction Losses: 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 lesser of the property’s adjusted basis, or the decline in the property’s value

48. Involuntary Conversions
An involuntary conversion results from
Theft – embezzlement, larceny and robbery (but not simply losing items)
Casualty – requires a sudden, unexpected, and unusual event such as a fire, flood, tornado, hurricane or vandalism
Condemnation – lawful taking of property for its fair market value by a government under the right of eminent domain

49. Casualties and Thefts
Gains and losses sustained on casualties and thefts are not under a taxpayer’s control so they receive special tax treatment
Allowable losses (including personal losses) are immediately deductible
Gains (due to receipt of insurance proceeds) may be deferred if all insurance proceeds are used to repair the damaged property or to acquire qualifying replacement property

50. Casualty and Theft Losses
Partial destruction of Business or Investment Property– Loss limited to the lesser of:
Decline in fair market value (or repair costs to restore property to pre-casualty condition)
The adjusted basis of the property Complete Destruction of Business Property
For business property that is completely destroyed, the loss is always the property’s adjusted basis.
The loss computed above is then reduced by any insurance proceeds received

53. Casualty &Theft Loss Deductions
Thefts are deductible in year of discovery
For casualties in designated disaster areas, taxpayer can elect to deduct loss in preceding year
A net business loss is deducted from ordinary income; an investment loss is an itemized deduction
Individuals have additional limits on losses from personal-use property:
$100 floor per casualty (per event)
10% of AGI threshold
Must itemize to deduct loss

54. Jim's business building was totally destroyed by fire
Jim's business building was totally destroyed by fire. The property had an adjusted basis of $150,000 and a FMV of $130,000 before the fire. Jim received insurance reimbursement of $120,000 for the destruction of the workshop. Jim's AGI was $70,000, before considering this loss. Jim had no casualty gains during the year. What is Jim’s fire loss deduction on his tax return? a. $ 2,900 b. $ 8,500 c. $ 30,000

57. Gains on Involuntary Conversions
If the insurance recovery on a casualty or theft is greater than the loss, the taxpayer has a gain
Condemnations usually result in gain because proceeds received are usually fair market value

58. Gains on Involuntary Conversions
If all proceeds are used to acquire qualified replacement property (or repair the property to its pre-casualty condition) within the required replacement period, the gain is deferred
Gain may have to be recognized if all proceeds are not used to acquire replacement property (or make repairs to the damaged property) within the required time period

60. Transaction Losses: 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 annually
Corporate taxpayers may not deduct any net capital loss
Carry-back for 3 years, then forward for 5

61. Transaction Losses: Investment-Related Losses
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

62. Transaction Losses: Investment-Related Losses
Losses on Related Party Sales are 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

63. Transaction Losses: Investment-Related Losses
Wash Sale losses are 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

64. Section 1244 Stock
Losses on stock are usually capital losses; individuals are limited to a $3,000 deduction against ordinary income annually after netting losses against capital gains
Section 1244 permits an ordinary loss deduction of up to $50,000 ($100,000 if a joint return) annually for losses on qualified stock if an individual is the original investor in a domestic small business corporation
Any excess loss is a capital loss

65. Section 1244 Stock Total capitalization cannot exceed $1 million
For the 5 preceding years
The corporation must be an operating company deriving 50% or more of its annual gross revenues from the sale of goods or services
Income from rents, royalties, dividends, interest, annuities and gain on sales of securities is limited to 50% or less

66. Section 1244 Stock-2 Vanessa bought 2,000 shares of Barbco stock when the company was formed for $107,000. The company had $900,000 of total capital upon formation; thus, it qualified as Section 1244 stock. Vanessa sold the stock three years later for $3,000. If Vanessa is single, how much and what kind of gain or loss does she have?

67. Section 1244 Stock-3 Vanessa has a total loss on the Section 1244 stock of $104,000 ($3,000 – $107,000). She can treat $50,000 of the loss as an ordinary loss, deductible from ordinary income. The remaining $54,000 loss is a long-term capital loss.

68. Section 1244 Stock She can deduct $3,000 this year as a capital loss giving her a total deduction of $53,000 in the current year. The remaining $51,000 of the long-term capital loss can only be carried forward and deducted at a rate of $3,000 per year after offsetting other net capital gains in future years.

69. In April 2013, Pam sold stock with a cost basis of $15,000, to Lisa, her sister, for $12, In September 2013, Lisa sold the same shares of stock to her neighbor, Niki, for $20, What is Pam's loss for 2010? a. $6,000 b. $5,000 c. $1,000 d. $10,000

72. In April 2013, Pam sold stock with a cost basis of $15,000, to Lisa, her sister, for $12, In September 2013, Lisa sold the same shares of stock to her neighbor, Niki, for $20,000. What isLisa's gain for 2010? a. $6,000 b. $5,000 c. $1,000 d. $10,000

74. Wash Sales
Wash sale - identical securities acquired within 30 days before or after the sale date (a 61-day period)
Wash sale losses are disallowed but gains are taxed
Loss is deferred by adding disallowed loss to basis of new shares
If more stock is sold than is purchased within the 61-day period, only a portion of the loss representing the repurchased stock is deferred

76. Wash Sale Moore bought 2,000 shares of VBT stock over the Internet on January 2 of year 4 for $50,000. On December 28 of year 3, his broker sold 3,000 shares of VBT for $85,000 that she had been holding in Moore’s account. This stock had been purchased in year 1 for $100,000. What is Moore’s realized and recognized gain or loss? What is his basis in the stock purchased on January 2?

77. Wash Sale The sale of the stock by the broker yields a $15,000 ($85,000 - $100,000) realized loss, but only $5,000 is recognized. Moore cannot recognize two-thirds of the loss due to his purchase of 2,000 shares in January after the loss on the sale of 3,000 shares in December due to the wash sale rules. The disallowed loss of $10,000 (2/3 x $15,000 total loss) is added to the basis of the 2,000 shares purchased in January for a total basis for those shares of $60,000 ($50,000 + $10,000).

79. Transaction Losses: Personal Use Losses
Losses from the disposition of personal use assets are generally not deductible
Exception exists for personal casualty and theft losses

80. Casualty and Theft Losses
Partial or complete destruction of Personal use Property– Loss limited to the lesser of:
Decline in fair market value (or repair costs to restore property to pre-casualty condition)
The adjusted basis of the property
The loss computed above is then reduced by any insurance proceeds received

81. Transaction Losses: Personal Casualty and Theft Losses
Loss is the lesser of
The property’s adjusted basis, or
The decline in FMV of the property (repair cost)
Loss cannot be more than FMV before event
Loss is reduced by
Insurance proceeds received,
$100 per event (Administrative convenience), and
10% of AGI per year

82. John bought a family auto for $20,000
John bought a family auto for $20,000. After 10 years of family use, the auto is worth $6,000. It is totally destroyed by a storm and it is not insured. John’s AGI is $50,000. What is the loss deduction?

84. Jane's residence was totally destroyed by fire
Jane's residence was totally destroyed by fire. The property had an adjusted basis of $150,000 and a FMV of $130,000 before the fire. Jane received insurance reimbursement of $120,000 for the destruction of her home. Jane's adjusted gross income was $70,000. Jane had no casualty gains during the year. What amount of the fire loss was Jane entitled to claim as an itemized deduction on her tax return? a. $ 2,900 b. $ 8, c. $ 8, d. $10,000

92. The End