1 Unit07. Losses and Bad Debts (PAK Chapter 8) As we ve begun to examine various types of deductions, you may have noticed that an underlying motivation of much of our tax code is encouraging risk taking in business endeavors. A large number of various types of expenses associated with operation of a trade or a business or with the acquisition, holding or disposition of investment property are tax deductible. In contrast, relatively few personal expenses are tax deductible and strict limits are placed on those deductions. This favorable tax treatment for business endeavors extends to losses and bad debts as well. It is as if those individuals who wrote tax law wanted to cushion the down side of such endeavors, perhaps to foster continued engagement with the market.
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Outline 3 Realization is a prerequisite for a tax loss. EXAMPLE: If a taxpayer holds stock that had a $25,000 fair market value at the beginning of the tax year and a $15,000 fair market value at the end of the tax, no loss is recognized for tax purposes, even though the value of the stock has decreased by $10,000. Outline 1. Transactions that may result in losses 2. Classifying losses on the taxpayer s tax return 3. Passive losses 4. Casualty and theft losses 5. Bad debts 6. Net operating losses 7. Tax planning considerations 8. Compliance and procedural considerations
4 1. Transactions that May Result in Losses 1) Sale or Exchange of Property In a sale or exchange, the amount of the loss is the excess of the property's adjusted basis over the amount realized. EXAMPLE: If the taxpayer realizes $10,000 from the sale of an asset with an adjusted basis of $18,000, the realized loss is $8,000 ($10,000 - $18,000). Losses incurred on the sale of personal-use property are not deductible. Losses on trade or business property and investment property are deductible. Study PAK Example 8-2
1. Transactions that May Result in Losses 2) Expropriated, seized, or confiscated property 5 Property expropriated, seized, or confiscated by a foreign government gives rise to a deductible loss only if the property is used in a trade or business or is held for investment. Any allowable deduction must be taken in the year of actual seizure. Any gain realized on seizure (compensation for seizure exceeds adjusted basis of property) would be treated under the involuntary conversion rules.
6 1. Transactions that May Result in Losses 3) Abandoned Property Abandoned property used in a trade or business or held for investment gives rise to a deductible loss. The amount of the loss is the adjusted basis of the asset at the date of abandonment. The character of the loss is ordinary, since there is no sale or exchange.
7 1. Transactions that May Result in Losses 4) Worthless Securities Securities determined to be worthless in a tax year are treated as a capital loss on the last day of the tax year. EXAMPLE: If a calendar-year taxpayer owns securities which become worthless on March 15, the tax treatment is to recognize a capital loss on December 31st. Study PAK Example 8-3
8 1. Transactions that May Result in Losses 5) Demolition of Property Demolition costs are to be added to the basis of the underlying property. EXAMPLE: A taxpayer buys real property for $150,000 and spends $30,000 to take down existing buildings in order to construct an apartment house. The basis of the land under the apartment house is $180,000 ($150,000 plus $30,000).
9 2. Classifying the Loss on the Taxpayer s Tax Return 1) Ordinary vs. Capital Loss The classification of a loss as ordinary or capital is dependent on the type of property involved and the type of transaction involved. Losses on qualifying Sec. 1244 stock are treated as ordinary ($50,000 or $100,000 limitation) rather than capital (offset capital gains plus $3,000 of ordinary income). To qualify as Sec. 1244 stock the stock must be issued and owned by an individual or partnership. The corporation must be a domestic corporation. The stock must be issued for cash or property and not for services. The corporation may not have derived over 50% of its gross receipts from passive income sources during the immediately preceding 5 tax years, and at the time the stock is issued, the amount of money and property contributed to both capital and paid-in surplus may not exceed $1 million. Study PAK Example 8-4
10 2. Classifying the Loss on the Taxpayer s Tax Return 2) Disallowance Possibilities Certain realized losses are disallowed in special situations, including related party transactions and wash sales. Other potential disallowance situations include transfers of property in exchange for stock - Sec. 351 (see Chap. I16), like-kind exchanges (see Chap. I12), and partnerships (both under the "atrisk" limitations and the passive loss rules).
11 3. Passive Losses Passive activity includes any rental activity or any trade or business in which the taxpayer does not materially participate. Passive activity loss limits were enacted in 1987 to prevent possible abuses.
12 3. Passive Loss 1) Computation of Passive Losses and Credits Passive losses may only offset passive income, not portfolio income or active income. Portfolio income includes non-business dividends, interest, royalties, annuities, and certain gains and losses on property. Credits generated from passive activities are also limited. These credits may only offset tax liability generated by passive income. Study PAK Example 8-5
13 3. Passive Loss 2) Carryovers Unutilized passive losses may be used against future passive income or on the disposition of the passive activity interest. The carryover is unlimited in amount and duration. Study PAK Examples 8-6, 8-7, 8-8, 8-9, 8-10.
14 3. Passive Loss 3) Definition of a Passive Activity Passive activity includes any rental activity and any trade, business, or investment activity in which the taxpayer does not materially participate. Investments in limited partnerships generate passive losses due to the legal restrictions on limited partners' involvement in the management of the partnership. Study PAK Examples 8-11, 8-12.
15 3. Passive Loss 4) Taxpayers Subject to Passive Loss Rules The passive loss rules apply to individuals, estates, trusts, closely-held C corporations, personal service corporations, and certain publicly-traded partnerships. While the passive loss rules do not apply to partnerships and S-Corporations directly, the rules do apply to the owners (i.e. the partners and shareholders). Study PAK Examples 8-13.
16 3. Passive Loss 5) Publicly-Traded Partnerships Publicly-traded partnerships are generally subject to corporate taxation. Publicly-traded partnerships are those whose interests are traded on an established securities market or are readily tradable on a secondary market. Certain publicly-traded partnerships may be taxed as partnerships where the passive loss rules apply at the partner level. Study PAK Example 8-14
17 3. Passive Loss 6) Real Estate Business Certain real estate professionals who "materially participate" in real estate activities will not be subject to passive activity loss limitations. "Material participation" for this exclusion is that the taxpayer (1) performs more than 1/2 of the taxpayer's personal services in real property trades or business, and (2) performs more than 750 hours of service during the taxable year in real property trades or businesses. If the above required services are performed as an employee, they will be counted only if the taxpayer owns at least 5% of the employer. Any loss allowed under this specific provision, will not reduce AGI for the purpose of applying the special $25,000 passive loss exclusion discussed later. Study PAK Example 8-15.
18 3. Passive Loss 7) Other Rental Real Estate Activities A $25,000 exception to the passive loss rules exists for certain individuals actively participating in real estate activities. The individual must own at least 10% of the value of the activity for the entire tax year and have an AGI less than or equal to $100,000. Individuals who otherwise qualify must reduce the $25,000 exception for 50% of the excess of AGI over $100,000. EXAMPLE: An individual has a rental real estate qualifying passive loss of $25,000 and an AGI of $130,000. The $25,000 that could be applied against portfolio or ordinary income would be reduced by [50% x ($130,000 - $100,000)] or $15,000. Only $10,000 would be deductible currently. Individuals who have an AGI equal to or exceeding $150,000 will not be eligible for a deduction under the $25,000 exception. Study PAK Example 8-16, 8-17, 8-18.
4. Casualty and Theft Losses 1) Casualty and Theft Defined 19 Casualty Defined (Example PAK 8-19) A casualty loss results from an identifiable event that was sudden, unexpected, or unusual. Qualifying casualties include fire, flood, hurricane, tornado, hail, and cyclone. Theft Defined Generally, criminal intent and violation of a state law are required to meet the definition of theft. Theft for tax purposes includes larceny, embezzlement, robbery, blackmail, extortion, and ransom.
4. Casualty and Theft Losses 2) Deductible Amount of Casualty Loss 20 The deductible amount for personal use property and a partial destruction of business property is the lesser of the reduction in FMV or adjusted basis. EXAMPLE: An individual taxpayer has an asset with an adjusted basis of $10,000. The fair market value of the asset is $12,000 before the fire damage and $5,000 after the fire damage. The deductible amount of the casualty loss (before statutory reductions) is $7,000 ($12,000 - $5,000 is less than the $10,000 adjusted basis). In the total destruction of business property the deductible amount is the property's adjusted basis. Study PAK Examples 8-20, 8-21, 8-22.
4. Casualty and Theft Losses 3) Limitations on Personal-Use Property 21 Personal-use property casualty and theft losses are subject to two reductions: Each separate casualty and theft loss is reduced by $500 in 2009. The total of all personal casualty and theft losses for the year is reduced by 10% of AGI. EXAMPLE: In 2009 the taxpayer has a personal casualty loss of $3,000 and a personal theft loss of $10,000 with an AGI of $40,000. Each loss is reduced by $500 [($3,000-500 = $2,500); ($10,000-500 = $9,500)]. The remaining total loss ($2,500 + $9,500 = $12,000) is further reduced by 10% of AGI ($4,000) for a net deduction of $8,000. Study PAK Examples 8-23, 8-24.
22 4. Casualty and Theft Losses 4) Netting Casualty Gains and Losses on Personal Use Property Gains and losses on personal-use property are netted separately from gain and losses on businessuse property. Net losses on personal-use property (after the reductions discussed above) are taken as an itemized deduction. Study PAK Example 8-25.
23 4. Casualty and Theft Losses 5) Casualty Gains & Losses Attributable to Business & Investment Property Business and investment casualty gains and losses are treated in the Section 1231 netting process (See Chapter 13). The $500 and 10% of AGI limitations are not applicable to business and investment losses.
4. Casualty and Theft Losses 6) Timing of Casualty Loss Deduction 24 Losses may be deductible In the year of loss (casualty) or discovery (theft), In the year insurance proceeds are finalized, or In the year preceding the casualty loss year for certain federally-declared disasters. Study PAK Examples 8-26, 8-27, 8-28, 8-29, 8-30
5. Bad Debts 1) Bona fide debtor-creditor relationship 25 In order to support a bad debt deduction, the underlying debt must be a valid and enforceable obligation to pay a fixed or determinable sum of money resulting from a debtor-creditor relationship. 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 Study PAK Example 8-31, 8-32.
5. Bad Debts 2) Taxpayer s basis in the debt 26 The creditor must have a basis in the debt for the bad debt to be deductible (i.e. cash basis accounts receivable do not generate a bad debt deduction). Study PAK Example 8-33.
5. Bad Debts 3) Debt must be worthless 27 The taxpayer must demonstrate that the debt is worthless.
5. Bad Debts 4) Nonbusiness bad debts 28 A non-business bad debt is treated as a short-term capital loss. Study PAK Examples 8-34,8-35, 8-36, 8-37
5. Bad Debts 5) Business bad debts 29 Partially or totally worthless business bad debts are deductible as an ordinary loss. Study PAK Example 8-38. Accounting for the Business Bad Debt Only the specific write-off method may be used for tax purposes, even though the allowance method may be preferable for financial purposes.
5. Bad Debts 6) Recovery of bad debts 30 Recoveries of bad debts previously written-off are income in the year received.
5. Bad Debts 7) Deposits in Insolvent Financial Institutions 31 Qualified individuals can elect to treat deposits in insolvent financial institutions as a personal casualty loss.
6. Net Operating Losses (NOL) 32 A net operating loss generally involves business income and deductions only. Deductible casualty and theft losses will increase an NOL. Study PAK Example 8-39
6. Net Operating Losses 1) Computing the Net Operating Loss for Individuals 33 Several adjustments are necessary to taxable income (loss) to reach net operating loss. Adjustments include adding back any prior year NOL deduction, certain capital loss deductions, personal and dependency exemptions, and any excess of non-business deductions over nonbusiness income. Computing NOL: 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 Study PAK Examples 8-40, 8-41, 8-42, 8-43
6. Net Operating Losses 2) Carryback and Carryover Periods 34 NOLs generally have a 2-year carryback and a 20- year carryforward. In a few limited situations, the carryback period can be extended to three years. Carryback 2 years Begin with oldest year first Then carry forward 20 years In chronological order May elect to forgo carryback period Losses from multiple years Use up earliest loss first
35 6. Net Operating Losses 3) 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
7. Tax Planning Considerations 36 Bad Debts Taxpayers should document their determination that a particular debt is worthless Casualties Documentation of fair market value is important to support a casualty loss Net Operating Losses Taxpayer should consider forgoing NOL carryback to only carry forward if higher marginal rate is expected in future or carryback would jeopardize tax credits
Addition Things to Study 37 Answers to Selected Textbook Problems: http://www.fcs.utah.edu/~fan/fcs5530/answers%20to%20selected% 20Problems/AnswersSelectedUnit07.pdf Self-study Quizzes on Publisher s website: http://wps.prenhall.com/bp_pope_fedtax_2010/120/30827/789192 3.cw/index.html Homework Assignment for Unit07 (Graded) PAK Chapter 8 Problems: 8-39, 8-41, 8-44, 8-49, 8-50, 8-56 Please go to Week 7 folder on course Homepage to find the link. You can also access it directly through the Assignments link. Discussion Topic for Unit07 (Graded) Don t forget to post your thoughts on the discussion topic of the week. Go to the Week 7 folder on course Homepage to find the link. You can also access it directly through the Discussions link.