Chapter I:8 Losses and <a href="/keyword/bad-debts/" >bad debts</a> Learning Objectives After studying this chapter, the student should be able to 1. 2. 3. 4. 5. 6. 7. 8. Identify transactions that may result in losses. Determine the proper classification for losses. Calculate the suspended loss from passive activities. Identify what constitutes a passive activity loss. Determine when a taxpayer has materially participated in a passive activity. Identify and calculate the deduction for a casualty or theft loss. Compute the deduction for a bad debt. Compute a net operating loss deduction. Areas of Greater Significance The treatment of passive losses is relatively complex. Passive loss rules have greatly influenced the use of limited partnerships as an investment vehicle. The treatment of business <a href="/keyword/bad-debts/" >bad debts</a> for tax purposes can be dramatically different from financial reporting, with corresponding book to tax differences. Areas of Lesser Significance In the interest of time, the instructor may determine that the following area is best covered by student reading, rather than class discussion: 1. Compliance and procedural considerations. I:IO8-1 Problem Areas for Students The following areas may prove especially difficult for students: 1. 2. 3. Computation of passive losses and credits. Computation of the deductible amount of casualty loss. Computation of the net operating loss. Highlights of Recent Tax Law Changes There are no new tax law changes in this chapter as compared with the 2007 edition: Teaching Tips 1. Stress the importance of the difference between ordinary losses and capital losses. This will reinforce the necessity of learning the rules regarding gain and loss from disposition of capital assets. 2. The passive loss rules are very complex. You may want to summarize the important points you want the students to know for examination purposes. Lecture Outline I. Transactions that May Result in Losses (Example I:8-1; Topic Review I:8-1) Realization is a prerequisite for a tax loss. EXAMPLE: If a taxpayer holds stock that had a $25,000 <a href="/keyword/fair-market-value/" >fair market value</a> at the beginning of the tax year and a $15,000 <a href="/keyword/fair-market-value/" >fair market value</a> 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. A. Sale or Exchange of Property (Example I:8-2) 1. 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). 2. Losses incurred on the sale of personal-use property are not deductible. 3. Losses on trade or business property and investment property are deductible. I:IO8-2 B. Expropriated, Seized, or Confiscated Property 1. 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. 2. Any allowable deduction must be taken in the year of actual seizure. 3. Any gain realized on seizure (compensation for seizure exceeds adjusted basis of property) would be treated under the involuntary conversion rules (see Chapter I:12). C. Abandoned Property 1. Abandoned property used in a trade or business or held for investment gives rise to a deductible loss. 2. The amount of the loss is the adjusted basis of the asset at the date of abandonment. 3. D. The character of the loss is ordinary, since there is no sale or exchange. Worthless Securities (Example I:8-3) 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. E. 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). I:IO8-3 II. Classifying the Loss on the Taxpayer's Tax Return A. Ordinary Versus Capital Loss (Example I:8-4; Question I:8-6; Problem I:8-39) 1. The classification of a loss as ordinary or capital is dependent on the type of property involved and the type of transaction involved. 2. 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. B. Disallowance Possibilities 1. Certain realized losses are disallowed in special situations, including related party transactions and wash sales. 2. Other potential disallowance situations include transfers of property in exchange for stock - Sec. 351 (see Chap. I:16), like-kind exchanges (see Chap. I:12), and partnerships (both under the &quot;at-risk&quot; limitations and the passive loss rules). III. Passive Losses (Instructor Aid I:8-1; Topic Review I:8-2) A. Computation of Passive Losses and Credits (Example I:8-5) 1. Passive losses may only offset passive income, not portfolio income or active income. 2. Portfolio income includes non-business dividends, interest, royalties, annuities, and certain gains and losses on property. 3. Credits generated from passive activities are also limited. These credits may only offset tax liability generated by passive income. I:IO8-4 B. Carryovers (Examples I:8-6, I:8-7) 1. Unutilized passive losses may be used against future passive income or on the disposition of the passive activity interest. 2. The carryover is unlimited in amount and duration. C. Definition of Passive Activity (Examples I:8-11, I:8-12; Question I:8-9) 1. Passive activity includes any rental activity and any trade, business, or investment activity in which the taxpayer does not materially participate. 2. Investments in limited partnerships generate passive losses due to the legal restrictions on limited partners' involvement in the management of the partnership. D. Taxpayers Subject to Passive Loss Rules (Example I:8-13) 1. The passive loss rules apply to individuals, estates, trusts, closely-held C corporations, personal service corporations, and certain publicly-traded partnerships. 2. While the passive loss rules do not apply to partnerships and SCorporations directly, the rules do apply to the owners (i.e. the partners and shareholders). E. Publicly-Traded Partnerships (Example I:8-14) 1. Publicly-traded partnerships are generally subject to corporate taxation. 2. Publicly-traded partnerships are those whose interests are traded on an established securities market or are readily tradable on a secondary market. 3. Certain publicly-traded partnerships may be taxed as partnerships where the passive loss rules apply at the partner level. F. Real Estate Businesses (Example I:8-15) 1. Certain real estate professionals who &quot;materially participate&quot; in real estate activities will not be subject to passive activity loss limitations. 2. &quot;Material participation&quot; 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. I:IO8-5 3. 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. 4. Any loss allowed under this specific provision, will not reduce AGI for the purpose of applying the special $25,000 passive loss exclusion discussed below. G. Other Rental Real Estate Activities (Example I:8-16; Problem I:8-44) 1. 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. 2. 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. 3. Individuals who have an AGI equal to or exceeding $150,000 will not be eligible for a deduction under the $25,000 exception. IV. Casualty and Theft Losses (Topic Review I:8-3; Instructor Aid I:8-2) A. Casualty Defined (Example I:8-19) 1. A casualty loss results from an identifiable event that was sudden, unexpected, or unusual. 2. Qualifying casualties include fire, flood, hurricane, tornado, hail, and cyclone. B. Theft Defined 1. Generally, criminal intent and violation of a state law are required to meet the definition of theft. 2. Theft for tax purposes includes larceny, embezzlement, robbery, blackmail, extortion, and ransom. I:IO8-6 C. Deductible Amount of Casualty Loss (Examples I:8-20, I:8-21, I:8-22) 1. 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 <a href="/keyword/fair-market-value/" >fair market value</a> 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). 2. In the total destruction of business property the deductible amount is the property's adjusted basis. D. Limitations on Personal-Use Property (Examples I:8-23, I:8-24; Question I:8-23) 1. Personal-use property casualty and theft losses are subject to two reductions: a. Each separate casualty and theft loss is reduced by $100. b. The total of all personal casualty and theft losses for the year is reduced by 10% of AGI. EXAMPLE: 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 $100 [($3,000 - 100 = $2,900); ($10,000 - 100 = $9,900)]. The remaining total loss ($2,900 + $9,900 = $12,800) is further reduced by 10% of AGI ($4,000) for a net deduction of $8,800. E. Netting Casualty Gains and Losses on Personal-Use Property (Example I:8-25) 1. Gains and losses on personal-use property are netted separately from gain and losses on business-use property. 2. Net losses on personal-use property (after the reductions discussed above) are taken as an itemized deduction. F. Casualty Gains and Losses Attributable to Business and Investment Property 1. Business and investment casualty gains and losses are treated in the Section 1231 netting process (See Chapter I:13). The $100 and 10% of AGI limitations are not applicable to business and investment losses. I:IO8-7 G. 50) Timing of Casualty Loss Deduction (Examples I:8-26, I:8-29, I:8-30; Problem I:8Loss may be deductible: 1. 2. 3. 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. V. <a href="/keyword/bad-debts/" >bad debts</a> (Topic Review I:8-4) A. Bona Fide Debtor-Creditor Relationship (Examples I:8-31, I:8-32) 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. Taxpayer's Basis in the Debt (Example I:8-33) 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). Debt Must be Worthless The taxpayer must demonstrate that the debt is worthless. Non-business <a href="/keyword/bad-debts/" >bad debts</a> (Examples I:8-35, I:8-36, I:8-37) A non-business bad debt is treated as a short-term capital loss. Business <a href="/keyword/bad-debts/" >bad debts</a> (Example I:8-38; Problem I:8-53) Partially or totally worthless business <a href="/keyword/bad-debts/" >bad debts</a> are deductible as an ordinary loss. 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. Recovery of <a href="/keyword/bad-debts/" >bad debts</a> Recoveries of <a href="/keyword/bad-debts/" >bad debts</a> previously written-off are income in the year received. Deposits in Insolvent Financial Institutions Qualified individuals can elect to treat deposits in insolvent financial institutions as a personal casualty loss. B. C. D. E. F. G. H. VI. Net Operating Losses (Example I:8-39; Topic Review I:8-5) I:IO8-8 A. General 1. only. 2. A net operating loss generally involves business income and deductions Deductible casualty and theft losses will increase an NOL. B. Computing the Net Operating Loss (Example I:8-41) 1. Several adjustments are necessary to taxable income (loss) to reach net operating loss. 2. 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 non-business income. C. Carryback and Carryover Periods 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. Recomputation of Taxable Income in the Carryover Year The NOL will be a deduction for AGI in the adjustment year. D. VII. Tax Planning Considerations A. <a href="/keyword/bad-debts/" >bad debts</a> Taxpayers should document their determination that a particular debt is worthless. Casualties Documentation of <a href="/keyword/fair-market-value/" >fair market value</a> is important to support a casualty loss deduction. Net Operating Losses The taxpayer should consider forgoing the NOL carryback period to only carry the NOL forward if a higher marginal rate is expected in the future or a carryback would jeopardize tax credits. B. C. I:IO8-9 Court Case Briefs Tussaud's Wax Museums, Inc. v. CIR, 25 TCM 1081, TC Memo 1966-211. Tussaud's Inc. had a display at the Seattle World's Fair using wax figures that had been leased from Stuberghs, a California corporation. Edward Hicks and Donald Crysdale, majority and minority stockholders of Tussaud's, borrowed $6,000 from a personal friend, Edward Liersch, to be used for promotion of the display. Liersch was to receive $10,000 as repayment for the loan. Tussaud's Inc. coincidentally paid amounts to Liersch totaling $8,100 and recorded them on Tussaud's Inc.'s books as &quot;Due from Ed Liersch and others.&quot; Liersch refused to sign a note for the money he had received and Tussaud's Inc. claimed the $8,100 as a deduction for a bad debt. This deduction was disallowed by the IRS. The IRS argued that Tussaud's Inc. had made payments in satisfaction of Hicks' and Crysdale's obligation and was actually discharging that obligation. The IRS contended that Tussaud's Inc. could have sued Liersch for the repayment. The court found that Tussaud's Inc. had not provided adequate proof that the loan to Liersch was uncollectible and therefore worthless. While a creditor is not required to resort to legal remedies to establish the worthlessness of the debt, Tussaud's Inc.'s unsuccessful request that Liersch sign a note was insufficient proof that the debt was worthless. Randall C. Carlson v. CIR, 1984 PH T.C. Memo &amp; 84,276, 48 TCM 154. Randall Carlson worked as a bank teller while attending the Colorado State University. He embezzled $30,000 to finance a drug deal with the intention of making a profit and returning the $30,000 before being discovered. He met with two accomplices, Hime and Lupo, who took the money to purchase the marijuana. Later the same evening they rendezvoused with Carlson without mentioning either the money or the marijuana. The next day Hime and Lupo told Carlson that they had been robbed at gunpoint and had neither the $30,000 nor the marijuana. Carlson confessed the embezzlement and decided while reflecting in jail that his accomplices had actually absconded with the money. Carlson reported the $30,000 embezzled funds as income on his 1979 return and claimed a deduction for a theft loss of $29,900 (Sec. 165 allowed a deduction only to the extent that the amount exceeded $100). The IRS denied the deduction. The court held that Carlson was not entitled to the deduction because he had not proved that he had sustained the loss or that it had been caused by theft. Carlson did not report the incident to the police, did not try to collect the money, and never saw Hime and Lupo again. Instructor Aid I:8-1 Passive Losses Types of Income (1) (2) (3) Active Income - wages, salaries, active business income Portfolio Income - dividends, interest, annuities, royalties Passive Income - from: (A) any rental activity (B) any trade, business, or investment in which the taxpayer does not materially participate GENERAL RULE: Passive losses can only be used to offset passive income. EXCEPTIONS: (2) (1) Real estate professionals who materially participate in real estate trade or business activities. Taxpayers actively participating in rental real estate activities with AGIs not in excess of $100,000 may deduct $25,000 of such rental real estate losses against portfolio and active income.* *The $25,000 amount is reduced by 50% of every dollar of AGI over $100,000. The $25,000 amount is totally phased-out at AGI of $150,000. Instructor Aid I:8-2 Casualty &amp; Theft Losses Qualifying Casualties Fire Flood Hurricane Tornado Hail Cyclone Southern Pine Beetles (Termites do not qualify) Qualifying Thefts Larceny Embezzlement Robbery Blackmail Extortion Ransom