7: Chapter Losses - Deductions and Limitations
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CHAPTER 7
LOSSES - DEDUCTIONS AND LIMITATIONS
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DISCUSSION QUESTIONS
1.
How are deductions and losses different? How are they similar? Explain.
Differences - The main difference is that most deductions are for current
expenditures and amortization of capital expenditures, whereas losses result from
either an excess of deductions over income (annual loss) or an excess of basis
over the amount realized on the disposition of an asset (transaction loss).
Similarities - Both deductions and losses represent amounts invested to produce
income and are reductions in taxable income under the ability-to-pay concept. In
addition, the general approach to the deductibility of losses is similar to the
approach taken for deductions. That is, tax relief is the result of legislative grace
and any deductions allowed must be specified in the tax law. The categorization of
losses by those incurred in a trade or business, production of income losses, and
personal use losses is identical to the approach for deductions. The limitation on
losses is similar to the limitations placed on deductions within each category.
2.
Discuss the basic differences between annual losses and transaction losses.
Annual losses result from an excess of deductions over income for a single
accounting period. Thus, they represent the effect of all the transactions affecting
an entity during the accounting period.
Transaction losses result when the amount realized from a sale or other
disposition of property is less than the basis of the property. That is, a transaction
loss represents an incomplete capital recovery on a single transaction by an
entity.
3.
What are the net operating loss carryback and carryforward periods? Does a taxpayer
have a choice of the years to which a net operating loss can be carried? Explain.
A net operating loss can be carried back 2 years to obtain a refund of taxes paid.
The loss must be carried to the earliest year in the carryback period first. If the
loss is not entirely used up in the earliest year, the previous year is then used. If
the entire loss is not used up during the 2-year carryback, any remaining loss can
be carried forward for 20 years. A taxpayer may elect not to carryback any of the
loss and only use the carryforward period. Note: For net operating losses (NOLs)
arising in 2001 and 2002, the two-year carryback period is increased to five years.
For each year, a taxpayer can make an irrevocable election to waive the five-year
period and use the existing two-year carryback period. In addition, as under prior
law, a taxpayer can elect not to carryback the loss and carry forward the loss for
twenty years.
4.
What are the characteristics of a tax shelter as the term is commonly used by tax
practitioners?
A tax shelter is an activity that is designed to produce losses through the use of
allowable deductions. These losses are then passed through to the owners of the
activity who use the losses to reduce their tax on other income sources. The
Chapter 7: Losses - Deductions and Limitations
7-2
owners of the shelter may pay a tax when they sell their investment. However,
such a sale (if it does occur) will take place in the future, thus providing the tax
shelter owner with a time value of money tax savings.
5.
How is a taxpayer's amount at risk in an activity different from the taxpayer's basis in the
same activity? What purpose does the amount at risk serve in regard to losses?
The amount at risk is the amount that the taxpayer stands to lose if the activity
should fail. Therefore, it represents any amounts invested in the activity that have
not yet been recovered, as well as any liabilities the taxpayer has to pay should the
activity be unable to pay the liabilities.
The amount at risk in an activity is very similar to the basis in the activity. That is,
the at-risk amount is adjusted in the same manner as basis for additional capital
investments, the share of income (loss) from the activity and any withdrawals or
other capital recoveries which the taxpayer receives from the activity. The primary
difference between the at risk amount and basis is the treatment of nonrecourse
debt used to finance real estate in the activity. Because the taxpayer is not liable
for nonrecourse debt, it is not added to basis. However, the tax law allows
nonrecourse debt used to finance real estate to increase the amount at risk in an
activity if the borrowing is made on reasonable commercial terms.
The purpose of the at risk rules is to limit loss deductions to an amount that the
taxpayer actually stands to lose should the activity fail. Therefore, the taxpayer
can only deduct losses from an activity to the extent she or he is at risk.
6.
What is a nonrecourse debt? How is financing using nonrecourse debt different from
financing using recourse debt?
A nonrecourse debt is a liability that is only secured by the underlying property
related to the debt; the other assets of the entity borrowing the money cannot be
used to pay the debt if the entity defaults on the loan. A recourse debt is one that
is secured by the property underlying the debt and the other assets of the entity
borrowing the money.
The main difference between the two financing methods is that nonrecourse debt
is generally not added to basis in the activity and can only increase the at-risk
amount in the activity if the financing relates to the holding of real estate. A
recourse debt is always added to basis in the activity and always increases the
amount at risk in the activity.
7.
What is the purpose of the passive loss rules?
The basic intention of the passive loss rules is to disallow the deduction of losses
from passive activities against other forms of income. That is, a passive loss
cannot be deducted against earned income or portfolio income of the taxpayer.
8.
Are the passive loss rules disallowance-of-loss provisions or are they loss deferral
provisions? Explain.
The passive loss rules are deferral of loss provisions. Any net passive loss not
deductible in the year it is incurred is suspended and carried forward to future
years and used to offset passive income. In addition, any suspended loss on an
activity is deductible in the year in which the taxpayer's entire interest in the
activity is disposed of in a taxable transaction.
Chapter 7: Losses - Deductions and Limitations
9.
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For purposes of the passive loss rules, what is a closely held corporation? How is the
tax treatment of passive losses incurred by a closely held corporation different from the
tax treatment of passive losses incurred by
A closely held corporation has five or fewer shareholders who own less than 50%
of the stock of the corporation during the last half of the tax year. Closely held
corporations are allowed to deduct passive losses against active business income
but not against portfolio income.
a. Individuals?
Individuals are only allowed to deduct passive losses against passive income
under the general passive loss rules. However, for rental real estate two major
exceptions exist. First, if a taxpayer passes the real estate professional exception,
the activity is not passive and all losses are deductible. To qualify under this
exception, a taxpayer must spend more than 50% of her/his personal service time
in a real property trade or business, the amount of time spent in the real property
trade or business must be greater than 750 hours and the taxpayer must materially
participate in the rental activity. To be a material participant, the taxpayer must
either spend greater than 500 hours managing the rental activity or must spend
more than 100 hours a year in the activity, and the 100 hours must be more hours
than any other owner or non-owner spends on the activity (known as the 100-hour
test). The second exception is for taxpayers who meet the active participant test.
To meet the active participant test, the taxpayer must own at least a 10% interest in
the property and have a significant and bonafide involvement in the activity.
Under this exception, an individual can deduct up to $25,000 of losses from the
rental activity each year against active and portfolio income. However, the
maximum allowable deduction is reduced when an individual's adjusted gross
income exceeds $100,000. The $25,000 maximum deduction is reduced $.50 for
every dollar of adjusted gross income in excess of $100,000. The $25,000 is
completely phased out when the taxpayer's adjusted gross income exceeds
$150,000.
b. Corporations?
Corporations are not subject to the passive loss rules. Therefore, they may deduct
all passive losses against any form of income.
10.
When a business sustains a loss from a casualty, one of two measurement rules is used
to determine the amount of the loss. Why is the use of two measurement rules
necessary for determining a business casualty loss?
Two measurement rules are necessary to insure that the amount of the capital
recovery from the loss does not exceed the amount invested in the asset. That is,
the amount of the loss from a casualty is generally the decline in the value of the
asset. However, when business property is partially destroyed, the measurement
rule is the lesser of the decline in value of the property or the property's basis.
This insures that the amount of loss can never exceed the amount invested in the
property (basis).
For business property fully destroyed or stolen, the
measurement of loss is the property's basis. This also insures that the full amount
of the taxpayer's unrecovered investment in the property is allowed as a loss. If
the first measurement rule were always used, assets whose values have declined
below their basis would not get a full capital recovery when they were destroyed.
11.
What are the limitations on the deductibility of capital losses by individuals? How do the
limitations compare with those for corporations?
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Capital losses of individuals are netted against other capital gains that the
individual has during the year. If the result of the netting is a loss, the individual
can deduct the net capital loss up to a maximum of $3,000. Any excess loss is
carried forward and used in the next year's capital gain and loss netting.
Corporations also net together capital losses and capital gains. However, if the
result of the netting is a net capital loss, the loss is not deductible in the period in
which it is incurred. The net capital loss can be carried back 3 years and netted
against any net capital gains on which the corporation paid tax to obtain a refund
of the taxes paid. If the carryback period is not sufficient to fully absorb the loss,
any remaining loss can be carried forward for 5 years and used to offset capital
gains.
12.
Most sales of securities at a loss result in capital losses. Under what circumstances
would a loss on the sale of a security be treated as an ordinary loss? Explain the
rationale for allowing this treatment.
Ordinary loss treatment is accorded to sales of securities in which the security
does not meet the definition of a capital asset. For example, a sale of a security by
a dealer in securities receives ordinary loss treatment because the securities
represent inventory for the dealer.
A second exception is provided for losses on the sale of qualified small business
stock. This exception allows an individual to deduct up to $50,000 ($100,000 for a
married couple) of losses on the sale of small business stock as an ordinary loss
each year. Any loss in excess of the limit is a capital loss.
The rules were adopted to encourage individuals to invest in small businesses.
Recent statistics suggest that 85% of the new jobs created in the U.S. are by small
businesses.
This provides protection (and incentive to invest in small
businesses) to investors who otherwise would be able to deduct only $3,000 in
losses each year.
13.
What is the purpose of the related party rules as they apply to sales of property?
The related party rules are designed to stop individuals from creating losses
through the sale of securities (or other property) to related parties at prices that
are not bargained at arms-length. This is accomplished by disallowing all losses
on the sale of property to a related party. Any disallowed loss can be used to
reduce any gain on the subsequent sale of the property to an unrelated party.
14.
Losses incurred on the sale of business assets are generally deductible in full in the year
the loss is realized. Describe a situation in which a realized loss on the sale of a
business asset is not deductible in the current year, and explain why it would not be
deductible.
If a business sells business assets at a loss to a related party, the realized loss is
not deductible by the business. The purpose of the related party provisions is to
stop businesses from creating losses by selling assets to related parties at prices
that are not made at arms-length.
15.
What is a wash sale? How is the treatment of a wash sale different from the treatment of
other sales of securities?
A wash sale occurs when securities are sold at a loss and the securities are
replaced with substantially identical securities within 30 days (before or after) of
the loss sale.
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Losses on shares that are replaced within the 30 day wash sale period are
disallowed. The disallowed loss is added to the basis of the replacement shares.
This treatment effectively views the replacement shares as a continuation of the
investment in the shares sold at a loss.
16.
How are the rules for deducting personal casualty and theft losses different from the
rules for business casualty and theft losses? Explain the difference in treatments and the
rationale for the difference.
The differences in the rules involve the measurement of the loss and limitations on
the deductions. The measurement of the loss is different for property fully
destroyed the loss on business property fully destroyed (stolen) is the adjusted
basis; personal property losses are measured as the lesser of 1) the adjusted
basis, or 2) the decline in fair market value resulting from the casualty or theft.
This measurement rule prevents individuals from deducting any loss in value that
occurred prior to the casualty (a personal use loss).
Personal casualty losses are only deductible as itemized deductions. Each loss
occurring during the year is reduced by the $100 statutory limit. The sum of all casualty
losses for the year is further reduced by 10% of the taxpayers adjusted gross income.
This treatment is based on administrative convenience. A business casualty loss is fully
deductible.
PROBLEMS
17.
The Graves Corporation was incorporated in 2002 and incurred a net operating loss of
$35,000. The companys operating income in 2003 was $47,000. Because of a
downturn in the local economy, the company suffers a net operating loss of $21,000 in
2004. What is the treatment of the 2004 loss?
A corporation is a taxable entity that is responsible for the payment of tax on its
income. Therefore, it is allowed a deduction for a net operating loss. The 2003
NOL is carried forward and used to reduce the 2003 operating income to $12,000
($47,000 - $35,000). Graves pays a tax of $1,800 (15% x $12,000) on the income
in 2002. The 2004 loss is carried back to 2002 and $12,000 of the $21,000 loss is
used to reduce the 2003 income to zero. This results in a refund of the $1,800 of
tax paid in 2003. The remaining $9,000 of loss is carried forward to 2005 and used
to reduce income.
Operating income
Carryforward of 2002 loss
2003 Taxable Income
Carryback of 2004 loss to 2003
Carryforward of 2004 loss to 2005
2003 Taxable income
Tax rate on $12,000 of income
2003 Tax paid (refund of carryback)
2002
$ (35,000)
2003
$ 47,000
(35,000)
$ 12,000
(12,000)
2004
$ (21,000)
12,000
$ (9,000)
$ 12,000
x
15%
$ 1,800
Instructor's Note: Graves has the option of electing not to carry the 2004 loss
back to 2003 and carrying it forward to 2005. Graves should make the election if it
feels that its marginal tax rate will increase and the net present value of the tax
savings of carrying the loss forward exceed carrying back the current year's loss.
Chapter 7: Losses - Deductions and Limitations
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How would your answer change if Graves were an S corporation?
An S corporation is a conduit entity that does not pay tax on its income. The
shareholders of Graves are taxed on any income and also receive their
proportionate share of any losses generated by Graves. For 2004, the $21,000
operating loss is distributed to each shareholder. The shareholder then takes the
appropriate allowable deduction on his/her return. Because the income and loss
is passed through to the individual shareholders each year, S corporations do not
have net operating loss carryforwards or carrybacks.
21.
Carlos opens a dry cleaning store during the year. He invests $30,000 of his own money
and borrows $60,000 from a local bank. He uses $40,000 of the loan to buy a building
and the remaining $20,000 for equipment. During the first year, the store has a loss of
$24,000. How much of the loss can Carlos deduct if the loan from the bank is
nonrecourse? How much does Carlos have at risk at the end of the first year?
Carlos is at risk for $30,000. He is only at risk for the $30,000 of personal funds he
invested in the business. He is not considered at-risk for the nonrecourse loan because
he is not personally liable on any of the debt and the loan is not used in the trade or
business of holding real property. Because he is considered at risk for $30,000, he can
deduct the entire $24,000 loss. The $24,000 loss reduces Carlos amount at-risk to
$6,000 ($30,000 - $24,000).
26.
Which of the following would be a passive activity? Explain.
a. Kevin is a limited partner in Marlin Bay Resort and owns a 15% interest in the
partnership.
A limited partnership interest is always considered to be a passive activity. As a
limited partner, Kevin has no involvement in managing the partnerships assets,
so he does not meet the material participation test.
b. Tom owns a 15% interest in a real estate development firm. He materially participates in
the management and operation of the business.
The real estate development firm qualifies as a trade or business. Because Tom
materially participates in the management of the firm, it is not considered a
passive activity.
c. Jasmine owns and operates a bed-and-breakfast.
The activity is not a rental activity under the passive activity loss rules because
Jasmine provides significant personal services in operating the bed-and-breakfast.
In addition, she is a material participant in the business. The activity is not
passive for Jasmine.
d. Howard owns an apartment complex that meets federal guidelines qualifying it as lowincome housing.
Investments in low-income housing are generally not considered to be passive
activities. Howard's investment is not a passive activity.
e. Felicia owns a 25% working interest in an oil and gas deposit.
A working interest in an oil and gas deposit is specified as not being a passive
activity.
Chapter Losses 7: - Deductions and Limitations
7-7
f. Assume the same facts as in part e, except that Felicia owns a 25% interest in a
partnership that owns a working interest in an oil and gas deposit. She does not
materially participate in the management and operation of the partnership.
Generally, a working interest in an oil and gas deposit is specified as not being a
passive activity. However, because the deposit is owned by a partnership, each
individual partner must be evaluated for material participation in the partnership to
determine whether the investment in the partnership is passive. In this case,
because Felicia does not materially participate in the management and operation
of the partnership, the activity is passive for her.
29.
Aretha and Betina own a 10-unit apartment complex. Aretha owns a 60% interest in the
apartment complex, and Betina has a 40% interest. Aretha is an investment banker and
spends 120 hours helping to manage the apartment complex. Betina is the co-owner of
a real estate agency where she works 1,600 hours a year. She also spends 520 hours
managing the apartment complex. During the current year, the apartment complex
generates a loss of $24,000. Arethas adjusted gross income before considering the loss
from the apartment complex is $175,000, and Betinas is $162,000. How much of the
loss can Aretha deduct? How much of the loss can Betina deduct?
To qualify under the real estate professional exception, an individual must spend
more than 50% of their personal service time in a real property trade or business,
the amount of time spent in the real property trade or business must be greater
than 750 hours, and the taxpayer must materially participate in the rental activity.
To materially participate in the activity the taxpayer must either spend greater than
500 hours managing the rental real estate activity, or spend more than 100 hours
in the activity and that must be more time than any owner or non-owner spends on
the activity. Only Betina qualifies under the real estate professional exception.
She spends more than one-half of her time in a real property trade or business, the
amount of time spent on the activities is greater than 750 hours and she spends
more than 500 hours managing the rental activity. Accordingly, the rental activity
is not passive and she can deduct her $9,600 ($24,000 x 40%) share of the loss
against her other income. Betina's adjusted gross income after the loss is
$152,400 ($162,000 - $9,600).
Aretha fails to qualify as a real estate professional. However, she is an active
participant in the activity. As an active participant, Aretha can deduct up to
$25,000 in losses from the rental activity. However, because her adjusted gross
income exceeds the $150,000 phase-out limit, she cannot deduct any portion of
her $14,400 ($24,000 - $9,600) share of the loss. The loss is suspended as a
passive loss and can be deducted in the following year either against passive
income or under next year's $25,000 limit. Arethas adjusted gross income
remains at $175,000.
a. Assume the same facts except that Arethas adjusted gross income before the rental loss
is $145,000 and Betinas is $140,000. How much of the loss can Aretha deduct? How
much of the loss can Betina deduct?
Betina can still deduct the full amount of her share of the loss. Betinas adjusted
gross income is $130,400 ($140,000 - $9,600).
Because Arethas adjusted gross income is less than $150,000, she can deduct
some of her loss from the rental activity. However, because her adjusted gross
income exceeds $100,000, she must reduce the $25,000 maximum by $.50 for each
dollar of adjusted gross income in excess of $100,000. As a result, Aretha must
reduce the $25,000 maximum by $22,500 [($145,000 - $100,000) x $.50] to $2,500.
Because Arethas loss from the passive activity ($14,400) exceeds the $2,500 limit,
Chapter 7: Losses - Deductions and Limitations
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her adjusted gross income can only be reduced by $2,500. Her adjusted gross
income is $142,500 ($145,000 - $2,500). The remaining loss of $11,900 ($14,400 $2,500) is suspended as a passive loss and can be deducted in the following year
either against passive income or under next year's $25,000 limit.
b. Assume the same facts as in part a, except that the apartment complex qualifies under
federal guidelines as low-income housing. How much of the loss can Aretha deduct?
How much of the loss can Betina deduct?
Investments in low-income housing are not generally considered to be passive
activities. Therefore, both Aretha and Betina can deduct the full amount of the
their share of the loss from the rental activity. Arethas adjusted gross income is
$160,600 ($175,000 - $14,400). Betina's adjusted gross income after the loss
deduction is $152,400 ($162,000 - $9,600).
Instructor's Note: The solution to this problem assumes that Betina and Aretha
have enough at-risk to deduct the losses.
35.
Janet has a taxable income of $54,000 from her salary and investment assets. She also
owns 3 passive activities that have the following income (loss) for the year:
Passive Activity 1
Passive Activity 2
Passive Activity 3
$ 12,000
$ (18,000)
$ ( 9,000)
a. What is the effect of the passive activities on Janet's income? Explain.
Janet has a net passive loss of $15,000:
Passive Activity 1
Passive Activity 2
Passive Activity 3
Net passive loss
$ 12,000
(18,000)
( 9,000)
$ (15,000)
Individuals are not allowed to deduct passive losses against nonpassive income.
Janet would include the $12,000 of income from PA1 in her gross income and is
allowed to deduct $12,000 of the loss from PA2 and PA3 against this income. The
net passive loss of $15,000 is suspended and carried forward to subsequent years
for netting against passive income. The net result is a taxable income of $54,000
(i.e., the income from her salary and investment assets).
b. How much suspended loss does Janet have in each passive activity?
The $15,000 of suspended loss must be allocated between PA2 and PA3 based on
their relative contribution to the loss:
PA2 - ($18,000 $27,000) x $15,000 = $10,000
PA3 - ($ 9,000 $27,000) x $15,000 = $ 5,000
36.
Return to the facts of problem 35. In the next year, Janet has a taxable income from her
salary and investment activities of $62,000. The results for her 3 passive activities are
Passive Activity 1
Passive Activity 2
Passive Activity 3
$ 15,000
$ ( 8,000)
$ ( 2,000)
Chapter 7: Losses - Deductions and Limitations
7-9
a. What is the effect of the passive activities on Janet's income? Explain.
There would be no effect on Janet's $62,000 taxable income. The $15,000 of
suspended loss from the previous year would be netted against the current year's
passive income and losses resulting in a net passive loss of $10,000:
Passive activity 1
Suspended loss passive activity 2
Passive activity 2
Suspended loss passive activity 3
Passive Activity 3
Net Passive Loss
15,000
(10,000)
(8,000)
(5,000)
(2,000)
$ (10,000)
The total loss from passive activity 2 of $18,000 ($10,000 + $8,000) and passive
activity 3 of $7,000 ($5,000 + $2,000) reduce the net passive activity income for
the year to zero. The total suspended loss from PA2 and PA3 is $10,000.
b. How much suspended loss does Janet have in each passive activity?
The suspended loss must be allocated based on the proportion of passive loss
from each activity over the two years to the total passive loss from all the activities
for the two years. Using this weighted average formula, the remaining suspend
loss for passive activity 2 and passive activity 3 is $ 7,200 and $2,800 respectively.
Formula:
Total passive loss from activity
Total passive losses all activities
X
Remaining suspended loss
PA2 -
($10,000 + $ 8,000)
($15,000 + $10,000)
x
$10,000
= $7,200
PA3 -
($ 5,000 + $ 2,000)
($15,000 + $10,000)
x
$10,000
= $2,800
39. Jeremy owns a passive activity that has a basis of $30,000 and a suspended loss
of $16,000. His taxable income from active and portfolio income is $81,000.
a. What is the effect on Jeremy's taxable income if he sells the passive activity for
$37,000?
Any suspended loss on a passive activity is deductible in full when the
entire interest in the activity is disposed of through a sale of the activity. In
this case, Jeremy has a capital gain of $7,000 ($37,000 - $30,000) on the
sale of the activity and a deduction of $16,000 for the suspended loss on the
activity. This results in a net deduction of $9,000. However, the $7,000
capital gain is netted with any other capital gains and losses that Jeremy
has during the year. Also, the tax rate on a net long-term capital gain is 15%
(5% if the taxpayers marginal tax rate is 10% or 15%), which further
complicates the tax effect of Jeremys net deduction of $9,000.
b. What is the effect on Jeremy's taxable income if he sells the passive activity for
$25,000?
Chapter 7: Losses - Deductions and Limitations
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In this case, Jeremy has a $5,000 capital loss ($25,000 - $30,000) on the
sale of the passive activity and is allowed a deduction for the $16,000
suspended loss. The capital loss must be netted with any other capital
gains and losses that Jeremy had during the year and therefore, may not be
deductible in full. For example, if Jeremy has no other capital gains and
losses during the year, only $3,000 of the capital loss may be deducted in
the year of sale.
45.
ABC Company owns a chain of furniture stores. How much loss can ABC Company
deduct in each of the following cases? Explain.
a. ABC closes a store in a depressed part of the county. Rather than move furniture to
other stores, ABC sells furniture that had cost $275,000 for $140,000.
The $135,000 ($140,000 - $275,000) loss on the sale of the inventory is an ordinary
loss that is fully deductible. All losses incurred in a trade or business are
deductible as ordinary losses.
b. A fire severely damages one store. The cost of repairing the damage is $127,000.
ABC's basis in the store building is $320,000. ABC's insurance company reimburses
ABC $100,000 for the fire damage.
The loss from the fire damage is measured as the lesser of the decline in the value
of the property or the property's basis. The cost of repairing the damage may be
used as the measure of the decline in value. The $127,000 of repairs is reduced by
the $100,000 of insurance proceeds to determine the net casualty loss of $27,000.
c. ABC decides to begin replacing some of its older delivery vans. It sells for $4,200 one
van that had a basis of $7,300.
The sale of a business asset results in an ordinary loss. The loss on the sale of
the van is $3,100 ($4,200 - $7,300).
d. ABC discovers that one of its buildings is infested with termites. The building is old and
has been fully depreciated for tax purposes. The cost of getting rid of the termites is
$8,400, none of which is covered by insurance.
Termite infestation is not a casualty. However, any loss incurred in a trade or
business is deductible. The question is whether the cost of fixing the termite
damage can be deducted immediately as a loss or must be capitalized as a
betterment that extends the life of the building.
e. Someone breaks into one store by destroying the security system. Cash of $9,000 is
missing from a safe. In addition, televisions that had cost $17,500 and were marked to
sell for $34,000 are gone. The security system has a basis of $10,800. Because the
system is outdated, a security expert estimates it is worth only $2,700 at the time it is
destroyed.
Thefts of business property are measured at their basis. The theft loss is $26,500
($9,000 cash + $17,500 televisions). The loss on the security system is the
$10,800 basis, for a total loss of $37,300 ($26,500 + $10,800).
49.
Stella owns a taxicab company. During the year, two of her cabs are involved in
accidents. One is totally destroyed; the other is heavily damaged. Stella is able to
replace the destroyed cab with an identical model for $5,500. Her adjusted basis in the
destroyed cab is $3,750, and the insurance company pays her $2,800. The adjusted
basis of the damaged cab is $3,800. The insurance adjuster estimates that the damaged
Chapter 7: Losses - Deductions and Limitations
7-11
cab is worth $3,600. Although a comparable cab sells for $7,800, the insurance company
gives Stella only $2,900. Write a letter to Stella explaining the amount of her deductible
casualty loss.
The loss on business property totally destroyed is the property's basis. The loss
on partially destroyed business property is measured as the lesser of the decline
in the value of the property or the property's basis. Whether the property is totally
destroyed or only partially destroyed, the measured loss is reduced by any
insurance reimbursement.
Stellas loss for the cab that is totally destroyed is its basis of $3,750. The $3,750
is reduced by the insurance reimbursement of $2,800 for a deductible loss of $950.
The loss on partially destroyed business property is the lesser of the decline in the
value of the property, $4,200 ($7,800 - $3,600) or the property's basis, $3,800.
Stellas loss is the cabs basis, $3,800 and is reduced by the $2,900 insurance
reimbursement for a net casualty loss deduction of $900. Stellas total casualty
loss on the two accidents is $1,850 ($950 + $900).
Lower of:
Adjusted basis
or
Reduction in FMV
Insurance reimbursement
Casualty loss
61.
Damaged Cab
Destroyed Cab
$3,750
5,500 $ 3,750
(2,800)
$ 950
$3,800
4,200
$ 3,800
(2,900)
$ 900
Elliot sells some stock to his sister, Nancy, for $4,000. His basis in the stock is $6,000.
Several years later, Nancy sells the stock for $7,000. What is the effect of the sales on
Elliot and Nancy?
Elliot and Nancy are related parties. Elliot is not allowed to deduct any of the
$2,000 loss on the sale of the stock to his sister. Upon subsequent sale to an
unrelated party, Nancy can use the loss to reduce gain on the sale but not below
zero. The gain on sale by Nancy is $3,000, which is reduced by Elliot's disallowed
loss of $2,000 and her recognized gain is $1,000.
Elliot
Selling price
$ 4,000
Less: Basis
(6,000)
Realized gain (Loss on sale)
$ (2,000)
Deductible loss
-0Recognized gain
a. Assume that the subsequent sale by Nancy is for $5,000.
Nancy
$ 7,000
(4,000)
$ 3,000
(2,000)
$ 1,000
The gain on the subsequent sale is only $1,000. Nancy may only use $1,000 of
Elliots disallowed loss to offset her gain. A loss cannot be created on the
subsequent sale by use of the disallowed loss. The remaining $1,000 of the
original loss is lost forever.
Elliot
Nancy
Selling price
$ 4,000
$ 5,000
Less: Basis
(6,000)
(4,000)
Realized gain (Loss on sale)
$ (2,000)
$ 1,000
Deductible loss
-0(1,000)
Recognized gain
$ -0b. Assume that the subsequent sale by Nancy is for $2,000.
Chapter 7: Losses - Deductions and Limitations
7-12
In this case, the subsequent sale results in a loss of $2,000 ($2,000 - $4,000).
Elliot's disallowed loss cannot be used to increase Nancys loss on the
subsequent sale. Nancy recognizes a $2,000 loss.
64.
Ed owns 500 shares of Northern Company for which he paid $15,000 several years ago.
On November 24, he purchases an additional 350 shares for $6,300. Ed sells the
original 500 shares for $10,000 on December 14. What are the effects of the December
14 sale? Explain.
The sale of the 500 shares results in a realized loss of $5,000. However, 350 of the
500 shares sold are replaced within the 30 day period that defines a wash sale.
Therefore, the loss on the 350 shares replaced is disallowed and added to the
basis of the 350 replacement shares purchased on November 24. The loss on the
150 shares that are not replaced is allowed as a capital loss. The disallowed loss
is $3,500 and the allowable loss is $1,500:
Amount realized
Less: Basis
Realized loss
Disallowed loss on 350 shares
(350 500) x $5,000
Allowable loss on 150 shares not replaced
$ 10,000
(15,000)
$ (5,000)
3,500
$ (1,500)
The basis of the 350 shares purchased on November 24 is $9,800 ($6,300 cost +
$3,500 disallowed loss on wash sale).
66.
Jorge and his wife own a beachfront vacation home in Savannah, Georgia. During the
year, high winds from a tropical storm shatter a sliding glass door and rain from the storm
causes extensive water damage to the kitchen. Fortunately, during a calm in the storm,
Jorge is able to board up the door, which limits the water damage to the kitchen. The
items damaged in the storm are:
Kitchen Furniture
TV
Refrigerator
Linoleum Flooring
Cost
$2,100
$ 250
$1,000
$1,600
Value
Before
$1,400
$ 200
$ 950
$ 900
Value
Insurance
After Proceeds
$400
$650
$ -0$125
$100
$800
$ -0$500
In addition, Jorge pays $625 to replace the sliding glass door. The insurance company
will not reimburse him for the cost of the new door because the old sliding glass door did
not meet the companys standards for a hurricane area. What is the amount of Jorges
casualty loss before considering any annual limitations that may apply?
The measure of a personal casualty loss is the lesser of the decline in market
value or the property's basis. In the case of a theft, the decline in market value is
the market value of the property prior to the theft. The measured loss must be
reduced by any insurance reimbursements and the $100 statutory floor. Jorge's
casualty loss is $1,400 before considering the annual personal casualty loss
limitation (i.e., 10% of adjusted gross income):
Kitchen furniture (decline in value)
Television (decline in value)
Refrigerator (decline in value)
Linoleum Flooring (decline in value)
Window damage (cost to repair)
$ 1,000
200
850
900
625
Chapter 7: Losses - Deductions and Limitations
Total loss before insurance reimbursement
Less: Insurance reimbursement ($650 + $125 + $800 + $500)
Loss net of insurance
Less: statutory floor
Net casualty loss before annual limitation
Adjusted basis
OR
Decline in value
($16,000 x 25% = $4,000)
Less: Insurance proceeds
Net loss
7-13
$ 3,575
(2,075)
$ 1,500
(100)
$ 1,400
$ 7,000
$ 4,000
$
9,000
(8,000)
(4,000)
3,000
$ (1,000)
Jamila can deduct the $8,000 loss on the business portion of the automobile.
Assuming Jamila has no other casualty losses during the year, she is not entitled
to a casualty loss on the personal portion of the automobile. The $900 loss ($1,000
- $100 statutory floor) does not exceed 10% of her adjusted gross income [ $900 <
$4,500 ($45,000 x 10%)].
77. Margery owns a passive activity with a basis of $15,000. The activity has a
$9,000 suspended loss. Margery sells the passive activity for $22,000.
There are two issues. The first is whether Margery has a gain or loss on the
sale of the passive activity. The second issue is whether the suspended
loss is deductible. Margery has a capital gain of $7,000 ($22,000 - $15,000)
on the sale of the activity and is allowed a deduction of $9,000 for the
suspended loss on the activity. Any suspended loss on a passive activity is
deductible in full when the entire interest in the activity is disposed of
through a sale of the activity. This results in a net deduction of $2,000.
However, the $7,000 capital gain is netted with any other capital gains and
losses that Margery has during the year. Also, the tax rate on a net longterm capital gain is 15% (5% if the taxpayers marginal tax rate is 10% or
15%), which further complicates the tax effect of Margery's net deduction of
$2,000.