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Chapter 7 - Losses -- Deductions and Limitations

Chapter 7 - Losses -- Deductions and Limitations - Chapter...

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Chapter 7: Losses—Deductions and Limitations I. Introduction a. Only losses that result from a profit-motivated transaction or venture are deductible b. Once a loss has been properly categorized, the rules for deductibility are applied by category i. All losses incurred in a trade or business are fully deductible ii. Losses incurred in an income-producing activity are subject to the capital loss limitations iii. Losses on personal used of property are generally disallowed II. Annual Losses a. Annual Losses: i. Result from an excess of deductions over income 1. Only deductions allowed for annual losses are for those incurred in a trade or business ii. Two primary types: 1. Net Operating Losses (NOLs) 2. Passive Activity Losses a. If the taxpayer does not materially participate in the business, the passive activity loss rules apply b. If the taxpayer does participate the NOL deduction is usually allowed III. Net Operating Losses a. NOLs: i. Annual losses incurred in a trade or business in which the taxpayer materially participates 1. Taxpayer pays no taxes in the year in which an NOL occurs
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a. Taxable entities are not allowed to pass the loss through to their owners for a deduction ii. A carryover system allows losses incurred in one year to be deducted against the income in other years 1. Carryback: a. The loss may be used to reduce income in prior years i. Because a tax has already been paid on the prior year’s income, a carryback results in a prompt refund of taxes paid b. Can be carried back for two years i. Requires the taxpayer to apply the loss to the earliest of the two carryback years first 1. If the earliest year doesn’t have sufficient income to entirely absorb the loss, any remaining loss is carried to the first year in the carryback period 2. Carryforward: a. The loss is used to offset income in future periods i. Doesn’t provide immediate tax savings 1. Reduces taxes to be paid on future income b. Can be carried forward for twenty years i. Advantageous when the prior two years’ income were taxed at low marginal rates and the taxpayer anticipates higher marginal tax rates in the near future IV.Tax-Shelter Losses: An Overview a. Tax shelter: i. Any investment activity that is designed to minimize the effect of the income tax on wealth accumulation 1. Generally applied to investments that produce significant tax losses as a result of the allowable deductions associated with the investment
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a. Losses are then used to offset taxable income from other income sources ii. Many tax advantages that allow such activities to generate losses are the result of a conscious effort by Congress to attract investment capital to activities with high national priority and/or a high degree of risk iii. Limited Partnerships are preferred vehicles for tax shelters: 1. Flow through of the income and deductions of a partnership to the owners allows investment by many individuals who have not involvement in the business 2. Possible to make special allocations of income and expense items,
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