chapter 7 losses - deductions and limitations ©2006 south-western kevin murphy mark higgins kevin...

Chapter 7Chapter 7

Losses - Deductions and Limitations

Losses - Deductions and Limitations

©2006 South-Western©2006 South-Western©2006 South-Western©2006 South-Western

Kevin MurphyKevin MurphyMark HigginsMark Higgins

Kevin MurphyKevin MurphyMark HigginsMark Higgins

Transparency 7 -2Transparency 7 -2© 2006 South-Western© 2006 South-Western

Definition of LossesDefinition of Losses

Annual (Activity) Losses result when an entity’s deductions for the period exceed its income

Transaction Losses result from the disposition of an asset


Losses may result from the disposition of an asset because

of the capital recovery concept.

Concept ReviewConcept Review



Most of the classification rules for deductions also apply to losses, because losses also result when

deductions exceed income.



The deductibility of losses is a matter oflegislative grace and is based on the

ability-to-pay concept.


Realized loss

Annual loss Transaction loss

Trade orbusiness

loss

Trade orbusiness

loss

PassiveActivity

NOLdeduction

Loss allowedor loss

deductionsuspended

Ordinaryloss

Capital loss

limitations

Non-deductible

Investment-related

loss

Personaluseloss

Figure 7-1

General Scheme for Treatment of LossesGeneral Scheme for Treatment of Losses


Annual Losses: Net Operating LossAnnual Losses: Net Operating Loss

Incurred in trade or business operationsCaused by business expensesMay not be caused by investment or personal

expenses

TreatmentNo tax in year NOL occursCarry-back 5 years

May elect to carry-back only 2 years

Carry-forward unused NOL 20 years May elect to forego carry-back


Annual Losses: Tax Shelter LossesAnnual Losses: Tax Shelter Losses

Dominant business purpose is lacking Primary motivation is tax reduction Are often vehicles for tax law abuse

Tax shelters are activities designed to minimize the effect of tax on wealth accumulation.


Tax Shelter LossesAt-Risk Rules

Tax Shelter LossesAt-Risk Rules

At-Risk Rules disallow the deduction of artificial lossesLoss 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


Tax Shelter Losses Passive Activity LossTax Shelter Losses

Passive Activity Loss

Passive Activity Loss Rules disallow the deduction of passive activity losses from other forms of income

A passive activity is any trade or business in which the taxpayer does not materially participate.


Passive Activity Loss Definition

Passive Activity Loss Definition

Three classifications for activities: Portfolio income: unearned income

derived from holding investments Active income: earned income Passive income: earned or unearned

income from a trade or business in which a taxpayer does not materially participate


Passive Activity LossPassive Activity Loss

Taxpayers subject to the limitations:All non-corporate taxable entitiesConduit 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


Passive Activity LossGeneral Rules for Limitations

Passive Activity LossGeneral Rules for Limitations

Passive activity losses must be netted against passive activity incomeNet passive losses are not deductibleNet passive gains are reported with

other income


Passive Activity LossException for Rental Real

Estate


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



Estate


Estate And, taxpayers who are active

participants in rental real estate business may offset a portion of lossesMust own at least 10% interest in the

activityMust have significant and bona fide

involvement


Active Participants in Real Estate

Active Participants in Real Estate

Active Participation Exception permits up to $25,000 of rental real estate loss to be deducted annuallyDeduction amount is reduced by $0.50 for

each dollar of AGI over $100,000. For AGI over $150,000, no allowed loss

deduction remains.


Passive Activity LossDisposition of Passive

Activities

Passive Activity LossDisposition 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 activityFirst, offsets other passive incomeSecond, offsets gain from disposalThird, any remaining PAL offsets ordinary

income


Disposition of Passive Activities

Disposition of Passive Activities

Disposition upon death leaves the passive activity in the decedent’s estatePassive 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


Transaction LossesTransaction Losses

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


Transaction Losses:Trade or Business LossesTransaction Losses:Trade or Business Losses

Business casualty and theft losses result from damage caused by a sudden, unexpected and/or unusual eventFor property fully destroyed, deduct the

adjusted basis less insurance recoveryFor property partially destroyed, deduct the

lesser of the property’s adjusted basis, or the decline in the property’s value


Transaction Losses:Investment-Related LossesTransaction Losses:Investment-Related Losses

Net capital losses result from netting short-term and long-term capital gains and lossesIndividual taxpayers may deduct only

$3,000 annuallyCorporate taxpayers may not deduct any

net capital loss Carry-back for 3 years, then forward for 5



Losses on Small Business Stock may be deducted up to $50,000 per person ($100,000 per married couple) per yearSmall business = a corporation with

capitalization of less than $1 millionStock must have been bought directly from

corporationExcess over $50,000 ($100,000) is netted

with other capital gains and losses



Losses on Related Party Sales are disallowed because they generally fail the arm’s length transaction conceptLoss 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



Wash Sale losses are disallowed because the sale violates the substance-over-form doctrineA 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


Transaction Losses: Personal Use LossesTransaction Losses: Personal Use Losses

Losses from the disposition of personal use assets are generally not deductible

Exception exists for personal casualty and theft losses


Transaction Losses:Personal Casualty and Theft Losses

Transaction Losses:Personal Casualty and Theft Losses Loss is the lesser of

The property’s adjusted basis, orThe decline in the value of the property

(repair cost)

Loss is reduced byInsurance proceeds received,$100 per event (Administrative

convenience), and10% of AGI per year


End of Chapter 7End of Chapter 7

chapter 7 losses - deductions and limitations ©2006 south-western kevin murphy mark higgins kevin...

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