Chapter 8

Losses and Bad Debts

Learning Objectives

• 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

Learning Objectives

• 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

Transactions That May Result In Losses

• Sale or exchange of property

• Expropriation, seizure, or confiscation of property

• Abandonment of property• Worthless securities• Demolition of property

Classifying The Loss On A Taxpayer’s Return

• Ordinary vs. Capital loss

• Disallowance possibilities

Ordinary Vs. Capital Loss

• Dependent on type of property involved and type of transaction involved

• Losses on qualifying Sec. 1244 stock are treated as ordinary rather than capital loss($50,000 limitation or $100,000 if filing MFJ)

Qualification as Sec. 1244 Stock

• Must be issued and owned by an individual or partnership

• Corporation must be domestic

• Stock must be issued for cash or property, not services

Qualification as Sec. 1244 Stock

• Corporation must not have derived > 50% of gross receipts from passive income sources during the immediately preceding 5 tax years, and

• At the time stock is issued, the amount of money and property contributed to both capital and paid-in surplus may not exceed $1 million

Disallowance Possibilities

• Transfers of property to a controlled corporation in exchange for stock

• Property sold to certain related parties

• Wash sales• Losses limited because the losses

exceed the amount for which the taxpayer is at risk.

Passive Losses

• Computation of passive losses and credits

• Carryovers

• Definition of passive activity

Passive Losses

• Taxpayers subject to passive loss rules

• Publicly traded partnerships

• Rental real estate trade or business

• Other rental real estate activities

Definition of a 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

• Applies to individuals, estates, trusts, closely-held C Corporations, Personal Service Corporations, and certain publicly traded partnerships

• While not applied to partnerships and S Corporations directly, applies to owners

Taxpayers Subject To Passive Loss Rules

Passive Losses

• Types of income– Active: wages, salaries, business– Portfolio: dividends, interest, annuities,

royalties– Passive: rental, trade, business or

investment

• General rule: passive losses can only be used to offset passive income

Passive Losses: Exceptions

• 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

Casualty & Theft Losses

• What is a casualty

• What is a theft

• Deductible amount of casualty loss

Casualty

• 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

• Generally, criminal intent and violation of a state law are required to meet the definition of theft

• Includes larceny, embezzlement, robbery, blackmail, extortion, and ransom

Casualty & Theft Losses• Limitations on personal use property

– Subject to two limitations: the losses sustained in each separate casualty are reduced by $100, and the total amount of all net casualty losses is reduced by 10 % of the taxpayer’s AGI

– Netting casualty gains and losses on personal use property

Casualty & Theft Losses

• Casualty gains and losses attributable to business and investment property

• When losses are deductible

Bad Debts• Bona fide debtor-

creditor relationship

• Taxpayer must have basis in the debt

• Debt must be worthless

• Non-business bad debts

Bad Debts

• Business bad debts

• Accounting for the business bad debts

• Recovery of bad debts

• Deposits in insolvent financial institutions

Net Operating Loss

• Involves business income and deductions only and will increase an Net Operating Loss (NOL)

• Computing the NOL• Carryback and

carryover periods• Recomputation of

taxable income in the carryover year

Tax Planning Considerations

• Taxpayers should document their determination that a particular debt is worthless

• Documentation of fair market value is important to support a casualty loss

• Taxpayer should consider forgoing NOL carryback to only carry forward if a higher marginal rate is expected in the future or a carryback would jeopardize tax credits

Compliance and Procedural

Considerations• Casualty losses

• Net Operating Losses

• Worthless Securities