Chapter 7

1. Chapter 7 Losses – Deductions and Limitations Murphy & Higgins Concepts in Federal Taxation, 2012 edition © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2. Concept Review • Losses may result from the disposition of an asset because of the capital recovery concept • 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 of legislative grace and is based on the ability-to-pay concept © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3. 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 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

4. General Scheme for Treatment of Losses Realized loss Annual loss Transaction loss Investment-related loss Trade or business loss Trade or business loss Personal use loss Passive Activity Capital loss limitations Loss allowed or loss deduction suspended Ordinary loss Non- deductible NOL deduction © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

5. Annual Losses: Net Operating Losses • Annual loss incurred in a trade or business in which the taxpayer materially participates • It results from an excess of allowable deductions over income for the accounting period • Incurred in trade or business operations • Caused by business expenses • May not be caused by investment or personal expenses • Treatment • No tax in year NOL occurs • Carry-back 2 years • Carry-forward unused NOL 20 years • May elect to forego carry-back © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

6. Annual Losses: Tax Shelters • Activities designed to minimize the effect of tax on wealth accumulation • Dominant business purpose is lacking • Primary motivation is tax reduction • Are often vehicles for tax law abuse © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

7. Tax Shelter Losses: At-Risk Rules • At-Risk Rules disallow the deduction of artificial losses • Loss deduction limited to amounts actually “at-risk” • To determine amounts actually at-risk, • Start with the amount of cash or other assets contributed • Add debts for which taxpayer is responsible • Adjust for share of income (loss) from the activity • Reduce by amount of withdrawals © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

8. Tax Shelter Losses: Passive Activity Loss • Passive activity: Any trade or business in which the taxpayer does not materially participate • Passive Activity Loss Rules: Disallow the deduction of passive activity losses from other forms of income • Two basic tests for material participation • Individual (including the individual’s spouse) participates in the activity for more than 500 hours per year • Taxpayer spends more than 100 hours a year in the activity, and the time spent in the activity is more hours than any other owner or non-owner spends on the activity (known as the 100-hour test) • Remaining five tests are: • Rental Activities • Limited Partnership Interests • Working Interest in Oil and Gas • Low-Income Housing Projects • Real Estate Professional Exception © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

9. Passive Activity Loss: Classifications • 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 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

10. Passive Activity Loss: Limitations • Taxpayers subject to the limitations: • All non-corporate taxable entities • Conduit 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 • General rules for limitations • Passive activity losses must be netted against passive activity income • Net passive losses are not deductible • Net passive gains are reported with other income © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

11. Passive Activity Loss: Exceptions • Rental real estate • By definition, all rental activities and limited partnership interests are passive • But, taxpayers who materiallyparticipate in rental real estate business are allowed to offset any losses against other active or portfolio income • And, taxpayers who are active participants in rental real estate business may offset a portion of losses • Must own at least 10% interest in the activity • Must have significant and bona fide involvement • Active participants in real estate • Active Participation Exception permits up to $25,000 of rental real estate loss to be deducted annually • Deduction amount is reduced by $0.50 for each dollar of AGI over $100,000 • For AGI over $150,000, no allowed loss deduction remains © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

12. Passive Activity Loss:Disposition of Passive Activities • Loss Activities • Disposition By Sale • Frees the suspended loss to offset income of any other activity • First, offsets other passive income • Second, offsets gain from disposal • Third, any remaining PAL offsets ordinary income • Disposition Upon Death • Leaves the passive activity in the decedent’s estate • Passive 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 • Disposition By Gift • Excess (suspended) losses must be accounted for in the year of disposition © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

13. Transaction Losses: Trade or Business Losses • Transaction losses • Result from the disposition of business, investment or personal-use assets • Allowance of deductions for losses follows the same line of reasoning as for the allowance of deductions • Trade or business losses • Business casualty and theft losses result from damage caused by a sudden, unexpected and/or unusual event • For property fully destroyed, deduct the adjusted basis less insurance recovery • For property partially destroyed, deduct the lesser of the property’s adjusted basis, or the decline in the property’s value © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

14. Investment-related losses Net capital losses result from netting short-term and long-term capital gains and losses Individual taxpayers may deduct only $3,000 of net capital loss annually Corporate 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 year Small business: A corporation with capitalization of less than $1 million Stock must have been bought directly from corporation Excess over $50,000 ($100,000) is netted with other capital gains and losses Transaction Losses: Investment-Related Losses (slide 1 of 2) © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

15. Transaction Losses: Investment-Related Losses (slide 1 of 2) • Losses on Related Party Sales: Disallowed because they generally fail the arm’s length transaction concept • Loss 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: Disallowed because the sale violates the substance-over-form doctrine • A 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 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

16. Transaction Losses: Personal Use, Personal Casualty & Theft Losses • Personal use losses • Losses from the disposition of personal use assets are generally not deductible • Exception exists for personal casualty and theft losses • Personal casualty and theft losses • Loss is the lesser of • Property’s adjusted basis, or • Decline in the value of the property (repair cost) • Loss is reduced by • Insurance proceeds received, • $100 per event (Administrative convenience), and • 10% of AGI per year © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.