1 / 80

Chapter 6

Chapter 6. Losses and Loss Limitations. The Big Picture (slide 1 of 3). Robyn is nearing the end of a year that she would like to forget. Several years ago she loaned a friend $25,000 to enable him to start a business.

nitsa
Download Presentation

Chapter 6

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. Chapter 6 Losses and Loss Limitations

  2. The Big Picture (slide 1 of 3) Robyn is nearing the end of a year that she would like to forget. Several years ago she loaned a friend $25,000 to enable him to start a business. The friend had made scheduled payments of $7,000 ($1,000 of this was interest) when he unexpectedly died in January. At the time of his death, he was insolvent. Robyn’s attempts to collect on the debt were fruitless. Last year Robyn invested $60,000 in the stock of a company started by her brother. The company declared bankruptcy in May of this year. Robyn is notified by the bankruptcy trustee that she can expect to receive nothing from the company. 2

  3. The Big Picture (slide 2 of 3) Robyn has owned and operated a bookstore as a sole proprietorship for the past 10 years. The bookstore previously has produced annual profits of about $75,000. Due to a chain bookstore opening down the street, Robyn’s bookstore sustained a net loss of $180,000 this year. In September, a tornado caused a large oak tree to blow over onto Robyn’s house. The cost of removing the tree and making repairs was $32,000. Robyn received a check for $25,000 from her insurance company in final settlement of the claim. Her adjusted basis for the house was $280,000. 3

  4. The Big Picture (slide 3 of 3) Robyn invested $20,000 for a 10% interest in a limited partnership that owns and operates orange groves in Florida. Due to a hard freeze that damaged much of the fruit, the partnership lost $200,000 and allocated $20,000 of ordinary loss to Robyn. Robyn comes to you for tax advice and would like to know the tax ramifications of each of the transactions listed above. Read the chapter and formulate your response. 4

  5. Bad Debts If an account receivable arising from credit sale of goods or services becomes worthless A bad debt deduction is permitted only if income arising from creation of the receivable was previously included in income No deduction is allowed if taxpayer is on the cash basis since no income is reported until the cash has been collected 5

  6. Business Bad Debts (slide 1 of 4) • Specific charge-off method must be used • Exception: Reserve method is allowed for some financial institutions • Deduct as ordinary loss in the year when debt is partially or wholly worthless

  7. Business Bad Debts (slide 2 of 4) • If a business bad debt previously deducted as partially worthless becomes totally worthless in a future year • Only the remainder not previously deducted can be deducted in the future year

  8. Business Bad Debts (slide 3 of 4) • In the case of total worthlessness, deduction is allowed for entire amount in the year the debt becomes worthless • Deductible amount depends on basis in bad debt • If debt arose from sale of services or products and the face amount was previously included in income • That amount is deductible • If the taxpayer purchased the debt • Deduction is equal to amount paid for debt instrument

  9. Business Bad Debts (slide 4 of 4) • If a receivable has been written off • The collection of the receivable in a later tax year may result in income being recognized • Income will result if the deduction yielded a tax benefit in the year it was taken

  10. Nonbusiness Bad Debts (slide 1 of 2) • Nonbusiness bad debt • Debt unrelated to the taxpayer’s trade or business • Deduct as short-term capital loss in year amount of worthlessness is known with certainty • No deduction is allowed for partial worthlessness of a nonbusiness bad debt

  11. Nonbusiness Bad Debts (slide 2 of 2) • Related party (individuals) bad debts are generally suspect and may be treated as gifts • Regulations state that a bona fide debt arises from a debtor-creditor relationship based on a valid and enforceable obligation to pay a fixed or determinable sum of money • Thus, individual circumstances must be examined to determine whether advances between related parties are gifts or loans

  12. Classification of Bad Debts • Individuals will generally have nonbusiness bad debts unless: • In the business of loaning money, or • Bad debt is associated with the individual’s trade or business • Determination is made either at the time the debt was created or when it became worthless

  13. The Big Picture - Example 4Nonbusiness Bad Debts Return to the facts of The Big Picture on p. 6-2. Robyn loaned her friend, Jamil, $25,000. Jamil used the money to start a business, which subsequently failed. When Jamil died after having made principal payments of $6,000 on the loan, he was insolvent. Even though the proceeds of the loan were used in a business, the loan is a nonbusiness bad debt The business was Jamil’s, not Robyn’s. 13

  14. Worthless Securities (slide 1 of 2) • Loss on worthless securities is deductible in the year they become completely worthless • These losses are capital losses deemed to have occurred on the last day of the year in which the securities became worthless • Capital losses may be of limited benefit due to the $3,000 capital loss limitation

  15. Worthless Securities (slide 2 of 2) • Example of worthless securities • On December 1, 2010, Sally purchased stock for $10,000. The stock became worthless on June 1, 2011. Sally’s loss is treated as having occurred on December 31, 2011. The result is a long-term capital loss.

  16. The Big Picture - Example 7Worthless Securities (slide 1 of 2) Return to the facts of The Big Picture on p. 6-2. Robyn, a calendar year taxpayer, owned stock in Owl Corporation. She acquired the stock on October 1, 2010 Cost was $60,000. On May 31, 2011, the stock became worthless as the company declared bankruptcy. The stock is deemed to have become worthless as of December 31, 2011 Robyn has a long-term capital loss 16

  17. The Big Picture - Example 7Worthless Securities (slide 2 of 2) Alternatively, if the stock is § 1244 small business stock (see below). She has a $50,000 ordinary loss and a $10,000 long-term capital loss. 17

  18. Bad Debt Deductions Summary

  19. Section 1244 Stock(slide 1 of 3) • Sale or worthlessness of § 1244 stock results in ordinary loss rather than capital loss for individuals • Ordinary loss treatment (per year) is limited to $50,000 ($100,000 for MFJ taxpayers) • Loss in excess of per year limit is treated as capital loss

  20. Section 1244 Stock(slide 2 of 3) • Section 1244 loss treatment is limited to stock owned by original purchaser who acquired the stock from the corporation • Corporation must meet certain requirements for stock to qualify • Major requirement is limit of $1 million of capital contributions • Section 1244 does not apply to gains

  21. Section 1244 Stock(slide 3 of 3) • Example of § 1244 loss • In 2008, Sam purchases from XYZ Corp. stock costing $150,000. (Total XYZ stock outstanding is $800,000.) In 2011, Sam sells the stock for $65,000. • Sam, a single taxpayer, has the following tax consequences: • $50,000 ordinary loss • $35,000 long-term capital loss

  22. Definition of Casualty & Theft (C & T) • Losses or damages to the taxpayer’s property that arise from fire, storm, shipwreck, or other casualty or theft • Loss is from event that is identifiable, damaging to taxpayer’s property, and sudden, unexpected, and unusual in nature • Events not treated as casualties include losses from disease and insect damage

  23. Definition of Theft • Theft includes robbery, burglary, embezzlement, etc. • Does not include misplaced items

  24. When Casualty & Theft Is Deductible • Casualties: year in which loss is sustained • Exception: If declared “disaster area” by President, can elect to deduct loss in year prior to year of occurrence • Thefts: year in which loss is discovered

  25. The Big Picture - Example 13Disaster Area Losses Return to the facts of The Big Picture on p. 6-2. On September 28, 2011, Robyn’s personal residence was damaged when a tornado caused an oak tree to fall onto the house. The amount of her uninsured loss was $7,000. Because of the extent of the damage in the area, the President of the United States designated the area a disaster area. Because Robyn’s loss is a disaster area loss, Robyn has 2 options. She may elect to file an amended return for 2010 and take the loss in that year. The amount of the loss will be reduced first by $100 and then by 10% of her 2010 AGI. Alternatively, she may take the loss on her 2011 income tax return. The amount of the loss will be reduced first by $100 and then by 10% of her 2011 AGI. 25

  26. Effect of Claim for Reimbursement • If reasonable prospect of full recovery: • No casualty loss is permitted • Deduct in year of settlement any amount not reimbursed • If only partial recovery is expected, deduct in year of loss any amount not covered • Remainder is deducted in year claim is settled

  27. Amount of C&T Deduction • Amount of loss and its deductibility depends on whether: • Loss is from nonpersonal (business or production of income) or personal property • Loss is partial or complete

  28. Amount of Nonpersonal C&T Losses • Theft or complete casualty (FMV after = 0) • Adjusted basis in property less insurance proceeds • Partial casualty • Lesser of decline in value or adjusted basis in property, less insurance proceeds

  29. Business and production of income losses (no insurance proceeds received) Adjusted FMV FMV Item Basis Before After Loss A 6,000 8,000 5,000 3,000 B 6,000 8,000 1,000 6,000 C 6,000 4,000 0 6,000 C&T Examples

  30. Nonpersonal C&T Losses • Losses on business, rental, and royalty properties • Deduction will be for AGI • Not subject to the $100 per event and the 10% of AGI limitation • Losses not connected with business, rental, and royalty properties • Deduction will be from AGI • Example - theft of a security • Theft losses of investment property are not subject to the 2% of AGI floor on certain miscellaneous itemized deductions

  31. Nonpersonal C&T Gains • Depending on the property, gain can be ordinary or capital • Amount of nonpersonal gains • Insurance proceeds less adjusted basis in property

  32. Personal C&T Gains and Losses (slide 1 of 4) • Casualty and theft losses attributable to personal use property are subject to the $100 per event and the 10% of AGI limitations • These losses are itemized deductions, but they are not subject to the 2% of AGI floor • Amount of personal C&T losses • Lesser of decline in value or adjusted basis in property, less insurance proceeds • Insurance proceeds may result in gain recognition on certain casualty and thefts

  33. Personal C&T Gains and Losses (slide 2 of 4) • If a taxpayer has both personal casualty and theft gains as well as losses, a special set of rules applies • A personal casualty gain is the recognized gain from a casualty or theft of personal use property • A personal casualty loss for this purpose is a casualty or theft loss of personal use property after the application of the $100 floor • Taxpayer must first net (offset) the personal casualty gains and personal casualty losses • Tax treatment depends on the results of this netting process

  34. Personal C&T Gains and Losses (slide 3 of 4) • If netting personal casualty gains and losses results in a net gain • Treat as gains and losses from the sale of capital assets • Short term or long term, depending on holding period • Personal casualty and theft gains and losses are not netted with the gains and losses on business and income-producing property

  35. Personal C&T Gains and Losses (slide 4 of 4) • If netting personal casualty gains and losses results in a net loss • All gains and losses are treated as ordinary items • The gains—and the losses to the extent of gains—are treated as ordinary income and ordinary loss in computing AGI • Losses in excess of gains are deducted as itemized deductions to the extent the losses exceed 10% of AGI

  36. Example of C&T Limitation(slide 1 of 2) • Karen (AGI = $40,000) has the following C&T in 2011 (amounts are lesser of decline in value or adjusted basis): 1. Car stolen ($6,000) with camera inside ($500) • Earthquake damage: house ($2,000), furniture ($1,000)

  37. Example of C&T Limitation(slide 2 of 2) • Example of C&T limitation (cont’d) • Karen has no insurance coverage for either loss: 1. $6,000 + $500 = $6,500 – $100 = $6,400 2. $2,000 + $1,000 = $3,000 – $100 = $2,900 • Karen’s deductible C&T loss is $5,300 [$6,400 + $2,900 – (10% $40,000)]

  38. Net Operating Losses(slide 1 of 4) • NOLs from any one year can be offset against taxable income of other years • The NOL provision is intended as a form of relief for business income and losses • Only losses from trade or business operations, casualty and theft losses, or losses from foreign government confiscations can create a NOL

  39. Net Operating Losses(slide 2 of 4) • No nonbusiness (personal) losses or deductions may be used in computing NOL • Exception: personal casualty and theft losses

  40. Net Operating Losses(slide 3 of 4) • Carryover period • Must carryback to 2 prior years, then carryforward to 20 future years • May make an irrevocable election to just carryforward • When there are NOLs from two or more years, use on a FIFO basis • 3 year carryback is available for: • Individuals with NOL from casualty or thefts • Small businesses with NOLs from Presidentially declared disasters • 5-year carryback period and a 20-year carryover period are allowed for a farming loss

  41. Net Operating Losses(slide 4 of 4) • Example of NOL carryovers • Ken has a NOL for 2011 • Ken must carryover his NOL in the following order: • Carryback to 2009 and 2010, then carryforward to 2012, 2012, ..., 2031 • Ken can elect to just carryforward his NOL • Carryover would be to 2012, 2013, ..., 2031

  42. Passive Loss Rules (slide 1 of 2) Require income and losses to be separated into three categories: Active Portfolio Passive Generally, disallow the deduction of passive losses against active or portfolio income 42

  43. Passive Loss Rules (slide 2 of 2) In general, passive losses can only offset passive income Passive losses are also subject to the at-risk rules Designed to prevent taxpayers from deducting losses in excess of their economic investment in an activity 43

  44. At-Risk Limits (slide 1 of 4) At-risk defined The amount of a taxpayer’s economic investment in an activity Amount of cash and adjusted basis of property contributed to the activity plus amounts borrowed for which taxpayer is personally liable (recourse debt) 44

  45. At-Risk Limits (slide 2 of 4) At-risk defined At-risk amount does not include nonrecourse debt unless the activity involves real estate For real estate activities, qualified nonrecourse debt is included in determining at-risk limitation 45

  46. At-Risk Limits (slide 3 of 4) At-risk limitation Can deduct losses from activity only to extent taxpayer is at-risk Any losses disallowed due to at-risk limitation are carried forward until at-risk amount is increased Previously allowed losses must be recaptured to the extent the at-risk amount is reduced below zero At-risk limitations must be computed for each activity of the taxpayer separately 46

  47. At-Risk Limits (slide 4 of 4) Interaction of at-risk rules with passive loss rules At-risk limitation is applied FIRST to each activity to determine maximum amount of loss allowed for year THEN, passive loss limitation applied to ALL losses from ALL passive activities to determine actual amount of loss deductible for year 47

  48. Calculation of At-Risk Amount Increases to a taxpayer’s at-risk amount: Cash and the adjusted basis of property contributed to the activity Amounts borrowed for use in the activity for which the taxpayer is personally liable or has pledged as security property not used in the activity Taxpayer’s share of amounts borrowed for use in the activity that are qualified nonrecourse financing Taxpayer’s share of the activity’s income Decreases to a taxpayer’s at-risk amount: Withdrawals from the activity Taxpayer’s share of the activity’s loss Taxpayer’s share of any reductions of debt for which recourse against the taxpayer exists or reductions of qualified nonrecourse debt 48

  49. Passive Loss Limits(slide 1 of 8) Active income Wages, salary, and other payments for services rendered Profit from trade or business activity in which taxpayer materially participates Gain from sale or disposition of assets used in an active trade or business Income from intangible property created by taxpayer 49

  50. Passive Loss Limits(slide 2 of 8) Portfolio income Interest, dividends, annuities, and certain royalties not derived in the ordinary course of business Gains/losses from disposition of assets that produce portfolio income or held for investment 50

More Related