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Chapter 15

Chapter 15. Losses and Bad Debts. §165(a). Deduction for “any loss sustained during the taxable year and not compensated for by insurance or otherwise.”. Business and Profit-Oriented Transactions. Loss from Trade or Business - §165(c)(1)

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Chapter 15

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  1. Chapter 15 Losses and Bad Debts

  2. §165(a) • Deduction for “any loss sustained during the taxable year and not compensated for by insurance or otherwise.”

  3. Business and Profit-Oriented Transactions • Loss from • Trade or Business - §165(c)(1) • Transaction entered into for profit - §165(c)(2) • Fire, storm, shipwreck, other casualty, or theft • Personal - no deduction for losses on sale or disposition of wholly personal-use property • If dual use: allocate loss between business and nonbusiness

  4. Closed and Completed Transaction Sale or other disposition of property Abandonment Worthlessness Demolition of Buildings §280B - capitalized and added to basis of land Business Casualties

  5. Insurance or Other Compensation Losses can be deducted only if “not compensated for by insurance or otherwise.” Waiver of compensation for valid business reasons should not bar a loss deduction Casualty loss - permitted if taxpayer files a timely insurance claim (personal) and is not reimbursed

  6. Amount Deductible • In general - §165(b) • Losses from sale/exchange or property are limited to adjusted basis of property for determining loss under §1011. • For casualty losses • Lesser of: • reduction in FMV, or • adjusted basis of property • Exception for business property which is completely destroyed • Adjusted basis

  7. Limitations on Loss Deductions • Related Parties §267(a) • Wash Sales §1091

  8. Related Parties • Disallowed Loss • Taxpayer is not allowed to deduct the loss from a sale or exchange of property directly or indirectly to a related party • Any loss disallowed may be used to offset any gain on a subsequent sale of the property by a related party to an unrelated third party • Related Parties §267(b) • members of family • > 50% shareholder / corporation • trusts -- grantor, fiduciary, beneficiary

  9. Example In-class handout

  10. Wash Sales Disallowed loss if taxpayer acquires, or enters into a contract or option to acquire, substantially identical stock within the period thirty days before or after the sale Basis adjustment; disallowed loss realized upon final close out

  11. Example In-class handout

  12. §166 • Deduction for debts becoming worthless within the taxable year • Must be a bona fide debt • Must be a ‘bad” debt • Forgiveness/cancellation may be seen as a gift • Do not have to pursue legal action to establish worthlessness

  13. Business or Nonbusiness Debts • Business bad debts fully deductible under §166(a)(1) in the year they become wholly worthless • Also partially deductible in years when amounts charged off • Nonbusiness bad debts deductible only when fully worthless • Defined as a “debt other than a debt created or acquired in connection with the taxpayer’s business, or a debt the loss from the worthlessness of which is incurred in the taxpayer’s business.” • United States v. Generes • Business motive must be dominant over personal motive for debt to be characterized as business debt

  14. Amount Deductible • Deduction equal to debt’s adjusted basis • No bad debt deduction allowed for cash basis taxpayers • Time spent on a job for services is not considered an expense

  15. Example Karynloaned $20,000 to her co-worker to begin a new business several years ago. If her co-worker declares bankruptcy on June 22nd of the current year, is Karyn allowed to deduct the bad debt loss this year? If she can deduct the loss, what is the character of the loss?

  16. Chapter 44 Limitations on Tax Shelters – Sections 465 and 469

  17. Tax Shelters • Two common features: • - little cash invested • - large amount of nonrecourse debt (limited liability) • allowing deductions for depreciation, amortization, business expenses, and interest to exceed cash outlay • deductions offset not only against tax shelter income, but also income from salaries, dividends, interest, and bus income of all types

  18. Statutory Remediesfor Tax Shelters §465 - “at-risk” limitations on losses §469 - “passive activity losses” §§6111 & 6112 - registration of tax shelters w/ IRS §§6111 & 6112 – penalties for improper reporting §448(a)(3) - accrual method required for tax shelters

  19. §465“At-Risk” Limitation on Losses Limits deductions to the amount which the taxpayer could actually lose from the investment–the amount “at-risk” - Not artificial accounting losses

  20. §465 (continued) • At-Risk • Taxpayer must (1) commit personal funds (or property) to the investment or (2)incur personal liability for borrowed funds (recourse debt) • Activity • Any trade or business or production of income activity conducted by a taxpayer • most common - partnership investments • Exception for Certain Real Property Activities: • §465(b)(6) - considers taxpayers to be “at-risk” for their share of any “qualified nonrecourse financing” secured by real property used in the activity

  21. Computation of At-Risk Amount • Increase in “At-Risk” amount: • contributions of money and property to the activity (adjusted basis) • increase in recourse debt (Taxpayer personally liable and lender has no interest in the activity) • increase in debt where FMV of property pledged as collateral (property not used in activity) • income produced by activity

  22. Computation of At-Risk Amount • Decrease in “At-Risk” amount: • cash or property withdrawals or distributions • decrease in recourse debt • decrease in debt with collateral • loss produced by the activity

  23. §465“At-Risk” Limitation on Losses Segregates all income and deductions for each “activity” Deductions for an activity can be applied up to full amount of income produced by that same activity Deductions exceeding income from that same activity (net loss) can be applied against income from other activities only to extent of taxpayer’s “at-risk” invested in the activity producing the loss However, the net loss may be disallowed under §469 if the taxpayer does not “materially participate” in the activity that produced the loss (discussed later) Disallowed losses are carried forward to the next tax year

  24. §469Passive Activity Loss Limitations Taxpayer’s income is divided into 3 types: • material participation income – wages, salaries, and other income from activities in which the taxpayer materially participates • portfolio income – interest, dividends, capital gains and losses • passive income – income from activities in which the taxpayer does not materially participate Expenses related to passive activities can be deducted only to the extent of income from all such passive activities. Any excess (passive activity loss) may not be deducted against other types of income, but is suspended and carried forward.

  25. §469Passive Activity Loss Limitations Targeted at Real Estate tax shelters which were exempt from §465 “at-risk” rules Focuses on investor participation in activity Applies to every trade or business in which the owner does not “materially participate” without regard to method of financing business Prohibits use of net loss from “passive” activity to offset income from any other source (salaries, interest, dividends, income from activity in which taxpayer materially participates)

  26. Passive Activity Loss CarryOvers • Passive Activity Losses must be used in the following order: • against income from the same activity • against income from other passive activities • carried over to next year (suspended) • §469(g)(1)(A) - allows suspended losses to be deducted in full on a fully taxable disposition of taxpayer’s entire interest in the passive activity

  27. “Passive Activity” • §469(c)(1) - any activity that involves the conduct of a trade of business or production of income in which the taxpayer does not materially participate • §469(c)(2) - any rental activityregardless of taxpayer’s participation • Always classified as passive

  28. “Material Participation” • §469(h)(1) - taxpayer involved in operations of activity on a regular, continuous, and substantial basis

  29. “Material Participation” (continued) • Regulations provide detailed mechanical test. Taxpayer must be ONE of the following: • more than 500 hours • Taxpayer’s participation = 100% of any individual • more than 100 hours and not less than any other individual • more than 100 hours in trade or business (but not more than 500 hours), AND more than 500 hours in all trade or business activities • Taxpayer materially participated for 5 of preceding 10 years • Taxpayer materially participated for any 3 preceding years (personal service activity) • facts and circumstances - regular, continuous, and substantial basis

  30. Limited Partnerships • §469(h)(2) - presumption of no material participation • Exceptions: • limited partnership interest held by a general partner • limited partnership interest held by a limited partner, IF one of the following tests is met: • 500 hour test • materially participated in 5 of preceding 10 years • materially participated in 3 preceding years (personal service activity)

  31. Example Larry recently invested $9,000 in purchasing a limited partnership interest. His share of the debt in the partnership is $11,000, but he is not personally responsible for paying the debt in the event the partnership cannot pay it. In addition, Larry’s share of the limited partnership loss for the year is $2,000, his share of income from a different limited partnership was $1,000, and he had $3,000 of dividend income from the stock he owns. • What is Larry’s tax basis in the limited partnership after considering his $2,000 loss for the year? • What is Larry’s at-risk amount in the limited partnership after considering the $2,000 loss for the year? • How much of Larry’s $2,000 loss from the limited partnership can he deduct in the current year?

  32. Rental Activities §469(c)(2) - treats any “rental” activity as a passive activity regardless of taxpayer’s participation §469(j)(8) - defines “Rental Activity” as any activity where payments are principally for the use of tangible property

  33. Rental Activities - Exceptions • §469(c)(7) - rental real estate • activity considered not passive if: • more than 50% of personal services performed in all trades or businesses are performed in real property trades or businesses in which taxpayer materially participates • Real estate agency • more than 750 hours in real property trades or businesses

  34. Rental Activities - Exceptions • §469(i) - rental real estate • Taxpayer who actively participates may deduct up to $25,000 of losses attributable to rental real estate annually • “active” participation = participation in mgmt decisions • presumed not active if own less than 10% • $25,000 is reduced by 50% of the excess of taxpayer’s AGI over $100,000 • Completely phased-out for taxpayer’s with AGI > $150,000

  35. Example Anwar owns a rental home and is involved in maintaining it and approving renters. During the year he has a net loss of $8,000 from renting the home. His other sources of income during the year were a salary of $111,000 and $34,000 of long-term capital gains. How much of Anwar’s $8,000 rental loss can he deduct currently if he has no sources of passive income?

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