Losses and Bad Debts

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Chapter 8

• Losses and Bad Debts

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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

3
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

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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

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Classifying The Loss On A Taxpayers Return

• Ordinary vs. Capital loss
• Disallowance possibilities

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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)

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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

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Qualification as Sec. 1244 Stock

• Corporation must not have derived gt 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

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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.

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Passive Losses

• Computation of passive losses and credits
• Carryovers
• Definition of passive activity

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Passive Losses

• Taxpayers subject to passive loss rules
• Publicly traded partnerships
• Rental real estate trade or business
• Other rental real estate activities

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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

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Taxpayers Subject To Passive Loss Rules

• 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

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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

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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
  

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Casualty Theft Losses

• What is a casualty
• What is a theft
• Deductible amount of casualty loss

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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

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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

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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 taxpayers AGI
• Netting casualty gains and losses on personal use
  property

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Casualty Theft Losses

• Casualty gains and losses attributable to
  business and investment property
• When losses are deductible

21
Bad Debts

• Bona fide debtor-creditor relationship
• Taxpayer must have basis in the debt
• Debt must be worthless
• Non-business bad debts

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Bad Debts

• Business bad debts
• Accounting for the business bad debts
• Recovery of bad debts
• Deposits in insolvent financial institutions

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Net Operating Loss

• Involves business income and deductions only and
  will increase an NOL(Net Operating Loss)
• Computing the NOL
• Carryback and carryover periods
• Recomputation of taxable income in the carryover
  year

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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

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Compliance and Procedural Considerations

• Net Operating Loss
• Worthless Securities