LOSSES AND BAD DEBTS

1
CHAPTER 8

• LOSSES AND BAD DEBTS

2
TRANSACTIONS THAT MAY RESULT IN LOSSES

• SALE OR EXCHANGE OF PROPERTY
• EXPROPRIATED, SEIZED, OR CONFISCATED PROPERTY
• ABANDONED PROPERTY
• WORTHLESS SECURITIES
• DEMOLITION OF PROPERTY

3
CLASSIFYING THE LOSS ON A TAXPAYERS RETURN

• ORDINARY VS. CAPITAL LOSS
• DEDUCTIONS FOR AGI VS. DEDUCTIONS FROM AGI
• DISALLOWANCE POSSIBILITIES

4
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 (50,000 OR 100,000 LIMITATION)
  RATHER THAN CAPITAL (OFFSET CAPITAL GAINS PLUS
  3,000 OF ORDINARY INCOME)

5
QUALIFICATION AS SEC. 1244 STOCK

• MUST BE ORIGINAL ISSUANCE OF STOCK
• 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
• MUST BE ISSUED AND OWNED BY AN INDIVIDUAL OR
  PARTNERSHIP
• CORPORATION MUST BE DOMESTIC
• STOCK MUST BE ISSUED FOR CASH OR PROPERTY, NOT
  SERVICES, AND
• CORPORATION MUST NOT HAVE DERIVED gt 50 OF GROSS
  RECEIPTS FROM PASSIVE INCOME SOURCES DURING THE
  IMMEDIATELY PRECEDING 5 TAX YEARS

6
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

7
Passive Activities Defined

• Material participant
• 500 hours of participation
• 100 or more hours and the most of any of the
  participants
• Unless excepted by the Code, all rental
  activities are deemed passive.

8
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

9
PASSIVE LOSSES

• TYPES OF INCOME
• ACTIVE WAGES, SALARIES, PROFIT FROM
  TRADE/BUSINESS WHERE TP MATERIAL PARTICIPANT
• PORTFOLIO DIVIDENDS, INTEREST, ANNUITIES,
  ROYALTIES and GAINS FROM DISPOSITION OF PROPERTY
  HELD FOR INVESTMENT
• PASSIVE RENTAL, TRADE, BUSINESS OR INVESTMENT

10
PASSIVE LOSSES

• GENERAL RULE PASSIVE LOSSES CAN ONLY BE USED TO
  OFFSET PASSIVE INCOME
• JOHN EARNS A SALARY OF 80,000. HE ALSO HAS
  DIVIDEND INCOME OF 12,000. DURING THE YEAR HE
  ACQUIRES AN INTEREST IN A LIMITED PARTNERSHIP
  WHICH PRODUCES A 3,000 LOSS. HOW MUCH OF THE
  LOSS CAN HE DEDUCT (ASSUME NO AT RISK
  LIMITATION)?

11
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
  

12
RENTAL REAL ESTATE EXCEPTION

• Taxpayer has Salary of 80,000, dividend income
  of 30,000 and losses of (28,000) from rental
  real estate activities. How much of the rental
  loss can she deduct?

13
WHAT IS A 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

14
WHAT IS A 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

15
LIMITATION ON 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

16
CASUALTY THEFT LOSSES

• CASUALTY GAINS AND LOSSES ATTRIBUTABLE TO
  BUSINESS AND INVESTMENT PROPERTY
• NO 10 AGI OR 100 LIMITATION
• MUST NET CASUALTY GAINS AND LOSSES
• LOSSES ON BUSINESS PROPERTY AND RENTAL OR ROYALTY
  PROPERTY ARE FOR AGI DEDUCTIONS
• LOSSES ON OTHER INVESTMENT PROPERTY ARE MISC.
  ITEMIZED DEDUCTION NOT SUBJECT TO 2 AGI FLOOR OR
  80 OVERALL REDUCTION OF ITEMIZED DEDUCTIONS.

17
CASUALTY THEFT LOSSES

• GENERALLY, CASUALTY AND THEFT LOSSES ARE
  DEDUCTIBLE IN TAX YEAR OF LOSS
• EXCEPTIONS
• THEFT LOSSES ARE DEDUCTIBLE IN YEAR DISCOVERED
• ANY INSURANCE REIMBURSEMENTS REASONABLY EXPECTED
  TO BE RECEIVED ARE SUBTRACTED IN DETERMINING THE
  DEDUCTIBLE AMOUNT EVEN THOUGH NOT RECEIVED IN THE
  YEAR OF LOSS
• DECLARED DISASTER AREA LOSSES MAY BE DEDUCTED IN
  THE YEAR PRECEDING THE YEAR OF THE LOSS
• TAXPAYER MAY FILE AN AMENDED RETURN IF DISASTER
  OCCURS AFTER FILING PREVIOUS YEAR RETURN

18
BAD DEBTS

• BONA FIDE DEBTOR-CREDITOR RELATIONSHIP
• LIMITED TO TAXPAYERS BASIS IN THE DEBT
• DEBT MUST BE WORTHLESS
• NONBUSINESS BAD DEBTS ARE SHORT TERM CAPITAL
  LOSSES
• BUSINESS BAD DEBTS
• DIRECT WRITE OFF METHOD MUST BE USED FOR
  ACCOUNTING FOR BUSINESS BAD DEBTS
• RECOVERY OF BAD DEBTS
• REPORTED AS INCOME IN YEAR OF RECOVERY
• DEPOSITS IN INSOLVENT FINANCIAL INSTITUTIONS
• MAY BE TREATED AS CASUALTY LOSSES IN YEAR OF LOSS

19
NET OPERATING LOSS

• OCCURS WHEN BUSINESS EXPENSES EXCEED BUSINESS
  INCOME
• FOR TAX YEARS BEGINNING AFTER AUGUST 5, 1997
  NOLS ARE CARRIED BACK 2 YEARS AND FORWARD 20
  YEARS
• PRIOR TO 8/5/97 BACK 3 FORWARD 15
• TAXPAYER MAY ELECT TO FORGO THE CARRYBACK YEARS
  AND CARRY THE NOL FORWARD

20
NET OPERATING LOSS

• BEGIN WITH TAXABLE INCOME
• NOLS FROM OTHER YEARS ARE ADDED BACK
• PERSONAL EXEMPTIONS ARE ADDED BACK
• EXCESS OF NONBUSINESS DEDUCTIONS OVER NONBUSINESS
  INCOME IS ADDED BACK
• CAPITAL LOSSES ARE LIMITED (see p. 8-29)

21
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