Tax USA Assignment 3

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Losses and Bad Debts

Chapter 8

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LOSSES AND BAD DEBTS (1 of 2)

Transactions that may result in losses

Classifying losses on the taxpayer’s tax return

Passive losses

Casualty and theft losses

Bad debts

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LOSSES AND BAD DEBTS (2 of 2)

Net operating losses

Tax planning considerations

Compliance and procedural considerations

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Transactions that May Result in Losses

Sale or exchange of property

Expropriated, seized, confiscated, or condemned property

Treat as sale or exchange

Abandoned property

Worthless securities

Demolition of property

Add to basis of land

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Sale or Exchange of Property

Amount realized includes liability transferred to buyer

Qualified residence exception

No gain on transfer AND no discharge of indebtedness income

Selling costs

Deducted in year incurred for inv.

Reduction of amt realized for noninv.

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Abandoned Property

Ordinary loss if business or investment property

Nondeductible if personal property

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Worthless Securities

Securities must be completely worthless

Capital loss on last day of tax year

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Classifying the Losses on Taxpayer’s Tax Return

Ordinary vs. capital loss

Disallowance possibilities

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Ordinary vs. Capital Loss (1 of 2)

Based on of type of property and type of transaction involved

§1231 property

Net §1231 loss is an ordinary loss

Includes real or depreciable property used in a trade or business and held for more than one year

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§1244 stock

Loss on sale of §1244 stock ordinary

Limited to $50K ($100K MFJ)

Excess loss is a capital loss

§1244 stock qualifications

≤ 50% of gross receipts from passive sources during prior 5 tax years, AND

Contributions to capital and paid-in surplus ≤ $1M at time of issue

Ordinary vs. Capital Loss (2 of 2)

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Disallowance Possibilities

Transfers of property to controlled corporation in exchange for stock

Sales to certain related parties

Wash sales

Losses limited for exceeding amount for which taxpayer is at risk

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Passive Losses

Passive loss & credit computations

Carryovers

Definition of a passive activity

Taxpayers subject to passive loss rules

Real estate business

Other rental real estate activities

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Computation of Passive Losses and Credits

Income classified into 3 categories

Active income

E.g., wages, salaries, active bus. inc.

Portfolio income (investment income)

E.g., interest, dividends, royalties

Passive income

Net income/loss calculated separately for each activity

Passive losses only offset passive income

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Carryovers

Suspended losses

Disallowed passive losses that are carried forward indefinitely

Taxable disposition of interest in passive activity

Suspended losses from activity

Reduce gain on disposition after losses used to offset current passive income

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Definition of a Passive Activity (1 of 3)

Any rental activity

Any trade, business, or investment activity in which taxpayer does not materially participate

Interest in limited partnership

Passive activity because limited partners legally barred from participating in management

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Definition of a Passive Activity (2 of 3)

Material participation tests

Only need to meet one test

Participate > 500 hours in activity

Participation constitutes substantially all participation in activity by all individuals

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Definition of a Passive Activity (3 of 3)

Only need to meet one test (cont’d)

Participate > 100 hrs in activity and participation more than all other individuals

Sum of participation in all passive-type activities > 500 hrs

Material participation in 5 of last 10 yrs

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Taxpayers Subject to Passive Loss Rules (1 of 2)

Individuals, estates, trusts, closely-held C Corporations, PSCs, and certain publicly traded partnerships

Owners of partnerships and S Corporations

Personal service corporations

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Taxpayers Subject to Passive Loss Rules (2 of 2)

Publicly traded partnerships (PTP)

Any partnership if partnership interests traded on primary or secondary markets

If corporate tax provisions apply to PTP, passive rules do not apply

If ptrshp tax provisions apply to PTP, passive loss rules apply at partner level

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Real Estate Business

Real estate professional exception

Rules do not apply if they materially participate in real estate trade or business activities if both criteria met

> 50% of personal services performed in real property trades or businesses

Taxpayer performs > 750 hours in real property trades or businesses

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Other Rental Real Estate Activities

Taxpayers actively participating in rental real estate activities with AGIs not in excess of $100K

May deduct $25K of such rental real estate losses against portfolio and active income

See Topic Review 2

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Casualty and Theft Losses (1 of 2)

Casualty defined

Theft defined

Deductible amount of casualty loss

Limits on personal-use property

Netting casualty gains and losses on personal-use property

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Casualty and Theft Losses (2 of 2)

Casualty gains and losses attributable to business and investment property

Timing of casualty loss deduction

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Casualty Defined

A casualty loss results from an identifiable event that was sudden, unexpected, or unusual

Qualifying casualties include fire, flood, hurricane, tornado, and hail

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Theft Defined

Generally, criminal intent and violation of state law required to meet definition of theft

Includes larceny, embezzlement, robbery, blackmail, extortion, and ransom

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Deductible Amount of Casualty Loss

Generally decline in FMV due to casualty

For partial destruction loss is lesser of decline in FMV or adjusted basis

Total destruction of business or investment property amount of loss is adjusted basis

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Limitations on Personal-Use Property

Two limitations

Losses sustained in each separate casualty reduced by $100, AND

Sum of all net casualty losses reduced by 10 % of taxpayer’s AGI

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Netting Casualty Gains and Losses on Personal-Use Property

Losses reduced by insurance reimbursement

Casualty losses must be netted against casualty gains prior to applying 10% of AGI limitation

Net casualty loss subject to 10% limitation

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Casualty Gains & Losses Attributable to Business & Investment Property

For AGI deduction

Investment property must be used to generate rents or royalties

Losses on other investment property are miscellaneous itemized deductions NOT subject to 2% of AGI floor

If property held <1yr, treat as ordinary

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Timing of Casualty Loss Deduction

Generally deduct losses in year in which taxpayer sustains loss

Exceptions

Theft loss deductible when discovered

If insurance reimbursement expected, loss deductible in year reimb. received

Disaster losses may be deducted in year prior to year sustained

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Bad Debts

Bona fide debtor-creditor relationship

Taxpayer’s basis in the debt

Debt must be worthless

Nonbusiness bad debts

Business bad debts

Deposits in insolvent financial institutions

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Bona Fide Debtor-Creditor Relationship Related Parties

Facts and circumstances test

Existence of written obligation to repay

Establishment of repayment schedule

Reasonableness of interest rate

Likelihood that unrelated party would have made loan

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Bona Fide Debtor-Creditor Relationship Third Party Debt

Guarantor becomes creditor if required to satisfy debt for third party

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Taxpayer’s Basis in the Debt

Creditor must have basis in debt

Generally, basis is amount loaned

May be income recognized for performing services to debtor

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Debt Must Be Worthless

Must prove worthlessness to deduct bad debt

Legal action not required

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Nonbusiness Bad Debts

Definition

Any debt other than

A debt created or acquired in connection to, or results from a trade or business

Tax treatment

Short-term capital loss in year debt becomes totally worthless

No loss for partial worthlessness

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Business Bad Debts

Provides ordinary loss deduction

Generally must use specific write-off method

Recovery of bad debts

Income in year of recovery to extent benefit received from loss

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Deposits in Insolvent Financial Institutions

Difference between basis in deposit and expected proceeds

Two choices

Treat as personal casualty loss

No limitation on maximum loss claimed

Treat as loss from for-profit activity

Ordinary loss subject $20K ($10K MFS) loss limit and 2% of AGI floor

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Net Operating Losses

Computing the net operating loss for individuals

Carryback and carryover periods

Recomputation of taxable income in the carryover year

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Computing the Net Operating Loss for Individuals

Taxable loss

+ NOL deductions

+ Capital loss deduction

(See Example 40 for specific rules)

+ Personal exemptions

+ Excess of nonbusiness deductions

over nonbusiness income

Personal Net Operating Loss

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Carryback and Carryover Periods

Carryback 2 years

Begin with oldest year first

After carryback, NOLs carried forward 20 yrs in chronological order

May elect to forgo carryback period

Losses from multiple years

Use up earliest loss first

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Recomputation of Taxable Income in the Carryover Year

NOL is a for AGI deduction because it is attributable to taxpayer’s trade or business

NOL carried to other years determined in same manner as original NOL computation

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Tax Planning Considerations (1 of 2)

Taxpayers should document their determination that a particular debt is worthless

Documentation of fair market value is important to support a casualty loss

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Tax Planning Considerations (2 of 2)

Taxpayer should consider forgoing NOL carryback to only carry forward if higher marginal rate is expected in future or carryback would jeopardize tax credits

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Casualty losses in previous year

File amended return on Form 1040X

Net Operating Losses

File 1040X or Form 1045 for quick refund

Worthless Securities

Report on Part I of Schedule D

Compliance & Procedural Considerations

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END Chapter 8

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