Chapter 8
Losses and Bad Debts
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
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
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
Classifying The Loss On A
Taxpayer’s Return
? Ordinary vs,
Capital loss
? Disallowance
possibilities
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)
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
Qualification as Sec,1244 Stock
? Corporation must not have derived >
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
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,
Passive Losses
? Computation of passive losses and
credits
? Carryovers
? Definition of passive activity
Passive Losses
? Taxpayers subject to passive loss
rules
? Publicly traded partnerships
? Rental real estate trade or business
? Other rental real estate activities
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
? 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
Taxpayers Subject To
Passive Loss Rules
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
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
Casualty & Theft Losses
? What is a casualty
? What is a theft
? Deductible amount of
casualty loss
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
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
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 taxpayer’s AGI
– Netting casualty gains and losses on
personal use property
Casualty & Theft Losses
? Casualty gains and losses
attributable to business
and investment property
? When losses are
deductible
Bad Debts
? Bona fide debtor-
creditor
relationship
? Taxpayer must
have basis in the
debt
? Debt must be
worthless
? Non-business
bad debts
Bad Debts
? Business bad debts
? Accounting for the
business bad debts
? Recovery of bad
debts
? Deposits in insolvent
financial institutions
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
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
Losses and Bad Debts
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
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
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
Classifying The Loss On A
Taxpayer’s Return
? Ordinary vs,
Capital loss
? Disallowance
possibilities
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)
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
Qualification as Sec,1244 Stock
? Corporation must not have derived >
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
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,
Passive Losses
? Computation of passive losses and
credits
? Carryovers
? Definition of passive activity
Passive Losses
? Taxpayers subject to passive loss
rules
? Publicly traded partnerships
? Rental real estate trade or business
? Other rental real estate activities
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
? 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
Taxpayers Subject To
Passive Loss Rules
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
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
Casualty & Theft Losses
? What is a casualty
? What is a theft
? Deductible amount of
casualty loss
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
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
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 taxpayer’s AGI
– Netting casualty gains and losses on
personal use property
Casualty & Theft Losses
? Casualty gains and losses
attributable to business
and investment property
? When losses are
deductible
Bad Debts
? Bona fide debtor-
creditor
relationship
? Taxpayer must
have basis in the
debt
? Debt must be
worthless
? Non-business
bad debts
Bad Debts
? Business bad debts
? Accounting for the
business bad debts
? Recovery of bad
debts
? Deposits in insolvent
financial institutions
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
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
