Essentials of taxation 2016 cengage chapter 06

Chapter Losses and Loss Limitations Essentials of Taxation © 2016 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part The Big Picture (slide of 3) • Robyn is nearing the end of a year that she would like to forget • Several years ago she loaned a friend, Jamil, $25,000 to enable him to start a business – Jamil had made scheduled payments of $7,000 ($1,000 of this was interest) when he unexpectedly died in January • At the time of his death, he was insolvent – Robyn’s attempts to collect on the debt were fruitless • Last year Robyn invested $60,000 in the stock of Owl Corp, a company started by her brother – The company declared bankruptcy in May of this year – Robyn is notified by the bankruptcy trustee that she can expect to receive nothing from the company The Big Picture (slide of 3) • Robyn has owned and operated a bookstore as a sole proprietorship for the past 10 years – The bookstore previously has produced annual profits of about $75,000 – Due to a downturn in the economy, Robyn’s bookstore sustained a net loss of $180,000 this year • In September, a tornado caused a large oak tree to blow over onto Robyn’s house – The cost of removing the tree and making repairs was $32,000 – Robyn received a check for $25,000 from her insurance company in final settlement of the claim – Her adjusted basis for the house was $280,000 The Big Picture (slide of 3) • Robyn invested $20,000 for a 10% interest in a limited partnership that owns and operates orange groves in Florida – Due to a hard freeze that damaged much of the fruit, the partnership lost $200,000 and allocated $20,000 of ordinary loss to Robyn • Robyn comes to you for tax advice and would like to know the tax ramifications of each of the transactions listed above • Read the chapter and formulate your response Bad Debts • If an account receivable arising from credit sale of goods or services becomes worthless – A bad debt deduction is permitted only if income arising from creation of the receivable was previously included in income – No deduction is allowed if taxpayer is on the cash basis since no income is reported until the cash has been collected The Big Picture - Example Bad Debts - Cash Basis Taxpayer • Return to the facts of The Big Picture on p 6-1 • Robyn is a cash basis taxpayer – She cannot take a bad debt deduction for unpaid accrued interest on the loan to her friend, Jamil, because it was never recognized as income Business Bad Debts (slide of 4) • Specific charge-off method must be used – Exception: Reserve method is allowed for some financial institutions • Deduct as ordinary loss in the year when debt is partially or wholly worthless Business Bad Debts (slide of 4) • If a business bad debt previously deducted as partially worthless becomes totally worthless in a future year – Only the remainder not previously deducted can be deducted in the future year Business Bad Debts (slide of 4) • In the case of total worthlessness, deduction is allowed for entire amount in the year the debt becomes worthless • Deductible amount depends on basis in bad debt – If debt arose from sale of services or products and the face amount was previously included in income • That amount is deductible – If the taxpayer purchased the debt • Deduction is equal to amount paid for debt instrument Business Bad Debts (slide of 4) • If a receivable has been written off – The collection of the receivable in a later tax year may result in income being recognized – Income will result if the deduction yielded a tax benefit in the year it was taken 10 Material Participation Tests (slide of 8) • Test – Based on the facts and circumstances, taxpayer participated in the activity on a regular, continuous, and substantial basis • Regular, continuous, and substantial are not specifically defined in the Regulations 76 Participation Defined • Participation generally includes any work done by an individual in an activity that he or she owns – Does not include work if of a type not customarily done by owners and if one of its principal purposes is to avoid the disallowance of passive losses or credits – Work done in an individual’s capacity as an investor is not counted in applying the material participation tests – Participation by an owner’s spouse counts as participation by the owner 77 Rental Activities • Rental of tangible (real or personal) property is automatically passive activity unless it meets one of the exceptions (Regs) • If exception applies, activity is subject to the material participation tests 78 Rental Activities • Rental of tangible (real or personal) property is automatically passive activity unless it meets one of the exceptions (Regs) • If exception applies, activity is subject to the material participation tests 79 Interaction of At-Risk and Passive Loss Limits • Passive loss rules are applied after the at-risk rules – Losses not allowed under the at-risk rules are suspended under the at-risk rules, not the passive loss rules – Basis is reduced by deductions even if not currently usable due to passive loss rules 80 Real Estate Passive Loss Limits (slide of 4) • Generally, losses from rental real estate are treated like other passive losses • There are two significant exceptions to the general rule 81 Real Estate Passive Loss Limits (slide of 4) • Exception 1: Real estate professionals – Rental real estate losses are not treated as passive if the following requirements are met: • Taxpayer performs more than half of his/her personal services in real property businesses in which the taxpayer materially participates, and • Taxpayer performs more than 750 hours of services in these real property businesses as a material participant 82 Real Estate Passive Loss Limits (slide of 4) • Exception 2: Real estate rental activities – Taxpayer can deduct up to $25,000 of losses on real estate rental activities against active or portfolio income – Benefit is reduced by 50% of taxpayer’s AGI in excess of $100,000 83 Real Estate Passive Loss Limits (slide of 4) • Exception 2: Real estate rental activities – To qualify for this exception the taxpayer must: • Actively participate in rental activity, and • Own at least 10% of all interests in activity – Active participation defined: • Requires only participation in making management decisions in a significant and bona fide sense 84 Suspended Losses • Losses can be suspended due to the passive loss limits or the at-risk limits • Losses suspended due to at-risk limitations are investment specific, thus no allocation of suspended losses is necessary • Suspended at-risk and passive losses can be carried forward indefinitely 85 Disposition of Passive Interests • Disposition at death: suspended loss deductible on decedent’s final tax return to extent of excess over any step-up in basis • Disposition by gift: suspended loss increases donee’s basis in property 86 Refocus On The Big Picture (slide of 3) • Robyn can receive tax benefits associated with her unfortunate occurrences during the current tax year • Bad Debt – It appears that Robyn’s loan to her friend, Jamil, was a bona fide debt • The amount of the loss deduction is the unpaid principal balance of $19,000 ($25,000 - $6,000) • Since the bad debt is a nonbusiness bad debt, it is classified as a short-term capital loss • Loss from stock investment – If Robyn purchased the stock directly from the company, the stock may qualify as small business stock under Đ 1244 If this is the case, the first $50,000 of the loss is an ordinary loss, and the remaining $10,000 loss is treated as a long-term capital loss – If the stock is not § 1244 stock, the entire $60,000 loss is treated as a long-term capital loss 87 Refocus On The Big Picture (slide of 3) • Loss from bookstore – The $180,000 loss from the bookstore is reported on Schedule C of Form 1040 • It is an ordinary loss, and it qualifies for NOL treatment if she does not have enough other income this year against which the loss could be offset • Any NOL can be carried back years or carried forward for the next 20 years to produce refunds of taxes paid from prior years or to reduce taxes owed on income earned in the future – Casualty Loss • The loss on the damage to Robyn’s personal residence is a personal casualty loss • Using the cost of repairs method, the amount of the casualty loss is $7,000 ($32,000 - $25,000) • This amount must be reduced by $100 and 10% of AGI 88 Refocus On The Big Picture (slide of 3) • Passive activity loss – The $20,000 loss on the limited partnership is not deductible currently due to the passive loss limitation – However, the loss can be carried forward and utilized in the future to offset any passive income generated from the venture What If? • What if instead of operating orange groves the partnership owns and rents apartments to college students and Robyn actively participates in the venture? – In this case, Robyn may qualify for a $20,000 ordinary loss deduction under the rental real estate with active participation exception 89 If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact: Dr Donald R Trippeer, CPA trippedr@oneonta.edu SUNY Oneonta © 2016 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part 90 ... much of the fruit, the partnership lost $200,000 and allocated $20,000 of ordinary loss to Robyn • Robyn comes to you for tax advice and would like to know the tax ramifications of each of the... qualify – Major requirement is limit of $1 million of capital contributions • Section 1244 does not apply to gains 20 Section 1244 Stock (slide of 3) • Example of § 1244 loss – In 2009, Sam purchases... an oak tree to fall onto the house – The amount of her uninsured loss was $7,000 – Because of the extent of the damage in the area, the President of the United States designated the area a disaster