TAX CH 9
Chapter 9: Losses & Bad Debts
- Passive activities (the Big Kahuna) - Loss transactions generally - Section 1244 stock losses - Casualty & theft losses - Bad debts
Passive Activity Provisions cont. Computation of Passive Losses and Credits:
*****(Computation of Passive Losses and Credits: -- Losses from passive activities allowable ONLY to extent of income from passive activities. Cannot offset passive losses against portfolio income or active income. -- Credits generated from passive activities are also limited. These credits may only offset tax liability generated by passive income. *****Suspended loss carryovers -- Suspended passive losses may be used against future passive income or on the disposition of the passive activity interest. -- The carryover is unlimited in $$ amount and duration (time).
Bad Debts
*****Bona fide debtor-creditor Relationship - In order to support a bad debt deduction, the underlying debt must be a valid and enforceable obligation to pay a fixed or determinable sum of money resulting from a debtor-creditor relationship. *****Taxpayer's basis in the debt - The creditor must have a basis in the debt for the bad debt to be deductible ----- Cash basis accounts receivable do not generate a bad debt deduction. *****Debt must be worthless - Burden on taxpayer to demonstrate *****Non-business bad debts - remember, STCL. Must be COMPETELY WORTHLESS for loss to be deductible.
Loss Transactions Generally
- Realization event must occur - Loss is the excess of the property's adjusted basis over the amount realized. ****Generally... **Losses incurred on the sale of personal-use property are not deductible. **Losses on trade or business property and investment property are deductible (perhaps subject to capital loss limits, passive loss limits, etc.)
Passive Activity Provisions Passive loss rules CONT...
-- Business income/loss can be from ACTIVE trade or business or PASSIVE trade or business -- Key is correct classification
Casualty & Theft Losses (continued) ITEMIZED DEDUCTIONS
-- Casualty and theft losses involving personal use property are ITEMIZED DEDUCTIONS -- Personal-use property casualty and theft losses are subject to two reductions *****Each separate casualty and theft event loss is reduced by $100. *****The total of all personal casualty and theft losses for the year is reduced by 10% of AGI. (10% floor)
Casualty & Theft Losses - general rule - exception - casualty defined - theft defined
-- General Rule: Losses on personal-use property are not deductible. ---- Exception: § 165 allows a loss if it arises from fire, storm, shipwreck, other casualty, or theft (casualty loss) *Casualty Defined: ***A casualty loss results from an identifiable event that was sudden, unexpected or unusual. ***Qualifying casualties include fire, flood, hurricane, tornado, hail, and cyclone. P.9-18 *Theft Defined: ***Generally, criminal intent and violation of a state law are required to meet the definition of theft. ***Theft for tax purposes includes larceny, embezzlement, robbery, blackmail, extortion, and ransom.
Disposing of Interest in Passive Activity
-- Generally, taxpayer can deduct suspended losses from a passive activity when the activity is sold or disposed of, so they are not lost -- Taxpayer computes gain/loss upon sale of activity and combines with any current year operating income/loss from the activity, as well as any currently suspended passive loss carry forwards from the activity. Any resulting loss is then offset against other passive income (from other passive activities) BEFORE offsetting against other (non-passive) income. --- No immediate deduction if taxpayer sells investment to related party. Can only recognize loss when sold to unrelated party.
Passive Activity Provisions Definition of Material Participation p. 8-11 (Annual determination): (continued)
-- Individual materially participated in the activity in any five years during the immediately preceding ten taxable years. Five years don't have to be consecutive. -- Individual materially participated in the activity for any three years prior to the year in question, and the activity was a personal service activity. -- Taxpayer participated on a regular, continuous, and substantial basis based on facts & circumstances
Taxpayers Subject to Passive Loss Rules
-- Individuals, Estates, Trusts -- Closely Held C Corporation -- Personal Service Corporation -- Publicly Traded Partnership
Bad Debts (continued)
--- Business bad debts ***Only the specific write-off method may be used for tax purposes, even though the allowance method may be preferable for financial purposes. ***Partially or totally worthless business bad debts are deductible as an ordinary loss. ***Recoveries of bad debts previously written-off are income in the year received.
Passive Activity Provisions Active Rental Real Estate Exception:
Active Rental Real Estate Exception: -- TPs can deduct a rental real estate loss of up to $25,000 provided that the TP actively participates in rental real estate activities. -- Active participation involves the making of management decisions or arranging for others to provide services in a significant and bona fide sense. *****Lesser standard than material participation -- The individual must own at least 10% of the value of the activity for the entire tax year and have an AGI less than or equal to $100,000.
Passive Activity Provisions Active Rental Real Estate Exception...continued!
Active Rental Real Estate Exception: (continued) -- Phase-out of $25,000 loss allowance: --***Individuals who otherwise qualify must reduce the $25,000 exception for 50% of the excess of AGI (before any passive or real estate loss) over $100,000. Individuals who have an AGI equal to or exceeding $150,000 will not be eligible for a deduction under the $25,000 exception.
Passive Activity Provisions Active Rental Real Estate Exception: (continued) EXAMPLE 3--------
Active Rental Real Estate Exception: (continued) Example 3: Howard is an economics professor at Enormous State University who owns three rental houses near campus. The rental homes produce $21,000 of tax losses in 2019 and Howard actively participates in their management. Howard's AGI is $140,000 without the rental loss. What is Howard's AGI with the rental loss?
Casualty & Theft Losses (continued) Deductible Amount of Casualty Loss
Deductible Amount of Casualty Loss -- The deductible amount for PARTIAL or COMPLETE DESTRUCTION of personal use property is the lesser of the reduction in FMV or adjusted basis. *****In lieu of reduction in FMV, may use cost of repairs See page 9-20 for requirements -- We will not be covering the rules for business use property. -- Amount of loss is reduced by any reimbursement (usually insurance) received or the taxpayer reasonably expects to receive ***If reimbursement was anticipated in a subsequent tax year but does not occur, deduct the loss in the subsequent tax year.
Passive Activity Provisions Definition of Material Participation
Definition of Material Participation pp. 9-11 & 9-12 (Annual determination, need only satisfy one): -- Individual participates in activity > 500 hours during year -- Individual's participation in activity for year constitutes substantially all of the participation in the activity by all individuals -- Individual participates in activity > 100 hours during year and that participation is more than any other individual's participation for the year -- Individual participates in "significant participation activities" for an aggregate of > 500 hours per year. Individual must spend more than 100 hours per year on any activity aggregated.
Passive Activity Provisions Example 1 Paula owns an interest in two passive activities. In 2019, Activity A produces $15,000 of income and Activity B produces a $24,000 loss. Paula can only deduct $15,000 of the $24,000 loss from Activity B because the loss is only allowable to extent of the passive income from Activity A. The excess $9,000 loss from Activity B ($24,000 - $15,000) is carried forward indefinitely...?
Example 1: Paula owns an interest in two passive activities. In 2019, Activity A produces $15,000 of income and Activity B produces a $24,000 loss. Paula can only deduct $15,000 of the $24,000 loss from Activity B because the loss is only allowable to extent of the passive income from Activity A. The excess $9,000 loss from Activity B ($24,000 - $15,000) is carried forward indefinitely. ***NOTE: Paula's tax return will reflect $15,000 of income from Activity A and a $15,000 loss from Activity B. They will net to $0 on the tax return.
Passive Activity Provisions Example 2 Paula owns an interest in three passive activities. In 2019, Activity A produces $15,000 of income, Activity B produces a $24,000 loss, and Activity C produces a $16,000 loss. Paula can only deduct $15,000 of losses from Activities B and C combined. How will allowed losses be prorated?
Example 2: Paula owns an interest in three passive activities. In 2019, Activity A produces $15,000 of income, Activity B produces a $24,000 loss, and Activity C produces a $16,000 loss. Paula can only deduct $15,000 of losses from Activities B and C combined. How will allowed losses be prorated?
Passive Activity Provisions Example 4:
Example 4: Paula owns an interest in three passive activities. In 2019, Activity A produces $10,000 of income, Activity B produces $9,000 of income, and Activity C produces a $6,000 loss. During 2019, Paula disposed of activity A, resulting in a $2,000 recognized gain. Paula also had suspended losses carried over from Activity A in the amount of $22,000. See example 9-7 also
Casualty & Theft Losses (continued) Example 5:
Example 5: Tom and Terry experience the following casualty/theft losses during 2020. Their AGI is $61,000. ***Fire loss - vacation home $6,000 ***Theft loss 1,200
Section 1244 Stock Losses
General rule: loss from sale or exchange of stock is capital *****Exception: Loss on the sale or worthlessness of "small business stock" is ordinary up to $50,000 ($100,000 MFJ) PER YEAR, and thus taxpayermay deduct against other ordinary income. -- Excess loss is capital *§1244 Requirements (all must be met): **Stock must be issued directly to (original issuee) and owned by an individual or partnership. **The corporation must be domestic.
Passive Activity Provisions Example 4 (continued):
If Paula had AGI of $70,000 before consideration of the passive activities, what is her AGI after?
Passive Activity Provisions Quiz Question #9:
Quiz Question #9: Due 3pm on Weds, 12/2 Paula owns an interest in three passive activities. In 2019, Activity A produces $10,000 of income, Activity B produces a $9,000 loss, and Activity C produces a $6,000 loss. During 2019, Paula disposed of activity A, resulting in a $2,000 recognized gain. Paula also had suspended losses carried over from Activity A in the amount of $22,000. If Paula's AGI is $70,000 before consideration of the passive activities, what is it after?
Passive Activity Provisions (continued) Passive activity defined:
Passive activity defined: **(i) any rental activity OR **(ii) any trade or business in which the taxpayer does not materially participate -- Investments in limited partnerships generate passive income/losses due to the legal restrictions on limited partners' involvement in the management of the partnership. -- If TP materially participates, then this is an active trade or business
Passive Activity Provisions Passive loss rules
Passive loss rules - TRA 1986 (Section 469) Purpose is to limit losses from 'tax shelters" Successful!! Tax simplification? Section 469 creates 3 "baskets" of income Active Income - wages, salaries, active business income Portfolio Income - dividends, interest, annuities, royalties, and certain gains and losses on property (including capital gains/losses). Passive Income - from passive activity
Passive Activity Provisions Real Property Trade or Business:
Real Property Trade or Business: TPs who are in the real estate business are not subject to passive loss rules. Requirements: -- More than ½ of the personal services that the TP performs in all trades or businesses during the year are in real property trades or businesses in which TP materially participates, AND -- TP performs more than 750 hours of work during the year in real property trades or businesses in which TP materially participates -- Treat as ACTIVE trade or business -- If the required services are performed as an employee, they will be counted only if the taxpayer owns at least 5% of the employer.
Casualty & Theft Losses (continued) Timing of Casualty Loss Deduction
Timing of Casualty Loss Deduction -- Loss may be deductible: 1.***In the year of loss (casualty) or discovery (theft), 2.***In the year insurance proceeds are finalized, or 3.***In the year preceding the casualty loss year for certain federally-declared disasters.
Section 1244 Stock Losses (continued) REQUIREMENTS
§1244 Requirements (all must be met): (continued) -- The stock must be issued for cash or property and not for services. -- The corporation may not have derived over 50% of its gross receipts from passive income sources during the immediately preceding 5 tax years. -AND- -- At the time the stock is issued, the amount of money and property contributed to both capital and paid-in surplus may not exceed $1 million.
