Bus 220 Chapter 9 pearson

Taxpayers subject to passive loss rules:

- Individuals, estates, trusts - Any closely held C corporation - Any personal service corporation - Certain publicly traded partnership

credits

A taxpayer may only use tax credits generated in a passive activity against the portion of the taxpayer's tax liability that is attributable to passive income. The taxpayer determines this amount by comparing the tax liability on all income for the year with the tax liability on all income excluding the passive income.

example of loss realization

Capital Corporation purchased 500 shares of Data Corporation stock for $10,000 on February 22 of the current year. By October 31 of the same year, the price of the stock declines to $8,000. Even though Capital has suffered an economic loss on the stock, no realization event has occurred, and the corporation may not deduct the $2,000 loss. However, if Capital sells the stock for $8,000 on October 31, it realizes the loss for tax purposes in the current year.

example of carryover period

During 2023, Sue has a NOL of $50,000 that she can carry forward. In the following year, 2024, Sue has taxable income of $60,000. Sue carries the NOL to 2024 and can deduct the lesser of: 1. the NOL carry forward of $50,000, or 2. 80% of taxable income before the NOL. In this case ×= 80% $60,000 $48,000. So Sue will be able to deduct $48,000 of the NOL in 2024, but will need to carry forward the remaining $2,000 of NOL from 2023 to future years.

For taxpayers to deduct a loss on property, the loss must be both realized and recognized for tax purposes.

Generally, realization occurs in a completed (closed) transaction evidenced by an identifiable event such as a sale or exchange. This is referred to as the closed transaction doctrine. As a general rule, taxpayers who have realized losses on business or investment property may recognize such losses for tax purposes unless a specific provision holds otherwise

identification of an activity

Identification of the activity becomes critical for several reasons. (1) The determination of whether a taxpayer materially participates in an activity is determined separately for each activity. (2) A taxpayer may deduct suspended losses of a passive activity when the taxpayer completely terminates his or her ownership of the activity. (3) As explained in a subsequent section of this chapter, taxpayers may deduct currently up to $25,000 of passive losses from rental real estate activities. Thus, taxpayers must not combine losses from passive business and rental real estate activities into one activity.

timing of casualty loss deduction

In general, taxpayers must deduct casualty losses in the tax year in which the taxpayer sustains the loss. In the following instances, however, taxpayers may deduct the loss in another year: - Theft losses - Insurance or other reimbursements that the taxpayer can reasonably expect to receive in a subsequent year - Certain disaster losses

calculating casualty loss

Measurement of a casualty loss begins by comparing the fair market value of the property immediately before the loss with the FMV immediately after the loss. However, the loss is limited to the taxpayer's basis in the property - in this case, $100,000 - Gabriel purchased a cabin and lake front property in 2013 for $100,000 for use as a vacation rental. In recent years, the area has become more popular with vacationers and the value of the property increased to $175,000. In the current year, a tornado ripped through the community, nearly destroying the cabin - the FMV of the property is now $40,000, just the value of the land. Unfortunately, Gabriel had not insured the cabin. what is his casualty loss for the year- $100,000

Computation of Passive Losses and Credits

Sec. 469 requires certain taxpayers to classify their income into three categories: - active income (such as wages, salaries, and active business income), - portfolio (or investment) income, Portfolio income includes dividends, interest, annuities, and royalties (and allocable expenses and interest expense) not derived in the ordinary course of a trade or business. Portfolio income also includes gains and losses on property that produces these types of income if the disposition of the property does not occur in the ordinary course of business. Portfolio income becomes part of net investment income, which is used in computing the deduction limit for investment interest expense. - passive income- Taxpayers compute income and loss in the passive category separately for each passive activity in which they have invested. In general, for any tax year, a taxpayer may use losses generated in one passive activity to offset income from other passive activities, but may not use them to offset either active or portfolio income

theft losses

Taxpayers must deduct a theft loss in the tax year in which the taxpayer discovers the theft. This rule is equitable and practical because a taxpayer may not discover a theft until a subsequent year.

Material participation by PSC's and closely held C corporations

These corporations materially participate in an activity only if one or more shareholders who own more than 50% in value of the outstanding stock materially participate in the activity. In addition, a closely held C corporation (other than a PSC) materially participates in an activity if it meets all of the following tests with regard to an activity: 1. A substantial portion of the services of at least one full-time employee is in the active management of the activity. 2. A substantial portion of the services of at least three full-time non-owner employees is directly related to the activity. 3. The Sec. 162 business deductions of the activity exceed 15% of the activity's gross income for the period.

During 2023, Tim, who is single, reports the following income/loss from his business activities: - Gross income from sole proprietorship $2,500,000 - Gross expenses from sole proprietorship ($2,200,000) - Net loss from ABC Partnership ($785,000)

Tim's excess business loss is $215,000, calculated as follows: - $ 2,985,000 -Business deductions ($2,200,000 + $785,000) - $2,789,000 - Business income plus $289,000 ($2,500,000 + $289,000) - $196,000- Excess Business Loss (2985000-2789000) - $215,000 of business losses are disallowed and will become an NOL carryover.

limitations on personal use property (page I9-20)

two limitations: (1) losses sustained in each separate casualty must be reduced by $100, and (2) the total amount of all net casualty losses for personal-use property is reduced by 10% of the taxpayer's AGI for the year. - For property destroyed in the same casualty, only $100 is deducted from all the properties (i.e., the taxpayer does not reduce the loss from each separate property by $100). - if the taxpayer's insurance covers the property, the taxpayer cannot take a casualty loss deduction unless he or she timely files an insurance claim for the loss. This disallowance relates only to the portion of the loss covered by the insurance.

Net operating loss ( NOL)

under Sec. 172 generally involves only business income and expenses. An NOL occurs when taxable income for any year is negative because business expenses exceed business income. A deduction for the NOL arises when a taxpayer car-ries the NOL to a year in which the taxpayer has taxable income. Thus, an NOL for one year becomes a deduction against taxable income in a subsequent year.

casualties - tax planning considerations

- A deduction is allowed for stolen property, but no deduction is allowed for lost property. - thus, taxpayers should always carefully document losses of property through theft (e.g., the filing of police reports or claims with the taxpayer's insurance company). - In addition, pictures and written appraisals may be helpful to prove the amount of the loss.

limited partnership

- A limited partner generally does not meet the material participation test and the limited partner's investment is treated as passive. Thus, most income and deductions passed through to a limited partner from a limited partnership are passive. - However, a limited partner can meet the material participation test if the individual meets either the 500 hour test or the fifth or sixth tests above (prior year tests)

In dealing with a deduction for bad debts, taxpayers must address the following requirements and issues

- A bona fide debtor-creditor relationship must exist between the taxpayer and some other person or entity. - The taxpayer must have basis in the debt. - The debt must actually have become worthless during the year. - The type and timing of a bad debt deduction depend on whether the debt is a business or nonbusiness bad debt.

real estate business

- A real property trade or business involves the development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokering of real property. - This exception only applies to a taxpayer if he or she meets both of the following requirements: 1. More than one-half of the personal services the taxpayer performs in all trades or businesses during the year are in real property trades or businesses in which the taxpayer materially participates. 2. The taxpayer performs more than 750 hours of work during the taxable year in real property trades or businesses in which the taxpayer materially participates. - in meeting these tests, personal services a taxpayer renders in his or her capacity as an employee are not treated as performed in real property trades or businesses unless the employee owns at least 5% of the employer. Furthermore, for married taxpayers filing a joint return, the exception applies only if one of the spouses separately meets both requirements.

active participation

- A taxpayer can achieve active participation, as opposed to material participation, without regular, continuous, and material involvement in the activity and without meeting any of the material participation tests. - However, the taxpayer still must participate in making management decisions or arranging for others to provide services in a significant and bona fide sense. - This includes approving new tenants, deciding on rental terms, approving expenditures, and other similar decisions. - Taxpayers may achieve active participation even if they hire a rental agent and others to provide the services. - However, a lessor under a net lease arrangement generally does not achieve active participation. - Additionally, a limited partner generally cannot actively participate in any activity of a limited partnership

recovery of bad debts

- A taxpayer may collect a debt that was previously written off for tax purposes. Since the taxpayer previously deducted the uncollectible debt, the taxpayer must report the recovery as income in the year it is collected. The amount of the income that must be reported depends on the tax benefit rule

casualty defined

- According to the IRS, a deductible casualty loss is one that occurs in an identifiable event that is sudden, unexpected, or unusual - beginning January 1, 2018, the deduction for personal casualty and theft losses is limited to those losses incurred in a "federally-declared disaster." - Casualty and theft losses of business and investment property are deductible.

demolition of property

- At times, taxpayers, intent on building their own facilities, purchase land with an exist-ing structure that must first be removed. Taxpayers may also demolish a structure they currently use to construct new facilities. - In both cases, taxpayers may not deduct any demolition costs or any loss sustained on account of the demolition. - Instead, under Sec. 280B, taxpayers must add these amounts to the basis of the land on which the demolished structure previously stood.

Add Back Excess of Nonbusiness Deductions over Nonbusiness Income (examples on page I9-31)

- Because nonbusiness deductions do not reflect an economic loss from business, they are not deductible in arriving at the NOL. However, these deductions do offset any nonbusiness income reported during the year. - Nonbusiness income includes sources of income such as dividends and interest, as well as nonbusiness capital gains in excess of nonbusiness capital losses. Wages and salary, even if they are earned in part-time employment, are considered business income. - Nonbusiness deductions include itemized deductions such as charitable contributions, medical expenses, and nonbusiness interest and taxes. Casualty losses on personal-use assets, however, are treated as business losses and are excluded from this adjustment. - If a taxpayer does not have itemized deductions in excess of the standard deduction, the standard deduction is used as the amount of the nonbusiness deductions

identifiable event

- Because the event that causes the loss must be identifiable, the act of losing or misplacing property is generally not considered a casualty. - However, an accidental loss of property can qualify as a deductible casualty if the loss is the result of an identifiable event

related party transacstions

- For example, if the taxpayer's intent is to provide property, cash, or services to someone else without receiving any consideration in return, a gift —not a loan— has been made. Some tests used to determine the taxpayer's intent include the following: - does a note or other written instrument exist which evidences an obligation to repay? - Have the parties established a definite schedule of repayment? - Have the parties documented a stated reasonable rate of interest? - Would a person unrelated to the debtor make the loan?

compliance and procedural considerations- casualty losses

- If a taxpayer sustains a casualty loss in a location that the President of the United States declares a disaster area, he or she may make an election to deduct the loss in the year pre-ceding the year in which the loss occurred. A taxpayer makes this election by either filing the return for the previous year and including the loss in that year (if the return has not already been filed) or filing an amended return or claim for refund for that year. The return should clearly include all the following information: - That the election is being made - The date of the disaster giving rise to the loss - The city, county, and state in which the damaged property is located - The taxpayer must make the election before the due date of the return for the year in which the disaster actually occurs

abondoned property

- If a taxpayer's property becomes worthless or is not worth repairing in order to return the property to a serviceable condition, the taxpayer may simply abandon the property. - If the property still has basis, the taxpayer realizes a loss. The taxpayer may not deduct such losses if the property is personal-use property. - However, the taxpayer may deduct losses on business or investment property. - because the abandonment of property is not a sale or exchange, the loss is an ordinary loss. The amount of the loss is the property's adjusted basis on the date of abandonment. - The taxpayer bears the burden of proof to verify that the property was actually abandoned. If the property is depreciable (e.g., machinery and buildings), the taxpayer must actually physically abandon it to take the full amount of the loss.

classifying the loss on taxpayers tax return

- if a loss is deductible, the taxpayer must determine whether the loss is an ordinary loss or a capital loss. - In addition, individual taxpayers must also identify the deductible amount as either a deduction for or from AGI.

Active vs passive

- In order for participation in a real property business to be considered active, more than half of the personal services the taxpayer perform in all trades or businesses during the year are in real property trades or businesses in which the taxpayer materially participates. Both Amanda and Jessica meet this test. - However, the taxpayer must also perform more than 750 hours of work during the taxable year in real property trades or businesses in which the taxpayer materially participates. Only Jessica meets this test, making Jessica's activity active and Amanda's passive.

Carla owns a bakery and a movie theater in each of two different shopping malls, one located in Baltimore and the other in Philadelphia. Depending on other relevant facts and circum-stances, a reasonable grouping of the operations may result in any of the following:

- One activity involving all four operations - Two activities: a bakery activity and a theater activity - Two activities: a Baltimore activity and a Philadelphia activity - Four activities

netting casualty gains and losses on personal use property

- Personal casualty losses that do not result from a federally declared disaster are deductible to the extent the taxpayer has personal casualty gains for the year. - An individual would first reduce the amount of personal casualty gains by the amount of non-federally declared disaster losses. - Any remaining personal casualty gain is then used to reduce the federally declared disaster loss. These gains and losses are not combined with casualty gains and losses on business and investment property. - For purposes of the netting process, the losses should be reduced by any insurance reimbursements and the $100 limitation, but not the 10% of AGI floor. - If the gains exceed the losses for the year, all the gains and losses are treated as capital gains and losses. - The taxpayer performs all of these calculations (the netting process and reductions) on Form 4684. If any loss remains after the netting and reductions, the taxpayer reports the loss as an itemized deduction on Schedule A of Form 1040

carryover periods

- Prior to the Tax Cuts and Jobs Act of 2017 (for tax years before 2018), NOLs were allowed to be carried back 2 years and carried forward 20 years. - The TCJA of 2017 provided that NOLs arising from non-farming businesses after December 31, 2017 were allowed to be carried forward indefinitely. - However, in providing COVID relief in the CARES Act of 2020, Congress changed the treatment of NOLs for tax years 2018, 2019, and 2020. For these years, taxpayers can now carry back an NOL for 5 years and carry forward indefinitely. - The original TCJA of 2017 rules (carry forward only indefinitely) still apply to years after December 31, 2020. --The amount that can be deducted in a following year is limited to the lesser of the aggregate net operating losses carried over or 80% of taxable income computed before any NOL deduction is taken--

Losses on property may arise in a variety of transactions, including:

- Sale or exchange of the property - Expropriation, seizure, confiscation, or condemnation of the property by a government - Abandonment of the property - Worthlessness of stock or securities - Planned demolition of the property in order to construct other property in its place - Destruction of the property by fire, storm, or other casualty - Theft - Deductible business expenses exceeding business income, giving rise to a net operating loss (NOL)

casualty and theft loss

- Taxpayers may deduct losses incurred in connection with business or investment property, but individuals generally are not allowed a deduction for losses on personal-use property. - However, under Sec. 165, individuals may take a limited deduction if the loss on personal-use property arises from a fire, storm, shipwreck, other casualty, or theft. - In other words, losses on personal-use property are deductible only if the loss results from a casualty. In order for an event to qualify as a casualty, the event must meet certain requirements.

Limitation on Deduction of Rental Real Estate Loss (ex: Page I9-15)

- Taxpayers must first apply rental real estate losses against other net passive income for the year. - may then reduce their portfolio or active business income by up to $25,000. - However, the tax law requires reduction of the $25,000 amount by 50% of the taxpayer's AGI in excess of $100,000. - For this purpose, AGI does not include any passive activity loss or any loss allowable to taxpayers who materially participate in real property trades or businesses (e.g., a real estate developer). - Thus, if a taxpayer has AGI of $150,000 or more, the rental real estate losses are not eligible for the $25,000 deduction and are aggregated with the taxpayer's other passive losses.

casualty gains and losses attributable to business and investment property

- Taxpayers must net casualty gains and losses on business and investment property held over one year. - If the losses exceed the gains, the business losses and losses on investment property that generate rents or royalties are for AGI deductions. - Losses on other investment property (e.g., the theft of a security) are itemized deductions. - The $100 or 10% of AGI limitations do not apply to losses on business and investment property. - Casualty gains and losses on business and investment property held one year or less are all treated as ordinary

insurance and other reimbursements

- Taxpayers must subtract any reimbursement received as compensation for a loss in arriving at the amount of the loss. - This is necessary even when the taxpayer has not yet received the reimbursement, as long as there is a reasonable prospect that the taxpayer will receive it in the future. - Thus, the taxpayer may not take a deduction in the year of loss if in that year a reasonable expectation of full recovery exists. - If no anticipation of full recovery exists, the taxpayer may deduct a loss in the year the casualty occurs for the estimated unrecovered amount. - As previously mentioned, the taxpayer may not take a deduction to the extent the taxpayer has insured the personal-use property and the taxpayer does not file a timely insurance claim

nonbusiness bad debts

- The distinction between a business bad debt and a nonbusiness bad debt is important because the classification of the debt determines its tax treatment. - A business bad debt gives rise to an ordinary deduction, whereas a taxpayer must treat a nonbusiness bad debt as a short-term capital loss. - All loans made by a corporation are assumed to be associated with the corporation's business; therefore, the provisions for nonbusiness bad debts do not apply to corporations.

closely held C corporations (example on page I9-13)

- The passive loss rules apply to closely held C corporations but only on a limited basis. - A closely held C corporation is a C corporation where more than 50% of the stock is owned by five or fewer individuals at any time during the last half of the corporation's taxable year.

generally, taxpayers must establish the reduction in the FMV of the property by an appraisal. If an appraisal is difficult or impossible to obtain, the taxpayer may use the cost of the repairs instead. The repairs must meet all of the following requirements before the taxpayer may use this alternative:

- The repairs will bring the property back to its condition immediately before the casualty. - The cost of the repairs is not excessive. - The repairs do no more than repair the damage incurred in the casualty. - The repairs do not increase the value of the property over its value immediately before the casualty.

examples of sudden, unexpected or unusual events

- Thus, the IRS has ruled that a deductible casualty loss occurred when a taxpayer went ice fishing and his automobile fell through the ice.- A taxpayer whose automobile was damaged as the result of an accident also sustained a deductible casualty loss. However, a taxpayer may not deduct losses incurred in an accident caused by the taxpayer's willful negligence or willful act. Damage sustained as the result of an accident in an automobile race was held to be nondeductible because accidents occur often and are not unusual events in automobile races EXAMPLES that constitute a deductible casualty loss: - Rust and water damage to furniture and carpets caused by the bursting of a water heater - Damage to the exterior paint of a building caused by a severe, sudden, and unexpected concentration of chemical fumes in the air - Loss caused by fire (unless the taxpayer sets the fire, in which case no deduction is available) - Damage to a building caused by an unusually large blast at a nearby quarry or a jet sonic boom - Death of trees just a few days after a sudden infestation of pine beetles EXAMPLES of events that have held NOT to be a casualty: - Water damage to the walls and ceiling of a taxpayer's personal residence as the result of the gradual deterioration of the roof - Trees dying because of gradual suffocation of the root systems - The loss of trees and shrubs because of disease - Damage to carpet and clothing caused by moths and carpet beetles - Damage to a road due to freezing, thawing, and gradual deterioration - Damage caused by drought because it occurs through progressive deterioration - The steady weakening of a building caused by normal wind and weather conditions - The rusting and deterioration of a water heater

bad debts- tax planning considerations

- To deduct a bad debt, a taxpayer must show that the debt is worthless. At times the IRS might assert that the debt being written off is either not yet worthless or that it became worthless in a previous year. If the taxpayer is unable to overcome the IRS's assertion concerning the year of worthlessness, the taxpayer might be barred from filing an amended return for the prior year because of the statute of limitations

debt must be worthless

- To deduct a bad debt, the taxpayer must show that the debt is worthless. This determination is made by reference to all the pertinent evidence, including the general financial condition of the debtor and whether the debt is secured by collateral - By simply showing that legal action is not warranted, the taxpayer provides sufficient proof that the debt is worthless. - Indications that an unsecured debt is worthless include bankruptcy of the debtor, disappearance or death of a debtor, and repeated unsuccessful attempts at collection. - Furthermore, if the surrounding circumstances warrant it, a taxpayer may deduct a worthless debt even before the debt comes due.

ordinary vs capital loss (example on I9-5)

- To incur a capital loss, a sale or exchange of a capital asset must occur. - If both elements (i.e., a sale or exchange and a capital asset) are not present, the deduction generally is an ordinary loss. - In general, all assets except inventory, notes and accounts receivable, and depreciable property and land used in a trade or business (i.e., property, plant, and machinery) are classified as capital assets. - Because a casualty is not a sale or exchange, the destruction of a capital asset in a casualty creates an ordinary rather than a capital loss. - Likewise, a deductible loss realized on the abandonment of property is an ordinary loss because an abandonment is not a sale or exchange.

theft defined

- Under Sec. 165, a taxpayer may also deduct a loss sustained as the result of a theft. - This includes theft of business, investment, or personal-use property. - The Treasury Regulations state that "the term theft shall be deemed to include, but shall not necessarily be limited to, larceny, embezzlement, and robbery." - A determination whether other actions also constitute theft often depends on whether the action involves criminal intent and is illegal under the state law where the action has occurred. Thus, the IRS has stated that black-mail, extortion, and kidnapping for ransom may also constitute theft.

disaster losses

- Under certain circumstances, a taxpayer may elect to deduct a casualty loss in the year preceding the year in which the loss actually occurs. This election is available to taxpayers who suffer losses attributable to a disaster that occurs in an area subsequently declared by the President of the United States as a disaster area. - Thus, an individual can elect to deduct a disaster loss occurring in 2023 on his or her 2022 tax return or report it in the regular way on his or her 2023 return. - The taxpayer must file an amended return (Form 1040X) unless he or she has not filed the prior year's return when the disaster is declared. - This election allows taxpayers the possibility of receiving financial help sooner from potential tax refunds by filing an amendment to the prior year's return

measuring the loss

- amount by which the casualty reduces the property's FMV. This is measured by comparing the property's FMV immediately before and immediately after the casualty. - The amount of the loss may not include any reduction in the FMV of the taxpayer's surrounding but undamaged property - Additionally, the cost of protecting property to prevent damage from a casualty is not a deductible loss - If business or investment property is totally destroyed in a casualty, the amount of the loss is the taxpayer's adjusted basis in the property, even if it is greater than the property's FMV. - However, if personal-use property is totally destroyed, the amount of the loss is limited to the lesser of the reduction in the property's FMV or the property's adjusted basis

excess business losses

- for taxable years beginning after December 31, 2020, a noncorporate taxpayer is not allowed to deduct any excess business losses. - Any excess losses are carried forward and are treated as a part of the taxpayer's NOL. - An excess business loss is the excess of aggregate business deductions for the year over the sum of a taxpayer's aggregate business gross income and gains plus $289,000 if single and $578,000 if married in 2023 ($270,000/$540,000 in 2022). - The excess business loss limitations for partnerships and S corporations are applied at the partner or shareholder level. - This limitation is applied to passive activities after the application of the passive loss rules

third party debt

- in some cases a taxpayer will guarantee or endorse someone else's obligation. If under the terms of the guarantee, the guarantor is required to pay the debtor's remaining outstanding principal as well as any accrued interest on the debt - if the guarantor's intent was a gift, the guarantor may not deduct the payment of the outstanding principal and accrued interest. - On the other hand, if the guarantor can prove that the guarantee was not a gift, the guarantor may deduct the principal and accrued interest as a bad debt issued to the debtor at the time of the payment.

passive activity definition

- includes any trade or business in which the taxpayer does not materially participate as well as any rental activity - The definition of a passive activity is based on two critical elements: an identification of exactly what constitutes an activity and a determination of whether the taxpayer has materially participated in that activity

tax treatment

- individuals deduct nonbusiness debts that become wholly worthless during the year as short-term capital losses. - Individuals generally prefer an ordinary deduction rather than a short-term capital loss because capital losses are first used to offset capital gains. If the capital losses exceed the capital gains, the individual taxpayer is limited to an additional $3,000 tax deduction each year. Any loss in excess of this limit is carried over to subsequent years to be included in the capital gain and loss netting process in those years

worthless securities

- securities that become worthless during the taxable year are deemed to have become worthless on the last day of the year - this treatment causes the loss to be treated as a long-term capital loss. - If the loss from the worthless security is long term, the taxpayer reports it in Part II of Schedule D (Form 1040) along with the other long-term gains and losses for the year. - The taxpayer reports short-term capital losses in Part I of Schedule D.

partial worthlessness ( page I9-28)

- taxpayers may not deduct a partially worthless nonbusiness debt. - Thus, a taxpayer cannot deduct a loss for a nonbusiness debt that is still partially recoverable during the year.

computing the net operating loss for individuals (examples on page I9-31)

- the sarting point in calculating an individual's NOL is generally taxable income. As mentioned earlier in this chapter, individuals may deduct three basic types of expenses to arrive at the amount of taxable income: business-related expenses, investment-related expenses, and certain personal expenses. The NOL, however, generally attempts to measure only the economic loss that occurs when business expenses exceed business income. - Thus, individual taxpayers must make several adjustments to taxable income to arrive at the amount of the NOL for any particular year. These include adjustments for an NOL deduction, a capital loss deduction, the deduction for personal exemptions, and the excess of nonbusiness deductions over nonbusiness income

working interest in an oil and gas property

-A working interest is an interest that is responsible for the cost of development or operation of the oil and gas property. - This type of interest in an oil and gas property is not a passive activity as long as the taxpayer's liability in the interest is not a limited interest. Thus, even though a taxpayer may not materially participate in the activity, the passive loss rules do not apply. This is so even if the taxpayer holds the interest through an entity such as a partnership.

accounting for the business bad debt

2 basic methods: write off and reserve method - Except for certain specialized industries, however, taxpayers can use only the specific write-off method for tax purposes. - specific write-off method- the taxpayer deducts each bad debt individually as it becomes worthless and the taxpayer writes it off as an expense. Taxpayers use this method for (1) business bad debts that are either totally or partially worthless and (2) nonbusiness bad debts that are totally worthless. However, as previously noted, taxpayers take no deduction for partially worthless nonbusiness bad debts.

if an individual taxpayer meets certain requirements, the taxpayer still may deduct against other income up to $25,000 of annual losses from these passive rental real estate activities. To meet this exception, an individual must do both of the following:

1. Actively participate in the activity 2. Own at least 10% of the value of the activity for the entire tax year - Additionally, in order to take a deduction in the current year for a loss sustained in a prior year, Section 469(i) requires the taxpayer to actively participate in the activity during both years

What is the proper treatment of the gains and losses for tax purposes?

1. If the Section 1231 losses for the year exceed the Section 1231 gains, then both the losses and gains are treated as ordinary. - example- Natalia has two transactions during the year: $8,000 Section 1231 gain $14,000 Section 1231 loss - both are ordinary gain/loss 2. If the Section 1231 gains for the year exceed the Section 1231 losses, then both the losses and gains are treated as capital - example - Natalie has two transactions during the year: $12,000 Section 1231 gain $9,000 Section 1231 loss - answer- $12,000 capital gain and $9,000 capital loss

On August 1 of this​ year, Sharon, a cash−method ​taxpayer, signs a lease for office space and begins business. The lease is for 3 years. At the time the lease is​ signed, Sharon pays the​ $12,600 rent for the entire 36−month lease term. How much can Sharon deduct this​ year?

1750 (12600 rent/36months = 350 x 5months left of this year= 1750)

definition of non business bad debt

A nonbusiness debt is defined as any debt other than: (1) a debt created or acquired in connection with a trade or business of the taxpayer or (2) a debt the loss from the worthlessness of which is incurred in the taxpayer's trade or business. This determination depends on an examination of the facts and circumstances surrounding the debt in question

Personal Service Corporation (PSC)

A personal service corporation (PSC) is a regular C corporation whose principal activity is the performance of personal services that are substantially performed by owner-employees. - However, a corporation is not a PSC unless owner-employees own more than 10% of the value of the stock. - In contrast with a closely held C corporation, the passive loss limitation rules apply in their entirety to a PSC. If a corporation is both a PSC and a closely held C corporation, the more restrictive rules for PSCs apply

carryovers ( page I9-8)

A taxpayer carries over disallowed passive activity losses indefinitely and treats them as losses allocable to that specific passive activity in the following tax years. The taxpayer may use these losses, known as suspended losses, to offset passive activity income of the subsequent year, but generally may not offset other types of income. If a taxpayer has invested in several passive activities, and for the year some of the activities generate income while others generate losses, the loss carried over for each loss activity is a pro rata portion of the total passive loss for the year.

EXPROPRIATED, SEIZED, CONFISCATED, OR CONDEMNED PROPERTY

A taxpayer may own property that the government expropriates, seizes, confiscates, or condemns. In these cases, the taxpayer incurs a deductible loss if the taxpayer used the property in a trade or business or held it for investment. The Tax Court has held that the confiscation, seizure, condemnation, or expropriation of property does not constitute a theft or a casualty. Rather, it is treated as a sale or exchange. Thus, no deductible loss arises if the seized property is personal-use property. - If the seized or condemned property is business or investment property, the classification of the loss depends on the type of property. A taxpayer may take the deduction only in the year in which the property is actually seized. Whether formal expropriation or nationalization occurs in a later year is irrelevant. - A taxpayer realizes gain if he or she receives compensation for the property in excess of its basis.

sudden, unexpected or unusual events

According to the IRS: - a sudden event is one that is swift, not gradual or progressive. -an unexpected event is one that is ordinarily unanticipated and not intended. - an unusual event is one that is not a day-to-day occurrence and that is not typical of the activity

Juan has a casualty loss of​ $32,500 on investment property after receiving an insurance settlement. This is​ Juan's only casualty transaction this year.​ Juan's loss is

Answer: Ordinary Loss This Casualty loss is Considered as an Ordinary loss If the loss is on sales of Property the loss is considered as a Capital Loss.

In 2016, Diego borrows $50,000 from his father, Juan, and invests in a very promising high-tech start-up. At the time of the loan, Juan does not require Diego to sign a loan agreement, although Diego promises to repay Juan in the future. Unfortunately, the company goes bankrupt and Diego's investment is worthless. By the current year, it is clear that Diego is sadly unable to repay Juan. How should Juan report this bad debt on this tax return in the current year?

Answer: should not be included on Juans tax return - With these facts, it does not appear that a bona fide debt exists. Since the parties are related, and no interest rate or repayment schedule exists, this is more likely characterized as a gift rather than a loan. Therefore, no bad debt is reported by Juan in the current year.

taxpayers basis in the debt

For a bad debt to be deductible, the creditor must have basis in the debt. The taxpayer may acquire this basis in different ways. If a taxpayer loans money, the taxpayer's basis in the debt is the amount loaned. If the debt arises because the taxpayer provides property or services for the other party, basis is established only if the taxpayer has previously included the FMV of the property or services in income.

Losses on Sec. 1244 Stock

For individuals, the tax law provides an exception for losses from the sale or worthlessness of small business corporation (Sec. 1244) stock. Individuals may deduct these losses as ordinary losses up to a maximum of $50,000 per tax year ($100,000 for married taxpayers filing a joint return). Any remaining loss for the year is a capital loss. - To qualify the loss as ordinary under Sec. 1244, the following requirements must be met: - The stock must be owned by an individual or a partnership. - The stock must have been originally issued by the corporation to the individual or to a partnership in which an individual is a partner. - The stock must be stock in a domestic (U.S.) corporation. - The taxpayer must have received the stock in exchange for cash or property (other than stock or securities) that the taxpayer contributed to the corporation. Stock issued to the taxpayer for services rendered is not eligible for Sec. 1244 treatment. - The corporation must not have derived over 50% of its gross receipts from passive income sources during the five tax years immediately preceding the year of sale or worthlessness. - The amount of money and property contributed to both capital and paid-in surplus may not exceed $1 million at the time the corporation issues the stock

During 2023, Ed worked as a songwriter in Nashville. He had gross income of $150,000 and expenses of $500,000. He also earned $400,000 from his job as an auditor for the State of Tennessee. Assuming that Ed is single, how much of Ed's business losses will become a NOL carryover?

For taxable years beginning after December 31, 2020, a non corporate taxpayer is not allowed to deduct any excess business losses. Excess business losses are the excess of aggregate business deductions for the year over the sum of a taxpayer's aggregate business income and gains plus $289,000. Excess business losses that are disallowed become a NOL carryover. Ed's business deductions total $500,000 and his business income of $150,000 plus $289,000 equals $439,000. As such, Ed's excess business losses are $500,000 - $439,000 = $61,000.

Material Participation

Once each activity is identified, taxpayers must determine whether the activity is passive or active. If the taxpayer does not materially participate in the activity, it is deemed to be a passive activity with respect to that taxpayer. Pursuant to the Treasury Regulations, 18 there is material participation in an activity if the taxpayer meets at least one of the following tests: - The individual participates in the activity for more than 500 hours during the year. - The individual's participation in the activity for the year constitutes substantially all of the participation in the activity by all individuals, including individuals who do not own any interest in the activity. - The individual participates in the activity for more than 100 hours during the year, and that participation is more than any other individual's participation for the year (including participation by individuals who do not own any interest in the activity). - The individual participates in "significant participation activities" for an aggregate of more than 500 hours during the year. Thus, an individual who spends over 100 hours each in several separate significant participation activities may aggregate the time spent in these activities in order to meet the 500-hour test. - The individual materially participated in the activity in any five years during the immediately preceding ten taxable years. These five years need not be consecutive. - The individual materially participated in the activity for any three years preceding the year in question, and the activity is a personal service activity. - The individual participates in the activity on a regular, continuous, and substantial basis during the year, taking into account all the relevant facts and circumstances

Bona fide debtor-creditor Relationship

Only items constituting bona fide debt are eligible to be deducted as a bad debt. - A bona fide debt is one that arises from a valid and enforceable obligation to pay a fixed or determinable sum of money and results in a debtor-creditor relationship

publicly traded partnerships (PTP)

Partners treat losses from a PTP as separate from any other type of income (passive, active business, or portfolio) and separate from any income from other PTPs. - Partners can only carry these losses forward and offset them against income generated by that particular PTP in a subsequent year. - Furthermore, a PTP loss may not offset any portfolio income that the PTP might generate. Any net income from PTPs portfolio income.

The way taxpayers combine or separate operations into activities can significantly impact the deductibility of losses generated by the activities.

Taxpayers may treat one or more activities as a single activity only if they constitute an "appropriate economic unit." Although the taxpayer makes this determination by examining all the relevant facts and circumstances, the following factors receive the greatest weight: - Similarities and differences in the types of business, - The extent of common control, - The extent of common ownership, - The geographical location, and - Any interdependencies between the operations (i.e., the extent to which the operations purchase or sell goods between each other, have the same customers, are accounted for with a single set of books, etc --A taxpayer may treat more than one operation as a single activity, even if all of these factors do not apply. Furthermore, a taxpayer may use any reasonable method of applying the relevant facts and circumstances in grouping the activities

disallowance possibilities

The tax law may disallow or defer losses incurred in certain transactions and activities. Some of these transactions include: - Transfers of property to a controlled corporation in exchange for stock of the corporation - Exchanges of property for other property considered to be like-kind to the property given up - Property sold to certain related parties - Wash sale transactions - Losses limited because the losses exceed the amount for which the taxpayer is at risk

add back any capital loss deduction (examples on page I9-31)

To compute taxable income, individuals may deduct up to a maximum of $3,000 capital losses in excess of capital gains in any year.Because capital losses have their separate carryover provisions, taxpayers must add back any deduction associated with these losses to taxable income to arrive at the NOL for the current loss year. To make this adjustment, the taxpayer must follow several steps: 1. A taxpayer must separate nonbusiness capital gains and losses from business capital gains and losses. The nonbusiness gains and losses are then netted, while the business gains and losses are netted separately. 2. If the nonbusiness capital gains exceed the nonbusiness capital losses, the excess, along with other types of nonbusiness income, is first used to offset any nonbusiness ordinary deductions. Any nonbusiness capital gain remaining is then used to offset any business capital loss in excess of the business capital gain for the year. 3. If both groups of transactions result in net losses, the capital loss deduction provided by these transactions must be added back. For purposes of the NOL, no deduction is allowed for either business or nonbusiness net capital losses. 4. If the taxpayer's nonbusiness capital losses exceed the nonbusiness capital gains, the losses may not be offset against the taxpayer's excess business capital gains. Allowing this offset would provide an indirect deduction for a nonbusiness economic loss.

add back any NOL deduction (examples on page I9-31)

Under certain circumstances, a taxpayer might have taken a deduction for an NOL arising from another tax year in computing the taxable loss for the current loss year. Allowing this deduction to create or increase the NOL of the current loss year would provide an unwarranted benefit. Thus, taxable income for the current loss year must be increased for this deduction.

During 2023, Muhammed was a partner in the ARM Partnership, which operated at a loss. Muhammed's share of the net loss was $425,000. Additionally, Muhammed operated a sole proprietorship with gross income of $400,000 and gross expenses of $220,000. Assuming that Muhammed is single, what is the amount of Muhammed's excess business loss, if any, for 2023?

answer- 0 For taxable years beginning after December 31, 2020, a noncorporate taxpayer is not allowed to deduct any excess business losses. Excess business losses are the excess of aggregate business deductions for the year over the sum of a taxpayer's aggregate business income and gains plus $289,000. Excess business losses that are disallowed become a NOL carryover. Muhammed's business deductions are the net loss from the partnership of $425,000 plus the business expenses of $220,000 for a total of $645,000. His business income is the $400,000 of gross income from the partnership plus $289,000 for a total of $689,000. As such, he has no excess business losses.

In the current year, an earthquake results in the following damage to Lucas' personal-use property: - A garage valued at $30,000 is completely destroyed. - The garage crushes and completely destroys a car with a purchase price of $25,000 and a FMV of $15,000. - Lucas' home sustains $20,000 in damage. - The area is declared a federal disaster zone. Lucas' AGI for the year is $175,000. What will be the decrease in his taxable income as a result of the earthquake?

answer: $47,400 (30,000 + 15,000 + 20,000) - $100 - (10% * 175,000)

Jose's home has been destroyed by a tornado that occurred on May 30, 2023. Because of extremely widespread damage, the area in which the home is located has been designated a disaster area by the President. Insurance recovery is expected in early 2024. After insurance, it is expected that Jose will have a loss of $50,000. During which tax year will Jose claim this loss?

answer: 2022 or 2023 - In general, losses are claimed in the year in which they actually occur. However, if an area has been declared a disaster area by the President, the taxpayer may elect to claim the loss either in the year in which it occurred or the prior year. If Jose has already filed his 2022 return, he may amend the return to claim a refund.

Fernanda has invested in three passive activities. During the current year, these investments generate the following results: Activity X generates a loss of $20,000 Activity Y generates a loss of $30,000 Activity Z generates income of $40,000 What is the passive loss carryover for Activity X for the current year?

answer: 4,000 - since passive losses ( X+Y: 50,000) exceed passive income (Z:40,000) by 10,000 (50,000-40,000) this amount is carried over and allocated to activities X and Y. The loss allocated to X is the prorata portion of the total passive loss for the year , $10,000x20,000/50,000= $4,000

Pedro is a cash method taxpayer and he provides accounting services for his client, Shady Company. He has billed Shady Company a total of $4,000 for services rendered in 2022. However, by the end of 2023, he discovers that Shady Company has left the area and all attempts to locate the owner are fruitless. How will this bad debt be recorded for tax purposes?

answer: Pedro will record business bad debt in 2023. - Since Pedro is a cash basis taxpayer, he never recorded revenue in 2022, nor took basis in the debt. As such, when the debt becomes worthless in 2023, he has no bad debt deduction.

business bad debts

the tax treatment of losses from business bad debts differs substantially from the treat-ment of nonbusiness bad debts. As previously discussed, a business bad debt provides an ordinary loss deduction. Furthermore, taxpayers may also deduct a business debt that has become only partially worthless during the year

In the case of loans between related​ parties, without proper documentation the lender faces the risk that the IRS will reclassify the loan as a bonus.

false

Securities held by a taxpayer became worthless during the year. The taxpayer plans to take a deduction for the loss. He will claim the deduction on page 1 of his Form 1040.

false

Deposits in Insolvent Financial Institutions

qualified individuals may treat a loss on deposits in qualified bankrupt or insolvent financial institutions as a personal casualty loss in the year in which the individual can reasonably estimate the loss. The recognized loss is the difference between the taxpayer's basis in the deposit and a reasonable estimate of the amount that the taxpayer will receive. This treatment allows the individual an ordinary loss deduction, but subjects the loss to the personal casualty loss limitations - Qualified financial institutions include banks, federal or state chartered savings and loans and thrift institutions, and federal or state insured credit unions.

transactions that may result in losses

table on page I9-7

deductible amount of casualty loss

the amount of a casualty loss deduction depends on the amount of the loss sustained, any insurance or other reimbursement the taxpayer received, and, in the case of personal-use property, the limitations imposed under the tax law.