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68 terms

Chapter 8 Losses and Bad Debt

TAX1 Woodward Fall2012 FSU
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If the taxpayer uses the property in a trade or business or holds the property for investment the tax law generally provides a
deduction for the losses
Other losses on personal-use property (e.g, a sale of personal residence at a loss)
are not deductible
For taxpayers to deduct a loss on property,
the loss must be both realized and recognized for tax purposes
The amount of loss realized on the sale of property is computed by
subtracting adjusted basis from amount realized.
Taxpayers can only deduct losses they incur in the sale or exchange of
property used in a trade or business or held for investment
A loss on business or investment property which is abandoned is deductible as an ordinary loss to the extent of the property's
adjusted basis on the date of abandonment.
A mere decline in value is not sufficient to create a deductible loss if the stock has
any recognizable value
Once the taxpayer determines the year of worthlessness , the taxpayer treats the loss as a
loss from the sale of a capital asset on the last day of the tax year
Taxpayers may not deduct any demolition costs or
any loss sustained on account of the demolition
Taxpayers must add demolition costs to the basis of
the land on which the demolished structure previously stood
Whether a deductible loss is ordinary or capital depends on
the type of property involved and the transaction in which the taxpayer sustains the loss
If both elements (i.e. a sale or exchange and a capital asset) are not present,
the deduction is an ordinary loss
Because a casualty is not a sale or exchange, the destruction of a capital asset in a casualty creates
an ordinary rather than capital loss
Taxpayers often invested in activities called tax shelters,
that would spin off tax deductions and credits, many were passive investments
In enacting the passive loss rules, Congress did not want to prevent taxpayers from
currently deducting or using losses and credits generated in active business endeavors of the taxpayer
When applying the limitations of the passive activity rules, a taxpayer's AGI is classified into active income, portfolio income and passive income. For this purpose, portfolio income includes
dividends, interest, annuities, and royalties.
Portfolio income becomes part of net investment income, which is used in computing
the deduction limit for investment interest expense
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
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
A taxpayer may use suspended losses to
offset passive activity income of the subsequent year, but not to offset other types of income
When a taxpayer disposes of a passive activity in a taxable transaction, the taxpayer can compute
the economic gain or loss by the activity and can deduct the suspended losses of the activity against other income
If the taxpayer sells the passive activity to a related party, he or she may not deduct the suspended loss until
the related party sells the activity to a nonrelated person
An activity that was previously passive may not be passive with respect to
the taxpayer for the current year
Passive activity includes
any trade or business in which the taxpayer does not materially participate as well as any rental activity
Passive activity is based on two critical elements:
An identification of exactly what constitutes as an activity and a determination of whether the taxpayer has materially participated in that activity
Taxpayers may deduct currently up to $25,000 of
passive losses from rental real estate activities
Once taxpayers establish the activities they must be consistent in grouping these activities in subsequent years unless
material changes in the facts and circumstances clearly make the groupings inappropriate
The taxpayer may not combine rental activities involving real estate with
rental activities involving personal property
Partnerships and S corporations must identify their business and rental activities by applying these rules at the partnership or S corporation level and then
must report the results of their operations by activity to the partners or shareholders
If the taxpayer does not Materially Participate in the activity, it is deemed to be a
passive activity with respect to that taxpayer
Many rental real estate activities are not considered rental real estate businesses and are, therefore,
subject to the passive loss rules
If an individual taxpayer meets certain requirements, the taxpayer still may deduct against income up to $25,000 of
annual losses from theses passive rental real estate activities
Individuals must do both of the following
- Actively participate in the activity
- Own at least 10% of the value of the activity for the entire tax year
Active participation is different from material participation, and is a
lesser standard of involvement
Up to $25,000 of passive losses attributable to rental real estate can be deducted each year against
income from nonpassive sources such as salary, interest, and dividends
Taxpayers may take a limited deduction if the loss on personal-use property arises from
a fire, shipwreck, other casualty, or theft.
Casualty loss
is one that occurs in an identifiable event that Is sudden, unexpected, unsusual.
A taxpayer may also deduct loss sustained as the result of a theft, which includes
theft of business, investment, or personal-use property
Measure the loss by comparing the property's
FMV immediately before and immediately after the casualty
Property partially destroyed, amount of the loss is the lesser of
the reduction in the property's FMV or the taxpayer's adjusted basis in the property
Business or Investment property 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
Personal-use property totally destroyed in a casualty, the amount of the loss is
limited to the lesser of the reduction in the property's FMV or the property's adjusted basis
The amount an individual may deduct for a casualty loss on personal-use property is subject to 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 is reduced by 10% of the taxpayers AGI for the year
Many taxpayers who sustain casualty and theft losses on personal-use property DO NOT receive
a tax deduction
If the casualty gains exceed the losses for the year, all the gains and losses are treated as
capital gains and losses
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
A bona fide debtor-creditor relationship mist exist between
the taxpayer and some other person or entity
Taxpayers may only use the specific write-off method of accounting in
deducting the bad debt
For bad debt to be deductible,
the creditor must have basis in the debt
A cash method taxpayer reports income only in the year in which
payment in the form of cash or property is received
Because a note constitutes the receipt of property, a cash method taxpayer
reports income in the year the note is received
If the cash method taxpayer does not receive a note and the receivable is an open account item,
the taxpayer reports no income until the receivable is collected
The taxpayer has no basis in the receivable and does not receive bad debt if
the receivable is not collected
Except for certain specialized industries, however, taxpayers can use only the
specific write-off method for tax purposes
Net operating loss generally involves only
business income and expenses
The starting point in calculating an individuals NOL is
generally taxable income
Net Operating Loss for Individuals
- ADD back any NOL DEDUCTION
- ADD BACK ANY CAPITAL LOSS DEDUCTION
- ADD BACK THE DEDUCTION FOR PERSONAL EXEMPTION
- ADD BACK EXCESS OF BUSINESS DEDUCTIONS OVER NONBUSINESS INCOME
NOL is initially carried back for two years and is deductible
as an offset to the taxable income of the carryback years
If any loss remains, taxpayers may then
carry it forward for a period of 20 years
For both carryback and carryforward periods, the loss must be deducted from
the years in chronological order
Any NOL that is not used during the carryover period
expires and is of no further tax benefit
A taxpayer may elect to not caryback the NOL, but to carry the loss
forward; which does not extend beyond 20 years
Loss carryovers from two or more years, the loss of the earliest year is always completely used first before
deducting any of the losses incurred in a subsequent year
Because the NOL is attributable to a taxpayer's trade or business, it is
deductible for AGI
All of these deductions except the deduction for charitable contributions must be
recomputed using the reduced AGI amount
If an NOL is incurred, when would a taxpayer elect to forgo the carryback period and only carry the loss deduction forward?
If an NOL is incurred, when would a taxpayer elect to forgo the carryback period and only carry the loss deduction forward?
How is a claim for refund of taxes filed by an individual who carries an NOL deduction back to a prior year?
A claim for refund of taxes is filed by either filing an amended return on Form 1040X or filing for a quick refund on Form 1045.