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Chapter 7. Losses-Deductions and Limits-2013 T13F-Chp-07-1-Losses-Deductions and Limits-2013

Chapter 7. Losses-Deductions and Limits-2013 T13F-Chp-07-1-Losses-Deductions and Limits-2013.

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Chapter 7. Losses-Deductions and Limits-2013 T13F-Chp-07-1-Losses-Deductions and Limits-2013

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  1. Chapter 7.Losses-Deductions and Limits-2013 T13F-Chp-07-1-Losses-Deductions and Limits-2013

  2. Part 1. IntroductionPart 2.Annual Losses Trade or Business, Rental ActivitiesPart 3.Losses, Loss Carryovers NOL, Tax Shelters (Passive Losses) Part 4.Trade or Business Losses Operating losses, Business casualty or theft losses Part 5.Investment related losses Capital losses (individuals and corp), Small business stock, Related party losses, Wash sales Part 6.Losses on Personal use items (Casualties)

  3. Definition of Losses • Annual (Activity) Lossesresult when an entity’s deductions for the period exceed its income • Transaction Lossesresult from disposition of an asset

  4. General Scheme for Treatment of Losses Figure 7-1 Realized loss Annual loss Transaction loss Trade or business loss Trade or business loss Personal use loss Investment- related loss Passive Activity Capital loss limitations Loss allowed or loss deduction suspended Ordinary loss Non- deductible NOL deduction

  5. Annual Losses: Net Operating Loss • Incurred in trade or business operations • Caused by business expenses • May not be caused by investment or personal expenses • Treatment • No tax in year NOL occurs • Carry-back 2 years (But consider 2009 law) • Carry-forward unused NOL 20 years • May elect to forego carry-back

  6. Annual Losses: Tax Shelter Losses Tax shelters are activities designed to minimize the effect of tax on wealth accumulation. Dominant business purpose is lacking • Primary motivation is tax reduction • Are often vehicles for tax law abuse

  7. Study the information given on the building on the preceding page. Assume the owner only pays interest on the mortgage. What is gain or loss on sale of the building, if it is sold on 1-1-Yr2, for $500,000? What happens to the taxable loss from Yr 1? We will also consider what happens if the value of the building declines over the period of ownership. You can lose from operations and from selling the property for less than basis.

  8. Assume Taxpayer owns the building for exactly 4 years and in each year the income statement looks like the one on the preceding slide. After 4 years (12-31-Yr-4), Taxpayer sells the building for $350,000. Taxpayer has been paying interest only. What is the gain or loss on the building? What happens to 4 years of losses?

  9. Tax Shelter Losses-At-Risk Rules • At-Risk Rules disallow the deduction of artificial losses • Loss deduction limited to amounts actually “at-risk” • To determine amounts actually at-risk, take the amount of cash or other assets contributed and • Add debts for which taxpayer is responsible • Adjust for share of income (loss) from the activity • Reduce by amount of withdrawals

  10. Tax Shelter Losses Passive Activity Loss • A passive activity is any trade or business in which the taxpayer does not materially participate • Passive Activity Loss Rulesdisallow the deduction of passive activity losses from other forms of income

  11. Types of Income and Losses • Active:salary and wages of an employee and income earned from a business in which the owner/recipient materially participates • Portfolio: interest and dividends • Passive: tax shelter income, income passed through to limited partners, and income from other businesses in which owner/recipient does not materially participate

  12. Passive Activity Loss • Taxpayers subject to the limitations: • All non-corporate taxable entities • Conduit entity passive losses flow-through to owners • Taxpayers not subject to the limitations: • Publicly held corporations • PAL can offset active and portfolio income • Closely held corporations • PAL can offset active income, but not portfolio

  13. Passive Activity LossGeneral Rules for Limitations • Passive activity losses must be netted against passive activity income • Net passive lossesare not deductible • Net passive gainsare reported with other income

  14. Passive Activity LossException for Rental Real Estate • By definition, all rental activities and limited partnership interests are passive • But, taxpayers who materially participate in rental real estate business are allowed to offset any losses against other active or portfolio income

  15. Passive Activity LossDisposition of Passive Activities • Excess (suspended) losses must be accounted for in the year of disposition • Disposition by sale frees the suspended loss to offset income of any other activity • First, offsets other passive income • Second, offsets gain from disposal • Third, any remaining PAL offsets ordinary income

  16. Disposition of Passive Activities • Disposition upon death leaves the passive activity in the decedent’s estate • Passive activity with unrealized gain • Beneficiary takes passive activity with stepped-up basis • Released excess loss is deductible against other income, but • Any unrealized gain on activity decreases amount of suspended loss to release • Passive activity with unrealized loss • No suspended loss is released

  17. General Loss Limitation • If a partner’s share of losses exceeds the partner’s basis • Partner can only deduct losses to the extent of basis • Excess losses are carried forward (indefinitely) to future years until there is sufficient basis against which to deduct the unused losses

  18. Material Participation • Current activity level • 500 hours or more participation in year • Participation is substantially all the activity by all persons • At least 100 hours and no one else participates more • At least 100 hours in more than one activity and aggregate of activities exceeds 500 hours

  19. Material Participation • Prior activity level • Materially participated in 5 of preceding 10 years • Materially participated in 3 prior years in personal service activity

  20. Rental Real Estate Relief • Taxpayers can qualify for up to $25,000 deduction for rental real estate losses • Taxpayer must own at least 10% and actively participatein management • Set rents, qualify renters, approve repairs • Deduction phases out for AGIs between $100,000 and $150,000

  21. Bud is single & received wages of $140,000 from IBM in 2013. Bud is a 50% partner in a partnership engaged in a rental real estate activity w/ $60,000 loss for the partnership. Bud was an active participant in the rental real estate activity. He had no other income. How much of the partnership rental loss may Bud deduct on his 2013 income tax return? (Sec. 469(i)) a. $0 b. $5,000 c. $15,000 d. $25,000

  22. Real PropertyBusiness Exception • Taxpayers must spend more than half their time in real property businesses in which they materially participate and time spent equals or exceeds 750 hours

  23. A taxpayer has this income (losses) for the current year:Active Income $43,000 Portfolio Income $29,000Passive Income $(27,000)What is the taxpayers taxable income (loss) if:

  24. T/P is single individual & passive income is not from rental?An individual cannot deduct passive losses against active or portfolio income. The individual taxpayer has taxable income of $72,000 ($43,000 + $29,000) and a suspended loss of $27,000.

  25. T/P is a single individual and the passive income results from a rental activity for which the taxpayer fails to qualify as a real estate professional?Individual - active participant in a rental real estate activity - is allowed to deduct up to $25,000 of losses from rental activities against active and portfolio income. The taxable income is $47,000 ($43,000 + $29,000 - $25,000).

  26. T/P is single and the passive income results from a rental activity for which the taxpayer qualifies as a real estate professional? An individual who qualifies as real estate professional can deduct all losses from the activity against active and portfolio income. The taxable income is $45,000 ($43,000 + $29,000 - $27,000).

  27. Laura owns a commercial office building. She spends more than 500 hours a year managing the building. She also spends 1,700 hours working in her own real estate development firm.

  28. Laura qualifies as a real estate professional. She spends more than 50% of her personal service time in a real property trade or business, the amount of time spent in the real property trade or business is greater than 750 hours, and she materially participates in the rental activity (i.e., spends greater than 500 hours managing the rental activity). Because she qualifies as a real estate professional, office building is not passive activity.

  29. Assume the same facts as in preceding slide, except that Laura hires a full-time manager for the commercial office building. She spends 75 hours meeting with the manager and reviewing the operations.The office building is a passive activity. Because Laura does not spend more than 500 hours managing the rental property, she does not qualify as a real estate professional.

  30. Transaction Losses Transaction lossesresult from the disposition of business, investment or personal-use assets.

  31. Transaction Losses:Trade or Business Losses • Business casualty and theft losses result from damage caused by a sudden, unexpected and/or unusual event • For property fully destroyed, deduct the adjusted basis less insurance recovery • For property partially destroyed, deduct lesser of the property’s adjusted basis, or the decline in the property’s value

  32. Involuntary Conversions • An involuntary conversion results from • Theft– embezzlement, larceny and robbery (but not simply losing items) • Casualty– requires a sudden, unexpected, and unusual event such as a fire, flood, tornado, hurricane or vandalism • Condemnation– lawful taking of property for its fair market value by a government under the right of eminent domain

  33. Casualties and Thefts • Gains and losses sustained on casualties and thefts are not under a taxpayer’s control so they receive special tax treatment • Allowable losses (including personal losses) are immediately deductible • Gains (due to receipt of insurance proceeds) may be deferred if all insurance proceeds are used to repair the damaged property or to acquire qualifying replacement property

  34. Casualty and Theft Losses • Partial destruction of Business or Investment Property– Loss limited to the lesser of: • Decline in fair market value (or repair costs to restore property to pre-casualty condition) • The adjusted basis of the property Complete Destruction of Business Property • For business property that is completely destroyed, the loss is always the property’s adjusted basis. • The loss computed above is then reduced by any insurance proceeds received

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