Chapter 9: Losses And Bad Debts

Question 1

Closed transaction doctrine

Answer 1

For a loss it be realized it must have occured in a completed (closed) transaction, evidenced by an identifiable event such as a sale or exchange

Question 2

Losses on Property used partially for business and partially for personal use

Answer 2

Loss attributable to business portion is deductible, but not the personal portion (unless loss was sustained in federally declared disaster zone)

Question 3

Calculating loss on sale or exchange of property

Answer 3

Amount realized (cash+ FMV of any property received+value of any liabilities assumed by the buyer) - adjusted basis

Question 4

Treatment of selling costs for inventory

Answer 4

Generally deductible period expenses but not part of gain or loss from sale

Question 5

Selling costs for property not usually held for sale in the ordinary course of taxpayer’s business

Answer 5

Selling costs reduced amount realized from sale or exchange

Question 6

Loss on sale of business inventory

Answer 6

Ordinary loss

Question 7

Loss on the sale of a capital asset

Answer 7

Capital loss

Question 8

Expropriated, sized, confiscated, or condemned property

Answer 8

If property used in trade or business: treated as sale or exchange and loss is deductible (type of loss depends on type of property)

No deduction for personal-use property

Deduction may be take only in the year property is actually seize

If receive compensation in excess of basis: recognize gain (potentially deferred)

Question 9

When may a taxpayer abandon property

Answer 9

If it becomes worthless or is not worth repairing in order to return property to a serviceable condition

Question 10

Tax treatment of abandoned property

Answer 10

If property still has a basis taxpayer may realize a loss

Loss only deductible if property is business or investment property

Loss is ordinary loss based on property’s adjusted value on date of abandonment

Question 11

Abandonment of depreciable property

Answer 11

Taxpayer must physically abandon the property to take a loss

Question 12

Tax treatment of worthless securities

Answer 12

Taxpayer may take a deduction for securities that become COMPLETELY worthless during the tax year

Treated as a loss from the sale of a capital asset on the last day of the tax year

Question 13

Determining when a security is worthless

Answer 13

Taxpayer must show that the security is completely worthless, beyond simple decline in value

Ex: bankruptcy where liabilities exceed FMV of assets so shareholders have no possibility of receiving anything of value

Question 14

Circumstance where a domestic corporation can treat loss from worthless securities of an affiliate as an ordinary loss

Answer 14

• domestic corporation owns at least 80% of the voting power of all classes of affiliated corporations stock and 80% of the total value of that stock
  AND
• more than 90% of the affiliated corporation’s gross receipts for all it’s taxable years must be from nonpassive income

Question 15

Nonpassive income

Answer 15

All income other than royalties, rents, dividends, interest, annuities, and gains from the sale or exchange or stocks and securities

Question 16

Demolition of property

Answer 16

Not a deductible loss but rather a cost to be added to the basis on the improved land on which the structure stood

Question 17

Capital loss

Answer 17

Loss on the:
- sale or exchange of a
- capital asset

Must be both of these above

Question 18

Ordinary loss

Answer 18

Losses that are not capital losses

Question 19

Capital assets

Answer 19

Generally all assets except:
- inventory
- notes and accounts receivable
- depreciable property and land used in trade or business

Question 20

Destruction or abandonment of a capital asset

Answer 20

Ordinary loss
(Because casualty is not a sale or exchange)

Question 21

Non sale or exchange transactions treated as sale or exchange

Answer 21

• securities becoming worthless
• seizure or condemnation of property

Question 22

Section 1231 property

Answer 22

Real or depreciable property used in trade or business and held for more than one year

Question 23

Gains and losses on section 1231 property

Answer 23

Must be netted together
If net gain = long term capital gain
If net loss= ordinary loss

Question 24

Section 1244 stock

Answer 24

Qualified small business stock

Question 25

Tax treatment of Loss on section 1244 stock

Answer 25

Deductible as ordinary losses up to a maximum of $50,000/tax year ($100,000 if MFJ) Any remaining loss is capital loss

Question 26

Qualifications for loss on section 1244 stock to be treated as ordinary

Answer 26

- stock owned by an individual or partnership - stock originally issued by the corporation to the individual or to a partnership in which the individual is a partner - must be stock in a domestic corporation - must must have been received in exchange for cash and property (other than stock or securities) contributed by the individual to the Corp (not for services) - corporation cannot have derived over 50% of gross receipts from passive income during the five tax years preceding sale/worthlessness - total money and property contributed (to paid in capital and APIC) may not exceed $1M at the time the Corp issued the stock (corporation may have grown after)

Question 27

Certain disallowed or deferred losses

Answer 27

- transfers of property to a controlled corporation in exchange for that corp's stock - certain like-kind exchanges of property - property sold to related parties - wash sale transactions - losses that exceed the amount for which the taxpayer was at risk

Question 28

Active income

Answer 28

Wages, salaries, active business income

Question 29

Portfolio income

Answer 29

Dividends, interest, annuities, and royalties (and allocable expenses, interest expense) not derived in the ordinary course of trade or business Also gains or losses on disposal of property that produced portfolio income

Question 30

Passive income

Answer 30

Income from a passive activity (any trade or business that the taxpayer makes money from but does not materially participate in)

Question 31

General rule for passive income and loss

Answer 31

Passive income and loss computed separately for each passive activity in which the taxpayer has invested Passive losses may be used to offset passive income but not to offset active or portfolio income

Question 32

Carryover of passive losses

Answer 32

Unused passive losses can be carried forward indefinitely, treating them as losses allocated to that specific passive activity May offset other passive income but not active or investment income

Question 33

Suspended losses

Answer 33

Loss from passive activity carried forward into subsequent years

Question 34

Determining carryover losses with multiple passive activity losses

Answer 34

Pro rata formula to determine amount of loss carried over vs amount applied to current year's income Total carryover amount x (loss from activity x/total loss for year) = loss carryover for activity x

Question 35

Tax treatment of disposal of passive activity in a taxable transaction

Answer 35

Any suspended losses from the activity disposed of, remaining after offsetting passive losses against passive incomes may be deducted from other income (after applying the limitation based on excess business losses for noncorporate taxpayers: $262,000 or $524,000 for MFJ)

Question 36

If passive activity is sold to a related party

Answer 36

Suspended loss cannot be deducted until related party sells the activity to a non-related person

Question 37

Deduction of suspended losses allowable on taxpayer death

Answer 37

Deduction allowed to the amount by which the suspended losses excess the increase in the basis (FMV) of the property (suspended losses up to amount of increase are never deductible)

Question 38

Disposal of a substantial part of a passive activity

Answer 38

May be treated as disposition of a separate activity (and suspended losses deducted) if taxpayer can establish with reasonable certainty the income, deductions, credits, and suspended losses allocable to that part of the activity

Question 39

When is determination of active vs passive activity made?

Answer 39

Annually

Question 40

Former passive activity

Answer 40

When an activity that was previously passive is not passive with respect to the taxpayer in the current year

Question 41

Tax treatment of suspended loss from former passive activity

Answer 41

Suspended loss can be deducted against current year's income from the activity even though it is no longer passive. Suspended loss in excess of activity's income remains subject to carryover limitations BUT losses sustained when activity is not passive are deductible against other active business income

Question 42

Passive activity and tax credits

Answer 42

Any tax credits generated in a passive activity may only be used against the portion of the taxpayer's tax liability attributable to passive income Unused credits may be carried forward but can only ever offset tax liability from passive income

Question 43

To determine tax liability attributable to passive income

Answer 43

Compare tax liability on income WITHOUT passive income to tax liability on all income

Question 44

Passive activity

Answer 44

Any trade or business in which a taxpayer does not materially participate, as well as any rental activity (with the exception of rental activity considered to be a real property trade or business)

Question 45

Identification of an "activity"

Answer 45

Taxpayers may use any reasonable method of applying the relevant facts and circumstances in grouping operations into activities Once activities are established the groupings must be consistent in subsequent years unless material changes make grouping inappropriate

Question 46

Factors used in determining single activities

Answer 46

- similarities and differences in the types of business - extent of common control - extent of common ownership - geographical location - interdependencies between the operations

Question 47

Grouping rental activities

Answer 47

Rental operations generally may NOT be grouped with trade or business operations. Unless rental operation is insubstantial in relation to business operation or vice versa May not combine real estate rental activities with personal property rental activities

Question 48

Identification of an activity for a pass through entity

Answer 48

Must apply same rules but at partnership/s corp level and report operations by activity to partners/shareholders Partners/shareholders then use same rules

Question 49

Tests of material participation

Answer 49

to be considered materially participating an individual must meet at least one of the following: - participates in activity for more than 500 hours/year - their participation constitutes substantially all participation by all individuals (inc non-owners) - participates for more than 100 hrs/year AND that participation is more than any other's participation in the year (including non-owners) - participates in separate "significant participation activities" for over 100 hrs each, for an aggregate of over 500 hrs/year - materially participated in the activity in any five years of the immediately preceding 10 tax years (need not be consecutive) - materially participated in the activity for any three years preceding the year in question if a personal service activity - participates in the activity on a regular, continuous, and substantial basis during the year talking into account all relevant facts and circumstances Participation of taxpayer's spouse also taken into account

Question 50

When must material participation tests be applied

Answer 50

Every year

Question 51

Limited partnerships

Answer 51

Generally income and deductions passed to a limited partner are passive, but depends on the material participation tests

Question 52

Working interest in an oil and gas property

Answer 52

An interest responsible for the cost of development or operation of an oil and gas property NOT passive as long as liability in interest is not limited

Question 53

Who do the passive loss rules apply to

Answer 53

- individuals, estates, and trusts (including partner and shareholders receiving income/loss from a S corp or partnership) - closely held C corporations - personal service corporation - certain publicly traded partnerships

Question 54

Closely held C corporation

Answer 54

A c corp where more than 50% of the stock is owed by five or fewer individuals at any time during the last half of the corporations taxable year

Question 55

Passive loss rules for closely held C corps

Answer 55

Passive losses may not offset portfolio income but MAY offset income from active business operations

Question 56

Personal service corporation

Answer 56

A C corp whose owner-employees hold more than 10% of the value of the stock and whose principal activity is performance of personal services that are substantially performed by owner employees

Question 57

Rules to determine if a personal service corporation material participated in an activity

Answer 57

- if one or more of the shareholders who own more than 50% of the value of the outstanding stock materially participate in an activity

Question 58

Passive loss rules for Personal service corporations

Answer 58

Rules apply in their entirety. Passive loss cannot be used to offset active business income or portfolio income

Question 59

Rules to determine if a closely held C corp materially participates

Answer 59

- if one or more of the shareholders who own more than 50% of the value of the outstanding stock materially participate in an activity Plus all the following: - a substantial portion of the services of at least one full time employee is in the active management of the activity -a substantial portion of the services of at least three full-time nonowner employees is directly related to the activity (Both above for the 12 month period ending last day of tax year) - section 162 business deductions of the activity exceed 15% of the activity's gross income for the period

Question 60

Publicly traded partnerships

Answer 60

PTP Any partnership if interests in the partnership are either traded on an established securities market or readily tradable on a secondary market

Question 61

Publicly traded partnerships and passive loss rules

Answer 61

- If corporate tax provisions apply generally passive loss rules DO NOT apply - if partnership tax provisions apply, passive loss rules apply at the partner level - losses from a PTP separate from other types of income, including income from other PTPs. Can only be offset against income from that particular PTP (but not portfolio income)

Question 62

If interest in a PTP disposed of

Answer 62

Partner may deduct suspended losses from a PTP if they dispose of their interest. However they may not if the PTP itself sells the passive activity

Question 63

Real property trade or business

Answer 63

Involves the development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokering of real property

Question 64

When do the passive loss rules not apply to a real property trade or business

Answer 64

Considered an active trade or business if taxpayer: - performs more than 750 hours of work during the taxable year in material participation in real property trades or businesses And - more than 1/2 the personal services performed by the taxpayer in all trades and businesses during the year are in material participation in real property trades or businesses Employee performing these tasks must own at least 5% of the employer For MFJ one spouse must separately meet both

Question 65

Rules for closely held C corporation real estate business to be an active business

Answer 65

Corporation must derive more than 1/2 it's gross receipts from real property businesses in which it materially participates

Question 66

Requirements to be allowed to deduct $25,000 of passive losses from real estate rental against other income

Answer 66

- individual taxpayers only Must: - actively participate in the activity - own at least 10% of the value of the activity for the entire year (both years if trying to take a deduction for loss sustained in prior year) - $25,000 limit on the sum of both deductions and credits (must convert credits to deduction equivalent)

Question 67

Active participation

Answer 67

Lesser standard of involvement than material participation Must participate in making management decisions and arranging for others to provide services in a significant and bona fide sense (Limited partner generally cannot actively participate)

Question 68

Limitation on deduction of rental real estate loss

Answer 68

- must first be applied against any other net passive income form the year, before against other income - $25,000 reduced by 50% of taxpayer's AGI on excess of $100,000 (AGI not including any passive activity or real property trade and business loss) Any remaining becomes a suspended passive loss - limit applied to sum of deductions and credits. must use deductions first

Question 69

Converting credits into deduction equivalents

Answer 69

Credit / marginal tax rate (aka the amount that, taken as a deduction, would reduce the tax liability by an amount equal to the credits)

Question 70

If taxpayer has losses from multiple passive activities eligible for the $25,000 deduction

Answer 70

Must allocate deduction ratably (proportionally) between the activities and have suspended losses for the remaining amounts

Question 71

Casualty loss

Answer 71

A loss that occurs in an identifiable event that is sudden, unexpected, or unusual

Question 72

Casualty and theft losses of business and investment property

Answer 72

Deductible

Question 73

Casualty and theft losses of personal-use property

Answer 73

As of 1/1/18 must be a loss incurred in a federally declared disaster to be deductible

Question 74

Sudden event

Answer 74

Swift, not gradual or progressive

Question 75

Loss sustained as a result of theft

Answer 75

Deductible Includes: larceny, embezzlement, robbery, blackmail, extortion, kidnapping for ransom

Question 76

Measuring casualty loss for deduction

Answer 76

- amount by which the casualty reduces the property's FMV (obtained by comparing FMV immediately before casualty and immediately after) use of sentimental value not allowed, no additional deductions for cost of protecting property - must be only only for property taxpayers owns - may not take deductions for loss of FMV on undamaged property

Question 77

Casualty loss on property only partially destroyed

Answer 77

The lesser of the reduction in the property's FMV of the taxpayer's adjusted basis

Question 78

Casualty loss on destroyed business or investment property

Answer 78

Amount of the taxpayer's adjusted basis (even if greater than FMV)

Question 79

Casualty loss on destroyed personal use property

Answer 79

Amount of loss is lesser of the reduction in the property's FMV or the property's adjusted basis

Question 80

How is the reduction in the FMV of property established

Answer 80

Ideally by appraisal Or By cost of repairs

Question 81

Requirements for using cost of repairs to establish reduction in FMV of property

Answer 81

- repairs will bring the property back into its condition immediately before the casualty - cost of repairs is not excessive - repairs limited to damage incurred to the property - repairs do not increase the value of the property over its value immediately before the casualty

Question 82

Destruction of more than one property by same casualty event

Answer 82

Loss on each property calculated separately

Question 83

Change in casualty loss amount of insurance received

Answer 83

Loss reduced by any insurance or other recovery received If payment causes a realized gain, taxpayer may be able to defer or exclude the gain on involuntary conversion

Question 84

Limitations on casualty loss on personal use property

Answer 84

- losses sustained in each separate category must be reduced by $100 - total for net casualty losses for personal property is reduced by 10% of the taxpayer's AGI for the year - if property is covered by insurance no casualty loss (for what is covered by insurance) can be claimed unless a timely insurance claim is filed

Question 85

Casualty loss as for or from AGI deduction

Answer 85

Business or rental investment property : for AGI Investment (not rental) or personal -use property: from AGI

Question 86

Gain on a casualty

Answer 86

If insurance proceeds exceed taxpayers basis in the property

Question 87

Personal casualty losses not resulting from a federal disaster area

Answer 87

Deductible to the extent that the taxpayer has personal casualty gains for the year

Question 88

Netting casualty gains and losses of personal-use property

Answer 88

Must net gains and losses 1st: reduce gains by losses from non - federally declared disasters 2nd: use any remaining gains to reduce amount of losses from federally declared disaster Loss also reduced by: - insurance reimbursements - $100 limitation 10% of AGI floor not considered until netting is done and results in a loss

Question 89

If casualty gains exceed casualty losses

Answer 89

All gains and losses treated as capital gains and losses Long term or short term depending on how long the asset was held

Question 90

Tax forms for casualty losses

Answer 90

Form 4648 (calculations for net casualty gain and loss) Schedule A form 1040 (itemizing any net loss)

Question 91

Netting Casualty gains and losses on business and investment property

Answer 91

Netted together for any property held over one year If held less than one year= ordinary loss

Question 92

If business and investment property casualty losses exceed gains

Answer 92

Business losses and losses on investment properties generating rents or royalties: for AGI deduction Losses on other investment properties: from AGI deduction No $100 or 10% AGI limitations

Question 93

Timing of casualty loss deduction

Answer 93

Generally in year when taxpayer sustains the loss Exceptions for: - theft losses - insurance/ other reimbursements expected in subsequent years - certain disaster losses

Question 94

Timing of deduction for theft loss

Answer 94

May be deducted in year taxpayer discovers the loss

Question 95

Tax treatment of loss if full recovery anticipated (insurance or otherwise)

Answer 95

Taxpayer may not take any deduction in the year of the loss if an expectation of full recovery exists If taxpayer does not receive the full amount of the recovery they may deduct the unrecovered portion in a subsequent year (when insurance finalized)

Question 96

Tax treatment of casualty loss if taxpayer does not anticipate full recovery

Answer 96

May deduct loss of estimated unrecovered amount (assuming had filed timely insurance claim for insured property)

Question 97

If subsequent recovery received for previously deducted casualty loss

Answer 97

Reimbursement must be included in income in the year of recovery Only have to include income to the amount of tax benefit received for previous deduction

Question 98

Taxpayers who suffer losses attributed to a disaster in an area subsequently declared by PotUS as a disaster area

Answer 98

Taxpayer may elect to deduct a casualty loss in the year proceeding the year in which it actually occured If has already filed previous years return when disaster is declared then, if elects, must file an amended return

Question 99

Requirements for deducting bad debt

Answer 99

- a bona fide debtor-creditor relationship exists between the taxpayer and another entity - taxpayer has basis in the debt - debt becomes worthless during the year

Question 100

Bona fide debt

Answer 100

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

Question 101

Determining if bona fide debt exists between related parties

Answer 101

Intent matters for gift vs loan Tests include: - does a note or 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? Is it really a capital contribution disguised as a loan or a disguised dividend or salary payment?

Question 102

Third party debt

Answer 102

If a taxpayer guarantees or endorses someone else's obligation and is required to pay if the debtor defaults

Question 103

Deduction of bad third party debt

Answer 103

In order to deduct bad debt, guarantor must be able to prove guarantee was not a gift Then may deduct principal and accrued interest paid on behalf of the debtor as bad debt issued to the debtor at the time of payment

Question 104

Taxpayer's basis in the debt

Answer 104

May be: - any money loaned - if property or services provided basis is only established if the taxpayer has previously included the FMV of property or services in their income (Accrual method taxpayer with open account receivable or a signed note. NOT cash method taxpayer who reports no income till payment received)

Question 105

Is legal action required to deduct worthless debt

Answer 105

No. In fact if surrounding circumstances show legal action would likely not result in collection of debt the lack of legal action itself may provide proof of worthlessness

Question 106

Partially worthless bad debt

Answer 106

business bad debt: some current deduction allowed Nonbusiness bad debt: must be totally worthless to be deducted

Question 107

Nonbusiness debt

Answer 107

Any debt other than 1) a debt created or acquired in connection with 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 Debts acquired with business, or incurred in the course of business continue as business debt

Question 108

Requirements for a business debt

Answer 108

Proximate relationship between the loan and the taxpayer's business Business motive is the dominant motive for making the loan

Question 109

Tax treatment business bad debt

Answer 109

Ordinary loss = ordinary business deduction

Question 110

Tax treatment nonbusiness bad debt

Answer 110

Short term capital losses in the year the non business debts become wholly worthless (no matter how long the debt has been outstanding) So any loss in excess of capital gains may only be offset against ordinary income up to $3000, and anything beyond that is carried forward

Question 111

Partial worthlessness

Answer 111

Nonbusiness debt: no deduction if still expected to be partially recoverable Business bad debt: may deduct unrecoverable portion in year becomes expected to be unrecoverable

Question 112

Tax method for accounting for business bad debts

Answer 112

Must use specific write off method where debts are written off individually as they become worthless (May create a temporary difference if using reserve/allowance method for book purposes)

Question 113

Recovery of previously written off bad debt

Answer 113

Included in income in year collected to the extent that taxpayer received a benefit for the deduction (tax benefit rule)

Question 114

Loss on deposits in qualified bankrupt or insolvent financial institutions

Answer 114

May elect to take as a personal casualty loss in the year in which the individual can reasonably estimate the loss Loss = difference between basis in deposit and reasonable estimate of what will be recovered Creates ordinary loss subject to casualty loss limitations Election applies to all losses sustained by individual in the same institution

Question 115

Qualified financial institutions

Answer 115

Banks Federal or state chartered savings and loans and thrift institutions Federal or state insured credit unions

Question 116

Net operating loss

Answer 116

NOL When taxable income for the year is negative because business expenses exceed business income

Question 117

Deduction for NOL

Answer 117

Taxpayer can carry a net operating loss from one year forward to offset a subsequent years net income (as a deduction)

Question 118

Arriving at taxable income to determine NOL for a year

Answer 118

- add back any NOL deduction taken for a previous year's loss - add back any capital loss deduction - add back excess of nonbusiness deductions over non business income (aka any nonbusiness reductions that reduced business income. Wages & salary considered business income & casualty losses on personal use assets are treated as business losses)

Question 119

Steps to add back capital loss deductions to taxable income for NOL calculations

Answer 119

- find net nonbusiness gain/loss vs net business gain/loss - nonbusiness net capital gains used to offset any nonbusiness ordinary deductions, THEN used to offset any net BUSINESS capital loss - it both groups have net losses both deductions have to be added back - nonbusiness net losses may not be used to offset net business capital gains

Question 120

Calculating NOL if you use the standard deduction

Answer 120

Standard deduction used as the amount of the nonbusiness deductions

Question 121

Calculating excess of nonbusiness deductions over non business income

Answer 121

Total deductions Less any deductions attributed to business Less nonbusiness income = Excess of nonbusiness deductions over non business income This amount added to taxable income to find NOL Would not create a NOL lower than taxable income!

Question 122

Carryover periods for NOLs

Answer 122

Losses arising before 2018: back 2 years and forward indefinitely Losses 2018-2020: back 5 years and forward indefinitely Losses after 2020: not back, only forward indefin

Question 123

Amount of NOL deduction allowable in a following year

Answer 123

The lesser of: - aggregate net operating losses carried over Or - 80% of taxable income (before NOL deduction)

Question 124

Excess business losses

Answer 124

The excess of aggregate business deductions for the year over the sun of the taxpayer's aggregate business gross income and gains plus $262,000 if single or $524,000 if MFJ

Question 125

Deduction of excess business loss

Answer 125

Not allowable for noncorporate taxpayers after Dec 31 2020 Carried forward and treated as part of the taxpayer's NOL Applies at partner/shareholder level