Chapter 6: Losses and Loss Limitations
Brief Introduction Notes:
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Losses are treated as negative gains
There are five reasons congress treats losses and gain differently:
o Congress often seeks to prevent taxpayers from sheltering certain types of income or
gains with other types of deductions or losses
o Some loss limitations deny deductions to higher-income taxpayers out of fairness idea
o Congress attempts to prevent excessive income shifting across tax years
o Denying losses increases government revenues
o The measure of taxable income for individuals generally excludes personal losses
I.
Bad Debts
 What is a bad debt?
o It is a debt that is not repaid
 An accrual basis taxpayer can deduct a bad debt; however, a cash basis
taxpayer cannot because no income is reported until the cash has been
collected. If you permitted a deduction to a cash basis taxpayer, then that would
essentially be a double deduction because the expenses are not inputted until
cash has been received.
 A cash basis taxpayer cannot deduct a bad debt expense because income was
never recognized.
a. Specific Charge-off Method
i. Using this method, you can claim the business debt when it becomes either
partially or wholly worthless.
1. If a business debt that was claimed at partially worthless was deducted
in the year prior, it can be completely deducted for the remaining portion
if it became worthless in the current year.
ii. A nonbusiness debt must be wholly worthless to deduct it
iii. For both types of charge-off’s the taxpayer must have proof of the insolvency
a. Examples of specific charge of method
i. If a debt is owed to a company, but it is never repaid
then you can deduct the entire amount of the loan
ii. If a bankruptcy occurs and the loan is expected to be
settled for 20 cents on the dollar you would calculated it
as follows (amount of loan – (amount of loan x .20) =
deduction.
1. If that same loan received 10 cents per dollar
instead, you would deduct the remaining amount
not paid.
iv. If a receivable is deducted as uncollectible, but paid back during the same tax
year, the write-off is reversed.
v. If a receivable is deducted, but paid back in a later year, then it will need to be
recognized as income.
vi. CONCEPT SUMMARY
Business Bad Debts
Nonbusiness Bad Debts
Timing of deduction A deduction is allowed when the
A deduction is allowed only when the
debt becomes either partially or
debt becomes wholly worthless
wholly worthless
Character of
The bad debt may be deducted as
The bad debt is classified as a short
deduction
an ordinary loss
term capital loss, subject to the
$3000 capital loss limitation for
individuals
Recovery of
If the account recovered was written
If the account recovered was written
amounts previously off during the current tax year, the
off during the current tax year, the
deducted
write-off entry is reversed. If the
write-off entry is reversed. If the
account was written off in a previous
tax year, income is created subject
to the tax benefit rule
II.
account was written off in a previous
tax year, income is created subject
to the tax benefit rule
b. Business vs. Nonbusiness Bad Debts
i. The nature of a debt determines whether the lender is engaged in the business
of lending money or whether there is a proximate relationship between the
creation of the lender’s trade or business
1. If true, the debt is classified as a business bad debt
2. If these conditions are not met, it is classified as nonbusiness
ii. If a loan is made to a friend for his business and is not repaid, then it is a
nonbusiness bad debt because it was not your business and you are not a lender
iii. Any loans made by a business entity (corporation or partnership) are considered
business bad debts because any loan made by these entities are automatically
assumed to be trade or business related
1. If you own a business and extend credit, but the credit becomes
insolvent, it is considered a business bad debt
iv. The distinction between the two is important
1. A business bad debt is deductible as an ordinary loss in the year
incurred
2. A nonbusiness bad debt is always treated as a short term capital loss
a. It is limited benefit due to the $3,000 capital loss limitation for
individuals
c. Loans between Related Parties
i. Loans between related parties are questioned for their validity because it is
difficult to distinguish whether the loan was bona fide
1. A bona fide debt is one between a debtor-creditor base on valid and
enforceable obligations to pay a fixed or determinable sum of money
2. Considerations for loans between related parties are:
a. Was a note properly executed?
b. Was there a reasonable rate of interest?
c. Was collateral provided?
d. What collection efforts were made?
e. What was the intent of the parties?
ii. If a loan from a shareholder is made to his corporation at a low interest it will
most likely be treated as a contribution to capital rather than a liability. Thus, it
cannot be deducted as a bad debt.
Worthless Securities and Small Business Stock Losses
a. Worthless Securities
i. A loss is allowed for securities that become completely worthless during the year
1. These securities are
a. Stock
b. Bonds
c. Notes
d. Other evidence of indebtedness issued by a corporation or
government
ii. The losses are treated as capital losses deemed to have occurred on the last day
of the tax year
1. Doing so allows a loss that would have been deemed short-term to be
classified as long-term
b. Small Business Stock Losses (§ 1244 Stock)
i. Congress created rules that encourage taxpayers to form and operated small
businesses
1. Such as § 1244
ii. The general rule for losses from the sale or exchange of corporate stock is that
shareholder receive capital loss treatment
III.
iii. However, it is possible to avoid capital loss limitation if the loss is sustained on
small business stock (§ 1244 stock)
1. Loss can be from sale of the stock or from the stock becoming worthless
a. Only individuals who acquired stock from the issuing corporation
qualify for ordinary loss treatment
b. §1244 limits the ordinary loss to $50,000 ($100,000 for married
individuals filing jointly) per year
i. Any loss in excess is treated as capital losses
iv. The issuing corporation must meet certain requirements under §1244 for the loss
on the stock to be treated as an ordinary loss rather than capital
1. The principle requirement is that the total capitalization of the corporation
must not exceed $1 million
a. This limit includes all money and other property received by the
corporation for stock and all capital contributions made to the
corporation
b. The $1 million test is made at the time the stock is issued
v. §1244 stock can be either common or preferred
vi. This section only applies to losses, if anything in §1244 sells at a gain, the
provision does not apply and the gain is capital gain (which, for individuals, may
be subject to preferential tax treatment)
1. §1244 only applies to stock sold to an individual from the issuing
corporation, NOT STOCK SOLD BY AN OUTSIDE PARTY.
vii. KEEP IN MIND, if you lost more than 50,000 you can spread the loss over more
than one year to avoid capital loss limitations!
Casualty and Theft Losses
a. Definition of Casualty
i. Generally, includes fire, storm, shipwreck, and theft.
ii. Also, losses from other casualties are all deductible if the losses result from an
event that is
1. Identifiable
2. Damaging to property
3. Sudden, unexpected, and unusual in nature
a. A sudden event is an event that is swift and precipitous and not
gradual or progressive
i. Like a hail storm that damages your vehicle
b. An unexpected event is one that is ordinarily unanticipated and
occurs without the intent of the taxpayer who suffers the loss
c. An unusual even is an event that is extraordinary and
nonrecurring and does not commonly occur during the activity in
which the taxpayer was engage when the destruction occurred
d. Circumstances that may arise under these circumstances:
i. A taxpayer can take a deduction for a casualty loss from
an automobile accident if the accident is not attributable
to the taxpayer’s willful act or willful negligence
ii. Weather that causes damage must be unusual and
sever for the region to qualify as a casualty
1. Furthermore, damage must be to the taxpayer’s
property to be deductible
iii. The term also includes accidental loss of property provided the loss qualifies
under the same rules as any other casualty.
iv. EVENTS THAT ARE NOT CASUALTIES
1. Progressive deterioration is not a casualty because it is not sudden
2. Losses resulting from a decline in value rather than an actual loss are
not allowed
b. Deduction of Casualty Losses
i. Can usually deduct in the year the loss occurs unless a reimbursement claim
with a reasonable prospect of full recovery exists
ii. If there is a partial claim, then only the part not covered by the claim can be
deducted and the rest in the year the claim is settled.
iii. If a taxpayer receives reimbursement for a claim previously deducted, then they
will need to report it as gross income in the year it is received
1. Disaster Area Losses
a. Casualties or business losses in an area determined to be a
disaster area by the president of the US
b. The taxpayer can claim the loss in the year following the year of
the loss
c. If the extended due date for the prior years return has not
passed, the taxpayer can elect to include the loss on the prior
year’s tax return.
d. If a disaster area is designated after the prior years return has
been filed, the return can be amended or a refund claim
i. Either way it is the taxpayer’s responsibility to show
clearly that the election is being made
c. Definition of Theft
i. Theft includes larceny, embezzlement, and robbery.
ii. Theft losses are deducted in the year of the discovery, it may not be the year of
the loss
iii. If an insurance claim is put in place and a reasonable recovery is expected, then
no deduction is permitted
iv. If in the year of the settlement the recovery is less than the assets adjusted base,
then a deduction may be available
1. If the recovery exceeds the assets adjusted base, casualty gain may be
recognized
d. Loss Measurement
i. If business or investment property is completely destroyed, the loss equals the
adjusted basis (typically cost less depreciation) of the property at the time of
destruction
ii. For partial business and partial/complete personal losses, the loss is the lesser
of:
1. The adjusted basis of the property, or
2. The difference between the fair market value of the property before the
event and the fair market value immediately after the event
iii. Any insurance reimbursement reduces the loss for business, investment and
personal property
1. A special rule applies to personal insured property:
a. Not allowed to deduct a casualty loss unless a claim is placed
b. This applies whether a full or partial reimbursement occurs
i. Generally, an appraisal before and after will need to
occur or the cost of repairs will usually suffice
iv. Multiple losses
1. When multiple losses occur in a year, each loss will need to be
computed separately
e. Casualty and Theft Losses of Individuals
i. Casualty and theft losses for a business or with rental and royalty activities are
deductible for adjusted gross income and are limited only by the rules previously
stated.
ii. Investment casualty and theft losses are classified as other misc. itemized
deductions.
1. Casualty and theft losses of personal use property are subject to special
limitations
a. Personal Use Property
i. Individual taxpayer’s face three limitations on their ability
to deduct personal casualty losses
1. After 2017, individuals can only deduct a
casualty loss if it occurs in a federally declared
disaster area
2. Taxpayers must reduce each casualty loss by a
$100 floor
a. Applies to all damaged property, not
each
3. The individual taxpayer can deduct only the
portion of the total of all personal casualty losses
the exceeds 10 percent of AGI
ii. If casualty and theft gains exceed losses during the year,
the gain and losses are treated as capital gains and
losses
iii.
IV.
V.
VI.
VII.
VIII.
IX.
Net Operating Losses
a. Introduction
b. General Rules
The Tax Shelter Problem
At Risk Limitations
Passive Activity Loss Limits
a. Classification and impact of passive activity income and loss
b. Taxpayers subject to the passive activity loss rules
c. Rules for determining pass activities
d. Material participation
e. Rental activities
f. Interaction of at risk and passive activity loss limits
g. Special rules for real estate
h. Disposition of passive activities
Excess Business Losses
a. Definition and rules
b. Computing the limit