CHAPTER 5
LOSSES AND LOSS LIMITATIONS
SOLUTIONS TO PROBLEM MATERIALS
Question/
Problem
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10
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15
16
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Status:
Present
Edition
Topic
Bad debts: business
Bad debts: tax benefit rule
Bad debt and § 1244 stock
§ 1244 stock
Issue recognition
Transfer of § 1244 stock to another individual
Casualty loss: amount of loss
Casualty loss: disaster area loss
Issue recognition
Casualty loss: insurance recovery
Net operating loss: calculation
At-risk rules
At-risk rules
Issue recognition
Passive loss rules: general application
Passive loss rules: general application
Sale of passive activity and suspended losses
Sale of passive activity
Passive losses of personal service corporation
Passive losses of corporation
Passive, active, portfolio income of non-PSC
Groupings of two types of businesses
Issue recognition
Interaction of at-risk and passive loss rules
Interaction of at risk and passive loss rules
Interaction of at-risk and passive loss rules
Modified
Unchanged
Modified
Unchanged
Unchanged
Unchanged
New
Unchanged
Unchanged
Unchanged
Modified
New
Unchanged
Unchanged
Unchanged
Unchanged
Modified
Unchanged
New
Unchanged
Unchanged
Unchanged
Unchanged
Unchanged
Unchanged
New
Q/P
in Prior
Edition
1
2
3
5
6
7
8
9
10
11
13
14
15
16
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20
21
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25
5-1
Status:
Q/P
5-2
2003 Entities Volume/Solutions Manual
Question/
Problem
27
28
29
30
31
Present
Edition
in Prior
Edition
Unchanged
Unchanged
New
Unchanged
Unchanged
27
28
Unchanged
Unchanged
Unchanged
Unchanged
Unchanged
32
33
34
35
36
Unchanged
37
Bad debt expense
At-risk rules
Passive activity loss rules: general application
Unchanged
Unchanged
Unchanged
1
2
3
Casualty loss
Offsetting rent income by passive losses
Passive activity: amount of deductible loss
Internet activity
Internet activity
Unchanged
Unchanged
New
Unchanged
Unchanged
1
2
Topic
Interaction of at-risk and passive loss rules
Issue recognition
Passive loss deduction amounts
Rental loss: active participation
Active income and passive income: real estate
activities
Ethics problem
Spousal participation in real estate activities
Real estate rental exception
Ethics problem
Passive activity loss allowed, suspended losses
and credits
Rental real estate loss deduction
32
33
34
35
36
37
30
31
Bridge Discipline
Problem
1
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3
Research
Problem
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5
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5
PROBLEM MATERIAL
1.
Smith, Raabe, and Maloney, CPAs
5191 Natorp Boulevard
Mason, OH 45040
January 29, 2002
Loon Finance Company
100 Tyler Lane
Erie, PA 16563
Dear Sir:
This letter is to inform you of the possibility of taking a bad debt deduction.
Your loan to Sara is a business bad debt; therefore, you are allowed to take a bad debt
deduction for partial worthlessness. You will be able to take a bad debt deduction in the
current year of $26,000 ($30,000 - $4,000) based on partial worthlessness.
Losses and Loss Limitations
5-3
Should you need more information or need to clarify anything, please contact me.
Sincerely,
John J. Jones, CPA
Partner
TAX FILE MEMORANDUM
January 29, 2002
From:
John J. Jones
Subject: Bad Debt Deduction
Loon Finance Company’s $30,000 loan to Sara is a business bad debt. Therefore, a bad
debt deduction is allowed for partial worthlessness of $26,000 (i.e., Sara has filed for
bankruptcy and Loon has been notified that the most the company can expect to receive is
$4,000). Loon will be able to claim an additional bad debt deduction in the year when a
final settlement has been reached with respect to the loan assuming the amount collected is
less than $4,000.
pp. 5-3 and 5-4
2.
In 2001, Tom has a bad debt of $4,000. Because this is a nonbusiness bad debt, it is treated
as a short-term capital loss. As such, Tom can use only $3,000 of the loss to offset ordinary
income in 2001. In 2002, the collection of the debt increases Tom’s gross income.
However, only $3,000 of the $4,000 received by Tom is included in his gross income in
2002 because this is the amount which produced a tax benefit in 2001. pp. 5-4 and 5-5
3.
Salary
§ 1244 ordinary loss
Short-term capital gain on § 1244 stock
Short-term capital loss (nonbusiness bad debt)
Net short-term capital gain
Adjusted gross income
pp. 5-4 to 5-7
$180,000
(95,000)
$25,000
(7,000)
18,000
$103,000
5-4
4.
2003 Entities Volume/Solutions Manual
Sell all of the stock in the current year:
Current year’s AGI
Salary
Ordinary loss (§ 1244 limit)
Long-term capital gain
Long-term capital loss ($80,000 - $50,000)
Long-term capital loss (limit)
AGI
Next year’s AGI
Salary
Long-term capital gain
Long-term capital loss carryover
($22,000 - $3,000)
Long-term capital loss (limit)
AGI
Total AGI
Current year
Next year
Total
$80,000
(50,000)
$8,000
(30,000)
( 3,000)
$27,000
$90,000
$10,000
(19,000)
( 3,000)
$87,000
$ 27,000
87,000
$114,000
Sell half of the stock this year and half next year:
Current year’s AGI
Salary
Ordinary loss (§ 1244 stock)
Long-term capital gain
AGI
$80,000
(40,000)
8,000
$48,000
Next year’s AGI
Salary
Ordinary loss (§ 1244 stock)
Long-term capital gain
AGI
$90,000
(40,000)
10,000
$60,000
Total AGI
Current year
Next year
Total
$ 48,000
60,000
$108,000
Mary’s combined AGI for the two years is lower if she sells half of her § 1244 stock this
year and half next year. p. 5-7
5.
John should be concerned with the following tax issues:

Was there a bona fide debt?

Business bad debt.

Nonbusiness bad debt.
Losses and Loss Limitations

John’s basis in the debt.

Date of worthlessness.

Classification as capital or ordinary.

Was there a § 1244 loss?

Date of worthlessness.

Amount of worthlessness.

Classification as capital or ordinary.
pp. 5-3 to 5-7
6.
Smith, Raabe, and Maloney, CPAs
5191 Natorp Boulevard
Mason, OH 45040
July 30, 2002
Mr. Mike Sanders
2600 Riverview Drive
Plank, MO 63701
Dear Mr. Sanders:
This letter is in response to your question with respect to stock you held in a corporation
that qualified as a small business corporation under § 1244. Our conclusion is based upon
the facts you provided us. Any change in facts may cause our conclusion to be inaccurate.
Your brother, Paul, gave you the stock a few months after he acquired the stock. Paul paid
$30,000 for the stock three years ago. You sold the stock this tax year for $10,000.
You may deduct the difference between the selling price of the stock, $10,000, and the cost
of the stock to your brother Paul, $30,000. When property is given to another, there is a
carryover of the basis the donor had in the property. Thus, your tax basis in the stock will
be the $30,000 tax basis your brother, Paul, had in the stock. You will have a long-term
capital loss of $20,000 on the sale of the stock. Because you were not the original holder of
the stock, you may not take an ordinary loss deduction on the sale.
Should you need more information or need to clarify our conclusion, do not hesitate to
contact me.
Sincerely yours,
David C. Via, CPA
Partner
5-5
5-6
2003 Entities Volume/Solutions Manual
TAX FILE MEMORANDUM
July 18, 2002
FROM:
David C. Via
SUBJECT:
Mike Sanders
Today I talked to Mike Sanders with respect to his sale of stock which was issued to his
brother, Paul, pursuant to § 1244. Paul paid $30,000 for the stock three years ago and gave
the stock to his brother, Mike, a few months after he acquired it. Mike sold the stock in the
current tax year for $10,000.
At issue: May a donee of stock in a corporation that qualified as a small business
corporation under § 1244 take an ordinary loss deduction pursuant to § 1244?
Conclusion: No. Only the original holder of § 1244 stock qualifies for ordinary loss
treatment.
pp. 5-6 and 5-7
7.
The amount of the loss is limited to the adjusted basis in the road of $20,000. The fact that
the adjusted basis in the land is more than $80,000 is irrelevant because the loss must be
determined by reference to the single, identifiable property damaged (i.e., the road) and not
the real property that surrounds it. The fact that Joe has been depreciating the road as a
separate item is contrary to any argument that the road is part of the real property.
p. 5-10
8.
The loss is a business loss. Therefore, for the farm building and the farm equipment that
were completely destroyed, the adjusted basis is used in calculating the amount of the
casualty loss. For the barn that was damaged, the lower of the adjusted basis or the decline
in value is used in calculating the amount of the casualty.
Building ($90,000 - $70,000)
Equipment ($40,000 - $25,000)
Barn ($50,000 - $25,000)
Total loss
$20,000
15,000
25,000
$60,000
Because the President declared the area a disaster area, Grackle could claim the loss on last
year's return or on the current year's tax return.
If Grackle applies the loss to the prior year, the benefit of the loss will be at lower tax rates.
If the loss is applied to the current year, the benefit will be at a tax rate of 39% and thus,
provide a tax savings of $23,400 ($60,000 X 39%) rather than $14,350 [($15,000 X 34%) +
(25,000 X 25%) + ($20,000 X 15%)].
Grackle should include the loss on the current year's tax return, since the tax savings is
$9,050 ($23,400 - $14,350) greater.
pp. 5-8 to 5-12
Losses and Loss Limitations
9.
The tax issues for Toucan Corporation are as follows.

Is this a casualty loss?

What is the amount of the loss?

The basis for computing the loss.

The decline in fair market value.

Replacement cost.
pp. 5-7 to 5-12
10.
Smith, Raabe, and Maloney, CPAs
5191 Natorp Boulevard
Mason, OH 45040
January 26, 2002
Snipe Industries
450 Colonel’s Way
Warrensburg, MO 64093
Gentlemen:
This letter is to inform you of the tax consequences of filing a claim versus not filing a
claim with your insurance company for reimbursement for damages to the car driven by
Sam Smith.
Because the claim is being made by a company and not an individual, you may deduct the
casualty loss in full even if no claim for insurance is filed. Thus, your plan will work. The
full $18,000 loss is deductible. Note that the result would have been different if the
casualty loss were claimed by an individual. In such a circumstance, because the car was
insured, the amount of the tax deduction would be determined as if a claim had been filed
with the insurance company and the reimbursement was received. Consequently, the
deduction would have been zero.
The benefit of filing the claim, absent any tax consequences, is an expected cash inflow of
$15,000 from the insurance company, while the tax savings from the casualty loss
deduction if no claim is made is $2,700 (assuming a 15% tax rate). Thus, the expected cost
of policy cancellation should be at least $12,300 ($15,000 - $2,700) to justify not filing a
claim.
Should you need more information or need to clarify anything, please contact me.
Sincerely,
John J. Jones, CPA
Partner
pp. 5-7 to 5-12
5-7
5-8
11.
2003 Entities Volume/Solutions Manual
a.
Business receipts
Business expenses
Net business loss
Salary
Interest income
Adjusted gross income
Less: Itemized deductions
Personal exemption (1 X $3,000)
Taxable income
$72,000
(90,000)
($18,000)
11,000
6,000
($ 1,000)
(14,000)
(3,000)
($18,000)
b.
Taxable income
Add: Personal exemption
Excess of nonbusiness deductions ($14,000)
over nonbusiness income ($6,000)
Net operating loss
($18,000)
3,000
8,000
($ 7,000)
p.5-14
12.
Fran had $50,000 at risk last year (as none of the partnership level debt can be included in
Fran’s at-risk basis). Consequently, she could deduct the $37,500 loss, and her at-risk
amount was decreased to $12,500. Because her at-risk amount is only $12,500 at the end of
the current year, she can deduct only this amount of the $20,000 loss. pp. 5-18 and 5-19
13.
Smith, Raabe, and Maloney CPAs
5191 Natorp Boulevard
Mason, OH 45040
February 5, 2002
Mr. Bill Parker
54 Oak Drive
St. Paul, MN 55162
Dear Mr. Parker:
This letter is in response to your inquiry regarding the tax treatment of losses that you could
expect this year and next year from an investment in Best Choice Partnership. As I
understand the facts, you would invest $60,000 in the partnership with the expectation that
your share of the partnership losses in the current and succeeding years would be $40,000
and $25,000, respectively.
Even though your investment would not be subject to the passive activity limitations, the
amount of the deduction that you may claim in any one year is subject to the at-risk rules.
Essentially, these rules provide that your deductions are limited to the amount that you have
invested in the venture or the amount that you could lose if the investment were to be
unsuccessful. Consequently, in your case, the initial amount that you would have at risk
would be $60,000. Therefore, you would be able to deduct $40,000 in the current year,
which would cause your at-risk basis to be lowered to $20,000 ($60,000 - $40,000).
Because your at-risk basis at the end of next year would be only $20,000, your share of the
partnership loss that would be deductible would be limited to $20,000. The amount not
deducted under this scenario would be deductible later when your at-risk basis increases,
for example by additional investments you may make in the partnership or because of
income generated by the partnership.
Losses and Loss Limitations
5-9
If you have additional questions or need further clarification, please call me.
Sincerely,
John J. Jones, CPA
pp. 5-18 and 5-19
14.

Whether the at-risk rules apply or whether Charles’s at-risk basis is sufficient to
support any losses that may be attributed to him. pp. 5-18 and 5-19
 How will these investments be grouped as activities (e.g., aggregating all businesses as
one retail activity, treating the software, bagel, and rental businesses as three separate
activities, or categorizing each location as a separate activity)? pp. 5-25 and 5-26
 Will Charles’s involvement in any one or more of the activities be sufficient to support
the classification of these businesses as active or will they be treated as passive? pp.
5-26 to 5-30
 Will the mountain bike and ski rental shops be classified as rental activities or will they
qualify for one of the exceptions involving rentals of personal property that are not
treated as rental activities? p. 5-30
 Assuming the passive activity rules apply, what is the best combination of grouping the
ventures as one or more activities, given the projected profits and losses, and Charles’s
willingness to stay with these investments without selling them for an extended period
of time? pp. 5-25 and 5-26
15.
Hazel can deduct none of the loss from either activity in the current year. Therefore, her
suspended loss at the end of the current year is $16,000 ($10,000 loss from Activity A +
$6,000 loss from Activity B). pp. 5-20 and 5-21
16.
The $50,000 loss is suspended under the passive loss rules because Ray is not a material
participant. AGI is $140,000. pp. 5-20 and 5-21
17.
Last year, Saundra could deduct nothing against nonpassive income, and was required to
allocate the $20,000 net loss among the three loss activities.
Income (loss):
Activity A
Activity B
Activity C
Activity D
Net passive loss
$30,000
(30,000)
(15,000)
(5,000)
($20,000)
Net passive loss allocated to:
Activity B (30/50 X $20,000)
Activity C (15/50 X $20,000)
Activity D (5/50 X $20,000)
Total suspended losses
($12,000)
(6,000)
(2,000)
($20,000)
In the current year, Saundra has a net gain of $10,000 from the sale of Activity D. She can
offset the $2,000 suspended loss from the activity and the current year's loss of $1,500 from
5-10
2003 Entities Volume/Solutions Manual
the activity against the $10,000 gain. In addition, the remaining net gain of $6,500
($10,000 - $2,000 - $1,500) from the sale may be used to absorb passive losses from the
other activities.
Examples 25 and 26
18.
a.
Net sales price
Less: Adjusted basis
Total gain
Less: Suspended losses
Taxable gain (passive)
$100,000
( 35,000)
$ 65,000
( 40,000)
$ 25,000
b.
Net sales price
Less: Adjusted basis
Total gain
Less: Suspended losses
Deductible loss
$100,000
( 75,000)
$ 25,000
( 40,000)
($ 15,000)
c.
Net sales price
Less: Adjusted basis
Total gain
Less: Suspended losses
Deductible loss
$100,000
( 75,000)
$ 25,000
( 40,000)
($ 15,000)
The suspended passive losses are fully deductible. The suspended credits are lost
forever because the sale of the activity did not generate any tax.
pp. 5-20 to 5-22 and Example 28
19.
A personal service corporation cannot offset passive losses against active or portfolio
income. Oak’s income is $560,000 ($500,000 active income + $60,000 dividend income).
pp. 5-24 and 5-25
20.
a.
A personal service corporation is not allowed to offset passive losses against ordinary
income. Therefore, White's taxable income based on the facts given is $436,000
($400,000 income from operations + $36,000 portfolio income). Example 30
b.
A closely held, non-personal service corporation is allowed to offset passive losses
against active income, but not against portfolio income. Therefore, White's taxable
income based on the facts given is $396,000 ($400,000 income from operations $40,000 passive loss + $36,000 portfolio income). Example 31
21.
A closely held, non-personal service corporation can offset passive losses against active
income, but not against portfolio income. Green's income is $60,000 ($50,000 active
income + $60,000 interest income - $50,000 passive loss deducted to extent of active
income). Green will have a suspended passive loss of $30,000 ($80,000 - $50,000 used).
Example 31
Losses and Loss Limitations
22.
5-11
Smith, Raabe, and Maloney, CPAs
5191 Natorp Boulevard
Mason, OH 45040
December 5, 2002
Mr. Greg Horne
431 Maple Avenue
Cincinnati, OH 45229
Dear Greg:
This letter is in response to your inquiry regarding the various strategies that are available
concerning your movie theater and drugstore ventures in Cincinnati, Indianapolis, and
Louisville. As you know, the basic issue relates to how the stores should be grouped or
reported under the passive activity rules so as to maximize the tax benefit.
As things currently stand and based on the projections that you have provided for the year,
the $400,000 salary from your radio show is active income. If you do not participate any
more in any of the movie theater or drugstore businesses, all profits and losses will be
passive. As a result, you would have a net passive loss of $55,000 ($89,000 loss + $41,000
loss + $15,000 loss - $56,000 profit - $34,000 profit) that would be suspended and not
available to offset your salary. To mitigate this result, three options are available.
Option 1 is based on the significant participation activity rule. If all of the businesses were
treated as separate activities, you would not be considered a material participant. Under the
significant participation activity rules, the drugstores would be considered significant
activities, but the movie theaters would not. Even with the drugstores, the total
participation is not expected to exceed the more-than-500 hour threshold (140 + 170 + 180
= 490). Therefore, if you could participate 11 more hours in any of the drugstore
businesses, they would be treated as active. You then could offset the net loss from the
drugstores of $145,000 ($89,000 + $41,000 + $15,000) against your salary. Further, if you
do not participate any more in the other theater businesses, their combined $90,000 of
income will be reported as passive income. This characterization as passive could be
helpful if you were to acquire additional passive businesses in the future that produce
passive losses.
Under option 2, both the movie theater and drugstore businesses could be combined as a
“single activity” based on common ownership. Because you have participated more than
500 hours in the five businesses, the net loss of $55,000 would be considered active and
could be used to offset the salary.
Based on product, option 3 would combine the drugstores as one activity and the theaters
would be treated as a separate activity. As with option 1, if you could participate 11 more
hours in any of the drugstore businesses, they would be treated as active and you could
offset the net loss of $145,000 ($89,000 + $41,000 + $15,000) against your salary. Also,
you could treat the theaters as a single business and the net income would be passive. This
could be helpful in the future if other passive ventures would be acquired.
Other grouping possibilities exist, such as a grouping by location, but they do not appear to
produce any tax advantages.
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2003 Entities Volume/Solutions Manual
Before making a decision on the above options, you should consider what is likely to
happen in the future. For example, what is the likely profit and loss pattern of the existing
businesses? Will you acquire additional businesses? If so, what types of businesses are
likely to be acquired, and how will the new businesses fit into the grouping method that you
adopt? Will you dispose of any of the existing businesses in the near future, and what
impact will that have on the current grouping decisions?
You will need to consider carefully all tax factors in deciding how to group your activities.
This is so because once activities have been grouped, they cannot be regrouped unless the
original grouping was clearly inappropriate or there has been a material change in facts and
circumstances.
Of course, our firm will be happy to assist you further in anyway we can concerning the
choices you face. If we can answer or clarify any questions you may have, please call me.
Sincerely,
John J. Reswick, CPA
Partner
pp. 5-25 to 5-28
23.

The amount of Rene’s at-risk basis in the hardware business and whether the losses
flowing from the entity are limited by the at-risk rules.

Whether the profits and losses from the public accounting firm are classified as passive
or active.

Whether Rene is a material participant in the hardware business.

Whether Rene is subject to the passive loss rules.
pp. 5-16 to 5-30
24.
Smith, Raabe, and Maloney, CPAs
5191 Natorp Boulevard
Mason, OH 45040
January 23, 2003
Ms. Kristin Bailey
123 Baskerville Mill Road
Jamison, PA 18929
Dear Kristin:
This letter is in response to your request for assistance in analyzing the tax consequences
resulting from two investment alternatives. One alternative is to make an additional
investment of $10,000 in Rocky Road Adventures in which you have an at-risk basis of $0,
suspended losses under the at-risk rules of $7,000, and suspended passive losses of $1,000.
If you were to make this investment, your share of the expected profits this year would be
$8,000, while if your investment stayed at the same level, your share of profits would be
$1,000. Your other choice is to invest $10,000 as a limited partner in the Ragged Mountain
Losses and Loss Limitations
5-13
Winery, which would produce passive income of $9,000 this year. I have prepared the
following analysis based on these facts.
Invest $10,000 in Rocky Road Adventures:
Expected profit from investment
Beginning at-risk basis
Increase due to profit
Increase to at-risk basis due to investment
Use of loss suspended by at-risk rules
Ending at-risk basis
Beginning suspended passive loss
Reclassified suspended passive loss
Use of suspended passive losses—revised
Current taxable income
Current tax liability
$8,000
$
-08,000
10,000
$18,000
(7,000)
$11,000
($ 1,000)
( 7,000)
Invest $10,000 in Ragged Mountain Winery:
Expected profit from investment—Ragged Mountain Winery
Expected profit from investment—Rocky Road Adventures
Use of suspended passive losses from Rocky Road Adventures
Current taxable income
Current tax liability ($9,000 X 30%)
(8,000)
$ -0$ -0$9,000
1,000
(1,000)
$9,000
$2,700
As you can see, the tax effects of the two options vary significantly and the differences
relate to the interplay of the at-risk rules and the passive activity loss rules. I hope that this
analysis will help you make a more informed investment decision. If you need any further
explanation, please contact me.
Sincerely,
Libba Eanes, CPA
Partner
Examples 44 to 47
25.
Lee’s share of ABC’s loss in 2002 is $80,000 ($400,000 X .20 ownership interest), and the
entire loss is suspended under the passive loss rules. His share of the passive income in
2003 is $40,000 ($200,000 X .20 ownership interest). His at-risk amount is $80,000
($120,000 - $80,000 passive loss in 2002 + $40,000 share of income in 2003). In 2003, he
may deduct $40,000 of his $80,000 suspended loss against the passive income. This leaves
a $40,000 suspended loss at the end of 2003. pp. 5-31 and 5-32
26.
Ann is allowed a $40,000 deduction. Because her at-risk basis is only $40,000, $10,000 of
the $50,000 loss is suspended. The available $40,000 loss is not subject to the passive
activity loss rules because she was a material participant. The loss is treated as an active
loss. Therefore, Ann’s AGI is $100,000 ($140,000 - $40,000). pp. 5-18 and 5-19
27.
a.
Initially the remaining $15,000 is disallowed by the at-risk limits. Since Soong is not
a material participant, $45,000 of his $60,000 loss is reclassified as a passive loss and
disallowed under the passive loss limits. Therefore, Soong's AGI is $218,000
($200,000 salary + $18,000 portfolio income).
5-14
2003 Entities Volume/Solutions Manual
b.
Initially the remaining $15,000 is disallowed by the at-risk limits. Since Soong is a
material participant, $45,000 of his $60,000 loss is deductible as an active loss.
Therefore, Soong's AGI is $173,000 ($200,000 salary + $18,000 portfolio income $45,000 active loss).
Examples 44 to 47
28.
The fundamental issue is how can the time that Alan devotes to his business best be
allocated across the various businesses in order to minimize the negative impact of the
material participation rules as set out in the Regulations. Related to this issue are several
points that need to be identified and resolved.

How are the various businesses grouped together to form activities and how many
hours does Alan spend working in each activity?

How many employees are working at each of the businesses and how many hours have
they worked?

What type of work can Alan’s wife do to ensure that her participation will be treated as
being his?

Whether Alan is a limited partner in any of the businesses (which would allow for
applying the rules in a different way).
pp. 5-25 to 5-29
29.
If losses were limited only by the at-risk rules, Gerald would be able to deduct the
following amounts in 2001 and 2002.
Year
Loss
Allowed*
Disallowed
2001
2002
$40,000
30,000
$30,000
-0-
$10,000
30,000
*Allowed under the at-risk rules, reclassified as a passive loss subject to the passive loss
limitations.
However, the losses also are limited by the passive loss rules as follows:
Year
Passive
Deductible
Suspended
2001
2002
$30,000
-0-
$-0-0-
$30,000
-0-
In 2003, the $50,000 income increases Gerald’s at-risk amount to $50,000 enabling him to
deduct the $40,000 of disallowed losses. The $50,000 is passive income that can be offset
by $50,000 of suspended losses, leaving a suspended loss of $20,000. At the end of 2003,
Gerald has no unused losses under the at-risk rules, $20,000 of suspended passive losses,
and a $10,000 adjusted basis in the activity [$30,000 (adjusted basis on 1/1/2001) - $40,000
(loss in 2001) - $30,000 (loss in 2002) + $50,000 (income in 2003)]. pp. 5-25 to 5-29
Losses and Loss Limitations
30.
5-15
Smith, Raabe, and Maloney, CPAs
5191 Natorp Boulevard
Mason, OH 45040
March 5, 2002
Mr. Joe Cook
125 Hill Street
Charleston, WV 25311
Dear Mr. Cook:
This letter is in response to your inquiry regarding the $50,000 loss you incurred this year in
conjunction with your investment in the apartment building, which I have assumed is not
low-income housing given that it is located in an exclusive part of the city. As I understand
your situation, you anticipate that your current AGI, exclusive of the loss flowing from the
real estate rental activity, will be $140,000 and you wish to determine whether the loss is
either partially or fully deductible.
As you are aware, the apartment rental activity is considered a passive activity, and, in
general, is subject to the passive activity rules. However, because you are an active
participant in the investment, you will be able to deduct $5,000 under a real estate rental
exception to the passive activity rules. More specifically, the law allows losses of up to
$25,000 from certain real estate rental activities to be deducted each year. However, if a
taxpayer's AGI exceeds $100,000, the amount deductible in the current year is reduced by
50% of every dollar of AGI over $100,000. Once a taxpayer's AGI reaches $150,000, no
current loss deduction is allowed. Because your AGI is expected to be $140,000, the
maximum allowable loss of $25,000 is reduced as follows: [$25,000 (maximum
allowable) - .50($140,000 AGI - $100,000)]. Therefore, your AGI would be $135,000 after
the allowable $5,000 loss ($140,000 - $5,000). The remaining $45,000 loss that would not
be deductible in the current year is suspended under the passive loss rules and would be
available in future years.
If you do not actively participate in this activity next year, and a loss is generated, none of it
will be deductible under the real estate rental exception. Joe, if you have any additional
questions or would like further clarification of this matter, please call me.
Sincerely,
John J. Jones, CPA
pp. 5-32 to 5-34
31.
Donald does not satisfy both requirements for certain real estate professionals that allow
nonpassive treatment for losses. Of the 2,300 hours Donald worked during the year, only
1,100 hours, or less than half, involved real estate trades or businesses in which he
materially participated. Therefore, his real estate rental activities are passive activities.
However, the 600 hours Donald devoted to his real estate development business satisfies
the 500-hour material participation requirement. Therefore, the $18,000 loss is fully
deductible.
5-16
2003 Entities Volume/Solutions Manual
Under the rental real estate exception, Donald can deduct $25,000 of his $26,000 of losses.
The remaining $1,000 of losses are suspended passive losses.
pp. 5-32 to 5-34
32.
Smith, Raabe, and Maloney, CPAs
5191 Natorp Boulevard
Mason, OH 45040
December 15, 2002
Scott Myers
603 Pittsfield Dr.
Champaign, IL 61821
Dear Scott,
Based on our discussion, I understand that you are attempting to qualify under the special
rules for real estate professionals as a material participant in order to deduct against your
nonpassive income any losses generated by this rental activity. Consequently, you should
document a sufficient number of hours so that you will meet the material participation
standard.
Your activities to date appear to be within the bounds of the tax law as it is written, but you
also appear to be stretching its limits. You need to be careful to avoid any appearance of or
taking any actual fraudulent actions on you or your wife’s part. Essentially, the issue is
whether the participation hours generated are of substance or merely of form. Another
issue is whether one of the principal purposes of the tasks being performed is to avoid the
disallowance of passive losses or credits.
Should you need more information or need me to clarify anything, please call.
Sincerely,
Jake Smith, CPA
pp. 5-32 and 5-33
33.
Maria and Jorge do not qualify to use the exception for real estate professionals in
re-characterizing their loss from the real estate development business because they cannot
combine their services to meet the 750-hour requirement. Therefore, the $18,000 loss is a
passive loss and cannot be offset against active or portfolio income and must be carried
forward to next year. Of the real estate rental passive loss, $25,000 can be deducted under
the real estate rental exception. The remaining $1,000 loss is suspended. pp. 5-32 to 5-34
Losses and Loss Limitations
5-17
34.
Gene is considered a material participant in the tax practice but not in the apartment leasing
operation. However, because he actively participates in the real estate rental activity and
owns at least 10% in the activity, $25,000 of the $30,000 loss is deductible in the current
year against his tax practice income. The remaining $5,000 loss from the rental activity is
suspended as a passive activity loss. pp. 5-32 to 5-34
35.
How Active is Active? Under the real estate rental activities exception, George and Louise
qualify to deduct a loss of up to $25,000 from the real estate rental activity if they actively
participate in the activity and own a 10 percent or more interest in the activity. Here the
issue is whether their involvement has reached the level of active participation for the year.
In general, being an active participant requires the owner to make management decisions in
a significant and bona fide sense. The facts revealed in the scenario suggest that they have
taken a “hands off” approach and have left most, if not all, of the management decisions to
the property manager. Nonetheless, the tax preparer servicing George and Louise should
inquire more about the role that they actually played in the operations of the rental unit to be
certain about their level of participation. For example, perhaps they actually were involved
in making key management decisions such as approving new tenants, deciding on rental
terms, and approving capital or repair expenditures. Such involvement would be enough
for them to be considered active participants. However, given that George and Louise are
surprised that a loss resulted from the operations, they may not have envisioned the need to
actively participate. Therefore, unless additional supporting evidence comes to light,
claiming a deduction under the real estate rental activities exception does not appear to be
supported by the facts of the scenario by virtue of their lack of participation. pp. 5-33 and
5-34
36.
Ida can utilize $20,000 of losses and $1,350 of credits as follows:
Income (Loss):
Activity A
Activity B
Activity C
Net loss
Utilized loss
Suspended loss
Utilized credit
Suspended credit
($12,000)
(18,000)
10,000
($20,000)
20,000
$
-0$ 1,350
$ 750
After deducting the loss of $20,000, Ida has available a deduction equivalent of $5,000
[$25,000 (maximum loss allowed) - $20,000 (utilized loss)]. Therefore, the maximum
amount of credits Ida may claim is $1,350 [$5,000 (deduction equivalent) X 27% (marginal
tax bracket)]. Examples 49 and 50
37.
Rental loss
Rental income
Other passive income
Net passive rental loss
Deductible against other income
Suspended rental loss
Example 49
($105,000)
25,000
32,000
($ 48,000)
25,000
($ 23,000)
5-18
2003 Entities Volume/Solutions Manual
BRIDGE DISCIPLINE PROBLEMS
1.
a.
Beginning allowance for bad debts
Bad debt expense
Bad debts written off during the year
Ending allowance for bad debts
$120,000
36,000
( 33,000)
$123,000
Given the $33,000 write-off and the $3,000 increase in the allowance for bad debts,
the bad debt expense for financial accounting purposes is $36,000.
b.
The bad debt expense for tax purposes is $33,000, the amount of accounts
receivable written off during the current year.
c.
The sole book/tax difference for Marketplace relates to the treatment for bad debts.
Bad debt expenses per books
Bad debt expense per tax
Excess of book expense over tax expense
$ 36,000
( 33,000)
$ 3,000
Therefore, the taxable income for Marketplace is computed as follows:
Before-tax net income for financial
accounting purposes
Excess of book expense over tax expense
Taxable income
2.
$545,000
3,000
$548,000
Based on the following, Alternative 2's benefit exceeds Alternative 1's by $1,917 ($55,059
- $53,142), primarily because of the flow of the benefits and the effect of the at-risk rules on
those benefits.
Alternative 1
Income
Yr. 1
($24,000)
Yr. 2
(24,000)
Yr. 3
72,000
Total present value
Tax cost/
benefit
After-tax
benefit
8% PV
factor
Present
value
$ 6,480 1
4,320 2
(17,280)
$ 6,480
4,320
54,720
0.92593
0.85734
0.79383
$ 6,000
3,704
43,438
$53,142
Losses and Loss Limitations
5-19
Alternative 2
Income
Tax cost/
benefit
Yr. 1
($48,000)
Yr. 2
32,000
Yr. 3
40,000
Total present value
$10,800 4
(6,480)
10,800
3
After-tax
benefit
8% PV
factor
Present
value
$10,800
25,520
29,200
0.92593
0.85734
0.79383
$10,000
21,879
23,180
$55,059
1
Because of the at-risk rules, Amanda's tax deduction in year 2 is limited to her
remaining at-risk basis of $16,000. The $8,000 loss that is not deductible in year 2 is
suspended until her at-risk basis increases. Therefore, her tax benefit from the
deduction is $4,320 ($16,000 X 27%).
2
Amanda's $72,000 share of income increases her at-risk basis and provides the
opportunity to claim the $8,000 suspended loss from the previous year. Therefore,
her taxable income for year 3 from this investment is $64,000 ($72,000 - $8,000) and
the tax cost is $17,280 ($64,000 X 27%).
3
Because of the at-risk rules, Amanda's tax deduction in year 1 is limited to her at-risk
basis of $40,000. The $8,000 loss that is not deductible in year 1 is suspended until
her at-risk basis increases. Therefore, her tax benefit from the deduction is $10,800
($40,000 X 27%).
4
Amanda's $32,000 share of income increases her at-risk basis and provides the
opportunity to claim the $8,000 suspended loss from the previous year. Therefore,
her taxable income from this investment in year 2 is $24,000 ($32,000 - $8,000) and
the tax cost is $6,480 ($24,000 X 27%).
pp. 5-18 and 5-19
3.
Option B's benefit exceeds Option A's by $7,198 ($21,629 - $14,431), primarily because of
the flow of the benefits and the ability to benefit from the passive loss deductions in years 1
and 2.
Option A
Income
Yr. 1
$8,000
Yr. 2
8,000
Yr. 3
8,000
Total present value
Tax cost/
benefit
After-tax
benefit
8% PV
factor
Present
value
($2,400)
(2,400)
(2,400)
$5,600
5,600
5,600
0.92593
0.85734
0.79383
$ 5,185
4,801
4,445
$14,431
Tax cost/
benefit
After-tax
benefit
8% PV
factor
Present
value
$ 2,400
600
23,800
0.92593
0.85734
0.79383
$ 2,222
514
18,893
$21,629
Option B
Income
Yr. 1
($ 8,000)
Yr. 2
(2,000)
Yr. 3
34,000
Total present value
$ 2,400
600
(10,200)
5-20
2003 Entities Volume/Solutions Manual
RESEARCH PROBLEMS
1.
Smith, Raabe, and Maloney, CPAs
5191 Natorp Boulevard
Mason, OH 45040
February 2, 2002
Mr. George Johnson
100 Apple Lane
St. Paul, Minnesota 55123
Dear Mr. Johnson:
This letter is in response to your request concerning whether you can claim a casualty loss
for the damage your automobile sustained when it fell through the ice as you were watching
an iceboat race.
Based on our research, we believe that the event constitutes a casualty and as such, you are
entitled to claim a casualty loss for the damage to your car.
Should you need more information or need further clarification on any matter, do not
hesitate to contact me.
Sincerely yours,
John J. Jones, CPA
Partner
TAX FILE MEMORANDUM
January 29, 2002
FROM:
John J. Jones
SUBJECT:
George Johnson’s Casualty Loss
Today I talked with George Johnson concerning an incident involving his car. Several
weeks ago, George parked his car on a lake while he was watching an iceboat race. During
the race, the ice beneath his car unexpectedly gave way, and the car sank to the bottom of
Losses and Loss Limitations
5-21
the lake. George wants to know whether he will be entitled to claim a casualty loss for the
damage to his car.
The facts of George’s case are similar to Rev. Rul. 69-88, 1969-1 C.B. 58. In the ruling, the
taxpayer’s automobile was parked on the ice while he was ice fishing. A casualty loss was
allowed for the purpose of claiming a deduction under § 165.
Based on this ruling, I have advised George that he will be entitled to claim a casualty loss
for the damage to his car.
2.
John and Samantha’s plan to generate rent income that would then be offset by otherwise
suspended passive losses is very creative. Unfortunately for John and Samantha, however,
Reg. § 1.469-2(f)(6) holds otherwise. If property is rented to a nonpassive activity, such as
John’s medical practice, then such gross rent income generated is treated as though it is not
from a passive activity if the property is used in a trade or business activity in which the
taxpayer materially participates. This Regulation would essentially eliminate the benefits
that John and Samantha desire by treating the rent income as active income rather than
passive.
In a case involving an attorney whose law practice rented a building owned by the attorney
and his wife, the validity of Reg. § 1.469-2(f)(6) was reviewed by a court. [Fransen v. U.S.,
98-2 USTC ¶50,776, 82 AFTR 2d 98-6621 (D.Ct. La., 1998), affd. in 99-2 USTC ¶50,882,
84 AFTR 2d 99-6360, 191 F.3d. 599 (CA-5, 1999)]. The Court concluded that the
Regulation is valid, in a fact pattern that is similar to John and Samantha’s. The IRS
properly recharacterized as non-passive the attorney and wife's income from the rental
activity. The income was treated as nonpassive because the building was rented by a trade
or business (i.e., his law firm) in which he materially participated. The statute, legislative
history, and the Regulation’s rationale showed that the Regulation did not arbitrarily negate
§ 469’s classification of rental activity as passive.
3.
Smith, Raabe, and Maloney, CPAs
5191 Natorp Boulevard
Mason, OH 45040
January 13, 2003
Mr. Lane Mitchell
77 Lakeview Drive
Salt Lake City, Utah 84109
Dear Mr. Mitchell:
I am responding to your inquiry regarding the current tax treatment of the investment in the
minor league baseball team. As you have been unable to devote any time to the baseball
5-22
2003 Entities Volume/Solutions Manual
club because of your full-time job, the activity will be characterized as passive.
Consequently, the passive loss flowing from this investment will not be deductible since
you have no passive income. But does this result change because your wife worked as an
office receptionist in connection with the activity for about 20 hours a week during the
year?
Normally, participation by a taxpayer’s spouse is treated as participation by the taxpayer.
[Temp. Reg. § 1.469-5T(f)(3)] Further, participation generally includes any work done by
an individual in an activity that he or she owns. However, it does not include work if it is of
a type not customarily done by owners and if one of its principal purposes is to avoid the
disallowance of passive losses. [Temp. Reg. § 1.469-5T(f)(2)(i)] Under these
circumstances, it appears that the work performed by your wife would not be counted in
determining whether you are a material participant. [Temp. Reg. § 1.469-5T(k), Example
7] Consequently, you have not materially participated, either directly or through your
wife’s efforts, and will not be considered to be a material participant. As a result, you
unfortunately will not be allowed to deduct your share of the loss from the activity.
If you have any questions regarding our conclusion or would like to discuss this further,
please do not hesitate to call me.
Sincerely,
Joyce Guthrie, CPA
4.
The Internet Activity research problems require that the student access various sites on the
Internet. Thus, each student’s solution likely will vary from that of the others.
You should determine the skill and experience levels of the students before making the
assignment, coaching them where necessary so as to broaden the scope of the exercise to
the entire available electronic world.
Make certain that you encourage students to explore all parts of the World Wide Web in
this process, including the key tax sites, but also information found through the web sites of
newspapers, magazines, businesses, tax professionals, government agencies, political
outlets, and so on. They should work with Internet resources other than the Web as well,
including newsgroups and other interest-oriented lists.
Build interaction into the exercise wherever possible, asking the student to send and receive
e-mail in a professional and responsible manner.
5.
See the Internet Activity comment above.