Chapter 7
Losses - Deductions and Limitations
Kevin Murphy
Mark Higgins
©2008 South-Western
Definition of Losses
Annual (Activity) Losses result
when an entity’s deductions for the
period exceed its income
Transaction Losses result from the
disposition of an asset
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Concept Review
Losses may result from
the disposition of an asset because
of the capital recovery concept.
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Concept Review
Most of the classification rules for
deductions also apply to losses,
because losses also result when
deductions exceed income.
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Concept Review
The deductibility of losses is a matter of
legislative grace and is based on the
ability-to-pay concept.
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General Scheme for
Treatment of Losses
Figure 7-1
Realized loss
Annual loss
Transaction loss
Trade or
business
loss
Passive
Activity
Trade or
business
loss
Investmentrelated
loss
Personal
use
loss
NOL
deduction
Loss allowed
or loss
deduction
suspended
Ordinary
loss
Capital
loss
limitations
Nondeductible
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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
 Carry-forward unused NOL 20 years
 May elect to forego carry-back
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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
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Tax Shelter Losses
At-Risk Rules
At-Risk Rules disallow the deduction of
artificial losses
Loss deduction limited to amounts actually “atrisk”
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
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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 Rules disallow the
deduction of passive activity losses from
other forms of income
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Passive Activity Loss
Definition
Three classifications for activities:
Portfolio income: unearned income
derived from holding investments
Active income: earned income
Passive income: earned or unearned
income from a trade or business in
which a taxpayer does not materially
participate
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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
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Passive Activity Loss
General Rules for Limitations
Passive activity losses must be
netted against passive activity
income
Net passive losses are not deductible
Net passive gains are reported with
other income
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Passive Activity Loss
Exception 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
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Passive Activity Loss
Exception for Rental Real Estate
And, taxpayers who are active
participants in rental real estate
business may offset a portion of losses
Must own at least 10% interest in the
activity
Must have significant and bona fide
involvement
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Active Participants in Real Estate
Active Participation Exception permits
up to $25,000 of rental real estate loss
to be deducted annually
Deduction amount is reduced by $0.50 for
each dollar of AGI over $100,000.
For AGI over $150,000, no allowed loss
deduction remains.
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Passive Activity Loss
Disposition 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
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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 steppedup 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
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Transaction Losses
Transaction losses result from the
disposition of business, investment or
personal-use assets.
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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 the
lesser of the property’s adjusted basis, or the
decline in the property’s value
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Transaction Losses:
Investment-Related Losses
Net capital losses result from netting
short-term and long-term capital gains
and losses
Individual taxpayers may deduct only
$3,000 annually
Corporate taxpayers may not deduct any
net capital loss
Carry-back for 3 years, then forward for 5
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Transaction Losses:
Investment-Related Losses
Losses on Small Business Stock may
be deducted up to $50,000 per person
($100,000 per married couple) per year
Small business = a corporation with
capitalization of less than $1 million
Stock must have been bought directly from
corporation
Excess over $50,000 ($100,000) is netted
with other capital gains and losses
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Transaction Losses:
Investment-Related Losses
Losses on Related Party Sales are
disallowed because they generally fail
the arm’s length transaction concept
Loss is carried forward with the property
Gain from later sale may be offset by deferred
loss
Loss cannot be created or increased by using
the deferred loss
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Transaction Losses:
Investment-Related Losses
Wash Sale losses are disallowed
because the sale violates the
substance-over-form doctrine
A wash sale occurs when a security is sold
at a loss, and during +/- 30 days of the sale
the seller buys substantially identical
securities
Disallowed loss amount is added to the
basis of the replacement security
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Transaction Losses:
Personal Use Losses
Losses from the disposition of personal
use assets are generally not deductible
Exception exists for personal casualty
and theft losses
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Transaction Losses:
Personal Casualty and Theft Losses
Loss is the lesser of
The property’s adjusted basis, or
The decline in the value of the property
(repair cost)
Loss is reduced by
Insurance proceeds received,
$100 per event (Administrative
convenience), and
10% of AGI per year
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