3 ae LOSSES AND BAD DEBTS - Samecaae Se ~ Ses) LEARNING OBJECTIVES After studying this chapter, you should be able to D> Identity transactions that may result in losses P> Determine the proper classification for losses P> Calculate the suspended loss from passive activities D> Identify what constitutes a passive activity loss D> Determine when a taxpayer has materially participated ina passive activity D> Identify and calculate the deduction for a casualty or theft loss D> Compute the deduction for a bad debt D> Compute a net operating loss deduction8-2 Individuals ¥ Chapter 8 CHAPTER OUTLINE “Transactions That May Result in Losses82 lasifying the Los onthe Taxpayers Tax Return. 2-4 Passive Losses..8-7 Casualty and Theft Losses..8-17 Bad Debts.8-28 Net Operating Losses..8:29, Tax Planning Consideations..834 Compliance and Procedural Consideration®..838, ‘Taxpayers often sustain losses on property sold, exchanged, or otherwise disposed of. If the taxpayer uses the property in a trade or business or holds the property for investment, the tax law generally provides a deduction for these losses. Noncorporate taxpayers may also take a limited deduction for losses on personal-use property that is either stolen or dam- aged in a casualty. Other losses on personal-use property (¢.g., a sale of a personal resi- dence at a loss) are not deductible. Taxpayers are also permitted a deduction for losses due to uncollectible business or nonbusiness debts. This chapter discusses the rules con- cerning the deductibility of these types of losses. (NNN TM ANSactTiIons THAT MAY B. i 1 Identity transactions that ‘may result in losses EXAMPLE L8-1 > ADDITIONAL COMMENT 1 property ied party fo bus ns el party fo pol the lon aferbabe to the un nest portions deductible but the issn the personae prton not une team wos sutatned imacasaty KEY POINT ‘Anticipated losses, including ‘those for which reserves have been established, are not deductible, * Se. 1001 2 Beulah B: Crane CIR, 38 AFTR 776, 47-1 USTC 49217 (USSC and Reg, Sec. 110012 RESULT IN LOSSES For taxpayers to deduct a loss on property, the loss must be both realized and recognized for tax purposes. Generally, realization occurs in a completed (closed) transaction evidenced by an identifiable event. This is referred to as the closed transaction doctrine. As a general rule, taxpayers recognize realized losses on business or investment property unless a specific pro- vision holds otherwise (see pages I:8-6 and I:8-7). Capital Corporation purchased 500 shares of Data Corporation stock for $10,000 on February 22of the current year. By October 31 ofthe same year, the price ofthe stock declines to $8,000. Even though Capital has suffered an economic loss on the stock, no realization event has ‘occurred, and the corporation may not deduct the $2,000 loss. However, if Capital sells the stock for $8,000 on October 31, itrealizes the oss for tax purposes in the currentyear. Losses on property may arise in a variety of transactions, including: Sale or exchange of the property Expropriation, seizure, confiscation, or condemnation of the property by a government Abandonment of the property ‘Worthlessness of stock or securities Planned demolition of the property in order to construct other property in its place Destruction of the property by fire, storm, or other casualty Theft Deductible business expenses exceeding business income, giving rise to a net operating, loss (NOL) vryvyyyy SALE OR EXCHANGE OF PROPERTY ‘The amount of the loss a taxpayer incurs in a sale or exchange of property equals the excess of the property's adjusted basis over the amount realized for the property.! The ‘amount realized for the property equals the sum of the money received plus the fair mar- ket value (FMV) of any other property received in the transaction. If the property sold or exchanged is subject to a mortgage or other liability, the amount realized also includes the amount of the liability transferred to the buyer. The treatment of any selling costs depends on the type of property sold or exchanged. Ifthe property is inventory (i.., prop- erty normally held for sale in the taxpayer's business), the selling costs are generally deductible expenses in the year in which they are paid or incurred. However, ifthe sale involves property not normally held for sale by the taxpayer, the selling costs reduce the amount realized from the sale or exchange.EXAMPLE 1:8-2 > Losses and Bad Debts W Individuals 8-3 Four years ago, Boyer Corporation purchased a plot of land as an investment for $50,000. Unfortunately, local economic conditions worsened after the land was purchased, and its value declined to $35,000. Boyer sells the property in the current year. At the time of the sale, the land is subject to a $10,000 mortgage. The terms of the sale are $25,000 paid in cash with the purchaser assuming the mortgage. Boyer also incurs $2,000 in sales commissions. The amount realized is $33,000 ($25,000 cash + $10,000 mortgage assumed by the buyer — $2,000 commis- sions). The loss on the sale is $17,000 ($50,000 basis ~ $33,000 amount realized). < In general, taxpayers can only deduct losses they incur in the sale or exchange of prop- erty used in a trade or business or held for investment. Taxpayers cannot deduct losses they incur in the sale or exchange of personal-use property. Furthermore, the type of deduction a taxpayer may take for a loss realized on the sale or exchange of business or investment property depends on the type of property sold. For example, if inventory is sold, the loss is an ordinary loss. Ifthe asset is a capital asset, the loss isa capital loss (see Chapter I:5). If the sale is of property used in a trade or business (a Sec. 1231 asset), the type of loss depends on the total net gain or loss realized on all the taxpayer's Sec. 1231 transactions during the year (see Chapter I:13).. EXPROPRIATED, SEIZED, CONFISCATED, OR CONDEMNED PROPERTY A taxpayer may own property that the government expropriates, seizes, confiscates, or condemns. In these cases, the taxpayer incurs a deductible loss if the taxpayer used the property in a trade or business or held it for investment. However, the Tax Court has held. that the confiscation, seizure, condemnation, or expropriation of property does not consti- tute a theft or a casualty. Rather, itis treated as a sale or exchange. Thus, no deductible loss arises if the seized property is personal-use property. If the seized or condemned property is business or investment property, the classification of the loss depends on the type of property. (See the section in this chapter titled Classifying the Loss on the Taxpayer's Return.) A taxpayer may take the deduction only in the year in which the property is actu- ally seized. Whether formal expropriation or nationalization occurs in a later year is irrel- evant.4 A taxpayer realizes gain if he or she receives compensation for the property in excess of its basis. Under certain circumstances, the taxpayer may defer this gain. (See Chapter I:12 for a discussion of the nonrecognition of gain in an involuntary conversion.) ABANDONED PROPERTY If a taxpayer's property becomes worthless or if it is not worth placing into a serviceable condition, the taxpayer may simply abandon the property Ifthe property still has basi, the taxpayer realizes a loss. The taxpayer may not deduct such losses if the property is per- sonal-use property. However, the taxpayer may deduct losses on business or investment property. Furthermore, because the abandonment of property is not a sale or exchange, the loss is an ordinary loss. The amount of the loss is the property's adjusted basis on the date Of abandonment. The taxpayer bears the burden of proof to show that the property was actually abandoned. Ifthe property is depreciable (e.g., machinery and buildings), the tax- payer must actually physically abandon it to take the full amount of the loss.S WORTHLESS SECURITIES A taxpayer may take a deduction for securities that become completely worthless during the tax year.® Because the deduction is only available in the year the security actually becomes worthless, both the taxpayer and the IRS may have problems determining the year in which the security becomes worthless. A mere decline in value is not sufficient to create a deductible loss if the stock has any recognizable value. Furthermore, the sale of the stock for a nominal amount such as $1 does not necessarily establish that the stock became 2 Willa J. Powers 36°EC. 191 (196). “For this purpose, security is defined in Sec, 16\g)2) as stock na compo 4 Rey. Rul 62-197, 1962-2 CB. 66 as moifed by Rev Rul. 69-498, 1969-2 ration, the righ to subseibe foro recsve a shae of stock ina corporation, (CB. 31 (See also Estate of Frank Fuchs CIR, 24 AFTR 2d 695077, 6:2 ora bond, debenture, not, or erieat of indebtedness sued bya corpo UsTC 99505 Reg Sec. ah S(a nd City 1969), tion ora goveenment either in registered form or with interest coupons Promissory noes sued by a corporation are generally not secures.