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CHAPTER 7 LOSSES - DEDUCTIONS AND LIMITATIONS DISCUSSION QUESTIONS

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CHAPTER 7 LOSSES - DEDUCTIONS AND LIMITATIONS DISCUSSION QUESTIONS

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    CHAPTER 7

    LOSSES - DEDUCTIONS AND LIMITATIONS

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DISCUSSION QUESTIONS

     1. How are deductions and losses different? How are they similar? Explain.

     Differences - The main difference is that most deductions are for current expenditures

    and amortization of capital expenditures, whereas losses result from either an excess of

    deductions over income (annual loss) or an excess of basis over the amount realized on

    the disposition of an asset (transaction loss).

     Similarities - Both deductions and losses represent amounts invested to produce

    income and are reductions in taxable income under the ability-to-pay concept. In

    addition, the general approach to the deductibility of losses is similar to the approach

    taken for deductions. That is, tax relief is the result of legislative grace and any

    deductions allowed must be specified in the tax law. The categorization of losses by

    those incurred in a trade or business, production of income losses, and personal use

    losses is identical to the approach for deductions. The limitation on losses is similar to

    the limitations placed on deductions within each category.

     2. Discuss the basic differences between annual losses and transaction losses.

     Annual losses result from an excess of deductions over income for a single accounting

    period. Thus, they represent the effect of all the transactions affecting an entity during

    the accounting period.

     Transaction losses result when the amount realized from a sale or other disposition of

    property is less than the basis of the property. That is, a transaction loss represents an

    incomplete capital recovery on a single transaction by an entity.

5. How is a taxpayer's amount at risk in an activity different from the taxpayer's basis in the same

    activity? What purpose does the amount at risk serve in regard to losses?

    The amount at risk is the amount that the taxpayer stands to lose if the activity should

    fail. Therefore, it represents any amounts invested in the activity that have not yet been

    recovered, as well as any liabilities the taxpayer has to pay should the activity be unable

    to pay the liabilities.

    The amount at risk in an activity is very similar to the basis in the activity. That is, the

    at-risk amount is adjusted in the same manner as basis for additional capital

    investments, the share of income (loss) from the activity and any withdrawals or other

    capital recoveries which the taxpayer receives from the activity. The primary difference

    between the at risk amount and basis is the treatment of nonrecourse debt used to

    finance real estate in the activity. Because the taxpayer is not liable for nonrecourse

    debt, it is not added to basis. However, the tax law allows nonrecourse debt used to

    finance real estate to increase the amount at risk in an activity if the borrowing is made

    on reasonable commercial terms.

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     Chapter 7: Losses - Deductions and Limitations 7-12

     The purpose of the at risk rules is to limit loss deductions to an amount that the taxpayer

    actually stands to lose should the activity fail. Therefore, the taxpayer can only deduct

    losses from an activity to the extent she or he is at risk.

7. What is the purpose of the passive loss rules?

     The basic intention of the passive loss rules is to disallow the deduction of losses from

    passive activities against other forms of income. That is, a passive loss cannot be

    deducted against earned income or portfolio income of the taxpayer.

20. Marlene opens an outdoor sports complex that features batting cages, minature

    golf, and a driving range. She invests $100,000 of her own money and borrows

    $750,000 from her bank. She uses $475,000 of the loan proceeds to acquire

    land and construct the office building for the sports complex. The remaining loan

    proceeds are used to acquire equipment and furnishings. The loan is secured by

    the land, building, and equipment. What is Marlene's amount at risk in the

    business if the $750,000 debt was obtained on reasonably commercial terms and

    is secured by

    a. The business assets purchased, and Marlene is personally liable if the business

    assets are insufficient to satisfy the debt?

     Marlene is at risk for $850,000. She is at risk for the $100,000 of personal

    funds she invested and for the $750,000 she borrowed because she is

    personally liable for the debt.

b. The business assets purchased, and Marlene is not personally liable if the

    business assets are insufficient to satisfy the debt?

     Marlene is at risk for $100,000. She is only at risk for the $100,000 of

    personal funds she invested in the business. She is not considered at-risk

    for the nonrecourse loan because she is not personally liable on any of the

    debt and the loan is not used in the trade or business of holding real

    property.

    c. Assume the same facts as in part b, except that Marlene uses the $750,000 loan

    to purchase an apartment complex.

     Marlene is at risk for $575,000. She is at risk for the $100,000 of personal

    funds invested and the $475,000 of the loan proceeds used to acquire the

    land and building. Although she is not personally liable on any of the debt, a

    nonrecourse loan that is used in the trade or business of holding real

    property that is secured by the real property used in the business is

    considered at risk. Therefore the $475,000 debt on the land and building us

    at risk, but the remaining $275,000 ($750,000 - $475,000) that is used for

    equipment and furnishings is not at risk.

21. Carlos opens a dry cleaning store during the year. He invests $30,000 of his own

    money and borrows $60,000 from a local bank. He uses $40,000 of the loan to

    buy a building and the remaining $20,000 for equipment. During the first year, the

    store has a loss of $24,000. How much of the loss can Carlos deduct if the loan

    from the bank is nonrecourse? How much does Carlos have at risk at the end of

    the first year?

     Chapter 7: Losses - Deductions and Limitations 7-13

     Carlos is at risk for $30,000. He is only at risk for the $30,000 of personal

    funds he invested in the business. He is not considered at-risk for the

    nonrecourse loan because he is not personally liable on any of the debt and

    the loan is not used in the trade or business of holding real property.

    Because he is considered at risk for $30,000, he can deduct the entire

    $24,000 loss. The $24,000 loss reduces Carlos’ amount at-risk to $6,000

    ($30,000 - $24,000).

22. Return to the facts of problem 21. In the next year, Carlos has a loss from the dry

    cleaning store of $18,000. How much of the loss can Carlos deduct? Explain.

     Because his at-risk amount in the dry cleaning store is only $6,000, Carlos

    can deduct only $6,000 of the $18,000 loss. The remaining $12,000 ($18,000

    - $6,000) of the loss is suspended due to the at-risk rules. He will be able to

    deduct the loss when his at-risk amount is increased either through

    additional investment in the business or when the business generates

    taxable income.

23. Wayne owns 30% of Label Maker Corporation. Label Maker is organized as an S

    corporation. During 2007, Label Maker has a loss of $160,000. At the beginning

    of 2007, Wayne's at risk amount in Label Maker is $30,000.

    a. Assuming that Wayne's investment in Label Maker is not a passive activity, what

    is his deductible loss in 2007?

     As an S corporation, the income and losses are passed through to its

    shareholders for taxation. In 2007, Wayne's share of the loss is $48,000

    ($160,000 x 30%). Wayne cannot deduct any loss in excess of his at-risk

    amount in Label Maker. Therefore, Wayne's 2007 loss deduction is limited

    to $30,000 (reducing his at-risk amount to zero). The remaining $18,000 of

    his loss is suspended until his at-risk amount increases.

    b. In 2008, Label Maker has a taxable income of $50,000. What is the effect on

    Wayne's 2008 income?

     The net effect on Wayne's income is zero. Wayne's share of the income is

    $15,000 ($50,000 x 30%), which is included in his 2008 gross income.

    However, the $15,000 of income from Label Maker increases his amount

    at-risk by $15,000 and he is allowed to deduct $15,000 of the $18,000

    suspended loss from 2007. After deducting the loss, Wayne's at risk

    amount is reduced to zero. His suspended loss in the activity due to the

    at-risk rules is $3,000 ($18,000 - $15,000).

26. Which of the following would be a passive activity? Explain.

    a. Kevin is a limited partner in Marlin Bay Resort and owns a 15% interest in the

    partnership.

     A limited partnership interest is always considered to be a passive activity.

    As a limited partner, Kevin has no involvement in managing the

    partnership’s assets, so he does not meet the material participation test.

b. Tom owns a 15% interest in a real estate development firm. He materially

    participates in the management and operation of the business.

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     The real estate development firm qualifies as a trade or business. Because

    Tom materially participates in the management of the firm, it is not

    considered a passive activity.

c. Jasmine owns and operates a bed-and-breakfast.

     The activity is not a rental activity under the passive activity loss rules

    because Jasmine provides significant personal services in operating the

    bed-and-breakfast. In addition, she is a material participant in the business.

    The activity is not passive for Jasmine.

    d. Howard owns an apartment complex that meets federal guidelines qualifying it as

    low-income housing.

     Investments in low-income housing are generally not considered to be

    passive activities. Howard's investment is not a passive activity.

e. Felicia owns a 25% working interest in an oil and gas deposit.

     A working interest in an oil and gas deposit is specified as not being a

    passive activity.

    f. Assume the same facts as in part e, except that Felicia owns a 25% interest in a

    partnership that owns a working interest in an oil and gas deposit. She does not

    materially participate in the management and operation of the partnership.

     Generally, a working interest in an oil and gas deposit is specified as not

    being a passive activity. However, because the deposit is owned by a

    partnership, each individual partner must be evaluated for material

    participation in the partnership to determine whether the investment in the

    partnership is passive. In this case, because Felicia does not materially

    participate in the management and operation of the partnership, the activity

    is passive for her.

28. Sidney and Gertrude Pearson own 40% of Bearcave Bookstore, an S corporation.

    The remaining 60% is owned by their son Boris. Sidney and Gertrude do not

    participate in operating or managing the store and they invested $19,000 in the

    business when it opened in 2004. The bookstore reported the following net

    income (loss) for the years 2004 through 2007:

     2004 2005 2006 2007

    $ (24,000) $ (14,000) $ (12,000) $ 5,000

a. How much do Sidney and Gertrude have at-risk in Bearcave at the end of each

    year (2004-2007)?

     The amount at-risk is the amount that Sidney and Gertrude stand to lose if

    the activity should fail. Therefore, it represents the amount they have

    invested in the activity that has not yet been recovered. At the beginning of

    2004, the amount they have at-risk is their investment of $19,000. The

    amount at-risk is increased by the income from the activity and is reduced

    by any losses incurred by the activity. Therefore, at the end of 2004, the

    amount at-risk is reduced by their share, $9,600 ($24,000 x 40%), of the

    loss to $9,400. In 2005, their share of the loss, $5,600 ($14,000 x 40%),

     Chapter 7: Losses - Deductions and Limitations 7-15

    reduces the amount they are at risk to $4,000 ($9,600 - $5,600). In 2006,

    their share of the loss, $4,800 ($12,000 x 40%), exceeds the amount that

    they have at-risk. Therefore, $1,000 of the loss is suspended due to the

    at-risk rules. In 2007, when their share of the bookstore income is $2,000

    ($5,000 x 40%), the amount of the loss suspended due to the at-risk rules is

    eliminated and their at-risk amount is $1,000.

     2004 2005 2006 2007_

     Investment/Beginning at-risk $ 19,000 $ 9,400 $ 3,800 $ -0-

     Share of income (loss) (9,600) (5,600) (4,800) 2,000

     Ending at risk $ 9,400 $ 3,800 $ -0- $ 1,000

     Suspended at-risk $ (1,000)

b. What amount can they recognize as income or loss from Bearcave for each year

    (2004-2007)?

     Because Sidney and Gertrude do not materially participate in the bookstore,

    it is a passive activity and their share of the losses can only offset income

    from other passive activities. In 2004, when Sidney and Gertrude are at-risk

    for the amount of the loss incurred, the loss is suspended due to the

    passive activity rules. In 2005, the $5,600 loss is also suspended due to the

    passive activity rules. In 2006, when the loss exceeds the amount they have

    at-risk, $3,800 is suspended due to both the at-risk rules and the passive

    activity rules and $1,000 is suspended due to the at-risk rules. In 2007, when

    the bookstore produces income of $2,000, the amount suspended due to

    the at-risk rules is eliminated. In addition, they are allowed to offset the

    $2,000 of income with $2,000 of the loss suspended under the passive

    activity rules.

     2004 2005 2006 2007

     Investment/Beginning at-risk $ 19,000 $ 9,400 $ 3,800 $ -0-

     Share of income (loss) (9,600) (5,600) (4,800) 2,000

     Ending at risk $ 9,400 $ 3,800 $ -0- $ 1,000

     Amount of income/loss $ (9,600) $ (5,600) $ (4,800) $ 2,000

     Allowable loss -0- -0- -0- (2,000)

     Suspended passive loss $ (9,600) $ (5,600) $ (4,800) N/A

     Total suspended passive loss $ 9,600 $ 15,200 $ 20,000* $18,000

     Total suspended at-risk $ 1,000

     * In a particular year, a loss can be suspended under both the at-risk and

    passive activity rules. In 2006, $1,000 is suspended under both sets of rules.

c. Assume that Sidney and Gertrude materially participate in Bearcave for each year

    (2004-2007). What amount can they recognize as income or loss from Bearcave

    for each year (2004-2007)?

     2004 2005 2006 2007

     Investment/Beginning at-risk $ 19,000 $ 9,400 $ 3,800 $ -0-

     Share of income (loss) (9,600) (5,600) (4,800) 2,000

     Ending at risk $ 9,400 $ 3,800 $ -0- $ 1,000

     Amount of income/loss $ (9,600) $ (5,600) $ (4,800) $ 2,000

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     Allowable loss (at-risk) $ (9,600) $ (5,600) $ (3,800) $ (1,000)

     Suspended at-risk $ 1,000

     Because Sidney and Gertrude materially participate in the bookstore, they

    can deduct losses from the activity up to the amount they are at-risk in the

    activity. In 2004, Sidney and Gertrude are at-risk for the entire amount of

    the loss, so they can deduct their $9,600 loss. In 2005, they can deduct their

    $5,600 loss. In 2006, Sidney and Gertrude only can deduct $3,800 of the

    loss because of the at-risk limitation. In 2007, when the bookstore

    produces income of $2,000, their amount at-risk increases by their share of

    the income ($2,000). The amount that they will report as income on their tax

    return is $1,000. The $2,000 of 2007 income is reduced by the $1,000 of loss

    they could not deduct in 2006 due to the at-risk limitations.

32. Katrina is the sole owner of rental real estate that produces a net loss of $18,000

    in 2006 and $22,000 in 2007 and income of $9,000 in 2008. Her adjusted gross

    income, before considering the rental property for the years 2006 through 2008, is

    $115,000, $137,000, and $88,000, respectively.

a. What is Katrina's adjusted gross income for 2006, 2007, and 2008 if she qualifies

    as a real estate professional?

     As a real estate professional, the rental activity is not passive and Katrina

    can deduct the 2006 and 2007 losses. In 2008, when the rental property has

    net income of $9,000, the amount is added to her adjusted gross income.

     2006 2007 2008

     Adjusted gross income before rental $ 115,000 $ 137,000 $ 88,000

     Rental income (loss) (18,000) (22,000) 9,000

     Adjusted gross income $ 97,000 $ 115,000 $ 97,000

b. What is Katrina's adjusted gross income for 2006, 2007, and 2008 if she actively

    participates in the rental activity?

     An active participant is allowed to deduct up to $25,000 per year against

    active and portfolio income. However, the $25,000 rental real estate

    deduction is reduced when an individual's adjusted gross income exceeds

    $100,000. The amount of the reduction is $.50 for every $1 of adjusted

    gross income in excess of $100,000.

     In 2006, when Katrina’s adjusted gross income is $115,000, the $25,000

    maximum loss is reduced to $17,500 {$25,000 - [($115,000 - $100,0000) x

    $.50]}. The remaining $500 of loss ($18,000 - $17,500) is suspended and

    carried forward to 2007. The loss can be used either against passive

    income or next year's $25,000 limit. Her adjusted gross income for the year

    is $97,500 ($115,000 - $17,500).

     In 2007, the $25,000 maximum loss is reduced to $6,500 {$25,000 -

    [($137,000 - $100,0000) x $.50]}. The remaining $15,500 of loss ($22,000 -

    $6,500) is suspended and carried forward with the $500 loss suspended in

    2006. Katrina’s total suspended loss is $16,000 ($500 + $15,500). Her

    adjusted gross income for the year is $130,500 ($137,000 - $6,500).

     In 2008, Katrina’s adjusted gross income is less than $100,000, so she is

    eligible to deduct up to $25,000 of losses from her rental activities.

    Although Katrina has income for the current year from the rental real estate

     Chapter 7: Losses - Deductions and Limitations 7-17

    of $9,000, she can offset the income with the $16,000 of suspended losses.

    Her adjusted gross income for the year is $81,000 [$88,000 - $7,000 ($9,000

    - $16,000)].

     2006 2007 2008

     Adjusted gross income before rental $ 115,000 $ 137,000 $ 88,000

     Rental income (loss) (17,500) (6,500) ( 7,000)

     Adjusted gross income $ 97,500 $ 130,500 $ 81,000

35. Janet has a taxable income of $54,000 from her salary and investment assets.

    She also owns 3 passive activities that have the following income (loss) for the

    year:

    Passive Activity 1 $ 12,000

    Passive Activity 2 $ (18,000)

    Passive Activity 3 $ ( 9,000)

a. What is the effect of the passive activities on Janet's income? Explain.

     Janet has a net passive loss of $15,000:

    Passive Activity 1 $ 12,000

    Passive Activity 2 (18,000)

    Passive Activity 3 ( 9,000)

    Net passive loss $ (15,000)

     Individuals are not allowed to deduct passive losses against nonpassive

    income. Janet would include the $12,000 of income from PA1 in her gross

    income and is allowed to deduct $12,000 of the loss from PA2 and PA3

    against this income. The net passive loss of $15,000 is suspended and

    carried forward to subsequent years for netting against passive income.

    The net result is a taxable income of $54,000 (i.e., the income from her

    salary and investment assets).

b. How much suspended loss does Janet have in each passive activity?

     The $15,000 of suspended loss must be allocated between PA2 and PA3

    based on their relative contribution to the loss:

    PA2 - ($18,000 $27,000) x $15,000 = $10,000

    PA3 - ($ 9,000 $27,000) x $15,000 = $ 5,000

39. Jeremy owns a passive activity that has a basis of $30,000 and a suspended loss

    of $16,000. His taxable income from active and portfolio income is $81,000.

a. What is the effect on Jeremy's taxable income if he sells the passive activity for

    $37,000?

     Any suspended loss on a passive activity is deductible in full when the

    entire interest in the activity is disposed of through a sale of the activity. In

    this case, Jeremy has a capital gain of $7,000 ($37,000 - $30,000) on the

    sale of the activity and a deduction of $16,000 for the suspended loss on the

    activity. This results in a net deduction of $9,000. However, the $7,000

    capital gain is netted with any other capital gains and losses that Jeremy

    has during the year. Also, the tax rate on a net long-term capital gain is 15%

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    (5% if the taxpayer’s marginal tax rate is 10% or 15%), which further

    complicates the tax effect of Jeremy’s net deduction of $9,000.

    b. What is the effect on Jeremy's taxable income if he sells the passive activity for

    $25,000?

     In this case, Jeremy has a $5,000 capital loss ($25,000 - $30,000) on the

    sale of the passive activity and is allowed a deduction for the $16,000

    suspended loss. The capital loss must be netted with any other capital

    gains and losses that Jeremy had during the year and therefore, may not be

    deductible in full. For example, if Jeremy has no other capital gains and

    losses during the year, only $3,000 of the capital loss may be deducted in

    the year of sale.

43. Masaya owns a passive activity that has a basis of $32,000 and a suspended loss

    of $13,000. Masaya's taxable income from active and portfolio income is $73,000.

    a. What is the effect on Masaya's taxable income if he sells the passive activity for

    $46,000?

     Any suspended loss on a passive activity is deductible in full when an entire

    interest in an activity is disposed of through a sale of the activity. In this

    case, Masaya has a capital gain of $14,000 ($46,000 - $32,000) on the sale

    of the activity and a deduction of $13,000 for the suspended loss on the

    activity. This results in a net increase in income of $1,000. However, the

    $14,000 capital gain is netted with any other capital gains and losses that

    Masaya has during the year. Also, the tax rate on a net long-term capital

    gain is 15% (5% if the taxpayer’s marginal tax rate is 10% or 15%), which

    further complicates the tax effect of the net increase in Masaya’s income of

    $1,000.

    b. What is the effect on Masaya's taxable income if he sells the passive activity for

    $26,000?

     In this case, Masaya has a $6,000 capital loss on the sale of the passive

    activity and is allowed a deduction for the $13,000 suspended loss. The

    capital loss must be netted with any other capital gains and losses that

    Masaya had during the year and therefore, may not be deductible in full.

    For example, if Masaya has no other capital gains and losses during the

    year, only $3,000 of the capital loss may be deducted in the year of sale.

    c. What is the effect on Masaya's taxable income if he dies this year while the fair

    market value of the passive activity is $40,000?

     A deduction is allowed for a suspended loss on a passive activity held at

    death, but only to the extent of the excess of any suspended loss over the

    unrealized gain on the passive activity. In this case, the unrealized gain is

    $8,000 ($40,000 - $32,000) and the suspended loss is $13,000, resulting in

    an excess of $5,000. Therefore, Masaya is allowed a deduction of $5,000.

    d. What is the effect on Masaya's taxable income if he dies this year while the fair

    market value of the passive activity is $22,000?

     Chapter 7: Losses - Deductions and Limitations 7-19

     A deduction is allowed for a suspended loss on a passive activity held at

    death, but only to the extent of the excess of any suspended loss over the

    unrealized gain on the passive activity. In this case, there is no unrealized

    gain ($22,000 - $32,000 = $10,000 loss) and Masaya is not allowed a

    suspended loss deduction of $10,000.

e. What is the effect on Masaya's taxable income if he gives the passive activity to

    his daughter Hideko when the fair market value of the passive activity is $40,000?

    What would the effect of this be on Hideko's taxable income?

     A suspended loss deduction is not allowed for a gift of a passive activity.

    The donee has a basis in the activity equal to the sum of the donor's basis

    and the amount of the suspended loss. Hideko's basis in the activity is

    $45,000 ($32,000 + $13,000). Neither Masaya nor Hideko receive a

    deduction for the $13,000 suspended loss. This treatment prevents Hideko

    from using the suspended loss deduction against passive income.

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