LOSSES - DEDUCTIONS AND LIMITATIONS
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.
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
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
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
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.
7-14 Chapter 7: Losses - Deductions and Limitations
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
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
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