DOC

CHAPTER 7 LOSSES - DEDUCTIONS AND LIMITATIONS DISCUSSION QUESTIONS

By Harold Lopez,2014-10-18 04:19
33 views 0
CHAPTER 7 LOSSES - DEDUCTIONS AND LIMITATIONS DISCUSSION QUESTIONS

___________________________________________________________________

    CHAPTER 7

    LOSSES - DEDUCTIONS AND LIMITATIONS

___________________________________________________________________

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.

    7-11

     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.

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

    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