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# South-Western Federal Taxation 2016 Essentials of Taxation Individuals and Business Entities 19th by Raabe sm

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## South-Western Federal Taxation 2016 Essentials of Taxation Individuals and Business Entities 19th by Raabe sm

CHAPTER 6
LOSSES AND LOSS LIMITATIONS
SOLUTIONS TO PROBLEM MATERIALS

COMPUTATIONAL EXERCISES
1. (LO 1) Jane must include the \$10,000 in gross income of the current tax year, but only to the extent of the tax benefit in the previous year. Because Jane had capital gains of \$5,000 in the previous year, the \$50,000 bad debt could be used to the extent of \$8,000 (\$5,000 + \$3,000) last year. Hence, Jane would have to include \$8,000 of the \$10,000 received in gross income in the current year.
2. (LO 1) Bob has no bad debt deduction. Rather, he has a gain of \$12,000 [\$60,000 − \$48,000 (basis in the account receivable)].
3. (LO 2) It is possible to receive an ordinary loss deduction if the loss is sustained on small business stock (§ 1244 stock). Only individuals who acquired the stock from the corporation are eligible to receive ordinary loss treatment under § 1244. The ordinary loss treatment is limited to \$50,000 (\$100,000 for married individuals filing jointly) per year. Losses on § 1244 stock in excess of the statutory limits receive capital loss treatment.

Therefore, Calvin’s total loss of \$61,750 (\$68,750 − \$7,000) is treated as follows: \$50,000 is ordinary loss and the remaining \$11,750 (\$61,750 − \$50,000) is long-term capital loss.

4. (LO 3) Mary should include the recovery as gross income in her 2015 tax return, but only to the extent of the tax benefit in the prior year. Mary’s deduction in the prior year would have been \$3,900 computed as follows:
Amount of loss \$ 8,000
Less: \$100 floor (100)
10%  40,000 (4,000)
Deduction \$ 3,900
Therefore, Mary must include \$3,900 in gross income in 2015.
5. (LO 3) The amount of the loss is \$600,000, the lesser of the decline in FMV \$600,000 (\$800,000 − \$200,000) or basis of \$650,000.
6. (LO 6)
Beginning at-risk amount \$ 0
Investment in partnership 30,000
Plus: Share of current partnership taxable income 2,000
Less: Withdrawals from the partnership (10,000)
Ending at-risk amount \$22,000

7. (LO 6)
Amount realized \$330,000
Total gain \$ 25,000
Less: Suspended losses (28,000)
Deductible loss (not passive) (\$ 3,000)

The \$3,000 loss may be deducted against ordinary and portfolio income.

8. (LO 8)
a. Beginning adjusted basis and at-risk amount \$ 7,500
Less: Current loss allowable (7,500)
Ending adjusted basis and at-risk amount \$ 0

b. The current passive loss is \$12,000. Because \$7,500 of the loss is used to reduce the at-risk amount to \$0, \$4,500 is suspended under the at-risk rules (\$12,000 − \$7,500 = \$4,500).

c. The \$7,500 loss that is not limited by the at-risk rules is subject to the passive loss rules. Because the taxpayer has not generated any passive income during the year, this \$7,500 current-year passive loss is suspended. Therefore, the total suspended passive loss carried forward to subsequent years totals \$9,000 (\$7,500 current-year suspended loss + \$1,500 prior year suspended loss).

9. (LO 9)
Passive income \$ 20,000
Real estate rental activity income \$ 33,000
Less: Real estate rental activity losses (70,000)
Net loss from real estate rental activities (37,000)
Deductible loss (\$ 17,000)

Because the losses arise from real estate rental activities in which Noah actively participates, up to \$25,000 of such losses may be deducted. In this case, the total amount of net real estate rental losses is deducted, and no further restrictions apply because his AGI is below \$100,000. The \$17,000 deductible loss may offset active and portfolio income.

10. (LO 10) When a transfer of a taxpayer’s interest occurs because of the taxpayer’s death, suspended passive losses are allowed to the decedent to the extent they exceed the amount of the allowed step-up in basis. At the time of Rose’s death, the property’s basis will be stepped up by \$25,000—from \$65,000 to its fair market value of \$90,000. Because the suspended passive loss is \$13,000 (i.e., below the \$25,000 step up in basis), none of the suspended loss is deductible. In addition, the beneficiary would not be allowed to deduct the \$13,000 suspended loss.

PROBLEMS
11. (LO 1) Raabe, Maloney, Young, Smith, & Nellen, CPAs
5191 Natorp Boulevard
Mason, OH 45040
January 29, 2016
Loon Finance Company
100 Tyler Lane
Erie, PA 16563
Dear Sir:
This letter is to inform you of the possibility of taking a bad debt deduction.
Your loan to Sara is a business bad debt; therefore, you are allowed to take a bad debt deduction for partial worthlessness. You will be able to take a bad debt deduction in the current year of \$25,000 [(\$30,000 − \$1,000) − \$4,000].
Sincerely,
John J. Jones, CPA
Partner

TAX FILE MEMORANDUM
Date: January 29, 2016
From: John J. Jones
Loon Finance Company’s \$30,000 loan to Sara is a business bad debt. Therefore, a bad debt deduction is allowed for partial worthlessness. Loon will be able to claim a bad debt deduction in the current year of \$25,000 [(\$30,000 − \$1,000) − \$4,000].

12. (LO 1) Monty must include up to \$10,000 in gross income, but only to the extent of a tax benefit in a prior year. Because the debt is a nonbusiness bad debt, the \$11,000 would have been reported as a short-term capital loss. Last year, Monty had capital gains of \$4,000 and taxable income of \$20,000. Therefore, \$7,000 of the \$11,000 loss produced a tax benefit. Hence, only \$7,000 would be included in Monty’s gross income this year.
13. (LO 2) Jack should be concerned with the following issues:
• Should this be treated as a worthless security?
• Should this be treated as a theft loss?
o Does the theft loss create an NOL?
o Can the NOL be carried back three years?
14. (LO 1) Worthless debts arising from unpaid wages are not deductible as a bad debt unless the taxpayer has included the amount in income for the year for which the bad debt is deducted or for a prior tax year. Jake used the cash method of reporting income. Therefore, fees for services by Jake that allegedly were owed by the City have never been included in income, and unpaid amounts, even if earned, do not constitute bad debts within the meaning of §166 for which a deduction for worthlessness may be claimed.
15. (LO 1, 2)
Salary \$120,000
§ 1244 ordinary loss (limit of \$100,000) (100,000)
Short-term capital gain on § 1244 stock \$ 20,000
Net short-term capital gain 1,000
Net long-term capital loss (remaining § 1244 loss) (5,000)
Net capital loss (limited to \$3,000; \$1,000 LTCL carryover) (3,000)

16. (LO 2) Sell all of the stock in the current year:

Current year’s AGI
Salary \$ 80,000
Ordinary loss (§ 1244 limit) (50,000)
Long-term capital gain \$ 8,000
Long-term capital loss (\$80,000 − \$50,000) (30,000)
Long-term capital loss (limited to \$3,000; \$19,000 LTCL carryover) (3,000)
AGI \$ 27,000

Next year’s AGI
Salary \$ 90,000
Long-term capital gain \$ 10,000
Long-term capital loss carryover (\$30,000 − \$11,000) (19,000)
Long-term capital loss (limited to \$3,000; \$6,000 LTCL carryover) (3,000)
AGI \$ 87,000

Total AGI
Current year \$ 27,000
Next year 87,000
Total \$114,000

Sell half of the stock this year and half next year:

Current year’s AGI
Salary \$ 80,000
Ordinary loss (§ 1244 stock) (40,000)
Long-term capital gain 8,000
AGI \$ 48,000
Next year’s AGI
Salary \$ 90,000
Ordinary loss (§ 1244 stock) (40,000)
Long-term capital gain 10,000
AGI \$ 60,000
Total AGI
Current year \$ 48,000
Next year 60,000
Total \$108,000
Mary’s combined AGI for the two years is lower if she sells half of her § 1244 stock this year and half next year.
17. (LO 3) The amount of the loss before the 10%-of-AGI limitation is computed as follows:
Home (\$350,000 − \$280,000) \$70,000
Auto (\$30,000 − \$20,000) 10,000
Total loss \$80,000
Less: \$100 (100)
Loss before 10% of AGI \$79,900
Because the President declared the area a disaster area, Olaf and Anna could claim the loss on last year’s return (2014) or on the current year’s return (2015).
Amount of loss on last year’s return:
Loss \$ 79,900
Less: 10% of AGI (10%  \$180,000) (18,000)
Total loss \$ 61,900
Amount of loss on current year’s return:
Loss \$ 79,900
Less: 10% of AGI (10%  \$300,000) (30,000)
Total loss \$ 49,900
If Olaf and Anna apply the loss to 2014, the benefit of the loss will be at a rate of 25% because taxable income will be \$78,100 (\$140,000 − \$61,900) and the loss falls entirely within the 25% tax bracket. If the loss is applied to 2015, the benefit will be at a rate of 28% because taxable income will be \$165,100 (\$215,000 − \$49,900) and the loss falls entirely within the 28% tax bracket. The tax savings will be \$15,475 (25%  \$61,900) if the loss is taken in 2014 and \$13,972 (28%  \$49,900) if the loss is taken in 2015. Therefore, Olaf and Anna should include the loss on their 2014 return, because the tax savings is \$1,503 (\$15,475 − \$13,972) greater.

18. (LO 3) The tax issues for John are as follows:
• Is the loss a theft loss or an investment loss?
• Is the loss subject to either the personal loss limits (\$100 floor and 10%-of-AGI floor) or the limits on itemized deductions (2%-of-AGI floor)?
• How is the amount of the loss determined?
• What year can the loss be taken?
19. (LO 4)
Interest income 3,000
Less: Itemized deductions (24,000)
Personal and dependency exemptions (3 × \$4,000) (12,000)
Taxable income (\$ 47,000)

b. Taxable income (\$ 47,000)
Add: Personal and dependency exemptions 12,000
over nonbusiness income (\$3,000 + \$22,000) –0–
NOL (\$ 35,000)

In calculating the NOL, the alimony received of \$22,000 is not treated as business income.

20. (LO 6) The at-risk rules limit Fred’s deductions. He can deduct \$35,000 in 2014, thereby reducing his at-risk amount to \$15,000 (\$50,000 original investment − \$35,000 deducted). He will be limited to a \$15,000 deduction in 2015 unless he increases his amount at risk. Fred’s share of the partnership losses is not subject to the passive loss restrictions because his interest is not a passive activity.

21. (LO 6) Raabe, Maloney, Young, Smith, & Nellen, CPAs
5191 Natorp Boulevard
Mason, OH 45040
November 4, 2015
Mr. Bill Parker
54 Oak Drive
St. Paul, MN 55164
Dear Mr. Parker:
This letter is in response to your inquiry regarding the tax treatment of losses that you could expect this year and next year from an investment in Best Choice Partnership. As I understand the facts, you would invest \$60,000 in the partnership with the expectation that your share of the partnership losses in the current and succeeding years would be \$40,000 and \$25,000, respectively.
Even though your investment would not be subject to the passive activity limitations, the amount of the deduction that you may claim in any one year is subject to the at-risk rules. Essentially, these rules provide that your deductions are limited to the amount that you have invested in the venture or the amount that you could lose if the investment were to be unsuccessful. Consequently, in your case, the initial amount that you would have at risk would be \$60,000. Therefore, you would be able to deduct \$40,000 in the current year, which would cause your at-risk basis to be reduced to \$20,000 (\$60,000 − \$40,000). Because your at-risk basis at the end of next year would be only \$20,000, your share of the partnership loss that would be deductible would be limited to \$20,000. The amount not deducted under this scenario would be deductible later when your at-risk basis increases, for example, by additional investments you may make in the partnership or because of income generated by the partnership.
If you have additional questions or need further clarification, please call me.
Sincerely,
John J. Jones, CPA
22. (LO 6) In 2014, Kay cannot deduct any of the passive loss because of the impact of the passive loss rules (she has no passive income). The \$35,000 loss is suspended and carried forward to 2015, where \$15,000 is deducted. After \$15,000 is deducted, the remaining \$20,000 of the 2014 passive loss remains suspended.
23. (LO 6)
If Activity A is sold in the current year, the following results:
Gain from Activity A \$115,000
Less: Suspended losses from Activity B
(\$35,000 + \$35,000 + \$8,000) (78,000)
Taxable gain \$ 37,000
Federal income tax (at 28%) \$ 10,360
In addition, the \$30,000 loss (and the corresponding tax benefit of \$8,400) from Activity B expected to be incurred next year would be suspended until passive income is generated. The prospects of gaining the use of the tax benefit at this time are nil.
If Activity A is sold next year, the following results:
Gain from Activity A \$108,000
Less: Suspended losses from Activity B
(\$35,000 + \$35,000 + \$8,000 + \$30,000) (108,000)
Taxable gain \$ –0–
Tax (at 28%) \$ –0–

Therefore, by deferring the sale until next year, Jorge is able to avoid the current payment of a \$10,360 Federal tax liability. In addition, the expected gain from the sale can be offset by all of the suspended passive loss from Activity B (including the expected \$30,000 loss from next year). By deferring the sale, Jorge’s short-term cash flow increases by \$3,360.

Reduced sales price (\$ 7,000)
Reduced Federal income tax 10,360
Increase in cash flow \$ 3,360
24. (LO 6) Last year, Sarah could deduct nothing against nonpassive income and was required to allocate the \$20,000 net loss among the three loss activities.
Income (loss):
Activity A \$30,000
Activity B (30,000)
Activity C (15,000)
Activity D (5,000)
Net passive loss (\$20,000)

Net passive loss allocated to:
Activity B (30/50 × \$20,000) (\$12,000)
Activity C (15/50 × \$20,000) (6,000)
Activity D (5/50 × \$20,000) (2,000)
Total suspended losses (\$20,000)

In the current year, Sarah has a net gain of \$10,000 from the sale of Activity D. She can offset the \$2,000 suspended loss from the activity and the current year’s loss of \$1,500 from the activity against the \$10,000 gain. In addition, the remaining net gain of \$6,500 (\$10,000 − \$2,000 − \$1,500) from the sale may be used to absorb passive losses from the other activities.
25. (LO 6)
a. Net sales price \$ 100,000
Total gain \$ 65,000
Less: Suspended losses (40,000)
Taxable gain (passive) \$ 25,000

b. Net sales price \$ 100,000
Total gain \$ 25,000
Less: Suspended losses (40,000)
Deductible loss (\$ 15,000)

c. Net sales price \$ 100,000
Total gain \$ 25,000
Less: Suspended losses (40,000)
Deductible loss (\$ 15,000)

The suspended passive losses are fully deductible. The suspended credits are lost forever because the sale of the activity did not generate any tax.
26. (LO 6)
a. A personal service corporation is not allowed to offset passive losses against active or portfolio income. Therefore, White’s taxable income is \$436,000 (\$400,000 income from operations + \$36,000 portfolio income).
b. A closely held, nonpersonal service corporation is allowed to offset passive losses against active income, but not against portfolio income. Therefore, White’s taxable income is \$396,000 (\$400,000 income from operations − \$40,000 passive loss + \$36,000 portfolio income).

27. (LO 7) John is entitled to treat the loss as active if his participation constitutes substantially all
of the participation in the activity of individuals (including nonowner employees) for the year. If
John is the only individual who participates in the activity, he would be entitled to an active loss deduction.
28. (LO 7)
• The amount of Rene’s at-risk basis in the hardware business and whether the losses flowing from the entity are limited by the at-risk rules.
• Whether the profits and losses from the public accounting firm are classified as passive or active.
• Whether Rene is a material participant in the hardware business.
• Whether Rene is subject to the passive loss rules.

29. (LO 6, 8) Raabe, Maloney, Young, Smith, & Nellen, CPAs
5191 Natorp Boulevard
Mason, OH 45040
January 23, 2016
Ms. Kristin Graf
Jamison, PA 18929
Dear Kristin:
This letter is in response to your request for assistance in analyzing the tax consequences from two investment alternatives. One alternative is to make an additional investment of \$10,000 in Rocky Road Excursions. Here you have an at-risk basis of \$0, suspended losses under the at-risk rules of \$7,000, and suspended passive losses of \$1,000. If this investment is made, your share of the projected profits for this year would increase from \$1,000 to \$8,000. The other choice is to invest \$10,000 as a limited partner in the Ragged Mountain Winery. This would produce passive income of \$9,000 this year. The following analysis is based on these facts.
Invest \$10,000 in Rocky Road Excursions:
Expected profit from investment \$8,000
Beginning at-risk basis \$ –0–
Increase to at-risk basis due to profit 8,000
Increase to at-risk basis due to investment 10,000
\$18,000
Use of loss suspended by at-risk rules (7,000)
Ending at-risk basis \$11,000
Beginning suspended passive loss (\$ 1,000)
Reclassified suspended passive loss (7,000)
Use of suspended passive losses—revised (8,000)
Current taxable income \$ –0–
Current tax liability \$ –0–
Invest \$10,000 in Ragged Mountain Winery:
Expected profit from investment—Ragged Mountain Winery \$9,000
Expected profit from investment—Rocky Road Excursions 1,000
Use of suspended passive losses from Rocky Road Excursions
(\$1,000 reclassified suspended loss under the at-risk rules +
\$1,000 suspended passive loss) (2,000)
Current taxable income \$8,000
Current tax liability (\$8,000  28%) \$2,240
As you can see, the tax effects of the two options vary significantly due to the interplay of the at-risk and the passive activity loss rules. This analysis should help you make a more informed investment decision. If you need any further explanation, please contact me.
Sincerely,
Libba Eanes, CPA
Partner
30. (LO 8)
a. Maxine’s accountant was referring to the impact of the at-risk and passive activity loss rules on the deductibility of the loss from the Teal investment. The at-risk rules are designed to prevent taxpayers from deducting losses in excess of the actual economic investment in the activity. The passive loss rules prevent taxpayers from deducting passive losses in excess of passive income. In Maxine’s current situation, she apparently has no other investments that produce passive income (i.e., she previously sold such an interest).
b. Maxine’s current at-risk amount is \$1,000, and she has no other investment activity that produces passive income. Therefore, Maxine’s current-year deduction is limited by both the at-risk and passive loss rules. The \$13,000 loss reduces the at-risk basis to \$0, and the \$12,000 balance of the loss is suspended. However, the \$1,000 loss not limited by the at-risk rules is suspended under the passive loss rules because Maxine does not have any passive income. Therefore, none of the \$13,000 loss can be deducted.
c. The financial adviser’s suggestion is faulty. By making an additional \$12,000 investment in Teal, the at-risk basis is increased to \$13,000 (\$1,000 + \$12,000). This avoids any suspension of the loss under the at-risk rules (giving her an ending at-risk basis of \$0). However, because Maxine has no passive income, the entire \$13,000 loss is suspended under the passive loss rules. Thus, none of the \$13,000 loss can be deducted in the current year.
d. Maxine has two basic choices. One choice involves two steps, the first being to make the additional \$12,000 investment in Teal as suggested by her financial adviser. In addition, she should purchase an interest in a new investment that is expected to produce passive income of at least \$13,000 annually. Under this alternative, the additional investment in Teal ensures that the at-risk rules will not limit the deduction, while the investment in a new passive activity will generate passive income against which the \$13,000 loss may be offset. Maxine’s second option is to consider selling her interest in Teal. The sale of the interest will not be restricted by the at-risk rules, and the final economic gain or loss from her investment will be recognized for tax purposes. If the entire interest is sold, the passive loss rules will not restrict the deductibility of the final year’s loss or any suspended losses present.
31. (LO 8) Lee’s share of BlueSky’s loss in 2015 is \$80,000 (\$400,000 × 20%), and the entire loss is suspended under the passive loss rules because he has no passive income. His share of the passive income in 2016 is \$40,000 (\$200,000 × 20%). His at-risk amount is \$80,000 (\$120,000 − \$80,000 passive loss in 2015 + \$40,000 share of income in 2016). In 2016, he may deduct \$40,000 of his \$80,000 suspended loss against the passive income. This leaves a \$40,000 suspended loss at the end of 2016.
32. (LO 6) Grace is allowed a \$40,000 deduction. Because her at-risk basis is only \$40,000, of the \$50,000 loss, \$10,000 is suspended. The available \$40,000 loss is not subject to the passive activity loss rules because she was a material participant. As the loss is treated as an active loss, Grace’s income for tax purposes is \$100,000 (\$140,000 − \$40,000).
33. (LO 5, 6, 8)
a. If Jonathan is not a material participant, \$45,000 of his \$60,000 loss (\$300,000 loss
× 20% interest) is reclassified as a passive loss and disallowed under the passive loss limits. The remaining \$15,000 is disallowed by the at-risk limits. Therefore, Jonathan’s AGI is \$218,000 (\$200,000 salary + 18,000 portfolio income).
b. If Jonathan is a material participant, \$45,000 of his \$60,000 loss is deductible as an active loss. The remaining \$15,000 is disallowed by the at-risk limits. Therefore, Jonathan’s AGI is \$173,000 (\$200,000 salary + \$18,000 portfolio income − \$45,000 active loss).
34. (LO 5, 6, 8) If losses were limited only by the at-risk rules, Gerald would be able to deduct the following amounts in 2014 and 2015.
Year Loss Allowed* Disallowed
2014 \$40,000 \$30,000 \$10,000
2015 30,000 –0– 30,000
* Allowed under the at-risk rules, reclassified as a passive loss subject to the passive loss limitations.
However, the losses also are limited by the passive loss rules as follows:
Year Passive Deductible Suspended

2014 \$30,000 \$–0– \$30,000
2015 –0– –0– –0–
In 2016, the \$50,000 income increases Gerald’s at-risk amount to \$50,000, enabling him to deduct the \$40,000 of disallowed losses. The \$50,000 is passive income that can be offset by \$50,000 of suspended losses, leaving a suspended loss of \$20,000. At the end of 2016, Gerald has no unused losses under the at-risk rules, \$20,000 of suspended passive losses, and a \$10,000 adjusted basis in the activity [\$30,000 (adjusted basis on 1/1/2014) − \$40,000 (loss in 2014) − \$30,000 (loss in 2015) + \$50,000 (income in 2016)].

35. (LO 5, 6, 7) Raabe, Maloney, Young, Smith, & Nellen, CPAs
5191 Natorp Boulevard
Mason, OH 45040
December 15, 2015
Scott Myers
603 Pittsfield Dr.
Champaign, IL 61821
Dear Scott,
Based on our discussion, I understand that you are attempting to qualify under the special rules for real estate professionals as a material participant in order to deduct against your nonpassive income any losses generated by this rental activity. Consequently, you should document a sufficient number of hours so that you will meet the material participation standard.
Your activities to date appear to be within the bounds of the tax law as it is written, but you also appear to be stretching its limits. You need to be careful to avoid any appearance of or taking any actual fraudulent actions on your or your wife’s part. Essentially, the issue is whether the participation hours generated are of substance or merely of form. Another issue is whether one of the principal purposes of the tasks being performed is to avoid the disallowance of passive losses or credits.