Pope Phft2012 Ind Sm 08

7/29/2019 Pope Phft2012 Ind Sm 08

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© 2012 Pearson Education, Inc. publishing as Prentice Hall

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Chapter I:8

Losses and Bad Debts

Discussion Questions

I:8-1 The closed transaction doctrine states that a realized loss must be evidenced by a completedtransaction or identifiable event. This doctrine exists to prevent taxpayers from recognizing a loss asa result of fluctuating prices prior to the disposition of the property. This is, of course, different fromthe economic concept for realized loss. p. I:8-2.

I:8-2 The amount of the deductible loss when property is disposed depends on (1) the type of property, (2) the manner in which the property is used, (3) the basis in the property, (4) the amountrealized upon disposition, and (5) the way the property is disposed. pp. I:8-2 and I:8-3.

I:8-3 In order to deduct a loss on worthless securities, the taxpayer must first establish when thesecurity actually became worthless. The deduction is only available in the year the security becomesworthless. Once this is determined, Sec. 165(g) provides that the loss incurred is treated as a lossfrom the sale of a capital asset on the last day of the taxable year. Because of the limitations imposedon the deductibility of capital losses, this may severely restrict the current tax benefit to the taxpayer.Under certain circumstances, if a domestic corporation holds worthless securities in an affiliatedcorporation, the loss to the domestic corporation is treated as having arisen from a sale of anoncapital asset. This makes the loss an ordinary loss. In order for this exception to apply, tworequirements must be met: (1) the domestic corporation must own at least 80% of the voting power of all classes of the affiliated corporation's stock, and (2) more than 90% of the affiliatedcorporation's gross receipts for all its taxable years must be from nonpassive income. pp. I:8-3 and

I:8-4.

I:8-4 If the worthless securities consist of securities of an affiliated corporation held by a domesticcorporation, the loss is treated as an ordinary loss rather than a capital loss. For this exception toapply the domestic corporation must own at least 80% of the voting power of all classes of theaffiliated corporation's stock and 80% of the total value of the stock. Additionally, more than 90% of the affiliated corporation's gross receipts for all its taxable years must be from nonpassive income.(i.e., sources other than dividends, interest royalties, rents, annuities, and gains from the sale or exchange of stock and securities.) pp. I:8-3 and I:8-4.

I:8-5 To have a capital loss, (1) there must be a sale or exchange and (2) the transaction must

involve a capital asset. For example, the loss from the destruction of a capital asset is an ordinaryloss and not a capital loss because there has not been a sale or exchange. Furthermore, a loss on thesale of inventory is ordinary because inventory is not a capital asset. pp. I:8-4 and I:8-5.

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I:8-6 In order for stock to be considered Sec. 1244 stock, the following requirements must be met:

1. The stock must be owned by an individual or a partnership.2. The stock must have been originally issued to the individual or to a

partnership in which the individual is a partner.

3. The stock must be stock in a domestic corporation.4. The stock must have been issued for cash or property other than stock or securities.5. The corporation may not have derived over 50% of its gross receipts from passiveincome sources (i.e., sources other than royalties, rents, dividends, interest, annuities, andsales or exchanges of stock and securities) during the immediately preceding five taxableyears.6. At the time the stock is issued, the amount of money and property contributed to bothcapital and paid-in surplus may not exceed $1 million. p. I:8-5.

I:8-7 Losses on the sale or worthlessness of Sec. 1244 stock are deductible as ordinary losses up toa maximum of $50,000 per taxable year ($100,000 for married taxpayers filing a joint return). Any

excess loss for the year is a capital loss. Gains on the sale of Sec. 1244 stock are capital gains. p.I:8-5.

I:8-8 A loss on the sale of investment property between an individual and a controlled partnershipor corporation (the individual owns more than 50% of the partnership or corporation) is disallowed.The individual and the controlled entity are deemed to be related parties, and therefore, the loss isdisallowed. If the loss were not disallowed, the individual would be able to create a tax loss and stillretain economic control of the property. The same reasoning applies to the wash sale provisionswhere losses on the sale of stock or securities are disallowed if substantially identical stock or securities are purchased within 30 days before or 30 days after the sale. A loss realized on propertytransferred to a controlled corporation in exchange for stock or securities of the corporation is

deferred. Furthermore, losses realized on exchanges of like-kind property are also deferred. p. I:8-6.

I:8-9 a. A passive activity is any trade or business in which the taxpayer does not materially participate. A passive activity also includes any rental activity that is not a trade or business.

b. Individuals, estates, trusts, closely held C corporations, personal service corporations,and certain publicly traded partnerships, are subject to the passive loss limitation rules. The purposeof the passive loss rules is to prevent certain taxpayers from offsetting their portfolio and activeincome with losses generated in passive activities. pp. I:8-10 through I:8-12.

I:8-10 a. A closely held C corporation is a C corporation where more than 50% of the stock isowned by five or fewer individuals at any time during the last half of the corporation's taxable year.

b. A closely held C corporation may offset its passive losses against its active businessincome but not its portfolio income. Individuals and personal service corporations may not offseteither their active or portfolio income with passive losses. pp. I:8-12 through I:8-14.

I:8-11 A taxpayer's material participation in an activity is determined separately for each activity.Furthermore, suspended losses are deductible only upon the complete disposition of the passiveactivity. Also, the rental losses allowed under the special real estate exceptions must not be mixed in

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with losses from other types of passive activities. For these reasons, it is critical to identify exactlywhat constitutes an activity. pp. I:8-10 and I:8-11.

I:8-12 a. Under the Regulations, different business operations may constitute one or moreactivities, depending upon all the pertinent facts and circumstances. The facts that are given more

weight in this determination include:

• Similarities and differences in the types of business• The extent of common control• The extent of common ownership• The geographical location, and• Any interdependencies between the operations (i.e., the extent to which they purchase or

sell goods between themselves, have the same customers, are accounted for with a singleset of books, etc.).

Generally, taxpayers have a good deal of flexibility in identifying how operations are to be

combined into activities based on these facts. However, once this determination is made, taxpayersmust be consistent from year to year.

b. In general, a business operation and a rental operation cannot be combined into the sameactivity for purposes of the passive activity loss rules. However, if the business operation and the

rental operation are situated at the same location and the business operation is insubstantial incomparison to the rental operation, or vice versa, the two may be combined into one activity. TheRegulations do not define what constitutes insubstantial. p. I:8-10.

I:8-13 a. No. The rental unit qualifies as a real property trade or business with respect to Laura.This is the case because she meets the following requirements:

1. The rental unit is Laura's only business and she spends over 750 hours during the year

managing and caring for the rental unit.2. Because Laura is the sole manager of the unit, she meets the material participation

requirement.3. More than 50% of Laura's personal services for the year is spent in this real estate

business. b. Yes. The lab is a passive activity with respect to Kami. A business activity is passive

with respect to a taxpayer if the taxpayer does not materially participate in the activity.In order to materially participate, the taxpayer must meet one of several tests:

1. The individual participates in the activity for more than 500 hours during the year.2. The individual's participation in the activity for the year constitutes substantially all of

the participation in the activity by all individuals, including individuals who do not

own any interest in the activity.3. The individual participates in the activity for more than 100 hours during the year,

and that participation is more than any other individual's participation for the year.4. Under the facts and circumstances, the individual participates in the activity on a

regular, continuous, and substantial basis during the year.

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The only test Kami possibly could meet is the fourth one. However, her participation is probably not continuous and substantial. Since Kami does not meet any of these tests, she does notmaterially participate, and the activity is passive.

c. There is a possibility that under the Regulations, the three operations (the lab, themedical supply company, and the medical services partnership) could be combined into one activity.

If this is the case, Kami will have materially participated (over 500 hours) in the activity and theactivity would not be passive with respect to her. If the three operations are treated as separateactivities, she probably does not materially participate in any of them, based upon the tests mentionedin part b above. However, since she has participated over 100 hours in each of them, they areconsidered "significant participation" activities. Taxpayers can aggregate participation in thesesignificant participation activities for purposes of determining material participation. Thisaggregation causes her participation to exceed the 500 hour test. Thus, none of the activities is passive with respect to Kami. pp. I:8-11 through I:8-14.

I:8-14 A taxpayer materially participates in an activity if he or she meets one of the following tests.

1. The individual participates in the activity for more than 500 hours during the year.2. The individual's participation in the activity for the year constitutes substantially all of the participation in the activity by all individuals, including individuals who do not own anyinterest in the activity.

3. The individual participates in the activity for more than 100 hours during the year, andthat participation is not less than any other individual's participation for the year (including participation by individuals who do not own any interest in the activity).4. The individual participates in "significant participation activities" for an aggregate of more than 500 hours during the year. A significant participation activity is one in which thetaxpayer participates for more than 100 hours during the year but which does not meet thematerial participation test alone. An individual who spends over 100 hours each in several

separate significant participation activities may aggregate the time spent in these activities inorder to meet the 500 hour test.5. The individual has materially participated in the activity in any five years during theimmediately preceding ten taxable years. These five years need not be consecutive.6. The individual materially participated in the activity for any three years preceding theyear in question, and the activity is a personal service activity.7. Taking into account all the relevant facts and circumstances, the individual participates in the activity on a regular, continuous, and substantial basis during the year.

Active participation, on the other hand, is a less strict test. The taxpayer need not be involvedon a regular or continuous basis. However, he or she still must be involved in management decisions

or in the arranging for others to provide services. The active participation test is used in the case of rental real estate activities. pp. I:8-11 and I:8-14.

I:8-15 a. Individual taxpayers who have actively participated in the rental of real estate maydeduct losses from that passive activity of up to $25,000 against their active and portfolio income.However, this deduction is reduced by 50% of the taxpayer's AGI in excess of $100,000. Thus, therequirements are (1) the taxpayer must be an individual, (2) the taxpayer must have actively

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participated in the management of the rental activity, (3) the activity generating the loss must be areal estate rental activity, and (4) the taxpayer must not have AGI in excess of $150,000 (the loss is phased out at a 50% rate for AGI between $100,000 and $150,000).

b. To be exempted from the passive activity loss rules, an individual's rental activitymust qualify as a real property trade or business. For individuals, more than one-half of the personal

services performed in trades or businesses by the taxpayer during the year must be performed in real property trades or businesses in which the taxpayer materially participates. Additionally, thetaxpayer must perform more than 750 hours of service during the taxable year in real property tradesor businesses in which the taxpayer materially participates. pp. I:8-14 through I:8-16.

I:8-16 Losses suspended under the passive loss rules are not lost forever. The suspended losses arecarried over indefinitely and are treated as losses allowable to the activity in the following taxableyears. Any suspended losses that still exist when the property or activity is disposed of may bededucted in the year of disposal. pp. I:8-7 and I:8-8.

I:8-17 A deductible casualty loss is a loss that (1) occurs in an identifiable event and (2) is sudden,

unexpected, or unusual. For a loss to be a deductible casualty loss, the taxpayer must be able todetermine or identify the event that caused or resulted in the loss. For example, a taxpayer will havea deductible casualty loss if she can show that a storm caused damage to her property. A suddenevent is one that is swift, not gradual or progressive. An unexpected event is one that is ordinarilyunanticipated and which the taxpayer did not intend. An unusual event is one that is not a day-to-dayoccurrence and that is not typical of the activity in which the taxpayer is engaged. For example,damage to property as a result of years of stormy weather will not qualify as a casualty loss. pp. I:8-17 through I:8-19.

I:8-18 A casualty gain is realized when the insurance proceeds received exceed the property's

adjusted basis. For personal-use property, all the casualty gains and losses realized during the year are netted together. If the losses exceed the gains, the excess is reduced by 10% of the taxpayer'sAGI and the remainder is deductible as a from AGI deduction. However, if the casualty gains exceedthe casualty losses for the year, the gain is treated as a long-term capital gain. p. I:8-20.

I:8-19 Under Sec. 165(h)(4)(E), no casualty loss deduction may be taken on personal-use property tothe extent it is covered by insurance but a timely insurance claim is not filed. Since Rulon’sinsurance will only cover half the damage, he may argue that the uncovered portion is eligible for acasualty loss deduction. However, $4,400 (half of the $9,000 damage minus $100 floor reduction)will not exceed the 10% of AGI limitation (10% x $50,000 = $5,000). Thus, Rulon probably won’t be able to deduct any of the casualty loss. p. I:8-20.

I:8-20 The casualty loss deduction on personal-use property is limited to the lesser of (1) thetaxpayer’s basis in the property or (2) the reduction in fair market value. This is the case whether the property is totally or partially destroyed.

The casualty loss deduction on partially destroyed business or investment property is limitedto the lesser of (1) basis or (2) reduction in FMV. The amount of the casualty loss deduction for thetotal destruction of business or investment property is equal to the basis of the property. Casualty

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losses on personal-use property are reduced by $100 per casualty and then are further reduced by10% of AGI. Casualty losses on business property are not subject to these limits and floors.Casualty losses on business property and investment property that produce rents or royalties are for AGI deductions. Casualty losses on other types of investment property are not subject to the 2% of AGI reduction. Furthermore, casualty losses on other types of investment property are not subject to

the overall limit on itemized deductions that will apply to years after 2010. pp. I:8-18 through I:8-20.

I:8-21 Theft losses are deducted in the tax year in which the theft is discovered, not when the theftactually occurs. Thus, if the theft is discovered in a year subsequent to the year of the theft, thededuction is taken in the later year. Also, if the insurance reimbursement is less than anticipated, theunrecovered portion can be deducted in the subsequent year. Another situation in which the casualtyloss can be deducted other than in the year in which the loss occurred, is if the taxpayer sustains aloss in a location that the President of the United States declares a disaster area. In this case, anelection can be made to deduct the loss in the year just prior to the year in which the loss occurred. pp. I:8-22 and I:8-23.

I:8-22 Casualty losses are first reported on Form 4684 (Casualties and Thefts). Casualty losses on personal-use property then flow to Schedule A where they are reported as itemized deductions.Casualty losses on business property flow from Schedule 4684 to Form 4797 and then to line 14 onForm 1040. p. I:8-21.

I:8-23 The reduction on personal-use casualty losses is $100 per casualty. The $100 reduction isnot imposed upon each individual item if more than one item is destroyed in a single casualty. The$100 floor decreases the amount of the casualty loss before the loss is netted against the casualtygains. pp. I:8-20 and I:8-21.

I:8-24 Sarah must treat the loan as a nonbusiness bad debt (assuming the loan is bona fide and is not

a gift) even though John used the money in a business. Thus, the $15,000 bad debt is treated as ashort-term capital loss. If Sarah has no capital gains for the year, she may take a capital lossdeduction of $3,000, carrying the remainder over to subsequent years. On the other hand, if Sarahwere in the business of lending money, then she could treat the loan as a business bad debt anddeduct the entire loss as an ordinary loss in the current year. p. I:8-25.

I:8-25 Dana may not take any deduction with respect to this bad debt. Although it is a bad debt thathad been incurred in her business, she has no basis in the debt because she is a cash basis taxpayer and did not report the receivable in income. pp. I:8-25 and I:8-26.

I:8-26 A third party guarantor of a loan who is required to repay the debt is entitled to a bad debt

deduction under certain circumstances. To obtain the bad debt deduction, the guarantee must not beconsidered a gift. pp. I:8-24 and I:8-25.

I:8-27 A nonbusiness bad debt is defined as any debt other than: (a) a debt created or acquired inconnection with a trade or business of the taxpayer or (b) a debt the loss from the worthlessness of which is incurred in the taxpayer's trade or business. Nonbusiness bad debts are deductible asshort-term capital losses. pp. I:8-26 and I:8-27.

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I:8-28 a. In deducting a loss on a deposit in a qualified financial institution a taxpayer may electto treat the loss as a personal casualty loss in the year in which the loss can be reasonably estimated.The taxpayer may also elect to treat the loss as incurred in a transaction entered into for profit (butnot a trade or business). The amount treated as such under this election is limited to $20,000 per institution per year and is subject to the 2% AGI reduction. If no election is made, the loss is a

nonbusiness bad debt in the year of worthlessness or partial recovery, whichever comes last. b. If a taxpayer would benefit more in the current year from a loss deduction, the election

to treat the loss as a personal casualty loss may be desirable. This is true in the case of partialworthlessness since no deduction is available for partially worthless nonbusiness debts. Also, sincethe election effectively converts a short-term capital loss into an ordinary loss, the taxpayer may usethe election to minimize taxable income. This may be so because of the $3,000 limit on thedeductibility of capital losses after netting against any capital gains. However, by treating the loss asa personal casualty loss, the total loss is reduced by 10% of the taxpayer's AGI. The second electionmight be made if the loss is less than the $20,000 limit and the taxpayer has other miscellaneousitemized deductions in excess of 2% of AGI. Otherwise, under this election a taxpayer may losemore tax benefits than if the election had not been made. pp. I:8-28 and I:8-29.

I:8-29 When a taxpayer collects a bad debt that was previously written off, the recovery must bereported in income to the extent the taxpayer received a tax benefit from the write-off in the prior year. p. I:8-28.

I:8-30 An NOL deduction is a deduction taken against the income of a year either preceding or following the year in which the NOL is incurred. The NOL arises when the taxpayer's businessdeductions (and personal casualty loss deductions) exceed the taxpayer’s business and other income.Generally, the deduction is first carried back to the two immediately prior years (in chronologicalorder) and then forward to the 20 succeeding years (again in chronological order). The statute allows

the deduction in an attempt to equalize the federal income tax burden imposed on taxpayers with business income that fluctuates from year to year, with the tax burden imposed on taxpayers with business income that is relatively stable from year to year. p. I:8-29.

I:8-31 An individual taxpayer's net tax loss is adjusted by the following items in computing an NOL:(1) any NOL deduction, (2) any capital loss deduction, (3) deductions for personal exemptions, and(4) the excess of nonbusiness deductions over nonbusiness income. These adjustments are madeeither in an attempt to measure only the economic loss that occurs when business expenses exceed business income or to prevent a possible double benefit from the deduction. For example, thededuction for personal exemptions does not reflect a true economic loss. Since capital losses havetheir own carryover provisions, allowing them to create or increase a net operating loss would create

a double benefit for the same loss. pp. I:8-30 and I:8-31.

I:8-32 a. Generally an NOL is carried back 2 years and carried forward for 20 years. For NOLsarising in certain farming businesses, the carryback period is 5 years. Furthermore, NOLs incurredin a qualified small business that are attributable to a Presidentially declared disaster, or in a casualtyor theft sustained by an individual, may be carried back 3 years. Likewise, for NOLs incurred in a taxyear that (1) either begins or ends in 2008 or 2009, or (2) begins or ends in 2009 or 2010, a special provision allows a taxpayer to elect to carry the loss back to the 5

th, 4

th, or 3

rdprior years. This

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election applies to only one of the eligible NOL years and is subject to detailed requirements. The purpose of this election is to enable taxpayers to receive a tax refund sooner in order to help themweather the economic downturn that occurred in 2008 through 2010.

b. A taxpayer may elect not to carry back the NOL and to carry the loss forward instead.

c. If the taxpayer anticipates higher income in the subsequent years, thus pushing thetaxpayer into higher marginal tax rates, it may be advantageous to forego thecarryback and carry the NOL forward in order to reduce taxable income.Furthermore, if carrying the NOL back will prevent the use of tax credits that willexpire, the taxpayer may want to forego the carryback. pp. I:8-32 and I:8-33.

I:8-33 Yes. For purposes of the NOL computation, casualty losses on personal-use assets are treatedas business losses. Therefore, casualty losses on personal-use assets are excluded in making theadjustment for excess nonbusiness deductions over nonbusiness income and can create or increase an

NOL. p. I:8-31.

I:8-34 An NOL deduction is a deduction for AGI. Thus, the prior year's AGI is reduced. Because of this reduction, other from AGI deductions taken in the year of the carry back may also have to bereduced since the amount of these deductions is dependent upon the taxpayer's AGI. For example,the taxpayer will have to recompute the medical expense deductions (these are deductible only if theyexceed 7.5% of AGI; 10% of AGI for tax years beginning after 2012), personal casualty losses (theseare deductible only if they exceed 10% of AGI), and miscellaneous itemized deductions (these aredeductible only if they exceed 2% of AGI). Although the deduction for charitable contributions islimited to a certain percentage of the taxpayer's AGI (the general limit is 50% of AGI), the charitablecontribution does not need to be recomputed. p. I:8-33.

Issue Identification Questions

I:8-35 The primary tax issues are (1) whether the stock is worthless, (2) when it became worthless,and (3) the character of the loss. Since stock held for investment is a capital asset, the loss, if allowed, should receive capital loss treatment. Under Sec. 165(g), a security that becomes worthlessduring the taxable year is treated as having been sold on the last day of the taxable year. In this case,Sheryl must determine exactly when the stock became worthless. Although bankruptcy is oneindication of worthlessness, the stock may, in fact, have become worthless in a prior year. Thus, if

Sheryl can demonstrate that the stock became worthless in the prior year, she can report a short-termcapital loss in that year. If it is determined that the stock became worthless in the current year, Sheryl

will report a long-term capital loss in the current year. pp. I:8-3 and I:8-4.

I:8-36 The primary tax issue is the character of the $75,000 loss (i.e., ordinary or capital). If, for thelast five years, more than 50% of Gold, Inc.’s aggregate gross receipts were from sources other thanroyalties, rents, dividends, interest, annuities, and sales or exchanges of stocks or securities, then theGold stock should qualify as Sec. 1244 stock because (1) Cora (an individual) received the stock inexchange for cash or property that she contributed directly to the corporation, (2) at the time the stock

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was issued, Gold, Inc.'s capital was less than $1,000,000, and (3) for the last five years, more than50% of its aggregate gross receipts were from sources other than royalties, rents, dividends, interest,annuities, and sales or exchanges of stocks or securities. Thus, of the total $75,000 loss, Cora willreport $50,000 as ordinary loss and $25,000 as a long-term capital loss. The capital loss, of course, isfirst netted against any capital gains. The current year deduction for any excess capital loss is limited

to $3,000. pp. I:8-5 and I:8-6.

I:8-37 The primary tax issue is whether the accident qualifies as a personal-use casualty loss. If qualified, Evan must apply the $100 and 10% of AGI limits to the personal-use casualty loss. Acorollary issue is whether the failure to file an insurance claim will invalidate the deduction.Although automobile accidents in general have been held to qualify for casualty loss treatment, anexception is made if the accident is caused by the taxpayer's willful negligence or willful act. Even if this accident qualifies as a casualty, no deduction is available if the taxpayer doesn't file an insuranceclaim to the extent that the loss is covered by insurance. Thus, if Evan does not file a claim, thecasualty loss should be limited to the amount of the loss that is not covered by insurance. p. I:8-17

through I:8-20.

I:8-38 The principal tax issue is the character of the bad debt (i.e., business or nonbusiness). Since anonbusiness bad debt is treated as a short-term capital loss, whereas a business bad debt is anordinary loss, the determination of what kind of loan Dan has made to Beta, Inc. becomes critical. Inorder to show that this loss is a business bad debt, Dan must demonstrate that his motivation inmaking the loan was to protect his job rather than to protect his stock ownership. In cases where theloan was made to protect the taxpayer's job, the courts have held that the loss is a business bad debt.On the other hand, if the loan was made to protect the taxpayer's investment, the loss is a nonbusiness bad debt. pp. I:8-25 through I:8-27.

Problems

I:8-39 a. Amount realized $ 22,000Minus: Basis ( 89,000)Loss recognized $(67,000)

Because the stock qualifies as Sec. 1244 stock, the first $50,000 of the loss is ordinary loss.The remainder is a long-term capital loss.

b. A $67,000 ordinary loss is recognized. The yearly limit on the ordinary loss deduction

for Sec. 1244 stock by a taxpayer who is married and filing a joint return is $100,000.c. To qualify the loss as ordinary under Sec. 1244, the stock must have been originally

issued to the individual or to a partnership in which an individual is a partner. Therefore, under thisrevised fact pattern the sale of the stock would result in a $67,000 long-term capital loss. Sec. 1244does not apply.

d. By selling a portion of the stock in one year and the remaining stock in another year the taxpayer could convert all $67,000 to an ordinary loss. The $50,000 maximum is per taxableyear. This would also avoid the annual $3,000 limit on the deductibility of capital losses. p. I:8-5.

I:8-40 a. Because Silver Fox is insolvent, all of its assets will go toward its debts, leavingnothing for Randall. Randall will not recover any of his basis in the stock. Because the stock was

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not acquired from the corporation on original issuance, the stock does not qualify as Sec. 1244 stock.Thus, Randall suffers a $250,000 long-term capital loss.

b. The stock is qualified Sec. 1244 stock since it is original issue stock. Since Randall issingle, the loss will consist of $50,000 ordinary loss and $200,000 long-term capital loss.

c. Since at least 80% of the voting power of Silver Fox’s stock is owned by RandallCorporation, and more than 90% of Silver Fox’s gross receipts are from its business operation, the$250,000 loss is all ordinary.

d. Same as part (c).

pp. I:8-5 and I:8-6.

I:8-41

Short-Term Long-Term Ordinary

ItemGain or

Loss ItemGain or

Loss ItemGain or

Loss

Tidal Radio $20,000 IBM $ 5,000 Salary $114,000Wavetable ( 6,000) Microsoft (20,000) Stewart (Sec. 1244) ( 15,000) Non-business bad debt ( 14,000) BTR ( 92,000) Net STCG $ -0- Net LTCL $(107,000) Ordinary $ 99,000

a. Brian’s Net Long-Term Capital Loss is $107,000 ($107,000 - $0). b. Brian’s AGI for the year is $96,000.

AGIOrdinary $99,000 Net LTCL ( 3,000)AGI $96,000

pp. I:8-5 and I:8-6.

I:8-42 Activity X $ 20,000Activity Y ( 35,000)Activity Z ( 15,000) Net passive loss carryover ($30,000)

Activity Y: $30,000 x$35,000$50,000

= $21,000

Activity Z: $30,000 x$15,000$50,000

= $9,000

These losses carry over to subsequent years and may be used to offset any income from passive activities. Additionally, any remaining loss attributable to an activity that is disposed of may be deducted in the year of disposal. This is why it is important to allocate the portion of the total net passive loss carryover to each individual activity. pp. I:8-7 through I:8-12.

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I:8-43 a. When a passive activity is disposed of, the suspended losses of that activity may offsetother than passive income.

Loss from Z for the year Suspended losses from ZGain from the sale of Z

Income from XLoss from Y

Loss deductible against active business and portfolio income

($20,000)( 40,000)30,000

$28,000( 10,000)

($30,000)

18,000

($12,000)

b. Clay’s AGI for the current year will be $88,000 ($100,000 - $12,000).

pp. I:8-7 through I:8-9.

I:8-44 a. Salary Income $130,000Minus: maximum rental real estate loss $25,000Reduced by phase out:($130,000 - $100,000) x 0.50 ( 15,000)

Deductible amount (not to exceedactual loss of $50,000) ( 10,000)

AGI $120,000

b. $40,000 - $10,000 = $30,000 suspended loss attributed to:

Activity Y: $30,000 x$30,000$50,000

= $18,000

Activity Z: $30,000 x$20,000$50,000

= $12,000

pp. I:8-15 and I:8-16.

I:8-45 Although in 2011, activity A is not a passive activity, it is treated as a former passive activity.Thus, the suspended losses of $24,000 for activity A are first offset against the current income of

activity A, leaving a remainder of $14,000 ($24,000 - $10,000). This $14,000 excess is still treatedas a passive activity suspended loss and is only deductible against passive income. Passive activity Bhas income of $20,000 in 2011. This income is first reduced by the $8,000 suspended loss fromactivity B, leaving a remainder of $12,000 of passive income. Thus, $12,000 of the remainingsuspended loss from activity A is used to offset this income. $2,000 of the suspended loss fromactivity A is carried over to 2012. pp. I:8-7 through I:8-9.

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I:8-12

I:8-46 Since Juan is in the 28% tax bracket, the credits equal $10,714 ($3,000 ÷ 0.28) in deduction

equivalents. This amount, plus the $6,000 in losses, equals a total of $16,714 in deductions anddeduction equivalents. Since this amount is less than the $25,000 real estate deduction amount, Juannormally would be able to use all of the loss deductions and credits against his active businessincome. However, because Juan has AGI in excess of $100,000, the real estate deduction is reduced

to $13,000 {$25,000 - [($124,000 - $100,000) x 0.50)]}, and the maximum that Juan may use is$13,000 in deductions and deduction equivalents. The deductions are taken first. Thus, Juan deductsthe total of the $6,000 losses, leaving $7,000 in deduction equivalents available to be used in thecurrent year. This translates to $1,960 ($7,000 x 0.28) in credits. Therefore, the suspended lossesand credits carried over to next year are:

Losses: $6,000 - $6,000 = $0

Credits: $3,000 - $1,960 = $1,040

pp. I:8-15 and I:8-16.

I:8-47 The first step is to compute AGI. This step consists of a two-step process. First the limit onthe deduction of the $25,000 real estate exemption for passive losses is computed as follows:

Salary $166,000Interest income 14,000 Net long-term capital gains 5,000Tentative AGI (for passive loss) $185,000

Thus, the passive loss exemption for real estate is reduced to $0 [$25,000 -($185,000 - $100,000) x0.50]. AGI is $185,000.

AGI $185,000

The next step is to compute the deductions from AGI.

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I:8-13

AGI $185,000Itemized DeductionsProperty taxes on residence 5,000Interest:

Qualified Residence 12,000Investment Interest ($21,000),Limited to Investment Income ($14,000) 14,000

26,000Charitable Contributions 8,000Miscellaneous Itemized:Tax preparation fees 2,500Unreimbursed Employee Expenses 2,000Minus 2% AGI ( 3,700)

800Total Itemized Deduction 39,800 ( 39,800)

Personal Exemption ( 3,700)

Taxable Income $141,500

Note: Since Julie did not use net LTCG in computing net investment income, she may use themaximum 15% rate for LTCG when computing her tax. pp. I:8-7 through I:8-16.

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I:8-14

I:8-48

Item

Casualty

Gain/(Loss)

Equipment A. The decrease in FMV is $8,300, which is less than Tony’s adjusted basis inthe property. Because the decrease in FMV is available, the cost to repair the equipmentshould not be used. The deductible loss is the amount of the loss not compensated for byinsurance, which is $4,600 ($8,300 - $3,700). ($ 4,600)

Equipment B. The decrease in FMV is $8,100, but the deductible loss is limited to Tony’s$3,000 adjusted basis in the property. Furthermore, the insurance company gives him$7,800 for the machine. Thus, Tony realized a casualty gain of $4,800. Unless thisqualifies as an involuntary conversion (which is discussed in a later chapter), he will netthis gain against his other business casualty losses. 4,800

Equipment C. Because the decrease in FMV is not available, the taxpayer can use the costof repairing the asset, as long as the repairs bring the property back to its conditionimmediately before the casualty, do not cost an excessive amount, do no more than repair the damage caused by the casualty, and do not increase the value of the property over itsvalue immediately before the casualty. Assuming Tony’s repairs on Equipment C meetthese requirements, the deductible loss is $2,400 – the $13,800 cost of repairs less $11,400 of insurance proceeds. ( 2,400)

Delivery Truck. The deductible loss is $1,500 – Tony’s adjusted basis in the truck,$17,500, less $16,000 of insurance proceeds. ( 1,500)

Net Business Casualty Loss Deduction ( 3,700)

Automobile. A personal casualty loss is limited to the lesser of the property’s fair marketvalue before the casualty or the taxpayer’s adjusted basis in the property, less any

insurance proceeds. The automobile’s fair market before the theft was $15,000, which isless than Tony’s $28,000 basis in the property. Therefore, the loss is $3,000 – the 15,000fair market value before the casualty less the $12,000 insurance reimbursement. This$3,000 loss is reduced by the $500 floor, and is further limited by the 10% AGI limitationon personal casualty deductions.

*Seecalculation

*AGI before casualty losses $80,000Less: Business casualty lossdeduction

( 3,700)

AGI $76,300

Personal casualty loss $ 3,000Less $100 floor ( 100)

$ 2,900Less: 10% AGI ( 7,630)

Deductible personal casualty loss $ 0


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I:8-15

I:8-49 a. The $3,000 cash is a business asset and is deductible without reduction or netting withother items. The ring and necklace are both personal-use items. Thus, the loss on the ring must benetted against the gain on the necklace.

Necklace ($6,000 insurance - $2,300 basis) $3,700

Minus: Ring ($3,000 - 100) (2,900) Net gain $ 800

Since Kelly has a $800 net personal casualty gain, the $3,700 gain on the necklace is reportedas a long-term capital gain and the $2,900 loss on the ring is reported as a short-term capital loss.Since a net gain was reported, there is no reduction for the 10% of AGI floor.

b. $0. Theft losses are deductible in the year of discovery. pp. I:8-17 through I:8-24.

I:8-50 a. The loss and reimbursement should not be reported since Jerry has a reasonableexpectation of full recovery.

Assuming you didn’t know until after you filed: b. A $9,200 loss should be reported in 2012.

Amount of loss ($15,000 - $1,500) $13,500Minus: $100 floor ( 100)

$13,400Minus: 10% of AGI ( 4,200)Deductible loss $ 9,200

c. Assuming the loss was deducted on the 2011 return, an amended return is not filed.The 2012 return should include in income an amount equal to the tax benefit the taxpayer receivedfor the previous deduction. pp. I:8-22 through I:8-23.

I:8-51 Automobile - lesser of basis or reduction for FMV decline $18,000Minus: Insurance reimbursement ( 14,000)Loss before limitation $ 4,000Minus: $100 floor ( 100) Net loss $ 3,900

Theft of antiques $ 8,000Minus: $100 floor ( 100) Net loss $ 7,900

Antiques $ 7,900Auto 3,900Total loss $11,800Minus: 10% of AGI ( 6,000)Deductible loss $ 5,800

pp. I:8-22 and I:8-23.

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I:8-16

I:8-52 Since the losses on the business property exceed the gains, they are all ordinary losses for AGI. Thus Pam's AGI is $65,000 ($80,000 - $15,000). Pam's net loss on the personal-use property is$11,000. This is first reduced by $100 because the losses were all suffered in the same casualty. Thenet $10,500 is then reduced by 10% of AGI for a deductible personal casualty loss of $4,000($10,500 - [0.10 x $65,000])

Asset Loss Insurance Net

Business 1Business 2Business 3

($15,000)( 8,000)( 18,000)

$ 4,0003,000

19,000

($11,000)( 5,000)

1,000

Net loss on business property ($15,000)

Personal 1Personal 2

Personal 3

($12,000)( 3,000)

( 6,000)

$ 2,000-0-

8,000

($10,000)( 3,000)

2,000

Net loss on personal use propertyLess: nondeductible floor

Net loss on nonbusiness property

($11,000)( 100)

($10,900)

Business incomeBusiness casualty

AGI

Residential interestProperty taxesCharitable ContributionsCasualty losses [$10,900 - (0.10 x $65,000)]

Personal exemptionTaxable income

$80,000(15,000)

$ 6,0002,0004,0004,400

$65,000

(16,400)

( 3,700)$44,900


I:8-53 The bad debt deduction is $0. Since Elaine is a cash-method taxpayer, she does not have any basis in the receivable. pp. I:8-25 and I:8-26.

I:8-54 2011: $0. No bad debt deduction is allowed since no bona-fide debtor-creditor relationshipexists.

2012: $0. No bad debt deduction is allowed since a bona-fide debtor-creditor relationshipdoes not exist. pp. I:8-26 and I:8-27.

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I:8-17

I:8-55 2011: $0. No deduction is allowed for partial worthlessness.

2012: $4,500. Since the debt is a nonbusiness bad debt, no deduction was available in 2011 because the debt was not totally worthless. pp. I:8-26 and I:8-27.

I:8-56

a. Taxable Income

Dental Practice Items:

Revenues $65,000Payroll and Salary Expense ( 49,000)Supplies ( 17,000)

Rent ( 16,400)Advertising ( 4,600)

Depreciation ( 8,100) Net Business Loss ($30,100)

Mark’s Salary 18,000Interest earned on savings account 1,200

Total AGI ($10,900)

Itemized Deductions:Interest paid on personal residence 7,100

Itemized deductions for state and local taxes 3,40010,500

or Standard Deduction 11,600 ( 11,600)Personal Exemptions ($3,700 x 3) ( 11,100)Taxable Income ($33,600)

b. NOL

Taxable Income ($33,600)

Non-business Deductions $11,600 Non-business Income ( 1,200)

Plus: Excess of Non-business Deductions over Non-business Income 10,400

Plus: Personal Exemptions 11,100

Net Operating Loss ($12,100)


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I:8-18

I:8-57

a. Taxable Income


Revenues $65,000Payroll and Salary Expense ( 49,000)

Supplies ( 17,000)Rent ( 16,400)Advertising ( 4,600)



Total AGI ($10,900)


Itemized deductions for state and local taxes 3,400Casualty Loss 4,500

15,000or Standard Deduction 11,600 ( 15,000)

Personal Exemptions ($3,700 x 3) ( 11,100)Taxable Income ($37,000)

b. NOL


Non-business DeductionsItemized Deductions $15,000

Minus: Casualty Loss Deduction ( 4,500)$10,500

Minus: Non-business Income ( 1,200)

Plus: Excess of Non-business Deductions over 9,300

Non-business Income

Plus: Personal Exemptions ($3,700 x 3) 11,100


pp. I:8-29 through I:8-32

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I:8-19

I:8-58

a. Taxable Income


Revenues $65,000Payroll and Salary Expense ( 49,000)

Supplies ( 17,000)Rent ( 16,400)Advertising ( 4,600)



Total AGI ($10,900)


Casualty Loss 3,40010,500

or Standard Deduction 11,600 ( 11,600)Personal Exemptions ($3,700 x 3) ( 11,100)


b. NOL


Non-business DeductionsItemized Deductions $11,600

Minus: Casualty Loss Deduction ( 3,400)$8,200

Minus: Non-business Income ( 1,200)

Plus: Excess of Non-business Deductions over 7,000

Non-business Income

Plus: Personal Exemptions ($3,700 x 3) 11,100



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I:8-20

I:8-59

a. Taxable Income

Interior Design Business

Revenues $52,000Cost of Goods Sold ( 41,000)

Advertising ( 3,300)Office Supplies ( 1,700)Rent ( 13,800)

Contract Labor ( 28,000) Net-Business Loss ($35,800)

Salary 13,500 Net Long-Term Capital Gain ($4,200 - $3,800) 400

Total AGI ($21,900)

Itemized Deductions: 5,200or Standard Deduction 5,800 ( 5,800)

Personal Exemption ( 3,700)Taxable Income ($31,400)

b. NOL


Non-business Deductions $ 5,800 Non-business Income ( 400)

Plus: Excess of Non-business Deductions over Non-business Income 5,400

Plus: Personal Exemptions 3,700



I:8-60

TO: Treehouse RentalsFROM: Your CPADATE: March 15, 2012SUBJECT: Suspended Passive Activity Losses

Due to a recent court ruling, you can deduct the suspended activity losses related to the propertiesyou sold in 2011.

In 1996, citing Sec. 1371(b), the IRS disallowed a former C corporation’s suspended passive activitylosses (PALs) related to property it sold after it had obtained S corporation status, (T.A.M.9628002). In 2000, however, the Tenth Circuit Court of Appeals ruled that the deduction of suchlosses was allowed under Sec. 469(b) (St. Charles Investment Co. v. Commissioner , 86 AFTR 2d

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I:8-21

2000-6882). Therefore, you can deduct the $63,000 and $112,000 previously suspended PALsrelated to property you sold in 2011.

I:8-61

TO: Seaton & Associates, LLCFROM: Your CPADATE: February 14, 2012SUBJECT: Losses Generated in 2011

Each member of your company can deduct his or her full portion of the $530,000 loss generated in2011.

A taxpayer may fully deduct a flow-through loss if the taxpayer materially participated in the business during the year. If the taxpayer did not materially participate in the business, the loss issubject to passive activity loss limitations. In general, a limited partner is not considered to material

participate in an activity (Reg. 1.469-5T(e)(1)). The limited partner does materially participate,however, if the partner meets one of three material participation tests (Reg. 1.469-5T(e)(2)).

Maria and Jamal both meet the first test, which is that the individual participate in the activity for more than 500 hours during the year. Therefore, they can both deduct their full portion of the loss,$53,000 each.

Jace, however, does not meet the first test because he worked only 215 hours during the year. Thetwo final tests are qualitative tests. One requires that the taxpayer materially participated in theactivity for any five of the previous ten taxable years. The activity has not been in existence longenough for Jace to meet this test.

Fortunately, Jace meets the final test. This requires that the activity be a personal service activityand the individual materially participated in the activity for any three taxable years preceding thetaxable years. The regulations specifically state that architectural services are a personal serviceactivity. Further, Jace worked as the CEO of an architectural firm for six years, thereby meeting thethree-year requirement.

Finally, this conclusion is supported by an Oregon U.S. District Court decision involving an LLCinvolved in health services (Gregg v. U.S., 87 AFTR 2d 2001-337). Thus, Jace can deduct his full portion of the loss, which is $424,000.

I:8-62 If the Kents stay in the rental home for more than the greater of 14 days or 10% of the totalrental days, they must recognize income and expenses relating to the home using the vacation homerules of Sec. 280A. Additionally, they must allocate the expenses of the rental property between therental activity and their personal use. If they do not stay in the home, the entire activity is treated asa passive activity entered into for profit, and the passive activity rules of Sec. 469 apply.

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I:8-22

Assuming they stay in the property in December, the tax consequences are as follows:

Vacation Home Treatment

Total Personal Rental ActivityRental income $16,000 $16,000

Mortgage interest* ( 12,400) ( 1,176) ( 11,224)Property taxes* ( 4,300) ( 408) ( 3,892)HOA fees* ( 3,500) ( 332) ( 3,168)Depreciation* ( 18,000) ( 1,707) ( 16,293) Net loss ($22,200) ($3,623) ($18,577)***Based on total use days (22/232)

**The loss is limited to the gross income from the property pursuant to Sec. 280(A).

Taxable Income

Ordinary Income

Deanna’s salary $75,000Alex’s salary 65,000Passive income 1,000Rental income 16,000

Rental expenses (16,000) $141,000

AGI

Less itemized deductions:Medical expenses 8,100Reduced by 7.5% AGI ( 10,575)

Taxes

State income taxes 9,700Property taxes (home) 2,900Property taxes (vacation home) 408

$13,008Mortgage interestPersonal residence 7,800Vacation home 1,176

8,976Charitable contribution 14,200Total itemized deductions ($36,184)

Personal exemptions ($3,700 x 2) ( 7,400)

NET TAXABLE INCOME $97,416

Since they stay in the rental home for the entire period from December 10 through December 31,their personal use totals 22 days, which is more than 10% of the 210 rental days. Thus, the Sec.280(A) limitations apply.

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I:8-23

Assuming they do not stay in the rental property, the tax consequences are as follows:

Passive Activity Treatment

Total Personal Passive ActivityRental income ($16,000) $16,000

Mortgage interest ( 12,400) ( 12,400)Property taxes ( 4,300) ( 4,300)HOA fees ( 3,500) ( 3,500)Depreciation ( 18,000) ( 18,000) Net loss ($22,200) ($22,200)

Taxable Income

Ordinary IncomeDeanna’s salary $75,000Alex’s salary 65,000

Passive income 1,000Less: Deductible passive loss ( 1,000)

_______ AGI before rental real estate deduction $140,000Rental real estate deduction: $25,000Decreased by 50% of AGI over $100,000($25,000 – (50% x $140,000 - $100,000) ( 5,000)

AGI $135,000

Less itemized deductions:

Medical expenses 8,100Reduced by 7.5% AGI ( 10,125)

TaxesState income taxes 9,700

Property taxes (home) 2,900$ 12,600

Mortgage interestPaid on personal residence 7,800

Charitable contribution 14,200Total itemized deductions ($34,600)

Personal exemptions ($3,700 x 2) ( 7,400)

NET TAXABLE INCOME $93,000

Note: The nondeductible passive loss of $16,200 [$22,200 – ($1,000 + $5,000)] may be carriedforward and deducted against passive activity income of a subsequent year.

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I:8-24

Passive Loss Carryforward Loss ($22,200)Less: Total allowed loss 6,000

Carryforward to future years ($16,200)

By staying in the home, their taxable income is increased by $4,416 ($97,516 - $93,100) because

they would be unable to deduct any of the loss attributable to the rental portion against the other passive income ($1,000). Furthermore, they could not deduct the additional $5,000 because of therental real estate active participation rule under the passive loss rules. They can, however, deduct anadditional $408 in property taxes and $1,176 in interest allocated to the personal use of the unit.

I:8-63 Jim can treat the loss in one of three different ways. The first two require an election.

1. Casualty Loss. The loss would be reduced by the $100 floor, then by 10% AGI($110,000 x .10 = $11,000). Thus, he would be allowed an itemized deduction of $88,900 ($100,000 - $100 - $11,000).

2. Loss incurred in a transaction entered into for profit (but not a business loss). Hewould be allowed a $20,000 itemized deduction (the limit on losses from financialinstitutions), decreased by 2% AGI ($110,000 x .20 = $2,200). Thus, he would beallowed a net itemized deduction of $17,800.

3. Nonbusiness bad debt. The loss would be treated as a short-term capital loss limitedto an ordinary deduction of $3,000 because he has no other capital gains or losses inthe current year. The remaining $97,000 can be carried forward to future years.

In this case, Jim should elect to treat the loss as a casualty loss. In other situations, where Jimreports large short-term capital gains, the third option may be more beneficial because the loss istreated as a short-term capital loss, which can offset (without reduction) the other short-termcapital gains.

Tax Form/Return Preparation Problems

I:8-64 (See Instructor’s Resource Manual)

I:8-65 (See Instructor’s Resource Manual)

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I:8-25

Case Study Problems

I:8-66 November 10, Current Year

Dr. John Brown

444 Physician's Drive, Suite 100Anytown, USA 88888

Dear Dr. Brown:

I thank you for the opportunity of helping you with your tax work this year.

I understand that for the current year you estimate you will earn $150,000 of taxable incomefrom your medical practice as well as $10,000 in dividends and interest income. You alsoanticipate that your share of Limited's loss this year will be $10,000 in addition to last year's$15,000 loss. Finally, you estimate $30,000 in taxable income from the new lab that youestablished this year. The lab is staffed by two full-time qualified technicians and a part-

time bookkeeper keeps the accounts. You have managed the lab to date, spending 320 hoursduring the year.

As you will recall, you were unable to deduct the $15,000 loss from Limited last year because of what are known as the passive loss limitations on passive activities. This loss isdeferred or suspended into subsequent years and is only deductible against your income from passive activities. Among other things, a business or investment is considered passive if youwork less than 500 hours in that activity during the year.

Through the end of this year, you will have a total of $25,000 in suspended passive lossesfrom Limited. In general, if you limit your involvement in the lab to less than 500 hours for the year, the lab will also be treated as a passive activity this year. That means that the

cumulative losses of $25,000 from Limited can be deducted against the $30,000 incomefrom the lab. On the other hand, if you work in the lab over 500 hours this year you will not be able to deduct the cumulative losses of $25,000 from Limited. Thus, I recommend thatyou limit your involvement in the lab for the rest of the year. Furthermore, each year weshould analyze your involvement in the lab because circumstances may change from year toyear.

I must mention that the IRS can, under certain circumstances treat a taxpayer's involvementin an activity as active even if the taxpayer's involvement is less than 500 hours. I believe,however, that the facts in your situation do not warrant this treatment since the lab should beself-sustaining without any of your efforts.

As always, my recommendations are based upon the facts as I have stated them above. If Ihave not identified the facts correctly, please contact me immediately since a change in thefacts may cause a change in the recommendation.

Again, I thank you for the opportunity of serving you.

Sincerely,

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© 2012 Pearson Education Inc publishing as Prentice Hall

I:8-67 Pursuant to Statement on Standards for Tax Services (SSTS) No. 1, a CPA should notrecommend that a tax return position be taken with respect to any item unless he or she "... has agood-faith belief that the position has a realistic possibility of being sustained administratively or judicially on its merits if challenged." [SSTS No. 1 .02(a)]. If a position does not meet the realistic possibility standard, a CPA may still recommend a position as long as it is not frivolous and the

position is adequately disclosed on the return. Furthermore, paragraph .04 states that a CPA. "... has both the right and responsibility to be an advocate for the taxpayer with respect to any positionsatisfying the aforementioned standards.”

According to SSTS Interpretation No. 1-1, the realistic possibility standard is less stringentthan both the "substantial authority" and the "more likely than not" standards that are established bythe Internal Revenue Code with regard to substantial understatements of liability. Furthermore, inaddition to the authorities used in establishing "substantial authority," a CPA can rely on "... well-reasoned treatises, articles in recognized professional tax publications, and other reference tools andsources of tax analyses commonly used by tax advisers and preparers of returns" in meeting therealistic possibility standard.

Although your client's position is a grey one, it appears that there is sufficient authority to

meet the realistic possibility standard, allowing you to sign the return taking the deduction.However, you should advise Jack that if there is not "substantial authority," he may be subject to a penalty unless he discloses the position. [SSTS No. 1 ¶.02(d)].

In any event, you should not take a position that exploits the audit selection process or serves

as a mere arguing position [SSTS No. 1 ¶.03].

Tax Research Problem

I:8-68 Kay will be allowed to deduct the $30,000 loan as a theft loss in the year of discovery. Theloan is not treated as a nonbusiness bad debt since the loan was made based upon the falserepresentations of Dan.

In R.S. Gerstell [46 T.C. 161 (1966)] and M. Monteleone [34 T.C. 688 (1960)], the taxpayerswere allowed to deduct as theft losses the amount of money or property taken from them under false pretenses. In both cases, the court stated that "for tax purposes, whether a theft loss has beensustained depends upon the law of the jurisdiction wherein the particular loss occurred"[Monteleone, p. 692]. For example, theft is defined in the California penal code as "the taking of money from another under false representations or false pretenses" [Monteleone, p. 692]. Assuminga similar law in the state where Kay resides, the $30,000 would be treated as a theft loss also. Of course, it will be subject to the $100 (or $500 in 2009) and 10% of AGI limitations.

The distinction must be made between a bona fide loan and a loan made based upon false pretenses. In Monteleone, the IRS contended that the loan was a nonbusiness bad debt and therefore

should be treated as a short-term capital loss. If the loan is a bona-fide loan made without deceit and

it subsequently becomes worthless due to bankruptcy or some other reason, the loan is treated as a bad debt. In the instant case, fraud was involved and, as a result, the loan, by definition, constitutestheft.

See also: Code Sec. 165, the Regulations under Sec. 165 and Paul C.F. Vietzke 37 T.C. 504(1961).

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