LOSSES AND LOSS LIMITATIONS

CHAPTER 5
LOSSES AND LOSS LIMITATIONS
SOLUTIONS TO PROBLEM MATERIALS
Status: Q/P
Question/ Present in Prior
Problem Topic Edition Edition
1 Bad debts: business Unchanged 1
2 Bad debts: tax benefit rule Unchanged 2
Bad debt and ! 12"" stoc# $e%
" Ethics problem $e%
& ! 12"" stoc# Unchanged "
' (ssue recognition Unchanged &
) *asualt+ loss: ,1-- and 1-. of /0( floors 1odified '
2 *asualt+ loss: disaster area loss Unchanged )
3 (ssue recognition Unchanged 2
1- *asualt+ loss: insurance reco4er+ 1odified 3
11 /t5ris# rules $e%
12 /t5ris# rules Unchanged 12
1 (ssue recognition Unchanged 1
1" /t5ris# rules 1odified 1"
1& Passi4e acti4it+ loss rules: general application Unchanged 1&
1' Passi4e acti4it+ loss rules: general application $e%
1) Passi4e loss rules: general application Unchanged 2
12 Sale of passi4e acti4it+ and suspended losses 1odified 1)
13 Sale of passi4e acti4it+ Unchanged 12
2- Passi4e losses of personal ser4ice corporation Unchanged 13
21 Passi4e losses of corporation Unchanged 2-
22 Passi4e6 acti4e6 portfolio income of non5PS* Unchanged 21
2 0roupings of t%o t+pes of businesses $e%
2" (ssue recognition Unchanged 2"
2& (nteraction of at5ris# and passi4e loss rules Unchanged 2&
2' (nteraction of at ris# and passi4e loss rules $e%
2) (nteraction of at5ris# and passi4e loss rules Unchanged 2)
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5-2 2001 Entities Volume/Solutions Manual
&51
Status: Q/P
Question/ Present in Prior
Problem Topic Edition Edition
22 (nteraction of at5ris# and passi4e loss rules Unchanged 22
23 (ssue recognition Unchanged 23
- Passi4e loss deduction and at5ris# amounts Unchanged -
1 7ental loss: acti4e participation Unchanged 1
2 /cti4e income and passi4e income: real estate $e%
acti4ities
Ethics problem Unchanged
" 1aterial participation in real propert+ trades or Unchanged "
businesses
& 7eal estate rental exception Unchanged &
' Ethics problem $e%
) Passi4e acti4it+ loss allo%ed6 suspended losses Unchanged )
and credits
2 7ental real estate loss deduction Unchanged 2
7esearch
Problem
1 *asualt+ loss Unchanged 1
2 8ffsetting rent income b+ passi4e losses $e%
/pplication of material participation acti4it+ Unchanged 2
rules
" (nternet acti4it+ Unchanged "
& (nternet acti4it+ Unchanged &
PROBLEM MATERIAL
19
Smith6 7aabe6 and 1alone+6 *P/s
&1-1 1adison 7oad
*incinnati6 8hio "&22)
:anuar+ 236 2---
;oon <inance *ompan+
1-- T+ler ;ane
Erie6 Penns+l4ania 1'&'
=ear Sir:
This letter is to inform +ou of the possibilit+ of ta#ing a bad debt deduction of ,26---9
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Losses and Loss Limitations 5-3
>our loan to Scott is a business bad debt? therefore6 +ou are allo%ed to ta#e a bad debt
deduction for partial %orthlessness9 >ou also ma+ be able to ta#e a bad debt deduction in
the +ear %hen there has been a final settlement on the debt if +ou collect less than
currentl+ expected9 /lternati4el+6 if +ou deduct an+ amount as a bad debt this +ear and
subse@uentl+ collect on the debt6 +ou ma+ recogniAe income in the +ear the bad debt is
collected9
Should +ou need more information or need to clarif+ an+thing6 please contact me9
Sincerel+6
:ohn :9 :ones6 *P/
Partner
TAX FILE MEMORANDUM
=ate: :anuar+ 236 2---
<rom: :ohn :9 :ones
SubBect: Bad =ebt =eduction for ;oon <inance *ompan+
;oon <inance *ompan+Cs ,2-6--- loan to Scott is a business bad debt9 Therefore6 a bad
debt deduction is allo%ed for partial %orthlessness of ,26--- Di9e96 Scott has filed for
ban#ruptc+ and ;oon has been notified that the most it can expect to recei4e is '- cents
on the dollarE9 ;oon %ill be able to claim a bad debt deduction in the +ear %hen a final
settlement has been reached %ith respect to the loan if less is collected than is currentl+
expected9 (f more is collected6 ;oon ma+ ha4e gross income9
pp9 &5 and &5"
29 (n 13336 Tom has a bad debt of ,"6---9 Because this is a nonbusiness bad debt6 it is
treated as a short5term capital loss9 /s such6 Tom can use onl+ ,6--- of the loss to offset
ordinar+ income in 13339 (n 2---6 the collection of the debt increases TomCs gross
income9 Fo%e4er6 onl+ ,6--- of the ,"6--- recei4ed b+ Tom is included in his gross
income in 2--- because this is the amount %hich produced a tax benefit in 13339 pp9 &5
and &5"
9 Salar+ ,1&-6---
! 12"" ordinar+ loss Dlimited to ,1--6---E D1--6---E
Short5term capital gain on ! 12"" stoc# ,126---
Short5term capital loss Dnonbusiness bad debtE D )6---E
$et short5term capital gain , &6---
;ong5term capital loss Gexcess of ! 12"" loss D1-6---E
D,11-6--- 5 ,1--6---EH
$et long5term capital loss D, &6---E
*apital loss limitation D 6---E
/dBusted gross income ,")6---
pp9 &5& and &5'
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5-4 2001 Entities Volume/Solutions Manual
"9 >ear of =eduction for Iorthless Securities Dpage )53E9 The issues raised are %hether the
stoc# has become %orthless6 and6 if %orthless6 the +ear it became %orthless9
=eterminations of %hether a securit+ has become %orthless and the +ear of %orthlessness
are @uestions of fact6 and the burden of proof is upon the taxpa+er9
0enerall+6 an adBudication of ban#ruptc+ is proof of %orthlessness and hence6 the loss on
the stoc# should be ta#en in the +ear of the adBudication9 (n this situation6 the fact that
:ac# %as not a%are of ban#ruptc+ is not controlling9 :ac# should not claim the loss on
the current +earCs return9 7ather6 he should file an amended return for the +ear the stoc#
became %orthless9
:ac# ma+ not claim the loss in the +ear most ad4antageous to him9 Fe must deduct it in
the +ear %hen all the facts point to its actual %orthlessness9
&9 Sell all of the stoc# in the current +ear:
*urrent +earCs /0(
Salar+ ,2-6---
8rdinar+ loss D! 12"" limitE D&-6---E
;ong5term capital gain ,26---
;ong5term capital loss D,2-6--- 5 ,&-6---E D-6---E
;ong5term capital loss DlimitE D 6---E
/0( ,2)6---
$ext +earCs /0(
Salar+ ,3-6---
;ong5term capital gain ,1-6---
;ong5term capital loss carr+o4er D136---E
D,-6--- 5 ,116---E
;ong5term capital loss DlimitE D 6---E
/0( ,2)6---
Total /0(
*urrent +ear , 2)6---
$ext +ear 2)6---
Total ,11"6---
Sell half of the stoc# this +ear and half next +ear:
*urrent +earCs /0(
Salar+ ,2-6---
8rdinar+ loss D! 12"" stoc#E D"-6---E
;ong5term capital gain 26---
/0( ,"26---
$ext +earCs /0(
Salar+ ,3-6---
8rdinar+ loss D! 12"" stoc#E D"-6---E
;ong5term capital gain 1-6---
/0( ,'-6---
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Losses and Loss Limitations 5-5
Total /0(
*urrent +ear , "26---
$ext +ear '-6---
Total ,1-26---
1ar+Cs combined /0( for the t%o +ears is lo%er if she sells half of her ! 12"" stoc# this
+ear and half next +ear9 p9 &5'
'9 :ohn should be concerned %ith the follo%ing tax issues:
Ias there a bona fide debtJ
Business bad debt9
$onbusiness bad debt9
:ohnCs basis in the debt9
=ate of %orthlessness9
*lassification as capital or ordinar+9
Ias there a ! 12"" lossJ
=ate of %orthlessness9
/mount of %orthlessness9
*lassification as capital or ordinar+9
pp9 &5 and &5"
)9 Fome D,--6--- 5 ,1)&6---E 5 ,1--6--- K ,2&6--- loss
/nti@ue cloc# D,26--- 5 ,16&--E K ,&-- gain
/nti@ue table D,6--- 5 ,6---E K ,-
/nti@ue organ D,2-6--- 5 ,&6---E K ,1&6--- gain
*asualt+ loss D,2&6--- 5 ,1-- floorE ,2"63--
;ess: *asualt+ gain D,1&6--- L ,&--E D1&6&--E
Excess of casualt+ loss o4er gain , 36"--
;ess: 1-. of /0( floor D,1--6--- M 1-.E D1-6---E
*asualt+ loss deduction from /0( , 5-5
pp9 &5) to &512
29 The loss is a business loss9 Therefore6 for the farm building and the farm e@uipment that
%ere completel+ destro+ed6 the adBusted basis is used in calculating the amount of the
casualt+ loss9 <or the barn that %as damaged6 the lo%er of the adBusted basis or the
decline in 4alue is used in calculating the amount of the casualt+9
Building D,2-6--- 5 ,'-6---E ,2-6---
E@uipment D,"-6--- 5 ,2&6---E 1&6---
Barn D,-6--- 5 ,2&6---E &6---
Total loss ,"-6---
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5-6 2001 Entities Volume/Solutions Manual
Because the President declared the area a disaster area6 0rac#le could claim the loss on
last +earNs return or on the current +earNs tax return9
(f 0rac#le applies the loss to the prior +ear6 the benefit of the loss %ill be at lo%er tax
rates9 (f the loss is applied to the current +ear6 the benefit %ill be at a tax rate of 3. and
thus6 pro4ide a tax sa4ings of ,1&6'-- D,"-6--- M 3.E rather than ,116&- GD,1&6--- M
".E L D2&6--- M 2&.EH9
0rac#le should include the loss on the current +earNs tax return6 since the tax sa4ings is
,"62&- D,1&6'-- 5 ,116&-E greater9
pp9 &5) to &512
39 The tax issues for Toucan *orporation are as follo%s9
(s this a casualt+ lossJ
Ihat is the amount of the lossJ
The basis for computing the loss9
The decline in fair mar#et 4alue9
7eplacement cost9
pp9 &5) to &512
1-9
Smith6 7aabe6 and 1alone+6 *P/s
&1-1 1adison 7oad
*incinnati6 8hio "&22)
:anuar+ 2'6 2---
Snipe (ndustries
"&- *olonelCs Ia+
Iarrensburg6 18 '"-3
0entlemen:
This letter is to inform +ou of the tax conse@uences of filing a claim 4ersus not filing a
claim %ith +our insurance compan+ for reimbursement for damages to the car dri4en b+
Sam Smith9
Because the claim is being made b+ a compan+ and not an indi4idual6 +ou ma+ deduct
the casualt+ loss in full e4en if no claim for insurance is filed9 Thus6 +our plan %ill %or#9
The full ,)6--- loss is deductible9 $ote that the result %ould ha4e been different if the
casualt+ loss %ere claimed b+ an indi4idual9 (n such a circumstance6 because the car %as
insured6 the amount of the tax deduction %ould be determined as if a claim had been filed
%ith the insurance compan+ and the reimbursement %as recei4ed9 *onse@uentl+6 the
deduction %ould ha4e been Aero9
The benefit of filing the claim6 absent an+ tax conse@uences6 is an expected cash inflo%
of ,'6--- from the insurance compan+6 %hile the tax sa4ings from the casualt+ loss
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Losses and Loss Limitations 5-7
deduction if no claim is made is ,262- Dassuming a ". tax rateE9 Thus6 the expected
cost of polic+ cancellation should be at least ,6'2- D,'6--- 5 ,262-E to Bustif+ not filing
a claim9
Should +ou need more information or need to clarif+ an+thing6 please contact me9
Sincerel+6
:ohn :9 :ones6 *P/
Partner
pp9 &5) to &512
119 The at5ris# rules limit <redCs deductions9 Fe can deduct ,&6--- in 13336 and his at5ris#
amount %ill be reduced to ,1&6--- D,&-6--- 5 ,&6--- deductedE9 Fe %ill be limited to a
,1&6--- deduction in 2--- unless he increases his amount at ris#9 <or example6 if <red
in4ests an additional ,1-6--- in 2---6 his at5ris# amount %ould be ,2&6--- D,1&6---
balance L ,1-6--- additional in4estmentE6 and he %ould be able to deduct the entire loss
in 2---9 pp9 &512 and &513
129 Smith6 7aabe6 and 1alone+ *P/s
&1-1 1adison 7oad
*incinnati6 8hio "&22)
<ebruar+ &6 2---
1r9 Bill Par#er
&" 8a# =ri4e
St9 Paul6 1$ &&1'2
=ear 1r9 Par#er:
This letter is in response to +our in@uir+ regarding the tax treatment of losses that +ou
could expect this +ear and next +ear from an in4estment in Best *hoice Partnership9 /s (
understand the facts6 +ou %ould in4est ,'-6--- in the partnership %ith the expectation
that +our share of the partnership losses in the current and succeeding +ears %ould be
,"-6--- and ,2&6---6 respecti4el+9
E4en though +our in4estment %ould not be subBect to the passi4e acti4it+ limitations6 the
amount of the deduction that +ou ma+ claim in an+ one +ear is subBect to the at5ris# rules9
Essentiall+6 these rules pro4ide that +our deductions are limited to the amount that +ou
ha4e in4ested in the 4enture or the amount that +ou could lose if the in4estment %ere to
be unsuccessful9 *onse@uentl+6 in +our case6 the initial amount that +ou %ould ha4e at
ris# %ould be ,'-6---9 Therefore6 +ou %ould be able to deduct ,"-6--- in the current
+ear6 %hich %ould cause +our at5ris# basis to be lo%ered to ,2-6--- D,'-6--- 5 ,"-6---E9
Because +our at5ris# basis at the end of next +ear %ould be onl+ ,2-6---6 +our share of
the partnership loss that %ould be deductible %ould be limited to ,2-6---9 The amount
not deducted under this scenario %ould be deductible later %hen +our at5ris# basis
increases6 for example b+ additional in4estments +ou ma+ ma#e in the partnership or
because of income generated b+ the partnership9
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(f +ou ha4e additional @uestions or need further clarification6 please call me9
Sincerel+6
:ohn :9 :ones6 *P/
pp9 &512 and &513
19 /pplication of the at5ris# rules:
Ihat is their at5ris# basis and does it include their share of the entit+5le4el
borro%ingJ
Ihat amount of the partnershipCs loss %ill 0eorge and Susie be able to deduct in the
current +ear and %hat amount Dif an+E %ill be suspended because of the at5ris# rulesJ
/pplication of the passi4e acti4it+ rules:
Ihether the in4estment is a passi4e acti4it+ or %hether 0eorge and Susie are treated
as material participants in the 4enture9
(f the passi4e acti4it+ rules appl+6 %hat amount ma+ be deducted in the current +ear
and %hat amount is suspended under the passi4e loss rules for future useJ
Ihat is the interaction bet%een the at5ris# rules and the passi4e acti4it+ rules in
determining the current treatment of losses flo%ing from the in4estmentJ
pp9 &51) to &522
1"9 Based on the follo%ing6 /lternati4e 2Ns benefit exceeds /lternati4e 1Ns b+ ,1631
D,&"63-' 5 ,&2633E6 primaril+ because of the flo% of the benefits and the effect of the at5
ris# rules on those benefits9
/lternati4e 1
Tax cost/ /fter5tax 2. PO Present
(ncome benefit benefit factor 4alue
>r9 1 D,2"6---E , '6)2- , '6)2- -932&3 , '6222
>r9 2 D2"6---E "6"2-
1
"6"2- -92&)" 62"1
>r9 )26--- D1)632-E
2
&"6-2--9)32 "263-
Total present 4alue ,&2633
/lternati4e 2
Tax cost/ /fter5tax 2. PO Present
(ncome benefit benefit factor 4alue
>r9 1 D,"26---E ,1162--

,1162---932&3 ,1-6)-
>r9 2 26--- D'6)2-E
"
2&622--92&)" 216')"
>r9 "-6--- 1162-- 2262---9)32 2262'2
Total present 4alue ,&"63-'
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Losses and Loss Limitations 5-9
1
Because of the at5ris# rules6 /mandaNs tax deduction in +ear 2 is limited to her
remaining at5ris# basis of ,1'6---9 The ,26--- loss that is not deductible in +ear 2
is suspended until her at5ris# basis increases9 Therefore6 her tax benefit from the
deduction is ,"6"2- D,1'6--- M 22.E9
2
/mandaNs ,)26--- share of income increases her at5ris# basis and pro4ides the
opportunit+ to claim the ,26--- suspended loss from the pre4ious +ear9 Therefore6
her taxable income for +ear from this in4estment is ,'"6--- D,)26--- 5 ,26---E
and the tax is ,1)632- D,'"6--- M 22.E9

Because of the at5ris# rules6 /mandaNs tax deduction in +ear 1 is limited to her at5
ris# basis of ,"-6---9 The ,26--- loss that is not deductible in +ear 1 is suspended
until her at5ris# basis increases9 Therefore6 her tax benefit from the deduction is
,1162-- D,"-6--- M 22.E9
"
/mandaNs ,26--- share of income increases her at5ris# basis and pro4ides the
opportunit+ to claim the ,26--- suspended loss from the pre4ious +ear9 Therefore6
her taxable income from this in4estment in +ear 2 is ,2"6--- D,26--- 5 ,26---E
and the tax due is ,'6)2- D,2"6--- M 22.E9
pp9 &512 and &513
1&9 (n 13336 Pa+ cannot deduct an+ of the passi4e loss9 The ,&6--- loss is suspended and
carried for%ard to 2---9 The 2--- income of ,1&6--- is reduced b+ ,1&6--- of the
suspended passi4e loss from 13339 /fter deducting ,1&6--- of the passi4e loss in 2---6
,2-6--- of the 1333 passi4e loss remains suspended9 pp9 &52- to &52
1'9 8ption BNs benefit exceeds 8ption /Ns b+ ,)622& D,216"&1 5 ,1"622'E6 primaril+ because
of the flo% of the benefits and the abilit+ to benefit from the passi4e loss deductions in
+ears 1 and 29
8ption /
Tax cost/ /fter5tax 2. PO Present
(ncome benefit benefit factor 4alue
>r9 1 ,26--- D,26"2-E ,&6&2- -932&3 , &6111
>r9 2 26--- D26"2-E &6&2- -92&)" "6)
>r9 26--- D26"2-E &6&2- -9)32 "622
Total present 4alue ,1"622'
8ption B
Tax cost/ /fter5tax 2. PO Present
(ncome benefit benefit factor 4alue
>r9 1 D, 26---E , 26"2- , 26"2- -932&3 , 2623'
>r9 2 D26---E '2- '2- -92&)" &2
>r9 "6--- D1-6&"-E26"'- -9)32 126'2
Total present 4alue ,216"&1
pp9 &512 and &513
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1)9 The ,&-6--- loss is suspended under the passi4e loss rules because 7a+ is not a material
participant9 /0( is ,1"-6---9
pp9 &512 and &513
129 ;ast +ear6 ;eanne could deduct nothing against nonpassi4e income6 and %as re@uired to
allocate the ,"-6--- net loss among the three loss acti4ities9
(ncome DlossE:
/cti4it+ / ,1-6---
/cti4it+ B D&6---E
/cti4it+ * D2&6---E
/cti4it+ = D2-6---E
$et passi4e loss D,"-6---E
$et passi4e loss allocated to:
/cti4it+ B D&/&- M ,"-6---E D, "6---E
/cti4it+ * D2&/&- M ,"-6---E D2-6---E
/cti4it+ = D2-/&- M ,"-6---E D1'6---E
Total suspended losses D,"-6---E
(n the current +ear6 ;eanne has a net gain of ,136--- from the sale of /cti4it+ =9 She can
offset the ,1'6--- suspended loss from the acti4it+ and the current +earNs loss of ,16---
from the acti4it+ against the ,136--- gain9 (n addition6 the remaining net gain of ,26---
D,136--- 5 ,1'6--- 5 ,16---E from the sale ma+ be used to absorb passi4e losses from
other acti4ities9 Examples 2& and 2'
139 a9 $et sales price ,1--6---
;ess: /dBusted basis D &6---E
Total gain , '&6---
;ess: Suspended losses D "-6---E
Taxable gain Dpassi4eE , 2&6---
b9 $et sales price ,1--6---
;ess: /dBusted basis D )&6---E
Total gain , 2&6---
;ess: Suspended losses D "-6---E
=eductible loss D, 1&6---E
c9 $et sales price ,1--6---
;ess: /dBusted basis D )&6---E
Total gain , 2&6---
;ess: Suspended losses D "-6---E
=eductible loss D, 1&6---E
The suspended passi4e losses are full+ deductible9 The suspended credits are lost
fore4er because the sale of the acti4it+ did not generate an+ tax9
pp9 &52- to &522 and Example 22
2-9 / personal ser4ice corporation cannot offset passi4e losses against acti4e or portfolio
income9 Bro%nCs income is ,&'-6--- D,&--6--- acti4e income L ,'-6--- di4idend
incomeE9 Example - and related discussion
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Losses and Loss Limitations 5-11
219 a9 / personal ser4ice corporation is not allo%ed to offset passi4e losses against
ordinar+ income9 Therefore6 IhiteNs taxable income based on the facts gi4en is
,"'6--- D,"--6--- income from operations L ,'6--- portfolio incomeE9
Example -
b9 / closel+ held6 non5personal ser4ice corporation is allo%ed to offset passi4e losses
against acti4e income6 but not against portfolio income9 Therefore6 IhiteNs taxable
income based on the facts gi4en is ,3'6--- D,"--6--- income from operations 5
,"-6--- passi4e loss L ,'6--- portfolio incomeE9 Example 1
229 / closel+ held6 non5personal ser4ice corporation can offset passi4e losses against acti4e
income6 but not against portfolio income9 0reenNs income is ,'-6--- D,&-6--- acti4e
income L ,'-6--- di4idend income 5 ,&-6--- passi4e loss deducted to extent of acti4e
incomeE9 0reen %ill ha4e a suspended passi4e loss of ,-6--- D,2-6--- 5 ,&-6--- usedE9
Example 1
29 Smith6 7aabe6 and 1alone+6 *P/s
&1-1 1adison 7oad
*incinnati6 8hio "&22)
=ecember &6 2---
1r9 0reg Forne
"1 1aple /4enue
*incinnati6 8F "&223
=ear 0reg:
This letter is in response to +our in@uir+ regarding the 4arious strategies that are a4ailable
concerning +our mo4ie theater and drugstore 4entures in *incinnati6 (ndianapolis6 and
;ouis4ille9 /s +ou #no%6 the basic issue relates to ho% the stores should be grouped or
reported under the passi4e acti4it+ rules so as to maximiAe the tax benefit9
/s things currentl+ stand and based on the proBections that +ou ha4e pro4ided for the
+ear6 the ,"--6--- salar+ from +our radio sho% is acti4e income9 (f +ou do not
participate an+ more in an+ of the mo4ie theater or drugstore businesses6 all profits and
losses %ill be passi4e9 /s a result6 +ou %ould ha4e a net passi4e loss of ,&&6---
D,236--- loss L ,"16--- loss L ,1&6--- loss 5 ,&'6--- profit 5 ,"6--- profitE that %ould
be suspended and not a4ailable to offset +our salar+9 To mitigate this result6 three options
are a4ailable9
8ption 1 is based on the significant participation acti4it+ rule9 (f all of the businesses
%ere treated as separate acti4ities6 +ou %ould not be considered a material participant9
Under the significant participation acti4it+ rules6 the drugstores %ould be considered
significant acti4ities6 but the mo4ie theaters %ould not9 E4en %ith the drugstores6 the
total participation is not expected to exceed the more5than5&-- hour threshold D1"- L 1)-
L 12- K "3-E9 Therefore6 if +ou could participate 11 more hours in an+ of the drugstore
businesses6 the+ %ould be treated as acti4e9 >ou then could offset the net loss from the
drugstores of ,1"&6--- D,236--- L ,"16--- L ,1&6---E against +our salar+9 <urther6 if
+ou do not participate an+ more in the other theater businesses6 their combined ,3-6---
of income %ill be reported as passi4e income9 This characteriAation as passi4e could be
helpful if +ou %ere to ac@uire additional passi4e businesses in the future that produce
passi4e losses9
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Under option 26 both the mo4ie theater and drugstore businesses could be combined as a
Qsingle acti4it+R based on common o%nership9 Because +ou ha4e participated more than
&-- hours in the fi4e businesses6 the net loss of ,&&6--- %ould be considered acti4e and
could be used to offset the salar+9
Based on product6 option %ould combine the drugstores as one acti4it+ and the theaters
%ould be treated as a separate acti4it+9 /s %ith option 16 if +ou could participate 11 more
hours in an+ of the drugstore businesses6 the+ %ould be treated as acti4e and +ou could
offset the net loss of ,1"&6--- D,236--- L ,"16--- L ,1&6---E against +our salar+9 /lso6
+ou could treat the theaters as a single business and the net income %ould be passi4e9
This could be helpful in the future if other passi4e 4entures %ould be ac@uired9
8ther grouping possibilities exist6 such as a grouping b+ location6 but the+ do not appear
to produce an+ tax ad4antages9
Before ma#ing a decision on the abo4e options6 +ou should consider %hat is li#el+ to
happen in the future9 <or example6 %hat is the li#el+ profit and loss pattern of the
existing businessesJ Iill +ou ac@uire additional businessesJ (f so6 %hat t+pes of
businesses are li#el+ to be ac@uired6 and ho% %ill the ne% businesses fit into the grouping
method that +ou adoptJ Iill +ou dispose of an+ of the existing businesses in the near
future6 and %hat impact %ill that ha4e on the current grouping decisionsJ
>ou %ill need to consider carefull+ all tax factors in deciding ho% to group +our
acti4ities9 This is so because once acti4ities ha4e been grouped6 the+ cannot be
regrouped unless the original grouping %as clearl+ inappropriate or there has been a
material change in facts and circumstances9
8f course6 our firm %ill be happ+ to assist +ou further in an+%a+ %e can concerning the
choices +ou face9 (f %e can ans%er or clarif+ an+ @uestions +ou ma+ ha4e6 please call
me9
Sincerel+6
:ohn :9 7es%ic#6 *P/
Partner
pp9 &52& to &522
2"9 The amount of 7eneCs at5ris# basis in the hard%are business and %hether the losses
flo%ing from the entit+ are limited b+ the at5ris# rules9
Ihether the profits and losses from the public accounting firm are classified as
passi4e or acti4e9
Ihether 7ene is a material participant in the hard%are business9
Ihether 7ene is subBect to the passi4e loss rules9
pp9 &51' to &5-
2&9 Smith6 7aabe6 and 1alone+6 *P/s
&1-1 1adison 7oad
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Losses and Loss Limitations 5-13
*incinnati6 8hio "&22)
:anuar+ 26 2---
1r9 :ohn :a+
12 Bas#er4ille 1ill 7oad
1cPenne+6 Oirginia 22)2
=ear :ohn:
This letter is in response to +our re@uest for assistance in anal+Aing the tax conse@uences
resulting from t%o in4estment alternati4es9 8ne alternati4e is to ma#e an additional
in4estment of ,1-6--- in 7oc#+ 7oad /d4entures in %hich +ou ha4e an at5ris# basis of
,-6 suspended losses under the at5ris# rules of ,)6---6 and suspended passi4e losses of
,16---9 (f +ou %ere to ma#e this in4estment6 +our share of the expected profits this +ear
%ould be ,26---6 %hile if +our in4estment sta+ed at the same le4el6 +our share of profits
%ould be ,16---9 >our other choice is to in4est ,1-6--- as a limited partner in the
7agged 1ountain Iiner+6 %hich %ould produce passi4e income of ,36--- this +ear9 (
ha4e prepared the follo%ing anal+sis based on these facts9
(n4est ,1-6--- in 7oc#+ 7oad /d4entures:
Expected profit from in4estment ,26---
Beginning at5ris# basis , 5-5
(ncrease to at5ris# basis due to in4estment 1-6---
,1-6---
Use of loss suspended b+ at5ris# rules D)6---E
Ending at5ris# basis , 6---
Beginning suspended passi4e loss D, 16---E
7eclassified suspended passi4e loss D )6---E
Use of suspended passi4e lossesSre4ised D26---E
*urrent taxable income , 5- 5
*urrent tax liabilit+ , 5- 5
(n4est ,1-6--- in 7agged 1ountain Iiner+:
Expected profit from in4estmentS7agged 1ountain Iiner+ ,36---
Expected profit from in4estmentS7oc#+ 7oad /d4entures 16---
Use of suspended passi4e losses from 7oc#+ 7oad /d4entures D16---E
*urrent taxable income ,36---
*urrent tax liabilit+ D,36--- M 1.E ,26)3-
/s +ou can see6 the tax effects of the t%o options 4ar+ significantl+ and the differences
relate to the interpla+ of the at5ris# rules and the passi4e acti4it+ loss rules9 ( hope that
this anal+sis %ill help +ou ma#e a more informed in4estment decision9 (f +ou need an+
further explanation6 please contact me9
Sincerel+6
;ibba Eanes6 *P/
Partner
Examples "" to ")
2'9 ;eeCs share of /B*Cs loss in 2--- is ,2-6--- D,"--6--- M 92- o%nership interestE6 and
the entire loss is suspended under the passi4e loss rules9 Fis share of the passi4e income
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5-14 2001 Entities Volume/Solutions Manual
in 2--1 is ,"-6--- D,2--6--- M 92- o%nership interestE9 Fis at5ris# amount is ,2-6---
D,12-6--- 5 ,2-6--- passi4e loss in 2--- L ,"-6--- share of income in 2--1E9 (n 2--16
he ma+ deduct ,"-6--- of his ,2-6--- suspended loss against the passi4e income9 This
lea4es a ,"-6--- suspended loss at the end of 2--19 pp9 &5- to &52
2)9 <ran is a material participant6 so the passi4e loss limits do not appl+9 The at5ris# rules
limit <ranNs prior +ear deduction to ,"-6---6 the amount she is at ris#9 This reduces her
at5ris# amount to ,- D,"-6--- at5ris# amount 5 ,"-6--- deductionE9 The remaining
,1-6--- is suspended under the at5ris# limits9 The current income increases <ranNs at5ris#
amount to ,-6--- D,- beginning balance L ,-6--- incomeE9 This %ill enable her to
deduct the ,1-6--- loss from last +ear that %as suspended under the at5ris# limits9 Fer
at5ris# amount at the end of the current +ear is ,2-6--- D,-6--- 5 ,1-6--- deduction for
the prior +ear lossE9 pp9 &512 and &513
229 a9 (nitiall+ the remaining ,1&6--- is disallo%ed b+ the at5ris# limits9 Since Soong is
not a material participant6 ,"&6--- of his ,'-6--- loss is reclassified as a passi4e
loss and disallo%ed under the passi4e loss limits9 Therefore6 SoongNs /0( is
,2126--- D,2--6--- salar+ L ,126--- portfolio incomeE9
b9 (nitiall+ the remaining ,1&6--- is disallo%ed b+ the at5ris# limits9 Since Soong is a
material participant6 ,"&6--- of his ,'-6--- loss is deductible as an acti4e loss9
Therefore6 SoongNs /0( is ,1)6--- D,2--6--- salar+ L ,126--- portfolio income 5
,"&6--- acti4e lossE9
Examples "" to ")
239 The fundamental issue is ho% can the time that /lan de4otes to his business best be
allocated across the 4arious businesses in order to minimiAe the negati4e impact of the
material participation rules as set out in the 7egulations9 7elated to this issue are se4eral
points that need to be identified and resol4ed9
Fo% are the 4arious businesses grouped together to form acti4ities and ho% man+
hours does /lan spend %or#ing in each acti4it+J
Fo% man+ emplo+ees are %or#ing at each of the businesses and ho% man+ hours
ha4e the+ %or#edJ
Ihat t+pe of %or# can /lanCs %ife do to ensure that her participation %ill be treated
as being hisJ
Ihether /lan is a limited partner in an+ of the businesses D%hich %ould allo% for
appl+ing the rules in a different %a+E9
pp9 &52& to &523
-9 (f losses %ere limited onl+ b+ the at5ris# rules6 Sam %ould be able to deduct the
follo%ing amounts in 1333 and 2---9
>ear ;oss /llo%edT =isallo%ed
1333 ,"-6--- ,-6--- ,1-6---
2--- -6--- 5-5 -6---
,)-6--- ,-6--- ,"-6---
T/llo%ed under the at5ris# rules6 then reclassified as passi4e losses and subBect to the
passi4e loss limitations9
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Losses and Loss Limitations 5-15
Fo%e4er6 the losses are limited b+ the passi4e loss rules as follo%s:
>ear Passi4e =eductible Suspended
1333 ,-6--- ,5-5 ,-6---
2--- 5-5 5-5 5-5
,-6--- ,5-5 ,-6---
(n 2--16 the ,&-6--- income increases SamNs at5ris# amount to ,&-6--- so he is allo%ed
to deduct the ,"-6--- of disallo%ed losses in 2--19 The ,&-6--- is passi4e income
%hich can be offset b+ ,-6--- of suspended losses6 lea4ing a suspended loss of ,2-6---9
/t the end of 2--16 Sam has no unused losses under the at5ris# rules6 ,2-6--- of
suspended passi4e losses and a ,1-6--- adBusted basis in the acti4it+ D,-6--- adBusted
basis on 1/1/33 5 ,"-6--- loss in 1333 5 ,-6--- loss in 2--- L ,&-6--- income in 2--1E9
Examples 21 and "" to ")
19 Smith6 7aabe6 and 1alone+6 *P/s
&1-1 1adison 7oad
*incinnati6 8hio "&22)
1arch &6 2---
1r9 :oe *oo#
12& Fill Street
*harleston6 IO 2&11
=ear 1r9 *oo#:
This letter is in response to +our in@uir+ regarding the ,&-6--- loss +ou incurred this +ear
in conBunction %ith +our in4estment in the apartment building6 %hich ( ha4e assumed is
not lo%5income housing gi4en that it is located in an exclusi4e part of the cit+9 /s (
understand +our situation6 +ou anticipate that +our current /0(6 exclusi4e of the loss
flo%ing from the real estate rental acti4it+6 %ill be ,1"-6--- and +ou %ish to determine
%hether the loss is either partiall+ or full+ deductible9
/s +ou are a%are6 the apartment rental acti4it+ is considered a passi4e acti4it+6 and6 in
general6 is subBect to the passi4e acti4it+ rules9 Fo%e4er6 because +ou are an acti4e
participant in the in4estment6 +ou %ill be able to deduct ,&6--- under a real estate rental
exception to the passi4e acti4it+ rules9 1ore specificall+6 the la% allo%s losses of up to
,2&6--- from certain real estate rental acti4ities to be deducted each +ear9 Fo%e4er6 if a
taxpa+erNs /0( exceeds ,1--6---6 the amount deductible in the current +ear is reduced b+
&-. of e4er+ dollar of /0( o4er ,1--6---9 8nce a taxpa+erNs /0( reaches ,1&-6---6 no
current loss deduction is allo%ed9 Because +our /0( is expected to be ,1"-6---6 the
maximum allo%able loss of ,2&6--- is reduced as follo%s: G,2&6--- Dmaximum
allo%ableE 5 9&-D,1"-6--- /0( 5 ,1--6---EH9 Therefore6 +our /0( %ould be ,1&6---
after the allo%able ,&6--- loss D,1"-6--- 5 ,&6---E9 The remaining ,"&6--- loss that
%ould not be deductible in the current +ear is suspended under the passi4e loss rules and
%ould be a4ailable in future +ears9
(f +ou do not acti4el+ participate in this acti4it+ next +ear6 and a loss is generated6 none of
it %ill be deductible under the real estate rental exception9 :oe6 if +ou ha4e an+ additional
@uestions or %ould li#e further clarification of this matter6 please call me9
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Sincerel+6
:ohn :9 :ones6 *P/
pp9 &52 to &5"
29 =onald does not satisf+ both re@uirements for certain real estate professionals that allo%
nonpassi4e treatment for losses9 8f the 26-- hours =onald %or#ed during the +ear6 onl+
161-- hours6 or less than half6 in4ol4ed real estate trades or businesses in %hich he
materiall+ participated9 Therefore6 his real estate rental acti4ities are passi4e acti4ities9
Fo%e4er6 the '-- hours =onald de4oted to his real estate de4elopment business satisfies
the &--5hour material participation re@uirement9 Therefore6 the ,126--- loss is full+
deductible9
Under the rental real estate exception6 =onald can deduct ,2&6--- of his ,2'6--- of
losses9 The remaining ,16--- of losses are suspended passi4e losses9
pp9 &52 to &5"
9 Smith6 7aabe6 and 1alone+6 *P/s
&1-1 1adison 7oad
*incinnati6 8hio "&22)
=ecember 1&6 2---
Scott 1+ers
'- Pittsfield =r9
*hampaign6 (; '1221
=ear Scott6
Based on our discussion6 ( understand that +ou are attempting to @ualif+ under the special
rules for real estate professionals as a material participant in order to deduct against +our
nonpassi4e income an+ losses generated b+ this rental acti4it+9 *onse@uentl+6 +ou should
document a sufficient number of hours so that +ou %ill meet the material participation
standard9
>our acti4ities to date appear to be %ithin the bounds of the tax la% as it is %ritten6 but
+ou also appear to be stretching its limits9 >ou need to be careful to a4oid an+
appearance of or ta#ing an+ actual fraudulent actions on +ou or +our %ifeCs part9
Essentiall+6 the issue is %hether the participation hours generated are of substance or
merel+ of form9 /nother issue is %hether one of the principal purposes of the tas#s being
performed is to a4oid the disallo%ance of passi4e losses or credits9
Should +ou need more information or need me to clarif+ an+thing6 please call9
Sincerel+6
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Losses and Loss Limitations 5-17
:a#e Smith6 *P/
p9 &5
"9 7oger is a material participant in the tax practice but not in the real estate de4elopment
acti4it+6 %hich causes the real estate de4elopment to be classified as passi4e9 <urther6 the
apartment leasing operation is a passi4e acti4it+ because it is a rental acti4it+ and it does
not @ualif+ for the real estate rental exception gi4en the taxpa+ersC le4el of income9
Therefore6 the income from the tax practice ma+ not be offset b+ either the losses from
the real estate de4elopment business or the apartment leasing operation9
7oger does not @ualif+ for the exception for real estate professionals because he has not
spent more than half of his personal ser4ices in real estate trades or businesses in %hich
he materiall+ participates9 Fe has not been a material participant in the real estate
de4elopment acti4it+ Di9e96 he has not spent more than &-- hours in the acti4it+E?
therefore6 the resulting loss is treated as a passi4e loss9 <urther6 he does not @ualif+ for
the limited ,2&6--- exception a4ailable for rental real estate acti4ities for the apartment
leasing operation because his Boint income tax return %ill sho% /0( in excess of
,1&-6---9
pp9 &526 &56 and Example "3
&9 0ene is considered a material participant in the tax practice but not in the apartment
leasing operation9 Fo%e4er6 because he acti4el+ participates in the real estate rental
acti4it+ and o%ns at least 1-. in the acti4it+6 ,2&6--- of the ,-6--- loss is deductible in
the current +ear against his tax practice income9 The remaining ,&6--- loss from the
rental acti4it+ is suspended as a passi4e acti4it+ loss9 pp9 &52 and &5
'9 Fo% /cti4e is /cti4eJ Under the real estate rental acti4ities exception6 0eorge and
;ouise @ualif+ to deduct a loss of up to ,2&6--- from the real estate rental acti4it+ if the+
actively participate in the acti4it+ and o%n a 1- percent or more interest in the acti4it+9
Fere the issue is %hether their in4ol4ement has reached the le4el of acti4e participation
for the +ear9 (n general6 being an acti4e participant re@uires the o%ner to ma#e
management decisions in a significant and bona fide sense9 The facts re4ealed in the
scenario suggest that the+ ha4e ta#en a Qhands offR approach and ha4e left most6 if not
all6 of the management decisions to the propert+ manager9 $onetheless6 the tax preparer
ser4icing 0eorge and ;ouise should in@uire more about the role that the+ actuall+ pla+ed
in the operations of the rental unit to be certain about their le4el of participation9 <or
example6 perhaps the+ actuall+ %ere in4ol4ed in ma#ing #e+ management decisions such
as appro4ing ne% tenants6 deciding on rental terms6 and appro4ing capital or repair
expenditures9 Such in4ol4ement %ould be enough for them to be considered acti4e
participants9 Fo%e4er6 gi4en that 0eorge and ;ouise are surprised that a loss resulted
from the operations6 the+ ma+ not ha4e en4isioned the need to acti4el+ participate9
Therefore6 unless additional supporting e4idence comes to light6 claiming a deduction
under the real estate rental acti4ities exception does not appear to be supported b+ the
facts of the scenario b+ 4irtue of their lac# of participation9
)9 (da can utiliAe ,2-6--- of losses and ,16"-- of credits as follo%s9
(ncome D;ossE: /cti4it+ / D,126---E
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/cti4it+ B D126---E
/cti4it+ * 1-6---
$et loss D,2-6---E
UtiliAed loss 2-6---
Suspended loss , 5-5
UtiliAed credit , 16"--
Suspended credit , )--
/fter deducting the loss of ,2-6---6 (da has a4ailable a deduction e@ui4alent of ,&6---
G,2&6--- Dmaximum loss allo%edE 5 ,2-6--- DutiliAed lossEH9 The maximum amount of
credits (da ma+ claim is ,16"-- G,&6--- Ddeduction e@ui4alentE x 922 Dmarginal tax
brac#etEH that is allocated to /cti4it+ /9 Examples "3 and &-
29 7ental loss D,1-&6---E
7ental income 2&6---
8ther passi4e income 26---
$et passi4e rental loss D, "26---E
=eductible against other income 2&6---
Suspended rental loss D, 26---E
Example "3
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Losses and Loss Limitations 5-19
RESEARCH PROBLEMS
19
Smith6 7aabe6 and 1alone+6 *P/s
&1-1 1adison 7oad
*incinnati6 8F "&22)
<ebruar+ 26 2---
1r9 0eorge :ohnson
1-- /pple ;ane
St9 Paul6 1innesota &&12
=ear 1r9 :ohnson:
This letter is in response to +our re@uest concerning %hether +ou can claim a casualt+
loss for the damage +our automobile sustained %hen it fell through the ice as +ou %ere
%atching an iceboat race9

Based on our research6 %e belie4e that the e4ent constitutes a casualt+ and as such6 +ou
are entitled to claim a casualt+ loss for the damage to +our car9
Should +ou need more information or need further clarification on an+ matter6 do not
hesitate to contact me9
Sincerel+ +ours6
:ohn :9 :ones6 *P/
Partner
T/M <(;E 1E187/$=U1
:anuar+ 236 2---
<781: :ohn :9 :ones
SUB:E*T: 0eorge :ohnsonCs *asualt+ ;oss
Toda+ ( tal#ed %ith 0eorge :ohnson concerning an incident in4ol4ing his car9
Se4eral %ee#s ago6 0eorge par#ed his car on a la#e %hile he %as %atching an iceboat
race9 =uring the race6 the ice beneath his car unexpectedl+ ga4e %a+6 and the car san# to
the bottom of the la#e9 0eorge %ants to #no% %hether he %ill be entitled to claim a
casualt+ loss for the damage to his car9
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The facts of 0eorgeCs case are similar to 7e49 7ul9 '35226 13'351 *9B9 &29 (n the
ruling6 the taxpa+erCs automobile %as par#ed on the ice %hile he %as ice fishing9 /
casualt+ loss %as allo%ed for the purpose of claiming a deduction under ! 1'&9
Based on this ruling6 ( ha4e ad4ised 0eorge that he %ill be entitled to claim a
casualt+ loss for the damage to his car9
29 :ohn and SamanthaCs plan to generate rent income that %ould then be offset b+ other%ise
suspended passi4e losses is 4er+ creati4e9 Unfortunatel+ for :ohn and Samantha6
ho%e4er6 7eg9 ! 19"'352DfED'E holds other%ise9 (f propert+ is rented to a nonpassi4e
acti4it+6 such as :ohnCs medical practice6 then such gross rent income generated is treated
as though it is not from a passi4e acti4it+ if the propert+ is used in a trade or business
acti4it+ in %hich the taxpa+er materiall+ participates9 This 7egulation %ould essentiall+
eliminate the benefits that :ohn and Samantha desire b+ treating the rent income as acti4e
income rather than passi4e9
(n a case in4ol4ing an attorne+ %hose la% practice rented a building o%ned b+ the
attorne+ and his %ife6 the 4alidit+ of 7eg9 ! 19"'352DfED'E %as re4ie%ed b+ a court9
GFransen v. U.S., 3252 UST* U&-6))'6 22 /<T7 2d 325''21 D=9*t9 ;a96 1332E6 affd9 in
3352 UST* U&-62226 2" /<T7 2d 335''-6 131 <9d9 &33 D*/5&6 1333EH9 The *ourt
concluded that the 7egulation is 4alid6 in a fact pattern that is similar to :ohn and
SamanthaCs9 The (7S properl+ recharacteriAed as non5passi4e the attorne+ and %ifeNs
income from the rental acti4it+9 The income %as treated as nonpassi4e because the
building %as rented b+ a trade or business Di9e96 his la% firmE in %hich he materiall+
participated9 The statute6 legislati4e histor+6 and the 7egulationCs rationale sho%ed that
the 7egulation did not arbitraril+ negate ! "'3Cs classification of rental acti4it+ as
passi4e9
9 /ssuming 0eorge and :ud+ can sho% that the+ are carr+ing on the chartering acti4it+ for
profit Di9e96 it is not a hobb+E6 an+ losses resulting from the acti4it+ %ould be considered
passi4e unless the+ can sho% that the+ are materiall+ participating in the chartering
4enture9 The+ ha4e ob4iousl+ not met the more than &--5hour standard of material
participation9 Fo%e4er6 Temp9 7eg9 ! 19"'35&TDaEDE pro4ides that if the taxpa+er
participates in an acti4it+ for more than 1-- hours Dbut not more than &-- hoursE6 the
material participation standard is met if the taxpa+erCs participation is e@ual to or more
than an+ other indi4idual in4ol4ed in the 4enture9 (n this case6 such other indi4idual is
*aptain 1ac9 Thus6 based on this test6 0eorge and :ud+ %ould be re@uired to de4ote
more hours in the acti4it+ than *aptain 1ac to be considered material participants9
(n all probabilit+6 *aptain 1ac has de4oted more than 12- hours during the course of a
rental season gi4en the scope of his duties9 Unless 0eorge and :ud+ can sho% that their
le4el of participation is at least e@ual to *aptain 1acCs6 their efforts %ould be considered
insubstantial and not at a le4el of material participation9 Therefore6 an+ losses resulting
from this chartering acti4it+ %ould be treated as passi4e9 See Thomas C. Oberle, et ux. v.
Commissioner DT9*9 1emo9 133251&'6 )& T*1 22-"E %here the Tax *ourt ruled in
similar fashion in a fact pattern li#e 0eorge and :ud+Cs9 (n addition6 see William A.
oshorn DT9*9 1emo9 1335&)26 '' T*1 1"33E and Chapin, !. Theodore DT9*9 1emo9
133'5&'6 )1 T*1 2-2)E9
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"9 The (nternet /cti4it+ research problems re@uire that the student access 4arious sites on
the (nternet9 Thus6 each studentCs solution li#el+ %ill 4ar+ from that of the others9
>ou should determine the s#ill and experience le4els of the students before ma#ing the
assignment6 coaching them %here necessar+ so as to broaden the scope of the exercise to
the entire a4ailable electronic %orld9
1a#e certain that +ou encourage students to explore all parts of the Iorld Iide Ieb in
this process6 including the #e+ tax sites6 but also information found through the %eb sites
of ne%spapers6 magaAines6 businesses6 tax professionals6 go4ernment agencies6 political
outlets6 and so on9 The+ should %or# %ith (nternet resources other than the Ieb as %ell6
including ne%sgroups and other interest5oriented lists9
Build interaction into the exercise %here4er possible6 as#ing the student to send and
recei4e e5mail in a professional and responsible manner9
&9 See the (nternet /cti4it+ comment abo4e9
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NOTES