Loss, of any type, is an unavoidable part of our lives. But within the universe of losses we can suffer, economic and financial losses have been particularly prominent recently. As difficult as losses may be to overcome, the income tax consequences from financial losses you may have experienced in most instances can provide a financial benefit.
Losses for income tax purposes are characterized in one of three broad categories—those related to personal use property, those arising from a trade or business, and those associated with investments.
When many of us would consider a loss to have occurred, however, differs significantly from when a loss for income tax purposes has occurred. Decreases in value rarely are recognized for purposes of determining taxable income. For a loss to produce an income tax benefit the owner of the property must relinquish ownership of it for a non-charitable reason. For example, selling, abandoning or confiscation of property can produce a loss that is recognized for income tax purposes; gifting items to others that have lost value normally will not provide a tax benefit.
Determining the amount of loss is usually established by comparing what you paid to acquire the property sold, abandoned or confiscated and comparing it to the value of the property, if any, received in exchange. In instances where the relinquished property was acquired by bequest or gift, the amount paid for the property by the decedent or the donor is generally used to determine whether a taxable loss has occurred.
Losses associated with property used personally are seldom recognized for income tax purposes. An exception to the general rule relates to losses resulting from theft or casualty such as flood, hurricane or tornado. Losses directly resulting from these events are always deductable for income tax purposes unless the loss is reimbursed by insurance. Generally speaking, for individuals, only the portion of the total loss from theft or casualty that exceeds $100 plus 10 percent of adjusted gross income is deductible.
Losses arising from the conduct of a trade or business are divided into two classes. One class, called passive losses, consists of losses arising from a business if the owner is not actively engaged in its activities or with managing it or if the income of the business is derived almost entirely from the use of property. Rent received from leasing real property is an example of income derived from the use of property. Passive losses generally can only be used to reduce passive income. For example, a net passive loss sustained in one tax year from leasing office space can reduce or eliminate net passive income generated in the same tax year from leasing a location to a retail business.
The other category consists of losses from all other businesses which can reduce taxable income of any type almost without limitation. In addition, an election can be made allowing these trade or business losses to be carried back and reduce taxable income in previous tax years generating an immediate tax refund. Consequently if a business owner expects a loss in the current tax year consideration should be given to accelerating expenses into the tax year to increase the loss which then can be carried back to a prior year and generate a larger tax refund.
The final category of loss is associated with investments and relates to an asset class normally called capital assets. Consequently, they are called capital losses. This category is directly related to money invested as opposed to efforts expended or for the use of property. Capital assets can vary from undeveloped land to shares of Microsoft. Similar to passive losses, capital losses are permitted to offset or reduce gains produced from the sale of capital assets almost without limitation.
For all non-corporate taxpayers, however, if total capital losses exceed capital gains during a tax year no more than $3,000 of taxable income from other categories can be offset by capital losses. The portion of capital losses that exceed $3,000 plus capital gains in a particular tax year are carried over to succeeding tax years where they can be used to reduce capital gains as well as $3,000 of income from other categories. Capital losses can continue to be carried-over until fully utilized.
Not surprisingly numerous exceptions to these general rules make reporting losses complicated. However, while the financial impact of losses is difficult to endure, they can be partially mitigated by the income tax benefits they can produce.
John D. Blair Sr. is a managing partner at Blair, Bohle & Whitsitt, PLLC, a CPA firm that provides accounting, assurance, tax compliance and planning services in addition to strategic planning and tax minimization strategies to privately held businesses. Contact him at 704-841-9800 or visit www.bbwpllc.com.