Chapter 7 1ax Notes

Worklng wlLh Lax formula for lndlvlduals requlres proper classlflcaLlon of lLems LhaL are deducLlons from ACl and
deducLlons for ACl
8uslness Lxpenses dlscussed ln Lhls chapLer are reducLlons of gross lncome Lo arrlve aL Lhe Laxpayers ACl
Lxpenses Losses lncurred ln connecLlon wlLh a LransacLlon enLered lnLo for proflL and aLLrlbuLable Lo renLs royalLles
are deducLed for ACl
All oLher expenses losses lncurred ln connecLlon wlLh a LransacLlon enLered lnLo for proflL are deducLed from ACl
Lxample Cambllng Losses
lf a Lrade or buslness losses are deducLlons for ACl
lf noL a Lrade or buslness losses are lLemlzed deducLlons for
ueducLlble losses on personal use properLy are noL deducLed as lLemlzed deducLlon
lLemlzed deducLlons are deducLlons from ACl
A buslness bad debL ls classlfled as a deducLlon for ACl
A nonbuslness bad debL ls classlfled as a shorLLerm caplLal loss

8ad uebLs
lf a Laxpayer sells goods or provldes servlces on credlL and Lhe accounL recelvable subsequenLly becomes
worLhless a bad debL deducLlon ls permlLLed only lf Lhe lncome arlslng from Lhe creaLlon of Lhe accounL
recelvable was prevlously lncluded ln lncome
no deducLlon ls allowed for a bad debL arlslng from Lhe sale of a producL or servlce when Lhe Laxpayer ls on Lhe
cash basls because no lncome ls reporLed unLll Lhe cash has been collecLed
ermlLLlng a bad debL deducLlon for a cash basls Laxpayer would amounL Lo a double deducLlon because Lhe
expenses of Lhe producL or servlce rendered are deducLed when paymenLs are made Lo suppllers and employees
or aL Lhe Llme of Lhe sale

Lxamp|e 1 age 73
1racy an |nd|v|dua| |s a so|e propr|etor She operates her bus|ness named Lxecut|ve Account|ng and 1ax Serv|ces
Last year at h|red 1racy to he|p h|m w|th the account|ng for h|s sma|| bus|ness 1racy a|so prepared the S
Corporat|on |ncome tax return for the bus|ness and at's persona| |ncome tax return 1racy b|||ed at 58000 for the
serv|ces she performed at has never pa|d the b||| h|s bus|ness no |onger ex|sts and h|s whereabouts are unknown
If 1racy |s an accrua| bas|s taxpayer she |nc|udes the 58000 |n |ncome when the serv|ces are performed When she
determ|ned that at's account w||| not be co||ected she deducts the 58000 as a bad debt expense
If 1racy |s a cash bas|s taxpayer she does not |nc|ude the 58000 |n |ncome unt|| payment |s rece|ved When she
determ|nes that at's account w||| not be co||ected she cannot deduct the 58000 as a bad debt expense because |t
was never recogn|zed as |ncome

A bad debL can also resulL from Lhe nonpaymenL of a loan made by Lhe Laxpayer or from purchased debL lnsLrumenLs

Speclflc Charge Cff MeLhod
1axpayers may use only Lhe speclflc charge off meLhod ln accounLlng for bad debLs
CerLaln flnanclal lnsLlLuLlons are allowed Lo use Lhe reserve meLhod for compuLlng deducLlons for bad debLs
A Laxpayer uslng a speclflc charge off meLhod may clalm a deducLlon when a speclfled buslness debL becomes
elLher parLlally or wholly worLhless or when a speclflc nonbuslness debL becomes wholly worLhless
lor Lhe buslness debL Lhe Laxpayer musL saLlsfy Lhe l8S LhaL Lhe debL ls parLlally worLhless and musL
demonsLraLe Lhe amounL of Lhe worLhlessness
lf buslness debL prevlously deducLed as parLlally worLhless becomes LoLally worLhless ln a fuLure year only Lhe
remalnder noL prevlously deducLed can be deducLed ln Lhe fuLure year
ln Lhe case of LoLal worLhlessness a deducLlon ls allowed for Lhe enLlre amounL ln Lhe year Lhe debL becomes
worLhless
1he amounL of Lhe deducLlon depends on Lhe Laxpayers basls ln Lhe bad debL
lf Lhe debL arose from Lhe sale of servlces or producLs and Lhe face amounL was prevlously lncluded ln lncome
LhaL amounL ls deducLlble
lf Lhe Laxpayer purchased Lhe debL Lhe deducLlon ls equal Lo Lhe amounL Lhe Laxpayer pald for Lhe debL
lnsLrumenL
Cne of Lhe more dlfflculL Lasks ls deLermlnlng lf and when a bad debL ls worLhless
1he loss ls deducLlble only ln Lhe year of parLlal or LoLal worLhlessness for buslness debLs and only ln Lhe year of
LoLal worLhlessness for nonbuslness debLs
Legal proceedlngs need noL be lnlLlaLed agalnsL Lhe debLor when Lhe surroundlng facLs lndlcaLe LhaL such acLlon
wlll noL resulL ln collecLlon

Lxamp|e 2 age 74
In 2009 koss |oaned 51000 to kay who agreed to repay the |oan |n two years In 2011 kay d|sappeared after the
note became de||nquent If a reasonab|e |nvest|gat|on by koss |nd|cates that he cannot f|nd kay or that a su|t aga|nst
kay wou|d not resu|t |n co||ect|on koss can deduct the 51000 |n 2011

8ankrupLcy ls generally an lndlcaLlon of aL leasL parLlal worLhlessness of a debL 8ankrupLcy may creaLe
worLhlessness before Lhe seLLlemenL daLe lf Lhls ls Lhe case Lhe deducLlon may be Laken ln Lhe year of
worLhlessness

lf a recelvable has been wrlLLen off (deducLed) as uncollecLlble durlng Lhe Lax year and ls subsequenLly collecLed
durlng Lhe currenL Lax year Lhe wrlLeoff ls reversed
lf a recelvable has been wrlLLen off (deducLed) as uncollecLlble Lhe collecLlon of a recelvable ln a laLer Lax year
may resulL ln lncome belng reporLed lncome wlll resulL lf Lhe deducLlon ylelded a Lax beneflL ln Lhe year lL was
Laken
Lxamples 41 and 42 ln ChapLer 3

8uslness versus nonbuslness 8ad uebLs
A nonbuslness bad debL ls a debL unrelaLed Lo Lhe Laxpayers Lrade or buslness elLher when lL was creaLed or
when lL became worLhless
1he naLure of a debL depends on wheLher Lhe lender was engaged ln Lhe buslness of lendlng money or wheLher
Lhere ls a proxlmaLe relaLlonshlp beLween Lhe creaLlon of Lhe debL and Lhe lenders Lrade or buslness
1he use Lo whlch Lhe borrowed funds are puL by Lhe debLor ls of no consequence
Loans Lo relaLlves or frlends are Lhe mosL common Lype of nonbuslness bad debL

Lxample 4 age 73
Martha |oaned her fr|end Iam|| 52S000 Iam|| used the money to start a bus|ness wh|ch subsequent|y fa||ed When
Iam|| d|ed after hav|ng made payments of 57000 on the |oan he was |nso|vent Lven though the proceeds of the |oan
were used |n a trade or bus|ness the |oan |s a nonbus|ness bad debt because the bus|ness was Iam||'s not Martha's

1he dlsLlncLlon beLween a buslness bad debL and a nonbuslness bad debL ls lmporLanL
A buslness bad debL ls deducLlble as an ordlnary loss ln Lhe year lncurred
A nonbuslness bad debL ls always LreaLed as a shorLLerm caplLal loss
8egardless of Lhe age of a nonbuslness bad debL Lhe deducLlon may be of a llmlLed beneflL due Lo
llmlLaLlons on caplLal loss deducLlblllLy ln one year
Maxlmum amounL of a shorLLerm caplLal loss Lhan an lndlvldual can deducL agalnsL ordlnary lncome ln any one
year ls $3000
AlLhough no deducLlon ls allowed when a nonbuslness debL ls parLlally worLhless
1he Laxpayer ls enLlLled Lo deducL Lhe neL amounL of Lhe loss upon flnal seLLlemenL







Lxamp|e S age 7S
In 2010 Le|f so|d h|s bus|ness but reta|ned a c|a|m (note or account rece|vab|e) aga|nst 8ob 1he c|a|m became
worth|ess |n 2011 Le|f's |oss treatment as a bus|ness bad debt because the debt was created |n the conduct of h|s
former trade or bus|ness Le|f |s accorded bus|ness bad debt treatment even though he was ho|d|ng the note as an
|nvestor and was no |onger |n a trade or bus|ness when the c|a|m became worth|ess

1he nonbuslness bad debL provlslons are noL appllcable Lo corporaLlons
lL ls assumed LhaL any loans made by a corporaLlon are relaLed Lo lLs Lrade or buslness
Any bad debLs of a corporaLlon are buslness bad debLs

Loans beLween relaLed parLles
Loans beLween relaLed parLles (especlally famlly members) ralse Lhe lssue of wheLher Lhe LransacLlon was a
bone flde loan or a glfL
8egulaLlons sLaLe LhaL a bone flde debL arlses from a debLorcredlLor relaLlonshlp based on a valld and
enforceable obllgaLlon Lo pay a flxed or deLermlnable sum of money
lndlvldual clrcumsLances musL be examlned Lo deLermlne wheLher advances beLween relaLed parLles are glfLs or
loans
Some conslderaLlons are Lhese
Was a noLe properly execuLed
Was Lhere a reasonable raLe of lnLeresL
Was collaLeral provlded
WhaL collecLlon efforLs were made
WhaL was Lhe lnLenL of Lhe parLles

Lxamp|e 6 age 76
Lana |oans 52000 to her w|dowed mother for an operat|on Lana's mother owns no property and |s not emp|oyed
and her on|y |ncome cons|sts of Soc|a| Secur|ty benef|ts No note |s |ssued for the |oan no prov|s|on for |nterest |s
made and no repayment date |s ment|oned In the current year Lana's mother d|es |eav|ng no estate Assum|ng the
|oan |s not repa|d Lana cannot take a deduct|on for a nonbus|ness bad debt because the facts |nd|cate that no debtor
cred|tor re|at|onsh|p ex|sted

WorLhless SecurlLles
A loss ls allowed for securlLles LhaL become compleLely worLhless durlng Lhe year (worLhless securlLles)
Such securlLles are shares of sLock bonds noLes or oLher evldence of lndebLedness lssued by a corporaLlon or
governmenL
1he losses are generally LreaLed as caplLal losses deemed Lo have occurred on Lhe lasL day of Lhe Laxable year
8y LreaLlng Lhe loss as havlng occurred on Lhe lasL day of Lhe Laxable year a loss LhaL would oLherwlse have been
classlfled as shorL Lerm (lf Lhe daLe of worLhlessness was used) may be classlfled as long Lerm caplLal loss
CaplLal losses may be of llmlLed beneflLs due Lo Lhe $3000 caplLal loss llmlLaLlon

Lxamp|e 7 age 76
Assume that Martha |s a ca|endar year taxpayer She owned stock |n Cw| Corporat|on (a pub||c|y he|d company) She
acqu|red the stock as an |nvestment on Cctober 1 2010 at a cost of 5S0000 Cn May 31 2011 the stock became
worth|ess as the company dec|ared bankruptcy S|nce the stock |s deemed to have become worth|ess as of December
31 2011 Martha has a cap|ta| |oss from an asset he|d for f1S months (a |ongterm cap|ta| |oss)








Small 8uslness SLock
1he general rule ls LhaL shareholders recelve caplLal galn or loss LreaLmenL upon Lhe sale or exchange of sLock
lL ls posslble Lo recelve an ordlnary loss deducLlon lf Lhe loss ls susLalned on small buslness sLock (SecLlon 1244
SLock)
1hls loss could arlse from a sale of Lhe sLock or from Lhe sLock becomlng worLhless
Cnly lndlvlduals who acqulred Lhe sLock from Lhe corporaLlon are ellglble Lo recelve ordlnary loss LreaLmenL
under SecLlon 1244
1he ordlnary loss LreaLmenL ls llmlLed Lo $30000 ($100000 for marrled lndlvlduals flllng [olnLly) per year
Losses on SecLlon 1244 sLock ln excess of Lhe sLaLuLory llmlLs recelve caplLal loss LreaLmenL

1he corporaLlon musL meeL cerLaln requlremenLs for Lhe loss on such sLock Lo be LreaLed as ordlnary raLher
Lhan caplLal
1he ma[or requlremenL ls LhaL Lhe LoLal amounL of money oLher properLy recelved by Lhe corporaLlon for
sLock as a conLrlbuLlon Lo caplLal (or paldln surplus) does noL exceed $1 mllllon
1he $1 mllllon LesL ls made aL Lhe Llme Lhe sLock ls lssued
SecLlon 1244 sLock can be common sLock or preferred sLock
SecLlon 1244 applles only Lo losses
lf SecLlon 1244 sLock ls sold aL a galn Lhe SecLlon ls noL appllcable and Lhe galn ls a caplLal galn
See ChapLer 18 for addlLlonal dlscusslon of SecLlon 1244

Lxamp|e 8 age 78
Ir|s a s|ng|e |nd|v|dua| was |ook|ng for an |nvestment that wou|d g|ve some d|vers|ty to her stock portfo||o A fr|end
suggested she acqu|re some stock |n Lag|e Corporat|on for 5100000 At the t|me Ir|s acqu|red her stock from Lag|e
Corporat|on the corporat|on had 5700000 of pa|d|ncap|ta| nence the stock qua||f|ed as Sect|on 1244 stock Cn
Iune 20 2011 Ir|s so|d a|| her Lag|e stock for 520000 8ecause the Lag|e stock |s Sect|on 1244 stock Ir|s has 5S0000
of ord|nary |oss and 530000 of |ongterm cap|ta| |oss

Losses of lndlvlduals
An lndlvldual may deducL Lhe followlng losses under SecLlon 163
Losses lncurred ln a Lrade or buslness
Losses lncurred ln a LransacLlon enLered lnLo for proflL
Losses caused by flre sLorm shlpwreck or oLher casualLy or by LhefL

An lndlvldual Laxpayer may deducL losses Lo properLy used ln Lhe Laxpayers Lrade or buslness or losses Lo
properLy used n a LransacLlon enLered lnLo for proflL
Lxamples lnclude a losL on properLy used ln a proprleLorshlp a loss on properLy held for renL or a loss on sLolen
bearer bonds
An lndlvlduals losses on properLy used ln a Lrade or buslness or on LransacLlons enLered lnLo for proflL are noL
llmlLed Lo losses caused by flre sLorm shlpwreck or oLher casualLy or by LhefL
An lndlvldual Laxpayer sufferlng losses from damage Lo nonbuslnsess properLy can deducL only Lhose losses
aLLrlbuLable Lo flre sLorm shlpwreck or oLher casualLy or LhefL
CLher casualLy casualLles analogous Lo flre sLorm or shlpwreck Also lncludes accldenLal loss of properLy
provlded Lhe loss quallfles under Lhe same rules as any oLher casualLy properLy provlded Lhe loss quallfles under
Lhe same rules as any oLher casualLy









1hese rules are LhaL Lhe loss musL resulL from an evenL LhaL ls
ldenLlflable
uamaglng Lo properLy
Sudden unexpecLed unusual ln naLure

Sudden LvenL one LhaL ls swlfL and preclplLous and noL gradual or progresslve
unexpecLed LvenL LvenL LhaL ls ordlnarlly unanLlclpaLed and occurs wlLhouL Lhe lnLenL of Lhe lndlvldual
who suffers Lhe loss
unusual LvenL one LhaL ls exLraordlnary and nonrecurrlng and does noL commonly occur durlng Lhe
acLlvlLy ln whlch Lhe Laxpayer was engaged when Lhe desLrucLlon occurred
Lxamples lnclude hurrlcanes Lornadoes floods sLorms shlpwrecks flres auLo accldenLs mlne cavelns
sonlc booms and vandallsm
1axpayer can Lake a deducLlon for casualLy loss from an auLomoblle accldenL only lf Lhe damage was noL
caused by Lhe Laxpayer's wlllful acL or wlllful negllgence
WeaLher LhaL causes damage (such as a droughL) musL be unusual and severe for Lhe parLlcular reglon

Lxamp|e 9 page 78
1ed parks h|s car on a h||| and fa||s to set the brake proper|y and to curb the whee|s As a resu|t of 1ed's neg||gence
the car ro||s down the h||| and |s damaged 1he repa|rs to 1ed's car shou|d qua||fy for casua|ty |oss treatment s|nce
1ed's act of neg||gence appears to be s|mp|e rather than w|||fu|

LvenLs LhaL are noL casualLles
noL all acL of Cod are LreaLed as casualLy losses for lncome Lax purposes
8ecause a casualLy musL be sudden unexpecLed unusual progresslve deLerloraLlon (such as eroslon
due Lo wlnd or raln) ls noL a casualLy because lL does noL meeL Lhe suddenness LesL
Lxamples of nonsudden evenLs LhaL generally do noL quallfy as casualLles lnclude dlsease lnsecL damage
1ermlLe damage over a perlod of years courLs dlsallowed
Cver a perlod of up Lo 13 monLhs some courLs held sudden deducLlble as casualLy loss
CLher examples LhaL are noL casualLles losses resulLlng from a decllne ln value raLher Lhan acLual loss
Lx 1axpayer home decllned ln value due Lo a landsllde LhaL desLroyed nelghborlng homes buL dld no damage Lo
Laxpayers home
Lx 1axpayer was allowed loss for acLual flood damage done Lo hls properLy buL noL for Lhe decllne ln markeL
value due Lo properLy belng flood prone
1hefL Losses
1hefL lncludes buL ls noL necessarlly llmlLed Lo larceny embezzlemenL robbery
1hefL does noL lnclude mlsplaced lLems
1hefL losses are compuLed [usL llke oLher casualLy losses (dlscussed ln Lhe followlng secLlon) buL Lhe Llmlng for
recognlLlon of Lhe loss dlffers
1hefLs are deducLed ln Lhe year of dlscovery noL Lhe year of Lhe LhefL unless Lhe dlscovery occurs ln Lhe same
year of Lhe LhefL
lf ln Lhe year of dlscovery a clalm exlsLs (agalnsL lnsurance company) and Lhere ls reasonable expecLaLlon of
recoverlng Lhe ad[usLed basls of Lhe asseL from Lhe lnsurance company no deducLlon ls permlLLed
lf ln Lhe year of seLLlemenL Lhe recovery ls less Lhan Lhe asseLs ad[usLed basls a parLlal deducLlon may be
avallable
lf Lhe recovery ls greaLer Lhan Lhe asseLs ad[usLed basls galn may be recognlzed

Lxamp|e 10 age 79
ke|th's new sa||boat wh|ch he uses for persona| purposes was sto|en from the storage mar|na |n December 2010 ne
d|scovered the |oss on Iune 3 2011 and f||ed a c|a|m w|th h|s |nsurance company that was sett|ed on Ianuary 20
2012 Assum|ng there |s a reasonab|e expectat|on of fu|| recovery no deduct|on |s a||owed |n 2011 A part|a|
deduct|on may be ava||ab|e |n 2012 |f the actua| |nsurance proceeds are |ess than the |ower of the fa|r market va|ue or
the ad[usted bas|s of the asset (Loss measurement ru|es are d|scussed |ater |n th|s chapter)

When Lo deducL a CasualLy Losses
Ceneral 8ule Cenerally a casualLy loss ls deducLed ln Lhe year Lhe loss occurs Powever no casualLy loss ls
permlLLed lf a relmbursemenL clalm wlLh a reasonable prospecL of full recovery exlsLs lf Lhe Laxpayer has a
parLlal clalm only parL of Lhe loss can be clalmed ln Lhe year of Lhe casualLy and Lhe remalnder ls deducLed ln
Lhe year Lhe clalm ls seLLled

Lxamp|e 11 age 710
8r|an's new sa||boat was comp|ete|y destroyed by f|re |n 2011 Its cost and fa|r market va|ue were 510000 8r|an's
on|y c|a|m aga|nst the |nsurance company was on a 57000 po||cy and was not sett|ed by yearend 1he fo||ow|ng
year 2012 8r|an sett|ed w|th the |nsurance company for 56000 ne |s ent|t|ed to a 53000 deduct|on |n 2011 and a
51000 deduct|on |n 2012

lf a Laxpayer recelves relmbursemenL for a casualLy loss susLalned and deducLed ln a prevlous year an amended
reLurn ls noL flled for LhaL year lnsLead Lhe Laxpayer musL lnclude Lhe relmbursemenL ln gross lncome on Lhe
reLurn for Lhe year ln whlch lL ls recelved Lo Lhe exLenL LhaL Lhe prevlous deducLlon resulLed ln a Lax beneflL

Lxample 12 age 710
Iran had a deduct|b|e casua|ty |oss of 5S000 on her 2010 tax return Iran's taxab|e |ncome for 2010 was 560000 In
Iune 2011 Iran |s re|mbursed 53000 for the pr|or year's casua|ty |oss Iran |nc|udes the ent|re 53000 |n gross |ncome
for 2011 because the deduct|on |n 2010 produced a tax benef|t

ulsasLer Area Losses
An excepLlon Lo Lhe general rule for Lhe Llme of deducLlon ls allowed for dlsasLer are losses whlch are casualLles
susLalned ln an area deslgnaLed as a dlsasLer area by Lhe resldenL of Lhe unlLed SLaLes
ln such cases Lhe Laxpayer may elecL Lo LreaL Lhe loss as havlng occurred ln Lhe Laxable year lmmedlaLely
precedlng Lhe Laxable year ln whlch Lhe dlsasLer acLually occurred
1he raLlonale for Lhls ls Lo provlde lmmedlaLe rellef Lo dlsasLer vlcLlms ln Lhe form of acceleraLed Lax beneflLs
lf Lhe due daLe plus exLenslon of Lhe prlor years Lax reLurn has noL passed a Laxpayer makes Lhe elecLlon Lo
clalm Lhe dlsasLer area loss on Lhe prlor years Lax reLurn
lf Lhe dlsasLer occurs afLer Lhe prlor years reLurn has been flled lL ls necessary Lo flle an amended reLurn or a
refund clalm
ulsasLer loss LreaLmenL also applles ln Lhe case of a personal resldence LhaL has been rendered unsafe for use as
a resldence because of a dlsasLer 1hls provlslon applles when wlLhln 120 days afLer Lhe resldenL deslgnaLes Lhe
area ls a dlsasLer area Lhe sLaLe or local governmenL where Lhe resldence ls locaLed orders Lhe Laxpayer Lo
demollsh or relocaLe Lhe resldence

Lxamp|e 13 age 710

W keturn to the facts of 1he 8|g |cture on p 72
W Cn September 28 2011 Martha's persona| res|dence was damaged when a hurr|cane caused an oak tree to
fa|| onto the house
1he amount of her un|nsured |oss was 57000
8ecause of the extent of the damage |n the area the res|dent of the Un|ted States des|gnated the
area a d|saster area
W 8ecause Martha's |oss |s a disoster oreo /oss Martha has 2 opt|ons
She may e|ect to f||e an amended return for 2010 and take the |oss |n that year
W 1he amount of the |oss w||| be reduced f|rst by 5100 and then by 10 of her 2010 AGI
A|ternat|ve|y she may take the |oss on her 2011 |ncome tax return
W 1he amount of the |oss w||| be reduced f|rst by 5100 and then by 10 of her 2011 AGI




Measurlng Lhe AmounL of Loss
1he rules for deLermlnlng Lhe amounL of a loss depend ln parL on wheLher buslness use lncomeproduclng use
or personal use properLy was lnvolved
AnoLher facLor LhaL musL be consldered ls wheLher Lhe properLy was parLlally or compleLely desLroyed
lf buslness properLy or properLy held or Lhe producLlon of lncome (ex renLal properLy) ls compleLely desLroyed
Lhe loss ls equal Lo Lhe ad[usLed basls of Lhe properLy aL Lhe Llme of desLrucLlon

Lxamp|e 14 age 711
V|ck|'s automob||e wh|ch was used on|y for bus|ness purposes was destroyed by f|re V|ck| had un|ntent|ona||y
a||owed her |nsurance coverage to exp|re 1he fa|r market va|ue of the automob||e was 59000 at the t|me of the f|re
and |ts ad[usted bas|s was 510000 V|ck| |s a||owed a |oss deduct|on of 510000 (the bas|s of the automob||e) 1he
510000 |oss |s a deduct|on for AGI

A dlfferenL measuremenL rule applles for parLlal desLrucLlon of buslness properLy and lncome produclng
properLy and for parLlal or compleLe desLrucLlon of personal use properLy ln Lhese slLuaLlons Lhe loss ls Lhe
lesser of Lhe followlng
1he ad[usLed basls of Lhe properLy
1he dlfference beLween Lhe falr markeL value of Lhe properLy before Lhe evenL and Lhe falr markeL value
lmmedlaLely afLer Lhe evenL

Lxamp|e 1S age 711
ke||y's un|nsured automob||e wh|ch was used on|y for bus|ness purposes was damaged |n an acc|dent At the date of
the acc|dent the fa|r market va|ue of the automob||e was 512000 and |ts ad[usted bas|s was 59000 After the
acc|dent the automob||e was appra|sed at 54000 ke||y's |oss deduct|on |s 58000 (the |esser of the ad[usted bas|s or
decrease |n fa|r market va|ue) 1he 58000 |oss |s a deduct|on for AGI

1he deducLlon for Lhe loss of properLy LhaL ls parL buslness and parL personal musL be compuLed separaLely for
Lhe buslness porLlon and Lhe personal porLlon
Any lnsurance recovery reduces Lhe loss for Lhe buslness producLlon of lncome and personal use losses
A Laxpayer may reallze a galn lf Lhe lnsurance proceeds exceed Lhe amounL of Lhe loss
ChapLer 14 dlscusses Lhe LreaLmenL of neL galns and losses on buslness properLy and lncome produclng properLy
A Laxpayer ls noL permlLLed Lo deducL a casualLy loss for damage Lo lnsured personal use properLy unless a
Llmely lnsurance clalm ls flled wlLh respecL Lo Lhe damage Lo Lhe properLy
1he rule applles Lo Lhe exLenL LhaL Lhe lnsurance pollcy provldes for full or parLlal relmbursemenL for Lhe loss
Cenerally an appralsal before and afLer Lhe casualLy ls needed Lo measure Lhe amounL of Lhe loss
Powever Lhe cosL of repalrs Lo Lhe damaged properLy ls accepLable as a meLhod of esLabllshlng Lhe loss ln value
provlded Lhe followlng crlLerla are meL
1he repalrs are necessary Lo resLore Lhe properLy Lo lLs condlLlon lmmedlaLely before Lhe casualLy
1he amounL spenL for such repalrs ls noL excesslve
1he repalrs do noL exLend beyond Lhe damage suffered
1he value of Lhe properLy afLer Lhe repalrs does noL as a resulL of Lhe repalrs exceed Lhe value of Lhe
properLy lmmedlaLely before Lhe casualLy

8educLlon for $100 and 10 of ACl lloors
1he amounL of Lhe loss for personal use properLy musL be furLher reduced by a $100 per evenL floor and a 10
of ACl aggregaLe floor
1he $100 floor applles separaLely Lo each casualLy applles Lo Lhe enLlre loss from each casualLy (ex lf a sLorm
damages boLh a Laxpayers resldence and auLomoblle only $100 ls subLracLed from Lhe LoLal amounL of Lhe loss)
1he losses are Lhen added LogeLher and Lhe LoLal ls reduced by 10 of Lhe Laxpayers ACl
1he resulLlng loss ls Lhe Laxpayers lLemlzed deducLlon for casualLy LhefL losses






Lxamp|e 16 age 712
kocky who had AGI of 530000 was |nvo|ved |n a motorcyc|e acc|dent |n 2011 n|s motorcyc|e wh|ch was used on|y
for persona| use and had a fa|r market va|ue of 512000 and an ad[usted bas|s of 59000 was comp|ete|y destroyed
ne rece|ved 5S000 from h|s |nsurance company kocky's casua|ty |oss deduct|on |s 5900 (59000 bas|s 5S000
|nsurance recovery 5100 f|oor 53000 (10 x 530000 AGI)) 1he 5900 casua|ty |oss |s an |tem|zed deduct|on (from
AGI)

When a nonbuslness casualLy loss ls spread beLween Lwo Laxable years because of Lhe reasonable prospecL of
recovery docLrlne Lhe loss ln Lhe 2
nd
year ls noL reduced by Lhe $100 floor
1hls resulL occurs because Lhls floor ls lmposed per evenL and has already reduced Lhe amounL of Lhe loss ln Lhe
flrsL year
1he loss ln Lhe 2
nd
year ls sLlll sub[ecL Lo 10 floor based on Laxpayers 2
nd
year ACl
1axpayers who suffer quallfled dlsasLer area losses can elecL Lo deducL Lhe losses ln Lhe year precedlng Lhe year
of occurrence
1he dlsasLer loss ls LreaLed as havlng occurred ln Lhe precedlng Laxable year Pence Lhe 10 of ACl floor ls
deLermlned by uslng Lhe ACl of Lhe year for whlch Lhe deducLlon ls clalmed

MulLlple Losses
1he rules for compuLlng loss deducLlons where mulLlple losses have occurred are explalned ln Lxamp|e 17 and 18

Lxamp|e 17 age 713

Dur|ng the year 1|m had the fo||ow|ng casua|ty |osses




Ia|r Mkt Va|ue of Asset
Asset Ad[usted
8as|s
8efore the
Casua|ty
After the
Casua|ty
Insurance
kecovery
A 900 600 0 400
8 300 800 2S0 100


Assets A and 8 were used |n 1|m's bus|ness at the t|me of the casua|ty 1he fo||ow|ng |osses are a||owed

Asset A 5S00 1he comp|ete destruct|on of a bus|ness asset resu|ts |n a deduct|on of the ad[usted bas|s of the
property (reduced by any |nsurance recovery) regard|ess of the assets fa|r market va|ue

Asset 8 5200 1he part|a| destruct|on of a bus|ness (or persona| use) asset resu|ts |n a deduct|on equa| to the |esser of
the ad[usted bas|s (300) or the dec||ne |n va|ue (SS0) reduced by any |nsurance recovery (100)

8oth the Asset A and Asset 8 |osses are deduct|ons for AGI 1he 5100 f|oor and the 10 of AGI f|oor do not app|y
because the assets are bus|ness assets







Lxamp|e 18 age 713
In 2011 Lm||y had AGI of 520000 and the fo||ow|ng casua|ty |osses




Ia|r Mkt Va|ue of Asset
Asset Ad[usted
8as|s
8efore the
Casua|ty
After the
Casua|ty
Insurance
kecovery
A 1900 1400 0 200
8 2S00 4000 1000 0
C 800 400 100 2S0

Assets A 8 and C were he|d for persona| use and the |osses to these three assets are from three d|fferent casua|t|es
1he |oss for each asset |s computed as fo||ows

Asset A 51100 1he |esser of the ad[usted bas|s of 51900 or the 51400 dec||ne |n va|ue reduced by the |nsurance
recovery of 5200 m|nus 5100 f|oor

Asset 8 52400 1he |esser of the ad[usted bas|s of 52S00 or the 53000 dec||ne |n va|ue m|nus the 5100 f|oor

Asset C 50 1he |esser of the ad[usted bas|s of 5800 or the 5300 dec||ne |n va|ue reduced by the |nsurance recovery of
52S0 m|nus the 5100 f|oor

Lm||y's |tem|zed casua|ty |oss deduct|on for the year |s 51S00
Asset A Loss 51100
Asset 8 Loss 52400
Asset C Loss 50
1ota| Loss 3S00
Less 10 of AGI (10 x 520000) (2000)
Item|zed Casua|ty Loss Deduct|on 1S00

SLaLuLory lramework for ueducLlng Losses of lndlvlduals

CasualLy 1hefL Losses lncurred by an lndlvldual ln connecLlon wlLh a Lrade or buslness are deducLlble for ACl
1hese losses are noL sub[ecL Lo Lhe $100 per evenL and Lhe 10 of ACl llmlLaLlons
CasualLy LhefL losses lncurred by an employee ln con[uncLlon wlLh a Lrade or buslness are deducLlble for ACl lf
Lhe loss ls relmbursed by Lhe employer
lf Lhe loss ls noL relmbursed Lhe loss ls deducLlble from ACl as a mlscellaneous lLemlzed deducLlon sub[ecL Lo
Lhe 2 of ACl lloor
1hese losses are noL sub[ecL Lo Lhe $100 per evenL and Lhe 10 of ACl

CasualLy LhefL losses lncurred by an lndlvldual ln a LransacLlon enLered lnLo for proflL are noL sub[ecL Lo Lhe
$100 per evenL and Lhe 10 of ACl lmlLaLlons
lf Lhese losses are aLLrlbuLable Lo renLs or royalLles Lhe deducLlon ls for ACl
lf Lhese losses are noL connecLed wlLh properLy held for Lhe producLlon of renLs royalLles Lhey are deducLlons
from ACl
1hese losses are classlfled as oLher mlscellaneous lLemlzed deducLlons
Lxample LhefL of a securlLy
1hefL losses of lnvesLmenL properLy are noL sub[ecL Lo Lhe 2of ACl floor on cerLaln mlscellaneous deducLlons
(explalned ln ChapLers 9 and 10)
CasualLy 1hefL losses aLLrlbuLable Lo personal use properLy are sub[ecL Lo Lhe $100 per evenL and Lhe 10 of
ACl buL Lhey are noL sub[ecL Lo Lhe 2 of ACl floor

ersonal CasualLy Calns Losses
lf a Laxpayer has a personal casualLy and LhefL galns as well as losses a speclal seL of rules applles for
deLermlnlng Lhe Lax consequences
A personal casualLy galn ls Lhe recognlzed galn from a casualLy or LhefL of personal use properLy
A personal casualLy loss for Lhls purpose ls a casualLy or LhefL loss of personal use properLy afLer Lhe appllcaLlon
of Lhe $100 floor
A Laxpayer who has boLh galns losses for Lhe Laxable year musL flrsL neL (offseL) Lhe personal casualLy galns
and personal casualLy losses
lf Lhe galns exceed Lhe losses Lhe galns losses are LreaLed as galns losses from Lhe sale of caplLal asseLs
1he caplLal galns losses are shorL Lerm or long Lerm dependlng on Lhe perlod Lhe Laxpayer held each of Lhe
asseLs
ln Lhe neLLlng process personal casualLy and LhefL galns losses are noL neLLed wlLh galns losses on buslness
and lncome produclng properLy

Lxamp|e 19 age 714

Asset no|d|ng er|od Ga|n]Loss
A 1hree months (300)
8 1hree ears (2400)
C 1wo ears 3200



C||ff computes the tax consequences as fo||ows
ersona| Casua|ty Ga|n 3200
ersona| Casua|ty Loss (300 + 2400) (2710)
Net ersona| Casua|ty Ga|n S00

C||ff treats a|| of the ga|ns |osses as cap|ta| ga|ns |osses and has the fo||ow|ng
Short term cap|ta| Loss (Asset A) 300
Long term cap|ta| Loss (Asset 8) 2400
Long term cap|ta| Ga|n (Asset C) 3200


lf personal casualLy losses exceed personal casualLy galns all galns and losses are LreaLed as ordlnary lLems 1he galns
and losses Lo Lhe exLenL of galns are LreaLed as ordlnary lncome and ordlnary loss ln compuLlng ACl Losses ln excess
of galns are deducLed as lLemlzed deducLlons Lo Lhe exLenL Lhe losses exceed 10 of ACl

















Lxamp|e 20 age 71S
Dur|ng the year naze| had AGI of 520000 and the fo||ow|ng persona| casua|ty ga|n and |oss (after deduct|ng the 5100
f|oor)

Asset no|d|ng er|od Ga|n]Loss
A 1hree years (2700)
8 Iour months 200

naze| computes the tax consequences as fo||ows
ersona| casua|ty |oss (2700)
ersona| casua|ty ga|n 200
Net persona| casua|ty |oss (2S00)

naze| treats the ga|n and |oss as ord|nary |tems 1he 5200 ga|n and 5200 of the |oss are |nc|uded |n comput|ng AGI
naze|'s |tem|zed deduct|on for casua|ty |osses |s computed as fo||ows
Casua|ty |oss |n excess of ga|n (2700 200) 52S00
Less 10 of AGI (10 x 520000) (2000)
Item|zed Deduct|on S00

8esearch LxperlmenLal LxpendlLures
SecLlon 174 covers Lhe LreaLmenL of research experlmenLal expendlLures 1he 8egulaLlons deflne 8esearch
LxperlmenLal LxpendlLures as follows
All such cosLs lncldenL Lo Lhe developmenL of an experlmenLal or plloL model a planL process a producL
a formula an lnvenLlon or slmllar properLy and Lhe lmprovemenL of an already exlsLlng properLy of Lhe
Lype menLloned 1he Lerm does noL lnclude expendlLures such as Lhose for Lhe ordlnary LesLlng or
lnspecLlon of maLerlals or producLs for quallLy conLrol or Lhose for efflclency surveys managemenL
sLudles consumer surveys adverLlslng or promoLlons
Lxpenses ln connecLlon wlLh Lhe acqulslLlon or lmprovemenL of land or depreclable properLy are noL research
and experlmenLal expendlLures
8aLher Lhey lncrease Lhe basls of Lhe land or depreclable properLy
Powever depreclaLlon on a bulldlng used for research may be a research and experlmenLal expense
Cnly Lhe depreclaLlon LhaL ls a research experlmenLal expense (noL Lhe cosL of Lhe asseL) ls sub[ecL Lo Lhe
Lhree alLernaLlve LesLs
1he law permlLs Lhe followlng 3 alLernaLlves for Lhe handllng of research experlmenLal expendlLures
Lxpenses ln Lhe year pald or lncurred
ueferred and amorLlzed
CaplLallzed
lf Lhe cosLs are caplLallzed a deducLlon ls noL avallable unLll Lhe research pro[ecL ls abandoned or ls deemed
worLhless
Slnce many producLs resulLlng from a research pro[ecLs do noL have a deflnlLe llmlLed useful llfe a Laxpayer
should ordlnarlly elecL Lo wrlLe off Lhe expendlLures lmmedlaLely or Lo defer and amorLlze Lhem
lL ls generally preferable Lo elecL an lmmedlaLe wrlLeoff of Lhe research expendlLures because of Lhe Llme value
of Lhe Lax deducLlon
1he law also provldes for a research acLlvlLles credlL
1he credlL amounLs Lo 20 of cerLaln research and experlmenLal expendlLures (credlL dlscussed more ln ChapLer
12)






Lxpense MeLhod
A Laxpayer can elecL Lo expense all of Lhe research experlmenLal expendlLures lncurred ln Lhe currenL year and
all subsequenL years
1he consenL of Lhe l8S ls noL requlred lf Lhe meLhod ls adopLed for Lhe flrsL Laxable year ln whlch such
expendlLures were pald or lncurred
Cnce Lhe elecLlon ls made Lhe Laxpayer musL conLlnue Lo expense all quallfylng expendlLures unless a requesL
for change ls made Lo and approved by Lhe l8S
ln cerLaln lnsLances a Laxpayer may lncur research experlmenLal expendlLures before acLually engaglng ln any
Lrade or buslness acLlvlLy
ln such lnsLances Lhe Supreme CourL has applled a llberal sLandard of deducLlblllLy and permlLLed a deducLlon ln
Lhe year of lncurrence

ueferral AmorLlzaLlon MeLhod
AlLernaLlvely research experlmenLal expendlLures may be deferred and amorLlzed lf Lhe Laxpayer makes an
elecLlon
under Lhe elecLlon research experlmenLal expendlLures are amorLlzed raLably over a perlod of noL less Lhan
60 monLhs
A deducLlon ls allowed beglnnlng wlLh Lhe monLh ln whlch Lhe Laxpayer flrsL reallzes beneflLs from Lhe
experlmenLal expendlLure
1he elecLlon ls blndlng a change requlres permlsslon from Lhe l8S

Lxamp|e 21 age 717
Go|d Corporat|on dec|des to deve|op a new ||ne of adhes|ves 1he pro[ect beg|ns |n 2011 Go|d |ncurs the
fo||ow|ng expenses |n 2011 |n connect|on w|th the pro[ect
Sa|ar|es 2S000
Mater|a|s 8000
Deprec|at|on of Mach|nery 6S00

Go|d |ncurs the fo||ow|ng expenses |n 2012 |n connect|on w|th the pro[ect
Sa|ar|es 43000
Mater|a|s 10000
Deprec|at|on on mach|nery 12200

1he benef|ts from the pro[ect w||| be rea||zed start|ng |n March 2013 If Go|d Corporat|on e|ects a 60month
deferra| and amort|zat|on per|od there |s no deduct|on pr|or to March 2013 the month the benef|ts from the
pro[ect beg|n to be rea||zed 1he deduct|on for 2013 |s 510867 computed as fo||ows

Sa|ar|es (2S000 + 18000) 43000
Mater|a|s (8000 + 2000) 10000
Deprec|at|on (6S00 + S700) 12200
1ota| 6S 200
56S200 x (10 months]60 months) 10867

1he opLlon Lo LreaL research experlmenLal expendlLures as deferred expense ls usually employed when a company
does noL have sufflclenL lncome Lo offseL Lhe research and experlmenLal expenses
8aLher Lhan creaLe neL operaLlng loss carryovers LhaL mlghL noL be uLlllzed because of Lhe 20 yr llmlLaLlon on such
carryovers Lhe deferral and amorLlzaLlon meLhod may be used
1he deferral of research experlmenLal expendlLures should also be consldered lf Lhe Laxpayer elecLs hlgher Lax raLes ln
Lhe fuLure





uomesLlc roducLlon AcLlvlLles ueducLlon
1he Amerlcan !obs CreaLlon AcL of 2004 was enacLed Lo replace cerLaln Lax provlslons LhaL our world Lradlng
parLners regarded as allowlng unfalr advanLage Lo uS exporLs
1he acL creaLed a deducLlon based on lncome from manufacLurlng acLlvlLles (deslgnaLed as producLlon acLlvlLles)
1he domesLlc producLlon acLlvlLles deducLlon (uAu) ls conLalned ln SecLlon 199

CperaLlonal 8ules
CalculaLlng Lhe uomesLlc roducLlon AcLlvlLles ueducLlon
lor Lax years beglnnlng ln 2010 and LhereafLer Lhe uAu ls based on Lhe followlng
9 x Lesser of Cuallfled producLlon acLlvlLles (CAu) or
9 x 1axable (or modlfled ad[usLed gross) lncome or alLernaLlve mlnlmum Laxable lncome
lor Lax years beglnnlng ln 2003 or 2006 Lhe 9 facLor was 3
lor Lax years beglnnlng ln 2007 2008 and 2009 Lhe 9 facLor was 6
1axable lncome ls deLermlned wlLhouL regard Lo Lhe uAu
ln Lhe case of an lndlvldual (sole proprleLor or an owner of a flowLhrough enLlLy) modlfled ad[usLed gross
lncome ls subsLlLuLed for Laxable lncome
1he Laxable lncome llmlLaLlon ls deLermlned afLer Lhe appllcaLlon of any neL operaLlon loss deducLlon for Lhe Lax
year
A company wlLh an nCL carryforward for a Lax year ls lnellglble for Lhe uAu lf Lhe carryforward ellmlnaLes Lhe
currenL Laxable lncome
A Laxpayer LhaL has a nCL carryback may lose parL or all of Lhe uAu beneflL for LhaL year
As Laxable lncome ls reduced by Lhe nCL carryback Lhere ls a correspondlng reducLlon ln Lhe uAu
lf quallfled producLlon acLlvlLles lncome (CAl) cannoL be used ln a parLlcular year due Lo Lhe Laxable lncome
llmlLaLlon lL ls losL forever

Lxamp|e 22 age 718
Cpa| Inc manufactures and se||s costume [ewe|ry It a|so se||s costume [ewe|ry purchased from other manufacturers
Dur|ng 2011 Cpa| had a prof|t of 5200000 (AI) from the sa|e of |ts own manufactured [ewe|ry and a |oss of 5S0000
from the sa|e of the purchased [ewe|ry 8ased on th|s |nformat|on Cpa|'s AI |s 5200000 and |t taxab|e |ncome |s
51S0000 (5200000 5S0000) Cpa|'s DAD becomes 513S00 (9 of the |esser of 5200000 (AI) or 51S0000
(taxab|e |ncome)

Lxamp|e 23 age 718
Assume the same facts |n Lxamp|e 22 except that Cpa| a|so has an NCL carryover from 2010 of 5300000 As taxab|e
|ncome for 2011 |s zero (5200000 5S0000 5300000) there |s no DAD


AnoLher lmporLanL llmlLaLlon ls LhaL Lhe amounL of uAu cannoL exceed 30 of cerLaln W2 Wages pald by Lhe
Laxpayer durlng Lhe Lax year
1hls ls Lo preserve uS manufacLurlng [obs and Lo dlscourage Lhelr ouLsourclng
An employer's W2 wages lnclude Lhe sum of Lhe aggregaLe amounL of wages and elecLlve deferrals requlred Lo
be lncluded on Lhe W2 wage sLaLemenLs for cerLaln employees durlng Lhe employer's Laxable year
LlecLlve deferrals lnclude Lhose amounLs deferred under SecLlon 437 plans and 8oLh conLrlbuLlons
An employer prevlously lncluded wages pald Lo all employees durlng a Lax year and noL [usL wages pald Lo
quallfled producLlon
As a resulL of recenL sLaLuLory change an employer ls permlLLed Lo lnclude only Lhose W2 wages pald Lo
employees engaged ln quallfled producLlon acLlvlLles





Lxamp|e 24 page 719
In 2011 ked Inc a ca|endar year taxpayer has AI of 52 m||||on and taxab|e |ncome of 521 m||||on S|nce ked
outsources much of |ts work to |ndependent contractors |ts W2 wage base wh|ch for ked |s re|ated ent|re|y to
product|on act|v|t|es |s 580000 A|though ked's DAD norma||y wou|d be 5180000 (9 of the |esser of 52 m||||on
(AI) or 521 m||||on (taxab|e |ncome) |t |s ||m|ted to 540000 (S0 of 580000 (W2 wages)

Lxamp|e 2S page 719
Assume the same facts as |n Lxamp|e 24 except that ked a|so pays sa|ar|es of 5S0000 re|ated to |ts nonproduct|on
act|v|t|es 8ecause these wages are not pa|d to emp|oyees engaged |n product|on act|v|t|es the wage ||m|tat|on on
the DAD rema|ns at 540000 (S0 of 580000 (580000 + 0))

CalculaLlon of Cuallfled roducLlon AcLlvlLles lncome
Cuallfled roducLlon AcLlvlLles lncome (CAl) ls Lhe excess of domesLlc producLlon gross recelpLs (uC8) over
Lhe sum of
1he cosL of goods sold allocaLed Lo such recelpLs
CLher deducLlons expenses or losses dlrecLly allocaLed Lo such recelpLs
1he raLable porLlon of deducLlons expenses and losses noL dlrecLly allocable Lo such recelpLs or anoLher
class of lncome

CAl ls deLermlned on an lLembylLem basls noL on a dlvlslon by dlvlslon or a LransacLlonbyLransacLlon basls
8ecause all lLems musL be neLLed ln Lhe calculaLlon Lhe flnal CAl amounL can be elLher poslLlve or negaLlve
1he effecL of Lhe neLLlng rule ls Lo preclude Laxpayers from selecLlng only proflLable producL llnes or proflLable
LransacLlons when calculaLlng CAL

Lxamp|e 26 age 719
A taxpayer manufactures pants and sh|rts w|th the fo||ow|ng AI resu|ts 5S for one pa|r of pants and a negat|ve 52
for one sh|rt 8ecause the two |tems are netted the AI amount that contro|s |s 53 (55S 52)
llve speclflc caLegorles of uC8 quallfy for Lhe uAu

1he lease llcense sale exchange or oLher dlsposlLlon or quallfled producLlon properLy (C) LhaL was
manufacLured produced grown or exLracLed (MCL) ln Lhe unlLed SLaLes
Cuallfled fllms largely creaLed ln Lhe unlLed SLaLes
1he producLlon of elecLrlclLy naLural gas or poLable waLer
ConsLrucLlon (buL noL selfconsLrucLlon) performed ln Lhe unlLed SLaLes
Lnglneerlng and archlLecLural servlces for domesLlc consLrucLlon

1he sale of food beverages prepared by a Laxpayer or aL a reLall esLabllshmenL and Lhe Lransmlsslon or
dlsLrlbuLlon of elecLrlclLy naLural gas poLable waLer are speclflcally excluded from Lhe deflnlLlon of uC8

Lllglble 1axpayers
1he deducLlon ls avallable Lo a varleLy of Laxpayers lncludlng lndlvlduals parLnershlps S corporaLlons C
corporaLlons cooperaLlves esLaLes LrusLs
lor a pass Lhrough enLlLy Lhe deducLlon flows Lhrough Lo Lhe lndlvldual owners
ln Lhe case of a sole proprleLor a deducLlon for ACl resulLs and ls clalmed on lorm 1040 llne 33 page 1
A lorm 8903 musL be aLLached Lo supporL Lhe deducLlon
More lnfo ln ChapLers 17 21 22








neL CperaLlng Losses

1he requlremenL LhaL every Laxpayer flle an annual lncome Lax reLurn (wheLher on a calendar year or flscal year)
may resulL ln cerLaln lnequlLles for Laxpayers who experlence a cycllcal paLLerns of lncome or expense
lnequlLles resulL from Lhe appllcaLlon of a progresslve raLe sLrucLure Lo Laxable lncome deLermlned on an annual basls
A neL operaLlng loss ln a parLlcular Lax year would produce no Lax beneflL lf Lhe Code dld noL provlde for Lhe carryback
and carryforward of such losses Lo proflLable years

Lxamp|e 27 age 721
Iuan|ta has a bus|ness and rea||zes the fo||ow|ng taxab|e |ncome or |oss over a f|veyear per|od ear 1 5S0000 ear
2 (530000) ear 3 5100000 ear 4 (5200000) ear S (5380000) She |s marr|ed and f||es a [o|nt return nubert a|so
has a bus|ness and has a taxab|e |ncome pattern of 560000 every year ne too |s marr|ed and f||es a [o|nt return
Note that both Iuan|ta and nubert have tota| taxab|e |ncome of 5300000 over the f|veyear per|od Assume there |s
no prov|s|on for the carryback or carryover of NCLs Iuan|ta and nubert wou|d have the fo||ow|ng f|veyear tax b|||s

ear Iuan|ta's 1ax nubert's 1ax
1 66S0 81S0
2 0 81S0
3 172S0 81S0
4 0 81S0
S 102872 81S0
1ota|s 126772 407S0


Lven Lhough !uanlLa and PuberL reallzed Lhe same LoLal Laxable lncome ($300000) over Lhe flveyear perlod !uanlLa had
Lo pay Laxes of $126772 whlle PuberL pald Laxes of only$40730

1o provlde parLlal rellef from Lhls lnequlLable Lax LreaLmenL a deducLlon ls allowed for nCLs
1hls permlLs nCLs for any one year Lo be offseL agalnsL Laxable lncome of oLher years
1he nCL provlslon ls lnLended as a form of rellef for buslness lncome and losses
1hus only losses from Lhe operaLlon of a Lrade or buslness (or professlon) casualLy and LhefL losses or losses
from Lhe conflscaLlon of a buslness by a forelgn governmenL can creaLe a nCL
Salarled lndlvldual wlLh lLemlzed deducLlons and personal exempLlons ln excess of gross lncome ls noL permlLLed
Lo deducL Lhe excess amounLs as an nCL
A personal casualLy loss ls LreaLed as buslness loss and can Lherefore creaLe (or lncrease) an nCL for an
lndlvldual

Carryback and Carryover erlods
Ceneral 8ules
An nCL generally musL be applled lnlLlally Lo Lhe Lwo Laxable years precedlng Lhe year of Lhe loss (unless an
elecLlon ls made noL Lo carry Lhe loss back aL all)
lL ls carrled flrsL Lo Lhe second prlor year and Lhen Lo lmmedlaLely precedlng Lax year (or unLll used up)
lf Lhe loss ls noL fully used ln Lhe carryback perlod lL musL be carrled forward Lo Lhe flrsL year afLer Lhe loss and
Lhen forward Lo Lhe second Lhlrd eLc year afLer Lhe loss year
1he carryover perlod ls 20 years
A loss susLalned ln 2011 ls used ln Lhls order 2009 2010 2012 Lhrough 2031
A 3year carryback perlod ls avallable for any porLlon of an lndlvldual's nCL resulLlng from a casualLy or LhefL
loss
1he 3year carryback rule also applles Lo nCLs LhaL are aLLrlbuLable Lo presldenLlally declared dlsasLers LhaL are
lncurred by a small buslness
A small buslness ls one whose average annual gross recelpLs for a 3year perlod are $3 mllllon or less
A 3year carryback perlod and a 20year carryover perlod are allowed for a farmlng loss
A Laxpayer may elecL Lo walve Lhe speclal 3year carryback
lf Lhls elecLlon ls made Lhe general 2year carryback perlod applles
A farmlng loss ls Lhe amounL of nCL for Lhe Laxable year lf only lncome and deducLlons aLLrlbuLable Lo Lhe
farmlng buslness are Laken lnLo accounL
Powever Lhe amounL of Lhe farmlng loss cannoL exceed Lhe amounL of Lhe Laxpayers nCL for Lhe Laxable year
1o deLermlne Lhe amounL of Lhe carryback and carryover a farmlng loss for any Laxable year ls LreaLed as a
separaLe nCL for such year and applled afLer Lhe remalnlng porLlon of nCL for Lhe year ls Laken lnLo accounL

Lxamp|e 28 age 723
Ior the year 2011 the taxpayer and spouse have an NCL of 5S0000 1he 5S0000 NCL |nc|udes a 540000 |oss
attr|butab|e to the farm|ng bus|ness Cn|y the 540000 |oss attr|butab|e to the farm|ng bus|ness can be carr|ed back S
years 1he |oss not attr|butab|e to the farm|ng bus|ness can be carr|ed back on|y 2 years

If the |oss |s be|ng carr|ed to a preced|ng year an amended return |s f||ed on Iorm 1040k or a qu|ck refund c|a|m |s
f||ed on Iorm 104S In e|ther case a refund of taxes prev|ous|y pa|d |s requested Iorm 104S |s an app||cat|on for a
tentat|ve refund 1he IkS norma||y w||| process Iorm 104S and pay the refund w|th|n 90 days of the date |t |s f||ed
When the |oss |s carr|ed forward the current return shows an NCL deduct|on for the pr|or year's |oss

Sequence of use f nCLs

When Lhe Laxpayer has nCLs ln Lwo or more years Lhe rule ls always Lo use Lhe earllesL year's loss flrsL unLll lL ls
compleLely absorbed
1he laLer years' losses can Lhen be used unLll Lhey are also absorbed or losL
1hus one year's reLurn could show nCL carryovers from 2 or more years
Lach loss ls compuLed and applled separaLely

LlecLlon Lo forgo Carryback
A Laxpayer can lrrevocably elecL Lo noL carry back an nCL Lo any of Lhe prlor years
ln LhaL case Lhe loss ls avallable as a carryover for 20 years
1he elecLlon ls made lf lL ls Lo Lhe Laxpayers Lax advanLage
lor example a Laxpayer mlghL be ln a low marglnal Lax brackeL ln Lhe carryback years buL expecL Lo be ln a hlgh
marglnal Lax brackeL ln fuLure years 1herefore lL would be Lo Lhe Laxpayers advanLage Lo use Lhe nCL Lo offseL
lncome ln years when Lhe Lax raLe ls hlgh raLher Lhan use lL when Lhe Lax raLe ls relaLlvely low


Lxamp|e 29 age 722
Ior 2011 taxpayer and spouse have an NCL of 510000 1he NCL may be carr|ed back and app||ed aga|nst taxab|e
|ncome f|rst |n 2009 and then |n 2010 Any rema|n|ng NCL |s carr|ed forward to years 2012 through 2031 If however
the taxpayer spouse e|ect to forego the carryback per|od the NCL |n|t|a||y |s carr|ed to 2012 and then to years 2013
through 2031

1ax Consequences of Lhe CroeLzlnger Case
ln Lhe CroeLzlnger case Lhe courL esLabllshed LhaL Lhe approprlaLe LesLs for deLermlnlng lf gambllng ls a Lrade or
buslness are wheLher an lndlvldual engages ln gambllng full Llme ln good falLh wlLh regularlLy and for Lhe
producLlon of lncome as a llvellhood and noL as a mere hobby
1he courL held LhaL 8oberL CroeLzlnger saLlsfled Lhe LesLs because of hls consLanL and large scale efforL
Sklll was requlred and was applled
Pe dld whaL he dld for a llvellhood Lhough wlLh less Lhan successful resulLs
Pls gambllng was noL a hobby a passlng fancy or an occaslonal beL for amusemenL
1herefore hls gambollng was a Lrade or buslness
Pence he was able Lo deducL hls gambllng losses for ACl
lf Lhe courL ruled lL was noL a Lrade or buslness hls gambllng losses would have been llmlLed Lo hls gambllng
wlnnlngs and would have been classlfled as lLemlzed deducLlons

uocumenLaLlon of 8elaLed1axpayer Loans CasualLy Losses and 1hefL Losses
Slnce nonbona flde loans beLween relaLed Laxpayers may be LreaLed as glfLs adequaLe documenLaLlon ls
needed Lo subsLanLlaLe a bad debL deducLlon lf Lhe loan subsequenLly becomes worLhless
uocumenLaLlon should lnclude proper execuLlon of Lhe noLe (legal form) and Lhe esLabllshmenL of a bona flde
purpose for Lhe loan
ln addlLlon lL ls deslrable Lo sLlpulaLe a reasonable raLe of lnLeresL and a flxed maLurlLy daLe
Slnce a LhefL loss ls noL permlLLed for mlsplaced lLems a loss should be documenLed by a pollce reporL and
evldence Lo Lhe value of Lhe properLy (ex Appralsals plcLures of Lhe properLy newspaper cllpplngs)
Slmllar documenLaLlon of Lhe value of Lhe properLy should be provlded Lo supporL a casualLy loss deducLlon
because Lhe amounL of loss ls measured ln parL by Lhe decllne ln falr markeL value of Lhe properLy
CasualLy Loss deducLlons musL be reporLed on lorm 4684

WorLhless SecurlLles
1o be deducLlble a securlLy musL be compleLely worLhless
1o obLaln Lhe deducLlon a Laxpayer musL prove LhaL Lhe securlLy was noL worLhless ln a prlor year and LhaL Lhe
securlLy was worLhless ln Lhe year clalmed
8ecause of Lhe sub[ecLlvlLy assoclaLed wlLh Lhls burden of proof Lhe only safe pracLlce ls Lo clalm a loss for Lhe
earllesL year when lL may posslbly be allowed and Lo renew Lhe clalm ln subsequenL years lf Lhere ls any
reasonable chance LhaL lL wlll be appllcable Lo Lhe lncome for Lhose years
lorLunaLely Lhe sLaLuLe of llmlLaLlons for worLhless securlLles ls 7 years

Small 8uslness SLock
8ecause SecLlon 1244 llmlLs Lhe amounL of loss classlfled as ordlnary loss on a yearly basls a Laxpayer mlghL
maxlmlze Lhe beneflLs of SecLlon 1244 by selllng Lhe sLock ln more Lhan one Laxable year
1he resulL could be Lhe losses ln any one Laxable year would noL exceed Lhe SecLlon 1244 llmlLs on ordlnary loss

Lxamp|e 30 age 724

M|tch a s|ng|e |nd|v|dua| purchased sma|| bus|ness stock |n 2009 for 51S0000 (1S0 shares at 51000 per share) Cn
December 20 2011 the stock |s worth 560000 (1S0 shares at 5400 per share) M|tch wants to se|| the stock at th|s
t|me M|tch earns a sa|ary of 580000 a year has no other cap|ta| transact|ons and does not expect any |n the future
If M|tch se||s a|| of the sma|| bus|ness stock |n 2011 h|s recogn|zed |oss w||| be 590000 (60000 1S0000) 1he |oss
w||| be character|zed as a 5S0000 ord|nary |oss and a 540000 |ongterm cap|ta| |oss In comput|ng taxab|e |ncome for
2011 M|tch cou|d deduct the 5S0000 ord|nary |oss but cou|d deduct on|y 53000 of the cap|ta| |oss 1he rema|nder of
the cap|ta| |oss cou|d be carr|ed over and used |n future years sub[ect to the 53000 ||m|tat|on |f M|tch has no cap|ta|
ga|ns If M|tch se||s 82 shares |n 2011 he w||| recogn|ze an ord|nary |oss of 549200 (82 x (1000 4) ) If M|tch then
se||s the rema|nder of the shares |n 2012 he w||| recogn|ze an ord|nary |oss of 540800 (68 x 51000 5400)) M|tch
cou|d deduct the 549200 ord|nary |oss |n comput|ng 2011 taxab|e |ncome and the 540800 ord|nary |oss |n comput|ng
2012 taxab|e |ncome












CasualLy Losses
A speclal elecLlon ls avallable for Laxpayers who susLaln casualLy losses ln an area deslgnaLed by Lhe resldenL as
a dlsasLer area
1hls elecLlon affecLs only Lhe Llmlng noL Lhe calculaLlon of Lhe deducLlon
1he deducLlon can be Laken ln Lhe year before Lhe year ln whlch Lhe loss occurred
1hus for a loss occurrlng beLween !anuary 1 and uecember 31 2011 an lndlvldual can Lake Lhe deducLlon on
Lhe 2010 reLurn
1he beneflL of course ls a fasLer refund (or reducLlon ln Lax )
lL wlll also be advanLageous Lo carry Lhe loss back lf Lhe Laxpayer's Lax raLe ln Lhe carryback year ls hlgher Lhan
Lhe Lax raLe ln Lhe year of Lhe loss
1o flnd ouL lf an evenL quallfles as a dlsasLer area loss one can look ln any of Lhe ma[or Lax servlces Lhe Weekly
CompllaLlon of resldenLlal documenLs or lnLernal 8evenue 8ulleLln


neL CperaLlng Losses
ln cerLaln lnsLances lL may be advlsable for a Laxpayer Lo elecL noL Lo carry back an nCL
lor an lndlvldual Lhe beneflLs from Lhe loss carryback could be scaled down or losL due Lo Lhe economlc
ad[usLmenL LhaL musL be made Lo Laxable lncome for Lhe year Lo whlch Lhe loss ls carrled
lor example a Laxpayer should aLLempL Lo mlnlmlze Lhe number of Laxable years Lo whlch an nCL ls carrled
1he more years Lo whlch Lhe nCL ls applled Lhe more beneflLs are losL from ad[usLmenLs for lLems such as
personal and dependency exempLlons
1he elecLlon noL Lo carry back Lhe loss mlghL also be advanLageous lf Lhere ls a dlsparlLy ln marglnal Lax raLes
appllcable Lo dlfferenL Lax years

Lxamp|e 31 age 72S

Abby susta|ned an NCL of 510000 |n ear 3 ner marg|na| tax bracket |n ear 1 was 1S In ear 4 however she
expects her bracket to be 3S due to a |arge prof|t she w||| make on a bus|ness dea| If Abby carr|es her |oss back her
refund w||| be 51S00 (1S x 510000) If she e|ects not to carry |t back to ear 1 but chooses |nstead to carry |t
forward her sav|ngs w||| be 53S00 (3S x 510000) Lven cons|der|ng the t|me va|ue of an |mmed|ate tax refund
Abby appears to be better off us|ng the carryover approach

key 1erms
8ad uebL 73
8uslness 8ad uebL 73
CasualLy Loss 78
ulsasLer Area Losses 710
uomesLlc roducLlon AcLlvlLles ueducLlon (uAu) 718
uomesLlc roducLlon Cross 8ecelpLs (uC8) 719
Modlfled Ad[usLed Cross lncome 718
neL CperaLlng Loss (nCL) 720
nonbuslness 8ad ueL 73
ersonal CasualLy Caln 714
ersonal CasualLy Loss 714
Cuallfled roducLlon AcLlvlLles lncome (CAl) 719
8esearch LxperlmenLal LxpendlLures 716
8eserve MeLhod 74
Small 8uslness SLock (SecLlon 1244 sLock) 76
Speclflc Charge Cff MeLhod 74
1hefL Losses 79
W2 Wages 718
WorLhless SecurlLles 76