Deducting Losses
In taxation you can deduct a loss on your individual income tax return. A loss is incurred when total costs or expenses exceed income. There are four types of losses that you can deduct on an individual income tax return: Business loss, passive loss, investment loss, and a casualty and theft loss. As you get to the end of the tax year it may be beneficial to see if you can take advantage of any of these types of losses.
Business loss
If you own a business which is in the business of making a profit you are entitled to deduct a loss on the business if business expenses exceed gross income. In addition to this obvious requirement the business must be attempting to make a profit and not be a sham business or hobby in which the taxpayer is really using the business as a personal hobby and is not really attempting to make a profit. There are a few requirements of determining if the business is a hobby but the primary requirement is that business must report a profit for at least three out of a five year period. If a business reports a loss year after year that is a good indication that the business is not a true business but a hobby and would fall under close scrutiny of the Internal Revenue Service.
Passive loss
A passive loss is a loss in which the taxpayer is not an active participant in the business. An active participant is defined as not having materially participated in the business. A passive loss is incurred when total expenses, typically incurred from a business investment property, exceeds the gross income from that property. A passive loss can only be deducted and offset against net passive income. However, there are exceptions to this rule when the passive loss involves residential rental properties. Most taxpayers are allowed to deduct passive losses from rental properties even though there is no offsetting passive income. But there is a limitation to this rule in that the loss is limited to $25,000 per year and the loss is slowly phased out when the taxpayer’s adjusted gross income exceed $100,000 and is completely phased out when the adjusted gross income exceeds $150,000. Any unused passive loss in a given year is carried forward to future years and will be eventually used when there would be either offsetting passive income or the asset or property is sold.
Investment loss
An investment loss is typically a loss incurred on the sale of a capital asset which is usually in the form of real estate or a security. The loss is incurred when the asset is sold and the cost exceeds the sales price. Both business losses and passive losses, which are mentioned above, are considered ordinary losses which means they are fully deductible against all income. An investment loss is also known as a capital loss and with this type of loss there is a limitation on deductibility. The capital loss can be deducted in full to the extent of capital gains. If any of the loss exceeds capital gains then the loss is limited to $3,000 per year. Any loss that is not used in a current year is carried forward to future years until it is eventually used.
Casualty and Theft Loss
A casualty and theft loss is a loss that is incurred when there is a sudden and unexpected event and the loss involves a personal asset. A sudden and unexpected event is usually in the form of a disaster i. e. earthquake, hurricane, tornado, flood, or other act of God. The loss is calculated by taking the lesser of the cost or FMV of the asset before the disaster and what the value of the asset is after the disaster. There is an income limitation on the amount of loss that is deductible. For any of the loss to be deductible you must first subtract $100 from the loss. The loss then must exceed 10% of the adjusted gross income of the taxpayer to be deductible. For example, assume a taxpayer incurs a casualty loss on a home due to a flood. Before the flood the home had a FMV of $200,000 and an original cost of $180,000. After the flood the value of the home is zero. Also assume that the taxpayer’s AGI for the year of the disaster is $150,000. To calculate the loss you would first take the lesser of the FMV or cost of the home which would be $180,000. You would then subtract $100 from the $180,000 which would result in $179,900. Then multiply the AGI of $150,000 by 10% which the result would by $15,000. Then subtract the $15,000 from $179,900 and the result would be $164,900. In this example the deductible loss would be $164,900. If the loss is the result of a theft the calculation to determine the loss would be the same.