6.1 Business and Investment Losses

Business and investment losses can significantly impact your tax liability. Understanding the different types of losses and their tax treatment is crucial for effective tax planning.

Ordinary losses, capital losses, and net operating losses each have unique characteristics and limitations. Knowing how to classify and utilize these losses can help you maximize deductions and minimize tax burdens in both the short and long term.

Ordinary vs Capital Losses

Types of Losses and Their Characteristics

• Ordinary losses stem from sale or exchange of non-capital assets used in trade or business (inventory, accounts receivable)
• Capital losses arise from sale or exchange of capital assets (stocks, bonds, real estate held for investment)
• Holding period determines capital loss classification
  • Short-term capital loss held for one year or less
  • Long-term capital loss held for more than one year
• Section 1231 losses represent hybrid category, potentially treated as ordinary losses but subject to special recapture rules
• Net operating losses (NOLs) occur when business's deductible expenses exceed taxable income for given year
• Loss characterization as ordinary or capital impacts tax treatment and ability to offset other income

Special Considerations for Loss Classification

• Passive activity losses subject to special rules, offsetting only passive income
  • Exceptions apply for real estate professionals and small landlords
• Wash sale rule disallows deduction of loss on security sale if substantially identical security purchased within 30 days before or after sale
• Section 1244 stock losses allow up to $50,000 ($100,000 for joint filers) of losses on small business stock treated as ordinary losses
• Hobby loss rules limit deductions for activities not engaged in for profit to income generated by activity
• Casualty and theft losses for personal-use property generally no longer deductible
  • Exception for federally declared disasters
  • Business and income-producing property losses remain deductible

Tax Treatment of Losses

Deductibility of Different Loss Types

• Ordinary losses generally fully deductible against all income types in occurrence year, subject to limitations
• Capital losses for individuals deductible against capital gains, plus up to $3,000 of ordinary income per year ($1,500 if married filing separately)
• Corporate capital losses only deductible against capital gains, no deduction against ordinary income allowed
• Net operating losses carried forward indefinitely for most businesses
  • Limited to 80% of taxable income in any given year
• At-risk rules limit loss deductions to amount of money or property taxpayer has at risk in activity
• Excess business loss limitation caps amount of business losses offsetting non-business income for non-corporate taxpayers

Special Rules and Limitations

• Passive activity losses only offset passive income, with exceptions
• Basis limitation rule restricts partner's or S corporation shareholder's ability to deduct losses exceeding basis in entity
• Alternative Minimum Tax (AMT) impacts utilization of loss carryforwards
  • AMT NOLs calculated differently from regular NOLs
• Section 382 of Internal Revenue Code governs limitations or elimination of loss carryforwards in cases of significant corporate ownership changes

Loss Carryforwards and Carrybacks

Carryforward Rules and Limitations

• Loss carryforwards allow unused losses applied against future years' income, potentially reducing tax liability
• Net operating losses (NOLs) carried forward indefinitely for most businesses
  • Limited to 80% of taxable income in any given year
• Individual capital loss carryforwards used indefinitely until exhausted
  • Maintain character as short-term or long-term
• Corporate capital losses carried forward 5 years, only offsetting capital gains
• AMT can impact utilization of loss carryforwards
  • AMT NOLs calculated differently from regular NOLs
• Section 382 limitations apply to loss carryforwards in cases of significant corporate ownership changes

Historical and Current Carryback Provisions

• Prior to Tax Cuts and Jobs Act of 2017, NOLs carried back 2 years and forward 20 years
• Current rules generally only allow indefinite carryforwards for NOLs
• Corporations can carry capital losses back 3 years and forward 5 years
  • Only used to offset capital gains
• Special carryback provisions may apply in certain circumstances (disaster losses, farming losses)

Limitations on Loss Deductions

General Limitations on Loss Deductions

• At-risk rules limit loss deductions to amount of money or property taxpayer has at risk in activity
• Passive activity loss rules restrict deductibility of losses from activities without material participation
• Excess business loss limitation caps business losses offsetting non-business income for non-corporate taxpayers
• Basis limitation rule restricts partner's or S corporation shareholder's ability to deduct losses exceeding basis in entity
• Hobby loss rules limit deductions for activities not engaged in for profit to income generated by activity

Specific Loss Deduction Rules

• Section 1244 stock losses allow up to $50,000 ($100,000 for joint filers) of small business stock losses treated as ordinary losses
• Casualty and theft losses for personal-use property generally no longer deductible
  • Exception for federally declared disasters
  • Business and income-producing property losses remain deductible
• Wash sale rule disallows deduction of loss on security sale if substantially identical security purchased within 30 days before or after sale
• Capital loss deduction for individuals limited to capital gains plus up to $3,000 of ordinary income ($1,500 if married filing separately)
• Corporate capital losses only deductible against capital gains, no deduction against ordinary income allowed