US Tax Limitations on Certain Losses and Deductions

At Catalyst, we have an entire team of accountants and trusted advisors that specialize in U.S. Tax and Cross Border Tax in Calgary and Alberta. Our recent blog series is […]

At Catalyst, we have an entire team of accountants and trusted advisors that specialize in U.S. Tax and Cross Border Tax in Calgary and Alberta. Our recent blog series is focusing on U.S. and Cross Border taxation matters that are pertinent to Canadians and Americans. This week we are looking at U.S. Tax Limitations on Certain Losses and Deductions.

By: Jeff Fortin CA, CPA (IL) -Tax Partner & James Luo CPA, CA, CPA (MA) – Senior Tax Manager

Most taxpayers prefer to pay less tax or defer payments of tax for as long as possible.  Taxation authorities, on the other hand, want to collect as much tax as they can as quickly as possible.  The U.S. Internal Revenue Code (the “Code”) has a series of rules designed to limit deductibility of investment expenses and losses or defer such deductibility into the future.  The following are a sample of such limitations in the Code.

At-Risk Limitations

Under the at-risk rules, loss deductions are limited to the amount the taxpayer has “at risk” in the activity. This is the capital a taxpayer has invested in an activity and the adjusted basis of other property the taxpayer contributed to the activity. It also includes the amount borrowed and used in the business activity for which the taxpayer is personally responsible.

When the at-risk rules apply, a taxpayer will not be allowed to offset his other sources of income such as salary, business or professional income with losses from investments in activities that are, for example, largely financed by nonrecourse loans for which the taxpayer is not personally responsible.

Passive Activity Loss Limitation

Losses that are otherwise allowable under the at-risk rules may, nevertheless, be disallowed by the passive activity loss limitations.

A passive activity for purposes of the passive activity limit on losses is an activity that involves the conduct of any trade or business in which the taxpayer does not materially participate. Examples of passive activities includes a rental activity managed by a third party or investments in a partnership as a limited partner. In general, a taxpayer is allowed to deduct losses from his passive activities to the extent of his profit or gain from other passive activities but and not against “active” or other ordinary income. Losses deferred under the passive activity loss limitation are carried forward indefinitely.

Accumulated losses from a passive activity become wholly deductible after the activity had been disposed of.

Personal Losses and Hobby Losses

In the U.S., income is income, and income is taxable unless specifically excluded under the Code, no matter the source.  Losses such as personal losses or losses from hobbies, on the hand, are generally not deductible.  Examples of personal losses include losses on the disposition of a car or vacation home.  Examples of hobby losses include losses from writing, movie making or auto racing in which the profit motive is remote.  There is a statutory presumption of profit motive where it can be shown that gross income derived from an activity for 3 or more years in a period of 5 consecutive years exceeds the deductions attributable to the activity.  Deductions related to a hobby activity are generally only allowed against the gross income of such activity.

Please don’t hesitate to contact your trusted Catalyst Advisor if you have any questions.  You can reach Jeff at (403) 767-1503 or James at (403) 767-1511.