16.1 Capital Loss Netting and Ordinary Business Loss Limits

16.1 Capital Loss Netting and Ordinary Business Loss Limits

REG Blueprint Area IV, Group D asks you to calculate the net tax loss allowed on the sale of capital property, including netting of capital gains and losses and capital loss carryforwards, and to calculate the amount of ordinary business loss allowed for an individual materially participating in a pass-through entity with sufficient basis in the entity. Character and holding period of capital assets were built in 14.3. Pass-through classification of a K-1 ordinary loss was 15.1. This section is the arithmetic of what is currently allowed.

Capital-loss netting for individuals

Keep two baskets. Net short-term capital gains against short-term capital losses. Net long-term capital gains against long-term capital losses. Then combine the two nets.

• Two nets that are both gains: both are recognized. Preferential long-term rates, collectibles, unrecaptured §1250, and NIIT are tax-computation issues in 17.1, not this limitation.
• One net is a gain and the other is a loss: they offset. Leftover character is whatever survives — leftover short-term loss is still short-term; leftover long-term loss is still long-term.
• Combined result is an overall net capital loss: an individual may deduct up to $3,000 of that net capital loss against ordinary income ($1,500 if married filing separately). Any unused capital loss carries forward indefinitely to later years and keeps its short-term or long-term character. There is no carryback for an individual's capital loss.

The $3,000 and $1,500 figures are statutory. They are not inflation-indexed, so they are testable. AICPA's assumption that you will not be tested on indexed limitations does not pull $3,000 off the exam.

Report the netting on Form 8949 and Schedule D, then on Form 1040. A capital-loss carryforward from last year enters this year's netting as a short-term or long-term loss of the same character it had when it left last year.

C corporations use a different statute. Corporate capital losses offset only capital gains, never ordinary income. Unused corporate capital losses carry back three years and forward five. That regime is developed in 18.3. For this individual chapter, remember only the contrast: do not give an individual a three-year capital-loss carryback, and do not put a $3,000 ordinary offset on Form 1120.

Worked scenario: $8,000 net STCL and $2,000 LTCG

Facts. Avery, a calendar-year individual who is not married filing separately, has a $8,000 net short-term capital loss and a $2,000 long-term capital gain. Avery has no other capital transactions and no capital-loss carryforward from a prior year.

Analysis.

1. Cross-net the baskets: $8,000 net STCL against $2,000 LTCG leaves a $6,000 net short-term capital loss.
2. Ordinary offset: $3,000 is allowed against Avery's ordinary income this year.
3. Carryforward: the remaining $3,000 carries forward indefinitely as a short-term capital loss.

If Avery were married filing separately, the ordinary offset would be $1,500 and the short-term carryforward would be $4,500. If the $8,000 net loss had been long-term and the $2,000 had been short-term gain, the leftover $6,000 would be a long-term capital loss; the current ordinary offset would still be $3,000, and the carryforward would be long-term.

Ordinary business losses: apply the stack in order

A K-1 ordinary loss keeps ordinary character. Current deductibility is a stack of limits. Apply them in this order. A later statute never restores what an earlier statute already suspended.

1. Basis. A partner's loss is limited to outside basis in the partnership interest (20.2). An S shareholder's loss is limited to stock basis plus debt basis (19.3). Excess is suspended at the owner and carried forward until basis exists. The blueprint task that states sufficient basis has already cleared this gate.
2. At-risk — IRC §465. The at-risk amount is money plus the adjusted basis of property contributed, plus amounts borrowed for which the taxpayer is personally liable or has pledged other property, plus qualified nonrecourse financing of real property used in the activity. Other nonrecourse debt generally does not increase at-risk. Loss above at-risk is a §465 carryforward, not a current deduction.
3. Passive activity — IRC §469. A passive activity loss is deductible only against passive activity income (and is fully allowed in the year the taxpayer disposes of the entire interest in a fully taxable transaction with an unrelated party). Material participation takes a trade or business out of §469. REG-level tests, from Temp. Treas. Reg. §1.469-5T, include: more than 500 hours during the year; substantially all of the participation in the activity; more than 100 hours and not less than any other individual; significant-participation activities aggregating more than 500 hours; material participation in five of the last ten years; a personal-service activity in which the taxpayer materially participated in any three prior years; and facts and circumstances (still generally more than 100 hours). Rental activities are per se passive unless a real-estate-professional exception applies. Do not use 500 hours to convert a rental into nonpassive without that overlay.
4. Excess business loss — IRC §461(l). After the first three gates, remaining trade-or-business deductions of a noncorporate taxpayer in excess of trade-or-business income plus an inflation-indexed threshold are disallowed as a current loss. AICPA will not test the dollar. Teach the existence of the limit: the excess is treated as a net operating loss carryforward, not as a current ordinary business loss.

Do not apply the $3,000 capital-loss ceiling to an ordinary K-1 loss. That ceiling is a capital rule.

Worked scenario: material participation and sufficient basis

Facts. Jordan, single, is a 50 percent partner in a retail partnership. The Schedule K-1 shows an ordinary business loss of $70,000. Jordan's outside basis is $90,000. Jordan's at-risk amount is $90,000. Jordan worked 620 hours in the shop; no other individual worked more. Jordan has no other trade or business. The facts state that the loss does not exceed the year's §461(l) threshold.

Analysis.

1. Basis. $90,000 ≥ $70,000. Basis does not limit.
2. At-risk. $90,000 ≥ $70,000. Section 465 does not limit.
3. Passive. 620 hours is more than 500 and is not less than anyone else's participation. Jordan materially participates. The loss is nonpassive.
4. §461(l). The facts take the indexed threshold off the table. The currently allowed ordinary business loss is $70,000.

If Jordan had worked only 80 hours, the $70,000 would be a suspended passive loss even though basis and at-risk were ample. If outside basis had been only $40,000, only $40,000 would pass the basis gate; $30,000 would wait for later basis, and the later gates would see only $40,000. If the facts instead stated that $70,000 exceeded the §461(l) threshold, the excess would leave this year's ordinary loss and become an NOL carryforward.

/practice/cpa-regPractice questions with detailed explanations