Ordinary Loss

An ordinary loss refers to a financial loss that is not treated as a capital loss for tax purposes. Unlike capital losses, which can only be used to offset capital gains, ordinary losses can offset both ordinary income (such as wages, salaries, and business income) and capital gains. This type of loss is particularly relevant to individual taxpayers, small business owners, entrepreneurs, and investors as it can provide significant tax relief. Understanding ordinary losses is essential for proper financial planning and tax strategy.

Types of Ordinary Losses

Ordinary losses can arise from various sources and activities, notably including:

1. Business Losses

• Operating Losses: These occur when a company’s expenses exceed its income during a tax year. They can stem from lower than expected sales, rising costs, or unexpected expenses. For instance, a restaurant that fails to attract enough customers and consequently spends more on operational costs than it earns would record an operating loss.

• Bad Debts: If a business is unable to collect payments owed for goods or services, it can write off these bad debts as ordinary losses. This typically applies to accrual basis taxpayers who recognize income when a sale is made rather than when it is collected.

• Casualty and Theft Losses: Losses resulting from natural disasters like hurricanes, fires, or theft of business property can be categorized as ordinary losses. The costs involved in repairing or replacing the property plus any lost revenue during downtime are deductible.

2. Losses from Real Estate Activities

• Rental Property Losses: When an investor’s rental income is less than the related expenses (mortgage interest, property taxes, repairs), the resulting loss is considered an ordinary loss. Under certain conditions, up to $25,000 of rental real estate losses can be deducted against other income.

• Foreclosure and Abandonment: If a property is foreclosed upon or abandoned by the owner, the loss incurred is usually treated as an ordinary loss.

3. Investment-Related Losses

• Section 1244 Stock: Losses realized from selling Section 1244 stock—stock in a small, domestic corporation that meets specific criteria—are considered ordinary losses. These can be deducted against ordinary income up to $50,000 ($100,000 for joint returns) annually.

• Worthless Securities: If securities, such as stocks or bonds, become completely worthless, the loss can sometimes be treated as an ordinary loss. This typically applies to business owners and some investors in certain conditions.

4. Employee Business Expenses

• Unreimbursed Employee Expenses: Certain unreimbursed expenses that employees incur in the course of doing their job, such as travel or supplies, can sometimes be claimed as ordinary losses.

Tax Treatment and Deductions

The primary benefit of ordinary losses is their ability to offset ordinary income, potentially leading to substantial tax savings. Here are some details on how these losses can be utilized:

1. Net Operating Loss (NOL)

An NOL occurs when a taxpayer’s allowable deductions exceed their gross income. NOLs can typically be carried forward to future tax years, enabling the taxpayer to use the loss to reduce taxable income in those years. Under the Tax Cuts and Jobs Act (TCJA), the carryover deduction is generally limited to 80% of the taxable income for the year it’s being applied, although exceptions can apply.

2. Deductions

Ordinary loss deductions are primarily reported on Schedule C (for sole proprietors) or Schedule E (for real estate investments) of the IRS Form 1040.

• Business Losses: Report operating losses on Schedule C.

• Real Estate Losses: Report rental property losses on Schedule E. A special allowance of up to $25,000 can be deducted against other income under the “active participation” rule.

• Investment Losses: Section 1244 losses are reported directly on Form 1040.

3. Limitation Rules

While ordinary losses offer favorable tax treatment, several limitations apply:

• At-Risk Limits: Deductions are limited to the amount the taxpayer has “at risk” in the business. This generally includes cash, property contributions, and borrowed amounts where the taxpayer is personally liable.

• Passive Activity Loss Rules: These govern the ability to deduct losses from passive activities, such as rental properties or businesses in which the taxpayer does not materially participate. Losses can only be deducted against passive income.

Practical Example

Consider a small tech startup facing high research and development costs while its products are not yet generating substantial revenue. For the first few years, the startup operates at a loss. These losses are ordinary losses and can be used to offset other income the entrepreneurs might have, such as wages from other employment or spousal income.

Similarly, a property investor who suffers a large enough loss on a rental property due to high maintenance costs and low rental rates can claim these as ordinary losses, subject to the $25,000 limit if they actively participate in the management.

Strategic Implications

Getting a handle on ordinary versus capital losses and understanding the tax rules around them can guide business decisions involving investments, loan structuring, and asset management. Avoiding pitfalls and optimizing the timing and nature of losses help in maximizing tax benefits.

For instance, restructuring business debt or adjusting the timing of significant purchases and sales can affect the type and timing of recognized losses. Another crucial aspect is rigorous record-keeping and financial forecasting to take full advantage of available tax deductions.

Financial Tools and Software

Tools like tax preparation software and financial management platforms can assist in calculating and reporting ordinary losses accurately. Popular platforms include:

• TurboxTax (TurboTax.com)

• H&R Block (HRBlock.com)

• QuickBooks (QuickBooks.Intuit.com)

These programs typically offer guidance on how to input, categorize, and manage various types of ordinary losses, ensuring compliance with relevant tax laws and maximizing potential deductions.

Professional Advice

Seeking advice from tax professionals or certified public accountants (CPAs) is often prudent, particularly for complex tax situations involving significant ordinary losses. Many accounting firms offer services specializing in loss management strategies, including:

• Deloitte (Deloitte.com)

• PwC (PwC.com)

• Ernst & Young (EY.com)

Experienced professionals can provide customized strategies and ensure that businesses and individuals comply with tax obligations while minimizing taxable income.