Among business owners I know, “I can write it off” has become almost a daily refrain. Business owners can definitely deduct legitimate expenses [1] from their income – and in some cases can claim a business loss if expenses exceed income.
But not all income tax losses are completely tax deductible.
If you have been dragging your feet on filing your taxes, read on for rules regarding some of the most common losses.
5 Simple Rules for Claiming Tax Losses
- Businesses: Established businesses can claim business losses when their expenses exceed their revenue. The IRS has a number of rules and requirements [2], and you should check with a tax advisor to see what makes sense in your own situation. Know that if your business is not intended to make a profit, you cannot claim losses against non-business income. Additionally, you cannot claim a loss against other income that exceeds what you personally invested in or borrowed for the business. If the business has a net operating loss, you can carry tax losses forward to future years.
- Hobbies: If your possible business endeavor does not qualify as a business using the IRS’s criteria [3], it probably counts as a hobby. Hobby losses can only be taken to the extent that you have hobby income – you cannot claim losses from your hobby against other income. So if you sell an item or two a year on Ebay, it’s viewed as a hobby rather than a business [4] – so you can’t deduct the full cost of your brand new computer!
- Gambling: If you are a frequent gambler and itemize deductions [5], this might interest you. You can deduct gambling losses/expenses [6] – but only to the extent of income. So if you spend $5 on a lotto ticket and win nothing, you can deduct nothing. Ditto for putting $100 into a slot machine. But if you win $20 on that lotto ticket, you can deduct the $5. And if you win $50 at the slot machine, you can deduct $50 of the original $100. Remember that you have to count the winnings as taxable income [7]!
- Investments: This is perhaps the most well-known of the commonly claimed losses. If you lose money on an investment, you can deduct it up to the amount that you gained on other investments – PLUS an additional $3,000 that you can use to offset ordinary income. If you have more than $3,000 ($1,500 for married filing separately [8]) in net losses, you can carry forward the losses to future years. In the future, if you have a loss that exceeds $3,000 consider selling some winners so that you can offset the gains. You can reinvest the money in a different stock/type of fund or wait 30 days to invest in the same or a similar fund. Remember that to claim losses you have to actually sell the investment and experience a loss – just having the stock or fund decline in value is not enough! Investment gains that cannot be offset by losses are taxed at a special rate [9].
- Lending: If you made a loan to someone that was not paid back and you do not expect it any part of it to be paid back, you can claim it as a personal bad debt. However, you must prove that it was an actual loan with expectation of repayment – you cannot ”lend” money to your child and tell them they don’t have to pay it back, and then claim it as a loss. Other rules [10] apply – for instance, you can only claim the debt in the year it became totally worthless. The loan is essentially treated as an investment, so it will be netted against capital gains and you can only claim an additional $3,000 against other income. Madison wrote [11] about how she claimed a bad Lending Club [12] loan using this rule.
Confused? If you think you may be able to claim significant losses, it’s probably worth talking to a professional. He or she can help you file your 2010 taxes and help you prepare to optimize losses and reduce taxes [13] in 2011.
If you need more time before the tax deadline [14], consider filing for an extension [15]. Just don’t avoid filing altogether – it will cost you [16]!