Definition
In financial terms, an ordinary loss is a decrease in the value of an asset, investment, or business that typically results from regular business operations and is fully deductible from taxable income. This differs from a capital loss, which results from the disposal of a capital asset. Ordinary loss can reduce the taxable income, thus minimizing the taxes one needs to pay.
Phonetic
The phonetic pronunciation of “Ordinary Loss” is “ɔrdɪˌneriː lɔs”.
Key Takeaways
- An Ordinary Loss is a decrease in the value of a financial asset or property that is generated from regular business operations and related transactions. This typically includes expenses, uncollectible payments, salaries, depreciation and other incidental costs.
- Ordinary Losses are tax deductible in the year in which they occur. This means they can be used to reduce the taxable income for businesses and individuals, thereby decreasing the total amount of taxes that need to be paid.
- Ordinary Loss is distinguished from a capital loss, which is generated by the sale or exchange of a capital asset. While both losses can offer a tax benefit, the Internal Revenue Service treats them differently in determining taxable income.
Importance
The business/finance term, Ordinary Loss, is crucial as it pertains to a loss incurred from normal business operations, not from a major or extraordinary event. This could be from the sale or exchange of assets, supplies, or services. Its importance is underscored in financial accounting and tax accounting, as ordinary losses can be deducted fully in the year they occur from the entity’s gross income. This then reduces the taxable income, and, therefore, the amount of tax to be paid. Understanding this term can help businesses make strategic and informed decisions by balancing gains and losses for the most efficient tax outcome.
Explanation
Ordinary loss is an important concept in the realm of finance and business, specifically in taxation. The purpose of an “ordinary loss” designation is majorly to provide tax relief to businesses, as it can be fully deducted from other forms of income in the same tax year, thus reducing a business’s tax liability. This loss typically originates from the cost of doing business and can include theft losses, office supplies, salaries, rent, and any losses on the sale or exchange of business property. The ability to declare an ordinary loss provides the potential to offset positive income, effectively lowering a company’s taxable income.Further, the tax-treated advantage of an ordinary loss, as compared to a capital loss, is pivotal for most businesses. The reason lies in the limitations imposed on capital losses, which are capped annually, while ordinary losses are not. In short, the existence and declaration of an ordinary loss improve a company’s liquidity position by reducing the cash outflow intended for tax payments. Additionally, they provide relief for businesses that have had a tough financial year, allowing such companies to potentially remain afloat. Therefore, ordinary losses can be seen as a form of financial aid to businesses dealing with unfortunate fiscal circumstances.
Examples
1. Real Estate Depreciation: An ordinary loss might occur if a real estate investor owns a residential rental property. They are allowed to depreciate the value of their property over a period of time (approximately 27.5 years for residential real estate) as the property gradually decreases in value due to normal wear and tear. This depreciation is considered an ordinary loss and can be used to offset regular income.2. Stock Asset Loss: Suppose an individual owns shares in a company whose stock price drops significantly due to market fluctuations or corporate mishaps. If the investor decides to sell these shares at a loss, this would be considered an ordinary loss. This loss could be used to offset the individual’s regular income for that year.3. Small Business Loss: For example, a small business owner may have experienced a particularly poor financial year due to a decrease in customers or unexpected costs. The net operating loss that year, after all income and expenses are accounted for, would be considered an ordinary loss. The Internal Revenue Service (IRS) in the U.S. allows these business owners to use ordinary losses to offset their income, effectively reducing their tax liability.
Frequently Asked Questions(FAQ)
What is an Ordinary Loss in finance?
An Ordinary Loss is a loss that occurs from the normal business operations and can be deducted from ordinary income to reduce the taxable income.
Where is an Ordinary Loss reported?
An Ordinary Loss is usually reported on your income tax return. Particularly IRS Form 4797, titled Sales of Business Property.
How does an Ordinary Loss affect business taxation?
An Ordinary Loss reduces the taxable income for an investor or a business, hence reducing the amount of tax they have to pay.
What distinguishes an Ordinary Loss from a Capital Loss?
An Ordinary Loss is associated with regular business activities, while a Capital Loss arises from the sale or exchange of a capital asset.
Is there any limit to how much of an Ordinary Loss you can claim?
There’s no limit on how much ordinary loss you can claim. The total amount of loss can be deducted from your taxable income.
Are all businesses allowed to claim an Ordinary Loss?
Not all business structures can claim an ordinary loss. This option is usually available to general partnerships, limited partnerships, Limited Liability Companies (LLCs), and S corporations.
Does an Ordinary Loss have an impact on a company’s financial statements?
Yes. An Ordinary Loss decreases the profitability of a company in its income statement, which can affect the owner’s equity reported on the balance sheet.
Can an Ordinary Loss be carried forward or backward against future or past profits?
The ability to carry losses forward or backward depends on the specifics of tax laws in your location. You should consult a tax professional for advice suited to your circumstances.
Is an Ordinary Loss always related to physical assets?
No. Other types of losses such as those from theft, fraud, or legal expenses in the course of business can also be classified as Ordinary Losses.
Can personal losses be claimed as Ordinary Losses?
No. Only losses incurred in carrying out business operations can be classified as Ordinary Losses. Personal losses cannot be claimed on your tax return as such.
Related Finance Terms
- Net Operating Loss (NOL): This term refers to years when a company or individual’s tax deductions exceed their taxable income, resulting in a negative taxable income as per Internal Revenue Service (IRS).
- Capital Loss: It is the loss that arises when the cost price of an investment is higher than its selling price. Unlike ordinary losses, capital losses are incurred on capital assets like stocks and bonds.
- Tax Loss Carryforward/Carryback: These are provisions that enable a business to use a net operating loss to offset tax liabilities in future or previous years.
- Depreciation: In business and accounting, this term signifies the gradual deduction of the cost of a tangible capital asset over its useful life due to wear and tear, or obsolescence.
- Section 1231 Property: This term refers to real or depreciable business property held for over a year. Section 1231 property includes buildings, machinery, land, timber and coal, and livestock.
