A toxic asset is an investment with a value that’s dropped to a point where there is no longer any market for it. Analysts coined the term after the 2008 real estate market bust that preceded a long global recession. For example, assume your client is a lender and its customer borrows $2.5 million to purchase a building for $3 million. Within the first year, a severe economic downturn hits, and real estate values in the community decline by 33%. The borrower closes down the business, vacates the building, and defaults on the loan. Your client’s $2.5 million mortgage receivable now has a lower value, making the prospect of selling it to a secondary lender very unlikely.
Toxic assets are a challenge for small business owners and accountants because their values often fall and are difficult to determine accurately. Your role as an accountant is to help clients get toxic assets they may already have off their books in a way that’s legal and ethical, and minimizes their loss. Financial Accounting Standards Board (FASB) rules require reporting the asset at its market value, but if there is no market, regulators allow lenders to use a bit of discretion in recording the losses from these assets. This form of mark to market accounting draws criticism for allowing lenders to mislead investors about the true value of toxic assets. In the above example, the collateral for a $2.5 million mortgage receivable dropped to $2 million, but it can continue to drop further. Assigning a value of $2 million to this asset could make it seem profitable if its value keeps declining.
If your client sells the asset for $1.5 million, recording the asset at that amount leaves a loss of $1 million that it must treat as a capital loss.
Capital losses can be used to offset capital gains. Canada Revenue Agency rules allow your client to apply capital losses against capital gains only, and not against other income. Your client can carry losses that exceed the amount of gains for a given year back three years and forward indefinitely.