ACCT 421 Chapter 7

From the government's standpoint, the standard deduction serves two purposes.

First, to help taxpayers with lower income, it automatically provides a minimum amount of income that is not subject to taxation. Second, it eliminates the need for the IRS to verify and audit itemized deductions for those taxpayers who chose to deduct the standard deduction.

Several types of employee expenses are restricted.

For example, the costs of job hunting qualify if the job is in the employee's current trade or business, but not for the individual's first job. In addition, the cost of education qualifies if it serves to maintain or improve the employee's skill in the business, but not if the education is required to qualify for a new business or profession

Tax Preparation Fees

Ordinary and necessary expenses incurred in connection with determining tax obligations imposed by federal, state, municipal, or foreign authorities are also deductible as miscellaneous itemized deductions subject to the 2 percent of AGI floor. While the most common tax preparation fees are the costs of preparing taxpayers' tax returns, taxpayers may also deduct other related expenses such as the cost of property appraisals for tax purposes and the costs of contesting tax liabilities.

Common medical expenses

Prescription medication, insulin, and medical aids such as eyeglasses, contact lenses, and wheel chairs. [Nonprescription medications are generally not deductible.] Payments to medical care providers such as doctors, dentists, and nurses and medical care facilities such as hospitals. Transportation for medical purposes. Long-term care facilities. Health insurance premiums (if not deducted for AGI by self-employed taxpayers) and insurance for long-term care services.3

Medical Expenses

Qualifying medical expenses include any payments for the care, prevention, diagnosis, or cure of injury, disease, or bodily function that are not reimbursed by health insurance or are not paid for through a "flexible spending account." Taxpayers may also deduct medical expenses incurred to treat their spouses and their dependents.

Individuals may deduct as itemized deductions payments made during the year for the following taxes:

State, local, and foreign income taxes, including state and local taxes paid during the year through employer withholding, estimated tax payments, and overpayments on the prior year return that the taxpayer applies to the current year (the taxpayer asks the state to keep the overpayment rather than refund it). Real estate taxes on property held for personal or investment purposes. Personal property taxes that are assessed on the value of the specific property. Taxpayers may elect to deduct state and local sales taxes instead of deducting state and local income taxes. This election is particularly advantageous for taxpayers in states that don't have an individual state income tax.

Limitation on Miscellaneous Itemized Deductions (2 percent of AGI Floor)

To apply the 2 percent floor limit and determine the miscellaneous itemized deduction, the sum of all deductions subject to the 2 percent floor limitation is reduced by 2 percent of AGI. If the 2 percent floor equals or exceeds the sum of miscellaneous itemized deductions, the deductions do not increase the taxpayer's itemized deductions (they don't provide any tax benefit). The 2 percent floor limitation makes it likely that most taxpayers will receive limited, if any, tax benefit from the deductions subject to the floor.

Miscellaneous itemized deductions

deductions representing the sum of certain itemized deductions, such as unreimbursed employee business expenses, investment expenses, and tax preparation fees, that are subject to a special floor limitation. Miscellaneous itemized deductions subject to the floor limitation include employee business expenses, investment expenses, and certain other expenses. These miscellaneous deductions are summed together and are deductible only to the extent that their sum exceeds 2 percent of the taxpayer's AGI.

Zach has miscellaneous itemized deductions totaling $450. His adjusted gross income is $54000. Zach will be able to deduct

$0. Miscellaneous deductions must be reduced by the 2% AGI floor ($450 - $1080)

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The amount of the itemized deduction phase-out for 2013 is the lessor of

3% * (AGI minus $300000 (275k for head of household, 250k for single, 150k for mfs) or 80% of the total itemized deductions subject to phaseout

Which of the following expenses are most easily bunched, or accelerated, into one year, so that the itemized deductions can be used in one year and the standard deduction can be used the following year?

Charitable contributions

Charitable Contributions

Congress encourages donations to charities by allowing taxpayers to deduct contributions of money and other property to qualified domestic charitable organizations. Qualifying charitable organizations include organizations that engage in educational, religious, scientific, governmental, and other public activities. Political and campaign contributions are not deductible even though they arguably indirectly support the government (contributions to which are generally deductible). The amount of the charitable contribution deduction depends on whether the taxpayer contributes money or other property to the charity. Note that in virtually all circumstances, donations are only deductible if the contribution is substantiated by written records.

Employee Business Expenses

Expenses that qualify include those that are appropriate and helpful for the employee's work such as the cost of professional dues, uniforms (unless suitable as normal attire), union dues, and subscriptions to publications related to employment.

Interest

First, subject to limitations, individuals can deduct interest paid on acquisition indebtedness and home-equity indebtedness secured by a qualified residence (the taxpayer's principal residence and one other residence)

Miscellaneous Itemized Deductions Not Subject to AGI Floor

individuals include all gambling winnings for the year in gross income but may also deduct gambling losses to the extent of gambling winnings for the year.30 The deductible gambling losses are miscellaneous itemized deductions; therefore, losses don't directly offset winnings.31 However, unlike other miscellaneous itemized deductions, gambling losses are not subject to the 2 percent of AGI floor. Casualty and theft losses on property held for investment and the unrecovered cost of a life annuity (the taxpayer died before recovering the full cost of the annuity) also qualify as miscellaneous itemized deductions not subject to the AGI floor.

Investment Expenses

investment expenses are itemized deductions. These expenses are classified as miscellaneous itemized deductions and include expenditures necessary for the production or collection of income, or for the management, conservation, or maintenance of property held for the production of income.26 Common investment expenses include: Expenses associated with investment income or property. Investment advisory fees. Safe-deposit box fees. Subscriptions to investment-related publications.

Private Operating Foundations

privately sponsored foundations that actually fund and conduct charitable activities.

Private nonoperating foundations

privately sponsored foundations that disburse funds to other charities.

Phase-out of Itemized Deductions

the amount of a taxpayer's total itemized deductions other than medical expenses, casualty losses, investment interest expense, and gambling losses is subject to a phase-out. That is, when AGI exceeds a certain threshold, itemized deductions are reduced. In 2013, the threshold begins at $300,000 for married taxpayers filing joint, $275,000 for heads of household, $250,000 for single taxpayers, and $150,000 for married taxpayers filing separately.

From the taxpayers' perspective, the standard deduction allows them to avoid taxation on a portion of their income, and for those not planning to itemize deductions, it eliminates the need to substantiate and collect information about them.

the standard deduction, however, is a double-edged sword. While it reduces taxes by offsetting income with an automatic deduction, it eliminates the tax benefits of itemized deductions up to the amount of the standard deduction. This is a very important point to consider when evaluating the tax benefits of itemized deductions.

Hobby expenses are deductible only to the extent of the revenue generated by the hobby

the tax law explicitly presumes that an activity is a business if it generates a profit in three of five consecutive years If an activity is determined to be a hobby, the taxpayer must include the revenue from the activity in gross income and may deduct the expenses, to the extent of the gross income from the activity, as itemized deductions (mortgage interest, real estate taxes, and miscellaneous itemized deductions). When hobby expenses exceed revenue, the expenses must be deducted in a particular sequence. Taxpayers first deduct expenses that are deductible anyway, such as mortgage interest or property taxes. Second, taxpayers deduct all other hobby expenses except depreciation expense (deducted as miscellaneous itemized deductions). Finally, they deduct depreciation expense (also deducted as a miscellaneous itemized deduction). As discussed below, miscellaneous itemized deductions are only deductible to the extent they exceed 2 percent of AGI.

Two rules limit the mortgage interest deduction:

(1) Taxpayers may only deduct mortgage interest on up to $1,000,000 of acquisition indebtedness and (2) The amount of qualified home-equity indebtedness is limited to the lesser of (a) the fair market value of the qualified residence(s) in excess of the acquisition debt related to the residence(s) (both the fair market value and acquisition debt amounts are determined when the home-equity loan is executed) and (b) $100,000 ($50,000 for married filing separately). In combination, these limitations allow taxpayers to deduct interest on up to $100,000 of home-equity debt (no matter what the taxpayer does with the proceeds from the home-equity loan) plus interest on up to $1,000,000 acquisition debt.

The amount of the tax loss from any specific casualty event (including theft) is the lesser of

(1) the decline in value of the property caused by the casualty or (2) the taxpayer's tax basis in the damaged or stolen asset. The loss is reduced by any reimbursements the individual is eligible to receive, such as insurance reimbursements. Likewise, any deductible loss reduces the taxpayer's basis in the underlying asset.

Casualty losses must exceed two separate floor limitations to qualify for itemized dedcutions

1st floor subtract $100 for each incident 2nd floor subtract 10% of AGI from total casualties

Contributions of Money

Cash contributions are deductible in the year paid, including donations of cash or by check, electronic funds transfers, credit card charges, and payroll deductions. When taxpayers use their personal vehicles for charitable transportation purposes, they may deduct, as a cash contribution, a standard mileage allowance for each mile driven (14 cents a mile in 2013). Set by congress, not adjusted every year.

Miscellaneous Itemized Deductions

Employee business expenses not reimbursed by an accountable plan. Investment expenses if not in a rental or royalty activity. Tax preparation fees and allowable hobby expenses. Total miscellaneous itemized deductions are subject to a 2 percent of AGI floor limit.

As a general rule, employees include reimbursements in gross income and deduct employee business expenses as miscellaneous itemized deductions.

However, if an employee is required to submit documentation supporting expenses to receive reimbursement and the employer reimburses only legitimate business expenses, then the employer's reimbursement plan qualifies as an accountable plan. Under an accountable plan (which is the most common method for reimbursement) employees exclude expense reimbursements from gross income and do not deduct the reimbursed expenses. If the expenses exceed the reimbursements, the excess (unreimbursed) portion of each expense is deductible as an employee business expense. Thus, miscellaneous itemized deductions for employee business expenses are commonly referred to as deductions for unreimbursed employee business expenses.

Capital gain property

In general, taxpayers are allowed to deduct the fair market value of capital gain property on the date of the donation. Capital gain property is any appreciated asset that would have generated a long-term capital gain if the taxpayer had sold the property for its fair market value instead of contributing the asset to charity. Capital assets include: Investment assets (stocks, bonds, land held for investment, paintings, etc.). Business assets (to the extent that gain on the sale of the business asset would not have been considered ordinary income). Personal-use assets. Contributing capital gain property is a particularly tax efficient way to make charitable contributions, because taxpayers are allowed to deduct the fair market value of the property, and they are not required to include the appreciation on the asset in gross income.

When taxpayers make contributions that are subject to different percentage limitations, they apply the AGI limitations in the following sequence:

Step 1: Determine the limitation for the 50 percent contributions. Step 2: Apply the limitations to the 30 percent contributions. The 30 percent contribution limit is the lesser of (a) AGI × 30% or (b) AGI × 50% minus the contributions subject to the 50 percent limit. Step 3: Apply the limitations to the 20 percent contributions. The 20 percent contribution limit is the lesser of (a) AGI × 20%, (b) AGI × 30% minus contributions subject to 30 percent limit, or (c) AGI × 50% minus the contributions subject to 50 percent and the contributions subject to the 30 percent limit.

Which of the following expenses are considered deductible investment expenses subject to the 2% of AGI floor?

Subscriptions to investment related publications Safe-deposit box fees Investment advisory fees

Ordinary Income Property

Taxpayers contributing ordinary income property can only deduct the lesser of (1) the property's fair market value (2) the property's adjusted basis. Ordinary income property consists of all assets other than capital gain property. That is, ordinary income property is property that if sold would generate income taxed at ordinary rates. This includes the following types of assets: Assets the taxpayer has held for a year or less. Inventory the taxpayer sells in a trade or business. Business assets held for more than a year to the extent the taxpayer would recognize ordinary income under the depreciation recapture rules if the taxpayer had sold the property. Assets, including investment assets and personal-use assets, with a value less than the taxpayer's basis in the assets (assets that have declined in value).

Charitable Contribution Deduction Limitations

The amount of a taxpayer's charitable contribution deduction for the year is limited to a ceiling or maximum deduction. The ceiling depends upon the type of property the taxpayer donates and the nature of the charity receiving the donation; donations to public charities (charities that are publicly supported such as churches and schools) and private operating foundations (privately sponsored foundations that actually fund and conduct charitable activities) are subject to less stringent restrictions than other charities.

The cost of travel and transportation associated with the employee's work responsibilities may also qualify as miscellaneous itemized deductions

The cost of travel is deductible if the primary purpose of the trip is business. However, the cost of commuting—traveling from a residence to the place of business—is personal and never deductible. When employees drive their personal automobiles for business purposes, they may deduct a standard mileage rate in lieu of deducting actual costs. In 2013, the standard business mileage rate is 56.5 cents per mile. When employees travel on business trips long enough to be away from home overnight, meals and lodging also qualify as employee business expenses. Although meals and lodging are deductible employee business expenses, employees are allowed to deduct only half the cost of the meals. For travel with both business and personal aspects, the meals (50 percent), lodging, transportation while at the location, and incidental expenses are deductible for the business portion of the trip (i.e., for the business days of the trip).

Certain contributions of capital gain property do not qualify for a fair market value deduction.

The deduction for capital gain property that is tangible personal property is limited to the adjusted basis of the property if the charity uses the property for a purpose that is unrelated to its charitable purpose. That is, this restriction applies to capital gains property that is (1) tangible, (2) personal property (not realty), (3) unrelated to the charity's operations. The third requirement does not apply if, at the time of the donation, the taxpayer reasonably anticipates that the charity will put the property to a related use.

Medical Expense Deduction Limitation

The deduction for medical expenses is limited to the amount of unreimbursed qualifying medical expenses paid during the year (no matter when the services were provided) reduced by 10 percent of the taxpayer's AGI. If a taxpayer or his or her spouse is age 65 or older at the end of the tax year, the 10 percent AGI floor is reduced to 7.5 percent of AGI through 2016. Ex 6-4

Individuals can also deduct interest paid on loans used to purchase investment assets such as stocks, bonds, or land (investment interest expense).

The deduction of investment interest is limited to a taxpayer's net investment income (investment income minus investment expenses). Any investment interest in excess of the net investment income limitation carries forward to the subsequent year.

Casualty losses must exceed two separate floor limitations to qualify as itemized deductions.

The first floor is $100 for each casualty event during the year. This floor eliminates deductions for small losses. The second floor limitation is 10 percent of AGI, and it applies to the sum of all casualty losses for the year (after applying the $100 floor). In other words, the itemized deduction is the aggregate amount of casualty losses that exceeds 10 percent of AGI.

Contributions of Property Other Than Money

When a taxpayer donates property to charity, the amount the taxpayer is allowed to deduct depends on whether the property is capital gain property or ordinary income property.

Bunching Itemized Deductions

a common planning strategy in which a taxpayer pays two year's worth of itemized expenses in one year to exceed the standard deduction in that year.

Personal exemption

a fixed deduction allowed for an individual taxpayer, and spouse if filing a joint tax return. $3900 a taxpayer's total exemption deduction is phased out based on AGI for relatively high income taxpayers.

Standard Deduction

a flat amount that most individuals can elect to deduct instead of deducting their itemized deductions (if any). That is, taxpayers generally deduct the greater of their standard deduction or their itemized deductions.

Casualty loss

a loss arising from a sudden, unexpected, or unusual event such as a "fire, storm, or shipwreck" or loss from theft.22 Taxpayers may deduct casualty losses in the year the casualty occurs or in the year the theft of an asset is discovered. Individuals cannot deduct losses they realize when they sell or dispose of assets used for personal purposes (personal-use assets as opposed to business or investment assets). However, individuals are allowed to deduct casualty and theft losses realized on personal-use assets

Floor limitation

a minimum amount that an expenditure (or credit or other adjustment to taxable income) must meet before any amount is allowed. Because this floor limitation is set at a high percentage of AGI, unreimbursed medical expenses rarely produce tax benefits, especially for high income taxpayers.

Accounting plan

an employer's reimbursement plan under which employees must submit documentation supporting expenses to receive reimbursement and reimbursements are limited to legitimate business expenses.

Acquisition indebtedness

any debt secured by a qualified residence that is incurred in acquiring, constructing, or substantially improving the residence. Home-equity indebtedness is any other debt secured by the taxpayer's qualified residence.

Itemized deductions

are personal in nature but are allowed to subsidize desirable activities such as home ownership and charitable giving. Other itemized deductions, such as medical expenses and casualty losses, provide relief for taxpayers whose ability to pay taxes has been involuntarily reduced.