TAX 4001 Exam 2

Describe how a business element is reflected in the requirements to deduct moving expenses and how Congress limited this deduction to substantial moves.

A business element is reflected in both the distance test and time test associated with the move. To satisfy the distance test, the distance from the taxpayer's old residence to the new place of work (business element) must be at least 50 miles more than the distance from the old residence to the old place of work (business element). The time test for a moving expense deduction requires the taxpayer to be employed full time 39 of the first 52 weeks (or self-employed for 78 of the first 104 weeks) after the move (obviously reflecting a business element).

Describe the type of event that qualifies as a casualty for tax purposes.

A casualty is defined as an unexpected, unforeseen, or unusual event such as a "fire, storm, or shipwreck" or loss from theft.

Contrast ceiling and floor limitations, and give an example of each.

A ceiling is a maximum amount for an exclusion or deduction. In contrast to a ceiling, a floor limitation eliminates any deduction for amounts below the minimum amount (i.e., the floor). Ceiling limitations may provide that amounts above the ceiling limit are lost (disallowed) or could be used in other years (carryover). Like a ceiling, a floor can be structured as either a fixed amount or a floating constraint based upon some intermediate number. Unlike ceilings, floor limits eliminate any amounts below the minimum thereby limiting the number of taxpayers who qualify for any adjustment to income. While there are many examples of ceiling and floor limits, two common examples are the personal casualty loss deduction (which contains two floors) and the charitable contribution deduction (which contains several ceilings). The $100 per casualty limit on personal casualty loss deductions is a floor limit placed on each casualty, and the 10 percent of AGI limit is an aggregate floor limit placed on the sum of all casualty losses in a particular year. If the casualty loss does not exceed both floors, then no deduction can be claimed. In contrast, the charitable contribution deduction contains ceiling limits -such as, cash deductions cannot exceed 50 percent of AGI. To the extent that contributions exceed the ceiling, the deductions carryover into the subsequent year.

Under what circumstances can a taxpayer deduct medical expenses paid for a member of his family? Does it matter if the family member reports significant amounts of gross income and cannot be claimed as a dependent?

A taxpayer can deduct medical expenses incurred for members of his family if they are dependents (i.e., either qualified children or qualified relatives). For purposes of deducting medical expenses, a dependent need not meet the gross income test (§213(a)).

All else being equal, would a taxpayer with passive losses rather have wage income or passive income?

A taxpayer in this situation would prefer passive income because the taxpayer's passive losses could be applied currently against the passive income to reduce the amount of tax paid currently. If the taxpayer had received wage income, the passive losses would have been suspended, and the tax benefits associated with the passive losses would be deferred.

When should investors consider making an election to amortize market discount on a bond into income annually? [Hint: see §1278(b)]

A taxpayer may elect under §1278(b) to amortize market discount on a bond into income currently (as ordinary income) rather than wait to recognize the accrued market discount as ordinary income when the bond is sold or matures. Generally, this election makes sense when the taxpayer's current marginal tax rate is expected to be significantly lower than the future marginal rate when the bond is sold or matures.

What is a "wash sale"? What is the purpose of the wash sale tax rules?

A wash sale is a tax term that applies to transactions in which a taxpayer purchases the same stock or "substantially identical" stock to the stock they sold at a loss within a 61-day period centered on the date of the sale. A wash sale occurs when an investor sells or trades stock or securities at a loss and within 30 days either before or after the day of sale buys substantially identical stocks or securities. Because the day of sale is included, the 30 days before and after period creates a 61-day window during which the wash sale provisions may apply. The purpose of the wash sale tax rules is to prevent taxpayers from accelerating losses on securities that have declined in value without actually changing their investment in the securities. The 61-day period ensures that taxpayers cannot deduct losses from stock sales while essentially continuing their investment in the stock.

Describe how interest income and dividend income are taxed. What are the similarities and differences in their tax treatment?

Because they are cash method taxpayers, individual investors typically are taxed on interest and dividends when they receive them. However, interest income is taxed using ordinary rates while qualified dividends are taxed at lower capital gains rates.

How is a business activity distinguished from an investment activity? Why is this distinction important for the purpose of calculating federal income taxes?

Both business and investment activities are motivated primarily by profit intent, but they can be distinguished by the level of profit-seeking activity. A business activity is commonly described as a sustained, continuous, high level of profit-seeking activity, whereas investment activities don't require a high level of involvement. The distinction can be important for the location of deductions, because business deductions are claimed above the line (for AGI on Schedule C) while investment deductions are generally itemized or from AGI deductions (with the exception of rent and royalty expenses which are deductible for AGI on Schedule E).

Identify which itemized deductions are subject to floor limitations, ceiling limitations, or some combination of these limits.

Charitable contributions and home mortgage interest are subject to ceiling limits (based on a percentage of AGI and on the amount of debt, respectively) whereas aggregate casualty losses, medical expenses, and miscellaneous deductions are subject to separate floor limits (based upon percentages of AGI) and each casualty loss is subject to a $100 flat floor limit. All itemized deductions are subject to the standard deduction which is a flat floor limitation.

Cash donations to charity are subject to a number of very specific substantiation requirements. Describe these requirements and how charitable gifts can be substantiated. Describe the substantiation requirements for property donations.

Charitable contributions are only deductible if substantiated with written records such as a cancelled check, bank record, or a written communication from the charity showing the name of the charity and the date and amount of the contribution. § 170(a)(1) and Reg § 1.170A-13(a)(1). Additional substantiation is required for: contributions of $250 or more (§ 170(f)(8)), non-cash contributions exceeding $500 (§170(f)(11)(B)), and contributions of cars, boats and planes (§ 170(f)(12)). For donations of property, including clothing and household items, taxpayers should keep a written record of the donation that includes a description of the property and its condition. Deductions are not allowed for used property unless the property is in good condition. Taxpayers must keep a contemporaneous, written acknowledgement from a charity for each deductible donation (either money or property) of $250 or more. For contributions of property in excess of $500, a description of the property must be attached to the tax return. A qualified appraisal of the property must be attached with the return for donations of property with a value in excess of $5,000.

How might the reimbursement of a portion of an employee expense influence the deductibility of the expense for the employee?

Employee expenses are deducted as miscellaneous itemized deductions subject to the 2% of AGI floor limit. A reimbursement of a portion of an employee business expense would normally be included in the employee's gross income and would have no effect on the deductibility of the expense. An important exception to this rule is for employee expenses reimbursed under an "accountable" plan. Among other things, an accountable plan requires that employees provide substantiation for reimbursement and that employers only reimburse legitimate deductible expenses. Reimbursements from an accountable plan are not required to be included in income, but the reimbursed expenses are not deductible, either. In essence, the reimbursements and expenses offset each other, and both are ignored for tax purposes. If the expense exceeds the reimbursement, the excess (unreimbursed) portion of each expense can be deducted as a miscellaneous itemized deduction subject to the 2% of AGI floor limit.

Compare and contrast the tax treatment of interest from a Treasury bond and qualified dividends from corporate stock.

For cash method taxpayers, both the interest from Treasury bonds and dividends are taxed in the year they are received. However, interest is taxed using ordinary rates while qualified dividends are taxed at lower capital gains rates. An additional difference between these types of income relates to their state income tax treatment. The interest from Treasury bonds is exempt from state income taxes while dividends are subject to state income taxes.

Explain how the standard deduction is rationalized and why the standard deduction might be viewed as a floor limit on itemized deductions.

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. 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 essentially eliminates the tax benefits of itemized deductions up to the amount of the standard deduction and thus may be viewed as a floor limit on itemized deductions because most taxpayers will not elect to itemize if the standard deduction exceeds itemized deductions.

How are Treasury notes and Treasury bonds treated for federal and state income tax purposes?

Generally, interest from Treasury bonds and notes is taxed annually as it is received at ordinary rates for federal income tax purposes. However, interest from Treasury bonds and Treasury notes is exempt from state income taxes. Treasury bonds and Treasury notes are issued at maturity value, at a discount, or at a premium, depending on prevailing interest rates. Treasury bonds and Treasury notes pay a stated rate of interest semiannually. When Treasury bonds and Treasury notes are either issued or subsequently purchased at either a premium or discount, special rules apply. Specifically, taxpayers may elect to amortize the premium to reduce the amount of interest currently reported. To the extent taxpayers amortize the premium, they reduce the tax basis in the related bond or note. If a portion of the premium is unamortized (either because the election to amortize the premium was not made or because the bond is sold prior to maturity), the unamortized premium remains part of the tax basis of the bond or note and affects the amount of capital gain or loss taxpayers recognize when the bond or note is sold or when it matures. Original issue discount must be amortized and included in gross income in addition to any interest payments taxpayers actually receive. Also, the tax basis of a bond or note is increased by the amount of original issue discount amortized into income. In contrast, market discount is not amortized into income unless taxpayers elect to do so. Rather, the market discount that would have been amortized into income (on an annual basis using a straight line method) if the taxpayer had elected to amortize the market discount into income is treated as ordinary income when the bond or note is sold or when it matures.

This year, David, a taxpayer in the highest tax rate bracket, has the option to purchase either stock in a Fortune 500 company or qualified small business stock in his friend's corporation. All else equal, which of the two will he prefer from a tax perspective if he intends to hold the stock for six years? Which would he prefer if he only plans to hold the stock for two years?

If David holds the stock in his friend's corporation for more than five years, 100% of his gain will be excluded. In contrast, gains from the sale of stock in the Fortune 500 company would be taxed at the prevailing maximum capital gains rate (maximum of 20% currently). Thus, David would prefer to purchase stock in his friend's corporation if taxes are the only consideration. If the stocks are only held for two years, the stock in his friend's corporation would not be treated as qualified small business stock and he would be indifferent, from a tax perspective, between purchasing the two stocks.

Explain the argument that the deductions for charitable contributions and home mortgage interest represent indirect subsidies for these activities.

In each case, the deduction reduces the after-tax cost of the activity, making it more likely that taxpayers will engage in the activity. For example, contributions to charity reduce the cost of giving thereby indirectly encouraging donations to charitable organizations.

What is the definition of a capital asset? Give three examples of capital assets.

In general, a capital asset is any asset other than an asset used in a trade or business (i.e., equipment, buildings, inventory, etc.), or accounts or notes receivable generated from the sale of services or property by a trade or business. Also, any property that is used for personal rather than business purposes is a capital asset. Examples of capital assets include investment assets such as corporate or governmental bonds, corporate stock, stocks in mutual funds, and land held for investment. Personal assets such as automobiles, personal residences, golf clubs, book collections, and televisions are also capital assets.

What tests are applied to determine if losses should be characterized as passive?

In general, losses from trade or business activities are passive unless individuals are material participants in the activity. Regulations provide seven separate tests for material participation, and individuals can be classified as material participants by meeting any one of the seven tests. The seven tests are as follows: 1. The individual participates in the activity more than 500 hours during the year. 2. The individual's activity constitutes substantially all of the participation in such activity by the individuals including non-owners. 3. The individual participates more than 100 hours during the year, and the individual's participation is not less than any other individual's participation in the activity. 4. The activity qualifies as a "significant participation activity" (more than 100 hours spent during the year) and the aggregate of all "significant participation activities" is greater than 500 hours for the year. 5. The individual materially participated in the activity for any five of the preceding 10 taxable years. 6. The individual materially participated for any three preceding years in any personal service activity (personal services in health, law, accounting, architecture, etc.) 7. Taking into account all the facts and circumstances, the individual participates on a regular, continuous, and substantial basis during the year.

What happens to capital losses that are not deductible in the current year?

Individual capital losses that are not deducted in the current year are carried forward indefinitely and treated as though they were incurred in the subsequent year.

What limitations are placed on the deductibility of capital losses for individual taxpayers?

Individual taxpayers can deduct up to $3,000 ($1,500 if married filing separately) of net capital losses against ordinary income. Net capital losses in excess of $3,000 ($1,500 if married filing separately) retain their short or long-term character and are carried forward.

What is the underlying policy rationale for the current tax rules applicable to interest income and dividend income?

Interest and dividends are typically taxed annually when received because taxpayers have the wherewithal to pay the tax at that time. Interest income is taxed at ordinary rates because it is viewed as a less risky type of income compared to other more risky forms of income such as the expected appreciation in capital assets. Qualified dividends are taxed at capital gains rates to mitigate the effect of double taxation on corporate earnings.

When taxpayers borrow money to buy municipal bonds, are they allowed to deduct interest expense on the loan? Why or why not?

Interest expense incurred on loans used to purchase municipal bonds is not deductible. The interest income from the municipal bonds is not included in income; therefore, the interest expense incurred to produce the tax exempt income is not deductible.

How is the amount of net investment income determined for a taxpayer with investment expenses and other noninvestment miscellaneous itemized deductions?

Investment expenses and miscellaneous itemized deductions are subject to the 2% of AGI limitation. So, when the two types of expenses are added together, only the amount in excess of 2% of AGI is deductible. The amount in excess of 2% of AGI is first considered to be the investment expenses. If these expenses are fully deductible, the remaining miscellaneous itemized deduction consists of the non-investment expenses. This sequence maximizes the deductibility of the investment expenses. The sequence is unfavorable for the taxpayer because maximizing the deductible investment expenses minimizes net investment income, which minimizes the investment interest expense deduction.

What limitations are placed on the deductibility of investment interest expense? What happens to investment interest expense that is not deductible because of the limitations?

Investment interest expense is deductible, as an itemized deduction, to the extent of net investment income. Net investment income is investment income minus deductible investment expenses. Investment interest expense that is not deductible because of the net investment income limitation is carried forward and treated as though it is incurred in the next year. Unused investment interest expense can be carried forward indefinitely.

It has been suggested that tax policy favors deductions for AGI compared to itemized deductions. Describe two ways in which deductions for AGI are treated more favorably than itemized deductions.

Itemized deductions must exceed the standard deduction before taxpayers receive any tax benefit from the deductions (this is equivalent to an overall floor limit). In contrast, business deductions that are deductible for AGI (above the line) reduce taxable income without being subject to an overall floor limit. Also, itemized deductions are subject to many mechanical limitations including ceilings, floors, and phase-outs whereas business deductions are generally not subject to these limits (there are limits on certain specific deductions, but this will be described in greater detail in chapter 9).

Jake is a retired jockey who takes monthly trips to Las Vegas to gamble on horse races. Jake also trains race horses part time at his Louisville ranch. So far this year, Jake has won almost $47,500 during his trips to Las Vegas while spending $27,250 on travel expenses and incurring $62,400 of gambling losses. Jake also received $60,000 in revenue from his training activities and he incurred $72,000 of associated costs. Explain how Jake's gambling winnings and related costs will be treated for tax purposes. Describe the factors that will influence how Jake's ranch expenses are treated for tax purposes.

Jake's $47,500 of gambling winnings is included in his gross income. The gambling losses are (total of $62,400) are only deductible as miscellaneous itemized deductions (not subject to the 2% of AGI floor) to the extent of the gambling winnings (thus, only $47,500 will be deductible). His travel costs are personal expenditures and are nondeductible. Likewise, the $60,000 revenues from Jake's training activities are included in Jake's gross income. The expenses associated with the ranch (assuming the expenses are ordinary and necessary and not capitalized) should be deductible as itemized deductions (mortgage interest, real estate taxes, and as miscellaneous itemized deductions subject to the 2% floor) to the extent of the related gross income if this activity is treated as a hobby. The factors in the regulations would likely dictate whether the activity is a hobby or a business. For example, how much time does Jake spend at the ranch—a few hours each week or does he work full time? It is unclear if he operates the ranch in a professional manner, takes the advice of professionals, or whether his success as a jockey would lead to success in training horses. Of course, his financial status (retired) and personal pleasure would likely count against business treatment.

Are dividends and capital gains considered to be investment income for purposes of determining the amount of a taxpayer's deductible investment interest expense for the year?

Long-term capital gains and dividends that qualify for the preferential 20% (or lower) tax rate are not considered to be investment income for purposes of determining the investment interest expense deduction unless the taxpayer makes an election to tax this income at ordinary rates. If the taxpayer makes this election, the dividends and long-term capital gains count as investment income for this purpose. Dividends and capital gains that are not eligible for the preferential rate are included in investment income in determining the deductibility of investment interest expense.

Are all long-term capital gains taxable at the same maximum rate? If not, what rates may apply to long-term capital gains?

Long-term capital gains may be taxed at one of five different rates (0, 15, 20, 25, or 28 percent). Unrecaptured §1250 gains from the sale of depreciable real estate investments are taxed at a 25% maximum rate, gains from collectibles held for more than one year are taxed at a 28% maximum rate, and recognized gains from the sale of qualified small business stock held for more than five years is taxable at a 28% maximum rate. The remaining long-term capital gains are taxed at 0, 15, or 20 percent depending on the taxpayer's ordinary income tax rate as follows: Ordinary Tax Bracket Capital Gains Tax Rate 10% or 15% 0% 25%, 28%, 33%, or 35% 15% 39.6% 20%

What types of losses may potentially be characterized as passive losses?

Losses from limited partnerships, and from rental activities, including rental real estate, are generally considered passive losses. In addition, losses from any other activity involving the conduct of a trade or business in which the taxpayer does not materially participate are also treated as passive losses. Material participation is defined as "regular, continuous, and substantial."

Describe the type of medical expenditures that qualify for the medical expense deduction. Does the cost of meals consumed while hospitalized qualify for the deduction? Do over-the-counter drugs and medicines qualify for the deduction?

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. Included are the costs of prescription medicine, insulin, and payments to doctors, dentists, and the like incurred by the taxpayer, taxpayer's spouse, and dependents. Over-the-counter drugs and medicines do not qualify for the deduction. Besides direct medical expenses, the deduction includes the cost of health insurance (if not already deducted above the line by self-employed taxpayers or if not offset by a premium tax credit under IRC Sec. 36B). Medical expenses also include long-term care services for disabled spouses and dependents to the extent the costs (including meals and lodging) are attributable to medical care. The cost of elective cosmetic surgery and over-the-counter drugs is not deductible. The cost of meals and lodging qualify if incurred at a medical-care facility or hospital and are incident to the care of the patient, but the cost of lodging is limited to $50 per eligible person per night. The cost of travel for and essential to medical care, including lodging (still limited to $50 per eligible person per night) is also deductible if the expense is not extravagant and the travel has no significant element of personal pleasure.

Describe the types of expenses that constitute miscellaneous itemized deductions and explain why these expenses rarely produce any tax benefits.

Miscellaneous itemized deductions consist of employee business expenses (not reimbursed under an accountable plan), investment expenses (not related to rental or royalty activities), and tax preparation fees. These deductions must be reduced by two percent of AGI before the deductions can be combined with other itemized deductions. This floor limit makes it unlikely these itemized deductions will generate any tax benefit.

What tax rate applies to net short-term capital gains?

Net short-term capital gains are taxed at the taxpayer's ordinary tax rates.

Why might investors purchase interest-paying securities rather than dividend- paying stocks?

Non-tax considerations may play a role. For example, investors may be willing to give up the tax rate benefit from receiving qualified dividend income in exchange for the certainty of receiving predicable interest payments. In addition, risk preferences might cause investors to prefer one investment over another. FDIC insurance guarantees the security of an investment in savings accounts and certificates of deposit up to a threshold amount; whereas, no guarantees exist for stock investments.

What are the implications of treating losses as passive?

Passive losses may not be used to offset portfolio income or active income. Passive losses can only be used to offset passive income. Passive losses that are limited will be suspended until taxpayers have passive income or until the activity producing the passive loss is sold.

Nick does not use his car for business purposes. If he sells his car for less than he paid for it, does he get to deduct the loss for tax purposes? Why or why not?

Personal-use of assets falls within the category of capital assets. When a taxpayer sells a personal-use asset, the gain from the sale of the personal-use asset is taxable even though it was not purchased for its appreciation potential. If a taxpayer sells a car for less than he paid for it, the loss from the sale of the personal-use asset is not deductible, and therefore never becomes part of the netting process. Hence losses recognized on assets used for personal purposes are not deductible. However, if Nick sold the car for more than he purchased it, he would be taxed on the capital gain.

Why does the tax law provide preferential rates on certain capital gains?

Preferential tax rates apply to gains on the sale of certain capital assets (e.g., capital assets held for more than one year). Among other things, these preferential rates are meant to encourage taxpayers to invest in those assets and to hold those assets for the long term. The government believes this will help the national economy by stimulating the demand for risky investments.

Compare and contrast the tax treatment of dividend-paying stocks and growth stocks.

Qualified dividends from dividend paying stocks and long-term capital gains from growth stocks are both taxed at favorable capital gains rates. However, dividends are taxed when received in contrast to the appreciation in growth stocks, which is taxed only when growth stocks are sold. All else equal, growth stocks will have a higher after-tax rate of return because the tax is deferred into the future while dividend paying stocks are taxed annually.

Clark owns stock in BCS Corporation that he purchased in January of the current year. The stock has appreciated significantly during the year. It is now December of the current year, and Clark is deciding whether or not he should sell the stock. What tax and nontax factors should Clark consider before making the decision on whether to sell the stock now?

Tax factors: Clark should consider the rate at which the gain will be taxed. If he sells the stock in December of the current year, the gain is a short-term gain that will likely be taxed at his marginal ordinary income rate. If he waits until he has held the stock for more than a year, the gain will be taxed at a maximum of 0/15/20% (depending on income). Clark should also assess his other capital gains and losses incurred during the year. The gain he recognizes on the sale will enter the netting process. Thus, if he has a large short-term capital loss, he may want to sell the stock this year to absorb the loss. Nontax factors: If Clark decides to hold the stock, there is risk that the value will decline. Likewise, the stock may appreciate in value if Clark decides to wait to sell. Clark should assess his risk of loss and appreciation potential of the stock before selling.

What types of taxes qualify to be deducted as itemized deductions? Would a vehicle registration fee qualify as a deductible tax?

Taxes qualifying for this deduction include state, local, and foreign income taxes, real estate taxes, and personal property taxes. State and local sales taxes may also be deducted but only in lieu of state and local income taxes. The deduction for sales tax can be based upon either the amount paid or the amount published in the IRS tables (IRS Publication 600). Vehicle registration fees are not deductible (unless calculated based on the value of the vehicle rather than its weight).

Why does the tax law allow a taxpayer to defer gains accrued on a capital asset until the taxpayer actually sells the asset?

Taxpayers are allowed to defer accrued gains on capital assets until the date of sale because the investment doesn't provide the wherewithal (i.e., cash) to pay the tax on the accrued gains until after it is sold. When the taxpayer sells the asset, the investment should provide the cash necessary to pay the taxes due on the gain.

Compare and contrast the limits on the deduction of interest on home acquisition indebtedness versus home equity loans. Are these limits consistent with horizontal equity? Explain.

Taxpayers can deduct qualified residence interest defined as either (1) interest paid on a loan to purchase or improve a residence (acquisition indebtedness) or (2) interest paid on a loan secured by the residence but not used to purchase or improve the residence (home equity loan). Interest paid can be deducted on $1 million of acquisition indebtedness and $100,000 of home equity debt regardless of the rate of interest on the loan. These limits are consistent with horizontal equity inasmuch as the limits treat taxpayers consistently across loan amounts. However, the deduction for interest on acquisition indebtedness and home equity loans is definitely not consistent with providing horizontal equity across homeowners and non-homeowners.

What methods may taxpayers use to determine the adjusted basis of stock they have sold?

Taxpayers can use the FIFO method to determine basis in the stock. That is, the first stock purchased (i.e., the stock the taxpayer has held for the longest time) is treated as though it is the first stock sold. Taxpayers can also use the specific identification method of determining the basis of the stock sold.

Describe the conditions in which a donation of property to a charity will result in a charitable contribution deduction of fair market value and when it will result in a deduction of the tax basis of the property.

Taxpayers deduct the fair market value of property (noncash) donations when they donate: (1) a capital asset that has appreciated in value (the value is greater than the basis of the property) and the taxpayer has owned the asset for more than a year before donating it (but see exceptions below), or (2) appreciated business assets (value greater than basis) the taxpayer owned for more than a year before donating but only to the extent that the gain on the asset would not be treated as ordinary income if it had been sold. However, the deduction for an appreciated capital asset that is tangible, personal property is limited to the adjusted basis of the property if the charity uses the property for a purpose unrelated to its charitable purpose. Taxpayers donating ordinary income property (or capital loss property) deduct the lesser of (1) the fair market value of the property and (2) the adjusted basis of the property. Thus when the value of ordinary income property (or capital loss property) is less than the basis, taxpayers deduct the value. Thus, taxpayers deduct the basis of the property when they contribute: ordinary income property that has appreciated in value. capital gain property donated to private nonoperating foundations (other than stock). capital gain property consisting of tangible personal property and the charity uses the property (and the taxpayer should have reasonably expected that) for a purpose unrelated to the reason it is a charity.  appreciated business assets held more than a year to the extent that the gain would be recaptured as ordinary income under the depreciation recapture rules.

Why would taxpayers generally prefer the tax treatment of market discount to the treatment of original issue discount on corporate bonds?

Taxpayers generally would prefer market discount to original issue discount on bonds because the ordinary income related to market discount is deferred until bonds are sold or until they mature. In contrast, taxpayers must report ordinary income from the amortization of original issue discount yearly until the bonds are sold or until they mature.

Explain why the cost of commuting from home to work is not deductible as a business expense.

The cost of commuting is almost entirely dictated by the location of an individual's residence. This is a personal (rather than business decision), and Congress likely did not want to be seen as subsidizing individuals who wished to live a substantial distance from their business location.

When is the cost of education deductible as an employee business expense?

The cost of education is deductible as an employee business expense if the education maintains or improves the employee's skill in the business, but not if the education is required to qualify a taxpayer for a new business or profession. For example, an IRS agent could not deduct the cost of a legal education even though the education would maintain or improve his skill as a tax auditor. This is because a law degree would also qualify the agent for a new profession (lawyer).

What is the deciding factor in determining whether a capital gain is a short-term or long-term capital gain?

The deciding factor is the amount of time an asset has been held by the taxpayer. When a capital asset that has been held for more than one year is sold, it generates a long-term capital gain. When it has been held for one year or less it generates a short-term capital gain when sold.

Explain why an employee should be concerned about whether his employer reimburses business expenses using an "accountable" plan?

The employee should be concerned because absent an accountable plan, reimbursements are reported as income to the employee and the expense is reported as a miscellaneous itemized deduction subject to the 2% AGI floor. Thus, the reimbursements would be treated as "wages" for purposes of withholding and employment taxes, and the deduction would be unlikely to generate any reduction in taxable income (e.g., because of the 2% AGI floor). On the other hand, if the plan qualifies as an accountable plan, reimbursements from the plan are not required to be included in income, but the reimbursed expenses are not deductible, either. If, however, the expense exceeds the reimbursement, the excess (unreimbursed) portion of each expense can be deducted as a miscellaneous itemized deduction subject to the 2% of AGI floor limit. 

Explain why Congress allows taxpayers to deduct interest forfeited as a penalty on the premature withdrawal from a certificate of deposit.

The full amount of the interest income is included in gross income, and this deduction reduces the net interest income to the amount actually received by the individual.

Explain why the overall phase-out of itemized deductions has been described as a "haircut" of itemized deductions. Explain whether it is possible for a taxpayer to lose all their itemized deductions under the phase-out rules.

The itemized deduction phase-out provision provides that when an individual's AGI exceeds a threshold amount, itemized deductions are reduced by 3% of the excess AGI above the threshold. The phase-out of itemized deductions is sometimes referred to as a cutback, or haircut, because itemized deductions can only be reduced, but not completely eliminated. This is because the maximum amount of the cutback is 80 percent of certain itemized deductions. Medical expenses, casualty losses, investment interest expense, and gambling losses are not subject to the phase-out.

A casualty loss from the complete destruction of a personal asset is limited to the lesser of fair market value or the property's adjusted basis. Explain the rationale for this rule as opposed to just allowing a deduction for the basis of the asset.

The loss from any specific event is limited to the lesser of the economic loss or the tax basis (cost) of the asset to prevent the deduction of otherwise nondeductible personal losses. If the basis (cost) of the asset was always allowed for a personal casualty loss deduction, then this would have the effect of allowing a deduction for the decline in the value of the asset prior to the casualty (assuming that original cost exceeds the value of the asset).

Describe the mechanical limitation on the deduction for interest on qualified educational loans.

The maximum deduction for interest expense on qualified education loans is the amount of interest expense paid up to $2,500. However, the deduction is reduced (phased-out) for taxpayers depending on the taxpayer's filing status and modified AGI. Specifically, the deduction for interest on educational loans is subject to proportional phase-out over a range of $15,000 ($30,000 for married filing jointly). The range begins for taxpayers at $65,000 of modified AGI ($130,000 for MFJ) and ends at $80,000 of modified AGI ($160,000 for married filing jointly). Modified AGI for this purpose is AGI before deducting interest expense on the qualified education loans and before deducting qualified education expenses. Married individuals who file separately are not allowed to deduct this expense under any circumstance.

Describe the mechanism for phasing out exemptions. Can a taxpayer lose the benefit of all of her personal and dependency exemptions?

The phase-out is triggered at relatively high levels of adjusted gross income, and it is done in increments. The process of determining the amount of the phase-out involves the following five steps: Step 1: Subtract the taxpayer's AGI from the AGI threshold based on the taxpayer's filing status. If the threshold equals or exceeds the taxpayer's AGI, the taxpayer deducts her full personal and dependency exemption. Step 2: Divide the excess AGI (the amount from Step 1) by 2,500. If the result is not a whole number (i.e., the excess AGI is not evenly divisible by 2,500), round up to the next whole number. [For married filing separate taxpayers, replace the 2,500 amount with 1,250). Step 3: Multiply the outcome of Step 2 by 2 percent, but limit the product to 100 percent. Step 4: Multiply the percentage determined in Step 3 by the taxpayer's total personal and dependency exemptions (i.e., number of personal and dependency exemptions times $4,050 in 2016). The product is the amount of personal and dependency exemption that is phased-out (i.e., the taxpayer is not allowed to deduct this amount). Step 5: Subtract the Step 4 result from the taxpayer's total personal and dependency exemptions that would be deductible without any phase-out (i.e., number of personal and dependency exemptions times $4,050 in 2016).

Explain how the calculation of the standard deduction limits the ability to shift income to a dependent.

The standard deduction for a taxpayer who is claimed as a dependent on another's tax return (such as a child) is limited to the greater of (1) $1,050 or (2) $350 plus the dependent's earned income (not to exceed the dependent's normal standard deduction of $6,300). This limits the amount that can be shifted without being taxed because it does not allow the dependent child to offset unearned income with the full standard deduction amount.

Describe the tax benefits from "bunching" itemized deductions in one year. Describe the characteristics of the taxpayers who are most likely to benefit from using bunching and explain why this is so.

The strategy of bunching itemized deductions (a cash-basis taxpayer paying two years' worth of deductible expenses in one year to the extent possible) makes it more likely that deductions will exceed a floor limit. This strategy can be effective for generating some incremental tax benefits from total itemized deductions and miscellaneous itemized deductions. Taxpayers are likely to benefit from bunching if (1) they are unlikely to have sufficient itemized deductions in any one year to easily exceed the standard deduction, but can easily exceed the standard deduction by summing itemized deductions for two consecutive years, (2) report on the cash-basis and (3) are able to time payments around year-end (to minimize the loss of present value). Charitable deductions and real estate taxes (due at year-end) can often be easily bunched into one year or another.

Explain why the medical expense and casualty loss provisions are sometimes referred to as "wherewithal" deductions and how this rationale is reflected in the limits on these deductions.

These deductions are designed to reduce the tax burden on taxpayers whose circumstances have involuntarily reduced their ability to pay. Both deductions are restricted to expenses that exceed insurance reimbursements and a floor limit based upon AGI. These limits ensure that taxpayers claiming the deduction have exceedingly large involuntary expenditures as measured by their ability to pay.

Explain why Congress allows self-employed taxpayers to deduct the cost of health insurance above the line (for AGI) when employees can only itemize this cost as a medical expense. Would a self-employed taxpayer ever prefer to claim health insurance premiums as an itemized deductions rather than a deduction for AGI? Explain.

This deduction provides a measure of equity between employees and the self-employed. The cost of health insurance is essentially a personal expense. However, employees typically aren't required to pay insurance premiums because their employers pay the premiums for them as a form of compensation. The employer is allowed to deduct the premium as a compensation expense, and the employee is allowed to exclude from taxable income the value of the premiums paid on his behalf. Thus, from the employee's perspective, this arrangement has the same effect as if (1) the employer pays the employee cash compensation in the amount of the premium and (2) the employee pays the premium and deducts the expense for AGI (completely offsetting the compensation income). In contrast to employees, self-employed taxpayers pay their own health insurance costs, because they don't have an employer to pay these costs for them. Absent a rule to the contrary, self-employed taxpayers would deduct their medical expenses as itemized deductions subject to strict limitations, because the cost of the health insurance is a personal expense rather than a business expense. To treat employees and self-employed taxpayers similarly, Congress allows self-employed taxpayers to deduct personal health insurance premiums as for AGI rather than itemized deductions. Thus, self-employed taxpayers are able to (1) receive business income and (2) use the business income to pay their health insurance premiums and deduct the premiums as a for AGI deduction (completely offsetting the business income they used to pay the premium). Given the preferential treatment of for AGI deductions relative to itemized deductions, a self-employed taxpayer should never prefer to claim health insurance premiums as an itemized deduction rather than a deduction for AGI.

Explain why Congress allows self-employed taxpayers to deduct the employer portion of their self-employment tax.

To put self-employed individuals on somewhat equal footing with other employers that are allowed to deduct the employer's share of the social security tax. Hence, self-employed taxpayers are allowed to deduct the employer's share of the self-employment tax.

In what ways are U.S. savings bonds treated more favorably for tax purposes than corporate bonds?

U.S. Savings Bonds compare favorably with corporate bonds because any interest related to the original issue discount on savings bonds is deferred until the savings bonds are cashed in. In comparison, any original issue discount on corporate bonds must be amortized and included in the investor's annual tax returns. Also, interest from savings bonds used to pay for qualifying educational expenses may be excluded entirely from income whereas interest from corporate bonds must eventually be reported.

This week Jim's residence was heavily damaged by a storm system that spread destruction throughout the region. While Jim's property insurance covers some of the damage, there is a significant amount of uninsured loss. The governor of Jim's state has requested that the president declare the region a federal disaster area and provide federal disaster assistance. Explain to Jim the income tax implications of such a declaration and any associated tax planning possibilities.

Under IRC §165(i), individuals who incur a disaster loss are subject to the regular casualty loss floor limits ($100/10 percent of AGI), but they may elect to claim a disaster loss for the tax year before the loss occurred (e.g., by filing an amended return if the original return has been filed). This deduction could accelerate the tax benefit of the loss (and any attendant refund), but also allow the taxpayer to choose the year with the most attractive tax outcome (in terms of AGI limits, other casualty losses (or gains), and marginal tax rate).

Frank paid $3,700 in fees for an accountant to tabulate business information (Frank operates as a self-employed contractor and files a Schedule C). The accountant also spent time tabulating Frank's income from his investments and determining Frank's personal itemized deductions. Explain to Frank whether or not he can deduct the $3,700 as a business expense or as an itemized deduction, and provide a citation to an authority that supports your conclusion.

Under Reg §1.67-1T(c), expenditures that relate to both a business activity (not subject to the 2% floor) and the production of income or tax preparation (both subject to the 2% floor) must be allocated between the activities on a reasonable basis. It would seem that billable hours would provide just such a basis.

Determine whether a taxpayer can change his or her election to itemize deductions once a return is filed. (Hint: Read about itemization under Reg. §1.63-1.)

Under §63(c), standard deduction is defined as the "basic" standard deduction plus an "additional" standard deduction for age and sight. However, §63(c)(2) only limits the "basic" standard deduction for a taxpayer claimed as a dependent on another's return to $1,050 or $350 plus the individual's earned income, whichever is greater. Hence, it would appear that a taxpayer claimed as a dependent on another's return could claim an addition to the standard deduction for age and sight.

Describe three basic tax planning strategies available to taxpayers investing in capital assets.

When a taxpayer holds capital assets for more than one year before selling, she is actually utilizing two basic strategies. First, she defers recognizing capital gains thereby reducing the present value of the capital gains tax due when the asset is sold. Second, by converting the capital gain into a long-term capital gain, the gain is taxed at a preferential maximum tax rate of 0/15/20% (depending on her income) instead of her ordinary rate. A third strategy is to sell investments with built-in losses. Selling loss assets reduces taxes by providing up to a $3,000 deduction against ordinary income and by reducing the amount of capital gains that would otherwise be subject to tax during the year. This is particularly beneficial for a taxpayer with short-term capital gains that would be taxed at high ordinary rates absent offsetting capital losses.

Using the Internal Revenue Code, describe two deductions for AGI that are not discussed in this chapter.

§62 is the quickest way to identify deductions for AGI, but several can also be identified from the front of form 1040. Examples include the performing artist deduction, deductions of business expenses for state and local officials, reforestation expenses, and remitted jury duty pay.