Module 27 Nonbusiness Deductions and Exemptions

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Module 27Nonbusiness Deductions and Exemptions
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Menu

• Classification of deductible expenses
• Deductions for adjusted gross income
• Standard deduction and itemized deductions
• Personal and dependency exemptions
• Phaseout of exemptions
• Reduction of itemized deductions

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Classification of Deductible Expenses

• Key Learning Objectives
• Allowable deductions of individual taxpayers
• Order of deductions
• Relationship of deductions
• For AGI and
• From AGI

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AGI Deductions From AGI

• Itemized deductions reduced by AGI
• Medical--7.5
• Miscellaneous--2
• Casualty--10
• Charitable--total deduction limited by AGI

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162 Trade or Business Expenses

• Generally deductible
• Must be
• Ordinary
• Necessary
• Reasonable

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162 Trade or Business Expenses

• If self-employed
• Deductible for AGI
• If employee
• Deductible from AGI if unreimbursed
• Reimbursed--non-accountable plan
• Subject to 2 floor

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212 Expenses forProduction of Income

• Generally deductible
• Must be
• Ordinary
• Necessary
• Reasonable

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212 Expenses forProduction of Income

• For production/collection of income
• For property held for production of income
• Management/conservation/maintenance
• Determination/collection/refund of any tax

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212 Expenses forProduction of Income

• For AGI
• Rental and royalty expenses on Sch E
• From AGI
• Most investment related items
• Except taxes, interest expense
• Miscellaneous 2

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262 Personal Expenses

• Generally not deductible
• Exceptions for certain itemized deductions

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Deductions for Personal ItemsOtherwise
Allowable

• Interest expense
• Charitable contributions
• Taxes
• Medical expenses
• Casualty losses

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AGI Limitations

• Medical--7.5 AGI offset
• Misc..-- 2 - 2 AGI offset
• Overall--3 AGI offset

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AMT Add-Backs

• 100 of taxes
• 100 of misc.... 2
• Additional 2.5 AGI offset on medical
• Equity interest expense

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Deductions for Adjusted Gross Income

• Key Learning Objectives
• Introduction to deductions for AGI
• Moving expenses--covered in Mod 25
• Alimony payments covered in Mod 25
• Penalty on early withdrawal of savings
• Health insurance costs for self-employed
  taxpayers
• Interest on certain student loans

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Standard Itemized Deductions

• Key Learning Objectives (1)
• Standard deduction
• Itemized deductions
• Medical expenses
• Taxes

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Standard Deduction 2000

• Married, Joint--------------- 7,350
• Married, Separate-----------3,675
• Head of Household---------6,450
• Single-------------------------4,400
• If dependent-- at least 700 increased by
• earned income plus 250
• but not to exceed 4,400
• Note several special rules for this group

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Standard Deduction Add On

• Blind and/or over 65
• Taxpayer and/or spouse only
• Could be 4 add-ons per married, joint return
• 2000 amounts
• Married -- 850
• Single and head of household -- 1,100

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Medical Expenses

• Qualified expenses paid in tax year
• For self, spouse, dependents
• Also for would be dependent
• Who has too much gross income

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Qualified Medical Expenses

• Only prescription medicine
• Limited weight loss
• Not cosmetic surgery after 1990

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Medical ExpensesCapital Expenditures

• Qualified expense for
• Cost more than the increase in FMV
• Meet strict requirements as to need

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Medical ExpensesInstitutionalized Care

• Nursing home only if medical care is primary
  purpose
• Special schools--blind etc....
• If special facilities are primary purpose

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Medical ExpensesReductions to Amount Spent

• Reduce by insurance proceeds
• Reduce by 7.5 of AGI
• Reimbursements generally not income
• Include in income if tax benefit in prior year

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Income Taxes

• All deductible
• Except U.S. Federal
• Optional credit treatment for foreign taxes

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Property TaxesAd Valorem

• Real estate taxes (RE)
• Prorate RE tax when property sold
• Other taxes if assessed on value
• Not assessment for improvements

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Standard Deductions and Itemized Deductions

• Key Learning Objectives (2)
• Itemized deductions
• Interest expense
• Charitable contributions
• Casualty and theft loss deductions for
  personal use property--on last test only
• Miscellaneous itemized deductions

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Interest Expense Categories

• Active T/B
• Qualified residence interest
• Investment interest
• Tax exempt investments--N/A
• Consumer interest--N/A after 1990
• Passive T/B--follow PAL rules
• To carry passive investment
• To run passive T/B

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General Limitations on Interest Deduction

• Payer must be obligated on debt
• Can't deduct prepaid interest

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Interest ExpenseFollow the Money

• Must track borrowing to show how money was used
• Interest expense limitations based on how funds
  spent

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Interest Expense Limitations

• Active T/B--no limits to deductibility
• Investment interest
• Current deduction limited
• To net investment income
• Excess carries over indefinitely

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Investment Income

• Investment income
• interest
• dividends
• Overpaid, refundable taxes
• Interest on the refund
• net capital gain
• if you give up special tax rates

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Investment Expense

• Investment expenses
• all related expenses
• real estate taxes on investment property
• management fees
• safety deposit box fees
• magazine subscriptions
• if subject to 2 limit, only that left in excess
  of the limitation

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Net Investment Income

• the excess of investment income over
• investment expenses

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Example 1 Deductible investment interest
expense No deductions relating to investments

• 20,000 of interest expense on funds borrowed to
  buy stock
• Taxable income
• 100,000 W2 wages
• 8,500 interest income

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Example 1 Deductible investment interest
expense No deductions relating to investments

• Investment income _______
• Related expenses _______
• Net investment income _______
• Investment interest deduction
  _______

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Example 1 Deductible investment interest
expense No deductions relating to investments

• Investment income 8,500
• Related expenses 0
• Net investment income 8,500
• Investment interest Deduction
  8,500
• Carryover 11,500

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Example 2 Deductible investment interest expense

• Deductions relating to investments
• RE taxes of 2,000
• 20,000 of interest expense on funds borrowed to
  buy stock
• Taxable income
• 100,000 W2 wages
• 8,500 interest income

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Example 2 Deductible investment interest expense

• RE taxes are fully deductible on Schedule A, so
• Investment income _______
• Related expenses _______
• Net investment income _______
• Investment interest deduction
  _______

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Example 2 Deductible investment interest expense

• Investment income 8,500
• Related expenses 2,000
• Net investment income 6,500
• Investment interest Deduction
  6,500
• Carryover 13,500

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Example 3 Deductible investment interest expense

• Deductions relating to investments
• Management fees of 2,000
• 20,000 of interest expense on funds borrowed to
  buy stock
• Taxable income
• 100,000 W2 wages
• 8,500 interest income

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Example 3 Deductible investment interest expense

• Mgt fees are deductible only if in excess of 2
  of AGI
• Here AGI 108,500
• 2 2,170
• Since mgt fee was only 2,000 and no other misc
  2 deductions, deduction 0

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Example 3 Deductible investment interest expense

• Investment income _______
• Related expenses _______
• Net investment income _______
• Investment interest deduction
  _______

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Example 3 Deductible investment interest expense

• Investment income 8,500
• Related expenses 0
• Net investment income 8,500
• Investment interest Deduction
  8,500
• Carryover 11,500

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Example 4 Deductible investment interest expense

• Deductions relating to investments
• Management fees of 8,000
• 20,000 of interest expense on funds borrowed to
  buy stock
• Taxable income
• 100,000 W2 wages
• 8,500 interest income

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Example 4 Deductible investment interest expense

• Management fees are deductible only if in excess
  of 2 of AGI
• Here AGI 108,500
• 2 2,170
• Since management fee is 8,000 and no other misc
  2 deductions, deduction 5,830

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Example 4 Deductible investment interest expense

• Investment income _______
• Related expenses _______
• Net investment income _______
• Investment interest deduction
  _______

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Example 4 Deductible investment interest expense

• Investment income 8,500
• Related expenses 5,830
• Net investment income 2,670
• Investment interest Deduction
  2,670 Carryover 17,330

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Special Rules for Qualified Residence Interest
(QRI)

• Only 2 principal residences
• 1 million total acquisition indebtedness
• Plus 100,000 equity indebtedness

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Acquisition Indebtedness (ACQ)

• Loan secured by property
• Funds used to build/improve etc....
• Limited to 1 million if after 10/16/89
• Outstanding loans at 10/17/89
• Grandfathered-in as QRI
• No limit as long as secured by property

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Equity indebtedness

• Excess of FMV over ACQ debt
• Funds can use for anything
• Must be secured by property
• Limited to 100,000 debt
• AMT add back

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Points Paid

• Points on acquisition of debt deductible if
• Purchase of principal personal residence
• Not borrowed from lender
• OK if paid by seller
• Points N/D if rental or if refinancing
• Amortize over life of loan

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Charitable Contributions

• To qualified charitable organization
• Not individual
• Not foreign
• Not political organization

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Charitable Contributions

• Money
• Not value of services
• Related out of pocket costs OK

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Charitable ContributionsGifts of Property

• Ordinary income property
• Inventory
• Other held lt 1 year
• Deduction limited to adjusted basis
• Unless FMV is smaller
• Generally subject to 50 of AGI limit

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Charitable ContributionsGifts of Property

• Long term capital gain property (CG)
• Deduction generally FMV if gt basis
• Gift of tangible property limited to basis if
• Unrelated use by charitable organization
• Contributed to nonoperating private foundation
• Can deduct basis to avoid 30 limit

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Check List for Gift of Appreciated Property

• Ordinary income or capital gains property?
• If ordinary use lower of adjusted basis (AB) or
  FMV.
• If capital gains property
• Is charitys use related?
• If yes use higher of AB or FMV
• If no use AB unless lt FMV.

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Example 1 Gift of Appreciated Property

• Artwork is given to the local boy scouts for
  annual auction.
• Cost 9,000
• FMV 11,000
• Held as investment since 1994
• What is taxpayers deduction

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Example 1 Gift of Appreciated Property

• Here gift is for public auction, so cant be
  related use
• Deduct lower of AB and FMV
• ANSWER 9,000

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Example 2 Gift of Appreciated Property

• Boat is given to the local boy scouts for summer
  camp.
• Cost 9,000
• FMV 11,000
• Used personally since 1994
• What is taxpayers deduction

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Example 2 Gift of Appreciated Property

• Here gift is for use in summer camp, so should be
  related use
• Deduct FMV
• ANSWER 11,000

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Charitable ContributionsLimitations on Current
Deduction

• Overall--50 of AGI
• Appreciated CG property
• 30 of AGI if deduction is FMV
• 50 if elect adjusted basis
• To private foundation--20 AGI

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Charitable ContributionsExcess Contributions

• Carry over for next 5 years
• Retain character as to AGI limits
• No carry back available

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Charitable ContributionsDocumentation for Cash

• Over 250 charity must substantiate
• Charity must disclose value of goods/services
  received in exchange if FMV gt 75

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Charitable ContributionsDocumentation for
Property

• FMV gt 500--attach Form 8283
• FMV gt 5,000 need formal, written appraisal
• Cost of appraisal is misc..... 2 deduction

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Casualty and Theft Losses Sudden, Unexpected,
Unusual

• Loss on disposal of personal-use asset is
  generally not allowed
• Casualty loss is exception
• Use lower of basis or decline in FMV to determine
  loss

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Casualty and Theft LossesInsurance Claims

• Adjust for actual or expected insurance
  reimbursement
• Gain could result if insurance gt basis
• See involuntary conversion rules
• Insurance claim must be filed to deduct loss

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Casualty and Theft LossPersonal-Use Property

• Each casualty loss reduced by 100
• Net casualty gains and losses
• Net gain for the year is capital gain
• Net loss for the year is ordinary loss
• Reduce by 10 of AGI floor
• Deduction from AGI

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Casualty and Theft EventsBusiness or Investment
Asset

• Return of capital doctrine
• Partial destruction
• Use lower of basis or decline in FMV
• Complete destruction
• Use basis
• Adjust for actual or expected insurance

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Casualty and Theft Events Business or Investment
Asset

• Business losses deductible for AGI
• Net loss for the year is ordinary loss
• No 100 or 10 floor
• Net gain for the year is
• 1231 gain or
• Ordinary gain
• Depending on holding period

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Miscellaneous Itemized Deductions

• Employee business expenses
• 212 expenses except
• Rents
• Royalties
• Total is reduced by 2 of AGI

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Employee Business Expenses

• Being an employee (eme) is a recognized T/B
• T/B not that of job, but being em'e
• Must distinguish between personal and T/B
  expenses
• Statutory em'e--expenses for AGI
• Performing artist--may be for AGI

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Employee Business Expenses

• All others--deductions from AGI
• Included with other misc..... 2 items
• Exception if eme reimbursed AND
• Em'e accounts to em'r
• Then em'r does not report in W2
• Eme does not report on tax return

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Miscellaneous Itemized Deductions

• Add together
• Meals entertainment--reduced by 50
• Other employee business expenses
• All 212 expenses except rent/royalty
• Reduce by 2 of AGI
• This is the amount deduct from AGI
• If itemized gt standard deduction

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In Class Exercise Calculate the Miscellaneous 2
Amount

• Valid business entertainment 8,000
• Employee business expenses 7,500
• Tax Preparation fee 250
• Management fee on mutual stock fund
  1,900
• Total 17,650
• Calculate final deduction if
• AGI 100,000 OR 500,000

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Solution In Class Exercise The Miscellaneous 2
Amount

• If AGI 100,000
• Final deduction 11,650
• Reduce entertainment by 50
• Deductions before 2 13,650
• 2 of AGI 2,000
• 13,650 reduced to 11,650

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In Class Exercise Calculate the Miscellaneous 2
Amount

• If AGI 500,000
• Final deduction 3,650
• 2 of AGI 10,000
• Reduce entertainment by 50
• Deductions before 2 13,650
• 13,650 reduced to 3,650
• Use standard deduction if no other deductions
  from AGI

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Personal and Dependency Exemptions

• Key Learning Objectives
• Personal exemptions
• Dependency exemptions

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Personal Exemptions

• 2,800 per allowance--2000--for
• Taxpayer
• And spouse if joint return
• N/A if dependent on another's return

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Dependency Exemptions

• 2,800 per allowance -- 2000
• Meet all of 5 of following tests
• Support
• Gross income
• Relationship
• Joint return test
• Citizenship/residency

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Multiple Support AgreementsNo One Provides gt 50
Support

• Group, not individual, gives gt50 of total
  support
• Group can decide who gets exemption
• Taxpayer getting deduction must have contributed
  at least 10 of total support

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Multiple Support AgreementsNo One Provides gt 50
Support

• Individual being claimed must not
• Have too much gross income or
• Fail to meet
• Joint return test
• Citizenship/residency test

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Multiple Support AgreementsNo One Provides gt 50
Support

• Members of groups must meet relationship test
• Relative or
• Non-relative dependent lives with

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In Class Exercise Who Can Claim D? (1)

• D, age 15, parents deceased, lives with
  Grandparents
• D's support this year was provided as follows
• Interest income--Ds account 1,000
• Social security survivor's benefits 2,000
• Grandparents
  3,000 6,000

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Solution--In Class Exercise Who Can Claim D?
(1)

• D would claim self since no one provides more
  than 50 of Ds support
• Note that most of Ds exemption is wasted since
  Ds income is only 1,000
• Grandparents would have to spend an extra dollar
  to claim D

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In Class Exercise Who Can Claim D? (2)

• D, age 15, parents deceased, lives with
  Grandparents. D's support this year was provided
  as follows
• Interest income Ds account 1,000
• Social security survivor's benefits 2,000
• Contributions by mothers friend 500
• Grandparents 3,000
• 6,500

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Solution--In Class Exercise Who Can Claim D?
(2)

• D would claim self since no one provides more
  than 50 of Ds support
• Since D lives with grandparents, friend cannot
  meet relationship test, so not part of group
• Grandparents now need to spend 501 to get
  exemption

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In Class Exercise Who Can Claim D? (3)

• D, age 15, parents deceased, lives with
  Grandparents. D's support this year was provided
  as follows
• Interest income Ds account 1,000
• Social security survivor's benefits 2,000
• Uncle Joe 500
• Grandparents 3,000
• 6,500

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Solution--In Class Exercise Who Can Claim D?
(3)

• Only the grandparents
• Grandparents and Uncle Joe are group since they
  meet relationship test
• Uncle Joe doesnt meet the 10 test

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In Class Exercise Who Can Claim D? (4)

• D, age 15, parents deceased, lives with
  Grandparents. D's support this year was provided
  as follows
• Interest income, Ds account 3,000
• Uncle Joe 1,000
• Grandparents 3,000
• 7,000

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Solution--In Class Exercise Who Can Claim D?
(4)

• Now either grandparents or Uncle Joe
• Group must decide who gets exemption
• The other members of the group must sign written
  waiver agreeing to not take exemption
• Form 2120

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Phaseout of Exemptions and Reduction of Itemized
Deductions

• Key Learning Objectives
• Phaseout of exemptions
• Reduction of itemized deductions

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Phase Out of Exemptions The Steps To Follow

• Calculate AGI, if lt threshold stop
• Calculate excess AGI
• AGI - Threshold
• Divide by 2,500
• Round up for any fraction
• Multiply by 2--this is the amount lost
• 1 - amount of exemptions allowed

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Threshold Amounts 2000

• Single 128,950
• Head of household 161,150
• Married, joint 193,400
• Married, separate 96,700

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In Class Exercise Phaseout of ExemptionsPart
1 Calculate AGI

• W2 170,000
• Bank interest 5,900
• State bond interest 4,500
• Alimony paid 5,000

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Solution--In Class ExercisePart 1 Calculate AGI

• AGI 170,900 170,000 5,900 - 5,000
• State bond interest excluded
• Alimony paid is deduction for AGI
• Now calculate taxable income IF
• Single
• Married, joint
• Head of Household
• In each case, taxpayer gets two exemptions

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Solution In Class ExerciseSingle, Exemption
Phaseout

• AGI 170,900
• THRESHOLD (128,950)
• EXCESS 41,950
• 2,500
• 16.78 -gt 17
• 17 times 2 loss amount (34)
• 1 - .34 deduction amount (66)
• Exemptions 2,800 x 2 x .66 3,696

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Solution In Class ExerciseSingle, Taxable Income

• AGI 170,900
• SD (4,400)
• EXS (3,696) 2,800 x 2 x .66
• TI 162,804

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Solution In Class Exercise Married, Exemption
Phaseout

• AGI 170,900
• THRESHOLD (193,400)
• EXCESS N/A
• Exemptions 2,800 x 2 5,600

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Solution In Class ExerciseMarried, Taxable
Income

• AGI 170,900
• SD (7,350)
• EXS (5,600) 2,800 x 2
• TI 157,950

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Solution In Class Exercise Head, Exemption
Phaseout

• AGI 170,900
• THRESHOLD (161,150)
• EXCESS 9,750
• 2,500
• 3.9 4
• 4 times 2 loss amount ( 8)
• 1 - .08 deduction amount (92)
• Exemptions 2,800 x 2 x .92 5,152

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Solution In Class Exercise Head, Taxable Income

• AGI 170,900
• STD (6,450)
• EXS (5,152) 2,800 x 2 x .92
• TI 159,298

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3 of AGI ReductionAll Itemized Deductions Except

• Medical
• Casualty
• Investment interest expense
• Gambling losses

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3 of AGI Reduction

• Threshold is same as the exemption phaseout for
  single filers
• For 2000, threshold is 128,950
• Know which deduction it applies to
• Know how to calculate

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3 ReductionNever Reduces to Zero

• Taxpayer always gets the largest of
• (1) Limited - offset unlimited
• (2) 20 of limited unlimited
• (3) Standard deduction

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In Class Exercise Itemized Deduction Phaseout
(1)

• AGI 200,000
• Mortgage interest paid 10,000
• What is the deduction from AGI?
• Apply all other limits first
• Reduce entertainment by 50 of cost
• Reduce medical by 7.5 of AGI
• Reduce miscellaneous by 2 of AGI
• Reduce casualty loss by 10 of AGI

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Solution In Class Exercise Itemized Deduction
Phaseout (1)(1) Calculate the 3 Reduction

• AGI 200,000
• Threshold 128,950 --gt same for all
• Excess 71,050
• x .03
• Reduction 2,132

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Solution In Class Exercise Itemized Deduction
Phaseout (1) (2) Compare the 3 Limits

• Taxpayer gets the largest of
• (1) 10,000 - 2,132 7,868
• (2) 20 of 10,000 2,000
• (3) Standard deduction
• 7,868 gt all standard deductions, so all filers
  would use 7,868

107
In Class Exercise Itemized Deduction Phaseout
(2)

• AGI 200,000
• Medical expenses paid 20,000
• What is the deduction from AGI?
• Remember to apply all other limits before 3
  reduction
• Medical reduced by 7.5 of AGI

108
Solution In Class Exercise Itemized Deduction
Phaseout (2)(1) Calculate the 7.5 Reduction

• Reduction 200,000 x 0.075 15,000
• Medical 20,000
• Reduction (15,000)
• Deductible 5,000

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Solution In Class Exercise Itemized Deduction
Phaseout (2)(2) Calculate the 3 Reduction

• Medical is not 3 limited, SO
• Taxpayer gets gt
• (1) 5,000
• (2) Standard deduction
• Only single/married separate use 5,000
• Others would use standard deduction
  

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In Class Exercise Itemized Deduction Phaseout
(3)

• AGI 200,000
• Medical expenses paid 20,000
• Mortgage interest paid 10,000
• What is the deduction from AGI?
• Remember to apply all other limits before 3
  reduction
• Medical reduced by 7.5 of AGI

111
Solution In Class Exercise Itemized Deduction
Phaseout (3)

• This is a combination of first two cases. Here
  taxpayer gets largest of
• (1) 7,868 5,000 12,868
• (2) 2,000 5,000 7,000
• (3) Standard deduction
• 12 ,868 gt all standard deductions
• All filers would use 12 ,868

112
In Class Exercise Itemized Deduction Phaseout
(4)

• AGI 200,000
• Business Entertainment 52,000
• What is the deduction from AGI ?
• Remember to apply all other limits before 3
  reduction
• Entertainment reduced by
• 50 of each dollar
• 2 of AGI

113
Solution In Class Exercise Itemized Deduction
Phaseout (4)(1) Reduce Entertainment by Limits

• Reduce entertainment by 50
• 52,000 x .5 26,000
• Reduced entertainment by 2 of AGI 26,000 -
  200,000 x .02 22,000

114
Solution In Class Exercise Itemized Deduction
Phaseout (4)(2) Apply 3 Offset Rules

• 3 reduction is still 2,132
• Taxpayer gets the largest of
• (1) 22,000 - 2,132 19,868
• (2) 22,000 x .20 4,400
• (3) Standard deduction
• 19,868 is gt all standard deductionsAll filers
  would use 19,868