Download - Chapter 3
Income Tax Fundamentals 2010 edition Gerald E. Whittenburg
Martha Altus-Buller
2010 Cengage Learning
Net Rental Income/Loss is part of gross income
◦ Report on Schedule E - Part I
Vacation Homes
◦ If both personal and rental use of residence, must allocate expenses
◦ Deductions limited based on period of time residence used for personal vs. rental
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Three Categories – different tax treatment for each◦ Category I: Primarily personal use
Rented for less than 15 days◦ Category II: Primarily rental use
Rented more than or equal to 15 days and personal use does not exceed greater of 14 days or 10% of rental days
◦ Category III: Rental/personal (dual use) of property Rented more than or equal to 15 days and personal use
exceeds greater of 14 days or 10% of rental days
See following screens for tax treatment for each scenario
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Treated as a personal residence Rental period is disregarded
◦ Rental income is not taxable◦ Mortgage interest/taxes reported on Schedule A
(itemized deductions)◦ Other expenses are personal and nondeductible
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Must allocate expenses between rental and personal use – calculated as follows:◦ Rental days / Total days used = Rental % ◦ Expenses x Rental % = Rental deductions◦ Personal days / Total days used = Personal %
If rental deductions exceed rental income, can deduct against other income, subject to passive loss rules
Personal % of mortgage interest & real estate taxes reported on Schedule A
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Allocate expenses between rental and personal based on same allocation formulas as prior screen
Rental deductions can be taken up to amount of rental income only, in order, as follows◦ Taxes and interest (can take into loss situation)◦ Utilities/maintenance (only up to remaining rental
income)◦ Depreciation (only up to remaining rental income)
Personal % of mortgage interest & real estate taxes reported on Schedule A
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Example
The Prebena family owns a ski condo in Alta, UT; in the current year personal use = 25 days and rental use = 50 days. Data pertaining to the rental follows; what amounts will be reported on Schedules E and A for the current year?
Rental income $10,000 Taxes $ 1,500 Interest $ 3,000 Utilities $ 2,000 Insurance $ 1,500 Snow removal $ 2,500 Depreciation $12,000
2010 Cengage Learning
2010 Cengage Learning
Example The Prebena family owns a ski condo in Alta, UT; in the current year personal use = 25 days and rental use = 50 days. Data pertaining to the rental follows; what amounts will be reported on Schedules E and A for the current year?
Rental income $10,000Taxes $ 1,500 Interest $ 3,000 Utilities $ 2,000Insurance
$ 1,500Snow removal $ 2,500Depreciation $12,000
SolutionStep 1: Personal use is > 14 days or 10% of rental (5 days); therefore, does exceed the greater number and this is dual use property
Step 2: Taxes/interest = $4,500 x 50/75 = $3,000 deduction on E
Step 3: Other expenses = $6,000 x 50/75 = $4,000 deduction on E
Step 4: Depreciation = $12,000 x 50/75 = $8,000 but limited to $3,000 (remaining income) because dual use property can’t create a loss
Step 5: = What amount goes to Schedule A? ($4,500 taxes/interest – $3,000 rental = $1,500)
Step 6: = What is the loss carry forward? $8,000 – 3,000 = $5,000
IRS requires that dual use of rental property allocation is based on total days of use
U.S. Tax Court has allowed allocation of interest and taxes using 365 as denominator◦ This allows more interest/taxes to be deducted on
Schedule A, creating greater potential to take other expenses on the Schedule E
This controversy between IRS and Tax Court is still not resolved
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Passive loss rule - When taxpayer has minimal or no involvement in an activity, generated losses are considered “passive” and may not be deducted in excess of passive gains, however:◦ Loss can be carried forward and deducted in future
years or◦ Can be deducted when investment is sold
Examples of passive activities
◦ Limited partnerships
◦ Rental real estate
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Passive Losses Rules Require income and losses to be separated
into three categories:◦ Active◦ Portfolio◦ Passive
Generally, disallow the deduction of passive losses against active or portfolio income
Passive Losses Rules In general, passive losses can only offset
passive income Passive losses are also subject to the at-risk
rules◦ Designed to prevent taxpayers from deducting losses
in excess of their economic investment in an activity
At Risk Limits At-risk defined
◦ The amount of a taxpayer’s economic investment in an activity Amount of cash and adjusted basis of property
contributed to the activity plus amounts borrowed for which taxpayer is personally liable (recourse debt)
At Risk Limits At-risk defined
◦ At-risk amount does not include nonrecourse debt unless the activity involves real estate For real estate activities, qualified nonrecourse debt
is included in determining at-risk limitation
At Risk Limits At-risk limitation
◦ Can deduct losses from activity only to extent taxpayer is at-risk
◦ Any losses disallowed due to at-risk limitation are carried forward until at-risk amount is increased
◦ Previously allowed losses must be recaptured to the extent the at-risk amount is reduced below zero
◦ At-risk limitations must be computed for each activity of the taxpayer separately
At Risk Limits Interaction of at-risk rules with passive loss
rules◦ At-risk limitation is applied FIRST to each activity
to determine maximum amount of loss allowed for year
◦ THEN, passive loss limitation applied to ALL losses from ALL passive activities to determine actual amount of loss deductible for year
Calculation of At-Risk Amount
Increases to a taxpayer’s at-risk amount:◦ Cash and the adjusted basis
of property contributed to the activity
◦ Amounts borrowed for use in the activity for which the taxpayer is personally liable or has pledged as security property not used in the activity
◦ Taxpayer’s share of amounts borrowed for use in the activity that are qualified nonrecourse financing
◦ Taxpayer’s share of the activity’s income
Decreases to a taxpayer’s at-risk amount:◦ Withdrawals from the activity◦ Taxpayer’s share of the
activity’s loss◦ Taxpayer’s share of any
reductions of debt for which recourse against the taxpayer exists or reductions of qualified nonrecourse debt
Passive Loss Limits Active income
◦ Wages, salary, and other payments for services rendered
◦ Profit from trade or business activity in which taxpayer materially participates
◦ Gain from sale or disposition of assets used in an active trade or business
◦ Income from intangible property created by taxpayer
PASSIVE LOSS LIMITS Portfolio income
◦ Interest, dividends, annuities, and certain royalties not derived in the ordinary course of business
◦ Gains/losses from disposition of assets that produce portfolio income or held for investment
PASSIVE LOSS LIMITS Passive losses defined
◦ Losses from trade or business activities in which taxpayer does not materially participate, and
◦ Certain rental activities
Passive Loss Limits Limitations on passive losses
◦ Generally, passive losses can only offset passive income, i.e., they cannot reduce active or portfolio income
◦ Disallowed losses are suspended and carried forward Suspended losses must be allocated to specific
activities
Passive Loss Limits Suspended losses are deductible in year
related activity is disposed of in a fully taxable transaction
Passive Loss Limits Passive credits
◦ Credits from passive activities are subject to loss limitation
◦ Utilize passive credits to the extent of tax attributable to passive income
◦ Credits disallowed are suspended and carried forward similar to losses Suspended credits can be used to offset tax from
disposition of activity but any credits left after activity is disposed of are lost forever
Passive Loss Limits Taxpayers subject to rules
◦ Individuals, estates, trusts, personal service corporations
◦ Closely-held corporations Can deduct passive losses against active income
◦ S Corp and partnership passive losses flow through to owners and limits applied at the owner level
Passive Loss Issues Passive losses are losses from trade or
business activities in which taxpayer does not materially participate and certain rental activities
What constitutes an activity? What is “material participation"? When is an activity a rental activity?
Identification of Activities Taxpayers with complex business operations
must determine if segments of their business are separate activities or entire business is treated as a single activity
Identification of Activities Regs allow grouping multiple trade or
businesses if they form an appropriate economic unit for measuring gain or loss◦ Once activities are grouped, can’t regroup unless:
Original groups were clearly inappropriate, or Material change in circumstances
Identification of Activities Factors given greatest weight in
determining an appropriate economic unit include:◦ Similarities and differences in types of businesses◦ Extent of common control and ownership◦ Geographic location of different units◦ Interdependencies among the activities
Material Participation Tests
An activity is treated as active rather than passive (thus, not subject to the passive loss limits) if taxpayer meets one of 7 material participation tests
Participation is generally defined as work performed by an owner
Material Participation Tests
Test 1◦ Taxpayer participates in the activity more than
500 hours during the year
Material Participation Tests
Test 2◦ Taxpayer’s participation in the activity is
substantially all of the participation in the activity of all individuals for the year
Material Participation Tests
Test 3◦ Taxpayer participates in the activity more than
100 hours during the year and not less than the participation of any other individual in the activity
Material Participation Tests
Test 4◦ Taxpayer’s participation in the activity is
significant and taxpayer’s aggregate participation in all significant participation activities during the year exceeds 500 hours
◦ Significant participation is more than 100 hours
Material Participation Tests
Test 5◦ Taxpayer materially participated in the activity for
any 5 years during the last 10 year period
Material Participation Tests
Test 6◦ The activity is a personal service activity in which
the taxpayer materially participated for any 3 preceding years
Material Participation Tests
Test 7◦ Based on the facts and circumstances, taxpayer
participated in the activity on a regular, continuous, and substantial basis Regular, continuous, and substantial are not
specifically defined in the Regulations
Rental property is specifically designated as passive, even if taxpayer actively manages
However, individual taxpayers◦ May take up to $25,000 of rental loss (even though
considered passive) against ordinary income
◦ The $25,000 loss capability is reduced by 50¢ for each $1 modified AGI (MAGI) > $100,000*
*Therefore, no deduction for rental losses exist for MAGI reaches $150,000
2010 Cengage Learning
If taxpayer if heavily involved in real estate rental activities, may be considered to have an active business
Requirements are◦ 50% or more of individual’s personal service
during year is performed in real property trade and
◦ More than 750 hours of service performed Then taxpayer may be able to deduct
entire loss on real estate business
2010 Cengage Learning
2010 Cengage Learning
ExampleBobbi Jo is single and owns one rental duplex that showed a loss of $20,000. Her modified AGI before the loss is $118,000. What amount of the rental loss can be claimed?
2010 Cengage Learning
ExampleBobbi Jo is single and owns one rental duplex that showed a loss of $20,000. Her modified AGI before the loss is $118,000. What amount of the rental loss can be claimed?
SolutionStep 1 Modified AGI exceeds $100,000 (therefore,
$25,000 allowable loss may be reduced)
Step 2 $118,000 - $100,000 = $18,000 excess, $25,000 - ($18,000 x 50%) = $16,000
Only $16,000 of the rental loss can be deducted
Bad debts arise when taxpayer sells good/services on credit and accounts receivable later becomes uncollectible◦ Deduction for bad debts allowed up to amount
previously included in income - cash basis taxpayers cannot take bad debts expense
◦ As they never reported original income Must use specific charge-off method
◦ IRS requires proof of worthlessness
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Two types of bad debts Business bad debts are ordinary deductions
◦ Those that arise from trade/business ◦ These are deductible
Non-business bad debts are short-term capital losses, which are netted against other capital gains and losses ◦ Report on Schedule D◦ Subject to $3,000/year loss limitation (discussed in
Chapter 8 in more detail)
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ExampleKeiko (a dentist) loans her friend, Lars, $20,000 to
start an upholstery business. Subsequently, Lars cannot repay Keiko; is this a business or a non-business bad debt and how much may Keiko deduct in the current year?
2010 Cengage Learning
ExampleKeiko (a dentist) loans her friend, Lars, $20,000 to start
an upholstery business. Subsequently, Lars cannot repay Keiko; is this a business or a non-business bad debt and how much may Keiko deduct in the current year?
SolutionThis is a non-business bad debt as Keiko is not in the
business of loaning money. It is a short-term capital loss (limited to $3,000 of deduction against ordinary income in any one year). She may carry forward the balance of the capital loss to future years.
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Cost of goods sold (COGS) is a significant deduction for many retail businesses◦ Cost of beginning and ending inventory
crucial to calculation of deduction◦ LIFO and FIFO most commonly used
methods of costing inventory
If LIFO is used for tax, it must also be used for financial statement purposes
◦ Form 970 used to elect LIFO
2010 Cengage Learning
NOLs are losses resulting from business and casualty items only
First, carry it back two years and then forward twenty◦ File amendments for prior years (1040X) or◦ 1045 (for quick claim for refund)
or May make an irrevocable election to forego carry back,
then carry forward◦ But must elect this in year of loss
American Recovery & Reinvestment Act provides relief for businesses that incurred an NOL in 2008. It allows them to elect to carry back the NOL to the most beneficial year between 2003 and 2006 (or carry it forward and forego carry back).
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Traditional IRA
◦ Deduction for AGI if certain conditions met
◦ Distributions in retirement are taxable
Roth IRA
◦ No current deduction
◦ Distributions in retirement are nontaxable
2010 Cengage Learning
Roth or traditional IRA contribution limited to lesser of:
◦ 100% of earned income
or
◦ $5,000 Spouse with no earned income will be able to
contribute up to $5,000 For 2009, taxpayers and spouses age 50 and over
can contribute an additional $1,000/year (called “catch-up provision”)
2010 Cengage Learning
Can make contributions up through April 15, 2010 for 2009
Roth IRA contribution maximum is reduced for all taxpayers over certain income levels
◦ Phase-out for contribution is reflected in table on page 3-15
If taxpayer contributes to both a traditional and Roth IRA, combined amount cannot exceed $5,000 ($6,000 if 50 or over)
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Traditional IRA deduction is dependent on AGI and active participation in another qualified retirement plan
◦ Single taxpayers – see table on top of page 3-16
◦ MFJ taxpayers – see table, phase-outs based on if one, both or neither spouse is an active participant
Note: if only one spouse is in a qualified plan, phase out for the non-active participant spouse begins when married filing joint couple’s AGI > $166,000
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ExampleOwen is 42, single, and wants to contribute the
maximum to his Roth IRA. His AGI = $105,000, so his contribution will be limited. Please calculate how much of IRA contribution is allowed. How would that change if Owen were 62?
2010 Cengage Learning
Example
Owen is 42, single, and wants to contribute the maximum to his Roth IRA. His AGI = $110,000, so his contribution will be limited. How much of IRA contribution is allowed? How would that change if Owen were 62?
Solution
Look at the phase-out chart on p. 3-15. The denominator to the calculation is the range of the phase-out amounts.
($120,000 – $110,000)/$15,000 x $5,000 = $3,333 Roth IRA contribution
If he were 62:
($120,000 – $110,000)/$15,000 x $6,000 = $4,000 Roth IRA contribution
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$120,000 - $105,000
ExampleLiza and Mikal (both 41) filed married filing jointly.
Liza is covered by a 401(k) plan at work and earns $96,000. Mikal is not covered by a plan at work and earns $30,000. How much can each of them contribute to a traditional IRA?
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Example
Liza and Mikal (both 41) are MFJ; Liza is covered by a 401(k) plan at work and earns $96,000. Mikal is not covered by a plan at work and earns $30,000. How much can each of them contribute to a traditional IRA?
Solution
Their combined AGI = $126,000. Their AGI exceeds the top end of the phase-out range for MFJ for ‘active participant spouse’, per Note 1 on the table on page 3-16.
Since Liza is the active plan participant, she may not make a deductible contribution to a traditional IRA. She could, however, make a $5,000 contribution to a Roth IRA, since their AGI is not in the Roth phase-out range (see table page 3-15).
Mikal can make the full $5,000 traditional IRA contribution since the AGI phase-out for the spouse that is not in an active plan does not kick in until $166,000.
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Distribution taxed as ordinary income ◦ Must begin taking distributions by age 70.5
◦ There’s a 10% penalty if you take distribution before age 59.5 plus tax
◦ Penalty-free withdrawals from IRAs may be made by taxpayers who are:
Disabled
Using special level payment option
Purchasing a home for the first time (up to $10,000)
Paying higher education expenses
Paying medical expenses > 7.5% of AGI or medical insurance premiums for dependents and on unemployment at least 12 weeks
Note: in order to offer relief to retirees after stock market drop, minimum distribution requirements suspended for 2009 only
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Qualified distributions are tax free as long as Roth IRA was open for five years
and◦ Distribution is made on/after age 59.5 ◦ Distribution is made due to a disability◦ Distribution is made on/after participant’s death◦ Distribution is used for first time home-buyer’s
expenses
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Participants must meet minimum age and years of service requirements
Retirement plan geared towards self-employed individuals
Tax free contributions are limited to lesser of 20% of net earned income (before Keogh deduction) or $49,000
◦ Net earned income includes business profits if significantly generated from taxpayer’s personal services
◦ Must reduce net earned income by ½ self-employment tax for contribution calculation
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Same dollar limits as Keogh plans, but contributions made to SEP-IRA◦ IRA account with higher funding limits
Participants must meet minimum age and years of service requirements
Pay early withdrawal penalty if receive distributions prior to age 59.5
Must start drawing by age 70.5
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Contributions by an employer to qualified retirement plans are tax deductible◦ Employee contributions are pre-tax ◦ Tax on earnings is deferred
To achieve qualified plan status, an employer-sponsored retirement plan must◦ Be for exclusive benefit of employees ◦ Be nondiscriminatory◦ Have certain participation and coverage requirements ◦ Comply with minimum vesting requirements ◦ Meet uniform distribution rules
Limitations on contributions to/benefits from qualified plans◦ Defined contribution – annual addition to employee’s account can’t exceed
lesser of 25% of compensation or $49,000◦ Defined benefit – annual benefit can’t exceed lesser of $195,000 or average
compensation for the highest three consecutive years
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§401(k) ◦ Employee chooses to defer some compensation into
plan Defer means to forego current compensation - the
reduction goes into a qualified retirement plan Employees choose % of wages to contribute to plan Not to exceed $16,500/year for all salary reduction plans
$22,000/year if 50 or older
◦ An employer may match to encourage participation, this is excludable from income
◦ When distributions occur, contributions/earnings taxable
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Beginning in 2006, employers allowed to set up Roth §401(k) plan◦ Employees may defer same annual amount as
traditional 401(k), but with no reduction in current taxable income
◦ Withdrawals/earnings generally tax free upon distribution
Expected to be popular with high income taxpayers because no AGI phase-out and much higher annual contribution than a Roth IRA
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Credit to encourage low-income taxpayer participation in retirement savings
Tax credit for percentage of retirement plan contribution based upon AGI
◦ Credit equal to 50%, 20% or 10% of contribution
◦ See chart on page 3-22
◦ Credit is direct deduction from income taxes payable
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Plan 1 Plan 2
Taxpayer instructs trustee of plan to directly transfer assets to trustee of another plan
No backup tax withholding necessary because $ goes right from one plan to another
Unlimited number of direct transfers per year
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Taxpayer
Plan 1 Taxpayer Plan 2 Taxpayer receives assets from fund, and then has 60 days to
get 100% of the $ from one plan to another to avoid penalties
◦ Or 120 days if first-time homebuyer, waived in other situations
20% federal backup tax withholding is mandatory
◦ So taxpayer must make up the 20% withholding and then wait until year-end to get refund!! Also if under 59.5 years old, portion of plan distribution not transferred subject to 10% penalty
◦ IRA distributions not subject to mandatory withholding
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80% of $
ExampleTheo is 54 and instructs her employer, Ecotrek LLP, to
distribute $250,000 of her non-IRA retirement account to her. How much must the trustee of the fund withhold and what must Theo do to avoid taxes and penalties on the distribution in the current year?
2010 Cengage Learning
Example
Theo is 54 and instructs her employer, Ecotrek LLP, to distribute $250,000 of her non IRA retirement accountto her. How much must the trustee of the fund withhold and what must Theo do to avoid taxes and penalties on the distribution in the current year?
Solution
The trustee must withhold 20%; therefore, Theo will receive $200,000 ($250,000 less withholding of $50,000). To avoid taxes she must contribute $250,000 to a new fund within 60 days. If Theo does not have the extra $50,000 to contribute, that portion of the distribution will be included in her taxable income and she will be subject to a 10% penalty. If she can contribute the full $250,000; the amount withheld will be accounted for on her annual tax return.
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Designed for use by employers with less than 100 employees
SIMPLE-IRA◦ Employees can defer up to $11,500 per year into SIMPLE-IRA
or $14,000 if 50 or older
Employer must either:◦ Match employees’ contributions dollar for dollar up to 3% of
gross wagesor
◦ Contribute 2% of gross wages of all employees who make over $5,000 per year (even if they don’t elect salary deferral)
Contributions are fully vested when made; first 2 years early withdrawals are subject to 25% penalty
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Example Sue, age 39, earns $70,000 and chooses
8% salary deferral to a SIMPLE IRA. How much is her contribution and what is the employer matching (assuming the 3% provision)?
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Example Sue, age 39, earns $70,000 and chooses 8%
salary deferral to a SIMPLE IRA. How much is her contribution and what is the employer matching (assuming the 3% provision)?
SolutionSue contributes $5,600 to the plan and her employer matches $2,100 (dollar for dollar up to 3% maximum match ($70,000 x 3%)).
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Example John, age 43, works for a computer software design business and has a salary of $500,000; John chooses 10% salary deferral (not to exceed maximum allowable by law). How much is his contribution and what is the employer matching (assuming the 2% provision)?
2010 Cengage Learning
Example John, age 43, works for a computer software design business and has a salary of $500,000; John chooses 10% salary deferral (not to exceed maximum allowable by law). How much is his contribution and what is the employer matching (assuming the 2% provision])
SolutionJohn contributes $13,000 to the plan [since $500,000 x
10% exceeds the maximum, he is only allowed $11,500]. His employer matches $10,000 (dollar for dollar up to 2% maximum match ($500,000 x 2%)).
2010 Cengage Learning
2010 Cengage Learning