pope phft2012 ind sm 07

© 2012 Pearson Education, Inc. publishing as Prentice Hall I:7-1

Chapter I:7 Itemized Deductions

Discussion Questions I:7-1 a. A taxpayer may deduct medical expenses incurred on behalf of the taxpayer, the taxpayer's spouse, the taxpayer's dependents, and the taxpayer’s children. The taxpayer may also deduct medical expenses paid for an individual who would otherwise qualify as a dependent except for the fact that the gross income test is not met, even though the taxpayer may not take an exemption for the individual.

b. No. Medical expenses incurred by the divorced parents of a child are deductible by whichever parent incurs the expenses, even though the parent incurring the expenses is not entitled to the dependency exemption for the child. p. I:7-2.

c. The taxpayer who is the subject of a multiple support agreement is treated as the dependent of the taxpayer who is entitled to take the dependency exemption. Since a taxpayer may deduct medical expenses (subject to the 7.5% of AGI limit) incurred for a dependent, the taxpayer entitled to the dependency exemption under the multiple support agreement should be the one who pays the medical expenses.

I:7-2 Medical care is defined as amounts paid for:

1. The diagnosis, cure, mitigation, treatment, or prevention of disease. 2. The purpose of affecting any structure or function of the body. (Medical expenses

incurred for cosmetic surgery are not deductible). 3. Transportation primarily for and essential to the first two items listed above. 4. Long-term care services for the chronically ill. Chronically ill generally is defined as

the loss of certain daily living activities such as eating, toileting, bathing, dressing, and continence.

5. Insurance covering all of the items above. However, the deductibility of long-term care insurance premiums is subject to a dollar ceiling based on age. pp. I:7-2 through I:7-6.

I:7-3 a. The Internal Revenue Code defines cosmetic surgery as any procedure that is directed at improving the patient's appearance and does not meaningfully promote the proper function of the body or prevent or treat illness or disease.

b. In general, the cost of cosmetic surgery is not deductible unless it is necessary to ameliorate a deformity arising from or directly related to, a congenital abnormality, a personal injury resulting from an accident or trauma, or a disfiguring disease. p. I:7-4.

I:7-4 a. In 2011, the deductible mileage rate for miles driven to receive medical care is 19 cents per mile. In addition, the cost of lodging and 50% of the cost of meals incurred en route to obtain medical treatment generally is deductible as a medical expense. However, the cost of meals on trips too short to warrant a stop for meals is not deductible. En route transportation, 50% of meals


and lodging costs for a nurse, parent, or spouse are also deductible if the sick or injured individual is unable to travel alone. Note, however, that the IRS’s position is that the cost of meals en route is not deductible.

b. In addition to the 50% limit on meals, the lodging costs are limited to $50 per person, per night. pp. I:7-4 and I:7-5. I:7-5 The cost of meals is not deductible for an individual receiving treatment as an outpatient while away from home. The cost of lodging for an outpatient is deductible if (1) the travel is undertaken primarily for medical care, (2) the medical care is provided by a physician in a licensed hospital (or a facility that is related or equivalent to a licensed hospital), and (3) there is no significant element of personal pleasure or recreation. Furthermore, the deduction for lodging is limited to $50 per night, per person. These rules also apply to a nurse, parent, or spouse if the sick or injured individual is unable to be alone. The cost of meals and lodging received by an individual as an inpatient are considered part of the treatment received and are, therefore, deductible as medical expenses. p. I:7-4. I:7-6 a. Capital expenditures qualify for a current deduction if incurred as a medical necessity for primary use by the taxpayer, taxpayer's spouse, or dependents in need of medical treatment. There are three types of capital expenditures that qualify for a deduction.

1. Expenditures that relate only to the sick person and not to the permanent improvement of the taxpayer's property. These include expenditures for items such as wheelchairs, eyeglasses, etc.

2. Expenditures that permanently improve the taxpayer's property as well as provide medical care.

3. Expenditures incurred in removing physical barriers in the home of a physically handicapped individual.

b. Capital expenditures in the first and third categories are fully deductible. However,

capital expenditures in the second category are deductible only to the extent the expenditure exceeds the increase in fair market value of the residence. p. I:7-5. I:7-7 The cost of the trip most likely would not be deductible because of the personal enjoyment factor. However, because Bill's doctor recommended the trip specifically as treatment for his ulcer, an argument could be made to deduct the cost of the trip costs as treatment for a specific ailment. pp. I:7-3 and I:7-4. I:7-8 If the premiums cover more than just health care or long-term care for the chronically ill, (i.e. coverage for loss of income or life) and the cost of the separate items are not identified as a component of the total premium, then none of the premiums are deductible. p. I:7-6. I:7-9 Medical expenses that exceed 7.5% of AGI are deductible from AGI, if the sum of this excess and all other deductions from AGI exceeds the standard deduction. A deduction can be taken in the year that the care is paid for; although, if the care is prepaid, the amount is deductible only after the services are performed unless the prepayment is required by the provider of the services or there is a


legal obligation to pay. Furthermore, under certain conditions, the prepayment of certain long-term care treatments may also be deductible when paid. pp. I:7-6 and I:7-7. I:7-10 a. The following taxes are specifically identified as deductible under Sec. 164:

• State, local, and foreign real property taxes • State and local personal property taxes if the tax is ad valorem • State, local, and foreign income, war profits, and excess profits tax • State and local sales taxes if an election is made to deduct them instead of

state and local income taxes. This deduction is only available for taxable years through 2011 unless Congress extends the provision.

• The federal generation-skipping transfer tax on income distributions • Other state, local, and foreign taxes, which are paid or incurred in either a

trade or business or an income-producing activity. • One-half of the self-employment taxes imposed on a self-employed individual.

Because of the temporary reduction in Social Security taxes imposed on employees and self-employed individuals, for 2011 this deduction is 59.6% of the Social Security taxes and 50% of the Medicare taxes imposed on self-employment income.

b. Certain taxes not specifically listed in Sec. 164 are still deductible as ordinary and

necessary expenses if incurred in the taxpayer's business or income-producing activity. Taxes paid in connection with the acquisition of property (such as a sales tax) are treated as part of the cost of the property and are capitalized accordingly. pp. I:7-9 and I:7-10. I:7-11 Cash method taxpayers deduct all state taxes in the year paid or withheld. A refund of state taxes must be included in gross income to the extent a tax benefit was received in the year the deduction was taken. p. I:7-10. I:7-12 An ad valorem tax is a tax determined by the value of the property being taxed. A personal property tax that is not an ad valorem tax is still deductible as an ordinary business expense if the property is used in a trade or business. If the tax is not an ad valorem tax and the property is not used in a trade or business or income-producing activity, the tax imposed on personal property is not deductible. p. I:7-10. I:7-13 When real estate is sold during a year, the real estate taxes on the property must be apportioned between the buyer and seller in order to properly determine the amount of gain or loss to the seller and the basis of the property in the hands of the buyer as well as the amount of deduction for the property tax that the seller and buyer each may deduct. The seller of real estate is treated as having paid the proportionate share of the real estate taxes up to the date of the sale and such fact is generally properly accounted for at the closing, regardless of who actually pays the tax. If the closing agreement does not allocate and account for the real estate taxes and the seller does not actually pay his or her share of the taxes, the selling price of the property will increase by the amount of the tax and the buyer's basis will increase by the same amount. If the closing agreement does not allocate and account for the real estate taxes and the buyer does not actually pay his or her share of the taxes,


the selling price will be decreased by the amount of the tax and the buyer's basis will decrease by the same amount. p. I:7-11. I:7-14 a. For tax purposes, interest expense is divided into the following categories: personal interest, active trade or business interest, passive activity interest, investment interest, qualified residence interest, and student loan interest. In general, the classification of interest is determined by the use of the borrowed money, not the nature of the property used to secure the loan. However, a home equity loan is determined by the nature of the property securing the loan, not the use of the money. b. Personal interest is not deductible. Active trade or business interest is deductible as a for AGI deduction on Schedule C. Passive activity interest is deductible against passive income and is deductible either for or from AGI, depending on the activity in which the interest is incurred. For example, interest incurred in a passive rental activity is a deduction for AGI. Investment interest is deductible as a from AGI deduction, up to the amount of the taxpayer’s net investment income. Qualified residence interest is deductible as a from AGI deduction on Schedule A. Student loan interest is a for AGI deduction. pp. I:7-12 through I:7-20. I:7-15 A point is equal to one percent of the loan amount. Points may represent an additional interest expense, or a service charge. If the points represent additional interest, they are deductible as interest. Points that represent a service fee are amortized and deducted only if incurred in a business or for investment. pp. I:7-17 and I:7-18. I:7-16 Points representing prepaid interest on a loan are deductible in the year that they are paid if the loan is obtained to purchase or improve the taxpayer's principal residence. If not, the points must be capitalized and amortized over the period to which the interest relates. pp. I:7-17 and I:7-18. I:7-17 Section 267 requires related cash-method lenders and accrual-method borrowers to report the results of the transactions in the same year. The restrictions imposed by Sec. 267 serve to prevent a related accrual-method taxpayer from taking a deduction in a year earlier than the year in which the related cash-method taxpayer reports the income. p. I:7-20. I:7-18 a. The deduction for investment interest expense is limited to the taxpayer's net investment income for the year.

b. Net investment income is the excess of investment income over the investment expenses (excluding the investment interest expense) that are directly connected with the production of investment income. Investment income is gross income from property held for investment including items such as dividends, interest, annuities, and royalties (if not earned in a trade or business). Investment income also includes net gain (all gains minus all losses) on the sale of investment property, but only to the extent the net gain exceeds the net capital gain (net long-term gains in excess of net short-term losses) on such property. Thus, a net short-term capital gain is included. If the taxpayer elects to subject them to the regular tax rates, net capital gains (net long-term gains in excess of short-term losses) are included in the definition to the extent the taxpayer elects to subject them to the regular tax rates. Gains on business or personal-use property are not included in the calculation of investment income. In computing net investment income, the expenses that are subject to the 2% of AGI limitation must first be reduced by that limit. Furthermore, in


computing the amount of the disallowed investment expenses, the 2% of AGI limitation is applied to the noninvestment expenses first.

c. Disallowed investment interest expense may be carried over and deducted in a subsequent year. The carryover amount is treated as paid or accrued in the subsequent year and is subject to the disallowance rules that pertain to the subsequent year. pp. I:7-14 and I:7-15. I:7-19 Acquisition indebtedness is debt that is secured by the taxpayer's residence and is incurred in acquiring, constructing, or substantially improving the qualified residence of the taxpayer. For debt incurred on October 13, 1987 or later, acquisition indebtedness is limited to $1,000,000. Acquisition debt incurred prior to that date is not limited. However, any pre-October 13, 1987 acquisition indebtedness reduces the $1,000,000 limit. Home equity indebtedness is any debt (other than acquisition indebtedness) that is secured by the taxpayer's qualified residence. It is limited to the lesser of $100,000 or the excess of the residence's FMV over the acquisition indebtedness and may be used for any purpose, including acquiring the residence. pp. I:7-16 and I:7-17. I:7-20 For any taxable year, a taxpayer may have two qualified residences: (1) the taxpayer's principal residence, and (2) one other residence selected by the taxpayer which the taxpayer personally uses more than the greater of (1) 14 days or (2) 10% of the rental days during the year. If the residence has not been rented by the taxpayer during the year, it may be selected by the taxpayer as the second residence with respect to which qualified residence interest may be deducted even though the taxpayer does not meet the 14-day or 10% test. p. I:7-18. I:7-21 The interest is disallowed as a deduction because the taxpayer would realize a double tax benefit if allowed to have the proceeds from the tax-exempt securities not taxed and also deduct the interest for the debt to purchase or hold the tax-exempt securities. If the interest was allowed to be deducted, a taxpayer could, under certain circumstances borrow money at a higher rate of interest than the rate at which it is invested, while still generating a positive net cash flow. p. I:7-14. I:7-22 The cash method taxpayer normally deducts the interest expense in the year paid.

Prepaid interest relating to a period which extends beyond the end of the tax year must be capitalized and amortized over the life of the loan. If points paid on a loan incurred to purchase or substantially improve the taxpayer's principal residence represent prepaid interest, the deduction can be taken in the year paid.

If a new loan with a third party is entered into to pay an existing loan, the amount of the payment which represents interest is deductible in the year paid. If the funds used to pay the first loan are borrowed from the same party and the purpose of the second loan is to pay the interest on the first loan, no interest deduction is available.

A cash-method taxpayer may deduct interest on a discounted note when the note is repaid. Personal interest, however, is not deductible. pp. I:7-19 and I:7-20. I:7-23 a. Capital gain property is property held over one year upon which a long-term capital gain would be recognized if it were sold at its FMV on the date of contribution. If a capital loss or a short-term capital gain would be recognized, the property is considered ordinary income property for


purposes of the charitable contribution deduction. Ordinary income property also includes property that would result in the recognition of ordinary income if the property were sold.

b. It is important to make the distinction between capital gain property and ordinary income property because of the different rules that apply in determining the amount of the charitable contribution deduction. If capital gain property is donated to a public charity, generally the amount of the contribution is its FMV except for special rules relating to tangible personal property. Ordinary income property contributed to a public charity generally results in a contribution amount equal to the FMV less the gain that would have been recognized if the property had been sold. pp. I:7-22 and I:7-23. I:7-24 In general, the amount of the charitable contribution of capital gain property donated to a private nonoperating foundation is equal to the FMV of the property reduced by the gain that would be recognized if the property were sold at its FMV. In the case of capital gain property donated to a public charity, the charitable contribution is equal to the FMV of the property. In this case, the limit on the charitable deduction is 30% of AGI. An individual may, however, elect to have the amount of the contribution become the property's FMV reduced by the gain that would be recognized. In this case, the limit is increased to 50% of AGI. If tangible personal property is donated to a public charity and the property consists of certain intangibles or is used for purposes unrelated to the charity's purposes, the amount of the contribution equals the property's FMV reduced by the gain, which would be realized if the property were sold. Special rules apply to certain types of inventory donated by a corporation. pp. I:7-22 and I:7-23. I:7-25 No charitable contribution deduction is available. In 2011, a married taxpayer filing a joint return is allowed the greater of the standard deduction of $11,600 or itemized deductions. In this situation, the itemized deductions total only $7,000 and the taxpayer would use the standard deduction. p. I:7-2. I:7-26 The overall deduction limitation on charitable contributions for individuals is 50% of the taxpayer's AGI for the year. The limitation for corporations is 10% of taxable income computed without regard to the dividends received deduction, the charitable contribution deduction, or any NOL or capital loss carrybacks. pp. I:7-24 and I:7-25. I:7-27 Charitable contributions that exceed the deduction limitation may be carried over and deducted in the subsequent five years. The carryovers are still subject to the limitations that apply in the subsequent years. pp. I:7-25 and I:7-26. I:7-28 Charitable contribution deductions are reported on Schedule A of the individual's tax return. If contributions of property exceed $500, Form 8283 must also be submitted. This form requires information about the type, location, holding period, basis, and FMV of the property. Additionally, if contributions of $250 are made, no deduction is allowed unless the taxpayer obtains and retains a contemporaneous, written acknowledgment by the donee organization. This acknowledgement must include whether or not the organization provided any goods or services in consideration for the cash or property received, including a description and good faith estimate of the value of any goods or services provided by the organization.


Separate payments generally are treated as separate contributions for purposes of applying the $250 threshold. Charitable contributions made in cash after August 17, 2006 are not deductible unless the donor can show a cancelled check or credit card statement or has a written statement from a charity verifying the contribution. pp. I:7-33 through I:7-35. I:7-29 Some of the more common miscellaneous itemized deductions include: expenses incurred in connection with the determination, collection, or refund of any tax (e.g. tax return preparation fees, accountant fees for a tax audit, fees paid for a private letter ruling, appraisal fees to determine the amount of a casualty loss or of a charitable contribution, and legal fees for tax estate planning), expenses associated with a hobby up to the income generated from the hobby, expenses associated with an investment activity other than one which generates rental and royalty income (safe deposit boxes, subscriptions to investment journals, bank service charges on investment accounts), and non-reimbursed employee business expenses. Note, however, that expenses of determining a tax which are incurred in connection with a taxpayer’s (1) trade or business or (2) an activity which produces rents or royalties are deductions for AGI. Miscellaneous itemized deductions are deductible only when the total exceeds 2% of AGI. pp. I:7-28 and I:7-29. I:7-30 For years 2006 through 2009, an additional reduction of the total itemized deductions was imposed on certain high income taxpayers if their AGI exceeded certain threshold limits. This additional reduction was eliminated for 2010 through 2012. However, unless Congress changes the tax law, this additional reduction will also apply for 2013 and beyond. pp. I:7-29 and I:7-30. Issue Identification Questions I:7-31 The primary tax issue is how Wayne and Maria can maximize their medical expense deductions by engaging in tax planning. A secondary issue is whether the proposed medical services (e.g., the orthodontic work) may be deducted despite the fact that the services may be performed, in part, in a subsequent year. Because of the 7.5% limit, it is preferable to "bunch" the medical expenses into one year. p. I:7-30. I:7-32 The primary tax issue is whether interest expense on capital gain property can be used to offset ordinary income. Chuck will not have income from his investment in the land for at least 5 years and then the income will be a capital gain taxed at only 15% if the 15% tax rate or capital gains is extended. He will get a deduction against ordinary income that is taxed at the maximum rate of 35%, and it will be a current deduction. Thus, he should take into consideration the amount of net investment income he might have in order to determine the amount of the current investment interest expense he can deduct. p. I:7-14.


I:7-33 The primary tax issue is whether the contribution is made to a qualified charitable organization. The payments to a political candidate indicate that the organization may not qualify. If the contribution is qualified, George needs to consider contribution limits and the character of the contribution (i.e., LTCG or ordinary income property). p. I:7-22. I:7-34 The primary tax issue is whether the charitable contribution limits (i.e., 30% of AGI for contributions of LTCG property) will apply and whether an election should be made to reduce the amount of the contribution to the property's basis so that the 50% limit is applied. A secondary issue is the application of the contribution carryover rules and their effect upon the deductibility of contributions in the current year. pp. I:7-24 and I:7-25. Problems I:7-35 AGI $58,000 Less itemized deductions: Medical*: Doctor bills $11,700 Hospital bills 9,400 Health premiums 600 Total $21,700 Less: Reimbursement (10,000) Less: 7.5% AGI ( 4,350) Deductible medical expenses $ 7,350 Mortgage interest** 2,750 Total itemized deductions $10,100 Compare to standard deduction 5,800 Deduction (itemized deduction > standard deduction) ( 10,100)Personal exemption ( 3,700)Taxable income $44,200

*The legal fees do not meet the definition of medical expenses in Sec. 213 of the IRC. **The car loan interest is considered to be personal interest and not deductible. pp. I:7-3 through I:7-6.


I:7-36 Angela must compute the amount of tax benefit from the medical expense deduction for the prior year. She must compare the actual taxable income for 2011 with what the 2011 taxable income would have been if the $4,000 additional reimbursement for her medical expenses had been received in 2011. AGI $58,000 Less itemized deductions: Medical: Doctor bills $11,700 Hospital bills 9,400 Health premiums 600 Total $21,700 Less: Reimbursement ($10,000 + $4,000) (14,000) Less: 7.5% AGI ( 4,350) Deductible medical expenses $ 3,350 Mortgage interest 2,750 Total itemized deductions $ 6,100 Compare to standard deduction 5,800 Deduction ( 6,100) Personal exemption ( 3,700) Taxable income $48,200 Actual 2011 taxable income 44,200 Tax benefit $ 4,000

Thus, Angela must include $4,000 in her gross income in 2012 because of the reimbursement. The reimbursement for the legal fees is not income to Angela because she did not originally deduct the legal fees when they were expended in 2010. p. I:7-7. I:7-37

Mileage (12 trips x 400 miles x .19 per mile) $ 912 Lodging (12 trips x $85 per night limited

to $50 per night) 600 Meals ($100 en route x 0.50) 50* Dan's qualified medical expense for the year $1,562

* Note that the IRS's position is that the meals en route are not deductible but the Tax Court and

the Sixth Circuit Court of Appeals have ruled that the meals are deductible. p. I:7-4.


I:7-38 Orthodontic work for Sara $3,000 Broken leg for Brett 2,000 Health insurance premium for Chad, Brett, Sara (not deductible) 0* Prescription drugs for Chad 400 Doctor bills for Chad 1,000

$6,400 Minus: 7.5% of $40,000 AGI (3,000) Medical expense deduction $3,400

* Health insurance premiums paid on a pre-tax basis have already been deducted for tax purposes from Chad’s salary.

pp. I:7-3 through I:7-6. I:7-39 a. AGI $38,000 Less itemized deductions: Medical: Hospital bills $14,000 Excess cost of pool over increased value of home ($25,000 - $22,000) 3,000 Maintenance of pool 930 Medical premiums 1,200 Wheelchair 2,300 Total expenses $21,430 Less: 7.5% AGI ( 2,850) $18,580 Compare to standard deduction 5,800 Total deduction ( 18,580) Personal exemption ( 3,700) Net taxable income $15,720

b. In 2012, Charla must include the $9,000 reimbursement in her taxable income to the

extent that it provided tax benefit in 2011. Amount Reported

In 2011 Amount if Reimbursement

Were Received in 2011 Total AGI $38,000 $38,000 Less itemized deductions: Medical deductions $21,430 $21,430 Less: Reimbursement - ( 9,000) Less: 7.5% AGI ( 2,850) ( 2,850) Total deduction $18,580 $ 9,580 Compare to standard deductions 5,800 5,700 Deduction ( 18,580) ( 9,580) Less exemption ( 3,700) ( 3,700) Net taxable income $15,720 $24,720 Increase in taxable income from the reimbursement: $ 9,000


In 2012, Charla’s AGI is $52,000 ($43,000 + $9,000 reimbursement). Her 2012 medical expense deduction is as follows: Fees paid to physical therapist $ 4,000 Hospital bed 3,800 Medical premiums 1,200 Pool maintenance 1,060 Total Expenses $10,060 Minus 7.5% AGI ( 3,900) Qualified medical expense deduction in 2012: $ 6,160 pp. I:7-3 through I:7-6 I:7-40 a. In 2010, Joyce may deduct $1,720 in state income tax, the $120 she paid with her 2009 state tax return and the $1,600 withheld from her paychecks.

b. In 2011, Joyce may deduct $2,300 in state income tax, the $200 she paid with her 2010 state tax return and the $2,100 withheld from her paychecks.

c. Her taxable income for 2011 is $41,550, computed as follows: AGI $51,000 Less itemized deductions: State tax deduction $2,300 Mortgage interest 5,500 Total itemized deductions 7,800 Compare to standard deduction 5,800 Deduction ( 7,800) Personal exemption ( 3,700) Taxable income $39,500 d. In 2012, Joyce must include the state tax refund in her adjusted gross income to the

extent that it provided a tax benefit in 2011. The refund provided $450 in tax benefit, so her 2011 AGI is $53,950 ($53,500 + $450). Amount Reported

In 2011 Amount if Reimbursement

Were Received in 2011 Total AGI $51,000 $51,000 Less itemized deductions: State tax deduction $2,300 $1,850 Mortgage interest 5,500 5,500 Total itemized deductions 7,800 7,350 Compare to standard deduction 5,800 5,800 Deduction ( 7,800) ( 7,350) Personal exemption ( 3,700) ( 3,700) Taxable income $39,500 $39,950 Increase in taxable income from the tax refund: $ 450 pp. I:7-9 through I:7-12.


I:7-41 a. Joyce’s 2011 taxable income is $41,050, computed as follows:

AGI $51,000 Less itemized deductions: State income tax deduction $2,300 Mortgage interest 3,000 Total itemized deductions 5,300 Compare to standard deduction 5,800 Deduction ( 5,800) Personal exemption ( 3,700) Taxable income $41,500

For tax years beginning before January 1, 2012, taxpayers could deduct the greater of (1) state and local income taxes or (2) state and local sales taxes. If Joyce had sales taxes in 2011 that were greater than $2,500, she would deduct the larger amount.

b. In 2012, Joyce need not include the state income tax refund in her adjusted gross income because it did not provide a tax benefit in 2011. Joyce did not deduct the state income taxes in 2011 because she took the standard deduction. So, her AGI will be $53,500.

pp. I:7-9 through I:7-12. I:7-42 a. Dawn's 2011 deduction for her taxes is as follows:

State income taxes $2,000* Ad valorem property taxes on the car (20,000 x 0.02) 400 Her portion of the property taxes on the house (104/365 x $1,850) 527 Itemized deduction for taxes $2,927

b. Dawn will report this deduction on Form 1040 Schedule A. pp. I:7-9 through I:7-11.

*If the sales taxes Dawn pays during the year exceed the state and local income taxes, she could make an election to deduct the sales taxes instead of the income taxes. I:7-43 July 1 of the prior year through April 30 of the current year equals 304 days. Thus, $4,997 ($6,000 x 304/365) of the taxes are apportioned to Tara. The remainder of the taxes of $1,003 ($6,000 - $4,997) are apportioned to Janet.

a. Janet may deduct $1,003 in the current year b. Tara may deduct $4,997 in the current year c. The total selling price of the building and the cost basis to the buyer (Janet) is

$504,997 ($500,000 + $4,997). p. I:7-10.


I:7-44 a. Scott's interest expense for the year is classified as follows:

Jan. 1 - Mar. 31 100% investment interest

Apr. 1 - Jun. 30 93.75% passive interest ($75,000/$80,000) 6.25% investment interest ($5,000/$80,000)

Jul. 1 - Nov. 30 93.75% passive interest

6.25% personal interest

Dec. 1 - Dec. 31 100% passive interest pp. I:7-12 through I:7-14. I:7-45 Computation of Taxable Income AGI before investments $130,000 Long-term capital gains 8,600 Short-term capital gains 7,300 Dividends 10,000 Interest Income 2,100 AGI $158,000 Less itemized deductions: State income taxes $ 8,400 Investment interest 2,400 ($30,000/$40,000 x $3,200) Miscellaneous itemized: Investment expenses $ 8,000 Total miscellaneous items Less 2% AGI ( 3,160) Miscellaneous items deduction 4,840 Total itemized deductions ($15,640) Exemption amount $ 3,700 Times number of exemptions claimed Less total exemption amount x 2 ( 7,400) Net taxable income $134,960

*Travis has $9,400 (7,300 + 2,100) of investment income and $4,560 ($9,400 - $4,840) of net investment income, which is calculated by reducing the investment income by the other investment expenses net of the 2% of AGI reduction. Thus the deduction for the investment interest expense is limited. pp. I:7-14 and I:7-15.


I:7-46 Tina is limited to interest expense deductions on a total of $1,000,000 acquisition indebtedness incurred on October 13, 1987 or thereafter. Thus, Tina may deduct interest paid on the $700,000 acquisition debt secured by the principal residence, and $300,000 of the acquisition debt secured by the condominium. In addition, since Tina's equity in the condominium is in excess of $100,000 ($600,000 - $450,000), $100,000 of the debt qualifies as home equity indebtedness. Thus, Tina may deduct interest on a total indebtedness of $1,100,000. pp. I:7-16 through I:7-18. I:7-47 a. In general, the maximum amount of a qualified home equity loan upon which the interest is deductible is the lesser of $100,000 or the home’s FMV reduced by any acquisition indebtedness. Thus, since the $50,000 home equity loan is less than $100,000 and less than $70,000 ($330,000 - $260,000), interest on the entire $50,000 is deductible as home equity indebtedness.

b. In this situation, the $80,000 loan exceeds $70,000 (the home’s FMV reduced by the acquisition indebtedness) and, therefore, interest on $70,000 would be deductible as home equity indebtedness. Interest on the remaining $10,000 would be considered personal interest and would not be deductible.

c. Since the home equity loan exceeds $100,000, the amount of the loan upon which interest would be deductible would be limited to $100,000 (the lesser of $100,000 or $150,000 ($410,000-$260,000). Interest on the remaining $10,000 ($110,000 - $100,000) would be considered personal interest and would not be deductible.

d. The maximum amount of home acquisition indebtedness upon which interest is deductible is $1,000,000. In addition, interest on a home equity loan of up to $100,000 may also be deducted, resulting in a maximum of $1,100,000 of qualified residence interest. In this case, the total amount of the outstanding mortgage is $1,200,000. Of this amount, $1,000,000 is considered acquisition indebtedness and $100,000 qualifies as home equity indebtedness. Magdelena has already reached the total limit for qualified residence interest and, therefore, none of the interest on the $80,000 is deductible. The entire amount would be considered as personal interest. pp. I:7-16 and I:7-17. I:7-48 55% 40% 60% 45%

a. Crown can deduct the entire interest accrued because it and BJ Partnership are not related parties. The same person does not own over 50% of both the partnership and corporation.

Jeremy

Brett

Susie

Crown

BJ


b. If Jeremy were Brett’s brother, Brett would constructively own 100% of BJ Partnership. Thus, Brett would own over 50% of both Crown Corp. and BJ Partnership. Crown could only deduct the interest in the period in which BJ Partnership would recognize the interest income, which would be the next year.

p.I:7-20. I:7-49 a. Since Henry is a cash method taxpayer, he must deduct the interest expense as the loan is repaid. Thus, the total amount of the interest expense of $1,800 ($12,000 - $10,200) is deductible as the loan is repaid. Four payments are to be made. Henry makes two payments in the current year (on July 1 and October 1). Thus, $900 (0.50 x $1,800) of the interest expense is deductible in the current year.

b. Since none of the loan is repaid during the current year, none of the interest is deductible during the current year. It will all be deductible by Henry when the loan is paid off in subsequent years.

c. Since Henry is an accrual method taxpayer, he may deduct the interest as it accrues. The loan is to be outstanding for one year. Three-fourths of the loan period occurs during the current year. Thus, $1,350 (0.75 x $1,800) of the interest expense is deductible during the current year. p. I:7-19.

I:7-50 AGI Itemized Deductions: Medical expenses Minus: 7.5% of AGI State income taxes Local property taxes Charitable contributions Total itemized deductions Minus: Greater of itemized deductions ($7,300) or standard

deduction ($5,800) Personal exemption Taxable income

$ 800 (2,625)

$ -0- 2,300 3,000 2,000 $7,300

$35,000 ( 7,300) ( 3,700) $24,000

pp. I:7-2 through I:7-30.


I:7-51 a.

Income:

Salary Interest Net capital gain ($23,000 - $15,000)

AGI Deductions:

Medical Minus: ($98,000 x 0.075) Taxes ($7,000* + $4,000) Qualified residence interest Investment interest (limited to net investment income of $13,000 ($28,000** - $15,000) Charitable contributions

Miscellaneous:

Investment expenses Tax return preparation and consulting fees

Minus: 2% of AGI ($98,000 x 0.02)

Personal exemption Taxable income

$ 8,000 ( 7,350) 15,000 5,000 20,000 ( 1,960)

$ 650 11,000 12,000 13,000 3,000 18,040

$70,000 20,000 8,000 $98,000

(57,690) ( 3,700) $36,610

*The state income taxes of $7,000 were greater than the state sales taxes of $4,500, so the larger amount was used. **$20,000 interest + $8,000 net capital gain.

b. The 2% of AGI reduction first reduces the tax preparation fee, leaving all of the investment expenses to be deducted. James’ excess investment interest expense of $3,000 ($16,000 - $13,000) is carried over to the next year. pp. I:7-2 through I:7-30.


I:7-52 Income:

Salary Interest Net capital gain ($23,000 - $15,000) AGI

Deductions:

Medical Minus: 7.5% AGI ($158,000 x 0.075) Taxes ($7,000 + $4,000) Qualified residence Investment interest (limited to net investment income of $5,000 ($20,000* - $15,000)** Charitable contributions

Miscellaneous:

Investment expenses Tax return preparation

Minus: 2% of AGI ($158,000 x 0.02)

Total Itemized Deductions

Personal exemption Taxable income

$ 8,000 ( 11,850)

15,000 5,000 20,000 ( 3,160)

$ -0- 11,000 12,000

5,000 3,000

16,840

$130,000 20,000 8,000 $158,000

(47,840)

( 3,700) $ 106,460

*The net LTCG is not included in investment income. The excess investment interest of $11,000 ($16,000 - $5,000) is carried over to next year. pp. I:7-2 through I:7-34. **The 2% of AGI reduction first reduces the tax return preparation fee to $1,840 ($5,000-3,160), leaving all of the investment expenses to be subtracted from the investment income. This leaves net investment income of $5,000 ($20,000-15,000).

I:7-53 When services are rendered to a qualified charitable organization only the unreimbursed expenses incurred while performing the services are deductible. Donna’s charitable contribution for the year is $800. p. I:7-24.


I:7-54 a. The charitable contribution is $40,000, subject to a limitation of 30% of AGI. b. The charitable contribution is $10,000, subject to a limitation of 50% of AGI. c. The charitable contribution is $100,000, subject to a limitation of 30% of AGI. d. The charitable contribution is $50,000, subject to a limitation of 50% of AGI. e. The charitable contribution is $500, subject to a limitation of 50% of AGI.

pp. I:7-24 and I:7-25.

I:7-55 a. The charitable contribution is $10,000 limited to the lesser of (1) 20% of the taxpayer's AGI or (2) 30% of AGI, reduced by any contributions of capital gain property donated to a public charity.

b. The charitable contribution is still $10,000 subject to a limitation of 30% of AGI. c. The charitable contribution is $50,000 limited to the lesser of (1) 20% of AGI or (2)

30% of AGI, reduced by capital gain property donated to a public charity. d. Same as (c) above. e. The charitable contribution is $500 limited to 30% of AGI. pp. I:7-22 through I:7-25.

I:7-56 The maximum charitable contribution deduction Helen can take for this year is $40,000. Under the regular rules, the charitable contribution is $50,000, subject to an overall 30% of AGI limit. Therefore, the charitable contribution would be $30,000 (0.30 x $100,000 AGI). Helen would have a $20,000 carryover of excess contributions under the general rule. If she elects to reduce the amount of the contribution by the long-term capital gain, the charitable contribution is $40,000 [$50,000 - ($50,000 - $40,000)] subject to an overall 50% of AGI limit. The amount of the charitable contribution deduction would be $40,000 for this year (50% of AGI limit is $50,000). If the election is made, there will be no carryover of unused contributions since all of the contribution is deductible in the current year. pp. I:7-24 and I:7-25.

I:7-57 a. Although she has contributed a total of $95,000, Melissa’s charitable contribution deduction for the year is $90,000 ($30,000 + $60,000) because of the limitations imposed on the deductibility of these contributions. The first limit imposed is the 50% of AGI overall limit (50% x $200,000 = $100,000) imposed on the donation to Middle State Univ. Thus, this donation is fully deductible. The deduction for the donation to the private nonoperating foundation is limited to the lesser of three amounts:

The remaining 50% limit: ($100,000 - $30,000) $70,000 The actual contribution $65,000 The 30% limit on contributions to private nonoperating foundations ($200,000 x 30%) $60,000

Thus, her charitable deduction for the current year is limited to $90,000 and she has a $5,000 charitable contribution carryover. The carryover would be limited to 30% of AGI in the future years.


b. Now Melissa’s charitable contribution deduction for the year is $100,000, computed as follows:

Contribution to Middle State (limited to 50% of AGI) $ 45,000

Contribution to private nonoperation foundation (lesser of) The remaining 50% limit: ($100,000 - $45,000) $ 55,000 The actual contribution $ 65,000 The 30% limit on contributions to private nonoperating foundations ($200,000 x 30%) $ 60,000

Total ($45,000 + $55,000) = $100,000

Melissa would have a $10,000 ($65,000 - $55,000) charitable contribution carryover. As above in a., the carryover would be limited to 30% of AGI in the future years. pp. I:7-24 and I:7-25.

I:7-58 Because Circle (1) manufactured the computer and the computer is included in Circle’s inventory, (2) the computer is donated to a higher education institution that will use the computer for research, and (3) City College certifies that it will use the computer in its research, Circle can deduct the computer’s basis plus ½ of the gain it would have recognized if it had sold the computer (not to exceed twice the computer’s basis). Thus,

a. Circle's contribution for the current year is as follows:

Donation of main-frame $475,000 ($650,000 - [$350,000 x 0.50]) Donation of stock 100,000 Total charitable contribution $575,000

b. Circle may deduct $400,000 ($4,000,000 x 0.10) and $175,000 may be carried forward for five years. p. I:7-24.

I:7-59

2008 2009 2010

2011

Amount of deduction Amount of carryover from 2008 from 2009

$25,000 15,000

$27,500 15,000 1,500

$29,000 11,000 1,500

$22,500 -0- -0-

pp. I:7-25 and I:7-26.


Comprehensive Problem I:7-60 Wages ($150,000+3,888) $153,888 Capital Gains/Losses: Cabinets, Inc. ( 2,700) The Outdoor Corporation 3,900 1,200 Total AGI $155,088 Less itemized deductions: Medical expenses $ 4,900 Reduced by 7.5% AGI ( 11,632) -0- State income taxes Withheld from Tim 8,500 Withheld from Monica 85 Paid with 2010 return 250 $ 8,835 Charitable contribution FMV donated asset $ 96,000 Limited to 30% AGI $ 46,526 Allowed deduction $46,526 Mortgage interest Paid on original loan 2,300 Paid on home equity loan 850 $ 3,150 Miscellaneous itemized Tax advice 700 Subscriptions 400 AMA membership fee 250 1,350 Reduced by 2% AGI ( 3,102) -0- ($58,511) Less: Exemption amount ($3,700 x 2) (7,400) Net taxable income $ 89,177


Tax Strategy Problems I:7-61 If the stock is donated directly, the contribution deduction would be the $30,000 FMV of the

stock. The tax benefit would be $10,500 (0.35 x $30,000), for a net positive cash flow of $10,500. If the stock is sold and the $30,000 proceeds are donated, the following would result:

Selling price Minus: Basis Gain Times: rate Increase in taxes

$30,000 10,000 $20,000 x 0.15 $ 3,000

Contribution deduction Times: rate Tax savings

$ 30,000 x 0.35 $ 10,500

Net tax benefit $10,500 - $3,000 = $7,500

The direct contribution would result in positive cash flow of $10,500. If the stock is sold and the proceeds are donated to the college, the positive cash flow is only $7,500. This is due to the fact that Dean must report the gain on the sale of the stock in his income tax return. pp. I:7-32 and I:7-33. I:7-62

Corporation FMV on Dec. 1

Adjusted Basis

Date Purchased

Unrealized Gain/Loss Character

Sycamore 9,600 7,800 5/22/06 1,800 LTCG Oak 2,900 3,800 9/10/07 ( 900) LTCL Redwood 5,400 4,900 6/15/11 500 STCG

Rebecca should donate the Sycamore stock to charity. If she donates the Redwood stock, she would only be allowed to deduct the adjusted basis, $4,900, in the stock because she held the stock for less than one year. She should not donate the Oak stock because she would permanently lose the tax benefit of a capital loss. Rebecca should also consider bunching her donations into one year. Her present habit of making an annual $5,000 donation provides no tax benefit in the form of a deduction because the standard deduction for a single individual is greater than $5,000. If she makes two donations in one year, the $10,000 total would exceed the standard deduction and provide tax savings. So, this year, she should consider donating the Sycamore stock. p. I:7-32. Tax Form/Return Preparation Problems I:7-63 (See Instructor’s Resource Manual) I:7-64 (See Instructor’s Resource Manual)


Case Study Problems I:7-65 Mr. Brian Brown

100 East Rosebrook Mesa, Arizona 85203

Dear Mr. Brown:

As you have requested, we have determined the tax consequences of your donation of land to the Rosepark Community College. As we understand them, the facts are as follows:

1. Your estimated adjusted gross income for the current year is $100,000. Since you

plan on retiring next year, you anticipate that your adjusted gross income will be $35,000 for all future years.

2. For federal income tax purposes, you file a joint return with your wife.

3. You purchased the land 14 months ago for $50,000. The land's current appraised

value is $58,000.

4. Selling the land and donating the cash is not an alternative.

5. You do not anticipate any additional large charitable contributions in the future.

6. You feel that an appropriate discount rate is 10%.

Because the results of our analysis are based upon these facts as we understand them, if the facts are not as stated, please notify us immediately.

In general, the amount of a contribution of long-term capital property is the fair market value of the property. Thus, under the general rule, the amount of your contribution is $58,000. However, such deductions are subject to an annual limitation of 30% of your adjusted gross income. Any excess is carried over and deducted in subsequent years.


If you choose this general rule, your discounted tax savings are as follows:

Deduction Marginal Year Limited: 30% AGI X Tax Rate X Discount = Savings

2011 $30,000 .25 1.00 $ 7,500

2012 10,500 .15* 0.91 1,433 2013 10,500 .15* 0.83 1,307 2014 7,000 .15* 0.75 788

Totals $58,000 $11,028 *Depending on other itemized deductions, this rate could be 10%.

Alternatively, you may make an election to reduce the amount of the contribution from the property's fair market value to your cost in the property. If you make the election, the amount of your contribution would be reduced from $58,000 to $50,000. However, if this election is made, the annual limitation increases to 50% of your adjusted gross income.

If you choose this alternative, your discounted tax savings are as follows:

Deduction Marginal

Year Limited: 50% AGI X Tax Rate X Discount = Savings

2011 $50,000 .25 1.00 $12,500

By making the election, your discounted tax savings are $1,472 higher than if you were to use the general rule. Thus, our recommendation is that you make the election.

We will be happy to help you make this election, as well as help you in any other tax matter or question you may have. If you have any questions, please feel free to call.

Sincerely,

p. I:7-32 and I:7-33. I:7-66 You know that an accrual-method corporation can take a charitable contribution in the year the contribution is pledged as long as the amount is actually paid within two and one-half months from the end of the tax year.

The circumstances, however, indicate that the pledge probably was not actually authorized until after the year's end, thus, requiring the deduction to be taken in the subsequent year. Statement on Standards for Tax Services (SSTS) No. 3, states:


In preparing or signing a return, a member may in good faith rely, without verification, on information furnished by the taxpayer or by third parties. However, a member should not ignore the implications of information furnished and should make reasonable inquiries if the information furnished appears to be incorrect, incomplete, or inconsistent either on its face or on the basis of other facts known to a member. (Emphasis added.) This is a difficult situation. You don't want to offend or possibly lose a valuable client. At

the same time, however, you recognize your ethical obligations and responsibilities. One possible action you could take is to request a conference with Bill in order to explain your position. In this conference, you could outline the risks (penalties) to both him and you that taking such a position would create. You might also do some forecasting of next year's income in order to demonstrate that the difference between taking the deduction this year or next is merely the difference in the present values of the tax savings (next year's being discounted only one year). At a constant 0.35 tax rate and a discount rate of 10%, the present value of next year's tax savings is $6,365 ($20,000 x 0.35 x 0.909). Thus, the difference amounts to only $637 ($7,000 - $6,363).

If Bill continues to insist on taking the deduction this year, and if you know that the authorization for the pledge was backdated, you should resign from the engagement. p. I:7-26. Tax Research Problem I:7-67 A taxpayer can deduct ordinary business expenditures, but cannot deduct personal interest (§162,163(h)(1)). Personal interest includes interest paid on “underpayments of individual Federal, State, or local income taxes” (Reg. §1.163-9T(b)(2)(i)(A)). Such an underpayment does not constitute a business expense, even when the “income underlying the deficiency originates from the taxpayer’s business” (Kikalos v. Comm., 84 AFTR 2d 99-5933). Thus, Mr. Hancock’s $18,000 interest payment is non-deductible personal interest, even though the interest related to his business as a lawyer. I:7-68 The total amount of medical expenses that Smith may claim in the current year is 0 ([$1,800 + $500] - [$60,000 X 0.075]). The $500 spent for pool maintenance and the $1,800 of other medical expenses qualify as medical expenses, but they do not exceed the 7.5% of AGI floor. The $8,000 (the increase in the value of the home due to the pool) does not qualify as a medical expense.

The Regulations under Sec. 213 state that a capital expenditure for a permanent improvement or betterment of property may "qualify as a medical expense to the extent that the expenditure exceeds he increase in the value of the related property, if the particular expenditure is related directly to medical care" [Reg. Sec. 1.213-1(e)(1)(iii)]. In other words, a deduction is allowed for capital expenditures only if the taxpayer pays more than the increase in FMV. In the case at hand, it must be determined if Smith paid more than the FMV of the property.


In P.A. Lerew [1982 PH T.C. Memo ¶82,483, 44 TCM 918] and J.H. Robbins [1982 PH T.C. Memo ¶82,565, 44 TCM 1254], the taxpayers were denied medical deductions for existing pools in homes they had purchased. The courts contended that the actual price paid for the home and pool (assuming an arm's length transaction) should be exactly equal to its FMV. Based on these and other discussions and the income tax regulations, it appears that Mr. Smith may deduct the $12,000 ($20,000 - $8,000) only if he can show that he paid $12,000 more than the increase in the FMV of the property.

“What Would You Do In This Situation?” Solutions Ch. I:7, p. I:7-37. Giving to Both: Goodwill and the IRS.

According to the AICPA SSTS and Treasury Department Circular 230, you should only take a position on the return, which has a reasonable possibility of being sustained on its merits if it is challenged administratively or judicially. This is particularly true on so-called "hot-button" issues like charitable donations of goods, which are subject to intense scrutiny by the IRS because of widespread valuation abuses in the past. Furthermore, under current law, a taxpayer can only take a deduction for clothing and household items that are in “good” condition.

Assuming these items are considered in good condition, several valuation and compliance procedures must be met in order for you to qualify Mr. and Mrs. Nice's donations to Goodwill as a charitable deduction on their tax return. First you must show that the donee is a qualified organization.

Second, you must identify the type of property donated and how it is to be used by the qualified organization. Here the reasonable assumption is that Goodwill will resell the goods in one of its thrift stores in the U.S. Your clients’ records already indicate the listing of goods contributed, original purchase prices, and condition of the goods at the time of contribution made in the current tax year. Because the total original cost basis in the goods was approximately $15,000, you will most likely use Form 8283 in conjunction with Mr. and Mrs. Nice's Schedule A on their joint 1040 return.

The real issue, which remains, is valuation. Most accountants use a rule of thumb, which says to claim ten percent of the original value of the items being donated. But does this rule best serve your client's interest? And would it be ethical to claim a higher value? According to the IRS publication 561 Determining the Value of Donated Property, certain guidelines may be used. First, if the total value of the donation claim is over $5,000, an independent outside appraisal will be required to be submitted with the return. In addition, comparable sales may be used to find out what the donated goods will sell for in the Goodwill Thrift Shops. For example, the average price of jeans sold is $7 while bridal gowns sell for $25. In addition, you might consult valuation guides such as Cash for Your Used Clothing, by William R. Lewis or other valuation texts.

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cost of cosmetic surgery

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