vol 01 chapter 10 2015

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Individual Income Taxes

1

Chapter 10

Deductions and Losses:Certain Itemized Deductions

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The Big Picture (slide 1 of 3)

• John and Susan Williamson have been renting an apartment since they were married. – They now want to purchase their own home.

• Their current monthly rent is $2,000.– They are willing to spend $2,500 per month

on an after-tax basis if necessary to purchase their first home.

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• After months of house hunting, they have found the perfect home, but they fear it may be too expensive.

• Using a standard mortgage to finance the purchase, the total cash outlay during the first year of ownership would be as follows.

Principal payments $ 2,000Interest payments 37,000Real estate taxes 4,000

Total cash outlay $43,000

Monthly cost ($43,000 ÷ 12) = $ 3,583

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• Alternatively, if they use investments to secure financing, they could qualify for a lower interest rate.– Reduces the interest charge from $37,000 to $35,000.

• Their Federal AGI will be $200,000 and their taxable income will be between $160,000 and $185,000 for the year.– They do not itemize their deductions.

• Can John and Susan Williamson afford to pursue their dream of home ownership?– Read the chapter and formulate your response.

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Itemized Deductions(slide 1 of 2)

• Personal expenditures that are deductible from AGI as itemized deductions include: – Medical expenses– Certain taxes– Mortgage and investment interest– Charitable Contributions– Miscellaneous itemized deductions

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Itemized Deductions(slide 2 of 2)

• Itemized deductions provide a tax benefit only to extent that, in total, they exceed the standard deduction amount for the taxpayer

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The Big Picture - Example 1

Allowable Itemized Deductions• Return to the facts of The Big Picture on p. 10-1. • With the purchase of a home, John and Susan will be able to

itemize their deductions for the first time instead of claiming the standard deduction. – Assuming the home mortgage interest expense and real estate taxes

meet the requirements discussed in this chapter, they will be deducted from AGI.

– Their total itemized deductions will exceed the amount of their allowable standard deduction.

• Further, other qualifying expenditures (e.g., state income taxes and charitable contributions) likewise will be deductible as itemized deductions, providing an explicit tax benefit to the Williamsons.

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Medical Expenses (slide 1 of 6)

• Medical expenses are deductible to the extent unreimbursed medical expenses, in total, exceed 10% of AGI– For taxpayers age 65 and older, the threshold is

7.5% of AGI until 2017, when it increases to 10%– Prior to 2013, the percentage threshold for regular

income tax purposes was 7.5% of AGI for all taxpayers

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• Example of medical expense deduction limitation:– Amy, age 24, has AGI of $10,000 and medical

expenses of $1,500– Amy’s medical expense deduction = $500

[$1,500 – ($10,000 × 10%)]

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• Example of medical expense deduction limitation:– Bob, age 67, has AGI of $4,000 and medical

expenses of $1,000– Bob’s medical expense deduction = $700

[$1,000 – ($4,000 × 7.5%)]

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• Expenditures for: – The diagnosis, cure, mitigation, treatment,

prevention of disease, or – The purpose of affecting any structure or function

of the body of the taxpayer, spouse, or dependents– Includes prescription drugs and insulin

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• Does not include the cost of items such as :– Unnecessary cosmetic surgery– General health items– Nonprescription drugs

• If cosmetic surgery is deemed necessary, it is deductible as a medical expense– Cosmetic surgery is necessary when it ameliorates

• A deformity arising from a congenital abnormality• A personal injury, or • A disfiguring disease

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• Medical expenditures are deductible in year paid – Includes payment by check or credit card

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Medical Expenses• Return to the facts of The Big Picture on p. 10-1.

• The Williamsons had medical expenses of $25,000.– $3,000 of medical expenses were reimbursed by

their insurance company. • With AGI of $200,000, the itemized deduction

for medical expenses is limited to $2,000.– [($25,000 − $3,000) – (10% × $200,000)]– Note: the Williamsons will not receive a tax

benefit from their medical expenses unless:• Unreimbursed medical expenses exceed $20,000, and • They itemize their deductions.

Examples of Deductible and Nondeductible Medical Expenses

15Exhibit 10.1

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Nursing Home Expenditures

• If primary reason for being in nursing home is medical, costs (including meals and lodging) qualify

• If primary purpose of placement in home is personal, only specific medical costs qualify (no meals or lodging)

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Special School Expenditures

• Medical expense deduction may include the expenses of a special school for a mentally or physically handicapped individual– Deduction is allowed if a principal reason for

sending the individual to the school is the school’s special resources for alleviating the infirmities

– In this case, the cost of meals and lodging, in addition to the tuition, is a proper medical expense deduction

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Capital Medical Expenditures

• May include a pool, air conditioners if they do not become permanent improvements, dust elimination systems, elevators, etc.

• Must be medical necessity, advised by a physician, used primarily by patient, and expense is reasonable

• Full amount of cost is medical expense in year paid• Maintenance on capital expenditures also medical

expense

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Capital Improvement to Home

• Deductible medical expense only to extent cost exceeds increase in value of home– Appraisal costs related to capital improvements are

also deductible, but not as medical expenses

• Exception: removal of structural barriers to home of handicapped are deemed to add no value to home– Thus, full amount is a medical expense

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Medical Care for Spouse and Dependents

• Taxpayer may deduct cost of medical care for spouse and dependents– Dependents need not meet gross income or joint

return tests– Medical expenses of children of divorced parents

can be deducted by non-custodial parent even though child is claimed as dependent of custodial parent

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Medical Transportation and Lodging

• Transportation costs to and from medical care are deductible– Mileage allowance of 23.5 cents per mile (in 2014) may be

used instead of actual out-of-pocket automobile expenses

• Lodging while away from home for medical care– Allowable amount is $50 per person per night

• If parent and/or aide needs to accompany patient, their expenses are also deductible

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Medical Expenses• Return to the facts of The Big Picture on p. 10-1. • Because of her disabilities, John’s mother, Martha, moves in with them.

– She becomes their dependent. • The family physician advises them that Martha needs specialized treatment

for her heart condition. – John and Martha fly to Cleveland, Ohio, where Martha receives therapy

• Expenses in connection with the trip are as follows:– Round-trip airfare ($250 each) $500– Lodging in Cleveland for two nights ($120 each per night) $480

• Assuming that the Williamsons itemize their deductions, the medical expense deduction is as follows:– Transportation $500 – Lodging ($50 per night per person) $200

• Because Martha is disabled, it is assumed that John’s accompanying her is justified.

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Medical Insurance Premiums(slide 1 of 2)

• Premiums paid for medical care insurance are deductible medical expenses– If employer pays all or part of taxpayer’s medical

insurance premiums the amount paid by employer is

• Not included in gross income by employee

• Not deductible by the employee as medical expense

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Medical Insurance Premiums(slide 2 of 2)

• For self-employed, 100% of insurance premiums are deductible for AGI– Includes amounts paid for taxpayer’s spouse and

dependents

– Not allowed if taxpayer is eligible to participate in a subsidized health plan maintained by any employer of the taxpayer or the taxpayer’s spouse

• Premiums paid for qualified long-term care insurance are deductible medical expenses– Subject to limitations based on age of the insured

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Medical Insurance Premiums• Return to the facts of The Big Picture on p. 10-1. • John Williamson is the sole practitioner in his

unincorporated accounting firm. • During the year, he paid health insurance premiums

of $8,000 for his own coverage and $7,000 for coverage for his wife, Susan. – John can deduct $15,000 as a business deduction (for AGI)

in computing their taxable income

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Reimbursement by Medical Insurance

• If reimbursed in same year as expense paid:– Reimbursement offsets medical expense – Amount deductible is excess of expenses over

reimbursement

• If reimbursed in the year after medical expenses were paid:– Reimbursement is income only to extent medical deduction

decreased taxable income in the earlier year (tax benefit rule)

– If standard deduction was taken in year expenses were paid, none of the reimbursement is included in income

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Example of Medical Reimbursements (slide 1 of 2)

• In 2014, taxpayer, age 35, paid medical expenses = $4,200; In 2014, reimbursed $800 by insurance company– For 2014, deductible medical expense is

$3,400 – (10% × AGI)

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Example of Medical Reimbursements (slide 2 of 2)

• In 2014, taxpayer, age 35, paid medicalexpenses of $4,200; In 2015, reimbursed $800 by insurance company– For 2014, deductible medical expense is

$4,200 – (10% × AGI)– For 2015, reimbursement is income to extent

taxpayer received a tax benefit from medical expense deduction in 2014

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Health Savings Accounts

• Used in conjunction with a high deductible medical insurance policy– Employee contributions to HSA are deductible for AGI and

earnings on funds in account are not taxable

– Deductible contributions are limited to the sum of the monthly limitations. The monthly deductible amount is limited to the lesser of one twelfth of:

• $3,300 for self-only ($6,550 for family coverage) in 2014

– Withdrawals from HSA are excludible to the extent used for qualified medical expenses

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Taxes (slide 1 of 4)

• State, local, and foreign income and real property taxes are deductible in the year paid– Real property taxes do not include taxes assessed

for local benefits • e.g., Special assessments for streets, sidewalks, curbing,

and other similar improvements

• State and local personal property taxes based on value (ad valorem) are deductible in the year paid

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• Other taxes such as FICA, excise, etc., are not deductible– May be deductible if incurred in business or

production of income activity

• Fees are not deductible as tax

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• Real estate taxes for year property is sold must be apportioned between the buyer and the seller– Failure to correctly apportion requires offsetting

adjustments to seller’s amount realized and buyer’s adjusted basis

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• Can elect to deduct either state & local income taxes or sales/use taxes– For state and local income taxes, deduct amounts paid

during year:• Amounts withheld• Estimated tax payments• Amounts paid in current year for prior year’s liability

– For sales/use taxes, deduct either:• Actual sales/use tax payments or • Amount from an IRS table

– Table amount may be increased by sales tax paid on certain specific items (e.g., purchase of motor vehicles, boats, etc.)

– This deduction alternative was available through 2013• Many tax professionals believe that Congress will extend this provision

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Deductible Property Taxes• Return to the facts of The Big Picture on p. 10-1. • If the Williamsons purchase their home, the real

estate taxes they pay will be deductible from AGI as an itemized deduction.

• If they also pay personal property tax on their car, the payment may be only partially deductible. – In their state, the motor vehicle registration tax is 2% of the

value of the vehicle plus 40 cents per hundredweight. – The Williamsons car is valued at $20,000 and weighs 3,000

lbs. – Their annual registration fee is $412.

• $400 (2% of $20,000) is deductible as a personal property tax.• The remaining $12, based on the weight of the car, is not

deductible.

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Interest Expense

• Deduction of interest expense is limited to:– Interest on qualified student loans– Investment interest – Qualified residence (home mortgage) interest– Business interest

• Personal interest expense is not deductible

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Interest on Qualified Student Loans

• Deductible for AGI, subject to limits– Maximum deduction is $2,500 per year – Deduction is phased out for taxpayers with

modified AGI (MAGI) between $60,000 and $75,000 ($125,000 and $155,000 on joint returns)

– Not allowed for those claimed as a dependent or for married filing separate returns

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Qualified Residence Interest (slide 1 of 4)

• Interest on indebtedness secured by the principal residence and one other residence (qualified residences)

• Interest must be on acquisition indebtedness or home equity loans

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• Acquisition indebtedness: amounts incurred to acquire, construct, or substantially improve the qualified residences– Interest paid on aggregate acquisition indebtedness

of $1 million or less ($500,000 for married, filing separately) is deductible as qualified residence interest

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• Home equity indebtedness: loans secured by qualified residences

• Interest is deductible only on portion of home equity loan that does not exceed the lesser of:– $100,000 ($50,000 for married, filing separate), or– FMV of home – acquisition indebtedness

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• Thus, maximum loans on qualified residences that will produce qualified residence interest is $1.1 million

• Interest on mortgage debt exceeding $1.1 million or on mortgage debt relating to nonqualified residence (e.g., second vacation home) is nondeductible personal interest

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Acquisition Indebtedness• Return to the facts of The Big Picture on p. 10-1. • John and Susan will need to borrow at least a portion of the

purchase price of their new home– A standard mortgage likely will qualify as acquisition indebtedness.– However, the interest on the acquisition indebtedness will be fully

deductible only if • The amount of the mortgage is $1 million or less (assuming they file a

joint return), and • The mortgage is secured by the home.

• Recall that they are also considering what appears to be a less expensive route of using their investments to secure the debt.– If they choose this alternative, the interest will not be deductible as

qualified residence interest because the loan would not be acquisition indebtedness.

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Interest Paid For Services (slide 1 of 2)

• “Points” paid for the use or forbearance of money qualify as deductible interest– Cannot be a service charge if they are to qualify as

deductible interest

• Points generally must be capitalized and amortized over the life of loan

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Interest Paid For Services (slide 2 of 2)

• Exception: Points paid in the acquisition or improvement of principal residence– Entire amount of such points are deductible in the

year paid– Points paid to refinance an existing home

mortgage must be capitalized and amortized over the life of the new loan

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Mortgage Insurance Payments

• Mortgage insurance premiums are deductible as interest if they relate to a qualified residence of the taxpayer– The deduction begins to phase out for taxpayers

with AGI in excess of $100,000 ($50,000 for married taxpayers filing separately)

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Investment Interest

• Investment interest on loans whose proceeds are used to purchase investment property may be deductible– e.g., Investment property may include stock,

bonds, and land held for investment

• Deduction of investment interest expense is limited to net investment income

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Classification of Interest Expense

• Whether interest is deductible for AGI or as an itemized deduction (from AGI) depends on purpose of indebtedness – If related to a business or the production of rent or royalty income

• Interest is deductible for AGI

– If incurred for personal use, such as qualified residence interest• Deduction is reported on Schedule A, Form 1040 if taxpayer itemizes• However, interest on a student loan is a deduction for AGI

– If the taxpayer incurs debt in relation to his or her employment• Interest is considered to be personal, or consumer, interest

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Charitable Contributions(slide 1 of 2)

• Individuals and corporations may deduct contributions made to qualified domestic organizations

• Contributor must have donative intent and expect nothing in return– If contributor receives tangible benefit, the FMV

of such benefit reduces the amount of the charitable contribution deduction

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Charitable Contributions(slide 2 of 2)

• Exception to tangible benefit rule– Allows deduction of 80% of amount paid for the

right to purchase athletic tickets from colleges and universities

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Contribution of Services

• No deduction is allowed for the contribution of services– Unreimbursed expenses related to the services are

deductible– Out-of-pocket transportation costs or a standard

mileage rate of 14 cents per mile are deductible– Deductions are also permitted for transportation,

reasonable expenses for lodging, and the cost of meals while away from home incurred in performing the donated services

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Nondeductible Items

• The following items may not be deducted as charitable contributions:– Dues, fees, or bills paid to country clubs, lodges, fraternal

orders, or similar groups

– Cost of raffle, bingo, or lottery tickets

– Cost of tuition

– Value of blood given to a blood bank

– Donations to homeowners associations

– Gifts to individuals

– Rental value of property used by a qualified charity

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Qualified Organizations

• To be deductible, contributions must be to a qualified domestic nonprofit organization or state or possession of U.S. or any subdivisions thereof– Many (but not all) qualified domestic charities are

listed in IRS Publication #78

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Record-Keeping Requirements

• No deduction is allowed for charitable contributions unless the taxpayer has appropriate documentation and substantiation– The specific type of documentation required

depends on the amount of the contribution and whether the contribution is made in cash or noncash property

– Special rules may apply to gifts of certain types of property (e.g., used automobiles) where Congress has noted taxpayer abuse in the past

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Ordinary Income Property

• Defined: assets that would produce ordinary income or short-term capital gain if sold

• Contribution amount– FMV of asset less ordinary income (or STCG)

potential; generally the lower of adjusted basis or FMV

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Capital Gain Property

• Defined: assets that would produce long-term capital gain or Section 1231 gain if sold

• Contribution amount– Generally FMV of asset

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Exceptions to FMV Deduction of Capital Gain Property (slide 1 of 3)

• Private nonoperating foundations– Deduction for contributions to private

nonoperating foundations must be reduced by the amount of long-term capital gain potential

– Thus, the contribution deduction is limited to the adjusted basis

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• For contributions of tangible personalty– The charitable deduction may limited to the

adjusted basis if the asset contributed is not used in charity’s exempt function

– This reduction generally does not apply if• The property is, in fact, not put to an unrelated use, or

• At the time of the contribution, it was reasonable to anticipate that the property would not be put to an unrelated use by the donee

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• For contributions of certain types of intellectual property– Contribution deduction is limited to the lesser of

the taxpayer’s basis in the property or the property’s fair market value

– Includes patents, certain copyrights, trademarks, trade names, trade secrets, know-how, and some software

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Example of Contributions of Tangible Personalty

• Taxpayer contributes painting to local charity: FMV $100,000 and adjusted basis $10,000– If charitable organization is a local museum that

hangs the painting for patrons to view, taxpayer has $100,000 contribution deduction

– If charitable organization is a local church that sells the painting immediately to obtain funds for its operation, taxpayer has $10,000 contribution

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Charitable ContributionLimitations (slide 1 of 4)

• 50% limit– In no case can the charitable contribution deduction for a

year exceed 50% of the taxpayer’s AGI

– Contributions of cash, ordinary income property, and certain capital gain property (where the contribution amount is adjusted basis) are subject to the 50% limit (50% assets)

– Generally, applies to contributions to public charities• e.g., Churches, schools, hospitals, and Federal, state, or local

governmental units

• Also applies to private operating foundations and certain private nonoperating foundations

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• 30% limit– Charitable contribution deduction for certain assets

cannot exceed 30% of the taxpayer’s AGI• Applies to 30% assets which are:

– Capital gain property for which the contribution amount is FMV

– Certain contributions to private nonoperating foundations

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• 30% limit– Taxpayer can elect to treat capital gain property as

50% assets by limiting the amount of such contributions to their adjusted bases

– Referred to as the reduced deduction election• Enables the taxpayer to move from the 30% limitation

to the 50% limitation

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• 20% limit– Certain contributions of capital gain property to

private nonoperating foundations

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Charitable Contributions Carryover

• Contributions that cannot be taken in current year due to limitations may be carried forward for 5 years– Contributions carried forward retain their

classification• e.g., If the contribution originally involved 30%

property, the carryover will continue to be classified as 30% property in the carryover year

– When using carryovers, current contributions are used first, then carryovers used on a FIFO basis

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Example of Charitable Contribution AGI Limits

• Taxpayer, AGI $100,000, contributed $40,000 cash and long-term stocks with a FMV of $35,000 and a basis of $8,000 to a University

• 50% limit = $50,000 30% limit = $30,000– Amount of deduction = $50,000 (40,000 cash +

10,000 stock)– Contribution carryforward = $25,000 stock (as

30% asset)

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Miscellaneous Itemized Deductions

• Some expenditures are deductible only to the extent they exceed 2% of AGI

• Examples include:– Professional dues– Uniforms– Tax return prep fees– Job-hunting costs– Certain investment expenses– Hobby losses– Unreimbursed employee expenses

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Misc. Itemized Deductions Not Subject to 2% of AGI Floor

• Examples include:– Gambling losses to the extent of gambling

winnings– Impairment-related work expenses of a

handicapped person– Deduction for repayment of amounts under a claim

of right if more than $3,000– Unrecovered investment in an annuity contract

when annuity ceases by reason of death

Itemized Deduction Phaseout (slide 1 of 3)

• For higher income taxpayers, the otherwise allowable itemized deductions are reduced by 3% of the amount AGI exceeds the applicable threshold amount– The reduction in itemized deductions is limited to

80% of affected itemized deductions

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• The limitation applies to the following frequently encountered itemized deductions:– Taxes

– Home mortgage interest, including points

– Charitable contributions

– Unreimbursed employee expenses and all other expenses subject to the 2%-of-AGI floor

• Certain itemized deductions are not subject to phaseout including:– Medical expenses

– Investment interest expense

– Wagering losses, and

– Casualty and theft losses68


• The applicable threshold amounts in 2014 for the itemized deduction phaseout are as follows:

Filing status AGI Threshold

Single $254,200

Married, filing jointly 305,050

Head of household 279,650

Married, filing separately 152,525

• These threshold amounts are adjusted for inflation annually

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Refocus On The Big Picture (slide 1 of 2)

• Because qualified residence interest and real estate taxes are deductible, the after-tax cost of a home purchase is reduced by the tax savings associated with these itemized tax deductions.

• Given the Williamsons’ projected taxable income, they are in the 28% Federal and 6% state tax brackets for an aggregate marginal tax bracket of 34%.

– As a result, the after-tax cost of financing the purchase of the home will be:

Nondeductible principal payments $ 2,000Deductible qualified residence interest and real estate taxes [($37,000 + $4,000) X (1- .34)] 27,060Total $29,060

After-tax monthly cost ($29,060 ÷ 12) $ 2,422

• Because the Williamsons will be able to itemize their deductions if they purchase a new home and will be able to deduct most of their monthly house payment, the home purchase will be affordable.

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Refocus On The Big Picture (slide 2 of 2)

• What if the Williamsons choose to finance the purchase of their home using their investments as security for the loan? – What may appear to be a cost-effective approach ends up being more costly

on an after-tax basis.

• With this approach, the interest expense is not deductible.– It is not qualified residence interest or investment interest.

• Therefore, the after-tax cost of financing the home using this approach makes the home unaffordable.

Nondeductible principal and interest payments $37,000Deductible real estate taxes [$4,000 X (1 - .34)] 2,640Total $39,640

After-tax monthly cost ($39,640 ÷ 12) $ 3,303

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 72

If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact:

Dr. Donald R. Trippeer, CPA [email protected]

SUNY Oneonta

vol 01 chapter 10 2015

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