1. Chapter 6 Individual For AGI Deductions © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

2. 6-2 Learning objectives 1. Identify the for AGI deductions directly related to business activities 2. Describe the loss limitation rules for passive activities, the rental use of a home, and home office deductions 3. Explain the for AGI deductions indirectly related to business activities and for AGI deductions that subsidize specific activities

3. 6-3 Deductions for AGI Three categories of deductions for AGI Directly related to business activities Indirectly related to business activities Deductions subsidizing specific activities

4. 6-4 Deductions for AGI Directly Related to Business Activities Taxpayers are allowed to deduct expenses incurred to generate business income For tax purposes activities are either profit-motivated or motivated by personal objectives Profit-motivated activities are classified as 1. business activities (called “trade or business”) or 2. investment activities

5. 6-5 Deductions for AGI Although both are motivated primarily by profit, business activities are distinguished from investment activities: Trade or Business activities require a relatively high involvement or effort from the taxpayer where as investment activities don’t require Investment activities involve investing in property for appreciation or for income payments

6. 6-6 Deductions for AGI Trade or Business Expenses must be: directly connected to the business activity ordinary and necessary for the activity (e.g., appropriate and helpful for generating a profit) reasonable in amount (not extravagant) Expenses are claimed on Schedule C Revenues from the same activity are also reported on the same Schedule C The net income or loss from Schedule C is transferred to Form 1040 (page 1) on line 12

7. 6-7 Deductions for AGI Rental & Royalty Expenses Claimed above the line (for AGI) Could either be an investment activity or a trade activity depending on facts Taxpayers report expenses and revenue on Schedule E and transfer the net income or loss from Schedule E to Form 1040 (page 1), line 17 Flow-through Entities Expenses and losses incurred by a flow-through entity pass through to the entity owners who typically report these amounts on Schedule E and Line 17

8. 6-8 Deductions for AGI Losses Taxpayers disposing of trade or business assets at a loss are allowed to deduct the loss for AGI Losses from investment assets (called capital assets) are offset against capital gains If capital losses exceed capital gains, this is called a net capital loss A net capital loss is deducted for AGI but limited to $3,000. Losses in excess of the $3,000 limit are carried forward indefinitely to subsequent years

9. 6-9 Deductions for AGI Flow-through entities Income, expenses, and losses from flow-through entities pass through to their owners. Expenses and losses from flow-through entities are subject to certain restrictions (basis, at-risk, and passive loss rules)

10. 6-10 Tax Basis Limitation Losses may not exceed an investor’s tax basis in the activity. Excess loss carried over until event occurs to create more tax basis. Increases to tax basis Cash invested Share of undistributed income Share of debt Decreases to tax basis Cash distributions Prior year losses

11. 6-11 At-Risk Limitation Losses may not exceed an investor’s amount at- risk in the activity. Excess loss carried forward until event occurs to create additional amount at-risk. At-risk amount calculated like tax basis except: The types of debt that increase a taxpayer’s at-risk amount is more restrictive than the types of debt that increase tax basis.

12. 6-12 Passive Activity Limitation Applied after tax basis and at-risk limitations. Losses from “passive activities” may only be deducted to the extent the taxpayer has income from passive activities or when the passive activity is sold. A passive activity is a trade or business or rental activity in which the taxpayer does not materially participate. Participants in rental real estate and limited partners without management rights are generally considered to be passive participants All other participants are considered to be passive unless their involvement is “regular continuous and substantial” Seven factors for testing material participation

13. 6-13 Loss Limitations - Rental Use of Home Three types of classifications for second home: Residence with minimal rental use (rents for 14 or fewer days) Residence with significant rental use (rents home for 15 or more days) Nonresidence A property is a residence if the taxpayer uses the home for personal purposes for more than the greater of 14 days or 10 percent of the rental days during the year

14. 6-14 Residence with Minimal Rental Use The taxpayer must live in the home for at least 15 days and rent it out for 14 days or less Rental income can be excluded No rental expenses except those that are personal itemized deductions (home mortgage interest and real estate taxes)

15. 6-15 Residence with Significant Rental Use (Vacation home) Rent home for 15 days or more Personal use, greater of 15 days More than 10% of the total FMV rented days. Include rental revenues in gross income and allocate expenses between personal use and rental use.

16. 6-16 Residence with Significant Rental Use Expense Allocation Expenses allocated to personal use are not deductible unless deductible under other provisions (generally mortgage interest and real estate taxes) Expenses to acquire tenants deductible in full Expenses allocated to rental use deductible only to the extent of gross rental income after deducting expenses to acquire tenants (generally no losses for a vacation home) Expenses must be deducted in a specific order.

17. 6-17 Residence with Significant Rental Use Expense Allocation Three categories or “tiers” of expenses: Tier 1: expenses that are deductible without regard to rental activity (interest/real estate taxes/expenses to acquire tenants) Tier 2: all other expenses except for depreciation Tier 3: depreciation Generally expenses allocated based on # of days used for each activity/total days used. Exception for tier 1 expenses which can be allocated based on total days in the year instead of days used (called the “Tax Court” or “Bolton” method)

18. 6-18 Nonresidence (Rental Property) The taxpayer includes all income and deducts all rental expenses. However, if the property is used for even a day of personal use the expenses must be allocated. Taxpayer not allowed to deduct the personal use portion of tier 1 interest expenses because the property doesn’t qualify as a residence. Personal use portion of tier 1 real property taxes are deductible as an (from AGI) itemized deduction

19. 6-19 Business Use of The Home: Home Office Expense Deduction To qualify for a “home office” deduction, a taxpayer must use her home or part of her home exclusively and regularly as either: The principal place of business for any of the taxpayer’s trade/business A place to meet with patients/clients in the normal course of business

20. 6-20 Home Office Expense Deduction If employee, deducted as unreimbursed employee business expense If self-employed, deducted for AGI but deduction limited to business income before the deduction

21. 6-21 Home Office Expense Deduction Must allocate expenses between personal and business use of home Direct vs. indirect expenses Indirect expenses allocated based on square footage Limitations on deductibility of expenses If employee, deductions are miscellaneous itemized deductions subject to two percent floor If self-employed, deduct for AGI

22. 6-22 Home Office Expense Deduction Deduction is limited to gross income derived from business use of home. Deduct using same tier 1 – 3 sequence used for vacation homes Depreciation expense Reduces basis in home Gain on sale due to depreciation is ineligible for exclusion Gain is taxed at a maximum 25 percent rate as unrecaptured §1250 gain

23. 6-23 Deductions Indirectly Related to Business Activities Individual Retirement Accounts Moving Expenses Health Insurance Deduction by Self- Employed Taxpayers Penalty for Early Withdrawal of Savings Self-Employment Tax Deduction

24. 6-24 Individual Retirement Accounts (IRAs) For AGI deduction for contributions Generally not allowed if participant in employer- sponsored plan unless For single taxpayers Taxpayer is single, deduction allowed if participate in employer plan but income is below certain thresholds In 2013, lesser of $5,500 or earned income If 50 years or older at end of year limit is $6,500  Additional “catch-up” contribution

25. 6-25 Individual Retirement Accounts (IRAs) For AGI deduction for contributions Generally, not allowed if participant in employer- sponsored plan unless For married taxpayers deduction is allowed if participate in employer plan but income is below certain thresholds In 2013, lesser of $5,500 or earned income of both spouses reduced by other spouse’s contributions to IRA or Roth IRA If 50 years or older at end of year limit is $6,500  Additional “catch-up” contribution

26. 6-26 Individual Retirement Accounts (IRAs) May make nondeductible contributions Deductible + nondeductible cannot exceed $5,500 for one taxpayer (plus catch-up) Must contribute by April 15 th of subsequent year

27. 6-27 Individual Retirement Accounts (IRAs) Distributions taxed as ordinary income 10% penalty if before 59 ½ Certain exceptions Medical expenses, insurance premiums, first home Same minimum distributions apply as to qualified contribution plans nontaxable percentage = nondeductible contributions divided by balance of account

28. 6-28 Roth IRAs Nondeductible contributions Contributions to a Roth IRA Same $5,500 limit ($6,500 if 50 or older at year end) Phase-out based on AGI

29. 6-29 Roth IRAs Distributions from a Roth Distributions of contributions never taxed Qualified distributions of earnings from Roth not taxed Account must be open for five years before can receive qualified distributions and  Taxpayer must be at least 59 ½ to receive qualified distribution or  Distributions on death of taxpayer or  Taxpayer is disabled or  First home (limited to $10,000) No minimum distribution requirements

30. 6-30 Roth IRAs Rollover from traditional to Roth Tax consequences Why roll over? Marginal tax rates Contribution limits to Roth are effectively higher  $5,500 limit of after tax vs. before-tax dollars

31. 6-31 Moving Expenses The cost of moving personal possessions is not a direct cost of doing business or being employed Moving Expenses are deductible for AGI if the move meets two tests 1. A distance test 2. A time test associated with a move

32. 6-32 Moving Expenses Distance test – the new job site must extend existing commute by 50 miles  A new job site is required, but a new employer is not essential Time test - Taxpayer must be employed at least 39 of 52 weeks or be self-employed for 78 of the 104 weeks following the move Taxpayers are allowed to deduct a mileage rate in lieu of the actual costs of driving their personal automobiles during the move (24 cents per mile in 2013)

33. 6-33 Deductions Indirectly Related to Business Activities Health Insurance deduction by Self-Employed Taxpayers Deduction provides equity with employees who receive health insurance as a qualified fringe benefit Insurance must be provided for taxpayer or dependents who are not eligible for employer- provided health insurance Penalty for early withdrawals of savings Reduces the taxpayer’s net interest income to the amount actually received

34. 6-34 Self-Employment Tax Deduction Employer and employees each pay the employee’s Social Security tax Employers deduct the portion of Social Security taxes they pay for employees Self-employed individuals are required to pay SE tax in lieu of Social Security tax Self-employed tax payers are allowed to deduct the employer portion of the SE tax they pay to compensate for employers deducting their portion of Social Security

35. 6-35 Deductions Subsidizing Specific Activities Alimony payments are deductible for AGI to maintain equity Interest expense on qualified educational loans Qualified educational expenses

36. 6-36 Deduction for Education Interest Deduction for Interest expense on loans used to fund qualified educational expenses Up to $2,500 of interest on education loans is deductible for AGI The interest deduction is phased-out for taxpayers with AGI exceeding $60,000 ($125,000 filing joint) The deduction is eliminated for taxpayers with AGI exceeding $75,000 ($155,000 filing joint)