1. Chapter 17 Tax Consequences of Personal Activities McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., All Rights Reserved.
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Objectives Taxable and nontaxable gratuitous receipts
Divorce, alimony, child support
Taxation of Social Security benefits
Itemized deductions for medical, taxes, charity
Casualty and theft
Hobby income and expenses
Tax benefits of home ownership
AMT

3. Gross Income
Sec. 61 of IRC states that gross income means all income from whatever source derived – even income from personal activities

4. Gratuitous Receipts Prizes and awards are taxable
Some exceptions to taxability if awards are given to charity
Scholarships are excluded to the extent spent on
Tuition, books, fees, equipment required by institution
Gifts, inheritances, and life insurance death benefits are excluded from gross income

5. Legal Settlements and Government Payments
Legal settlements are taxable unless they represent compensation for physical injury or illness
Workers’ compensation payments are nontaxable
Unemployment compensation payments are taxable
Need-based payments like welfare and food stamps are nontaxable
Social security is nontaxable or taxed on 50% or 85% depending on income level

6. Application Problem 1
Marcy Tucker received the following items this year. Determine to what extent each item is included in her AGI.
A $25,000 cash gift from her parents
A $500 cash award from the local Chamber of Commerce for her winning entry in a contest to name a new public park
$8,000 alimony from her former husband
$100,000 cash inheritance from her grandfather

7. Divorce Property settlements are nontaxable - like gifts
The transferred property takes on a carryover basis
Alimony is taxable to the recipient, deductible for AGI by the payer
Child support is not taxable nor deductible

8. Divorce Example
Ted and Alice divorced on July 1, As part of the property settlement, Ted transferred ½ ownership of the house (FMV $250,000) to Alice. In addition, he agrees to pay $450 per month alimony and $800 per month child support. What is the taxable effect of the divorce on Ted?
Ted receives no deduction for the transfer of the house or payment of child support. He does have a deduction for AGI of $2,700 ($450 x 6 months) for alimony paid.
What is the taxable effect of the divorce on Alice?
Alice derives no income from the child support or transfer of the home. However, she must report taxable income from receipt of alimony of $2,700.

9. Personal Use Assets and Personal Expenses
Personal use assets may not be depreciated
The sale of personal use assets usually results in losses which are not deductible
Gains from the sale of personal use assets are generally capital in nature
No deduction is allowed for personal, living, or family expenses except for
Medical expenses
Local, state, and foreign income tax payments
Home mortgage interest
Charitable contributions

10. Personal Expenses - Medical
Taxpayers may deduct the excess of unreimbursed expenses over 7.5% of AGI as an itemized deduction
Qualifying medical expenses include
Doctors, dentists, chiropractors
Clinics, hospitals, long-term care facilities
Medical aids (e.g., hearing aids, crutches)
Prescription drugs
Medical insurance premiums

11. Medical Expenses Example
Sam incurred the following expenses during the current year
Heath Insurance Premiums $2,200
Prescription Drugs
Hospital Bills 2,000
Wheel Chair
Diet food and pills, non Rx
If Sam’s AGI is $55,000, what is the amount of his medical expense deduction?
[$4,900 – ($55,000 x .075)] = $775

12. Personal Expenses - Taxes
Individuals may deduct real or personal property taxes paid on personal assets
Individuals may elect to deduct either state and local sales taxes or state and local income taxes
Costs of tax compliance (e.g. tax preparation fees) are miscellaneous expenses deductible if > 2% AGI in aggregate
Common taxes NOT deductible include
Gift and estate taxes
Employee payroll taxes
Employment taxes paid for household employees

13. Personal Expenses – Charitable Contributions
General limit - deduct up to 50% of AGI for cash donation (less for capital assets)
Carryover excess as an itemized deduction for 5 years
Deduction amount
LT capital assets = FMV of property
Other property = lesser of FMV or basis

14. Charitable Contribution Example
Mrs. Bates gave the following items to charity during the current year
Antiques, owned 15 years, cost of $50,000; FMV of $125,000
Painting, owned 9 months, cost of $25,000; FMV of $27,000
What is the amount of Mrs. Bates’ itemized deduction for charitable contributions before considering any AGI limitation?
$125,000 (FMV of antiques) + $25,000 (basis of painting) = $150,000

15. Tax Subsidies for Education
EE Savings Bonds - interest excluded to the extent used for tuition and fees; phase out for higher-income individuals
Deduct $4,000 qualified tuition and fees expense. Phase out for high income individuals
Qualified educational loan interest is deductible for first 60 months of payments - max $2,500 per year. Phase out for high income individuals
Hope scholarship credit – Available for first 2 years of college. Max $1,800 per year per student based on tuition/fees; phase out for higher-income individuals

16. Tax Subsidies for Education
Lifetime learning credit – Equal to 20% of tuition/fees; $2,000 credit max per year per tax return; phase out for higher-income individuals
Education savings account (Coverdell plan or section 529 state-sponsored plan) - withdrawals spent on education are tax-free

17. Personal Losses
Recall that losses on disposition of personal assets are not deductible, while the gains on disposition of personal assets are taxable
Casualty and theft losses
Loss = lesser of (adjusted basis or decline in FMV) - insurance proceeds
Deduction = Loss - $100 per casualty - 10% AGI

18. Casualty Loss Example
Cheryl’s home (basis of $275,000) was damaged in a fire. $100,000 of damage was incurred and the insurance company reimbursed Cheryl $75,000 for the loss. If Cheryl’s AGI was $125,000, what was the amount of her casualty loss?
[$100,000 (decline in FMV) - $75,000 (insurance proceeds) - $100 - $12,500 (10% of AGI)] = $12,400

19. Personal Losses Hobby income is taxable
Hobby deductions (to the extent that miscellaneous deductions exceed 2% of AGI) are limited to the amount of hobby income
If the activity generates a profit in 3 of 5 years, the IRS presumes it is a business and occasional losses are fully deductible
Gambling losses are treated very much like hobbies, except that gambling losses are not subject to the 2% of AGI limitation

20. Home Ownership
The following types of qualified residence interest are deductible as an itemized deduction
Interest on acquisition debt up to $1 million
Interest on home equity debt up to $100,000
The deduction is available for the principal residence and one other personal residence (not a primary rental property)

21. Home Mortgage Interest Example
Mr. and Mrs. Wimple have incurred $48,000 of interest on $1,200,000 of acquisition debt related to their principal residence. In addition, they incurred $4,720 of interest on an $80,000 home equity line of credit. What amount of home mortgage interest can they deduct?
Acquisition debt (limited) $1,000,000
Home equity debt ,000
$1,080,000
Qualified home interest:
$1,080,000 x $52,720 = $44,482.50
$1,280,000

22. Home Ownership Vacation home rental activity
Deductions related to a house are treated as for a vacation home (as opposed to a rental house) if the personal use exceeds the greater of 14 days or 10% of rental days
Deductions (based on the number of days of rental usage) are limited to gross rents less any mortgage interest or property taxes allocable to the rental period
Thus, vacation rental deductions cannot generate a net rental loss
Carry forward excess rental deductions

23. Gain on Sale of Principal Residence
Exclude $250,000 of gain on sale if home is principal residence 2 years out of 5 years ending on date of sale
Exclude only one gain every 2 years
The maximum exclusion is doubled (to $500,000) for MFJ if either spouse meets the 2 of 5 year ownership requirement and both spouses meet the 2 of 5 year use requirement

24. Gain Exclusion Example
Bill purchased a house in April of On March 15, 2006, Sue moved into the house and on July 4, 2007 they were married. They sold the house on August 7, 2008 generating a $270,000 gain. How much of the gain may be excluded?
$270,000; Bill meets the 2 year ownership requirement and both Bill and Sue meet the 2 year use requirement

25. Itemized Deductions as AMT Adjustments
Medical deductions are allowed only to the extent they exceed 10% AGI (not the usual 7.5%)
State and Local tax payment deductions are disallowed
Miscellaneous itemized deductions (including investment and employment-related deductions) are disallowed
Interest on home equity debt is disallowed