1. Chapter 3 Tax Determination; Personal and Dependency Exemptions; An Overview of Property Transactions Copyright ©2006 South-Western/Thomson Learning Individual Income Taxes

2. C3 - 2 Individual Income Taxes Tax Formula (slide 1 of 2) Income(broadly conceived)$x,xxx Less:Exclusions (x,xxx) Gross Income$x,xxx Less:Deductions for AGI (x,xxx) AGI$x,xxx Less:The greater of- Total itemized deductions or the standard deduction (x,xxx) Personal & dependency exemptions(x,xxx) Taxable Income$x,xxx Income(broadly conceived)$x,xxx Less:Exclusions (x,xxx) Gross Income$x,xxx Less:Deductions for AGI (x,xxx) AGI$x,xxx Less:The greater of- Total itemized deductions or the standard deduction (x,xxx) Personal & dependency exemptions(x,xxx) Taxable Income$x,xxx FIGURE 3–1

3. C3 - 3 Individual Income Taxes Tax Formula (slide 2 of 2) Tax on taxable income (see Tax Tables or Tax Rate Schedules) $ x,xxx Less: Tax credits (including income taxes withheld and prepaid) (xxx) Tax due (or refund) $ xxx Tax on taxable income (see Tax Tables or Tax Rate Schedules) $ x,xxx Less: Tax credits (including income taxes withheld and prepaid) (xxx) Tax due (or refund) $ xxx FIGURE 3–1

4. C3 - 4 Individual Income Taxes Standard Deduction (slide 1 of 2) The basic standard deduction (BSD) amount depends on filing status of taxpayer Filing status 2004 2005. Single $4,850 $5,000 MFJ, SS 9,700 10,000 HH 7,150 7,300 MFS 4,850 5,000 TABLE 3–1

5. C3 - 5 Individual Income Taxes Standard Deduction (slide 2 of 2) Additional standard deduction (ASD) –For taxpayers age 65 or older and/or legally blind Additional standard deduction (ASD) –For taxpayers age 65 or older and/or legally blind Filing Status 2004 2005. Single $1,200 $1,250 MFJ, SS 950 1,000 HH 1,200 1,250 MFS 950 1,000 TABLE 3–2

6. C3 - 6 Individual Income Taxes Determining Standard Deduction Examples (2005 tax year): –Taxpayer is single, blind, and age 65 or older SD = $5,000 (BSD) + $1,250 (ASD) + $1,250 (ASD) = $7,500 –Taxpayers are married, filing jointly, one blind, and both age 65 or older SD = $10,000 (BSD) + $1,000 (ASD) + $1,000 (ASD) + $1,000 (ASD) = $13,000 Examples (2005 tax year): –Taxpayer is single, blind, and age 65 or older SD = $5,000 (BSD) + $1,250 (ASD) + $1,250 (ASD) = $7,500 –Taxpayers are married, filing jointly, one blind, and both age 65 or older SD = $10,000 (BSD) + $1,000 (ASD) + $1,000 (ASD) + $1,000 (ASD) = $13,000

7. C3 - 7 Individual Income Taxes Taxpayers Ineligible For Standard Deduction Certain taxpayers cannot use the SD: –Married, filing separately, when either spouse itemizes deductions –Nonresident aliens –Individual filing return for tax year of less than 12 months because of change in annual accounting period Certain taxpayers cannot use the SD: –Married, filing separately, when either spouse itemizes deductions –Nonresident aliens –Individual filing return for tax year of less than 12 months because of change in annual accounting period

8. C3 - 8 Individual Income Taxes SD Limit For Person Claimed as Dependent Individual claimed as dependent has a BSD limited to the greater of: – $800 or – $250 plus earned income (but not exceeding normal BSD) ASD amount(s) still available Individual claimed as dependent has a BSD limited to the greater of: – $800 or – $250 plus earned income (but not exceeding normal BSD) ASD amount(s) still available

9. C3 - 9 Individual Income Taxes Examples of SD Limit (slide 1 of 2) Dependent’s SD (2005 tax year): –A blind child who earns $200 and is claimed by parents as a dependency exemption SD = $800 (BSD) + $1,250 (ASD) = $2,050 –A child who earns $1,500 and is claimed by parents as a dependency exemption SD = $1,750 [BSD equal to greater of $800 or ($250 + $1,500 earned income)] Dependent’s SD (2005 tax year): –A blind child who earns $200 and is claimed by parents as a dependency exemption SD = $800 (BSD) + $1,250 (ASD) = $2,050 –A child who earns $1,500 and is claimed by parents as a dependency exemption SD = $1,750 [BSD equal to greater of $800 or ($250 + $1,500 earned income)]

10. C3 - 10 Individual Income Taxes Examples of SD Limit (slide 2 of 2) Examples of dependent’s SD (2005 tax year) –A child who earns $5,500 and is claimed by parents as a dependency exemption SD = $5,000 [BSD limited to normal amount] Examples of dependent’s SD (2005 tax year) –A child who earns $5,500 and is claimed by parents as a dependency exemption SD = $5,000 [BSD limited to normal amount]

11. C3 - 11 Individual Income Taxes Personal and Dependency Exemption Amounts Amounts –2004: $3,100 per exemption –2005: $3,200 per exemption Personal and dependency exemptions –One per taxpayer (two personal exemptions when married, filing jointly) and for each dependent Exception: Individual claimed as dependent by another taxpayer does not receive a personal exemption Amounts –2004: $3,100 per exemption –2005: $3,200 per exemption Personal and dependency exemptions –One per taxpayer (two personal exemptions when married, filing jointly) and for each dependent Exception: Individual claimed as dependent by another taxpayer does not receive a personal exemption

12. C3 - 12 Individual Income Taxes Personal and Dependency Exemptions In Year Of Death Personal exemption allowed on joint return for spouse who dies during the year –Example: Tom and Betty were married in 1990. Tom dies on February 1, 2005. A personal exemption may be claimed for Tom on the taxpayers’ 2005 joint return. Personal exemption allowed on joint return for spouse who dies during the year –Example: Tom and Betty were married in 1990. Tom dies on February 1, 2005. A personal exemption may be claimed for Tom on the taxpayers’ 2005 joint return.

13. C3 - 13 Individual Income Taxes Personal and Dependency Exemption Tests-Prior to 2005 A dependency exemption may be claimed for each individual that meets all of the following tests: –Support –Relationship (or household member) –Gross income –Joint return –Citizen or residency A dependency exemption may be claimed for each individual that meets all of the following tests: –Support –Relationship (or household member) –Gross income –Joint return –Citizen or residency

14. C3 - 14 Individual Income Taxes Support Test Taxpayer must provide more than 50% of the dependent’s support –Only amounts expended are considered in the support test –Scholarships of children are not considered in the support test Two exceptions to support test requirement: –Multiple support agreements –Children of divorced parents Taxpayer must provide more than 50% of the dependent’s support –Only amounts expended are considered in the support test –Scholarships of children are not considered in the support test Two exceptions to support test requirement: –Multiple support agreements –Children of divorced parents

15. C3 - 15 Individual Income Taxes Multiple Support Agreements Allows one member of a group providing > 50% of support to claim individual even though no one person provides > 50% support –Eligible parties must provide > 10% of support –Each eligible party must meet all other dependency requirements Example - Allows children of elderly parent to claim exemption for parent when none individually meets the 50% support test Allows one member of a group providing > 50% of support to claim individual even though no one person provides > 50% support –Eligible parties must provide > 10% of support –Each eligible party must meet all other dependency requirements Example - Allows children of elderly parent to claim exemption for parent when none individually meets the 50% support test

16. C3 - 16 Individual Income Taxes Children of Divorced Parents For post 1984 divorce decrees, custodial parent gets exemption for children Noncustodial parent may claim exemption for children if custodial parent signs a Release of Claim to Exemption, Form 8332 For post 1984 divorce decrees, custodial parent gets exemption for children Noncustodial parent may claim exemption for children if custodial parent signs a Release of Claim to Exemption, Form 8332

17. C3 - 17 Individual Income Taxes Relationship Test Dependent must be one of the specified relatives of the taxpayer (either taxpayer, if joint return) or be a member of the taxpayer’s household for the entire year Once a relationship is established by marriage, it continues even if there is a change in marital status Dependent must be one of the specified relatives of the taxpayer (either taxpayer, if joint return) or be a member of the taxpayer’s household for the entire year Once a relationship is established by marriage, it continues even if there is a change in marital status

18. C3 - 18 Individual Income Taxes Gross Income Test Dependent’s gross income cannot be greater than amount allowed for an exemption ($3,200 for 2005) –Exception: No gross income limitation if dependent is child of taxpayer AND either: i) Less than age 19, OR ii) Less than age 24 and a full-time student Dependent’s gross income cannot be greater than amount allowed for an exemption ($3,200 for 2005) –Exception: No gross income limitation if dependent is child of taxpayer AND either: i) Less than age 19, OR ii) Less than age 24 and a full-time student

19. C3 - 19 Individual Income Taxes Example of Gross Income Test (slide 1 of 2) Grandparent (age 70) meets all dependency tests except has gross income of $3,500 –Grandparent fails gross income test and cannot be claimed by taxpayer as dependency exemption Grandparent (age 70) meets all dependency tests except has gross income of $3,500 –Grandparent fails gross income test and cannot be claimed by taxpayer as dependency exemption

20. C3 - 20 Individual Income Taxes Example of Gross Income Test (slide 2 of 2) Child (age 16) meets all dependency tests for taxpayer except has gross income of $4,000 –Gross income exception for child applies and taxpayer can claim child as dependency exemption Child (age 16) meets all dependency tests for taxpayer except has gross income of $4,000 –Gross income exception for child applies and taxpayer can claim child as dependency exemption

21. C3 - 21 Individual Income Taxes Joint Return Test Dependent cannot file a joint return with spouse unless: –Filing solely for refund of tax withheld –No tax liability exists for either spouse –Neither spouse required to file return Dependent cannot file a joint return with spouse unless: –Filing solely for refund of tax withheld –No tax liability exists for either spouse –Neither spouse required to file return

22. C3 - 22 Individual Income Taxes Citizen or Residency Test Dependent must be a U.S. citizen or a resident of U.S., Canada, or Mexico

23. C3 - 23 Individual Income Taxes Dependency Exemptions - After 2004 (slide 1 of 2) One objective of the Working Families Tax Relief Act of 2004 (WFTRA of 2004) –Establish a uniform definition of qualifying child for purposes of the: Dependency exemption Child tax credit Earned income credit Dependent care credit, and Head-of-household filing status One objective of the Working Families Tax Relief Act of 2004 (WFTRA of 2004) –Establish a uniform definition of qualifying child for purposes of the: Dependency exemption Child tax credit Earned income credit Dependent care credit, and Head-of-household filing status

24. C3 - 24 Individual Income Taxes Dependency Exemptions - After 2004 (slide 2 of 2) Under WFTRA of 2004, a dependent is one who is either a qualifying child or a qualifying relative –A qualifying child must meet the following tests: Relationship Domicile, and Age Under WFTRA of 2004, a dependent is one who is either a qualifying child or a qualifying relative –A qualifying child must meet the following tests: Relationship Domicile, and Age

25. C3 - 25 Individual Income Taxes Relationship Test The child must be the taxpayer’s: –Son or daughter –Stepson or stepdaughter –Brother or sister –Stepbrother or stepsister –Half brother or half sister, or –A descendant of such individual (e.g., grandchildren, nephews, nieces) A child who has been adopted, or whose adoption is pending, qualifies A foster child may also qualify The child must be the taxpayer’s: –Son or daughter –Stepson or stepdaughter –Brother or sister –Stepbrother or stepsister –Half brother or half sister, or –A descendant of such individual (e.g., grandchildren, nephews, nieces) A child who has been adopted, or whose adoption is pending, qualifies A foster child may also qualify

26. C3 - 26 Individual Income Taxes Domicile Test The child must have the same principal place of abode as the taxpayer for more than half of the taxable year –Temporary absences from the household due to special circumstances (e.g., illness, education) are not considered The child must have the same principal place of abode as the taxpayer for more than half of the taxable year –Temporary absences from the household due to special circumstances (e.g., illness, education) are not considered

27. C3 - 27 Individual Income Taxes Age Test The child must be under age 19 (or under age 24 in the case of a full-time student) –Exception - individuals who are disabled are not subject to any limitations as to age The child must be under age 19 (or under age 24 in the case of a full-time student) –Exception - individuals who are disabled are not subject to any limitations as to age

28. C3 - 28 Individual Income Taxes Support Except in one situation, the definition of qualifying child makes the support of an individual irrelevant –The one case where support becomes relevant involves self-support A child who provides more than one-half of his or her own support cannot be claimed as a dependent Except in one situation, the definition of qualifying child makes the support of an individual irrelevant –The one case where support becomes relevant involves self-support A child who provides more than one-half of his or her own support cannot be claimed as a dependent

29. C3 - 29 Individual Income Taxes Qualifying Relative Under the qualifying relative category, individuals must also satisfy the gross income and support tests –In large part, therefore, the pre-2005 rules are carried over Qualifying relative is somewhat misleading in that a “relative” need not be involved –An unrelated individual who is a member of the taxpayer’s household can qualify if the other dependency tests are satisfied –Not every “relative” is eligible Only those who meet the relationship test set forth in the Code qualify Under the qualifying relative category, individuals must also satisfy the gross income and support tests –In large part, therefore, the pre-2005 rules are carried over Qualifying relative is somewhat misleading in that a “relative” need not be involved –An unrelated individual who is a member of the taxpayer’s household can qualify if the other dependency tests are satisfied –Not every “relative” is eligible Only those who meet the relationship test set forth in the Code qualify

30. C3 - 30 Individual Income Taxes Phase-out of Exemptions (slide 1 of 2) Applies when taxpayer’s AGI in 2005 exceeds: $218,950 for married, filing jointly, or surviving spouse $182,450 for head of household $145,950 for single $109,475 for married, filing separately Applies when taxpayer’s AGI in 2005 exceeds: $218,950 for married, filing jointly, or surviving spouse $182,450 for head of household $145,950 for single $109,475 for married, filing separately

31. C3 - 31 Individual Income Taxes Phase-out of Exemptions (slide 2 of 2) Exemptions deduction is reduced by 2% for every $2,500 ($1,250 for MFS), or part thereof, that AGI exceeds threshold amounts

32. C3 - 32 Individual Income Taxes Child Tax Credit $1,000 tax credit is allowed for each dependent child under the age of 17 –Qualifying child includes stepchildren and eligible foster children $1,000 tax credit is allowed for each dependent child under the age of 17 –Qualifying child includes stepchildren and eligible foster children

33. C3 - 33 Individual Income Taxes Taxes Rates Prior to recent legislation, tax rates were 15%, 28%, 31%, 36%, and 39.6% Effective January 1, 2003 –Tax rates are 10%, 15%, 25%, 28%, 33%, and 35% Prior to recent legislation, tax rates were 15%, 28%, 31%, 36%, and 39.6% Effective January 1, 2003 –Tax rates are 10%, 15%, 25%, 28%, 33%, and 35%

34. C3 - 34 Individual Income Taxes Kiddie Tax (slide 1 of 4) Net unearned income (NUI) of child is taxed at parents’ rate –Child must be under age 14 at end of year –NUI generally equals unearned income less $1,600 (2005 tax year) Net unearned income (NUI) of child is taxed at parents’ rate –Child must be under age 14 at end of year –NUI generally equals unearned income less $1,600 (2005 tax year)

35. C3 - 35 Individual Income Taxes Kiddie Tax (slide 2 of 4) Unearned income includes: –Taxable interest –Dividends –Capital gains –Rents –Royalties –Pension and annuity income, and –Unearned income from trusts Unearned income includes: –Taxable interest –Dividends –Capital gains –Rents –Royalties –Pension and annuity income, and –Unearned income from trusts

36. C3 - 36 Individual Income Taxes Kiddie Tax (slide 3 of 4) Computing NUI for Kiddie Tax: Unearned income Less: $800 Less: The greater of: i) $800, or ii) Allowable itemized deductions connected with production of unearned income Equals: net unearned income Computing NUI for Kiddie Tax: Unearned income Less: $800 Less: The greater of: i) $800, or ii) Allowable itemized deductions connected with production of unearned income Equals: net unearned income

37. C3 - 37 Individual Income Taxes Kiddie Tax (slide 4 of 4) Net unearned income taxed at parents’ rate –Remainder of taxable income taxed at child’s rate Two options for computing the tax –A separate return may be filed for the child, or –The parents may elect to report child’s income on their own return The tax on net unearned income (referred to as the allocable parental tax) is computed as though the income had been included on the parents’ return – Form 8615 is used to compute the tax Net unearned income taxed at parents’ rate –Remainder of taxable income taxed at child’s rate Two options for computing the tax –A separate return may be filed for the child, or –The parents may elect to report child’s income on their own return The tax on net unearned income (referred to as the allocable parental tax) is computed as though the income had been included on the parents’ return – Form 8615 is used to compute the tax

38. C3 - 38 Individual Income Taxes Filing Requirements (slide 1 of 2) General Rule: Tax return must be filed if gross income is ≥ the sum of the standard deduction and exemption amount ASD for blind does not apply for this determination –Special rules apply for dependents and self- employed taxpayers General Rule: Tax return must be filed if gross income is ≥ the sum of the standard deduction and exemption amount ASD for blind does not apply for this determination –Special rules apply for dependents and self- employed taxpayers

39. C3 - 39 Individual Income Taxes Filing Requirements (slide 2 of 2) Tax return of an individual is due on or before the 15th day of the 4th month after taxpayer’s year end Most individuals are calendar year taxpayers, thus, due date is April 15 May obtain an extension of time to file Tax return of an individual is due on or before the 15th day of the 4th month after taxpayer’s year end Most individuals are calendar year taxpayers, thus, due date is April 15 May obtain an extension of time to file

40. C3 - 40 Individual Income Taxes Filing Status There are 5 filing statuses –Single –Married, filing jointly –Surviving spouse (qualifying widow or widower) –Head of household –Married, filing separately Filing status affects tax rate brackets, standard deduction, and other amounts There are 5 filing statuses –Single –Married, filing jointly –Surviving spouse (qualifying widow or widower) –Head of household –Married, filing separately Filing status affects tax rate brackets, standard deduction, and other amounts

41. C3 - 41 Individual Income Taxes Single Filing Status Includes a taxpayer who is unmarried or separated from spouse by a divorce decree or separate maintenance agreement and does not qualify for another filing status –Marital status is determined as of the last day of the tax year When a spouse dies during the year, marital status is determined as of the date of death Includes a taxpayer who is unmarried or separated from spouse by a divorce decree or separate maintenance agreement and does not qualify for another filing status –Marital status is determined as of the last day of the tax year When a spouse dies during the year, marital status is determined as of the date of death

42. C3 - 42 Individual Income Taxes Married Filing Jointly (MFJ) Filing Status Married as of last day of taxable year, or Spouse dies during taxable year Married as of last day of taxable year, or Spouse dies during taxable year

43. C3 - 43 Individual Income Taxes Surviving Spouse Filing Status Same tax rate brackets as married, filing jointly File as surviving spouse for 2 years after death of spouse if taxpayer maintains a home in which a dependent child lives Same tax rate brackets as married, filing jointly File as surviving spouse for 2 years after death of spouse if taxpayer maintains a home in which a dependent child lives

44. C3 - 44 Individual Income Taxes Married Filing Separately Filing Status Married but not filing a return with spouse and not abandoned spouse

45. C3 - 45 Individual Income Taxes Head of Household (HH) Filing Status Must be unmarried as of end of year or an abandoned spouse Must pay > half the cost of maintaining a household which is the principal home of a dependent for more than half of tax year –For tax years after 2004, a dependent must satisfy either the qualifying child or the qualifying relative category A qualifying relative must also meet the relationship test Must be unmarried as of end of year or an abandoned spouse Must pay > half the cost of maintaining a household which is the principal home of a dependent for more than half of tax year –For tax years after 2004, a dependent must satisfy either the qualifying child or the qualifying relative category A qualifying relative must also meet the relationship test

46. C3 - 46 Individual Income Taxes Exception to the HH Requirements HH may be claimed if taxpayer maintains a separate home for his or her parents –At least one parent must qualify as a dependent HH may be claimed if taxpayer maintains a separate home for his or her parents –At least one parent must qualify as a dependent

47. C3 - 47 Individual Income Taxes Abandoned Spouse Allows married taxpayer to file as Head of Household if taxpayer: –Does not file a joint return –Paid > half the cost of maintaining a home –Spouse did not live in home during last 6 months of tax year –Home was principal residence of taxpayer’s child for > half of year –Can claim child as a dependent Allows married taxpayer to file as Head of Household if taxpayer: –Does not file a joint return –Paid > half the cost of maintaining a home –Spouse did not live in home during last 6 months of tax year –Home was principal residence of taxpayer’s child for > half of year –Can claim child as a dependent

48. C3 - 48 Individual Income Taxes Gains and Losses from Property Transactions (slide 1 of 3) In order for gains (losses) to be recognized (included in gross income), they must be realized: –Realized gain (loss) = amount realized - adjusted basis Amount realized = selling price - costs of disposition Adjusted basis = cost + capital additions - cost recovery In order for gains (losses) to be recognized (included in gross income), they must be realized: –Realized gain (loss) = amount realized - adjusted basis Amount realized = selling price - costs of disposition Adjusted basis = cost + capital additions - cost recovery

49. C3 - 49 Individual Income Taxes Gains and Losses from Property Transactions (slide 2 of 3) All realized gains are recognized unless a specific tax provision provides otherwise (e.g., nontaxable exchanges) Realized losses may or may not be recognized depending on the circumstances –Generally, losses on the sale or disposition of personal use property are not recognized All realized gains are recognized unless a specific tax provision provides otherwise (e.g., nontaxable exchanges) Realized losses may or may not be recognized depending on the circumstances –Generally, losses on the sale or disposition of personal use property are not recognized

50. C3 - 50 Individual Income Taxes Gains and Losses from Property Transactions (slide 3 of 3) Once recognized gains or losses have been determined, they must be classified as ordinary or capital –Ordinary gains are fully taxable –Ordinary losses are fully deductible Capital gains and losses are subject to special tax treatment Once recognized gains or losses have been determined, they must be classified as ordinary or capital –Ordinary gains are fully taxable –Ordinary losses are fully deductible Capital gains and losses are subject to special tax treatment

51. C3 - 51 Individual Income Taxes Gains and Losses from Capital Asset Transactions (slide 1 of 2) Capital assets are defined as any property other than: –Inventory, –Accounts Receivable, and –Depreciable property or real property used in a business Most personal use assets owned by individuals are capital assets –Losses on these assets are not deductible Capital assets are defined as any property other than: –Inventory, –Accounts Receivable, and –Depreciable property or real property used in a business Most personal use assets owned by individuals are capital assets –Losses on these assets are not deductible

52. C3 - 52 Individual Income Taxes Gains and Losses from Capital Asset Transactions (slide 2 of 2) Gains and losses from capital asset transactions must be netted –Net gains and losses by holding period –If excess losses result, they are shifted to the category carrying the highest tax rate Gains and losses from capital asset transactions must be netted –Net gains and losses by holding period –If excess losses result, they are shifted to the category carrying the highest tax rate

53. C3 - 53 Individual Income Taxes Max Tax Rates for Net Capital Gains of Individuals Classification Maximum Rate Short-term gains (held ≤ one year) 35% Long-term gains (held > one year) Collectibles 28% Certain depreciable property used in a trade or business (unrecaptured § 1250 gain) 25% All other long-term capital gains 15% or 5% Classification Maximum Rate Short-term gains (held ≤ one year) 35% Long-term gains (held > one year) Collectibles 28% Certain depreciable property used in a trade or business (unrecaptured § 1250 gain) 25% All other long-term capital gains 15% or 5%

54. C3 - 54 Individual Income Taxes Treatment of Capital Losses Net capital losses of individuals are deductible FOR AGI up to $3,000 yearly –Excess capital losses are carried over to the next tax year –When carried over, capital losses retain their classification as short- or long-term Net capital losses of individuals are deductible FOR AGI up to $3,000 yearly –Excess capital losses are carried over to the next tax year –When carried over, capital losses retain their classification as short- or long-term

55. C3 - 55 Individual Income Taxes If you have any comments or suggestions concerning this PowerPoint Presentation for West's Federal Taxation, please contact: Dr. Donald R. Trippeer, CPA TRIPPEDR@oneonta.edu SUNY Oneonta If you have any comments or suggestions concerning this PowerPoint Presentation for West's Federal Taxation, please contact: Dr. Donald R. Trippeer, CPA TRIPPEDR@oneonta.edu SUNY Oneonta