1. Module 27 Nonbusiness Deductions and Exemptions

2. Menu Classification of deductible expenses Deductions for adjusted gross income Standard deduction and itemized deductions Personal and dependency exemptions Phaseout of exemptions Reduction of itemized deductions

3. Classification of Deductible Expenses Key Learning Objectives Allowable deductions of individual taxpayers n Order of deductions n Relationship of deductions u For AGI and u From AGI

4. AGI & Deductions From AGI n Itemized deductions reduced by AGI u Medical--7.5% u Miscellaneous--2% u Casualty--10% n Charitable--total deduction limited by AGI

5. §162 Trade or Business Expenses n Generally deductible n Must be u Ordinary u Necessary u Reasonable

6. §162 Trade or Business Expenses n If self-employed u Deductible for AGI n If employee u Deductible from AGI if unreimbursed u Reimbursed--non-accountable plan u Subject to 2% floor

7. §212 Expenses for Production of Income n Generally deductible n Must be u Ordinary u Necessary u Reasonable

8. §212 Expenses for Production of Income n For production/collection of income n For property held for production of income u Management/conservation/maintenance n Determination/collection/refund of any tax

9. §212 Expenses for Production of Income n For AGI u Rental and royalty expenses on Sch E n From AGI u Most investment related items u Except taxes, interest expense u Miscellaneous 2%

10. §262 Personal Expenses n Generally not deductible n Exceptions for certain itemized deductions

11. Deductions for Personal Items “Otherwise Allowable” n Interest expense n Charitable contributions n Taxes n Medical expenses n Casualty losses

12. AGI Limitations n Medical--7.5% AGI offset n Misc..-- 2% - 2% AGI offset n Overall--3% AGI offset

13. AMT Add-Backs n 100% of taxes n 100% of misc.... 2% n Additional 2.5% AGI offset on medical n Equity interest expense

14. Deductions for Adjusted Gross Income Key Learning Objectives n n Introduction to deductions for AGI u Moving expenses--covered in Mod 25 u Alimony payments covered in Mod 25 u Penalty on early withdrawal of savings u Health insurance costs for self-employed taxpayers u Interest on certain student loans

15. Standard & Itemized Deductions Key Learning Objectives (1) n n Standard deduction n n Itemized deductions u Medical expenses u Taxes

16. Standard Deduction 2000 n Married, Joint--------------- 7,350 n Married, Separate-----------3,675 n Head of Household---------6,450 n Single-------------------------4,400 n If dependent-- at least 700 increased by u earned income plus 250 u but not to exceed 4,400 F Note: several special rules for this group

17. Standard Deduction Add On n Blind and/or over 65 n Taxpayer and/or spouse only u Could be 4 add-ons per married, joint return n 2000 amounts u Married -- $850 u Single and head of household -- $1,100

18. Medical Expenses n Qualified expenses paid in tax year n For self, spouse, dependents n Also for would be dependent u Who has too much gross income

19. Qualified Medical Expenses n Only prescription medicine n Limited weight loss n Not cosmetic surgery after 1990

20. Medical Expenses Capital Expenditures n Qualified expense for u Cost more than the increase in FMV u Meet strict requirements as to need

21. Medical Expenses Institutionalized Care n Nursing home only if medical care is primary purpose n Special schools--blind etc.... u If special facilities are primary purpose

22. Medical Expenses Reductions to Amount Spent n Reduce by insurance proceeds n Reduce by 7.5% of AGI n Reimbursements generally not income u Include in income if tax benefit in prior year

23. Income Taxes n All deductible u Except U.S. Federal n Optional credit treatment for foreign taxes

24. Property Taxes Ad Valorem n Real estate taxes (RE) u Prorate RE tax when property sold n Other taxes if assessed on value n Not assessment for improvements

25. Standard Deductions and Itemized Deductions Key Learning Objectives (2) n n Itemized deductions u Interest expense u Charitable contributions u Casualty and theft loss deductions for personal use property--on last test only u Miscellaneous itemized deductions

26. Interest Expense Categories n Active T/B n Qualified residence interest n Investment interest n Tax exempt investments--N/A n Consumer interest--N/A after 1990 n Passive T/B--follow PAL rules u To carry passive investment u To run passive T/B

27. General Limitations on Interest Deduction n Payer must be obligated on debt n Can't deduct prepaid interest

28. Interest Expense “Follow the Money” n Must track borrowing to show how money was used n Interest expense limitations based on how funds spent

29. Interest Expense Limitations n Active T/B--no limits to deductibility n Investment interest u Current deduction limited u Tonet investment income u To net investment income u Excess carries over indefinitely

30. Investment Income n Investment income u interest u dividends u Overpaid, refundable taxes u Interest on the refund u net capital gain F if you give up special tax rates

31. Investment Expense n Investment expenses u all related expenses F real estate taxes on investment property F management fees F safety deposit box fees F magazine subscriptions u if subject to 2% limit, only that left in excess of the limitation

32. Net Investment Income n the excess of investment income over n investment expenses

33. Example 1: Deductible investment interest expense No deductions relating to investments $20,000 of interest expense on funds borrowed to buy stock Taxable income:   $100,000W2 wages   $ 8,500 interest income

34. Example 1: Deductible investment interest expense No deductions relating to investments Investment income _______ Related expenses _______ Net investment income _______ Investment interest deduction _______

35. Example 1: Deductible investment interest expense No deductions relating to investments Investment income $8,500 Related expenses 0 Net investment income 8,500 Investment interest Deduction 8,500 Carryover 11,500

36. Example 2: Deductible investment interest expense Deductions relating to investments   RE taxes of $2,000 $20,000 of interest expense on funds borrowed to buy stock Taxable income:   $100,000W2 wages   $ 8,500 interest income

37. Example 2: Deductible investment interest expense RE taxes are fully deductible on Schedule A, so Investment income _______ Related expenses _______ Net investment income _______ Investment interest deduction _______

38. Example 2: Deductible investment interest expense Investment income $8,500 Related expenses 2,000 Net investment income 6,500 Investment interest Deduction 6,500 Carryover 13,500

39. Example 3: Deductible investment interest expense Deductions relating to investments   Management fees of $2,000 $20,000 of interest expense on funds borrowed to buy stock Taxable income:   $100,000W2 wages   $ 8,500 interest income

40. Example 3: Deductible investment interest expense Mgt fees are deductible only if in excess of 2% of AGI Here AGI = $108,500 2% = $2,170 Since mgt fee was only $2,000 and no other misc 2% deductions, deduction = 0

41. Example 3: Deductible investment interest expense Investment income _______ Related expenses _______ Net investment income _______ Investment interest deduction _______

42. Example 3: Deductible investment interest expense Investment income $8,500 Related expenses 0 Net investment income 8,500 Investment interest Deduction 8,500 Carryover 11,500

43. Example 4: Deductible investment interest expense Deductions relating to investments   Management fees of $8,000 $20,000 of interest expense on funds borrowed to buy stock Taxable income:   $100,000W2 wages   $ 8,500 interest income

44. Example 4: Deductible investment interest expense Management fees are deductible only if in excess of 2% of AGI Here AGI = $108,500 2% = $2,170 Since management fee is $8,000 and no other misc 2% deductions, deduction = $5,830

45. Example 4: Deductible investment interest expense Investment income _______ Related expenses _______ Net investment income _______ Investment interest deduction _______

46. Example 4: Deductible investment interest expense Investment income $8,500 Related expenses 5,830 Net investment income 2,670 Investment interest Deduction 2,670 Carryover 17,330

47. Special Rules for Qualified Residence Interest (QRI) n Only 2 principal residences n 1 million total acquisition indebtedness n Plus 100,000 equity indebtedness

48. Acquisition Indebtedness (ACQ) n Loan secured by property n Funds used to build/improve etc.... n Limited to 1 million if after 10/16/89 n Outstanding loans at 10/17/89 u Grandfathered-in as QRI u No limit as long as secured by property

49. Equity indebtedness n Excess of FMV over ACQ debt n Funds can use for anything n Must be secured by property n Limited to 100,000 debt n AMT add back

50. Points Paid n Points on acquisition of debt deductible if u Purchase of principal personal residence u Not borrowed from lender u OK if paid by seller n Points N/D if rental or if refinancing u Amortize over life of loan

51. Charitable Contributions n To qualified charitable organization u Not individual u Not foreign u Not political organization

52. Charitable Contributions n Money n Not value of services n Related out of pocket costs OK

53. Charitable Contributions Gifts of Property n Ordinary income property u Inventory u Other held < 1 year n Deduction limited to adjusted basis u Unless FMV is smaller n Generally subject to 50% of AGI limit

54. Charitable Contributions Gifts of Property n Long term capital gain property (CG) n Deduction generally FMV if > basis n Gift of tangible property limited to basis if u Unrelated use by charitable organization u Contributed to nonoperating private foundation n Can deduct basis to avoid 30% limit

55. Check List for Gift of Appreciated Property Ordinary income or “capital gains” property? If ordinary use lower of adjusted basis (AB) or FMV. If capital gains property   Is charity’s use “related?”   If yes use higher of AB or FMV   If no use AB unless < FMV.

56. Example 1: Gift of Appreciated Property Artwork is given to the local boy scouts for annual auction.   Cost $ 9,000   FMV $11,000 Held as investment since 1994 What is taxpayer’s deduction

57. Example 1: Gift of Appreciated Property n Here gift is for public auction, so can’t be related use n Deduct lower of AB and FMV n ANSWER: $9,000

58. Example 2: Gift of Appreciated Property Boat is given to the local boy scouts for summer camp.   Cost $ 9,000   FMV $11,000 Used personally since 1994 What is taxpayer’s deduction

59. Example 2: Gift of Appreciated Property n Here gift is for use in summer camp, so should be related use n Deduct FMV n ANSWER: $11,000

60. Charitable Contributions Limitations on Current Deduction n Overall--50% of AGI n Appreciated CG property u 30% of AGI if deduction is FMV u 50% if elect adjusted basis n To private foundation--20% AGI

61. Charitable Contributions Excess Contributions n Carry over for next 5 years n Retain character as to AGI limits n No carry back available

62. Charitable Contributions Documentation for Cash n Over $250 charity must substantiate n Charity must disclose value of goods/services received in exchange if FMV > $75

63. Charitable Contributions Documentation for Property n FMV > 500--attach Form 8283 n FMV > 5,000 need formal, written appraisal n Cost of appraisal is misc..... 2% deduction

64. Casualty and Theft Losses Sudden, Unexpected, Unusual n Loss on disposal of personal-use asset is generally not allowed n Casualty loss is exception n Use lower of basis or decline in FMV to determine loss

65. Casualty and Theft Losses Insurance Claims n Adjust for actual or expected insurance reimbursement n Gain could result if insurance > basis u See involuntary conversion rules n Insurance claim must be filed to deduct loss

66. Casualty and Theft Loss Personal-Use Property n Each casualty loss reduced by $100 n Net casualty gains and losses n Net gain for the year is capital gain n Net loss for the year is ordinary loss u Reduce by 10% of AGI floor u Deduction from AGI

67. Casualty and Theft Events Business or Investment Asset n Return of capital doctrine n Partial destruction u Use lower of basis or decline in FMV n Complete destruction u Use basis n Adjust for actual or expected insurance

68. Casualty and Theft Events Business or Investment Asset n Business losses deductible for AGI n Net loss for the year is ordinary loss u No 100 or 10% floor n Net gain for the year is u §1231 gain or u Ordinary gain u Depending on holding period

69. Miscellaneous Itemized Deductions n Employee business expenses n §212 expenses except u Rents u Royalties n Total is reduced by 2% of AGI

70. Employee Business Expenses n Being an employee (em’e) is a recognized T/B u T/B not that of job, but being em'e n Must distinguish between personal and T/B expenses n Statutory em'e--expenses for AGI n Performing artist--may be for AGI

71. Employee Business Expenses n All others--deductions from AGI n Included with other misc..... 2% items n Exception if em’e reimbursed AND n Em'e accounts to em'r u Then em'r does not report in W2 u Em’e does not report on tax return

72. Miscellaneous Itemized Deductions n Add together u Meals & entertainment--reduced by 50% u Other employee business expenses u All §212 expenses except rent/royalty n Reduce by 2% of AGI n This is the amount deduct from AGI u If itemized > standard deduction

73. In Class Exercise: Calculate the Miscellaneous 2% Amount n Valid business entertainment 8,000 n Employee business expenses 7,500 n Tax Preparation fee 250 n Management fee on mutual stock fund 1,900 n Total 17,650 n Calculate final deduction if u AGI = 100,000 OR 500,000

74. Solution: In Class Exercise: The Miscellaneous 2% Amount n If AGI = 100,000 n Final deduction = 11,650 n Reduce entertainment by 50% n Deductions before 2% = 13,650 n 2% of AGI = 2,000 n 13,650 reduced to 11,650

75. In Class Exercise: Calculate the Miscellaneous 2% Amount n If AGI = 500,000 n Final deduction = 3,650 n 2% of AGI = 10,000 u Reduce entertainment by 50% u Deductions before 2% = 13,650 n 13,650 reduced to 3,650 n Use standard deduction if no other deductions from AGI

76. Personal and Dependency Exemptions Key Learning Objectives n n Personal exemptions n n Dependency exemptions

77. Personal Exemptions n 2,800 per allowance--2000--for u Taxpayer u And spouse if joint return u N/A if dependent on another's return

78. Dependency Exemptions n 2,800 per allowance -- 2000 n Meet all of 5 of following tests u Support u Gross income u Relationship u Joint return test u Citizenship/residency

79. Multiple Support Agreements No One Provides > 50% Support n Group, not individual, gives >50% of total support n Group can decide who gets exemption n Taxpayer getting deduction must have contributed at least 10% of total support

80. Multiple Support Agreements No One Provides > 50% Support n Individual being claimed must not n Have too much gross income or n Fail to meet u Joint return test u Citizenship/residency test

81. Multiple Support Agreements No One Provides > 50% Support n Members of groups must meet relationship test u Relative or u Non-relative dependent lives with

82. In Class Exercise: Who Can Claim D? (1) n D, age 15, parents deceased, lives with Grandparents n D's support this year was provided as follows: n Interest income--D’s account 1,000 n Social security survivor's benefits 2,000 n Grandparents 3,000 6,000

83. Solution--In Class Exercise: Who Can Claim D? (1) n D would claim self since no one provides more than 50 of D’s support n Note that most of D’s exemption is wasted since D’s income is only 1,000 n Grandparents would have to spend an extra dollar to claim D

84. In Class Exercise Who Can Claim D? (2) n D, age 15, parents deceased, lives with Grandparents. D's support this year was provided as follows: n Interest income D’s account 1,000 n Social security survivor's benefits 2,000 n Contributions by mother’s friend 500 n Grandparents 3,000 6,500 6,500

85. Solution--In Class Exercise: Who Can Claim D? (2) n D would claim self since no one provides more than 50% of D’s support n Since D lives with grandparents, friend cannot meet relationship test, so not part of group n Grandparents now need to spend $501 to get exemption

86. In Class Exercise Who Can Claim D? (3) n D, age 15, parents deceased, lives with Grandparents. D's support this year was provided as follows: n Interest income D’s account 1,000 n Social security survivor's benefits 2,000 n Uncle Joe 500 n Grandparents 3,000 6,500 6,500

87. Solution--In Class Exercise: Who Can Claim D? (3) n Only the grandparents n Grandparents and Uncle Joe are group since they meet relationship test n Uncle Joe doesn’t meet the 10% test

88. In Class Exercise Who Can Claim D? (4) n D, age 15, parents deceased, lives with Grandparents. D's support this year was provided as follows: n Interest income, D’s account 3,000 n Uncle Joe 1,000 n Grandparents 3,000 7,000 7,000

89. Solution--In Class Exercise: Who Can Claim D? (4) n Now either grandparents or Uncle Joe n Group must decide who gets exemption n The other members of the group must sign written waiver agreeing to not take exemption u Form 2120

90. Phaseout of Exemptions and Reduction of Itemized Deductions Key Learning Objectives n n Phaseout of exemptions n n Reduction of itemized deductions

91. Phase Out of Exemptions The Steps To Follow n Calculate AGI, if < threshold stop n Calculate excess AGI u AGI - Threshold n Divide by 2,500 u Round up for any fraction n Multiply by 2%--this is the amount lost n 1 - % = amount of exemptions allowed

92. Threshold Amounts 2000 n Single128,950 n Head of household 161,150 n Married, joint 193,400 n Married, separate 96,700

93. In Class Exercise: Phaseout of Exemptions Part 1: Calculate AGI n W2 170,000 n Bank interest 5,900 n State bond interest 4,500 n Alimony paid 5,000

94. Solution--In Class Exercise Part 1: Calculate AGI AGI = 170,900 [170,000 + 5,900 - 5,000] n State bond interest excluded n Alimony paid is deduction for AGI n Now calculate taxable income IF u Single u Married, joint u Head of Household n In each case, taxpayer gets two exemptions

95. Solution: In Class Exercise Single, Exemption Phaseout n AGI 170,900 n THRESHOLD(128,950) n EXCESS 41,950 n ÷2,500 n 16.78 -> 17 n 17 times 2% = loss amount (34%) n 1 -.34 = deduction amount (66%) n Exemptions = 2,800 x 2 x.66 = 3,696

96. Solution: In Class Exercise Single, Taxable Income n AGI 170,900 n SD (4,400) n EXS (3,696) 2,800 x 2 x.66 n TI 162,804

97. Solution: In Class Exercise Married, Exemption Phaseout n AGI 170,900 n THRESHOLD(193,400) n EXCESS N/A n Exemptions = 2,800 x 2 = 5,600

98. Solution: In Class Exercise Married, Taxable Income n AGI 170,900 n SD (7,350) n EXS (5,600 ) 2,800 x 2 n TI 157,950

99. Solution: In Class Exercise Head, Exemption Phaseout n AGI 170,900 n THRESHOLD(161,150) n EXCESS 9,750 n ÷ 2,500 n 3.9 = 4 n 4 times 2% = loss amount ( 8%) n 1 -.08= deduction amount (92%) n Exemptions = 2,800 x 2 x.92 = 5,152

100. Solution: In Class Exercise Head, Taxable Income n AGI 170,900 n STD (6,450) n EXS (5,152) 2,800 x 2 x.92 n TI 159,298

101. 3% of AGI Reduction All Itemized Deductions Except n Medical n Casualty n Investment interest expense n Gambling losses

102. 3% of AGI Reduction n Threshold is same as the exemption phaseout for single filers n For 2000, threshold is 128,950 n Know which deduction it applies to n Know how to calculate

103. 3% Reduction Never Reduces to Zero n Taxpayer always gets the largest of (1) Limited - offset + unlimited (2) 20% of limited + unlimited (3) Standard deduction

104. In Class Exercise: Itemized Deduction Phaseout (1) n AGI 200,000 n Mortgage interest paid = 10,000 n What is the deduction from AGI? n Apply all other limits first u Reduce entertainment by 50% of cost u Reduce medical by 7.5% of AGI u Reduce miscellaneous by 2% of AGI u Reduce casualty loss by 10% of AGI

105. Solution: In Class Exercise: Itemized Deduction Phaseout (1) (1) Calculate the 3% Reduction n AGI200,000 n Threshold128,950 --> same for all n Excess 71,050 n x.03 n Reduction 2,132

106. Solution: In Class Exercise: Itemized Deduction Phaseout (1) (2) Compare the 3 Limits n Taxpayer gets the largest of ( 1) 10,000 - 2,132 7,868 (2) 20% of 10,000 2,000 (3) Standard deduction n 7,868 > all standard deductions, so all filers would use 7,868

107. In Class Exercise: Itemized Deduction Phaseout (2) n AGI 200,000 n Medical expenses paid 20,000 n What is the deduction from AGI? n Remember to apply all other limits before 3% reduction n Medical reduced by 7.5% of AGI

108. Solution: In Class Exercise: Itemized Deduction Phaseout (2) (1) Calculate the 7.5% Reduction n Reduction = 200,000 x 0.075 = 15,000 n Medical 20,000 n Reduction (15,000) n Deductible 5,000

109. Solution: In Class Exercise: Itemized Deduction Phaseout (2) (2) Calculate the 3% Reduction n Medical is not 3% limited, SO n Taxpayer gets > (1) 5,000 (2) Standard deduction n Only single/married separate use 5,000 n Others would use standard deduction

110. In Class Exercise: Itemized Deduction Phaseout (3) n AGI 200,000 n Medical expenses paid 20,000 n Mortgage interest paid 10,000 n What is the deduction from AGI? n Remember to apply all other limits before 3% reduction u Medical reduced by 7.5% of AGI

111. Solution: In Class Exercise: Itemized Deduction Phaseout (3) n This is a combination of first two cases. Here taxpayer gets largest of (1) 7,868 + 5,000 = 12,868 (2) 2,000 + 5,000 = 7,000 (3) Standard deduction n 12,868 > all standard deductions n All filers would use 12,868

112. In Class Exercise: Itemized Deduction Phaseout (4) n AGI 200,000 n Business Entertainment 52,000 n What is the deduction from AGI ? n Remember to apply all other limits before 3% reduction n Entertainment reduced by u 50% of each dollar u 2% of AGI

113. Solution: In Class Exercise: Itemized Deduction Phaseout (4) (1) Reduce Entertainment by Limits n Reduce entertainment by 50% 52,000 x.5 = 26,000 n Reduced entertainment by 2% of AGI 26,000 - [200,000 x.02] = 22,000

114. Solution: In Class Exercise: Itemized Deduction Phaseout (4) (2) Apply 3% Offset Rules n 3% reduction is still 2,132 n Taxpayer gets the largest of (1) 22,000 - 2,132 = 19,868 (2) 22,000 x.20 = 4,400 (3) Standard deduction n 19,868 is > all standard deductionsAll filers would use 19,868