Chapter 6 Individual Deductions Discussion Questions 1. [LO 1] It has been suggested that tax policy favors deductions for AGI compared to itemized deductions. Describe two ways in which deductions for AGI are treated more favorably than itemized deductions. Itemized deductions must exceed the standard deduction before taxpayers receive any tax benefit from the deductions (this is equivalent to an overall floor limit). In contrast, business deductions that are deductible for AGI (above the line) reduce taxable income without being subject to an overall floor limit. Also, itemized deductions are subject to many mechanical limitations including ceilings and floors, whereas business deductions are generally not subject to these limits (there are limits on certain specific deductions, but this will be described in greater detail in chapter 9). 2. [LO 1] How is a business activity distinguished from an investment activity? Why is this distinction important for the purpose of calculating federal income taxes? Both business and investment activities are motivated primarily by profit intent, but they can be distinguished by the level of profit-seeking activity. A business activity is commonly described as a sustained, continuous, high level of profit-seeking activity, whereas investment activities don’t require a high level of involvement. The distinction between business and investment activities is critical for determining whether a deduction associated with the activity is above or below the line, or even deductible. With one exception, business expenses are deducted for AGI. The lone exception is unreimbursed employee business expenses, which are not deductible. In contrast, investment expenses are deductible as itemized deductions, if deductible at all, with one exception. Expenses associated with rental and royalty activities are deductible for AGI regardless of whether the activity qualifies as an investment or a business. 3. [LO 1] Explain why Congress allows self-employed taxpayers to deduct the cost of health insurance as a for AGI deduction when employees can only itemize this cost as a medical expense. Would a self-employed taxpayer ever prefer to claim health insurance premiums as an itemized deduction rather than a deduction for AGI? Explain. This deduction provides a measure of equity between employees and the self-employed. The cost of health insurance is essentially a personal expense. However, employees typically aren’t required to pay insurance premiums because their employers pay the premiums for them as a form of compensation. The employer is allowed to deduct the premium as a compensation expense, and the employee is allowed to exclude from taxable income the value of the premiums paid on his behalf. Thus, from the employee’s perspective, this arrangement has the same effect as if (1) the employer pays the employee cash compensation in the amount of the premium and (2) the employee pays the premium and deducts the expense for AGI (completely offsetting the compensation income). In contrast to employees, self-employed taxpayers pay their own health insurance costs, because they don’t have an employer to pay these costs for them. Absent a rule to the contrary, self-employed taxpayers would deduct their medical expenses as itemized deductions subject to strict limitations, because the cost of the health insurance is a personal expense rather than a business expense. To treat employees and self-employed taxpayers similarly, Congress allows self-employed taxpayers to deduct personal health insurance premiums as for AGI rather than itemized deductions. Thus, self-employed taxpayers are able to (1) receive business income and (2) use the business income to pay their health insurance premiums and deduct the premiums as a for AGI deduction (completely offsetting the business income they used to pay the premium). Given the preferential treatment of for AGI deductions relative to itemized deductions, a self-employed taxpayer should never prefer to claim health insurance premiums as an itemized deduction rather than a deduction for AGI. 4. [LO 1] Explain why Congress allows self-employed taxpayers to deduct the employer portion of their self-employment tax. To put self-employed individuals on somewhat equal footing with other employers that are allowed to deduct the employer’s share of the social security tax. Hence, self-employed taxpayers are allowed to deduct the employer’s share of the self-employment tax. 5. [LO 1] {Research} Using the Internal Revenue Code, describe two deductions for AGI that are not discussed in this chapter. §62 is the quickest way to identify deductions for AGI, but several can also be identified from page 2 of form 1040. Examples include the performing artist deduction, deductions of business expenses for state and local officials, reforestation expenses, and remitted jury duty pay. 6. [LO 1] Explain why Congress allows taxpayers to deduct interest forfeited as a penalty on the premature withdrawal from a certificate of deposit. The full amount of the interest income is included in gross income, and this deduction reduces the net interest income to the amount actually received by the individual. 7. [LO 1] Describe the mechanical limitation on the deduction for interest on qualified educational loans. The maximum deduction for interest expense on qualified education loans is the amount of interest expense paid up to $2,500. However, the deduction is reduced (phased-out) for taxpayers depending on the taxpayer’s filing status and modified AGI. Specifically, the deduction for interest on educational loans is subject to proportional phase-out over a range of $15,000 ($30,000 for married filing jointly). The range begins for taxpayers at $70,000 of modified AGI ($140,000 for MFJ) and ends at $85,000 of modified AGI ($170,000 for married filing jointly). Modified AGI for this purpose is AGI before deducting interest expense on the qualified education loans and before deducting qualified education expenses. Married individuals who file separately are not allowed to deduct this expense under any circumstance. 8. [LO 2] Explain why the medical expense provisions are sometimes referred to as “wherewithal” deductions and how this rationale is reflected in the limit on these deductions. These deductions are designed to reduce the tax burden on taxpayers whose circumstances have involuntarily reduced their ability to pay. The deductions are restricted to expenses that exceed insurance reimbursements and a floor limit based upon AGI. These limits ensure that taxpayers claiming the deduction have exceedingly large involuntary expenditures as measured by their ability to pay. 9. [LO 2] Describe the type of medical expenditures that qualify for the medical expense deduction. Does the cost of meals consumed while hospitalized qualify for the deduction? Do over-the-counter drugs and medicines qualify for the deduction? Medical expenses include any payments for the care, prevention, diagnosis, or cure of injury, disease, or bodily function that are not reimbursed. Included are the costs of prescription medicine, insulin, and payments to doctors, dentists, and the like incurred by the taxpayer, taxpayer’s spouse, and dependents. Over-the-counter drugs and medicines do not qualify for the deduction. Besides direct medical expenses, the deduction includes the cost of health insurance (if not already deducted above the line by self-employed taxpayers or if not offset by a premium tax credit under IRC Sec. 36B). Medical expenses also include long-term care services for disabled spouses and dependents to the extent the costs (including meals and lodging) are attributable to medical care. The cost of elective cosmetic surgery is not deductible. The cost of meals and lodging qualify if incurred at a medical-care facility or hospital and are incident to the care of the patient, but the cost of lodging is limited to $50 per eligible person per night. The cost of travel for and essential to medical care, including lodging (still limited to $50 per eligible person per night) is also deductible if the expense is not extravagant and the travel has no significant element of personal pleasure. 10. [LO 2] Under what circumstances can a taxpayer deduct medical expenses paid for a member of his family? Does it matter if the family member reports significant amounts of gross income and cannot be claimed as a dependent? A taxpayer can deduct medical expenses incurred for members of his family if they are dependents (i.e., either qualified children or qualified relatives). For purposes of deducting medical expenses, a dependent need not meet the gross income test (§213(a)). 11. [LO 2] What types of taxes qualify to be deducted as itemized deductions? Would a vehicle registration fee qualify as a deductible tax? Taxes qualifying for this deduction include state, local, and foreign income taxes, state and local real estate taxes, and state and local personal property taxes. State and local sales taxes may also be deducted but only in lieu of state and local income taxes. The deduction for sales tax can be based upon either the amount paid or the amount published in the IRS tables (see Form 1040, Schedule A instructions or https://www.irs.gov/credits-deductions/individuals/sales-tax-deduction-calculator). Vehicle registration fees are not deductible (unless calculated based on the value of the vehicle rather than its weight). 12. [LO 2] Explain the argument that the deductions for charitable contributions and home mortgage interest represent indirect subsidies for these activities. In each case, the deduction reduces the after-tax cost of the activity, making it more likely that taxpayers will engage in the activity. For example, contributions to charity reduce the cost of giving thereby indirectly encouraging donations to charitable organizations. 13. [LO 2] {Research} Cash donations to a charity are subject to a number of very specific substantiation requirements. Describe these requirements and how charitable gifts can be substantiated. Describe the substantiation requirements for property donations. Charitable contributions are only deductible if substantiated with written records such as a cancelled check, bank record, or a written communication from the charity showing the name of the charity and the date and amount of the contribution. (§170(a)(1) and Reg § 1.170A-13(a)(1).) Additional substantiation is required for: contributions of $250 or more (§170(f)(8)), non-cash contributions exceeding $500 (§170(f)(11)(B)), and contributions of cars, boats and planes (§ 170(f)(12)). For donations of property, including clothing and household items, taxpayers should keep a written record of the donation that includes a description of the property and its condition. Deductions are not allowed for used property unless the property is in good condition. Taxpayers must keep a contemporaneous, written acknowledgement from a charity for each deductible donation (either money or property) of $250 or more. For contributions of property in excess of $500, a description of the property must be attached to the tax return. A qualified appraisal of the property must be attached with the return for donations of property with a value in excess of $5,000. 14. [LO 2] Describe the conditions in which a donation of property to a charity will result in a charitable contribution deduction of fair market value and when it will result in a deduction of the tax basis of the property. Taxpayers deduct the fair market value of property (noncash) donations when they donate: (1) a capital asset that has appreciated in value (the value is greater than the basis of the property) and the taxpayer has owned the asset for more than a year before donating it (but see exceptions below), or (2) appreciated business assets (value greater than basis) the taxpayer owned for more than a year before donating but only to the extent that the gain on the asset would not be treated as ordinary income if it had been sold. However, the deduction for an appreciated capital asset that is tangible, personal property is limited to the adjusted basis of the property if the charity uses the property for a purpose unrelated to its charitable purpose. Taxpayers donating ordinary income property (or capital loss property) deduct the lesser of (1) the fair market value of the property and (2) the adjusted basis of the property. Thus when the value of ordinary income property (or capital loss property) is less than the basis, taxpayers deduct the value. Thus, taxpayers deduct the basis of the property when they contribute: ordinary income property that has appreciated in value. capital gain property donated to private nonoperating foundations (other than stock). capital gain property consisting of tangible personal property and the charity uses the property (and the taxpayer should have reasonably expected that) for a purpose unrelated to the reason it is a charity. Appreciated business assets held more than a year to the extent that the gain would be recaptured as ordinary income under the depreciation recapture rules. 15. [LO 2] Jake is a retired jockey who takes monthly trips to Las Vegas to gamble on horse races. Jake also trains race horses part time at his Louisville ranch. So far this year, Jake has won almost $47,500 during his trips to Las Vegas while spending $27,250 on travel expenses and incurring $62,400 of gambling losses. Explain how Jake’s gambling winnings and related costs will be treated for tax purposes. Jake’s $47,500 of gambling winnings is included in his gross income. The gambling losses and expenses (total of $89,650) are only deductible as an itemized deduction, limited to the amount of gambling winnings. Thus, only $47,500 will be deductible. 16. [LO 2] {Research} Frank paid $3,700 in fees for an accountant to tabulate business information (Frank operates as a self-employed contractor and files a Schedule C). The accountant also spent time tabulating Frank’s income from his investments and determining Frank’s personal itemized deductions. Explain to Frank whether or not he can deduct the $3,700 as a business expense or as an itemized deduction, and provide a citation to an authority that supports your conclusion. Under Reg §1.67-1T(c), expenditures that relate to both a business activity (deductible for AGI) and the production of income or tax preparation (nondeductible) must be allocated between the activities on a reasonable basis. It would seem that billable hours would provide just such a basis. 17. [LO 2] Contrast ceiling and floor limitations, and provide an example of each. A ceiling is a maximum amount for an exclusion or deduction. In contrast to a ceiling, a floor limitation eliminates any deduction for amounts below the minimum amount (i.e., the floor). Ceiling limitations may provide that amounts above the ceiling limit are lost (disallowed) or could be used in other years (carryover). Like a ceiling, a floor can be structured as either a fixed amount or a floating constraint based upon some intermediate number. Unlike ceilings, floor limits eliminate any amounts below the minimum thereby limiting the number of taxpayers who qualify for any adjustment to income. While there are many examples of ceiling and floor limits, two common examples are the medical expense deduction (which contains a floor) and the charitable contribution deduction (which contains several ceilings). The 7.5 percent AGI floor is an aggregate floor limit placed on the sum of all deductible medical expenses in a particular year. If medical expenses do not exceed the floor, then no deduction can be claimed. In contrast, the charitable contribution deduction contains ceiling limits –such as, cash deductions to public charities cannot exceed 60 percent of AGI. To the extent that contributions exceed the ceiling, the deductions carryover into the subsequent year. 18. [LO 2] Identify which itemized deductions are subject to floor limitations, ceiling limitations, or some combination of these limits. Charitable contributions, home mortgage interest, and taxes are subject to ceiling limits (based on a percentage of AGI, on the amount of debt, and a flat amount, respectively) whereas aggregate medical expenses and gambling expenses and losses are subject to separate floor limits (based upon percentages of AGI and amount of gambling income, respectively). All itemized deductions are subject to the standard deduction which is a flat floor limitation. 19. [LO 3] Describe the tax benefits from “bunching” itemized deductions in one year. Describe the characteristics of the taxpayers who are most likely to benefit from using bunching and explain why this is so. The strategy of bunching itemized deductions (a cash-basis taxpayer paying two years’ worth of deductible expenses in one year to the extent possible) makes it more likely that deductions will exceed a floor limit. This strategy can be effective for generating some incremental tax benefits from total itemized deductions. Taxpayers are likely to benefit from bunching if (1) they are unlikely to have sufficient itemized deductions in any one year to easily exceed the standard deduction, but can easily exceed the standard deduction by summing itemized deductions for two consecutive years, (2) report on the cash-basis and (3) are able to time payments around year-end (to minimize the loss of present value). Charitable deductions and real estate taxes (due at year-end) can often be easily bunched into one year or another. 20. [LO 3] Explain how the standard deduction is rationalized and why the standard deduction might be viewed as a floor limit on itemized deductions. From the government’s standpoint, the standard deduction serves two purposes. First, to help taxpayers with lower income, it automatically provides a minimum amount of income that is not subject to taxation. Second, it eliminates the need for the IRS to verify and audit itemized deductions for those taxpayers who chose to deduct the standard deduction. From the taxpayers’ perspective, the standard deduction allows them to avoid taxation on a portion of their income, and for those not planning to itemize deductions, it eliminates the need to substantiate and collect information about them. The standard deduction essentially eliminates the tax benefits of itemized deductions up to the amount of the standard deduction and thus may be viewed as a floor limit on itemized deductions because most taxpayers will not elect to itemize if the standard deduction exceeds itemized deductions. 21. [LO 3] {Research} Determine whether a taxpayer can change his or her election to itemize deductions once a return is filed. (Hint: Read about itemization under Reg. §1.63-1.) The election to itemize is made on the return and Reg.§1.63-1 specifies that the election can be changed by filing an amended return any time within the statute of limitations (except for taxpayers filing married-separately, both of whom must file consistently). 22. [LO 3] {Research} Determine whether a taxpayer who is claimed as a dependent on another return is entitled to an addition to the standard deduction for age or blindness. (Hint: Read the calculation of the standard deduction under §63.) Under §63(c), standard deduction is defined as the “basic” standard deduction plus an “additional” standard deduction for age and sight. However, §63(c)(2) only limits the “basic” standard deduction for a taxpayer claimed as a dependent on another’s return to $1,100 or $350 plus the individual's earned income, whichever is greater. Hence, it would appear that a taxpayer claimed as a dependent on another’s return could claim an addition to the standard deduction for age and sight. 23. [LO 4] Describe what is meant by qualified business income for purposes of the deduction for qualified business income. Qualified business income means the net amount of qualified items of income, gain, deduction, and loss with respect to the taxpayer’s qualified trade or business conducted within the United States. Qualified items do not include specified investment-related income, deductions, or loss (e.g., capital gains or losses, dividends, interest income not allocable to a trade or business, etc.). For self-employed taxpayers, qualified business income is generally reduced by the deductible portion of self-employment taxes, the self-employed health insurance deduction, and the deduction for contributions to qualified self-employed retirement plans. A qualified trade or business means any trade or business other than a specified service trade or business and other than the trade or business of being an employee. A specified service trade or business means any trade or business involving the performance of services in the fields of health, law, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners, or which involves the performance of services that consist of investing and investment management trading, or dealing in securities, partnership interests, or commodities. Architecture and engineering services are specifically excluded from the definition of specified service trade or business. For any year in which the taxpayer’s taxable income (before the deduction for qualified business income) is less than $163,300 ($326,600, in the case of a joint return; $163,300 for married filing separate), the exclusion for specified service trades or business will not apply (the business will be deemed a qualified trade or business). For taxpayers with taxable income above $163,300 ($326,600, in the case of a joint return; $163,300 for married filing separate), the exclusion from the definition of a qualified business for specified service trades or businesses phases in over a $50,000 range ($100,000, in the case of a joint return). The exclusion from the definition of a qualified business for specified service trades or businesses is fully phased in for taxpayers with taxable income in excess of $213,300 ($426,600 in the case of a joint return; $213,300 for married filing separate). 24. [LO 4] Under what circumstances would business income from an accounting practice qualify for the deduction for qualified business income? Unfortunately, accounting services is specifically defined as specified service trade or business that is not considered a qualified trade or business for the deduction. Thus, generally business income from an accounting practice is not eligible for the deduction for qualified business income. However, for any year in which the taxpayer’s taxable income (before the deduction for qualified business income) is less than $163,300 ($326,600, in the case of a joint return; $163,300 for married filing separate), the exclusion for specified service trades or business will not apply (an accounting practice will be deemed a qualified trade or business). For taxpayers with taxable income above $163,300 ($326,600, in the case of a joint return; $163,300 for married filing separate), the exclusion from the definition of a qualified business for specified service trades or businesses phases in over a $50,000 range ($100,000, in the case of a joint return). The exclusion from the definition of a qualified business for specified service trades or businesses is fully phased in for taxpayers with taxable income in excess of $213,300 ($426,600 in the case of a joint return; $213,300 for married filing separate). Thus, business income from an accounting practice would at least partially qualify for the deduction for qualified business income if the taxpayer had taxable income (before the deduction for qualified business income) less than $213,300 ($426,600, in the case of a joint return; $213,300 for married filing separate). 25. [LO 4] For purposes of the deduction for qualified business income, what is a specified service trade or business and why is it important? A specified service trade or business means any trade or business involving the performance of services in the fields of health, law, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners, or which involves the performance of services that consist of investing and investment management trading, or dealing in securities, partnership interests, or commodities. Architecture and engineering services are specifically excluded from the definition of specified service trade or business. It is important because specified service trade or businesses are generally not eligible for the deduction for qualified business income (i.e., they are not considered a qualified trade or business). Problems 26. [LO 1] Clem is married and is a skilled carpenter. Clem’s wife, Wanda, works part-time as a substitute grade school teacher. Determine the amount of Clem’s expenses that are deductible for AGI this year (if any) under the following independent circumstances: a. Clem is self-employed, and this year he incurred $525 in expenses for tools and supplies related to his job. Because neither was covered by a qualified health plan, Wanda paid health insurance premiums of $3,600 to provide coverage for herself and Clem (not through an exchange). b. Clem and Wanda own a garage downtown that they rent to a local business for storage. This year they incurred expenses of $1,250 in utilities and $780 of depreciation. c. Clem paid self-employment tax of $15,300 (the employer portion is $7,650) and Wanda had $3,000 of Social Security taxes withheld from her pay. d. Clem paid $45 to rent a safety deposit box to store his coin collection. Clem has collected coins intermittently since he was a boy and he expects to sell his collection when he retires. a. $4,125 – The tools and supplies and the health insurance are deductible for AGI. b. $2,030 – The utilities and depreciation are deductible for AGI (rental activity). c. $7,650 –The employer portion of the self-employment tax is deductible for AGI but the Social Security tax is not deductible. d. $0 – The safety deposit box fee is a nondeductible investment expense as it appears that Clem is investing in rare coins rather than a dealer in coins – a business. 27. [LO 1] Don Juan, a single taxpayer, is the sole owner, of DJ’s Inc., an S corporation. This year, DJ’s Inc. incurred a massive $600,000 business loss, all of which is allocable to Don Juan as the sole shareholder. Assume that the $600,000 loss is not limited by the basis, at-risk, or passive loss rules, and that Don Juan has no other business income or business losses. How much of the $600,000 loss will Don Juan be able to deduct this year? What happens to any loss not deducted this year? Unfortunately, the $600,000 business loss is subject to the excess business loss limitation. An excess business loss is the excess of aggregate business deductions for the year over the sum of aggregate business gross income or gain of the taxpayer plus a threshold amount. The threshold amount for a tax year is $518,000 for married taxpayers filing jointly and $259,000 for other taxpayers. Since Don Juan is single, his excess business loss is $341,000 (the excess of his $600,000 business loss over the sum of his other business income ($0) and the $259,000 threshold amount). Don Juan may deduct $259,000 of the loss this year. The $341,000 excess business loss will be carried forward next year to Don Juan’s tax return. 28. [LO 1] Smithers is a self-employed individual who earns $30,000 per year in self-employment income. Smithers pays $2,200 in annual health insurance premiums (not through an exchange) for his own medical care. In each of the following situations, determine the amount of the deductible health insurance premium for Smithers before any AGI limitation. a. Smithers is single, and the self-employment income is his only source of income. b. Smithers is single, but besides being self-employed, Smithers is also employed part time by SF Power Corporation. This year Smithers elected not to participate in SF’s health plan. c. Smithers is self-employed and is also married. Smithers’s spouse, Samantha, is employed full-time by SF Power Corporation and is covered by SF’s health plan. Smithers is not eligible to participate in SF’s health plan. d. Smithers is self-employed and is also married. Smithers’s spouse, Samantha, is employed full time by SF Power Corporation and is covered by SF’s health plan. Smithers elected not to participate in SF’s health plan. a. Smithers can deduct $2,200 either as a deduction for AGI or claim $2,200 as an itemized medical expense. b. Smithers can claim only $2,200 as an itemized medical expense. Even though he is self-employed, he is not eligible to deduct the health insurance premiums as a for AGI deduction because he is eligible to participate in his employer’s plan (even though he did not actually participate). c. Smithers can deduct $2,200 either as a deduction for AGI or claim $2,200 as an itemized medical expense. d. Smithers can claim only $2,200 as an itemized medical expense. Even though he is self-employed, he is not eligible to deduct the health insurance premiums as a for AGI deduction because he is eligible to participate in his spouse’s employer’s plan (even though he did not actually participate in her plan). 29. [LO 1] Hardaway earned $100,000 of compensation this year. He also paid (or had paid for him) $3,000 of health insurance (not through an exchange). What is Hardaway’s AGI in each of the following situations? (Ignore the effects of Social Security and self-employment taxes.) a. Hardaway is an employee, and his employer paid Hardaway’s $3,000 of health insurance for him as a nontaxable fringe benefit. Consequently, Hardaway received $97,000 of taxable compensation and $3,000 of nontaxable compensation. b. Hardaway is a self-employed taxpayer, and he paid $3,000 of health insurance himself. He is not eligible to participate in an employer-sponsored plan. a. Hardaway’s AGI is $97,000, consisting of the $97,000 of taxable compensation he received from his employer. b. Hardaway’s AGI is $97,000 (the same as in part a), consisting of $100,000 of taxable earnings minus $3,000 for AGI deduction for the health insurance. 30. [LO 1] {Tax Forms} Betty operates a beauty salon as a sole proprietorship. Betty also owns and rents an apartment building. This year Betty had the following income and expenses. Determine Betty’s AGI and complete page 1 (through line 8b) and Schedule 1 of Form 1040 for Betty. You may assume that Betty will owe $2,502 in self-employment tax on her salon income, with $1,251 representing the employer portion of the self-employment tax. You may also assume that her divorce from Rocky was finalized in 2016. The beauty parlor salaries and expenses are deductible on Schedule C as business expenses and the depreciation and real estate taxes for the apartment building are deductible for AGI as rental/royalty related deductions. The interest income is included in AGI, and the alimony expense is deductible for AGI. Note that this solution assumes that the apartment building amounts represent Betty’s interest and not the total. The residential real estate taxes and the charitable contributions are itemized deductions. *Betty would owe $2,502 in self-employment tax ($17,710 salon income x 92.35% x 15.3% = $2,502). Of the $2,502, $1,251 ($17,710 x 92.35% x 7.65%) would be deductible as a for AGI deduction. Form 1040, Page 1: Form 1040, Schedule 1: 31. [LO 1] Lionel is an unmarried law student at State University Law School, a qualified educational institution. This year Lionel borrowed $24,000 from County Bank and paid interest of $1,440. Lionel used the loan proceeds to pay his law school tuition. Calculate the amounts Lionel can deduct for higher education expenses and interest on higher education loans under the following circumstances: a. Lionel’s AGI before deducting interest on higher education loans is $50,000. b. Lionel’s AGI before deducting interest on higher education loans is $79,000. c. Lionel’s AGI before deducting interest on higher education loans is $90,000. a. The maximum interest deduction is the amount paid up to $2,500. The deduction is phased out as AGI exceeds $70,000 (before applying the interest deduction). Consequently, because his AGI is below the trigger amount for the phase-out, Lionel can deduct $1,440, which is the lesser of (1) $2,500 or (2) $1,440 (the amount of interest expense he paid). Lionel paid $24,000 of qualified educational expenses. Because his modified AGI ($50,000 - $1,440 deduction for interest on higher education loan = $48,560) is less than the trigger for the deduction for qualified education expense phase-out ($65,000), Lionel can deduct $4,000 for qualified education expenses, which is the lesser of (1) $4,000 or (2) $24,000 (qualified education expenses paid). b. Lionel can deduct $576 of qualified educational interest expense computed as follows:
Description Amount Explanation
(1) Modified AGI $79,000
(2) Amount of interest paid up to $2,500 1,440 Lesser of amount paid or $2,500
(3) Phase-out (reduction) percentage 60% [(1) – 70,000] / 15,000, limited to 100 percent
(4) Phase-out amount (reduction in maximum) 864 (2) x (3)
Deductible interest expense $576 (2) – (4)
Since Lionel’s modified AGI ($74,000 - $576 deduction for interest on higher education loan = $73,424) exceeds $65,000 but is less than or equal to $80,000, Lionel can also deduct $2,000 of qualified education expenses, which is the lesser of (1) $2,000 or (2) $24,000 (qualified education expenses paid). c. Lionel is not allowed to deduct any qualified educational interest expense computed as follows:
Description Amount Explanation
(1) Modified AGI $90,000
(2) Amount of interest paid up to $2,500 1,440 Lesser of amount paid or $2,500
(3) Phase-out (reduction) percentage 100% [(1) – 70,000] / 15,000, limited to 100 percent
(4) Phase-out amount (reduction in maximum) 1,440 (2) x (3)
Deductible interest expense $0 (2) – (4)
Lionel is also not allowed to deduct any qualified education expenses because his modified AGI ($90,000) exceeds $80,000. 32. [LO 1] This year Jack intends to file a married-joint return. Jack received $172,500 of salary, and paid $5,000 of interest on loans used to pay qualified tuition costs for his dependent daughter, Deb. This year Jack has also paid moving expenses of $4,300 and $28,300 of alimony to his ex-wife, Diane, who divorced him in 2012. a. What is Jack’s adjusted gross income? b. Suppose that Jack also reported income of $8,800 from a half share of profits from a partnership. Disregard any potential self-employment taxes on this income. What AGI would Jack report under these circumstances? AGI is $142,050. Jack’s modified AGI calculated without adjustment for educational interest expense is $144,200. The moving expense is not deductible. He is allowed to deduct part of his student loan interest because his modified AGI is not above $170,000. Jack’s maximum deduction before the phase-out is $2,500 (the amount of interest paid up to $2,500). The maximum deduction of $2,500 is phased-out ratably over a $30,000 range beginning with modified AGI over $140,000. Consequently, Jack’s education interest expense deduction is $2,150 = ($2,500 - $2,500 * [($144,200-140,000) / 30,000]). Jack’s AGI is computed as follows; b. AGI is $151,583. Jack’s modified AGI calculated without adjustment for educational interest expense is $153,000. The moving expense is not deductible. He is allowed to deduct part of his student loan interest because his modified AGI is not above $170,000. Jack’s maximum deduction before the phase-out is $2,500 (the amount of interest paid up to $2,500). The maximum deduction of $2,500 is phased-out ratably over a $30,000 range beginning with modified AGI over $140,000. Consequently, Jack’s education interest expense deduction is $1,417 = ($2,500 - $2,500 * [($153,000-140,000)/30,000]). Jack’s AGI is computed as follows: 33. [LO 1, LO 2] In each of the following independent cases, indicate the amount (1) deductible for AGI, (2) deductible from AGI, and (3) deductible neither for nor from AGI before considering income limitations or the standard deduction. a. Ted paid $50 rent on a safety deposit box at the bank. In this box he kept the few shares of stock that he owned. b. Tyler paid $85 for minor repairs to the fence at a rental house he owned. c. Timmy paid $545 for health insurance premiums this year (not through an exchange and not with pre-tax dollars). Timmy is employed full time and his employer paid the remaining premiums as a qualified fringe benefit. d. Tess paid $1,150 of state income taxes on her consulting income. a. Not deductible – investment expense (other than investment interest expenses or rental or royalty expenses associated with an investment activity) is generally not deductible b. Deduction for AGI – rental/royalty expense c. The health insurance is from AGI – medical itemized deduction but subject to an AGI floor limitation. d. The state income taxes are deductible from AGI (an itemized deduction). 34. [LO 1, LO 2] In each of the following independent cases, indicate the amount (1) deductible for AGI, (2) deductible from AGI, and (3) deductible neither for nor from AGI before considering income limitations or the standard deduction. a. Fran spent $90 for uniforms for use on her job. Her employer reimbursed her for $75 of this amount under an accountable plan (and did not report the reimbursement as wages). b. Timothy, a plumber employed by ACE Plumbing, spent $65 for small tools to be used on his job, but he was not reimbursed by ACE. c. Jake is a perfume salesperson. Because of his high pay, he receives no allowance or reimbursement from his employer for advertising expenses even though his position requires him to advertise frequently. During the year, he spent $2,200 on legitimate business advertisements. d. Trey is a self-employed special-duty nurse. He spent $120 for uniforms. e. Mary, a professor at a community college, spent $340 for magazine subscriptions. The magazines were helpful for her research activities but she was not reimbursed for the expenditures. f. Wayne lost $325 on the bets he made at the race track, but he won $57 playing slot machines. a. Not deductible. The unreimbursed employee business expenses of $15 are not deductible. Income and expenses associated with the $75 reimbursement from an accountable plan completely offset each other and are ignored. Note that the accountable plan only reimburses deductible expenses. b. Not deductible. The unreimbursed employee business expenses of $65 are not deductible. c. Not deductible. The unreimbursed employee business expenses of $2,200 are not deductible. d. for AGI deduction- trade expense assuming that the special duty uniforms cannot be adapted to normal use. e. Not deductible. The unreimbursed employee business expenses of $340 are not deductible. f. $57 from AGI as another itemized deduction. Wayne’s gambling loss deduction is limited to his winnings. The remaining $268 is not deductible. 35. [LO 2] Penny, a full-time biochemist, loves stock car racing. To feed her passion, she bought a used dirt-track car and has started entering some local dirt-track races. The prize money is pretty small ($1,000 for the winner), but she really is not in it for the money. Penny reported the following income and expenses from her nights at the track: What are the tax effects of Penny’s racing income and expenses assuming that the racing activity is a hobby for Penny? Penny must include the $2,500 of hobby revenue in gross income, but hobby expenses are not deductible. Thus, the net impact of the hobby activity is to increase Penny’s gross income by $2,500. 36. [LO 2] Simpson, age 45, is a single individual who is employed full time by Duff Corporation. This year Simpson reports AGI of $50,000 and has incurred the following medical expenses: a. Calculate the amount of medical expenses that will be included with Simpson’s itemized deductions after any applicable limitations. b. Suppose that Simpson was reimbursed for $250 of the physician's charges and $1,200 for the hospital costs. Calculate the amount of medical expenses that will be included with Simpson’s itemized deductions after any applicable limitations. a. All expenses are qualified medical expenses except for the over-the-counter drugs. Hence, Simpson’s medical expense deduction is $6,625 less $3,750 (7.5 percent * 50,000) = $2,875 and this amount is included with Simpson’s other itemized deductions. b. Same as (a) except Simpson’s medical expenses are first reduced by reimbursements $6,625 less $1,450 then reduced by the floor limit $3,750 (7.5 percent* 50,000) = $1,425 and this amount is included with Simpson’s other itemized deductions. 37. [LO 2] {Research} Tim is age 45 years old and is considering enrolling in an insurance program that provides for long-term care insurance. He is curious about whether the insurance premiums are deductible as a medical expense. If so, he wants to know the maximum amount that can be deducted in any year. §213(d)(10)(A) limits the deduction depending upon the age of the insured. The amounts listed are indexed for inflation under §213(d)(10), so reference needs to be made to the inflation adjusted amounts listed in a current Revenue Procedure. For 2020, Rev Proc 2019-44, provides that for taxpayers over age 40 but not yet over age 50, the maximum deduction is $810. 38. [LO 2] {Research} Doctor Bones prescribed physical therapy in a pool to treat Jack’s broken back. In response to this advice (and for no other reason), Jack built a swimming pool in his backyard and strictly limited use of the pool to physical therapy. Jack paid $25,000 to build the pool, but he wondered if this amount could be deducted as a medical expense. Determine if a capital expenditure such as the cost of a swimming pool qualifies for the medical expense deduction. Under Reg. 1.213-1(e)(1)(iii) capital expenditures that are medical necessities are deductible to the extent the expenditure exceeds the increase in the value of the underlying property. No deduction is allowed for the cost of making the architectural changes for aesthetic purposes. Hence, the taxpayer could likely deduct some part of the $25,000 expenditure depending upon the extent of any increase in the value of the residence. The IRS will not issue advance rulings on this issue (Rev Proc 87-3, 1987-1 CB 523), so the taxpayer should expect some interaction with the service if the deduction is large. Rev Rul 87-106, 1987-2 CB 67, lists other types of capital expenditures that may be acceptable as medical expenses. 39. [LO 1, LO 2] Charles has AGI of $50,000 and has made the following payments related to (1) land he inherited from his deceased aunt and (2) a personal vacation taken last year. Calculate the amount of taxes Charles may include in his itemized deductions for the year under the following circumstances: a. Suppose that Charles holds the land for appreciation. b. Suppose that Charles holds the land for rent. c. Suppose that Charles holds the land for appreciation and that the vacation was actually a business trip. a. Deductible taxes = $2,190 ($1,500 + $690). The inheritance tax, the airline tax, and the hotel tax are nondeductible personal expenses. The special assessment is also not deductible because it is capitalized to the value of the property. b. The $2,190 of taxes are deductions for AGI associated with rental property. c. The inheritance tax and the special assessment are still not deductible (as in a. above). The airline tax and the hotel tax are nondeductible as an unreimbursed business expenses. 40. [LO 2] Dan has AGI of $50,000 and paid the following taxes during this tax year. Calculate how much Dan can deduct for taxes as an itemized deduction this year. Deductible taxes = $2,150 (only the $750 state income tax estimated tax payments and $1,400 state income tax withholding will be deductible) The $300 fee for the auto license is not deductible as property tax since the fee is based on weight, not value. Dan could opt to deduct state sales tax in lieu of state income taxes. 41. [LO 1, LO 2] Tim is a single, cash-method taxpayer with an AGI of $50,000. In April of this year Tim paid $1,020 with his state income tax return for the previous year. During the year, Tim had $5,400 of state income tax and $18,250 of federal income tax withheld from his salary. In addition, Tim made estimated payments of $1,360 and $1,900 for state and federal income taxes, respectively. Finally, Tim expects to receive a refund of $500 for state income taxes when he files his state tax return for this year in April next year. What is the amount of taxes that Tim can deduct as an itemized deduction? Tim can deduct the state taxes paid with last year’s return, state tax withheld during the year, and estimated payments of state tax, a total of $7,780 ($1,020 +$5,400 + $1,360). The expected refund next year will not affect the deductions for this year, but may be taxable next year under the tax benefit rule. 42. [LO 2] This year Randy paid $28,000 of interest (Randy borrowed $450,000 to buy his residence, and it is currently worth $500,000). Randy also paid $2,500 of interest on his car loan and $4,200 of margin interest to his stockbroker (investment interest expense). How much of this interest expense can Randy deduct as an itemized deduction under the following circumstances? a. Randy received $2,200 of interest this year and no other investment income or expenses. His AGI is $75,000. b. Randy had no investment income this year, and his AGI is $75,000. a. Randy can deduct $30,200. The interest on the car loan is nondeductible personal interest but Randy may deduct all $28,000 of his interest on the home loan as an itemized deduction because the loan is less than the limit of $750,000 on acquisition indebtedness. The $4,200 of margin interest is likely investment interest, and this itemized deduction is limited to net investment income. Because the $2,200 of interest income qualifies as investment income and Randy has no deductible investment expenses, the investment interest expense would be limited to his $2,200 in net investment income. Randy would carry forward $2,000 to next year. b. Randy may deduct all $28,000 of his interest on the home loan as an itemized deduction. Randy has no net investment income. Hence, the investment interest would not be deductible this year and would carry forward to next year. 43. [LO 2] Janyce, a single taxpayer, has AGI of $125,000 and paid the following taxes this year. Calculate how much Janyce can deduct for taxes as an itemized deduction this year. All of the above taxes are deductible ($7,200 + $600 + $800 + $1,900 = $10,500) but they are limited to a maximum deduction of $10,000. 44. [LO 2] This year, Major Healy paid $40,000 of interest on a mortgage on his home (Major Healy borrowed $800,000 to buy the residence in 2015; $900,000 original purchase price and value at purchase), $6,000 of interest on a $120,000 home equity loan on his home (loan proceeds were used to buy antique cars), and $10,000 of interest on a mortgage on his vacation home (borrowed $200,000 to purchase the home in 2010; home purchased for $500,000). Major Healy’s AGI is $220,000. How much interest expense can Major Healy deduct as an itemized deduction? $50,000. Major Healy’s acquisition debt on his home and vacation home does not exceed $1,000,000 (the applicable limit on acquisition indebtedness incurred before December 16, 2017). Thus, he can deduct the $40,000 mortgage interest on his home and $10,000 of mortgage interest on his vacation home. The interest on his home equity loan is not deductible. 45. [LO 2] Jack, who files married separate, has AGI of $45,000 and paid the following taxes this year. Calculate how much Jack can deduct for taxes as an itemized deduction this year. Deductible taxes are ($6,200 + $500 +$1,000 = $7,700) but they are limited to a maximum deduction of $5,000 since Jack files married separate. The $800 automobile tax for the auto is not deductible as property tax since it is based on weight, not value. 46. [LO 2] Ray Ray made the following contributions this year. Determine the maximum amount of charitable deduction for each of these contributions ignoring the AGI ceiling on charitable contributions and assuming that the American Heart Association plans to sell the antique painting to fund its operations. Ray Ray has owned the painting and Coca-Cola stock since 1990. The maximum amount is $9,000 for the cash contributions and $35,000 for the property donations. Because Ray Ray has reason to expect that the American Heart Association will sell the antique painting, the antique is used for a purpose unrelated to the American Heart Association’s charitable purpose. Thus, Ray Ray’s deduction for the painting is limited to his basis in the painting ($15,000). The amount of the deduction for the Coca Cola stock is its fair market value ($20,000) because the stock is considered intangible, appreciated long-term capital gain property. 47. [LO 2] Juanita paid $50,000 of interest on a mortgage on her home (loan of $1,000,000 at 5% interest rate to buy the residence in 2018; $1,200,000 original purchase price and value at purchase) and $6,500 of interest on a $100,000 home-equity loan on her home (loan proceeds were used to buy furniture). Juanita’s AGI is $600,000. How much interest expense can Juanita deduct as an itemized deduction?
$37,500. Juanita may only deduct interest on up to $750,000 of acquisition debt since it was incurred after December 15, 2017. Thus, she may only deduct $37,500 (5% interest on $750,000 debt). The $6,500 of interest on her home equity loan is not deductible. 48. [LO 2] Calvin reviewed his canceled checks and receipts this year for charitable contributions, which included an antique painting and IBM stock. He has owned the IBM stock and the painting since 2005. Calculate Calvin’s charitable contribution deduction and carryover (if any) under the following circumstances. a. Calvin’s AGI is $100,000. b. Calvin’s AGI is $100,000, but the State Museum told Calvin that it plans to sell the painting. c. Calvin’s AGI is $50,000. d. Calvin’s AGI is $100,000 and Hobbs is a private nonoperating foundation. e. Calvin’s AGI is $100,000, but the painting is worth $10,000. a. Calvin can deduct $33,000. All the contributions are deductible except the donation to the needy family. This donation will not qualify for a charitable deduction because the family is not a qualified charity (in contrast, a donation of food and clothes to a qualified organization, such as the Red Cross, would qualify). The IBM stock is long-term capital gain property, so Calvin can deduct the FMV of the stock ($22,000) subject to a 30 percent of AGI ($30,000) ceiling. The painting is not capital gain property because it has not appreciated in value. Hence, Calvin can only deduct the fair market value of the painting subject to the 50 percent of AGI ceiling ($50,000). The cash contribution to the United Way is subject to the 60 percent of AGI ceiling ($60,000). Calvin’s deductible donations are $33,000, calculated as follows:
Description Amount Explanation
(1) AGI $100,000
(2) 60% contributions 8,000 Cash contribution
(3) 60% AGI contribution limit 60,000 (1) x 60%
(4) Allowable 60% deductions 8,000 Lesser of (2) or (3)
(5) 50% contributions 3,000 painting
(6) 50% AGI contribution limit 42,000 [(1) x 50%] - (4)
(7) Allowable 50% deductions 3,000 Least of (5) or (6)
(8) 30% contributions 22,000 stock
(9) 30% AGI contribution limit 30,000 (1) x 30%
(10) Remaining 50% AGI contribution limit 39,000 (6) – (7)
(11) Allowable 30% deductions 22,000 Least of (8), (9), or (10)
Deductible charitable contributions $ 33,000 (4) + (7) + (11)
b. No difference with a. because the painting is not capital gain property. c. The reduction in AGI does not limit the cash and painting contribution deduction, but it does limit the deduction for the IBM stock to $14,000. The remaining value of the stock, $8,000 ($22,000 - $14,000), is carried over to next year subject to the 30 percent of AGI limit. Calvin’s deductible donations are $25,000, calculated as follows:
Description Amount Explanation
(1) AGI $50,000
(2) 60% contributions 8,000 Cash contribution
(3) 60% AGI contribution limit 30,000 (1) x 60%
(4) Allowable 60% deductions 8,000 Lesser of (2) or (3)
(5) 50% contributions 3,000 painting
(6) 50% AGI contribution limit 17,000 [(1) x 50%] - (4)
(7) Allowable 50% deductions 3,000 Least of (5) or (6)
(8) 30% contributions 22,000 stock
(9) 30% AGI contribution limit 15,000 (1) x 30%
(10) Remaining 50% AGI contribution limit 14,000 (6) – (7)
(11) Allowable 30% deductions 14,000 Least of (8), (9), or (10)
Deductible charitable contributions $ 25,000 (4) + (7) + (11)
d. The IBM stock is long-term capital gain property but because the donee is a private nonoperating foundation, the deduction for the value of the stock is subject to a 20 percent of AGI limitation. The remaining value of the stock, $2,000 ($22,000 - $20,000), is carried over to next year subject to the 20 percent of AGI limit. Calvin’s deductible donations are $31,000, calculated as follows:
Description Amount Explanation
(1) AGI $100,000
(2) 60% contributions 8,000 Cash contribution
(3) 60% AGI contribution limit 60,000 (1) x 60%
(4) Allowable 60% deductions 8,000 Lesser of (2) or (3)
(5) 50% contributions 3,000 painting
(6) 50% AGI contribution limit 42,000 [(1) x 50%] - (4)
(7) Allowable 50% deductions 3,000 Least of (5) or (6)
(8) 20% contributions 22,000 stock
(9) 20% AGI contribution limit 20,000 (1) x 20%
(10) Remaining 50% AGI contribution limit 39,000 (6) – (7)
(11) Allowable 30% deductions 20,000 Least of (8), (9), or (10)
Deductible charitable contributions $ 31,000 (4) + (7) + (11)
e. Now both the IBM stock and the painting are capital gain properties. Hence, Calvin can only deduct the aggregate fair market value of the stock and painting ($22,000 plus $10,000) subject to the 30 percent AGI limit ($30,000). This assumes that the painting will be used for the state museum’s charitable purposes. The remaining value of the capital gain property, $2,000 ($32,000 - $30,000), is carried over to next year subject to the 30 percent of AGI limit. Calvin’s deductible donations are $38,000, calculated as follows:
Description Amount Explanation
(1) AGI $100,000
(2) 60% contributions 8,000 Cash contribution
(3) 60% AGI contribution limit 60,000 (1) x 60%
(4) Allowable 60% deductions 8,000 Lesser of (2) or (3)
(5) 30% contributions 32,000 Stock and painting
(6) 30% AGI contribution limit 30,000 (1) x 30%
(7) Remaining 50% AGI contribution limit 42,000 [(1) x 50%] - (4)
(8) Allowable 30% deductions 30,000 Least of (5), (6), or (7)
Deductible charitable contributions $ 38,000 (4) + (8)
49. [LO 2] In addition to cash contributions to charity, Dean decided to donate shares of stock and a portrait painted during the earlier part of the last century. Dean purchased the stock and the portrait many years ago as investments. Dean reported the following recipients: a. Determine the maximum amount of charitable deduction for each of these contributions ignoring the AGI ceiling on charitable contributions. b. Assume that Dean’s AGI this year is $150,000. Determine Dean’s itemized deduction for his charitable contributions this year and any carryover. c. Suppose Dean is a dealer in antique paintings and had held the painting for sale before the contribution. What is Dean’s charitable contribution deduction for the painting in this situation (ignoring AGI limitations)? d. Suppose that Dean’s objective with the donation to the museum was to finance expansion of the historical collection. Hence, Dean was not surprised when the museum announced the sale of the painting because of its limited historical value. What is Dean’s charitable contribution deduction for the painting in this situation (ignoring AGI limitations)? a. The maximum amount is $29,500 for the cash contributions and $99,000 for the property donations. The amount of the deduction for property is fair market value if the property is long-term capital gain property and either intangible (the stock) or related to the charity’s exempt function (the antique to a museum). Hence, the value of the antique is deductible. Because the stock has declined in value it is not considered to be capital gain property, so the deduction for this donation is the lesser of fair market value or basis. In this case, the deductible amount is the $17,000 fair market value. b. $75,000. In this situation, Dean has contributed to public charities and he can deduct all of his cash contributions (subject to the 60% AGI limit) and the value of the stock (subject to the 50% AGI limit). Note that the stock is subject to the 50 percent of AGI limit and not the 30 percent AGI limit because it is ordinary income due to the fact its basis exceeds its value (it is not capital gain property). The antique painting is subject to the 30% AGI limit, resulting in a deduction of $28,500 this year (see calculation below) The remaining value of the antique $53,500 ($82,000 - $28,500) is carried over to next year subject to the 30 percent of AGI limit.
Description Amount Explanation
(1) AGI $150,000
(2) 60% contributions 29,500 Cash
(3) 60% AGI contribution limit 90,000 (1) x 60%
(4) Allowable 60% deductions 29,500 Lesser of (2) or (3)
(5) 50% contributions 17,000 Stock
(6) 50% AGI contribution limit 45,500 [(1) x 50%] - (4)
(7) Allowable 50% deductions 17,000 Least of (5) or (6)
(8) 30% contributions 82,000 Painting
(9) 30% AGI contribution limit 45,000 (1) x 30%
(10) Remaining 50% AGI contribution limit 28,500 (6) – (7)
(11) Allowable 30% deductions 28,500 Least of (8), (9), or (10)
Deductible charitable contributions $ 75,000 (4) + (7) + (11)
c. Because Dean is an antique dealer, the antique painting is ordinary income property, not capital gain property. Thus, Dean may deduct only the basis of the painting, $5,000, and this deduction is subject to the 50 percent AGI limit, not the 30 percent AGI limit. d. Because Dean had reason to expect the Museum would sell the antique, the antique is used for a purpose unrelated to the museum’s charitable purposes. Thus, Dean may deduct only the basis of the antique, $5,000, but this deduction is subject to the 50 percent AGI limit, not the 30 percent AGI limit. 50. [LO 2]{Planning} Trevor is a single individual who is a cash-method, calendar-year taxpayer. For each of the next two years (year 1 and year 2), Trevor expects to report AGI of $80,000, contribute $8,000 to charity, and pay $2,800 in state income taxes. a. Estimate Trevor’s taxable income for year 1 and year 2 using the 2020 amounts for the standard deduction for both years. b. Now assume that Trevor combines his anticipated charitable contributions for the next two years and makes the combined contribution in December of year 1. Estimate Trevor’s taxable income for each of the next two years using the 2020 amounts for the standard deduction. Reconcile the total taxable income to your solution to part (a). c. Trevor plans to purchase a residence next year, and he estimates that additional property taxes and residential interest will cost $2,000 and $10,000, respectively, each year. Estimate Trevor’s taxable income for each of the next two years (year 1 and year 2) using the 2020 amounts for the standard deduction and also assuming Trevor makes the charitable contribution of $8,000 and state tax payments of $2,800 in each year. d. Assume that Trevor makes the charitable contribution for year 2 and pays the real estate taxes for year 2 in December of year 1. Estimate Trevor’s taxable income for year 1 and year 2 using the 2020 amounts for the standard deduction. Reconcile the total taxable income to your solution to part (c). e. Explain the conditions in which the bunching strategy in part (d) will generate tax savings for Trevor. a. Trevor will elect the standard deduction of $12,400 (rather than itemized deductions of $10,800) and report taxable income of $67,600. His total taxable income for the two years will be $135,200 ($67,600 + $67,600) calculated as follows. b. Trevor can now itemize his deductions in year 1, because the total $18,800 itemized deductions ($8,000 + $8,000 +$2,800) now exceed the standard deduction. He will report lower total taxable income ($128,800 calculated below) over the two years because $6,600 of his itemized deductions now reduce taxable income. c. Now Trevor can itemize his deductions so he reports taxable income of $57,200 ($80,000-22,800 for both years). d. Itemized deductions in year 1 will be $4,000 (real estate taxes) + $10,000 (residential interest) + $16,000 (charitable contribution) + $2,800 (state tax deduction) = $32,800. Itemized deductions in year 2 are $10,000 (residential interest) + $2,800 (state tax deduction) = $12,800. Trevor reports the same total of taxable income, $114,400 for the two years, but the timing of the taxable income differs as follows: e. By bunching his deductions in part d. Trevor will not reduce his taxable income because he is already itemizing in both years. Trevor may save taxes using this strategy if his tax rate is higher in year 1 than year 2. 51. [LO 2] Simon lost $5,000 gambling this year on a trip to Las Vegas. In addition, he paid $2,000 to his broker for managing his $200,000 portfolio, and $1,500 to his accountant for preparing his tax return. In addition, Simon incurred $2,500 in transportation costs commuting back and forth from his home to his employer’s office, which were not reimbursed. Calculate the amount of these expenses that Simon is able to deduct (assuming he itemizes his deductions). $0. Gambling losses are only deductible to the extent of gambling winnings. Thus, Simon cannot deduct any of the $5,000 gambling losses. Unfortunately, the investment expenses, tax return fees, and commuting expenses are also nondeductible. 52. [LO 1, LO 2] {Research} Tammy teaches elementary school history for the Metro School District. In 2020 she has incurred the following expenses associated with her job: Noncredit correspondence course on history $ 900
Teaching cases for classroom use 1,800
Tammy’s employer does not provide any funding for the correspondence course or teaching cases. Identify the amount and type (for AGI or from AGI) of deductible expenses. The correspondence course is not likely to qualify as a qualified education deduction, because it is not for credit. $250 of the teaching cases and noncredit correspondence course would qualify for the educator’s deduction (IRC Sec. 62(d)). The remaining $2,450 would be nondeductible as an unreimbursed employee business expenses. 53. [LO 3] Stephanie is 12 years old and often assists neighbors on weekends by babysitting their children. Calculate the 2020 standard deduction Stephanie will claim under the following independent circumstances (assume that Stephanie’s parents will claim her as a dependent). a. Stephanie reported $850 of earnings from her babysitting. b. Stephanie reported $1,500 of earnings from her babysitting. c. Stephanie reported $18,000 of earnings from her babysitting. a. Stephanie can claim a standard deduction of $1,200, the greater of the minimum standard deduction ($1,100) or $350 plus her earned income ($850). b. Stephanie can claim a standard deduction of $1,850, the greater of the minimum standard deduction ($1,100) or $350 plus her earned income ($1,500). c. Stephanie can claim a standard deduction of $12,400, the greater of the minimum standard deduction ($1,100) or $350 plus her earned income but limited to the maximum standard deduction for her filing status, (single is $12,400 for 2020). 54. [LO 3] Jackson is 18 years old and has a dog-sitting business. Calculate the 2020 standard deduction Jackson will claim under the following independent circumstances. a. Jackson reported $2,000 of earnings from his dog sitting and $300 in interest income from his savings account. Jackson’s parents claim him as a dependent. b. Jackson reported $500 of earnings from his dog sitting and $2,000 in interest income from his savings account. Jackson’s parents claim him as a dependent. c. Jackson reported $8,000 of earnings from his dog sitting and $3,000 in interest income. Jackson’s parents do not claim him as a dependent. a. Jackson can claim a standard deduction of $2,350, the greater of the minimum standard deduction ($1,100) or $350 plus his earned income ($2,000). The interest income does not impact his standard deduction. b. Jackson can claim a standard deduction of $1,100, the greater of the minimum standard deduction ($1,100) or $350 plus his earned income ($500). The interest income does not impact his standard deduction. c. Jackson may claim a standard deduction of $12,400, the standard deduction for a single taxpayer in 2020. 55. [LO 3] Amelie, a retired physician, is 66 years old. Determine her standard deduction under the following scenarios.
a. Amelie is married to Roget, age 52, and they file married joint. b. Amelie is single. c. Amelie is single and her 10-year-old granddaughter, Emma, lives with her. Amelie supports Emma and claims her as a dependent.
a. Amelie and Roget’s standard deduction would be $26,100 ($24,800 based standard deduction for married filing joint plus $1,300 since Amelie is 65 or older). b. Amelie’s standard deduction would be $14,050 ($12,400 based standard deduction for single taxpayer plus $1,650 since Amelie is 65 or older). c. Amelie’s standard deduction would be $20,300 ($18,650 based standard deduction for head of household plus $1,650 since Amelie is 65 or older). 56. [LO 4] Roquan, a single taxpayer, is an attorney and practices as a sole proprietor. This year, Roquan had net business income of $90,000 from his law practice (net of the associated for AGI self-employment tax deduction). Assume that Roquan pays $40,000 in wages to his employees, has $10,000 of property (unadjusted basis of equipment he purchased last year), and has no capital gains or qualified dividends. His taxable income before the deduction for qualified business income is $100,000. a. Calculate Roquan’s deduction for qualified business income. b. Assume the same facts provided above, except Roquan’s taxable income before the deduction for qualified business income is $300,000. a. Legal services fall within the definition of specific service or trade businesses, which are deemed not to be “qualified trade or businesses” for purposes of the deduction for qualified business income. However, because Roquan’s taxable income (before the 20 percent deduction for qualified business income) is less than $163,300, the exclusion for specified service trades or business will not apply (the business will be deemed a qualified trade or business). Hence, Roquan is eligible for the deduction.
The deduction for qualified business income cannot exceed the greater of: (i) 50 percent of the wages paid with respect to the qualified trade or businesses, or
(ii) the sum of 25 of percent of the wages with respect to the qualified trade or businesses plus 2.5 percent of the unadjusted basis, immediately after acquisition, of all qualified property in the qualified trade or businesses. However, the wage-based limits only apply to taxpayers with taxable income in excess of $163,300 ($326,600, in the case of a joint return; $163,300 for married filing separate). Because Roquan’s taxable income (before the deduction for qualified business income) is less than $163,300, the wage-based limits do not apply. Thus, Roquan may deduct $18,000 ($90,000 net business income x 20%) as a deduction for qualified business income. Note that because Roquan has no capital gains or qualified dividends and his taxable income ($100,000) is greater than his qualified business income ($90,000), the taxable income limitation does not apply. b. If Roquan has taxable income (before the deduction for qualified business income) of $300,000, his law practice would be considered a specified service or trade business. Thus, he would not be eligible for the deduction for qualified business income. 57. [LO 4] Katie, a single taxpayer, is a shareholder in Engineers One, a civil engineering company. This year, Katie’s share of net business income from Engineers One is $200,000 (net of the associated for AGI self-employment tax deduction). Assume that Katie’s allocation of wages paid by Engineers One to its employees is $300,000 and her allocation of Engineers One’s qualified property is $150,000 (unadjusted basis of equipment, all purchased within past three years). Assume Katie has no other business income and no capital gains or qualified dividends. Her taxable income before the deduction for qualified business income is $400,000. a. Calculate Katie’s deduction for qualified business income. b. Assume the same facts provided above, except Katie’s net business income from Engineers One is $400,000 (net of the associated for AGI self-employment tax deduction) and her taxable income before the deduction for qualified business income is $350,000. a. Engineering services do not fall within the definition of specific service or trade businesses. Thus, Engineers One is a “qualified trade or businesses” for purposes of the deduction for qualified business income. Katie is not limited by the wage-base limitation because 20 percent of her qualified business income ($200,000 x 20% = $40,000) is less than the greater of:
(a) 50 percent of her allocable wages ($300,000 x 50% = $150,000) or (b) 25 percent of her allocable wages ($300,000 x 25% = $75,000) plus 2.5 percent of the unadjusted basis of qualified property ($150,000 x 2.5% = $3,750).
Likewise, Katie is not limited by taxable income limitation because 20 percent of her qualified business income ($200,000 x 20% = $40,000) is less than 20 percent of her taxable income before the deduction ($400,000 x 20% = $80,000). Thus, she may deduct $40,000 as a deduction for qualified business income.
b. Engineering services do not fall within the definition of specific service or trade businesses. Thus, Engineers One is a “qualified trade or businesses” for purposes of the deduction for qualified business income. Katie is not limited by the wage-base limitation because 20 percent of her qualified business income ($400,000 x 20% = $80,000) is less than the greater of:
(a) 50 percent of her allocable wages ($300,000 x 50% = $150,000) or (b) 25 percent of her allocable wages ($300,000 x 25% = $75,000) plus 2.5 percent of the unadjusted basis of qualified property ($150,000 x 2.5% = $3,750). However, Katie is limited by taxable income limitation because 20 percent of her qualified business income ($400,000 x 20% = $80,000) is greater than 20 percent of her taxable income before the deduction ($350,000 x 20% = $70,000) Thus, she may deduct $70,000 as a deduction for qualified business income. Comprehensive Problems 58. This year Evan graduated from college, and took a job as a deliveryman in the city. Evan was paid a salary of $72,300 and he received $700 in hourly pay for part-time work over the weekends. Evan summarized his expenses as follows. Calculate Evan’s AGI and taxable income if he files single. Assume that interest payments were initially required on Evan’s student loans this year. AGI is $71,000; Taxable income is $58,600, computed as follows: Evan’s moving expenses and uniform expenses are not deductible. Evan’s modified AGI for determining the deductibility of his educational loan interest is $3,000 beyond the threshold amount of $70,000, and hence his deduction for educational loan interest is subject to a phase-out. Evan’s maximum deduction before the phase-out is $2,500 (the amount of interest paid ($2,800) up to $2,500). The ratio is $3,000/$15,000 resulting in a phase-out of 20% percent of the maximum deduction of $2,500. Hence, Evan can only deduct $2,000 of the student loan interest ($2,500-$500). Therefore, Evan’s AGI is $71,000. The charitable contribution would be deductible as an itemized deduction, but Evan would choose his standard deduction instead of itemizing (because the standard deduction ($12,400) exceeds the sum of his itemized deductions ($1,300 charitable contributions)). 59. {Tax Forms} Read the following letter and help Shady Slim with his tax situation. Please assume that gross income is $172,900 (which consists only of salary) for purposes of this problem. December 31, 2020 To the friendly student tax preparer: Hi, it’s Shady Slim again. I just got back from my 55th birthday party, and I’m told that you need some more information from me in order to complete my tax return. I’m an open book! I’ll tell you whatever I think you need to know. Let me tell you a few more things about my life. As you may recall, I am divorced from my wife, Alice. I know that it’s unusual, but I have custody of my son, Shady Jr. The judge owed me a few favors and I really love the kid. He lives with me full time and my wife gets him every other weekend. I pay the vast majority of my son’s expenses. I think Alice should have to pay some child support, but she doesn’t have to pay a dime. The judge didn’t owe me that much, I guess. I had to move this year after getting my job at Roca Cola. We moved on February 3 of this year, and I worked my job at Roca Cola for the rest of the year. I still live in the same state, but I moved 500 miles away from my old house. I hired a moving company to move our stuff at a cost of $2,300, and I drove Junior in my car. Junior and I got a hotel room along the way that cost us $65 (I love Super 8!). Can you believe I’m still paying off my student loans, even after 15 years? I paid a total of $900 in interest on my old student loans this year. Remember when I told you about that guy that hit me with his car? I had a bunch of medical expenses that were not reimbursed by the lawsuit or by my insurance. I incurred a total of $20,000 in medical expenses, and I was only reimbursed for $11,000. Good thing I can write off medical expenses, right? I contributed a lot of money to charity this year (and have receipt documentation for all contributions). I’m such a nice guy! I gave $1,000 in cash to the March of Dimes. I contributed some of my old furniture to the church. It was some good stuff! I contributed a red velvet couch and my old recliner. The furniture is considered vintage and is worth $5,000 today (the appraiser surprised me!), even though I only paid $1,000 for it back in the day. When I contributed the furniture, the pastor said he didn’t like the fabric and was going to sell the furniture to pay for some more pews in the church. Oh well, some people just have no taste, right? Roca Cola had a charity drive for the United Way this year and I contributed $90. Turns out, I don’t even miss it because Roca Cola takes it right off my paycheck every month…$15 a month starting in July. My pay stub verifies that I contributed the $90 to the United Way. Oh, one other bit of charity from me this year. An old buddy of mine was down on his luck. He lost his job and his house. I gave him $500 to help him out. I paid a lot of money in interest this year. I paid a total of $950 in personal credit card interest. I also paid $18,000 in interest on my $500,000 home mortgage that helped me buy my dream home. I also paid $2,000 in real estate taxes for my new house. A few other things I want to tell you about this year. Someone broke into my house and stole my kid’s brand new bicycle and my set of golf clubs. The total loss from theft was $900. I paid $125 in union dues this year. I had to pay $1,200 for new suits for my job. Roca Cola requires its managers to wear suits every day on the job. I spent a total of $1,300 to pay for gas to commute to my job this year. Oh, this is pretty cool. I’ve always wanted to be a firefighter. I spent $1,400 in tuition to go to the local firefighter’s school. I did this because someone told me that I can deduct the tuition as an itemized deduction, so the money would be coming back to me. That should be all the information you need right now. Please calculate my taxable income and complete page 1 of Form 1040 (through taxable income, line 11b) and Schedule A. You’re still doing this for free, right? Taxable income is $150,810, computed as follows: Notes: 1. None of the moving expenses are deductible. 2. Student loan interest is not deductible because Slim’s AGI exceeds the threshold amount of income. 3. Unreimbursed medical expenses of $9,000 do not exceed the floor limitation of 7.5 percent of AGI ($172,900 x 7.5% = $12,968) so they are non-deductible. 4. Personal credit card interest is not deductible. 5. Slim can deduct the $1,000 cash donation, the $90 payroll deduction and the $1,000 basis of the furniture he contributed (capital gain property put to unrelated use). 6. Slim’s casualty losses are not deductible as they are not attributable to a federally declared disaster. 7. The union dues are nondeductible unreimbursed employee business expenses. 8. Other non-deductible items: clothing for work, commuting expenses, firefighter education expenses.
60. Jeremy and Alyssa Johnson have been married for five years and do not have any children. Jeremy was married previously and has one child from the prior marriage. He is self-employed and operates his own computer repair store. For the first two months of this year, Alyssa worked for Office Depot as an employee. In March, Alyssa accepted a new job with Super Toys, Inc. (ST) where she worked for the remainder of the year. This year the Johnsons received $255,000 of gross income. Determine the Johnson’s AGI given the following information: a. Expenses associated with Jeremy’s store include $40,000 in salary (and employment taxes) to employees, $45,000 of supplies, and $18,000 in rent and other administrative expenses. b. As a salesperson, Alyssa incurred $2,000 in travel expenses related to her employment that were not reimbursed by her employer. c. The Johnsons own a piece of raw land held as an investment. They paid $500 of real property taxes on the property and they incurred $200 of expenses in travel costs to see the property and to evaluate other similar potential investment properties. d. The Johnsons own a rental home. They incurred $8,500 of expenses associated with the property. e. Jeremy paid $4,500 for health insurance coverage for himself (not through an exchange). Alyssa was covered by health plans provided by her employer, but Jeremy is not eligible for the plan until next year. f. Jeremy paid $2,500 in self-employment taxes ($1,250 represents the employer portion of the self-employment taxes). g. Jeremy paid $5,000 in alimony and $3,000 in child support from his prior marriage (divorce decree executed in 2010). h. The Johnsons donated $2,000 to their favorite charity. $132,750, computed as follows:
Johnson’s AGI
Description Amount Explanation
Gross income $255,000
a. Ordinary and necessary business expenses 103,000 Ordinary expenses associated with Jeremy’s business ($40,000 salary + $45,000 supplies + $18,000 rent).
b. Unreimbursed employment expenses - Unreimbursed employee business expenses are not deductible
c. Real property taxes and investment expenses. - Taxes are deductible from AGI not for AGI; investment expenses are not deductible.
d. Rental expenses 8,500 Rental expenses are deductible for AGI even though they are technically investment or “production of income expenses.”
e. Self-employed health insurance 4,500 Jeremy may deduct all the costs of his health insurance because he is not eligible for ST’s health plan.
f. Self-employment taxes 1,250 The employer portion of self-employment taxes are allowed as for AGI deduction
g. Alimony 5,000 Alimony allowed as for AGI deduction
h. Child support - Child support is not deductible
i Charitable contributions - Charitable contributions are from AGI deductions, not for AGI deductions
Total for AGI deductions 122,250
AGI $132,750 AGI
61. {Tax Forms} Shauna Coleman is single. She is employed as an architectural designer for Streamline Design (SD). Shauna wanted to determine her taxable income. She correctly calculated her AGI. However, she wasn’t sure how to compute the rest of her taxable income. She provided the following information with hopes that you could use it to determine her taxable income. a. Shauna paid $4,680 for medical expenses for care from a broken ankle. Also, Shauna’s boyfriend, Blake, drove Shauna (in her car) a total of 115 miles to the doctor’s office so she could receive care for her broken ankle. b. Shauna paid a total of $3,400 in health insurance premiums during the year (not through an exchange). SD did not reimburse any of this expense. Besides the health insurance premiums and the medical expenses for her broken ankle, Shauna had Lasik eye surgery last year and paid $3,000 for the surgery (she received no insurance reimbursement). She also incurred $450 of other medical expenses for the year. c. SD withheld $1,800 of state income tax, $7,495 of Social Security tax, and $14,500 of federal income tax from Shauna’s paychecks throughout the year. d. In 2020, Shauna was due a refund of $250 for overpaying her 2019 state taxes. On her 2019 state tax return that she filed in April of 2020, she applied the overpayment towards her 2020 state tax liability. She estimated that her state tax liability for 2020 will be $2,300. e. Shauna paid $3,200 of property taxes on her personal residence. She also paid $500 to the developer of her subdivision because he had to replace the sidewalk in certain areas of the subdivision. f. Shauna paid a $200 property tax based on the state’s estimate of the value of her car. g. Shauna has a home mortgage loan in the amount of $220,000 that she secured when she purchased the home. The home is worth about $400,000. Shauna paid interest of $12,300 in interest on the loan this year. h. Shauna made several charitable contributions throughout the year. She contributed stock in ZYX Corp. to the Red Cross. On the date of the contribution, the FMV of the donated shares was $1,000 and her basis in the shares was $400. Shauna originally bought the ZYX Corp. stock in 2009. Shauna also contributed $300 cash to State University and religious artifacts she has held for several years to her church. The artifacts were valued at $500 and Shauna’s basis in the items was $300. Shauna had every reason to believe the church would keep them on display indefinitely. Shauna also drove 200 miles doing church-related errands for her minister. Finally, Shauna contributed $1,200 of services to her church last year. i. Shauna paid $250 in investment advisory fees and another $150 to have her tax return prepared (that is, she paid $150 in 2020 to have her 2019 tax return prepared). j. Shauna is involved in horse racing as a hobby. During the year, she won $2,500 in prize money and incurred $10,000 in expenses. She has never had a profitable year with her horse racing activities, so she acknowledges that this is a hobby for federal income tax purposes. k. Shauna sustained $2,000 in gambling losses over the year (mostly horse-racing bets) and had only $200 in winnings. Required: A. Determine Shauna’s taxable income and complete page 1 of Form 1040 (through taxable income, line 11b) and Schedule A assuming her AGI is $107,000. B. Determine Shauna’s taxable income and complete page 1 of Form 1040 (through taxable income, line 11b) and Schedule A assuming her AGI is $207,000 Part A: $83,697, computed as follows:
Description Amount Explanation
(1) AGI $107,000
From AGI deductions:
a) and b) Medical expenses $ 3,525 Medical expenses in excess of 7.5 percent of AGI are deductible. See Note A below.
c) and d) State taxes 2,050 State income taxes paid are deductible $1,800 withheld and 250 overpayment applied on last year’s return treated as paid last year).
e) Real property taxes 3,200 Real property taxes deductible from AGI. Payment to developer is not a tax.
f) Personal property taxes 200 Property tax on personal property based on value deductible from AGI
g) Interest on loans secured by her home 12,300 Primary home loan interest deductible from AGI
h) Charitable contributions 1,828 See Note B below
i) Investment expenses and tax return preparation fees 0 Nondeductible expenses
j) Horse racing activities 0 Nondeductible hobby expenses
k) Gambling losses 200 Gambling losses are limited to earnings from gambling deductible as an itemized deduction
(2) Total itemized deductions 23,303
(3) Standard deduction 12,400 Single taxpayer
(4) Greater of Itemized deductions or standard deduction 23,303 Greater of (2) or (3). Shauna should choose to itemize deductions.
Taxable income $83,697 (1) - (4)
Note A: $3,525. Medical expenses = $4,680 (medical expenses for broken ankle), + $20 (115 miles x 17¢ per mile) + 3,400 (unreimbursed health insurance premiums) + 3,000 (Lasik eye surgery) + 450 (other medical expenses) - $8,025 (AGI of 107,000 x 7.5 percent) = $3,525. Note B: $1,828. Capital gain property generally in the form of stock deductible at FMV; Thus, Shauna can deduct $1,000 for her ZYX stock donation to the Red Cross. Cash contributions of $300 are fully deductible. Religious artifacts are used by church in its normal function as a non-profit organization and thus are deductible at FMV of $500. Finally, Shauna may deduct $28 (as a cash donation) expense for her charitable mileage (200 miles x 14¢ per mile). Note that the value of services donated is not deductible. Accordingly, Shauna’s charitable contribution deduction is $1,828 (1,000 + 300 + 500 + 28). Shauna need not be concerned about the AGI-based limitations on her contributions because her AGI is relatively high and her contributions are relatively low. Part B: $187,222 computed as follows:
Description Amount Explanation
(1) AGI $207,000
From AGI deductions:
a) and b) Medical expenses 0 Medical expenses in excess of 7.5 percent of AGI are deductible. See note A below.
c) and d) State taxes 2,050 State income taxes paid last year are deductible ($1,800 withheld and 250 overpayment applied on last year’s return treated as paid last year.
e) Real property taxes 3,200 Real property taxes deductible from AGI. Payment to developer is not a tax.
f) Personal property taxes 200 Property tax on personal property based on value deductible from AGI
g) Interest on loans secured by her home 12,300 Primary home loan and home equity loan deductible from AGI
h) Charitable contributions 1,828 See note B below
i) Investment expenses and tax return preparation fees 0 Nondeductible expenses
j) Horse racing activities 0 Nondeductible hobby expenses
k) Gambling losses 200 Gambling losses are limited to earnings from gambling deductible as a miscellaneous itemized deduction but not subject to 2% of AGI floor or phase out.
(2) Total itemized deductions 19,778
(3) Standard deduction 12,400 Single taxpayer
(4) Greater of Itemized deductions or standard deduction 19,778 Greater of (2) or (3). Shauna should choose to itemize deductions.
Taxable income $187,222 (1) - (4)
Note A: $0. Medical expenses = $4,680 (medical expenses for broken ankle), + $20 (115 miles x 17¢ per mile) + 3,400 (unreimbursed health insurance premiums) + 3,000 (Lasik eye surgery) + 450 (other medical expenses) - $15,525 (AGI of 207,000 x 7.5 percent) < $0. Because 7.5 percent of Shauna’s AGI exceeds her total medical expenses, Shauna is unable to deduct any medical expenses. Note B: $1,828. Capital gain property generally in the form of stock is deductible at FMV; Thus, Shauna can deduct $1,000 for her ZYX stock donation to the Red Cross. Cash contributions of $300 are fully deductible. Religious artifacts are used by church in its normal function as a non-profit organization and thus are deductible at FMV of $500. Finally, Shauna may deduct $28 (as a cash donation) expense for her charitable mileage (200 miles x 14¢ per mile). Note that the value of services donated is not deductible. Accordingly, Shauna’s charitable contribution deduction is $1,828 (1,000 + 300 + 500 + 28). Shauna need not be concerned about the AGI-based limitations on her contributions because her AGI is relatively high and her contributions are relatively low. 62. {Tax Forms} Joe and Jessie are married and have one dependent child, Lizzie. Lizzie is currently in college at State University. Joe works as a design engineer for a manufacturing firm while Jessie runs a craft business from their home. Jessie’s craft business consists of making craft items for sale at craft shows that are held periodically at various locations. Jessie spends considerable time and effort on her craft business, and it has been consistently profitable over the years. Joe and Jessie own a home and pay interest on their home loan (balance of $220,000) and a personal loan to pay for Lizzie’s college expenses (balance of $35,000). Neither Joe nor Jessie is blind or over age 65, and they plan to file as married joint. Based on their estimates, determine Joe and Jessie’s AGI and taxable income for the year and complete page 1 of Form 1040 (through taxable income, line 11b), Schedule 1, and Schedule A. Assume that the employer portion of the self-employment tax on Jessie’s income is $831. Joe and Jessie have summarized the income and expenses they expect to report this year as follows: The interest from municipal bonds is not taxable. Joe and Jessie’s maximum deduction for the educational interest deduction before the phase-out is $2,500 (the amount of interest paid ($3,200) up to $2,500). Joe and Jessie’s modified AGI of $142,400 (for the student loan interest deduction) is above the phase-out trigger for student loan interest in 2020, $140,000 for MJ. Hence, the maximum deduction for the educational loan interest ($2,500) is reduced by the excess AGI over the threshold ($142,400-$140,000) divided by the phase-out range ($2,400/30,000) or 8 percent. Thus, their deduction for student loan interest is $2,300 ($2,500 – $200 [8 percent of $2,500]). Qualifying education expenses are deductible up to a maximum of $4,000. Since the Johnson’s modified AGI of $140,100 (AGI without deducting education expenses) exceeds $130,000, the Johnsons are allowed to deduct the lesser of their actual qualified expenditures of $5,780 or $2,000. Note A: Jessie’s business qualifies for the deduction for qualified business income because it is not a “specified service trade or business.” Jessie is not subject to the wage limitation because Joe and Jessie’s taxable income before the deduction for qualified business income is $111,575, (calculated as $138,100 AGI less $26,525 itemized deductions = $111,575), which is less than $326,600. Likewise, Joe and Jessie are not limited by the taxable income limitation because 20 percent of their net qualified business income ([$11,765 - $831] x 20% = $2,187) is less than 20 percent of their taxable income before the deduction ($111,575 x 20% = $22,315). Thus, their qualified business income deduction is $2,187 ([$11,765 qualified business income - $831 employer portion of self-employment tax] x 20%). Note B: The automobile licenses, tuition expenses and room and board expenses for Lizzie, the interest on Master debt credit card, and Joe’s unreimbursed employee business expenses are not deductible. Solution Manual for McGraw-Hill's Taxation of Individuals and Business Entities 2021 Brian C. Spilker, Benjamin C. Ayers, John A. Barrick, Troy Lewis, John Robinson, Connie Weaver, Ronald G. Worsham 9781260247138, 9781260432534
