Chapter 14 Tax Consequences of Home Ownership Discussion Questions 1. [LO 1] How does a taxpayer determine whether a dwelling unit is treated as a residence or no residence for tax purposes? Whether a dwelling unit is treated as a residence or not depends on the number of days the dwelling unit is used for personal purposes compared to the number of days it is used for rental purposes. A dwelling unit is considered to be a residence if the number of personal use days of the home exceeds the greater of (1) 14 days or (2) 10% of the number of rental days during the year. 2. [LO 1] For tax purposes, does a residence need to be situated at a fixed location? Explain. No. A residence is a dwelling unit that provides a place suitable for people to occupy (live and sleep). For tax purposes, a dwelling unit includes a house, condominium, mobile home, and boat. As long as the taxpayer lives in the property (uses it for personal purposes) for the requisite number of days, the property qualifies as a residence even if it is mobile. 3. [LO 1] When determining whether a dwelling unit is treated as a residence or a no residence for tax purposes, what constitutes a day of personal use and what constitutes a day of rental use? Personal use by a taxpayer includes days when (1) the taxpayer or other owner stays in the home, (2) a relative of an owner stays in the home, even if the relative pays full fair market value rent, except if the relative is renting the home as his or her principal residence, (3) a nonowner stays in the home under a vacation home exchange or swap arrangement, and (4) the taxpayer rents out the property for less than fair market value. Rental use includes days when the property is rented out at fair market value. Days spent repairing or maintaining the vacation home for rental use count as rental days, and days when the home is available for rent, but not actually rented out, do not count as personal days or as rental days. 4. [LO 1] A taxpayer owns a home in Salt Lake City, Utah and a second home in St. George, Utah. How does the taxpayer determine which home her principal residence is for tax purposes? When a taxpayer lives in more than one residence during the year, the determination of which residence is the principal residence depends on the facts and circumstances. Factors to consider in making this determination include the amount of time the taxpayer spends at each residence during the year, the proximity of each residence to the taxpayer’s employment, the principal place of abode of the taxpayer’s family, and the taxpayer’s mailing address for bills and correspondence among other things. 5. [LO 2] What are the ownership and use requirements a taxpayer must meet to qualify for the exclusion of gain on the sale of a residence? Ownership test: The taxpayer must have owned the property for a total of two or more years during the five-year period ending on the date of the sale. Use test: The taxpayer must have used the property as the taxpayer’s principal residence for a total of two or more years during the five-year period ending on the date of the sale. Married couples are eligible for the married filing jointly exclusion amount if at least one spouse meets the ownership test and both spouses meet the principal use test. 6. [LO 2] Under what circumstances, if any, can a taxpayer fail to meet the ownership and use requirements but still be able to exclude all of the gain on the sale of a principal residence? The taxpayer may be able to exclude the gain on the sale of a principal residence when the taxpayer sells the home due to unforeseen circumstances such as a change in employment, significant health issues, or other unforeseen financial difficulties. The maximum exclusion available to a taxpayer selling under these circumstances is the product of (1) the maximum exclusion had the taxpayer fully qualified for the exclusion (i.e., $250,000 for a single taxpayer or $500,000 for a taxpayer filing a joint return) and (2) the ratio of (a) the number of days or number of months the taxpayer met the ownership and use requirements to (b) 730 days or 24 months, respectively. The taxpayer may use either days or months in the computation. Note that under this unforeseen circumstances provision, the maximum limitation is reduced, not necessarily the excludable gain. Consequently, if the taxpayer has a gain on the sale of the residence that is less than the reduced maximum exclusion, the full amount of the gain may be excluded. 7. [LO 2] Under what circumstances can a taxpayer meet the ownership and use requirements for a residence but still not be allowed to exclude all realized gain on the sale of the residence? A taxpayer is limited to one exclusion on a sale of a principal residence every two years. That is, once the taxpayer sells a residence and uses the exclusion on the sale, the taxpayer will not be allowed a second exclusion until at least two years passes from the time of the first sale. Consequently, although a taxpayer may meet the use and ownership tests on two residences, the taxpayer can’t exclude gain from the sale of her second residence if the taxpayer has sold the first residence within the two preceding years. Also, if a taxpayer sells a home after December 31, 2008, and the taxpayer had nonqualified use of the property after December 31, 2008 (that is, the taxpayer used the property for a purpose other than as a principal residence such as vacation home or rental property) the taxpayer is not allowed to deduct a certain percentage of the otherwise excludable gain. Note, however, that nonqualified use does not include use during any portion of the five-year period that is after the last date the property was used as the principal residence of the taxpayer or the taxpayer’s spouse. That is, this exception allows the taxpayer a five-year period to sell the principal residence after moving out of it without having to count the time the house is available for sale as nonqualified use. The percentage of the gain that is not excludable is the period of nonqualified use after December 31, 2008, divided by the period of time the taxpayer owned the home before selling. 8. [LO 2] A taxpayer purchases and lives in a home for a year. The home appreciates in value by $50,000. The taxpayer sells the home and purchases a new home. What information do you need to obtain to determine whether the taxpayer is allowed to exclude the gain on the sale of the first home? Because the taxpayer lived in the home for only a year, the taxpayer would not be able to meet the ownership and use tests. However, the taxpayer could potentially exclude all or a portion of the gain if the taxpayer were able to show that he or she sold the home due to unforeseen circumstances such as a change in employment, medical reasons, or other unusual/unforeseen circumstances. You would need to determine the reason for the move and whether that reason qualified as an unforeseen circumstance. 9. [LO 3] Juanita owns a principal residence in New Jersey, a cabin in Montana, and a houseboat in Washington. All of these properties have mortgages incurred before 2017 on which Juanita pays interest. What limits, if any, apply to Juanita’s home mortgage interest deductions? Explain whether deductible interest is deductible for AGI or from AGI. Taxpayers are allowed to deduct home mortgage interest as an itemized deduction (from AGI). Home mortgage interest includes interest paid on loans secured by the taxpayer’s principal residence and one other residence. The second qualified residence is an annual election for a taxpayer with more than two residences. If the taxpayer rents the second residence for part of the year, it still qualifies as a residence for interest deduction purposes as long as the taxpayer’s personal use of the property exceeds the greater of (1) 14 days or (2) 10% of the number of rental days during the year. This use limitation is designed to ensure that taxpayers are using the property as a residence for a significant part of the year relative to the rental use of the property. A taxpayer’s residence needs not be a typical home attached to the ground; rather, it could include a houseboat or mobile home. Hence, Juanita’s principal residence in New Jersey as well as either the cabin in Montana or the houseboat in Washington will qualify as qualified residences. The deduction for mortgage interest is subject to a limitation on acquisition indebtedness. For debt incurred before 12/16/2017 (which is the case with Juanita), interest expense on up to $1,000,000 of acquisition indebtedness is deductible as home mortgage interest. Once acquisition indebtedness is established for a qualifying residence (or qualifying residences), it is reduced by principal payments on the loan(s) and can only be increased by additional indebtedness, secured by the residence, incurred to substantially improve the residence. 10. [ LO 3] For purposes of determining a taxpayer's deductible home mortgage interest, does it matter when the taxpayer incurred the debt to acquire the home? Explain. Yes, it matters for taxpayers with acquisition debt over $750,000. Taxpayers can deduct mortgage interest on acquisition indebtedness up to $1,000,000 ($500,000 if married filing separately) if the debt was incurred before December 16, 2017. If taxpayers incur the debt before this date and then refinance the remaining debt after December 15, 2017 the $1,000,000 limit still applies. However, for acquisition indebtedness occurring after December 15, 2017, taxpayers may only deduct interest on up to $750,000 of acquisition indebtedness ($375,000 if married filing separately). 11. [LO 3] Lars and Leigha saved up for years before they purchased their dream home. They were considering (1) using all of their savings to make a large down payment on the home (90 percent of the value of the home) and barely scraping by without backup savings or (2) making a more modest down payment (50 percent of the value of the home) and holding some of the savings in reserve as needed if funds got tight. They decided to make a large down payment because they figured they could always refinance the home to pull some equity out of it if they needed cash. What advice would you give them about the tax consequences of their decision? If the couple is forced to refinance their loan sometime in the future, the refinanced loan is treated as acquisition debt only to the extent that the principal amount of the refinancing does not exceed the amount of the acquisition debt immediately before the refinancing. That is, the refinancing cannot increase their acquisition indebtedness. Consequently, any amount borrowed in excess of the remaining principal on the original loan does not qualify as acquisition indebtedness (unless it is used to substantially improve the home). 12. [LO 3] Is it possible for a taxpayer to have more than one loan that is treated as acquisition indebtedness for tax purposes, even if one of the loans is considered to be a “home equity loan” by the bank lending the money? Yes. Acquisition indebtedness is defined as debt secured by the home that is incurred in acquiring, constructing, or substantially improving the home. A taxpayer could incur acquisition indebtedness by borrowing money to acquire a home and then incur additional acquisition indebtedness with a loan used to finish the basement, add onto the house, or some other substantial improvement - even if the loan were taken out long after the home was acquired or constructed. While a bank might call such a loan a “home equity loan” it would be considered to be acquisition indebtedness for tax purposes to the extent it is used to substantially improve the home. As long as the sum of the loans are under the acquisition debt limit, the taxpayer would be able to deduct all the interest on both loans. 13. [LO 3] Why might it be good advice from a tax perspective to think hard before deciding to quickly pay down mortgage debt? If the taxpayer has a cash crunch in the future due to quickly paying down the mortgage debt, he may be forced to refinance the loan to get the necessary cash. However, when a taxpayer refinances his home, and the amount of the refinancing exceeds the amount of the acquisition indebtedness immediately before the refinancing (and the taxpayer doesn’t use the proceeds to substantially improve the home), the excess cannot be classified as acquisition indebtedness, and thus is not deductible. Thus, the taxpayer may be in a situation where he will not be able to deduct as much interest due to the refinance as he would have been able to deduct if he had not quickly paid down the mortgage debt. That is, by decreasing the acquisition indebtedness by paying down the debt, the taxpayer may be unable to deduct a portion of his interest payments due to refinancing. 14. [LO 3] Does the deductible amount of a taxpayer’s home mortgage interest potentially depend on when the taxpayer executed the mortgage? Explain. Yes. Taxpayers can deduct home mortgage interest expense on interest paid on a home mortgage up to the acquisition indebtedness limit. For mortgages executed before 12/16/2017, the acquisition indebtedness limit is $1,000,000. For mortgages executed after 12/15/2017, the acquisition indebtedness limit is $750,000. The deductible mortgage interest for a taxpayer with more than $750,000 of acquisition indebtedness therefore depends on when the mortgage was executed.. 15. [LO 3] Compare and contrast the characteristics of a deductible point from a nondeductible point on a first home mortgage. Deductible points include points paid to lenders in exchange for a reduced interest rate on the loan or for loan origination fees. These points are immediately deductible as qualified residence interest if certain requirements are met. In contrast, nondeductible points are points paid to compensate lenders for specific services such as appraisal fees, document fees, or notary fees. Points paid for a reduced interest rate or for a loan origination fee in refinancing a home loan are not immediately deductible by the homeowner. These points must be amortized and deducted on a straight-line basis over the life of the loan. 16. [LO 3] Is the break-even period generally longer or shorter for points paid to reduce the interest rate on initial home loans or points paid for the same purpose on a refinance? Explain. The break-even period is generally shorter for points paid to reduce the interest rate on initial home loans than for points paid for a refinance. The reason for the extended break-even period in a refinance situation is that the refinance points are not immediately deductible, and hence, they effectively cost more (on a present value basis) than points on initial home loans. Thus, it takes longer to recoup these greater costs. Note, however, that this is true only if the taxpayer itemizes deductions. If the taxpayer does not itemize, neither points paid on an initial home loan or points paid on a refinance generate any tax savings. 17. [LO 3] {Planning} Under what circumstances is it likely economically beneficial to pay points to reduce the interest rate on a home loan? Generally speaking, the longer the taxpayer plans on staying in the home and maintaining the loan (i.e., not refinancing the loan), the more likely it is financially beneficial to pay points to obtain a lower interest rate. However, paying points can be costly if after a short time the taxpayer sells the home or refinances the home loan. In these situations, the taxpayer may not reach the break-even point. 18. [LO 3] Harry decides to finance his new home with a 30-year fixed mortgage. Because he figures he will be in this home for a long time, he decides to pay a fully deductible discount point on his mortgage to reduce the interest rate. Assume that Harry itemizes deductions and has a constant marginal tax rate over time. Will the time required to recover the cost of the discount point be shorter or longer if Harry makes extra principal payments starting in the first year (as opposed to not making any extra principal payments)? Explain. The time required to recoup the cost of the discount point will be longer if Harry makes extra principal payments. If Harry makes extra principal payments on his mortgage during the first year, the balance of the loan is reduced and, as a result, Harry will pay less interest than he would have paid had he not made the extra loan payments (a smaller loan principal times the same interest rate equals a smaller amount of interest). Consequently, his after-tax savings from having the lower interest rate is reduced relative to what it would have been had he not made the extra payments. Because the interest expense is deductible for tax purposes, the after-tax savings from having the lower interest rate is calculated as follows: Interest saved = principal amount of loan × (original interest rate – lower interest rate) After-tax interest savings = interest saved – (interest saved × MTR) Because, the after-tax cost of paying points remains constant, the reduction in after-tax savings from the lower interest rate increases the break-even point. Recall that the break-even point is calculated as follows: Break-even point = after-tax cost of paying points/after-tax savings of lower interest rate. 19. [LO 3, LO 4] Consider the settlement statement in Appendix B to this chapter. What amounts on the statement are the Jeffersons allowed to deduct on their 2020 tax return? Indicate the settlement statement line number for each deductible amount (discuss any issues that must be addressed to determine deductibility) and label each deduction as a for AGI deduction or a from AGI deduction. Line 801 Loan origination fees $3,000 from AGI deduction as home mortgage interest. Line 802 Loan discount $6,000 from AGI deduction as home mortgage interest. Note: Rev. Proc. 94-27 1994-1 C.B. 613 indicates that as a matter of administrative convenience points paid are deductible qualified residence interest if the following requirements are met: 1. The settlement statement clearly designate the amounts as points payable in connection with the loan (includes loan origination fees and discount points) 2. The amounts must be computed as a percentage of the stated principal amount of the loan. 3. The amounts paid must conform to an established business general practice of charging points for loans in the area in which the residence is located, and the amount of the points paid must not exceed the amount generally charged in that area. 4. The amounts must be paid in connection with the acquisition of the taxpayer’s principal residence and the loan must be secured by that residence (the deduction for points is not available for points paid in connection with a loan for a second home). 5. The buyer must provide enough funds in the down payment on the home to at least equal the cost of the points (the buyer is not allowed to borrow from the lender to pay the points). Here it appears that the Jeffersons meet the requirements and should be able to deduct the amounts on both Line 801 and Line 802 (sum of 801 and 802 on line 803). Line 901: Interest from 1/31/2020 through 2/10/2020 of $411 as home mortgage interest. Note that as of the settlement date, this is prepaid interest. But once the time passes and the interest accrues, the Jeffersons will be allowed to deduct this amount as a from AGI deduction. Line 1004: This line reflects property taxes held in escrow as a reserve. The Jeffersons will be able to potentially deduct the real property taxes when they are paid (but only for the part of 2020 that they actually owned the property). However, note that the itemized deduction for all taxes (state income tax and real property taxes) is limited to $10,000. The chapter indicates that the Jeffersons paid $15,000 in state income taxes during the year so incrementally the property taxes does not change their total itemized deductions. 20. [LO 4] A taxpayer sells a piece of real property in year 1. The amount of year 1 real property taxes is estimated at the closing of the sale and the amounts are allocated between the buyer and the taxpayer. At the end of year 1, the buyer receives a property tax bill that is higher than the estimate. After paying the tax bill, the buyer contacts the taxpayer at the beginning of year 2 and asks the taxpayer to pay the taxpayer’s share of the shortfall. The taxpayer sends a check to the buyer. Should the taxpayer be concerned that she won’t get to deduct the extra tax payment because it was paid to the buyer and not to the taxing jurisdiction? Explain. The taxpayer will be allowed to deduct her share of the real property taxes (subject to the deduction limitation on taxes) even though she didn’t pay the taxing jurisdiction. In most situations, the buyer and seller will agree to divide the responsibility for the tax payments based on the portion of the property tax year that each party held the property. This allocation of taxes between buyer and seller is generally spelled out on the settlement statement when the sale becomes final. However, the amount specified at settlement is generally just an estimate, so the actual taxes may differ from amounts for taxes on the settlement statement. For tax purposes, however, it doesn’t matter who actually pays the tax to the taxing jurisdiction. Assuming the taxes are actually paid by someone, the tax deduction is based on the relative amount of time each party held the property during the year. Thus, the taxpayer will get to deduct the total share of the tax bill allocated to her which is dependent on how long she held the property during the year. The buyer will get to deduct the remaining portion. This is true even if the taxpayer does not send the extra payment to the seller. 21. [LO 4] Are real property taxes subject to any deduction limitations? Explain. Yes. Taxpayers may deduct only $10,000 of taxes in total ($5,000 if married filing separately). This includes state and local income tax, real property taxes, and personal property taxes. Consequently, even if taxpayers paid no state income tax or personal property taxes during the year, their real property tax deduction would be limited to $10,000. If they have $10,000 or more state income taxes and/or personal property taxes, they would not receive any tax benefit from real property taxes because the real property taxes would not increase their itemized deductions. 22. [LO 4] Is a homeowner allowed a property tax deduction for amounts included in the monthly mortgage payment that are earmarked for property taxes? Explain. Frequently homeowners pay their real estate taxes through an escrow (holding) account with their mortgage lender. Each monthly payment to the lender includes an amount that represents roughly 1/12th of the anticipated real property taxes for the year. The actual annual tax payment is made by the mortgage company with funds accumulated in the escrow account. The homeowner gets a deduction (subject to limitation) when the actual taxes are paid to the taxing jurisdiction and not when the homeowner makes payments for taxes to the escrow account. 23. [LO 5] {Planning} Is it possible for a taxpayer to receive rental income that is not subject to taxation? Explain. Yes. A taxpayer (owner) who lives in a home for at least 15 days and rents it out for 14 days or less (residence with minimal rental use) is not required to include the gross receipts in rental income but is not allowed to deduct any expenses related to the rental. The taxpayer would be able to deduct home mortgage interest and real property taxes (subject to limitation) just as if the taxpayer had not rented out the property. 24. [LO 5] Halle just acquired a vacation home. She plans on spending several months each year vacationing in the home and renting out the property for the rest of the year. She is projecting tax losses on the rental portion of the property for the year. She is not too concerned about the losses because she is confident she will be able to use the losses to offset her income from other sources. Is her confidence misplaced? Explain. Yes. Because Halle will be living in the home for several months, the home will be considered a residence with significant rental use. Consequently, she may deduct expenses to obtain tenants (direct rental expenses such as advertising and realtor commissions) and, assuming she itemizes deductions, mortgage interest expense and real property taxes (to the extent her itemized deduction for taxes is less than $10,000) allocated to the rental use of the home. To the extent that these expenses exceed gross rental income she may deduct the loss (the passive loss rules do not apply). However, the remaining expenses allocated to the rental use of the home may only be deducted to the extent of the net rental income after deducting the direct rental expenses and rental mortgage interest and certain real property taxes allocated to the property. This limitation reduces her ability to deduct a rental loss from the home. 25. [LO 5] {Planning} A taxpayer is planning to stay in his second home for the entire month of September but not any other days during the year. He would like the home to fall into the residence-with-significant-rental-use category for tax purposes. What is the maximum number of days he can rent out the home and have it qualify? To qualify for the residence with significant rental use category, the taxpayer must have used the home for personal purposes more than the greater of (1) 14 days or (2) 10% of the total days it is rented out during the tax year and rented the house for more than 14 days. In this situation, the taxpayer used the second home for personal purposes for 30 days (the entire month of September). To qualify, the 30 days of personal use must be greater than 10% of the number of days the property is rented out. If the taxpayer rents the property out for 300 days, the number of personal use days will be exactly 10% of the number of rental days, and the property would not qualify as residence. However, if the taxpayer rents out the property for 299 days, the 30 days of personal use will be greater than 10% of the number of rental days, so the property would qualify as a residence with significant rental use. So, the maximum number of days the taxpayer can rent out the home and have it qualify as a residence with significant rental use is 299 days. Anything more than that and the property would be considered a no residence with rental use. 26. [LO 5] Compare and contrast the IRS method and the Tax Court method for allocating expenses between personal use and rental use for vacation homes. Include the Tax Court’s justification for departing from the IRS method in your answer. The IRS method of allocating deductions between personal and rental use allocates the deductions based on a fraction with the number of days the property was used for rental property in the numerator and the number of days the property was used for any reason during the year in the denominator. Each expense relating to the home is multiplied by this fraction to determine the amount allocable to rental use. Subject to the gross rental income limitation, tier 1 expenses are deducted first, followed by tier 2 expenses, and then tier 3 expenses. The Tax Court and the IRS method of allocating deductions are identical except for the allocation of the tier 1 expenses of certain mortgage interest and real property taxes amounts. Under the Tax Court approach, interest and taxes are allocated to rental use based on the fraction of days that the property was rented over the number of days in the year (not the number of days the property was used for any purpose during the year). The Tax Court justifies this approach by pointing out that interest expense and property taxes accrue over the entire year regardless of the level of personal or rental use. 27. [LO 5] In what circumstances is the IRS method for allocating expenses between personal use and rental use for vacation homes more beneficial to a taxpayer than the Tax Court method and when is the Tax Court method generally more beneficial? The IRS method is generally more beneficial than the Tax Court method when the property is considered to be a no residence with rental use because interest allocated to the personal use is not deductible. Thus, under these circumstances, the taxpayer is better off by allocating as little interest as possible to personal use which is what happens under the IRS method. Because the IRS method allocates more mortgage interest expense and property taxes to rental use than the Tax Court method, the IRS method is generally more beneficial when the taxpayer claims the standard deduction or the gross income limitation does not apply (all rental expenses are immediately deductible as for AGI deductions). Conversely, because the Tax Court method allocates more mortgage interest expense and property taxes to personal use of the property, the Tax Court method is generally more beneficial when the taxpayer itemizes deductions and the gross income limitation applies. However, because these are only general rules, taxpayers should analyze their specific facts and circumstances to determine whether the IRS method or the Tax Court method is more advantageous. In any event, use of the Tax Court method likely involves more risk of IRS scrutiny than the IRS method 28. [LO 5] Under what circumstances would a taxpayer who generates a loss from renting a home that is not a residence be able to fully deduct the loss? What potential limitations apply? By definition, a rental activity is considered to be a passive activity. Because they are passive losses, losses from rental property are generally not allowed to offset other ordinary or investment type income. However, the loss from a rental activity may be deductible under two circumstances. First, the taxpayer may offset the passive loss from the rental activity against other sources of passive income. Second, a taxpayer who is an active participant in the rental activity may be allowed to deduct up to $25,000 of the rental loss against other types of income (subject to phase-out beginning at $100,000 AGI). 29. [LO 5] Describe the circumstances in which a taxpayer acquires a home and rents it out and is not allowed to deduct a portion of the interest expense on the loan the taxpayer used to acquire the home. When a rental home is not a residence for tax purposes, the interest allocable to any personal-use days is nondeductible. Consequently, if the taxpayer uses a no residence for even one personal day the taxpayer will not be allowed to deduct all the interest expense on the loan for the year. 30. [LO 5] Is it possible for a rental property to generate a positive annual cash flow and at the same time produce a loss for tax purposes? Explain. Yes. A taxpayer is able to have a positive cash flow and at the same time produce a loss for tax purposes. This outcome is possible due to depreciation expense that is deductible for tax purposes but does not require an annual cash outflow. A rental property could provide a positive cash flow (gross receipts greater than cash expense for the year) but generate a tax loss when depreciation expense is deducted. 31. [LO 5, LO 6] How are the tax issues associated with home offices and vacation homes used as rentals similar? How are the tax issues or requirements dissimilar? The tax issues facing those who rent out second homes are similar in a lot of ways with tax issues facing taxpayers qualifying for home office deductions. Both taxpayers with home offices and taxpayers with vacation homes are allowed to deduct business or rental expenses not associated with the use of the home as for AGI deductions without income limitations. Taxpayers with home offices allocate expenses of the entire home between personal use of the home and business use of the home. In a similar way, renters of second homes generally allocate expenses of the second home between personal use of the home and rental use of the home. Taxpayers with home offices and vacation homes may deduct mortgage interest and real property taxes (to the extent the taxpayer’s itemized deduction for taxes is less than $10,000) allocated to the business or rental use of the home as for AGI deductions without income limitations. Other expenses allocated to business use of the home and rental use of a residence with significant rental use may be limited by the income generated by the property (after deducting business and rental expenses unrelated to the home and after deducting mortgage interest and certain real property taxes allocated to the business or rental use of the home). Disallowed expenses are carried over and treated as incurred in the next year. The treatment of home offices and vacation homes are also dissimilar. By definition, a home office is located in the taxpayer’s “home” and the home office must be used exclusively and regularly for business purposes. In contrast, the tax consequences of owning a second home depend on the extent to which the property is used for personal and for rental purposes. Personal use of a rental property is allowed. This is not the case for home offices. 32. [LO 6] Can both employees and self-employed taxpayers claim the home office deduction? Explain. No. Self-employed taxpayers can claim the home office deduction if they meet the requirement of using the home office as either (1) the principal place of business for any of the taxpayer’s trade or businesses or (2) as a place to meet with patients, clients, or customers in the normal course of business. Employees are not eligible to claim the home office deduction. 33. [LO 6] How do self-employed taxpayers report home office deductions on their tax returns? Self-employed taxpayers report their home office deduction on Schedule C of Form 1040. If taxpayers use the actual expense method, rather than the simplified method, they must also report the expenses on Form 8829. Thus, a self-employed taxpayer’s home office deduction is a for AGI deduction. 34. [LO 6] For taxpayers qualifying for home office deductions, what are considered to be indirect expenses of maintaining the home? How are these expenses allocated to personal and home office use? Can taxpayers choose to calculate home office expenses without regard to actual expenses allocated to the home office? Explain. Indirect expenses are expenses incurred in maintaining and using the home. Indirect expenses include insurance, utilities, interest, real property taxes, general repairs, and depreciation on the home as if it were used entirely for business purposes. Under the actual expense method for determining home office expenses, indirect expenses allocated to the home office space are deductible. If the rooms in the home are roughly of equal size, the taxpayer may allocate the indirect expenses to the business portion of the home based on the number of rooms. Alternatively, the taxpayer may allocate indirect expenses based on the amount of the space or square footage of the business-use room relative to the total square footage in the home. Each year, taxpayers can elect to use the simplified method of determining home office expenses or the actual method. Under the simplified method, taxpayers do not consider actual home office expenses. Rather, they multiply the square footage of the home office space (limited to 300 square feet) by a $5.00 application rate. Under this method, taxpayers deduct all property taxes (subject to limitation) and mortgage interest as itemized deductions on Schedule A (taxes and interest are not deductible as home office expenses). Further, under the simplified method, taxpayers do not claim depreciation expense. 35. [LO 6] What limitations exist for self-employed taxpayers in deducting home office expenses, and how does the taxpayer determine which expenses are deductible and which are not in situations when the overall amount of the home office deduction is limited? The total home office deductions other than mortgage interest and real property taxes allocated to business use of the home allowable for the taxpayer in any given year is limited to a taxpayer’s Schedule C net income (without any home office expense deductions) minus mortgage interest and real property taxes allocated to business use of the home. Thus, home office deductions other than mortgage interest and real property taxes cannot either create or increase a loss on the taxpayer’s Schedule C. Amounts that are not deducted in the current year are carried over and deducted in the next year subject to the same Schedule C limitation. The sequence of deductions for the home office follows the exact same sequence of deductions for homes with significant personal use and significant rental use. Tier 1-type expenses that would be deductible as itemized deductions (interest and taxes) are deducted first (and deducted in full regardless of income to the extent the taxpayer’s itemized deduction for taxes is less than $10,000). Tier 2-type expenses are deducted second, and Tier 3-type expense (depreciation) is deducted last. Under the simplified method for calculating home office expenses, deductible home office expenses are limited to gross revenues from the business minus business expenses not allocated to the home. Expenses in excess of the limit are not deductible and do not carry over to subsequent years. Note under the simplified method, home office expenses are computed by multiplying the square footage of the home office (limited to 300 feet) by a $5 application rate. Under this method, taxpayers deduct all mortgage interest and property taxes (to the extent the taxpayer’s itemized deduction for taxes is less than $10,000) as itemized deductions only. Further, they do not deduct any depreciation expense on the home. 36. [LO 2, LO 6] A self-employed taxpayer deducts home office expenses, including depreciation expense. The taxpayer then sells the home at a $100,000 gain. Assuming the taxpayer meets the ownership and use tests, does the full gain qualify for exclusion? Explain. No. When a taxpayer deducts depreciation as a home office expense, the depreciation expense reduces the taxpayer’s basis in the home. Consequently, when the taxpayer sells the home, the gain on the sale will be greater than it would have been had depreciation not been deducted. Further, the gain on the sale of the home attributable to depreciation is not eligible to be excluded under the home sale exclusion provisions (except for depreciation attributable to periods before May 6, 1997). This gain is treated as unrecaptured §1250 gain and is subject to a maximum 25% tax rate. Problems 37. [LO 1] Several years ago, Junior acquired a home that he vacationed in part of the time and rented out part of the time. During the current year Junior: • Personally stayed in the home for 22 days. • Rented it to his favorite brother at a discount for 10 days. • Rented it to his least favorite brother for eight days at the full market rate. • Rented it to his friend at a discounted rate for four days. • Rented the home to third parties for 58 days at the market rate. • Did repair and maintenance work on the home for two days. • Marketed the property and made it available for rent for 150 days during the year (but did not rent it out). How many days of personal use and how many days of rental use did Junior experience on the property during the year? Junior has 44 days of personal use and 60 days of rental use. Personal use days include the 22 days used personally, the combined 18 days rented to relatives, and the 4 days rented out at a discount. The rental days include the 58 days rented out to third parties at the market rate and the 2 days for repairs and maintenance. 38. [LO 1] Lauren owns a condominium. In each of the following alternative situations, determine whether the condominium should be treated as a residence or no residence for tax purposes? a. Lauren lives in the condo for 19 days and rents it out for 22 days. b. Lauren lives in the condo for 8 days and rents it out for 9 days c. Lauren lives in the condo for 80 days and rents it out for 120 days d. Lauren lives in the condo for 30 days and rents it out for 320 days. a. Residence: personal use (19 days) exceeds 14 days and 10% of rental days (2.2) b. No residence: Personal use does not exceed 14 days. c. Residence: personal use (80 days) exceeds 14 days and 10% of rental days (12) d. No residence: Personal use (30 days) exceeds 14 days but not 10% of rental days (32). 39. [LO 2] Steve and Stephanie Pratt purchased a home in Spokane, Washington for $400,000. They moved into the home on February 1 of year 1. They lived in the home as their primary residence until June 30 of year 5, when they sold the home for $700,000. a. What amount of gain on the sale of the home are the Pratts required to include in taxable income? b. Assume the original facts, except that Steve and Stephanie live in the home until January 1 of year 3, when they purchase a new home and rent out the original home. They finally sell the original home on June 30 of year 5 for $700,000. Ignoring any issues relating to depreciation taken on the home while it is being rented, what amount of realized gain on the sale of the home are the Pratts required to include in taxable income? c. Assume the same facts as in (b), except that the Pratts live in the home until January of year 4, when they purchase a new home and rent out the first home. What amount of realized gain on the sale of the home will the Pratts include in taxable income if they sell the first home on June 30 of year 5 for $700,000? d. Assume the original facts, except that Stephanie moves in with Steve on March 1 of year 3 and the couple is married on March 1 of year 4. Under state law, the couple jointly owns Steve’s home beginning on the date they are married. On December 1 of year 3, Stephanie sells her home that she lived in before she moved in with Steve. She excludes the entire $50,000 gain on the sale on her individual year 3 tax return. What amount of gain must the couple recognize on the sale in June of year 5? a. $0. They are allowed to exclude the entire realized gain. Since the Pratts owned and used the Spokane home for at least 2 years during the 5-year period ending on the date of the sale, they qualify for the gain exclusion. The maximum exclusion for married taxpayers filing jointly is $500,000. Because the exclusion is more than the gain realized on the sale, the entire gain is excluded from taxation. The Pratts will not be required to pay any taxes on the gain on the sale of their home. b. $300,000. Because the Pratts used the home as their principal residence for less than 2 years (February 1 of year 1 to January 1 of year 3) and their reason for leaving wasn’t due to unusual circumstances they don’t qualify for the home sale exclusion. Consequently, they must recognize all $300,000 of gain realized on the sale. c. $0. The Pratts owned and used the home for at least two years (February 1 of year 1 to January of year 4) during the five-year period ending on the date of sale, so they qualify for the exclusion. Consequently, the Pratts can exclude the entire $300,000 realized gain from taxable income. d. $50,000. Steve meets the ownership and use test but Stephanie does not (even though she meets the use test) because she sold her own home on December 1, year 3 and excluded the entire gain on the sale of her home. She is not eligible to claim another exclusion for two years after December 1, year 3. Consequently, Steve qualifies for the $250,000 exclusion (not the $500,000 exclusion because Stephanie does not qualify). Steve (and Stephanie) must recognize $50,000 of the $300,000 gain. 40. [LO 2] Steve and Stephanie Pratt purchased a home in Spokane, Washington for $400,000. They moved into the home on February 1, of year 1. They lived in the home as their primary residence until November 1 of year 1 when they sold the home for $500,000. The Pratts’ marginal ordinary tax rate is 35 percent. a. Assume that the Pratts sold their home and moved because they didn’t like their neighbors. How much gain will the Pratts recognize on their home sale? At what rate, if any, will the gain be taxed? b. Assume the Pratts sell the home because Stephanie’s employer transfers her to an office in Utah. How much gain will the Pratts recognize on their home sale? c. Assume the same facts as in (b), except that the Pratts sell their home for $700,000. How much gain will the Pratts recognize on the home sale? d. Assume the same facts as (b), except that on December 1 of year 0 the Pratts sold their home in Seattle and excluded the $300,000 gain from income on their year 0 tax return. How much gain will the Pratts recognize on the sale of their Spokane home? a. $100,000. The Pratts owned and used the Spokane home for only 9 months (February 1 to November 1 of year 1), and so they fail the ownership and use tests required to qualify for the exclusion. They also don’t qualify for the hardship exception because disliking one’s neighbors does not meet the “unforeseen circumstances” test. Thus the entire $100,000 gain is recognized. The gain is taxed at the Pratts’ ordinary income rate of 35% because they did not hold the home (a capital asset) for more than one year, so the gain is a short-term capital gain, subject to ordinary income rates (note that this assumes that they did not have any capital losses). Note that if the Pratts’ AGI exceeds $250,000 (if they file jointly), the gain on the sale will be considered investments for purposes of computing the 3.8% net investment income tax. b. $0. A change in employment qualifies as an “unforeseen circumstance,” so the Pratts won’t be disqualified for the exclusion. However, the maximum available exclusion must be reduced to reflect the amount of time the Pratts owned and used the Spokane home relative to the two-year ownership and use requirements as follows: The Pratts can exclude up to $187,500 of gain on the sale. They realized a gain of only $100,000 ($500,000 – $400,000). Consequently, the Pratts are not required to pay any taxes on the gain on the sale of the home. c. $112,500. A change in employment qualifies as an unforeseen circumstance, so the Pratts won’t be disqualified from the exclusion. However, the maximum available exclusion must be reduced to reflect the amount of time the Pratts owned and used the Spokane home relative to the two-year ownership and use requirements as follows: The Pratts can exclude up to $187,500 of gain on the sale. Because they realized a gain of only $300,000 ($700,000 – $400,000) they are able to exclude $187,500 of the gain from income but they must include $112,500 in their income. The gain is taxed at the Pratts’ ordinary tax rate because they did not own the home (a capital asset) for more than a year before they sold it. d. $0. Same answer as b. The rule that prohibits taxpayers from claiming an exclusion more than once every two years does not apply to taxpayers who are selling homes under hardship circumstances. 41. [LO 2] Steve Pratt, who is single, purchased a home in Spokane, Washington for $400,000. He moved into the home on February 1 of year 1. He lived in the home as his primary residence until June 30 of year 5, when he sold the home for $700,000. a. What amount of gain will Steve be required to recognize on the sale of the home? b. Assume the original facts, except that the home is Steve’s vacation home and he vacations there four months each year. Steve does not ever rent the home to others. What gain must Steve recognize on the home sale? c. Assume the original facts except that Steve married Stephanie on February 1 of year 3 and the couple lived in the home until they sold it in June of year 5. Under state law, Steve owned the home by himself. How much gain must Steve and Stephanie recognize on the sale (assume they file a joint return in year 5). a. $50,000. Since Steve owned and used the Spokane home for at least 2 years during the 5-year period ending on the date of the sale, he qualifies for the gain exclusion. The maximum exclusion for single taxpayers is $250,000. This exclusion will reduce Steve’s recognized gain to $50,000 ($300,000 gain realized less the $250,000 exclusion). b. $300,000 gain recognized. Steve must recognize all of the realized gain because he does not meet the use test. That is, the home was not his principal residence for two years during the five-year period ending on the date of the sale. c. $0 gain recognized. They realized a $300,000 gain on the sale. However, the couple qualifies for the married filing joint exclusion of $500,000 because Steve meets the ownership test and Steve and Stephanie meet the principal use test. Consequently, they can exclude the entire gain. 42. [LO 2] Celia has been married to Daryl for 52 years. The couple has lived in their current home for the last 20 years. On October of year 0, Daryl passed away. Celia sold their home and moved into a condominium. What is the maximum exclusion Celia is entitled to if she sells the home on December 15 of year 1? Celia may exclude up to $500,000 of gain on the sale of her home because she sold it within two years of the date of the death of her spouse, she meets the ownership and use tests, and her husband met the ownership and use tests prior to his death. 43. [LO 2] Sarah (single) purchased a home on January 1, 2008 for $600,000. She eventually sold the home for $800,000. What amount of the $200,000 gain on the sale does Sarah recognize in each of the following alternative situations? (Assume accumulated depreciation on the home was $0 at the time of sale.) a. Sarah used the home as her principal residence through December 31, 2017. She used the home as a vacation home from January 1, 2018 until she sold it on January 1, 2021. b. Sarah used the property as a vacation home through December 31, 2017. She then used the home as her principal residence from January 1, 2018 until she sold it on January 1, 2021. c. Sarah used the home as a vacation home from January 1, 2008 until January 1, 2020. She used the home as her principal residence from January 1, 2020 until she sold it on January 1, 2021. d. Sarah used the home as a vacation home from January 1, 2008 through December 31, 2014. She used the home as her principal residence from January 1, 2015 until she sold it on January 1, 2021. a. $0 gain recognized (all $200,000 of gain is excluded). Sarah meets the ownership and use tests because she has owned the property for two or more years and used it as her principal residence for at least two out of the five years before selling, so she can exclude her gain up to $250,000. She does not have any nonqualified use because the nonqualified use period does not include the five tax years immediately after she stopped using the home as a principal residence. b. $138,460 gain is recognized ($61,540 of gain is excluded). If not for the limitation for nonqualified use after December 31, 2008, Sarah could have excluded the entire $200,000 gain. However, because Sarah sold the home after December 31, 2008 and she had nonqualified use after December 31, 2008, she is not allowed to exclude a percentage of the gain that would otherwise be excluded. The percentage of the gain that is not excluded is a fraction, the numerator of which is the nonqualified use after December 31, 2008, and the denominator is the amount of time she owned the property. In this case, the numerator of the disallowance fraction is 9 years of post-2008 nonqualified use (January 1, 2009 through December 31, 2017) and the denominator is 13 years of ownership (January 1, 2008 through January 1, 2021) (9/13 = 69.23%). The gain that is not eligible for exclusion is $138,460 ($200,000 × 69.23%). c. $200,000 gain recognized. $0 gain is excluded. While Sarah meets the ownership test, she does not meet the use test because she used the property as her principal residence for less than two of the five years preceding the sale. d. $92,300 of gain is recognized and $107,700 is excluded. If not for the limitation for nonqualified use after December 31, 2008, Sarah could have excluded the entire $200,000 gain. However, because Sarah sold the home after December 31, 2008 and she had nonqualified use after December 31, 2008, she is not allowed to exclude a percentage of the gain that would otherwise be excluded. The percentage of the gain that is not excluded is a fraction, the numerator of which is the nonqualified use after December 31, 2008, and the denominator is the amount of time she owned the property. In this case, the numerator of the disallowance fraction is six years of post-2008 nonqualified use (2009-2014) and the denominator is 13 years of ownership (2008-2020) (6/13 = 46.15%). So the gain not eligible for exclusion is $92,300 ($200,000 × 46.15%). 44. [LO 2] Troy (single) purchased a home in Hopkinton, Massachusetts, on January 1, 2007 for $300,000. He sold the home on January 1, 2020 for $320,000. How much gain must Troy recognize on his home sale in each of the following alternative situations? a. Troy rented the home out from January 1, 2007 through November 30, 2008. He lived in the home as his principal residence from December 1, 2008 through the date of sale. Assume accumulated depreciation on the home at the time of sale was $7,000. b. Troy lived in the home as his principal residence from January 1, 2007 through December 31, 2015. He rented the home from January 1, 2016 through the date of the sale. Assume accumulated depreciation on the home at the time of sale was $2,000. c. Troy lived in the home as his principal residence from January 1, 2007 through December 31, 2017. He rented out the home from January 1, 2018 through the date of the sale. Assume accumulated depreciation on the home at the time of sale was $0. d. Troy rented out the home from January 1, 2007 through December 31, 2015. He lived in the home as his principal residence from January 1, 2016 through December 31, 2016. He rented out the home from January 1, 2017 through December 31, 2017 and he lived in the home as his principal residence from January 1, 2018, through the date of the sale. Assume accumulated depreciation on the home at the time of sale was $0. a. $7,000 of gain recognized. Troy meets the ownership and use tests but gain created by the accumulated depreciation is not eligible for exclusion. Troy realized a gain of $27,000 ($320,000 amount realized minus $293,000 adjusted basis (basis reduced by $7,000 of accumulated depreciation). Troy does not have any nonqualified use because he did not rent out the property after 2008. b. $22,000 gain recognized. Troy meets the ownership test but he fails the use test because he did not use the home as his principal residence for two years between January 1, 2015 and January 1, 2020 (five-year period ending on the date of sale). During this five-year period, he lived in the home as his principal residence from January 1, 2015 through December 31, 2015 which is less than two years. Troy’s gain is $22,000 ($320,000 - $298,000). Note that the basis of the home was reduced by the $2,000 of accumulated depreciation. c. $0 gain recognized. Troy meets the ownership and use tests. Further, the period from January 1, 2018, through the date of the sale is not nonqualified use because nonqualified use does not include any period during the five-year period ending on date of sale that is after the last date the taxpayer used the home as a principal residence. d. $12,308 of gain recognized and $7,692 is excluded. Troy meets the ownership and use requirements. However, his use from January 1, 2009 through December 31, 2015 (seven years) and his use from January 1, 2017 through December 31, 2017 (one year) is nonqualified use (post 2008 use as other than principal residence and does not extend beyond his last use of the home as a principal residence). Troy had eight years of nonqualified use (7 + 1) of the home that he owned for 13 years (January 1, 2007 through January 1, 2020). Consequently, of the $20,000 gain realized, Troy must recognize $12,308 ($20,000 × 8/13). 45. [LO 3] Javier and Anita Sanchez purchased a home on January 1, 2020 for, $600,000 by paying $200,000 down and borrowing the remaining $400,000 with a 7 percent loan secured by the home. The loan requires interest-only payments for the first five years. The Sanchezes would itemize deductions even if they did not have any deductible interest. The Sanchezes’ marginal tax rate is 32 percent. a. What is the after-tax cost of the interest expense to the Sanchezes in 2020? b. Assume the original facts, except that the Sanchezes rent a home and pay $21,000 in rent during the year. What is the after-tax cost of their rental payments in 2020? c. Assuming the interest expense is their only itemized deduction for the year and that Javier and Anita file a joint return, have great eyesight, and are under 60 years of age, what is the after-tax cost of their 2020 interest expense? a. $19,040 The $400,000 loan is treated as acquisition indebtedness, since it was to initially acquire the home. Interest on up to $750,000 of acquisition indebtedness incurred in 2020 is deductible as an itemized deduction. Since the $400,000 loan principal is less than the limit, all of the interest associated with the loan is deductible. The after-tax cost of the interest expense is calculated as follows: Description Amount Explanation (1) Before-tax interest expense $28,000 $400,000 × 7%. All deductible. (2) Marginal tax rate × 32% (3) Tax savings from interest expense $8,960 (1) × (2) After-tax cost of interest expense $19,040 (1) – (3) b. $21,000. Because rental payments are not deductible, they do not generate any tax savings, so the before- and after-tax cost of the rental payments is the same. c. $26,976. Because the Sanchezes had no other itemized deductions, their interest expense only produces a benefit to them to the extent that it exceeds the standard deduction, calculated as follows: Description Amount Explanation (1) Before-tax interest expense $28,000 $400,000 × 7%. All deductible. (2) Standard deduction 24,800 MFJ (3) Interest in excess of standard deduction $3,200 (1) – (2) (4) Marginal tax rate × 32% (5) Tax savings from interest expense $1,024 (3) × (4) After-tax cost of interest expense $26,976 (1) – (5) 46. [LO 3] Javier and Anita Sanchez purchased a home on January 1 of year 1 for $1,000,000 by paying $200,000 down and borrowing the remaining $800,000 with a 6 percent loan secured by the home. The Sanchezes made interest only payments on the loan in years 1 and 2. a. Assuming year 1 is 2017, how much interest would the Sanchez’s deduct in year 2? b. Assuming year 1 is 2020, how much interest would the Sanchez’s deduct in year 2? c. Assume year 1 is 2020 and by the beginning of year 4, the Sanchezes have paid down the principal amount of the loan to $500,000. In year 4, they borrow an additional $100,000 through a loan secured by the home in order to finish their basement. The new loan carries a 7 percent interest rate and is termed a “home equity loan” by the lender. What amount of interest can the Sanchezes deduct on the $100,000 loan? d. Assume year 1 is 2020 and by the beginning of year 4, the Sanchezes have paid down the principal amount of the loan to $500,000. In year 4, they borrow an additional $100,000 through a loan secured by the home in order to finish purchase a new car. The new loan carries a 7 percent interest rate and is termed a “home equity loan” by the lender. What amount of interest can the Sanchezes deduct on the $100,000 loan? a. $48,000 ($800,000 × 6%). For loans incurred before December 16, 2017, interest on up to $1,000,000 of acquisition debt can be deducted. Because $800,000 is under that limit, the Sanchezes can deduct all $48,000 of interest on the loan in year 2. b. $45,000 ($750,000 × 6%). For loans incurred after December 15, 2017, interest on up to $750,000 of acquisition debt can be deducted. Because $800,000 is over that limit, the Sanchezes can deduct interest on only $750,000 of the $800,000 loan. Their deduction is $45,000 ($750,000 × 6%). c. $7,000 ($100,000 × 7%). The acquisition indebtedness limit for interest deductibility is $750,000. The original acquisition debt balance is $500,000 and the $100,000 second loan is acquisition debt because it was incurred to substantially improve the home even though it is called a “home equity loan” by the lender. Consequently, interest on the $100,000 loan is fully deductible. d. $0. Because the $100,000 loan was not used to substantially improve the home, the loan is not acquisition indebtedness for tax purposes. Consequently, the interest on the loan is nondeductible. 47. [LO 3] Lewis and Laurie are married and jointly own a home valued at $240,000. They recently paid off the mortgage on their home. The couple borrowed money from the local credit union in January of 2020 How much interest may the couple deduct in each of the following alternative situations (assume they itemize deductions no matter the amount of interest)? a. The couple borrows $40,000 and the loan is secured by their home. The credit union calls the loan a “home equity loan.” Lewis and Laurie use the loan proceeds for purposes unrelated to the home. The couple pays $1,600 interest on the loan during the year and the couple files a joint return. b. The couple borrows $110,000 and the loan is secured by their home. The credit union calls the loan a “home equity loan.” Lewis and Laurie use the loan proceeds to add a room to their home. The couple pays $5,200 interest on the loan during the year and the couple files a joint return. a. $0. The couple would not be able to deduct any of the interest because it is not acquisition indebtedness. b. $5,200. Because the loan is acquisition indebtedness (it is secured by the home and used to substantially improve the home) and the debt is below the $750,000 limitation. 48. [LO 3] On January 1 of year 1, Arthur and Aretha Franklin purchased a home for $1.5 million by paying $200,000 down and borrowing the remaining $1.3 million with a 7 percent loan secured by the home. The Franklins paid interest only on the loan for year 1, year 2 and year 3 (unless stated otherwise). a. What is the amount of interest expense the Franklins may deduct in year 3 assuming year 1 is 2017? b. What is the amount of interest expense the Franklins may deduct in year 2 assuming year 1 is 2019? c. Assume that year 1 is 2020 and that in year 2, the Franklins pay off the entire loan but at the beginning of year 3, they borrow $300,000 secured by the home at a 7 percent rate. They make interest-only payments on the loan during the year and they use the loan proceeds for purposes unrelated to the home. What amount of interest expense may the Franklins deduct in year 3 on this loan? a. $70,000. Because the acquisition indebtedness limit for acquisition debt incurred before 12/16/2017 is $1,000,000, they may deduct interest on $1,000,000 of the $1,300,000 loan. Consequently their deductible interest expense in year 3 (2019) is calculated as follows: b. $52,500. Because the acquisition indebtedness limit for acquisition debt incurred after 12/15/2017, is $750,000, they may deduct interest on $750,000 of the $1,300,000 loan. Consequently their deductible interest expense in year 2 (2020) is calculated as follows: c. $0. Once acquisition indebtedness is established, only payments on principal can reduce the indebtedness and only additional indebtedness secured by the residence and incurred to substantially improve the residence can increase it. In this case, the Franklins reduced their original acquisition indebtedness to zero. Because the Franklins do not use the additional loan in year 3 to substantially improve their home, the loan cannot be classified as acquisition indebtedness. Thus, the interest on the loan is not deductible. 49. [LO 3] On January 1 of 2020, Jason and Jill Marsh acquired a home for $500,000 by paying $400,000 down and borrowing $100,000 with a 7 percent loan secured by the home. On January 1, 2021, the Marshes needed cash so they refinanced the original loan by taking out a new $250,000 7 percent loan. With the $250,000 proceeds from the new loan, the Marshes paid off the original $100,000 loan and used the remaining $150,000 to fund their son’s college education. a. What amount of interest expense on the refinanced loan may the Marshes deduct in 2021? b. Assume the original facts except that the Marshes use the $150,000 cash from the refinancing to add two rooms and a garage to their home. What amount of interest expense on the refinanced loan may the Marshes deduct in 2021? a. $7,000, determined as follows: Because the Marshes paid off all of their original acquisition indebtedness and did not increase it by making substantial improvements on their home, their acquisition indebtedness remains at $100,000 with the refinance. Therefore, the Marshes may deduct interest on $100,000 of the acquisition indebtedness portion of the loan for the year. This amounts to $7,000 ($100,000 × 7%). b. $17,500. In this case, because the Marshes used the loan proceeds to add on to their house, the entire refinanced loan qualifies as acquisition indebtedness. Because the total acquisition indebtedness is under $750,000, the Marshes may deduct all of the interest on the refinanced loan. The interest on the loan and the Marshes’ deduction is $17,500 ($250,000 × 7%). 50. [LO 3] {Research} Jennifer has been living in her current principal residence for three years. Six months ago Jennifer decided that she would like to purchase a second home near a beach so she can vacation there for part of the year. Despite her best efforts, Jennifer has been unable to find what she is looking for. Consequently, Jennifer recently decided to change plans. She purchased a parcel of land for $200,000 with the intention of building her second home on the property. To acquire the land, she borrowed $200,000 secured by the land. Jennifer would like to know whether the interest she pays on the loan before construction on the house is completed is deductible as mortgage interest. a. How should Jennifer treat the interest if she has begun construction on the home and plans to live in the home in 12 months from the time construction began? b. How should Jennifer treat the interest if she hasn’t begun construction on the home, but plans to live in the home in 15 months? c. How should Jennifer treat the interest if she has begun construction on the home but doesn’t plan to live in the home for 37 months from the time construction began? See Reg §1.163-10T(p)(5). a. Unless the taxpayer has begun construction of a home on the land that the taxpayer can occupy within 24 months, the land would be considered an investment and the interest paid on the second mortgage would not qualify as deductible mortgage interest. Because Jennifer will be in the home within 12 months, the interest qualifies as mortgage interest. b. Because Jennifer has not begun construction on the home, the interest on the loan is not eligible for mortgage interest even though Jennifer will live in the home in 15 months. She would be able to deduct the interest as investment interest expense (subject to limitations on the expense) if she itemizes her deductions. c. Even though she has begun construction, because Jennifer will not occupy the home within 24 months the interest expense does not qualify as mortgage interest. However, she would be able to deduct it as an itemized deduction for investment interest expense (subject to limitations on investment interest expenses deductibility). 51. [LO 3] {Planning} Rajiv and Laurie Amin are recent college graduates looking to purchase a new home. They are purchasing a $200,000 home by paying $20,000 down and borrowing the other $180,000 with a 30-year loan secured by the home. The Amins have the option of (1) paying no discount points on the loan and paying interest at 8 percent or (2) paying 1 discount point on the loan and paying interest of 7.5 percent. Both loans require the Amins to make interest-only payments for the first five years. Unless otherwise stated, the Amins itemize deductions irrespective of the amount of interest expense. The Amins are in the 24 percent marginal ordinary income tax bracket. a. Assuming the Amins do not itemize deductions, what is the break-even point for paying the point to get a lower interest rate? b. Assuming the Amins do itemize deductions, what is the break-even point for paying the point to get a lower interest rate? c. Assume the original facts except that the amount of the loan is $300,000. What is the break-even point for the Amins for paying the point to get a lower interest rate? d. Assume the original facts except that the $180,000 loan is a refinance instead of an original loan. What is the break-even point for paying the point to get a lower interest rate? e. Assume the original facts except that the amount of the loan is $300,000 and the loan is a refinance and not an original loan. What is the break-even point for paying the point to get a lower interest rate? a. 2 years. Because the Amins do not itemize deductions, they will receive no tax benefit from the deduction for the points paid. Consequently, the after-tax cost of the point is the same as the before-tax cost of the point—$1,800. The Amins need to determine how long it will take them to recoup this cost due to a lower interest rate. To do this, they should divide the after-tax cost of paying the point by the yearly after-tax interest savings from the point. The after-tax cost of paying the point is $1,800. The after-tax savings due to a lower interest rate is $900 calculated as follows: Because the Amins are not itemizing deductions, additional interest payments do not generate any tax savings, therefore the after-tax savings from the lower interest rate is the same as the before-tax savings of $900. The break-even period, then, is 2 years ($1,800 after-tax cost of the point/$900 after-tax annual savings from the lower interest rate). b. 2 years. Loan summary: $180,000; 8% rate with no points. 7.5% rate with 1 point. The Amins pay only interest for the first five years. Description Amounts Calculation (1) Initial cash outflow from paying 1 point ($1,800) $180,000 × 1% (2) Tax benefit from deducting points + $432 (1) × 24% (3) After-tax cost of points ($1,368) (1) + (2) (4) Before-tax savings per year from 7.5% vs. 8% interest rate $900 [$180,000 × (8% –7.5%)] (5) Forgone tax benefit per year of higher interest rate ($216) (4) × 24% (6) After-tax savings per year of 7.5% vs. 8% interest rate $684 (4) + (5) Break-even point in years 2 years (3) / (6) The break-even period is 2 years. This is the same break-even point for the Amins even if they don’t itemize deductions. c. 2 years. Loan summary: $300,000; 8% rate with no points. 7.5% rate with 1 point. The Amins pay only interest for the first five years. Description Amounts Calculation (1) Initial cash outflow from paying 1 point ($3,000) $300,000 × 1% (2) Tax benefit from deducting points + $720 (1) × 24% (3) After-tax cost of points ($2,280) (1) + (2) (4) Before-tax savings per year from 7.5% vs. 8% interest rate $1,500 [$300,000 × (8% -7.5%)] (5) Forgone tax benefit per year of higher interest rate ($360) (4) × 24% (6) After-tax savings per year of 7.5% vs. 8% interest rate $1,140 (4) + (5) Break-even point in years 2 years (3) / (6) d. 2.58 years. Loan summary: $180,000; 8% rate with no points. 7.5% rate with 1 point. The Amins pay interest only for the first 5 years. 30-year loan. Description Amounts Calculation (1) Initial cash outflow from paying points ($1,800) $180,000 × 1% (2) Tax benefit from deducting points 0 (3) After-tax cost of points ($1,800) (1) + (2) (4) Before-tax savings per year from 7.5% vs. 8% interest rate $900 [$180,000 × (8% -7.5%)] (5) Foregone tax benefit per year of higher interest payments ($216) (4) × 24% (6) After-tax savings per year of 7.5% vs. 8% interest rate $684 (4) + (5) (7) Annual tax savings from amortizing points $14.4 (1) / 30 years × 24% (8) Annual after-tax cash flow benefit of paying points $698.4 (6) + (7) Break-even point in years 2.58 years (3) / (8) Because this is a refinance, the $1,800 paid for the point is not immediately deductible. Consequently, the after-tax cost of the point is $1,800. The $1,800 is amortized over 30 years, generating a $60 deduction each year. The $60 deduction will save the Amins $14.4 in taxes each year ($60 × 24%). e. 2.58 years. Loan summary: $300,000; 8% rate with no points. 7.5% rate with 1 point. The Amins pay interest only for the first 5 years. 30-year loan. Description Amounts Calculation (1) Initial cash outflow from paying points ($3,000) $300,000 × 1% (2) Tax benefit from deducting points 0 (3) After-tax cost of points ($3,000) (1) + (2) (4) Before-tax savings per year from 7.5% vs. 8% interest rate $1,500 [$300,000 × (8% -7.5%)] (5) Foregone tax benefit per year of higher interest payments ($360) (4) × 24% (6) After-tax savings per year of 7.5% vs. 8% interest rate $1,140 (4) + (5) (7) Annual tax savings from amortizing points $24 (1) / 30 years × 24% (8) Annual after-tax cash flow benefit of paying points $1,164 (6) + (7) Break-even point in years 2.58 years (3) / (8) Because this is a refinance, the $3,000 paid for the point is not immediately deductible. Consequently, the after-tax cost of the point is $3,000. The $3,000 is amortized over 30 years, generating a $100 deduction each year. The $100 deduction will save the Amins $24 in taxes each year ($100 × 24%). 52. [LO 4] Peter and Shaline Johnsen moved into a home in a new subdivision. Theirs was one of the first homes in the subdivision. During the year, they paid $1,500 in real property taxes on the home to the state government, $500 to the developer of the subdivision for an assessment to pay for the sidewalks, and $900 for real property taxes on land they hold as an investment. What amount of property taxes are the Johnsens allowed to deduct assuming their itemized deductions exceed the standard deduction amount before considering any property tax deductions and they pay $5,000 of state income taxes for the year and no other deductible taxes? The Johnsens may deduct $2,400 of property taxes as itemized deductions. This includes the $1,500 paid in property taxes on their home and $900 in property taxes paid on land they are holding as an investment. However, taxpayers are not allowed to deduct fees paid for water and sewer services, and assessments for local benefits such as streets and sidewalks. Thus, the Johnsens may not deduct the $500 assessment fee to pay for sidewalks. The Johnsens’ combined deductible taxes are $7,400 ($5,000 + $2,400) which is under the $10,000 itemized deduction limit for taxes. 53. [LO 4] Jesse Brimhall is single. In 2020, his itemized deductions were $9,000 before considering any real property taxes he paid during the year. Jesse’s adjusted gross income was $70,000 (also before considering any property tax deductions). In 2020, he paid real property taxes of $3,000 on property 1 and $1,200 of real property taxes on property 2. He did not pay any other deductible taxes during the year. a. If property 1 is Jesse’s primary residence and property 2 is his vacation home (he does not rent it out at all), what is his taxable income after taking property taxes into account? b. If property 1 is Jesse’s business building (he owns the property) and property 2 is his primary residence, what is his taxable income after taking property taxes into account (ignore the deduction for qualified business income)? c. If property 1 is Jesse’s primary residence and property 2 is a parcel of land he holds for investment, what is his taxable income after taking property taxes into account? a. $56,800 The property tax on both properties are deductible as itemized deductions because neither property is used for business or rental activities and the sum of Jesse’s itemized deductions, including property taxes, exceeds his standard deduction. Description Amount Calculation (1) AGI $70,000 (2) Standard deduction (12,400) (3) Itemized deductions (13,200) $9,000+ $3,000 + $1,200 Taxable income after property taxes $56,800 (1) + (3) b. $54,600. The property tax on the business building is deductible for AGI, and the tax on the personal residence is deductible as an itemized deduction Description Amount Calculation (1) AGI before property taxes $70,000 (2) Business property taxes (3,000) For AGI deduction (3) AGI 67,000 (1) + (2) (4) Standard deduction (12,400) (5) Itemized deductions (including property taxes) (10,200) $9,000 + $1,200 (6) Greater of standard deduction or itemized deductions (12,400) (4) > (5) Taxable income after property taxes $54,600 (3) + (6) c. $56,800. The answer is the same as part (a). The property taxes on both properties (residence and investment property) are deductible as itemized deductions because neither property is used for business or rental activities. 54. [LO 4] Craig and Karen Conder purchased a new home on May 1 of year 1 for $200,000. At the time of the purchase, it was estimated that the real property tax rate for the year would be one percent of the property’s value. How much in property taxes on the new home are the Conders allowed to deduct under each of the following circumstances (the Conders’ itemized deductions exceed the standard deduction before considering property taxes and the property tax is the only deductible tax they pay during the year)? a. The property tax estimate proves to be accurate. The seller and the Conders paid their share of the tax. The full property tax bill is paid to the taxing jurisdiction by the end of the year. b. The actual property tax bill was 1.05 percent of the property’s value. The Conders paid their share of the estimated tax bill and the entire difference between the one percent estimate and the 1.05 percent actual tax bill and the seller paid the rest. The full property tax bill is paid to the taxing jurisdiction by the end of the year. c. The actual property tax bill was .95 percent of the property’s value. The seller paid taxes based on their share of the one percent estimate and the Conders paid the difference between what the seller paid and the amount of the final tax bill. The full property tax bill is paid to the taxing jurisdiction by the end of the year. a. $1,333 ($200,000 × .01 × 8/12). Because the Conders owned the property for 8 of 12 months in year 1, they are allowed to deduct two-thirds (8/12) of the actual property taxes paid to the taxing jurisdiction for the year. b. $1,400 ($200,000 × .0105 × 8/12). Because the Conders owned the property for 8 of 12 months in year 1, they are allowed to deduct two-thirds (8/12) of the actual property taxes paid to the taxing jurisdiction for the year. This is true even though the Conders ended up paying more than $1,400 to the taxing jurisdiction for the year. c. $1,267 ($200,000 × .0095 × 8/12). Because the Conders owned the property for 8 of 12 months in year 1, they are allowed to deduct two-thirds (8/12) of the actual property taxes paid to the taxing jurisdiction for the year. This is true even though the Conders ended up paying less than $1,267 to the taxing jurisdiction for the year. 55. [LO 4] Kirk and Lorna Newbold purchased a new home on August 1 of year 1 for $300,000. At the time of the purchase, it was estimated that the real property tax rate for the year would be .5 percent of the property’s value. Because the taxing jurisdiction collects taxes on a July 1 year-end, it was estimated that the Newbolds would be required to pay $1,375 in property taxes for the property tax year relating to August through June of year 2 ($300,000 × .005 × 11/12). The seller would be required to pay the $125 for July of year 1. Along with their monthly payment of principal and interest, the Newbolds paid $125 to the mortgage company to cover the property taxes. The mortgage company placed the money in escrow and used the funds in the escrow account to pay the property tax bill in July of year 2. The Newbolds’ itemized deductions exceed the standard deduction before considering property taxes and they don’t pay any other deductible taxes during the year. a. How much in property taxes can the Newbolds deduct for year 1? b. How much in property taxes can the Newbolds deduct for year 2? c. Assume the original facts except that the Newbolds were not able to collect $125 from the Seller for the property taxes for July of year 1. How much in property taxes can the Newbolds deduct for year 1 and year 2? d. Assume the original facts except that the tax bill for July 1 of year 1 through June 30 of year 2 turned out to be $1,200 instead of $1,500. How much in property taxes can the Newbolds deduct in year 1 and year 2?] a. $0. Homeowners are allowed to deduct property taxes when the actual taxes are paid to the taxing jurisdiction and not when they make payments for taxes to the escrow account. Consequently, the Newbolds will deduct their share of the property taxes when the taxes are actually paid in year 2. They are not allowed to deduct any property taxes in year 1 because they did not pay any taxes to the taxing jurisdiction during year 1. b. For tax purposes, it doesn’t matter who actually pays the tax. Assuming the taxes are paid, the tax deduction is based on the relative amount of time each party held the property during the year. Thus, the Newbold’s tax deduction is $1,375, calculated as follows: c. For tax purposes, it doesn’t matter who actually pays the tax. Thus, it doesn’t matter that the Newbolds were unable to collect $125 from the seller for property taxes. Assuming the taxes are paid, the tax deduction is based on the relative amount of time each party held the property during the year. Since no taxes were paid during year 1, no deduction is allowed for year one. The Newbold’s tax deduction for year 2 is still $1,375, calculated as follows: d. Since no taxes were paid during year 1, the Newbolds don’t deduct any property taxes for year one. However, the Newbold’s tax deduction for year 2 is $1,100 calculated as follows: 56. [LO 4] {Research} Jenae and Terry Hutchings own a parcel of land as tenants by the entirety. That is, they both own the property but when one of them dies the other becomes the sole owner of the property. For nontax reasons, Jenae and Terry decide to file separate tax returns for the current year. Jenae paid the entire $3,000 property tax bill for the land. How much of the $3,000 property tax payment is each spouse entitled to deduct in the current year assuming they pay no other deductible taxes during the year? According to Rev. Rul. 72-79, 1972-1 CB 51, if spouses are co-owners of property and they are jointly and severally liable for the property tax and they file separate tax returns for the year, each spouse is allowed to deduct on his or her separate return the amount of the property taxes he or she paid for the year. In this case, because Jenae paid the entire $3,000 property tax bill, she is allowed to deduct the entire $3,000 on her separate tax return. 57. [LO 5] Dillon rented his personal residence at Lake Tahoe for 14 days while he was vacationing in Ireland. He resided in the home for the remainder of the year. Rental income from the property was $6,500. Expenses associated with use of the home for the entire year were as follows: a. What effect does the rental have on Dillon’s AGI? b. What effect does the rental have on Dillon’s itemized deductions (assuming he itemizes deductions before considering the deductions associated with the home)? a. Since Dillon resided in his home for at least 15 days during the year and rented the home for fewer than 15 days, he excludes the rental income from taxable income and does not deduct the associated rental expenses. So, the rental has no effect on Dillon’s AGI. b. He will be allowed to deduct the real property taxes of $3,100 (this assumes his other tax payment such as state income taxes don’t put him over the $10,000 deduction limit for taxes) and mortgage interest of $12,000 as itemized deductions. Use the following facts to answer problems 58 and 59. Natalie owns a condominium near Cocoa Beach in Florida. This year, she incurs the following expenses in connection with her condo: During the year, Natalie rented out the condo for 75 days, receiving $10,000 of gross income. She personally used the condo for 35 days during her vacation. Natalie’s itemized deduction for nonrental taxes is less than $10,000 by more than the property taxes allocated to the rental use of the property. 58. [LO 5] {Tax Forms} Assume Natalie uses the IRS method of allocating expenses to rental use of the property. a. What is the total amount of for AGI (rental) deductions Natalie may deduct in the current year related to the condo? b. What is the total amount of itemized deductions Natalie may deduct in the current year related to the condo (assuming she itemizes deductions before considering the deductions associated with the condo)? c. If Natalie’s basis in the condo at the beginning of the year was $150,000, what is her basis in the condo at the end of the year? d. Assume that gross rental revenue was $2,000 (rather than $10,000), what amount of for AGI deductions may Natalie deduct in the current year related to the condo? e. Assume that gross rental revenue was $2,000 (rather than $10,000) and that Natalie’s itemized deduction for taxes is $10,000 before considering property taxes allocated to the rental use of the property, what amount of for AGI deductions may Natalie deduct in the current year related to the condo? f. Using the original facts, complete Natalie’s Form 1040, Schedule E for this property. Also, partially complete Natalie’s 1040, Schedule A to include her from AGI deductions related to the condo. Note that the home falls into the residence with significant rental use category. a. $10,000, calculated as follows: Gross rental income $10,000 Tier 1 expenses: Advertising expense = $500 Mortgage interest = (75/110) × $3,500=$2,386 Property taxes= (75/110) × $900=$614 Less: total Tier 1 expenses (3,500) Balance $6,500 Tier 2 expenses: Insurance = (75/110) × $1,000=$682 Repairs & Maintenance = (75/110) × $650=$443 Utilities= (75/110) × $950=$648 Less: total Tier 2 expenses (1,773) Balance $4,727 Tier 3 expenses: Depreciation (75/110) × $8,500= $5,795, but the deduction is limited to the remaining income of $4,727. The nondeductible portion of $1,068 carries over to the next year. (4,727) Balance $0 Total “For AGI” deductions ($3,500 + $1,773 + $4,727) $10,000 b. Natalie may deduct the personal-use portion of the mortgage interest and property taxes since they are deductible without regard to rental income. Her deductions for these items are computed as follows: c. $145,273, calculated as follows: d. $3,500. Even though it creates a loss ($2,000 - $3,500), Natalie is allowed to deduct all of the advertising expense and the portion of the mortgage interest expense and real property taxes allocated to the rental use of the home as for AGI deductions (these deductions are not limited to rental revenue). The loss is not subject to the passive loss rule limitations. e. $2,886. The advertising expense of $500 and mortgage interest amount of $2,386 are treated as tier 1 expenses and are not limited to rental revenue. However, the real property taxes of $614 are treated as tier 2 expenses in this scenario because Natalie has already exceeded the $10,000 overall tax limitation and are thus subject to the rental revenue limitation with the other tier 2 expenses. f. 59. [LO 5] Assume Natalie uses the Tax Court method of allocating expenses to rental use of the property. a. What is the total amount of for AGI (rental) deductions Natalie may deduct in the current year related to the condo? b. What is the total amount of itemized deductions Natalie may deduct in the current year related to the condo (assuming she itemizes deductions before considering deductions associated with the condo)? c. If Natalie’s basis in the condo at the beginning of the year was $150,000, what is her basis in the condo at the end of the year? d. Assume that gross rental revenue was $2,000 (rather than $10,000), what amount of for AGI deductions may Natalie deduct in the current year related to the condo? Note that the home falls into the residence with significant rental use category a. $8,972, calculated as follows: Gross rental income $10,000 Tier 1 expenses: Advertising expense = $500 Mortgage interest = (75/366) × $3,500 = $717 Property taxes= (75/366) × $900 = $184 Less: total Tier 1 expenses (1,401) Balance $8,599 Tier 2 expenses: Insurance = (75/110) × $1,000=$682 Repairs & Maintenance = (75/110) × $650=$443 Utilities= (75/110) × $950=$648 Less: total Tier 2 expenses (1,773) Balance $6,826 Tier 3 expenses: Depreciation (75/110) × $8,500= $5,795 (5,795) Balance—net income from rental of condo $1,031 Total “For AGI” deductions ($1,401 + $1,773 + $5,795) $8,969 b. Natalie may deduct the personal-use portion of the mortgage interest and property taxes since they are deductible without regard to rental income. Her deductions for these items are computed as follows: c. $144,205, calculated as follows: d. $2,000. Natalie is allowed to deduct all $1,401 of the tier 1 expenses (advertising expense and the portion of the mortgage interest expense and real property taxes allocated to the rental use of the home) as for AGI deductions (these deductions would not be limited to rental revenue even if it created a loss). Natalie is also able to deduct $599 of the tier two expenses. In total, she will deduct $2,000 of rental related expenses—leaving her with $0 net income from the property. Use the following facts to answer problems 60, 61, and 62. Alexa owns a condominium near Cocoa Beach in Florida. This year, she incurs the following expenses in connection with her condo: During the year, Alexa rented out the condo for 100 days. She did not use the condo at all for personal purposes during the year. Alexa’s AGI from all sources other than the rental property is $200,000. Unless otherwise specified, Alexa has no sources of passive income. 60. [LO 5] Assume Alexa receives $30,000 in gross rental receipts. a. What effect do the expenses associated with the property have on her AGI? b. What effect do the expenses associated with the property have on her itemized deductions? a. Expenses reduce AGI by $28,900. Alexa’s property is treated as a nonresidence with rental use property because she rented it for 100 days and did not use it all for personal purposes. The rental deductions are fully deductible for AGI. Thus, the expenses reduce Alexa’s AGI by $28,900 and the gross rental income increases the AGI by $30,000. Overall, Alexa’s AGI will be increased by the rental net income of $1,100, calculated as follows: Gross rental income $30,000 Expenses: Insurance Mortgage interest Property taxes Repairs and maintenance Utilities Depreciation Less: total expenses (2,000) (6,500) (2,000) (1,400) (2,500) (14,500) (28,900) Balance—net rental income $1,100 b. Because Alexa did not use the rental property for personal purposes, all expenses associated with the property were allocated to rental use and were deducted for AGI. Thus, the expenses associated with the property have no effect on her itemized deductions. 61. [LO 5] Assuming Alexa receives $20,000 in gross rental receipts, answer the following questions: a. What effect does the rental activity have on her AGI for the year? b. Assuming that Alexa’s AGI from other sources is $90,000, what effect does the rental activity have on Alexa’s AGI? Alexa makes all decisions with respect to the property. c. Assuming that Alexa’s AGI from other sources is $120,000 what effect does the rental activity have on Alexa’s AGI? Alexa makes all decisions with respect to the property. d. Assume that Alexa’s AGI from other sources is $200,000. This consists of $150,000 salary, $10,000 of dividends, $25,000 of long-term capital gain, and net rental income from another rental property in the amount of $15,000. What effect does the Cocoa Beach condo rental activity have on Alexa’s AGI? Note that the property is a nonresidence with rental use property. a. Alexa’s AGI will be reduced by $0, calculated as follows: Gross rental income $20,000 Expenses: Insurance Mortgage interest Property taxes Repairs & maintenance Utilities Depreciation Less: total expenses (2,000) (6,500) (2,000) (1,400) (2,500) (14,500) (28,900) Balance—net rental loss ($8,900) By definition, a rental activity [unless it is a residence with significant rental use (a vacation home rental)], is considered to be a passive activity. Consequently, losses from rental property are not allowed to offset other ordinary or investment type income. As a result, Alexa will include $20,000 of rental income in gross income. She will also get to deduct $20,000 of expenses related to the rental property. The remaining $8,900 of expenses (the rental loss) is not deductible this year because (1) the rental activity is a passive activity, (2) Alexa has no passive income from other sources, and (3) Alexa’s AGI of $200,000 is above the phase-out range ($100,000 - $150,000) so she is not allowed to deduct any of the loss under the rental real estate exception to the passive loss rules. She may, however, carry the loss forward to future years in which she has passive income to offset. b. Reduction of $8,900. Under a rental real estate exception, a taxpayer who is an “active” participant in the rental activity may be allowed to deduct up to $25,000 of the rental loss against other types of income. To be considered an active participant, the taxpayer must (1) own at least 10% of the rental property and (2) participate in the process of making management decisions such as approving new tenants, deciding on rental terms, and approving repairs and capital expenditures. Since Alexa owns 100% of the property, and she makes all decisions with respect to the property, she is an active participant in the rental activity. Thus, she meets the rental real estate exception, and, because her AGI of $90,000 is below $100,000, she is eligible to deduct up to $25,000 of the loss against other types of income. In this case, she may deduct the entire $8,900 loss as an ordinary deduction in the current year. c. Reduction of $8,900. Under a rental real estate exception, a taxpayer who is an “active” participant in the rental activity may be allowed to deduct up to $25,000 of the rental loss against other types of income. To be considered an active participant, the taxpayer must (1) own at least 10% of the rental property and (2) participate in the process of making management decisions such as approving new tenants, deciding on rental terms, and approving repairs and capital expenditures. The $25,000 maximum exception amount is phased out by 50 cents for every dollar the taxpayer’s adjusted gross income exceeds $100,000. Consequently, the entire $25,000 is phased-out when the taxpayer’s adjusted gross income reaches $150,000. Since, Alexa owns 100% of the property, and she makes all decisions with respect to the property, she is an active participant in the rental activity. Thus, she meets the rental real estate exception, and she may potentially deduct the rental loss as an ordinary deduction in the current year. However, because her AGI exceeds $100,000, part of the exception amount is phased out as follows: Exception amount = $25,000 (maximum) - $10,000 (phase-out) = $15,000 Since Alexa’s rental loss of $8,900 is less than the exception amount of $15,000, she can deduct the entire $8,900 as an ordinary deduction in the current year. d. The rental activity reduces her AGI by $8,900. (All transactions described in the problem decrease her AGI to $191,100.) Since Alexa has passive income (the rental income from another property), she can deduct the loss against this passive income. Thus, her net passive income is $6,100 ($15,000 rental income - $8,900 rental loss). In summary, she will include $150,000 salary, $10,000 dividends, $25,000 LTCG, and $35,000 rental income ($15,000 + $20,000) in gross income. She will also be able to deduct all of the expenses related to the rental property ($28,900) from the income in arriving at AGI. The $8,900 loss from the rental property reduces her AGI by $8,900. 62. [LO 5] {Planning} Assume that in addition to renting the condo for 100 days, Alexa uses the condo for 8 days of personal use. Also assume that Alexa receives $30,000 of gross rental receipts and her itemized deductions exceed the standard deduction before considering expenses associated with the condo and that her itemized deduction for non-home business taxes is less than $10,000 by more than the real property taxes allocated to rental use of the home. Answer the following questions: a. What is the total amount of for AGI deductions relating to the condo that Alexa may deduct in the current year? Assume she uses the IRS method of allocating expenses between rental and personal days. b. What is the total amount of from AGI deductions relating to the condo that Alexa may deduct in the current year? Assume she uses the IRS method of allocating expenses between rental and personal days. c. Would Alexa be better or worse off after taxes in the current year if she uses the Tax Court method of allocating expenses? Note that the home is considered to be a nonresidence with rental use. a. $26,760. Since Alexa used the condo personally for 8 days, she must allocate the expenses between personal use and rental use days. As illustrated below, the portion attributable to the rental days are deductible as “for AGI” deductions. Gross rental income $30,000 Expenses: Insurance [100/108] × $2,000 Mortgage interest [100/108] × $6,500 Property taxes [100/108] × $2,000 Repairs & maintenance [100/108] × $1,400 Utilities [100/108] × $2,500 Depreciation [100/108] × $14,500 Less: total expenses (1,852) (6,019) (1,852) (1,296) (2,315) (13,426) (26,760) Balance—net rental income $3,240 Total “for AGI” deductions $26,760 b. Alexa may deduct the personal-use portion of property taxes (to the extent the taxpayer’s itemized deduction for taxes is less than $10,000) since they are deductible without regard to rental income. However, she is not allowed to deduct the mortgage interest related to personal-use days because the property no longer qualifies as a personal residence. Her deduction for the property taxes is calculated as follows: Real property taxes = (8/108) × $2,000 = $148. c. The Tax Court method is less favorable in this circumstance because it allocates less interest expense to the rental activity and more to personal use. The interest expense allocated to personal use, however, does not qualify for an interest deduction because the taxpayer does not meet the minimum amount of personal use required for the deduction. By using the Tax Court method, any mortgage interest allocated to the personal-use days generates no tax benefit. Also, since this is primarily rental property, the taxpayer may deduct expenses in excess of income from the property. So, the taxpayer may not be as concerned about allocating more taxes to the rental property because doing so does not limit the taxpayer’s ability to deduct other expenses, as it might with mixed-use property. Note however, that a loss may not be immediately deductible due to the passive activity rules. 63. [LO 6]{Tax Forms} Brooke owns a sole proprietorship in which she works as a management consultant. She maintains an office in her home where she meets with clients, prepares bills, and performs other work-related tasks. The home office is 300 square feet and the entire house is 4,500 square feet. Brooke incurred the following home-related expenses during the year. Brooke itemizes her deductions and her itemized deduction for non-home business taxes is less than $10,000 by more than the real property taxes allocated to business use of the home. Unless indicated otherwise, assume Brooke uses the actual expense method to compute home office expenses. a. What amount of each of these expenses is allocated to the home office? The expenses are allocated to the home office as follows: Expense Amount Type Allocated to home office 6.667% of indirect (300/4,500 sq. ft) Real property taxes $3,600 Indirect $240 Interest on home mortgage 14,000 Indirect 933 Operating expenses of home 5,000 Indirect 333 Depreciation 12,000 Indirect 800 Repairs to home theater room 1,000 Unrelated 0 Total expenses $35,600 $2,306 b. What are the total amounts of tier 1, tier 2, and tier 3 expenses allocated to the home office? • Tier 1 expenses: $1,173 ($240 real property + $933 interest on home mortgage). • Tier 2 expenses: $333 (operating expenses of the home) • Tier 3 expense: $800 depreciation. c. If Brooke reported $2,000 of Schedule C income before the home office expense deduction, what is the amount of her home office expense deduction and how much of the home office expenses, if any, would she carry over to next year? $2,000 home office expense in total and $306 depreciation expense carryover to next year. She would subtract all $1,173 of the tier 1 expenses and all $333 of the tier 2 expenses from her $2,000 of Schedule C income. This leaves $494 ($2,000 - $1,173 – 333) of net income before depreciation (tier 3 expense). Because the home office expense deduction can reduce net income to $0 but not below, Brook may deduct $494 of depreciation expense and carry the remaining $306 over to next year. d. Assuming Brooke reported $2,000 of Schedule C income before the home office expense deduction, complete Form 8829 for Brooke’s home office expense deduction. Also assume the value of the home is $500,000 and the adjusted basis of the home (exclusive of land) is $468,019. e. Assume that Brooke uses the simplified method for computing home office expenses. If Brooke reported $2,000 of Schedule C net income before the home office expense deduction, what is the amount of her home office expense deduction and what home office expenses, if any, would she carry over to next year? Home office expense deduction is $1,500 (300 square feet × $5.00 per square foot). The gross income limit does not apply here because the Schedule C net income before the home office expense deduction ($2,000) exceeds the home office expenses of $1,500. Under the simplified method, taxpayers cannot carryforward expenses to the next year even when the gross income limits the amount of the home office expense deduction. Use the following facts to answer problems 64 and 65. Rita owns a sole proprietorship in which she works as a management consultant. She maintains an office in her home (500 square feet) where she meets with clients, prepares bills, and performs other work-related tasks. Her business expenses, other than home office expenses, total $5,600. The following home-related expenses have been allocated to her home office under the actual expense method for calculating home office expenses. Also, assume that not counting the sole proprietorship, Rita’s AGI is $60,000. Rita itemizes deductions and her itemized deduction for non-home business taxes is less than $10,000 by more than the real property taxes allocated to business use of the home. 64. [LO 6] {Planning} Assume Rita’s consulting business generated $15,000 in gross income. a. What is Rita’s home office deduction for the current year? b. What would Rita’s home office deduction for the current year be if her business generated $10,000 of gross income instead of $15,000? (Answer for both the actual expense method and the simplified method). c. Given the original facts, what is Rita’s AGI for the year? d. Given the original facts, what types and amounts of expenses will she carry over to next year? a. $9,100, using the actual expense method calculated as follows: Gross Income $15,000 Less: business expenses (5,600) Balance $9,400 Less: Tier 1 expenses (interest $5,100 + $1,600 taxes) (6,700) Balance after tier 1 expenses $2,700 Less Tier 2 expenses (operating expenses) (800) Balance after tier 2 expenses 1,900 Less Tier 3 expenses (depreciation) (1,600) Net income from business $300 Rita is allowed to deduct all $9,100 of expenses allocated to the home office ($6,700 interest and taxes + $800 home operating expenses + $1,600 depreciation). Under the simplified method, Rita’s home office deduction would have been limited to $1,500 (300 square feet × $5 application rate). However, she also would have been able to deduct all of the $6,700 for interest and taxes as itemized deductions (subject to the combined $10,000 tax deduction limit). This would have provided her with $1,500 + $6,700 = $8,200 of deductions but this is still less than the $9,100 in deductions under the actual method. Further, assuming she is single, her standard deduction is $12,400 so she may not get any tax benefit from itemized deductions. b. Rita's home office deduction would be $6,700 under the actual expense method and $1,500 (300 x $5) under the simplified method. Under the actual expense method, she would report a net loss from the business of $2,300. Gross Income $10,000 Less: business expenses (5,600) Balance $4,400 Less: Tier 1 expenses (interest $5,100 + $1,600 taxes) (6,700) Loss after tier 1 expenses ($2,300) Less Tier 2 expenses (operating expenses) 0 Loss after tier 2 expenses ($2,300) Less Tier 3 expenses (depreciation) 0 Net loss from business ($2,300) Rita is allowed to deduct only the mortgage interest and real property taxes allocated to the business use of the home. The remaining expenses (tier 2 and tier 3) are suspended and carried over to next year. Under the simplified method, Rita would report $2,900 ($4,400 less home office expense of $1,500) of Schedule C net income but she would have $6,700 more for itemized deductions for mortgage interest and taxes. However, assuming she is single, her standard deduction is $12,400. Unless she has other itemized deductions she will not receive any tax benefit from the itemized deductions. c. Rita’s AGI is $60,300 for the year. This is her AGI without the sole proprietorship plus the net income from the business ($60,000 + $300). d. None. Because Rita is allowed to deduct all of the expenses this year, she does not carry any over to next year. 65. [LO 6] Assume Rita’s consulting business generated $13,000 in gross income for the current year. Further, assume Rita uses the actual expense method for computing her home office expense deduction. a. What is Rita’s home office deduction for the current year? b. What is Rita’s AGI for the year? c. Assuming the original facts, what types and amounts of expenses will she carry over to next year? a. $7,400, calculated as follows: Gross Income $13,000 Less: business expenses (5,600) Balance $7,400 Less: Tier 1 expenses (interest $5,100 + $1,600 taxes) (6,700) Balance after tier 1 expenses $700 Less: Tier 2 expenses (operating expenses $800 before limit) (700) Balance after tier 2 expenses 0 Less Tier 3 expenses (depreciation $1,600 before limit) (0) Net income from business $0 Rita is allowed to deduct a total of $7,400 in home office expenses ($6,700 in interest and taxes and $700 of home operating expenses). b. $60,000. This is the $60,000 of AGI without the sole proprietorship plus $0 net income from the home business. c. Rita will carry over $100 of tier 2 expenses (operating expenses) and $1,600 of tier 3 expenses (depreciation expense) to next year. 66. [LO 6] {Research } Boodeesh is contemplating running a consulting business out of her home. She has a large garage apartment in her backyard that would be perfect for her business. Given that the garage apartment is separate from her house (about 30 feet behind her house) would the office be considered part of her home for purposes of the home office rules? Yes, the garage apartment is likely to be considered a part of the home as it would be considered appurtenant to Boodeesh’s dwelling unit. IRC Sec. 280A(f)(1) defines a dwelling unit to include a house, apartment, condominium, mobile home, boat, or similar property, and all structures or other property appurtenant to such dwelling unit. See Charles Scott, 84 TC 683 (1985) for a discussion of when a structure is appurtenant to a dwelling unit. 67. [LO 2, LO 6] Alisha, who is single, owns a sole proprietorship in which she works as a management consultant. She maintains an office in her home where she meets with clients, prepares bills, and performs other work-related tasks. She purchased the home at the beginning of year 1 for $400,000. Since she purchased the home and moved into it she has been able to deduct $10,000 of depreciation expenses to offset her consulting income. At the end of year 3, Alisha sold the home for $500,000. What is the amount of taxes Alisha will be required to pay on the gain from the sale of the home? Alisha’s ordinary marginal tax rate is 32 percent. (Ignore the net investment income tax.) $2,500, calculated as follows: Amount realized $500,000 Beginning basis $400,000 Less depreciation (10,000) Adjusted basis $390,000 Gain realized $110,000 Gain eligible for exclusion (gain realized minus depreciation expense) $100,000 Less: exclusion amount (lesser of gain eligible for exclusion or $250,000) (100,000) Total gain recognized (Gain realized minus exclusion) $10,000 When a taxpayer deducts depreciation as a home office expense, the depreciation expense reduces the taxpayer’s basis in the home. Consequently, when the taxpayer sells the home, the gain on the sale will be greater than it would have been had depreciation not been deducted. Further, the gain on the sale of the home attributable to depreciation is not eligible to be excluded under the home sale exclusion provisions. This gain is treated as unrecaptured §1250 gain and is subject to a maximum 25% tax rate. Thus, Alisha will owe $2,500 ($10,000 × 25%) in taxes on the sale. Comprehensive Problems 68. {Planning} Derek and Meagan Jacoby recently graduated from State University and Derek accepted a job in business consulting while Meagan accepted a job in computer programming. Meagan inherited $75,000 from her grandfather who recently passed away. The couple is debating whether they should buy or rent a home. They located a rental home that meets their needs. The monthly rent is $2,250. They also found a three-bedroom home that would cost $475,000 to purchase. The Jacobys could use Meagan’s inheritance for a down-payment on the home. Thus they would need to borrow $400,000 to acquire the home. They have the option of paying 2 discount points to receive a fixed interest rate of 4.5 percent on the loan or paying no points and receiving a fixed interest rate of 5.75 percent for a 30-year fixed loan. Though anything could happen, the couple expects to live in the home for no more than five years before relocating to a different region of the country. Derek and Meagan don’t have any school-related debt, so they will save the $75,000 if they don’t purchase a home. Also, consider the following information: • The couple’s marginal tax rate is 24 percent. • Regardless of whether they buy or rent, the couple will itemize their deductions and have the ability to deduct all of the property taxes from the purchase of a residence. • If they buy, the Jacobys would purchase and move into the home on January 1, 2020. • If they buy the home, the property taxes for the year are $3,600. • Disregard loan-related fees not mentioned above. • If the couple does not buy a home, they will put their money into their savings account where they earn 5 percent annual interest. • Assume all unstated costs are equal between the buy and rent option. Required: Help the Jacobys with their decisions by answering the following questions: a. If the Jacobys decide to rent the home, what is their after-tax cost of the rental for the first year (include income from the savings account in your analysis)? b. What is the approximate break-even point in years (or months) for paying the points to receive a reduced interest rate (to simplify this computation, assume the Jacobys will make interest-only payments and ignore the time value of money)? c. What is the after-tax cost of the interest expense and property taxes of living in the home for 2020? Assume that the Jacoby’s interest rate is 5.75 percent, they do not pay discount points, they make interest-only payments for the first year, and the value of the home does not change during the year. d. Assume that on March 1, 2020, the Jacobys sold their home for $525,000, so that Derek and Meagan could accept job opportunities in a different state. The Jacobys used the sale proceeds to (1) pay off the $400,000 principal of the mortgage, (2) pay a $10,000 commission to their real estate broker, and (3) make a down payment on a new home in the different state. However, the new home cost only $300,000. What gain or loss do the Jacobys realize and recognize on the sale of their home and what amount of taxes must they pay on the gain, if any (assume they make interest only payments on the loan)? e. Assume the same facts as in (d), except that the Jacobys sell their home for $450,000 and they pay a $7,500 commission. What effect does the sale have on their 2019 income tax liability? Recall that the Jacobys are subject to an ordinary marginal tax rate of 24 percent and assume that they do not have any other transactions involving capital assets in 2020. a. $24,150, computed as follows: Rent the Home Description Amount Calculation (1) Monthly rent ($2,250) (2) Total rent payments for the year (27,000) (1) × 12 months (3) Interest earned on inheritance 3,750 $75,000 × 5% (4) Taxes on earnings (900) (3) × 24% (5) After-tax interest earnings 2,850 (3) + (4) Total after-tax cost of renting for first year ($24,150) (2) + (5) b. 1.6 years (19.2 months), computed as follows: Loan summary: $400,000; 5.75% rate with no points. 4.5% rate with 2 points ($8,000). Assume the Jacobys pay interest only for first three years. Description Amounts Calculation (1) Initial cash outflow from paying points ($8,000) $400,000 × 2% (2) Tax benefit from deducting points + 1,920 (1) × 24% (3) After-tax cost of points ($6,080) (1) + (2) (4) Before-tax savings per year from 4.5% vs. 5.75% interest rate $5,000 [$400,000 × (5.75% - 4.5%)] (5) Forgone tax benefit per year of higher interest rate ($1,200) (4) × 24% (6) After-tax savings per year of 4.5% vs. 5.75% interest rate $3,800 (4) + (5) Break-even point in years (months) 1.6 years (19.2 months) (3) / (6) c. $20,216, computed as follows: Description Amount Explanation (1) Marginal tax rate 24% (2) Mortgage principal $400,000 (3) Mortgage interest rate 5.75% (4) First year interest payment (23,000) (2) × (3) (5) Tax savings from interest payments 5,520 (1) × (4) (6) After-tax cost of interest payments (17,480) (4) + (5) (7) Deductible property taxes for year (3,600) (8) Tax savings from property tax deduction 864 (1) × (7) (9) After-tax cost of real property taxes (2,736) (7) + (8) After-tax cost of buying home for 2020 ($20,216) (6) + (9) d. $40,000 gain realized; $0 recognized gain; $0 taxes payable on gain, computed as follows: Description Amount Explanation (1) Sales proceeds $525,000 (2) Sales commission (10,000) (3) Amount realized $515,000 (1) + (2) (4) Basis in home (475,000) Initial purchase price. Assumes interest only payments on mortgage (5) Gain realized $40,000 (3) + (4) (6) Exclusion for sale of home (40,000) Because after 2 months the Jacobys moved for work reasons, they qualify for a maximum exclusion on their home of $41,667 ($500,000 × 2/24) (7) Gain recognized and taxes payable on gain $0 (5) + (6), no gain, no taxes on the gain. e. $32,500 loss realized; $0 recognized loss; $0 tax benefit from loss, computed as follows: Description Amount Explanation (1) Sales proceeds $450,000 (2) Sales commission (7,500) (3) Amount realized $442,500 (1) + (2) (4) Basis in home (475,000) Initial purchase price. Assumes interest only payments on mortgage (5) Loss realized (32,500) (3) + (4) Effect of loss on Jacoby’s tax liability $0 Loss not deductible because it is a personal loss so no effect on tax liability. 69. James and Kate Sawyer were married on New Year’s Eve of 2019. Before their marriage, Kate lived in New York and worked as a hair stylist for one of the city’s top salons. James lives in Atlanta where he works for a public accounting firm earning an annual salary of $100,000. After their marriage, Kate left her job in New York and moved into the couple’s newly purchased 3,200-square-foot home in Atlanta. Kate incurred $2,200 of moving expenses. The couple purchased the home on January 3, 2020 by paying $100,000 down and obtaining a $400,000 mortgage for the remainder. The interest rate on this loan was 7 percent, and the Sawyers made interest-only payments on the loan through December 31, 2020 (assume they paid exactly one year’s worth of interest on this loan by December 31). On July 1, 2020, the Sawyers borrowed an additional $50,000, secured by the home, in order to make home improvements (the loan was called a “home equity loan” by the lender). The interest rate on the loan was 7 percent (assume they paid interest only for the year and they paid exactly one-half of a year’s worth of interest on this loan by year end). Shortly after moving into the new home, Kate started a new business called Kate’s Beauty Cuts LLC. She set up shop in a 384-square-foot corner room of the couple’s home and began to get it ready for business. The room conveniently had a door to the outside providing customers direct access to the shop. Kate paid $2,100 to have the carpet replaced with a tile floor. She also paid $1,200 to have the room painted with vibrant colors and $650 to have the room rewired for appropriate lighting. Kate ran an ad in the local newspaper and officially opened her shop on January 24, 2020. By the end of the year, Kate’s Beauty Cuts LLC generated $40,000 of net income before considering the home office deduction. The Sawyers incurred the following home-related expenditures during 2020: • $4,200 of real property taxes. • $2,000 for homeowner’s insurance. • $2,400 for electricity. • $1,500 for gas and other utilities. They determined depreciation expense for their entire house for the year was $17,424. Also, on March 2, Kate was able to finally sell her one-bedroom Manhattan condominium for $478,000. She purchased the condo, which she had lived in for six years prior to her marriage, for $205,000. Kate owns a vacation home in Myrtle Beach, South Carolina. She purchased the home several years ago, largely as an investment. To help cover the expenses of maintaining the home, James and Kate decided to rent the home out. They rented the home for a total of 106 days at fair market value (this included eight days that they rented the home to James’s brother Jack). In addition to the 106 days, Kate allowed a good friend and customer, Clair, to stay in the home for half-price for two days. James and Kate stayed in the home for six days for a romantic getaway and another three days in order to do some repair and maintenance work on the home. The rental revenues from the home in 2020 were $18,400. The Sawyers incurred the following expenses associated with the home. • $9,100 of interest expense (assume not limited by acquisition debt limit). • $3,400 of real property taxes. • $1,900 for homeowner’s insurance. • $1,200 for electricity. • $1,600 for gas, other utilities, and landscaping. • $5,200 for depreciation. Required: Determine the Sawyers’ taxable income for 2020. Disregard self-employment taxes and the qualified business income deduction. Assume the couple paid $4,400 in state income taxes and files a joint return. For determining the deductible home office expenses and allocating expenses to the rental, the Sawyers would like to use the methods that minimize their overall taxable income for the year. James and Kate have taxable income of $115,813. See the analysis below. Description Amount Explanation Total income James’s Salary $100,000 Kate’s Schedule C income before home office deduction 40,000 Home-office deduction (for AGI) (10,823) See Note A below for computation. Not limited by income limitation Rent revenue 18,400 Rental expenses (for AGI) (11,995) Used Tax Court method because it generated $379 more in current deductions than IRS method; See Note B below for computation Gain on sale of principal residence after exclusion 23,000 $478,000 – 205,000 = $273,000 gain minus 250,000 exclusion (1) AGI $158,582 Itemized deductions: (2) State income taxes (4,400) (3) Real property taxes on principal residence (3,696) $4,200 – 504 (deducted as home office expense) (4) Real property taxes on vacation/rental home (2,462) $3,400 – 938 (deducted as rental expense) ($558 not deductible due to $10,000 limit) (5) Deductible taxes (10,000) (2) + (3) + (4), limited to $10,000 (Sum is $10,558 but limited to $10,000) (6) Home mortgage interest expense on principal residence (26,180) $29,750 – 3,570 (deducted as home office expense) (7) Home mortgage interest expense on vacation/rental home (6,589) $9,100 – 2,511 (deducted as rental expense) (8) Total itemized deductions (42,769) (5) + (6) + (7) > $24,800 standard deduction for MFJ Taxable income $115,813 (1) + (8) Note A: Home office deduction computation using the actual expense method: Home Office Deduction Type (A) Amount (B) Office % (384/3,200 for indirect) (A) × (B) Home office Expense New flooring Direct $2,100 100% $2,100 New paint for office Direct 1,200 100% 1,200 New office lighting Direct 650 100% 650 Real property taxes Indirect 4,200 12% 504 Home interest expense* Indirect 29,750 12% 3,570 Utilities Indirect 3,900 12% 468 Homeowner’s insurance Indirect 2,000 12% 240 Depreciation Indirect 17,424 12% 2,091 Total expenses $61,224 $10,823 *Total interest expense for the year is computed as follows: Original loan: $400,000 × 7% × ½ of a year = $14,000. Original plus additional loan: $450,000 (additional $50,000 is acquisition debt because it was used to improve the home so interest on entire line is fully deductible): $450,000 × 7% × ½ = $15,750. Total interest expense = $29,750 ($14,000 from original loan through June 3 + $15,750 interest on original plus additional loan from July 1 through the end of the year). Note that under the simplified method, the home office expense deduction is $1,500 (300 square feet × $5). Under this method, the Sawyers would be able to deduct an additional $3,570 of home interest epense but they would not be able to benefit from the additional $504 of real property taxes that would be potentially deductible but is not because the Sawyers would exceed the $10,000 deduction limit for taxes even without the additional real property tax amount. Nevertheless, the deductions allowed under the simplified method are considerably less than those under the actual expense method. Note B: Rental expenses: The Sawyers used the rental home as follows: Rental days: 101 (98 rental to unrelated parties at fair market value + 3 maintenance); Personal days: 16 days (6 vacation days + 8 rented to brother + 2 rented at less than fair market value). Because personal use of 16 is more than the greater of (1) 14 days or (2) 10% of the number of rental days (10.1), their residence qualifies as property with significant personal and significant rental use (mixed use or vacation home)—this means deductions are limited to gross rental income. Because the Tax Court method allows them to deduct $379 more deductions overall (rental + personal interest – taxes over the limit so no tax benefit), they use the Tax Court method to determine their deductions from the rental. Rental Home Expense Allocation Allocation method to rental use Expense Amount Tier IRS method (101/117) Tax Court method (101/366 tier 1 101/117 other) Interest $9,100 1 $7,856 $2,511 Total tier 1 expenses $9,100 1 $7,856 $2,511 Real estate taxes# 3,400 1 2,935 938 Electricity 1,200 2 1,036 1,036 Gas/other utilities and landscaping 1,600 2 1,381 1,381 Insurance 1,900 2 1,640 1,640 Total tier 2 expenses $8,100 2 $6,992 $4,995 Depreciation (tier 3) 5,200 3 4,489 4,489 Total Expenses on property $22,400 Net income from rental IRS method Tax Court method Rental receipts $18,400 $18,400 Less tier 1 expenses (7,856) (2,511) Income after tier 1 expenses 10,544 15,889 Less tier 2 expenses (6,992) (4,995) Income after tier 2 expenses 3,552 10,894 Less: tier 3 expenses (3,552) (4,489) Taxable rental income $0 $6,405 Deductible personal use interest $1,244 $6,589 Deductible personal use real property taxes – 465 1,904* Deductible rental expenses (sum of tier 1, 2, and 3 expenses) (for AGI) limited to gross income 18,400 11,995 Depreciation expense carried over to next year 937 0 Total deductions associated with property (for and from) $20,109 $20,488 #Treated as tier 2 expenses because the $10,000 overall limit is exceeded from the state income taxes of $4,400, residual residence taxes (net of home office) of $3,696 plus this rental amount. *Remaining $558 ($2,462 minus $1,904) not deductible due to $10K deduction limit on itemized deduction for taxes. 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
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