This Document Contains Chapters 5 to 7 Chapter 5 Gross Income and Exclusions Learning Objectives 5-1. Apply the concept of realization. 5-2. Discuss the distinctions between the various sources of income, including income from services and property. 5-3. Apply basic income exclusion provisions to compute gross income. Teaching Suggestions Chapter 4 presented an overview of individual taxation, and this chapter digs deeper into the tax formula to determine gross income. The focus is on the sources of income and whether a particular type of income is excluded from a taxpayer’s gross income. Chapter 4 defined gross income as income that is realized and recognized during the year. Now we learn that realized income is from whatever source derived minus income that is either excluded from taxation or deferred until a subsequent year. In the previous chapter, we discussed gross income in general terms. In this chapter we explain the requirements for taxpayers to recognize gross income, and we describe the most common sources of gross income. This content requires describing many of the judicially created tax doctrines (such as constructive receipt and tax benefit) and calculating the return of capital, most dramatically demonstrated by an annuity calculation. The chapter concludes with a description of the most common exclusion provisions. Assignment Matrix Learning Objectives Text Feature Problem Time Difficulty LO1 LO2 LO3 Research Planning Forms DQ5-1 10 min. Easy X DQ5-2 10 min. Easy X DQ5-3 15 min. Medium X DQ5-4 15 min. Medium X DQ5-5 15 min. Medium X DQ5-6 15 min. Medium X DQ5-7 15 min. Medium X DQ5-8 20 min. Medium X DQ5-9 15 min. Medium X DQ5-10 10 min. Easy X DQ5-11 15 min. Medium X DQ5-12 10 min. Easy X DQ5-13 15 min. Medium X DQ5-14 15 min. Medium X DQ5-15 15 min. Medium X DQ5-16 10 min. Easy X DQ5-17 20 min. Medium X DQ5-18 15 min. Medium X DQ5-19 15 min. Medium X DQ5-20 20 min. Medium X DQ5-21 15 min. Easy X DQ5-22 15 min. Medium X DQ5-23 10 min. Medium X DQ5-24 15 min. Medium X DQ5-25 10 min. Medium X DQ5-26 15 min. Medium X DQ5-27 15 min. Medium X DQ5-28 15 min. Medium X DQ5-29 10 min. Easy X DQ5-30 15 min. Medium X DQ5-31 5 min. Easy X DQ5-32 15 min. Medium X DQ5-33 10 min. Medium X DQ5-34 10 min. Medium X DQ5-35 10 min. Medium X DQ5-36 10 min. Medium X DQ5-37 15 min. Medium X DQ5-38 15 min. Medium X P5-39 15 min. Medium X P5-40 45 min. Medium X X P5-41 45 min. Medium X X P5-42 90 min. Hard X X P5-43 20 min. Medium X P5-44 15 min. Easy X P5-45 30 min. Medium X X P5-46 30 min. Medium X P5-47 15 min. Easy X P5-48 15 min. Easy X P5-49 15 min. Easy X P5-50 45 min. Medium X X P5-51 20 min. Medium X P5-52 25 min. Medium X P5-53 30 min. Medium X X P5-54 15 min. Easy X P5-55 15 min. Medium X P5-56 25 min. Medium X P5-57 25 min. Medium X P5-58 15 min. Easy X P5-59 20 min. Medium X P5-60 20 min. Medium X P5-61 45 min. Medium X X P5-62 30 min. Hard X P5-63 15 min. Medium X P5-64 20 min. Medium X P5-65 15 min. Medium X P5-66 15 min. Medium X P5-67 15 min. Medium X P5-68 20 min. Medium X X P5-69 15 min. Medium X P5-70 20 min. Medium X P5-71 20 min. Medium X P5-72 10 min. Medium X CP5-73 45 min. Hard CP5-74 50 min. Hard CP5-75 60 min. Hard X CP5-76 45 min. Hard X CP5-77 60 min. Hard X Lecture Notes 1) Realization and Recognition of Income a) What is included in gross income? i) Reg. §1.61-(a) provides further insight into the definition of gross income as follows: Gross income means all income from whatever source derived, unless excluded by law. Gross income includes income realized in any form, whether in money, property, or services. (1) Economic benefit (2) Realization principle (a) Income is realized when: (i) A taxpayer engages in a transaction with another party, and (ii) The transaction results in a measurable change in property rights. (b) Work through Example 5-1. (3) Recognition b) Other income concepts i) Form of receipt (1) Work through Example 5-2. ii) Return of capital principle iii) Recovery of amounts previously deducted (1) Work through Example 5-3. c) When do taxpayers recognize income? i) Accounting methods (1) Accrual method (2) Cash method ii) Constructive receipt (1) The constructive receipt doctrine states that a taxpayer must realize and recognize income when it is actually or constructively received. (2) Work through Example 5-4. iii) Claim of right d) Who recognizes the income? i) Taxpayers attempt to shift income to other related taxpayers through the income-shifting strategy. ii) Example of income-shifting strategy: A father (with a high marginal income tax rate) might wish to assign his paycheck to his baby daughter (with a low marginal income tax rate) to minimize their collective tax burden. iii) Assignment of income (a) Work through Example 5-5. iv) Community property systems (1) For federal income tax purposes, the community property system has the following consequences: (a) Half of the income earned from the services of one spouse is included in the gross income of the other spouse. (b) Half of the income from property held as community property by the married couple is included in the gross income of each spouse. (c) In five community property states (Arizona, California, Nevada, New Mexico, and Washington), all of the income from property owned separately by one spouse is included in that spouse’s gross income. (d) In Texas, Louisiana, Wisconsin, and Idaho, half of the income from property owned separately by one spouse is included in the gross income of each spouse. v) Common law systems (1) For federal income tax purposes, the common law system has the following consequences: (a) All of the income earned from the services of one spouse is included in the gross income of the spouse who earned it. (b) For property owned separately, all of the income from the separately owned property is included in that spouse’s gross income. (c) For property owned jointly (that is, not separately), each co-owner is taxed on the income attributable to his share of the property. For example, suppose that a parcel of property is jointly owned by husband and wife. One-half would be included in the gross income of each spouse. Similarly, income from property owned by three or more persons would be included in the gross income of each co-owner based on his or her respective ownership share. (2) Work through Example 5-6. 2) Types of Income a) Income from services i) Common source of gross income—income from labor ii) Payments for services including salary, wages, and fees that a taxpayer earns through services in a nonemployee capacity are all considered income from services. iii) Income from services is often referred to as earned income. (a) Work through Example 5-7. b) Income from property i) Work through Examples 5-8, 5-9, and 5-10. ii) Annuities (1) An annuity is an investment that pays a stream of equal payments over time. (2) Annuities paid over a fixed period. (3) Annuities paid over a person’s life (for as long as the person lives). (4) Use of annuity exclusion ratio to determine the return of capital (nontaxable) portion of each payment. (5) Use of IRS tables to determine the expected number of payments based upon the taxpayer’s life expectancy at the start of the annuity. (a) Work through Example 5-11. iii) Property dispositions (1) Taxpayers can realize a gain or loss when disposing of an asset. (2) Taxpayers are allowed to recover the capital invested in property tax-free. (3) Payments from purchased annuities are part income and part return of capital. (4) When property is sold or disposed, the realized gain or loss equals the sale proceeds reduced by the tax basis of the property. (5) Formula for calculation gain or loss: Sales proceeds (−) Selling expenses (=) Amount realized (−) Basis in property sold (=) Gain/Loss on sale. (6) The rate at which taxpayers are taxed on gains from property dispositions and the extent to which they can deduct losses from property dispositions depends on whether the taxpayer used the asset for business purposes, investment purposes, or personal purposes. (7) Work through Example 5-12. c) Other sources of gross income i) Income from flow-through entity (a) Work through Example 5-13. ii) Alimony (1) When couples legally separate or divorce, one spouse may be required to provide financial support to the other in the form of alimony. (2) The tax law defines alimony as (a) a transfer of cash made under a written separation agreement or divorce decree, (b) the separation or divorce decree does not designate the payment as something other than alimony, and (c) the payments cannot continue after the death of the recipient. (3) For divorce or separation agreements executed before January 1, 2019, alimony is included in gross income of the recipient and deductible for AGI by the payor. (4) For divorce or separation agreements executed after 2018, alimony is not taxable to the recipient or deductible by the payor. (5) Work through Examples 5-14, 5-15, and 5-16. iii) Prizes, awards, and gambling winnings (1) Awards are included in gross income unless (a) made for scientific, literary, or charitable achievement and transferred to a federal, state, or local government unit or a qualified charity, (b) made to employees for length of service or safety achievement (limited to $400 of tangible property per employee per year), or (c) made to Team USA athletes from U.S. Olympic Committee on account of their competition in Olympic and Paralympic games (AGI limit applies). (a) Work through Example 5-17. iv) Social Security benefits (1) A taxpayer may be required to include up to 85 percent of Social Security benefits in gross income depending on the taxpayer’s filing status, Social Security benefits, and modified AGI. (2) Modified AGI is regular AGI (including 50 percent of Social Security benefits) plus tax-exempt interest income, excluded foreign income, and certain other deductions for AGI. High-income individuals include a portion of their benefits up to a maximum of 85 percent of the total Social Security benefits. (3) As an example, show calculation summary for single taxpayers in text. (4) Work through Example 5-18. v) Imputed income (1) Work through Examples 5-19 and 5-20. vi) Discharge of indebtedness (1) When a taxpayer’s debt is forgiven by a lender (the debt is discharged), the taxpayer must include the amount of debt relief in gross income. (2) Note that there are other circumstances in which taxpayers may exclude a discharge of indebtedness (e.g., home mortgage forgiveness). (3) In order to provide tax relief for insolvent taxpayers—taxpayers with liabilities, including tax liabilities, exceeding their assets—a discharge of indebtedness is not taxable if the taxpayer is insolvent before and after the debt forgiveness. (4) If the discharge of indebtedness makes the taxpayer solvent, the taxpayer recognizes taxable income to the extent of her solvency. (5) Work through Example 5-21. 3) Exclusion Provisions a) Common exclusions i) Municipal bond interest (1) Municipal bonds include bonds issued by state and local governments located in the United States, and this exclusion is generally recognized as a subsidy to state and local governments. (2) Work through Example 5-22. ii) Gain on the sale of personal residence (1) $250,000 exclusion ($500,000 if married filing jointly) (2) Ownership test (3) Use test (4) Work through Example 5-23. iii) Fringe benefits (1) The value of these benefits is included in the employee’s gross income as compensation for services. (2) Certain “qualifying fringe benefits” are excluded from gross income. (a) Common qualifying fringe benefits are medical and dental health insurance coverage, life insurance coverage, de minimis (small) benefits. (3) Work through Examples 5-24 and 5-25. iv) Education-related exclusions (1) Scholarships (a) Students seeking a college degree can exclude scholarships that pay for required tuition, fees, books, and supplies. (b) Work through Example 5-26. (2) Other educational subsidies (a) Taxpayers are allowed to exclude from gross income earnings on investments in qualified education plans such as 529 plans and Coverdell education savings accounts as long as they use the earnings to pay for qualifying educational expenditures. (b) Taxpayers can elect to exclude interest earned on Series EE savings bonds when the redemption proceeds are used to pay qualified higher education expenses. (c) The exclusion of interest on Series EE savings bonds is restricted to taxpayers with modified AGI below specific limits. v) Exclusions that mitigate double taxation (1) Gifts and inheritances (a) Individuals may transfer property to other taxpayers without receiving or expecting to receive value in return. (b) If the transferor is alive at the time of the transfer, the property transfer is called a gift. (c) If the property is transferred from the decedent’s estate (transferor is deceased), it is called an inheritance. (d) Gifts and inheritances are subject to federal transfer taxes and are therefore excluded from the income of the recipient. (e) Work through Example 5-27. (2) Life insurance proceeds (a) In some ways, life insurance proceeds are similar to inheritances. (b) If the policy holder dies, the beneficiary receives the death benefit proceeds. The decedent is generally subject to estate taxation on the amount of the insurance proceeds. (c) In order to avoid potential double taxation on the life insurance proceeds, the tax laws allow taxpayers receiving life insurance proceeds to exclude the proceeds from taxable income. (d) If the insurance proceeds are paid over a period of time rather than in a lump sum, a portion of the payments represents interest and must be included in gross income. (e) The life insurance proceeds exclusion generally does not apply when a life insurance policy is transferred to another party for valuable consideration. In this case, the eventual life insurance proceeds collected by the purchaser are excluded up to the sum of the purchase price of the policy and any subsequent premiums, with remaining proceeds taxable as ordinary income. (f) If a taxpayer simply cancels a life insurance contract and is paid the policy’s cash surrender value, she would recognize ordinary income to the extent the proceeds received exceed previous premiums paid. If premiums paid exceed the proceeds received, the loss is not deductible. (g) If the taxpayer is terminally ill (medically certified with an illness expected to cause death within 24 months), early receipt of life insurance proceeds (accelerated death benefits) is not taxable. (h) Work through Example 5-28. (3) Foreign-earned income (a) A maximum of $107,600 (2020) of foreign-earned income can be excluded from gross income for qualifying individuals. (b) To be eligible for the foreign-earned income and housing exclusions, the taxpayer must have her tax home in a foreign country and (1) be considered a resident of the foreign country by living in the country for the entire year (calendar year) or (2) live in the foreign country for 330 days in a consecutive 12-month period. (c) Taxpayers meeting the requirement for the foreign-earned income exclusion may also exclude from income reasonable housing costs that exceed 16 percent of the statutory foreign-earned income exclusion amount for the year (exceed 16 percent × $107,600 = $17,216 in 2020). The exclusion, however, is limited to a maximum of 14 percent of the statutory exclusion amount (14 percent × $107,600 = $15,064 in 2020). (d) Work through Example 5-29. vi) Sickness and injury-related exclusions (1) Workers’ compensation (a) Payments from workers’ compensation plans are excluded from gross income. (2) Payments associated with personal injury (a) Payments received as compensation for a physical injury are excluded from gross income, but punitive damages are included in gross income. (b) Work through Example 5-30. (3) Health care reimbursement (a) Reimbursements by health and accident insurance policies for medical expenses paid by the taxpayer are excluded from gross income. (4) Disability insurance (a) Disability insurance, also called wage replacement insurance, pays the insured individual for wages lost when the individual misses work due to injury or disability. (b) If an individual purchases disability insurance directly, the cost of the policy is not deductible, but any disability benefits are excluded from gross income. (c) Work through Example 5-31. vii) Deferral provisions (1) Deferral provisions allow taxpayers to defer (but not permanently exclude) the recognition of certain types of realized income. (2) Transactions generating deferred income include installment sales, like-kind exchanges, involuntary conversions, and contributions to non-Roth qualifying retirement accounts. Class Activities 1. Suggested class activities A good activity for helping students understand constructive receipt is using examples based upon a “parade of horribles.” Begin with the question of whether a taxpayer should be able to avoid income by simply refusing to cash a check for services. Then, progressively extend the example to more difficult situations (e.g., a check received on December 31st, December 31st after the banks have closed, December 31st and the check is postdated January 1st). This example will help students understand that rules are typically based upon a continuum of behaviors and that judgment may be necessary in determining what type of behavior breaks the spirit of the rule. Probably the most difficult of the legal doctrines in this chapter is tax benefit. You might consider revisiting this type of problem in the next chapter after students have had an opportunity to study itemized deductions (especially state income taxes). 2. Ethics discussion From page 5-17: Discussion points: • Do you think that finding $100 meets the definition of gross income? • Is there a “materiality” threshold for when you have to report income? • Does not reporting the $100 violate tax law and/or ethical standards? • If you are more likely to report the $100,000, why? Does not reporting the $100,000 violate tax law and/or ethical standards? Chapter 6 Individual Deductions Learning Objectives 6-1. Identify the common deductions necessary for calculating adjusted gross income (AGI). 6-2. Describe the different types of itemized deductions available to individuals. 6-3. Determine the standard deduction available to individuals. 6-4. Calculate the deduction for qualified business income. Teaching Suggestions In Chapter 5, we discussed the calculation of gross income and identified several specific types of taxable income and exclusions. In Chapter 6, we describe the deductions allowed in the computation of taxable income. It is important to emphasize that taxpayers are only allowed to deduct expenditures if there is a specific tax law authorizing the deductions. Of course, Congress grants many deductions for taxpayers for a variety of reasons, and these deductions appear in one of two places in the individual income tax formula. Deductions “for AGI” are subtracted directly from gross income. In contrast, deductions “from AGI” are subtracted from AGI. Deductions for AGI are preferred over deductions from AGI because these deductions reduce taxable income dollar for dollar. An indirect benefit of deductions for AGI is that these deductions reduce AGI. Because many of the limitations on tax benefits for higher-income taxpayers are based upon AGI, deductions for AGI reduce these limitations, thereby increasing potential tax benefits. In contrast to deductions for AGI, itemized deductions will have no effect on taxable income unless the total exceeds the standard deduction. Students often confuse the location of the deduction with the deduction rule. So, a good rule is to emphasize the order of the questions. First, determine if the expense is deductible. Next, determine the location of the deduction (for or from). If the students have already been exposed to the calculation of taxable income for other entities (e.g., corporations, partnerships, etc.), it might be helpful to discuss which deductions and limitations are specific to individuals relative to other entities. For example, the distinction between for and from AGI deductions does not exist for corporations. If the objective of the course is a survey of tax rules (as opposed to an in-depth understanding of the specific deductions), it might be preferable to skip the details of itemized deductions. A good approach might be to have students read the first part of the chapter and skim the second part (itemized deductions). Assignment Matrix Learning objective Text feature Problem Time Difficulty LO1 LO2 LO3 LO4 Research Planning Forms DQ6-1 10 min. Easy X DQ6-2 10 min. Easy X DQ6-3 20 min. Medium X DQ6-4 15 min. Medium X DQ6-5 45 min. Medium X X DQ6-6 15 min. Medium X DQ6-7 15 min. Medium X DQ6-8 10 min. Medium X DQ6-9 15 min. Medium X DQ6-10 10 min. Easy X DQ6-11 15 min. Medium X DQ6-12 10 min. Medium X DQ6-13 45 min. Medium X X DQ6-14 20 min. Medium X DQ6-15 20 min. Medium X DQ6-16 45 min. Medium X X DQ6-17 20 min. Medium X DQ6-18 15 min. Medium X DQ6-19 15 min. Medium X DQ6-20 15 min. Medium X DQ6-21 30 min. Medium X X DQ6-22 30 min. Medium X X DQ6-23 30 min. Medium X DQ6-24 20 min Medium X DQ6-25 20 min Medium X P6-26 15 min. Easy X P6-27 15 min. Medium X P6-28 15 min. Easy X P6-29 10 min. Easy X P6-30 40 min. Medium X X P6-31 30 min. Medium X P6-32 20 min. Medium X P6-33 20 min. Medium X X P6-34 20 min. Medium X X P6-35 20 min. Medium X P6-36 15 min. Medium X P6-37 45 min. Medium X X P6-38 45 min. Medium X X P6-39 10 min. Medium X X P6-40 10 min. Medium X P6-41 10 min. Medium X X P6-42 20 min. Medium X P6-43 20 min. Medium P6-44 20 min. Medium X P6-45 15 min. Medium P6-46 10 min. Medium X P6-47 10 min. Medium P6-48 40 min. Medium X P6-49 40 min. Hard X P6-50 40 min. Medium X X P6-51 15 min. Medium X P6-52 45 min. Medium X X X P6-53 15 min. Medium X P6-54 15 min. Medium X P6-55 15 min. Medium X P6-56 30 min. Medium X P6-57 30 min. Medium X CP-58 60 min. Hard CP-59 60 min. Hard X CP-60 60 min. Hard CP-61 60 min. Hard X CP-62 60 min. Hard Lecture Notes 1) Deductions for AGI a) Congress allows taxpayers to claim a variety of deductions for AGI. b) Deductions directly related to business activities i) Work through Example 6-1. ii) Refer to Exhibit 6-1 for Individual Business and Investment-Related Expense Deductions for AGI, from AGI, and Not Deductible. iii) Trade or business expenses iv) Refer to Exhibit 6-2 for Parts I and II from Schedule C Profit or Loss from Business. v) Work through Example 6-2. vi) Rental and royalty expenses (1) Taxpayers are allowed to deduct their expenses associated with generating rental or royalty income for AGI. (2) Refer to Exhibit 6-3 for Page 1 of Schedule E Rental or Royalty Income. (3) Work through Example 6-3. vii) Losses on dispositions (1) Taxpayers disposing of business assets at a loss are allowed to deduct the losses for AGI deductions. viii) Flow-through entities (1) Income from flow-through entities such as partnerships, LLCs, and S corporations passes through to the owners of those entities, with the related net business income reported on Schedule E of the tax returns of the owners. (2) Expenses and losses incurred by the entity pass through to the entity owners, who typically treat them as deductions for AGI. ix) Excess business loss limitation (1) An excess business loss for the year is the excess of aggregate business deductions for the year over the sum of business gross income or gain of the taxpayer plus a threshold amount. (2) The threshold amount for 2020 is $518,000 for married taxpayers filing jointly and $259,000 for other taxpayers. (3) Excess business loss is not deductible but is carried forward. (4) Work through Example 6-4. c) Deductions indirectly related to business activities i) Taxpayers are allowed to deduct several expenses that are indirectly related to business activities as deductions for AGI. ii) Moving expenses (1) Generally are not deductible. (2) Employer reimbursements are taxable. (3) Exception for active-duty military. (4) Work through Example 6-5. iii) Health insurance deduction by self-employed taxpayers (1) Intended to help self-employed taxpayers who must pay their own insurance premiums. iv) Self-employment tax deduction (1) Work through Example 6-6. v) Deductions for individual retirement accounts (IRAs) (1) Deductible contributions to traditional IRAs are for AGI deductions (2) The deductible amount of the contribution depends on a number of factors (filing status, whether the taxpayer is an active participant in an employer-sponsored retirement plan, and the taxpayer’s modified AGI). (3) Distributions from traditional IRAs are taxed as ordinary income to the taxpayer, and early distributions (before age 59 ½) are generally subject to a 10 percent penalty. (4) Taxpayers with earned income that are not eligible to make deductible contributions can make nondeductible contributions. On distribution, the taxpayer is taxed on the earnings generated by nondeductible contributions but not on the actual nondeductible contributions. vi) Penalty for early withdrawal of savings (1) Allows a deduction for AGI for any interest income an individual forfeits to a bank as a penalty for prematurely withdrawing a certificate of deposit or similar deposit. (2) Work through Example 6-7. d) Deductions subsidizing specific activities i) Deduction for interest on qualified education loans (1) Up to $2,500 of interest on education loans is deductible for AGI. (2) A loan qualifies as an education loan if the proceeds are used to fund qualified education expenses. (3) The interest deduction is phased out for taxpayers with AGI exceeding $70,000 ($140,000 married filing jointly). (4) Refer to Exhibit 6-4 for Summary of Limitations on Deduction of Interest on Education Loans. (5) Work through Example 6-8. ii) Qualified education expenses (1) Up to $4,000 of qualified education expenses can be deducted for AGI. (2) Qualified education expenses are limited to the tuition and fees required for enrollment at a postsecondary institution of higher education. (3) For purposes of the qualified education expense deduction, modified AGI is AGI after deducting the education loan interest expense but before deducting qualified education expenses. (4) The deduction is reduced for taxpayers with modified AGI over $65,000 ($130,000 married filing jointly) and eliminated for taxpayers with modified AGI exceeding $80,000 ($160,000 married filing jointly). (5) Refer to Exhibit 6-5 for Summary of 2020 Limitations on Qualified Education Expenses. (6) Work through Example 6-9. e) Summary: Deductions for AGI i) Refer to Exhibits 6-6, 6-7, 6-8, and 6-9. 2) Deductions from AGI: Itemized deductions i) Medical expenses (1) Designed to provide relief for taxpayers whose ability to pay taxes is seriously hindered by health-related circumstances. (2) Qualified medical expenses include any payments for the care, prevention, diagnosis, or cure of injury, disease, or bodily function that are not reimbursed by health insurance or are not paid for through a “flexible spending account.” (3) Common medical expenses include: (a) Prescription medication, insulin, and medical aids such as eyeglasses, contact lenses, and wheelchairs. Over-the-counter medicines are generally not deductible. (b) Payments to medical care providers such as doctors, dentists, and nurses and medical care facilities such as hospitals. (c) Transportation for medical purposes. (d) Long-term care facilities. (e) Health insurance premiums (if not deducted for AGI by self-employed taxpayers) and insurance for long-term care services. (4) Work through Example 6-10. (5) Transportation and travel for medical purposes (a) Taxpayers traveling for the primary purpose of receiving essential and deductible medical care may deduct the cost of lodging while away from home overnight (with certain restrictions) and transportation. (b) Taxpayers using personal automobiles for medical transportation purposes may deduct a standard mileage allowance in lieu of actual costs. (c) Work through Example 6-11. (6) Hospitals and long-term care facilities (a) Taxpayers may deduct the cost of meals and lodging at hospitals. (b) Work through Example 6-12. (7) Medical expense deduction limitation (a) The deduction for medical expenses is limited to the amount of unreimbursed qualified medical expenses paid during the year (no matter when the services were provided) reduced by 7.5 percent of the taxpayer’s AGI. (b) Work through Example 6-13. ii) Taxes (1) Individuals may deduct as itemized deductions the payments they made during the year for the following taxes: (a) State, local, and foreign income taxes, including state and local taxes paid during the year through employer withholding, estimated tax payments, and overpayments on the prior-year return that the taxpayer applies to the current year (the taxpayer asks the state to keep the overpayment rather than refund it). (b) State and local real estate taxes on property held for personal or investment purposes. (c) State and local personal property taxes that are assessed on the value of the specific property. (2) Taxpayers may elect to deduct state and local sales taxes instead of deducting state and local income taxes. The total itemized deduction for state and local taxes is limited to $10,000 ($5,000 married filing separately). The itemized deduction for foreign income taxes is not subject to this limitation. (3) Work through Example 6-14. iii) Interest (1) Individuals can deduct interest paid on loans secured by a personal residence (on acquisition indebtedness up to $1,000,000 ($500,000 if filing married separate) if indebtedness originated before December 16, 2017; $750,000 ($375,000 if married filing separately) if indebtedness originated after December 15, 2017). (2) Individuals can also deduct interest paid on loans used to purchase investment assets such as stocks, bonds, or land (investment interest expense). (3) Work through Example 6-15. iv) Charitable contributions (1) Congress encourages donations to charities by allowing taxpayers to deduct contributions of money and other property to qualified domestic charitable organizations. (2) Qualified charitable organizations include organizations that engage in educational, religious, scientific, governmental, and other public activities. (3) Work through Example 6-16. (4) Contributions of money (a) Cash contributions are deductible in the year paid, including donations of cash or by check, electronic funds transfers, credit card charges, and payroll deductions. (b) Work through Example 6-17. (5) Contributions of property other than money (a) When a taxpayer donates property to charity, the amount the taxpayer is allowed to deduct depends on whether the property is capital gain property or ordinary income property. (b) Work through Examples 6-18, 6-19, and 6-20. (6) Charitable contribution deduction limitations (a) The amount of a taxpayer’s charitable contribution deduction for the year is limited to a ceiling or maximum deduction. (b) Refer to Exhibit 6-10 for Summary of Charitable Contribution Limitation Rules. (c) Work through Example 6-21. v) Casualty and theft losses on personal-use assets (1) Only casualty losses on personal-use assets attributable to a federally declared disaster are deductible (subject to $100 floor for each casualty and 10 percent of AGI floor for all casualties in a year). vi) Other Itemized Deductions (1) Unreimbursed employee business expenses, tax preparation fees, investment expenses (other than investment interest expense), and hobby expenses are no longer deductible as other itemized deductions subject to 2 percent AGI floor. (2) Gambling expenses and losses are deductible to extent of gambling winnings for the year. (3) Casualty and theft losses on property held for investment (not personal-use property) and the unrecovered cost of a life annuity (if the taxpayer died before recovering the full cost of the annuity) also are deductible as other itemized deductions. vii) Summary of itemized deductions (1) Work through Example 6-22. (2) Refer to Exhibit 6-11 for Courtney’s Form 1040, Schedule A. 3) The standard deduction a) Standard deduction i) A flat amount that most individuals can elect to deduct instead of deducting their itemized deductions (if any). ii) Taxpayers generally deduct the greater of their standard deduction or their itemized deductions. iii) The amount of the standard deduction varies according to the taxpayer’s filing status, age, and eyesight. iv) Basic standard deduction is greater for married taxpayers filing jointly and those supporting a family (head of household) than it is for married taxpayers filing separately and unmarried taxpayers not supporting a family. v) Taxpayers who are at least 65 years of age on the last day of the year or blind are entitled to additional standard deduction amounts above and beyond their basic standard deduction. vi) Refer to Exhibit 6-12 for Standard Deduction Amounts. vii) Work through Examples 6-23 and 6-24. viii) Bunching itemized deductions (1) Some taxpayers may deduct the standard deduction every year because their itemized deductions always fall just short of the standard deduction amount and thus never produce any tax benefit. (2) The basic strategy consists of shifting itemized deductions into one year such that the amount of itemized deductions exceeds the standard deduction for the year, and then deducting the standard deduction in the next year (or vice versa). (3) Work through Example 6-25. 4) Deduction for qualified business income a) Deduction for qualified business income i) Deduction is limited to qualified trade or business. (1) Excludes specified service trade or business (except for taxpayers with taxable income below $163,300; $326,600 if married filing jointly; $163,300 if married filing separate). b) Work through Example 6-26. c) Limitations i) The deduction for qualified business income cannot exceed the greater of: (1) 50 percent of the wages paid with respect to the qualified trade or business, or (2) The sum of 25 percent of the wages with respect to the qualified trade or business plus 2.5 percent of the unadjusted basis, immediately after acquisition, of all qualified property in the qualified trade or business. d) Work through Example 6-27. 5) Taxable income summary a) Refer to Exhibits 6-13, 6-14, and 6-15. 6) Conclusion 7) Summary 8) Key Terms Class Activities 1. Suggested class activities A great activity for this chapter is to compile a list of the deductions that are to be emphasized in the chapter (business, rental/royalty, education, medical, charitable, etc.) and have students prepare a set of examples for each type of deduction. Alternatively, prepare a list of expenditures and have students determine whether the expenditure is deductible and, if so, where the deduction is claimed. 2. Ethics discussion From page 6-23: Discussion points: • If Sabrina gets an appraisal that states the value of the clothes is $6,000, how much tax deduction will she receive for the clothes? • If Sabrina’s clothes are worth $6,000, is she better off getting the appraisal or reporting a deduction of $4,900? What information would you need to answer this question? • Does Sabrina’s reporting $4,900 violate tax law and/or ethical standards? • Do you think the IRS has reason to be suspicious of contributions that fall just below $5,000? Why? Chapter 7 Investments Learning Objectives 7-1. Explain how interest income and dividend income are taxed. 7-2. Compute the tax consequences associated with the disposition of capital assets, including the netting process for calculating gains and losses. 7-3. Calculate the deduction for investment interest expense. 7-4. Apply tax-basis, at-risk, and passive activity loss limits to losses from passive investments. Teaching Suggestions The focus of this chapter is on the tax rules that typically apply to individual investors. While we certainly discuss the rules applicable to portfolio investments such as stocks and bonds, we also discuss the rules relating to passive investments in flow-through entities and real estate because we believe these are frequently thought of by individuals as “investments.” This chapter also maintains a planning emphasis via an extended example of a family considering tax consequences as it makes investment decisions. Thus, this chapter lends itself to a discussion of both the relevant tax rules as well as the planning implications of these rules. Use the planning ideas as a hook to generate interest among the students in this topic. The following advanced topics can be omitted from a discussion of the chapter at the discretion of the instructor without causing any interruption in the flow or logic of the chapter: • Netting of 0/15/20 percent, 25 percent, and 28 percent capital gains • Investment interest expense • Tax-basis, at-risk, and passive activity loss limitations Students usually need additional time to understand these topics, and you should take this into account if you decide to cover them. Assignment Matrix Learning Objectives Text Feature Difficulty LO 7-1 LO 7-2 LO 7-3 LO 7-4 Research Planning Tax Forms DQ7-1 20 min. Medium X DQ7-2 20 min. Medium X DQ7-3 20 min. Medium X DQ7-4 20 min. Medium X DQ7-5 20 min. Medium X DQ7-6 20 min. Medium X DQ7-7 20 min. Medium X X DQ7-8 20 min. Medium X DQ7-9 20 min. Medium X DQ7-10 20 min. Medium X DQ7-11 20 min. Medium X DQ7-12 10 min. Medium X DQ7-13 10 min. Medium X DQ7-14 10 min. Medium X DQ7-15 10 min. Medium X DQ7-16 10 min. Medium X DQ7-17 25 min. Hard X DQ7-18 25 min. Hard X DQ7-19 25 min. Hard X X DQ7-20 20 min. Hard X DQ7-21 20 min Medium X DQ7-22 20 min Medium X X DQ7-23 20 min Hard X X DQ7-24 20 min Hard X DQ7-25 20 min Hard X DQ7-26 20 min Hard X DQ7-27 20 min Hard X DQ7-28 25 min Hard X DQ7-29 25 min Hard X DQ7-30 15 min Medium X DQ7-31 20 min Hard X DQ7-32 20 min Hard X X P7-33 15 min Easy X P7-34 15 min Easy X P7-35 20 min Medium X P7-36 20 min Medium X P7-37 10 min. Easy X P7-38 20 min Medium X P7-39 15 min. Easy X P7-40 15 min. Easy X X P7-41 20 min. Medium X P7-42 20 min. Medium X P7-43 20 min. Medium X X P7-44 20 min. Medium X P7-45 15 min. Easy X P7-46 25 min. Medium X P7-47 20 min. Medium X P7-48 25 min Hard X P7-49 30 min. Hard X P7-50 20 min. Medium X P7-51 20 min. Medium X P7-52 15 min. Easy X P7-53 20 min. Easy X P7-54 20 min. Medium X X P7-55 25 min. Medium X X P7-56 30 min Medium X P7-57 30 min Medium X X P7-58 30 min Medium X X P7-59 30 min Medium X P7-60 30 min Medium X P7-61 30 min Medium X P7-62 30 min Medium X CP7-63 50 min Hard X Lecture Notes 1) Investments Overview a) Taxes are levied on investment income, and thus, it would be unwise to make an investment without considering the tax cost. b) It is possible that two investments with identical before-tax rates of return will generate different after-tax rates of return because the investments are taxed differently. c) It is possible that an investment with a lower before-tax rate of return compared to an alternative investment will have a higher after-tax rate of return because income from the investment is taxed at a later date or at a lower rate than the alternative investment. d) Two key tax characteristics that affect after-tax rates of return from investments are: i) The timing of tax payments or tax benefits, and ii) The rate at which investment income or gains are taxed or deductible expenses or losses generate tax savings. e) Income from portfolio investments, which are investments producing dividends, interest, royalties, annuities, or capital gains, may be taxed at ordinary or preferential rates, or it may be exempt from taxation. f) Depending on the type of investment, tax on income from a portfolio investment may be imposed annually or may be deferred until the taxpayer sells the investment. g) Losses from portfolio investments are deferred until the investment is sold and are typically subject to limitations. h) In contrast to portfolio investments, passive investments generate operating income and operating losses. i) Operating income is always taxed annually at ordinary rates, while operating losses are either deducted annually at ordinary rates or deferred and deducted later at ordinary rates, depending on the investor’s circumstances. j) Losses from passive investments are also subject to limitations. 2) Portfolio Income: Interest and Dividends a) Taxpayers who desire current cash flows from their investments may choose investments that generate interest or regular dividends. b) Investments generating interest income include certificates of deposit (CDs), savings accounts, corporate bonds, and governmental bonds. c) Investments generating dividend income include direct equity investments in corporate stocks and investments in mutual funds and exchange traded funds (ETFs) that invest in corporate stock. d) Interest i) Taxpayers recognize interest income from investments when they receive the interest payments. ii) Interest is taxed at ordinary rates. iii) Taxpayers investing in savings accounts, money market accounts, CDs, and most bonds receive interest payments based on a stated annual rate of return at yearly or more frequent intervals. iv) Special rules apply for determining the timing and amount of interest from bonds when there is a bond discount—that is, when bonds are issued at an amount below the maturity value—or a bond premium—that is, when bonds are issued at an amount above the maturity value. v) Corporate and U.S. Treasury bonds (1) The tax consequences of corporate and Treasury bonds are very similar. (2) The two primary differences are that (1) interest from Treasury bonds is exempt from state taxation while interest from corporate bonds is not, and (2) Treasury bonds always pay interest periodically while corporate bonds may or may not. vi) U.S. savings bonds (1) U.S. savings bonds such as Series EE or Series I bonds are issued at either face value or at a discount. (2) The amount of interest income taxpayers recognize when they redeem the bonds is the excess of the bond proceeds over the taxpayer’s basis (purchase price) in the bonds. vii) Work through Examples 7-1 and 7-2. viii) Refer to Exhibit 7-1 for Timing of Interest Payments and Taxes. e) Dividends i) Dividend payments (including reinvested dividends) are taxed annually. ii) Qualified dividends are taxed at preferential rates. Refer to Exhibit 7-2 for Holding Period for Qualified Dividends. iii) Nonqualified dividends are not eligible for the reduced rate and are therefore taxed at ordinary rates. iv) Work through Example 7-3. 3) Portfolio Income: Capital Gains and Losses a) When taxpayers buy and hold assets with appreciation potential, they typically are investing in capital assets. b) From a tax perspective, the real advantages of investing in capital assets are that: i) Gains are deferred for tax purposes until the taxpayer sells or otherwise disposes of the assets and ii) Gains generally are taxed at preferential rates relative to ordinary income. c) When a taxpayer sells a capital asset for more than its tax basis, the taxpayer recognizes a capital gain; if a taxpayer sells a capital asset for less than its tax basis, the taxpayer recognizes a capital loss (to the extent the loss is deductible). d) The amount realized or selling price of a capital asset includes the cash and fair market value of other property received, less broker’s fees and other selling costs. e) The basis of any asset, including a capital asset, is generally the taxpayer’s “cost” of acquiring the asset, including the initial purchase price and other costs incurred to purchase or improve the asset. f) Because taxpayers cannot accurately compute the gain or loss on the sale of a capital asset without knowing its basis, it is important to maintain accurate records to track the basis in capital assets. g) By default, taxpayers are required to use the first-in, first-out (FIFO) method of determining the basis of the shares they sell. h) However, if they (or their broker) track the basis of their stock, taxpayers can sell (or instruct their broker to sell) specific shares using the specific identification method to determine the basis of the shares they sell. Taxpayers using the specific identification method can choose to sell their high-basis stock first, minimizing their gains or increasing their losses on stock dispositions. i) Work through Example 7-4. j) Types of capital gains and losses i) Short-term capital gains are taxed at ordinary rather than preferential rates. ii) Long-term gains are taxed at preferential rates. iii) Refer to Exhibit 7-3 for Taxable Income by Filing Status. iv) 25 percent gains (1) When individuals sell depreciable real property held more than one year at a gain, a portion (or even all) of the gain may be taxed at a maximum rate of 25 percent (the unrecaptured §1250 gain portion), and a portion may be taxed as a 0/15/20 percent gain. (2) Work through Example 7-5. v) 28 percent gains (1) Gains from two types of capital assets are taxable at a maximum 28 percent rate. (a) Collectibles (i) Consists of works of art, rugs or antiques, metals or gems, stamps or coins, alcoholic beverages, or other similar items held for more than one year. (b) Qualified small business stock (§1202 stock) (i) Must be held for more than five years. (ii) In general, IRC §1202 defines qualified small business stock as stock received at original issue from a C corporation with a gross tax basis in its assets both before and after the issuance of no more than $50,000,000 and with at least 80 percent of the value of its assets used in the active conduct of certain qualified trades or businesses. (iii) The capital gain not excluded from income is taxed at 28 percent. (iv) Refer to Exhibit 7-4 for Exclusion for §1202 Stock Held More Than Five Years. (c) Work through Example 7-6. (d) Refer to Exhibit 7-5 for Classification of Capital Gains by Maximum Applicable Tax Rates. vi) Netting process for gains and losses (1) To determine the appropriate tax treatment for the capital gains and losses recognized during the year, the taxpayer must complete a netting process. (2) This process can be complex when taxpayers recognize capital losses and long-term capital gains subject to different maximum tax rates. (a) Certain gains from the sale of depreciable real property held long term are taxed at a maximum rate of 25 percent (unrecaptured §1250 gain). Gains from collectibles and from qualified small business stock not held for five years are taxed at a maximum rate of 28 percent. (b) When taxpayers have 25 or 28 percent rate capital gains, the netting process requires that losses be applied to higher-rate groups before lower-rate groups. (c) When taxable income without long-term capital gains exceeds the maximum 15 percent rate amount, 25 and 28 percent capital gains are taxed at their maximum rate. Otherwise, applicable capital gains rates must be adjusted to reflect their inclusion in lower ordinary income rate brackets. (3) Work through Examples 7-7 and 7-8. (4) Reporting capital gains and losses (a) Refer to Exhibits 7-6 and 7-7 for Jeb’s Form 8949 and Jeb’s Schedule D. vii) Calculating tax liability on net capital gains (1) Refer to the guidelines in the book to calculate the tax liability on net capital gains. (2) Work through Example 7-9. k) Limits for capital loss deductions i) Losses on the sale of personal-use assets (1) Personal-use assets fall within the category of capital assets. (2) The gain from the sale of a personal-use asset is taxable even though it was not purchased for its appreciation potential. (3) Losses on the sale of personal-use assets are not deductible, and therefore never become part of the netting process. ii) Capital losses on sales to related persons (1) When taxpayers sell capital assets at a loss to related persons, they are not able to deduct the loss. iii) Wash sales (1) A wash sale occurs when an investor sells or trades stock or securities at a loss and within 30 days either before or after the day of sale buys substantially identical stocks or securities. (2) Because the day of sale is included, the 30 days before and after period creates a 61-day window during which the wash sale provisions may apply. (3) When the wash sale provisions apply to a sale of stock, realized losses are not recognized; instead, the amount of the unrecognized loss is added to the basis of the newly acquired stock. (4) The 61-day period ensures that taxpayers cannot deduct losses from stock sales without exposing themselves to the risk that the stock they sold will subsequently increase in value. (5) Work through Example 7-10. l) Balancing tax planning strategies for capital assets with other goals i) When taxpayers invest in capital assets and hold the assets for more than a year, they receive at least two benefits. (1) First, they are able to defer recognizing gains on the assets until they sell them—the longer the deferral period, the lower the present value of the capital gains tax when taxpayers ultimately sell the assets. (2) Second, they pay taxes on the gains at preferential rates. ii) A productive strategy for managing investments in capital assets is to sell investments with built-in losses. iii) Work through Example 7-11. 4) Portfolio Income Summary a) Tax planning must not be done in a vacuum or without considering all relevant parties and taxpayers’ economic and personal objectives. 5) Investment Interest Expense a) Beginning in 2018, the only expense associated with investments that remains deductible is investment interest expense. b) When taxpayers borrow money to acquire investments, the interest expense they pay on the loan is investment interest expense. c) Investment interest expense may be deductible as an itemized deduction. i) Limited to the taxpayer’s net investment income for the year. (1) To avoid confusion, we use the term investment income rather than the term net investment income to discuss the investment interest expense limitation. (2) Because the Tax Cuts and Jobs Act (TCJA) eliminated the deduction for investment expenses, net investment income is simply gross investment income. (3) Gross investment income includes interest, annuity, and royalty income not derived in the ordinary course of a trade or business. It also includes net short-term capital gains and nonqualified dividends. (4) However, investment income generally does not include capital gains taxed at a preferential rate and qualified dividends because of the preferential rate. d) Work through Examples 7-12 and 7-13. e) Taxpayers may deduct their investment interest expense up to the amount of their investment income. i) Any investment interest expense in excess of investment income is carried over and treated as though it was incurred in the next year when it is subject to the same limitations. ii) The carryover amount never expires. f) Congress allows taxpayers to elect to include preferentially taxed income in invest¬ment income if they are willing to subject this income to tax at the ordinary (not prefer¬ential) tax rates. (1) Work through Example 7-14. g) Net investment income tax i) A net investment income tax is imposed on net investment income. ii) The tax imposed is 3.8 percent of the lesser of (1) net investment income or (2) the excess of modified adjusted gross income over $250,000 for married-joint filers and surviving spouses, $125,000 for married-separate filers, and $200,000 for other taxpayers. 6) Passive Activity Income and Losses a) Taxpayers may invest in business- and income-producing activities: i) In ways in which the taxpayer is taxed on portfolio income from the investment. ii) In ways in which the taxpayer is taxed directly on the actual income from the business. b) If the activities generate losses, the losses must clear three hurdles to be currently deductible. The three hurdles are the tax-basis, at-risk, and passive loss limits. c) The tax-basis hurdle limits a taxpayer’s deductible operating losses to the taxpayer’s tax basis in the business or rental activity. d) In order to apply the tax-basis loss limitation, we must first determine the taxpayer’s tax basis in the activity. e) When a loss from a business or business-related activity clears the tax-basis hurdle, it next must clear an at-risk hurdle on its journey toward deductibility. f) Losses that do not clear the at-risk hurdle are suspended until the taxpayer generates more at-risk amounts to absorb the loss or until the activity is sold, when they may offset the seller’s gain from the disposition of the activity. g) The at-risk rules are meant to limit the ability of investors to deduct “artificial” ordinary losses produced with certain types of debt. These rules limit ordinary losses to a taxpayer’s economic risk in an activity. h) Work through Example 7-15. i) Passive activity definition i) Defined as “any activity which involves the conduct of a trade or business, and in which the taxpayer does not materially participate.” ii) According to the tax code, participants in rental activities, including rental real estate, and limited partners in partnerships are generally deemed to be passive participants, and participants in all other trade or business activities are passive unless their involvement in an activity is “regular, continuous, and substantial.” Clearly, these terms are quite subjective and difficult to apply. iii) Refer to Exhibit 7-8 for Tests for Material Participation. j) Income and loss categories i) The three different categories are as follows: (1) Passive activity income or loss—income or loss from an activity in which the taxpayer is not a material participant. (2) Portfolio income—income from investments including capital gains and losses, dividends, interest, annuities, and royalties. (3) Active business income—income from sources in which the taxpayer is a material participant. ii) Refer to Exhibit 7-9 for Income and Loss Categories. iii) Work through Example 7-16. k) Rental real estate exception to the passive activity loss rules i) Applies to active participants in rental property. ii) Deduct up to $25,000 of rental real estate loss against ordinary income. iii) $25,000 maximum deduction phased out by 50 cents for every dollar of AGI over $100,000 (excluding the rental loss deduction). iv) Fully phased out at $150,000 of AGI. l) Net investment income tax on net passive income i) Net investment income tax applies to net passive income. ii) Work through Example 7-18. 7) Conclusion 8) Summary 9) Key Terms Class Activities 1. Suggested class activities ○ Elimination: Develop several multiple-choice questions (A, B, C answers) and/or true/false questions (you could draw questions from the test bank) relating to important topics from the chapter. Have each class member write the letters A, B, and C on separate sheets of paper. Have the entire class stand up. When you ask a question, have each class member hold up their response to the question (A, B, or C). Those who miss must sit down. Continue until you have asked all your questions or until all but one student has been eliminated. Award bonus points (or acknowledgment of a job well done) to those still standing. ○ Comprehensive problems: Have students work in groups (two to four students) to complete the comprehensive problem. Problem 63 is a computational/compliance problem. Make yourself available to students to answer questions but try to get them to work together to resolve their questions. You could choose one question (what is the amount of capital gain? or what are taxes payable or taxes due?) for students to report to you. You can write the answer from each group on the board and then reveal the correct answer. Give credit to the group(s) that is (are) correct/closest. ○ Tax policy debate: There are changes to ordinary and capital gains rates. Consider having students discuss and debate the following questions and perhaps others if time permits: 1) What are the likely effects of the changes on taxpayers’ investing behavior? 2) What will be the impact on the price of investment assets? 3) Who will likely bear the cost of a rate increase or decrease? 2. Ethics discussion From page 7-24: Discussion points: • The wash sale rules are designed to prevent taxpayers from selling loss stock at year-end to offset ordinary income when they repurchase the stock within a short time period, thereby retaining an investment in the stock. • The rules specifically disallow a repurchase of “substantially identical” stocks or securities within a 61-day window. • One issue is whether substantially identical stocks include common and preferred stock and whether T.D. is bearing some change in risk by selling common stock and repurchasing preferred stock temporarily and then purchasing common again when the wash sale period ends. Instructor 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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