SECTION F-2020 - A LITTLE MORE EARLY HELP SOME INCOME TAX DEDUCTIONS
AND SOME TAX PROCEDURES
Table Of Contents
Table Of Contents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -1Section F-2020 - A Little More Early Help Some Income Tax Deductions And Some Tax Procedure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -11The purpose of these tax texts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -11Using these tax texts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Viewing Professor Jegen’s tax texts and other tax materials . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Some more comments about Corel WordPerfect software . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Some more comments about Microsoft Word software . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Some more comments about Adobe Reader software . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
So use whichever software pleases you . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
If you have some problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
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Study The Following Drawing Of Picasso Very Carefully . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -14Some general comments about the nature and function of income tax deductions . . . . . . . . . . . . . . . . . . . . . .
The ups and downs of income tax deductions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
The character of income tax deductions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Function of deductions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Reduction of gross income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Reduction of income tax owed . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
One deduction which may be offset against income before the determination of gross income . . . . .
Computing taxable income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Types of deductions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
The format of most deduction sections . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
This next point is a very important point . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
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Realized, recognized, and deductible loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
When is realized loss, deductible loss? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Definition of the terms “adjusted gross income” and “taxable income” . . . . . . . . . . . . . . . . . . . . . . . .
Before the amount of AGI or taxable income can be determined, several things must occur . . . . . . .
Before AGI or taxable income can be determined, the taxpayer must have “realized loss” . . . . . . . . .
Realized loss must be recognized loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Is recognized loss “deductible loss”? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
The difference between nonrecognized loss and nondeductible loss . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Business expenses versus investment expenses versus personal expenses . . . . . . . . . . . . . . . . . . . . . .
In general, substantially all expenses incurred in earning a living or in profit activities are deductible.
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Deduction taken above AGI versus deductions taken below AGI . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Miscellaneous itemized deductions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Some examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
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Where do the most common and important deduction sections begin in the IRC? . . . . . . . . . . . . . . . . . . . . . . -37Copyright ©1986 Through 2012, Professor Jegen’s Taxsite
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Section 162 through section 198 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -37Trade or business expenses and production of income expenses - section 162 and section 212 . . . . . . . . . . . .
The meaning of the terms “ordinary” and “necessary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
The meaning of the terms “paid” and “incurred” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Scope of section 162 and section 212 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Capital expenditures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Section 162 is used by all types of businesses such as the following . . . . . . . . . . . . . . . . . . . . . . . . . .
Section 162 income tax deductions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Investment expenses; expenses for the production of income - section 212 . . . . . . . . . . . . . . . . . . . .
More comparisons of personal expenses and investment expenses and business expenses . . . . . . . . .
Personal use? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Investment use? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Business use? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
To repeat. Where are investment expenses deductible? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
The meaning of the phrase “in connection with the determination, collection, or refund of any tax” .
No deductions for payments of other individuals’ expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
To be deductible, compensation paid to employees must be reasonable . . . . . . . . . . . . . . . . . . . . . . .
Business travel expenses, including meals and lodging . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
The cost of commuting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Transportation expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Transportation after taxpayer arrives at work . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Rent paid for property used in a trade or business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
No deduction is allowable for certain illegal payments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
In general, lobbying expenses are not deductible . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Payments for education expensive . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Some examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
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Some questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -72Dividends distributed from a C corporation to the C corporation’s shareholders . . . . . . . . . . . . . . . . -74Activities not engaged in for profit (hobby deductions) - section 183 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Deductions for business and investment expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
However, read section 183(b) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
When is an activity engaged in for profit? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
A rebuttable presumption . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
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Personal expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -80In general, no deductions may take for personal expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -80Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -80Net operating loss deduction - section 172 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -81Copyright ©1986 Through 2012, Professor Jegen’s Taxsite
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The term net “operating loss” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Net operating loss carry backs and carry forwards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Some examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Some questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
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Interest expenses - section 163 and section 221 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
General rules about interest paid or accrued . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Four types of loans which, in general, will result in interest deductions . . . . . . . . . . . . . . . . . . . . . . .
Business activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Investment activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Personal activities (if the loan is secured by first or second residence) . . . . . . . . . . . . . . . . . .
Education activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Where, in the income tax computation, is interest deducted? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
In general, personal interest is not allowable as a deduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Interest with respect to “qualified residence mortgage loans” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Qualified residence interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Home equity indebtedness . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Some examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
"Points" charged by a lender generally qualify as interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Some examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Some questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Interest paid with respect to student loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Interest paid with respect to investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Some examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Some questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Personal interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Interest paid to finance the purchase of, for example, state and local bonds . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Some questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
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State and local tax expenses - sections 164, 1001, 1012, and 453 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -95The taxes which are allowable deductions under section 164 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -96The definitions of a “state and local tax” and a “foreign tax” and a “generation skipping transfer tax”
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -96Taxes other than federal income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -96Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -97Some questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -98Sales or exchanges of real property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -99Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -100Some questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -100Section 164 income tax deductions for state and local taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -101Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -102Treatment of real property taxes when real property is sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -104Allocation of real property taxes upon the sale/purchase of real property - in general . . . . . . . . . . . -104Copyright ©1986 Through 2012, Professor Jegen’s Taxsite
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Some examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -104Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -104Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -105Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -105At the heart of the method for allocating real property taxes when real property is sold (or purchased)
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -105Section 164(d) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -105Section 1001(b) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -105Section 1012 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -105Some examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -105Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -105Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -106Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -109Section 453 - reporting gain on the installment method of accounting . . . . . . . . . . . . . . . . . . . . . . . -110Definition of an “installment sale” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -110General advantages to the seller who reports gain from the sale of property by using the installment method
of reporting such gain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -110In general, the installment method of reporting gain is not mandatory . . . . . . . . . . . . . . . . . . . . . . . -110Some limitations on the use of the installment method of reporting gain for income tax purposes are as
follows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -111Broker’s commission and other selling expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -111Gross profit percentage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -112The “total contract price“and the “gross profit ratio” and “qualified indebtedness” . . . . . . . . . . . . . -112Electing out of using the installment method for reporting gain or loss . . . . . . . . . . . . . . . . . . . . . . . -112Some examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -112Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -112Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -113Paul’s basis is as follows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -114John may deduct the following real property taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -114Paul may deduct the following real property taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -114Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -114Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -114Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -115Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -117Property which is sold subject to a mortgage debt or with the purchaser assuming the mortgage debt
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -117Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -117Using the installment method when some of the gain is recaptured as ordinary income due to section 1245
or section 1250 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -118Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -118Using the installment method when some of the selling price is unascertainable . . . . . . . . . . . . . . . -118Installment sales involving related parties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -119Special installment sales involving large amounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -119An installment sale in which the stated interest is less than the applicable federal rate (AFR) . . . . . -119As stated above, taxpayers may elect out of the installment method of reporting gain . . . . . . . . . . . -120Some questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -120Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -131To return to section 453 - reporting gain on the installment method accounting . . . . . . . . . . . . . . . . -132Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -132Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -132Some more comments about Indiana real property taxes and about the sales of Indiana real property
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -133A explanation of the facts of a real property sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -134John’s gain is as follows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -134Copyright ©1986 Through 2012, Professor Jegen’s Taxsite
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Paul’s basis is as follows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -135John may deduct the following real property taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -135Paul may deduct the following real property taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -135Losses sustained - sections 165, 465, and 1211 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Section 165(a) states that a loss is only deductible if the loss is “sustained” . . . . . . . . . . . . . . . . . . .
The basis for determining the loss with respect to property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
A limitation with respect to the deduction for losses in the case of individuals . . . . . . . . . . . . . . . . .
Losses from the disposition of business or investment property . . . . . . . . . . . . . . . . . . . . . . . . . . . .
The “at risk” limitation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Casualty and theft losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Some examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Some questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
-137-137-138-138-139-139-142-144-144-144-144-144-145-145-
Bad debts - section 166 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
The purpose of section 166 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Business bad debts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Non-business bad debts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
A limitation on the deduction of a bad debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Treatment of a guarantor of a bad debt who must pay the amount of the guaranty . . . . . . . . . . . . . .
Some examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Some questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
-146-146-148-148-149-149-150-150-150-150-
Depreciation and expending of property - sections 167, 168, 179, 280F, 1016, 1245, and 1250 . . . . . . . . . .
The concept of depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
The only property which may be depreciated through section 167 is as follows . . . . . . . . . . . . . . . .
Property which is used in a trade or business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Property held for the production of income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
The effect on the basis of property as the property is depreciated . . . . . . . . . . . . . . . . . . . . . . . . . . .
The three most common methods of depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Expending business tangible personal property - section 179 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
The deduction categories for certain depreciable or amortizable property are as follows . . . . . . . . .
Personal property and intangibles are depreciable if the property is as follows . . . . . . . . . . . . . . . . .
Property is not depreciable if it is not exhaustible or if it is not subject to wear and tear . . . . . . . . .
Property used solely for “personal use” is not depreciable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
In addition, section 280F(b) limits depreciation deductions with respect to “listed property” . . . . . .
Depreciation of certain listed property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Some examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Some questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Dual purpose doctrine . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
What happens if a taxpayer should take depreciation deductions, but does not do so? . . . . . . . . . . .
What happens if a taxpayer takes more depreciation deductions than is allowable? . . . . . . . . . . . . .
Depreciation methods for tangible personal property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
The applicable depreciation method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
-152-158-164-164-165-165-171-171-172-172-172-173-175-175-177-177-177-177-177-178-178-181-184-184-
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The applicable recovery period . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
The applicable convention . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
The modified accelerated cost recovery system (MACRS) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
A cap on the maximum MACRS deduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Depreciating real property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
In general, depreciable real property must be depreciated by using the straight line method
.................................................................
Two types of real property which may be depreciated . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Nonresidential real property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Residential rental real property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
In general, personal residences are not depreciable real property . . . . . . . . . . . . . . . . . . . . .
The useful lives of property are generally prescribed by the Regulations . . . . . . . . . . . . . . . . . . . . .
Computer software and race horses - three years . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Automobiles, light trucks, and computers - five years . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Other tangible personal property - seven years . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Residential real property - 27.5 years . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Other (nonresidential) real property - 39 years . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Depreciation conventions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Tangible personal property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Real property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Some examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Some questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
An alternative depreciation system . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Recapture of certain depreciation taken with respect to real property . . . . . . . . . . . . . . . . . . . . . . . .
Some examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Some more comments about recapture of depreciation for depreciable real property . . . . . . . . . . . .
Some examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Some questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
-184-184-184-185-186-186-186-186-186-186-186-187-187-187-187-187-187-187-187-188-188-188-189-189-190-191-196-196-196-196-196-196-202-202-202-202-202-202-202-202-202-202-205-205-
Section 611 and section 613 - depletion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
One definition of “depletion” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Depletion deductions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
The basis for depletion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Percentage depletion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Related deductions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
-206-207-207-207-208-208-
Charitable contributions - section 170 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -208Copyright ©1986 Through 2012, Professor Jegen’s Taxsite
F-2020 EH Some Income Tax Deductions
-6-
Charitable organizations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Deductible contributions must be gifts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Percentage limitations with respect to charitable contributions . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Charitable contributions of appreciated property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
The differences between the 30% test and the 50% test . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Charitable contributions of cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
More about the 50% and the 30% limitations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Some examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Some questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Increasing a contribution from the 30% limitation to the 50% limitation . . . . . . . . . . . . . . . . . . . . .
Charitable contributions of marketable securities to private foundations . . . . . . . . . . . . . . . . . . . . . .
Some examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Some questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Charitable contributions by C corporations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Which limitation is applied first - - - the 30% limitation or the 50% limitation? . . . . . . . . . . . . . . . .
Some repeating of some basic concepts charitable contribution deduction . . . . . . . . . . . . . . . . . . . .
Charitable contributions of tangible personal property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Some examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Charitable contribution carryovers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
The term “ordinary income property” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Some questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Charitable contributions of real property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Types of real property for charitable contribution purposes . . . . . . . . . . . . . . . . . . . . . . . . .
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Property held for the production income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Property held for business purposes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Personal property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Making gifts of property now, but keeping the property until you die . . . . . . . . . . . . . . . . . . . . . . . .
Charitable contributions of your house and land (your residence) . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Charitable contributions of farms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Charitable contributions of partial interests . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Some examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Copyright ©1986 Through 2012, Professor Jegen’s Taxsite
F-2020 EH Some Income Tax Deductions
-209-210-214-216-218-218-218-220-221-221-224-224-224-224-224-226-226-227-227-227-227-227-228-228-229-231-232-233-233-233-233-234-234-235-236-236-236-236-236-236-236-236-237-237-238-238-238-238-239-241-241-241-242-242-7-
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Charitable remainder trusts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Some examples. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Charitable lead trusts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Pooled income funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
-242-243-244-244-245-245-248-248-249-250-251-251-253-254-259-261-262-264-273-273-273-274-285-287-290-292-294-295-
Transactions involving bonds - sections 1012, 165, 171, 454, 1271, and 1273 . . . . . . . . . . . . . . . . . . . . . . .
Transactions involving bonds generation involve the following types of transactions . . . . . . . . . . .
In general, bonds may be purchased in the following amounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
At par value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
At a premium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
At a discount . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
A bond's par value has two functions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Bond premium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Accrual of bond discount . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
State and local bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Adjustments to the basis of the bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Disposition of bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Original issue discount . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Some questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Worthless securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Some examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Some questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
-295-298-308-308-309-309-309-309-311-313-315-316-318-319-320-325-328-329-329-330-330-
Amortization - sections 171, 174,195, 197, 248, and 709 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -330171(a), 174(a), 195(a), 197(a), 248(a), and 709(a) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -330Definitions of “amortization” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -332Copyright ©1986 Through 2012, Professor Jegen’s Taxsite
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The term “amortization” is not a substitute term for “depreciation” . . . . . . . . . . . . . . . . . . . . . . . . .
The purchase of a life or term interest in property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
The deduction categories for certain depreciable or amortizable property are as follows . . . . . . . . .
-334-335-336-337-
Amortizable bond premium - section 171 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -337Research and experimental expenditures - section 174 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -338The purpose of section 174 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -338Start-up expenditures - section 195 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -338The purpose of section 195 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -338Amortization of goodwill and certain other intangibles - section 197 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
The purpose of section 197 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Section 197 intangibles include, among other assets, the following . . . . . . . . . . . . . . . . . . . . . . . . . .
Section 197 provides a 15-year amortization period for “section 197 property” . . . . . . . . . . . . . . . .
Some examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Some questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
-339-339-339-339-339-339-340-340-
Organizational expenditures - section 248 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -340The purpose of section 248 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -341The definition of the term “organizational expenditures” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -341The treatment of organization and syndication fees - section 709 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -341The purpose of section 709 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -341The definition of “organization fees” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -341Where do the most common and important deduction sections begin in the IRC? . . . . . . . . . . . . . . . . . . . . . -342Trade or business expenses and production of income expenses - section 162 and section 212 . . . . . . . . . . . -342The meaning of the terms “ordinary” and “necessary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -342The meaning of the terms “paid” and “incurred” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -344Scope of section 162 and section 212 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -344Capital expenditures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -345Section 162 is used by all types of businesses such as the following . . . . . . . . . . . . . . . . . . . . . . . . . -348Section 162 income tax deductions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -348Investment expenses; expenses for the production of income - section 212 . . . . . . . . . . . . . . . . . . . -349Does it matter to a taxpayer if the taxpayer, for example, rents a safe deposit box for any one of the following
reasons . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -350Personal use? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -350Investment use? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -350Business use? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -350To repeat. Where are investment expenses deductible? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -350The meaning of the phrase “in connection with the determination, collection, or refund of any tax . -351Medical, dental, etc., expenses - sections, 213, 104, 105, and 106 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Some examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Self-employed individuals may deduct 45% of their health insurance costs as a business expense. .
Some questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
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Alimony and separate maintenance payments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -358Moving expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -358The cost of moving to a new residence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -358Section 243 through section 248 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -360Where do the most common and important deduction disallowance sections begin in the IRC? . . . . . . . . . .
Section 262 and they end at section 280H . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
The format of most deduction disallowance sections . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Section 262 - payments for personal expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Section 263 and section 263A - capital expenditures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Section 265 - payments to generate excluded income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Section 266 - payments of certain taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Section 267 - losses between related taxpayers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Section 274 - payments for entertainment expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
-361-361-361-361-362-363-363-363-363-
Some Tax Procedure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -374A little bit of tax procedure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . -374-
Copyright ©1986 Through 2012, Professor Jegen’s Taxsite
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Section F-2020 - A Little More Early Help Some Income Tax Deductions And Some Tax Procedures
Examine The Following Comments Carefully
I.
The purpose of these tax texts. These tax texts are used primarily for a beginning income tax course of three
to four hours and for other two or three-hour courses dealing with: corporation income tax; gratuitous
transfer taxes; tax procedure; and/or state and local taxes. For the assumptions which are used in these tax
texts, read Section F-2001 of these tax texts.
II.
Using these tax texts. In order to view, for no charge, Professor Jegen’s Federal and State tax texts and other
tax materials, whether or not you are a student, a lawyer, or an accountant, you must go to Professor Jegen’s
Taxsite, the Internet address for which is as follows. Examine this taxsite carefully, before reading any
additional part of these tax texts. http://www.iupui.edu/~taxsite
A.
Viewing Professor Jegen’s tax texts and other tax materials.
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
In order to view all of Professor Jegen’s Federal and State tax texts and other tax materials,
whether or not you are a student, a lawyer, or an accountant, you must go to Professor
Jegen’s Taxsite, the Internet address for which is: http://www.iupui.edu/~taxsite
There are tax texts, forms, etc. for all viewers, but particularly with respect to students, there
are schedules, assignments, and a variety of informative documents about each course which
Professor Jegen teaches.
After you locate the tax texts (the files) which you wish to read, notice that the name of each
file has an extension (ending). A “file extension” is at the end of the basic file name (with
a dot in front of it) which has been assigned to the file, generally, by the drafter of the
content of the file. There are some extensions with which you probably already familiar,
such as the following three.
The extension for WordPerfect document is: wpd.
The extension for a Word document is: doc or docx.
The extension for a Adobe portable document format is: pdf.
To repeat. A “file extension” is at the end of the basic file name (with a dot in front of the
extension) which extension has been assigned to the file, by me for my files or by someone
else for their files.
You should be familiar with the following, very common, extensions.
a.
Microsoft Word uses a doc or docx extension. The docx extension is the more
recent release of the two.
(1)
You may download a Microsoft Office Compatibility pack to ensure that
you can view newer documents with the .docx file extension.
b.
If you use Corel WordPerfect, then you are familiar with the wpd extension.
c.
Adobe Acrobat uses the pdf extension and to read these files, you must go on line
and acquire, free of charge, the Adobe Reader program.
(1)
For this purpose, you might want to use the following link:
http://www.adobe.com/reader
The file of extension of pdf stands for “portable document format” and this type of file is
used in competition and as a complement with other types of files, e.g., the doc extension for
Microsoft Word and the wpd extension for Word Perfect Documents. One advantage of a
pdf file type or commonly referred to as “a pdf file” is that a file which is a pdf file type may
be consistently viewed and printed by computer users who normally use other operating
systems or software for wordprocessing, e.g., Word, Works, WordPerfect, StarOffice or
OpenOffice.
Therefore, it does not matter whether or not you normally use Microsoft Word, Microsoft
Works, Corel WordPerfect, Sun StarOffice or OpenOffice , you can consistently view and
print files which have a pdf extension by using the Adobe Reader, which is generally
referred to as “Adobe”.
Copyright ©1986 Through 2012, Professor Jegen’s Taxsite
F-2020 EH Some Income Tax Deductions
-11-
11.
B.
Some more comments about Corel WordPerfect software.
1.
2.
C.
Two individuals, Bastian and Ashton, decided to create a word processing program for a
minicomputer system in 1979 and began selling WordPerfect in 1980. Corel later purchased
the rights to the software and began introducing updated versions. For several years, this
software was the most popular word processing software until overtaken by Word during the
1990s. Its popularity was mainly due to the fact that it was available for a wide variety of
operating systems and it was highly compatible with many systems.
Corel WordPerfect is still number two in sales behind Word and some universities also
include the cost of the software in fees and permit students to download WordPerfect Office
X5. See the IUware online website at http://iuware.iu.edu. As stated above, the most
common file extension of WordPerfect files is .wpd. Kendall Callas states the Corel
WordPerfect software is still the most popular word processor for lawyers due to
PerfectScript, the programming language that, when combined with macros, allows law firms
to more readily create their widely varying legal documents than with other leading word
processing programs such as Microsoft Word (microcounsel.com).
Some more comments about Microsoft Word software.
1.
D.
Even though an individual normally uses other software (e.g., Word, Works, WordPerfect,
StarOffice or OpenOffice) to edit and view or print files, that individual may use the Adobe
Reader for pdf files and this allows the drafter of the documents in a make such pdf files
available for viewing by more individuals, without having to make more than one file
available for each type of wordprocessor software and/or each type of operating system and
further ensures that the document is consistently formatted for viewing and printing. A
distinct advantage is clearly provided to the authors of such files, however, a recipient of
such file also is provided with the advantage that they can read such file regardless of their
word processing software or operating system.
According to contributors to Wikipedia, Microsoft first introduced Word in 1983 under the
name Multi-Tool Word. While it was not well received initially and struggled to compete
with the well-established WordPerfect, Word slowly, but steadily gained a greater share of
the market. The release of Word software with Macintosh-compatible in 1985 gave Word
more credibility and increased distribution. Further, Microsoft offers these programs to
college students at a greatly reduced cost and some universities allow current students to
download them with the cost already included in technology fees. See the IUware online
website at http://iuware.iu.edu. This has assured the promulgation of Word to the next
generation of professionals.
Some more comments about Adobe Reader software.
1.
2.
First introduced in 1993 by Adobe, the pdf format has evolved from a proprietary format
only being available on Macintosh and requiring a user to purchase software to access such
documents to the current state in which the pdf format is near standard format for viewing
files and is further an open file format available on all major operating systems. The Adobe
software to view the pdf format is available for free from Adobe's site and further since the
file format is no longer proprietary there are numerous third party software vendors which
provide software to not only view but to create and edit pdf files. In fact you will find
features to generate pdf files from most recent major word processing tools.
As stated, the Adobe Reader is available to computer users for no charge and a link has been
provided on Professor Jegen’s taxsite which allows computer users to download the Adobe
Reader in order to view and print all pdf files which are located at Professor Jegen’s taxsite.
If you are wondering how Adobe makes its money, it is due to Adobe’s sales and support
of pdf authoring and related software (the software which allows an individual to edit a pdf
file) and licensing of their technology to other companies. The site at which computer users
Copyright ©1986 Through 2012, Professor Jegen’s Taxsite
F-2020 EH Some Income Tax Deductions
-12-
can download the Adobe Reader
http://www.adobe.com/prodindex/acrobat/readstep.html
E.
no
charge)
is:
So use whichever software pleases you.
1.
F.
(at
Therefore, it does not matter whether or not you normally use Microsoft Word, Microsoft
Works, Corel WordPerfect, Sun StarOffice or OpenOffice , you can reliably view and print
files which have a pdf extension by using the Adobe Reader. This allows the author of such
files to make such one file available for viewing which can be used by a larger group of
computer users without having to make more than one file for each type of wordprocessor
software and/or each type of operating system.
If you have some problems.
1.
If you have difficulty opening part or all of some of the files which are on Professor Jegen's
taxsite, then you should first download the particular document to your or the law school's
hard drive, and then, open the particular file. If you still are unable to open a particular
document in whole or in part, then you should speak with one of the individuals who provide
student help in the law school computer rooms or contact the University Information
Technology Services (UITS) support center at 317-274-4357.
Copyright ©1986 Through 2012, Professor Jegen’s Taxsite
F-2020 EH Some Income Tax Deductions
-13-
Study The Following Drawing Of Picasso Very Carefully
INCOME
REALIZED
INCOME
SECTION 61
GROSS INCOME
THE LINE
SECTION 162 ETC.
ITEMIZABLE
DEDUCTIONS
+
SECTION 151
PERSONAL
EXEMPTIONS
GROSS RECEIPTS
MINUS ADJUSTED
BASIS OF PROPERTY
GAIN (NOT MINUS LOSS)
POSTPONED INCOME
RECOGNIZED INCOME
EXCLUDED INCOME
SECTION 162 ETC.
DEDUCTIONS
FROM
GROSS INCOME
TO
ADJUSTED
GROSS INCOME
2%
7.5%
10%
50-30%
SECTION 63
TAXABLE
INCOME
Copyright ©1986 Through 2012, Professor Jegen’s Taxsite
SECTION 62
ADJUSTED
GROSS INCOME
SECTION 63(c) & 63(f)
STANDARD
DEDUCTION
+
SECTION 151
PERSONAL
EXEMPTIONS
SECTION 63
TAXABLE
INCOME
F-2020 EH Some Income Tax Deductions
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I.
Some general comments about the nature and function of income tax deductions.
A.
The ups and downs of income tax deductions.
1.
In order to deduct an item for income tax purposes, there must be a section which authorizes
the deduction.
2.
Deductions may be classified into two categories: deductions taken "above the line" and
deductions taken "below the line."
3.
Deductions taken above the line are deductions taken from gross income in arriving at
adjusted gross income.
4.
Deductions taken "below the line" are deductions taken from adjusted gross income in
arriving at taxable income.
5.
Deductions taken "below the line" are itemized deductions.
6.
After you determine whether or not a particular item is deductible, you must then determine,
in the case of individuals and fiduciaries, whether the deduction is allowable above or below
adjusted gross income.
7.
In general, deductions are ordinary deductions (not capital losses), because they do not arise
from the sale or exchange of a capital asset and generally, there is no specific section which
states that they are to be treated as capital losses (even though they are in fact ordinary
deductions).
a.
However, and obviously, capital losses are not ordinary losses.
8.
Some deductions are deductible only above AGI and some deductions are deductible only
below AGI.
a.
No deduction may be deducted both above AGI and below AGI.
B.
The character of income tax deductions.
1.
The standard deductions are ordinary deductions (not capital losses), because they do not
arise from the sale or exchange of a capital asset.
C.
Function of deductions.
1.
Like income tax exclusions, income tax deductions reduce the amount of income which is
includible in taxable income and which will be subjected to income tax.
2.
Income tax exclusions reduce the amount of income prior to gross income and some income
tax deductions reduce the amount of gross income prior to adjusted gross income and other
income tax deductions reduce the amount of adjusted gross income prior to taxable income.
3.
If a taxpayer has $1,000 of income and a $1,000 income tax exclusion with respect to that
income, then the taxpayer has no gross income.
4.
If a taxpayer has $1,000 of income and $1,000 of income tax deductions below the line, then
the taxpayer still has gross income of $1,000.
5.
If a taxpayer has $1,000 of gross income and $1,000 of income tax deductions, then the
taxpayer has no taxable income.
a.
If these income tax deductions are income tax deductions in arriving at the
taxpayer’s adjusted gross income, then the taxpayer has no adjusted gross income.
D.
Reduction of gross income.
1.
A dollar of income tax exclusion or income tax deduction will reduce a dollar of gross
income, and this will save (for the taxpayer) the amount of income tax which would
otherwise be imposed on such dollar of income.
2.
If a taxpayer is in the 28% income tax bracket, then, using the “marginal rate theory” a dollar
of income tax exclusions or a dollar of income tax deductions will save the taxpayer 28
cents.
a.
Therefore, if the taxpayer’s marginal income tax rate is 28% and the taxpayer has
a $1,000 income tax deduction, that deduction will offset $1,000 of gross income
which gross income would have been income taxed at the 28% rate, which means
that the taxpayer save $280 of income tax.
Copyright ©1986 Through 2012, Professor Jegen’s Taxsite
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-15-
E.
Reduction of income tax owed.
1.
A dollar of income tax credit will reduce a dollar of the income tax owed and that will save
the taxpayer) the amount of income tax which would otherwise be imposed on such dollar
of income.
F.
One deduction which may be offset against income before the determination of gross income.
1.
All income tax deductions are taken after gross income and not before gross income, with
one exception.
a.
If a bond pays stated interest and if the owner of the bond elects to amortize the
amortizable bond premium, then section 171 states that the amortizable bond
premium for the tax period then involved is to be offset against the stated interest
then payable with respect to the bond.
b.
Thus, the allowable premium which is generally deductible for investors (but only
below the line) below the line for investors may, upon a proper election, be offset
against the applicable stated interest payment with respect to the bond in
determining gross income.
G.
Computing taxable income.
1.
In computing taxable income, every individual taxpayer is allowed to deduct a personal
exemption of $2,500 (adjusted for inflation). If a joint return is filed, both spouses are
“taxpayers” (even if one has no income), so two personal exemptions are allowed. If a
married person files a separate return, however, a personal exemption is allowable for the
taxpayer’s spouse only if the spouse has no gross income and is not the dependent of another
taxpayer. Read section 151(a), which states as follows:
Section 151. Allowance of deductions for personal exemptions.
(a) Allowance of deductions
In the case of an individual, the exemptions provided by this section shall
be allowed as deductions in computing taxable income.
2.
In addition to the personal exemption, a dependency exemption in an amount equal to the
personal exemption for each individual who: (1) is related to the taxpayer by blood,
marriage, or adoption; (2) receives more than one half of his support from the taxpayer or
satisfies a special support requirement; and (3) either has gross income for the taxable year
less than the amount of the personal exemption or is relieved of this requirement by section
151(c)(1)(B), relating to certain children of the taxpayer. Read section 151( c ), which states
as follows:
Section 151. Allowance of deductions for personal exemptions.
(c) Additional exemption for dependents.
An exemption of the exemption amount for each individual who is a
dependent (as defined in section 152) of the taxpayer for the taxable year.
Section 152 states as follows:
Section 152. Dependent defined
(a) In general
For purposes of this subtitle, the term “dependent” means—
(1) a qualifying child, or
(2) a qualifying relative.
a.
Two special rules limit the benefits of the personal exemptions. First, personal and
dependency exemptions are phased out for high-income taxpayers. Second, the
personal exemption is denied to any taxpayer who may be claimed as a dependent
on the return of another person. Read section 151(d)(2), which states as follows:
Section 151. Allowance of deductions for personal exemptions.
(d) Exemption amount.
For purposes of this section—
(2) Exemption amount disallowed in case of certain dependents
In the case of an individual with respect to whom a deduction under
this section is allowable to another taxpayer for a taxable year
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(1)
beginning in the calendar year in which the individual’s taxable
year begins, the exemption amount applicable to such individual
for such individual’s taxable year shall be zero.
For example, no personal exemption is allowed on the return of a child who
can be claimed as a dependent on the return of his parents, even if the child
is an adult with earned income.
H.
Types of deductions.
1.
Deductions may be classified into two general categories: deductions taken "above the line"
and deductions taken "below the line."
2.
Deductions taken above the line are deductions taken from gross income in arriving at
adjusted gross income.
3.
Deductions taken "below the line" are deductions taken from adjusted gross income in
arriving at taxable income.
a.
Deductions taken "below the line" are referred to as “itemized deductions”.
(1)
However, read the title of the area which begins just above section 161. As
far as the IRC is concerned, most deductions can be take either above or
below AGI.
I.
The format of most deduction sections.
1.
In general, these sections state, in subsection “a”, that a particular type of expense is
deductible from gross income, and then state, in, for example, subsection “b”, that another
particular type of expense is not deductible from gross income (or from anywhere else).
2.
These sections are very important sections, because they are the major sections that really
tell us, straight-out, what is deductible from gross income or from AGI as the case may be.
3.
These sections state: this item is deductible, and then state, this other item is not.
4.
Whenever you are dealing with deductions for individuals, you must always ask the question
of: “Where is that deduction deductible?”.
J.
This next point is a very important point.
1.
The basis of property is not a “deduction”.
2.
Instead, the basis of property is a reduction. It reduces what otherwise would have been
income, but for the basis offset.
3.
Even section 61(a)(3) states that, upon a sale or exchange of property by a taxpayer, only
the gain is gross income.
a.
So basis is not a deduction (through section 162 et seq or through any other section).
b.
Basis is a reduction of what might have been gross income, but for the basis of the
sold asset, which basis must be recovered before a taxpayer has gross income,
according to section 61(a)(3).
Sections 61(a)(3) and 162 state as follows:
Section 61. Gross income defined
(a) General definition
Except as otherwise provided in this subtitle, gross income means all
income from whatever source derived, including (but not limited to) the
following items:
(3) Gains derived from dealings in property;
Section 162. Trade or business expenses
(a) In general
There shall be allowed as a deduction all the ordinary and necessary
expenses paid or incurred during the taxable year in carrying on any trade
or business, including—
(1) a reasonable allowance for salaries or other compensation for personal
services actually rendered;
(2) traveling expenses (including amounts expended for meals and lodging
other than amounts which are lavish or extravagant under the
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4.
II.
circumstances) while away from home in the pursuit of a trade or
business; and
(3) rentals or other payments required to be made as a condition to the
continued use or possession, for purposes of the trade or business, of
property to which the taxpayer has not taken or is not taking title or in
which he has no equity.
For purposes of the preceding sentence, the place of residence of a Member of
Congress (including any Delegate and Resident Commissioner) within the State,
congressional district, or possession which he represents in Congress shall be
considered his home, but amounts expended by such Members within each taxable
year for living expenses shall not be deductible for income tax purposes in excess
of $3,000. For purposes of paragraph (2), the taxpayer shall not be treated as being
temporarily away from home during any period of employment if such period
exceeds 1 year. The preceding sentence shall not apply to any Federal employee
during any period for which such employee is certified by the Attorney General (or
the designee thereof) as traveling on behalf of the United States in temporary duty
status to investigate or prosecute, or provide support services for the investigation
or prosecution of, a Federal crime.
Further, the offset of basis (upon the sale or exchange of property) is done prior to arriving
at gross income.
a.
If basis were a deduction, then the deduction would be after gross income, not
before.
b.
Without considering what happens in the case of gains and losses from passthrough
entities, there is only one deduction which is taken prior to gross income and this
deduction will be discussed later.
Realized, recognized, and deductible loss.
A.
When is realized loss, deductible loss?
1.
If, using the above computation, you determine that you have realized loss, then the next step
is to determine whether or not the realized loss is disallowed or postponed or recognized.
2.
Probably, the easiest way to do this is to determine whether or not there is a section which
states that the particular expense or loss is deductible.
a.
If you do not find a section which states that a particular expense or loss is
deductible, then that ends the matter. You have a nondeductible expense or loss.
(1)
This is equivalent to a realized gain being excluded.
b.
Further, to reinforce this notion, there are a series of sections which disallow
deductions, which might otherwise appear to be deductible.
3.
However, even if find a section, for example, which states that a particular loss is deductible,
the recognition of the loss might be postponed.
a.
A postponing section postpones the recognition of the loss and a you might start
your hunt for postponing sections by looking at section 1031 et seq.
4.
But to repeat, there is no section which “excludes” losses, because the philosophy with
respect to deductions is different from the philosophy with respect to gross income. The
deduction philosophy is that no item is allowable as a deduction unless a section states that
the item is deductible. Therefore, the parallel philosophy to finding an exclusion section is
to find a deduction section which allows the deduction and if you cannot find such a section,
then the item involved is not deductible. If you can find an applicable deduction section,
then the item is probably deductible, but that is not a sure thing.
a.
So in the case of losses which are realized and with respect to which you find an
IRC deduction section which allows the loss to be deducted, then you can state that
the loss is deductible now, providing that the recognition of the loss is not postponed
and also providing that the loss is not disallowed by section 261 et seq.
b.
Income which is realized and not excluded and not postponed is gross income.
c.
Expenses or losses which are realized and are stated to be allowable as a deduction
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5.
by a specific section (and which are not specifically disallowed by section 261et seq
and which are postponed by a specific section) are recognized deductions.
d.
The primary section which states whether or not a recognized loss is deductible is
section 165 which allows deductions for losses. Section 165(a) states as follows:
Section 165. Losses
(a) General rule
There shall be allowed as a deduction any loss sustained during the taxable
year and not compensated for by insurance or otherwise.
However, just like inclusionary gross income sections have provisions in them which state
that a particular item of income is not gross income if - - - - section 165(c) states that a loss
(which is otherwise deductible) is not deductible unless the loss is sustained:
a.
In a business activity; or,
b.
In an investment activity; or,
c.
As a casualty or theft of personal property.
B.
Definition of the terms “adjusted gross income” and “taxable income”.
1.
Section 62 defines the term “adjusted gross income” and section 63 defines the term
“taxable income”.
a.
And, in order to determine AGI or taxable income of a taxpayer, the taxpayer must
subtract the taxpayer’s allowable deductions either from gross income or from AGI.
b.
The term “taxable income” may be defined as “gross income minus all deductions”.
However, in the case of individuals, “taxable income” may also be defined as “gross
income minus some deductions equals AGI, and, AGI minus other deductions equals
taxable income.
C.
Before the amount of AGI or taxable income can be determined, several things must occur.
1.
The taxpayer must have loss or an expenditure of some type and that loss or expenditure
must be an allowable income tax deduction through a section.
2.
In the case of sales or exchanges of property, there must be a “loss” from the sale or
exchange of the property prior to the determination of a taxpayer’s AGI or taxable income.
a.
“Losses” from the sale or exchange of property are not includable in the
computation of taxable income prior to the determination of gross income.
(1)
Instead, losses are deductible, if at all, after the determination of gross
income in arriving at AGI or after AGI in arriving at taxable income.
3.
There is no loss from the sale or exchange of property unless the taxpayer has receipts from
the sale or exchange which are less than the taxpayer’s adjusted basis for the property which
the taxpayer either sold or exchanged.
D.
Before AGI or taxable income can be determined, the taxpayer must have “realized loss”.
1.
Mere depreciation in value of property does not produce realized loss.
a.
Property must be, for example, sold or exchanged in order for the taxpayer to have
realized loss (or realized gain, for that matter).
2.
Section 1001 provides a method for determining the amount of loss realized from the
disposition of property: The gain from the sale or other disposition of property is the excess
of the amount realized therefrom over the adjusted basis provided in section 1011 for
determining gain, and the loss is the excess of the adjusted basis provided in such section for
determining loss over the amount realized. Section 1001(a) states as follows:
Section 1001. Determination of amount of and recognition of gain or loss
(a) Computation of gain or loss
The gain from the sale or other disposition of property shall be the excess
of the amount realized therefrom over the adjusted basis provided in section
1011 for determining gain, and the loss shall be the excess of the adjusted
basis provided in such section for determining loss over the amount
realized.
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a.
E.
In either case, disposition expenses are subtracted from the gross receipts in order
to determine the amount realized.
Realized loss must be recognized loss.
1.
Section 1001(c) also states that the entire amount of the gain or loss on the sale or exchange
of property is to be recognized. Section 1001© states as follows:
Section 1001. Determination of amount of and recognition of gain or loss
(c) Recognition of gain or loss
Except as otherwise provided in this subtitle, the entire amount of the gain
or loss, determined under this section, on the sale or exchange of property
shall be recognized.
2.
That is, even if a taxpayer has realized loss from the sale or exchange of an asset, the realized
loss must be “recognized loss”.
3.
All realized loss is recognized loss unless there is a section which states that the loss is not
a recognized loss.
a.
“Part III of Subchapter O, Common Nontaxable Exchanges”, provides for the
nonrecognition of gain and/or loss, but there are other sections which do so too.
Read, for example, sections 1031, 1032, 1033, 1035, 1036, 1037, 1038, 1040, 1042,
1043, 1044, and 1045.
(1)
In theory, if the recognition of loss is postponed, then the loss will be
recognized later.
Sections 1031, 1032, 1033, 1035, 1036, 1037, 1038, 1040, 1042, 1043, 1044, and 1045, state
as follows:
Section 1031. Exchange of property held for productive use or investment
(a) Nonrecognition of gain or loss from exchanges solely in kind
(1) In general
No gain or loss shall be recognized on the exchange of property
held for productive use in a trade or business or for investment if
such property is exchanged solely for property of like kind which
is to be held either for productive use in a trade or business or for
investment.
(2) Exception
This subsection shall not apply to any exchange of—
(A) stock in trade or other property held primarily for sale,
(B) stocks, bonds, or notes,
(C) other securities or evidences of indebtedness or
interest,
(D) interests in a partnership,
(E) certificates of trust or beneficial interests, or
(F) choses in action.
For purposes of this section, an interest in a partnership which has in effect a valid
election under section 761 (a) to be excluded from the application of all of
subchapter K shall be treated as an interest in each of the assets of such partnership
and not as an interest in a partnership.
(3) Requirement that property be identified and that exchange be
completed not more than 180 days after transfer of exchanged
property
For purposes of this subsection, any property received by
the taxpayer shall be treated as property which is not
like-kind property if—
(A) such property is not identified as property to be
received in the exchange on or before the day which is 45
days after the date on which the taxpayer transfers the
property relinquished in the exchange, or
(B) such property is received after the earlier of—
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(i) the day which is 180 days after the date on
which the taxpayer transfers the property
relinquished in the exchange, or
(ii) the due date (determined with regard to
extension) for the transferor’s return of the tax
imposed by this chapter for the taxable year in
which the transfer of the relinquished property
occurs.
Section 1032. Exchange of stock for property
(a) Nonrecognition of gain or loss
No gain or loss shall be recognized to a corporation on the receipt of money
or other property in exchange for stock (including treasury stock) of such
corporation. No gain or loss shall be recognized by a corporation with
respect to any lapse or acquisition of an option, or with respect to a
securities futures contract (as defined in section 1234B), to buy or sell its
stock (including treasury stock).
Section 1033. Involuntary conversions
(a) General rule
If property (as a result of its destruction in whole or in part, theft, seizure,
or requisition or condemnation or threat or imminence thereof) is
compulsorily or involuntarily converted—
(1) Conversion into similar property
Into property similar or related in service or use to the property so
converted, no gain shall be recognized.
(2) Conversion into money
Into money or into property not similar or related in service or use
to the converted property, the gain (if any) shall be recognized
except to the extent hereinafter provided in this paragraph:
(A) Nonrecognition of gain
If the taxpayer during the period specified in subparagraph
(B), for the purpose of replacing the property so converted,
purchases other property similar or related in service or use
to the property so converted, or purchases stock in the
acquisition of control of a corporation owning such other
property, at the election of the taxpayer the gain shall be
recognized only to the extent that the amount realized upon
such conversion (regardless of whether such amount is
received in one or more taxable years) exceeds the cost of
such other property or such stock. Such election shall be
made at such time and in such manner as the Secretary
may by regulations prescribe. For purposes of this
paragraph—
(i) no property or stock acquired before the disposition of
the converted property shall be considered to have
been acquired for the purpose of replacing such
converted property unless held by the taxpayer on
the date of such disposition; and
(ii) the taxpayer shall be considered to have purchased
property or stock only if, but for the provisions of
subsection (b) of this section, the unadjusted basis of such
property or stock would be its cost within the meaning of
section 1012.
(B) Period within which property must be replaced
The period referred to in subparagraph (A) shall be the
period beginning with the date of the disposition of the
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converted property, or the earliest date of the threat or
imminence of requisition or condemnation of the converted
property, whichever is the earlier, and ending—
(i) 2 years after the close of the first taxable year in which
any part of the gain upon the conversion is
realized, or
(ii) subject to such terms and conditions as may be
specified by the Secretary, at the close of such later date as
the Secretary may designate on application by the
taxpayer. Such application shall be made at such time and
in such manner as the Secretary may by regulations
prescribe.
(C) Time for assessment of deficiency attributable to gain upon
conversion
If a taxpayer has made the election provided in
subparagraph (A), then—
(i) the statutory period for the assessment of any
deficiency, for any taxable year in which any part of the
gain on such conversion is realized, attributable to such
gain shall not expire prior to the expiration of 3 years from
the date the Secretary is notified by the taxpayer (in such
manner as the Secretary may by regulations prescribe) of
the replacement of the converted property or of an
intention not to replace, and
(ii) such deficiency may be assessed before the expiration
of such 3–year period notwithstanding the
provisions of section 6212 (c) or the provisions of
any other law or rule of law which would
otherwise prevent such assessment.
(D) Time for assessment of other deficiencies attributable to
election
If the election provided in subparagraph (A) is made by the
taxpayer and such other property or such stock was
purchased before the beginning of the last taxable year in
which any part of the gain upon such conversion is
realized, any deficiency, to the extent resulting from such
election, for any taxable year ending before such last
taxable year may be assessed (notwithstanding the
provisions of section 6212 (c) or 6501 or the provisions of
any other law or rule of law which would otherwise
prevent such assessment) at any time before the expiration
of the period within which a deficiency for such last
taxable year may be assessed.
(E) Definitions
For purposes of this paragraph—
(i) Control The term “control” means the ownership of
stock possessing at least 80 percent of the total combined
voting power of all classes of stock entitled to vote and at
least 80 percent of the total number of shares of all other
classes of stock of the corporation.
(ii) Disposition of the converted property The term
“disposition of the converted property” means the
destruction, theft, seizure, requisition, or condemnation of
the converted property, or the sale or exchange of such
property under threat or imminence of requisition or
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condemnation.
Section 1035. Certain exchanges of insurance policies
(a) General rules
No gain or loss shall be recognized on the exchange of—
(1) a contract of life insurance for another contract of life insurance or for
an endowment or annuity contract; or
(2) a contract of endowment insurance
(A) for another contract of endowment insurance which provides
for regular payments beginning at a date not later than the
date payments would have begun under the contract
exchanged, or
(B) for an annuity contract; or
(3) an annuity contract for an annuity contract.
Section 1036. Stock for stock of same corporation
(a) General rule
No gain or loss shall be recognized if common stock in a corporation is
exchanged solely for common stock in the same corporation, or if preferred
stock in a corporation is exchanged solely for preferred stock in the same
corporation.
Section 1037. Certain exchanges of United States obligations
(a) General rule
When so provided by regulations promulgated by the Secretary in
connection with the issue of obligations of the United States, no gain or loss
shall be recognized on the surrender to the United States of obligations of
the United States issued under chapter 31 of title 31 in exchange solely for
other obligations issued under such chapter.
Section 1038. Certain reacquisitions of real property
(a) General rule
If—
(1) a sale of real property gives rise to indebtedness to the seller which is
secured by the real property sold, and
(2) the seller of such property reacquires such property in partial or full
satisfaction of such indebtedness,
then, except as provided in subsections (b) and (d), no gain or loss
shall result to the seller from such reacquisition, and no debt shall
become worthless or partially worthless as a result of such
reacquisition.
Section 1040. Transfer of certain farm, etc., real property
(a) General rule
If the executor of the estate of any decedent transfers to a qualified heir
(within the meaning of section 2032A (e)(1)) any property with respect to
which an election was made under section 2032A, then gain on such
transfer shall be recognized to the estate only to the extent that, on the date
of such transfer, the fair market value of such property exceeds the value of
such property for purposes of chapter 11 (determined without regard to
section 2032A).
Section 1042. Sales of stock to employee stock ownership plans or certain cooperatives
(a) Nonrecognition of gain
If—
(1) the taxpayer or executor elects in such form as the Secretary may
prescribe the application of this section with respect to any sale of qualified
securities,
(2) the taxpayer purchases qualified replacement property within the
replacement period, and
(3) the requirements of subsection (b) are met with respect to such sale,
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then the gain (if any) on such sale which would be recognized as
long-term capital gain shall be recognized only to the extent that
the amount realized on such sale exceeds the cost to the taxpayer
of such qualified replacement property.
Section 1043. Sale of property to comply with conflict-of-interest requirements
(a) Nonrecognition of gain
If an eligible person sells any property pursuant to a certificate of
divestiture, at the election of the taxpayer, gain from such sale shall be
recognized only to the extent that the amount realized on such sale exceeds
the cost (to the extent not previously taken into account under this
subsection) of any permitted property purchased by the taxpayer during the
60-day period beginning on the date of such sale
Section 1044. Rollover of publicly traded securities gain into specialized small business
investment companies
(a) Nonrecognition of gain
In the case of the sale of any publicly traded securities with respect to which
the taxpayer elects the application of this section, gain from such sale shall
be recognized only to the extent that the amount realized on such sale
exceeds—
(1) the cost of any common stock or partnership interest in a specialized
small business investment company purchased by the taxpayer during the
60-day period beginning on the date of such sale, reduced by
(2) any portion of such cost previously taken into account under this
section.
This section shall not apply to any gain which is treated as ordinary
income for purposes of this subtitle.
Section 1045. Rollover of gain from qualified small business stock to another qualified small
business stock
(a) Nonrecognition of gain
In the case of any sale of qualified small business stock held by a taxpayer
other than a corporation for more than 6 months and with respect to which
such taxpayer elects the application of this section, gain from such sale shall
be recognized only to the extent that the amount realized on such sale
exceeds—
(1) the cost of any qualified small business stock purchased by the taxpayer
during the 60-day period beginning on the date of such sale,
reduced by
(2) any portion of such cost previously taken into account under this
section.
This section shall not apply to any gain which is treated as ordinary
income for purposes of this title.
F.
Is recognized loss “deductible loss”?
1.
After a taxpayer has determined that the taxpayer’s realized loss from the sale or exchange
of property is recognized, the taxpayer must determine whether or not the recognized loss
is “deductible loss”.
2.
This is equivalent to the taxpayer not having excluded gain.
3.
If the recognized loss is not a deductible loss, then the nondeductible loss will never be
deductible for income tax purposes.
a.
Nondeductible loss is not deductible now nor in the future, unlike loss, the
recognition of which is postponed, which may be deductible later.
4.
If a taxpayer realizes loss from the sale or exchange of property and if that realized loss is
recognized loss and if the recognized loss is deductible loss, then the loss is deductible in
arriving at the taxpayer’s AGI or deductible from the taxpayer’s AGI in arriving at the
taxpayer’s taxable income.
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a.
However, in the case of a deductible loss from the sale or exchange of property, the
loss in deductible in arriving at AGI. Read section 62(a), which states as follows:
Section 62. Adjusted gross income defined.
(a) General rule
For purposes of this subtitle, the term “adjusted gross income”
means, in the case of an individual, gross income minus the following
deductions:
(1) Trade and business deductions
The deductions allowed by this chapter (other than by part VII of
this sub-chapter) which are attributable to a trade or business
carried on by the taxpayer, if such trade or business does not
consist of the performance of services by the taxpayer as an
employee.
(2) Certain trade and business deductions of employees
(A) Reimbursed expenses of employees
The deductions allowed by part VI (section 161 and
following) which consist of expenses paid or incurred by
the taxpayer, in connection with the performance by him
of services as an employee, under a reimbursement or other
expense allowance arrangement with his employer. The
fact that the reimbursement may be provided by a third
party shall not be determinative of whether or not the
preceding sentence applies.
(B) Certain expenses of performing artists
The deductions allowed by section 162 which consist of
expenses paid or incurred by a qualified performing artist
in connection with the performances by him of services in
the performing arts as an employee.
(C) Certain expenses of officials
The deductions allowed by section 162 which consist of
expenses paid or incurred with respect to services
performed by an official as an employee of a State or a
political subdivision thereof in a position compensated in
whole or in part on a fee basis.
(D) Certain expenses of elementary and secondary school teachers
In the case of taxable years beginning during 2002, 2003,
2004, 2005, 2006, or 2007, the deductions allowed by
section 162 which consist of expenses, not in excess of
$250, paid or incurred by an eligible educator in
connection with books, supplies (other than nonathletic
supplies for courses of instruction in health or physical
education), computer equipment (including related
software and services) and other equipment, and
supplementary materials used by the eligible educator in
the classroom.
(E) Certain expenses of members of reserve components of the
Armed Forces of the United States. The deductions allowed by
section 162 which consist of expenses, determined at a rate not in
excess of the rates for travel expenses (including per diem in lieu
of subsistence) authorized for employees of agencies under
subchapter I of chapter 57 of title 5, United States Code, paid or
incurred by the taxpayer in connection with the performance of
services by such taxpayer as a member of a reserve component of
the Armed Forces of the United States for any period during which
such individual is more than 100 miles away from home in
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connection with such services.
(3) Losses from sale or exchange of property
The deductions allowed by part VI (sec. 161 and following) as
losses from the sale or exchange of property.
(4) Deductions attributable to rents and royalties
The deductions allowed by part VI (sec. 161 and following), by
section 212 (relating to expenses for production of income), and by
section 611 (relating to depletion) which are attributable to
property held for the production of rents or royalties.
(5) Certain deductions of life tenants and income beneficiaries of
property.
In the case of a life tenant of property, or an income beneficiary of
property held in trust, or an heir, legatee, or devisee of an estate, the
deduction for depreciation allowed by section 167 and the
deduction allowed by section 611.
(6) Pension, profit-sharing, and annuity plans of self-employed
individuals.
In the case of an individual who is an employee within the meaning
of section 401 (c)(1), the deduction allowed by section 404.
(7) Retirement savings
The deduction allowed by section 219 (relating to deduction of
certain retirement savings).
[(8) Repealed. Pub. L. 104–188, title I, §?1401(b)(4), Aug. 20, 1996, 110
Stat. 1788]
(9) Penalties forfeited because of premature withdrawal of funds
from time savings accounts or deposits.
The deductions allowed by section 165 for losses incurred in any
transaction entered into for profit, though not connected with a
trade or business, to the extent that such losses include amounts
forfeited to a bank, mutual savings bank, savings and loan
association, building and loan association, cooperative bank or
homestead association as a penalty for premature withdrawal of
funds from a time savings account, certificate of deposit, or similar
class of deposit.
(10) Alimony.
The deduction allowed by section 215.
(11) Reforestation expenses.
The deduction allowed by section 194.
(12) Certain required repayments of supplemental unemployment
compensation benefits.
The deduction allowed by section 165 for the repayment to a trust
described in paragraph (9) or (17) of section 501(c) of
supplemental unemployment compensation benefits received from
such trust if such repayment is required because of the receipt of
trade readjustment allowances under section 231 or 232 of the
Trade Act of 1974 (19 U.S.C. 2291 and 2292).
(13) Jury duty pay remitted to employer.
Any deduction allowable under this chapter by reason of an
individual remitting any portion of any jury pay to such
individual’s employer in exchange for payment by the employer of
compensation for the period such individual was performing jury
duty. For purposes of the preceding sentence, the term “jury pay”
means any payment received by the individual for the discharge of
jury duty.
(14) Deduction for clean-fuel vehicles and certain refueling
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property.
The deduction allowed by section 179A.
(15) Moving expenses.
The deduction allowed by section 217.
(16) Archer MSAs.
The deduction allowed by section 220.
(17) Interest on education loans
The deduction allowed by section 221.
(18) Higher education expenses
The deduction allowed by section 222.
(19) Health savings accounts
The deduction allowed by section 223.
(20) Costs involving discrimination suits, etc.
Any deduction allowable under this chapter for attorney fees and
court costs paid by, or on behalf of, the taxpayer in connection with
any action involving a claim of unlawful discrimination (as defined
in subsection (e)) or a claim of a violation of subchapter III of
chapter 37 of title 31, United States Code [1] or a claim made under
section 1862(b)(3)(A) of the Social Security Act (42 U.S.C. 1395y
(b)(3)(A)). The preceding sentence shall not apply to any deduction
in excess of the amount includible in the taxpayer’s gross income
for the taxable year on account of a judgment or settlement
(whether by suit or agreement and whether as lump sum or periodic
payments) resulting from such claim.
(21) Attorneys fees relating to awards to whistle blowers
Any deduction allowable under this chapter for attorney fees and
court costs paid by, or on behalf of, the taxpayer in connection with
any award under section 7623 (b) (relating to awards to whistle
lowers). The preceding sentence shall not apply to any deduction
in excess of the amount includible in the taxpayer’s gross income
for the taxable year on account of such award.
Nothing in this section shall permit the same item to be deducted more than once.
G.
The difference between nonrecognized loss and nondeductible loss.
1.
The difference between nonrecognized loss and nondeductible loss is that: loss which is not
recognized is loss, the recognition of which, is postponed. However, nondeductible loss is
loss which will never be deductible.
2.
Section 165, which concerns the sale of a residence at a loss, is an example of a section
which excludes realized and recognized loss as a deduction in certain cases.
a.
Example. During the current taxable year, Beverly owned a house and land which
was used by Beverly as a residence. Beverly never owned another residence.
Beverly had a cost basis for the property of $100,000. During the current taxable
year, Beverly sold the residence to Paul for $80,000.
(1)
Beverly has loss of $20,000, which loss is realized loss and which loss is
recognized gain, but Beverly may not deduct the loss for income tax
purposes due to section 165(c).
(2)
Paul will have a cost basis for the real property in the amount of $80,000.
3.
Section 1031, which concerns the exchange of investment or business property for
investment or business property, is an example of a section which postpones the recognition
of loss from such a transaction. Section 1031(a) states as follows:
Section 1031. Exchange of property held for productive use or investment
(a) Nonrecognition of gain or loss from exchanges solely in kind
(1) In general
No gain or loss shall be recognized on the exchange of property
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4.
5.
6.
held for productive use in a trade or business or for investment if
such property is exchanged solely for property of like kind which
is to be held either for productive use in a trade or business or for
investment.
(2) Exception
This subsection shall not apply to any exchange of—
(A) stock in trade or other property held primarily for sale,
(B) stocks, bonds, or notes,
(C) other securities or evidences of indebtedness or interest,
(D) interests in a partnership,
(E) certificates of trust or beneficial interests, or
(F) choses in action.
For purposes of this section, an interest in a partnership which has in effect a valid
election under section 761 (a) to be excluded from the application of all of
subchapter K shall be treated as an interest in each of the assets of such partnership
and not as an interest in a partnership.
(3) Requirement that property be identified and that exchange be completed
not more than 180 days after transfer of exchanged property
For purposes of this subsection, any property received by the
taxpayer shall be treated as property which is not like-kind property
if—
(A) such property is not identified as property to be received in the
exchange on or before the day which is 45 days after the
date on which the taxpayer transfers the property
relinquished in the exchange, or
(B) such property is received after the earlier of—
(i) the day which is 180 days after the date on which the
taxpayer transfers the property relinquished in the
exchange, or
(ii) the due date (determined with regard to extension) for
the transferor’s return of the tax imposed by this
chapter for the taxable year in which the transfer
of the relinquished property occurs.
a.
Example. During the current taxable year, Beverly owned some investment real
property. Beverly received the real property from Beverly’s mother as a gift, and
therefore, Beverly had a carryover basis (from Beverly’s mother, who had an
adjusted basis for the real property in the amount of $100,000), and therefore,
Beverly’s adjusted basis for the real property is $100,000 and the fair market value
of Beverly’s real property was $80,000. During the current taxable year, Beverly
exchanged Beverly’s real property with Paul for Paul’s investment real property
which also had a fair market value of $80,000.
(1)
Beverly has loss of $50,000, which loss is realized loss, but which loss is
non-recognized loss, and therefore, the deduction of the loss is postponed.
Theoretically, non-recognized loss will be recognized later. But a nondeductible loss will
not be deductible later.
Section 165, which concerns deductions for losses, prohibits certain deductions from being
deducted. Section 165 states as follows:
Section 165. Losses
(a) General rule
There shall be allowed as a deduction any loss sustained during the taxable
year and not compensated for by insurance or otherwise.
Nondeductible loss is less beneficial to taxpayers than nonrecognized loss.
a.
Nondeductible loss will never be deductible for income tax purposes - - - not now,
not later.
b.
Non-recognized loss is deductible - - - not now, but probably later.
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H.
Business expenses versus investment expenses versus personal expenses.
1.
Most expenses paid or incurred in earning a living or in investing or in making a profit are
deductible. However, personal expenses are not deductible unless they are explicitly allowed
by a specific section.
2.
Deductions allowable in computing adjusted gross income (deductions allowable in arriving
at adjusted gross income) may be taken providing that the conditions of the substantive
section are met.
3.
Most expenses and losses incurred in the conduct of a trade or business may be deducted in
arriving at adjusted gross income, while most investment expenses and personal expenses
are deductible from AGI in arriving at taxable income.
I.
In general, substantially all expenses incurred in earning a living or in profit activities are deductible.
However, personal expenses are not deductible unless explicitly allowed by a specific section.
1.
Deductions allowable in computing adjusted gross income (in other words, deductions
allowable as deductions in arriving at adjusted gross income) may be taken without further
restriction, providing that the conditions of the substantive section in the IRC allowing the
deduction is met.
2.
In general, most expenses and losses incurred in the conduct of a trade or business may be
deducted in arriving at adjusted gross income, while all deductions allowable under the IRC
for personal expenses are deductible taken from adjusted gross income in arriving at taxable
income.
J.
Deduction taken above AGI versus deductions taken below AGI.
1.
A taxpayer may deduct business expenses paid or accrued or investment expenses paid or
accrued either above AGI or after AGI as either an itemizable deduction, business expense,
or passive activity deduction, subject to certain restrictions.
a.
The above or below is not a choice of the taxpayer. Deductions are taken above or
below AGI depending on the provisions in section 62. Section 62(a) states as
follows:
Section 62. Adjusted gross income defined
(a) General rule
For purposes of this subtitle, the term “adjusted gross income”
means, in the case of an individual, gross income minus the
following deductions:
(1) Trade and business deductions
The deductions allowed by this chapter (other than by part
VII of this subchapter) which are attributable to a trade or
business carried on by the taxpayer, if such trade or
business does not consist of the performance of services by
the taxpayer as an employee.
(2) Certain trade and business deductions of employees
(A) Reimbursed expenses of employees
The deductions allowed by part VI (section 161
and following) which consist of expenses paid or
incurred by the taxpayer, in connection with the
performance by him of services as an employee,
under a reimbursement or other expense allowance
arrangement with his employer. The fact that the
reimbursement may be provided by a third party
shall not be determinative of whether or not the
preceding sentence applies.
(B) Certain expenses of performing artists
The deductions allowed by section 162 which
consist of expenses paid or incurred by a qualified
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performing artist in connection with the
performances by him of services in the performing
arts as an employee.
(C) Certain expenses of officials
The deductions allowed by section 162 which
consist of expenses paid or incurred with respect
to services performed by an official as an
employee of a State or a political subdivision
thereof in a position compensated in whole or in
part on a fee basis.
(D) Certain expenses of elementary and secondary school
teachers
In the case of taxable years beginning during
2002, 2003, 2004, 2005, 2006, or 2007, the
deductions allowed by section 162 which consist
of expenses, not in excess of $250, paid or
incurred by an eligible educator in connection
with books, supplies (other than nonathletic
supplies for courses of instruction in health or
physical education), computer equipment
(including related software and services) and other
equipment, and supplementary materials used by
the eligible educator in the classroom.
(E) Certain expenses of members of reserve components of
the Armed Forces of the United States
The deductions allowed by section 162 which
consist of expenses, determined at a rate not in
excess of the rates for travel expenses (including
per diem in lieu of subsistence) authorized for
employees of agencies under subchapter I of
chapter 57 of title 5, United States Code, paid or
incurred by the taxpayer in connection with the
performance of services by such taxpayer as a
member of a reserve component of the Armed
Forces of the United States for any period during
which such individual is more than 100 miles
away from home in connection with such services.
(3) Losses from sale or exchange of property
The deductions allowed by part VI (sec. 161 and
following) as losses from the sale or exchange of property.
(4) Deductions attributable to rents and royalties
The deductions allowed by part VI (sec. 161 and
following), by section 212 (relating to expenses for
production of income), and by section 611 (relating to
depletion) which are attributable to property held for the
production of rents or royalties.
(5) Certain deductions of life tenants and income beneficiaries of
property
In the case of a life tenant of property, or an income
beneficiary of property held in trust, or an heir, legatee, or
devisee of an estate, the deduction for depreciation allowed
by section 167 and the deduction allowed by section 611.
(6) Pension, profit-sharing, and annuity plans of self-employed
individuals
In the case of an individual who is an employee within the
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meaning of section 401 (c)(1), the deduction allowed by
section 404.
(7) Retirement savings
The deduction allowed by section 219 (relating to
deduction of certain retirement savings).
[(8) Repealed. Pub. L. 104–188, title I, §?1401(b)(4), Aug. 20,
1996, 110 Stat. 1788]
(9) Penalties forfeited because of premature withdrawal of funds
from time savings accounts or deposits
The deductions allowed by section 165 for losses incurred
in any transaction entered into for profit, though not
connected with a trade or business, to the extent that such
losses include amounts forfeited to a bank, mutual savings
bank, savings and loan association, building and loan
association, cooperative bank or homestead association as
a penalty for premature withdrawal of funds from a time
savings account, certificate of deposit, or similar class of
deposit.
(10) Alimony
The deduction allowed by section 215.
(11) Reforestation expenses
The deduction allowed by section 194.
(12) Certain required repayments of supplemental unemployment
compensation benefits
The deduction allowed by section 165 for the repayment to
a trust described in paragraph (9) or (17) of section 501(c)
of supplemental unemployment compensation benefits
received from such trust if such repayment is required
because of the receipt of trade readjustment allowances
under section 231 or 232 of the Trade Act of 1974 (19
U.S.C. 2291 and 2292).
(13) Jury duty pay remitted to employer
Any deduction allowable under this chapter by reason of
an individual remitting any portion of any jury pay to such
individual’s employer in exchange for payment by the
employer of compensation for the period such individual
was performing jury duty. For purposes of the preceding
sentence, the term “jury pay” means any payment received
by the individual for the discharge of jury duty.
(14) Deduction for clean-fuel vehicles and certain refueling
property
The deduction allowed by section 179A.
(15) Moving expenses
The deduction allowed by section 217.
(16) Archer MSAs
The deduction allowed by section 220.
(17) Interest on education loans
The deduction allowed by section 221.
(18) Higher education expenses
The deduction allowed by section 222.
(19) Health savings accounts
The deduction allowed by section 223.
(20) Costs involving discrimination suits, etc.
Any deduction allowable under this chapter for attorney
fees and court costs paid by, or on behalf of, the taxpayer
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in connection with any action involving a claim of
unlawful discrimination (as defined in subsection (e)) or a
claim of a violation of subchapter III of chapter 37 of title
31, United States Code [1] or a claim made under section
1862(b)(3)(A) of the Social Security Act (42 U.S.C. 1395y
(b)(3)(A)). The preceding sentence shall not apply to any
deduction in excess of the amount includible in the
taxpayer’s gross income for the taxable year on account of
a judgment or settlement (whether by suit or agreement
and whether as lump sum or periodic payments) resulting
from such claim.
(21) Attorneys fees relating to awards to whistleblowers
Any deduction allowable under this chapter for attorney
fees and court costs paid by, or on behalf of, the taxpayer
in connection with any award under section 7623 (b)
(relating to awards to whistleblowers). The preceding
sentence shall not apply to any deduction in excess of the
amount includible in the taxpayer’s gross income for the
taxable year on account of such award.
Nothing in this section shall permit the same item to be deducted more than
once.
2.
3.
4.
The most significant distinction between deductions taken in arriving at AGI and deductions
taken from AGI is that a taxpayer may claim the standard deduction in lieu of claiming any
itemizable deductions. Read section 63(b), which states as follows:
Section 63. Taxable income defined.
(b) Individuals who do not itemize their deductions
In the case of an individual who does not elect to itemize his deductions for
the taxable year, for purposes of this subtitle, the term “taxable income”
means adjusted gross income, minus—
(1) the standard deduction, and
(2) the deduction for personal exemptions provided in section 151.
Section 151(a) states as follows:
Section 151. Allowance of deductions for personal exemptions
(a) Allowance of deductions
In the case of an individual, the exemptions provided by this section shall
be allowed as deductions in computing taxable income.
This limitation does not apply to deductions allowable in arriving at AGI; these deductions
are allowable even if the taxpayer claims a standard deduction instead of electing to itemize
deductions.
Among the classes of itemized deductions, further distinctions are made. “Miscellaneous
itemized deductions” may be claimed only to the extent that their aggregate amount exceeds
2% of AGI (read section 67(a)), which states as follows:
Section 67. 2-percent floor on miscellaneous itemized deductions.
(a) General rule.
In the case of an individual, the miscellaneous itemized deductions for any
taxable year shall be allowed only to the extent that the aggregate of such
deductions exceeds 2 percent of adjusted gross income.
; medical expenses may be claimed only to the extent their aggregate
amount exceeds 7.5% of AGI (read section 213(a)), which states as follows:
Section 213. Medical, dental, etc., expenses
(a) Allowance of deduction
There shall be allowed as a deduction the expenses paid during the taxable
year, not compensated for by insurance or otherwise, for medical care of the
taxpayer, his spouse, or a dependent (as defined in section 152, determined
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5.
K.
without regard to subsections (b)(1), (b)(2), and (d)(1)(B) thereof), to the
extent that such expenses exceed 7.5 percent of adjusted gross income.
; and, casualty losses may be claimed only to the extent their aggregate amount exceeds 10%
of AGI (read section 165(a)), which states as follows:
Section 165. Losses.
(a) General rule.
There shall be allowed as a deduction any loss sustained during the taxable
year and not compensated for by insurance or otherwise.
For taxpayers with an AGI in excess of an annually indexed amount, the deductibility of the
taxpayer’s itemized deductions (with certain exceptions) are phased out.
Read section 68(a), which states as follows:
Section 68. Overall limitation on itemized deductions.
(a) General rule.
In the case of an individual whose adjusted gross income exceeds the
applicable amount, the amount of the itemized deductions otherwise
allowable for the taxable year shall be reduced by the lesser of—
(1) 3 percent of the excess of adjusted gross income over the applicable
amount, or
(2) 80 percent of the amount of the itemized deductions otherwise allowable
for such taxable year.
a.
The total amount of itemized deductions must be reduced by an amount equal to the
lesser of (1) 3% of the amount by which the taxpayer’s AGI exceeds an annually
indexed amount; or, (2) eighty percent of total itemized deductions. Read section
68(a), which states as follows:
Section 68. Overall limitation on itemized deductions
(a) General rule
In the case of an individual whose adjusted gross income exceeds
the applicable amount, the amount of the itemized deductions
otherwise allowable for the taxable year shall be reduced by the
lesser of—
(1) 3 percent of the excess of adjusted gross income over the
applicable amount, or
(2) 80 percent of the amount of the itemized deductions otherwise
allowable for such taxable year.
Miscellaneous itemized deductions.
1.
Miscellaneous itemized deductions are allowable only to the extent that they in the
aggregate, exceed 2% of AGI. Read section 67(a), which states as follows:
Section 67. 2-percent floor on miscellaneous itemized deductions.
(a) General rule.
In the case of an individual, the miscellaneous itemized deductions for any
taxable year shall be allowed only to the extent that the aggregate of such
deductions exceeds 2 percent of adjusted gross income.
2.
To the extent any other limit or restriction is placed on a miscellaneous itemized deduction,
that other limit applies before the 2% floor.
a.
For example, the 50% limit for business meals and entertainment is applied before
the 2% percent floor. Read Reg. §1.67-1T(a)(2).
3.
Miscellaneous itemized deductions that do not exceed 2% of AGI may not be carried
forward; they are lost.
4.
Miscellaneous itemized deductions (for example, deductions subject to the 2% test) include
the following.
a.
Unreimbursed employee business expenses.
b.
Union and professional dues.
c.
Home-office expenses.
d.
Expenses for the maintenance and production of income.
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5.
6.
e.
Tax return preparation fees.
f.
Hobby expenses.
Read Reg. §1.67-1T(a)(1).
Itemized deductions not subject to the 2% test include the following.
a.
Medical expenses.
b.
Taxes.
c.
Interest.
d.
Charitable contributions.
e.
Casualty losses.
f.
Amortizable bond premiums.
Some examples.
a.
Example. During that last year, Alan's AGI was $100,000, all of which was
ordinary income from Alan's business as an employee, without considering the
following transactions, and Alan was single and had no dependents.
Business entertainment expenses of Alan . . . . . . . . . . . . . . . . . . . . . . . . $14,000
Reimbursements of such business entertainment expenses by Alan's clients$8,000
(1)
The amount of Alan's taxable income is as follows. Any reimbursement is
gross income. Entertainment expenses are deductible up to 50% of the
expenses. If the entertainment expenses are unreimbursed, then the
deduction is also subject to the 2% test. Those unreimbursed entertainment
expenses subject to the 2% test would be deductible as follows.
(a)
$6,000 x .50 = $3,000.
(b)
Then take 2% of the AGI. $100,000 x .02 = 2,000.
(c)
Then take the 2% floor and subtract that from the total itemizable
deductions. $3,000 - $2,000 = $1,000.
(d)
Because the total itemizable deductions are $1,000, a standard
deduction should be taken.
Beginning gross income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 100,000
Reimbursements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . + 8,000
Gross income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 108,000
Minus: reimbursements expenses . . . . . . . . . . . . . . . . . . . . . . . .
8,000
Adjusted gross income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000
Minus: standard deduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000
Personal exemptions . . . . . . . . . . . . . . . . . . . . . . . . . . .
3,000
Taxable income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 93,000
Therefore, the answer is $93,000.
b.
Example. During the current year, Alan (who is single, age 45 years, with no
dependents, and an employee) had AGI of $30,000 of which $29,000 is Alan's
salary and $1,000 is from Indiana Bank savings account interest (without taking into
account the information which is hereinafter stated in this paragraph) and Alan made
the following expenses or expenditures during the current year. None of the
expenses or expenditures were reimbursed.
Office rent for employment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,000
Publications for share and bond investments . . . . . . . . . . . . . . . . . . . . . . . $1,000
Income tax return preparation fee . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,000
Supplies for employment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,000
(1)
The amount of Alan's taxable income for the current year with respect to
these facts is as follows. Certain itemized deductions are deductible only
to the extent that the aggregate of such deductions exceed 2% of the
taxpayer's AGI. Read section 67(a), which states as follows:
Section 67. 2-percent floor on miscellaneous itemized deductions.
(a) General rule.
In the case of an individual, the miscellaneous
itemized deductionsfor any taxable year shall be allowed
only to the extent that the aggregate of such deductions
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7.
exceeds 2 percent of adjusted gross income.
This is similar to the computation of the medical expense deduction under
section 213(a) and is the opposite of the charitable contribution deduction,
for individuals, under section 170(b)(1). Unreimbursed business expenses
of an employee are within the 2% test (the office rent and supplies
expenses). Expenses for the maintenance and production of income also
fall under the 2% test (the publications for share and bond investment
expense). Read section 212, which states as follows:
Section 212. Expenses for production of income.
In the case of an individual, there shall be allowed as a deduction
all the ordinary and necessary expenses paid or incurred during the
taxable year—
(1) for the production or collection of income;
(2) for the management, conservation, or maintenance of property
held for the production of income; or
(3) in connection with the determination, collection, or refund of
any tax.
Tax preparation fees also fall under the 2% test.
Gross income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 30,000
Deductions at adjusted gross income . . . . . . . . . . . . . . . . . . . . . . 0
Adjusted gross income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 30,000
Alan's total itemized deductions:
Office rent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 10,000
Publications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000
Tax preparation fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000
Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . + 1,000
Total itemized deductions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 13,000
2% floor:
total itemizable deductions:
$ 30,000
$ 13,000
- 600
X .02
$ 600
$12,400
Because Alan's itemizable deductions are greater than Alan's standard
deduction, Alan will take the itemized deduction, for example, $12,400 >
$5,000.
Alan's taxable income is as follows.
Adjusted gross income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 30,000
Minus: itemizable deductions . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,400
Personal exemption . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000
Taxable income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 14,600
Therefore, the answer is $14,600.
Question 1. During the current year, Alan is single, has no dependents, and is an employee,
with AGI of $30,000 of which $29,000 is Alan's salary and $1,000 is from Indiana Bank
savings account interest (and without taking into account the following information) and
Alan paid the following expenses or expenditures during the current year.
Office rent for employment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,000
Publications for share and bond investments ($1,000 of which was reimbursed
by Alan's employer) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,000
Income tax return preparation fee . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,000
Supplies for employment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,000
Entertainment of clients ($1,000 of which was reimbursed by Alan's employer) . $2,000
Alan's taxable income for the current year with respect to these facts (considering all
deduction limitations) is as follows.
a.
None/Zero
b.
$21,100
c.
$22,900
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8.
9.
10.
11.
12.
III.
d.
$23,100
e.
No prior stated answer
The 2% test only applies to some itemizable deductions and it does not apply to deductions
which are deductible above the line.
If an individual taxpayer itemizes the individual’s below the line deductions instead of taking
the standard deduction, then some of the itemizable deductions may not be deducted until
the deductions, in total, exceed 2% of the taxpayer’s AGI.
Section 67(a) states that the miscellaneous itemized deductions for any taxable year shall be
allowed only to the extent that the aggregate of such deductions exceeds 2% of adjusted
gross income.
Then, section 67(b) states that the term "miscellaneous itemized deductions" means all of the
itemized deductions OTHER THAN 12 specific deductions only nine of which I have listed,
based on your likelihood of having a particular deduction limited.
a.
Deductions allowable under section 163 (relating to interest).
b.
Deductions allowable section 164 (relating to state and local taxes).
c.
Deductions allowable under section 165(a) for casualty or theft losses described in
paragraph (2) or (3) of section 165(c) or for losses described in section 165(d).
d.
Deductions allowable under section 170 (relating to charitable, etc., contributions
and gifts) and section 642(c) (relating to deduction for amounts paid or permanently
set aside for a charitable purpose).
e.
Deductions allowable under section 213 (relating to medical, dental, etc., expenses).
f.
Deductions allowable under section 691(c) (relating to deduction for estate tax in
case of income in respect of the decedent).
g.
Deductions allowable under section 1341 (relating to computation of tax where
taxpayer restores substantial amount held under claim of right).
h.
Deductions under section 72(b)(3) (relating to deduction where annuity payments
cease before investment recovered).
i.
Deductions allowable under section 171 (relating to deduction for amortizable bond
premium).
The 2% does not apply to each of the above deductions separately. The 2% limitation limits
the total of the above deductions.
a.
An individual may deduct the total of such deductions, but only to the extent that the
total of these deductions exceeds 2% of an individual’s AGI.
b.
The limitation is the same, in operation, as the 7.5% medical expense limitation,
which limits the medical expense deduction to the excess of the total of the total
medical expenses (minus insurance recoveries) which exceeds 7.5% of the
individual’s AGI.
Where do the most common and important deduction sections begin in the IRC? These deduction sections
begin at section 161 and end at section 198. Then, another series of the most common and important sections
begin at section 211 and end at section 223 and another series begins at section 241 and ends at section 249.
Sections 161 and 211 and 241 do nothing more than to state that taxpayers are entitled to deduct the
following deductions.
A.
Section 162 through section 198.
1.
These sections are applicable to all types of taxpayers, including, but not limited to
individuals, fiduciaries, corporations, partnerships, and limited liability companies. Just
read, for example, section 162 and section 170 in order to understand how broad based these
sections are. Section 162 and 170 state as follows:
Section 162. Trade or business expenses
(a) In general
There shall be allowed as a deduction all the ordinary and necessary
expenses paid or incurred during the taxable year in carrying on any trade
or business, including—
(1) a reasonable allowance for salaries or other compensation for personal
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services actually rendered;
(2) traveling expenses (including amounts expended for meals and lodging
other than amounts which are lavish or extravagant under the
circumstances) while away from home in the pursuit of a trade or
business; and
(3) rentals or other payments required to be made as a condition to the
continued use or possession, for purposes of the trade or business, of
property to which the taxpayer has not taken or is not taking title or in
which he has no equity.
For purposes of the preceding sentence, the place of residence of a
Member of Congress (including any Delegate and Resident
Commissioner) within the State, congressional district, or
possession which he represents in Congress shall be considered his
home, but amounts expended by such Members within each taxable
year for living expenses shall not be deductible for income tax
purposes in excess of $3,000. For purposes of paragraph (2), the
taxpayer shall not be treated as being temporarily away from home
during any period of employment if such period exceeds 1 year.
The preceding sentence shall not apply to any Federal employee
during any period for which such employee is certified by the
Attorney General (or the designee thereof) as traveling on behalf of
the United States in temporary duty status to investigate or
prosecute, or provide support services for the investigation or
prosecution of, a Federal crime.
Section 170. Charitable, etc., contributions and gifts
(a) Allowance of deduction
(1) General rule
There shall be allowed as a deduction any charitable contribution
(as defined in subsection (c)) payment of which is made within the
taxable year. A charitable contribution shall be allowable as a
deduction only if verified under regulations prescribed by the
Secretary.
(2) Corporations on accrual basis
In the case of a corporation reporting its taxable income on the
accrual basis, if—
(A) the board of directors authorizes a charitable contribution
during any taxable year, and
(B) payment of such contribution is made after the close of such
taxable year and on or before the 15th day of the third month
following the close of such taxable year,
then the taxpayer may elect to treat such contribution as
paid during such taxable year. The election may be made
only at the time of the filing of the return for such taxable
year, and shall be signified in such manner as the Secretary
shall by regulations prescribe.
(3) Future interests in tangible personal property
For purposes of this section, payment of a charitable contribution
which consists of a future interest in tangible personal property
shall be treated as made only when all intervening interests in, and
rights to the actual possession or enjoyment of, the property have
expired or are held by persons other than the taxpayer or those
standing in a relationship to the taxpayer described in section 267
(b) or 707 (b). For purposes of the preceding sentence, a fixture
which is intended to be severed from the real property shall be
treated as tangible personal property.
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IV.
Trade or business expenses and production of income expenses - section 162 and section 212. Read section
162(a) and section 212(a), which state as follows:
Section 162. Trade or business expenses
(a) In general
There shall be allowed as a deduction all the ordinary and necessary
expenses paid or incurred during the taxable year in carrying on any trade
or business, including—
(1) a reasonable allowance for salaries or other compensation for personal
services actually rendered;
(2) traveling expenses (including amounts expended for meals and lodging
other than amounts which are lavish or extravagant under the
circumstances) while away from home in the pursuit of a trade or
business; and
(3) rentals or other payments required to be made as a condition to the
continued use or possession, for purposes of the trade or business, of
property to which the taxpayer has not taken or is not taking title or in
which he has no equity.
For purposes of the preceding sentence, the place of residence of a
Member of Congress (including any Delegate and Resident
Commissioner) within the State, congressional district, or
possession which he represents in Congress shall be considered his
home, but amounts expended by such Members within each taxable
year for living expenses shall not be deductible for income tax
purposes in excess of $3,000. For purposes of paragraph (2), the
taxpayer shall not be treated as being temporarily away from home
during any period of employment if such period exceeds 1 year.
The preceding sentence shall not apply to any Federal employee
during any period for which such employee is certified by the
Attorney General (or the designee thereof) as traveling on behalf of
the United States in temporary duty status to investigate or
prosecute, or provide support services for the investigation or
prosecution of, a Federal crime.
Section 212. Expenses for production of income
In the case of an individual, there shall be allowed as a deduction all the ordinary
and necessary expenses paid or incurred during the taxable year—
(1) for the production or collection of income;
(2) for the management, conservation, or maintenance of property held for
the production of income; or
(3) in connection with the determination, collection, or refund of any tax.
A.
The meaning of the terms “ordinary” and “necessary”.
1.
Both section 162 and section 212 state that the expense involved must an ordinary and
necessary expense.
2.
The word “ordinary” has developed to mean “common”.
a.
The term "ordinary" refers to currently deductible expenses, as distinguished from
capital expenditures.
b.
In some cases, however, deductions have been disallowed because the expenses
were unusual or unique.
3.
The word “necessary” has developed to mean “helpful”.
a.
The term "necessary" has been interpreted by the courts to require only that an
expenditure be appropriate and helpful to the conduct of the trade or business. A
necessary expense does not have to be an essential one.
B.
The meaning of the terms “paid” and “incurred”.
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1.
C.
Both section 162 and section 212 use both the words “paid” and “incurred”, which allow
taxpayers who use either the cash or accrual method of accounting to deduct the items which
are authorized as deductions by section 162 or section 212.
Scope of section 162 and section 212.
1.
Section 162 authorizes deductions for all types of expenses, both legal ones and illegal ones,
unless the expenses are paid or incurred in an illegal drug business (read section 280E) or
violate sharply defined public policy or are otherwise disallowed by other sections.
Section 280E, states as follows:
Expenditures in connection with the illegal sale of drugs
No deduction or credit shall be allowed for any amount paid or incurred during the
taxable year in carrying on any trade or business if such trade or business (or the
activities which comprise such trade or business) consists of trafficking in controlled
substances (within the meaning of schedule I and II of the Controlled Substances
Act) which is prohibited by Federal law or the law of any State in which such trade
or business is conducted.
2.
Section 212 authorizes deductions for the following three categories.
a.
Expenses for the production or collection of income.
b.
Expenses for the management, conservation, or maintenance of property held for the
production of income.
c.
Expenses in connection with the determination, collection, or refund of any tax.
3.
Neither section 162 nor section 212 authorize deductions for capital expenditures.
4.
In general, business and investment deductions are ordinary deductions (not capital losses),
because neither section 162 nor section 212 expenses arise from the sale or exchange of a
capital asset and generally there is no specific section which states that capital losses are to
be treated as ordinary deductions.
5.
Some business and some investment deductions are deductible only above AGI and some
business deductions and some investment deductions are deductible only below AGI.
a.
The positioning of the deductions rests solely on the provisions of section 62.
b.
No business or investment deduction may be deducted both above AGI and below
AGI.
6.
Read section 162(a) and section 212(a) again, which state as follows:
Section 162(a). Trade or business expenses
(a) In general. There shall be allowed as a deduction all the ordinary and necessary
expenses paid or incurred during the taxable year in carrying on any trade
or business, including—
(1) a reasonable allowance for salaries or other compensation for personal
services actually rendered;
(2) traveling expenses (including amounts expended for meals and lodging
other than amounts which are lavish or extravagant under the
circumstances) while away from home in the pursuit of a trade or
business; and
(3) rentals or other payments required to be made as a condition to the
continued use or possession, for purposes of the trade or business,
of property to which the taxpayer has not taken or is not taking title
or in which he has no equity.
For purposes of the preceding sentence, the place of residence of a
Member of Congress (including any Delegate and Resident
Commissioner) within the State, congressional district, or
possession which he represents in Congress shall be considered his
home, but amounts expended by such Members within each taxable
year for living expenses shall not be deductible for income tax
purposes in excess of $3,000. For purposes of paragraph (2), the
taxpayer shall not be treated as being temporarily away from home
during any period of employment if such period exceeds 1 year.
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The preceding sentence shall not apply to any Federal employee
during any period for which such employee is certified by the
Attorney General (or the designee thereof) as traveling on behalf of
the United States in temporary duty status to investigate or
prosecute, or provide support services for the investigation or
prosecution of, a Federal crime.
Section 212. Expenses for production of income.
In the case of an individual, there shall be allowed as a deduction all the ordinary
and necessary expenses paid or incurred during the taxable year—
(1) for the production or collection of income;
(2) for the management, conservation, or maintenance of property held for
the production of income; or
(3) in connection with the determination, collection, or refund of any tax.
a.
Notice that both of these section use the terms “ordinary” and “necessary”.
b.
In general, section 162 provides that ordinary and necessary expenses which are
involved in the carrying on a trade or business for profit are deductible in computing
taxable income.
c.
In general, section 212 provides that ordinary and necessary expenses which are of
the following three types are deductible.
(1)
Expenses for the production or collection of income.
(2)
Expenses for the management, conservation, or maintenance of property
held for the production of income.
(3)
Expenses in connection with the determination, collection, or refund of any
tax.
D.
Capital expenditures.
1.
Capital expenditures include amounts paid or incurred to add to the fair market value of or
to substantially extend the useful life of property owned by the taxpayer. Read section
263(a), which states as follows:
Section 263. Capital expenditures.
(a) General rule.
No deduction shall be allowed for—
(1) Any amount paid out for new buildings or for permanent improvements
or betterments made to increase the value of any property or estate.
This paragraph shall not apply to—
(A) expenditures for the development of mines or deposits
deductible under section 616,
(B) research and experimental expenditures deductible under
section 174,
(C) soil and water conservation expenditures deductible under
section 175,
(D) expenditures by farmers for fertilizer, etc., deductible under
section 180,
(E) expenditures for removal of architectural and transportation
barriers to the handicapped and elderly which the taxpayer
elects to deduct under section 190,
(F) expenditures for tertiary injectants with respect to which a
deduction is allowed under section 193; [1]
(G) expenditures for which a deduction is allowed under section
179; [1]
(H) expenditures for which a deduction is allowed under section
179A,
(I) expenditures for which a deduction is allowed under section
179B,
(J) expenditures for which a deduction is allowed under section
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2.
179C,
(K) expenditures for which a deduction is allowed under section
179D, or
(L) expenditures for which a deduction is allowed under section
179E.
(2) Any amount expended in restoring property or in making good the
exhaustion thereof for which an allowance is or has been made.
a.
A capital expenditure differs from a deductible expense because the anticipated
benefit of the capital expenditure extends beyond the taxable year.
Capital expenditures may not be deducted except through the authorization of a specific
section, for example
a.
Section 167 - depreciation, which states as follows:
Section 167. Depreciation
(a) General rule
There shall be allowed as a depreciation deduction a reasonable
allowance for the exhaustion, wear and tear (including a reasonable
allowance for obsolescence)—
(1) of property used in the trade or business, or
(2) of property held for the production of income.
b.
Section 179 - expensing of business tangible personal property, which states as
follows:
Section 179. Election to expense certain depreciable business assets
(a) Treatment as expenses
A taxpayer may elect to treat the cost of any section 179 property
as an expense which is not chargeable to capital account. Any cost
so treated shall be allowed as a deduction for the taxable year in
which the section 179 property is placed in service.
c.
Section 611 - depletion, which states as follows:
Section 611. Allowance of deduction for depletion
(a) General rule
In the case of mines, oil and gas wells, other natural deposits, and
timber, there shall be allowed as a deduction in computing taxable
income a reasonable allowance for depletion and for depreciation
of improvements, according to the peculiar conditions in each case;
such reasonable allowance in all cases to be made under regulations
prescribed by the Secretary. For purposes of this part, the term
“mines” includes deposits of waste or residue, the extraction of ores
or minerals from which is treated as mining under section 613 (c).
In any case in which it is ascertained as a result of operations or of
development work that the recoverable units are greater or less than
the prior estimate thereof, then such prior estimate (but not the
basis for depletion) shall be revised and the allowance under this
section for subsequent taxable years shall be based on such revised
estimate.
d.
Section 171 - bond premiums, which states as follows:
Section 171. Amortizable bond premium
(a) General rule
In the case of any bond, as defined in subsection (d), the following
rules shall apply to the amortizable bond premium (determined
under subsection (b)) on the bond:
(1) Taxable bonds
In the case of a bond (other than a bond the interest on
which is excludable from gross income), the amount of the
amortizable bond premium for the taxable year shall be
allowed as a deduction.
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e.
f.
g.
h.
(2) Tax-exempt bonds
In the case of any bond the interest on which is excludable
from gross income, no deduction shall be allowed for the
amortizable bond premium for the taxable year.
(3) Cross reference
For adjustment to basis on account of amortizable bond
premium, see section 1016 (a)(5).
Section 197 - various intangibles, which states as follows:
Section 197. Amortization of goodwill and certain other intangibles
(a) General rule
A taxpayer shall be entitled to an amortization deduction with
respect to any amortizable section 197 intangible. The amount of
such deduction shall be determined by amortizing the adjusted
basis (for purposes of determining gain) of such intangible ratably
over the 15-year period beginning with the month in which such
intangible was acquired.
Section 195 - start up of a business, which states as follows:
Section 195. Start-up expenditures
(a) Capitalization of expenditures
Except as otherwise provided in this section, no deduction shall be
allowed for start-up expenditures.
Section 248 - start up expenditures of a corporation, which states as follows:
Section 248. Organizational expenditures
(a) Election to deduct
If a corporation elects the application of this subsection (in
accordance with regulations prescribed by the Secretary) with
respect to any organizational expenditures—
(1) the corporation shall be allowed a deduction for the taxable year
in which the corporation begins business in an amount
equal to the lesser of—
(A) the amount of organizational expenditures with respect
to the taxpayer, or
(B) $5,000, reduced (but not below zero) by the amount by
which such organizational expenditures exceed
$50,000, and
(2) the remainder of such organizational expenditures shall be
allowed as a deduction ratably over the 180-month period
beginning with the month in which the corporation begins business.
Section 709 - start up expenditures of a partnership, which states as follows:
Section 709. Treatment of organization and syndication fees
(a) General rule
Except as provided in subsection (b), no deduction shall be allowed
under this chapter to the partnership or to any partner for any
amounts paid or incurred to organize a partnership or to promote
the sale of (or to sell) an interest in such partnership.
E.
Section 162 is used by all types of businesses such as the following.
1.
Individuals.
2.
General partnerships (GPs).
3.
Limited partnerships (LPs).
4.
Limited liability companies (LLCs).
5.
Corporations - the largest and the smallest, and, C corporations and S corporations.
6.
Fiduciaries of trusts or estates.
F.
Section 162 income tax deductions.
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1.
2.
3.
4.
5.
Read section 162(a), which states as follows:
Section 162. Trade or business expenses.
(a) In general
There shall be allowed as a deduction all the ordinary and necessary
expenses paid or incurred during the taxable year in carrying on any trade
or business, including—
(1) a reasonable allowance for salaries or other compensation for personal
services actually rendered;
(2) traveling expenses (including amounts expended for meals and lodging
other than amounts which are lavish or extravagant under the
circumstances) while away from home in the pursuit of a trade or
business; and
(3) rentals or other payments required to be made as a condition to the
continued use or possession, for purposes of the trade or business,
of property to which the taxpayer has not taken or is not taking title
or in which he has no equity.
For purposes of the preceding sentence, the place of residence of a Member of
Congress (including any Delegate and Resident Commissioner) within the State,
congressional district, or possession which he represents in Congress shall be
considered his home, but amounts expended by such Members within each taxable
year for living expenses shall not be deductible for income tax purposes in excess
of $3,000. For purposes of paragraph (2), the taxpayer shall not be treated as being
temporarily away from home during any period of employment if such period
exceeds 1 year. The preceding sentence shall not apply to any Federal employee
during any period for which such employee is certified by the Attorney General (or
the designee thereof) as traveling on behalf of the United States in temporary duty
status to investigate or prosecute, or provide support services for the investigation
or prosecution of, a Federal crime.
Section 162 provides one type of ordinary income tax deduction, specifically, a deduction
for business expenses.
Business expenses include, for example, payments for:
a.
Rent.
b.
Services rendered.
c.
Interest on borrowed money:
d.
Meals furnished to employees.
e.
Travel expenses.
f.
Electricity.
g.
Insurance
h.
Books.
i.
Paper.
j.
And so on.
If a sole proprietor withdraws money or other property from the business, no income tax
deduction is allowable for such withdrawal, because the withdrawal is not an expense of the
business, as the term “expense” is used under section 162.
All of the assets of a sole proprietorship are owned by the sole proprietor. Therefore, if the
sole proprietor “withdraws” funds from the sole proprietor’s business bank account and puts
the money in the sole proprietor’s personal bank account, then the sole proprietor has not
realized any income.
a.
There has merely been a transfer of one of the sole proprietor’s assets from one bank
account to another bank account of the sole proprietor.
b.
The sole proprietor owned the cash before the transfer and the sole proprietor owns
the cash after the transfer.
c.
Therefore, the sole proprietor does not realize any income when the withdrawal is
made.
d.
And, the “sole proprietorship” is not entitled to any income tax deduction when the
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withdrawal is made.
G.
Investment expenses; expenses for the production of income - section 212.
1.
In the case of an individual, there is allowable as a deduction all the ordinary and necessary
expenses paid or incurred during the taxable year for the production or collection of income,
for the management, conservation, or maintenance of property held for the production of
income (even if building held as investment), or in connection with the determination,
collection, or refund of any tax. Read section 212, which states as follows:
Section 212. Expenses for production of income.
In the case of an individual, there shall be allowed as a deduction all the ordinary
and necessary expenses paid or incurred during the taxable year—
(1) for the production or collection of income;
(2) for the management, conservation, or maintenance of property held for
the production of income; or
(3) in connection with the determination, collection, or refund of any tax
2.
Specifically, section 212 states that in the case of an individual, there shall be allowed as a
deduction all the ordinary and necessary expenses (not capital expenditures) paid or incurred
during the taxable year for:
a.
The production or collection of income.
b.
The management, conservation, or maintenance of property held for the production
of income.
c.
In connection with the determination, collection, or refund of any tax.
3.
Section 212 authorizes deductions for investment expenses whereas section 162 provides
deductions for business expenses. Both of these sections allow deductions for “ordinary and
necessary” expenses.
a.
Common expenses which are deductible under section 212.
(1)
Tax advice fees.
(2)
Legal fees.
(3)
Accounting fees.
(4)
Investment periodicals.
(5)
Safe deposit box fees.
(6)
Painting parts of a building held for investment.
(7)
Fuel costs for a building held for investment.
(8)
Management fees for a building held for investment.
4.
Section 212 allows investors to deduct expenses (not capital expenditures), with very broad
standards. However, section 212 does not allow deductions through section 179, because
section 179 allows deductions only for tangible personal business property.
H.
More comparisons of personal expenses and investment expenses and business expenses.
1.
Does it matter to a taxpayer if the taxpayer, e.g., rents a safe deposit box for any one of the
following reasons.
a.
Personal use?
(1)
This expense is not deductible.
b.
Investment use?
(1)
This expense is deductible, but unless it is used in connection with the
taxpayer’s investments in rental property, the deduction is below AGI and
is included in the 2% test.
c.
Business use?
(1)
This expense is deductible, above the line for a self-employed individual
and below the line (and subject to the 2% test) for employees.
I.
To repeat. Where are investment expenses deductible?
1.
Expenses for the production of rents and royalties are deductible in arriving at AGI. Read
section 62(a)(4), which states as follows:
Section 62. Adjusted gross income defined
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2.
(a) General rule. For purposes of this subtitle, the term “adjusted gross income”
means, in the case of an individual, gross income minus the following deductions:
(4) Deductions attributable to rents and royalties
The deductions allowed by part VI (sec. 161 and following), by
section 212 (relating to expenses for production of income), and by
section 611 (relating to depletion) which are attributable to
property held for the production of rents or royalties.
All other expenses incurred for the production of income are deductible from AGI, because
they are not listed under section 62.
J.
The meaning of the phrase “in connection with the determination, collection, or refund of any tax”.
1.
This category includes, for example, expenses paid or incurred:
a.
For tax counsel;
b.
For preparation of tax returns;
c.
In connection with any proceeding involved in determining the taxpayer's tax
liability;
d.
For contesting the taxpayer's tax liability. Read Reg. §1.21201(l).
2.
However, the cost of estate planning, other than the portion properly allocable to the tax
aspects, is generally nondeductible.
3.
Deductions for tax advice are generally miscellaneous itemized deductions subject to the 2%
floor. Read section 67(a), which states as follows:
Section 67. 2-percent floor on miscellaneous itemized deductions
(a) General rule.In the case of an individual, the miscellaneous itemized deductions
for any taxable year shall be allowed only to the extent that the aggregate
of such deductions exceeds 2 percent of adjusted gross income.
4.
Because section 641(b) states that fiduciaries should compute their taxable incomes in the
same way that an individual does, section 212 is applicable to fiduciaries as is the 2% test
for miscellaneous deductions.
5.
Expenses attributable to the operation of a business building are deductible under section 162
and are deductible above AGI due to section 62(a)(1). But expenses attributable to the
operation of a building which is being held as an investment for appreciation are deductible,
but only above the line. However, expenses attributable to the operation of a building which
is being held for the production of rents are deductible above the line.
K.
No deductions for payments of other individuals’ expenses.
1.
In general, a taxpayer may not deduct payments for the expenses of another taxpayer.
a.
This principle has sometimes been applied to deny employees a deduction for travel
or entertainment expenses incurred in connection with their employment if they
were entitled to reimbursement from their employer but failed to claim it.
2.
However, payment of another taxpayer’s liability or expense is deductible if it serves an
independent business purpose of the taxpayer.
3.
The courts have sometimes disallowed deductions on the ground that they would frustrate
sharply defined public policy, but this principle has been largely supplanted by statutory
rules prohibiting the deduction of such things as fines for criminal violations, bribes and
other illegal expenditures, and certain types of lobbying expenses. Read sections 162(c),
section 162(e), and section 162(f), which state as follows:
Section 162. Trade or business expenses.
(c) Illegal bribes, kickbacks, and other payments
(1) Illegal payments to government officials or employees
No deduction shall be allowed under subsection (a) for any
payment made, directly or indirectly, to an official or employee of
any government, or of any agency or instrumentality of any
government, if the payment constitutes an illegal bribe or kickback
or, if the payment is to an official or employee of a foreign
government, the payment is unlawful under the Foreign Corrupt
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Practices Act of 1977. The burden of proof in respect of the issue,
for the purposes of this paragraph, as to whether a payment
constitutes an illegal bribe or kickback (or is unlawful under the
Foreign Corrupt Practices Act of 1977) shall be upon the Secretary
to the same extent as he bears the burden of proof under section
7454 (concerning the burden of proof when the issue relates to
fraud).
(2) Other illegal payments
No deduction shall be allowed under subsection (a) for any
payment (other than a payment described in paragraph (1)) made,
directly or indirectly, to any person, if the payment constitutes an
illegal bribe, illegal kickback, or other illegal payment under any
law of the United States, or under any law of a State (but only if
such State law is generally enforced), which subjects the payor to
a criminal penalty or the loss of license or privilege to engage in a
trade or business. For purposes of this paragraph, a kickback
includes a payment in consideration of the referral of a client,
patient, or customer. The burden of proof in respect of the issue, for
purposes of this paragraph, as to whether a payment constitutes an
illegal bribe, illegal kickback, or other illegal payment shall be
upon the Secretary to the same extent as he bears the burden of
proof under section 7454 (concerning the burden of proof when the
issue relates to fraud).
(3) Kickbacks, rebates, and bribes under medicare and medicaid
No deduction shall be allowed under subsection (a) for any
kickback, rebate, or bribe made by any provider of services,
supplier, physician, or other person who furnishes items or services
for which payment is or may be made under the Social Security
Act, or in whole or in part out of Federal funds under a State plan
approved under such Act, if such kickback, rebate, or bribe is made
in connection with the furnishing of such items or services or the
making or receipt of such payments. For purposes of this
paragraph, a kickback includes a payment in consideration of the
referral of a client, patient, or customer.
(e) Denial of deduction for certain lobbying and political expenditures
(1) In general. No deduction shall be allowed under subsection (a) for any
amount paid or incurred in connection with—
(A) influencing legislation,
(B) participation in, or intervention in, any political campaign on
behalf of (or in opposition to) any candidate for public
office,
(C) any attempt to influence the general public, or segments
thereof, with respect to elections, legislative matters, or
referendums, or
(D) any direct communication with a covered executive branch
official in an attempt to influence the official actions or
positions of such official.
(2) Exception for local legislation
In the case of any legislation of any local council or similar
governing body—
(A) paragraph (1)(A) shall not apply, and
(B) the deduction allowed by subsection (a) shall include all
ordinary and necessary expenses (including, but not
limited to, traveling expenses described in subsection
(a)(2) and the cost of preparing testimony) paid or incurred
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during the taxable year in carrying on any trade or
business—
(i) in direct connection with appearances before,
submission of statements to, or sending
communications to the committees, or individual
members, of such council or body with respect to
legislation or proposed legislation of direct interest
to the taxpayer, or
(ii) in direct connection with communication of
information between the taxpayer and an
organization of which the taxpayer is a member
with respect to any such legislation or proposed
legislation which is of direct interest to the
taxpayer and to such organization,
and that portion of the dues so paid or incurred
with respect to any organization of which the
taxpayer is a member which is attributable to the
expenses of the activities described in clauses (i)
and (ii) carried on by such organization.
(3) Application to dues of tax-exempt organizations
No deduction shall be allowed under subsection (a) for the portion
of dues or other similar amounts paid by the taxpayer to an
organization which is exempt from tax under this subtitle which the
organization notifies the taxpayer under section 6033 (e)(1)(A)(ii)
is allocable to expenditures to which paragraph (1) applies.
(4) Influencing legislation
For purposes of this subsection—
(A) In general
The term “influencing legislation” means any attempt to
influence any legislation through communication with any
member or employee of a legislative body, or with any
government official or employee who may participate in
the formulation of legislation.
(B) Legislation
The term “legislation” has the meaning given such term by
section 4911 (e)(2).
(5) Other special rules
(A) Exception for certain taxpayers
In the case of any taxpayer engaged in the trade or
business of conducting activities described in paragraph
(1), paragraph (1) shall not apply to expenditures of the
taxpayer in conducting such activities directly on behalf of
another person (but shall apply to payments by such other
person to the taxpayer for conducting such activities).
(B) De minimis exception
(i) In general Paragraph (1) shall not apply to any in-house
expenditures for any taxable year if such
expenditures do not exceed $2,000. In determining
whether a taxpayer exceeds the $2,000 limit under
this clause, there shall not be taken into account
overhead costs otherwise allocable to activities
described in paragraphs (1)(A) and (D).
(ii) In-house expenditures For purposes of clause (i), the
term “in-house expenditures” means expenditures
described in paragraphs (1)(A) and (D) other
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than—
(I) payments by the taxpayer to a person engaged
in the trade or business of conducting
activities described in paragraph (1) for
the conduct of such activities on behalf of
the taxpayer, or
(II) dues or other similar amounts paid or incurred
by the taxpayer which are allocable to
activities described in paragraph (1).
(C) Expenses incurred in connection with lobbying and political
activities Any amount paid or incurred for research for, or
preparation, planning, or coordination of, any activity
described in paragraph (1) shall be treated as paid or
incurred in connection with such activity.
(6) Covered executive branch official
For purposes of this subsection, the term “covered executive branch
official” means—
(A) the President,
(B) the Vice President,
(C) any officer or employee of the White House Office of the
Executive Office of the President, and the 2 most senior
level officers of each of the other agencies in such
Executive Office, and
(D)
(i) any individual serving in a position in level I of the
Executive Schedule under section 5312 of title 5,
United States Code,
(ii) any other individual designated by the President as
having Cabinet level status, and
(iii) any immediate deputy of an individual described in
clause (i) or (ii).
(7) Special rule for Indian tribal governments
For purposes of this subsection, an Indian tribal government shall
be treated in the same manner as a local council or similar
governing body.
(8) Cross reference
For reporting requirements and alternative taxes related to this
subsection, see section 6033 (e).
(f) Fines and penalties
No deduction shall be allowed under subsection (a) for any fine or similar
penalty paid to a government for the violation of any law.
L.
To be deductible, compensation paid to employees must be reasonable.
1.
The deduction for compensation paid to employees and others for services rendered to a
trade or business is limited to a reasonable allowance, taking into account such factors as the
type of services rendered, the type of business involved, and the amount paid by similar
businesses for like services. Read section 162(a)(1), which states as follows:
Section 162. Trade or business expenses
(a) In general.
There shall be allowed as a deduction all the ordinary and necessary
expenses paid or incurred during the taxable year in carrying on any trade
or business, including—
(1) a reasonable allowance for salaries or other compensation for personal
services actually rendered;
2.
Compensation agreements are to be judged by the circumstances existing at the time the
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3.
4.
contract was entered into, not when it is questioned. Read Reg. §1.162-7(b)(3).
Contingent compensation, such as a percentage of sales or profits, is generally deductible if
paid pursuant to a free bargain entered into before the services are rendered even though it
might turn out to be more than the amount that would ordinarily be paid. Read Reg. §1.1627(b)(2).
a.
There is no free bargain if the employee is also a majority shareholder of the
employer or is otherwise closely related to the controlling shareholders.
b.
In the case of shareholder-employees, the possibility exists that salary payments are
in fact disguised dividends, which the corporation is not entitled to deduct. The fact
that a profitable corporation has paid little or no dividends is a factor that may
indicate that compensation paid to a shareholder-employees is unreasonable, but a
deduction will not be denied on this ground alone (constructive dividend). Read
Rev. Rul. 79-8, 1979-1 C.B. 92.
c.
Compensation generally remains taxable to the employee even if it is determined to
be unreasonable and therefore, not deductible by the employer. Read Reg. §1.162-8.
(1)
Employees who repay compensation determined to be unreasonable are
entitled to a deduction, provided there was a binding legal obligation to do
so at the time the compensation was received. Read Rev. Rul. 69-115,
1969-1 C.B. 50.
The deduction for compensation paid to the chief executive officer and up to four other
highest paid executives of a publicly held corporation is generally limited to $1,000,000
annually. Read section 162(m)(1), which states as follows:
Section 162. Trade or business expenses
(m) Certain excessive employee remuneration.
(1) In general. In the case of any publicly held corporation, no deduction
shall be allowed under this chapter for applicable employee remuneration
with respect to any covered employee to the extent that the amount of such
remuneration for the taxable year with respect to such employee exceeds
$1,000,000.
(2) Publicly held corporation
For purposes of this subsection, the term “publicly held
corporation” means any corporation issuing any class of common
equity securities required to be registered under section 12 of the
Securities Exchange Act of 1934.
(3) Covered employee
For purposes of this subsection, the term “covered employee”
means any employee of the taxpayer if—
(A) as of the close of the taxable year, such employee is the chief
executive officer of the taxpayer or is an individual acting
in such a capacity, or
(B) the total compensation of such employee for the taxable year
is required to be reported to shareholders under the
Securities Exchange Act of 1934 by reason of such
employee being among the 4 highest compensated officers
for the taxable year (other than the chief executive officer).
(4) Applicable employee remuneration
For purposes of this subsection—
(A) In general
Except as otherwise provided in this paragraph, the term
“applicable employee remuneration” means, with respect
to any covered employee for any taxable year, the
aggregate amount allowable as a deduction under this
chapter for such taxable year (determined without regard
to this subsection) for remuneration for services performed
by such employee (whether or not during the taxable year).
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(B) Exception for remuneration payable on commission basis
The term “applicable employee remuneration” shall not
include any remuneration payable on a commission basis
solely on account of income generated directly by the
individual performance of the individual to whom such
remuneration is payable.
(C) Other performance-based compensation
The term “applicable employee remuneration” shall not
include any remuneration payable solely on account of the
attainment of one or more performance goals, but only if—
(i) the performance goals are determined by a
compensation committee of the board of directors
of the taxpayer which is comprised solely of 2 or
more outside directors,
(ii) the material terms under which the remuneration is to
be paid, including the performance goals, are
disclosed to shareholders and approved by a
majority of the vote in a separate shareholder vote
before the payment of such remuneration, and
(iii) before any payment of such remuneration, the
compensation committee referred to in clause (i) certifies
that the performance goals and any other material terms
were in fact satisfied.
(D) Exception for existing binding contracts
The term “applicable employee remuneration” shall not
include any remuneration payable under a written binding
contract which was in effect on February 17, 1993, and
which was not modified thereafter in any material respect
before such remuneration is paid.
(E) Remuneration
For purposes of this paragraph, the term “remuneration”
includes any remuneration (including benefits) in any
medium other than cash, but shall not include—
(i) any payment referred to in so much of section 3121
(a)(5) as precedes subparagraph (E) thereof, and
(ii) any benefit provided to or on behalf of an employee if
at the time such benefit is provided it is reasonable
to believe that the employee will be able to
exclude such benefit from gross income under this
chapter.
For purposes of clause (i), section 3121 (a)(5)
shall be applied without regard to section 3121
(v)(1).
(F) Coordination with disallowed golden parachute payments
The dollar limitation contained in paragraph (1) shall be
reduced (but not below zero) by the amount (if any) which
would have been included in the applicable employee
remuneration of the covered employee for the taxable year
but for being disallowed under section 280G.
(G) Coordination with excise tax on specified stock compensation
The dollar limitation contained in paragraph (1) with
respect to any covered employee shall be reduced (but not
below zero) by the amount of any payment (with respect to
such employee) of the tax imposed by section 4985
directly or indirectly by the expatriated corporation (as
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5.
defined in such section) or by any member of the expanded
affiliated group (as defined in such section) which includes
such corporation.
a.
Exceptions are provided for commissions and certain other "performance based"
compensation.
No deduction is allowable for payments made to officers, shareholder-employees, and highly
compensated individuals to the extent such payments exceed the recipient's base
compensation for the preceding five years, if the aggregate present value of the payments is
at least three times such base compensation and the payments are contingent on a change in
ownership or control of a corporation. Read section 280G, which states as follows:
Section 280G. Golden parachute payments
(a) General rule. No deduction shall be allowed under this chapter for any excess
parachute payment.
a.
The recipient is also subject to a nondeductible excise tax of 20% on such excess
parachute payments, to be withheld at the time of payment, in addition to regular
income taxes. Read section 4999(a), which states as follows:
Section 4999. Golden parachute payments
(a) Imposition of tax
There is hereby imposed on any person who receives an excess parachute
payment a tax equal to 20 percent of the amount of such payment.
(1)
Exceptions are provided for small business corporations and corporations
with no readily tradable securities. Read section 280G(b)(5), which states
as follows:
Section 280G. Golden parachute payments
(b) Excess parachute payment
For purposes of this section—
(5) Exemption for small business corporations, etc.
(A) In general
Notwithstanding paragraph (2), the term “parachute
payment” does not include—
(i) any payment to a disqualified individual with respect to
a corporation which (immediately before the
change described in paragraph (2)(A)(i)) was a
small business corporation (as defined in section
1361 (b) but without regard to paragraph (1)(C)
thereof), and
(ii) any payment to a disqualified individual with respect
to a corporation (other than a corporation
described in clause (i)) if—
(I) immediately before the change
describ
ed in paragraph (2)(A)(i), no stock in such
corporation was readily tradeable on an
established securities market or otherwise,
and
(II) the shareholder approval
require
ments of subparagraph (B) are met with
respect to such payment.
The Secretary may, by regulations, prescribe that the
requirements of subclause (I) of clause (ii) are not met
where a substantial portion of the assets of any entity
consists (directly or indirectly) of stock in such corporation
and interests in such other entity are readily tradeable on
an established securities market, or otherwise. Stock
described in section 1504 (a)(4) shall not be taken into
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account under clause (ii)(I) if the payment does not
adversely affect the shareholder’s redemption and
liquidation rights.
M.
Business travel expenses, including meals and lodging.
1.
Business travel expenses, including amounts spent for meals and lodging while away from
home on business that are not lavish or extravagant under the circumstances, are deductible.
Read section 162(a)(2), which states as follows:
Section 162. Trade or business expenses.
(a) In general
There shall be allowed as a deduction all the ordinary and necessary
expenses paid or incurred during the taxable year in carrying on any trade
or business, including—
(2) traveling expenses (including amounts expended for meals and lodging
other than amounts which are lavish or extravagant under the
circumstances) while away from home in the pursuit of a trade or
business; and
2.
Ordinary and necessary expenses, incurred while traveling "away from home" in pursuit of
a trade or business are deductible as long as they are reasonable. Read section 162(a)(2),
which states as follows:
Section 162. Trade or business expenses.
(a) In general
There shall be allowed as a deduction all the ordinary and necessary
expenses paid or incurred during the taxable year in carrying on any trade
or business, including—
(2) traveling expenses (including amounts expended for meals and lodging
other than amounts which are lavish or extravagant under the
circumstances) while away from home in the pursuit of a trade or
business; and
a.
Away from home, generally means away from home overnight.
3.
No deduction is allowed for the individual's spouse who accompanied the individual unless
it can be shown that the spouses presence served as a bona fide business purpose. Read
section 162(a), which states as follows:
Section 162. Trade or business expenses.
(a) In general
There shall be allowed as a deduction all the ordinary and necessary
expenses paid or incurred during the taxable year in carrying on any trade
or business, including—
(2) traveling expenses (including amounts expended for meals and lodging
other than amounts which are lavish or extravagant under the
circumstances) while away from home in the pursuit of a trade or
business; and
4.
The IRS generally states that a taxpayer's “home” is the general location of the taxpayer's
principal place of business, not the location of the taxpayer's residence. Read section
162(a)(2) and Rev. Rul. 75-432, 1975-2 C.B. 60. However, generally the location of a
taxpayer’s home, for the purposes of section 162, is determined by looking at several facts.
a.
Where does the taxpayer spend most of the taxpayer’s time?.
b.
Where does the taxpayer have the taxpayer’s lodging?
c.
Where does the taxpayer earn most of the taxpayer’s money?
d.
Where does the taxpayer: Vote? Hold a valid driver’s license? Hold most of the
taxpayer’s memberships?
e.
Where do the taxpayer’s children attend school?
f.
Etc., Etc.
g.
However, if a taxpayer has a regular place of abode and no principal place of
business, the place of the taxpayer's residence will be recognized as the taxpayer's
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h.
i.
j.
k.
home and a deduction is available for travel expenses to temporary job sites away
from that general locality. Read Rev. Rul. 71-247, 1971-1 C.B. 54.
Transient workers, such as traveling salesmen, who have neither a regular place of
abode nor a principal place of business are viewed as having no home to be away
from, and the cost of their meals and lodging is not deductible.
The courts have generally refused to embrace the business headquarters test for
determining the location of the taxpayer's home, but have said that a deduction is
allowable only for expenses incurred as a matter of business necessity rather than
personal choice, a test that usually produces the same result.
A taxpayer is considered to be away from home only if the taxpayer is away for a
sufficient period of time to require sleep or rest. Read U.S. v. Correll, 389 U.S. 299
(1967). Thus, the cost of meals on one-day business trips is not deductible.
The cost of meals and lodging at temporary job sites away from the general locality
of the taxpayer's principal place of business is deductible on the theory that the
taxpayer is away from home.
(1)
The IRS considers employment to be temporary if its expected and actual
duration is one year or less. If the expected duration of the employment is
more than one year or indefinite, no deduction is allowable regardless of
whether or not the period of employment actually exceeds one year.
(2)
If employment is initially expected to last for no more than one year but
circumstances arise later which cause the expected period of employment
to exceed one year, the employment is considered to be temporary until the
date the expectation changes. Read Rev. Rul. 93-86, 1993-40 I.R.B. 4.
N.
The cost of commuting.
1.
Read Reg. §1.162-2(e) and Reg. §1.262-1(b)(5).
2.
This rule is sometimes explained on the basis that where a person lives in relation to the
person's work is a matter of personal choice, but deductions for commuting expenses have
been disallowed even though no housing was available near the taxpayer's place of work.
3.
Expenses of carrying tools from home to work can be deducted, but only to the extent the
taxpayer incurs additional expenses for carrying the tools.
a.
An airline pilot was denied a deduction for the cost of driving the airline pilot's
automobile to work, even though the airline pilot took along the airline pilot's flight
bags and an overnight bag, because the airline pilot would have traveled by
automobile anyway.
b.
The IRS states that a deduction is available only for the excess cost of commuting
with the tools by the same mode of transportation as that actually used. Read Rev.
Rul. 75-380, 1975-2 C.B. 59. Thus, the cost of renting a trailer to carry tools would
be deductible, but the mere cost of driving an automobile in excess of the cost of
alternative transportation would not be deductible.
O.
Transportation expenses.
1.
Read section 162(a), which states as follows:
Section 162. Trade or business expenses.
(a) In general
There shall be allowed as a deduction all the ordinary and necessary
expenses paid or incurred during the taxable year in carrying on any trade
or business, including—
(2) traveling expenses (including amounts expended for meals and lodging
other than amounts which are lavish or extravagant under the
circumstances) while away from home in the pursuit of a trade or
business; and
2.
An employee or self-employed individual may deduct the cost of operating a passenger
automobile to the extent that it is used in a trade or business. However, no portion of the
operating cost that is attributable to personal use is deductible.
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3.
4.
Read section 262(a), which states as follows:
Section 262. Personal, living, and family expenses
(a) General rule. Except as otherwise expressly provided in this chapter, no
deduction shall be allowed for personal, living, or family expenses
a.
No deduction is allowed under section 162 with respect to any listed property (as
defined in section 280F(d)(4) to include passenger automobiles and any other
property used as a means of transportation) unless the taxpayer complies with
certain substantiation requirements.
Read section 274(d), which states as follows:
Section 274. Disallowance of certain entertainment, etc., expenses.
(d) Substantiation required
No deduction or credit shall be allowed—
(1) under section 162 or 212 for any traveling expense (including meals and
lodging while away from home),
(2) for any item with respect to an activity which is of a type generally
considered to constitute entertainment, amusement, or recreation,
or with respect to a facility used in connection with such an
activity,
(3) for any expense for gifts, or
(4) with respect to any listed property (as defined in section 280F (d)(4)),
unless the taxpayer substantiates by adequate records or by
sufficient evidence corroborating the taxpayer’s own statement
(A) the amount of such expense or other item,
(B) the time and place of the travel, entertainment, amusement,
recreation, or use of the facility or property, or the date
and description of the gift,
(C) the business purpose of the expense or other item, and
(D) the business relationship to the taxpayer of persons entertained,
using the facility or property, or receiving the gift. The
Secretary may by regulations provide that some or all of
the requirements of the preceding sentence shall not apply
in the case of an expense which does not exceed an amount
prescribed pursuant to such regulations. This subsection
shall not apply to any qualified nonpersonal use vehicle (as
defined in subsection (i)).
In general, there are two methods to compute deductible travel expenses. The taxpayer may
utilize the mileage allowance as outlined in IRS publications which are released annually,
or may use actual allowable expenses if the taxpayer maintains adequate records or other
sufficient evidence for proper substantiation. Read Rev. Proc. 91-67, 1991-52 I.R.B. 11.
a.
Each year the IRS provides optional standard mileage rates for employees, selfemployed individuals, or other taxpayers which may be used in computing the
deductible costs paid or incurred in operating a passenger automobile for business,
charitable, medical, or moving expense purposes.
b.
The IRS may prescribe rules under which such allowances, if in accordance with
reasonable business practice, will be regarded as equivalent to substantiation, by
adequate records or other sufficient evidence, of the amount of such travel and
transportation expenses satisfying the requirements of an adequate accounting to the
employer of the amount of such expenses. Read Reg. §1.274-5T(c)(2).
An employee, in determining the employee’s AGI, is allowed a deduction for the expenses
paid or incurred by the employee in connection with the performance of services as an
employee under a reimbursement or other expense allowance arrangement with a payer.
Read section 62(a)(2)(A), which states as follows:
Section 62. Adjusted gross income defined
(a) General rule. For purposes of this subtitle, the term “adjusted gross income”
means, in the case of an individual, gross income minus the following
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a.
deductions:
(2) Certain trade and business deductions of employees
(A) Reimbursed expenses of employees
The deductions allowed by part VI (section 161 and
following) which consist of expenses paid or incurred by
the taxpayer, in connection with the performance by him
of services as an employee, under a reimbursement or other
expense allowance arrangement with his employer. The
fact that the reimbursement may be provided by a third
party shall not be determinative of whether or not the
preceding sentence applies.
An arrangement will not be treated as a reimbursement or other expense allowance
arrangement if it: does not require the employee to substantiate the expenses
covered by the arrangement to the payer; or, provides the employee with the right
to retain any amount in excess of the substantiated expenses covered under the
arrangement.
Read section 62 (c), which states as follows:
Section 62. Adjusted gross income defined.
(c) Certain arrangements not treated as reimbursement arrangements
For purposes of subsection (a)(2)(A), an arrangement shall in no
event be treated as a reimbursement or other expense allowance
arrangement if—
(1) such arrangement does not require the employee to substantiate
the expenses covered by the arrangement to the person
providing the reimbursement, or
(2) such arrangement provides the employee the right to retain any
amount in excess of the substantiated expenses covered
under the arrangement.
The substantiation requirements of the preceding sentence
shall not apply to any expense to the extent that
substantiation is not required under section 274 (d) for
such expense by reason of the regulations prescribed under
the 2nd sentence thereof.
b.
5.
A reimbursement or other expense allowance arrangement satisfies the requirements
of section 62(c) if it meets the requirements of business connection, substantiation,
and returning amounts in excess of expenses as specified in the regulations. Read
Reg. §1.62-2(c)(1).
The following are definitions used in computing the mileage allowance.
a.
The term "standard mileage rate" means the applicable amount provided by the IRS
for optional use by employees or self-employed individuals in computing the
deductible costs of operating passenger automobiles owned by them (including vans,
pickups, or panel trucks) for business purposes, or by taxpayers in computing the
deductible costs of operating passenger automobiles for charitable, medical, or
moving expense purposes. Read Rev. Proc. 91-67, 1991-52 I.R.B. 11.
b.
The term "transportation expenses" means the expenses of operating a passenger
automobile for local travel or transportation away from home. Read Rev. Proc. 9167, 1991-52 I.R.B. 11.
c.
The term "mileage allowance" means a payment under a reimbursement or other
expense allowance arrangement that is: paid with respect to the ordinary and
necessary business expenses incurred, or which the payer reasonably anticipates will
be incurred, by an employee for transportation expenses in connection with the
performance of services as an employee of the employer; reasonably calculated not
to exceed the amount of the expenses or the anticipated expenses; and, paid at the
applicable standard mileage rate, a flat rate or stated schedule, or in accordance with
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6.
any other service-specified rate or schedule. Read Rev. Proc. 91-67, 1991-52 I.R.B.
11.
(1)
A mileage allowance is paid at a flat rate or stated schedule if it is provided
on a uniform and objective basis with respect to the expenses. Such
allowance may be paid periodically at a fixed rate, at a cents-per-mile rate,
at a variable rate based on a stated schedule, at a rate that combines any of
these rates, or on any other basis that is consistently applied and in
accordance with reasonable business practice.
(2)
Thus, for example, a periodic payment at a fixed rate to cover the fixed
costs (including depreciation, insurance, registration and license fees, and
personal property taxes) of driving an automobile in connection with the
performance of services as an employee of the employer, coupled with a
periodic payment at a cents-per-mile rate to cover the operating costs
(including gasoline and all taxes thereon, oil, tires, and routine maintenance
and repairs) of using an automobile for such purposes, is an allowance paid
at a flat rate or stated schedule. Likewise, a periodic payment at a variable
rate based on a stated schedule for different locales to cover the costs of
driving an automobile in connection with the performance of services as an
employee is an allowance paid at a flat rate or stated schedule. Read Rev.
Proc. 91-67, 1991-52 I.R.B. 11.
A taxpayer may, on a yearly basis, deduct an amount equal to either the business standard
mileage rate times the number of business miles traveled or the actual costs (both operating
and fixed) paid or incurred by the taxpayer that are allocable to traveling those business
miles. Read Rev. Proc. 91-67, 1991-52 I.R.B. 11.
a.
A deduction computed using the standard mileage rate for business miles is in lieu
of operating and fixed costs of the automobile allocable to business purposes. Such
items as depreciation, maintenance and repairs, tires, gasoline (including all taxes
thereon), oil, insurance, and registration fees are included in operating and fixed
costs. Read Rev. Proc. 91-67, 1991-52 I.R.B. 11.
b.
Parking fees and tolls attributable to use of the automobile for business purposes
may be deducted as separate items.
c.
Likewise, interest relating to the purchase of the automobile as well as state and
local taxes (other than those included in the cost of gasoline) may be deducted as
separate items, but only to the extent that the interest and taxes are allowable
deductions under section 163 or section 164, respectively.
d.
If the automobile is operated less than 100% for business purposes, an allocation is
required to determine the business and nonbusiness portion of the taxes and interest
deduction allowable.
(1)
However, section 163(h)(2)(A) expressly provides that interest is
nondeductible personal interest when it is paid or accrued on indebtedness
properly allocable to the trade or business of performing services as an
employee, section 163(h)(2)(A) states as follows:
Section 163. Interest
(h) Disallowance of deduction for personal interest
(2) Personal interest
For purposes of this subsection, the term “personal
interest” means any interest allowable as a
deduction under this chapter other than—
(A) interest paid or accrued on indebtedness
properly allocable to a trade or business (other
than the trade or business of performing services
as an employee),
(2)
Section 164 also expressly provides that state and local taxes that are paid
or accrued by a taxpayer in connection with an acquisition or disposition of
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7.
8.
property will be treated as part of the cost of the acquired property or as a
reduction in the amount realized on the disposition of such property.
Section 164(a) states as follows:
Section 164. Taxes
(a) General rule
Except as otherwise provided in this section, the following
taxes shall be allowed as a deduction for the taxable year
within which paid or accrued:
(1) State and local, and foreign, 2.
(2) State and local personal property taxes.
(3) State and local, and foreign, income, war profits, and
excess profits taxes.
(4) The GST tax imposed on income distributions.
(5) The environmental tax imposed by section 59A.
In addition, there shall be allowed as a deduction
State and local, and foreign, taxes not described in
the preceding sentence which are paid or accrued
within the taxable year in carrying on a trade or
business or an activity described in section 212
(relating to expenses for production of income).
Notwithstanding the preceding sentence, any tax
(not described in the first sentence of this
subsection) which is paid or accrued by the
taxpayer in connection with an acquisition or
disposition of property shall be treated as part of
the cost of the acquired property or, in the case of
a disposition, as a reduction in the amount realized
on the disposition.
The business standard mileage rate may not be used to compute the deductible expenses of:
vehicles used for hire, such as taxicabs; two or more automobiles used simultaneously (such
as in fleet operations); or, any vehicle that is leased, rather than owned, by the taxpayer.
a.
The business standard mileage rate may not be used if: the automobile has
previously been depreciated using a method other than straight-line for its estimated
useful life; additional first-year depreciation has been claimed; or, the taxpayer has
used the accelerated cost recovery system (ACRS) under section 168. By using the
business standard mileage rate, the taxpayer has elected to exclude the automobile
from ACRS pursuant to section 168(f)(1). If, after using the business standard
mileage rate, the taxpayer uses actual costs, the taxpayer must use straight-line
depreciation for the automobile's estimated useful life (subject to the applicable
depreciation deduction limitations under section 280F for any passenger
automobile).
The ordinary and necessary expenses paid or incurred by an employee in driving an
automobile in connection with the performance of services as an employee of the employer
will be deemed substantiated when a payer reimburses such expenses with a mileage
allowance using a flat rate or stated schedule that combines periodic fixed and variable rate
payments or allowance.
a.
The amount of a fixed and variable rate payment or allowance must be based on data
that: is derived from the base locality; reflects retail prices paid by consumers; and,
is reasonable and statistically defensible in approximating the actual expenses of
employees receiving the allowance.
(1)
A fixed and variable rate payment or allowance includes periodic fixed
payments and periodic variable payments. A payer may maintain more than
one fixed and variable rate payment or allowance. A fixed and variable
rate payment or allowance that uses the same payer, standard automobile
(or an automobile of the same make and model that is comparably
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b.
c.
d.
e.
f.
g.
h.
equipped), retention period, and business use percentage is considered one
fixed and variable rate payment or allowance, even though other features
of the allowance may vary.
(2)
A fixed and variable rate payment or allowance also includes any optional
high mileage payments; however, such optional high mileage payments are
included in the employee's gross income, are reported as wages or other
compensation on the employee's W-2 form, and are subject to withholding
and payment of employment taxes when paid.
An optional high mileage payment covers the additional depreciation for a standard
automobile attributable to business miles driven and substantiated by the employee
for a calendar year in excess of the annual business mileage for that year. If an
employee is covered by the fixed and variable rate payment or allowance for less
than the entire calendar year, the annual business mileage may be prorated on a
monthly basis for purposes of the preceding sentence.
A periodic fixed payment covers the projected fixed costs (including depreciation,
insurance, registration and license fees, and personal property taxes) of driving a
standard automobile in connection with the performance of services as an employee
of the employer in a base locality, and must be paid at least quarterly.
(1)
A periodic fixed payment may be computed by: dividing the total projected
fixed costs for the standard automobile for all years of the retention period,
determined at the beginning of the retention period, by the number of
periodic fixed payments in the retention period; and, multiplying the
resulting amount by the business use percentage.
A periodic variable payment covers the projected operating costs (including gasoline
and all taxes thereon, oil, tires, and routine maintenance and repairs) of driving a
standard automobile in connection with the performance of services as an employee
of the employer in a base locality, and must be paid at least quarterly. The rate of
a periodic variable payment for a computation period may be computed by dividing
the total projected operating costs for the standard automobile for the computation
period, determined at the beginning of the computation period, by the computation
period mileage. A computation period can be any period of a year, or less.
Computation period mileage is the total mileage (business and personal) a payer
reasonably projects a standard automobile will be driven during a computation
period and equals the retention mileage divided by the number of computation
periods in the retention period. For each business mile substantiated by the
employee for the computation period, the periodic variable payment must be paid
at a rate that does not exceed the rate for that computation period.
A base locality is the particular geographic locality or region of the United States
in which the costs of driving an automobile in connection with the performance of
services as an employee of the employer are generally paid or incurred by the
employee. Thus, for purposes of determining the amount of fixed costs, the base
locality is generally the geographic locality or region in which the employee resides.
For purposes of determining the amount of operating costs, the base locality is
generally the geographic locality or region in which the employee drives the
automobile in connection with the performance of services as an employee of the
employer.
A standard automobile is the automobile selected by the payer on which a specific
fixed and variable rate payment or allowance is based.
The standard automobile cost for a calendar year may not exceed 95 percent of the
sum of: the retail dealer invoice cost of the standard automobile in the base locality;
and, state and local sales or use taxes applicable on the purchase of such an
automobile. Further, the standard automobile cost may not exceed $22,500.
Annual mileage is the total mileage (business and personal) a payer reasonably
projects a standard automobile will be driven during a calendar year. Annual
mileage equals the annual business mileage divided by the business use percentage.
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i.
9.
Annual business mileage is the mileage a payer reasonably projects a standard
automobile will be driven by an employee in connection with the performance of
services as an employee of the employer during the calendar year, but may not be
less than 6,250 miles for a calendar year. Annual business mileage equals the
annual mileage multiplied by the business use percentage.
j.
A business use percentage is determined by dividing the annual business mileage by
the annual mileage. The business use percentage may not exceed 75%. In lieu of
demonstrating the reasonableness of the business use percentage based on records
of total mileage and business mileage driven by the employees annually, a payer
may use a business use percentage that is less than or equal to the following
percentages for a fixed and variable rate payment or allowance that is paid for the
following annual business mileage:
k.
A retention period is the period in calendar years selected by the payer during which
the payer expects an employee to drive a standard automobile in connection with the
performance of services as an employee of the employer before the automobile is
replaced. Such period may not be less than two calendar years.
l.
Retention mileage is the annual mileage multiplied by the number of calendar years
in the retention period.
If a payer pays a mileage allowance in lieu of reimbursing actual transportation expenses
incurred or to be incurred by an employee, the amount of the expenses that is deemed
substantiated to the payer is either: for any mileage allowance other than a fixed and
variable rate payment or allowance, the lesser of the amount paid under the mileage
allowance or the applicable standard mileage rate multiplied by the number of business miles
substantiated by the employee; or, for a fixed and variable rate payment or allowance, the
amount paid under the fixed and variable rate payment or allowance less the sum of: any
periodic variable rate payment that relates to miles in excess of the business miles
substantiated by the employee and that the employee fails to return to the payer although
required to do so; any portion of a periodic fixed payment that relates to a period during
which the employee is treated as not covered by the fixed and variable rate payment or
allowance and that the employee fails to return to the payer although required to do so; and,
any optional high mileage payments.
a.
If the amount of transportation expenses is deemed substantiated, and the employee
actually substantiates to the payer the elements of time, place (or use), and business
purpose of the transportation expenses, then the employee is deemed to satisfy the
adequate accounting requirements of Reg. §1.274-5T(f), as well as the requirement
to substantiate by adequate records or other sufficient evidence for purposes of Reg.
§1.274-5T(c). Read Reg. §1.62-2(e)(1) for the rule that an arrangement requires
business expenses to be substantiated to the payer within a reasonable period of
time.
b.
An arrangement providing mileage allowances will be treated as satisfying the
requirement of Reg. §1.62-2(f)(2) with respect to returning amounts in excess of
expenses as follows.
(1)
For a mileage allowance other than a fixed and variable rate payment or
allowance, the requirement to return excess amounts will be treated as
satisfied if the employee is required to return within a reasonable period of
time (as defined in Reg. §1.62-2(g)) any portion of such an allowance that
relates to miles of travel not substantiated by the employee, even though the
arrangement does not require the employee to return the portion of such an
allowance that relates to the miles of travel substantiated and that exceeds
the amount of the employee's expenses deemed substantiated.
(a)
For example, assume a payer provides an employee an advance
mileage allowance of $60 based on an anticipated 200 business
miles at 30 cents per mile (at a time when the applicable business
standard mileage rate is 28 cents per mile), and the employee
substantiates 120 business miles.
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(b)
10.
11.
12.
13.
14.
The requirement to return excess amounts will be treated as
satisfied if the employee is required to return the portion of the
allowance that relates to the 80 unsubstantiated business miles
($24), even though the employee is not required to return the
portion of the allowance ($2.40) that exceeds the amount of the
employee's expenses deemed substantiated ($33.60) for the 120
substantiated business miles.
(c)
However, the $2.40 excess portion of the allowance is treated as
paid under a nonaccountable plan.
(2)
For a fixed and variable rate payment or allowance, the requirement to
return excess amounts will be treated as satisfied if the employee is required
to return within a reasonable period of time (as defined in Reg. §1.62-2(g)),
the portion (if any) of the periodic variable payment received that relates to
miles in excess of the business miles substantiated by the employee; and,
the portion (if any) of a periodic fixed payment that relates to a period
during which the employee was not covered by the fixed and variable rate
payment or allowance.
An employee is not required to include in gross income the portion of a mileage allowance
received from a payer that is less than or equal to the amount deemed substantiated. Read
Reg. §1.274-5T(t)(2)(i).
a.
In addition, such portion of the allowance is treated as paid under an accountable
plan, is not reported as wages or other compensation on the employee's W-2 form,
and is exempt from the withholding and payment of employment taxes. Read Reg.
§1.62-2(c)(2) and Reg. §1.62-2(c)(2)(c)(4).
An employee is required to include in gross income only the portion of a mileage allowance
received from a payer that exceeds the amount deemed substantiated. Read Temp. Reg.
§1.274-5T(f)(2)(ii).
a.
In addition, the excess portion of the allowance is treated as paid under a
nonaccountable plan, is reported as wages or other compensation on the employee's
W-2 form, and is subject to withholding and payment of employment taxes. Read
Reg. §1.62-2(c)(3)(ii); Reg. §1.62-2(c)(5); and, Reg. §1.62-2(h)(2)(i)(b).
If the amount of the expenses deemed substantiated under the rules provided above is less
than the amount of the employee's business transportation expenses, the employee may claim
an itemized deduction for the amount by which the business transportation expenses exceed
the amount that is deemed substantiated, provided the employee substantiates all the business
transportation expenses, includes on IRS Form 2106, employee business expenses, the
deemed substantiated portion of the mileage allowance received from the payer, and includes
in gross income the portion (if any) of the mileage allowance received from the payer that
exceeds the amount deemed substantiated. Read Reg. §1.274-5T(f)(2)(iii).
a.
However, for purposes of claiming this itemized deduction, substantiation of the
amount of the expenses is not required if the employee is claiming a deduction that
is equal to or less than the applicable standard mileage rate multiplied by the number
of business miles substantiated by the employee minus the amount deemed
substantiated. The itemized deduction is subject to the 2% floor on miscellaneous
itemized deductions.
Read section 67(a), which states as follows:
Section 67. 2-percent floor on miscellaneous itemized deductions
(a) General rule. In the case of an individual, the miscellaneous itemized
deductions for any taxable year shall be allowed only to the extent that the
aggregate of such deductions exceeds 2 percent of adjusted gross income.
An employee may deduct an amount computed only as an itemized deduction. This itemized
deduction is subject to the 2% floor on miscellaneous itemized deductions provided in
section 67.
A self-employed individual may deduct an amount to AGI.
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15.
Read section 62(a)(1), which states as follows:
Section 62. Adjusted gross income defined.
(a) General rule. For purposes of this subtitle, the term “adjusted gross income”
means, in the case of an individual, gross income minus the following
deductions:
(1) Trade and business deductions
The deductions allowed by this chapter (other than by part VII of
this subchapter) which are attributable to a trade or business carried
on by the taxpayer, if such trade or business does not consist of the
performance of services by the taxpayer as an employee.
If a payer's reimbursement or other expense allowance arrangement evidences a pattern of
abuse of the rules of section 62(c) and the regulations thereunder, all payments under the
arrangement will be treated as made under a nonaccountable plan. Thus, such payments are
included in the employee's gross income, are reported as wages or other compensation on
the employee's W-2 form, and are subject to withholding and payment of employment taxes.
Read: Reg. §1.62-2(c)(3); Reg. §1.62-2(c)(3)(c)(5); and, Reg. §1.62-2(c)(3)(h)(2).
P.
Transportation after taxpayer arrives at work.
1.
Read Rev. Rul. 55-109, 1955-1 C.B. 261.
2.
Read Rev. Rul. 90-23, 1990-1 C.B. 28.
3.
If a taxpayer has a regular place of business, transportation expenses between the taxpayer's
residence and a temporary work location are deductible regardless of whether or not the
temporary location is inside or outside the metropolitan area in which the taxpayer ordinarily
works.
4.
Example. If an attorney stops for a meeting with a client on the attorney's way to work, both
the transportation expenses from the attorney's residence to the meeting with the client and
the transportation expenses from the meeting place to the attorney's regular place of work
are deductible.
5.
If a taxpayer ordinarily works at temporary job sites in a particular metropolitan area but has
no regular place of work, transportation is deductible between the taxpayer's residence and
temporary work locations outside the metropolitan area, but not temporary work locations
within the metropolitan area. Read Rev. Rul. 190, 1953-2 C.B. 303; Rev. Rul. 94-47,
1994-29 I.R.B. 6.
6.
Transportation between a taxpayer's residence and a regular place of business is
nondeductible, even if the place of business is secondary or located outside the metropolitan
area in which the taxpayer ordinarily works.
a.
Thus, transportation between a doctor's residence and one or more offices, clinics,
or hospitals at which the doctor works on a regular basis is nondeductible.
b.
A lawyer whose permanent residence was in Jackson, Mississippi, but who was
employed as vice-president and general counsel of a railroad with business
headquarters in Mobile, Alabama, was denied a deduction for traveling from
Jackson to Mobile. See Commissioner v. Flowers, 326 U.S. 465 (1946).
c.
A Harvard law student, who had a residence in Boston where the law student's
husband was employed full-time, was denied a deduction for travel and living
expenses in connection with a summer job in New York city on the ground that
because the law student had no business ties to Boston the law student's decision to
maintain the law student's residence there was purely personal. See Hantzis v.
Commissioner, 638 F.2d 248 (1st Cir. 1981).
Q.
Rent paid for property used in a trade or business
1.
Read section 162(a)(3), which states as follows:
Section 162. Trade or business expenses.
(a) In general. There shall be allowed as a deduction all the ordinary and necessary
expenses paid or incurred during the taxable year in carrying on any trade
or business, including—
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2.
3.
R.
(3) rentals or other payments required to be made as a condition to the
continued use or possession, for purposes of the trade or business,
of property to which the taxpayer has not taken or is not taking title
or in which he has no equity.
If rental payments are higher than the fair rental value of the property and the lessee has an
option to acquire title to the property at some point for a price less than the fair market value,
then the transaction may be characterized as an installment purchase rather than a lease.
a.
The lessee is then required to capitalize the payments under the lease, except for
interest, and recover the lessee's investment through depreciation deductions over
the useful life of the property. Similarly, the lessor is viewed as making an
installment sale of the property in this situation, giving rise to gain or loss from the
sale of property rather than rental income.
A lease may also be characterized as a mere financing arrangement, particularly when the
rental payments are geared to cover the lessor's principal and interest payments on a loan
taken out to finance the acquisition of the property. In such cases, the lessee is treated as the
true owner of the property and the lessor is viewed as being a lender.
No deduction is allowable for certain illegal payments.
1.
For example, no deduction is allowable for payments which are for illegal bribes or
kickbacks to government officials or employees.
2.
Further, no deduction is allowable for any other payments that are illegal under federal law
or under a generally enforced state law,that subjects the payer to criminal penalties or loss
of license or privilege to engage in a trade or business.
Read section 162 (c), which states as follows:
Section 162. Trade or business expenses.
(c) Illegal bribes, kickbacks, and other payments
(1) Illegal payments to government officials or employees
No deduction shall be allowed under subsection (a) for any
payment made, directly or indirectly, to an official or employee of
any government, or of any agency or instrumentality of any
government, if the payment constitutes an illegal bribe or kickback
or, if the payment is to an official or employee of a foreign
government, the payment is unlawful under the Foreign Corrupt
Practices Act of 1977. The burden of proof in respect of the issue,
for the purposes of this paragraph, as to whether a payment
constitutes an illegal bribe or kickback (or is unlawful under the
Foreign Corrupt Practices Act of 1977) shall be upon the Secretary
to the same extent as he bears the burden of proof under section
7454 (concerning the burden of proof when the issue relates to
fraud).
(2) Other illegal payments
No deduction shall be allowed under subsection (a) for any
payment (other than a payment described in paragraph (1)) made,
directly or indirectly, to any person, if the payment constitutes an
illegal bribe, illegal kickback, or other illegal payment under any
law of the United States, or under any law of a State (but only if
such State law is generally enforced), which subjects the payor to
a criminal penalty or the loss of license or privilege to engage in a
trade or business. For purposes of this paragraph, a kickback
includes a payment in consideration of the referral of a client,
patient, or customer. The burden of proof in respect of the issue, for
purposes of this paragraph, as to whether a payment constitutes an
illegal bribe, illegal kickback, or other illegal payment shall be
upon the Secretary to the same extent as he bears the burden of
proof under section 7454 (concerning the burden of proof when the
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3.
S.
issue relates to fraud).
(3) Kickbacks, rebates, and bribes under medicare and medicaid
No deduction shall be allowed under subsection (a) for any
kickback, rebate, or bribe made by any provider of services,
supplier, physician, or other person who furnishes items or services
for which payment is or may be made under the Social Security
Act, or in whole or in part out of Federal funds under a State plan
approved under such Act, if such kickback, rebate, or bribe is made
in connection with the furnishing of such items or services or the
making or receipt of such payments. For purposes of this
paragraph, a kickback includes a payment in consideration of the
referral of a client, patient, or customer.
Further, no deduction is allowable for any fine or similar penalty paid to a government for
violation of any law.
Read section 162(f), which states as follows:
Section 162. Trade or business expenses
(f) Fines and penalties
No deduction shall be allowed under subsection (a) for any fine or similar
penalty paid to a government for the violation of any law.
In general, lobbying expenses are not deductible.
1.
However, fees paid to individuals for appearances before local city or county councils in
connection with legislation of direct interest to the taxpayer are deductible. Read 162(e).
2.
Expenses for "grassroots" lobbying of the general public or for political campaigning are
not deductible.
Read section 162(e), which states as follows:
Section 162. Trade or business expenses
(e) Denial of deduction for certain lobbying and political expenditures
(1) In general
No deduction shall be allowed under subsection (a) for any amount
paid or incurred in connection with—
(A) influencing legislation,
(B) participation in, or intervention in, any political campaign on
behalf of (or in opposition to) any candidate for public
office,
(C) any attempt to influence the general public, or segments
thereof, with respect to elections, legislative matters, or
referendums, or
(D) any direct communication with a covered executive branch
official in an attempt to influence the official actions or
positions of such official.
(2) Exception for local legislation
In the case of any legislation of any local council or similar
governing body—
(A) paragraph (1)(A) shall not apply, and
(B) the deduction allowed by subsection (a) shall include all
ordinary and necessary expenses (including, but not
limited to, traveling expenses described in subsection
(a)(2) and the cost of preparing testimony) paid or incurred
during the taxable year in carrying on any trade or
business—
(i) in direct connection with appearances before,
submission of statements to, or sending
communications to the committees, or individual
members, of such council or body with respect to
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legislation or proposed legislation of direct interest
to the taxpayer, or
(ii) in direct connection with communication of informa
tion between the taxpayer and an organization of
which the taxpayer is a member with respect to
any such legislation or proposed legislation which
is of direct interest to the taxpayer and to such
organization,
and that portion of the dues so paid or incurred
with respect to any organization of which the
taxpayer is a member which is attributable to the
expenses of the activities described in clauses (i)
and (ii) carried on by such organization.
(3) Application to dues of tax-exempt organizations
No deduction shall be allowed under subsection (a) for the portion
of dues or other similar amounts paid by the taxpayer to an
organization which is exempt from tax under this subtitle which the
organization notifies the taxpayer under section 6033 (e)(1)(A)(ii)
is allocable to expenditures to which paragraph (1) applies.
(4) Influencing legislation
For purposes of this subsection—
(A) In general
The term “influencing legislation” means any attempt to
influence any legislation through communication with any
member or employee of a legislative body, or with any
government official or employee who may participate in
the formulation of legislation.
(B) Legislation
The term “legislation” has the meaning given such term by
section 4911 (e)(2).
(5) Other special rules
(A) Exception for certain taxpayers
In the case of any taxpayer engaged in the trade or
business of conducting activities described in paragraph
(1), paragraph (1) shall not apply to expenditures of the
taxpayer in conducting such activities directly on behalf of
another person (but shall apply to payments by such other
person to the taxpayer for conducting such activities).
(B) De minimis exception
(i) In general Paragraph (1) shall not apply to any in-house
expenditures for any taxable year if such
expenditures do not exceed $2,000. In determining
whether a taxpayer exceeds the $2,000 limit under
this clause, there shall not be taken into account
overhead costs otherwise allocable to activities
described in paragraphs (1)(A) and (D).
(ii) In-house expenditures For purposes of clause (i), the
term “in-house expenditures” means expenditures
described in paragraphs (1)(A) and (D) other
than—
(I) payments by the taxpayer to a person engaged
in the trade or business of conducting
activities described in paragraph (1) for
the conduct of such activities on behalf of
the taxpayer, or
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3.
(II) dues or other similar amounts paid or incurred
by the taxpayer which are allocable to
activities described in paragraph (1).
(C) Expenses incurred in connection with lobbying and political
activities
Any amount paid or incurred for research for, or
preparation, planning, or coordination of, any activity
described in paragraph (1) shall be treated as paid or
incurred in connection with such activity.
(6) Covered executive branch official
For purposes of this subsection, the term “covered executive branch
official” means—
(A) the President,
(B) the Vice President,
(C) any officer or employee of the White House Office of the
Executive Office of the President, and the 2 most senior
level officers of each of the other agencies in such
Executive Office, and
(D)
(i) any individual serving in a position in level I of the
Executive Schedule under section 5312 of title 5,
United States Code,
(ii) any other individual designated by the President as
having Cabinet level status, and
(iii) any immediate deputy of an individual described in
clause (i) or (ii).
(7) Special rule for Indian tribal governments
For purposes of this subsection, an Indian tribal government shall
be treated in the same manner as a local council or similar
governing body.
(8) Cross reference
For reporting requirements and alternative taxes related to this
subsection, see section 6033 (e).
Example. During the current year, Alan, who is an employee Floppy Corporation, had AGI
of $100,000, all of which is Alan's salary, and Alan made the following expenses or
expenditures during the current year.
Cash contribution to a federal congressional campaign . . . . . . . . . . . . . . . . . . . . . $1,000
Airplane expense to travel to federal congresswoman's office in order
to influence the congresswoman to vote for legislation which would
help Alan's business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,000
a.
The amount of Alan's taxable income for the current year with respect to these facts
is as follows. Any amount paid or incurred in influencing legislation is not
deductible. Read section 162(e)(1)(A), which states as follows:
Section 162. Trade or business expenses
(e) Denial of deduction for certain lobbying and political expenditures
(1) In general
No deduction shall be allowed under subsection (a) for any
amount paid or incurred in connection with—
(A) influencing legislation,
Therefore, contributions to congressional campaigns are not deductible. Because
Alan is single, Alan's standard deduction $5,000. Alan's taxable income is as
follows.
Adjusted gross income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 100,000
Minus: standard deduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000
personal exemption . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3,000
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Taxable income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $
T.
V.
92,000
Payments for education expensive.
1.
A deduction may be denied for education expenses on the ground that such expenses are
primarily personal or that they constitute a capital expenditure or both. Read Reg. §1.162-5.
2.
To be deductible as a business expense, the education must either of the following.
a.
Maintain or improve skills required in the taxpayer's trade or business. or
b.
Meet requirements imposed by an employer or by law as a condition to retaining
employment or status.
3.
However, even if one or both of these conditions is met, no deduction is allowable for the
following.
a.
The minimum education necessary for the taxpayer's employment or other business,
or
b.
Education that qualifies the taxpayer for a new trade or business, whether or not the
taxpayer intends to engage in that trade or business.
(1)
For example, the cost of going to law school and the cost of taking a bar
review course are not deductible.
(2)
However, the cost of certain law courses taken by doctors might be
deductible.
4.
Deductible education expenses include travel expenses incurred in connection with obtaining
such education, but travel cannot be considered a form of education.
Read section 274(m)(2).
Section 274. Disallowance of certain entertainment, etc., expenses.
(m) Additional limitations on travel expenses
(2) Travel as form of education
No deduction shall be allowed under this chapter for expenses for
travel as a form of education
a.
For example, a French teacher cannot deduct the cost of traveling to France on the
theory that the trip is a form of education related to the French teacher's trade or
business.
Some examples.
1.
Example. During the current year, Mary, who was president of Winner College and who
received a salary of $100,000, was asked, by the college's board of trustee's to attend the
class reunion of the class of 1950 in Dallas, Texas. Mary was told that if Mary took John,
then Mary would be reimbursed for both Mary's and John's expenses. Mary did this, and
thus, Mary was reimbursed for a total of $2,000 of reasonable travel expenses, 50% of which
were Mary's and 50% of which were John's.
a.
The total character and amount of Mary's and John's gross income for the current
year as a result of the reimbursement is as follows. Mary's salary of $100,000 is
includible in Mary's gross income. The reimbursement of travel expenses is also
includible in Mary's gross income. Therefore, the answer is $102,000 ordinary
income.
b.
The amount of Mary's and John's AGI for the current year is as follows. Mary's
travel expense is deductible, John's is not. Because 50% of the travel expense are
attributable to John, $1,000 of the $2,000 reimbursement is deductible in arriving
at AGI. Mary's and John's AGI will be $101,000 ($102,000 - $1,000). Therefore
the answer is $101,000.
2.
Example. During the current year, Alan, who is an employee of Jeffrey Corporation, had
AGI of $30,000 of which $29,000 is Alan's salary and $1,000 is from Indiana Bank savings
account interest (without taking into account the information which is hereinafter stated in
this paragraph) and Alan made the following expenses or expenditures during the current
year. None of the expenses or expenditures were reimbursed.
Publications to learn how to be a better salesman . . . . . . . . . . . . . . . . . . . . . $500
Course tuition to learn how to be a better salesman . . . . . . . . . . . . . . . . . . . $500
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3.
4.
Transportation expenses for Alan to drive to and from Alan's
home to Alan's employment office . . . . . . . . . . . . . . . . . . . . . . . . $5,000
Moving expenses so that Alan could take another job (all of
these expenses are deductible) . . . . . . . . . . . . . . . . . . . . . . . . . . $10,000
a.
The amount of Alan's taxable income for the current year with respect to these facts
is as follows.
Education expenses are deductible if made by an individual to maintain or improve
skills required in the individual's business or employment. Read Reg. §1.162-5.
Here, the publications and the course tuition are deductible. Expenses of commuting
between an individual's residence and the individual's regular business location are
not deductible. Read Reg. §1.162-2(e) and Reg. §1.162-2(f). A taxpayer's
unreimbursed expenses in moving from the taxpayer's former residence to a new
residence are deducible if the move results from a change in the individual's
principal place of work and if distance and time working at the new location tests
are met. This expense is deductible in arriving at AGI.
Read section 217(a).
Section 217. Moving expenses.
(a) Deduction allowed
There shall be allowed as a deduction moving expenses paid or
incurred during the taxable year in connection with the
commencement of work by the taxpayer as an employee or as a
self-employed individual at a new principal place of work.
Alan's adjusted gross income is determined as follows.
Gross income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 30,000
Minus: moving expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000
Adjusted gross income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 20,000
b.
The publications expense and tuition expense are both deductible from AGI. They
are itemized deductions, subject to the 2% test.
c.
The total allowable itemizable deductions are:
Publications . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 500
Tuition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500
Total itemizable deductions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000
Adjusted gross income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000
2% limitation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . x
.02
2% floor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400
Total itemizable deductions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000
2% floor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . - 400
Itemized deduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 600
d.
Because the itemized deductions are less than the standard deduction of $5,000 Alan
will take a standard deduction. Alan's taxable income is as follows.
Adjusted gross income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 20,000
Minus: standard deduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000
Personal exemption . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000
Taxable income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 12,000
Example. During the current year, Sue owed $1,000 of interest with respect to an Indiana
Bank loan which was made to Sue in order to help Sue's sole proprietorship keep operating.
During the current year, Mary paid the interest to Indiana Bank as a gift to Sue.
a.
Mary's paying off Sue's debt is considered a gift. Gifts are excludable from gross
income. Therefore, the answer is none.
b.
Only Sue, the indebted person, may deduct business interest. Even though Mary
pays the debt, Sue may take the deduction. Therefore, the answer is $1,000 ordinary
deduction to AGI
c.
Mary's paying Sue's debt is a gift. Gifts are not deductible. Therefore, the answer
is none.
Example. During the current year, Alan was employed by Wright Corporation as an outside
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.
5.
6.
salesman and received a salary of $30,000. In addition, Alan was reimbursed $5,000 for
$7,000 of business transportation expenses which Alan paid during the current year.
The amount of Alan's gross income for the current year is as follows. Reimbursements are
treated as gross income and are deducted at AGI.
Salary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000
Reimbursements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . + 5,000
Gross income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35,000
Minus: reimbursed business expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000
Adjusted gross income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000
Alan also had unreimbursed business expenses of $2,000. This latter amount is deductible
from AGI but is subject to the 2% test. Therefore, the allowable itemizable deduction would
be $30,000 x .02 = $600; $2,000 - $600 = $1,400. However, because Alan’s standard
deduction of $5,000 is greater than Alan’s itemizable deductions of $1,400, Alan will take
the standard deduction. Therefore:
Adjusted gross income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000
Minus: standard deduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000
personal exemption . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000
Taxable income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22,000
Example. During the current year, Alan was employed by Wright Corporation as a salesman
of illegal drugs and received a salary of $30,000. In addition, Alan had reimbursed business
entertainment expenses of $2,000 for expenses which Alan paid during the current year.
a.
The amount of Alan's gross income for the current year is as follows.
Salary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 30,000
Reimbursement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . + 2,000
Gross income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 32,000
Therefore, the answer is $32,000.
b.
The amount of Alan's AGI for the current year is as follows.
Even though Alan was involved in an illegal activity, Alan may, nevertheless,
deduct the business entertainment expenses of $2,000. The reimbursed
entertainment expense is deductible. Alan’s AGI is:
Gross income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 32,000
Minus: entertainment expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2,000
Adjusted gross income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 30,000
c.
The amount of Alan's taxable income for the current year is as follows.
Adjusted gross income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 30,000
Minus: standard deduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000
Personal exemption . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000
Taxable income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 22,000
Therefore, the answer is $23,000.
Example. During the current year, Alan was employed by Tops Corporation as a salesman
and received a salary of $30,000. In addition, Alan had unreimbursed business accounting
expenses of $7,500 which Alan paid during the current year. The amount of Alan's gross
income for the current year is as follows. Alan did not get reimbursed for Alan's business
expenses hence Alan's gross income is $30,000.
a.
The amount of Alan's AGI for the current year is as follows.
Alan does not have any deductions in arriving at AGI. Therefore, Alan’s AGI is
$30,000.
b.
The amount of Alan's taxable income for the current year is as follows.
Unreimbursed business expenses are deductible from AGI subject to the 2% test.
Therefore, the allowable itemizable deductions are as follows.
$30,000
$7,500
600
x
.02
600
$6,900
$6,900 > $4,000, therefore Alan will utilize the itemized deductions.
Alan's taxable income is as follows.
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7.
8.
Adjusted gross income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 30,000
Minus: itemized deductions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,900
Personal exemption . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000
Taxable income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 20,100
Therefore, the answer is $20,100.
Example. During the current year, Alan, who is blind, was employed by Elegant
Corporation as a salesman and received a salary of $100,000. In addition, Alan paid $10,000
for business entertainment expenses, 80% of which was reimbursed by Alan's employer, and
$10,000 of business travel meals, 80% of which was reimbursed by Alan's employer. The
amount of Alan's gross income for the current year with respect to these facts is as follows.
a.
Salary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 100,000
80% reimbursed entertainment expense . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000
80% reimbursed travel meals expense . . . . . . . . . . . . . . . . . . . . . . . . . . + 8,000
Gross income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 116,000
b.
The amount of Alan's AGI is as follows.
An employee may deduct from gross income reimbursed employee expenses.
Read section 62(a)(2)(A).
Section 62. Adjusted gross income defined
(a) General rule. For purposes of this subtitle, the term “adjusted gross
income”
means, in the case of an individual, gross income minus the
following deductions:
(2) Certain trade and business deductions of employees
(A) Reimbursed expenses of employees
The deductions allowed by part VI (section 161
and following) which consist of expenses paid or
incurred by the taxpayer, in connection with the
performance by him of services as an employee,
under a reimbursement or other expense allowance
arrangement with his employer. The fact that the
reimbursement may be provided by a third party
shall not be determinative of whether or not the
preceding sentence applies.
Reimbursed business entertainment and travel expenses are deductible in full in
arriving at AGI. Read section 274(n)(2)(A).
Section 274. Disallowance of certain entertainment, etc., expenses
(n) Only 50 percent of meal and entertainment expenses allowed as
deduction
(2) Exceptions
Paragraph (1) shall not apply to any expense if—
(A) such expense is described in paragraph (2), (3), (4),
(7), (8), or (9) of subsection (e),
Alan's AGI is as follows.
Gross income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 116,000
Minus: 80% reimbursed entertainment expense . . . . . . . . . . . . . . . . . . . . . 8,000
80% reimbursed travel meals expense . . . . . . . . . . . . . . . . . . . . . . . . . . .
8,000
Adjusted gross income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 100,000
Example. During last year, John gave Alan, an employee of John, as a bonus, some Hero
Corporation's common shares which John had held for two years and which had a fair market
value of $5,000 at the time when John transferred the common shares to Alan. Alan sold the
common shares one month later, during the current year, for $4,000.
a.
The income tax result to John for last year due to the transfer of the common shares
to Alan is as follows.
Amount realized . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,000
Minus: adjusted basis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
5,000
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9.
10.
VI.
Short term capital loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (1,000)
Therefore, the answer is $1,000 short term capital loss, deductible in arriving at
AGI.
If Alan had sold the stock for $6,000 then:
Amount realized . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 6,000
Minus: adjusted basis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000
Short term capital gain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,000
The transfer of stock to Alan was compensation and deductible to John. Therefore,
the answer is $5,000 ordinary deduction, deductible in arriving at AGI.
Example. John died on July 1 of the current year. With respect to John's final taxable
period, John had a net operating loss (from John's sole proprietorship book sales business)
of $10,000. John had net operating losses for the prior three years for a total of $30,000.
During the first taxable period of the estate, the estate continued to operate the business, as
a sole proprietorship of the estate and the estate received $50,000 of gross income from the
business and the estate paid business expenses of $10,000. The estate was not required to
distribute any net income to any beneficiary during the estate's first taxable period and that
the estate did not make any such distribution.
a.
The amount of John's net operating loss which the estate may deduct for the first
taxable period of the estate is as follows. Net operating losses may be carried back
two years and forward 20 years. This carry forward provision terminates at death.
The estate may not deduct any of John's net operating loss. Therefore, the answer
is none.
b.
The amount of the estate's taxable income for the estate's first taxable period is as
follows.
Gross income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 50,000
Minus: operating expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000
Standard deduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
600
Taxable income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 39,400
Therefore, the answer is $39,400.
Example. John died on July 1 of the current year. With respect to John's final taxable
period, John had no gross income and John had a long term capital loss (from John's sales
of securities) of $30,000. During the first taxable period of the estate, the estate received
$150,000 of long term capital gains (from the estate's sales of securities).
a.
The amount of John's long term capital loss which the estate may deduct for the first
taxable period of the estate is as follows. Capital losses may be carried forward until
the taxpayer dies. The estate may not deduct the capital losses sustained before John
died. Therefore, the answer is none.
Some questions.
1.
Question 1. For many years, John sold diamonds for a living. During the current year, John
sold a diamond to Peter for $15,000, and which had cost John $20,000. John's ordinary
expense or ordinary loss deduction for the current year with respect to the sale of the
diamond to Peter is as follows.
a.
None/Zero
b.
$5,000
c.
$20,000
d.
$15,000
e.
No prior stated answer
2.
Question 2. For many years, John sold diamonds for a living. During the current year, John
sold a diamond, which had cost John $20,000 to Bright Corporation for $15,000. John
owned all of the common shares of Bright Corporation. John's ordinary expense or ordinary
loss deduction for the current year with respect to the sale of the diamond to Bright
Corporation is as follows.
a.
None/Zero
b.
$5,000
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3.
4.
5.
6.
7.
8.
9.
10.
c.
$20,000
d.
$15,000
e.
No prior stated answer
Question 3. At the time when Mary died, Mary owed interest on Mary's business credit card
account of $1,000. The executor of the estate paid the interest during the current year. The
estate's ordinary income tax deduction for the current year with respect to the interest is as
follows.
a.
None/Zero
b.
$1,000
c.
No prior stated answer
Question 4. Referring to question 3, Mary's ordinary income tax deduction for the current
year with respect to the payment of the interest is as follows.
a.
None/Zero
b.
$1,000
c.
No prior stated answer
Question 5. Referring to question 3, Mary used the accrual method of accounting. The
estate's ordinary income tax deduction for the current year with respect to the payment of the
interest is as follows.
a.
None/Zero
b.
$1,000
c.
No prior stated answer
Question 6. At the time when Mary died, Mary owed interest on Mary's business credit card
account of $2,000. The executor of the estate paid the interest during the current year. The
estate's ordinary expense or ordinary loss deduction for the current year with respect to the
interest is as follows.
a.
None/Zero
b.
$2,000
c.
No prior stated answer
Question 7. Referring to question 6, Mary's ordinary expense or ordinary loss deduction for
the current year with respect to the payment of the interest is as follows.
a.
None/Zero
b.
$2,000
c.
No prior stated answer
Question 8. Referring to question 6, Mary used the accrual method of accounting. The
estate's ordinary expense or ordinary loss deduction for the current year with respect to the
payment of the interest is as follows.
a.
None/Zero
b.
$2,000
c.
No prior stated answer
Question 9. John died on July 1 of the current year. With respect to John's final taxable
period, John had a net operating loss (from John's sole proprietorship book sales business)
of $10,000. Further, John had a net operating loss of $10,000 for each of the prior three
years. During the first taxable period of the estate, the estate continued to operate the
business, as a sole proprietorship of the estate and the estate received $15,000 of ordinary
income from the business and the estate paid business expenses with respect to the business
of $10,000. The estate was not required to distribute any net income to any beneficiary
during the estate's first taxable period and the estate did not make any such distribution. The
estate's total income tax deductions for the estate's first taxable period of the estate with
respect to these facts is as follows.
a.
None/Zero
b.
$50,000
c.
$10,000
d.
$15,000
e.
No prior stated answer
Question 10. John died on July 1 of the current year. With respect to John's final taxable
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11.
12.
13.
14.
15.
B.
period, John had a net operating loss (from John's sole proprietorship book sales business)
of $20,000. Further, John had a net operating loss of $10,000 for each of the prior three
years. During the first taxable period of the estate, the estate continued to operate the
business, as a sole proprietorship of the estate and the estate received $15,000 of ordinary
gross income from the business and the estate paid business expenses with respect to the
business of $10,000. The estate was not required to distribute any net income to any
beneficiary during the estate's first taxable period and the estate did not make any such
distribution. The estate's total income tax deductions for the estate's first taxable period of
the estate with respect to these facts is as follows
a.
None/Zero
b.
$60,000
c.
$10,600
d.
$15,600
e.
No prior stated answer
Question 11. John died on July 1 of the current year. With respect to John's final taxable
period, John had no gross income and John had a long term capital loss carry forward (from
John's sales of securities in prior years) of $10,000. During the first taxable period of the
estate, the estate received $150,000 of long term capital gains (from the estate's sales of
securities). The estate's income tax deduction for the first taxable period of the estate with
respect to John's long term capital loss carryover of $10,000 with respect to these facts is as
follows.
a.
None/Zero
b.
$10,000
c.
No prior stated answer
Question 12. John died on July 1 of the current year. With respect to John's final taxable
period, John had no gross income and John had a long term capital loss carry forward (from
John's sales of securities in prior years) of $20,000. During the first taxable period of the
estate, the estate received $15,000 of long term capital gains (from the estate's sales of
securities) and $25,000 of dividends. The estate's income tax deduction for the first taxable
period of the estate with respect to John's long term capital loss carry forward to these facts
is as follows.
a.
None/Zero
b.
$18,600
c.
$20,600
d.
$18,000
e.
No prior stated answer
Question 13. During the current year, Sue owed $1,000 of interest with respect to an Indiana
Bank loan which was made to Sue in order to help Sue's sole proprietorship keep operating.
During the current year, Mary paid the interest to Indiana Bank as a gift to Sue. Sue's
ordinary income for the current year with respect to the payment of the interest is as follows.
a.
None/Zero
b.
$1,000
c.
No prior stated answer
Question 14. Referring to question 13, Sue's ordinary income tax deduction for the current
year with respect to the payment of the interest is as follows.
a.
None/Zero
b.
$1,000
c.
No prior stated answer
Question 15. Referring to question 13, Mary's ordinary income tax deduction for the current
year with respect to the payment of the interest is as follows.
a.
None/Zero
b.
$1,000
c.
No prior stated answer
Dividends distributed from a C corporation to the C corporation’s shareholders.
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1.
A somewhat similar situation is when a C corporation distributes money or property, as
dividends, to the C corporation's shareholders. The C corporation may not deduct the
dividend distribution. However, the distribution is gross income to the recipient.
a.
A dividend is defined, under section 316, as a distribution by a corporation to a
shareholder during a year in which the corporation had current or accumulated
earnings and profits, Section 316(a) states as follows:
Section 316. Dividend defined
(a) General rule
For purposes of this subtitle, the term “dividend” means any
distribution of property made by a corporation to its shareholders—
(1) out of its earnings and profits accumulated after
February 28, 1913, or
(2) out of its earnings and profits of the taxable year
(computed as of the
close of the taxable year without diminution by
reason of any distributions made during the
taxable year), without regard to the amount of the
earnings and profits at the time the distribution
was made.
Except as otherwise provided in this subtitle, every distribution is made out
of earnings and profits to the extent thereof, and from the most recently
accumulated earnings and profits. To the extent that any distribution is,
under any provision of this subchapter, treated as a distribution of property
to which section 301 applies, such distribution shall be treated as a
distribution of property for purposes of this subsection.
b.
2.
Further, dividend distributions by a C corporation to shareholders will cause double
income taxation to occur because, in all likelihood, because the C corporation was
income taxed when the C corporation received the amount which the C corporation
distributed to the shareholder as a dividend, and then, the C corporation could not
deduct, for income tax purposes, the dividend which the C corporation distributed
to the shareholder, but nevertheless, the shareholder must include such dividend in
the shareholder's gross income.
(1)
Thus, the funds which are used for the dividend distribution may be subject
to double income taxation.
A C corporation might mitigate the harsh effects of double income taxation by paying a
salary to the shareholder rather than paying a dividend to the shareholder.
a.
However, compensation must be reasonable in order to obtain an income tax
deduction. No portion of the salary paid which is unreasonable compensation is
deductible. Read section 162(a).
Section 162. Trade or business expenses.
(a) In general. There shall be allowed as a deduction all the ordinary and
necessary expenses paid or incurred during the taxable year in
carrying on any trade or business, including—
(1) a reasonable allowance for salaries or other compensation for
personal services actually rendered;
(2) traveling expenses (including amounts expended for meals and
lodging other than amounts which are lavish or extravagant
under the circumstances) while away from home in the
pursuit of a trade or business; and
(3) rentals or other payments required to be made as a condition to
the continued use or possession, for purposes of the trade
or business, of property to which the taxpayer has not
taken or is not taking title or in which he has no equity.
For purposes of the preceding sentence, the place of
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3.
residence of a Member of Congress (including any
Delegate and Resident Commissioner) within the State,
congressional district, or possession which he represents in
Congress shall be considered his home, but amounts
expended by such Members within each taxable year for
living expenses shall not be deductible for income tax
purposes in excess of $3,000. For purposes of paragraph
(2), the taxpayer shall not be treated as being temporarily
away from home during any period of employment if such
period exceeds 1 year. The preceding sentence shall not
apply to any Federal employee during any period for
which such employee is certified by the Attorney General
(or the designee thereof) as traveling on behalf of the
United States in temporary duty status to investigate or
prosecute, or provide support services for the investigation
or prosecution of, a Federal crime.
If a shareholder is paid unreasonable compensation, then the unreasonable compensation
might be recharacterized as a constructive dividend.
a.
In such a case, the shareholder would still include the distribution in the
shareholder's gross income, but the C corporation would not be entitled to an income
tax deduction for the distribution (whether or not the distribution is categorized as
a dividend or as unreasonable compensation).
b.
Thus, if, for example, a C corporation pays a shareholder reasonable compensation
for services which the shareholder has rendered to the C corporation or reasonable
rent with respect to property which the C corporation has rented from the
shareholder or reasonable interest with respect to a loan which the shareholder has
made to the C corporation, then the C corporation may be entitled to an income tax
deduction for the expense.
Read section 162(a), which states as follows:
Section 162. Trade or business expenses.
(a) In general.
There shall be allowed as a deduction all the ordinary and
necessary expenses paid or incurred during the taxable year in
carrying on any trade or business, including—
(1) a reasonable allowance for salaries or other compensation for
personal services actually rendered;
(2) traveling expenses (including amounts expended for meals and
lodging other than amounts which are lavish or extravagant
under the circumstances) while away from home in the
pursuit of a trade or business; and
(3) rentals or other payments required to be made as a condition to
the continued use or possession, for purposes of the trade
or business, of property to which the taxpayer has not
taken or is not taking title or in which he has no equity.
For purposes of the preceding sentence, the place of
residence of a Member of Congress (including any
Delegate and Resident Commissioner) within the State,
congressional district, or possession which he represents in
Congress shall be considered his home, but amounts
expended by such Members within each taxable year for
living expenses shall not be deductible for income tax
purposes in excess of $3,000. For purposes of paragraph
(2), the taxpayer shall not be treated as being temporarily
away from home during any period of employment if such
period exceeds 1 year. The preceding sentence shall not
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(1)
(2)
VII.
apply to any Federal employee during any period for
which such employee is certified by the Attorney General
(or the designee thereof) as traveling on behalf of the
United States in temporary duty status to investigate or
prosecute, or provide support services for the investigation
or prosecution of, a Federal crime.
In such a case, the C corporation would be offsetting gross income which
would otherwise be subject to the corporate income tax and the shareholder
would still include the compensation, rent, or interest in the taxpayer’s gross
income. Read section 61(a).
Section 61. Gross income defined
(a) General definition
Except as otherwise provided in this subtitle, gross income means
all income from whatever source derived, including (but not limited
to) the following items:
(1) Compensation for services, including fees, commissions, fringe
benefits, and similar items;
(2) Gross income derived from business;
(3) Gains derived from dealings in property;
(4) Interest;
(5) Rents;
(6) Royalties;
(7) Dividends;
(8) Alimony and separate maintenance payments;
(9) Annuities;
(10) Income from life insurance and endowment contracts;
(11) Pensions;
(12) Income from discharge of indebtedness;
(13) Distributive share of partnership gross income;
(14) Income in respect of a decedent; and
(15) Income from an interest in an estate or trust.
Thus, single income taxation, not double income taxation, would occur if
these types of corporate expenses were paid to the shareholder, because the
C corporation could deduct these expenses for income tax purposes (but a
dividend paid to a shareholder by the C corporation is not deductible by the
C corporation).
(a)
And, whether or not the C corporation pays an expense or a
dividend to the shareholder, the shareholder is income taxed on the
payment of the C corporation’s expense or the dividend which is
distributed to the shareholder.
Activities not engaged in for profit (hobby deductions) - section 183. Read sections 183(a), 162(a), and
212(a), which states a follows:
Section 183. Activities not engaged in for profit
(a) General rule
In the case of an activity engaged in by an individual or an S
corporation, if such activity is not engaged in for profit, no
deduction attributable to such activity shall be allowed under this
chapter except as provided in this section.
Section 162. Trade or business expenses
(a) In general
There shall be allowed as a deduction all the ordinary and
necessary expenses paid or incurred during the taxable year in
carrying on any trade or business, including—
(1) a reasonable allowance for salaries or other compensation for
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personal services actually rendered;
(2) traveling expenses (including amounts expended for meals and
lodging other than amounts which are lavish or extravagant
under the circumstances) while away from home in the
pursuit of a trade or business; and
(3) rentals or other payments required to be made as a condition to
the continued use or possession, for purposes of the trade
or business, of property to which the taxpayer has not
taken or is not taking title or in which he has no equity.
For purposes of the preceding sentence, the place of residence of a Member
of Congress (including any Delegate and Resident Commissioner) within
the State, congressional district, or possession which he represents in
Congress shall be considered his home, but amounts expended by such
Members within each taxable year for living expenses shall not be
deductible for income tax purposes in excess of $3,000. For purposes of
paragraph (2), the taxpayer shall not be treated as being temporarily away
from home during any period of employment if such period exceeds 1 year.
The preceding sentence shall not apply to any Federal employee during any
period for which such employee is certified by the Attorney General (or the
designee thereof) as traveling on behalf of the United States in temporary
duty status to investigate or prosecute, or provide support services for the
investigation or prosecution of, a Federal crime.
Section 212. Expenses for production of income
In the case of an individual, there shall be allowed as a deduction all the
ordinary and necessary expenses paid or incurred during the taxable year—
(1) for the production or collection of income;
(2) for the management, conservation, or maintenance of property
held for the production of income; or
(3) in connection with the determination, collection, or refund of
any tax.
A.
Deductions for business and investment expenses.
1.
Deductions for business and investment expenses and for depreciation are generally
allowable only for activities engaged in for profit under section 162 and section 167 and
section 212.
B.
However, read section 183(b),which states as follows:
Section 183. Activities not engaged in for profit
(b) Deductions allowable
In the case of an activity not engaged in for profit to which subsection (a) applies,
there shall be allowed—
(1) the deductions which would be allowable under this chapter for the taxable year
without regard to whether or not such activity is engaged in for profit, and
(2) a deduction equal to the amount of the deductions which would be allowable
under this chapter for the taxable year only if such activity were engaged in for
profit, but only to the extent that the gross income derived from such activity for the
taxable year exceeds the deductions allowable by reason of paragraph (1).
1.
Section 183(b) provides that if an activity is not engaged in for profit, then deductions are
allowable, but only in the following order and to the following extent.
2.
First - - - the deductions which are deductible due to other sections without regard to whether
or not there is a profit motive involved. Examples of these deductions are as follows.
Read section 183(b)(1), which states as follows:
Section 183. Activities not engaged in for profit
(b) Deductions allowable
In the case of an activity not engaged in for profit to which subsection (a) applies,
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3.
4.
5.
C.
there shall be allowed—
(1) the deductions which would be allowable under this chapter for the taxable year
without regard to whether or not such activity is engaged in for profit, and
a.
Interest on home mortgage debts.
b.
Casualty losses.
c.
State and local taxes.
Second, if there is still some gross income from the activity involved, then all of the other
related expenses are deductible up to that remaining amount of gross income. Examples of
these deductions are as follows.
Read section 183(b)(2).
Section 183. Activities not engaged in for profit
(b) Deductions allowable
In the case of an activity not engaged in for profit to which subsection (a) applies,
there shall be allowed—
(2) a deduction equal to the amount of the deductions which would be allowable
under this chapter for the taxable year only if such activity were engaged in
for profit, but only to the extent that the gross income derived from such
activity for the taxable year exceeds the deductions allowable by reason of
paragraph (1).
a.
Repairs.
b.
Maintenance.
c.
Depreciation.
Whether or not an activity is engaged in for profit is answered by looking to section 162 and
section 212(1)-(2).
a.
Deductions for business and investment expenses and for depreciation are generally
allowable only for activities engaged in for profit under section 162 and section 167
and section 212.
Read section 183(a).
Section 183. Activities not engaged in for profit.
(a) General rule
In the case of an activity engaged in by an individual or an S corporation,
if such activity is not engaged in for profit, no deduction attributable to such
activity shall be allowed under this chapter except as provided in this
section.
However, to repeat. Section 183(b) provides that if an activity is not engaged in for profit,
then deductions are allowable only in the following order stated above. Section 183(b) states
as follows:
Section 183. Activities not engaged in for profit
(a) General rule
In the case of an activity engaged in by an individual or an S corporation,
if such activity is not engaged in for profit, no deduction attributable to such
activity shall be allowed under this chapter except as provided in this
section.
When is an activity engaged in for profit?
1.
The answer to this question is to be determined by section 162 and section 212(1)-(2).
a.
However, in certain cases, section 183(d) creates a presumption that an the activity
is engaged in for profit if the deductions, referred to above, are not allowable under
section 162 and 212(1)-(2).
2.
A rebuttable presumption. Section 183 creates a rebuttable presumption that an activity is
engaged in for profit if there is a net profit from the activity in any three years out of the
five-year period ending with the taxable year in question.
a.
The presumption is for two profitable years out of seven for breeding, training,
showing, or racing of horses.
Read section 183(d).
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b.
VIII.
Section 183. Activities not engaged in for profit
(d) Presumption
If the gross income derived from an activity for 3 or more of the taxable
years in the period of 5 consecutive taxable years which ends with the
taxable year exceeds the deductions attributable to such activity (determined
without regard to whether or not such activity is engaged in for profit), then,
unless the Secretary establishes to the contrary, such activity shall be
presumed for purposes of this chapter for such taxable year to be an activity
engaged in for profit. In the case of an activity which consists in major part
of the breeding, training, showing, or racing of horses, the preceding
sentence shall be applied by substituting “2” for “3” and “7” for “5”.
In the case of a new activity, the taxpayer may elect to postpone determination of
the presumption until the end of the fifth (or seventh) year of the activity.
Read section 183(e).
Section 183. Activities not engaged in for profit.
(e) Special rule
(1) In general
A determination as to whether the presumption provided by
subsection (d) applies with respect to any activity shall, if the
taxpayer so elects, not be made before the close of the fourth
taxable year (sixth taxable year, in the case of an activity described
in the last sentence of such subsection) following the taxable year
in which the taxpayer first engages in the activity. For purposes of
the preceding sentence, a taxpayer shall be treated as not having
engaged in an activity during any taxable year beginning before
January 1, 1970.
(2) Initial period
If the taxpayer makes an election under paragraph (1), the
presumption provided by subsection (d) shall apply to each taxable
year in the 5-taxable year (or 7-taxable year) period beginning with
the taxable year in which the taxpayer first engages in the activity,
if the gross income derived from the activity for 3 (or 2 if
applicable) or more of the taxable years in such period exceeds the
deductions attributable to the activity (determined without regard
to whether or not the activity is engaged in for profit).
(3) Election
An election under paragraph (1) shall be made at such time and
manner, and subject to such terms and conditions, as the Secretary
may prescribe.
(4) Time for assessing deficiency attributable to activity
If a taxpayer makes an election under paragraph (1) with respect to
an activity, the statutory period for the assessment of any
deficiency attributable to such activity shall not expire before the
expiration of 2 years after the date prescribed by law (determined
without extensions) for filing the return of tax under chapter 1 for
the last taxable year in the period of 5 taxable years (or 7 taxable
years) to which the election relates. Such deficiency may be
assessed notwithstanding the provisions of any law or rule of law
which would otherwise prevent such an assessment.
(1)
If three (or two) profitable years occur during that period, then the
presumption relates back to the beginning of the activity.
(2)
If the presumption does not apply, then the test is whether or not the
taxpayer has a bona-fide intent to make a profit, taking into account all of
the facts and circumstances.
Personal expenses.
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A.
IX.
In general, no deductions may take for personal expenses.
1.
In general, no deduction is allowable for personal, living, or family expenses.
Read section 262(a).
Section 262. Personal, living, and family expenses
(a) General rule.
Except as otherwise expressly provided in this chapter, no
deduction shall be allowed for personal, living, or family expenses
2.
However, many expenses which could be called personal expenses may be deductible as
business expenses if they are involved with business activities.
3.
Example. At the time when Mary died, Mary owed interest on Mary's business credit card
account in the amount of $1,000. The executor of the estate paid the interest during the
current year. The income tax result to the estate for the current year because of the estate's
payment of the interest is as follows.
a.
Deductions for a decedents business expenses (section 162) are available to the
decedent's estate if the estate is liable for the obligation giving rise to the deductions
and it is not allowable in the decedents final return. A decedent's last tax year ends
at this death. A cash basis decedent's final return includes only the deductions the
decedent actually paid. Mary owed $1,000 for business expenses. The estate
assumes the liability of Mary thus by paying the expense the estate can deduct.
Therefore, the answer is $1,000 ordinary deduction, deductible in arriving at AGI.
Personal expenses are not deductible. Therefore, the answer is none.
4.
Referring to the example above, Mary used the accrual method of accounting. The income
tax result to Mary with respect to the taxable period in which Mary died is as follows.
a.
No deduction is allowable for personal expenses regardless of the method of
accounting. Therefore, the answer is none.
Net operating loss deduction - section 172. There is allowable as a deduction for the taxable year an amount
equal to the aggregate of the net operating losses carryovers to such year, plus the net operating loss carry
backs to such year.
Read section 172(a).
Section 172. Net operating loss deduction
(a) Deduction allowed
There shall be allowed as a deduction for the taxable year an amount equal
to the aggregate of
(1) the net operating loss carryovers to such year, plus
(2) the net operating loss carrybacks to such year. For purposes of this
subtitle, the term “net operating loss deduction” means the deduction
allowed by this subsection.
A.
The term net “operating loss”.
1.
A “net operating loss” is the excess of the taxpayer's deductions over the taxpayer's gross
income.
Read section 172 (c), which states as follows:
Section 172. Net operating loss deduction
(C) Specified liability losses
In the case of a taxpayer which has a specified liability loss (as defined in
subsection (f)) for a taxable year, such specified liability loss shall be a net
operating loss carryback to each of the 10 taxable years preceding the
taxable year of such loss.
2.
However, the deductibility of loss is limited to the losses attributable to a trade or business
as distinguished from investment losses and personal deductions.
Read section 172(d).
Section 172. Net operating loss deduction.
(D) Bad debt losses of commercial banks
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In the case of any bank (as defined in section 585 (a)(2)), the portion of the
net operating loss for any taxable year beginning after December 31, 1986,
and before January 1, 1994, which is attributable to the deduction allowed
under section 166 (a) shall be a net operating loss carryback to each of the
10 taxable years preceding the taxable year of the loss and a net operating
loss carryover to each of the 5 taxable years following the taxable year of
such loss.
B.
Net operating loss carry backs and carry forwards.
1.
A net operating loss may be carried back for two taxable years prior to the taxable year in
which the loss arose and any unused net operating loss may be carried forward for 20 years
after the taxable year in which the loss was incurred.
2.
A net operating loss must first be carried back to the second preceding year, and any loss not
offset against income is applied to reduce income of the first preceding year (just prior to the
taxable year of the loss), and thereafter, any remaining loss is carried forward until the loss
is consumed, in chronological order, or until the end of the 20th taxable year, which ever is
shorter.
Read section 172(b)(1), which states as follows:
Section 172. Net operating loss deduction.
(b) Net operating loss carrybacks and carryovers
(1) Years to which loss may be carried
(A) General rule
Except as otherwise provided in this paragraph, a net
operating loss for any taxable year—
(i) shall be a net operating loss carryback to each of the 2
taxable years preceding the taxable year of such
loss, and
(ii) shall be a net operating loss carryover to each of the 20
taxable years following the taxable year of the
loss.
3.
However, a taxpayer can elect not to carry back a net operating loss, and if the taxpayer so
elects, the taxpayer will only carry forward such loss for 20 years.
Read section 172(b)(3).
Section 172. Net operating loss deduction.
(b) Net operating loss carrybacks and carryovers
(3) Election to waive carryback
Any taxpayer entitled to a carryback period under paragraph (1)
may elect to relinquish the entire carryback period with respect to
a net operating loss for any taxable year. Such election shall be
made in such manner as may be prescribed by the Secretary, and
shall be made by the due date (including extensions of time) for
filing the taxpayer’s return for the taxable year of the net operating
loss for which the election is to be in effect. Such election, once
made for any taxable year, shall be irrevocable for such taxable
year.
C.
Some examples.
1.
Example. Mary, a single individual, operated a sole proprietorship nursery business (raising
trees, bushes, plants, etc.) for many years. During each year of 1981 through 1997, Mary
had $5,000 of net profits from this business (and Mary had no other gross income or
deductions - - - other than the standard deduction and a personal exemption for any of the
years involved in this question). During 1998, Mary had a net loss from the business in the
amount of $100,000. During 1999, and for each taxable year thereafter, Mary had a profit
of $20,000 from the business.
a.
The earliest year (excluding the loss year) in which Mary may deduct any of the
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2.
D.
1998 net operating loss, taking into account any net operating loss carry back
provisions and any net operating loss carry forward provisions of the law, is as
follows. The loss was sustained in 1998. The earliest year the taxpayer may carry
back the net operating loss is two years or 1996. Therefore, the answer is 1996.
b.
The last year (excluding the loss year) in which Mary may deduct any of the 1998
net operating loss, if Mary did not elect to utilize any net operating loss carry back
provisions of the law, is as follows. Mary did not elect to carry back Mary's net
operating loss, therefore, Mary may carry forward the loss for 15 years. Mary had
a net operating loss in 1998 of $100,000, the amount of net operating loss deducted
in each year should be:
1999 2000 2001 2002 2003 2004
20
20
20
20
20
none
Therefore, the answer is 2003.
Example. John died on July 1 of the current year. With respect to John's final taxable
period, John had a net operating loss (from John's sole proprietorship book sales business)
of $10,000. John had net operating losses for the prior three years for a total of $30,000.
During the first taxable period of the estate, the estate continued to operate the
business, as a sole proprietorship of the estate and the estate received $50,000 of gross
income from the business and the estate paid business expenses of $10,000. The estate was
not required to distribute any net income to any beneficiary during the estate's first taxable
period and that the estate did not make any such distribution.
a.
The amount of John's net operating loss which the estate may deduct for the first
taxable period of the estate is as follows. Net operating loss may be carried back
two years and forward twenty years. This carry forward provision terminates at
death. The estate may not deduct any of John's net operating loss. Therefore, the
answer is none.
b.
The amount of the estate's taxable income for the estate's first taxable period is as
follows.
Gross income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 50,000
Minus: operating expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000
Standard deduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
600
Taxable income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 39,400
Therefore, the answer is $39,400.
Some questions.
1.
Question 1. Mary, a single individual, operated a sole proprietorship nursery business
(raising trees, bushes, plants, etc.) for many years. During each year of 1981 through 1997,
Mary had $5,000 of net profits from this business (and Mary had no other gross income or
deductions - - - other than the standard deduction and a personal exemption for any of the
years involved in this question). During 1998, Mary had a net loss from the business of
$100,000. During 1999, and for each taxable year thereafter, Mary had a profit of $25,000
from the business. The earliest year (excluding the loss year) in which Mary may deduct any
of the 1998 net operating loss, taking into account any net operating loss carry back
provisions and any net operating loss carry forward provisions of the law, is as follows.
a.
1995
b.
1996
c.
1999
d.
2000
e.
No prior stated answer
2.
Question 2. Referring to question 1, Mary continues to live and does not elect to take into
account any net operating loss carry back provisions, the last year (excluding the loss year)
in which Mary may deduct any of the 1998 net operating loss is as follows.
a.
1999
b.
2000
c.
2001
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3.
X.
d.
2002
e.
No prior stated answer
Question 3. John died on July 1 of the current year. With respect to John's final taxable
period, John had a net operating loss (from John's sole proprietorship book sales business)
of $20,000. Further, John had a net operating loss of $10,000 for each of the prior three
years. During the first taxable period of the estate, the estate continued to operate the
business, as a sole proprietorship of the estate and the estate received $15,000 of ordinary
gross income from the business and the estate paid business expenses with respect to the
business of $10,000. The estate was not required to distribute any net income to any
beneficiary during the estate's first taxable period and the estate did not make any such
distribution. The estate's total income tax deductions for the estate's first taxable period of
the estate with respect to these facts is as follows.
a.
None/Zero
b.
$60,000
c.
$10,600
d.
$15,600
e.
No prior stated answer
Interest expenses - section 163 and section 221. Read section 163(a) and section 221(a), which state as
follows:
Section 163. Interest.
(a) General rule.
There shall be allowed as a deduction all interest paid or accrued within the
taxable year on indebtedness.
Section 221. Interest on education loans.
(a) Allowance of deduction.
In the case of an individual, there shall be allowed as a deduction for the
taxable year an amount equal to the interest paid by the taxpayer during the
taxable year on any qualified education loan.
A.
General rules about interest paid or accrued.
1.
In general, there is allowable as an income tax deduction all interest paid or accrued within
the taxable year on indebtedness. Read section 163(a), which states as follows:
Section 163. Interest.
(a) General rule.
There shall be allowed as a deduction all interest paid or accrued within the
taxable year on indebtedness.
2.
“Interest” is generally defined as amounts paid for the use of borrowed money.
a.
Interest does not include separate payments for services performed by the lender,
such as appraisals, surveys, and inspections.
3.
Section 163 and section 221 income deductions are ordinary deductions, because they do not
arise from the sale or exchange of a capital asset.
4.
Interest is deductible only if it is paid in connection with a bona fide debt.
5.
Transactions between family members are closely scrutinized in this regard, as are loans to
or from a controlled corporation.
6.
In addition, interest deductions have sometimes been disallowed on the ground that the entire
transaction was a sham, designed only to generate an interest deduction for tax purposes but
otherwise devoid of economic reality.
7.
In general, interest deductions are ordinary deductions (not capital losses), because they do
not arise from the sale or exchange of a capital asset and generally, there is no specific
section which states that they are to be treated as capital losses (even though they are in fact
ordinary deductions).
a.
However, and obviously, capital losses are not ordinary losses.
8.
Some Interest deductions are deductible only above AGI and some interest deductions are
deductible only below AGI.
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9.
a.
No interest deduction may be deducted both above AGI and below AGI.
Some interest expenses are deductible only above AGI and some interest deductions are
deductible only below AGI.
a.
No interest deduction may be deducted both above AGI and below AGI.
B.
Four types of loans which, in general, will result in interest deductions.
1.
There are four types of loans which will generally yield interest deductions for income tax
purposes to the borrower of the funds.
2.
Three types of these loans are granted under section 163 and these types of loans are as
follows.
a.
Business activities. Interest may be deducted if the interest is paid or accrued with
respect to a loan which was borrowed in connection with the taxpayer’s business
activities.
b.
Investment activities. Interest may be deducted if the interest is paid or accrued with
respect to a loan which was borrowed in connection with the taxpayer’s investment
activities, but only to the extent of that year’s investment income, with an unlimited
carryover period (until the death of the borrower) to the extent of future investment
income.
c.
Personal activities (if the loan is secured by first or second residence). Interest may
be deducted if the interest is paid or accrued in connection with a loan which was
used for almost any personal activity or other activity of the taxpayer BUT ONLY
IF THE DEBT IS SECURED BY THE TAXPAYER’S FIRST AND/OR SECOND
RESIDENTIAL PROPERTY.
(1)
There are two types of loans which will qualify for this treatment - - - home
acquisition loans; and, home equity loans.
(2)
A home acquisition loan is for the purchase of the taxpayer’s residential
property and the loan may not exceed $1,000,000.
(3)
A home equity loan is for the purchase of the taxpayer’s residential property
or for almost any other purpose, but it may not exceed $100,000.
(a)
In general, the taxpayer may not use the borrowed funds to
purchase bonds which yield excluded interest income under section
103 nor may the taxpayer use the funds to purchase a life insurance
policy, which proceeds are also excluded from gross income due to
section 101.
(b)
However, the taxpayer may used the borrowed funds to gamble in
Los Vegas or to take a vacation.
(c)
Therefore, a taxpayer may secure loans with the taxpayer’s
residential property up to $1,100,000 and deduct the interest on the
loans.
(4)
Generally, a home acquisition loan will be made and be paid off over year,
with the debt always going down.
(5)
A home equity loan will be borrowed in the amount of $20,000 and repaid
and borrowed again in the amount of $35,000 and repaid and so on.
3.
Education activities. Section 221 allows interest to be deducted if the loan is an “education
loan”.
C.
Where, in the income tax computation, is interest deducted?
1.
A taxpayer may deduct interest paid on indebtedness as either an itemizable deduction,
business expense, or passive activity deduction, subject to certain restrictions.
D.
In general, personal interest is not allowable as a deduction.
1.
Therefore, interest on personal loans is not deductible.
2.
Personal interest includes the following types of payments, if the payments are not made
with respect to business or investment or education loans.
a.
Finance charges on installment purchases.
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b.
c.
d.
e.
f.
g.
Credit card interest.
Revolving charge account interest.
Insurance policy loans used to purchase consumer goods.
Interest on tax deficiencies or late payment of taxes.
Interest on judgments. and
Redeemable ground rents.
E.
Interest with respect to “qualified residence mortgage loans”.
1.
Interest paid with respect to “qualified residence mortgages loans” is almost always
deductible.
F.
Qualified residence interest.
1.
Qualified residence interest is any interest paid or accrued during the tax year on acquisition
indebtedness or home equity indebtedness with respect to any property that, at the time the
interest is accrued, is the taxpayer's qualified residence.
Read section 163(h)(3)(A).
Section 163. Interest.
(h) Disallowance of deduction for personal interest
(3) Qualified residence interest
For purposes of this subsection—
(A) In general
The term “qualified residence interest” means any interest
which is paid or accrued during the taxable year on—
(i) acquisition indebtedness with respect to any qualified
residence of the taxpayer, or
(ii) home equity indebtedness with respect to any qualified
residence of the taxpayer.
For purposes of the preceding sentence, the determination of whether any
property is a qualified residence of the taxpayer shall be made as of the time
the interest is accrued.
2.
A qualified residence is the taxpayer's principal residence and any other residence the
taxpayer elects to treat as qualified for the tax year.
Read section 163(h)(4)(A)(i)(I).
Section 163. Interest.
(h) Disallowance of deduction for personal interest
(4) Other definitions and special rules
For purposes of this subsection—
(A) Qualified residence
(i) In general The term “qualified residence” means—
(I) the principal residence (within the meaning of
section 121) of the taxpayer, and
3.
A second residence rented out to others cannot qualify unless the taxpayer also uses it as a
residence during the year for more than the greater of 14 days or 10% of the number of days
the residence was rented.
Read section 163(h)(4)(A)(i-ii).
(h) Disallowance of deduction for personal interest
(4) Other definitions and special rules
For purposes of this subsection—
(A) Qualified residence
(i) In general The term “qualified residence” means—
(I) the principal residence (within the meaning of
section 121) of the taxpayer, and
(II) 1 other residence of the taxpayer which is
selected by the taxpayer for purposes of this
subsection for the taxable year and which is used
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4.
5.
6.
by the taxpayer as a residence (within the meaning
of section 280A (d)(1)).
(ii) Married individuals filing separate returns If a married
couple does not file a joint return for the taxable
year—
(I) such couple shall be treated as 1 taxpayer for
purposes of clause (i), and
(II) each individual shall be entitled to take into
account 1 residence unless both individuals
consent in writing to 1 individual taking into
account the principal residence and 1 other
residence.
A second residence that was not rented during the year may qualify even if the taxpayer has
not lived in the residence at any time during the year.
Read section 163(h)(4)(a)(iii), which states as follows:
(h) Disallowance of deduction for personal interest
(4) Other definitions and special rules
For purposes of this subsection—
(A) Qualified residence
(iii) Residence not rented For purposes of clause (i)(II),
notwithstanding section 280A (d)(1), if the taxpayer does
not rent a dwelling unit at any time during a taxable year,
such unit may be treated as a residence for such taxable
year.
Acquisition indebtedness is debt which is incurred in acquiring, constructing, or substantially
improving the taxpayer's principal or second residence, and debt incurred to refinance the
current balance of such a loan. Acquisition indebtedness of a taxpayer is limited to
$1,000,000 ($500,000 for a married individual filing separately).
Read section 163(h)(3)(B), which states as follows:
(h) Disallowance of deduction for personal interest
(3) Qualified residence interest
For purposes of this subsection—
(B) Acquisition indebtedness
(i) In general The term “acquisition indebtedness” means
any indebtedness which—
(I) is incurred in acquiring, constructing, or
substantially improving any qualified residence of
the taxpayer, and
(II) is secured by such residence.
Such term also includes any indebtedness
secured by such residence resulting from
the refinancing of indebtedness meeting
the requirements of the preceding
sentence (or this sentence); but only to the
extent the amount of the indebtedness
resulting from such refinancing does not
exceed the amount of the refinanced
indebtedness.
(ii) $1,000,000 limitation The aggregate amount treated as
acquisition indebtedness for any period shall not
exceed $1,000,000 ($500,000 in the case of a
married individual filing a separate return).
Home equity indebtedness. Home equity indebtedness is debt that does not exceed the
difference between acquisition indebtedness with respect to a residence and the fair market
value of the residence, whether or not the loan is used for personal expenditures. Home
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7.
equity indebtedness of a taxpayer is limited to $100,000 ($50,000 in case of a married
individual filing a separate return).
Read section 163(h)(3) c, which states as follows,
(h) Disallowance of deduction for personal interest
(3) Qualified residence interest
For purposes of this subsection—
(C) Home equity indebtedness
(i) In general The term “home equity indebtedness” means
any indebtedness (other than acquisition
indebtedness) secured by a qualified residence to
the extent the aggregate amount of such
indebtedness does not exceed—
(I) the fair market value of such qualified residence,
reduced by
(II) the amount of acquisition indebtedness with respect to
such residence.
(ii) Limitation The aggregate amount treated as home
equity indebtedness for any period shall not
exceed $100,000 ($50,000 in the case of a separate
return by a married individual).
a.
Home equity indebtedness is deductible even if the indebtedness is used for person
purposes. However, such home equity indebtedness is not deducted if the loan
proceeds are used to by a single premium life insurance policy or tax-exempt income
producing property like state and local bonds.
Some examples.
a.
Example. John borrows $50,000 at 5% secured on John's house, and uses $25,000
of the loan proceeds to purchase General Motors Corporation bonds and uses the
other $25,000 to purchase New York state bonds. Also, the General Motors
Corporation bonds yield interest for the current year of $2,000 and the New York
state bonds also yield $2,000.
(1)
The amount of the deductible interest expense for the current year is as
follows. Because the home equity indebtedness is used to purchase both
tax-exempt bonds and taxable bonds, the interest expense must be
apportioned. The interest attributable to the tax-exempt bond interest may
not be deducted. However, the interest attributable to the taxable bond
interest may be deducted. The total interest expense is $50,000 x .05 =
$2,500. One half of the interest is attributable to the tax-exempt bond
interest. Thus, $1,250 of the interest expense is deductible. Therefore, the
answer is $1,250, deductible from AGI.
b.
Example. During the current year, Mary paid interest of $6,000 on Mary's home
mortgage debt. The amount of the debt was, during the current year, $100,000, and
the debt had been secured by Mary's home for over ten years. Mary initially
incurred the debt, for the purpose of purchasing Mary's home, and the initial amount
of the debt was $500,000, and the initial cost of the home was $600,000, and the
home had (and has had for quite some time) a fair market value of $600,000.
(1)
The $6,000 is qualified residence interest paid on the acquisition debt.
Interest on acquisition debt is deductible up to the interest incurred on
$1,000,000 of debt. Here, the initial loan was for $500,000. All the interest
incurred is deductible. Therefore, the answer is $6,000 ordinary deduction,
from AGI.
(2)
During the current year Mary borrowed an additional $40,000, for the
purpose of sending Sue to college ($25,000), and for the purpose of paying
certain medical expenses of Mary ($15,000), and that the additional $40,000
of debt is (as is the initial remaining $100,000 of debt) secured by Mary's
home. Also, Mary paid, during the current year, interest of $1,000 on the
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(3)
G.
$40,000 of debt.
(a)
The $1,000 is qualified residence interest paid on the home equity
debt. Interest on home equity debt is deductible up to the interest
incurred on $100,000 of the home equity debt. Therefore, all o the
$1,000 is deductible as an ordinary deduction below the line.
The $40,000 debt was secured only by a vacant lot, which Mary owned for
recreational purposes and which was located in the state of Florida. Mary
may not deduct any of the $1,000 of interest, because the loan is personal
and not associated with a home, business, or investment activities.
"Points" charged by a lender generally qualify as interest.
1.
One point is equal to 1% of a loan.
2.
A point is a fee or charge which is to equal to 1% of the principal amount of the loan and
which among is collected by the lender at the time the loan is made.
a.
To be deductible, the charging of points must reflect an established business practice
in the geographical area where the loan is made and the deduction allowable may
not exceed the number of points which is generally charged in that area. Read
section 461(g)(2), which states as follows:
Section 461. General rule for taxable year of deduction.
(g) Prepaid interest
(2) Exception
This subsection shall not apply to points paid in respect of
any indebtedness incurred in connection with the purchase
or improvement of, and secured by, the principal residence
of the taxpayer to the extent that, under regulations
prescribed by the Secretary, such payment of points is an
established business practice in the area in which such
indebtedness is incurred, and the amount of such payment
does not exceed the amount generally charged in such area.
b.
Points that a borrower pays to a lender in order to obtain a mortgage loan which is
secured by the borrower’s residence are deductible.
c.
The points must be paid out of the borrower's own funds and not out of the loan
proceeds.
(1)
However, home purchasers may deduct points paid by the seller with
respect to the purchaser's mortgage, provided that the purchaser's basis for
the home is reduced by the amount deducted. Read Rev. Proc. 94-27,
1994-15 I.R.B. 17.
d.
Points paid with respect to the purchase or improvement of a primary residence are
deductible in the year in which the points are paid.
(1)
Points paid for other purposes are treated as paid, pro rata over the period
of the mortgage debt. Read section 461(g), which states as follows:
Section 461. General rule for taxable year of deduction.
(g) Prepaid interest
(1) In general
If the taxable income of the taxpayer is computed under the cash
receipts and disbursements method of accounting, interest paid by
the taxpayer which, under regulations prescribed by the Secretary,
is properly allocable to any period—
(A) with respect to which the interest represents a charge for the
use or forbearance of money, and
(B) which is after the close of the taxable year in which paid,
shall be charged to capital account and shall be treated as
paid in the period to which so allocable.
(2) Exception
This subsection shall not apply to points paid in respect of any
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indebtedness incurred in connection with the purchase or
improvement of, and secured by, the principal residence of the
taxpayer to the extent that, under regulations prescribed by the
Secretary, such payment of points is an established business
practice in the area in which such indebtedness is incurred, and the
amount of such payment does not exceed the amount generally
charged in such area.
H.
Some examples.
1.
Example. If the loan is $100,000 and the borrower is to pay two points at the inception of
the loan and to pay 5% simple interest each year with respect to the unpaid balance of the
loan, then the borrower would pay $2,000 when the loan was closed and $5,000 at the end
of the first year, a total of $7,000 for the first year of the loan.
2.
Example. On January 1 of the last year, Mary borrowed $50,000 from Indiana Bank in order
to purchase a house to live in and Mary purchased the house for $80,000 and secured the
loan with the house. The loan was a ten-year loan with an annual, simple rate of interest of
8%, which interest and 10% of the loan principal was payable on each subsequent December
31. At the time when Mary borrowed the $50,000, Mary had to pay to Indiana Bank two
points as interest, which requirement was common in that banking community, and Mary
paid the interest which was due on December 31 of last year.
a.
Interest paid with respect to a mortgage debt on real estate is deductible. Read
section 163(a), which states as follows:
Section 163. Interest
(a) General rule
There shall be allowed as a deduction all interest paid or accrued
within the taxable year on indebtedness.
Loan amount . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 50,000
Interest rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . x
.08
Interest due . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,000
The lender charges two points or 2% of $50,000 which equals $1,000. The total
deductible interest is $5,000 ($4,000 + $1,000). Therefore, the answer is $5,000
ordinary expense or ordinary loss deduction, deductible from AGI.
(1)
If the loan were an unsecured business loan without points being paid by
Mary, then as a business loan, the interest is a deductible business expense.
The points would not be deductible because the loan is not related to Mary's
principal residence. Therefore, the is $4,000 ordinary deduction,
deductible in arriving at AGI.
I.
Some questions.
1.
Question 1. On January 1 of the last year, Mary borrowed $40,000 from Indiana Bank in
order to purchase a house to live in and Mary purchased the house for $80,000 and secured
the loan with the house. The loan was a ten-year loan with an annual, simple rate of interest
was six percent which interest and 10% of the loan principal was payable on each December
31, including, December 31 of last year. At the time when Mary borrowed the money, Mary
had to pay to Indiana Bank two points as interest, which requirement was common in that
banking community, and Mary paid the interest which was due on December 31 of last year.
Mary's itemizable ordinary deduction for interest for last year with respect to these facts is:
(1)
None/Zero
(2)
$5,200
(3)
$2,400
(4)
$4,200
(5)
No prior stated answer
2.
Question 2. On January 1 of the last year, Mary borrowed $50,000 from Indiana Bank in
order to purchase a house to live in and Mary purchased the house for $80,000 and secured
the loan with the house. The loan was a ten-year loan with an annual, simple rate of interest
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3.
4.
5.
6.
7.
was eight percent which interest and 10% of the loan principal was payable on each
December 31, including, December 31 of last year. At the time when Mary borrowed the
$50,000, Mary had to pay to Indiana Bank one point as interest, which requirement was
common in that banking community, and Mary paid the interest which was due on December
31 of last year. Mary's itemizable ordinary deduction for interest for last year is as follows.
a.
None/Zero
b.
$9,500
c.
$4,500
d.
$4,000
e.
No prior stated answer
Question 3. Referring to question 2, Mary borrowed an additional $40,000 (in addition to
the $50,000 of debt) for the purpose of sending Sue to college ($20,000) and for the purpose
of paying certain medical expenses of Mary ($20,000) and that the additional $40,000 of
debt is also secured by Mary's home. Also, Mary paid, during the current year, interest of
$1,000 on the $40,000 of debt. Mary's ordinary itemizable income tax deduction for the
current year with respect to the interest paid with respect to the $40,000 debt is as follows.
a.
None/Zero
b.
$1,000
c.
$500
d.
No prior stated answer
Question 4. Referring to question 3, the $40,000 debt was secured only by a vacant lot,
which Mary owned for recreational purposes and which was located in the state of Florida.
Mary's ordinary itemizable income tax deduction for the current year with respect to the
interest paid with respect to the $40,000 debt is as follows.
a.
None/Zero
b.
$1,000
c.
$500
d.
No prior stated answer
Question 5. Referring to question 3, the $40,000 debt was unsecured. Mary's ordinary
itemizable income tax deduction for the current year with respect to the interest paid with
respect to the $40,000 debt is as follows.
a.
None/Zero
b.
$1,000
c.
$500
d.
No prior stated answer
Question 6. On January 1 of the last year, Mary borrowed $40,000 from Indiana Bank in
order to send Sue ($20,000) and for the purpose of paying certain medical expenses of Mary
($20,000) and that the debt is secured by Mary's home and that this is the only debt which
Mary has. The loan was a ten-year loan with an annual, simple rate of interest was 10%
which interest and 10% of the loan principal was payable on each December 31, including,
December 31 of last year. At the time when Mary borrowed the money, Mary had to pay
to Indiana Bank two points as interest, which requirement was common in that banking
community, and Mary paid the interest which was due on December 31 of last year. Mary's
itemizable ordinary deduction for interest for last year with respect to these facts is as
follows.
a.
None/Zero
b.
$4,800
c.
$4,000
d.
$4,200
e.
No prior stated answer
Question 7. Referring to question 6, the $40,000 debt was secured only by a vacant lot,
which Mary owned for recreational purposes and which was located in the state of Florida.
Mary's itemizable ordinary deduction for interest for last year with respect to the interest
with respect to these facts is as follows.
a.
None/Zero
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8.
b.
$4,800
c.
$4,000
d.
$4,200
e.
No prior stated answer
Question 8. Referring to question 6, the $40,000 debt was unsecured. Mary's itemizable
ordinary deduction for interest for the current year with respect to theses facts is as follows.
a.
None/Zero
b.
$4,800
c.
$4,000
d.
$4,200
e.
No prior stated answer
J.
Interest paid with respect to student loans.
1.
A deduction in arriving at AGI is allowable for certain student loan interest. Read section
221(a), which states as follows:
Section 221. Interest on education loans
(a) Allowance of deduction
In the case of an individual, there shall be allowed as a deduction for the
taxable year an amount equal to the interest paid by the taxpayer during the
taxable year on any qualified education loan.
2.
The amount allowable for the deduction is indexed.
3.
The deduction is available only for loan expenses used to pay for education expenses for a
½ time or greater student at a qualified educational institution, except that certain medical
residency and internship programs also qualify as education institutions.
4.
The loan may be for any indebtedness incurred in financing higher education for the
taxpayer, spouse, or dependent of the taxpayer, or any refinancing of the indebtedness, other
than indebtedness from related persons (within the meaning of section 267(b) or section
707(b)(1)).
5.
The deduction for student loan interest is both indexed and also phased out as a deduction
for taxpayers with too high AGI.
6.
Married couples must file jointly to claim this deduction.
7.
A person who is considered a dependent of another taxpayer may not take this deduction
8.
The deduction is only allowable for the first sixty months in which interest payments are
required on the loan, including any refinancing of the loan.
K.
Interest paid with respect to investments.
1.
For taxpayers other than corporations, the amount allowable as a deduction for investment
interest for any taxable year may not exceed the net investment income of the taxpayer for
the taxable year. Read section 163(d)(1), which states as follows:
Section 163. Interest.
(d) Limitation on investment interest
(1) In general. In the case of a taxpayer other than a corporation, the amount allowed
as a deduction under this chapter for investment interest for any taxable
year shall not exceed the net investment income of the taxpayer for the
taxable year.
2.
Interest which is nondeductible is carried forward and treated as investment interest in the
succeeding taxable year, subject to the same limit of net investment income in such year.
3.
Investment interest is interest on indebtedness allocable to property held for investment, but
it does not include qualified residence interest or interest attributable to a passive activity that
is subject to the limitation on the deduction of passive losses under section 469.
4.
Net investment income includes income minus deductible expenses (other than interest) from
property held for investment) and "portfolio income" such as dividends, interest, and
royalties.
a.
Portfolio income does not include rent.
b.
Net capital gain gross income from the disposition of property held for investment
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may be includible in investment income at the election of the taxpayer, but the
amount of net capital gain gross income which is eligible for the 20% maximum tax
rate on capital gain gross incomes is reduced by the amount so elected.
L.
Some examples.
1.
Example. John borrows $50,000 at five percent, secured by a vacant lot of John, and John
uses $25,000 of the loan proceeds to purchase General Motors Corporation bonds and uses
the other $25,000 to purchase New York State bonds. Also, the interest received from the
General Motors bonds is $1,000 and New York state bonds is $1,000.
a.
Interest expenses are deductible to the extent of interest income. The $1,250 of
interest expense attributable to the General Motors Corporation bonds is deductible
up to $1,000, the interest income from the bonds. Therefore, $1,000 is deductible
from AGI.
2.
Example. During the current year, Mary borrowed, as an unsecured loan from Indiana Bank,
$50,000, in order to invest in General Motors Corporation shares and in Ford Motor Co.
shares. Mary kept the balance of the borrowed funds in a savings account. By the end of
the current year, Mary had paid interest on the debt of $2,000 and received dividends of
$500 and interest of $500 and capital gain gross income of $500.
a.
Mary is entitled a deduction for the current year for the interest which Mary paid.
Investment interest is deductible up to the amount of the investment income (500 +
500 + 500), specifically, up to $1,500 is deductible from AGI.
M.
Some questions.
1.
Question 1. During the current year, Mary borrowed, as an unsecured loan from Indiana
Bank, $100,000, in order to invest in General Motors Corporation shares and in Ford Motor
co. shares. Mary kept the balance of the borrowed funds in a savings account. By the end
of the current year, Mary had paid interest on the debt of $6,000 and received dividends of
$500 and interest of $500 and capital gain gross income of $1,000. Mary's ordinary
itemizable income tax deduction for the current year with respect to the interest paid with
respect to the $100,000 debt is as follows.
a.
None/Zero
b.
$6,000
c.
$1,000
d.
$2,000
e.
No prior stated answer
2.
Question 2. During the current year, Mary borrowed, as an unsecured loan from Indiana
Bank, $100,000, in order to invest in General Motors Corporation shares and in Ford Motor
co. shares. Mary kept the balance of the borrowed funds in a savings account. By the end
of the current year, Mary had paid interest on the debt of $6,000 and received dividends of
$5,000 and interest of $500 and capital gains of $1,000. Mary wants to deduct all of the
interest which Mary can during the current year. Mary's itemizable ordinary deduction for
interest for the current year with respect to these facts is as follows.
a.
None/Zero
b.
$6,000
c.
$1,000
d.
$2,000
e.
No prior stated answer
N.
Personal interest.
1.
In the case of a taxpayer other than a corporation, no deduction is allowable for personal
interest paid or accrued during the taxable year. Read section 163(h)(1).
Section 163. Interest.
(h) Disallowance of deduction for personal interest
(1) In general. In the case of a taxpayer other than a corporation, no
deduction shall be allowed under this chapter for personal interest paid or
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2.
3.
O.
accrued during the taxable year.
Personal interest is any interest except business interest (other than the trade or business of
performing services as a employee), investment interest, interest taken into account in
computing the taxpayer's income or loss from passive activities for the year (read section
469), and qualified residence interest. Read section 163(h)(2), which states as follows:.
Section 163. Interest.
(h) Disallowance of deduction for personal interest.
(2) Personal interest
For purposes of this subsection, the term “personal interest” means
any interest allowable as a deduction under this chapter other
than—
(A) interest paid or accrued on indebtedness properly allocable to
a trade or business (other than the trade or business of
performing services as an employee),
(B) any investment interest (within the meaning of subsection (d)),
(C) any interest which is taken into account under section 469 in
computing income or loss from a passive activity of the
taxpayer,
(D) any qualified residence interest (within the meaning of
paragraph (3)),
(E) any interest payable under section 6601 on any unpaid portion
of the tax imposed by section 2001 for the period during
which an extension of time for payment of such tax is in
effect under section 6163, and
(F) any interest allowable as a deduction under section 221
(relating to interest on educational loans).
Example. During last year, Mary's and John's AGI was $100,000, without considering the
following transactions, and John and Mary had no dependents.
Interest paid with respect to a home mortgage debt of $200,000 which was incurred
in order to acquire John's and Mary's home is deductible . . . . $ 20,000
Interest paid with respect to a separate home mortgage debt of $10,000 incurred
to pay for a vacation is deductible . . . . . . . . . . . . . . . . . . . . . . . . $1,000
Interest paid with respect to an unsecured debt of $10,000 incurred to pay
for tuition to college for Sue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,000
Interest paid to the IRS with respect to a tax deficiency . . . . . . . . . . . . . . $1,000
a.
The interest paid with respect to a home mortgage debt, which was incurred in order
to acquire John's and Mary's home, is deductible, as is the interest with respect to the
vacation home. Read section 163, which states as follows:
Section 163. Interest
(a) General rule
There shall be allowed as a deduction all interest paid or accrued
within the taxable year on indebtedness.
b.
Interest paid with respect to an unsecured debt incurred to pay for tuition to college
for Sue is deductible.
c.
Interest paid to the IRS with respect to a loan, which was not secured by John’s and
Mary’s first and second residence is not deductible.
Interest paid to finance the purchase of, for example, state and local bonds.
1.
No deduction is allowable for interest on debt incurred to procure tax exempt securities (for
example, state or local bonds), even if the debt is secured by the purchaser’s home. Read
section 265(a).
Section 265. Expenses and interest relating to tax-exempt income
(a) General rule. No deduction shall be allowed for—
(1) Expenses
Any amount otherwise allowable as a deduction which is allocable
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2.
P.
XI.
to one or more classes of income other than interest (whether or not
any amount of income of that class or classes is received or
accrued) wholly exempt from the taxes imposed by this subtitle, or
any amount otherwise allowable under section 212 (relating to
expenses for production of income) which is allocable to interest
(whether or not any amount of such interest is received or accrued)
wholly exempt from the taxes imposed by this subtitle.
Example. During the current year, Mary borrowed $50,000 from Indiana Bank and secured
the loan with Mary's house and land, and then, Mary promptly purchased State of Utah
bonds. By the end of the current year, Mary paid interest on the debt of $2,000 and Mary
had received interest on the bonds of $3,000.
a.
Interest received on all state and local bonds is exempt from federal income tax.
Read section 103(a), which states as follows:
Section 103. Interest on State and local bonds
(a) Exclusion
Except as provided in subsection (b), gross income does
not include interest on any State or local bond.
Therefore, no deduction is allowable for expenses in generating tax-exempt income.
Some questions.
1.
Question 1. During the current year, Mary borrowed $50,000 from Indiana Bank and
secured the loan with Mary's house and land, and then, Mary promptly purchased State of
Utah bonds. By the end of the current year, Mary paid interest on the debt of $4,000 and
Mary had received interest on the bonds of $3,000. Mary's ordinary itemizable income tax
deduction for the current year with respect to the interest paid with respect to the $50,000
debt is as follows.
a.
None/Zero
b.
$3,000
c.
$4,000
d.
$2,000
e.
No prior stated answer
2.
Question 2. During the current year, Mary borrowed $50,000 from Indiana Bank and
secured the loan with Mary's house and land, and then, Mary promptly purchased State of
Utah bonds. By the end of the current year, Mary paid interest on the debt of $4,000 and
Mary had received interest on the bonds of $3,000. Mary's itemizable ordinary deduction
for the interest for the current year with respect to these facts is as follows.
a.
None/Zero
b.
$3,000
c.
$4,000
d.
$2,000
e.
No prior stated answer
State and local tax expenses - sections 164, 1001, 1012, and 453. Read sections 164(a), 1001(a), 1012(a),
and 453(a), which state as follows:
Section 164. Taxes
(a) General rule
Except as otherwise provided in this section, the following taxes shall be
allowed as a deduction for the taxable year within which paid or accrued:
(1) State and local, and foreign, real property taxes.
(2) State and local personal property taxes.
(3) State and local, and foreign, income, war profits, and excess profits
taxes.
(4) The GST tax imposed on income distributions.
(5) The environmental tax imposed by section 59A.
In addition, there shall be allowed as a deduction State and local, and foreign, taxes
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not described in the preceding sentence which are paid or accrued within the taxable
year in carrying on a trade or business or an activity described in section 212
(relating to expenses for production of income). Notwithstanding the preceding
sentence, any tax (not described in the first sentence of this subsection) which is
paid or accrued by the taxpayer in connection with an acquisition or disposition of
property shall be treated as part of the cost of the acquired property or, in the case
of a disposition, as a reduction in the amount realized on the disposition.
Section 1001. Determination of amount of and recognition of gain or loss
(a) Computation of gain or loss
The gain from the sale or other disposition of property shall be the excess
of the amount realized therefrom over the adjusted basis provided in section
1011 for determining gain, and the loss shall be the excess of the adjusted
basis provided in such section for determining loss over the amount
realized.
Section 1012. Basis of property—cost
The basis of property shall be the cost of such property, except as otherwise
provided in this subchapter and subchapters C (relating to corporate distributions
and adjustments), K (relating to partners and partnerships), and P (relating to capital
gains and losses). The cost of real property shall not include any amount in respect
of real property taxes which are treated under section 164 (d) as imposed on the
taxpayer.
Section 453. Installment method
(a) General rule
Except as otherwise provided in this section, income from an installment
sale shall be taken into account for purposes of this title under the
installment method.
A.
The taxes which are allowable deductions under section 164.
1.
In general, the following state and local and foreign taxes are allowable deductions for the
taxable year within which such taxes are paid or accrued.
a.
State and local and foreign real property taxes.
b.
State and local personal property taxes, the term "personal property tax" means an
ad valorem tax which is imposed on an annual basis with respect of personal
property. So what about Indiana’s vehicle tax?
c.
State and local and foreign income, war profits, and excess profits taxes.
(1)
In lieu of deducting the state and local income taxes, the taxpayer may
deduct state and local sales and use taxes.
d.
The federal generation skipping transfer tax imposed which is imposed on income
distributions.
e.
The environmental tax imposed by section 59A.
2.
In general, state and local deductions are ordinary deductions (not capital losses), because
they do not arise from the sale or exchange of a capital asset and generally, there is no
specific section which states that they are to be treated as capital losses (even though they
are in fact ordinary deductions).
a.
However, and obviously, capital losses are not ordinary losses.
3.
Some state and local deductions are deductible only above AGI and some state and local
deductions are deductible only below AGI.
a.
No state and local deduction may be deducted both above AGI and below AGI.
B.
The definitions of a “state and local tax” and a “foreign tax” and a “generation skipping transfer tax”.
1.
A state or local tax includes only a tax imposed by a state, a possession of the United States,
or a political subdivision of any of the foregoing, or by the District of Columbia.
2.
A foreign tax includes only a tax imposed by the authority of a foreign country.
3.
A generation skipping transfer tax imposed on income distributions is the tax imposed by
section 2601 and any state tax which is described in section 2604.
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C.
Taxes other than federal income taxes.
1.
Taxes other than federal income taxes may be deducted as business expenses (section 162)
or as investment expenses (section 212).
2.
However, taxes incurred in connection with the acquisition of property, such as state and
local sales taxes, must be capitalized and added to the basis of the property.
3.
Estate, gift and inheritance taxes, federal income taxes, and the employee's share of FICA
taxes are not deductible, even as business expenses.
Read section 275(a), which states as follows:
Section 275. Certain taxes
(a) General rule. No deduction shall be allowed for the following taxes:
(1) Federal income taxes, including—
(A) the tax imposed by section 3101 (relating to the tax on
employees under the Federal Insurance Contributions Act);
(B) the taxes imposed by sections 3201 and 3211 (relating to the
taxes on railroad employees and railroad employee
representatives); and
(C) the tax withheld at source on wages under section 3402.
(2) Federal war profits and excess profits taxes.
(3) Estate, inheritance, legacy, succession, and gift taxes.
(4) Income, war profits, and excess profits taxes imposed by the
authority of any foreign country or possession of the United States
if—
(A) the taxpayer chooses to take to any extent the benefits of
section 901, or
(B) such taxes are paid or accrued with respect to foreign trade
income (within the meaning of section 923(b)) [1] of a FSC,.[2]
(5) Taxes on real property, to the extent that section 164 (d) requires such
taxes to be treated as imposed on another taxpayer.
(6) Taxes imposed by chapters 41, 42, 43, 44, 45, 46, and 54.
Paragraph (1) shall not apply to the tax imposed by section 59A.
Paragraph (1) shall not apply to any taxes to the extent such taxes
are allowable as a deduction under section 164 (f).
4.
In the case of the self-employed individual, there is allowable as a deduction for the taxable
year an amount equal to 50% of the self-employment taxes.
a.
Specifically, section 164(f) states that in the case of an individual, in addition to the
taxes described in subsection (a), there shall be allowed as a deduction for the
taxable year an amount equal to one-half of the taxes imposed by section 1401 for
such taxable year.
b.
The deduction is to be treated as attributable to a trade or business carried on by the
taxpayer which does not consist of the performance of services by the taxpayer as
an employee.
5.
Assessments for local benefits of a kind tending to increase the fair market value of the
property (whether or not the fair market value in fact increases) are not deductible.
Read section 164 (c) , which states as follows:
Section 164. Taxes
(c) Deduction denied in case of certain taxes
No deduction shall be allowed for the following taxes:
(1) Taxes assessed against local benefits of a kind tending to increase the
value of the property assessed; but this paragraph shall not prevent
the deduction of so much of such taxes as is properly allocable to
maintenance or interest charges.
(2) Taxes on real property, to the extent that subsection (d) requires such
taxes to be treated as imposed on another taxpayer.
6.
Example. During last year, Mary's and John's AGI was $100,000, without considering the
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following transactions.
State and local income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,000
Local property taxes with respect to home real property . . . . . . . . . . . . . . . . . . . . $4,000
Local property taxes on the building which John uses in John's business . . . . . . . $4,000
State and local sales taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,000
Local property taxes with respect to home tangible personal property . . . . . . . . . $4,000
Local assessment for installation of sewer system on home real property . . . . . . . $4,000
a.
The amount of Mary's and John's taxable income is as follows. State and local
personal property taxes and state and local real property taxes which are attributable
to self-employment activities or to the production of rents and royalties are
deductible in arriving at AGI. State and local income taxes, personal property taxes
(which are not associated with self-employment or for the production of rents or
royalties), and real estates taxes (which are not associated with self-employment or
for the production of rents or royalties) are deductible from AGI. State and local by
using a chart of the IRS and by not taking a deduction for income taxes during the
year involved. The assessment for the sewer, which tends to increase the fair market
value of the assessed property and which is not an ad valorem tax is not deductible.
In the above example, $12,000 ($4,000 state and local income taxes + $4,000
personal property taxes + $4,000 real property taxes) is deductible from AGI.
Taxable income is as follows.
Adjusted gross income ($100,000 - $4,000) . . . . . . . . . . . . . . . . . . . . . $ 96,000
Minus: ordinary deduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000
Personal exemptions (2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
9,000
Taxable income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 75,000
Therefore, the answer is $75,000.
D.
Some questions.
1.
Question 1. During the current year, Mary's and John's AGI was $100,000, without
considering the following transactions, and John and Mary had no dependents.
State and local income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,000
Local property taxes with respect to home real property . . . . . . . . . . . . . . . . . . . . $3,000
Local property taxes on a building which John owns and uses in John's business . $3,000
Local property taxes on a building which Mary owns as an investment . . . . . . . . $3,000
State and local sales taxes on home furniture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,000
Local assessment for installation of sewer system on investment building . . . . . . $1,000
Mary's and John's AGI for the current year (considering all deduction limitations) is as
follows.
a.
None/Zero
b.
$100,000
c.
$97,000
d.
$94,000
e.
No prior stated answer
2.
Question 2. During the current year, Mary's and John's AGI was $100,000, without
considering the following transactions.
State and local income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5,000
Local property taxes with respect to home real property . . . . . . . . . . . . . . . . . . . . $5,000
Local property taxes on a building which John owns and uses in John's business . $5,000
Local property taxes on a building which Mary owns as an investment . . . . . . . . $5,000
State and local sales taxes on home furniture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5,000
Local assessment for installation of sewer system on home real property . . . . . . . $5,000
Mary's and John's AGI for the current year (considering all deduction limitations) is as
follows.
a.
None/Zero
b.
$100,000
c.
$95,000
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d.
e.
E.
$90,000
No prior stated answer
Sales or exchanges of real property.
1.
Read section 164(d), section 1012, and section1001(b), which state as follows:
Section 164. Taxes.
(d) Apportionment of taxes on real property between seller and purchaser
(1) General rule.
For purposes of subsection (a), if real property is sold during any
real property tax year, then—
(A) so much of the real property tax as is properly allocable to that
part of such year which ends on the day before the date of
the sale shall be treated as a tax imposed on the seller, and
(B) so much of such tax as is properly allocable to that part of such
year which begins on the date of the sale shall be treated as
a tax imposed on the purchaser.
Section 1012. Basis of property—cost.
The basis of property shall be the cost of such property, except as otherwise
provided in this subchapter and subchapters C (relating to corporate distributions
and adjustments), K (relating to partners and partnerships), and P (relating to capital
gains and losses). The cost of real property shall not include any amount in respect
of real property taxes which are treated under section 164 (d) as imposed on the
taxpayer.
Section 1001. Determination of amount of and recognition of gain or loss
(b) Amount realized
The amount realized from the sale or other disposition of property shall be
the sum of any money received plus the fair market value of the property
(other than money) received. In determining the amount realized—
(1) there shall not be taken into account any amount received as reimbur
sement for real property taxes which are treated under section 164
(d) as imposed on the purchaser, and
(2) there shall be taken into account amounts representing real property
taxes which are treated under section 164 (d) as imposed on the
taxpayer if such taxes are to be paid by the purchaser.
2.
When real property is sold, the deduction for real property taxes for the year of sale must be
allocated between the purchaser and seller according to the number of days each owned the
property during the real property tax year.
3.
This allocation is controlling for income tax purposes regardless of how the parties allocate
the burden of paying such taxes in the sale agreement.
4.
If the purchaser agrees to pay any real property taxes allocable to the seller (read section
164(d)), then the amount of such taxes is includible in the amount realized for purposes of
computing gain or loss on the sale to the seller (read section 1001(b)) and in the purchaser's
cost basis (read section 1012), which state as follows:
Section 1001. Determination of amount of and recognition of gain or loss
(b) Amount realized
The amount realized from the sale or other disposition of property shall be
the sum of any money received plus the fair market value of the property
(other than money) received. In determining the amount realized—
(1) there shall not be taken into account any amount received as reimbur
sement for real property taxes which are treated under section 164
(d) as imposed on the purchaser, and
(2) there shall be taken into account amounts representing real property
taxes which are treated under section 164 (d) as imposed on the
taxpayer if such taxes are to be paid by the purchaser.
Section 1012. Basis of property—cost.
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5.
F.
The basis of property shall be the cost of such property, except as otherwise provided
in this subchapter and subchapters C (relating to corporate distributions and
adjustments), K (relating to partners and partnerships), and P (relating to
capital gains and losses). The cost of real property shall not include any
amount in respect of real property taxes which are treated under section 164
(d) as imposed on the taxpayer
Example. During last year, Mary's and John's AGI was $100,000, without considering the
following transactions.
State and local income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,000
Local property taxes with respect to home real property . . . . . . . . . . . . . . . . . . . . $4,000
Local property taxes on the building which John uses in John's business . . . . . . . $4,000
State and local sales taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,000
Local property taxes with respect to home personal property . . . . . . . . . . . . . . . . $4,000
Local assessment for installation of sewer system on home real property . . . . . . . $4,000
a.
The amount of Mary's and John's taxable income is as follows. State and local
personal property taxes and state and local real property taxes which are attributable
to self-employment activities or to the production of rents and royalties are
deductible in arriving at AGI. State and local income taxes, personal property taxes
(which are not associated with self-employment or for the production of rents or
royalties), and real estates taxes (which are not associated with self-employment or
for the production of rents or royalties) are deductible from AGI. State and local
sales taxes are not deductible. The assessment for the sewer, which does tend to
increase the fair market value of the assessed property, is not deductible. In the
above example, $12,000 ($4,000 state and local income taxes + $4,000 personal
property taxes + $4,000 real property taxes) is deductible from AGI. Taxable
income is as follows.
Gross income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $100,000
Minus: real property taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000
Adjusted gross income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 96,000
Minus: ordinary deduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000
Personal exemption . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000
Taxable income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 75,000
Therefore, the answer is $75,000.
Some questions.
1.
Question 1. During the current year, Mary's and John's AGI was $100,000, without
considering the following transactions, and John and Mary had no dependents.
State and local income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,000
Local property taxes with respect to home real property . . . . . . . . . . . . . . . . . . . . $3,000
Local property taxes on a building which John owns and uses in John's business . $3,000
Local property taxes on a building which Mary owns as an investment . . . . . . . . $3,000
State and local sales taxes on home furniture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,000
Local assessment for installation of sewer system on home real property . . . . . . . $1,000
Mary's and John's taxable income for the current year (considering all deduction limitations)
is as follows.
a.
None/Zero
b.
$100,000
c.
$97,000
d.
$94,000
e.
No prior stated answer
2.
Question 2. During the current year, Mary's and John's AGI was $100,000, after considering
the following transactions, and John and Mary had no dependents.
State and local income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5,000
Local property taxes with respect to home real property . . . . . . . . . . . . . . . . . . . . $5,000
Local property taxes on a building which John owns and uses in John's business $5,000
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Local property taxes on a building which Mary owns as an investment . . . . . . . . $5,000
State and local sales taxes on home furniture . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5,000
Local assessment for installation of sewer system on home real property . . . . . . . $5,000
Mary's and John's taxable income for the current year (considering all deduction limitations)
is as follows.
a.
None/Zero
b.
$90,000
c.
$86,000
d.
$89,000
e.
No prior stated answer
G.
Section 164 income tax deductions for state and local taxes.
1.
Section 164 income tax deduction for state and local taxes are ordinary deductions, because
they do not arise from the sale or exchange of a capital asset.
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Example - - - How cash method taxpayers are to deduct Indiana income taxes as itemizable deductions on federal income tax returns and how such Indiana
income taxes are to be treated as credits against the Indiana taxes owed.
2003
1/15
4th QP
2002
4/15
FP
2002
+
1stQP
2003
2004
6/15
2nd QP
2003
9/15
3ndQP
2003
Withholding - Indiana Income Taxes From Wages
wwww Withholding For The Entire Year wwww
1/15
4th QP
2003
4/15
FP
2003
+
1stQP
2004
2005
6/15
2nd QP
2004
9/15
3rdQP
2004
Withholding - Indiana Income Taxes From Wages
wwww Withholding For The Entire Year wwww
1/15
4th QP
2004
4/15
FP
2004
+
1stQP
2005
6/15
2nd QP
2005
9/15
3rdQP
2005
Withholding - Indiana Income Taxes From Wages
wwww Withholding For The Entire Year wwww
1.
2003 - - a.
1/15 - Fourth quarter estimated payment of 2002 Indiana income taxes. This is a federal income tax deduction for 2003 and a credit for Indiana
income taxes for 2002.
b.
4/15 - Final payment of 2002 Indiana income taxes. This is a federal income tax deduction for 2003 and a credit for Indiana income taxes for
2002.
c.
4/15 - First quarter estimated payment of 2003 Indiana income taxes. This is a federal income tax deduction for 2003 and a credit for Indiana
income taxes for 2003.
d.
6/15 - Second quarter estimated payment of 2003 Indiana income taxes. This is a federal income tax deduction for 2003 and a credit for Indiana
income taxes for 2003.
e.
9/15 - Third quarter estimated payment of 2003 Indiana income taxes. This is a federal income tax deduction for 2003 and a credit for Indiana
income taxes for 2003.
f.
wwwww - This is withholding of Indiana income taxes for 2003. This is a federal income tax deduction for 2003 and a credit for Indiana
income taxes for 2003.
2.
2004 - - a.
1/15 - Fourth quarter estimated payment of 2003 Indiana income taxes. This is a federal income tax deduction for 2004 and a credit for Indiana
income taxes for 2003.
b.
4/15 - Final payment of 2003 Indiana income taxes. This is a federal income tax deduction for 2004 and a credit for Indiana income taxes for
2003.
c.
4/15 - First quarter estimate payment of 2004 Indiana income taxes. This is a federal income tax deduction for 2004 and a credit for Indiana
income taxes for 2004.
d.
6/15 - Second quarter estimated payment of 2004 Indiana income taxes. This is a federal income tax deduction for 2004 and a credit for Indiana
income taxes for 2004.
e.
9/15 - Third quarter estimated payment of 2004 Indiana income taxes. This is a federal income tax deduction for 2004 and a credit for Indiana
income taxes for 2004.
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f.
wwwww - This is withholding of Indiana income taxes for 2004. This is a federal income tax deduction for 2004 and a credit for Indiana
income taxes for 2004.
3.
2005 - - a.
1/15 - Fourth quarter estimated payment of 2004 Indiana income taxes. This is a federal income tax deduction for 2005 and a credit for Indiana
income taxes for 2004.
b.
4/15 - Final payment of 2004 Indiana income taxes. This is a federal income tax deduction for 2005 and a credit for Indiana income taxes for
2004.
c.
4/15 - First quarter estimated payment of 2005 Indiana income taxes. This is a federal income tax deduction for 2005 and a credit for Indiana
income taxes for 2005.
d.
6/15 - Second quarter estimated payment of 2005 Indiana income taxes. This is a federal income tax deduction for 2005 and a credit for Indiana
income taxes for 2005.
e.
9/15 - Third quarter estimated payment of 2005 Indiana income taxes. This is a federal income tax deduction for 2005 and a credit for Indiana
income taxes for 2005.
f.
wwwww - This is withholding of Indiana income taxes for 2005. This is a federal income tax deduction for 2005 and a credit for Indiana
income taxes for 2005.
1.
2003 - - a.
1/15 - Fourth quarter estimated payment of 2002 Indiana income taxes. This is a federal income tax deduction for 2003 and a credit for Indiana
income taxes for 2002.
b.
4/15 - Final payment of 2002 Indiana income taxes. This is a federal income tax deduction for 2003 and a credit for Indiana income taxes for
2002.
c.
4/15 - First quarter estimated payment of 2003 Indiana income taxes. This is a federal income tax deduction for 2003 and a credit for Indiana
income taxes for 2003.
d.
6/15 - Second quarter estimated payment of 2003 Indiana income taxes. This is a federal income tax deduction for 2003 and a credit for Indiana
income taxes for 2003.
e.
9/15 - Third quarter estimated payment of 2003 Indiana income taxes. This is a federal income tax deduction for 2003 and a credit for Indiana
income taxes for 2003.
f.
wwwww - This is withholding of Indiana income taxes for 2003. This is a federal income tax deduction for 2003 and a credit for Indiana
income taxes for 2003.
2.
2004 - - a.
1/15 - Fourth quarter estimated payment of 2003 Indiana income taxes. This is a federal income tax deduction for 2004 and a credit for Indiana
income taxes for 2003.
b.
4/15 - Final payment of 2003 Indiana income taxes. This is a federal income tax deduction for 2004 and a credit for Indiana income taxes for
2003.
c.
4/15 - First quarter estimate payment of 2004 Indiana income taxes. This is a federal income tax deduction for 2004 and a credit for Indiana
income taxes for 2004.
d.
6/15 - Second quarter estimated payment of 2004 Indiana income taxes. This is a federal income tax deduction for 2004 and a credit for Indiana
income taxes for 2004.
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e.
f.
9/15 - Third quarter estimated payment of 2004 Indiana income taxes. This is a federal income tax deduction for 2004 and a credit for Indiana
income taxes for 2004.
wwwww - This is withholding of Indiana income taxes for 2004. This is a federal income tax deduction for 2004 and a credit for Indiana
income taxes for 2004.
3.
2005 - - a.
1/15 - Fourth quarter estimated payment of 2004 Indiana income taxes. This is a federal income tax deduction for 2005 and a credit for Indiana
income taxes for 2004.
b.
4/15 - Final payment of 2004 Indiana income taxes. This is a federal income tax deduction for 2005 and a credit for Indiana income taxes for
2004.
c.
4/15 - First quarter estimated payment of 2005 Indiana income taxes. This is a federal income tax deduction for 2005 and a credit for Indiana
income taxes for 2005.
d.
6/15 - Second quarter estimated payment of 2005 Indiana income taxes. This is a federal income tax deduction for 2005 and a credit for Indiana
income taxes for 2005.
e.
9/15 - Third quarter estimated payment of 2005 Indiana income taxes. This is a federal income tax deduction for 2005 and a credit for Indiana
income taxes for 2005.
f.
wwwww - This is withholding of Indiana income taxes for 2005. This is a federal income tax deduction for 2005 and a credit for Indiana
income taxes for 2005.
XII.
Treatment of real property taxes when real property is sold. All of the computations below are done by months. However, such computations should
be done by using days. Read section 164(d).
A.
Allocation of real property taxes upon the sale/purchase of real property - in general.
1.
Real property taxes of a real property tax year are allocable to the seller of real property based on the number of days of the real
property tax year during which the seller owns the real property and the remaining real property taxes of the real property tax year are
allocated to the purchaser of the real property. Read section 164(d).
2.
In effect, section 164(d)(1) treats such real property taxes as though they consisted of a series of daily charges throughout the real
property tax year, rather than a lump-sum obligation which is imposed on the seller when the real property is sold.
3.
While the real property taxes are allocated through section 164(d) by using a daily allocation computation. However, in Professor
Jegen’s tax texts, the real property taxes are allocated by month, for ease of computation of students. In the real world, you should
always use a daily allocation.
4.
Real property taxes, in the state of Indiana, are due and payable in the year after the year in which the real property taxes accrue. Real
property taxes accrue on March 1 and are due and payable in the months of May and November of the subsequent year. The real
property tax year in the state of Indiana is the calendar year.
B.
Some examples.
1.
Example. If John owns real property in the state of Indiana and if, on March 1 of the current taxable year, real property taxes of $2,400
accrue for the current taxable year, then these real property taxes are payable in two equal installments in May and November of the
next year, $1,200 in May of next year and $1,200 in November of next year. If John sold the real property, located in the state of
Indiana, on July 1 of the current taxable year, then, because John owned the real property from January 1 to July 1, a six-month period,
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2.
3.
6/12 of the total real property taxes of the current taxable year are allocable to John and John is treated as owing these real property
taxes for the purposes of computing John’s gain or loss from the sale of the real property through section 164, section 1001, and section
1012.
Example. John sells real property to Paul on August 1 of the current taxable year and the real property taxes that accrued on March
1 of the current taxable year were $3,600. Also $3,000 in real property taxes accrued in March of the last taxable year and are due
and payable in May and November of the current taxable year. Through section 164, Paul will owe the real property taxes for the
current taxable year for August 1 to December 31 or 5/12 of the total $3,600. John will owe the real property taxes that are due and
payable in May and November of the current taxable year. John will also owe 7/12 of the $3,600 of the real property taxes for the
current taxable year.
Example. Referring to the example which is immediately above this one, John agreed to pay all of the real property taxes which were
due and payable on or before day of sale and Paul agreed to pay all of the real property taxes which were due and payable after the
day of sale. Because John owed all the real property taxes that were due and payable during the current taxable year ($3,600), any
amount that Paul pays will result in John including the amount that Paul pays in John’s amount realized as a result of the sale.
C.
At the heart of the method for allocating real property taxes when real property is sold (or purchased).
1.
Section 164(d).- This section concerns a seller’s and a purchaser’s income tax deductions for real property taxes when real property
is sold.
2.
Section 1001(b). - This section concerns the inclusion of real property taxes in the seller’s amount realized when real property is sold.
3.
Section 1012. - This section concerns the capitalizing of real property taxes in the basis of the purchaser when the purchaser purchases
real property.
D.
Some examples.
1.
Example. During the current year, John agreed to sell his investment land, which John held for several years, to Paul on July 1, 2008
for $1,000,000 of cash plus an assumption of John’s mortgage debt of $100,000 plus an assumption of the following real property
taxes. John’s selling expenses were $10,000 and John’s adjusted basis for the land was $200,000 and Paul’s purchase expenses were
$12,000. John held the land as an investment asset.
a.
Paul gave John a downpayment of $1,000,000 plus an assumption of John’s mortgage assumption document.
b.
The real property taxes which accrued on March 1 of last year and which were payable on May 10 and November 10 of the
year of sale (the current year) were a total of $1,800 ($900 being payable on May 10 of the current year and $900 being
payable on November 10 of the current year).
c.
The real property taxes which accrued on March 1 of the current year and which were payable on May 10 and November 10
of the next taxable year were a total of $2,400 ($1,200 being payable on May 10 of the next taxable year and $1,200 being
payable on November 10 of the next taxable year).
d.
John agreed to pay the real property taxes which were due and payable on May 10 of the year of sale (the current taxable year)
and also to pay all of the real property taxes which were payable in years prior to the year of sale.
e.
Paul agreed to pay the real property taxes which were due and payable on November 10 of the year of sale (the current taxable
year) and also to pay all of the real property taxes which were payable after the year of sale.
f.
John’s gross receipts are as follows.
(1)
$1,000,000
Cash to be paid by Paul to John.
(2)
+ 100,000
John’s mortgage debt assumed by Paul.
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(3)
(4)
+
+
900
1,200
The November installment payable in November of the current year which Paul agreed to pay.
The amount of taxes which 164(d) allocates to John and which Paul agreed to pay (6/12 of 2,400 =
1,200). This computation should be done on a daily basis and not on a monthly basis. However, here
it done on a monthly basis to make it easier for the reader when making the computation.
_ _______
$1,102,100
Total gross receipts.
John’s selling expenses.
10,000
$1,092,100
Amount realized.
John’s adjusted basis.
- 200,000
$ 892,100
John’s long term capital gain.
Paul’s basis is as follows.
$1,000,000
Cash to be paid by Paul to John.
+ 100,000
John’s mortgage debt assumed by Paul.
+
900
The November 10 installment payable on November 10 of the current year which Paul agreed to pay.
+
1,200
The amount of taxes which 164(d) allocates to John and which Paul agreed to pay (7/12 of 2,400 =
1,400).
(15)
________
(16)
$1,102,100.
This amount is the same as John’s gross receipts.
Paul’s purchases expenses.
(17)
+ 12,000
Paul’s adjusted basis for the land.
(18)
$1,114,100
g.
John may deduct the following amounts of real property taxes.
(1)
$
900
John owed them and John paid them.
(2)
+
900
John owed them but Paul paid them and Paul benefitted from the payment because his basis went up.
(3)
+
1,200
These taxes were allocated to John under 164(d), even though Paul paid them, but because Paul paid
them, they increased John’s gross receipts.
(4)
________
John’s deduction for real property taxes.
(5)
$
3,000
h.
Paul may deduct the following amounts of real property taxes.
(6/12 of 2,400 = 1,200) these are the real property taxes which were allocated to Paul under 164(d)
(1)
$
1,000
and he paid them.
Example. During the current year, John agreed to sell his investment land, which John held for several years, to Paul on August 1,
2008 for $1,000,000 of cash plus an assumption of John’s mortgage debt of $100,000 plus an assumption of the following real property
taxes. John’s selling expenses were $10,000 and John’s adjusted basis for the land was $200,000 and Paul’s purchase expenses were
$12,000. John held the land as an investment asset.
a.
Paul gave John a downpayment of $1,000,000 plus an assumption of John’s mortgage assumption document.
b.
The real property taxes which accrued on March 1 of last year and which were payable on May 10 and November 10 of the
year of sale (the current year) were a total of $1,800 ($900 being payable on May 10 of the current year and $900 being
payable on November 10 of the current year).
c.
The real property taxes which accrued on March 1 of the current year and which were payable on May 10 and November 10
of the next taxable year were a total of $2,400 ($1,200 being payable on May 10 of the next taxable year and $1,200 being
(5)
(6)
(7)
(8)
(9)
(10)
(11)
(12)
(13)
(14)
2.
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d.
e.
f.
g.
h.
payable on November 10 of the next taxable year).
John agreed to pay the real property taxes which were due and payable on May 10 of the year of sale (the current taxable year)
and also to pay all of the real property taxes which were payable in years prior to the year of sale.
Paul agreed to pay the real property taxes which were due and payable on November 10 of the year of sale (the current taxable
year) and also to pay all of the real property taxes which were payable after the year of sale.
John’s gross receipts are as follows.
(1)
$1,000,000
Cash to be paid by Paul to John.
(2)
+ 100,000
John’s mortgage debt assumed by Paul.
(3)
+
900
The November installment payable in November of the current year which Paul agreed to pay.
(4)
+
1,400
The amount of taxes which 164(d) allocates to John and which Paul agreed to pay (7/12 of 2,400 =
1,400). This computation should be done on a daily basis and not on a monthly basis. However, here
it done on a monthly basis to make it easier for the reader when making the computation.
_ _______
(5)
$1,102,300
Total gross receipts.
John’s selling expenses.
(6)
10,000
(7)
$1,092,300
Amount realized.
John’s adjusted basis.
(8)
- 200,000
(9)
$ 892,300
John’s long term capital gain.
(10)
Paul’s basis is as follows.
(11)
$1,000,000
Cash to be paid by Paul to John.
(12)
+ 100,000
John’s mortgage debt assumed by Paul.
(13)
+
900
The November 10 installment payable on November 10 of the current year which Paul agreed to pay.
(14)
+
1,400
The amount of taxes which 164(d) allocates to John and which Paul agreed to pay (7/12 of 2,400 =
1,400).
(15)
________
(16)
$1,102,300.
This amount is the same as John’s gross receipts.
Paul’s purchases expenses.
(17)
+ 12,000
Paul’s adjusted basis for the land.
(18)
$1,114,300
John may deduct the following amounts of real property taxes.
(1)
$
900
John owed them and John paid them.
(2)
+
900
John owed them but Paul paid them and Paul benefitted from the payment because his basis went up.
(3)
+
1,400
These taxes were allocated to John under 164(d), even though Paul paid them, but because Paul paid
them, they increased John’s gross receipts.
(4)
________
John’s deduction for real property taxes.
(5)
$
3,200
Paul may deduct the following amounts of real property taxes.
(5/12 of 2,400 = 1,000) these are the real property taxes which were allocated to Paul under 164(d)
(1)
$
1,000
and he paid them.
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Example - - - How Indiana real property taxes accrue and how such real property taxes are treated for federal income tax purposes upon the sale of real property
which is located in the State of Indiana. This diagram uses a July 1, sale date.
2007
3/1
2007
real prop
taxes
accrue
(1,800)
5/10
50% of
2006
real prop
taxes paid
(700)
2008
11/10
50% of
2006
real prop
taxes paid
(700)
3/1
2008
real prop
taxes
accrue
(2,400)
5/10
50% of
2007
real prop
taxes paid
(900)
2007
3/1
1,800
5/10
700
7/1
real prop
is sold
2009
11/10
50% of
2007
real prop
taxes paid
(900)
3/1
2009
real prop
taxes
accrue
(3,600)
2008
11/10
700
3/1
2,400
Copyright ©1986 Through 2012, Professor Jegen’s Taxsite
5/10
900
7/1
real prop
is sold
5/10
50% of
2008
real prop
taxes paid
(1,200)
11/10
50% of
2008
real prop
taxes paid
(1,200)
2009
11/10
900
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3/1
3,600
5/10
1,200
11/10
1,200
-107-
XIII.
Section 453 - reporting gain on the installment method of accounting.
A.
Definition of an “installment sale”.
1.
An installment sale is any disposition of property with at least one payment to be received
after the close of the taxable year. Read section 453(b)(1).
2.
The main IRC provision dealing with installment sales is section 453.
a.
This section deals with a seller’s reporting of gross income over a period of time
when the seller sells property with payments to be made to the seller over more than
one year.
3.
Gain on an installment sale of property is, in general, prorated among all payments to be
received by the seller, and then, reported as the payments are received.
B.
In most cases, the purchaser's obligation to pay the seller for the property sold is capable of being
valued and the transaction is treated as being “closed” in the year of sale.
1.
Thus, if the taxpayer elects out of installment reporting as provided by section 453, the
entire gain must be reported in the year of sale. And, if the seller later receives payments in
excess of the value which the seller used to determine the seller’s gross income with respect
to the value of the future payments in the year of sale, such excess is treated as ordinary
income even if the property sold was a capital asset.
a.
In such a case, the transaction is treated as a sale in the year of sale, and therefore,
if the seller sold a capital asset, then any gain realized by the seller in the year of
sale would be capital gain - - - gain from the sale or exchange of a capital asset.
b.
On the other hand, any payments to the seller in years after the sale year would be
ordinary income to the seller because each tax period stands alone and there would
not be a sale or exchange by the seller in these later years.
2.
If property is sold for payments to be made in the future, then the amount realized in the year
of sale is usually the full sale price unless the total of the present values of the notes or other
obligations for future payments is less than face value of such notes or other obligations.
a.
However, in the case of an installment sale, any gain is normally prorated among all
of the payments to be received by the seller, and then, the seller is required to
include in the seller’s gross income a percentage of each payment which is made to
the seller, unless the seller elects to report the entire gain in the year of sale. Read
section 453.
b.
If the seller elects out of installment reporting as provided in section 453 and if the
future payments are subject to contingencies which make it impossible to determine
their present fair market value of the future payments, then the transaction is to be
held open until all of the payments have been received, and as the payments are
received by the seller, the payments are offset against the seller's basis until the basis
has been completely recovered, and then, any further payments are reported as gain.
If the asset sold was a capital asset, then the payments in excess of basis can be
reported as capital gain, except for interest on the deferred payments.
C.
General advantages to the seller who reports gain from the sale of property by using the installment
method of reporting such gain:
1.
The seller does not have any gain until the seller receives payments.
2.
The seller does not owe any income tax until the seller receives the cash to pay the income
tax.
3.
The seller has the same character of gain to report (generally, capital gain) over the period
during which the seller receives the payments.
D.
In general, the installment method of reporting gain is not mandatory.
1.
A seller does not have to use the installment method of accounting. However, if a seller of
property on the installment method does nothing with respect to electing to be not subject
to the installment method of reporting for income tax purposes, then the seller will be
automatically subject to the installment sales provisions of section 453.
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a.
2.
3.
Therefore, if a seller of property is to receive the purchase price in installments, the
seller will automatically use the installment method for income tax purposes unless
the seller elects to not use the installment method of reporting the gain, in which
case, the seller will generally be required to report the gain in the year of sale by
valuing the installment notes as payments in the year of sale.
b.
Obviously, if the seller had a loss from the sale, then the seller would elect to not use
the installment method of reporting gain for income tax purposes. Read section
453(d).
To repeat this concept with some expansion, gains from the sale of real property or "nondealer" personal property under a contract which requires payments to be made in more than
one year must be reported through the installment method, unless the taxpayer elects to have
all of the gain income taxed in the year of sale.
In general, the installment method provides that the total capital gain from the sale is to be
allocated among the various payments received.
a.
However, any ordinary income due to a recapture of depreciation is fully taxable in
the year of sale. Therefore, it is important to plan for the first year's installment
payments to be at least enough in order to pay the income tax which is attributable
to the ordinary income recapture.
E.
Some limitations on the use of the installment method of reporting gain for income tax purposes are
as follows.
1.
A seller may not use the installment method for sales of publicly traded property (e.g., stocks
or bonds) or for sales of property by a dealer.
2.
There are also limitations with respect to sales to related parties. For example, the original
seller might be required to immediately recognize the remaining deferred gain on the
installment sale if the property is sold, within two years, by the initial purchaser who is
related to initial seller.
3.
Any ordinary income due to a recapture of depreciation is fully taxable in the year of sale.
a.
Therefore, it is important to plan for the first year's installment payments to be at
least enough in order to pay the income tax which is attributable to the ordinary
income recapture.
4.
If the sale involves mortgaged, depreciable real property, then there are additional problems.
If the mortgage debt balance exceeds the seller’s adjusted basis for the property and the
purchaser assumes the mortgage debt, then such excess is treated as a payment which is
received by the seller in the year of sale and is income taxable.
5.
For purpose of determining the taxpayer's amount realized in the sale, the stated face amount
is not controlling. Instead, the amount realized equals the adjusted issue price of the debt
instrument or the stated price minus imputed interest. Read section 1273 through section
1274 and section 483.
a.
If the transaction is eligible for installment reporting, this is the amount attributable
to the note that would be included in the sales price.
6.
In general, the installment method of accounting is not allowable for dispositions of property
by dealers, except in the case of farm property. Read section 453(b)(2), (l).
7.
In the case of timeshare interests in residential real property and certain residential lots, the
installment method of accounting may be used by a dealer if the dealer elects to pay interest
on the deferred taxes. Read section 453(l).
F.
Broker’s commission and other selling expenses.
1.
Broker's commissions and other selling expenses generally reduce the seller’s amount
realized on the sale. Read: Reg. § 1.263(a)-2(e); and, Reg. § 15A.453-1(b)(2).
2.
On the other hand, the purchase expenses of a purchaser are added to the purchaser’s
adjusted basis of the property purchased.
G.
Gross profit percentage.
1.
In order to determine the amount includible in any year, a taxpayer must compute the ratio
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of gross profit to the contract price, and then, multiply this ratio by the total amount of the
principal payment received to determine the portion of the payment which represents gain.
H.
The “total contract price“and the “gross profit ratio” and “qualified indebtedness”.
1.
In computing the gross profit ratio, the selling price is not reduced by the amount of any
indebtedness assumed by the purchaser or to which the property is subject when the
purchaser takes title to the property. Read Reg. § 15A.453-1(b)(2)(ii).
2.
The total contract price, however, is the selling price minus the amount of any "qualifying
indebtedness" which the purchaser assumes or to which the property is subject when the
purchaser takes title to the property.
a.
Further, liabilities are includible in the contract price to the extent the liabilities
exceed the seller's adjusted basis for the property. Read Reg. § 15A.453-1(b)(2)(iii).
3.
In general, "qualified indebtedness" includes any mortgage debt lien which relates to the
property, but excludes the assumption by the purchaser of unrelated indebtedness or
indebtedness incurred by the seller which is incident to the disposition. Read Reg. §
15A.453-1(b)(2)(iv).
4.
Upon an installment sale, the seller is to compute a "gross profit
percentage," which is the total capital gain profit from the sale divided by
the total sales price.
a.
The principal portion of each installment payment is multiplied by this percentage
in order to determine the amount which is taxable as gain and the amount which is
a return of basis in the property.
b.
Any interest which is included in the installment payment is taxable separately as
ordinary income.
I.
Electing out of using the installment method for reporting gain or loss.
1.
If the seller elects out of installment reporting through section 453, and if future payments
are subject to contingencies which make it impossible to determine their present fair market
value, then the transaction is held open until all of the payments have been received.
2.
In this case, the payments are offset against the seller's adjusted basis until the adjusted basis
has been completely recovered, and then, any further payments are reported as gain.
3.
If the asset sold were a capital asset, the payments in excess of adjusted basis can be reported
as capital gain gross income (except for interest on the deferred payments).
4.
In most cases, the purchaser's obligations are susceptible of valuation, and the transaction
is treated as closed in the year of sale.
a.
Thus, if the taxpayer elects out of installment reporting through section 453, the
entire gain must be reported in the year of sale.
b.
If the taxpayer later receives payments in excess of the value placed on the future
payments in the year of sale, such excess must be treated as ordinary income even
if the property sold was a capital asset.
c.
This result is based on the theory that the sale transaction was closed out in the year
of sale, and any further gain does not result from the sale or exchange of a capital
asset.
J.
Some examples.
1.
Example. Paul sells to John real property with an adjusted basis of $30,000 for $100,000,
with John paying $20,000 at the closing and $80,000 in four equal annual installments
commencing one year after the closing, with interest at 10% (which is the applicable AFR)
on the deferred payments) and Paul incurs $10,000 of selling expense.
a.
The gross profit to Paul as a result of the sale is as follows.
Sales price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 100,000
Minus: selling expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000
Amount realized . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90,000
Minus: adjusted basis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000
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b.
c.
2.
Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 60,000
The gross profit ratio is as follows.
The contract price equals the sales price in this example.
$ 60,000 = .60 = 60%.
Gross profit
Contract price
$ 100,000
The amount of income which is includible in Paul's gross income during the year of
the sale is as follows. .60 x $20,000 ($80,000/4) = $12,000.
Example. During the current year, John agreed to sell his investment land to Paul on July
1, 2008 for $1,000,000 of cash plus an assumption of John’s mortgage debt of $100,000 plus
an assumption of the following real property taxes. John’s selling expenses were $10,000
and John’s adjusted basis for the land was $200,000 and Paul’s purchase expenses were
$12,000. John held the land as an investment asset.
Paul gave John a down payment of $100,000 plus nine note payable consecutively, one each
year for nine years with a face amount of $100,000 per note, and with a simple interest rate
of 10% per year on the unpaid balance all notes and interest being payable on July 1 of each
year (for the nine-year period).
The real property taxes which accrued on March 1 of 2006 and which were payable on May
10, 2007 and November 10, 2007 totaled $1,400 ($700 being payable on May 10, 2007 and
$700 being payable on November 10, 2007. These real property taxes are not involved with
this problem.
The real property taxes which accrued on March 1 of 2007 and which were payable on May
10, 2008 and November 10, 2008 totaled $1,800 ($900 being payable on May 10, 2008 and
$900 being payable on November 10, 2008.
The real property taxes which accrued on March 1 of 2008 and which were payable on May
10, 2009 and November 10, 2009 totaled $2,400 ($1,200 being payable on May 10, 2009
and $1,200 being payable on November 10, 2009.
The real property taxes which accrued on March 1 of 2009 and which were payable on May
10, 2010 and November 10, 2010 totaled $3,600 ($1,800 being payable on May 10, 2010
and $1,800 being payable on November 10, 2010. These real property taxes are not involved
in this problem.
John agreed to pay the real property taxes which were due and payable on May 10, 2008 and
also to pay those real property taxes which were payable prior 2008.
Paul agreed to pay the real property taxes which were due and payable on November 10,
2008 and also to pay those real property taxes which were payable after 2008.
John’s capital gain is as follows.
Cash to be paid by Paul to John . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,000,000
John’s mortgage debt assumed by Paul . . . . . . . . . . . . . . . . . . . . . . . . . . . . . + 100,000
The installment payable on November 10, 2004 which Paul agreed to pay . . . +
900
The amount of taxes which 164(d) allocates to John and which Paul agreed
to pay (6/12 of 2,400 = 1,200) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . +
1,200
Total gross receipts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,102,100
Minus: John’s selling expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
10,000
Amount realized . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,092,100
Minus: John’s adjusted basis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200,000
John’s capital gain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 892,100
Paul’s basis is as follows.
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Cash to be paid by Paul to John . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,000,000
John’s mortgage debt assumed by Paul . . . . . . . . . . . . . . . . . . . . . . . . . . . . . + 100,000
The installment payable on November 10, 2004 which Paul agreed to pay . . . +
900
The amount of taxes which 164(d) allocates to John and which Paul agreed
to pay (6/12 of 2,400 = 1,200) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . +
1,200
Total payments by Paul to John (this amount is the same as John’s gross
receipts) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,102,100
Paul’s purchases expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
12,000
Paul’s adjusted basis for the land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,114,100
John may deduct the following real property taxes.
John owed them and John paid them . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
John owed them but Paul paid them and Paul benefitted from the payment
because his basis went up, but the payment caused John to have
more income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
These taxes were allocated to John under 164(d), even though Paul paid
them, but because Paul paid them, John’s gross receipts were
increased. (6/12 of 2,400) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Total real property taxes which John may deduct. . . . . . . . . . . . . . . . . . . . . . .
$
900
+
900
.+
$
1,200
3,000
Paul may deduct the following real property taxes.
Total real property taxes which Paul may deduct. (6/12 of 2,400 = 1,200)
these are the real property taxes which were allocated to Paul
under 164(d) and Paul paid them . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $
1,200
3.
Example. During the current taxable year, Beverly sold a personal sailboat (which Beverly
had used for years) to Mary for $50,000. The sale required a down payment of $10,000 and
a $40,000 personal promissory note, payable in eight installments over a two-year period of
time. During the current taxable year, Beverly received the $10,000 downpayment and one
$5,000 payment on a note. The sailboat has an adjusted basis to Beverly of $29,000, and
selling expenses were $1,000. The gain on the sale is computed as follows.
Sales price
$50,000
Minus: selling expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1,000
Amount realized . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 49,000
Minus: adjusted basis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29,000
Gross profit (gain realized, gain recognized, long term capital gain) . . . . . . . . . $ 20,000
The gross profit percentage is 40% ($20,000 (the gross profit) divided by $50,000 (the
contract price). During the current taxable year, Beverly has long term capital gain of $6,000
(10,000 + 5,000 = 15,000 x 40%) and every time a note is paid by Mary, Beverly has more
long term capital gain of $2,000 (5,000 x 40%).
4.
Example. Paul sells to John real property with an adjusted basis of $130,000 for $200,000
and John assumes a $100,000 mortgage debt and pays $100,000 of cash, of which $20,000
is payable at the closing and $80,000 of which is payable in four equal annual installments
commencing one year after the closing, with interest at 10% (which is the AFR) on the
deferred payments, and Paul pays $10,000 of selling expenses.
a.
The gross profit to Paul as a result of the sale is as follows.
Sales price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 200,000
Minus: selling expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000
adjusted basis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 130,000
Gross profit (gain realized, gain recognized, long term capital gain) . $ 60,000
b.
The contract price is as follows.
Sales price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 200,000
Minus: mortgage debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000
Contract price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 100,000
c.
The gross profit ratio is as follows.
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d.
5.
Gross profit
$60,000 = .60 = 60%
Contract price
$100,000
The amount of income which is includible in Paul's gross income during the year of
the sale is as follows. .60 x $20,000 ($80,000/4) = $12,000. Therefore, the answer
is $12,000.
Example. On June 1 of the last taxable year, Mary sold some Indiana vacant real property
(which Mary leased for various purposes) and which real property Mary had owned for ten
years, and which real property Mary sold to Mary's friend, Paul. Mary had an adjusted basis
for the real property of $400,000 at the date of the sale. Under the terms of the sale, Paul
agreed to pay Mary a total of $1,100,000 cash, with $100,000 of such amount to be paid as
a down payment on the date of sale, and the balance of such amount to be paid in amounts
of $100,000 on each subsequent anniversary date of the sale date. Paul gave Mary ten
negotiable notes, each with a face value of $100,000, with an interest rate of 7% per year on
the unpaid balance, which notes were payable consecutively. In addition, Mary agreed to
pay all of the real property taxes which were due and payable on or before the day of sale.
Paul agreed to pay all of the real property taxes which were due and payable after the day
of sale. The real property taxes which were due and payable in the year of sale (payable the
last taxable year) were $10,000 and the real property taxes which accrued in the year of sale,
but which were payable during the current taxable year, were $12,000. Further, Paul agreed
to pay Mary's mortgage debt liability, to which the real property was subject, in the amount
of $100,000. Each party fulfilled Mary's or Paul's part of the bargain. Further, Paul paid
$20,000 on the mortgage debt during the last taxable year and $20,000 during the current
taxable year, both payments being made as regular payments on the mortgage debt. Further,
Mary had selling expenses of $50,000 and Paul had purchase expenses of $10,000. An
explanation of the character and amount of any gross income (exclusive of interest) to Mary
for the last taxable year as a result of the sale of the real property is as follows.
a.
The real property tax allocation is as follows. May (the last taxable year): $10,000
of real property taxes accrued two years ago while Mary was owner and are due and
payable in May and November of the last taxable year. Mary will pay $5,000 of
these taxes because they are due and payable before the sale. June (the last taxable
year): Paul purchases the vacant lot. Because Mary owned the property for 5/12 of
the year (January 1 through May 31), real property taxes have accrued. These
accrued real property taxes are not due and payable until May and November of next
year (the current taxable year in this example). Paul agreed to pay the taxes due and
payable after the date of the sale, thus Paul will pay the $5,000 (5/12 x $12,000 =
$5,000) in real property taxes that accrued to Mary before the sale. This is a $5,000
benefit to Mary. November (the last taxable year): $10,000 of real property taxes
accrued two years ago while Mary was owner, and $5,000 are due and payable in
November the last taxable year. Paul is the owner of the real property at this time
and Paul agreed to pay the taxes due and payable after the date of the sale. Mary
gets a benefit for Paul paying the $5,000 in taxes. The total benefits to Mary for the
real property taxes paid by Paul which are due and payable after the date of the sale
but accrued while Mary was the owner is $10,000.
b.
The gross income to Mary is as follows.
Downpayment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 100,000
Balance due - - - 7% note . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000,000
Mortgage debt paid by Paul . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000
Total real property taxes paid by Paul . . . . . . . . . . . . . . . . . . . . . . . . . + 10,000
Amount realized . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,210,000
Minus: Selling expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
50,000
Adjusted basis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
400,000
Gain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 760,000
Because this is an installment sale, not all of the $760,000 gain is recognized this
year. The gain must be amortized over the ten-year installment period. The
$760,000 gain must be divided into the total purchase price of $1,100,000 ($100,000
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c.
d.
e.
f.
6.
downpayment + $1,000,000 balance).
$760,000 (gain realized)/$1,100,000 (cash received) = .6909.
Amount received each year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 100,000
Multiplied by the following percentage . . . . . . . . . . . . . . . . . . . . . . . . . .
.6909
Long term capital gain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 69,090
An explanation of the point of deduction, character, and amount of the maximum
deduction for real property taxes which Mary may deduct for the last taxable year
is as follows. Even though Paul will pay real property taxes that accrued to Mary,
Mary is allowed a deduction for the taxes. Because Mary had leased the property
Mary sold, the property will be considered business property. Any deduction is
taken in arriving at adjusted gross income. Mary will be able to deduct $15,000 as
an ordinary deduction ($5,000 due and payable in May the last taxable year; $5,000
due and payable in November the last taxable year; and $5,000 in taxes that accrued
prior to the sale). Therefore, the answer is $15,000 ordinary deduction, deductible
in arriving at adjusted gross income.
All of the interest on all of the outstanding notes was payable annually, as that year's
interest accrued, on each anniversary date of the sale date. That is, the total accrued
interest on all of the notes, for the preceding year, was payable when a note for the
current taxable year was payable. An explanation of the character and amount of
the total interest gross income to Mary, for the current taxable year, when the first
note and all of the appropriate interest was paid is as follows. The interest rate is 7%
and the outstanding balance is $1,000,000. The total interest income to Mary is as
follows.
Outstanding balance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,000,000
Interest rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
.07
Ordinary income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $
70,000
The amount of Paul's adjusted basis for the real property as of the sale date is as
follows.
Paul's cost basis is as follows.
Downpayment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $
100,000
Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000,000
Mortgage debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000
Real property taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . + 10,000
Amount paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,210,000
Purchase expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . + 10,000
Adjusted basis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,220,000
$892,300 (John’s gain) / $1,000,000 (the cash to be paid to John) = 89.23%.
(1)
Every time that John received $100,000 from Paul, John should report
$89,230 as gain from the sale of the land.
(2)
Therefore, due to the downpayment of $100,000, John should report long
term capital gain of $89,230 and each time that Paul paid another $100,000
(each of the nine payments for the nine-year period), then John would report
$89,230 of capital gain and 10 payments of $100,000 each would be
$1,000,000 and $89,230 times 10 is $892,300.
(3)
In addition, Paul was required to pay John simple interest on the unpaid
balance each year, and therefore, after the first year, Paul was obligated for
Paul to pay interest of $90,000 (10% of the outstanding balance of
$900,000) and after the second year, Paul would owe interest of $80,000
(10% of $800,000) all of which would be ordinary gross income to John.
Example.
a.
On September 1 of the current taxable year, John sold 100 common shares of Strong
Corporation to Paul for $100,000. John had owned the stock for many years and
John’s adjusted basis for the stock was $30,000 and John paid a broker $2,000 to
arrange the sale. Paul gave John a downpayment of $10,000 and nine installment
notes, payable annually on each September 1. The notes provided a simple interest
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rate of 8% per year on the unpaid balance with the proper amount of interest being
paid at the time when each note was payable. John’s gross income for the current
taxable year is as follows.
(1)
$100,000
Gross receipts - cash to be paid to John
(2)
- 2,000
Selling expenses
(3)
98,000
Amount realized
(4)
- 30,000
Adjusted basis
(5)
68,000
Realized gain
(6)
68,000 / 100,000 = .68 % = 68% = percentage of each dollar which is gain.
(7)
10,000 x 68% = 6,800 of long term capital gain. With respect to the
downpayment and each unit (note)of $10,000 paid thereafter.
(8)
When the downpayment is made, there is no interest due.
(9)
When the first note is paid, there is $7,200 of ordinary interest income due
(8% x 90,000 = 7,200).
(10)
When the second note is paid, there is $6,400 of interest due (all ordinary
income).
K.
Property which is sold subject to a mortgage debt or with the purchaser assuming the mortgage debt.
1.
If property is transferred subject to a mortgage debt that exceeds the seller's adjusted basis,
the seller must recognize gain in the year of the sale equal to the excess amount. This excess
amount is treated as a payment in the year of the sale and the contract price is treated as
including the portion of the mortgage debt in excess of the seller's adjusted basis. See Reg.
§ 15A.453-1(b)(3)(i); Reg. § 15A.453-1(b)(2)(iii).
2.
The result is an inclusion ratio of 100% for each payment. Therefore, subsequent cash
payments received are fully includible as gain from the sale.
3.
Example. Paul sells to John real property with an adjusted basis of $130,000 for $200,000
with John assuming a $150,000 mortgage debt and paying $50,000 cash, of which $10,000
is payable at the closing and $10,000 in four equal annual installments commencing one year
after the closing, with interest at 10% on the deferred payments, and Paul incurs $10,000 of
selling expenses.
a.
The gross profit to Paul as a result of the sale is as follows.
Sales price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 200,000
Minus: selling expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000
Adjusted basis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 130,000
Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 60,000
Mortgage debt in excess of adjusted basic inclusive of selling
expenses is as follows.
b.
The contract price is as follows.
Cash payments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 50,000
Mortgage debt in excess of adjusted basis . . . . . . . . . . . . . . . . . . . . . . . . + 10,000
Contract price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 60,000
c.
The gross profit ratio is as follows.
$60,000 = 1
Gross profit
Contract price
$60,000
d.
The amount of income as a result of the sale to be includible in Paul's gross income
during the year of the sale is as follows.
1 x $20,000 - - - determined as follows.
10,000 (150,000- 140,000)
+ 10,000 (140,000 - 130,000)
= 20,000
L.
Using the installment method when some of the gain is recaptured as ordinary income due to section
1245 or section 1250.
1.
Installment sale treatment is denied for the portion of gain (if any) that is depreciation
recapture income through section 1245 or section 1250. That portion of gain must be
recognized in the year of sale, even if no payments are received. Therefore, to avoid taxing
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2.
3.
4.
the same gain twice, for purposes of computing the inclusion ratio, the basis of the property
is increased by the amount of recapture income that was recognized in the year of sale.
Example. Paul sells to John real property with an adjusted basis of $130,000 for $200,000
with John assuming a $150,000 mortgage debt and paying $50,000 cash, of which $10,000
is payable at the closing and $10,000 in four equal annual installments commencing one year
after the closing, with interest at 10% on the deferred payments, and Paul incurs $10,000 of
selling expenses.
a.
The gross profit to Paul as a result of the sale is as follows.
Sales price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 200,000
Minus: selling expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000
Adjusted basis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 130,000
Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 60,000
Mortgage debt in excess of adjusted basic inclusive of selling
expenses is as follows.
b.
The contract price is as follows.
Cash payments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 50,000
Mortgage debt in excess of adjusted basis . . . . . . . . . . . . . . . . . . . . . . . . + 10,000
Contract price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 60,000
c.
The gross profit ratio is as follows.
$60,000 = 1. = 100%
Gross profit
Contract price
$60,000
d.
The amount of income as a result of the sale to be includible in Paul's gross income
during the year of the sale is as follows.
1 x $20,000 - - - determined as follows.
10,000 (150,000- 140,000)
+ 10,000 (140,000 - 130,000)
= 20,000
Thus, e.g., if $20,000 of the $60,000 gross profit were section 1250 recaptured income, then
for purposes of computing the ratio, the gross profit would be reduced to $40,000 ($200,000
- ($140,000 + $20,000)), and the inclusion ratio would be reduced to 80%
($40,000/$50,000).
Consequently, the income per installment would be $8,000 ($10,000 x 80%); and total
income would be $20,000 recapture income in the year of sale, plus five times $8,000, as
payments are received.
M.
Using the installment method when some of the selling price is unascertainable.
1.
The installment method of accounting may be used even if the total selling price is
unascertainable, e.g. because some or all of the payments are contingent on future income
or production from the property sold. Read section 453(j)(2).
2.
In this case, if the payments are to be made over a fixed period of time, the adjusted basis
of the property sold is generally allocated ratably over that period and deducted from the
payments received each year.
3.
In the case of contingent payments over an indeterminate period but with a stated maximum
selling price, the gross profit percentage is generally determined in accordance with such
stated maximum.
4.
If the maximum selling price is later reduced, the gross profit ratio is recomputed for
subsequent payments.
5.
Finally, if there are contingent payments with neither a fixed period nor a maximum selling
price, the adjusted basis of the property sold generally can be recovered against payments
received over a 15-year period.
6.
The installment method of accounting is not available for sales of depreciable property to a
corporation or partnership 50% or more of which is owned by the taxpayer, unless it can be
established that there is no tax avoidance purpose. Read section 453(g).
N.
Installment sales involving related parties.
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1.
2.
If other property is sold to a related party in an installment sale, and the purchaser in turn
resells or otherwise disposes of the property, recognition of income to the initial seller
generally is accelerated, unless it can be shown that there was no tax avoidance purpose for
either disposition. Read section 453(e).
In the case of property other than marketable securities, however, this acceleration rule
applies only if the related purchaser resells the property within two years after purchase.
Read section 453(e)(2).
O.
Special installment sales involving large amounts.
1.
Special rules apply through section 453A to installment sales for more than $150,000. If the
total installment obligations arising from such sales during a taxable year exceeds
$5,000,000, the seller must pay interest each year on the deferred tax liability. Read section
453A(b)(2) and section 453A(c).
2.
In addition, if the seller borrows money using the installment obligations as security, the
proceeds of the loan are treated as payments received on the installment obligations. Read
section 453A(d). These rules do not apply to sales of personal use property (e.g., a personal
residence) or property used or produced on a farm. Read section 453A(b)(3).
3.
There is also an exception for installment obligations arising out of the disposition of a
residential lot or timeshare interest in residential real property, if the seller elects to pay
interest on the deferred tax liability through section 453(l). Read section 453A(b)(4).
4.
The remaining income on installment obligations generally must be reported in the year of
disposition. Read section 453B.
a.
The character of the income is determined by reference to the property originally
sold. A disposition for this purpose includes a gift, but not a transfer at death. Read
section 453B(c).
b.
Through section 691(a)(4) and section 691(a)(5), income from installment
obligations passing at death is treated as income in respect of a decedent, which is
income taxed to the decedent's estate or other person receiving the installment
payments.
P.
An installment sale in which the stated interest is less than the applicable federal rate (AFR).
1.
If the stated interest on deferred payments in an installment contract is less than the
applicable federal rate determined through section 1274, a portion of the principal amount
of the obligation is treated as interest through section 483 and section 1274.
2.
Applicable federal rates are determined monthly by the IRS for three categories of
obligations.
a.
Short term (three years or less).
b.
Mid-term (over three to nine years).
c.
Long term (over nine years).
d.
However, if the principal amount of seller financing for sales of real property does
not exceed $2,800,000, the imputed interest rate is limited by section 1274A to the
lesser of the applicable federal rate or 9% compounded semi-annually.
e.
For sales of real property up to $500,000 between family members, the imputed
interest rate is limited to 6%, compounded semi-annually. Read section 483(e) and
section 1274(c)(3)(F).
f.
In the case of sales of a principal residence, sales of farm real property up to
$1,000,000, and other transactions involving total payments of $250,000 or less,
interest is imputed through section 483. Read section 1274(c)(3).
g.
In other cases, the interest is imputed under the original issue discount rules in
section 1272 and section 1274.
h.
The main difference is that under the original issue discount rules the parties are
required to account for the imputed interest on the accrual basis, so that imputed
interest may have to be reported even in years when no payments are received,
whereas through section 483 the imputed interest is accounted for under the
taxpayer's usual method of accounting. In either case, the imputed interest is
includible in the seller's gross income as ordinary income, and the purchaser is
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entitled to a corresponding interest deduction. Imputed interest is excludable from
both the selling price and the contract price for purposes of section 453. See Reg.
§ 15A.453-1(b)(2)(ii).
Q.
As stated above, taxpayers may elect out of the installment method of reporting gain.
1.
If they do, gain must be reported in the year of sale to the extent the amount realized exceeds
the adjusted basis of the property sold, as provided in section 1001.
2.
If the fair market value of the obligations received by the seller can be ascertained, the
transaction is closed and the entire gain must be reported in the year of sale, even by a cash
method of accounting taxpayer.
3.
If the fair market value of the obligations received by the seller cannot be determined, the
transaction is not closed in the year of sale. Payments received by the seller are first offset
against the adjusted basis of the property sold. When the basis has all been recovered in this
fashion, any additional amounts received are fully includible in gross income as gain from
the sale of the property. Open transactions are rare because most obligations are capable of
valuation, unless the payments are subject to some contingency, such as productivity or use
of the property sold.
R.
Some questions.
1.
Question 1. At the time when Mary died, Mary was owed a fee of $1,000, by Paul, for work
which Mary did for Paul, and the fee was collected by the executor of the estate during the
current taxable year. The estate's ordinary income for the current taxable year with respect
to the fee is as follows.
a.
None/Zero
b.
$1,000
c.
None of the above
2.
Question 2. Referring to question 1, Mary used the accrual method of accounting. The
estate's ordinary income for the current taxable year with respect to the fee is as follows.
a.
None/Zero
b.
$1,000
c.
None of the above
3.
Question 3. On January 1 of the current taxable year, Nice Corporation declared a dividend
of cash which was payable to shareholders who owned Nice Corporation common shares on
February 1 of the current taxable year. The dividend was payable on April 1 of the current
taxable year. Mary died on March 1 of the current taxable year and the executor of the estate
received the dividend of $1,000 on April 1 of the current taxable year. The estate's ordinary
income for the current taxable year with respect to the dividend is as follows.
a.
None/Zero
b.
$1,000
c.
None of the above
4.
Question 4. Referring to question 3, Mary used the accrual method of accounting. Mary's
ordinary income for the current taxable year with respect to the dividend is as follows.
a.
None/Zero
b.
$1,000
c.
None of the above
5.
Question 5. At the time when Mary died, Mary owed Marion County, Indiana real property
taxes, with respect to Mary's residence, of $1,000, and the real property taxes were paid by
the executor of the estate during the current taxable year. The estate's ordinary income tax
deduction for the current taxable year with respect to the real property taxes is as follows.
a.
None/Zero
b.
$1,000
c.
None of the above
6.
Question 6. Referring to question 5, Mary used the accrual method of accounting. Mary's
ordinary income tax deduction for the current taxable year with respect to the real property
taxes is as follows.
a.
None/Zero
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7.
8.
9.
10.
11.
12.
b.
$1,000
c.
None of the above
Question 7. During the current taxable year, John's employer, Jolly Corporation, which
regularly sold furniture to customers, allowed John to purchase a table out of Jolly
Corporation's inventory (which table had an adjusted basis of $4,000 and which table had
a fair market value of $15,000) for $10,000, because John had worked so hard for Jolly
Corporation during the last taxable year, and therefore, Jolly Corporation wanted to give
John a bonus for the current taxable year. John paid for and received the table (with no
restrictions attached) on November 1 of the current taxable year. John's ordinary gross
income for the current taxable year with respect to the transfer to John is as follows.
a.
None/Zero
b.
$15,000
c.
$10,000
d.
$5,000
e.
None of the above
Question 8. Referring to question 7, Jolly Corporation's ordinary gross income for the
current taxable year with respect to the transfer to John is as follows.
a.
None/Zero
b.
$11,000
c.
$5,000
d.
$10,000
e.
None of the above
Question 9. Referring to question 7, John’s adjusted basis for the property transferred to
John is as follows.
a.
None/Zero
b.
$10,000
c.
$5,000
d.
$15,000
e.
None of the above
Question 10. Referring to question 7, John owned the property for two years as John's
personal property, using the property in John's home, and then, John took the property to
John's sole proprietorship location, at which John sold furniture, and sold the property to
Paul for $7,000 at a time when John’s adjusted basis for the property was $3,000. John's
ordinary gross income from the sale of the property is as follows.
a.
None/Zero
b.
$4,000
c.
$7,000
d.
$3,000
e.
None of the above
Question 11. On March 1 of the current taxable year, John went to the Cayman Islands for
a few days to do scuba diving with a tour group. While visiting a store there, John purchased
a pistol for $10,000, which looked very old and valuable to John. A few days after John
brought the item back to the United States of America, and during the current taxable year,
John had the item appraised by a reputable dealer who stated that the item then had a fair
market value of $15,000. John's gross income for the current taxable year is as follows.
a.
None/Zero
b.
$10,000
c.
$5,000
d.
$15,000
e.
None of the above
Question 12. Referring to question 11, John’s adjusted basis for the pistol is as follows.
a.
None/Zero
b.
$10,000
c.
$15,000
d.
$5,000
e.
None of the above
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13.
14.
15.
16.
17.
18.
19.
Question 13. Referring to question 11, John held the pistol as an investment and during
December of the next taxable year, John sold the pistol to a collector of pistols for $7,000,
at a time when John’s adjusted basis for the pistol was $8,000. John's deductible capital loss
for the next taxable year with respect to the sale of the item is as follows.
a.
None/Zero
b.
$7,000
c.
$8,000
d.
$3,000
e.
None of the above
Question 14. On March 1 of the current taxable year, John went to the Bahamas for a few
days to do scuba diving with a tour group. While diving, John found a coin, which John was
supposed to turn into the Bahamian government, but which John hid in John's luggage and
brought back to the United States of America. A few days after John brought the coin back
to the United States of America, and during the current taxable year, John had the coin
appraised by a reputable dealer who stated that the coin then had a fair market value of
$12,000. John's gross income for the current taxable year is as follows.
a.
None/Zero
b.
$12,000
c.
None of the above
Question 15. Referring to question 14, John’s adjusted basis for the coin is as follows.
a.
None/Zero
b.
$12,000
c.
None of the above
Question 16. John held a coin as a dealer for several years which John had purchased for
$10,000 and held the coin as part of John’s inventory. During January of the current taxable
year, when the coin had a fair market value of $30,000, John gave the coin to Peter and Peter
held the coin, as a personal asset, until December of the current taxable year at which time
Peter exchanged the coin with Paul, for Paul's coin, which Paul had purchased several
taxable years ago as an investment for $10,000 and which had a fair market value of $30,000
at the time of the exchange. Peter held the new coin as a personal asset and Paul held the
new coin as an investment asset. John's gross income for the current taxable year is as
follows.
a.
None/Zero
b.
$20,000
c.
$10,000
d.
$30,000
e.
None of the above
Question 17. Referring to question 16, Peter’s gross income for the current taxable year is
as follows.
a.
None/Zero
b.
$10,000
c.
$20,000
d.
$30,000
e.
None of the above
Question 18. Referring to question 16, Paul’s gross income for the current taxable year is
as follows.
a.
None/Zero
b.
$10,000
c.
$20,000
d.
$30,000
e.
None of the above
Question 19. Referring to question 16, during the current taxable year, Peter did not
exchange the coin with Paul. Instead, the coin was stolen from Peter during December of
the current taxable year. Peter had no insurance with respect to the theft of the coin. Peter’s
ordinary expense or ordinary loss deduction (without considering any percentage limitations)
for the current taxable year is as follows.
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20.
21.
22.
23.
24.
25.
26.
27.
a.
None/Zero
b.
$30,000
c.
$20,000
d.
$10,000
e.
None of the above
Question 20. Referring to question 19, John had insurance with respect to coin thefts and,
because John had never told the insurance company about the gift to Peter, John told the
insurance company that the coin was stolen from John, and John collected $20,000 of
insurance proceeds. John’s gross income for the current taxable year is as follows.
a.
None/Zero
b.
$30,000
c.
$20,000
d.
$10,000
e.
None of the above
Question 21. During the current taxable year, Mary earned $5,000 selling books as an
employee of UpAndAtom Corporation. Because Sue was going to go to college in a few
years, Mary asked UpAndAtom Corporation to issue a check directly to Sue for $5,000,
which UpAndAtom Corporation did as a favor to Mary. Also, as a favor to Mary, UpAnd
Atom Corporation issued an IRS Form W-2 to Sue for the $5,000 for the current taxable
year. Sue reported the $5,000 as gross income to Sue for the current taxable year. Mary did
not report the $5,000 as gross income for the current taxable year. UpAndAtom Corporation
deducted, during the current taxable year, for income tax purposes, the $5,000 payment to
Sue. Mary’s gross income for the current taxable year is as follows.
a.
None/Zero
b.
$5,000
c.
None of the above
Question 22. Referring to question 21, Sue’s gross income for the current taxable year is as
follows.
a.
None/Zero
b.
$5,000
c.
None of the above
Question 23. Referring to question 21, UpAndAtom Corporation is entitled to a $5,000
income tax deduction for the payment of the $5,000 to Sue.
a.
Yes
b.
No
Question 24. Referring to question 21, it is very likely that Mary and UpAndAtom
Corporation have committed criminal fraud for income tax purposes with respect to all of
this, through section 7201, which states, in part that - - - any person who willfully attempts
in any manner to evade or defeat any tax imposed by this title or the payment thereof shall,
in addition to other penalties provided by law, be guilty of a felony.
a.
Yes
b.
No
Question 25. Referring to question 24, if Atom Corporation did commit a crime and is fined
$10,000 for doing so, then Atom Corporation may deduct the amount of the fine for federal
income tax purposes.
a.
Yes
b.
No
Question 26. At the time when Mary died, Mary was owed a fee of $5,000, by Paul, for
work which Mary did for Paul, and the fee was collected by the executor of Mary’s estate
during the current taxable year. The executor of Mary’s estate must include the $5,000 fee
in both the estate’s federal estate tax return (IRS Form 706) and the estate's fiduciary income
tax return (IRS Form 1041).
a.
Yes
b.
No
c.
None of the above
Question 27. Referring to question 26, Mary used the accrual method of accounting. The
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28.
29.
30.
31.
32.
33.
34.
amount which the estate must include in the estate’s gross income is as follows.
a.
None/Zero
b.
$5,000
c.
None of the above
Question 28. On January 1 of the current taxable year, Nice Corporation declared a dividend
of cash which was payable to shareholders who owned Nice Corporation common stock on
February 1 of the current taxable year. The dividend was payable on April 1 of the current
taxable year. Mary died on February 2 of the current taxable year, and the executor of
Mary’s estate received the dividend of $150 on April 1 of the current taxable year. Mary's
ordinary gross income for the current taxable year with respect to the dividend is as follows.
a.
None/Zero
b.
$150
c.
None of the above
Question 29. Referring to question 28, Mary used the accrual method of accounting. The
estate's ordinary gross income for the current taxable year is as follows.
a.
None/Zero
b.
$150
c.
None of the above
Question 30. Mary died on July 5 of the current taxable year. When Mary died, Mary
owned a bank account, with respect to which bank account interest was credited each day,
including the day on which Mary died. The total interest credited to the bank account for
the period of January 1 of the current taxable year, through July 5 of the current taxable year,
was $900. The total interest credited to the bank account for the period of July 6 of the
current taxable year, through December 31 of the current taxable year, was $1,000. Mary's
ordinary gross income for the current taxable year is as follows.
a.
None/Zero
b.
$900
c.
$1,000
d.
$1,900
e.
None of the above
Question 31. Referring to question 30, the estate's ordinary gross income for the current
taxable year is as follows.
a.
None/Zero
b.
$1,900
c.
$900
d.
$1,000
e.
None of the above
Question 32. On July 1 of the current taxable year, Mary died and at Mary’s death, Mary
owed Marion County, Indiana real property taxes, with respect to Mary's residence, of
$1,500, and the real property taxes were paid by the executor of Mary’s estate during the
current taxable year. The estate's ordinary expense or ordinary loss deduction (on the estate's
federal fiduciary income tax (IRS Form 1041) for the current taxable year is as follows.
a.
None/Zero
b.
$750
c.
$1,500
d.
None of the above
Question 33. Referring to question 32, the amount which the estate may deduct as a liability
on the estate's federal estate tax return (IRS Form 706) is as follows.
a.
None/Zero
b.
$750
c.
$1,500
d.
None of the above
Question 34. Referring to question 32, Mary used the accrual method of accounting. Mary's
ordinary expense or ordinary loss deduction for the current taxable year is as follows.
a.
None/Zero
b.
$750
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35.
36.
37.
38.
39.
c.
$1,500
d.
None of the above
Question 35. Mary was a dealer in grain. During December of the last taxable year, when
Peter attained age 25 years, Mary formed Free, LLC to sell grain through Free, LLC. In
forming Free, LLC, Mary transferred to Free, LLC cash of $200,000 and a building (which
Mary had not depreciated), with an adjusted basis of $40,000 and a fair market value of
$200,000. In return for these two assets, Mary acquired a 50% interest in Free, LLC's net
profit and a 50% interest in Free, LLC's capital. Thereafter, Mary had Free, LLC transfer,
through a legal conveyance to Peter, the other 50% interest in Free, LLC's net profit and the
other 50% interest in Free, LLC's capital for no consideration. Free, LLC did not do any
business during the last taxable year, but during the current taxable year, Free, LLC had a
net profit of $160,000, all of which was from fees from the sale of grain, with all of Free,
LLC’s work being done by Mary, Peter, and a secretary in a rented office. Mary was paid
a gross salary from Free, LLC of $30,000 and Peter was paid a gross salary of $20,000.
Mary's gross income for the current taxable year is as follows.
a.
None/Zero
b.
$190,000
c.
$30,000
d.
$110,000
e.
None of the above
Question 36. Referring to question 35, Peter's gross income for the last taxable year is as
follows.
a.
None/Zero
b.
$20,000
c.
$80,000
d.
$100,000
e.
None of the above
Question 37. Referring to question 35, Mary had Free, LLC issue a check in the amount of
$80,000 to Peter, which $80,000 was for 50% of Free, LLC's net profit for the current
taxable year. Peter's gross income for the current taxable year is as follows.
a.
None/Zero
b.
$20,000
c.
$80,000
d.
$100,000
e.
None of the above
Question 38. During the current taxable year, Mary organized Fair Corporation, transferred
all of Mary's sole proprietorship assets (with a fair market value of $100,000 and a total
adjusted basis of $25,000, all appreciated assets) to Fair Corporation, and Mary received,
from Fair Corporation, in exchange for the assets, all of Fair Corporation's issued and
outstanding common shares. One category of assets which Mary transferred to Fair
Corporation was accounts receivable, which Mary had received in the ordinary course of
operating Mary’s sole proprietorship and with respect to which Mary had an adjusted basis
of $17,000 and which had a fair market value of $20,000. Mary's ordinary gross income for
the current taxable year with respect to the transfer of the accounts receivable to Fair
Corporation is as follows.
a.
None/Zero
b.
$17,000
c.
$10,000
d.
$20,000
e.
None of the above
Question 39. Referring to question 38, Fair Corporation’s adjusted basis for the accounts
receivable is as follows.
a.
None/Zero
b.
$17,000
c.
$10,000
d.
$20,000
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40.
41.
42.
43.
44.
45.
e.
None of the above
Question 40. Referring to question 38, Fair Corporation had an adjusted basis for the
accounts receivable of $17,000 and the accounts receivable has a face value of $20,000 and
during the next taxable year, Fair Corporation collected the entire face amount of the
accounts receivable ($20,000). Fair Corporation's ordinary gross income for the next taxable
year with respect to the collection of the accounts receivable is as follows.
a.
None/Zero
b.
$3,000
c.
$20,000
d.
$17,000
e.
None of the above
Question 41. During the current taxable year, Mary did some accounting work for Beverly,
who had a sole proprietorship, and, because of this, Beverly allowed Mary to use Beverly's
vacation condominium for a month, rent free, during the summer of the current taxable year
for Mary's vacation. Had Beverly rented the condominium to Mary, Beverly would have
charged Mary $1,200 and Mary would have had to pay the utilities for the month of $100,
which Beverly paid. Mary's gross income for the current taxable year is as follows.
a.
None/Zero
b.
$1,300
c.
$1,200
d.
$100
e.
None of the above
Question 42. Referring to question 41, Mary's ordinary expense or ordinary loss deduction
for the current taxable year is as follows.
a.
None/Zero
b.
$1,300
c.
$1,200
d.
$100
e.
None of the above
Question 43. Beverly, who was an expert amateur rifle markswoman, won a championship
match. Beverly’s chief competitor was so angry that the competitor threw Beverly’s best
rifle, which was a personal asset to Beverly, in front of a moving cement truck, which
promptly crushed the rifle flat so that the rifle had no salvage value. Beverly purchased the
rifle two taxable years ago for $4,000 and at the time when the rifle was crushed, the rifle
had a fair market value of $5,000. Beverly recovered $3,600 of insurance due to the damage
to the rifle. Beverly's ordinary expense or ordinary loss deduction (without considering any
percentage limitations) is as follows.
a.
None/Zero
b.
$400
c.
$5,000
d.
$300
e.
None of the above
Question 44. During the current taxable year, Peter owed $2,500 of interest on a mortgage
debt which was secured by Peter’s residence (a house and land which Peter owned) and,
during the current taxable year, Mary paid the interest to Indiana Bank as a gift to Peter.
Peter's debt was incurred when Peter purchased the residence for $90,000 (which included
Peter's borrowing of $81,000). Peter's gross income for the current taxable year is as
follows.
a.
None/Zero
b.
$2,500
c.
None of the above
Question 45. Referring to question 44, Peter's ordinary expense or ordinary loss deduction
for the current taxable year is as follows.
a.
None/Zero
b.
$2,500
c.
None of the above
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46.
47.
48.
49.
50.
51.
52.
53.
54.
Question 46. Referring to question 44, Mary's ordinary expense or ordinary loss deduction
for the current taxable year is as follows.
a.
None/Zero
b.
$2,500
c.
None of the above
Question 47. Mary died during the current taxable year and at the time when Mary died,
Mary owed interest on Mary's credit card account balance of $150. Mary only used this
credit card for personal purposes. The executor of Mary’s estate paid the interest during the
current taxable year. Mary's ordinary expense or ordinary loss deduction for the current
taxable year is as follows.
a.
None/Zero
b.
$150
c.
None of the above
Question 48. Referring to question 47, the estate's ordinary expense or ordinary loss
deduction, on the estate's federal fiduciary income tax return (IRS Form 1041), for the
current taxable year is as follows.
a.
None/Zero
b.
$75
c.
None of the above
Question 49. Referring to question 47, the amount which the estate may deduct as a liability
on the estate's federal estate tax return (IRS Form 706) is as follows.
a.
None/Zero
b.
$75
c.
$150
d.
None of the above
Question 50. Referring to question 47, Mary used the accrual method of accounting. Mary's
ordinary expense or ordinary loss deduction for the current taxable year is as follows.
a.
None/Zero
b.
$75
c.
$150
d.
None of the above
Question 51. Mary died during the current taxable year and at the time when Mary died,
Mary owed interest in the amount of $500 on a debt which Mary incurred in operating
Mary’s sole proprietorship. The executor of Mary’s estate paid the interest during the
current taxable year. Mary's ordinary expense or ordinary loss deduction for the current
taxable year is as follows.
a.
None/Zero
b.
$400
c.
$500
d.
None of the above
Question 52. Referring to question 51, the estate's ordinary expense or ordinary loss
deduction, on the estate's federal fiduciary income tax return (IRS Form 1041), for the
current taxable year is as follows.
a.
None/Zero
b.
$400
c.
$500
d.
None of the above
Question 53. Referring to question 51, the amount which the estate may deduct as a liability
on the estate's federal estate tax return (IRS Form 706) is as follows.
a.
None/Zero
b.
$400
c.
$500
d.
None of the above
Question 54. Referring to question 51, Mary used the accrual method of accounting. Mary's
ordinary expense or ordinary loss deduction for the current taxable year is as follows.
a.
None/Zero
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55.
56.
57.
58.
59.
b.
$500
c.
None of the above
Question 55. John died on July 1 of the current taxable year. With respect to John's final
taxable year, John had a net operating loss (from John's sole proprietorship book sales
business) of $25,000. Further, John had a net operating loss of $5,000 for each of the prior
two years. During John’s estate’s first taxable year, the estate continued to operate the
business, as a sole proprietorship of the estate and the estate received $10,000 of ordinary
gross income from the business, and the estate paid business expenses with respect to the
business of $7,000. The estate was not required to distribute any net income to any
beneficiary during the estate’s first taxable year and the estate did not make any such
distribution. The estate's taxable income for the estate’s first taxable year is as follows.
a.
None/Zero
b.
$2,400
c.
$3,000
d.
$10,000
e.
None of the above
Question 56. John died during the current taxable year and during John’s final taxable year,
John gave $30,000 of cash to the Salvation Army. John’s adjusted gross income for John’s
final taxable year was $50,000. John’s estate’s adjusted gross income for the estate’s first
taxable year was $20,000. John’s ordinary expense or ordinary loss deduction (considering
all deduction limitations) for John’s charitable contribution is as follows.
a.
None/Zero
b.
$25,000
c.
$30,000
d.
$20,000
e.
None of the above
Question 57. Referring to question 56, the estate’s ordinary expense or ordinary loss
deduction (considering all deduction limitations) for John’s charitable contribution is as
follows.
a.
None/Zero
b.
$25,000
c.
$20,000
d.
$30,000
e.
None of the above
Question 58. John died on July 1 of the current taxable year. With respect to John's final
taxable year (the current taxable year), John had no gross income and John had a short term
capital loss carryover (from John's sales of securities in prior taxable years) of $35,000.
During the first taxable year of John’s estate, the estate received $15,000 of short term
capital gain gross income (from the estate's sales of securities) and $10,000 of dividends.
John's estate's adjusted gross income for the estate's taxable year was $100,000. The estate's
ordinary expense or ordinary loss deduction plus any personal exemption to which the estate
is entitled for the estate’s first taxable year total is as follows.
a.
None/Zero
b.
$600
c.
$15,000
d.
$3,600
e.
None of the above
Question 59. During a prior taxable year, John determined that Paul owed John a fee of
$7,000, because John, a lawyer, had helped Paul draft a contract for Paul to use when Paul
allowed persons to rent John's business warehouse. John sent to Paul a bill for $7,000 for
John's work, but Paul stated that the bill was too high and that Paul did not owe the $7,000
fee and that Paul did not intend to pay the $7,000 fee. However, later, during the current
taxable year, Paul paid John $5,000 and Paul promptly sued John for the return of the
money. The lawsuit was settled during the next taxable year and John repaid Paul $2,000
during the next taxable year. John's gross income for the current taxable year is as follows.
a.
None/Zero
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60.
61.
62.
63.
64.
65.
b.
$2,000
c.
$5,000
d.
$7,000
e.
None of the above
Question 60. Referring to question 59, Paul’s ordinary expense or ordinary loss deduction
for the current taxable year is as follows.
a.
None/Zero
b.
$2,000
c.
$5,000
d.
$7,000
e.
None of the above
Question 61. Referring to question 59, John's ordinary expense or ordinary loss deduction
for the next taxable year when John repaid part of the fee is as follows.
a.
None/Zero
b.
$2,000
c.
$3,000
d.
$5,000
e.
None of the above
Question 62. Referring to question 59, Paul’s gross income for the next taxable year when
John repaid part of the fee is as follows.
a.
None/Zero
b.
$2,000
c.
$3,000
d.
$5,000
e.
None of the above
Question 63. During the current taxable year, Paul paid real property taxes to Marion
County, Indiana with respect to Paul’s personal residential property in the amount of $2,000.
During the current taxable year, Paul appealed the computation of such real property taxes
to the proper hearing officers. During the next taxable year, Paul received a refund of $1,500
with respect to such real property taxes. During the current taxable year, Paul deducted the
real property taxes. Paul’s gross income for the next taxable year is as follows.
a.
None/Zero
b.
$1,500
c.
$2,000
d.
$500
e.
None of the above
Question 64. During the current taxable year, Paul won a state of Indiana lottery and had the
choice of receiving a lump sum of $10,000,000 during the current taxable year or receiving
$600,000 for and during each year of Paul's remaining life, beginning on January 1 of the
next taxable year. An actuary estimated that Paul would live for 20 more years. Paul elected
to receive the $600,000 per year payments. Paul's gross income for the current taxable year
is as follows.
a.
None/Zero
b.
$10,000,000
c.
$600,000
d.
$9,400,000
e.
None of the above
Question 65. During the current taxable year, Peter asked John if Peter could purchase the
lake cottage which John owned for $70,000. John had purchased the lake cottage several
taxable years ago for $50,000 and the lake cottage now had a fair market value of $80,000.
John agreed to the purchase by Peter and Peter paid to John the full amount during the
current taxable year. John's gross income for the current taxable year is as follows.
a.
None/Zero
b.
$20,000
c.
$50,000
d.
$70,000
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66.
67.
68.
69.
70.
e.
None of the above
Question 66. Referring to question 65, Peter’s gross income for the current taxable year is
as follows.
a.
None/Zero
b.
$20,000
c.
$50,000
d.
$70,000
e.
None of the above
Question 67. On June 1 of the last taxable year, Mary sold some Indiana vacant real
property (which Mary leased for various purposes) and which real property Mary had owned
for ten years, and which real property Mary sold to Tom. Mary had an adjusted basis for the
real property of $300,000 at the date of the sale. Under the terms of the sale, Tom agreed
to pay Mary a total of $1,100,000 cash, with $100,000 of such amount to be paid as a down
payment on the date of sale, and the balance of such amount to be paid in amounts of
$100,000 on each subsequent anniversary date of the sale date. Tom gave Mary ten
negotiable notes, each with a face value of $100,000, with an interest rate of 7% per year on
the unpaid balance, which notes were payable consecutively. In addition, Mary agreed to
pay all of the real property taxes which were due and payable on or before day of sale. Tom
agreed to pay all of the real property taxes which were due and payable after the day of sale.
The real property taxes which were due and payable in the year of sale (payable the last
taxable year) were $10,000 and the real property taxes which accrued in the year of sale, but
which were payable during the current taxable year, were $12,000. Further, Tom agreed to
pay Mary's mortgage debt liability, to which the real property was subject, of $100,000.
Each party fulfilled Mary's or Tom's part of the bargain. Further, Tom paid $20,000 on the
mortgage debt during the last taxable year and $20,000 during the current taxable year, both
payments being made as regular payments on the mortgage debt. Further, Mary had selling
expenses of $50,000 and Tom had purchase expenses of $10,000. Mary's long term capital
gain for the last taxable year as a result of the sale of the real property to Tom is as follows.
a.
None/Zero
b.
$78,180
c.
$88,180
d.
$91,200
e.
None of the above
Question 68. Referring to question 67, Mary's income tax deduction for real property taxes,
which Mary may deduct for the last taxable year with respect to these facts, is as follows.
a.
None/Zero
b.
$15,000
c.
$10,000
d.
$12,000
e.
None of the above
Question 69. Referring to question 67, all of the interest on all of the outstanding notes was
payable annually, as that year's interest accrued, on each anniversary date of the sale date.
That is, the total accrued interest on all of the notes, for the preceding year, was payable
when a note for the current taxable year was payable. Mary's ordinary (total interest from
all of the notes) gross income for the current taxable year, when the first note and all of the
appropriate interest was paid, is as follows.
a.
None/Zero
b.
$100,000
c.
$80,000
d.
$70,000
e.
None of the above
Question 70. Referring to question 67, Tom's adjusted basis for the real property as of the
sale date with respect to these facts is as follows.
a.
None/Zero
b.
$1,220,000
c.
$1,225,000
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d.
e.
S.
$1,125,000
None of the above
Section 164 concerns a seller’s and a purchaser’s income tax deductions for real property taxes when
real property is sold.
1.
Section 1001 concerns the inclusion of real property taxes in the amount realized of the seller
when real property is sold. section 1012 concerning the capitalizing of real property taxes
in the basis of the purchaser when the purchaser purchases real property.
2.
Example. During the current year, John agreed to sell his land to Paul on August 1, 2004 for
$1,000,000 of cash plus an assumption of John’s mortgage debt of $100,000 plus an
assumption of the following real property taxes. John’s selling expenses were $10,000 and
John’s adjusted basis for the land was $200,000 and Paul’s purchase expenses were $12,000.
John held the land as an investment asset.
a.
Paul gave John a downpayment of $100,000 plus nine note payable consecutively,
one each year for nine years with a face amount of $100,000 per note, and with a
simple interest rate of 10% per year on the unpaid balance all notes and interest
being payable on August 1 of each year (for the nine-year period).
b.
The real property taxes which accrued on March 1 of last year and which were
payable on May 10 and November 10 of the year of sale (the current year) were a
total of $1,800 ($900 being payable on May 10 of the current year and $900 being
payable on November 10 of the current year).
c.
The real property taxes which accrued on March 1 of the current year and which
were payable on May 10 and November 10 of the next taxable year were a total of
$2,400 ($1,200 being payable on May 10 of the next taxable year and $1,200 being
payable on November 10 of the next taxable year).
d.
John agreed to pay the real property taxes which were due and payable on May 10
of the year of sale (the current taxable year) and also to pay all of the real property
taxes which were payable in years prior to the year of sale.
e.
Paul agreed to pay the real property taxes which were due and payable on November
10 of the year of sale (the current taxable year) and also to pay all of the real
property taxes which were payable after the year of sale.
f.
John’s gain from the sale are as follows.
(1)
$1,000,000
Cash to be paid by Paul to John.
(2)
+ 100,000
John’s mortgage debt assumed by Paul.
(3)
+
900
The November installment payable in November of the
current year which Paul agreed to pay,
(4)
+
1,400
The amount of taxes which 164(d) allocates to John and
which Paul agreed to pay (7/12 of 2,400 = 1,400).
(5)
$1,102,300
Total gross receipts.
(6)
10,000
John’s selling expenses.
(7)
1,092,300
John’s amount realized
(8)
- 200,000
John’s adjusted basis.
(9)
892,300
John’s gain.
g.
Paul’s basis is as follows.
(1)
$1,000,000
Cash to be paid by Paul to John.
(2)
+ 100,000
John’s mortgage debt assumed by Paul.
(3)
+
900
The November 10 installment payable on November 10 of
the current year which Paul agreed to pay,
(4)
+
1,400
The amount of taxes which 164(d) allocates to John and
which Paul agreed to pay (7/12 of 2,400 = 1,400).
(5)
1,102,300
A total of $1,102,300 which, at this point is the same as the
seller’s gross receipts.
(6)
+ 2,000
Paul’s purchases expenses.
(7)
1,114,300
Paul’s basis for the land.
h.
John may deduct the following real property taxes.
(1)
$ 900 John owed them and John paid them.
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(2)
i.
+ 900 John owed them but Paul paid them and Paul benefitted from the
payment because his basis went up.
(3)
+1,400 These taxes were allocated to John under 164(d), even though Paul
paid them, but because Paul paid them, they increased John’s gross
receipts, so John might be income taxed on them, so John is
granted the deduction to offset the possible gross income.
(4)
3,200 John’s deduction for real property taxes
Paul may deduct the following real property taxes.
(1)
$1,000 (5/12 of 2,400 = 1,000) these are the real property taxes which were
allocated to Paul under 164(d) and Paul paid these taxes.
T.
To return to section 453 - reporting gain on the installment method accounting.
1.
Example. This computation refers to the example, just above.
a.
$892,300 (John’s gain) / $1,000,000 (the cash to be paid to John) = 89.23%.
b.
Every time that John received $100,000 from Paul, John would report $89,230 as
gain from the sale of the land.
c.
Therefore, due to the downpayment of $100,000, John would report long term
capital gain of $89,230 and each time that Paul paid another $100,000 (for nine
years), then John would report $89,230 of capital gain and 10 payments of $100,000
each would be $1,000,000 and $89,230 times 10 is $892,300.
d.
In addition, Paul was required to pay John simple interest on the unpaid balance
each year, and therefore, after the first year, Paul was obligated for Paul to pay
interest of $90,000 (10% of the outstanding balance of $900,000) and after the
second year, Paul would owe interest of $80,000 (10% of $800,000) all of which
would be ordinary gross income to John.
2.
Example. On September 1 of the current taxable year, John sold 100 common shares of
Strong Corporation to Paul for $100,000. John had owned the stock for many years and
John’s adjusted basis for the stock was $30,000 and John paid a broker $2,000 to arrange the
sale. Paul gave John a downpayment of $10,000 and nine installment notes, payable
annually on each September 1. The notes provided a simple interest rate of 8% per year on
the unpaid balance with the proper amount of interest being paid at the time when each note
was payable. John’s gross income for the current taxable year is as follows.
a.
$100,000
Gross receipts - cash to be paid to John
b.
- 2,000
Selling expenses
c.
98,000
Amount realized
d.
- 30,000
Adjusted basis
e.
68,000
Realized gain
f.
68,000 / 100,000 = 68% = percentage of each dollar which is gain.
g.
10,000 x 68% = 6,800 of long term capital gain. With respect to the downpayment
and each unit (note)of $10,000 paid thereafter.
h.
When the downpayment is made, there is no interest due.
i.
When the first note is paid, there is $7,200 of ordinary interest income due (8% x
90,000 = 7,200).
j.
When the second note is paid, there is $6,400 of interest due (all ordinary income).
U.
Some more comments about Indiana real property taxes and about the sales of Indiana real property.
1.
Generally, in order to understand the relevant points involved in this topic, you must
understand some of the principal points about how the Indiana real property tax system
relates to the federal income tax system.
a.
For example, you must understand that you generally must have three contiguous
taxable years in order to determine:
(1)
The amount of a seller’s income tax gain from the sale of the real property;
(2)
The amount of the purchaser’s basis of the real property which was
purchased by the purchaser;
(3)
The amount of the seller’s income tax deduction for the real property taxes
with respect to the real property sold; and,
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(4)
b.
c.
d.
e.
V.
The amount of the purchaser’s income tax deduction for the real property
tax with respect to the real property purchased.
For example, if the real property is sold during the calender year of 2011, then you
want to obtain real property tax information for the calender years of 2010 and 2012
so that you have Indiana real property tax information for the calendar years of
2010, 2011, and 2012..
The real property taxes for each of the three calendar years, accrues (becomes a
liability of the owner and a lien on the real property), in Indiana, on March 1st of
each calendar year and such real property taxes for each of such three accrual years
are payable in the next calendar year (after the calendar year in which the real
property taxes occurs). Specifally, such is acrrued real property taxes are payable
in the next calendar year on May 7 and November 7, in equal shares.
When real property is sold or when the owner just walks away from the real
property and another person takes over the real property, the real property
taxes continue to be a lien on such real property until the real property taxes
are paid. So if an owner just walks away from the real property and lets the
new owner take over the property, the former owner is generally continues
to be liable for payment of the real property taxes, but the state is not too
concerned about that, because the state can foreclose on its lien and sell the
property to get the money to pay the real property taxes. So if the new
"owner" wants to keep the real property, then he or she will have to pay the
delinquent real property taxes.
Returning to a sale of the real property, the seller and the purchaser should agree
which of them will pay for the real property taxes which are payable in the year of
sale and the real property taxes which are payable thereafter.
(1)
For example, the seller could agree to pay all real property taxes which are
due and payable up to the date of sale and the purchaser could agree to pay
all real property taxes which are payable after the date of sale.
Or, the seller could agree to pay all real property taxes which are due and
payable in the year of sale and the purchaser could agree to pay all real
property taxes which are payable after the year of sale.
Or, the seller could agree to pay all real property taxes which are
obligations of the seller due to the provisions of section 164, including
section 164(d) and the purchaser could agree which of them will pay the
real property taxes which are payable in the year of sale and the real
property taxes which are payable thereafter.
A explanation of the facts of a real property sale.
1.
During the current year, John agreed to sell his land to Paul on July 1, 2004 for $1,000,000
of cash plus an assumption of John’s mortgage debt of $100,000 plus an assumption of the
following real property taxes. John’s selling expenses were $10,000 and John’s adjusted
basis for the land was $200,000 and Paul’s purchase expenses were $12,000. John held the
land as an investment asset.
2.
Paul gave John a downpayment of $100,000 plus nine note payable consecutively, one each
year for nine years with a face amount of $100,000 per note, and with a simple interest rate
of 10% per year on the unpaid balance all notes and interest being payable on July 1 of each
year (for the nine-year period).
3.
The real property taxes which accrued on March 1 of 2002 and which were payable on May
10, 2003 and November 10, 2003 totaled $1,400 ($700 being payable on May 10, 2003 and
$700 being payable on November 10, 2003. These real property taxes are not involved with
this problem.
4.
The real property taxes which accrued on March 1 of 2003 and which were payable on May
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10, 2004 and November 10, 2004 totaled $1,800 ($900 being payable on May 10, 2004 and
$900 being payable on November 10, 2004.
5.
The real property taxes which accrued on March 1 of 2004 and which were payable on May
10, 2005 and November 10, 2005 totaled $2,400 ($1,200 being payable on May 10, 2005
and $1,200 being payable on November 10, 2005.
6.
The real property taxes which accrued on March 1 of 2005 and which were payable on May
10, 2006 and November 10, 2006 totaled $3,600 ($1,800 being payable on May 10, 2006
and $1,800 being payable on November 10, 2006. These real property taxes are not involved
in this problem.
7.
John agreed to pay the real property taxes which were due and payable on May 10, 2004 and
also to pay those real property taxes which were payable prior 2004.
8.
Paul agreed to pay the real property taxes which were due and payable on November 10,
2004 and also to pay those real property taxes which were payable after 2004.
W.
John’s gain is as follows.
1.
$ 1,000,000
Cash to be paid by Paul to John.
2.
+ 100,000 John’s mortgage debt assumed by Paul.
3.
+
900
The installment payable on November 10, 2004 which Paul agreed to pay,
4.
+ 1 ,200
The amount of taxes which 164(d) allocates to John and which Paul agreed
to pay (6/12 of 2,400 = 1,200).
5.
1,102,100
Total gross receipts of $1,102,100.
6.
10,000 John’s selling expenses.
7.
- 200,000 John’s adjusted basis.
8.
892,100
John’s gain.
X.
Paul’s basis is as follows.
1.
$ 1,000,000
Cash to be paid by Paul to John.
2.
+ 100,000 John’s mortgage debt assumed by Paul.
3.
+
900
The installment payable on November 10, 2004 which Paul agreed to pay.
4.
+
1,200
The amount of taxes which 164(d) allocates to John and which Paul agreed
to pay (7/12 of 2,400 = 1,400).
5.
$ 1,102,100 Subtotal
6.
+
12,000 Paul’s purchases expenses.
7.
$ 1,114,100 Paul’s adjusted basis for the land.
Y.
John may deduct the following real property taxes.
1.
$
900 John owed them and John paid them.
2.
+
900 John owed them but Paul paid them and Paul benefitted from the payment
because his basis went up, but the payment caused John to have more
income.
3.
+
1,200 These taxes were allocated to John under 164(d), even though Paul paid
them, but because Paul paid them, John’s gross receipts were increased.
(6/12 of 2,400). 3,000 Total real property taxes which John may deduct.
Z.
Paul may deduct the following real property taxes.
i.
$1,200
Total real property taxes which Paul may deduct. (6/12 of 2,400 = 1,200)
these are the real property taxes which were allocated to Paul under 164(d)
and Paul paid them.
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XIV.
Losses sustained - sections 165, 465, and 1211. Read sections 165(a), 465(a), and 1211(a), which state as
follows:
Section 165. Losses.
(a) General rule.
There shall be allowed as a deduction any loss sustained during the taxable
year and not compensated for by insurance or otherwise.
Section 465. Deductions limited to amount at risk
(a) Limitation to amount at risk
(1) In general
In the case of—
(A) an individual, and
(B) a C corporation with respect to which the stock ownership
requirement of paragraph (2) of section 542 (a) is met,
engaged in an activity to which this section applies, any
loss from such activity for the taxable year shall be
allowed only to the extent of the aggregate amount with
respect to which the taxpayer is at risk (within the meaning
of subsection (b)) for such activity at the close of the
taxable year.
Section 1211. Limitation on capital losses.
(a) Corporations
In the case of a corporation, losses from sales or exchanges of capital assets
shall be allowed only to the extent of gains from such sales or exchanges.
A.
Section 165(a) states that a loss is only deductible if the loss is “sustained”.
1.
Regardless of the taxpayer’s method of accounting, a loss is only deductible if it is
“sustained”. Losses are not “paid” or “accrued”.
Read section 165(a), which states as follows:
Section 165. Losses.
(a) General rule.
There shall be allowed as a deduction any loss sustained during the taxable
year and not compensated for by insurance or otherwise.
2.
In general, section 165(a) provides that there is allowable as a deduction any loss sustained
during the taxable year and not compensated for by insurance or otherwise.
Read section 165(a), which states as follows:
Section 165. Losses.
(a) General rule
. There shall be allowed as a deduction any loss sustained during the taxable
year and not compensated for by insurance or otherwise.
3.
In general, loss deductions are ordinary deductions (not capital losses), because they do not
arise from the sale or exchange of a capital asset and generally, there is no specific section
which states that they are to be treated as capital losses (even though they are in fact ordinary
deductions).
a.
However, and obviously, capital losses are not ordinary losses.
4.
Some loss deductions are deductible only above AGI and some loss deductions are
deductible only below AGI.
a.
No loss deduction may be deducted both above AGI and below AGI.
5.
Some loss deductions are ordinary loss deductions which are deductible in full against all
types of income. Some loss deductions are capital losses which are only deductible, each
year, against capital gains plus up to $3,000 of ordinary income.
6.
Section 165(g) supplies the “sale or exchange” element for worthless securities which are
capital assets, and therefore, such losses are capital losses instead of ordinary losses.
a.
If you own some stock and it begins to go down in value and you sell the stock, you
will generally have a capital loss.
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b.
c.
d.
e.
f.
g.
However, if the stock declines until the stock is worthless, then you would have an
ordinary loss, because there would be no sale or exchange.
Therefore, in order to deny persons the benefit of ordinary losses, section 165
provides that when a security, which is a capital asset, becomes worthless, that the
holder will not have an ordinary loss, but instead, the loss will be a capital loss
(long or short term measured by the holder’s date of acquisition through the last day
of the month in which the securities became worthless).
Thus, all sales or exchanges of securities at a loss and all worthless securities are
deductible, if at all, above the line (above AGI).
(1)
If the securities are sold at a loss, then the loss in deductible above AGI,
because all losses, which are deductible due to the sale or exchange of
property (whether or not the property is a capital asset or an ordinary asset)
are deductible above the line.
(2)
And, if a security, which is a capital asset becomes worthless, then the loss
is treated under section 165(g) as the loss from the sale or exchange of a
capital asset, and therefore, this type of loss is deductible above the line
(because it has become a loss from the sale or exchange of an asset and all
losses from the sale or exchange of an asset are deductible under section
62(a)(3).
A business loss is not from personal activity.
An investment loss is not from personal activity.
Casualty or theft losses may be deducted only to the extent that they exceed $100,
and they also must exceed certain casualty gains and they must also exceed 10% of
the taxpayer’s AGI.
B.
The basis for determining the loss with respect to property.
1.
The basis of property for determining the amount of the deduction for any loss is the basis
which is provided in section 1011 for determining the loss from the sale or other disposition
of property. Read section 165(b), which states as follows:
Section 165. Losses
(b) Amount of deduction
For purposes of subsection (a), the basis for determining the amount of the
deduction for any loss shall be the adjusted basis provided in section 1011
for determining the loss from the sale or other disposition of property.
C.
A limitation with respect to the deduction for losses in the case of individuals.
1.
In the case of individuals, the deductions for losses are limited to the following three types
of transactions.
a.
Losses incurred in a trade or business,
b.
Losses incurred in any transaction entered into for profit, though not connected with
a trade or business, and
c.
Losses incurred due to casualty or theft.
Read section 165© which states as follows:
Section 165. Losses.
(c) Limitation on losses of individuals
In the case of an individual, the deduction under subsection (a) shall be
limited to—
(1) losses incurred in a trade or business;
(2) losses incurred in any transaction entered into for profit, though not
connected with a trade or business; and
(3) except as provided in subsection (h), losses of property not connected
with a trade or business or a transaction entered into for profit, if
such losses arise from fire, storm, shipwreck, or other casualty, or
from theft.
D.
Losses from the disposition of business or investment property.
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1.
2.
3.
E.
Losses realized from the disposition of property used in a trade or business or property
purchased for investment, are generally deductible in full, subject to the limitations which
are applicable to capital losses from the disposition of capital assets.
Read section 1211(a), which states as follows:
Section 1211. Limitation on capital losses.
(a) Corporations
In the case of a corporation, losses from sales or exchanges of capital assets
shall be allowed only to the extent of gains from such sales or exchanges.
a.
Section 1211(a) provides that in the case of a corporation, losses from sales or
exchanges of capital assets shall be allowed only to the extent of gains from such
sales or exchanges.
b.
Section 1211(b) provides that in the case of a noncorporate taxpayer, losses from
sales or exchanges of capital assets shall be allowed only to the extent of the gains
from such sales or exchanges, plus (if such losses exceed such gains) the lower of-(1) $3,000 ($1,500 in the case of a married individual filing a separate return), or
(2) the excess of such losses over such gains.
If John sells GM stock (an investment activity) and has a loss, then this loss is deductible,
because it meets the limitations in section 165(c).
a.
However, it must also meet the capital loss deduction limitations which are stated
in section 1211(b).
However, losses attributable to property purchased primarily for personal purposes, such as
a personal residence or personal automobile, are not deductible if the property is sold or
exchanged.
a.
You must meet the three tests in section 165(c) in order to be able to deduct any
loss.
The “at risk” limitation.
1.
The deduction of losses arising from business and investment activities is limited to the
amount of the taxpayer's investment that is at risk in the activity.
Read section 465(a), which states as follows:
Section 465. Deductions limited to amount at risk
(a) Limitation to amount at risk
(1) In general
In the case of—
(A) an individual, and
(B) a C corporation with respect to which the stock ownership
requirement of paragraph (2) of section 542 (a) is met,
engaged in an activity to which this section applies, any
loss from such activity for the taxable year shall be
allowed only to the extent of the aggregate amount with
respect to which the taxpayer is at risk (within the meaning
of subsection (b)) for such activity at the close of the
taxable year.
(2) Deduction in succeeding year
Any loss from an activity to which this section applies not allowed
under this section for the taxable year shall be treated as a
deduction allocable to such activity in the first succeeding taxable
year.
(3) Special rules for applying paragraph (1)(B)
For purposes of paragraph (1)(B)—
(A) section 544 (a)(2) shall be applied as if such section did not
contain the phrase “or by or for his partner”; and
(B) sections 544 (a)(4)(A) and 544 (b)(1) shall be applied by
substituting “the corporation meet the stock ownership
requirements of section 542 (a)(2)” for “the corporation a personal
holding company”.
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2.
A taxpayer's amount at risk consists of the taxpayer’s cash investment in the activity, the
adjusted basis of property contributed to the activity, borrowed amounts used in the activity
if the taxpayer is personally liable for repayment (recourse debt), and the net fair market
value of the taxpayer's personal assets which secure nonrecourse loans used in the activity.
Otherwise, a taxpayer is not considered to be at risk with respect to nonrecourse loans.
Read section 465(b), which states as follows:
Section 465. Deductions limited to amount at risk
(b) Amounts considered at risk
(1) In general. For purposes of this section, a taxpayer shall be considered
at risk for an activity with respect to amounts including—
(A) the amount of money and the adjusted basis of other property
contributed by the taxpayer to the activity, and
(B) amounts borrowed with respect to such activity (as determined
under paragraph (2)).
(2) Borrowed amounts
For purposes of this section, a taxpayer shall be considered at risk
with respect to amounts borrowed for use in an activity to the
extent that he—
(A) is personally liable for the repayment of such amounts, or
(B) has pledged property, other than property used in such activity,
as security for such borrowed amount (to the extent of the
net fair market value of the taxpayer’s interest in such
property).
No property shall be taken into account as security if such
property is directly or indirectly financed by indebtedness
which is secured by property described in paragraph (1).
(3) Certain borrowed amounts excluded
(A) In general
Except to the extent provided in regulations, for purposes
of paragraph (1)(B), amounts borrowed shall not be
considered to be at risk with respect to an activity if such
amounts are borrowed from any person who has an interest
in such activity or from a related person to a person (other
than the taxpayer) having such an interest.
(B) Exceptions
(i) Interest as creditor Subparagraph (A) shall not apply to
an interest as a creditor in the activity.
(ii) Interest as shareholder with respect to amounts
borrowed by corporation In the case of amounts borrowed
by a corporation from a shareholder, subparagraph (A)
shall not apply to an interest as a shareholder.
(C) Related person
For purposes of this subsection, a person (hereinafter in
this paragraph referred to as the “related person”) is related
to any person if—
(i) the related person bears a relationship to such person
specified in section 267 (b) or section 707 (b)(1), or
(ii) the related person and such person are engaged in
trades or business under common control (within the
meaning of subsections (a) and (b) of section 52).
For purposes of clause (i), in applying section 267
(b) or 707 (b)(1), “10 percent” shall be substituted
for “50 percent”.
(4) Exception
Notwithstanding any other provision of this section, a taxpayer
shall not be considered at risk with respect to amounts protected
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against loss through nonrecourse financing, guarantees, stop loss
agreements, or other similar arrangements.
(5) Amounts at risk in subsequent years
If in any taxable year the taxpayer has a loss from an activity to
which subsection (a) applies, the amount with respect to which a
taxpayer is considered to be at risk (within the meaning of
subsection (b)) in subsequent taxable years with respect to that
activity shall be reduced by that portion of the loss which (after the
application of subsection (a)) is allowable as a deduction.
(6) Qualified nonrecourse financing treated as amount at risk
For purposes of this section—
(A) In general
Notwithstanding any other provision of this subsection, in
the case of an activity of holding real property, a taxpayer
shall be considered at risk with respect to the taxpayer’s
share of any qualified nonrecourse financing which is
secured by real property used in such activity.
(B) Qualified nonrecourse financing
For purposes of this paragraph, the term “qualified
nonrecourse financing” means any financing—
(i) which is borrowed by the taxpayer with respect
to the activity of holding real property,
(ii) which is borrowed by the taxpayer from a
qualified person or represents a loan from any
Federal, State, or local government or
instrumentality thereof, or is guaranteed by any
Federal, State, or local government,
(iii) except to the extent provided in regulations,
with respect to which no person is personally
liable for repayment, and
(iv) which is not convertible debt.
(C) Special rule for partnerships
In the case of a partnership, a partner’s share of any
qualified nonrecourse financing of such partnership shall
be determined on the basis of the partner’s share of
liabilities of such partnership incurred in connection with
such financing (within the meaning of section 752).
(D) Qualified person defined
For purposes of this paragraph—
(i) In general The term “qualified person” has the
meaning given such term by section 49
(a)(1)(D)(iv).
(ii) Certain commercially reasonable financing
from related persons For purposes of clause (i),
section 49 (a)(1)(D)(iv) shall be applied without
regard to subclause (I) thereof (relating to
financing from related persons) if the financing
from the related person is commercially
reasonable and on substantially the same terms as
loans involving unrelated persons.
(E) Activity of holding real property
For purposes of this paragraph—
(i) Incidental personal property and services The
activity of holding real property includes
the holding of personal property and the
providing of services which are incidental
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3.
F.
to making real property available as living
accommodations.
(ii) Mineral property The activity of holding real
property shall not include the holding of
mineral property.
a.
In the case of real property loans there is an exception for nonrecourse loans
obtained from an unrelated third-party lender, and even for nonrecourse loans
obtained from a related party (other than a person from whom the property was
purchased) if the terms are commercially reasonable and substantially the same as
those of loans involving unrelated persons.
b.
If a taxpayer is guaranteed reimbursement for losses, the taxpayer is not considered
to be at risk with respect to such protected amounts.
Read section 465(b)(4), which states as follows:
Section 465. Deductions limited to amount at risk
(b) Amounts considered at risk
(4) Exception
Notwithstanding any other provision of this section, a taxpayer shall
not be considered at risk with respect to amounts protected against
loss through nonrecourse financing, guarantees, stop loss
agreements, or other similar arrangements.
Losses disallowed due to the at-risk limitation may be carried forward and deducted against
income from the activity in later years, or against other income of the taxpayer to the extent
the taxpayer’s amount at risk in the particular activity increases.
Read section 465(a)(2), which states as follows:
Section 465. Deductions limited to amount at risk
(a) Limitation to amount at risk
(2) Deduction in succeeding year
Any loss from an activity to which this section applies not allowed
under this section for the taxable year shall be treated as a
deduction allocable to such activity in the first succeeding taxable
year.
Casualty and theft losses.
1.
`A “casualty loss” is a loss arising from a fire, storm, shipwreck, or other similar casualty,
such as, physical damage to property caused by an external force of sudden, unusual, or
unexpected origin.
2.
The deduction for theft losses has been interpreted broadly to cover larceny, robbery,
embezzlement, and anything constituting theft under state law. Read Reg. §1.165-8(d).
a.
Theft losses are deductible in the year in which the taxpayer discovers the loss.
Read section 165(e), which states as follows:
Section 165. Losses
(e) Theft losses
For purposes of subsection (a), any loss arising from theft shall be
treated as sustained during the taxable year in which the taxpayer
discovers such loss.
3.
For property that is not business or income producing property, the amount of the loss is the
difference between the fair market value of the property immediately before and immediately
after the casualty, but not in excess of the property’s adjusted basis. Read Reg. §1.1657(b)(1).
a.
Casualty and theft losses are deductible only to the extent each casualty or theft loss
exceeds $100 and also exceeds the total of all casualty losses for the year (reduced
by any casualty gains) exceeds 10% of the taxpayer's AGI.
Read section 165(h), which states as follows:
(h) Treatment of casualty gains and losses
(1) $100 limitation per casualty
Any loss of an individual described in subsection (c)(3) shall be allowed only to the
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extent that the amount of the loss to such individual arising from each casualty, or
from each theft, exceeds $100.
b.
4.
5.
6.
If business or income producing property is totally destroyed or stolen, the amount
of the loss is the adjusted basis for the property, and the $100 and 10% limitations
do not apply.
Casualty and theft losses are deductible only to the extent they are not compensated for by
insurance or otherwise and only if there is no reasonable prospect of reimbursement.
a.
No deduction is allowable for losses covered by insurance if the taxpayer does not
file a timely claim for reimbursement.
Read section 165(h)(4)(E), which states as follows:
Section 165. Losses
(h) Treatment of casualty gains and losses
(4) Special rules
(E) Claim required to be filed in certain cases
Any loss of an individual described in subsection (c)(3) to the extent
covered by insurance shall be taken into account under this section only if
the individual files a timely insurance claim with respect to such loss.
If personal casualty losses exceed personal casualty gains for the year, then all such gains
and losses are treated as ordinary.
Read section 165(h)(2), which states as follows:
Section 165. Losses
(h) Treatment of casualty gains and losses
(2) Net casualty loss allowed only to the extent it exceeds 10 percent of
adjusted gross income
(A) In general
If the personal casualty losses for any taxable year exceed
the personal casualty gains for such taxable year, such
losses shall be allowed for the taxable year only to the
extent of the sum of—
(i) the amount of the personal casualty gains for the taxable
year, plus
(ii) so much of such excess as exceeds 10 percent of the
adjusted gross income of the individual.
(B) Special rule where personal casualty gains exceed personal
casualty losses
If the personal casualty gains for any taxable year exceed
the personal casualty losses for such taxable year—
(i) all such gains shall be treated as gains from sales or
exchanges of capital assets, and
(ii) all such losses shall be treated as losses from sales or
exchanges of capital assets.
a.
Losses in excess of the $100 floor are deductible in computing AGI to the extent of
casualty gains.
(1)
Any remaining loss is deductible as an itemized deduction to the extent it
exceeds 10% of the taxpayer's AGI.
b.
If personal casualty gains exceed personal casualty losses for the year, then all such
gains and losses are treated as capital gains and capital losses.
(1)
In this case, losses in excess of the $100 floor may be deducted without
regard to the 10% limit.
If an individual has a ring stolen from the individual, which ring which cost the individual
$5,000 and which has a value of $15,000 at the time of the theft and if the insurance
company pays $12,000 to the individual (due to the theft), then the individual has a casualty
gain of $7,000 (12,000 - 5,000 = 7,000).
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G.
Some examples.
1.
Example. During last year, Mary's and John's AGI was $100,000, without considering the
following transactions. During last year, Mary's diamond ring was stolen. Mary had paid
$3,000 for the ring three years ago and Mary purchased the ring in order to have a nice ring
to wear when John and Mary went to dinner with guests. At the time of the theft, the ring
had a fair market value of $5,000. Mary received insurance proceeds of $4,000 due to the
ring theft and Mary decided to not purchase another ring.
a.
If Mary wanted to report as much gross income as Mary could have during last year
the amount of any additional gross income which Mary would have as a result of
these transactions is as follows. With respect to the theft of personal property, the
deductible loss is the lesser of the property's fair market value immediately before
the theft or the property's adjusted basis minus insurance proceeds received to cover
the theft (theft loss). Here, because the cost basis ($3,000) is less than the fair
market value ($5,000), the cost basis will be used. Mary received $4,000 in
insurance proceeds. These proceeds will reduce the deductible amount to zero with
$1,000 remaining. The excess insurance proceeds will be recognized as ordinary
income to Mary ($4,000 insurance proceeds - $3,000 basis = $1,000 ordinary
income).
b.
Mary purchased another diamond ring with $3,500 of the insurance proceeds. The
amount of any additional gross income which Mary would have as a result of these
transactions is as follows. Mary received $4,000 from Mary's insurance company
to due to the loss of the ring. Mary bought a new replacement ring for $3,500.
Mary must recognize the difference above the cost of the replacement ring.
Consequently, Mary as additional gross income of $500 ($4,000 - $3,500).
Therefore, the answer is $500.
2.
Example. During last year, John had $50 of cash stolen from John's wallet. John did not
receive any insurance proceeds due to the wallet theft. John’s loss is $50, but the $100 floor
will eliminate any deduction for John.
3.
Example. During last year, John had an automobile accident, which was John's fault. John's
automobile was significantly damaged. John had paid $20,000 for the automobile three
years ago and due to the automobile accident, the automobile declined in value $3,000. This
latter amount (of $3,000) was determined by using the cost of the repair of John's
automobile, which cost was paid by John. John received insurance proceeds of $2,500 due
to the automobile accident.
With respect to property which is held for personal use, the amount of casualty loss
is the lesser of the property's adjusted basis or its decline in fair market value (fair
market value immediately before the casualty minus its fair market value
immediately after). Read section 165(a), which states as follows:
Section 165. Losses
(a) General rule
There shall be allowed as a deduction any loss sustained during the
taxable year and not compensated for by insurance or otherwise.
The deductible loss is reduced by the insurance compensation received. Read
section 165(a).(see above) Here, the declined in fair market value was $3,000. John
received $2,500 insurance proceeds as compensation. The total deductible loss is
$500 ($3,000 - $2,500 = $500). No gross income will be recognized.
4.
Example. During last year, Mary purchased a painting for the living room with $3,500 of
the insurance proceeds. The amount of any additional gross income which Mary would have
as a result of these transactions is as follows. Mary did not purchase another ring.
Therefore, Mary will recognize gross income to the extent Mary the insurance proceeds
exceed Mary's adjusted basis for the ring. Mary will have gross income of $1,000 ($4,000
insurance proceeds - $3,000 adjusted basis = $1,000). Therefore, the answer is $1,000.
5.
Example. Prior to January 1, of last year, John purchased some business equipment for
$10,000. On January 1, of the current year, the equipment was stolen at a time when the
equipment had an adjusted basis to John of $6,000 and a fair market value of $8,000. John
did not have any insurance with respect to the theft.
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a.
b.
H.
A deduction may be taken for losses sustained due to theft. For theft of business or
investment property the deductible loss is the adjusted basis of the property minus
insurance. Here, the adjusted basis of the equipment was $6,000 and John did not
have any insurance. Therefore, the answer is $6,000 ordinary deduction, to AGI.
John had insurance and that John received an insurance check for the loss, in the
amount of $7,000. The income tax result to John for the current year is as follows.
The proceeds exceed the adjusted basis of the stolen business equipment. The
$1,000 excess ($7,000 - $6,000) is treated as a recapture of depreciation under
section 1245 (for example, a sale or exchange of a capital asset). Therefore, the
answer is $1,000 ordinary income.
Some questions.
1.
Question 1. Prior to January 1, of last year, John purchased some business equipment for
$10,000. On January 6 of the current year, the equipment was stolen at a time when the
equipment had an adjusted basis (after taking into account depreciation of $4,000) to John
of $6,000 and a fair market value of $8,000. John received insurance proceeds of $4,000
from John's insurance carrier, but John did not replace the equipment. John's income tax
deduction in arriving at AGI for the current year with respect to the equipment theft and the
receipt of the insurance proceeds is as follows.
a.
None/Zero
b.
$10,000
c.
$4,000
d.
$2,000
e.
No prior stated answer
2.
Question 2. Prior to January 1, of last year, John purchased some business equipment for
$10,000. On January 6 of the current year, the equipment was stolen at a time when the
equipment had an adjusted basis (after taking into account depreciation of $4,000) to John
of $6,000 and a fair market value of $8,000. John received insurance proceeds of $7,000
from John's insurance carrier, but John did not replace the equipment. This is the only
relevant transaction with respect to these facts. John's ordinary gross income for the current
year with respect to the equipment theft and receipt of the insurance proceeds is as follows.
a.
None/Zero
b.
$8,000
c.
$1,000
d.
$7,000
e.
No prior stated answer
3.
Question 3. During last year, Beverly's AGI was $100,000, without considering the
following transactions, and Beverly had no dependents. During last year, Beverly's diamond
ring was stolen. Beverly had paid $3,000 for the ring three years ago as a "dinner" ring. At
the time of the theft, the ring had a fair market value of $5,000. Beverly received insurance
proceeds of $4,000 with respect to the ring theft and Beverly decided to not purchase another
ring. Beverly's gross income for the current year with respect to the theft and the receipt of
the insurance proceeds is as follows.
a.
None/Zero
b.
$4,000
c.
$1,000
d.
$5,000
e.
No prior stated answer
4.
Question 4. During last year, Beverly's AGI was $100,000, without considering the
following transactions, and Beverly had no dependents. During last year, Beverly's diamond
ring was stolen. Beverly had paid $4,000 for the ring three years ago as a "dinner" ring. At
the time of the theft, the ring had a fair market value of $5,000. Beverly received insurance
proceeds of $3,000 with respect to the ring theft and Beverly decided to not purchase another
ring. Beverly's ordinary expense or ordinary loss deduction for the current year with respect
to the theft and the receipt of the insurance proceeds (considering all deduction limitations)
is as follows.
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a.
b.
c.
d.
e.
XV.
None/Zero
$4,000
$1,000
$5,000
No prior stated answer
Bad debts - section 166.
Read section 166(a), which states as follows:
Section 166. Bad debts
(a) General rule
(1) Wholly worthless debts
There shall be allowed as a deduction any debt which becomes
worthless within the taxable year.
(2) Partially worthless debts
When satisfied that a debt is recoverable only in part, the Secretary
may allow such debt, in an amount not in excess of the part charged
off within the taxable year, as a deduction.
A.
The purpose of section 166.
1.
Section 166 allows income tax deductions for bad debts of business loans (read section
166(a)) and for bad debts of nonbusiness loans (read section 166(d)), which state as follows:
Section 166. Bad debts
(a) General rule
(1) Wholly worthless debts
There shall be allowed as a deduction any debt which becomes
worthless within the taxable year.
(2) Partially worthless debts
When satisfied that a debt is recoverable only in part, the Secretary
may allow such debt, in an amount not in excess of the part charged
off within the taxable year, as a deduction.
Section 166. Bad debts
(d) Nonbusiness debts
(1) General rule
In the case of a taxpayer other than a corporation—
(A) subsection (a) shall not apply to any nonbusiness debt; and
(B) where any nonbusiness debt becomes worthless within the
taxable year, the loss resulting therefrom shall be considered a loss
from the sale or exchange, during the taxable year, of a capital asset
held for not more than 1 year.
(2) Nonbusiness debt defined
For purposes of paragraph (1), the term “nonbusiness debt” means
a debt other than—
(A) a debt created or acquired (as the case may be) in connection
with a trade or business of the taxpayer; or
(B) a debt the loss from the worthlessness of which is incurred in
the taxpayer’s trade or business.
2.
There are the following three types of bad debts.
a.
Investment - capital loss. Read section 165©, which states as follows:
Section 165. Losses
(c) Limitation on losses of individuals
In the case of an individual, the deduction under subsection (a)
shall be limited to—
(1) losses incurred in a trade or business;
(2) losses incurred in any transaction entered into for profit, though
not connected with a trade or business; and
(3) except as provided in subsection (h), losses of property not
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3.
4.
5.
connected with a trade or business or a transaction entered into for
profit, if such losses arise from fire, storm, shipwreck, or other
casualty, or from theft.
b.
Business - ordinary loss. Read section 162(a), which states as follows:
Section 162. Trade or business expenses
(a) In general. There shall be allowed as a deduction all the ordinary and
necessary expenses paid or incurred during the taxable year in carrying on
any trade or business, including—
(1) a reasonable allowance for salaries or other compensation for
personal services actually rendered;
(2) traveling expenses (including amounts expended for meals and
lodging other than amounts which are lavish or extravagant
under the circumstances) while away from home in the
pursuit of a trade or business; and
(3) rentals or other payments required to be made as a
condition to the continued use or possession, for purposes
of the trade or business, of property to which the taxpayer
has not taken or is not taking title or in which he has no
equity.
For purposes of the preceding sentence, the place of residence of a Member
of Congress (including any Delegate and Resident Commissioner) within
the State, congressional district, or possession which he represents in
Congress shall be considered his home, but amounts expended by such
Members within each taxable year for living expenses shall not be
deductible for income tax purposes in excess of $3,000. For purposes of
paragraph (2), the taxpayer shall not be treated as being temporarily away
from home during any period of employment if such period exceeds 1 year.
The preceding sentence shall not apply to any Federal employee during any
period for which such employee is certified by the Attorney General (or the
designee thereof) as traveling on behalf of the United States in temporary
duty status to investigate or prosecute, or provide support services for the
investigation or prosecution of, a Federal crime.
c.
Nonbusiness - capital loss (short term).
Read section 166(d)(1)(B), which states as follows:
Section 166. Bad debts
(d) Nonbusiness debts
(1) General rule. In the case of a taxpayer other than a corpora
tion—
(B) where any nonbusiness debt becomes worthless within
the taxable year, the loss resulting therefrom shall
be considered a loss from the sale or exchange,
during the taxable year, of a capital asset held for
not more than 1 year.
Section 166(a) provides, in general, that business bad debts are ordinary deductions, because
there is no sale or exchange of a capital asset when a business debt becomes worthless.
On the other hand, section 166(d) provides that nonbusiness bad debts are to be treated as
short term capital losses.
a.
Nonbusiness bad debts are capital assets. However, when a debt becomes a bad
debt, there is no sale or exchange.
b.
Nevertheless, section 166(d) treats the bad debt as a short time capital loss.
In general, any debt which becomes worthless during the taxable year is an allowable
deduction.
Read section 166(a)(1), which states as follows:
Section 166. Bad debts
(a) General rule
(1) Wholly worthless debts
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6.
There shall be allowed as a deduction any debt which becomes
worthless within the taxable year.
A bad debt arises when a bona fide debt owed to the taxpayer becomes worthless and
whether or not a debt has become worthless.
a.
If the statute of limitations has run with respect to the collection of the debt, then the
debt is a worthless debt and a bad debt.
B.
Business bad debts.
1.
Business bad debts are deductible as they become wholly worthless or when they become
totally worthless.
a.
If the primary purpose of a loan was connected with the taxpayer's trade or business,
the bad debt is deductible as an ordinary loss.
2.
Loans by a shareholder to the shareholder's corporation usually do not qualify as business
bad debts if they become worthless, because being a shareholder is not viewed as being in
a business.
3.
But, a loan by an employee to the employee's corporate employer can qualify as a business
debt if the primary purpose for making the loan was to protect the employee's job.
a.
In Cox v. Commissioner, 68 F.3d 128 (5th Cir.1995), the taxpayer lent money to his
wholly owned corporation. When the corporation was reorganized in bankruptcy,
the taxpayer refrained from filing a claim with respect to the debt for the purpose of
facilitating the reorganization. The taxpayer claimed a bad debt deduction and
argued that the bankruptcy evidenced the worthlessness of the debt. The court held
that the loan was not wholly worthless because if the taxpayer had filed a claim in
bankruptcy, he would have received partial repayment; thus, the deduction was
disallowed.
C.
Non-business bad debts.
1.
Nonbusiness bad debts are deductible only as short term capital losses and only when the
debts are wholly worthless.
Read section 166(a)(2), which states as follows:
Section 166. Bad debts
(a) General rule
(1) Wholly worthless debts
There shall be allowed as a deduction any debt which becomes
worthless within the taxable year.
(2) Partially worthless debts
When satisfied that a debt is recoverable only in part, the Secretary
may allow such debt, in an amount not in excess of the part charged
off within the taxable year, as a deduction.
2.
Bad debts arising out of loans made for investment or personal reasons which become
worthless within the taxable year is treated as short term capital losses.
Read section 166(d)(1), (2),which states the following:
Section 166. Bad debts
(d) Nonbusiness debts
(1) General rule
In the case of a taxpayer other than a corporation—
(A) subsection (a) shall not apply to any nonbusiness debt; and
(B) where any nonbusiness debt becomes worthless within the
taxable year, the loss resulting therefrom shall be considered a loss
from the sale or exchange, during the taxable year, of a capital asset
held for not more than 1 year.
(2) Nonbusiness debt defined
For purposes of paragraph (1), the term “nonbusiness debt” means
a debt other than—
(A) a debt created or acquired (as the case may be) in connection
with a trade or business of the taxpayer; or
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3.
(B) a debt the loss from the worthlessness of which is incurred in
the taxpayer’s trade or business.
Loans to family members can give rise to a bad debt deduction if the transaction was a bona
fide debt and not just a gift. Read section 166(d)(1), which states the following:
Section 166. Bad debts
(d) Nonbusiness debts
(1) General rule
In the case of a taxpayer other than a corporation—
(A) subsection (a) shall not apply to any nonbusiness debt; and
(B) where any nonbusiness debt becomes worthless within the
taxable year, the loss resulting therefrom shall be
considered a loss from the sale or exchange, during the
taxable year, of a capital asset held for not more than 1
year.
D.
A limitation on the deduction of a bad debt.
1.
The allowable deduction for bad debt is limited to the extent of the taxpayer's basis for the
worthless obligation. Read section 166(b), which states the following:
Section 166. Bad debts
(b) Amount of deduction
For purposes of subsection (a), the basis for determining the
amount of the deduction for any bad debt shall be the adjusted basis
provided in section 1011 for determining the loss from the sale or
other disposition of property.
2.
In the case of accounts receivable, the taxpayer's basis depends on the taxpayer's method of
accounting.
a.
A cash method taxpayer who has not yet received an account receivable will have
a basis of zero, and therefore no bad debt deduction, if the account becomes
uncollectible.
b.
On the other hand, the amount includible in gross income for accounts receivable
by an accrual method taxpayer becomes the basis for such obligations, and also the
measure of the loss if the debt becomes worthless.
E.
Treatment of a guarantor of a bad debt who must pay the amount of the guaranty.
1.
A loss due to the taxpayer’s guaranty of a debt was became worthless is generally treated the
same as a bad debt, giving rise to a deduction when the guarantor pays the debt if the
guarantor's rights over against the debtor are worthless.
2.
However, Reg. §1.166-9(e) denies a bad debt deduction for amounts paid on loan guarantees
unless the guarantor agreed to act as such in the course of the guarantor's trade or business
or in a transaction entered into for profit.
3.
As evidence of the requisite purpose, the taxpayer must demonstrate that the taxpayer
received reasonable consideration for entering into the guaranty agreement, and such
consideration must be in the form of cash or property if it is received from the taxpayer's
spouse or dependents.
F.
Some examples.
1.
Example. During last year, Alan had the following transactions and Alan had AGI of
$200,000, all ordinary income from Alan's sole proprietorship, aside from the particular item
below.
Bad debt due to loan of money which Alan made to a friend . . . . . . . . . . . . . . . . . $5,000
Bad debt due to loan of money which Alan made to Alan's business supplier . . . . $5,000
Repayment of accounting fee to client, which fee was paid to Alan four
years ago, and which was repaid by Alan because Alan did not
properly prepare the client's income tax return . . . . . . . . . . . . . . . . . . . . . $5,000
a.
The amount which Alan may deduct in arriving at Alan's AGI for last year is as
follows. Business bad debts are deductible as ordinary deductions. They are
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2.
G.
deductible even if the bad debt is not completely worthless. Non business bad debts
are deductible as short term capital loss and only deductible if the bad debt is
completely worthless. Read section 166. Here, the bad debt due to the loan to
Alan's friend (a non business bad debt of $5,000, of which $3,000 is allowable
because it is considered a short term capital loss), the bad debt due to the loan to
Alan's business supplier ($5,000), and the repayment of the fee (because fee was
includible in gross income four years ago and are subject to income taxation, Alan
should be able to deduct the repayment last year) are deductible in arriving at AGI.
Therefore, the answer is $13,000. Section 166 states as follows:
Section 166. Bad debts
(a) General rule
(1) Wholly worthless debts
There shall be allowed as a deduction any debt which
becomes worthless within the taxable year.
(2) Partially worthless debts
When satisfied that a debt is recoverable only in part, the
Secretary may allow such debt, in an amount not in excess
of the part charged off within the taxable year, as a
deduction.
Example. During the current year, Mary received the following receipts or benefits.
Royalties from Mary's book sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $6,000
Indiana income tax refund for Indiana income taxes which Mary paid three years ago. All
of the Indiana income taxes had been deducted on Mary's and John's prior federal income
tax return as an itemizable income tax deduction . . . . . . . . . . . . . . . . . . . . . . . . . $6,000
Repayment of a debt which Mary had written off, two year
ago, for income tax purposes, as being a bad debt . . . . . . . . . . . . . . . . . . . $6,000
a.
The amount of Mary's gross income for the current year is as follows. Royalties are
treated as gross income. Tax refunds for taxes previously deducted are includible
in gross income in the year the refund is received. Receipt of a debt payment which
had be written off and previously deducted is gross income. Mary's gross income
for the current year is as follows.
Royalties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 6,000
Tax refund . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000
Debt repayment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . + 6,000
Gross income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 18,000
Therefore, the answer is $18,000.
Some questions.
1.
Question 1. During the current year, Alan had the following transactions and Alan had AGI
of $200,000, all ordinary income from Alan's sole proprietorship, and without considering
any of the following information.
Bad debt with respect to loan of money which Alan made to friend . . . . . . . . . . . $4,000
Bad debt with respect to loan of money which Alan made to Alan's
business supplier . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,000
Neither Alan's friend nor Alan's business supplier were (or were about to be) insolvent, but,
because Alan could no longer collect these debts, because the applicable statutes of
limitation for such collection had run during the current year, Alan determined that such
debts were worthless. Alan's AGI for the current year with respect to these facts is as
follows.
a.
None/Zero
b.
$200,000
c.
$196,000
d.
$193,000
e.
No prior stated answer
2.
Question 2. Referring to question 1, Alan's friend's gross income for the current year with
respect to these facts is as follows.
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3.
4.
5.
6.
7.
8.
a.
None/Zero
b.
$4,000
c.
No prior stated answer
Question 3. Referring to question 1, Alan's business supplier's gross income for the current
year with respect to these facts is as follows.
a.
None/Zero
b.
$4,000
c.
No prior stated answer
Question 4. During the current year, Alan had the following transactions and Alan had AGI
of $100,000, all ordinary income from Alan's sole proprietorship, and without considering
any of the following information.
Bad debt with respect to loan of money which Alan made to friend . . . . . . . . . . $10,000
Bad debt with respect to loan of money which Alan made to
Alan's business supplier . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,000
Neither Alan's friend nor Alan's business supplier were (or were about to be) insolvent, but,
because Alan could no longer collect these debts, because the applicable statutes of
limitation for such collection had run during the current year, Alan determined that such
debts were worthless. Alan's AGI for the current year with respect to these facts is as
follows.
a.
None/Zero
b.
$100,000
c.
$187,000
d.
$180,000
e.
No prior stated answer
Question 5. Referring to question 4, Alan's friend's gross income for the current year with
respect to these facts is as follows.
a.
None/Zero
b.
$4,000
c.
No prior stated answer
Question 6. Five years ago, Mary loaned Peter (Mary's adult child) $3,000. During the
current year, as part of a Hanukkah celebration, Peter said "Happy Hanukkah, Mom, and I
intend to repay the $3,000 loan next week". Mary said (and meant it): "You do not have to
pay me back. Just keep the money." To which Peter said: "Ok, and thanks". Peter's gross
income for the current year with respect to these facts is as follows.
a.
None/Zero
b.
$3,000
c.
$3,300
d.
No prior stated answer
Question 7. Referring to question 6 Mary's ordinary income tax deduction for the current
year with respect these facts is as follows.
a.
None/Zero
b.
$3,000
c.
$3,300
d.
No prior stated answer
Question 8. Five years ago, Mary loaned Peter (Mary's adult child) $3,000. During the
current year, as part of a Hanukkah celebration, Peter said "Happy Hanukkah, mom, and I
intend to repay the $3,000 loan next week". Mary said (and meant it): "You do not have to
pay me back the $3,000, but it would make me happy if you would give $1,000 of the money
to the Hebrew congregation to help the elderly members of our congregation. And Happy
Hanukkah to you”. Paul did as Mary asked. Peter's gross income for the current year with
respect to these facts is as follows.
a.
None/Zero
b.
$3,000
c.
$2,000
d.
$1,000
e.
No prior stated answer
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9.
XVI.
Question 9. Referring to question 8, Mary's ordinary expense or ordinary loss deduction for
the current year with respect these facts is as follows.
a.
None/Zero
b.
$3,000
c.
$1,000
d.
$2,000
e.
No prior stated answer
Depreciation and expending of property - sections 167, 168, 179, 280F, 1016, 1245, and 1250. Read sections
167(a), 168(a), 179(a), 280F(a), 1016(a), 1245(a), and 1250(a), which state as follows:
Section 167. Depreciation
(a) General rule
There shall be allowed as a depreciation deduction a reasonable allowance
for the exhaustion, wear and tear (including a reasonable allowance for
obsolescence)—
(1) of property used in the trade or business, or
(2) of property held for the production of income.
Section 168. Accelerated cost recovery system
(a) General rule
Except as otherwise provided in this section, the depreciation deduction
provided by section 167 (a) for any tangible property shall be determined
by using—
(1) the applicable depreciation method,
(2) the applicable recovery period, and
(3) the applicable convention.
Section 179. Election to expense certain depreciable business assets
(a) Treatment as expenses
A taxpayer may elect to treat the cost of any section 179 property as an
expense which is not chargeable to capital account. Any cost so treated shall
be allowed as a deduction for the taxable year in which the section 179
property is placed in service.
Section 280F. Limitation on depreciation for luxury automobiles; limitation where certain
property used for personal purposes
(a) Limitation on amount of depreciation for luxury automobiles
(1) Depreciation
(A) Limitation
The amount of the depreciation deduction for any taxable year for
any passenger automobile shall not exceed—
(i) $2,560 for the 1st taxable year in the recovery period,
(ii) $4,100 for the 2nd taxable year in the recovery period,
(iii) $2,450 for the 3rd taxable year in the recovery period, and
(iv) $1,475 for each succeeding taxable year in the recovery period.
Section 1016. Adjustments to basis
(a) General rule
Proper adjustment in respect of the property shall in all cases be made—
(1) for expenditures, receipts, losses, or other items, properly chargeable to
capital account, but no such adjustment shall be made—
(A) for taxes or other carrying charges described in section 266, or
(B) for expenditures described in section 173 (relating to
circulation expenditures),
for which deductions have been taken by the taxpayer in determining
taxable income for the taxable year or prior taxable years;
(2) in respect of any period since February 28, 1913, for exhaustion, wear
and tear, obsolescence, amortization, and depletion, to the extent of
the amount—
(A) allowed as deductions in computing taxable income under this
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subtitle or prior income tax laws, and
(B) resulting (by reason of the deductions so allowed) in a
reduction for any taxable year of the taxpayer’s taxes under this
subtitle (other than chapter 2, relating to tax on self-employment
income), or prior income, war-profits, or excess-profits tax laws,
but not less than the amount allowable under this subtitle or prior income
tax laws. Where no method has been adopted under section 167 (relating to
depreciation deduction), the amount allowable shall be determined under
the straight line method. Subparagraph (B) of this paragraph shall not apply
in respect of any period since February 28, 1913, and before January 1,
1952, unless an election has been made under section 1020 (as in effect
before the date of the enactment of the Tax Reform Act of 1976). Where for
any taxable year before the taxable year 1932 the depletion allowance was
based on discovery value or a percentage of income, then the adjustment for
depletion for such year shall be based on the depletion which would have
been allowable for such year if computed without reference to discovery
value or a percentage of income;
(3) in respect of any period—
(A) before March 1, 1913,
(B) since February 28, 1913, during which such property was held
by a person or an organization not subject to income
taxation under this chapter or prior income tax laws,
(C) since February 28, 1913, and before January 1, 1958, during
which such property was held by a person subject to tax under part
I of subchapter L (or the corresponding provisions of prior income
tax laws), to the extent that paragraph (2) does not apply, and
(D) since February 28, 1913, during which such property was held
by a person subject to tax under part II [1] of subchapter L
(or the corresponding provisions of prior income tax laws),
to the extent that paragraph (2) does not apply,
for exhaustion, wear and tear, obsolescence, amortization, and depletion, to
the extent sustained;
(4) in the case of stock (to the extent not provided for in the foregoing
paragraphs) for the amount of distributions previously made which, under
the law applicable to the year in which the distribution was made, either
were tax-free or were applicable in reduction of basis (not including
distributions made by a corporation which was classified as a personal
service corporation under the provisions of the Revenue Act of 1918 (40
Stat. 1057), or the Revenue Act of 1921 (42 Stat. 227), out of its earnings
or profits which were taxable in accordance with the provisions of section
218 of the Revenue Act of 1918 or 1921);
(5) in the case of any bond (as defined in section 171 (d)) the interest on
which is wholly exempt from the tax imposed by this subtitle, to the extent
of the amortizable bond premium disallowable as a deduction pursuant to
section 171 (a)(2), and in the case of any other bond (as defined in section
171 (d)) to the extent of the deductions allowable pursuant to section 171
(a)(1) (or the amount applied to reduce interest payments under section 171
(e)(2)) with respect thereto;
(6) in the case of any municipal bond (as defined in section 75 (b)), to the
extent provided in section 75 (a)(2);
(7) in the case of a residence the acquisition of which resulted, under
section 1034 (as in effect on the day before the date of the enactment of the
Taxpayer Relief Act of 1997), in the nonrecognition of any part of the gain
realized on the sale, exchange, or involuntary conversion of another
residence, to the extent provided in section 1034 (e) (as so in effect);
(8) in the case of property pledged to the Commodity Credit Corporation,
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to the extent of the amount received as a loan from the Commodity
Credit Corporation and treated by the taxpayer as income for the
year in which received pursuant to section 77, and to the extent of
any deficiency on such loan with respect to which the taxpayer has
been relieved from liability;
(9) for amounts allowed as deductions as deferred expenses under section
616 (b) (relating to certain expenditures in the development of
mines) and resulting in a reduction of the taxpayer’s taxes under
this subtitle, but not less than the amounts allowable under such
section for the taxable year and prior years;
[(10) Repealed. Pub. L. 94–455, title XIX, § 1901(b)(21)(G), Oct. 4, 1976,
90 Stat. 1798]
(11) for deductions to the extent disallowed under section 268 (relating to
sale of land with unharvested crops), notwithstanding the
provisions of any other paragraph of this subsection;
(12) to the extent provided in section 28(h) of the Internal Revenue Code
of 1939 in the case of amounts specified in a shareholder’s consent
made under section 28 of such code;
[(13) Repealed. Pub. L. 108–357, title IV, § 413(c)(19), Oct. 22, 2004, 118
Stat. 1509]
(14) for amounts allowed as deductions as deferred expenses under section
174 (b)(1) (relating to research and experimental expenditures) and
resulting in a reduction of the taxpayers’ taxes under this subtitle,
but not less than the amounts allowable under such section for the
taxable year and prior years;
(15) for deductions to the extent disallowed under section 272 (relating to
disposal of coal or domestic iron ore), notwithstanding the
provisions of any other paragraph of this subsection;
(16) in the case of any evidence of indebtedness referred to in section 811
(b) (relating to amortization of premium and accrual of discount in
the case of life insurance companies), to the extent of the
adjustments required under section 811 (b) (or the corresponding
provisions of prior income tax laws) for the taxable year and all
prior taxable years;
(17) to the extent provided in section 1367 in the case of stock of, and
indebtedness owed to, shareholders of an S corporation;
(18) to the extent provided in section 961 in the case of stock in controlled
foreign corporations (or foreign corporations which were controlled
foreign corporations) and of property by reason of which a person
is considered as owning such stock;
(19) to the extent provided in section 50 (c), in the case of expenditures with
respect to which a credit has been allowed under section 38;
(20) for amounts allowed as deductions under section 59 (e) (relating to
optional 10-year writeoff of certain tax preferences);
(21) to the extent provided in section 1059 (relating to reduction in basis for
extraordinary dividends);
(22) in the case of qualified replacement property the acquisition of which
resulted under section 1042 in the nonrecognition of any part of the
gain realized on the sale or exchange of any property, to the extent
provided in section 1042 (d),[2]
(23) in the case of property the acquisition of which resulted under section
1043, 1044, 1045, or 1397B in the nonrecognition of any part of
the gain realized on the sale of other property, to the extent
provided in section 1043 (c), 1044 (d), 1045 (b)(3), or 1397B
(b)(4), as the case may be,[2]
(24) to the extent provided in section 179A (e)(6)(A),[2]
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(25) to the extent provided in section 30 (d)(1),[2]
(26) to the extent provided in sections 23 (g) and 137 (e),[2]
(27) in the case of a residence with respect to which a credit was allowed
under section 1400C, to the extent provided in section 1400C (h),[2]
(28) in the case of a facility with respect to which a credit was allowed
under section 45F, to the extent provided in section 45F (f)(1),[2]
(29) in the case of railroad track with respect to which a credit was allowed
under section 45G, to the extent provided in section 45G (e)(3),[2]
(30) to the extent provided in section 179B (c),[2]
(31) in the case of a facility with respect to which a credit was allowed
under section 45H, to the extent provided in section 45H (d),[2]
(32) to the extent provided in section 179D (e),[2]
(33) to the extent provided in section 45L (e), in the case of amounts with
respect to which a credit has been allowed under section 45L,[2]
(34) to the extent provided in section 25C (e), in the case of amounts with
respect to which a credit has been allowed under section 25C,[2]
(35) to the extent provided in section 25D (f), in the case of amounts with
respect to which a credit has been allowed under section 25D,[2]
(36) to the extent provided in section 30B (h)(4),[2] and
(37) to the extent provided in section 30C (f).
Section 1245. Gain from dispositions of certain depreciable property
(a) General rule
(1) Ordinary income
Except as otherwise provided in this section, if section 1245
property is disposed of the amount by which the lower of—
(A) the recomputed basis of the property, or
(B)
(i) in the case of a sale, exchange, or involuntary
conversion, the amount realized, or
(ii) in the case of any other disposition, the fair market
value of such property,
exceeds the adjusted basis of such property shall
be treated as ordinary income. Such gain shall be
recognized notwithstanding any other provision of
this subtitle.
Section 1250. Gain from dispositions of certain depreciable realty
(a) General rule
Except as otherwise provided in this section—
(1) Additional depreciation after December 31, 1975
(A) In general
If section 1250 property is disposed of after December 31,
1975, then the applicable percentage of the lower of—
(i) that portion of the additional depreciation (as defined in
subsection (b)(1) or (4)) attributable to periods
after December 31, 1975, in respect of the
property, or
(ii) the excess of the amount realized (in the case of a sale,
exchange, or involuntary conversion), or the fair
market value of such property (in the case of any
other disposition), over the adjusted basis of such
property,
shall be treated as gain which is ordinary income. Such gain shall
be recognized notwithstanding any other provision of this subtitle.
(B) Applicable percentage
For purposes of subparagraph (A), the term “applicable
percentage” means—
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(i) in the case of section 1250 property with respect to
which a mortgage is insured under section 221(d)(3) or
236 of the National Housing Act, or housing financed or
assisted by direct loan or tax abatement under similar
provisions of State or local laws and with respect to which
the owner is subject to the restrictions described in section
1039 (b)(1)(B) (as in effect on the day before the date of
the enactment of the Revenue Reconciliation Act of 1990),
100 percent minus 1 percentage point for each full month
the property was held after the date the property was held
100 full months;
(ii) in the case of dwelling units which, on the average,
were held for occupancy by families or individuals eligible
to receive subsidies under section 8 of the United States
Housing Act of 1937, as amended, or under the provisions
of State or local law authorizing similar levels of subsidy
for lower-income families, 100 percent minus 1 percentage
point for each full month the property was held after the
date the property was held 100 full months;
(iii) in the case of section 1250 property with respect to
which a depreciation deduction for rehabilitation
expenditures was allowed under section 167 (k), 100
percent minus 1 percentage point for each full month in
excess of 100 full months after the date on which such
property was placed in service;
(iv) in the case of section 1250 property with respect to
which a loan is made or insured under title V of the
Housing Act of 1949, 100 percent minus 1 percentage
point for each full month the property was held after the
date the property was held 100 full months; and
(v) in the case of all other section 1250 property, 100
percent.
In the case of a building (or a portion of a building devoted to
dwelling units), if, on the average, 85 percent or more of the
dwelling units contained in such building (or portion thereof) are
units described in clause (ii), such building (or portion thereof)
shall be treated as property described in clause (ii). Clauses (i), (ii),
and (iv) shall not apply with respect to the additional depreciation
described in subsection (b)(4) which was allowed under section 167
(k).
(2) Additional depreciation after December 31, 1969, and before January 1,
1976
(A) In general
If section 1250 property is disposed of after December 31,
1969, and the amount determined under paragraph
(1)(A)(ii) exceeds the amount determined under paragraph
(1)(A)(i), then the applicable percentage of the lower of—
(i) that portion of the additional depreciation attributable to
periods after December 31, 1969, and before
January 1, 1976, in respect of the property, or
(ii) the excess of the amount determined under paragraph
(1)(A)(ii) over the amount determined under
paragraph (1)(A)(i),
shall also be treated as gain which is ordinary income. Such gain
shall be recognized notwithstanding any other provision of this
subtitle.
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(B) Applicable percentage
For purposes of subparagraph (A), the term “applicable
percentage” means—
(i) in the case of section 1250 property disposed of
pursuant to a written contract which was, on July 24, 1969,
and at all times thereafter, binding on the owner of the
property, 100 percent minus 1 percentage point for each
full month the property was held after the date the property
was held 20 full months;
(ii) in the case of section 1250 property with respect to
which a mortgage is insured under section 221(d)(3) or
236 of the National Housing Act, or housing financed or
assisted by direct loan or tax abatement under similar
provisions of State or local laws, and with respect to which
the owner is subject to the restrictions described in section
1039 (b)(1)(B) (as in effect on the day before the date of
the enactment of the Revenue Reconciliation Act of 1990),
100 percent minus 1 percentage point for each full month
the property was held after the date the property was held
20 full months;
(iii) in the case of residential rental property (as defined in
section 167 (j)(2)(B)) other than that covered by
clauses (i) and (ii), 100 percent minus 1
percentage point for each full month the property
was held after the date the property was held 100
full months;
(iv) in the case of section 1250 property with respect to
which a depreciation deduction for rehabilitation
expenditures was allowed under section 167 (k), 100
percent minus 1 percentage point for each full month in
excess of 100 full months after the date on which such
property was placed in service; and
(v) in the case of all other section 1250 property, 100
percent.
Clauses (i), (ii), and (iii) shall not apply with
respect to the additional depreciation described in
subsection (b)(4).
(3) Additional depreciation before January 1, 1970
(A) In general
If section 1250 property is disposed of after December 31,
1963, and the amount determined under paragraph
(1)(A)(ii) exceeds the sum of the amounts determined
under paragraphs (1)(A)(i) and (2)(A)(i), then the
applicable percentage of the lower of—
(i) that portion of the additional depreciation attributable to
periods before January 1, 1970, in respect of the
property, or
(ii) the excess of the amount determined under paragraph
(1)(A)(ii) over the sum of the amounts determined
under paragraphs (1)(A)(i) and (2)(A)(i),
shall also be treated as gain which is ordinary income. Such gain
shall be recognized notwithstanding any other provision of this
subtitle.
(B) Applicable percentage
For purposes of subparagraph (A), the term “applicable
percentage” means 100 percent minus 1 percentage point
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for each full month the property was held after the date on
which the property was held for 20 full months.
(4) Special rule
For purposes of this subsection, any reference to section 167 (k) or
167 (j)(2)(B) shall be treated as a reference to such section as in
effect on the day before the date of the enactment of the Revenue
Reconciliation Act of 1990.
(5) Cross reference
For reduction in the case of corporations on capital gain treatment
under this section, see section 291 (a)(1).
A.
The concept of depreciation.
1.
Depreciation is the "writing off" of the cost of tangible personal or real property which is
used in a trade or business or which is used in an investment activity.
2.
There is allowable as a deduction a reasonable allowance for the exhaustion, wear and tear
(including a reasonable allowance for obsolescence) of property used in the trade or
business, or of property held for the production of income.
Read section 167(a), which states as follows:
Section 167. Depreciation
(a) General rule
There shall be allowed as a depreciation deduction a reasonable allowance
for the exhaustion, wear and tear (including a reasonable allowance for
obsolescence)—
(1) of property used in the trade or business, or
(2) of property held for the production of income
3.
Depreciation is the writing off of costs over time; only property that will last more than one
year is depreciable property.
Read section 1016(a), which states as follows:
Section 1016. Adjustments to basis
(a) General rule
Proper adjustment in respect of the property shall in all cases be made—
(1) for expenditures, receipts, losses, or other items, properly chargeable to
capital account, but no such adjustment shall be made—
(A) for taxes or other carrying charges described in section 266, or
(B) for expenditures described in section 173 (relating to
circulation expenditures),
for which deductions have been taken by the taxpayer in
determining taxable income for the taxable year or prior
taxable years;
(2) in respect of any period since February 28, 1913, for exhaustion, wear
and tear, obsolescence, amortization, and depletion, to the extent of
the amount—
(A) allowed as deductions in computing taxable income under this
subtitle or prior income tax laws, and
(B) resulting (by reason of the deductions so allowed) in a
reduction for any taxable year of the taxpayer’s taxes under this
subtitle (other than chapter 2, relating to tax on self-employment
income), or prior income, war-profits, or excess-profits tax laws,
but not less than the amount allowable under this subtitle
or prior income tax laws. Where no method has been
adopted under section 167 (relating to depreciation
deduction), the amount allowable shall be determined
under the straight line method. Subparagraph (B) of this
paragraph shall not apply in respect of any period since
February 28, 1913, and before January 1, 1952, unless an
election has been made under section 1020 (as in effect
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before the date of the enactment of the Tax Reform Act of
1976). Where for any taxable year before the taxable year
1932 the depletion allowance was based on discovery
value or a percentage of income, then the adjustment for
depletion for such year shall be based on the depletion
which would have been allowable for such year if
computed without reference to discovery value or a
percentage of income;
(3) in respect of any period—
(A) before March 1, 1913,
(B) since February 28, 1913, during which such property was held
by a person or an organization not subject to income
taxation under this chapter or prior income tax laws,
(C) since February 28, 1913, and before January 1, 1958, during
which such property was held by a person subject to tax
under part I of subchapter L (or the corresponding
provisions of prior income tax laws), to the extent that
paragraph (2) does not apply, and
(D) since February 28, 1913, during which such property was held
by a person subject to tax under part II [1] of subchapter L
(or the corresponding provisions of prior income tax laws),
to the extent that paragraph (2) does not apply,
for exhaustion, wear and tear, obsolescence, amortization,
and depletion, to the extent sustained;
(4) in the case of stock (to the extent not provided for in the foregoing
paragraphs) for the amount of distributions previously made which,
under the law applicable to the year in which the distribution was
made, either were tax-free or were applicable in reduction of basis
(not including distributions made by a corporation which was
classified as a personal service corporation under the provisions of
the Revenue Act of 1918 (40 Stat. 1057), or the Revenue Act of
1921 (42 Stat. 227), out of its earnings or profits which were
taxable in accordance with the provisions of section 218 of the
Revenue Act of 1918 or 1921);
(5) in the case of any bond (as defined in section 171 (d)) the interest on
which is wholly exempt from the tax imposed by this subtitle, to
the extent of the amortizable bond premium disallowable as a
deduction pursuant to section 171 (a)(2), and in the case of any
other bond (as defined in section 171 (d)) to the extent of the
deductions allowable pursuant to section 171 (a)(1) (or the amount
applied to reduce interest payments under section 171 (e)(2)) with
respect thereto;
(6) in the case of any municipal bond (as defined in section 75 (b)), to the
extent provided in section 75 (a)(2);
(7) in the case of a residence the acquisition of which resulted, under
section 1034 (as in effect on the day before the date of the
enactment of the Taxpayer Relief Act of 1997), in the
nonrecognition of any part of the gain realized on the sale,
exchange, or involuntary conversion of another residence, to the
extent provided in section 1034 (e) (as so in effect);
(8) in the case of property pledged to the Commodity Credit Corporation,
to the extent of the amount received as a loan from the Commodity
Credit Corporation and treated by the taxpayer as income for the
year in which received pursuant to section 77, and to the extent of
any deficiency on such loan with respect to which the taxpayer has
been relieved from liability;
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(9) for amounts allowed as deductions as deferred expenses under section
616 (b) (relating to certain expenditures in the development of
mines) and resulting in a reduction of the taxpayer’s taxes under
this subtitle, but not less than the amounts allowable under such
section for the taxable year and prior years;
[(10) Repealed. Pub. L. 94–455, title XIX, § 1901(b)(21)(G), Oct. 4, 1976,
90 Stat. 1798]
(11) for deductions to the extent disallowed under section 268 (relating to
sale of land with unharvested crops), notwithstanding the
provisions of any other paragraph of this subsection;
(12) to the extent provided in section 28(h) of the Internal Revenue Code
of 1939 in the case of amounts specified in a shareholder’s consent
made under section 28 of such code;
[(13) Repealed. Pub. L. 108–357, title IV, § 413(c)(19), Oct. 22, 2004, 118
Stat. 1509]
(14) for amounts allowed as deductions as deferred expenses under section
174 (b)(1) (relating to research and experimental expenditures) and
resulting in a reduction of the taxpayers’ taxes under this subtitle,
but not less than the amounts allowable under such section for the
taxable year and prior years;
(15) for deductions to the extent disallowed under section 272 (relating to
disposal of coal or domestic iron ore), notwithstanding the
provisions of any other paragraph of this subsection;
(16) in the case of any evidence of indebtedness referred to in section 811
(b) (relating to amortization of premium and accrual of discount in
the case of life insurance companies), to the extent of the
adjustments required under section 811 (b) (or the corresponding
provisions of prior income tax laws) for the taxable year and all
prior taxable years;
(17) to the extent provided in section 1367 in the case of stock of, and
indebtedness owed to, shareholders of an S corporation;
(18) to the extent provided in section 961 in the case of stock in controlled
foreign corporations (or foreign corporations which were controlled
foreign corporations) and of property by reason of which a person
is considered as owning such stock;
(19) to the extent provided in section 50 (c), in the case of expenditures with
respect to which a credit has been allowed under section 38;
(20) for amounts allowed as deductions under section 59 (e) (relating to
optional 10-year writeoff of certain tax preferences);
(21) to the extent provided in section 1059 (relating to reduction in basis for
extraordinary dividends);
(22) in the case of qualified replacement property the acquisition of which
resulted under section 1042 in the nonrecognition of any part of the
gain realized on the sale or exchange of any property, to the extent
provided in section 1042 (d),[2]
(23) in the case of property the acquisition of which resulted under section
1043, 1044, 1045, or 1397B in the nonrecognition of any part of
the gain realized on the sale of other property, to the extent
provided in section 1043 (c), 1044 (d), 1045 (b)(3), or 1397B
(b)(4), as the case may be,[2]
(24) to the extent provided in section 179A (e)(6)(A),[2]
(25) to the extent provided in section 30 (d)(1),[2]
(26) to the extent provided in sections 23 (g) and 137 (e),[2]
(27) in the case of a residence with respect to which a credit was allowed
under section 1400C, to the extent provided in section 1400C
(h),[2]
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4.
5.
(28) in the case of a facility with respect to which a credit was allowed
under section 45F, to the extent provided in section 45F (f)(1),[2]
(29) in the case of railroad track with respect to which a credit was allowed
under section 45G, to the extent provided in section 45G (e)(3),[2]
(30) to the extent provided in section 179B (c),[2]
(31) in the case of a facility with respect to which a credit was allowed
under section 45H, to the extent provided in section 45H (d),[2]
(32) to the extent provided in section 179D (e),[2]
(33) to the extent provided in section 45L (e), in the case of amounts with
respect to which a credit has been allowed under section 45L,[2]
(34) to the extent provided in section 25C (e), in the case of amounts with
respect to which a credit has been allowed under section 25C,[2]
(35) to the extent provided in section 25D (f), in the case of amounts with
respect to which a credit has been allowed under section 25D,[2]
(36) to the extent provided in section 30B (h)(4),[2] and
(37) to the extent provided in section 30C (f).
Section 167(a) provides a deduction (allowance) for a reasonable amount of the exhaustion,
wear and tear (including a reasonable allowance for obsolescence) of property used in the
trade or business or for property held for the production of income.
Read section 167(a), which states as follows:
Section 167. Depreciation
(a) General rule
There shall be allowed as a depreciation deduction a reasonable allowance
for the exhaustion, wear and tear (including a reasonable allowance for
obsolescence)—
(1) of property used in the trade or business, or
(2) of property held for the production of income.
A person must reduce the basis of their property by the amount of depreciation that was
allowed (that is, which was actually depreciated) and by the amount of depreciation which
the taxpayer could have taken even though the taxpayer did not take the depreciation (that
is allowable). Read section 1016(a), which states as follows:
Section 1016. Adjustments to basis
(a) General rule
Proper adjustment in respect of the property shall in all cases be made—
(1) for expenditures, receipts, losses, or other items, properly chargeable to
capital account, but no such adjustment shall be made—
(A) for taxes or other carrying charges described in section 266, or
(B) for expenditures described in section 173 (relating to
circulation expenditures),
for which deductions have been taken by the taxpayer in
determining taxable income for the taxable year or prior
taxable years;
(2) in respect of any period since February 28, 1913, for exhaustion, wear
and tear, obsolescence, amortization, and depletion, to the extent of
the amount—
(A) allowed as deductions in computing taxable income under this
subtitle or prior income tax laws, and
(B) resulting (by reason of the deductions so allowed) in a
reduction for any taxable year of the taxpayer’s taxes
under this subtitle (other than chapter 2, relating to tax on
self-employment income), or prior income, war-profits, or
excess-profits tax laws,
but not less than the amount allowable under this subtitle
or prior income tax laws. Where no method has been
adopted under section 167 (relating to depreciation
deduction), the amount allowable shall be determined
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under the straight line method. Subparagraph (B) of this
paragraph shall not apply in respect of any period since
February 28, 1913, and before January 1, 1952, unless an
election has been made under section 1020 (as in effect
before the date of the enactment of the Tax Reform Act of
1976). Where for any taxable year before the taxable year
1932 the depletion allowance was based on discovery
value or a percentage of income, then the adjustment for
depletion for such year shall be based on the depletion
which would have been allowable for such year if
computed without reference to discovery value or a
percentage of income;
(3) in respect of any period—
(A) before March 1, 1913,
(B) since February 28, 1913, during which such property was held
by a person or an organization not subject to income
taxation under this chapter or prior income tax laws,
(C) since February 28, 1913, and before January 1, 1958, during
which such property was held by a person subject to tax
under part I of subchapter L (or the corresponding
provisions of prior income tax laws), to the extent that
paragraph (2) does not apply, and
(D) since February 28, 1913, during which such property was held
by a person subject to tax under part II [1] of subchapter L
(or the corresponding provisions of prior income tax laws),
to the extent that paragraph (2) does not apply,
for exhaustion, wear and tear, obsolescence, amortization,
and depletion, to the extent sustained;
(4) in the case of stock (to the extent not provided for in the foregoing
paragraphs) for the amount of distributions previously made which,
under the law applicable to the year in which the distribution was
made, either were tax-free or were applicable in reduction of basis
(not including distributions made by a corporation which was
classified as a personal service corporation under the provisions of
the Revenue Act of 1918 (40 Stat. 1057), or the Revenue Act of
1921 (42 Stat. 227), out of its earnings or profits which were
taxable in accordance with the provisions of section 218 of the
Revenue Act of 1918 or 1921);
(5) in the case of any bond (as defined in section 171 (d)) the interest on
which is wholly exempt from the tax imposed by this subtitle, to
the extent of the amortizable bond premium disallowable as a
deduction pursuant to section 171 (a)(2), and in the case of any
other bond (as defined in section 171 (d)) to the extent of the
deductions allowable pursuant to section 171 (a)(1) (or the amount
applied to reduce interest payments under section 171 (e)(2)) with
respect thereto;
(6) in the case of any municipal bond (as defined in section 75 (b)), to the
extent provided in section 75 (a)(2);
(7) in the case of a residence the acquisition of which resulted, under
section 1034 (as in effect on the day before the date of the
enactment of the Taxpayer Relief Act of 1997), in the
nonrecognition of any part of the gain realized on the sale,
exchange, or involuntary conversion of another residence, to the
extent provided in section 1034 (e) (as so in effect);
(8) in the case of property pledged to the Commodity Credit Corporation,
to the extent of the amount received as a loan from the Commodity
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Credit Corporation and treated by the taxpayer as income for the
year in which received pursuant to section 77, and to the extent of
any deficiency on such loan with respect to which the taxpayer has
been relieved from liability;
(9) for amounts allowed as deductions as deferred expenses under section
616 (b) (relating to certain expenditures in the development of
mines) and resulting in a reduction of the taxpayer’s taxes under
this subtitle, but not less than the amounts allowable under such
section for the taxable year and prior years;
[(10) Repealed. Pub. L. 94–455, title XIX, § 1901(b)(21)(G), Oct. 4, 1976,
90 Stat. 1798]
(11) for deductions to the extent disallowed under section 268 (relating to
sale of land with unharvested crops), notwithstanding the
provisions of any other paragraph of this subsection;
(12) to the extent provided in section 28(h) of the Internal Revenue Code
of 1939 in the case of amounts specified in a shareholder’s consent
made under section 28 of such code;
[(13) Repealed. Pub. L. 108–357, title IV, § 413(c)(19), Oct. 22, 2004, 118
Stat. 1509]
(14) for amounts allowed as deductions as deferred expenses under section
174 (b)(1) (relating to research and experimental expenditures) and
resulting in a reduction of the taxpayers’ taxes under this subtitle,
but not less than the amounts allowable under such section for the
taxable year and prior years;
(15) for deductions to the extent disallowed under section 272 (relating to
disposal of coal or domestic iron ore), notwithstanding the
provisions of any other paragraph of this subsection;
(16) in the case of any evidence of indebtedness referred to in section 811
(b) (relating to amortization of premium and accrual of discount in
the case of life insurance companies), to the extent of the
adjustments required under section 811 (b) (or the corresponding
provisions of prior income tax laws) for the taxable year and all
prior taxable years;
(17) to the extent provided in section 1367 in the case of stock of, and
indebtedness owed to, shareholders of an S corporation;
(18) to the extent provided in section 961 in the case of stock in controlled
foreign corporations (or foreign corporations which were controlled
foreign corporations) and of property by reason of which a person
is considered as owning such stock;
(19) to the extent provided in section 50 (c), in the case of expenditures with
respect to which a credit has been allowed under section 38;
(20) for amounts allowed as deductions under section 59 (e) (relating to
optional 10-year writeoff of certain tax preferences);
(21) to the extent provided in section 1059 (relating to reduction in basis for
extraordinary dividends);
(22) in the case of qualified replacement property the acquisition of which
resulted under section 1042 in the nonrecognition of any part of the
gain realized on the sale or exchange of any property, to the extent
provided in section 1042 (d),[2]
(23) in the case of property the acquisition of which resulted under section
1043, 1044, 1045, or 1397B in the nonrecognition of any part of
the gain realized on the sale of other property, to the extent
provided in section 1043 (c), 1044 (d), 1045 (b)(3), or 1397B
(b)(4), as the case may be,[2]
(24) to the extent provided in section 179A (e)(6)(A),[2]
(25) to the extent provided in section 30 (d)(1),[2]
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6.
(26) to the extent provided in sections 23 (g) and 137 (e),[2]
(27) in the case of a residence with respect to which a credit was allowed
under section 1400C, to the extent provided in section 1400C
(h),[2]
(28) in the case of a facility with respect to which a credit was allowed
under section 45F, to the extent provided in section 45F (f)(1),[2]
(29) in the case of railroad track with respect to which a credit was allowed
under section 45G, to the extent provided in section 45G (e)(3),[2]
(30) to the extent provided in section 179B (c),[2]
(31) in the case of a facility with respect to which a credit was allowed
under section 45H, to the extent provided in section 45H (d),[2]
(32) to the extent provided in section 179D (e),[2]
(33) to the extent provided in section 45L (e), in the case of amounts with
respect to which a credit has been allowed under section 45L,[2]
(34) to the extent provided in section 25C (e), in the case of amounts with
respect to which a credit has been allowed under section 25C,[2]
(35) to the extent provided in section 25D (f), in the case of amounts with
respect to which a credit has been allowed under section 25D,[2]
(36) to the extent provided in section 30B (h)(4),[2] and
(37) to the extent provided in section 30C (f).
As property is depreciated, the adjusted basis of the property is reduced until the basis is
zero. The basis of property may not be depreciated below zero.
B.
The only property which may be depreciated through section 167 is as follows.
1.
Property which is used in a trade or business.
a.
This includes tangible personal property and real property which is physically
“used” in a trade or business; and,
b.
Has an exhaustible useful life that can be determined with reasonable accuracy (Reg.
§1.167(a)-1(b)).
c.
This does not include inventory because inventory is not “used” in a trade or
business.
2.
Property held for the production of income.
a.
This include tangible personal property and real property which is “held” for the
production of income.
b.
This does not include inventory because inventory is not “used” in a trade or
business.
c.
This does not include stocks and bonds, because these are not “tangible” assets.
C.
The effect on the basis of property as the property is depreciated.
1.
The taxpayer must reduce the basis of the taxpayer’s property by the amount of depreciation
that was “allowed” (i.e., the amount of depreciation which was actually taken) and by the
amount of depreciation which was “allowable” (i.e., the amount of depreciation which the
taxpayer could have taken even though the taxpayer did not take the depreciation). Read
section 1016(a), which states as follows:
Section 1016. Adjustments to basis
(a) General rule
Proper adjustment in respect of the property shall in all cases be made—
(1) for expenditures, receipts, losses, or other items, properly chargeable to
capital account, but no such adjustment shall be made—
(A) for taxes or other carrying charges described in section 266, or
(B) for expenditures described in section 173 (relating to
circulation expenditures),
for which deductions have been taken by the taxpayer in
determining taxable income for the taxable year or prior
taxable years;
(2) in respect of any period since February 28, 1913, for exhaustion, wear
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and tear, obsolescence, amortization, and depletion, to the extent of
the amount—
(A) allowed as deductions in computing taxable income under this
subtitle or prior income tax laws, and
(B) resulting (by reason of the deductions so allowed) in a
reduction for any taxable year of the taxpayer’s taxes
under this subtitle (other than chapter 2, relating to tax on
self-employment income), or prior income, war-profits, or
excess-profits tax laws,
but not less than the amount allowable under this subtitle
or prior income tax laws. Where no method has been
adopted under section 167 (relating to depreciation
deduction), the amount allowable shall be determined
under the straight line method. Subparagraph (B) of this
paragraph shall not apply in respect of any period since
February 28, 1913, and before January 1, 1952, unless an
election has been made under section 1020 (as in effect
before the date of the enactment of the Tax Reform Act of
1976). Where for any taxable year before the taxable year
1932 the depletion allowance was based on discovery
value or a percentage of income, then the adjustment for
depletion for such year shall be based on the depletion
which would have been allowable for such year if
computed without reference to discovery value or a
percentage of income;
(3) in respect of any period—
(A) before March 1, 1913,
(B) since February 28, 1913, during which such property was held
by a person or an organization not subject to income
taxation under this chapter or prior income tax laws,
(C) since February 28, 1913, and before January 1, 1958, during
which such property was held by a person subject to tax
under part I of subchapter L (or the corresponding
provisions of prior income tax laws), to the extent that
paragraph (2) does not apply, and
(D) since February 28, 1913, during which such property was held
by a person subject to tax under part II [1] of subchapter L
(or the corresponding provisions of prior income tax laws),
to the extent that paragraph (2) does not apply,
for exhaustion, wear and tear, obsolescence, amortization,
and depletion, to the extent sustained;
(4) in the case of stock (to the extent not provided for in the foregoing
paragraphs) for the amount of distributions previously made which,
under the law applicable to the year in which the distribution was
made, either were tax-free or were applicable in reduction of basis
(not including distributions made by a corporation which was
classified as a personal service corporation under the provisions of
the Revenue Act of 1918 (40 Stat. 1057), or the Revenue Act of
1921 (42 Stat. 227), out of its earnings or profits which were
taxable in accordance with the provisions of section 218 of the
Revenue Act of 1918 or 1921);
(5) in the case of any bond (as defined in section 171 (d)) the interest on
which is wholly exempt from the tax imposed by this subtitle, to
the extent of the amortizable bond premium disallowable as a
deduction pursuant to section 171 (a)(2), and in the case of any
other bond (as defined in section 171 (d)) to the extent of the
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deductions allowable pursuant to section 171 (a)(1) (or the amount
applied to reduce interest payments under section 171 (e)(2)) with
respect thereto;
(6) in the case of any municipal bond (as defined in section 75 (b)), to the
extent provided in section 75 (a)(2);
(7) in the case of a residence the acquisition of which resulted, under
section 1034 (as in effect on the day before the date of the
enactment of the Taxpayer Relief Act of 1997), in the
nonrecognition of any part of the gain realized on the sale,
exchange, or involuntary conversion of another residence, to the
extent provided in section 1034 (e) (as so in effect);
(8) in the case of property pledged to the Commodity Credit Corporation,
to the extent of the amount received as a loan from the Commodity
Credit Corporation and treated by the taxpayer as income for the
year in which received pursuant to section 77, and to the extent of
any deficiency on such loan with respect to which the taxpayer has
been relieved from liability;
(9) for amounts allowed as deductions as deferred expenses under section
616 (b) (relating to certain expenditures in the development of
mines) and resulting in a reduction of the taxpayer’s taxes under
this subtitle, but not less than the amounts allowable under such
section for the taxable year and prior years;
[(10) Repealed. Pub. L. 94–455, title XIX, § 1901(b)(21)(G), Oct. 4, 1976,
90 Stat. 1798]
(11) for deductions to the extent disallowed under section 268 (relating to
sale of land with unharvested crops), notwithstanding the
provisions of any other paragraph of this subsection;
(12) to the extent provided in section 28(h) of the Internal Revenue Code
of 1939 in the case of amounts specified in a shareholder’s consent
made under section 28 of such code;
[(13) Repealed. Pub. L. 108–357, title IV, § 413(c)(19), Oct. 22, 2004, 118
Stat. 1509]
(14) for amounts allowed as deductions as deferred expenses under section
174 (b)(1) (relating to research and experimental expenditures) and
resulting in a reduction of the taxpayers’ taxes under this subtitle,
but not less than the amounts allowable under such section for the
taxable year and prior years;
(15) for deductions to the extent disallowed under section 272 (relating to
disposal of coal or domestic iron ore), notwithstanding the
provisions of any other paragraph of this subsection;
(16) in the case of any evidence of indebtedness referred to in section 811
(b) (relating to amortization of premium and accrual of discount in
the case of life insurance companies), to the extent of the
adjustments required under section 811 (b) (or the corresponding
provisions of prior income tax laws) for the taxable year and all
prior taxable years;
(17) to the extent provided in section 1367 in the case of stock of, and
indebtedness owed to, shareholders of an S corporation;
(18) to the extent provided in section 961 in the case of stock in controlled
foreign corporations (or foreign corporations which were controlled
foreign corporations) and of property by reason of which a person
is considered as owning such stock;
(19) to the extent provided in section 50 (c), in the case of expenditures with
respect to which a credit has been allowed under section 38;
(20) for amounts allowed as deductions under section 59 (e) (relating to
optional 10-year writeoff of certain tax preferences);
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2.
3.
(21) to the extent provided in section 1059 (relating to reduction in basis for
extraordinary dividends);
(22) in the case of qualified replacement property the acquisition of which
resulted under section 1042 in the nonrecognition of any part of the
gain realized on the sale or exchange of any property, to the extent
provided in section 1042 (d),[2]
(23) in the case of property the acquisition of which resulted under section
1043, 1044, 1045, or 1397B in the nonrecognition of any part of
the gain realized on the sale of other property, to the extent
provided in section 1043 (c), 1044 (d), 1045 (b)(3), or 1397B
(b)(4), as the case may be,[2]
(24) to the extent provided in section 179A (e)(6)(A),[2]
(25) to the extent provided in section 30 (d)(1),[2]
(26) to the extent provided in sections 23 (g) and 137 (e),[2]
(27) in the case of a residence with respect to which a credit was allowed
under section 1400C, to the extent provided in section 1400C
(h),[2]
(28) in the case of a facility with respect to which a credit was allowed
under section 45F, to the extent provided in section 45F (f)(1),[2]
(29) in the case of railroad track with respect to which a credit was allowed
under section 45G, to the extent provided in section 45G (e)(3),[2]
(30) to the extent provided in section 179B (c),[2]
(31) in the case of a facility with respect to which a credit was allowed
under section 45H, to the extent provided in section 45H (d),[2]
(32) to the extent provided in section 179D (e),[2]
(33) to the extent provided in section 45L (e), in the case of amounts with
respect to which a credit has been allowed under section 45L,[2]
(34) to the extent provided in section 25C (e), in the case of amounts with
respect to which a credit has been allowed under section 25C,[2]
(35) to the extent provided in section 25D (f), in the case of amounts with
respect to which a credit has been allowed under section 25D,[2]
(36) to the extent provided in section 30B (h)(4),[2] and
(37) to the extent provided in section 30C (f).
As property is depreciated, the adjusted basis of the property is reduced until, in theory, the
adjusted basis is zero. The basis of property may not be depreciated below zero.
a.
Of course, the property might be sold or destroyed before the basis of the property
is fully depreciated and if, for example, the property is sold, then the remaining
adjusted basis of the property would be offset against the amount realized from the
sale in order to determine the realized gain or loss from the sale.
Depreciation is the process of deducting the basis of a business or investment asset (real
property or tangible personal property) over a period of time.
a.
As the basis is depreciated and income tax deductions are taken for the amounts of
the depreciation, the basis of the property is reduced by the depreciation amounts,
and the result of the reductions is an amount which is referred to as “adjusted basis.”
Read section 167(a), section 1011(a), and section 1016(a), which state as follows:
Section 167. Depreciation
(a) General rule
There shall be allowed as a depreciation deduction a reasonable
allowance for the exhaustion, wear and tear (including a reasonable
allowance for obsolescence)—
(1) of property used in the trade or business, or
(2) of property held for the production of income.
Section 1011. Adjusted basis for determining gain or loss
(a) General rule
The adjusted basis for determining the gain or loss from the sale or
other disposition of property, whenever acquired, shall be the basis
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(determined under section 1012 or other applicable sections of this
subchapter and subchapters C (relating to corporate distributions
and adjustments), K (relating to partners and partnerships), and P
(relating to capital gains and losses)), adjusted as provided in
section 1016.
Section 1016. Adjustments to basis
(a) General rule
Proper adjustment in respect of the property shall in all cases be made—
(1) for expenditures, receipts, losses, or other items, properly chargeable to
capital account, but no such adjustment shall be made—
(A) for taxes or other carrying charges described in section 266, or
(B) for expenditures described in section 173 (relating to
circulation expenditures),
for which deductions have been taken by the taxpayer in
determining taxable income for the taxable year or prior
taxable years;
(2) in respect of any period since February 28, 1913, for exhaustion, wear
and tear, obsolescence, amortization, and depletion, to the extent of
the amount—
(A) allowed as deductions in computing taxable income under this
subtitle or prior income tax laws, and
(B) resulting (by reason of the deductions so allowed) in a
reduction for any taxable year of the taxpayer’s taxes
under this subtitle (other than chapter 2, relating to tax on
self-employment income), or prior income, war-profits, or
excess-profits tax laws,
but not less than the amount allowable under this subtitle
or prior income tax laws. Where no method has been
adopted under section 167 (relating to depreciation
deduction), the amount allowable shall be determined
under the straight line method. Subparagraph (B) of this
paragraph shall not apply in respect of any period since
February 28, 1913, and before January 1, 1952, unless an
election has been made under section 1020 (as in effect
before the date of the enactment of the Tax Reform Act of
1976). Where for any taxable year before the taxable year
1932 the depletion allowance was based on discovery
value or a percentage of income, then the adjustment for
depletion for such year shall be based on the depletion
which would have been allowable for such year if
computed without reference to discovery value or a
percentage of income;
(3) in respect of any period—
(A) before March 1, 1913,
(B) since February 28, 1913, during which such property was held
by a person or an organization not subject to income
taxation under this chapter or prior income tax laws,
(C) since February 28, 1913, and before January 1, 1958, during
which such property was held by a person subject to tax
under part I of subchapter L (or the corresponding
provisions of prior income tax laws), to the extent that
paragraph (2) does not apply, and
(D) since February 28, 1913, during which such property was held
by a person subject to tax under part II [1] of subchapter L
(or the corresponding provisions of prior income tax laws),
to the extent that paragraph (2) does not apply,
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for exhaustion, wear and tear, obsolescence, amortization,
and depletion, to the extent sustained;
(4) in the case of stock (to the extent not provided for in the foregoing
paragraphs) for the amount of distributions previously made which,
under the law applicable to the year in which the distribution was
made, either were tax-free or were applicable in reduction of basis
(not including distributions made by a corporation which was
classified as a personal service corporation under the provisions of
the Revenue Act of 1918 (40 Stat. 1057), or the Revenue Act of
1921 (42 Stat. 227), out of its earnings or profits which were
taxable in accordance with the provisions of section 218 of the
Revenue Act of 1918 or 1921);
(5) in the case of any bond (as defined in section 171 (d)) the interest on
which is wholly exempt from the tax imposed by this subtitle, to
the extent of the amortizable bond premium disallowable as a
deduction pursuant to section 171 (a)(2), and in the case of any
other bond (as defined in section 171 (d)) to the extent of the
deductions allowable pursuant to section 171 (a)(1) (or the amount
applied to reduce interest payments under section 171 (e)(2)) with
respect thereto;
(6) in the case of any municipal bond (as defined in section 75 (b)), to the
extent provided in section 75 (a)(2);
(7) in the case of a residence the acquisition of which resulted, under
section 1034 (as in effect on the day before the date of the
enactment of the Taxpayer Relief Act of 1997), in the
nonrecognition of any part of the gain realized on the sale,
exchange, or involuntary conversion of another residence, to the
extent provided in section 1034 (e) (as so in effect);
(8) in the case of property pledged to the Commodity Credit Corporation,
to the extent of the amount received as a loan from the Commodity
Credit Corporation and treated by the taxpayer as income for the
year in which received pursuant to section 77, and to the extent of
any deficiency on such loan with respect to which the taxpayer has
been relieved from liability;
(9) for amounts allowed as deductions as deferred expenses under section
616 (b) (relating to certain expenditures in the development of
mines) and resulting in a reduction of the taxpayer’s taxes under
this subtitle, but not less than the amounts allowable under such
section for the taxable year and prior years;
[(10) Repealed. Pub. L. 94–455, title XIX, § 1901(b)(21)(G), Oct. 4, 1976,
90 Stat. 1798]
(11) for deductions to the extent disallowed under section 268 (relating to
sale of land with unharvested crops), notwithstanding the
provisions of any other paragraph of this subsection;
(12) to the extent provided in section 28(h) of the Internal Revenue Code
of 1939 in the case of amounts specified in a shareholder’s consent
made under section 28 of such code;
[(13) Repealed. Pub. L. 108–357, title IV, § 413(c)(19), Oct. 22, 2004, 118
Stat. 1509]
(14) for amounts allowed as deductions as deferred expenses under section
174 (b)(1) (relating to research and experimental expenditures) and
resulting in a reduction of the taxpayers’ taxes under this subtitle,
but not less than the amounts allowable under such section for the
taxable year and prior years;
(15) for deductions to the extent disallowed under section 272 (relating to
disposal of coal or domestic iron ore), notwithstanding the
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b.
provisions of any other paragraph of this subsection;
(16) in the case of any evidence of indebtedness referred to in section 811
(b) (relating to amortization of premium and accrual of discount in
the case of life insurance companies), to the extent of the
adjustments required under section 811 (b) (or the corresponding
provisions of prior income tax laws) for the taxable year and all
prior taxable years;
(17) to the extent provided in section 1367 in the case of stock of, and
indebtedness owed to, shareholders of an S corporation;
(18) to the extent provided in section 961 in the case of stock in controlled
foreign corporations (or foreign corporations which were controlled
foreign corporations) and of property by reason of which a person
is considered as owning such stock;
(19) to the extent provided in section 50 (c), in the case of expenditures with
respect to which a credit has been allowed under section 38;
(20) for amounts allowed as deductions under section 59 (e) (relating to
optional 10-year writeoff of certain tax preferences);
(21) to the extent provided in section 1059 (relating to reduction in basis for
extraordinary dividends);
(22) in the case of qualified replacement property the acquisition of which
resulted under section 1042 in the nonrecognition of any part of the
gain realized on the sale or exchange of any property, to the extent
provided in section 1042 (d),[2]
(23) in the case of property the acquisition of which resulted under section
1043, 1044, 1045, or 1397B in the nonrecognition of any part of
the gain realized on the sale of other property, to the extent
provided in section 1043 (c), 1044 (d), 1045 (b)(3), or 1397B
(b)(4), as the case may be,[2]
(24) to the extent provided in section 179A (e)(6)(A),[2]
(25) to the extent provided in section 30 (d)(1),[2]
(26) to the extent provided in sections 23 (g) and 137 (e),[2]
(27) in the case of a residence with respect to which a credit was allowed
under section 1400C, to the extent provided in section 1400C
(h),[2]
(28) in the case of a facility with respect to which a credit was allowed
under section 45F, to the extent provided in section 45F (f)(1),[2]
(29) in the case of railroad track with respect to which a credit was allowed
under section 45G, to the extent provided in section 45G (e)(3),[2]
(30) to the extent provided in section 179B (c),[2]
(31) in the case of a facility with respect to which a credit was allowed
under section 45H, to the extent provided in section 45H (d),[2]
(32) to the extent provided in section 179D (e),[2]
(33) to the extent provided in section 45L (e), in the case of amounts with
respect to which a credit has been allowed under section 45L,[2]
(34) to the extent provided in section 25C (e), in the case of amounts with
respect to which a credit has been allowed under section 25C,[2]
(35) to the extent provided in section 25D (f), in the case of amounts with
respect to which a credit has been allowed under section 25D,[2]
(36) to the extent provided in section 30B (h)(4),[2] and
(37) to the extent provided in section 30C (f).
Section 1016 provides that the basis of depreciable property is to be reduced by
depreciation which is allowed or allowable.
(1)
Allowed depreciation is depreciation which the taxpayer deducted, whether
or not the depreciation was properly taken.
(2)
Allowable depreciation is the amount which is proper under the applicable
law.
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D.
The three most common methods of depreciation.
1.
These three methods are not indexed.
a.
The straight line method.
b.
The sum of the years method.
c.
The declining balance method.
E.
Expending business tangible personal property - section 179.
1.
Read section 179(a), which states as follows:
Section 179. Election to expense certain depreciable business assets
(a) Treatment as expenses
A taxpayer may elect to treat the cost of any section 179 property as an
expense which is not chargeable to capital account. Any cost so treated shall
be allowed as a deduction for the taxable year in which the section 179
property is placed in service.
2.
Section 179 allows taxpayers to expense a fixed amount of business tangible personal
property for new acquisitions each year.
3.
The amount which currently may be expensed is up to $108,000.
a.
If the business tangible persons property cost more the $108,000, then the amount
which exceeds $108,000 may be depreciated by using the other provisions which are
discussed in this area.
F.
The deduction categories for certain depreciable or amortizable property are as follows.
Type Of Property
Amount, Period,
Or Method
Tangible personal business property
108,000
Computer software and race horses
Three years
Automobiles, light trucks, computers, and other mechanical items
Five years
Other tangible personal property, such as, heavy trucks, office equipment,
such as, furniture, manufacturing equipment, rental equipment, etc.
Seven years
Customer lists, goodwill, and covenants not to compete
15 years
Residential real property
27.5 years
Other real property
39 years
Depletion - timber
Cost
Business organization costs
Up to $5,000 as
expense;
remainder over
180 months
Except as otherwise stated, no fiduciary establishes a reserve for
depreciation.
G.
Personal property and intangibles are depreciable if the property is as follows.
1.
Is used in a trade or business or held for the production of income. Read section 167(a),
which states as follows:
Section 167. Depreciation
(a) General rule
There shall be allowed as a depreciation deduction a reasonable allowance
for the exhaustion, wear and tear (including a reasonable allowance for
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2.
3.
obsolescence)—
(1) of property used in the trade or business, or
(2) of property held for the production of income.
Has an exhaustible useful life that can be determined with reasonable accuracy (Reg.
§1.167(a)-1(b).
Is not inventory or stock in trade.
a.
Inventory is not depreciable property. Inventory is stock in trade or a business
including raw materials, work in process, supplies used in operations, and finished
goods.
H.
Property is not depreciable if it is not exhaustible or if it is not subject to wear and tear.
1.
Read section 167(a), which states as follows:
Section 167. Depreciation
(a) General rule
There shall be allowed as a depreciation deduction a reasonable allowance
for the exhaustion, wear and tear (including a reasonable allowance for
obsolescence)—
(1) of property used in the trade or business, or
(2) of property held for the production of income.
2.
Land is not depreciable, because it is not exhaustible or it is not subject to wear and tear.
a.
Natural resources may be depleted, because they can be exhausted.
3.
Even though property may diminish in fair market value if the decrease in fair market value
is not the result of exhaustion, wear and tear or obsolescence, the property is not depreciable.
Read Reg. §1.167(a)-1(a).
I.
Property used solely for “personal use” is not depreciable. Read section 280F, which states as
follows:
Section 280F. Limitation on depreciation for luxury automobiles; limitation where certain
property used for personal purposes
(a) Limitation on amount of depreciation for luxury automobiles
(1) Depreciation
(A) Limitation
The amount of the depreciation deduction for any taxable
year for any passenger automobile shall not exceed—
(i) $2,560 for the 1st taxable year in the recovery period,
(ii) $4,100 for the 2nd taxable year in the recovery period,
(iii) $2,450 for the 3rd taxable year in the recovery period,
and
(iv) $1,475 for each succeeding taxable year in the
recovery period.
(B) Disallowed deductions allowed for years after recovery period
(i) In general Except as provided in clause (ii), the
unrecovered basis of any passenger automobile shall be
treated as an expense for the 1st taxable year after the
recovery period. Any excess of the unrecovered basis over
the limitation of clause (ii) shall be treated as an expense
in the succeeding taxable year.
(ii) $1,475 limitation The amount treated as an expense
under clause (i) for any taxable year shall not exceed
$1,475.
(iii) Property must be depreciable No amount shall be
allowable as a deduction by reason of this subparagraph
with respect to any property for any taxable year unless a
depreciation deduction would be allowable with respect to
such property for such taxable year.
(iv) Amount treated as depreciation deduction For
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1.
2.
purposes of this subtitle, any amount allowable as a
deduction by reason of this subparagraph shall be treated
as a depreciation deduction allowable under section 168.
(C) Special rule for certain clean-fuel passenger automobiles
(i) Modified automobiles In the case of a passenger
automobile which is propelled by a fuel which is not a
clean-burning fuel and to which is installed qualified
clean-fuel vehicle property (as defined in section 179A
(c)(1)(A)) for purposes of permitting such vehicle to be
propelled by a clean burning fuel (as defined in section
179A (e)(1)), subparagraph (A) shall not apply to the cost
of the installed qualified clean burning vehicle property.
(ii) Purpose built passenger vehicles In the case of a
purpose built passenger vehicle (as defined in section 4001
(a)(2)(C)(ii)), each of the annual limitations specified in
subparagraphs (A) and (B) shall be tripled.
(iii) Application of subparagraph This subparagraph shall
apply to property placed in service after August 5,
1997, and before January 1, 2007.
(2) Coordination with reductions in amount allowable by reason of personal
use, etc.
This subsection shall be applied before—
(A) the application of subsection (b), and
(B) the application of any other reduction in the amount of any
depreciation deduction allowable under section 168 by reason of
any use not qualifying the property for such credit or depreciation
deduction.
Read Reg. §1.167(a)-2. If property is used both for personal and for business or income
production, the depreciation is deductible only to the extent of non personal use.
If property is used for personal use and in a trade or business and the use the property for the
trade or business is greater than half the total use of the property, then the percentage of use
in trade or business is depreciable.
Read section 280F, which states as follows:
Section 280F. Limitation on depreciation for luxury automobiles; limitation where certain
property used for personal purposes
(a) Limitation on amount of depreciation for luxury automobiles
(1) Depreciation
(A) Limitation
The amount of the depreciation deduction for any taxable
year for any passenger automobile shall not exceed—
(i) $2,560 for the 1st taxable year in the recovery period,
(ii) $4,100 for the 2nd taxable year in the recovery period,
(iii) $2,450 for the 3rd taxable year in the recovery period,
and
(iv) $1,475 for each succeeding taxable year in the
recovery period.
(B) Disallowed deductions allowed for years after recovery period
(i) In general Except as provided in clause (ii), the
unrecovered basis of any passenger automobile shall be
treated as an expense for the 1st taxable year after the
recovery period. Any excess of the unrecovered basis over
the limitation of clause (ii) shall be treated as an expense
in the succeeding taxable year.
(ii) $1,475 limitation The amount treated as an expense
under clause (i) for any taxable year shall not exceed
$1,475.
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3.
J.
(iii) Property must be depreciable No amount shall be
allowable as a deduction by reason of this subparagraph
with respect to any property for any taxable year unless a
depreciation deduction would be allowable with respect to
such property for such taxable year.
(iv) Amount treated as depreciation deduction For
purposes of this subtitle, any amount allowable as a
deduction by reason of this subparagraph shall be treated
as a depreciation deduction allowable under section 168.
(C) Special rule for certain clean-fuel passenger automobiles
(i) Modified automobiles In the case of a passenger
automobile which is propelled by a fuel which is not a
clean-burning fuel and to which is installed qualified
clean-fuel vehicle property (as defined in section 179A
(c)(1)(A)) for purposes of permitting such vehicle to be
propelled by a clean burning fuel (as defined in section
179A (e)(1)), subparagraph (A) shall not apply to the cost
of the installed qualified clean burning vehicle property.
(ii) Purpose built passenger vehicles In the case of a
purpose built passenger vehicle (as defined in section 4001
(a)(2)(C)(ii)), each of the annual limitations specified in
subparagraphs (A) and (B) shall be tripled.
(iii) Application of subparagraph This subparagraph shall
apply to property placed in service after August 5,
1997, and before January 1, 2007.
(2) Coordination with reductions in amount allowable by reason of personal
use, etc.
This subsection shall be applied before—
(A) the application of subsection (b), and
(B) the application of any other reduction in the amount of any
depreciation deduction allowable under section 168 by
reason of any use not qualifying the property for such
credit or depreciation deduction.
a.
If, however, the use of the property in a trade or business is less than half of the total
use of the property, no depreciation deduction is allowable for that portion of the
business use.
Section 280F(a)(1) requires the IRS to prescribes, each taxable year, limitations on the
amount of depreciation deductions and the amount of section 179 deductions which a
taxpayer take with respect to the purchase of an automobile.
In addition, section 280F(b) limits depreciation deductions with respect to “listed property”.
1.
“Listed property” is all of the following property.
a.
Passenger automobiles.
b.
Other property used for transportation.
c.
Property of a type generally used for entertainment, recreation, or amusement.
d.
Computers and related equipment, unless it is used only at a regular business
establishment and owned or leased by the person operating the establishment (a
regular business establishment includes a portion of a dwelling unit, if (and only if)
that portion is used both regularly and exclusively for business).
e.
Cellular telephones and similar telecommunication equipment placed in service or
leased.
2.
Section 280F(b) limits such deductions when the listed property is not predominantly used
in a qualified business use. A “qualified business” use is any use in a trade or business.
a.
Property is not predominantly used in a qualified business use if the business use
does not exceed 50% of the total use.
b.
However, the term “qualified business use” does not include the following.
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c.
d.
e.
f.
K.
The use of property held merely to produce income.
The leasing of property to any 5% owner or related person (to the extent that the
property is used by a 5% owner or person related to the owner or lessee of the
property).
The use of property as pay for services of a 5% owner or related person.
The use of property as pay for services of any person (other than a 5% owner or
related person) unless the value of the use is included in that person's gross income
for the use of the property and income tax is withheld on that amount where
required.
Depreciation of certain listed property.
1.
Certain "listed property" is required to be depreciated under the alternative depreciation
system, rather than accelerated cost recovery system, if the property is not used more than
50% for business.
Read section 280F(b), which states as follows:
Section 280F. Limitation on depreciation for luxury automobiles; limitation where certain
property used for personal purposes
(b) Limitation where business use of listed property not greater than 50 percent
(1) Depreciation
If any listed property is not predominantly used in a qualified
business use for any taxable year, the deduction allowed under
section 168 with respect to such property for such taxable year and
any subsequent taxable year shall be determined under section 168
(g) (relating to alternative depreciation system).
(2) Recapture
(A) Where business use percentage does not exceed 50 percent
If—
(i) property is predominantly used in a qualified business
use in a taxable year in which it is placed in
service, and
(ii) such property is not predominantly used in a qualified
business use for any subsequent taxable year,
then any excess depreciation shall be included in
gross income for the taxable year referred to in
clause (ii), and the depreciation deduction for the
taxable year referred to in clause (ii) and any
subsequent taxable years shall be determined
under section 168 (g) (relating to alternative
depreciation system).
(B) Excess depreciation
For purposes of subparagraph (A), the term “excess
depreciation” means the excess (if any) of—
(i) the amount of the depreciation deductions allowable
with respect to the property for taxable years before the 1st
taxable year in which the property was not predominantly
used in a qualified business use, over
(ii) the amount which would have been so allowable if the
property had not been predominantly used in a
qualified business use for the taxable year in
which it was placed in service.
(3) Property predominantly used in qualified business use
For purposes of this subsection, property shall be treated as
predominantly used in a qualified business use for any taxable year
if the business use percentage for such taxable year exceeds 50
percent.
2.
Listed property includes automobiles and other means of transportation, property used for
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3.
4.
entertainment or recreation, computers (except for computers used exclusively at a regular
business establishment owned by the owner of the computer), and cellular telephones.
If listed property is used more than 50% for business in the first year, but the business use
declines to less than 50% in a later year, the excess accelerated cost recovery system
deductions claimed in the prior years are recaptured as gross income in the later year.
No depreciation deductions at all are allowable for listed property owned by an employee
and used in connection with the employee's employment unless such use is for the
convenience of the employer and required as a condition of employment.
Read section 280F(d)(3), which states as follows:
Section 280F. Limitation on depreciation for luxury automobiles; limitation where certain
property used for personal purposes
(d) Definitions and special rules
For purposes of this section—
(3) Deductions of employee
(A) In general
Any employee use of listed property shall not be treated as
use in a trade or business for purposes of determining the
amount of any depreciation deduction allowable to the
employee (or the amount of any deduction allowable to the
employee for rentals or other payments under a lease of
listed property) unless such use is for the convenience of
the employer and required as a condition of employment.
(B) Employee use
For purposes of subparagraph (A), the term “employee
use” means any use in connection with the performance of
services as an employee.
L.
Some examples.
1.
Example. On January 1, of last year, John purchased a computer, for $10,000, to use both
for personal matters and business matters. During last year, John used the computer: 40%
for personal purposes and 60% for business purposes. The percentage of the regular
depreciation which John may deduct, for income tax purposes, during last year is as follows
(not taking into account section 179).
a.
Personal use of the computer is not deductible. Business use of the computer is
deductible. Therefore, the answer is 60%.
2.
Example. On January 1, of last year, John purchased an automobile, for $10,000, to use both
for personal matters and business matters. During last year, John used the automobile: 40%
for personal purposes and 60% for business purposes.
a.
The percentage of the regular depreciation which John may deduct, during last year
is as follows (not taking into account section 179).
Personal use of the automobile is not deductible. Business use of the automobile is
deductible. Therefore, the answer is 60%.
3.
Example. On January 1, of last year, John purchased a computer, for $10,000, to use both
for personal matters and business matters. During last year, John used the computer: 40%
for business purposes and 60% for personal purposes.
a.
The percentage of the regular depreciation which John may deduct, for income tax
purposes, during last year is as follows (not taking into account section 179).
Because John's personal use of the computer is more than half of the total use of the
computer, no depreciation deduction is allowable for the use of the computer for
business matters. Therefore the answer is none.
M.
Some questions.
1.
Question 1. On January 1 of the current year, John purchased a computer, a computer
printer, and various other computer equipment for $20,000, all of which John used 100% of
the time, during the current year, in John's sole proprietorship business. John's maximum
depreciation deduction for the current year for depreciation and income tax expensing in
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2.
3.
arriving at AGI with respect to the computer is as follows.
a.
None/Zero
b.
$18,000
c.
$17,500
d.
$20,000
e.
No prior stated answer
Question 2. During last year, Mary sold a machine, which Mary used in Mary's soleproprietorship, for $8,000. Mary had purchased the machine for $10,000 three years ago and
had taken $4,000 of depreciation deductions with respect to such machine. Mary's ordinary
income for last year as a result of the sale of the machine is as follows.
a.
None/Zero
b.
$2,000
c.
$1,000
d.
$1,500
e.
No prior stated answer
Question 3. During last year, Mary sold a machine, which Mary used in Mary's soleproprietorship, for $11,000. Mary had purchased the machine for $10,000 three years ago
and Mary had taken $4,000 of depreciation deductions with respect to such machine.
Mary's possible capital gain gross income for last year with respect to these facts is as
follows.
a.
None/Zero
b.
$11,000
c.
$1,000
d.
$6,000
e.
No prior stated answer
N.
Dual purpose doctrine.
1.
A taxpayer may only depreciate property used in trade or business or held for investment.
a.
A question may arise where property is available for rent and also available for sale.
Under the dual purpose doctrine, property may be depreciated while it is held for
rent but not when it is held for sale. For example, if property is leased, then the
lessor may depreciate the property while the property is being leased.
O.
What happens if a taxpayer should take depreciation deductions, but does not do so?
1.
Read section 1016, which states as follows:
Section 1016. Adjustments to basis
(a) General rule
Proper adjustment in respect of the property shall in all cases be made—
(1) for expenditures, receipts, losses, or other items, properly chargeable to
capital account, but no such adjustment shall be made—
(A) for taxes or other carrying charges described in section 266, or
(B) for expenditures described in section 173 (relating to
circulation expenditures),
for which deductions have been taken by the taxpayer in
determining taxable income for the taxable year or prior
taxable years;
(2) in respect of any period since February 28, 1913, for exhaustion, wear
and tear, obsolescence, amortization, and depletion, to the extent of
the amount—
(A) allowed as deductions in computing taxable income under this
subtitle or prior income tax laws, and
(B) resulting (by reason of the deductions so allowed) in a
reduction for any taxable year of the taxpayer’s taxes
under this subtitle (other than chapter 2, relating to tax on
self-employment income), or prior income, war-profits, or
excess-profits tax laws,
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but not less than the amount allowable under this subtitle
or prior income tax laws. Where no method has been
adopted under section 167 (relating to depreciation
deduction), the amount allowable shall be determined
under the straight line method. Subparagraph (B) of this
paragraph shall not apply in respect of any period since
February 28, 1913, and before January 1, 1952, unless an
election has been made under section 1020 (as in effect
before the date of the enactment of the Tax Reform Act of
1976). Where for any taxable year before the taxable year
1932 the depletion allowance was based on discovery
value or a percentage of income, then the adjustment for
depletion for such year shall be based on the depletion
which would have been allowable for such year if
computed without reference to discovery value or a
percentage of income;
(3) in respect of any period—
(A) before March 1, 1913,
(B) since February 28, 1913, during which such property was held
by a person or an organization not subject to income
taxation under this chapter or prior income tax laws,
(C) since February 28, 1913, and before January 1, 1958, during
which such property was held by a person subject to tax
under part I of subchapter L (or the corresponding
provisions of prior income tax laws), to the extent that
paragraph (2) does not apply, and
(D) since February 28, 1913, during which such property was held
by a person subject to tax under part II [1] of subchapter L
(or the corresponding provisions of prior income tax laws),
to the extent that paragraph (2) does not apply,
for exhaustion, wear and tear, obsolescence, amortization,
and depletion, to the extent sustained;
(4) in the case of stock (to the extent not provided for in the foregoing
paragraphs) for the amount of distributions previously made which,
under the law applicable to the year in which the distribution was
made, either were tax-free or were applicable in reduction of basis
(not including distributions made by a corporation which was
classified as a personal service corporation under the provisions of
the Revenue Act of 1918 (40 Stat. 1057), or the Revenue Act of
1921 (42 Stat. 227), out of its earnings or profits which were
taxable in accordance with the provisions of section 218 of the
Revenue Act of 1918 or 1921);
(5) in the case of any bond (as defined in section 171 (d)) the interest on
which is wholly exempt from the tax imposed by this subtitle, to
the extent of the amortizable bond premium disallowable as a
deduction pursuant to section 171 (a)(2), and in the case of any
other bond (as defined in section 171 (d)) to the extent of the
deductions allowable pursuant to section 171 (a)(1) (or the amount
applied to reduce interest payments under section 171 (e)(2)) with
respect thereto;
(6) in the case of any municipal bond (as defined in section 75 (b)), to the
extent provided in section 75 (a)(2);
(7) in the case of a residence the acquisition of which resulted, under
section 1034 (as in effect on the day before the date of the
enactment of the Taxpayer Relief Act of 1997), in the
nonrecognition of any part of the gain realized on the sale,
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exchange, or involuntary conversion of another residence, to the
extent provided in section 1034 (e) (as so in effect);
(8) in the case of property pledged to the Commodity Credit Corporation,
to the extent of the amount received as a loan from the Commodity
Credit Corporation and treated by the taxpayer as income for the
year in which received pursuant to section 77, and to the extent of
any deficiency on such loan with respect to which the taxpayer has
been relieved from liability;
(9) for amounts allowed as deductions as deferred expenses under section
616 (b) (relating to certain expenditures in the development of
mines) and resulting in a reduction of the taxpayer’s taxes under
this subtitle, but not less than the amounts allowable under such
section for the taxable year and prior years;
[(10) Repealed. Pub. L. 94–455, title XIX, § 1901(b)(21)(G), Oct. 4, 1976,
90 Stat. 1798]
(11) for deductions to the extent disallowed under section 268 (relating to
sale of land with unharvested crops), notwithstanding the
provisions of any other paragraph of this subsection;
(12) to the extent provided in section 28(h) of the Internal Revenue Code
of 1939 in the case of amounts specified in a shareholder’s consent
made under section 28 of such code;
[(13) Repealed. Pub. L. 108–357, title IV, § 413(c)(19), Oct. 22, 2004, 118
Stat. 1509]
(14) for amounts allowed as deductions as deferred expenses under section
174 (b)(1) (relating to research and experimental expenditures) and
resulting in a reduction of the taxpayers’ taxes under this subtitle,
but not less than the amounts allowable under such section for the
taxable year and prior years;
(15) for deductions to the extent disallowed under section 272 (relating to
disposal of coal or domestic iron ore), notwithstanding the
provisions of any other paragraph of this subsection;
(16) in the case of any evidence of indebtedness referred to in section 811
(b) (relating to amortization of premium and accrual of discount in
the case of life insurance companies), to the extent of the
adjustments required under section 811 (b) (or the corresponding
provisions of prior income tax laws) for the taxable year and all
prior taxable years;
(17) to the extent provided in section 1367 in the case of stock of, and
indebtedness owed to, shareholders of an S corporation;
(18) to the extent provided in section 961 in the case of stock in controlled
foreign corporations (or foreign corporations which were controlled
foreign corporations) and of property by reason of which a person
is considered as owning such stock;
(19) to the extent provided in section 50 (c), in the case of expenditures with
respect to which a credit has been allowed under section 38;
(20) for amounts allowed as deductions under section 59 (e) (relating to
optional 10-year writeoff of certain tax preferences);
(21) to the extent provided in section 1059 (relating to reduction in basis for
extraordinary dividends);
(22) in the case of qualified replacement property the acquisition of which
resulted under section 1042 in the nonrecognition of any part of the
gain realized on the sale or exchange of any property, to the extent
provided in section 1042 (d),[2]
(23) in the case of property the acquisition of which resulted under section
1043, 1044, 1045, or 1397B in the nonrecognition of any part of
the gain realized on the sale of other property, to the extent
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2.
3.
4.
P.
provided in section 1043 (c), 1044 (d), 1045 (b)(3), or 1397B
(b)(4), as the case may be,[2]
(24) to the extent provided in section 179A (e)(6)(A),[2]
(25) to the extent provided in section 30 (d)(1),[2]
(26) to the extent provided in sections 23 (g) and 137 (e),[2]
(27) in the case of a residence with respect to which a credit was allowed
under section 1400C, to the extent provided in section 1400C
(h),[2]
(28) in the case of a facility with respect to which a credit was allowed
under section 45F, to the extent provided in section 45F (f)(1),[2]
(29) in the case of railroad track with respect to which a credit was allowed
under section 45G, to the extent provided in section 45G (e)(3),[2]
(30) to the extent provided in section 179B (c),[2]
(31) in the case of a facility with respect to which a credit was allowed
under section 45H, to the extent provided in section 45H (d),[2]
(32) to the extent provided in section 179D (e),[2]
(33) to the extent provided in section 45L (e), in the case of amounts with
respect to which a credit has been allowed under section 45L,[2]
(34) to the extent provided in section 25C (e), in the case of amounts with
respect to which a credit has been allowed under section 25C,[2]
(35) to the extent provided in section 25D (f), in the case of amounts with
respect to which a credit has been allowed under section 25D,[2]
(36) to the extent provided in section 30B (h)(4),[2] and
(37) to the extent provided in section 30C (f).
This section states that the taxpayer’s basis for property is reduced by the depreciation
“allowed”.
If a taxpayer fails to take a deduction in one year, the taxpayer may not take a larger
deduction in a later year to make up for the lost deduction in the earlier year. Read Reg.
§1.167(a)-10(a).
Nevertheless, the taxpayer’s basis is reduced by the amount of depreciation which the
taxpayer has not taken.
If the three-year statute of limitations has not expired, then the taxpayer can amended some
of the taxpayer’s income tax returns and take the omitted deductions.
What happens if a taxpayer takes more depreciation deductions than is allowable?
1.
Read section 1016(a). This section states that the taxpayer’s basis for property is reduced
by the depreciation “allowed”. Section 1016(a) states as follows:
Section 1016. Adjustments to basis
(a) General rule
Proper adjustment in respect of the property shall in all cases be made—
(1) for expenditures, receipts, losses, or other items, properly chargeable to
capital account, but no such adjustment shall be made—
(A) for taxes or other carrying charges described in section 266, or
(B) for expenditures described in section 173 (relating to
circulation expenditures),
for which deductions have been taken by the taxpayer in
determining taxable income for the taxable year or prior
taxable years;
(2) in respect of any period since February 28, 1913, for exhaustion, wear
and tear, obsolescence, amortization, and depletion, to the extent of
the amount—
(A) allowed as deductions in computing taxable income under this
subtitle or prior income tax laws, and
(B) resulting (by reason of the deductions so allowed) in a
reduction for any taxable year of the taxpayer’s taxes
under this subtitle (other than chapter 2, relating to tax on
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self-employment income), or prior income, war-profits, or
excess-profits tax laws,
but not less than the amount allowable under this subtitle
or prior income tax laws. Where no method has been
adopted under section 167 (relating to depreciation
deduction), the amount allowable shall be determined
under the straight line method. Subparagraph (B) of this
paragraph shall not apply in respect of any period since
February 28, 1913, and before January 1, 1952, unless an
election has been made under section 1020 (as in effect
before the date of the enactment of the Tax Reform Act of
1976). Where for any taxable year before the taxable year
1932 the depletion allowance was based on discovery
value or a percentage of income, then the adjustment for
depletion for such year shall be based on the depletion
which would have been allowable for such year if
computed without reference to discovery value or a
percentage of income;
(3) in respect of any period—
(A) before March 1, 1913,
(B) since February 28, 1913, during which such property was held
by a person or an organization not subject to income
taxation under this chapter or prior income tax laws,
(C) since February 28, 1913, and before January 1, 1958, during
which such property was held by a person subject to tax
under part I of subchapter L (or the corresponding
provisions of prior income tax laws), to the extent that
paragraph (2) does not apply, and
(D) since February 28, 1913, during which such property was held
by a person subject to tax under part II [1] of subchapter L
(or the corresponding provisions of prior income tax laws),
to the extent that paragraph (2) does not apply,
for exhaustion, wear and tear, obsolescence, amortization,
and depletion, to the extent sustained;
(4) in the case of stock (to the extent not provided for in the foregoing
paragraphs) for the amount of distributions previously made which,
under the law applicable to the year in which the distribution was
made, either were tax-free or were applicable in reduction of basis
(not including distributions made by a corporation which was
classified as a personal service corporation under the provisions of
the Revenue Act of 1918 (40 Stat. 1057), or the Revenue Act of
1921 (42 Stat. 227), out of its earnings or profits which were
taxable in accordance with the provisions of section 218 of the
Revenue Act of 1918 or 1921);
(5) in the case of any bond (as defined in section 171 (d)) the interest on
which is wholly exempt from the tax imposed by this subtitle, to
the extent of the amortizable bond premium disallowable as a
deduction pursuant to section 171 (a)(2), and in the case of any
other bond (as defined in section 171 (d)) to the extent of the
deductions allowable pursuant to section 171 (a)(1) (or the amount
applied to reduce interest payments under section 171 (e)(2)) with
respect thereto;
(6) in the case of any municipal bond (as defined in section 75 (b)), to the
extent provided in section 75 (a)(2);
(7) in the case of a residence the acquisition of which resulted, under
section 1034 (as in effect on the day before the date of the
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enactment of the Taxpayer Relief Act of 1997), in the
nonrecognition of any part of the gain realized on the sale,
exchange, or involuntary conversion of another residence, to the
extent provided in section 1034 (e) (as so in effect);
(8) in the case of property pledged to the Commodity Credit Corporation,
to the extent of the amount received as a loan from the Commodity
Credit Corporation and treated by the taxpayer as income for the
year in which received pursuant to section 77, and to the extent of
any deficiency on such loan with respect to which the taxpayer has
been relieved from liability;
(9) for amounts allowed as deductions as deferred expenses under section
616 (b) (relating to certain expenditures in the development of
mines) and resulting in a reduction of the taxpayer’s taxes under
this subtitle, but not less than the amounts allowable under such
section for the taxable year and prior years;
[(10) Repealed. Pub. L. 94–455, title XIX, § 1901(b)(21)(G), Oct. 4, 1976,
90 Stat. 1798]
(11) for deductions to the extent disallowed under section 268 (relating to
sale of land with unharvested crops), notwithstanding the
provisions of any other paragraph of this subsection;
(12) to the extent provided in section 28(h) of the Internal Revenue Code
of 1939 in the case of amounts specified in a shareholder’s consent
made under section 28 of such code;
[(13) Repealed. Pub. L. 108–357, title IV, § 413(c)(19), Oct. 22, 2004, 118
Stat. 1509]
(14) for amounts allowed as deductions as deferred expenses under section
174 (b)(1) (relating to research and experimental expenditures) and
resulting in a reduction of the taxpayers’ taxes under this subtitle,
but not less than the amounts allowable under such section for the
taxable year and prior years;
(15) for deductions to the extent disallowed under section 272 (relating to
disposal of coal or domestic iron ore), notwithstanding the
provisions of any other paragraph of this subsection;
(16) in the case of any evidence of indebtedness referred to in section 811
(b) (relating to amortization of premium and accrual of discount in
the case of life insurance companies), to the extent of the
adjustments required under section 811 (b) (or the corresponding
provisions of prior income tax laws) for the taxable year and all
prior taxable years;
(17) to the extent provided in section 1367 in the case of stock of, and
indebtedness owed to, shareholders of an S corporation;
(18) to the extent provided in section 961 in the case of stock in controlled
foreign corporations (or foreign corporations which were controlled
foreign corporations) and of property by reason of which a person
is considered as owning such stock;
(19) to the extent provided in section 50 (c), in the case of expenditures with
respect to which a credit has been allowed under section 38;
(20) for amounts allowed as deductions under section 59 (e) (relating to
optional 10-year writeoff of certain tax preferences);
(21) to the extent provided in section 1059 (relating to reduction in basis for
extraordinary dividends);
(22) in the case of qualified replacement property the acquisition of which
resulted under section 1042 in the nonrecognition of any part of the
gain realized on the sale or exchange of any property, to the extent
provided in section 1042 (d),[2]
(23) in the case of property the acquisition of which resulted under section
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2.
3.
4.
1043, 1044, 1045, or 1397B in the nonrecognition of any part of
the gain realized on the sale of other property, to the extent
provided in section 1043 (c), 1044 (d), 1045 (b)(3), or 1397B
(b)(4), as the case may be,[2]
(24) to the extent provided in section 179A (e)(6)(A),[2]
(25) to the extent provided in section 30 (d)(1),[2]
(26) to the extent provided in sections 23 (g) and 137 (e),[2]
(27) in the case of a residence with respect to which a credit was allowed
under section 1400C, to the extent provided in section 1400C
(h),[2]
(28) in the case of a facility with respect to which a credit was allowed
under section 45F, to the extent provided in section 45F (f)(1),[2]
(29) in the case of railroad track with respect to which a credit was allowed
under section 45G, to the extent provided in section 45G (e)(3),[2]
(30) to the extent provided in section 179B (c),[2]
(31) in the case of a facility with respect to which a credit was allowed
under section 45H, to the extent provided in section 45H (d),[2]
(32) to the extent provided in section 179D (e),[2]
(33) to the extent provided in section 45L (e), in the case of amounts with
respect to which a credit has been allowed under section 45L,[2]
(34) to the extent provided in section 25C (e), in the case of amounts with
respect to which a credit has been allowed under section 25C,[2]
(35) to the extent provided in section 25D (f), in the case of amounts with
respect to which a credit has been allowed under section 25D,[2]
(36) to the extent provided in section 30B (h)(4),[2] and
(37) to the extent provided in section 30C (f).
If a taxpayer fails to take a deduction in one year, the taxpayer may not take a larger
deduction in a later year to make up for the lost deduction in the earlier year. Read Reg.
§1.167(a)-10(a).
Nevertheless, the taxpayer’s basis is reduced by the amount of depreciation which the
taxpayer has not taken.
If the three-year statute of limitations has not expired, then the taxpayer can amended some
of the taxpayer’s income tax returns and take the omitted deductions.
Q.
Depreciation methods for tangible personal property.
1.
In general, the depreciation deduction for any tangible property is determined by using the
following.
a.
The applicable depreciation method.
b.
The applicable recovery period.
c.
The applicable convention.
R.
The modified accelerated cost recovery system (MACRS). Read section 168(a), which states as
follows:
Section 168. Accelerated cost recovery system
(a) General rule. Except as otherwise provided in this section, the depreciation
deduction provided by section 167 (a) for any tangible property shall be determined
by using—
(1) the applicable depreciation method,
(2) the applicable recovery period, and
(3) the applicable convention.
1.
In general, the applicable depreciation method (the modified accelerated cost recovery
system or MACRS) is the 200 percent declining balance method, switching to the straight
line method for the first taxable year for which using the straight line method with respect
to the adjusted basis as of the beginning of such year will yield a larger allowance.
Read section 168(b)(1), which states as follows:
Section 168. Accelerated cost recovery system
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a.
S.
(b) Applicable depreciation method
For purposes of this section—
(1) In general
Except as provided in paragraphs (2) and (3), the applicable
depreciation method is—
(A) the 200 percent declining balance method,
(B) switching to the straight line method for the 1st taxable year for
which using the straight line method with respect to the
adjusted basis as of the beginning of such year will yield
a larger allowance.
The 150 percent declining balance method should be used in the case of any of the
following.
(1)
15-year or 20-year property.
(2)
Any property used in a farming business, or
(3)
Taxpayers may elect to use the 150% declining balance method over the
class life for property other than 27.5-year and 39-year real property.
A cap on the maximum MACRS deduction.
1.
A cap is imposed on the maximum MACRS deduction that can be claimed in any one year
for an automobile. Read section 280F(a), which states as follows:
Section 280F. Limitation on depreciation for luxury automobiles; limitation where certain
property used for personal purposes
(a) Limitation on amount of depreciation for luxury automobiles
(1) Depreciation
(A) Limitation
The amount of the depreciation deduction for any taxable
year for any passenger automobile shall not exceed—
(i) $2,560 for the 1st taxable year in the recovery period,
(ii) $4,100 for the 2nd taxable year in the recovery period,
(iii) $2,450 for the 3rd taxable year in the recovery period,
and
(iv) $1,475 for each succeeding taxable year in the
recovery period.
(B) Disallowed deductions allowed for years after recovery period
(i) In general Except as provided in clause (ii), the
unrecovered basis of any passenger automobile shall be
treated as an expense for the 1st taxable year after the
recovery period. Any excess of the unrecovered basis over
the limitation of clause (ii) shall be treated as an expense
in the succeeding taxable year.
(ii) $1,475 limitation The amount treated as an expense
under clause (i) for any taxable year shall not exceed
$1,475.
(iii) Property must be depreciable No amount shall be
allowable as a deduction by reason of this subparagraph
with respect to any property for any taxable year unless a
depreciation deduction would be allowable with respect to
such property for such taxable year.
(iv) Amount treated as depreciation deduction For
purposes of this subtitle, any amount allowable as a
deduction by reason of this subparagraph shall be treated
as a depreciation deduction allowable under section 168.
(C) Special rule for certain clean-fuel passenger automobiles
(i) Modified automobiles In the case of a passenger
automobile which is propelled by a fuel which is not a
clean-burning fuel and to which is installed qualified
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2.
clean-fuel vehicle property (as defined in section 179A
(c)(1)(A)) for purposes of permitting such vehicle to be
propelled by a clean burning fuel (as defined in section
179A (e)(1)), subparagraph (A) shall not apply to the cost
of the installed qualified clean burning vehicle property.
(ii) Purpose built passenger vehicles In the case of a
purpose built passenger vehicle (as defined in section 4001
(a)(2)(C)(ii)), each of the annual limitations specified in
subparagraphs (A) and (B) shall be tripled.
(iii) Application of subparagraph This subparagraph shall
apply to property placed in service after August 5,
1997, and before January 1, 2007.
(2) Coordination with reductions in amount allowable by reason of personal
use, etc.
This subsection shall be applied before—
(A) the application of subsection (b), and
(B) the application of any other reduction in the amount of any
depreciation deduction allowable under section 168 by reason of
any use not qualifying the property for such credit or depreciation
deduction.
This cap, which is adjusted each year for inflation, causes the MACRS recovery period to
be longer than five years for expensive automobiles (in 1995, expensive cars were those
costing more than $15,300).
T.
Depreciating real property.
1.
In general, depreciable real property must be depreciated by using the straight line method.
Read section 168(b)(3), which states as follows:
Section 168. Accelerated cost recovery system
(b) Applicable depreciation method
For purposes of this section—
(3) Property to which straight line method applies
The applicable depreciation method shall be the straight line
method in the case of the following property:
(A) Nonresidential real property.
(B) Residential rental property.
(C) Any railroad grading or tunnel bore.
(D) Property with respect to which the taxpayer elects under
paragraph (5) to have the provisions of this paragraph
apply.
(E) Property described in subsection (e)(3)(D)(ii).
(F) Water utility property described in subsection (e)(5).
(G) Qualified leasehold improvement property described in
subsection (e)(6).
(H) Qualified restaurant property described in subsection (e)(7).
2.
Two types of real property which may be depreciated.
a.
Nonresidential real property.
b.
Residential rental real property.
3.
In general, personal residences are not depreciable real property.
a.
A residence is personal real property and any gain or loss from the disposition of the
personal residence is capital gain or capital loss.
U.
The useful lives of property are generally prescribed by the Regulations.
1.
The deduction of the cost of depreciable property is spread out over its recovery period or
useful life. Read Reg. §1.263(a)-1. In general, the applicable recovery period is determined
in accordance with the following.
2.
Computer software and race horses - three years.
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3.
4.
5.
6.
V.
Automobiles, light trucks, and computers - five years.
Other tangible personal property - seven years.
a.
For example, heavy trucks, office equipment, manufacturing equipment, rental
equipment, etc.
Residential real property - 27.5 years.
a.
The term residential rental property means any building or structure if 80 percent or
more of the gross rental income from such building or structure of the taxable year
is rental income from dwelling units (a house or apartment used to provide living
accommodations but does not include a hotel, motel, or other establishment more
than 50% of the units in which are used on a transient basis, and if any portion of the
building or structure is occupied by the taxpayer, the gross rental income from such
building includes the rental value of the portion so occupied. Read section
168(e)(2)(A)(ii)) and 168(e)(2)(A)(I), which state as follows
Section 168. Accelerated cost recovery system
(e) Classification of property
(2) Residential rental or nonresidential real prop-erty
(A) Residential rental property
(ii) Definitions For purposes of clause (i)—
Section 168. Accelerated cost recovery system
(e) Classification of property
(2) Residential rental or nonresidential real prop-erty
(A) Residential rental property
(I) the term “dwelling unit” means a
house or apartment used to provide living
accommodations in a building or
structure, but does not include a unit in a
hotel, motel, or other establishment more
than one-half of the units in which are
used on a transient basis, and
Other (nonresidential) real property - 39 years.
Depreciation conventions.
1.
Tangible personal property.
a.
In general, the applicable convention for tangible personal property is the half-year
convention in determining the first and last years depreciation allowance. Read
section 168(d)(1), which states as follows:
Section 168. Accelerated cost recovery system
(d) Applicable convention
For purposes of this section—
(1) In general
Except as otherwise provided in this subsection, the
applicable convention is the half-year convention.
b.
Thus, half of a year's depreciation is allowable for the year an asset is placed in
service, and for the year of disposition if the asset is disposed of before the end of
the recovery period.
c.
If more than 40% of the taxpayer's personal property placed in service during the
taxable year is placed in service during the last quarter of the year, however, a midquarter convention is required; that is, all property is treated as if it is placed in
service (or disposed of) at the mid-point quarter.
2.
Real property.
a.
In the case of nonresidential real property and nonresidential rental property the
applicable convention is the mid-month convention. Read section 168(d)(2), which
states as follows:
Section 168. Accelerated cost recovery system
(d) Applicable convention
(2) Real property
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In the case of—
(A) nonresidential real property,
(B) residential rental property, and
(C) any railroad grading or tunnel bore,
the applicable convention is the mid-month
convention.
W.
Some examples.
1.
Example. John purchased a building March 1 of last year. John paid $400,000 for the
building and John intends to rent the building for business offices.
a.
For last year, the amount of allowable depreciation deduction is as follows. Because
John will be entitled to a depreciation deduction for the half of the first month. The
allowable depreciation period for nonresidential real property is 39 years, therefore,
the annual depreciation is $10,256 ($400,000/39 years = $10,256 per year. John is
allowable 9.5/12 of the $10,256 depreciation deduction or $8,119 for last year.
Therefore, the answer is $8,119.
b.
John's adjusted basis at the beginning of the current year will be as follows. John's
original basis for the building was $400,000 minus the depreciation deduction of
$8,119 equals $391,881. Therefore the answer is $391,881.
c.
John's adjusted basis at the beginning of the next year is as follows. John is allowed
a depreciation deduction of $10,256. John's beginning adjusted basis is $381,625
($391,881 - $10,256). Therefore, the answer is $381,625.
d.
John sold the building in December of the current year for $425,000. The character
and amount of gain to John is as follows. John can only take ½ depreciation for the
month of December; therefore, the adjusted basis at the time of the sale is $382,052
($391,881 - $9,289) ($10,256 x 11.5/12 = $382,052). Therefore, the gain, which is
capital gain because John held the building as an investment, is $42,948 ($425,000 $382,052). Therefore, the answer is $42,948 long term capital gain.
2.
Example. On January 1 of the current year, John purchased a building (which had been
constructed in 1980) and some land and some equipment and some back rents, all of which
"went with" the building. John promptly rented the various rooms in the building to other
persons for business offices. At the time of the purchase, John paid $2,000,000 for the
property (that is, for the land, the building, and the equipment), and it is estimated that the
land had a fair market value of $550,000 and that the equipment (which had an income tax
depreciation life of seven years) had a fair market value of $250,000 and that the back rents
(which John also purchased separately) had a fair market value of $30,000 (though the rents
had a face, or gross, amount of $50,000). John wants to take the maximum income tax
deduction for depreciation which John can for the current year with respect to the building.
a.
An explanation of the point of deduction, character, and amount of any deduction
for depreciation to which John is entitled with respect to the building for the current
year is as follows. Investment and business property may be depreciated, however,
land or personal residences may not be depreciated.
Read section 167(a), which states as follows:
Section 167. Depreciation
(a) General rule. There shall be allowed as a depreciation deduction a
reasonable allowance for the exhaustion, wear and tear (including a
reasonable allowance for obsolescence)—
(1) of property used in the trade or business, or
(2) of property held for the production of income.
Non-residential business property is depreciated over a period of 39 years. This
non-residential business property should be depreciated utilizing the straight line
method. The allowable depreciation in the current year is as follows.
Cost of the building (John's basis) . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,000,000
Minus: fair market value of the land . . . . . . . . . . . . . . . . . . . . . . . . . . . . 550,000
Fair market value of equipment . . . . . . . . . . . . . . . . . . . . . . . . . 250,000
Fair market value of back rents . . . . . . . . . . . . . . . . . . . . . . . .
30,000
Total depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,170,000
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b.
$1, 170,000 = $30,000 x 11.5/12 = $28,750
39 years
Therefore, the answer is $28,750 ordinary deduction, to AGI.
If John rented the building under separate apartment leases for the lessee to use for
personal residences, then the depreciable period is 27.5 years instead of 39 years.
The fair market value of the building will be the same, i.e., $1,170,000. The
allowable depreciation deduction for the current year is as follows.
$1, 170,000 = $42,545 x 11.5/12 = $40,773
27.5 years
Therefore, the answer is $40,773 ordinary deduction in arriving at John’s AGI.
X.
Some questions.
1.
Question 1. On January 1 of the last year, John purchased a building (which had been
constructed in 1980) and some land and some equipment and some back rents, all of which
"went with" the building. John promptly rented the various rooms in the building to other
persons for business offices. At the time of the purchase, John paid $978,750 for the
property (that is, for the land, the building, and the equipment), and the rent, and it is
estimated that the land had a fair market value of $70,000 and that the equipment (which had
an income tax depreciation life of seven years) had a fair market value of $50,000 and that
the back rents had a fair market value of $30,000 (though the rents had a face, or gross,
amount of $50,000). John wants to take the maximum income tax deduction for depreciation
which John can for the current year with respect to the building. John's ordinary income tax
deduction for the current year for depreciation with respect to the building is as follows.
a.
None/Zero
b.
$22,000
c.
$21,000
d.
$21,250
e.
No prior stated answer
2.
Question 2. On January 1 of the last year, John purchased a building (which had been
constructed in 1980) and some land and some equipment and some back rents, all of which
"went with" the building. John promptly rented the various rooms in the building to other
persons for business offices. At the time of the purchase, John paid $978,750 for the
property (that is, for the land, the building, and the equipment), and the rent, and it is
estimated that the land had a fair market value of $50,000 and that the equipment (which had
an income tax depreciation life of seven years) had a fair market value of $70,000 and that
the back rents had a fair market value of $30,000 (though the rents had a face, or gross,
amount of $50,000). John wants to take the maximum income tax deduction for depreciation
which John can for the current year with respect to the building. John's ordinary income tax
deduction for the current year for depreciation with respect to the building is as follows.
a.
None/Zero
b.
$22,000
c.
$21,000
d.
$21,250
e.
No prior stated answer
Y.
An alternative depreciation system.
1.
Taxpayers may elect to use an alternative depreciation system under which assets are
depreciated using the straight line method and a recovery period equal to the property's class
life under Rev. Proc. 87-56.
2.
The alternative recovery period is five years for automobiles and light duty trucks, 12 years
for personal property with no class life, and 40 years for most real property.
3.
The alternative depreciation system is also used in computing the amount of modified
accelerated cost recovery system deductions allowable in computing the alternative
minimum tax. In the case of the alternative minimum tax, however, the 150% declining
balance method is used rather than the straight line method.
4.
To avoid any adjustment for alternative minimum tax purposes, taxpayers may elect to use
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5.
6.
7.
8.
the 150% declining balance method over the class life of the property for regular tax
purposes, as stated above.
Example. An airplane (5-year property) is purchased for $60,000 in 1992 for use in a trade
or business. If the class life of the plane for purposes of the alternative depreciation system
is six years, depreciation deductions could be computed in four different ways, as follows.
Alternative accelerated cost recovery system depreciation
150% db
straight line
straight line
Year 200% db
1992 $12,000
$7,500
$6,000
$5,000
1993 19,200
13,125
12,000
10,000
1994 11,520
9,844
12,000
10,000
1995
6,912
8,437
12,000
10,000
1996
6,912
8,437
12,000
10,000
1997
3,456
8,437
6,000
10,000
1998
---4,220
---5,000
Total $60,000
$60,000
$60,000
$60,000
If the plane was sold in 1995, only 50% of a year's depreciation would be allowable
for that year under the half-year convention.
A taxpayer may elect to treat the cost of any depreciable business property as an expense
rather than a capital expenditure. Read section 179(a), which states as follows:
Section 179. Election to expense certain depreciable business assets
(a) Treatment as expenses
A taxpayer may elect to treat the cost of any section 179 property as an
expense which is not chargeable to capital account. Any cost so treated shall
be allowed as a deduction for the taxable year in which the section 179
property is placed in service.
The aggregate cost which may be taken into account for any taxable year may not exceed
$19,000 for taxable years beginning in 1999, with the amount increasing to $25,000 by for
taxable years beginning in or after 2003. Read section 179(b)(1), which states as follows:
Section 179. Election to expense certain depreciable business assets
(b) Limitations
(1) Dollar limitation
The aggregate cost which may be taken into account under
subsection (a) for any taxable year shall not exceed $25,000
($100,000 in the case of taxable years beginning after 2002 and
before 2010).
a.
The $19,000 limitation is reduced (but not below zero) by the amount by which the
cost of the property placed in service during such taxable year exceeds $200,000.
Read section 179(b)(2), which states as follows:
Section 179. Election to expense certain depreciable business assets
(b) Limitations
(2) Reduction in limitation
The limitation under paragraph (1) for any taxable year
shall be reduced (but not below zero) by the amount by
which the cost of section 179 property placed in service
during such taxable year exceeds $200,000 ($400,000 in
the case of taxable years beginning after 2002 and before
2010).
Example. On January 1 of the current year, John purchased a computer, a computer printer,
and various other computer equipment for $50,000, all of which John used 100% of the time,
during the current year, in John's sole proprietorship business.
a.
An explanation of the point of deduction, character, and amount of the maximum
deduction for depreciation and expensing to which John is entitled with respect to
the equipment for the current year is as follows. Equipment is depreciated over a
seven year period and the double declining balance method of depreciation is used.
John may deduct $17,500 in the first year.
Read section 179(a), which states as follows:
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Section 179. Election to expense certain depreciable business assets
(a) Treatment as expenses
A taxpayer may elect to treat the cost of any section 179 property
as an expense which is not chargeable to capital account. Any cost
so treated shall be allowed as a deduction for the taxable year in
which the section 179 property is placed in service.
The total allowable deduction allowable in the current year is as follows.
(1)
100% = 14.29%
7 years
Due to the double declining balance method 14.29% needs to be doubled:
2 x 14.29% = 28.58%
(2)
Fair market value of equipment . . . . . . . . . . . . . . . . . . . . . . . . $ 50,000
Minus: Section 179 expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19,000
Deductible portion of equipment . . . . . . . . . . . . . . . . . . . . . . . $ 31,000
(3)
Take the total overall deductible portion of the equipment, $31,000, and
multiply that against the depreciation percentage.
Deductible portion of equipment . . . . . . . . . . . . . . . . . . . . . . . $ 31,000
Depreciation percentage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . x .2858
Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 8,857
(4)
Figure in the half-year convention
$8,857 = $4,429
2
(5)
Total deduction: $4,429 + $19,000 = $23,429
Therefore, the answer is $23,429 ordinary deduction, to AGI.
9.
Z.
Question 1. On January 1 of the current year, John purchased a computer, a computer
printer, and various other computer equipment for $20,000, all of which John used 100% of
the time, during the current year, in John's sole proprietorship business. John's maximum
depreciation deduction for the current year for depreciation and income tax expensing in
arriving at AGI with respect to the computer is as follows.
a.
None/Zero
b.
$18,000
c.
$17,500
d.
$20,000
e.
No prior stated answer
Recapture of certain depreciation taken with respect to real property.
1.
In general, depreciable real property held for more than one year must be recaptured only to
the extent depreciation deductions are taken under an accelerated method in excess of
straight line depreciation. Read section 1250(a), which states as follows:
Section 1250. Gain from dispositions of certain depreciable realty
(a) General rule. Except as otherwise provided in this section—
(1) Additional depreciation after December 31, 1975
(A) In general
If section 1250 property is disposed of after December 31,
1975, then the applicable percentage of the lower of—
(i) that portion of the additional depreciation (as defined in
subsection (b)(1) or (4)) attributable to periods
after December 31, 1975, in respect of the
property, or
(ii) the excess of the amount realized (in the case of a sale,
exchange, or involuntary conversion), or the fair
market value of such property (in the case of any
other disposition), over the adjusted basis of such
property,
shall be treated as gain which is ordinary income.
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Such gain shall be recognized notwithstanding any
other provision of this subtitle.
(B) Applicable percentage
For purposes of subparagraph (A), the term “applicable
percentage” means—
(i) in the case of section 1250 property with respect to
which a mortgage is insured under section
221(d)(3) or 236 of the National Housing Act, or
housing financed or assisted by direct loan or tax
abatement under similar provisions of State or
local laws and with respect to which the owner is
subject to the restrictions described in section
1039 (b)(1)(B) (as in effect on the day before the
date of the enactment of the Revenue
Reconciliation Act of 1990), 100 percent minus 1
percentage point for each full month the property
was held after the date the property was held 100
full months;
(ii) in the case of dwelling units which, on the average,
were held for occupancy by families or individuals
eligible to receive subsidies under section 8 of the
United States Housing Act of 1937, as amended,
or under the provisions of State or local law
authorizing similar levels of subsidy for
lower-income families, 100 percent minus 1
percentage point for each full month the property
was held after the date the property was held 100
full months;
(iii) in the case of section 1250 property with respect to
which a depreciation deduction for rehabilitation
expenditures was allowed under section 167 (k),
100 percent minus 1 percentage point for each full
month in excess of 100 full months after the date
on which such property was placed in service;
(iv) in the case of section 1250 property with respect to
which a loan is made or insured under title V of
the Housing Act of 1949, 100 percent minus 1
percentage point for each full month the property
was held after the date the property was held 100
full months; and
(v) in the case of all other section 1250 property, 100
percent.
In the case of a building (or a portion of a building
devoted to dwelling units), if, on the average, 85
percent or more of the dwelling units contained in
such building (or portion thereof) are units
described in clause (ii), such building (or portion
thereof) shall be treated as property described in
clause (ii). Clauses (i), (ii), and (iv) shall not apply
with respect to the additional depreciation
described in subsection (b)(4) which was allowed
under section 167 (k).
(2) Additional depreciation after December 31, 1969, and before January 1,
1976
(A) In general
If section 1250 property is disposed of after December 31,
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1969, and the amount determined under paragraph
(1)(A)(ii) exceeds the amount determined under paragraph
(1)(A)(i), then the applicable percentage of the lower of—
(i) that portion of the additional depreciation attributable to
periods after December 31, 1969, and before
January 1, 1976, in respect of the property, or
(ii) the excess of the amount determined under paragraph
(1)(A)(ii) over the amount determined under
paragraph (1)(A)(i),
shall also be treated as gain which is ordinary
income. Such gain shall be recognized
notwithstanding any other provision of this
subtitle.
(B) Applicable percentage
For purposes of subparagraph (A), the term “applicable
percentage” means—
(i) in the case of section 1250 property disposed of
pursuant to a written contract which was, on July
24, 1969, and at all times thereafter, binding on
the owner of the property, 100 percent minus 1
percentage point for each full month the property
was held after the date the property was held 20
full months;
(ii) in the case of section 1250 property with respect to
which a mortgage is insured under section
221(d)(3) or 236 of the National Housing Act, or
housing financed or assisted by direct loan or tax
abatement under similar provisions of State or
local laws, and with respect to which the owner is
subject to the restrictions described in section
1039 (b)(1)(B) (as in effect on the day before the
date of the enactment of the Revenue
Reconciliation Act of 1990), 100 percent minus 1
percentage point for each full month the property
was held after the date the property was held 20
full months;
(iii) in the case of residential rental property (as defined in
section 167 (j)(2)(B)) other than that covered by
clauses (i) and (ii), 100 percent minus 1
percentage point for each full month the property
was held after the date the property was held 100
full months;
(iv) in the case of section 1250 property with respect to
which a depreciation deduction for rehabilitation
expenditures was allowed under section 167 (k),
100 percent minus 1 percentage point for each full
month in excess of 100 full months after the date
on which such property was placed in service; and
(v) in the case of all other section 1250 property, 100
percent.
Clauses (i), (ii), and (iii) shall not apply with
respect to the additional depreciation described in
subsection (b)(4).
(3) Additional depreciation before January 1, 1970
(A) In general
If section 1250 property is disposed of after December 31,
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1963, and the amount determined under paragraph
(1)(A)(ii) exceeds the sum of the amounts determined
under paragraphs (1)(A)(i) and (2)(A)(i), then the
applicable percentage of the lower of—
(i) that portion of the additional depreciation attributable to
periods before January 1, 1970, in respect of the
property, or
(ii) the excess of the amount determined under paragraph
(1)(A)(ii) over the sum of the amounts determined
under paragraphs (1)(A)(i) and (2)(A)(i),
shall also be treated as gain which is ordinary
income. Such gain shall be recognized
notwithstanding any other provision of this
subtitle.
(B) Applicable percentage
For purposes of subparagraph (A), the term “applicable
percentage” means 100 percent minus 1 percentage point
for each full month the property was held after the date on
which the property was held for 20 full months.
(4) Special rule
For purposes of this subsection, any reference to section 167 (k) or
167 (j)(2)(B) shall be treated as a reference to such section as in
effect on the day before the date of the enactment of the Revenue
Reconciliation Act of 1990.
(5) Cross reference
For reduction in the case of corporations on capital gain treatment
under this section, see section 291 (a)(1).
2.
3.
4.
Because most real property placed in service after 1986 is limited to straight line accelerated
cost recovery system deductions only, no depreciation is recaptured on a disposition of such
property, unless it is held for less than one year.
In the case of nonresidential real property acquired during 1981-86 and held for more than
one year, no recapture is required if the straight line method was used for computing
deductions under accelerated cost recovery system, but if an accelerated method was used,
then the full amount of cost recovery deductions is subject to recapture on disposition of the
property.
In general, depreciation must be recaptured on any sale or other disposition of tangible
person property, even if gain would not otherwise be recognized.
Read section 1245(a), which states as follows:
Section 1245. Gain from dispositions of certain depreciable property
(a) General rule
(1) Ordinary income
Except as otherwise provided in this section, if section 1245 property is
disposed of the amount by which the lower of—
(A) the recomputed basis of the property, or
(B)
(i) in the case of a sale, exchange, or involuntary
conversion, the amount realized, or
(ii) in the case of any other disposition, the fair market
value of such property,
exceeds the adjusted basis of such property shall be treated
as ordinary income. Such gain shall be recognized
notwithstanding any other provision of this subtitle.
(2) Recomputed basis
For purposes of this section—
(A) In general
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The term “recomputed basis” means, with respect to any property,
its adjusted basis recomputed by adding thereto all adjustments
reflected in such adjusted basis on account of deductions (whether
in respect of the same or other property) allowed or allowable to
the taxpayer or to any other person for depreciation or
amortization.
(B) Taxpayer may establish amount allowed
For purposes of subparagraph (A), if the taxpayer can establish by
adequate records or other sufficient evidence that the amount
allowed for depreciation or amortization for any period was less
than the amount allowable, the amount added for such period shall
be the amount allowed.
(C) Certain deductions treated as amortization
Any deduction allowable under section 179, 179A, 179B, 179C,
179D, 179E, 181, 190, 193, or 194 shall be treated as if it were a
deduction allowable for amortization.
(3) Section 1245 property
For purposes of this section, the term “section 1245 property” means any
property which is or has been property of a character subject to the
allowance for depreciation provided in section 167 and is either—
(A) personal property,
(B) other property (not including a building or its structural components)
but only if such other property is tangible and has an adjusted basis
in which there are reflected adjustments described in paragraph (2)
for a period in which such property (or other property)—
(i) was used as an integral part of manufacturing, production, or
extraction or of furnishing transportation, communications,
electrical energy, gas, water, or sewage disposal services,
(ii) constituted a research facility used in connection with any of
the activities referred to in clause (i), or
(iii) constituted a facility used in connection with any of the
activities referred to in clause (i) for the bulk storage of
fungible commodities (including commodities in a liquid
or gaseous state),
(C) so much of any real property (other than any property described in
subparagraph (B)) which has an adjusted basis in which there are
reflected adjustments for amortization under section 169, 179,
179A, 179B, 179C, 179D, 179E, 185,[1] 188 (as in effect before its
repeal by the Revenue Reconciliation Act of 1990), 190, 193, or
194,[2]
(D) a single purpose agricultural or horticultural structure (as defined in
section 168 (i)(13)),
(E) a storage facility (not including a building or its structural components)
used in connection with the distribution of petroleum or any
primary product of petroleum, or
(F) any railroad grading or tunnel bore (as defined in section 168 (e)(4)).
AA.
Some examples.
1.
Example. John purchases tangible person property for $10,000 and takes depreciation
deductions of $6,000 such that John's adjusted basis is $4,000. Then John sells the property
for $6,000. John will have a recognizable ordinary gain of $2,000.
2.
Example. John purchases tangible person property for $10,000 and takes depreciation
deductions of $6,000 such that John's adjusted basis is $4,000. Then John sells the property
for $8,000. John will have a recognizable ordinary gain of $4,000.
3.
Example. John purchases tangible personal property for $10,000 and takes depreciation
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4.
BB.
deductions of $6,000 such that John's adjusted basis is $4,000. Then John sells the property
for $10,000. John will have a recognizable ordinary gain of $6,000.
Example. John purchases tangible person property for $10,000 and takes depreciation
deductions of $6,000 such that John's adjusted basis is $4,000. Then John sells the property
for $12,000. John will have a recognizable ordinary gain of $6,000, and a recognizable long
term capital gain of $2,000.
Some more comments about recapture of depreciation for depreciable real property.
1.
With respect to newly acquired real property, depreciation is not recaptured if the straight
line method of depreciation is used. Read section 1245(a) and section 1250(a).
Read section 1245(a), which states as follows:
Section 1245. Gain from dispositions of certain depreciable property
(a) General rule
(1) Ordinary income
Except as otherwise provided in this section, if section 1245
property is disposed of the amount by which the lower of—
(A) the recomputed basis of the property, or
(B)
(i) in the case of a sale, exchange, or involuntary
conversion, the amount realized, or
(ii) in the case of any other disposition, the fair market
value of such property,
exceeds the adjusted basis of such property shall
be treated as ordinary income. Such gain shall be
recognized notwithstanding any other provision of
this subtitle.
(2) Recomputed basis
For purposes of this section—
(A) In general
The term “recomputed basis” means, with respect to any
property, its adjusted basis recomputed by adding thereto
all adjustments reflected in such adjusted basis on account
of deductions (whether in respect of the same or other
property) allowed or allowable to the taxpayer or to any
other person for depreciation or amortization.
(B) Taxpayer may establish amount allowed
For purposes of subparagraph (A), if the taxpayer can
establish by adequate records or other sufficient evidence
that the amount allowed for depreciation or amortization
for any period was less than the amount allowable, the
amount added for such period shall be the amount allowed.
(C) Certain deductions treated as amortization
Any deduction allowable under section 179, 179A, 179B,
179C, 179D, 179E, 181, 190, 193, or 194 shall be treated
as if it were a deduction allowable for amortization.
(3) Section 1245 property
For purposes of this section, the term “section 1245 property”
means any property which is or has been property of a character
subject to the allowance for depreciation provided in section 167
and is either—
(A) personal property,
(B) other property (not including a building or its structural
components)
but only if such other property is tangible and has an
adjusted basis in which there are reflected adjustments
described in paragraph (2) for a period in which such
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property (or other property)—
(i) was used as an integral part of manufacturing,
production, or extraction or of furnishing
transportation,communications, electrical energy,
gas, water, or sewage disposal services,
(ii) constituted a research facility used in connection with
any of the activities referred to in clause (i), or
(iii) constituted a facility used in connection with any of
the activities referred to in clause (i) for the bulk
storage of fungible commodities (including
commodities in a liquid or gaseous state),
(C) so much of any real property (other than any property described
in
subparagraph (B)) which has an adjusted basis in which
there are reflected adjustments for amortization under
section 169, 179, 179A, 179B, 179C, 179D, 179E, 185,[1]
188 (as in effect before its repeal by the Revenue
Reconciliation Act of 1990), 190, 193, or 194,[2]
(D) a single purpose agricultural or horticultural structure (as
defined in
section 168 (i)(13)),
(E) a storage facility (not including a building or its structural
components) used in connection with the distribution of
petroleum or any primary product of petroleum, or
(F) any railroad grading or tunnel bore (as defined in section 168
(e)(4)).
Section 1250. Gain from dispositions of certain depreciable realty
(a) General rule. Except as otherwise provided in this section—
(1) Additional depreciation after December 31, 1975
(A) In general
If section 1250 property is disposed of after December 31,
1975, then the applicable percentage of the lower of—
(i) that portion of the additional depreciation (as defined in
subsection (b)(1) or (4)) attributable to periods
after December 31, 1975, in respect of the
property, or
(ii) the excess of the amount realized (in the case of a sale,
exchange, or involuntary conversion), or the fair
market value of such property (in the case of any
other disposition), over the adjusted basis of such
property,
shall be treated as gain which is ordinary income.
Such gain shall be recognized notwithstanding any
other provision of this subtitle.
(B) Applicable percentage
For purposes of subparagraph (A), the term “applicable
percentage” means—
(i) in the case of section 1250 property with respect to
which a mortgage is insured under section
221(d)(3) or 236 of the National Housing Act, or
housing financed or assisted by direct loan or tax
abatement under similar provisions of State or
local laws and with respect to which the owner is
subject to the restrictions described in section
1039 (b)(1)(B) (as in effect on the day before the
date of the enactment of the Revenue
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Reconciliation Act of 1990), 100 percent minus 1
percentage point for each full month the property
was held after the date the property was held 100
full months;
(ii) in the case of dwelling units which, on the average,
were held for occupancy by families or individuals
eligible to receive subsidies under section 8 of the
United States Housing Act of 1937, as amended,
or under the provisions of State or local law
authorizing similar levels of subsidy for
lower-income families, 100 percent minus 1
percentage point for each full month the property
was held after the date the property was held 100
full months;
(iii) in the case of section 1250 property with respect to
which a depreciation deduction for rehabilitation
expenditures was allowed under section 167 (k),
100 percent minus 1 percentage point for each full
month in excess of 100 full months after the date
on which such property was placed in service;
(iv) in the case of section 1250 property with respect to
which a loan is made or insured under title V of
the Housing Act of 1949, 100 percent minus 1
percentage point for each full month the property
was held after the date the property was held 100
full months; and
(v) in the case of all other section 1250 property, 100
percent.
In the case of a building (or a portion of a building
devoted to dwelling units), if, on the average, 85
percent or more of the dwelling units contained in
such building (or portion thereof) are units
described in clause (ii), such building (or portion
thereof) shall be treated as property described in
clause (ii). Clauses (i), (ii), and (iv) shall not apply
with respect to the additional depreciation
described in subsection (b)(4) which was allowed
under section 167 (k).
(2) Additional depreciation after December 31, 1969, and before January 1,
1976
(A) In general
If section 1250 property is disposed of after December 31,
1969, and the amount determined under paragraph
(1)(A)(ii) exceeds the amount determined under paragraph
(1)(A)(i), then the applicable percentage of the lower of—
(i) that portion of the additional depreciation attributable to
periods after December 31, 1969, and before
January 1, 1976, in respect of the property, or
(ii) the excess of the amount determined under paragraph
(1)(A)(ii) over the amount determined under
paragraph (1)(A)(i),
shall also be treated as gain which is ordinary
income. Such gain shall be recognized
notwithstanding any other provision of this
subtitle.
(B) Applicable percentage
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For purposes of subparagraph (A), the term “applicable
percentage” means—
(i) in the case of section 1250 property disposed of
pursuant to a written contract which was, on July
24, 1969, and at all times thereafter, binding on
the owner of the property, 100 percent minus 1
percentage point for each full month the property
was held after the date the property was held 20
full months;
(ii) in the case of section 1250 property with respect to
which a mortgage is insured under section
221(d)(3) or 236 of the National Housing Act, or
housing financed or assisted by direct loan or tax
abatement under similar provisions of State or
local laws, and with respect to which the owner is
subject to the restrictions described in section
1039 (b)(1)(B) (as in effect on the day before the
date of the enactment of the Revenue
Reconciliation Act of 1990), 100 percent minus 1
percentage point for each full month the property
was held after the date the property was held 20
full months;
(iii) in the case of residential rental property (as defined in
section 167 (j)(2)(B)) other than that covered by
clauses (i) and (ii), 100 percent minus 1
percentage point for each full month the property
was held after the date the property was held 100
full months;
(iv) in the case of section 1250 property with respect to
which a depreciation deduction for rehabilitation
expenditures was allowed under section 167 (k),
100 percent minus 1 percentage point for each full
month in excess of 100 full months after the date
on which such property was placed in service; and
(v) in the case of all other section 1250 property, 100
percent.
Clauses (i), (ii), and (iii) shall not apply with
respect to the additional depreciation described in
subsection (b)(4).
(3) Additional depreciation before January 1, 1970
(A) In general
If section 1250 property is disposed of after December 31,
1963, and the amount determined under paragraph
(1)(A)(ii) exceeds the sum of the amounts determined
under paragraphs (1)(A)(i) and (2)(A)(i), then the
applicable percentage of the lower of—
(i) that portion of the additional depreciation attributable to
periods before January 1, 1970, in respect of the
property, or
(ii) the excess of the amount determined under paragraph
(1)(A)(ii) over the sum of the amounts determined
under paragraphs (1)(A)(i) and (2)(A)(i),
shall also be treated as gain which is ordinary
income. Such gain shall be recognized
notwithstanding any other provision of this
subtitle.
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2.
3.
4.
(B) Applicable percentage
For purposes of subparagraph (A), the term “applicable
percentage” means 100 percent minus 1 percentage point
for each full month the property was held after the date on
which the property was held for 20 full months.
(4) Special rule
For purposes of this subsection, any reference to section 167 (k) or
167 (j)(2)(B) shall be treated as a reference to such section as in
effect on the day before the date of the enactment of the Revenue
Reconciliation Act of 1990.
(5) Cross reference
For reduction in the case of corporations on capital gain treatment
under this section, see section 291 (a)(1).
Consequently, the character of any gain from a sale of real property is capital gain gross
income.
No gain which is recaptured as ordinary income under section 1245 or section 1250 will be
taken into account under section 1231 and no gain, which is recaptured under section 1250
as capital gain will be taken into account under section 1231. Section 1245 and section 1250
have already characterized the recaptured depreciation as either ordinary income or capital
gain.
Under section 1231, gains and losses from sales or exchanges of property used in a trade or
business, and from certain involuntary conversions, are netted in order to determine the
character of such gains and losses. If the total section 1231 gains exceed the total section
1231 losses, then all of the 1231 gains and all of the 1231 losses are treated as long term
capital gains and long term capital losses. If the total section 1231 gains do not exceed the
total section 1231 losses, then all of the section 1231 gains and all of the section 1231 losses
are treated as ordinary gains and ordinary losses.
Read section 1231(a), which states as follows:
Section 1231. Property used in the trade or business and involuntary conversions
(a) General rule
(1) Gains exceed losses
If—
(A) the section 1231 gains for any taxable year, exceed
(B) the section 1231 losses for such taxable year,
such gains and losses shall be treated as long-term capital
gains or long-term capital losses, as the case may be.
(2) Gains do not exceed losses
If—
(A) the section 1231 gains for any taxable year, do not exceed
(B) the section 1231 losses for such taxable year,
such gains and losses shall not be treated as gains and
losses from sales or exchanges of capital assets.
(3) Section 1231 gains and losses
For purposes of this subsection—
(A) Section 1231 gain
The term “section 1231 gain” means—
(i) any recognized gain on the sale or exchange of property
used in the trade or business, and
(ii) any recognized gain from the compulsory or
involuntary conversion (as a result of destruction
in whole or in part, theft or seizure, or an exercise
of the power of requisition or condemnation or the
threat or imminence thereof) into other property or
money of—
(I) property used in the trade or business, or
(II) any capital asset which is held for more than
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1 year and is held in connection with a
trade or business or a transaction entered
into for profit.
(B) Section 1231 loss
The term “section 1231 loss” means any recognized loss
from a sale or exchange or conversion described in
subparagraph (A).
(4) Special rules
For purposes of this subsection—
(A) In determining under this subsection whether gains exceed
losses—
(i) the section 1231 gains shall be included only if and to
the extent taken into account in computing gross
income, and
(ii) the section 1231 losses shall be included only if and to
the extent taken into account in computing taxable
income, except that section 1211 shall not apply.
(B) Losses (including losses not compensated for by insurance or
otherwise) on the destruction, in whole or in part, theft or
seizure, or requisition or condemnation of—
(i) property used in the trade or business, or
(ii) capital assets which are held for more than 1 year and
are held in connection with a trade or business or
a transaction entered into for profit,
shall be treated as losses from a compulsory or
involuntary conversion.
(C) In the case of any involuntary conversion (subject to the
provisions of this subsection but for this sentence) arising from fire,
storm, shipwreck, or other casualty, or from theft, of any—
(i) property used in the trade or business, or
(ii) any capital asset which is held for more than 1 year and
is held in connection with a trade or business or a
transaction entered into for profit,
this subsection shall not apply to such conversion
(whether resulting in gain or loss) if during the
taxable year the recognized losses from such
conversions exceed the recognized gains from
such conversions.
CC.
Some examples.
1.
Example. John purchased property to be used as business property for $10,000, and takes
depreciation deductions of $6,000 over several years, and then, John sells the business
property to Alan for $7,000. All of the $3,000 gain is ordinary income under section 1245
and there is no section 1231 gain.
2.
Example. John purchased property to be used as business property for $10,000, and takes
depreciation deductions of $6,000 over several years, and then, John sells the business
property to Alan for $11,000. $6,000 of the gain is ordinary income under section 1245 and
$1,000 of the gain is section 1231 gain. If all of John's section 1231 gains exceed all of
John's total section 1231 losses, then the $1,000 of section 1231 gain will be $1,000 long
term capital gain.
3.
Example. John purchased property to be used as business property for $10,000, and takes
depreciation deductions of $6,000 over several years, and then, John sells the business
property to Alan for $11,000. $6,000 of the gain is ordinary income under section 1245 and
$1,000 of the gain is section 1231 gain. If all of John's section 1231 gains do not exceed all
of John's total section 1231 losses, then the $1,000 of section 1231 gain will be $1,000
ordinary income.
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4.
5.
6.
7.
8.
9.
Example. John purchased property to be used as business property for $10,000, and takes
depreciation deductions of $6,000 over several years, and then, John sells the business
property to Alan for $3,000. John will have a $1,000 ordinary loss.
Example. John purchased property to be used as investment property for $10,000, and takes
depreciation deductions of $6,000 over several years, and then, John sells the business
property to Alan for $7,000. All of the $3,000 gain is ordinary income under section 1245
and there is no section 1231 gain.
Example. John purchased property to be used as investment property for $10,000, and takes
depreciation deductions of $6,000 over several years, and then, John sells the investment
property to Alan for $11,000. $6,000 of the gain is ordinary income under section 1245 and
$1,000 of the gain is long term capital gain. There is no section 1231 gain.
Example. John purchased property to be used as investment property for $10,000, and takes
depreciation deductions of $6,000 over several years, and then, John sells the investment
property to Paul for $11,000. $6,000 of the gain is ordinary income under section 1245 and
$1,000 of the gain is long term capital gain. There is no section 1231 gain.
Example. John purchased property to be used as investment property for $10,000, and takes
depreciation deductions of $6,000 over several years, and then, John sells the investment
property to Paul for $3,000. John will have a $1,000 long term capital loss.
Example. During last year, Mary sold a building for $120,000 which Mary had been holding
as an investment. Mary purchased the building for $100,000 five years ago and Mary had
taken $15,000 of depreciation deductions with respect to such building, using the straight
line method of depreciation.
a.
The income tax result to Mary for last year as a result of the sale of the building is
as follows. Because Mary's depreciation method is the straight line, no recapture of
depreciation will occur. Read section 1250(a), which states as follows:
Section 1250. Gain from dispositions of certain depreciable realty
(a) General rule. Except as otherwise provided in this section—
(1) Additional depreciation after December 31, 1975
(A) In general
If section 1250 property is disposed of after December 31,
1975, then the applicable percentage of the lower of—
(i) that portion of the additional depreciation (as defined in
subsection (b)(1) or (4)) attributable to periods
after December 31, 1975, in respect of the
property, or
(ii) the excess of the amount realized (in the case of a sale,
exchange, or involuntary conversion), or the fair
market value of such property (in the case of any
other disposition), over the adjusted basis of such
property,
shall be treated as gain which is ordinary income.
Such gain shall be recognized notwithstanding any
other provision of this subtitle.
(B) Applicable percentage
For purposes of subparagraph (A), the term “applicable
percentage” means—
(i) in the case of section 1250 property with respect to
which a mortgage is insured under section
221(d)(3) or 236 of the National Housing Act, or
housing financed or assisted by direct loan or tax
abatement under similar provisions of State or
local laws and with respect to which the owner is
subject to the restrictions described in section
1039 (b)(1)(B) (as in effect on the day before the
date of the enactment of the Revenue
Reconciliation Act of 1990), 100 percent minus 1
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percentage point for each full month the property
was held after the date the property was held 100
full months;
(ii) in the case of dwelling units which, on the average,
were held for occupancy by families or individuals
eligible to receive subsidies under section 8 of the
United States Housing Act of 1937, as amended,
or under the provisions of State or local law
authorizing similar levels of subsidy for
lower-income families, 100 percent minus 1
percentage point for each full month the property
was held after the date the property was held 100
full months;
(iii) in the case of section 1250 property with respect to
which a depreciation deduction for rehabilitation
expenditures was allowed under section 167 (k),
100 percent minus 1 percentage point for each full
month in excess of 100 full months after the date
on which such property was placed in service;
(iv) in the case of section 1250 property with respect to
which a loan is made or insured under title V of
the Housing Act of 1949, 100 percent minus 1
percentage point for each full month the property
was held after the date the property was held 100
full months; and
(v) in the case of all other section 1250 property, 100
percent.
In the case of a building (or a portion of a building
devoted to dwelling units), if, on the average, 85
percent or more of the dwelling units contained in
such building (or portion thereof) are units
described in clause (ii), such building (or portion
thereof) shall be treated as property described in
clause (ii). Clauses (i), (ii), and (iv) shall not apply
with respect to the additional depreciation
described in subsection (b)(4) which was allowed
under section 167 (k).
(2) Additional depreciation after December 31, 1969, and before January 1,
1976
(A) In general
If section 1250 property is disposed of after December 31,
1969, and the amount determined under paragraph
(1)(A)(ii) exceeds the amount determined under paragraph
(1)(A)(i), then the applicable percentage of the lower of—
(i) that portion of the additional depreciation attributable to
periods after December 31, 1969, and before
January 1, 1976, in respect of the property, or
(ii) the excess of the amount determined under paragraph
(1)(A)(ii) over the amount determined under
paragraph (1)(A)(i),
shall also be treated as gain which is ordinary
income. Such gain shall be recognized
notwithstanding any other provision of this
subtitle.
(B) Applicable percentage
For purposes of subparagraph (A), the term “applicable
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percentage” means—
(i) in the case of section 1250 property disposed of
pursuant to a written contract which was, on July
24, 1969, and at all times thereafter, binding on
the owner of the property, 100 percent minus 1
percentage point for each full month the property
was held after the date the property was held 20
full months;
(ii) in the case of section 1250 property with respect to
which a mortgage is insured under section
221(d)(3) or 236 of the National Housing Act, or
housing financed or assisted by direct loan or tax
abatement under similar provisions of State or
local laws, and with respect to which the owner is
subject to the restrictions described in section
1039 (b)(1)(B) (as in effect on the day before the
date of the enactment of the Revenue
Reconciliation Act of 1990), 100 percent minus 1
percentage point for each full month the property
was held after the date the property was held 20
full months;
(iii) in the case of residential rental property (as defined in
section 167 (j)(2)(B)) other than that covered by
clauses (i) and (ii), 100 percent minus 1
percentage point for each full month the property
was held after the date the property was held 100
full months;
(iv) in the case of section 1250 property with respect to
which a depreciation deduction for rehabilitation
expenditures was allowed under section 167 (k),
100 percent minus 1 percentage point for each full
month in excess of 100 full months after the date
on which such property was placed in service; and
(v) in the case of all other section 1250 property, 100
percent.
Clauses (i), (ii), and (iii) shall not apply with
respect to the additional depreciation described in
subsection (b)(4).
(3) Additional depreciation before January 1, 1970
(A) In general
If section 1250 property is disposed of after December 31,
1963, and the amount determined under paragraph
(1)(A)(ii) exceeds the sum of the amounts determined
under paragraphs (1)(A)(i) and (2)(A)(i), then the
applicable percentage of the lower of—
(i) that portion of the additional depreciation attributable to
periods before January 1, 1970, in respect of the
property, or
(ii) the excess of the amount determined under paragraph
(1)(A)(ii) over the sum of the amounts determined
under paragraphs (1)(A)(i) and (2)(A)(i),
shall also be treated as gain which is ordinary
income. Such gain shall be recognized
notwithstanding any other provision of this
subtitle.
(B) Applicable percentage
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For purposes of subparagraph (A), the term “applicable
percentage” means 100 percent minus 1 percentage point
for each full month the property was held after the date on
which the property was held for 20 full months.
10.
DD.
(4) Special rule
For purposes of this subsection, any reference to section 167 (k) or
167 (j)(2)(B) shall be treated as a reference to such section as in
effect on the day before the date of the enactment of the Revenue
Reconciliation Act of 1990.
(5) Cross reference
For reduction in the case of corporations on capital gain treatment
under this section, see section 291 (a)(1).
The income tax result is as follows.
Amount realized . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 120,000
Minus: adjusted basis($100,000 - $15,000) . . . . . . . . . . . . . . . . . . . . . . . 85,000
Long term capital gain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 35,000
Therefore, the answer is $35,000 long term capital gain.
Example. During last year, Mary sold a building for $80,000 which Mary had been holding
as an investment. Mary purchased the building for $100,000 five years ago and Mary had
taken $15,000 of depreciation deductions with respect to such building, using the straight
line method of depreciation.
a.
The income tax result to Mary for last year as a result of the sale of the building is
as follows.
Amount realized . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 80,000
Minus: adjusted basis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . - 85,000
Long term capital loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (5,000)
Therefore, the answer is $5,000 long term capital loss, deductible to adjusted gross
income.
Some questions.
1.
Question 1. During last year, Mary sold a building for $95,000 which Mary had been
holding as an investment. Mary purchased the building for $100,000 five years ago and
Mary had taken $15,000 of depreciation deductions with respect to such building, using the
straight line method of depreciation. Mary's ordinary income for last year with respect to
the sale of the building is as follows.
a.
None/Zero
b.
$20,000
c.
$15,000
d.
$10,000
e.
No prior stated answer
2.
Question 2. During last year, Mary sold a building for $70,000 which Mary had been
holding as an investment. Mary purchased the building for $100,000 five years ago and
Mary had taken $15,000 of depreciation deductions with respect to such building, using the
straight line method of depreciation. Mary's long term capital loss income tax deduction
with respect to the sale of the building is as follows.
a.
None/Zero
b.
$20,000
c.
$15,000
d.
$10,000
e.
No prior stated answer
XVII. Section 611 and section 613 - depletion. Read section 611(a) and section 613(a), which state as follows:
Section 611. Allowance of deduction for depletion
(a) General rule
In the case of mines, oil and gas wells, other natural deposits, and timber,
there shall be allowed as a deduction in computing taxable income a
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reasonable allowance for depletion and for depreciation of improvements,
according to the peculiar conditions in each case; such reasonable allowance
in all cases to be made under regulations prescribed by the Secretary. For
purposes of this part, the term “mines” includes deposits of waste or
residue, the extraction of ores or minerals from which is treated as mining
under section 613 (c). In any case in which it is ascertained as a result of
operations or of development work that the recoverable units are greater or
less than the prior estimate thereof, then such prior estimate (but not the
basis for depletion) shall be revised and the allowance under this section for
subsequent taxable years shall be based on such revised estimate.
Section 613. Percentage depletion
(a) General rule
In the case of the mines, wells, and other natural deposits listed in
subsection (b), the allowance for depletion under section 611 shall be the
percentage, specified in subsection (b), of the gross income from the
property excluding from such gross income an amount equal to any rents or
royalties paid or incurred by the taxpayer in respect of the property. Such
allowance shall not exceed 50 percent (100 percent in the case of oil and
gas properties) of the taxpayer’s taxable income from the property
(computed without allowance for depletion and without the deduction under
section 199). For purposes of the preceding sentence, the allowable
deductions taken into account with respect to expenses of mining in
computing the taxable income from the property shall be decreased by an
amount equal to so much of any gain which
(1) is treated under section 1245 (relating to gain from disposition
of certain depreciable property) as ordinary income, and
(2) is properly allocable to the property. In no case shall the
allowance for depletion under section 611 be less than it would be
if computed without reference to this section.
A.
One definition of “depletion”.
1.
Depletion is the expensing or "writing off" of the cost of oil, gas, minerals, timber, etc.
2.
The owner of an economic interest in minerals or other natural deposits that will eventually
be exhausted is entitled to a depletion deduction under section 611 as the minerals are
recovered and sold.
3.
In many cases, taxpayers may deduct cost depletion or percentage depletion, whichever is
greater. Read section 613, which states as follows:
Section 613. Percentage depletion
(a) General rule
In the case of the mines, wells, and other natural deposits listed in subsection
(b), the allowance for depletion under section 611 shall be the percentage, specified
in subsection (b), of the gross income from the property excluding from
such gross income an amount equal to any rents or royalties paid or incurred
by the taxpayer in respect of the property. Such allowance shall not exceed
50 percent (100 percent in the case of oil and gas properties) of the
taxpayer's taxable income from the property (computed without allowance
for depletion and without the deduction under section 199). For purposes
of the preceding sentence, the allowable deductions taken into account with
respect to expenses of mining in computing the taxable income from the
property shall be decreased by an amount equal to so much of any gain
which
(1) is treated under section 1245 (relating to gain from disposition
of certain depreciable property) as ordinary income, and
(2) is properly allocable to the property. In no case shall the
allowance for depletion under section 611 be less than it
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would be if computed without reference to this section.
B.
Depletion deductions.
1.
Depletion deductions are not allowable unless the taxpayer has an economic interest in the
minerals in place, such as, an interest under which the taxpayer must look solely to
extraction of the mineral for profit.
C.
The basis for depletion.
1.
The taxpayer's basis for a mineral deposit is allocated to the estimated number of units
available to obtain the cost depletion deduction for each unit sold.
2.
Taxpayers may elect to deduct currently the cost of drilling an oil or gas well, rather than
treating such costs as capital expenditures. Read section 263©, which states as follows:
Section 263. Capital expenditures
(c) Intangible drilling and development costs in the case of oil and gas wells and
geothermal wells Notwithstanding subsection (a), and except as provided in
subsection (i), regulations shall be prescribed by the Secretary under this subtitle
corresponding to the regulations which granted the option to deduct as expenses
intangible drilling and development costs in the case of oil and gas wells and which
were recognized and approved by the Congress in House Concurrent Resolution 50,
Seventy-ninth Congress. Such regulations shall also grant the option to deduct as
expenses intangible drilling and development costs in the case of wells drilled for
any geothermal deposit (as defined in section 613 (e)(2)) to the same extent and in
the same manner as such expenses are deductible in the case of oil and gas wells.
This subsection shall not apply with respect to any costs to which any deduction is
allowed under section 59 (e) or 291.
3.
Intangible drilling costs that are capitalized are recovered through depletion deductions (or
depreciation deductions in the case of expenditures for physical assets). Read Rev. Rul. 87134, 1987-51 I.R.B. 5.
4.
An example of cost depletion is as follows.
a.
On January 1 of the current year, Mary, purchased several acres of land with trees
on the land. Mary frequently made such purchases so that Mary could cut the trees
and sell the logs to saw mills. Mary paid $1,000,000 for the land and trees, and
Mary estimated that the land, after the cutting of the trees, would have a fair market
value of $200,000. Mary also estimated that the trees contained 500,000 board feet.
During the current year, Mary cut and sold 10,000 board feet of trees.
b.
An explanation of the point of deduction, character, and amount of any income tax
deduction to which Mary is entitled for the current year is as follows. All
exhaustible natural deposits and timber qualify for a deduction of a reasonable
allowance for depletion.
Read section 611(a), which states as follows:
Section 611. Allowance of deduction for depletion
(a) General rule
In the case of mines, oil and gas wells, other natural deposits, and timber,
there shall be allowed as a deduction in computing taxable income a
reasonable allowance for depletion and for depreciation of improvements,
according to the peculiar conditions in each case; such reasonable allowance
in all cases to be made under regulations prescribed by the Secretary. For
purposes of this part, the term "mines" includes deposits of waste or residue,
the extraction of ores or minerals from which is treated as mining under
section 613 (c). In any case in which it is ascertained as a result of
operations or of development work that the recoverable units are greater or
less than the prior estimate thereof, then such prior estimate (but not the
basis for depletion) shall be revised and the allowance under this section for
subsequent taxable years shall be based on such revised estimate.
Here the cost depletion method is used. Under this method:
Original cost of land - final fair market value = $/unit
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Amount of units sold
$1,000,000 - $200,000 = $800,000 = $1.6/board feet
500,000 board feet
500,000
$1.6/board feet x 10,000 board feet sold = $16,000
Therefore, the answer is $16,000 ordinary deduction, to AGI.
D.
Percentage depletion.
1.
A specified percentage is applied to the taxpayer's gross income from the depletable property
to obtain percentage depletion deductions.
a.
This deduction cannot exceed 50% of the taxpayer's taxable income from the
property, computed before deducting depletion.
b.
Percentage depletion deductions are not limited to the taxpayer's basis for the
property. Thus, total percentage depletion deductions may exceed basis.
E.
Related deductions.
1.
An election to deduct mining exploration expenditures currently is allowable by section 617.
A similar election is allowable under section 616 for development costs of mines and other
natural deposits after the existence of minerals in commercially marketable quantities has
been established.
XVIII. Charitable contributions - section 170. Read section 170(a), which states as follows:
Section 170. Charitable, etc., contributions and gifts
(a) Allowance of deduction
(1) General rule
There shall be allowed as a deduction any charitable contribution (as
defined in subsection (c)) payment of which is made within the taxable
year. A charitable contribution shall be allowable as a deduction only if
verified under regulations prescribed by the Secretary.
(2) Corporations on accrual basis
In the case of a corporation reporting its taxable income on the accrual
basis, if—
(A) the board of directors authorizes a charitable contribution
during any
taxable year, and
(B) payment of such contribution is made after the close of such
taxable year and on or before the 15th day of the third month
following the close of such taxable year,
then the taxpayer may elect to treat such contribution as
paid during such taxable year. The election may be made
only at the time of the filing of the return for such taxable
year, and shall be signified in such manner as the Secretary
shall by regulations prescribe.
(3) Future interests in tangible personal property
For purposes of this section, payment of a charitable contribution which
consists of a future interest in tangible personal property shall be treated as
made only when all intervening interests in, and rights to the actual
possession or enjoyment of, the property have expired or are held by
persons other than the taxpayer or those standing in a relationship to the
taxpayer described in section 267 (b) or 707 (b). For purposes of the
preceding sentence, a fixture which is intended to be severed from the real
property shall be treated as tangible personal property.
A.
Charitable organizations.
1.
In general, individuals may deduct contributions to qualified charitable organizations made
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2.
within the taxable year.
Read section 170(a)(1), which states as follows:
Section 170. Charitable, etc., contributions and gifts
(a) Allowance of deduction
(1) General rule
There shall be allowed as a deduction any charitable contribution
(as defined in subsection (c)) payment of which is made within the
taxable year. A charitable contribution shall be allowable as a
deduction only if verified under regulations prescribed by the
Secretary.
In general, a charitable organization includes a corporation, trust, or community trust, or
foundation created or organized and operated exclusively for religious, charitable, scientific,
literary, or education purposes, or to foster national or international amateur sports
competition, or for the prevention of cruelty to children or animals.
Read section 170©, which states as follows:
Section 170. Charitable, etc., contributions and gifts
(C) Special limitation with respect to contributions described in
subparagraph (A) of certain capital gain property
(i) In the case of charitable contributions described in
subparagraph (A) of capital gain property to which
subsection (e)(1)(B) does not apply, the total
amount of contributions of such property which
may be taken into account under subsection (a) for
any taxable year shall not exceed 30 percent of the
taxpayer’s contribution base for such year. For
purposes of this subsection, contributions of
capital gain property to which this subparagraph
applies shall be taken into account after all other
charitable contributions (other than charitable
contributions to which subparagraph (D) applies).
(ii) If charitable contributions described in subparagraph
(A) of capital gain property to which clause (i)
applies exceeds 30 percent of the taxpayer’s
contribution base for any taxable year, such excess
shall be treated, in a manner consistent with the
rules of subsection (d)(1), as a charitable
contribution of capital gain property to which
clause (i) applies in each of the 5 succeeding
taxable years in order of time.
(iii) At the election of the taxpayer (made at such time and
in such manner as the Secretary prescribes by
regulations), subsection (e)(1) shall apply to all
contributions of capital gain property (to which
subsection (e)(1)(B) does not otherwise apply)
made by the taxpayer during the taxable year. If
such an election is made, clauses (i) and (ii) shall
not apply to contributions of capital gain property
made during the taxable year, and, in applying
subsection (d)(1) for such taxable year with
respect to contributions of capital gain property
made in any prior contribution year for which an
election was not made under this clause, such
contributions shall be reduced as if subsection
(e)(1) had applied to such contributions in the year
in which made.
(iv) For purposes of this paragraph, the term “capital gain
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property” means, with respect to any contribution,
any capital asset the sale of which at its fair
market value at the time of the contribution would
have resulted in gain which would have been
long-term capital gain. For purposes of the
preceding sentence, any property which is
property used in the trade or business (as defined
in section 1231 (b)) shall be treated as a capital
asset.
B.
Deductible contributions must be gifts.
1.
If the taxpayer receives something in return for the contribution, the amount deductible is
the excess of the contribution over the fair market value of any benefit received. However,
insubstantial benefits are ignored.
2.
If a contribution to a college or university entitles the contributor to purchase tickets for an
athletic event, 80% of the contribution can be deducted.
Read section 170(m), which states as follows:
Section 170. Charitable, etc., contributions and gifts
(m)Certain donee income from intellectual property treated as an additional
charitable contribution
(1) Treatment as additional contribution
In the case of a taxpayer who makes a qualified intellectual
property contribution, the deduction allowed under subsection (a)
for each taxable year of the taxpayer ending on or after the date of
such contribution shall be increased (subject to the limitations
under subsection (b)) by the applicable percentage of qualified
donee income with respect to such contribution which is properly
allocable to such year under this subsection.
(2) Reduction in additional deductions to extent of initial deduction
With respect to any qualified intellectual property contribution, the
deduction allowed under subsection (a) shall be increased under
paragraph (1) only to the extent that the aggregate amount of such
increases with respect to such contribution exceed the amount
allowed as a deduction under subsection (a) with respect to such
contribution determined without regard to this subsection.
(3) Qualified donee income
For purposes of this subsection, the term “qualified donee income”
means any net income received by or accrued to the donee which
is properly allocable to the qualified intellectual property.
(4) Allocation of qualified donee income to taxable years of donor
For purposes of this subsection, qualified donee income shall be
treated as properly allocable to a taxable year of the donor if such
income is received by or accrued to the donee for the taxable year
of the donee which ends within or with such taxable year of the
donor.
(5) 10-year limitation
Income shall not be treated as properly allocable to qualified
intellectual property for purposes of this subsection if such income
is received by or accrued to the donee after the 10-year period
beginning on the date of the contribution of such property.
(6) Benefit limited to life of intellectual property
Income shall not be treated as properly allocable to qualified
intellectual property for purposes of this subsection if such income
is received by or accrued to the donee after the expiration of the
legal life of such property.
(7) Applicable percentage
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For purposes of this subsection, the term “applicable percentage”
means the percentage determined under the following table which
corresponds to a taxable year of the donor ending on or after the
date of the qualified intellectual property contribution:
Taxable Year of Donor
Ending on or After
Date of Contribution:
Applicable Percentage:
1st
2nd
3rd
4th
5th
6th
7th
8th
9th
10th
11th
12th
100
100
90
80
70
60
50
40
30
20
10
10.
(8) Qualified intellectual property contribution
For purposes of this subsection, the term “qualified intellectual
property contribution” means any charitable contribution of
qualified intellectual property—
(A) the amount of which taken into account under this section is
reduced by reason of subsection (e)(1), and
(B) with respect to which the donor informs the donee at the time
of such contribution that the donor intends to treat such
contribution as a qualified intellectual property
contribution for purposes of this subsection and section
6050L.
(9) Qualified intellectual property
For purposes of this subsection, the term “qualified intellectual
property” means property described in subsection (e)(1)(B)(iii)
(other than property contributed to or for the use of an organization
described in subsection (e)(1)(B)(ii)).
(10) Other special rules
(A) Application of limitations on charitable contributions
Any increase under this subsection of the deduction
provided under subsection (a) shall be treated for purposes
of subsection (b) as a deduction which is attributable to a
charitable contribution to the donee to which such increase
relates.
(B) Net income determined by donee
The net income taken into account under paragraph (3)
shall not exceed the amount of such income reported under
section 6050L (b)(1).
(C) Deduction limited to 12 taxable years
Except as may be provided under subparagraph (D)(i), this
subsection shall not apply with respect to any qualified
intellectual property contribution for any taxable year of
the donor after the 12th taxable year of the donor which
ends on or after the date of such contribution.
(D) Regulations
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3.
4.
The Secretary may issue regulations or other guidance to
carry out the purposes of this subsection, including
regulations or guidance—
(i) modifying the application of this subsection in the case
of a donor or donee with a short taxable year, and
(ii) providing for the determination of an amount to be
treated as net income of the donee which is properly
allocable to qualified intellectual property in the case of a
donee who uses such property to further a purpose or
function constituting the basis of the donee’s exemption
under section 501 (or, in the case of a governmental unit,
any purpose described in section 170 (c)) and does not
possess a right to receive any payment from a third party
with respect to such property.
a.
If a taxpayer works for a charitable organization, the taxpayer is not allowable a
charitable deduction for the fair market value of the services rendered by the
taxpayer. If, however, the taxpayer pays another to work for a charitable
organization, the taxpayer is allowable a charitable deduction for the amount paid
to the person to work for the charitable organization.
No deduction is allowable for the fair market value of personal services donated to a
charitable organization, but a deduction is allowable for any out-of-pocket expenses incurred
in performing volunteer services for a charitable organization. Read Reg. § 1.170a-1(g)
No deduction is allowable for charitable contributions of $250 or more unless the taxpayer
substantiates the contribution by a contemporaneous written acknowledgment from the
donee organization.
a.
Alternatively, the donee organization may file a return with the IRS reporting the
information required on the written acknowledgment to substantiate the amount of
the contribution. Read section 170(f)(8), which states as follows:
Section 170. Charitable, etc., contributions and gifts
(f) Disallowance of deduction in certain cases and special rules
(8) Substantiation requirement for certain contributions
(A) General rule
No deduction shall be allowed under subsection
(a) for any contribution of $250 or more unless the
taxpayer substantiates the contribution by a
contemporaneous written acknowledgment of the
contribution by the donee organization that meets
the requirements of subparagraph (B).
(B) Content of acknowledgement
An acknowledgement meets the requirements of
this subparagraph if it includes the following
information:
(i) The amount of cash and a description (but not
value) of any property other than cash
contributed.
(ii) Whether the donee organization provided any
goods or services in consideration, in
whole or in part, for any property
described in clause (i).
(iii) A description and good faith estimate of the
value of any goods or services referred to in clause
(ii) or, if such goods or services consist solely of
intangible religious benefits, a statement to that
effect.
For purposes of this subparagraph, the term
“intangible religious benefit” means any
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intangible religious benefit which is provided by
an organization organized exclusively for religious
purposes and which generally is not sold in a
commercial transaction outside the donative
context.
(C) Contemporaneous
For purposes of subparagraph (A), an
acknowledgment shall be considered to be
contemporaneous if the taxpayer obtains the
acknowledgment on or before the earlier of—
(i) the date on which the taxpayer files a return for
the taxable year in which the contribution
was made, or
(ii) the due date (including extensions) for filing
such return.
(D) Substantiation not required for contributions reported
by the donee organization
Subparagraph (A) shall not apply to a contribution
if the donee organization files a return, on such
form and in accordance with such regulations as
the Secretary may prescribe, which includes the
information described in subparagraph (B) with
respect to the contribution.
(E) Regulations
The Secretary shall prescribe such regulations as
may be necessary or appropriate to carry out the
purposes of this paragraph, including regulations
that may provide that some or all of the
requirements of this paragraph do not apply in
appropriate cases.
C.
Percentage limitations with respect to charitable contributions.
1.
Contributions to publicly supported charitable organizations (section 170(b)(1)(A)) may be
deducted up to 50% of the taxpayer's adjusted gross income.
2.
Deductions for contributions to any other qualified charitable organizations (private
foundations) are limited to the lesser of the following.
a.
30% of the taxpayer's adjusted gross income, or
b.
50% of the taxpayer's adjusted gross income reduced by any contributions to
publicly supported charitable organizations.
Read section 170(b)(1)(B), which states as follows:
Section 170. Charitable, etc., contributions and gifts
(b) Percentage limitations
(1) Individuals
In the case of an individual, the deduction provided in subsection
(a) shall be limited as provided in the succeeding subparagraphs.
(B) Other contributions
Any charitable contribution other than a charitable
contribution to which subparagraph (A) applies shall be
allowed to the extent that the aggregate of such
contributions does not exceed the lesser of—
(i) 30 percent of the taxpayer’s contribution base for the
taxable year, or
(ii) the excess of 50 percent of the taxpayer’s contribution
base for the taxable year over the amount of
charitable contributions allowable under
subparagraph (A) (determined without regard to
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3.
subparagraph (C)).
If the aggregate of such contributions exceeds the
limitation of the preceding sentence, such excess
shall be treated (in a manner consistent with the
rules of subsection (d)(1)) as a charitable
contribution (to which subparagraph (A) does not
apply) in each of the 5 succeeding taxable years in
order of time.
Contributions in excess of these percentage limits may be carried forward for up to five years
such that such excess is treated as a charitable contribution paid in the subsequent five
taxable years. Read section 170(d), which states as follows:
Section 170. Charitable, etc., contributions and gifts
(d) Carry overs of excess contributions
(1) Individuals
(A) In general
In the case of an individual, if the amount of charitable
contributions described in subsection (b)(1)(A) payment of
which is made within a taxable year (hereinafter in this
paragraph referred to as the “contribution year”) exceeds
50 percent of the taxpayer’s contribution base for such
year, such excess shall be treated as a charitable
contribution described in subsection (b)(1)(A) paid in each
of the 5 succeeding taxable years in order of time, but,
with respect to any such succeeding taxable year, only to
the extent of the lesser of the two following amounts:
(i) the amount by which 50 percent of the taxpayer’s
contribution base for such succeeding taxable year exceeds
the sum of the charitable contributions described in
subsection (b)(1)(A) payment of which is made by the
taxpayer within such succeeding taxable year (determined
without regard to this subparagraph) and the charitable
contributions described in subsection (b)(1)(A) payment of
which was made in taxable years before the contribution
year which are treated under this subparagraph as having
been paid in such succeeding taxable year; or
(ii) in the case of the first succeeding taxable year, the
amount of such excess, and in the case of the second, third,
fourth, or fifth succeeding taxable year, the portion of such
excess not treated under this subparagraph as a charitable
contribution described in subsection (b)(1)(A) paid in any
taxable year intervening between the contribution year and
such succeeding taxable year.
(B) Special rule for net operating loss carryovers
In applying subparagraph (A), the excess determined under
subparagraph (A) for the contribution year shall be reduced
to the extent that such excess reduces taxable income (as
computed for purposes of the second sentence of section
172 (b)(2)) and increases the net operating loss deduction
for a taxable year succeeding the contribution year.
(2) Corporations
(A) In general
Any contribution made by a corporation in a taxable year
(hereinafter in this paragraph referred to as the
“contribution year”) in excess of the amount deductible for
such year under subsection (b)(2)(A) shall be deductible
for each of the 5 succeeding taxable years in order of time,
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but only to the extent of the lesser of the two following
amounts:
(i) the excess of the maximum amount deductible for such
succeeding taxable year under subsection
(b)(2)(A) over the sum of the contributions made
in such year plus the aggregate of the excess
contributions which were made in taxable years
before the contribution year and which are
deductible under this subparagraph for such
succeeding taxable year; or
(ii) in the case of the first succeeding taxable year, the
amount of such excess contribution, and in the case of the
second, third, fourth, or fifth succeeding taxable year, the
portion of such excess contribution not deductible under
this subparagraph for any taxable year intervening between
the contribution year and such succeeding taxable year.
(B) Special rule for net operating loss carryovers
For purposes of subparagraph (A), the excess of—
(i) the contributions made by a corporation in a taxable
year to which this section applies, over
(ii) the amount deductible in such year under the limitation
in subsection (b)(2)(A),
shall be reduced to the extent that such excess
reduces taxable income (as computed for purposes
of the second sentence of section 172 (b)(2)) and
increases a net operating loss carryover under
section 172 to a succeeding taxable year.
D.
Charitable contributions of appreciated property.
1.
In general, when appreciated property is given to a charitable organization, the donor
recognizes no income even though the fair market value of the property is the measure of the
donor's contribution. There are limits on the amount deductible, however, depending on the
nature of the property and the type of charitable organization to which it is donated. Read
section 170(a), which states as follows:
Section 170. Charitable, etc., contributions and gifts
(a) Allowance of deduction
(1) General rule
There shall be allowed as a deduction any charitable contribution
(as defined in subsection (c)) payment of which is made within the
taxable year. Acharitable contribution shall be allowable as a
deduction only if verified under regulations prescribed by the
Secretary.
(2) Corporations on accrual basis
In the case of a corporation reporting its taxable income on the
accrual basis, if—
(A) the board of directors authorizes a charitable contribution during
any taxable year, and
(B) payment of such contribution is made after the close of such
taxable year and on or before the 15th day of the third
month following the close of such taxable year,
then the taxpayer may elect to treat such contribution as paid
during such taxable year. The election may be made only
at the time of the filing of the return for such taxable year,
and shall be signified in such manner as the Secretary shall
by regulations prescribe.
(3) Future interests in tangible personal property
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2.
3.
4.
5.
For purposes of this section, payment of a charitable contribution
which consists of a future interest in tangible personal property
shall be treated as made only when all intervening interests in, and
rights to the actual possession or enjoyment of, the property have
expired or are held by persons other than the taxpayer or those
standing in a relationship to the taxpayer described in section 267
(b) or 707 (b). For purposes of the preceding sentence, a fixture
which is intended to be severed from the real property shall be
treated as tangible personal property.
An individual is allowed a charitable deduction up to 50% or 30% of the individual's
adjusted gross income depending on the type of property contributed and the type of
charitable organization. Read section 170(a), which states as follows:
Section 170. Charitable, etc., contributions and gifts
(a) Allowance of deduction
(1) General rule
There shall be allowed as a deduction any charitable contribution
(as defined in subsection (c)) payment of which is made within the
taxable year. A charitable contribution shall be allowable as a
deduction only if verified under regulations prescribed by the
Secretary.
(2) Corporations on accrual basis
In the case of a corporation reporting its taxable income on the
accrual basis, if—
(A) the board of directors authorizes a charitable contribution during
any taxable year, and
(B) payment of such contribution is made after the close of such
taxable year and on or before the 15th day of the third
month following the close of such taxable year,
then the taxpayer may elect to treat such contribution as paid
during such taxable year. The election may be made only
at the time of the filing of the return for such taxable year,
and shall be signified in such manner as the Secretary shall
by regulations prescribe.
(3) Future interests in tangible personal property
For purposes of this section, payment of a charitable contribution
which consists of a future interest in tangible personal property
shall be treated as made only when all intervening interests in, and
rights to the actual possession or enjoyment of, the property have
expired or are held by persons other than the taxpayer or those
standing in a relationship to the taxpayer described in section 267
(b) or 707 (b). For purposes of the preceding sentence, a fixture
which is intended to be severed from the real property shall be
treated as tangible personal property.
These deductions are deductions from adjusted gross income.
The 50% test applies when property has been held for one year or less or has not appreciated
in fair market value or is not a capital asset (for example, the gift is inventory) or property
which is tangible personal property which is not related to the function of the charitable
organization.
a.
Under the 50% test, the taxpayer may deduct up to 50% of the taxpayer’s adjusted
gross income.
b.
Cash contributions for charitable deductions are under the 50% test.
The 30% test applies only when the property contributed is a capital asset which has been
held for more than one year and which has appreciated in fair market value. Under the 30%
test, the individual may deduct the fair market value of the property contributed up to 30%
of the individual’s adjusted gross income.
a.
Therefore, if the contributed property is a capital asset that has not been held by the
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b.
c.
taxpayer for more than one year, the 30% test will not apply; instead, the 50% test
will apply.
If the contributed property is a capital asset that has not appreciated in fair market
value regardless of the holding period, then the 50% test, not the 30% test will apply
and under the 50% test, the individual may deduct no more than the individual’s
adjusted basis for the property, up to 50% of the individual’s adjusted gross income.
Tangible personal property which is contributed to a charitable organization which
and which is a capital asset to the donor and which has been held by the donor for
more than one year and which has appreciated in value, must meet an additional
requirement in order for the donor to be able to deduct the fair market value of the
tangible personal property under the 30% test. Specifically, the tangible personal
property must be related to the function of the charitable organization.
E.
The differences between the 30% test and the 50% test.
1.
The difference between the 30% test and the 50% test is that the 30% test only applies to
capital assets and for the purposes of section 170, section 170(b)(1)(C) defines a “capital
asset” as being a capital asset which has been held for more than one year.
a.
Therefore, assets such as inventory will only be subject to the 50% test as will
common stock which has been held by the donor for one year or less.
b.
If an asset is subject to the 30% test, rather than the 50% test, the donor may deduct
the full fair market value of the asset, which is the good news. If an asset is subject
to the 50% test, then the donor may only deduct the lower of the fair market value
of the property and the adjusted basis of the property.
c.
The 30% test is favorable if the contributed asset has appreciated in fair market
value.
(1)
Example. Alan's adjusted gross income is $100,000 and Alan decides to
contribute property with a fair market value of $60,000 and with an adjusted
basis to Alan of $20,000. If the 30% test applies, then Alan's allowable
current charitable deduction is $30,000 (30% of $100,000) (with a $30,000
carryover). If the 50% test applies, then Alan's allowable charitable
deduction is $20,000.
2.
If the 30% test applies, then the individual may make a special election, and thus, come
within the scope of the 50% test.
a.
If the individual makes this election, the individual will lose any appreciation that
of the contributed property. Therefore, this special election will, when available, be
made if the contributed property has not significantly appreciated in fair market
value.
b.
For example, the 50% test might be more advantageous than the 30% test if the asset
is a capital asset held for more than one year and the asset’s fair market value is
$40,000 and the asset’s adjusted basis is $39,900 and the taxpayer’s adjusted gross
income is $80,000. Under the 30% test, the taxpayer could deduct $24,000, but
under the 50% test, the taxpayer could deduct $39,900.
3.
If the charitable organization sells the contributed property within two years after the
contribution, the property will not be considered to be related to the function of the
charitable organization. Contributions of property not related to the function of the
charitable organization will be subject to the 50% test.
F.
Charitable contributions of cash.
1.
Charitable contributions of cash, by a transferor, are deductible up to 50% of the transferor's
adjusted gross income. Read section 170(b)(1)(A), which states as follows:
Section 170. Charitable, etc., contributions and gifts
(b) Percentage limitations
(1) Individuals
In the case of an individual, the deduction provided in subsection
(a) shall be limited as provided in the succeeding subparagraphs.
(A) General rule
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2.
Any charitable contribution to—
(i) a church or a convention or association of churches,
(ii) an educational organization which normally maintains
a regular faculty and curriculum and normally has
a regularly enrolled body of pupils or students in
attendance at the place where its educational
activities are regularly carried on,
(iii) an organization the principal purpose or functions of
which are the providing of medical or hospital
care or medical education or medical research, if
the organization is a hospital, or if the
organization is a medical research organization
directly engaged in the continuous active conduct
of medical research in conjunction with a hospital,
and during the calendar year in which the
contribution is made such organization is
committed to spend such contributions for such
research before January 1 of the fifth calendar year
which begins after the date such contribution is
made,
(iv) an organization which normally receives a substantial
part of its support (exclusive of income received in
the exercise or performance by such organization
of its charitable, educational, or other purpose or
function constituting the basis for its exemption
under section 501 (a)) from the United States or
any State or political subdivision thereof or from
direct or indirect contributions from the general
public, and which is organized and operated
exclusively to receive, hold, invest, and administer
property and to make expenditures to or for the
benefit of a college or university which is an
organization referred to in clause (ii) of this
subparagraph and which is an agency or
instrumentality of a State or political subdivision
thereof, or which is owned or operated by a State
or political subdivision thereof or by an agency or
instrumentality of one or more States or political
subdivisions,
(v) a governmental unit referred to in subsection (c)(1),
(vi) an organization referred to in subsection (c)(2) which
normally receives a substantial part of its support
(exclusive of income received in the exercise or
performance by such organization of its charitable,
educational, or other purpose or function
constituting the basis for its exemption under
section 501 (a)) from a governmental unit referred
to in subsection (c)(1) or from direct or indirect
contributions from the general public,
(vii) a private foundation described in subparagraph (E), or
(viii) an organization described in section 509 (a)(2) or (3),
shall be allowed to the extent that the aggregate of
such contributions does not exceed 50 percent of
the taxpayer’s contribution base for the taxable
year.
If the charitable contribution exceeds 50% of the transferor's adjusted gross income, then the
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3.
4.
excess charitable contribution may be carried forward, and deducted, for income tax
purposes, until used-up, for five consecutive years.
Read section 170(d)(1), which states as follows:
Section 170. Charitable, etc., contributions and gifts
(d) Carryovers of excess contributions
(1) Individuals
(A) In general
In the case of an individual, if the amount of charitable
contributions described in subsection (b)(1)(A) payment of which
is made within a taxable year (hereinafter in this paragraph referred
to as the “contribution year”) exceeds 50 percent of the taxpayer’s
contribution base for such year, such excess shall be treated as a
charitable contribution described in subsection (b)(1)(A) paid in
each of the 5 succeeding taxable years in order of time, but, with
respect to any such succeeding taxable year, only to the extent of
the lesser of the two following amounts:
(i) the amount by which 50 percent of the taxpayer’s
contribution base for such succeeding taxable
year exceeds the sum of the charitable
contributions described in subsection (b)(1)(A)
payment of which is made by the taxpayer within
such succeeding taxable year (determined without
regard to this subparagraph) and the charitable
contributions described in subsection (b)(1)(A)
payment of which was made in taxable years
before the contribution year which are treated
under this subparagraph as having been paid in
such succeeding taxable year; or
(ii) in the case of the first succeeding taxable year, the
amount of such excess, and in the case of the
second, third, fourth, or fifth succeeding taxable
year, the portion of such excess not treated under
this subparagraph as a charitable contribution
described in subsection (b)(1)(A) paid in any
taxable year intervening between the contribution
year and such succeeding taxable year.
(B) Special rule for net operating loss carryovers
In applying subparagraph (A), the excess determined under
subparagraph (A) for the contribution year shall be reduced
to the extent that such excess reduces taxable income (as
computed for purposes of the second sentence of section
172 (b)(2)) and increases the net operating loss deduction
for a taxable year succeeding the contribution year.
Cash charitable contributions include the following.
a.
Currency.
b.
Checks.
c.
Money orders.
d.
Bank drafts.
Example. Alan makes a cash charitable contribution of $10,000 to a charitable organization.
If Alan's adjusted gross income is $20,000 or more, then Alan may take a charitable
contribution deduction for the entire $10,000 during the year during which the charitable
contribution is made.
a.
If, however, Alan's adjusted gross income is $10,000 and Alan makes a charitable
contribution of $10,000, then Alan may take a charitable contribution deduction of
the charitable contribution up to only 50% of Alan's adjusted gross income in the
first year, or $5,000.
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b.
5.
6.
G.
The following year, Alan may take a charitable contribution deduction for the value
of the charitable contribution remaining, or $5,000, as long as Alan's adjusted gross
income is $10,000 or more in that year.
If cash charitable contributions are paid in connection with or in return for admission to a
fund-raising event, then the receipt of tickets or other privileges presumes that the cash was
given as a payment for such privileges and not as a charitable contribution.
a.
The transferor may take a charitable contribution deduction only for that portion of
the payment which was made with the intention of making a charitable contribution.
b.
Example. John purchased a ticket for a fund raising dinner, at a cost to the transferor
of $50 per person. The charitable organization sponsoring the fund raising event
must provide to John the direct cost per person of the items involved in the dinner,
including the cost of food, a band, the location, decorations, etc. John may take a
charitable contribution deduction for the difference between the cost to John of $50,
and the fair market value to the charitable organization to operate the fund raising
event.
While cash might be the easiest charitable gift it is also the most expensive to make because
the donor will presumably have already been taxed at either ordinary or capital gain gross
income rates on the cash contributed.
More about the 50% and the 30% limitations.
1.
A charitable contribution of appreciated securities made by a transferor is deductible up to
30% of the transferor's adjusted gross income, if the securities are capital assets to the donor
and the donor has held the securities for more than one year.
Read section 170(b)(1)(C) and section 1221, which states as follows:
Section 170. Charitable, etc., contributions and gifts
(b) Percentage limitations
(1) Individuals
In the case of an individual, the deduction provided in subsection
(a) shall be limited as provided in the succeeding subparagraphs.
(C) Special limitation with respect to contributions described in
subparagraph (A) of certain capital gain property
(i) In the case of charitable contributions described in
subparagraph (A) of capital gain property to which
subsection (e)(1)(B) does not apply, the total amount of
contributions of such property which may be taken into
account under subsection (a) for any taxable year shall not
exceed 30 percent of the taxpayer’s contribution base for
such year. For purposes of this subsection, contributions of
capital gain property to which this subparagraph applies
shall be taken into account after all other charitable
contributions (other than charitable contributions to which
subparagraph (D) applies).
(ii) If charitable contributions described in subparagraph
(A) of capital gain property to which clause (i) applies
exceeds 30 percent of the taxpayer’s contribution base for
any taxable year, such excess shall be treated, in a manner
consistent with the rules of subsection (d)(1), as a
charitable contribution of capital gain property to which
clause (i) applies in each of the 5 succeeding taxable years
in order of time.
(iii) At the election of the taxpayer (made at such time and
in such manner as the Secretary prescribes by
regulations), subsection (e)(1) shall apply to all
contributions of capital gain property (to which
subsection (e)(1)(B) does not otherwise apply)
made by the taxpayer during the taxable year. If
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such an election is made, clauses (i) and (ii) shall
not apply to contributions of capital gain property
made during the taxable year, and, in applying
subsection (d)(1) for such taxable year with
respect to contributions of capital gain property
made in any prior contribution year for which an
election was not made under this clause, such
contributions shall be reduced as if subsection
(e)(1) had applied to such contributions in the year
in which made.
(iv) For purposes of this paragraph, the term “capital gain
property” means, with respect to any contribution,
any capital asset the sale of which at its fair
market value at the time of the contribution would
have resulted in gain which would have been
long-term capital gain. For purposes of the
preceding sentence, any property which is
property used in the trade or business (as defined
in section 1231 (b)) shall be treated as a capital
asset.
Section 1221. Capital asset defined
(a) In general. For purposes of this subtitle, the term “capital asset” means property
held by the taxpayer (whether or not connected with his trade or business), but does
not include—
(1) stock in trade of the taxpayer or other property of a kind which would
properly be included in the inventory of the taxpayer if on hand at
the close of the taxable year, or property held by the taxpayer
primarily for sale to customers in the ordinary course of his trade
or business;
(2) property, used in his trade or business, of a character which is subject to
the allowance for depreciation provided in section 167, or real
property used in his trade or business;
(3) a copyright, a literary, musical, or artistic composition, a letter or
memorandum, or similar property, held by—
(A) a taxpayer whose personal efforts created such property,
(B) in the case of a letter, memorandum, or similar property, a
taxpayer for whom such property was prepared or
produced, or
(C) a taxpayer in whose hands the basis of such property is
determined, for purposes of determining gain from a sale
or exchange, in whole or part by reference to the basis of
such property in the hands of a taxpayer described in
subparagraph (A) or (B);
(4) accounts or notes receivable acquired in the ordinary course of trade or
business for services rendered or from the sale of property
described in paragraph (1);
(5) a publication of the United States Government (including the
Congressional Record) which is received from the United States
Government or any agency thereof, other than by purchase at the
price at which it is offered for sale to the public, and which is held
by—
(A) a taxpayer who so received such publication, or
(B) a taxpayer in whose hands the basis of such publication is
determined, for purposes of determining gain from a sale
or exchange, in whole or in part by reference to the basis
of such publication in the hands of a taxpayer described in
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subparagraph (A);
(6) any commodities derivative financial instrument held by a commodities
derivatives dealer, unless—
(A) it is established to the satisfaction of the Secretary that such
instrument has no connection to the activities of such
dealer as a dealer, and
(B) such instrument is clearly identified in such dealer’s records as
being described in subparagraph (A) before the close of the
day on which it was acquired, originated, or entered into
(or such other time as the Secretary may by regulations
prescribe);
(7) any hedging transaction which is clearly identified as such before the
close of the day on which it was acquired, originated, or entered
into (or such other time as the Secretary may by regulations
prescribe); or
(8) supplies of a type regularly used or consumed by the taxpayer in the
ordinary course of a trade or business of the taxpayer.
2.
If the charitable contribution exceeds 30% of the transferor's adjusted gross income, then the
excess charitable contribution may be carried forward, and deducted until used-up, for five
consecutive years. Read section 170(d)(1), which states as follows:
Section 170. Charitable, etc., contributions and gifts
(d) Carryovers of excess contributions
(1) Individuals
(A) In general
In the case of an individual, if the amount of charitable
contributions described in subsection (b)(1)(A) payment of
which is made within a taxable year (hereinafter in this
paragraph referred to as the “contribution year”) exceeds
50 percent of the taxpayer’s contribution base for such
year, such excess shall be treated as a charitable
contribution described in subsection (b)(1)(A) paid in each
of the 5 succeeding taxable years in order of time, but,
with respect to any such succeeding taxable year, only to
the extent of the lesser of the two following amounts:
(i) the amount by which 50 percent of the taxpayer’s
contribution base for such succeeding taxable year
exceeds the sum of the charitable contributions
described in subsection (b)(1)(A) payment of
which is made by the taxpayer within such
succeeding taxable year (determined without
regard to this subparagraph) and the charitable
contributions described in subsection (b)(1)(A)
payment of which was made in taxable years
before the contribution year which are treated
under this subparagraph as having been paid in
such succeeding taxable year; or
(ii) in the case of the first succeeding taxable year, the
amount of such excess, and in the case of the
second, third, fourth, or fifth succeeding taxable
year, the portion of such excess not treated under
this subparagraph as a charitable contribution
described in subsection (b)(1)(A) paid in any
taxable year intervening between the contribution
year and such succeeding taxable year.
(B) Special rule for net operating loss carryovers
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a.
b.
3.
In applying subparagraph (A), the excess determined under
subparagraph (A) for the contribution year shall be reduced
to the extent that such excess reduces taxable income (as
computed for purposes of the second sentence of section
172 (b)(2)) and increases the net operating loss deduction
for a taxable year succeeding the contribution year. Read
section 170(d)(1).
Securities must be held more than 12 months to qualify as long term appreciated
securities. Read section 1222(3), which states as follows:
Section 1222. Other terms relating to capital gains and losses
For purposes of this subtitle—
(3) Long-term capital gain
The term “long-term capital gain” means gain from the
sale or exchange of a capital asset held for more than 1
year, if and to the extent such gain is taken into account in
computing gross income.
Example. During last year, John's and Mary's adjusted gross income was $100,000,
without considering the following transactions. No election was made with respect
to these facts.
Charitable contribution of common shares held for two years, with an adjusted basis
of $50,000 and a fair market value of . . . . . . . . . . . . . . . . . . . . . . . . . . $100,000
(1)
The amount of John's and Mary's taxable income is as follows.
The contributed asset was held for more than one year and appreciated in
fair market value. Thus, the 30% test applies, and the fair market value of
the gift is deductible.
Adjusted gross income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 100,000
30% test . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . x
.30
Deduction ceiling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 30,000
Because the fair market value is $100,000, $30,000 is an allowable
deduction this year, and $70,000 will be carried forward and is deductible
in the next five years.
Adjusted gross income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 100,000
Minus: charitable deduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000
Personal exemptions (3) . . . . . . . . . . . . . . . . . . . . . . . .
9,000
Taxable income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 61,000
Therefore, the answer is $61,000.
As stated, if the securities have not appreciated in fair market value, but rather depreciated
in fair market value, then the 50% test will apply.
H.
Some examples.
1.
Example. If John purchases stock for $8,000 and the stock depreciates to $7,000. The 30%
test does not apply because the stock's fair market value did not appreciate. Even though
John's adjusted basis is $8,000, John may not deduct more than the fair market value of the
stock. The amount of the allowable deduction for the charitable contribution is $7,000
($7,000 v $8,000; $200,000 x 50% = $100,000).
2.
Example. John has a law practice and used law books in the practice and John decides to
contribute the law books to a local library. John purchased the law books many years ago
for $500 and the law books now have a fair market value of $800. Also, John has fully
depreciated the law books; therefore, John's adjusted basis for the law books is $0. Because
the law books were used in John’s business and the law books have appreciated in value, the
fair market value of the books is allowable as a deduction under the 30% test under section
170(b)(1)(C)(iv).
I.
Some questions.
1.
Question 1. During the current year, Alan had adjusted gross income of $100,000, without
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2.
3.
4.
5.
J.
considering the following transactions. No election was made with respect to these facts.
During the current taxable year, Alan made a charitable contribution of common shares
which Alan had held for two years, with an adjusted basis of $10,000 and a fair market value
of $80,000. Alan's ordinary, itemizable income tax deduction for the current year with
respect to the charitable contribution (considering all deduction limitations) is as follows.
a.
None/Zero
b.
$50,000
c.
$30,000
d.
$100,000
e.
$10,000
Question 2. During the current year, Alan had adjusted gross income of $100,000, without
considering the following transactions and Alan made no election with respect to these facts.
During the current year, Alan made a charitable contribution of common shares which Alan
owned for two years, with an adjusted basis of $40,000 and a fair market value $100,000.
Alan's ordinary expense or ordinary loss deduction for the current year with respect to the
charitable contribution (considering all deduction limitations) is as follows.
a.
None/Zero
b.
$20,000
c.
$8,000
d.
$100,000
e.
No prior stated answer
Question 3. During the current year, Alan had adjusted gross income of $100,000, without
considering the following transactions and Alan made no election was made with respect to
these facts. During the current year, Alan made a charitable contribution of common shares
which Alan owned for seven months, with adjusted basis of $8,000 and a fair market value
of $20,000. Alan's ordinary expense or ordinary loss deduction for the current year with
respect to the charitable contribution (considering all deduction limitations) is as follows.
a.
None/Zero
b.
$20,000
c.
$8,000
d.
$12,000
e.
$10,000
Question 4. During the current year, Alan had adjusted gross income of $100,000, without
considering the following transactions and no election was made with respect to these facts.
Alan made a charitable contribution of common shares held for two years, with an adjusted
basis of $100,000 and a fair market value of $10,000. Alan's ordinary, itemizable income
tax deduction for the current year with respect to the charitable contribution (considering all
deduction limitations) is as follows.
a.
None/Zero
b.
$50,000
c.
$30,000
d.
$100,000
e.
$10,000
Question 5. During the current year, Alan had adjusted gross income of $100,000, without
considering the following transactions and Alan made no election with respect to these facts.
During the current year, Alan made a charitable contribution of common shares which Alan
had for two years, with an adjusted basis of $40,000 and a fair market value of $30,000.
Alan's ordinary expense or ordinary loss deduction for the current year with respect to the
charitable contribution (considering all deduction limitations) is as follows.
a.
None/Zero
b.
$50,000
c.
$30,000
d.
$100,000
e.
$10,000
Increasing a contribution from the 30% limitation to the 50% limitation.
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1.
As stated above, a transferor may take a charitable contribution deduction for the fair market
value of charitable contributions of securities, which are appreciated capital held for more
than one year, up to 30% of the transferor's adjusted gross income.
Read section 170(b)(1)(C)(iii), which states as follows:
Section 170. Charitable, etc., contributions and gifts
(b) Percentage limitations
(1) Individuals
In the case of an individual, the deduction provided in subsection
(a) shall be limited as provided in the succeeding subparagraphs.
(C) Taxable income
For purposes of this paragraph, taxable income shall be
computed without regard to—
(iii) any net operating loss
carryback to the taxable year under section 172,
a.
b.
K.
A transferor may increase the charitable contribution deduction to 50% of the
transferor's adjusted gross income if the charitable contribution value of the
securities is voluntarily reduced by the amount of the appreciation.
If the transferor is an individual, then the fair market value of the securities may be
taken as a charitable contribution deduction for charitable contributions of
appreciated securities to private non-operating foundations only if the securities are
qualified appreciated stock.
(1)
Appreciated stock is any stock of a corporation for which market quotations
are readily available on an established securities market and which, if sold,
would result in long term capital gain to the transferor.
(2)
If a charitable contribution is of securities which are not qualified stock,
then the amount of the charitable contribution deduction is reduced by the
amount that would have been long term capital gain if the property had been
sold.
Charitable contributions of marketable securities to private foundations.
1.
Charitable contributions of marketable securities and other capital gain gross income
property to private foundations are limited to 20% of the transferor's adjusted gross income,
unless such charitable contributions are made to one or the other of the following two types
of private foundations. Read section 170(b)(1)(D), which states as follows:
Section 170. Charitable, etc., contributions and gifts
(b) Percentage limitations
(1) Individuals
In the case of an individual, the deduction provided in subsection
(a) shall be limited as provided in the succeeding subparagraphs.
(D) Special limitation with respect to contributions of capital gain
property to organizations not described in subparagraph
(A)
(i) In general In the case of charitable contributions (other
than charitable contributions to which
subparagraph (A) applies) of capital gain property,
the total amount of such contributions of such
property taken into account under subsection (a)
for any taxable year shall not exceed the lesser
of—
(I) 20 percent of the taxpayer’s contribution base
for the taxable year, or
(II) the excess of 30 percent of the taxpayer’s
contribution base for the taxable year over
the amount of the contributions of capital
gain property to which subparagraph (C)
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2.
L.
applies.
For purposes of this subsection, contributions of capital
gain property to which this subparagraph applies shall be
taken into account after all other charitable contributions.
(ii) Carryover If the aggregate amount of contributions
described in clause (i) exceeds the limitation of
clause (i), such excess shall be treated (in a
manner consistent with the rules of subsection
(d)(1)) as a charitable contribution of capital gain
property to which clause (i) applies in each of the
5 succeeding taxable years in order of time.
a.
If to a private "operating" corporation, then 30% of adjusted gross income is the
limit.
b.
If to a "pass through" private foundation, where the assets received are distributed
to public charitable organizations within two months after the end of the taxable
year, then 30% is the limit.
Normally, a transferor may take a charitable contribution deduction for the cost-basis of
charitable contributions of securities held short term, up to 50% of the transferor's adjusted
gross income for contributions to charitable organizations which are not private foundations.
Some examples.
1.
Example. Alan makes a charitable contribution of common stock which Alan has held for
three years. The fair market value of the stock is $25,000; the stock's adjusted basis is
$10,000; and, Alan's adjusted gross income is $100,000. Alan may take a charitable
contribution deduction for the full $25,000 fair market value of the stock, because the stock
was held by Alan for more than one year, up to 30% of Alan's adjusted gross income of
$100,000, or $30,000; or, Alan may take a charitable contribution deduction for the stock's
adjusted basis of $10,000, up to 50% of Alan's adjusted gross income of $100,000, or
$50,000.
2.
Example. During last year, Mary's and John's adjusted gross income was $100,000, without
considering the following transactions and John and Mary made the special election with
respect to these facts. During last year, Mary and John contributed to a charitable
organization common shares which they had held for three years, with an adjusted basis of
$140,000 and a fair market value of $150,000.
a.
The amount of Mary's and John's taxable income is as follows. The common shares
are a capital asset, held for more than one year, and have appreciated in fair market
value. Thus, the 30% test applies. However, the special election is made so that the
50% test will be applied instead of the 30% test.
Adjusted gross income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 100,000
50% test . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . x
.5
Deduction ceiling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 50,000
Because the adjusted basis of the common shares is $140,000, $50,000 is
an allowable deduction this year and $90,000 will be carried forward.
Adjusted gross income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 100,000
Minus: charitable deduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000
Personal exemptions (3) . . . . . . . . . . . . . . . . . . . . . . . .
9,000
Taxable income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 41,000
Therefore, the answer is $41,000.
3.
Example. Alan held common stock for one year or less and the stock had a cost basis of
$10,000 and a fair market value of $20,000 and Alan contributed the stock to the Salvation
Army. Alan may deduct the $10,000 cost basis up to 50% of Alan's adjusted gross income
of $100,000, or $50,000.
4.
Example. During last year, John's and Mary's adjusted gross income was $100,000, without
considering the following transactions and no election was made with respect to these facts.
Charitable contribution of common shares held for seven months, with an adjusted
basis of $60,000 and a fair market value of . . . . . . . . . . . . . . . . . . . . . $ 100,000
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(1)
The amount of John's and Mary's taxable income is as follows.
The asset was held for less than one year, thus the 50% test applies.
Adjusted gross income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 100,000
50% test . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . x
.50
Deduction ceiling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 50,000
Because the adjusted basis is $60,000, $50,000 is an allowable deduction
this year, and $10,000 ($60,000 - $50,000) will be carried forward to next
year.
Adjusted gross income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 100,000
Minus: charitable deduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000
Personal exemptions (3) . . . . . . . . . . . . . . . . . . . . . . . . .
9,000
Taxable income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 41,000
Therefore, the answer is $41,000.
M.
Some questions.
1.
Question 1. During the current year, Alan had adjusted gross income of $100,000, without
considering the following transactions. No election was made with respect to these facts.
Charitable contribution of common shares held for seven months, with an adjusted
basis of $10,000 and a fair market value of . . . . . . . . . . . . . . . . . . . . . . $100,000
Alan's ordinary, itemizable income tax deduction for the current year with respect
to the charitable contribution (considering all deduction limitations) is as follows.
A. None/Zero
B. $50,000
C. $30,000
D. $100,000
E. $10,000
N.
Charitable contributions by C corporations.
1.
If a C corporation makes a contribution of cash or of appreciated securities to a charitable
organization, then the charitable contribution deduction is limited to 10% of the corporation's
taxable income. Read section 170(b)(2), which states as follows:
Section 170. Charitable, etc., contributions and gifts
(b) Percentage limitations
(2) Corporations
In the case of a corporation—
(A) In general
The total deductions under subsection (a) for any taxable
year (other than for contributions to which subparagraph
(B) applies) shall not exceed 10 percent of the taxpayer’s
taxable income.
(B) Qualified conservation contributions by certain corporate
farmers and ranchers
(i) In general Any qualified conservation contribution (as
defined in subsection (h)(1))—
(I) which is made by a corporation which, for the
taxable year during which the
contribution is made, is a qualified farmer
or rancher (as defined in paragraph
(1)(E)(v)) and the stock of which is not
readily tradable on an established
securities market at any time during such
year, and
(II) which, in the case of contributions made after
the date of the enactment of this
subparagraph, is a contribution of
property which is used in agriculture or
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2.
O.
livestock production (or available for such
production) and which is subject to a
restriction that such property remain
available for such production,
shall be allowed to the extent the
aggregate of such contributions does not
exceed the excess of the taxpayer’s
taxable income over the amount of
charitable contributions allowable under
subparagraph (A).
(ii) Carryover If the aggregate amount of contributions
described in clause (i) exceeds the limitation of
clause (i), such excess shall be treated (in a
manner consistent with the rules of subsection
(d)(2)) as a charitable contribution to which clause
(i) applies in each of the 15 succeeding years in
order of time.
(iii) Termination This subparagraph shall not apply to any
contribution made in taxable years beginning after
December 31, 2007.
(C) Taxable income
For purposes of this paragraph, taxable income shall be
computed without regard to—
(i) this section,
(ii) part VIII (except section 248),
(iii) any net operating loss carryback to the taxable year
under section 172,
(iv) section 199, and
(v) any capital loss carryback to the taxable year under
section 1212 (a)(1).
a.
If the charitable contribution exceeds 10% of the corporate transferor's adjusted
gross income, then the excess charitable contribution may be carried forward, and
deducted until used-up, for five consecutive years.
The owner of closely held stock may make a charitable contribution to the owner's private
foundation followed by the redemption of the stock by the corporation.
Read section 302(a), which states as follows:
Section 302. Distributions in redemption of stock
(a) General rule. If a corporation redeems its stock (within the meaning of section
317 (b)), and if paragraph (1), (2), (3), or (4) of subsection (b) applies, such
redemption shall be treated as a distribution in part or full payment in
exchange for the stock.
a.
In such a case, the shareholder receives a charitable contribution deduction equal to
the fair market value of the stock contributed.
b.
The foundation receives cash from the corporation.
c.
The IRS has approved this type of plan provided there is no legal obligation or other
compulsion of the foundation to sell or the corporation to buy.
Which limitation is applied first - - - the 30% limitation or the 50% limitation?
1.
An individual may not take a charitable contribution deduction of 80% (30% + 50%). So
if the 50% test is fully met, are any of the 30% deductions allowable? No.
a.
If you full meet the 30% test, then you have 20% of the 50% test left.
(1)
Of course, you could still contribute the full amount of the 50% test, but if
you did, then you would have the entire 30% as a carryover.
2.
In determining the extent to which charitable contributions are currently deductible under
the various limitations, all other contributions must be considered before the 30% limitation
is imposed. Read section 170(b)(1)©, which states as follows:
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Section 170. Charitable, etc., contributions and gifts
(b) Percentage limitations
(1) Individuals
In the case of an individual, the deduction provided in subsection
(a) shall be limited as provided in the succeeding subparagraphs.
(C) Special limitation with respect to contributions described in
subparagraph (A) of certain capital gain property
(i) In the case of charitable contributions described in
subparagraph (A) of capital gain property to which
subsection (e)(1)(B) does not apply, the total
amount of contributions of such property which
may be taken into account under subsection (a) for
any taxable year shall not exceed 30 percent of the
taxpayer’s contribution base for such year. For
purposes of this subsection, contributions of
capital gain property to which this subparagraph
applies shall be taken into account after all other
charitable contributions (other than charitable
contributions to which subparagraph (D) applies).
(ii) If charitable contributions described in subparagraph
(A) of capital gain property to which clause (i)
applies exceeds 30 percent of the taxpayer’s
contribution base for any taxable year, such excess
shall be treated, in a manner consistent with the
rules of subsection (d)(1), as a charitable
contribution of capital gain property to which
clause (i) applies in each of the 5 succeeding
taxable years in order of time.
(iii) At the election of the taxpayer (made at such time and
in such manner as the Secretary prescribes by
regulations), subsection (e)(1) shall apply to all
contributions of capital gain property (to which
subsection (e)(1)(B) does not otherwise apply)
made by the taxpayer during the taxable year. If
such an election is made, clauses (i) and (ii) shall
not apply to contributions of capital gain property
made during the taxable year, and, in applying
subsection (d)(1) for such taxable year with
respect to contributions of capital gain property
made in any prior contribution year for which an
election was not made under this clause, such
contributions shall be reduced as if subsection
(e)(1) had applied to such contributions in the year
in which made.
(iv) For purposes of this paragraph, the term “capital gain
property” means, with respect to any contribution,
any capital asset the sale of which at its fair
market value at the time of the contribution would
have resulted in gain which would have been
long-term capital gain. For purposes of the
preceding sentence, any property which is
property used in the trade or business (as defined
in section 1231 (b)) shall be treated as a capital
asset.
a.
In applying the other limitations, however, charitable contributions of long term
capital gain property to 50% organizations must be considered as though the
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3.
charitable contributions were deductible without regard to any special limitation.
Stock in an S corporation may not be held by a charitable organization. Read section
170(e)(4)(d), which states as follows:
Section 170. Charitable, etc., contributions and gifts
(e) Certain contributions of ordinary income and capital gain property
(4) Special rule for contributions of scientific property used for research
(D) Corporation
For purposes of this paragraph, the term “corporation”
shall not include—
(i) an S corporation,
(ii) a personal holding company (as defined in section
542), and
(iii) a service organization (as defined in section 414
(m)(3)).
a.
Holding beyond 60 days will result in the S corporation's ineligibility unless the
charitable contribution is planned with a testamentary charitable lead or remainder
trust.
b.
The trustee must dispose of the stock within 60 days of receipt.
(1)
It is possible to place the stock in a qtip trust for the spouse for life,
remainder to the charitable organization.
(2)
It is also possible to place the stock in a trust with a charitable remainder,
which pays all income for life to someone other than the spouse.
(3)
For the above two trusts, the trustee must still dispose of the stock within
60 days of receipt of the remainder interest by the organization, or the
corporation's election will be lost.
P.
Some repeating of some basic concepts charitable contribution deduction.
1.
If the fair market value of the property contributed to a charitable organization is greater than
the amount of the adjusted basis of the property and the other tests are met, then the donor
may deduct the fair market value of the property, but the donor is subject to the 30% test.
2.
If the fair market value of the property is not greater than the amount of the adjusted basis
of the property, then the donor will be subject to the 50% test and the donor may deduct the
greater of the amount of the adjusted basis of the property and the fair market value of the
property, which, under this statement, is probably the fair market value of the property.
3.
If the fair market value of the property is greater than the amount of the adjusted basis of the
property, but and the contribution is subject to the 50% test, then the most that a donor may
deduct is the amount of the adjusted basis of the property.
4.
If the contribution is subject to the 50% test, but the fair market value of the property is less
than the adjusted basis of the property, then the most that a donor may deduct is the fair
market value of the property.
5.
A transferor may take a charitable contribution deduction for the lesser of the fair market
value and cost basis of ordinary income property (property held by the transferor for the
production of income) up to 50% of the transferor's adjusted gross income.
6.
If the asset has depreciated in value, then the allowable charitable contribution deduction
is limited to the fair market value of the property if the fair market value of the property is
less than the transferor's adjusted basis for the property.
a.
No loss deduction is allowable with regard to the difference between the property's
basis and fair market value.
7.
No capital gain gross income is realized on a charitable contribution of appreciated property.
Q.
Charitable contributions of tangible personal property.
1.
A transferor may take a charitable contribution deduction for the fair market value of the
property a charitable contribution of tangible personal property, held for over one year, up
to 30% of the transferor's adjusted gross income provided that the charitable contributed
property is related to the purpose or function for which the charitable organization's exempt
status is granted. Read section 170(b)(1)(c)(i) and section 170(e)(1)(b)(I), which states as
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2.
3.
follows:
Section 170. Charitable, etc., contributions and gifts
(b) Percentage limitations
(1) Individuals
In the case of an individual, the deduction provided in subsection
(a) shall be limited as provided in the succeeding subparagraphs.
(C) Special limitation with respect to contributions described in
subparagraph (A) of certain capital gain property
(i) In the case of charitable contributions described in
subparagraph (A) of capital gain property to which
subsection (e)(1)(B) does not apply, the total amount of
contributions of such property which may be taken into
account under subsection (a) for any taxable year shall not
exceed 30 percent of the taxpayer’s contribution base for
such year. For purposes of this subsection, contributions of
capital gain property to which this subparagraph applies
shall be taken into account after all other charitable
contributions (other than charitable contributions to which
subparagraph (D) applies).
Section 170. Charitable, etc., contributions and gifts
(e) Certain contributions of ordinary income and capital gain property
(1) General rule
The amount of any charitable contribution of property otherwise
taken into account under this section shall be reduced by the sum
of—
(B) in the case of a charitable contribution—
(i) of tangible personal property—
(I) if the use by the donee is unrelated to the
purpose or function constituting the basis for its
exemption under section 501 (or, in the case of a
governmental unit, to any purpose or function
described in subsection (c)), or
A charitable contribution of appreciated tangible personal property must be related to the
charitable organization's purpose or function or mission in order for the transferor to realize
the maximum charitable contribution deduction.
If the appreciated tangible personal property is related to the charitable organization's
purpose, then a transferor may take a charitable contribution deduction, for income tax
purposes, in the amount of the property's fair market value, up to 30% of transferor's adjusted
gross income.
a.
If the charitable contribution exceeds 30% of the transferor's adjusted gross income,
then the excess charitable contribution may be carried forward, and deducted, for
income tax purposes, until used-up, for five consecutive years.
b.
If the appreciated tangible personal property is not related to the charitable
organization's mission, then a transferor may take a charitable contribution
deduction, for income tax purposes, in the amount of the property's adjusted basis,
up to 50% of the transferor's adjusted gross income.
c.
If the charitable contribution exceeds 50% of the transferor's adjusted gross income,
then the excess charitable contribution may be carried forward, and deducted, for
income tax purposes, until used-up, for five consecutive years.
d.
In general, the IRS has a two-year period after a charitable organization is given a
gift of tangible period property to request proof that the appreciated tangible
personal property is related to the mission of the charitable organization.
(1)
In such a case, the transferor must demonstrate that the appreciated tangible
personal property is being (or was) so used.
(2)
The transferor must have reasonably anticipated that, at the time of the
charitable contribution, the charitable organization would use the
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(3)
R.
appreciated tangible personal property for the charitable organization's
mission.
If the transferor is unable to prove that the appreciated tangible personal
property was related to the mission of the charitable organization, then the
amount of the transferor's charitable contribution deduction may be
affected, requiring the transferor to pay tax on the difference between the
deduction actually taken and the deduction which should have been taken.
Some examples.
1.
Example. The following charitable contributions of tangible personal property would be
related to the respective charitable organization's function or purpose.
a.
Artwork to an art museum or other organization which has an art collection or art
class offered as a part of the charitable organization's purpose or function.
b.
Books to a library or other organization which has a book collection or class offered
as a part of the charitable organization's purpose or function.
c.
An antique automobile to a car museum or other organization which has an antique
automobile collection or educational course offered as part of the charitable
organization's purpose or function.
2.
Example. During last year, Mary's and John's adjusted gross income was $100,000, without
considering the following transactions, and John and Mary had no dependents. No election
was made with respect to these facts.
a.
Charitable contribution of tangible personal property held for two years, which the
charitable organization promptly sold for $6,000, with an adjusted basis to John of
$10,000 and a fair market value (at the time of contribution) of . . . . . . . . $6,000
b.
The amount of Mary's and John's taxable income is as follows. If the contributed
property has depreciated in fair market value (adjusted basis > fair market value),
then the total deductible is the fair market value. Because the total allowable
charitable deduction is less than the standard deduction ($6,000 > $7,000) the
standard deduction should be used.
Adjusted gross income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 100,000
Minus: standard deduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000
Personal exemptions (2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
6,000
Taxable income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 87,000
3.
Example. During last year, John's and Mary's adjusted gross income was $100,000, without
considering the following transactions, and John and Mary had no dependents. No election
was made with respect to these facts.
a.
Charitable contribution of tangible personal property held for two years, which the
charitable organization promptly sold for $50,000, with an adjusted basis to John of
$10,000 and a fair market value (at the time of contribution) of . . . . . . . $50,000
b.
The amount of John's and Mary's taxable income is as follows. Because the
charitable organization sold the contributed property within two years after
contribution, the property is not considered related to the function of the charitable
organization. Thus, the 50% test applies, not the 30% test (even though the property
was a capital asset held for more than one year and had appreciated in fair market
value).
Adjusted gross income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 100,000
50% test . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . x
.5
Deduction ceiling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 50,000
Because the adjusted basis of the contributed property is $10,000, John and Mary
may deduct $10,000.
Adjusted gross income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 100,000
Minus: charitable deduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000
Personal exemptions (2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
6,000
Taxable income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 84,000
c.
The reduced deduction, for income tax purposes, may be claimed up to 50% of the
transferor's adjusted gross income.
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d.
4.
If the charitable contribution exceeds 50% of the transferor's adjusted gross income,
then the excess charitable contribution may be carried forward, and deducted, for
income tax purposes, until used-up, for five consecutive years. Read section
170(b)(1)©, which states as follows:
Section 170. Charitable, etc., contributions and gifts
(b) Percentage limitations
(1) Individuals
In the case of an individual, the deduction provided in subsection
(a) shall be limited as provided in the succeeding subparagraphs.
(C) Special limitation with respect to contributions described in
subparagraph (A) of certain capital gain property
(i) In the case of charitable contributions described in
subparagraph (A) of capital gain property to which
subsection (e)(1)(B) does not apply, the total
amount of contributions of such property which
may be taken into account under subsection (a) for
any taxable year shall not exceed 30 percent of the
taxpayer's contribution base for such year. For
purposes of this subsection, contributions of
capital gain property to which this subparagraph
applies shall be taken into account after all other
charitable contributions (other than charitable
contributions to which subparagraph (D) applies).
Example. Alan, with an adjusted gross income of $100,000, makes a charitable contribution
of a piece of artwork with a fair market value of $10,000, which Alan has held for more than
one year, to an art museum. Because the item contributed relates to the purpose or function
for which the charitable organization's exempt status is granted, Alan may take a charitable
contribution deduction, for income tax purposes, for the full fair market value of the painting
of $100,000, up to 30% of Alan's adjusted gross income of $100,000, or $30,000.
a.
If the artwork has not been held for more than one year, then Alan would only be
able to take a charitable contribution deduction, for income tax purposes, for the cost
basis of the item contributed, or the fair market value of the item contributed,
whichever is less.
S.
Charitable contribution carryovers.
1.
If the charitable contribution exceeds 50% of the transferor's adjusted gross income, then the
excess charitable contribution may be carried forward, and deducted, for income tax
purposes, until used-up, for five consecutive years.
2.
Similarly, if the charitable contribution exceeds 30% of the transferor's adjusted gross
income, then the excess charitable contribution may be carried forward, and deducted, for
income tax purposes, until used-up, for five consecutive years.
3.
In each case, the carryovers are treated as being in the 50% category or 30% category, as the
case may be, for each of the carryover years.
T.
The term “ordinary income property”.
1.
Read section 64, which states as follows:
Section 64. Ordinary income defined
For purposes of this subtitle, the term “ordinary income” includes any gain from the
sale or exchange of property which is neither a capital asset nor property described
in section 1231 (b). Any gain from the sale or exchange of property which is treated
or considered, under other provisions of this subtitle, as “ordinary income” shall be
treated as gain from the sale or exchange of property which is neither a capital asset
nor property described in section 1231 (b).
2.
“Ordinary income property” is property held by the transferor for the production of income.
Read section 64, which states as follows:
Section 64. Ordinary income defined
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3.
4.
5.
6.
7.
U.
For purposes of this subtitle, the term “ordinary income” includes any gain from the
sale or exchange of property which is neither a capital asset nor property described
in section 1231 (b). Any gain from the sale or exchange of property which is treated
or considered, under other provisions of this subtitle, as “ordinary income” shall be
treated as gain from the sale or exchange of property which is neither a capital asset
nor property described in section 1231 (b).
This property includes short term capital assets, business inventory, recapture property,
accounts and notes receivables, copyrights, original issue discount debt instruments, market
discount bonds, partnership interests, products grown on a farm, section 306 stock,
depreciable property, artwork, manuscripts, and letters or memoranda prepared by the
transferor.
Short term capital gain arises from the sale or exchange of a capital asset which has been
held for one year or less.
If recapture property is contributed to a charitable organization, then the fair market value
of the charitable contribution must be reduced by the amount that would have been subject
to recapture as ordinary income had the property been sold.
A transferor may take a charitable contribution deduction of the cost basis of the property
up to 50% of the transferor's adjusted gross income. Read section 170(b)(1), which states
as follows:
Section 170. Charitable, etc., contributions and gifts
(b) Percentage limitations
(1) Individuals
In the case of an individual, the deduction provided in subsection
(a) shall be limited as provided in the succeeding subparagraphs.
a.
Any amount in excess of the 50% limitation may be carried forward for five
consecutive years, and deducted, for income tax purposes, until the amount is usedup.
If the ordinary income property has appreciated, then the amount of the potential charitable
contribution must be reduced by the amount of ordinary income which would have been
recognized had the property been sold by the transferor at the property's fair market value
at the time of the property's contribution to the charitable organization. Read section
170(e)(1)(a).
Section 170. Charitable, etc., contributions and gifts
(e) Certain contributions of ordinary income and capital gain property
(1) General rule
The amount of any charitable contribution of property otherwise
taken into account under this section shall be reduced by the sum
of—
(A) the amount of gain which would not have been long-term
capital gain (determined without regard to section 1221 (b)(3)) if
the property contributed had been sold by the taxpayer at its fair
market value (determined at the time of such contribution), and
Some questions.
1.
Question 1. During the current year, Alan had adjusted gross income of $100,000, without
considering the following transactions and no election was made with respect to these facts.
Alan made a charitable contribution of Alan's inventory with an adjusted basis of $10,000
and a fair market value of $100,000. Alan's ordinary, itemizable income tax deduction for
the current year with respect to the charitable contribution (considering all deduction
limitations) is as follows.
a.
None/Zero
b.
$50,000
c.
$30,000
d.
$100,000
e.
$10,000
2.
Question 2. During the current year, Alan had adjusted gross income of $100,000, without
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considering the following transactions and Alan made no election with respect to these facts.
During the current year, Alan made a charitable contribution of Alan's inventory which Alan
had owned for two years with an adjusted basis of $100,000 and a fair market value of
$10,000. Alan's ordinary expense or ordinary loss deduction for the current year with
respect to the charitable contribution (considering all deduction limitations) is as follows.
a.
None/Zero
b.
$50,000
c.
$30,000
d.
$100,000
e.
$10,000
V.
Charitable contributions of real property.
1.
Types of real property for charitable contribution purposes.
a.
Inventory - - - an ordinary income property under section 64.
b.
Property held for the production income - - - a capital asset which is depreciable and
which is an ordinary income property under section 64.
c.
Property held for business purposes - - - a depreciable asset which is ordinary
income property under section 64.
d.
Personal property - - - a capital asset which is not depreciable and which is not
ordinary income property under section 64.
2.
A transfer of real property is effected for purposes of the charitable contribution deduction
at the time a properly executed deed for the property is delivered by the transferor to the
charitable organization.
3.
A charitable contribution deduction is allowable for unencumbered appreciated real property
up to 30% of the transferor's adjusted gross income.
a.
Any amount in excess of the 30% limitation may be carried forward for five
consecutive years, and deducted until the amount is used-up.
b.
A transferor may take a charitable contribution deduction for the charitable
contribution up to 50% of adjusted gross income by reducing the size of the
charitable contribution by of the property's appreciation.
4.
If encumbered appreciated real property is contributed to a charitable organization, then the
transaction is treated as part gift, part sale (i.e., a bargain sale).
a.
The charitable contribution deduction is reduced by the amount of the encumbrance.
b.
The amount of the encumbrance is treated as an amount realized and the transferor
is taxed, for income tax purposes, on the gain which is allocated to the sale portion
of the transaction.
5.
Example. The transferor with an adjusted gross income of $100,000, makes a charitable
contribution of 60 acres of wooded land which has a fair market value of $180,000 to the
local university's school of forestry.
a.
The transferor is able to take a charitable contribution deduction, for income tax
purposes, for the fair market value of the land, assuming it had been held by the
transferor for more than one year, up to 30% of the transferor's adjusted gross
income of $100,000, or $30,000.
(1)
The difference between the property's fair market value of $180,000 and the
amount deducted in the year of the gift of $30,000, or $150,000, may be
carried forward for five years, and deducted, for income tax purposes, until
the amount is used-up.
W.
Making gifts of property now, but keeping the property until you die.
1.
With four exceptions, the current federal income tax laws do not allow a taxpayer to make
a charitable contribution today which the taxpayers may deduct today, yet not get the
charitable organization the possession of the contributed item until, for example, the death
of the taxpayer-donor.
a.
For example, Peter gives a charitable organization Peter’s electric train set today, but
keeps possession of the train set until Peter dies. Peter will not be entitled to a
charitable deduction today. Instead, Peter’s estate will be entitled to a deduction on
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2.
Peter’s estate’s income tax return when Peter dies.
There are four exceptions to this denial of a current income tax deduction.
a.
Giving your house and land to a charitable organization today, but retaining the use
of the property for a number or years or until you die.
b.
Giving your farm property (land and buildings) to a charitable organization today,
but retaining the use of the property for a number or years or until you die.
c.
Establishing a charitable remainder trust during your life, but retaining an income
interest in the arrangement for a number of years or until you die.
d.
Establishing a pooled income fund with a charitable organization.
X.
Charitable contributions of your house and land (your residence).
1.
Giving your house and land to a charitable organization today, but retaining the property for
a number or years or until you die is a very popular thing to do with larger older home which
are near colleges or universities.
2.
Any property used by its owner as a personal residence, but not necessarily as the owner's
principal residence, qualifies as a charitable contribution deduction, for income tax purposes,
if given to a charitable organization.
3.
A personal residence includes a vacation home, stock owned in a cooperative housing
corporation, and a yacht, so long as all are used by the owner as a residence under normal
conditions.
a.
A personal residence does not include household furnishings or other tangible
personal property, and therefore, no charitable contribution deduction, for income
tax purposes, is allowable for charitable contributions of a remainder interest in such
property.
4.
A charitable contribution of a remainder interest in a personal residence must be in the
residence itself and not in the proceeds from the sale of the property, unless by the terms of
the agreement, the sale of the transferor's personal residence was required upon the death of
the life tenant, with the sale proceeds paid to the charitable organization.
5.
A transferor may designate that the remainder interest in a personal residence be shared
between two beneficiaries, as tenants in common.
a.
A charitable contribution deduction, for income tax purposes, is allowable only for
the value donated to a charitable organization.
6.
A charitable contribution of a remainder interest in a personal residence must be an
irrevocable charitable contribution of the residence itself.
a.
A condition imposed on a charitable contribution of a remainder interest in a
personal residence may result in the disallowance of the charitable contribution
deduction, for income tax purposes, unless the possibility that the condition could
defeat the charitable organization's interest is so remote as to be negligible.
b.
A contingency imposed on a charitable contribution of a remainder interest in a
personal residence may result in the disallowance of the charitable contribution
deduction, for income tax purposes, unless the probability that the contingency will
occur is so remote as to be negligible.
7.
Example. The transferor makes a charitable contribution of the transferor's home to the local
college, for use as a residence for the college's president.
a.
The transferor could retain the residence to live in until the transferor's death, or an
earlier stated time, and the transferor would be entitled to a charitable contribution
deduction, for income tax purposes, for the value of the remainder interest in the
property, taking into consideration the transferor's age.
b.
The transferor would be able to take a charitable contribution deduction, for income
tax purposes, for the remainder value, up to 30% of the transferor's adjusted gross
income in the first year, and then carry forward, for five consecutive years, any
additional charitable contribution deduction, for income tax purposes, remaining
after the first year.
Y.
Charitable contributions of farms.
1.
Land used by its owner for the production of crops, fruit, or other agricultural products, or
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2.
3.
4.
5.
Z.
for the raising of livestock, qualifies as a charitable contribution deduction, for income tax
purposes, to a charitable organization.
A charitable contribution of a remainder interest in a farm must be in the farm itself and not
the proceeds from the sale of the farm, unless by the terms of the agreement, the sale of the
transferor's farm was required upon the death of the life tenant, with the sales proceeds paid
to the charitable organization.
A transferor may designate that the remainder interest in a farm be shared between two
beneficiaries, as tenants in common.
a.
A charitable contribution deduction, for income tax purposes, is allowable only for
the value donated to a charitable organization.
A charitable contribution of a remainder interest in a farm must be an irrevocable
contribution as the farm itself.
a.
A condition imposed on a charitable contribution of a remainder interest in a farm
may result in the disallowance of the charitable contribution deduction, for income
tax purposes, unless the possibility that the condition could defeat the charitable
organization's interest is so remote as to be negligible.
b.
A contingency imposed on a charitable contribution of a remainder interest in a farm
may result in the disallowance of the charitable contribution deduction, for income
tax purposes, unless the probability that the contingency will occur is so remote as
to be negligible.
Example. John makes a charitable contribution of John's farm to the state university's college
of agriculture.
a.
The transferor could retain the farm to continue operating until the transferor's death,
or an earlier stated time, and the transferor would be entitled to a charitable
contribution deduction, for income tax purposes, for the value of the remainder
interest in the property, taking into consideration the transferor's age.
b.
The transferor would be able to take a charitable contribution deduction, for income
tax purposes, for the remainder value up to 30% of the transferor's adjusted gross
income in the first year, and then carry forward, for five consecutive years, any
additional charitable contribution deduction, for income tax purposes, remaining
after the first year.
Charitable contributions of partial interests.
1.
Severe restrictions apply to the deductibility of charitable remainders, income interests, and
other partial interests given to charitable organization, if the donor retains the remaining
interest or gives the remaining interest to a noncharitable beneficiary.
2.
No deduction is allowable for a charitable contribution of an income interest in a trust or
other property unless the income interest is includible in the donor's gross income and the
charitable interest consists of either a fixed annuity or a fixed percentage of the fair market
value of the property determined annually. Read section 170(f)(2)(b), which states as
follows:
170(f)(2)(b), which states as follows:
Section 170. Charitable, etc., contributions and gifts
(f) Disallowance of deduction in certain cases and special rules
(2) Contributions of property placed in trust
(B) Income interests, etc.
No deduction shall be allowed under this section
for the value of any interest in property (other than
a remainder interest) transferred in trust unless the
interest is in the form of a guaranteed annuity or
the trust instrument specifies that the interest is a
fixed percentage distributed yearly of the fair
market value of the trust property (to be
determined yearly) and the grantor is treated as the
owner of such interest for purposes of applying
section 671. If the donor ceases to be treated as the
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3.
4.
owner of such an interest for purposes of applying
section 671, at the time the donor ceases to be so
treated, the donor shall for purposes of this chapter
be considered as having received an amount of
income equal to the amount of any deduction he
received under this section for the contribution
reduced by the discounted value of all amounts of
income earned by the trust and taxable to him
before the time at which he ceases to be treated as
the owner of the interest. Such amounts of income
shall be discounted to the date of the contribution.
The Secretary shall prescribe such regulations as
may be necessary to carry out the purposes of this
subparagraph.
a.
A gift of a future interest in tangible personal property is not deductible until all
intervening interests have either expired or been transferred to someone unrelated
to the taxpayer. Read section 170(a)(3), which states as follows:
Section 170. Charitable, etc., contributions and gifts
(a) Allowance of deduction
(3) Future interests in tangible personal property
For purposes of this section, payment of a charitable
contribution which consists of a future interest in tangible
personal property shall be treated as made only when all
intervening interests in, and rights to the actual possession
or enjoyment of, the property have expired or are held by
persons other than the taxpayer or those standing in a
relationship to the taxpayer described in section 267 (b) or
707 (b). For purposes of the preceding sentence, a fixture
which is intended to be severed from the real property shall
be treated as tangible personal property.
Example. During last year, John, who was single, and who had adjusted gross income of
$100,000, without considering the following transactions, and John had no dependents. No
election was made with respect to these facts.
a.
Charitable contribution of John's rare gun set to the Rare Gun Museum of America,
under an agreement with the charitable organization, which agreement allowed John
to keep the gun set until John died, which gun set had been owned by John for many
years, and which gun set had an adjusted basis to John of $50,000, and which gun
set had a fair market value of $100,000, and with respect to which the fair market
value of John's life estate was $60,000, and with respect to which the fair market
value of the charitable organization's remainder interest was . . . . . . . . . $40,000
b.
The amount of John's taxable income is as follows. Because John donated John's
rare gun set to the Rare Gun Museum the contribution is related to the function of
the charitable organization. However, because John retains the gun set until John
dies, a successive interest has been created (John has the gun set for life, remainder
to the charitable organization). Accordingly, John is not allowed a charitable
deduction for the actuarial value of the remainder interest the gun museum holds in
the gun set.
Adjusted gross income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 100,000
Minus: standard deduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000
personal exemption . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3,000
Taxable income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 93,000
Therefore, the answer is $93,000.
Question 1. During the current year, Alan had adjusted gross income of $100,000, without
considering the following transactions. No election was made with respect to these facts.
a.
Charitable contribution of Alan's rare gun set to the Rare Gun Museum of America,
under an agreement with the charitable organization, which agreement allowable
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5.
6.
7.
Alan to keep the gun set until Alan died, which gun set had been owned by Alan for
many years, and which gun set had an adjusted basis to Alan of $10,000, and which
gun set had a fair market value of $100,000, and with respect to which the fair
market value of Alan's life estate was $60,000, and with respect to which the fair
market value of the charitable organization's remainder interest was $40,000. Alan's
ordinary, itemizable income tax deduction for the current year with respect to the
charitable contribution (considering all deduction limitations) is as follows.
(1)
None/Zero
(2)
$40,000
(3)
$30,000
(4)
$100,000
(5)
$10,000
Gifts to charitable organizations of a remainder interest in other property generally qualify
for a deduction only if made in the form of an annuity trust (which pays a fixed dollar
amount annually to the noncharitable beneficiary), a unitrust (which pays the noncharitable
beneficiary a fixed percentage of the yearly value of the property), or a pooled income fund
(a fund pooling the contributions of many donors).
A gift of property not in trust will nevertheless qualify for a charitable deduction if the gift
consists of a remainder interest in a personal residence or farm, an undivided portion of the
taxpayer's entire interest in property, or a qualified contribution of an interest in real property
for conservation purposes. Read section 170(f)(3)(b), which states as follows:
Section 170. Charitable, etc., contributions and gifts
(f) Disallowance of deduction in certain cases and special rules
(3) Denial of deduction in case of certain contributions of partial interests
in property
(A) In general
In the case of a contribution (not made by a transfer in
trust) of an interest in property which consists of less than
the taxpayer’s entire interest in such property, a deduction
shall be allowed under this section only to the extent that
the value of the interest contributed would be allowable as
a deduction under this section if such interest had been
transferred in trust. For purposes of this subparagraph, a
contribution by a taxpayer of the right to use property shall
be treated as a contribution of less than the taxpayer’s
entire interest in such property.
(B) Exceptions
Subparagraph (A) shall not apply to—
(i) a contribution of a remainder interest in a personal
residence or farm,
(ii) a contribution of an undivided portion of the taxpayer’s
entire interest in property, and
(iii) a qualified conservation contribution.
Example. During last year, Alan, who was single, and who had adjusted gross income of
$100,000, without considering the following transactions, and Alan had no dependents. No
election was made with respect to these facts.
Charitable contribution of Alan's General Motors Corporation common stock to the Indiana
University foundation, under an agreement the charitable organization which stated that Alan
would receive an annuity payment, each year until Alan died, equal to 6% of the fair market
value of the stock at the date of transfer (which was $100,000), which stock had been owned
by Alan for many years, and which stock had an adjusted basis to Alan of $50,000, and
which stock had a fair market value of $100,000 at the date of the transfer to the charitable
organization, and with respect to which the fair market value of Alan's life estate (determined
actuarially) was $60,000, and with respect to which the fair market value of the charitable
organization's remainder interest was . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $40,000
a.
The amount of Alan's taxable income is as follows. With charitable remained trusts
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Alan retains a life interest with the charitable organization having a remainder
interest. Alan is allowable a current charitable deduction of the remainder interest
or $40,000. The stock is a capital asset, held for more than one year and has
appreciated in fair market value. Thus, the 30% test applies.
Adjusted gross income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 100,000
30% test . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . x
.3
Deduction ceiling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 30,000
Because the fair market value of the remainder interest is $40,000, a deduction of
$30,000 is allowable this year, and $10,000 will be carried forward.
Adjusted gross income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 100,000
Minus: charitable deduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000
personal exemption . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3,000
Taxable income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 67,000
Therefore, the answer is $67,000.
AA.
Some examples.
1.
Example. If a transferor sells the transferor's property to a charitable organization for less
than the property's fair market value, then the bargain element serves as the charitable
contribution, with the transferor taking a charitable contribution deduction, for income tax
purposes, for the amount of the bargain (fair market value less the charitable organization's
purchase price). Read section 1011(b), which states as follows:
Section 1011. Adjusted basis for determining gain or loss
(b) Bargain sale to a charitable organization
If a deduction is allowable under section 170 (relating to charitable
contributions) by reason of a sale, then the adjusted basis for determining
the gain from such sale shall be that portion of the adjusted basis which
bears the same ratio to the adjusted basis as the amount realized bears to the
fair market value of the property.
a.
When a transferor transfers property to a charitable organization through a bargain
sale agreement, the transferor must allocate the property's cost basis between the
portion gifted and the portion sold. Read Reg. §1-1011-2(b).
(1)
Such an allocation will determine the amount of gain the transferor must
pay on the portion being sold, through the bargain sale arrangement, to the
charitable organization.
(2)
If the transferor does not receive a charitable contribution deduction, for
income tax purposes, for the bargain sale, then the transferor is not required
to allocate the property's cost basis for the property between the portion
transferred to the charitable organization and the portion sold to the
charitable organization.
(3)
If the transferor must carryover the charitable contribution deduction, for
income tax purposes, into future years, because of the allowable percentage
limitations, then the property's cost basis must still be allocated between the
portion transferred to the charitable organization and the portion sold to the
charitable organization.
2.
Example. A transferor sells stock which has a fair market value of $50,000 and a cost basis
of $10,000, to a local university for $20,000.
a.
The bargain sale resulted in a sale of $20,000 and a charitable contribution of
$30,000.
b.
The stock's cost basis must be proportionately divided between the charitable
contribution portion of the bargain sale and the sale portion of the bargain sale.
c.
The basis for the charitable contribution portion is: ($30,000 ÷ $50,000) x $10,000
= $6,000
d.
The basis for the sale portion is: (20,000 ÷ 50,000) x $10,000 = $4,000
(1)
Example.
Fair market value of property given/sold . . . . . . . . . . . . . . . . . . . . . $
15,000
Sales price of property given/sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000
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Adjusted basis of property given/sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000
10,000/15,000 = 2/3
2/3 x 3,000 = 2,000
Fair market value of property given/sold . . . . . . . . . . . . . . . . . . . . . . $
15,000
Minus sales price of property given/sold . . . . . . . . . . . . . . . . . . . . . . . . . 10,000
Gift to charitable organization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000
Sales price of property given/sold . . . . . . . . . . . . . . . . . . . . . . . . . . . $
10,000
Minus allocate portion of adjusted basis of property given/sold . . . . . . . . 2,000
Gain from property given/sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000
(2)
Example. John sold some land to the YMCA for $100,000, with no sales
commissions. The land had a fair market value of $400,000, and John's
adjusted basis for the land was $60,000.
Sales price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 100,000
Minus adjusted basis($100,000/$400,000=25%; 25%x$60,000) . . . . . 15,000
Gain from sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85,000
3.
Fair market value of property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 400,000
Minus sales price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000
Charitable contribution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300,000
e.
The bargain sale agreement, which applies only to appreciated property, is
advantageous for those transferors who may not be able to or want to give the full
value of the property.
(1)
The transferor does not sell the property prior to the bargain sale, but
instead the charitable organization assumes the responsibility of either
maintaining or selling the property after the bargain sale arrangement is
complete.
(a)
The transferor is relieved of the burden of selling the property
while the charitable organization benefits from receipt of property
at a bargain price.
f.
The amount of the charitable contribution deduction, for income tax purposes, which
is allowable depends on how much the transferred property has appreciated. Read
Reg. §1-1011(a)(1).
(1)
If there is no appreciation, then there is an immediate charitable
contribution deduction, for income tax purposes, for the difference between
the purchase price received and the fair market value of the property.
(2)
If there is appreciation, then the transferor's cost basis is allocated between
the charitable contribution and sale portions of the transaction.
g.
The transferor might also realize taxable gain on the transferor's bargain sale. Read
Reg. §1.1001-1(a).
(1)
Such gain is typically computed by subtracting the basis from the selling
price.
(2)
When a transferor transfers property to a charitable organization through a
bargain sale agreement, the transferor must allocate the property's gain
between the portion gifted and the portion sold.
Example. A transferor sells land, with a fair market value of $100,000, and a cost basis of
$10,000, to a local hospital for $25,000.
(a)
This bargain sale results in two types of transactions - a charitable contribution of
$75,000 and sales proceeds of $25,000. Therefore, there are two results from this
transaction, specifically, a contribution of $75,000 and a sale of the property for
sales proceeds of $25,000. But another computation must be made in order to
determine the gain from the sale, specifically, there must be an allocation of the
adjusted basis of the property between the contribution part of the transactions and
the sales part of the transaction. The allocation of the adjusted basis to the
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4.
contribution part of the transaction is not really important to the donor, but the
portion of the adjusted basis which is allocable to the sales part of the transaction is,
obviously, important in order to determine the gain from the transaction.
(1)
In order to determine the gain from this bargain sale, you must first
determine what percent the sale price is of the total fair market value of the
property given to charitable organization. Because the sale price of $25,000
is 25% of the fair market value of the property given to charitable
organization (25,000/100,000), 25% of the adjusted basis of the property is
used in order to determine the gain from the sale of the property. Therefore,
because 25% of the basis of $10,000 is $2,500, the gain from the sale of the
property is $22,500, which is $25,000 minus $2,500.
b.
A charitable contribution of a partnership interest to a charitable organization, which
interest is subject to partnership liabilities, is a bargain sale. Read Rev. Rul. 75-194.
(1)
The transferor's share of the partnership liabilities is considered the
transferor's proceeds from the bargain sale.
c.
The transferor should provide a written letter of donative intent, to have a bargain
sale arrangement, to the charitable organization to ensure there will be no problems,
in the future, between the transferor, the transferor's heirs and the charitable
organization.
d.
The bargain sale agreement should include a statement as to how much of the
property the transferor intends to treat as a charitable contribution.
e.
Once the sale agreement has been reached, any attempt to negotiate a higher price
for the bargain sale arrangement may endanger the charitable contribution
deduction, for income tax purposes.
f.
If encumbered property is transferred to a charitable organization through a bargain
sale arrangement, then the transferor may be relieved of future obligations on that
mortgage and the charitable organization may assume that responsibility. Read Reg.
§1.1011-2(b)(3).
g.
The transferor may transfer property subject to a debt, to a charitable organization,
while specifying in the bargain sale agreement that the charitable organization is not
required to assume the debt. Read Reg. §1-1011(b)(3).
(1)
However, if the charitable organization does assume the debt on the
property, then the transferor is treated as having capital gain gross income,
for income tax purposes, in the amount of the debt.
(2)
If the property transferred is ordinary income property, then the charitable
contribution deduction, for income tax purposes, is limited to the
transferor's basis for the property.
(3)
The charitable organization receiving property subject to a debt must
carefully state, in the bargain sale agreement with the transferor, how the
debt or mortgage will be paid.
h.
The bargain sale charitable contribution may consist of an exchange of bargain sale
property for property with a lesser fair market value.
(1)
The property with a lesser fair market value can either be owned by the
charitable organization, or by a third party with the charitable organization
being the ultimate beneficiary.
Example. A transferor exchanges stock, which has a fair market value of $20,000, and a cost
basis of $11,000, for land, from a third party, with a fair market value of $7,000.
a.
The ultimate beneficiary is the local art museum.
b.
The transferor is receiving the land with a fair market value of $7,000 in exchange
for the stock with a fair market value of $20,000.
c.
The bargain sale resulted in a sale of $7,000 and a charitable contribution of
$13,000.
d.
As indicated above, the basis of the item sold must be allocated between the portion
sold for the $7,000 land, and the portion contributed to the charitable organization,
or $13,000.
e.
The basis of the land for the sale portion is as follows: ($7,000 fair market value of
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5.
6.
the land times $11,000 cost basis) divided by $20,000 fair market value of the stock
equals a basis of $3,850 for the land.
f.
When a bargain sale is arranged with property subject to depreciation recapture, the
allocation must be made as to the property's cost basis, and the ordinary income and
capital gain gross income elements of the property's appreciation.
(1)
The gain recognized as ordinary income is determined by the ratio of the
amount realized on the bargain sale to the property's fair market value,
multiplied by the ordinary income which would be recognized if the entire
property were sold at the property's fair market value.
Example. The transferor enters into a bargain sale agreement with the local college, to sell
to the college the transferor's horse trailer which the college will use in its program of
veterinary medicine.
a.
The trailer has a fair market value of $8,000 and a cost basis of $4,000 and an
adjusted basis of $2,000, and the transferor sells the trailer to the college for $2,000.
b.
If the transferor sold the trailer for its fair market value of $8,000, then $2,000 of the
gain of $6,000 would be considered ordinary income, and the transferor would be
taxed accordingly.
c.
The remaining $4,000 would be considered capital gain gross income, for income
tax purposes, and would be taxed accordingly.
d.
The cost basis must be allocated between the charitable contribution portion and the
sale portion.
e.
The basis of the trailer for the sale portion is: $2,000 (amount realized) divided by
$8,000 (fair market value) x $2,000 cost basis = $500
f.
Thus, the recognized gain to the transferor will be $1,500 ($2,000 - $500), of which
$500 is considered ordinary income ($2,000 (amount realized) divided by $8,000
(fair market value) x $2,000 (ordinary income)) and $1,000 is considered capital
gain gross income ($2,000 (amount realized) divided by $8,000 (fair market value)
x $4,000 (capital gain gross income)).
g.
When a bargain sale is arranged in conjunction with an installment sale, the
transferor must not only allocate the property's cost basis and gain to the transfer and
sale portions of the arrangement, but the transferor must also allocate the total
taxable gain from the transaction over the installment payment period. Read section
453 and Reg. §1-1001-1(d).
(1)
The installment sale may not be used for any of the following.
(a)
Stock in trade.
(b)
Inventory.
(c)
Property held primarily for sale to customers through the ordinary
course of business, if the transferor is subject to the alternative
minimum tax.
(d)
A sale by a transferor who regularly sells or disposes of property
under an installment plan.
(e)
A disposition of real property to customers through the ordinary
course of business.
(2)
While the IRC is not specific as to whether a charitable contribution
deduction, for income tax purposes, for an installment bargain sale may be
taken in its entirety in the year of the bargain sale or must be allocated to
each installment payment, the transferor should be able to take the entire
charitable contribution deduction, for income tax purposes, for the
installment bargain sale in the year of the sale.
Example. The transferor enters into a bargain sale agreement with the local art museum in
which the transferor sells a piece of fine sculpture for $100,000.
a.
The sculpture has a fair market value of $500,000 and a cost basis of $50,000.
b.
The art museum will pay $20,000 per year for each of five years in order to acquire
the sculpture.
c.
The cost basis of the sculpture must be allocated between the charitable contribution
portion and the sale portion of the bargain sale.
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d.
e.
f.
g.
BB.
The basis of the sculpture for the sale portion is: $100,000 (amount realized) divided
by $500,000 (fair market value) x $50,000 (cost basis) = $10,000.
The capital gain gross income, for income tax purposes, resulting from the bargain
sale of the sculpture to the art museum is $90,000 ($100,000 (amount realized) $10,000 (basis of the sale portion)).
The transferor can apportion the $90,000 gain over each of the five installments of
$20,000, giving the transferor a taxable gain for each of the five years of the
installments of $18,000.
The transferor is allowed a charitable contribution deduction, for income tax
purposes, of $400,000 in the year in which the bargain sale was made.
Charitable remainder trusts.
1.
A trust from which a specified amount, which is not less than five percent, and not more than
50%, of the initial net fair market value of all property placed in trust, is to be paid to one
or more persons for a term of not more than 20 years or for the life or lives of such
beneficiary or beneficiaries. Read section 664(d)(1) and Reg. §1.664-1(a). Section 664(d)(1)
states as follows:
Section 664. Charitable remainder trusts
(d) Definitions
(1) Charitable remainder annuity trust
For purposes of this section, a charitable remainder annuity trust is
a trust—
(A) from which a sum certain (which is not less than 5 percent nor
more than 50 percent of the initial net fair market value of
all property placed in trust) is to be paid, not less often
than annually, to one or more persons (at least one of
which is not an organization described in section 170 (c)
and, in the case of individuals, only to an individual who
is living at the time of the creation of the trust) for a term
of years (not in excess of 20 years) or for the life or lives
of such individual or individuals,
(B) from which no amount other than the payments described in
subparagraph (A) and other than qualified gratuitous transfers
described in subparagraph (C) may be paid to or for the use of any
person other than an organization described in section 170 (c),
(C) following the termination of the payments described in
subparagraph (A), the remainder interest in the trust is to be
transferred to, or for the use of, an organization described in section
170 (c) or is to be retained by the trust for such a use or, to the
extent the remainder interest is in qualified employer securities (as
defined in subsection (g)(4)), all or part of such securities are to be
transferred to an employee stock ownership plan (as defined in
section 4975 (e)(7)) in a qualified gratuitous transfer (as defined by
subsection (g)), and
(D) the value (determined under section 7520) of such remainder
interest is at least 10 percent of the initial net fair market
value of all property placed in the trust.
(2) Charitable remainder unitrust
For purposes of this section, a charitable remainder unitrust is a
trust—
(A) from which a fixed percentage (which is not less than 5 percent
nor more than 50 percent) of the net fair market value of its
assets, valued annually, is to be paid, not less often than
annually, to one or more persons (at least one of which is
not an organization described in section 170 (c) and, in the
case of individuals, only to an individual who is living at
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a.
b.
c.
the time of the creation of the trust) for a term of years (not
in excess of 20 years) or for the life or lives of such
individual or individuals,
(B) from which no amount other than the payments described in
subparagraph (A) and other than qualified gratuitous transfers
described in subparagraph (C) may be paid to or for the use of any
person other than an organization described in section 170 (c),
(C) following the termination of the payments described in
subparagraph (A), the remainder interest in the trust is to be
transferred to, or for the use of, an organization described in section
170 (c) or is to be retained by the trust for such a use or, to the
extent the remainder interest is in qualified employer securities (as
defined in subsection (g)(4)), all or part of such securities are to be
transferred to an employee stock ownership plan (as defined in
section 4975 (e)(7)) in a qualified gratuitous transfer (as defined by
subsection (g)), and
(D) with respect to each contribution of property to the trust, the
value (determined under section 7520) of such remainder interest
in such property is at least 10 percent of the net fair market value
of such property as of the date such property is contributed to the
trust.
(3) Exception
Notwithstanding the provisions of paragraphs (2)(A) and (B), the
trust instrument may provide that the trustee shall pay the income
beneficiary for any year—
(A) the amount of the trust income, if such amount is less than the
amount required to be distributed under paragraph (2)(A),
and
(B) any amount of the trust income which is in excess of the
amount required to be distributed under paragraph (2)(A), to the
extent that (by reason of subparagraph (A)) the aggregate of the
amounts paid in prior years was less than the aggregate of such
required amounts.
(4) Severance of certain additional contributions
If—
(A) any contribution is made to a trust which before the contrib
ution is
a
charitab
l
e
remaind
e
r
unitrust,
and
(B) such contribution would (but for this paragraph) result in such
trust ceasing to be a charitable unitrust by reason of
paragraph (2)(D),
such contribution shall be treated as a transfer to a separate
trust under regulations prescribed by the Secretary.
The amount must be paid at least annually.
At least one of the income beneficiaries must not be a charitable organization.
(1)
Income beneficiaries include individuals, trusts, estates, partnerships,
associations, companies, and corporations.
(2)
If the term is measured by a life, then the income beneficiary is limited to
an individual or a section 170(c) organization.
Each individual beneficiary must be living at the time of the creation of the trust.
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d.
2.
The annuity amount may be payable to members of a named class, but all
individuals in the class must be alive and ascertainable when the trust is created
unless the period for which the annuity trust amount is to be paid to the class is a
term of years.
e.
No remainder payment may be paid to or for the use of any person other than a
charitable organization.
(1)
The remainder interest in the trust is to be transferred to, or for the use of,
a charitable organization or is retained by the trust for such use.
(a)
The charitable organization must qualify under section 170(c),
section 2522(a), and section 2055(a).
(b)
The remainder interest may be designated to benefit one or more
charitable organizations, consecutively or concurrently.
(c)
The trust agreement must provide for alternative remainder persons
or the method by which an alternate remainder persons are to be
chosen, in the event that one of the originally designated charitable
remainder persons is not a qualified charitable organization. Read
Reg. §1.664-2(a)(6)(iv).
(2)
If a personal residence is used to fund a charitable remainder trust, the
beneficiary cannot live in the residence and must vacate before the trust is
funded. Read PLR 76-357, 1976-2 C.B. 285.
(3)
The trust may provide that a charitable remainder person receive a
distribution at the death of a beneficiary or at the end of a term for years and
as a result the amount payable to the other beneficiaries may be reduced
after the distribution, provided:
(a)
The reduced amount payable is the same for each remaining years
of the trust, either as to each beneficiary or as to the total amount
payable annually.
(b)
The annuity amount is not less than five percent after the
distribution to the charitable remainder person.
(c)
The deceased beneficiary's share of income cannot be retained by
the trust until the trust terminates.
(d)
No part of the trustee's fee can be charged against or payable out of
the annuity amount.
Some examples.
a.
Example. The transferor makes a cash charitable contribution of $100,000 to the
local charitable organization for the purpose of establishing a charitable remainder
annuity trust.
(1)
The transferor and the charitable organization agree on the following terms
of the trust.
(2)
The transferor will receive income in the amount of $6,000 (more than five
percent, and less than 50%, of the initial fair market value of the property
placed in trust).
(3)
At the death of the transferor, the transferor's spouse, should the spouse
survive the transferor, will receive income in the amount of $6,000, until the
death of the transferor's spouse.
(4)
The income payments will be made in quarterly installments of $1,500 each
to be paid at the beginning of the first, fourth, seventh and tenth months of
the charitable organization's fiscal year.
(5)
At the death of the last to survive, the transferor or the transferor's spouse,
the remainder interest will revert to the charitable organization, as described
in section x 170(c).
(6)
The trust agreement also provides that if the charitable organization to
which the remainder interest is designated no longer qualifies under section
170(c), section 2522(a) or section 2055(a), then the remainder interest will
benefit another specifically named charitable organization which does
qualify under the three above sections.
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(a)
(7)
The donor should be advised of the advantage of establishing a
charitable remainder annuity trust in times of slow or declining
economic conditions.
i)
Because the annuity trust is established to pay out a
specific amount of money, as opposed to a specific
percentage of the principal with a charitable remainder
unitrust, the amount paid will remain the same despite a
declining economy.
ii)
Charitable remainder trusts allow tax-free build-up inside
of the trust. To the extent income earned by the trust
exceeds the annual unitrust or annuity trust payout, such
income accumulates free of tax.
iii)
Charitable remainder trusts may be useful to satisfy fixed
obligations to children, ex-spouses or elderly relatives.
iv)
The older the beneficiary is on the date the trust is created,
the larger the value of the remainder interest.
v)
The holding period of the property (long or short-term)
must be considered in determining the value of the
remainder interest as well as the nature of the gain
(ordinary or capital gain gross income) which would have
been incurred on a sale of the property by the donor.
A charitable contribution to establish a charitable remainder annuity trust
results in a charitable contribution which is offset by the charitable
contribution deduction, for gift tax purposes, and for which a gift tax return
must be filed. Read section 2503(b), which states as follows:
Section 2503. Taxable gifts
(b) Exclusions from gifts
(1) In general
In the case of gifts (other than gifts of future
interests in property) made to any person by the
donor during the calendar year, the first $10,000
of such gifts to such person shall not, for purposes
of subsection (a), be included in the total amount
of gifts made during such year. Where there has
been a transfer to any person of a present interest
in property, the possibility that such interest may
be diminished by the exercise of a power shall be
disregarded in applying this subsection, if no part
of such interest will at any time pass to any other
person.
(2) Inflation adjustment
In the case of gifts made in a calendar year after
1998, the $10,000 amount contained in paragraph
(1) shall be increased by an amount equal to—
(A) $10,000, multiplied by
(B) the cost-of-living adjustment determined
under section 1 (f)(3) for such calendar year by
substituting “calendar year 1997” for “calendar
year 1992” in subparagraph (B) thereof.
If any amount as adjusted under the
preceding sentence is not a multiple of
$1,000, such amount shall be rounded to
the next lowest multiple of $1,000.
(a)
If the income beneficiary is someone other than the transferor, then
the current value of the income beneficiary's interest is considered
a taxable gift, which qualifies for the annual $10,000 exclusion per
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transferor, per transferee.
If the income beneficiary is the transferor's spouse, and the
charitable contribution was made after December 31, 1981, then the
charitable contribution will qualify for the marital deduction, for
gift tax purposes. Read section 2523, which states as follows:
Section 2523. Gift to spouse
(a) Allowance of deduction
Where a donor transfers during the calendar year
by gift an interest in property to a donee who at
the time of the gift is the donor’s spouse, there
shall be allowed as a deduction in computing
taxable gifts for the calendar year an amount with
respect to such interest equal to its value.
i)
If the charitable contribution was made before December
31, 1981, then the charitable contribution is considered a
terminable interest and will not qualify for a marital
deduction, for gift tax purposes.
Example. If the transferor designates the transferor's issue to be the income
beneficiary, then the income payment to the issue will be considered a taxable gift.
(1)
If the income payment is less than $10,000, then the transferor will pay no
gift tax because of the annual $10,000 exclusion.
(2)
If the income payment is more than $10,000, then the transferor will owe
gift tax on the amount exceeding $10,000.
(3)
If the income payment is designated to benefit the transferor's spouse, then
the transferor will owe no gift tax despite the amount of income payment,
as the payment would qualify for the marital deduction, for gift tax
purposes.
(4)
A charitable contribution to a charitable annuity trust is irrevocable. Read
Reg. §1.664-1(a).
(a)
However, a revocable charitable remainder annuity trust, for the
life of the first deceased spouse, and irrevocable thereafter permits
a marital deduction, for estate tax purposes, for the surviving
spouse's interest.
(b)
To prevent taxes and debts, the revocable trust should pour over
into a new charitable remainder annuity trust.
(5)
The amount of the annuity may be either a specified dollar amount or a
fraction or percentage of the initial net fair market value of the property in
trust. Read Reg. §1.664-1(a).
(a)
Unlike the specified dollar amount annuity, fraction annuities do
not result in disqualification of a trust due to a subsequent
redetermination of the fair market value of the trust property.
(6)
Additional charitable contributions may not be made to an annuity trust.
Read Reg. §1.664-2(b).
Example. Once the transferor has established the specific terms of the charitable
remainder annuity trust and made the charitable contribution of the trust's assets to
the charitable organization, the transferor may not add to the trust's assets.
(1)
Should the transferor desire to make additional charitable contributions to
the charitable remainder annuity trust, the transferor will need to establish
a new charitable remainder annuity trust, rather than make an additional
charitable contribution to an existing charitable remainder annuity trust.
(2)
However, charitable remainder trusts allow tax-free build-up inside of the
trust. To the extent income earned by the trust exceeds the annual unitrust
or annuity trust payout, such income accumulates free of tax.
(3)
A charitable remainder annuity trust enables a transferor to make a
substantial charitable contribution to a charitable organization and obtain
a charitable contribution deduction, for income tax purposes, while
(b)
b.
c.
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d.
retaining or designating an income interest in the property. Read Reg.
§1.664-1(a).
(4)
There are four factors which determine the amount of the charitable
contribution deduction, for income tax purposes.
(5)
The age(s) of the income beneficiary or beneficiaries.
(a)
The number of income beneficiaries.
(b)
The term of years by which the trust is measured, if not for a life or
lives of income beneficiaries.
(c)
Specific amounts of money to be paid out.
(d)
Planning consideration. An older donor should be advised of the
advantage of establishing a charitable remainder annuity trust as
opposed to a charitable remainder unitrust.
(e)
An older donor may be more interested in pre-arranged payment
amounts, for personal budgeting purposes, which is allowable with
the charitable remainder annuity trust.
(6)
The annuity trust is not required to pay the same total amount of annuities
during the annuity trust's entire term. Read Reg. §1.664-2(a)(2).
(a)
A reduction in the amount of the annuity paid is allowable only if
the following apply.
i)
A distribution is made to a qualified charitable
organization upon the death of the annuity recipient or
expiration of the term of years.
ii)
The total amount of annuities payable after the distribution
to the charitable organization must not be less than a
specified dollar amount which equals the same ratio to six
percent of the initial fair market value of the trust assets as
the net fair market value of the trust assets after the
distribution to the charitable organization bears to the net
fair market value of the trust assets immediately before the
distribution.
(7)
The income payment is payable in either cash or in kind. Read Reg.
§1.664-1(a)(5).
(a)
If the payment is made in kind, then the annuity trust may realize
a gain or a loss.
i)
The trust is not income taxed, but rather the gain or loss
will be considered for income tax distribution.
ii)
The income beneficiary or beneficiaries will receive a fair
market value basis for the property distributed.
(8)
The first income payment to the income beneficiary begins with the first tax
year of the trust and continues for the life of a named income beneficiary or
beneficiaries or for a maximum term of 20 years. Read Reg. §1-6642(a)(5).
(a)
If the income payment is to continue for the life of the named
income beneficiary or beneficiaries, then the income payment must
be based on the lives of the income beneficiary or beneficiaries,
and not based on the life of another person.
(b)
When income payment is to be made to an income beneficiary or
beneficiaries, all such beneficiaries must be living at the time the
trust is created.
(c)
An income beneficiary may be a person, trust, estate, partnership,
association, company, corporation, or a charitable organization.
Example. The transferor creates a charitable remainder annuity trust with the
transferor's spouse as the income beneficiary until the death of the transferor's
spouse, then the income will be paid to the transferor's son should the son survive
the transferor's spouse.
(1)
The income payment will continue for the life of the transferor's spouse and
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3.
for the life of the transferor's son before it will revert to the charitable
organization.
(2)
The transferor may also establish a trust to which the income payments are
made.
(3)
The transferor's spouse and the transferor's son could be the beneficiaries
of the trust, with the remainder, at the death of the last to die of the
transferor's spouse or son, reverting to the charitable remainder annuity
trust, benefitting the charitable organization.
The income payments made to the income beneficiary are taxed according to the
characteristics of the income paid, in the following order. Read Reg. §1.664-1(d).
(1)
Ordinary income.
(2)
Capital gain gross income.
(3)
Other income, including tax exempt income.
(4)
Principal.
b.
Example. If the transferor makes a charitable contribution of cash, securities, and
state bonds, then the income generated from those charitable contributions will be
comprised of ordinary income, capital gain gross income, and tax exempt income.
(1)
The payments to the income beneficiary must first come from the ordinary
income of the trust.
(2)
After the ordinary income has been paid, and the trust still owes the income
beneficiary additional income, the next payment will be made from capital
gain gross income.
(3)
After both the ordinary income and capital gain gross income have been
paid, and the trust still owes the income beneficiary additional income, the
next payment will be made from tax exempt income.
(4)
If the trust does not generate sufficient income to cover the income
payments, then the trustee must supplement the income payments by taking
the difference between the income generated and income to be paid from
principal.
(a)
If an annuity beneficiary receives property instead of cash for the
beneficiary's annuity amount, the basis of the property for the
recipient would be a stepped-up basis, that is, its fair market value
at the time it was paid.
(5)
If there are two or more income beneficiaries, then the income is to be
distributed pro-rata, from each of the four categories above. Read Reg.
§1.664-1(d).
(6)
An early death of the income beneficiary will not cause the charitable
contribution deduction, for income tax purposes, to increase.
(a)
The value of the remainder is determined on the actual date of the
charitable contribution.
(7)
Remainder payments of any kind to a noncharitable recipient, from the
charitable remainder annuity trust, except as to the prescribed income
beneficiary, will not generate a charitable contribution deduction, for
income tax purposes. Read Reg. §1.664-1(2).
(8)
If a charitable organization chooses to serve as trustee of the charitable
organization's charitable remainder annuity trust, then the charitable
organization should be aware of potential conflict-of-interest problems
arising as the charitable organization makes its own investments. Read
Rev. Rul. 83-19, 1983-1 C.B. 115.
(a)
If the charitable remainder person is also the trustee, then a
potential conflict-of-interest can be reduced by employing an
investment advisor.
(9)
IRC regulations require that the instrument governing the charitable
remainder annuity trust must state an alternative remainder person. Read
Reg. §1.664-2(a)(6)(iv).
(10)
Remainder interest in a charitable remainder annuity trust can be designated
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(11)
(12)
(13)
(14)
to benefit more than one charitable organization, either concurrently or
successively. Read Reg. §1.664-2(a)(6)(iii).
The trustee may not accumulate any of the income payments from a
charitable remainder annuity trust. Read Reg. §1.664-1(a)(1)(iii)(c).
However, charitable remainder trusts allow tax-free build-up inside of the
trust. To the extent income earned by the trust exceeds the annual unitrust
or annuity trust payout, such income accumulates free of tax.
(a)
The trustee must have complete flexibility in investing the
charitable remainder annuity trust assets.
i)
If the trustee does not have such complete flexibility, then
no charitable contribution deduction, for income tax
purposes, will be allowed.
A donor may name himself trustee of the charitable remainder unitrust he
sets up and even receive trustee fees so long as the fees are reasonable, not
excessive and are based on the amount ordinarily paid to trustees under
state law.
(a)
A donor as trustee does not have the power to sprinkle unitrust
payments among the income recipients. Read Rev. Rul. 77-285,
1977-2 C.B. 213.
The trustee is not permitted to commingle the assets of a charitable
remainder annuity trust with the assets of other trusts. Read Rev. Rul. 8319, 1983-1 C.B. 115.
(a)
But, if a charitable organization is serving as trustee, then the IRS
has ruled that the assets of a charitable remainder annuity trust may
be invested within its general endowment (Rev. Rul. 83-19, 1983-1
C.B. 115; Private Letter Ruling No. 8212067) or with assets of
other charitable remainder annuity trusts (Private Letter Rulings
Nos. 8220120 and 8237068).
i)
Records must be maintained by the trustee that sufficiently
identify the portion of jointly invested assets that are
attributable to each annuity trust and any income earned by
that portion.
ii)
Trust assets should not be commingled unless authorized
by the trust instrument of each trust being commingled.
iii)
Even if commingling is authorized by all trusts involved,
the trustee should check whether state law will allow the
commingling of trust assets.
(b)
The trustee must have complete flexibility in investing the
charitable remainder annuity trust assets.
i)
If the trustee does not have complete flexibility, then no
charitable contribution deduction, for income tax purposes,
will be allowed.
ii)
A trust will not be qualified if the trustee is restricted from
investing the trust assets in a way which has the possibility
of resulting in the annual realization of a reasonable
amount of income or gain from the sale or disposition of
trust assets.
iii)
Annuity trusts have been disqualified where the trustee
was required to retain the assets used to fund the trust or
which required the trustee to make specified investments.
Some, if not all, of the private foundation prohibitions apply to charitable
remainder annuity trusts.
(a)
Those private foundation prohibitions include: engaging in any act
of self-dealing as defined in section 4941(d); making any taxable
expenditure as defined in section 4945(d); retaining excess business
holdings as defined in section 4943(c); and making any investment
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which jeopardizes its purposes as defined in section 4944.
The charitable contribution to a charitable remainder annuity trust may not
be conditioned upon the charitable organization meeting certain needs or
performing some act. Read Rev. Rul. 70-452, 1970-2 C.B. 199.
(a)
No charitable contribution deduction, for income, gift, or estate tax
purposes, is allowable unless then the probability that the charitable
contribution will not be made is "so remote as to be negligible."
i)
If the probability that the gift will not be made is less than
five percent, than the probability is considered "so remote
as to be negligible."
Example. The transferor makes a charitable contribution of stock, which has a fair
market value of $100,000, to a charitable remainder annuity trust, to benefit the local
art museum.
(1)
The transferor has requested that the art museum will be entitled to the
remainder value of the annuity trust if the art museum is able to acquire a
rare painting which the art museum is uninterested in acquiring and unlikely
to acquire.
(2)
The charitable contribution deduction, for income tax purposes, for the
remainder value of the charitable remainder annuity trust, would be denied
to the transferor because the probability that the art museum would acquire
the painting is so remote as to be negligible.
(3)
A charitable contribution of tangible personal property to a charitable
remainder annuity trust does not yield an immediate charitable contribution
deduction, for income tax purposes, if the income is payable to the
transferor or the transferor's close relative. Read section 170(a)(3), which
states as follows:
Section 170. Charitable, etc., contributions and gifts
(a) Allowance of deduction
(3) Future interests in tangible personal property
For purposes of this section, payment of a
charitable contribution which consists of a future
interest in tangible personal property shall be
treated as made only when all intervening interests
in, and rights to the actual possession or
enjoyment of, the property have expired or are
held by persons other than the taxpayer or those
standing in a relationship to the taxpayer described
in section 267 (b) or 707 (b). For purposes of the
preceding sentence, a fixture which is intended to
be severed from the real property shall be treated
as tangible personal property.
(a)
Because tangible personal property is generally non-income
producing, the income postponed charitable remainder unitrust
should be used instead of the charitable remainder annuity trust,
unless the charitable organization sells the property and reinvests
the sale proceeds within one year of the establishment of the trust.
(b)
The charitable contribution deduction, for income tax purposes, for
a charitable contribution of tangible personal property is the fair
market value of the property.
i)
If the charitable organization may not use the transferred
property, then the charitable contribution deduction, for
income tax purposes, is the cost basis of such property.
(c)
Tangible personal property does not include cash, securities,
buildings or an interest in an oil well.
(d)
A close relative includes the transferor's spouse, ancestors, lineal
descendants, and siblings. Read section 267(b) and section x
(15)
c.
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d.
e.
267(c)(4).
Example. The transferor makes a charitable contribution of a painting the transferor
has held for 15 years, which has a fair market value of $100,000.
(1)
The transferor has asked the charitable organization to establish a charitable
remainder annuity trust equal to the appraised value of the painting.
(2)
The only way the charitable organization could establish a charitable
remainder annuity trust for the transferor would be to sell the painting for
$100,000.
(3)
Because the painting does not generate any income, the painting would be
sold to yield cash or securities which would then generate sufficient income
to make the income payment to the transferor.
(4)
A transfer of encumbered property to a charitable remainder annuity trust
raises the following four potential income tax problems. Read Reg. §1.6642(a)(1).
Unrelated debt-financed income (unrelated business income) will exclude the
charitable remainder annuity trust from being tax exempt to the charitable
organization for that year.
(1)
Property which is debt-financed, the income of which is not related to the
charitable organization's purpose, is unrelated business income.
(a)
Debt-financed property does not allow a charitable contribution
deduction.
(2)
Acts of self-dealing, which may result from the transferor and trustees
transacting between themselves, will yield excise tax penalties. Read
section 4947(a)(2), which states as follows:
Section 4947. Application of taxes to certain nonexempt trusts
(a) Application of tax
(2) Split-interest trusts
In the case of a trust which is not exempt from tax
under section 501 (a), not all of the unexpired
interests in which are devoted to one or more of
the purposes described in section 170 (c)(2)(B),
and which has amounts in trust for which a
deduction was allowed under section 170, 545
(b)(2), 642 (c), 2055, 2106 (a)(2), or 2522, section
507 (relating to termination of private foundation
status), section 508 (e) (relating to governing
instruments) to the extent applicable to a trust
described in this paragraph, section 4941 (relating
to taxes on self-dealing), section 4943 (relating to
taxes on excess business holdings) except as
provided in subsection (b)(3), section 4944
(relating to investments which jeopardize
charitable purpose) except as provided in
subsection (b)(3), and section 4945 (relating to
taxes on taxable expenditures) shall apply as if
such trust were a private foundation. This
paragraph shall not apply with respect to—
(A) any amounts payable under the terms
of such trust to income
beneficiaries, unless a deduction
was allowed under section 170
(f)(2)(B), 2055 (e)(2)(B), or 2522
(c)(2)(B),
(B) any amounts in trust other than
amounts for which a deduction was
allowed under section 170, 545 (b)(2),
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f.
g.
642 (c), 2055, 2106 (a)(2), or 2522, if
such other amounts are segregated from
amounts for which no deduction was
allowable, or
(C) any amounts transferred in trust
before May 27, 1969.
(a)
Prohibited acts between the donor and the trustee include sales,
leases, loans, etc.
(3)
Payments distributed to those other than the charitable organization and the
income beneficiaries are prohibited and will result in a disqualification of
the trust.
(a)
Such prohibited payments include mortgage payments.
i)
The IRS has held in a private letter ruling that no qualified
charitable remainder trust was created for transferred
mortgaged property where the trust continued to make
mortgage payments on which the donor was still liable
because the trust created was a grantor trust under section
x 677(a) and Reg. §1.677(a)-(1)(d). Read Private Letter
Ruling No. 9015038. Read Private Letter Rulings No.
8931023 and 9126065 for inconsistent rulings.
(4)
The transfer of encumbered property to a charitable remainder annuity trust
may result in a bargain sale with the transferor paying tax on the capital
gain gross income, as if the mortgage amount were proceeds from a sale of
the encumbered property.
Examples of language for the charitable remainder annuity trust.
(1)
Read appendix b for Rev. Proc. 89-21 and 90-32.
The trust itself is exempt from federal income tax except when the following occurs:
(1)
It receives unrelated business tax income. Read sections 512 through 513;
Reg. §1.664-1(c).
(2)
It has debt-financed income. Read sections 512 through 513; Reg. §1.6641(c).
(3)
It fails to pay the unitrust amount to the beneficiary within the time required
to file the trust's form 5227 for the year (including extensions). Read Reg.
§1.664-2(a)(1)(i).
(4)
It does not pay real property taxes or assessments by the due date. Read
section 514(c)(2)©, which states as follows:
Section 514. Unrelated debt-financed income
(c) Acquisition indebtedness
(2) Property acquired subject to mortgage, etc.
For purposes of this subsection—
(C) Liens for taxes or assessments
Where State law provides that—
(i) a lien for taxes, or
(ii) a lien for assessments,
made by a State or a political subdivision thereof attaches to
property prior to the time when such taxes or assessments become
due and payable, then such lien shall be treated as similar to a
mortgage (within the meaning of subparagraph (A)) but only after
such taxes or assessments become due and payable and the
organization has had an opportunity to pay such taxes or
assessments in accordance with State law.
(5)
It has mortgaged property. Read section 514(c)(2)(a), (b), which states as
follows:
Section 514. Unrelated debt-financed income
(c) Acquisition indebtedness
(2) Property acquired subject to mortgage, etc.
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4.
For purposes of this subsection—
(A) General rule
Where property (no matter how acquired)
is acquired subject to a mortgage or other
similar lien, the amount of the
indebtedness secured by such mortgage or
lien shall be considered as an
indebtedness of the organization incurred
in acquiring such property even though
the organization did not assume or agree
to pay such indebtedness.
(B) Exceptions
Where property subject to a mortgage is
acquired by an organization by bequest or
devise, the indebtedness secured by the
mortgage shall not be treated as
acquisition indebtedness during a period
of 10 years following the date of the
acquisition. If an organization acquires
property by gift subject to a mortgage
which was placed on the property more
than 5 years before the gift, which
property was held by the donor more than
5 years before the gift, the indebtedness
secured by such mortgage shall not be
treated as acquisition indebtedness during
a period of 10 years following the date of
such gift. This subparagraph shall not
apply if the organization, in order to
acquire the equity in the property by
bequest, devise, or gift, assumes and
agrees to pay the indebtedness secured by
the mortgage, or if the organization makes
any payment for the equity in the property
owned by the decedent or the donor.
(a)
An exception is made when the property was mortgaged more than
five years before the inter vivos transfer to the trust and the donor
owned the property more than fives years before the transfer to the
trust.
(b)
As a result, the trust should not be deemed to have an acquisition
indebtedness during the ten years following the transfer to the trust.
(c)
This exception does not apply if the mortgaged property was
transferred to the trust by the donor's will.
A trust from which a fixed percentage, which is not less than five percent and not more than
50% of the initial net fair market value of all property placed in trust, valued annually, is to
be paid to one or more persons for a term of not more than 20 years or for the life or lives
of such beneficiary or beneficiaries. Read section 664(d)(2), which states as follows:
Section 664. Charitable remainder trusts
(d) Definitions
(2) Charitable remainder unitrust
For purposes of this section, a charitable remainder unitrust is a
trust—
(A) from which a fixed percentage (which is not less than 5 percent
nor more than 50 percent) of the net fair market value of its
assets, valued annually, is to be paid, not less often than
annually, to one or more persons (at least one of which is
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a.
b.
c.
d.
e.
not an organization described in section 170 (c) and, in the
case of individuals, only to an individual who is living at
the time of the creation of the trust) for a term of years (not
in excess of 20 years) or for the life or lives of such
individual or individuals,
(B) from which no amount other than the payments described in
subparagraph (A) and other than qualified gratuitous transfers
described in subparagraph (C) may be paid to or for the use of any
person other than an organization described in section 170 (c),
(C) following the termination of the payments described in
subparagraph (A), the remainder interest in the trust is to be
transferred to, or for the use of, an organization described in section
170 (c) or is to be retained by the trust for such a use or, to the
extent the remainder interest is in qualified employer securities (as
defined in subsection (g)(4)), all or part of such securities are to be
transferred to an employee stock ownership plan (as defined in
section 4975 (e)(7)) in a qualified gratuitous transfer (as defined by
subsection (g)), and
(D) with respect to each contribution of property to the trust, the
value (determined under section 7520) of such remainder interest
in such property is at least 10 percent of the net fair market value
of such property as of the date such property is contributed to the
trust.
The amount is paid at least annually.
At least one of the income beneficiaries must not be a charitable organization.
(1)
Income beneficiaries include individuals, trusts, estates, partnerships,
associations, companies and corporations.
(2)
If the term is measured by a life, then the income beneficiary is limited to
an individual or a section x 170(c) organization.
Each individual beneficiary must be living at the time of the creation of the trust.
(1)
The unitrust amount may be payable to members of a named class as long
as all individuals in the class are alive and ascertainable when the trust is
created.
(2)
All members of the class need not be alive and ascertainable at the trust's
creation if the period for which the unitrust amount is to be paid to the class
is a term of years.
If the unitrust amount is payable for a term of years, the term must be ascertainable
at the creation of the trust.
(1)
The term may be terminated, however, by the death of the beneficiary or by
the transferor's exercise by will of a retained power to revoke the interest of
any non section x 170 organization beneficiary.
If a personal residence is used to fund a charitable remainder trust, the beneficiary
cannot live in the residence and must vacate before the trust is funded. Read Private
Revenue Ruling 76-357, 1976-2 C.B. 285. No remainder payment may be paid to
or for the use of any person other than a charitable organization.
(1)
The remainder interest in the trust is to be transferred to, or for the use of,
a charitable organization or is retained by the trust for such use.
(a)
The charitable organization must qualify under section 170(c),
section 2522(a), and section 2055(a).
(b)
The remainder interest may be designated to benefit one or more
charitable organizations, consecutively or concurrently.
(c)
The trust agreement must provide for alternative remaindermen or
the method by which an alternative remainder person is to be
chosen, in the event one of the originally designated charitable
remainder person is not a qualified charitable organization. Read
Reg. §1.664-3(a)(6)(iv).
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(2)
(3)
(4)
(5)
(6)
(7)
(8)
Additional charitable contributions may be made to an existing charitable
remainder unitrust.
The principal of the trust may not be invaded except to fulfill the required
payout.
No charitable contribution deduction, for income tax purposes, is allowed
for the transfer of tangible personal property to a charitable remainder
unitrust.
The trustee must be free to invest and re-invest the trust assets, if
appropriate, without any influence from the transferor.
The trust may provide that a charitable remainder person receive a
distribution at the death of a beneficiary or at the end of a term for years and
as a result the fixed percentage payable to the other beneficiaries may be
reduced after the distribution, provided:
(a)
The reduced fixed percentage is the same for each remaining years
of the trust, either as to each beneficiary or as to the total amount
payable annually.
(b)
The unitrust amount is not less than five percent after the
distribution to the charitable remainder person.
(c)
The deceased beneficiary's share of income cannot be retained by
the trust until the trust terminates.
(d)
No part of the trustee's fee can be charged against or payable out of
the unitrust amount.
The creator of a charitable remainder unitrust that provides unitrust interest
to the creator for the creator's life and upon the creator's death to the
creator's spouse for the spouse's life may receive an income tax charitable
deduction by transferring a fractional portion of the creator's income interest
to the charitable remainder person.
(a)
The reason the couple wanted to give part of their income interest
to charitable organization was because the trust assets had
appreciated so much.
(b)
The creator's original transfer to the unitrust must not have been an
attempt to avoid the partial interest prohibition.
(c)
The spouse of the creator is not entitled to an income tax charitable
deduction.
Example. The transferor makes a cash charitable contribution of $100,000
to establish a charitable remainder unitrust.
(a)
The terms of the trust agreement are as follows.
(b)
The charitable remainder unitrust will pay income to the transferor
for the life of the transferor, then at the death of the transferor the
trust will pay income to the transferor's spouse for the life of the
transferor's spouse if the transferor's spouse does not predecease the
transferor.
(c)
The trust's income payment will be in the amount of $9,000 per
year, or nine percent of the initial net fair market value of all
property placed in trust, and will be divided into four quarterly
payments during each year.
(d)
Both the transferor and the transferor's spouse are living at the time
the trust is created.
(e)
If the transferor so chooses, then the transferor may make
additional charitable contributions to the existing charitable
remainder unitrust in anticipation of increasing the annual payment
of $9,000.
(f)
The percentage of the initial next fair market value of the property
placed in trust will remain the same at nine percent, but the amount
of principal or fair market value of trust property will increase,
generating additional income.
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(g)
f.
The transferor may not specify how the trustee will invest the
charitable contribution of $100,000.
(9)
A donor should be advised of the advantage of establishing a charitable
remainder unitrust in times of rising economic conditions.
(a)
Because the unitrust is established to pay-out a percentage of the
principal, as opposed to a specific dollar amount with a charitable
remainder annuity trust, the amount paid out will increase as the
economic conditions improve.
(b)
Charitable remainder trusts allow tax-free build-up inside of the
trust. To the extent income earned by the trust exceeds the annual
unitrust or annuity trust payout, such income accumulates free of
tax.
(c)
Assets contributed or held by a charitable remainder unitrust should
be capable of easy valuation since they must be revalued annually.
A charitable contribution to establish a charitable remainder unitrust results in a
charitable contribution which is offset by the charitable contribution deduction, for
gift tax purposes, and for which a gift tax return must be filed. Read section
2503(b), which states as follows:
Section 2503. Taxable gifts
(b) Exclusions from gifts
(1) In general
In the case of gifts (other than gifts of future interests in
property) made to any person by the donor during the
calendar year, the first $10,000 of such gifts to such person
shall not, for purposes of subsection (a), be included in the
total amount of gifts made during such year. Where there
has been a transfer to any person of a present interest in
property, the possibility that such interest may be
diminished by the exercise of a power shall be disregarded
in applying this subsection, if no part of such interest will
at any time pass to any other person.
(2) Inflation adjustment
In the case of gifts made in a calendar year after 1998, the
$10,000 amount contained in paragraph (1) shall be
increased by an amount equal to—
(A) $10,000, multiplied by
(B) the cost-of-living adjustment determined under section
1 (f)(3) for such calendar year by substituting
“calendar year 1997” for “calendar year 1992” in
subparagraph (B) thereof.
If any amount as adjusted under the preceding sentence is not a multiple of
$1,000, such amount shall be rounded to the next lowest multiple of $1,000.
(1)
If the income beneficiary is someone other than the transferor, then the
current value of the income beneficiary's interest is considered a taxable
gift, which qualified for the annual $10,000 exclusion per transferor, per
transferee.
(2)
If the income beneficiary is the transferor's spouse, and the charitable
contribution was made after December 31, 1981, then the charitable
contribution will qualify for the marital deduction, for gift tax purposes.
Read section 2523(a), which states as follows:
Section 2523. Gift to spouse
(a) Allowance of deduction
Where a donor transfers during the calendar year by gift an
interest in property to a donee who at the time of the gift is
the donor’s spouse, there shall be allowed as a deduction
in computing taxable gifts for the calendar year an amount
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with respect to such interest equal to its value.
If the charitable contribution was made before December 31, 1981,
then the charitable contribution is considered a terminable interest
and will not qualify for a marital deduction, for gift tax purposes.
A charitable contribution to a charitable remainder unitrust is irrevocable. Read
Reg. §1.664-1(a).
(1)
However, revocable charitable remainder unitrust for the life of the first
deceased spouse and irrevocable thereafter permits a marital deduction, for
estate tax purposes, for the surviving spouse's interest.
(2)
To prevent taxes and debts, the revocable trust should pour over into a new
charitable remainder unitrust.
Charitable remainder unitrusts enable transferors to make a substantial charitable
contribution to a charitable organization, including a charitable contribution
deduction, for income tax purposes, while retaining or designating an income
interest in the property. Read Reg. §1.664-1(a).
(1)
There are four factors which determine the amount of the charitable
contribution deduction, for income tax purposes.
(a)
The age(s) of the income beneficiary or beneficiaries.
(b)
The number of income beneficiaries.
(c)
The term of years by which the trust is measured, if not for a life or
lives of income beneficiary.
(d)
Specific percentage of the trust to be paid out.
(2)
Planning considerations:
(a)
A younger donor should be advised of the advantage of
establishing a charitable remainder unitrust, as opposed to a
charitable remainder annuity trust.
i)
A younger donor may be more interested in a percentage
pay-out, which has a likelihood of generating a larger
income over time, given favorable economic conditions.
(b)
The older a donor is on the date the trust is created, the larger the
value of the remainder interest.
(c)
The greater the number of beneficiaries, the smaller the value of the
remainder interest.
(d)
If the trust is measured in a term of years, the longer the term, the
smaller is the value of the remainder interest.
(e)
A property's holding period (long or short-term) and the nature of
the gain (ordinary or capital) from the sale of the property must be
considered when determining the value of the remainder interest.
There are two acceptable variations to the charitable remainder unitrust. Read Reg.
§1.664-3(a)(1)(b).
(1)
In the "income only" unitrust, if the amount of the trust income is less than
the fixed percentage, the amount of the annual payment is limited to the
amount of the trust income.
(a)
Planning consideration. This unitrust benefits the remainder
beneficiary by leaving the entire corpus intact.
i)
The donor who chooses to establish such a unitrust will be
more interested in the remainder beneficiary receiving the
full value of the corpus, upon termination of their trust,
than the amounts of income received by the income
beneficiary during the life of the unitrust.
(b)
Example. The transferor makes a cash charitable contribution of
$100,000 to establish a charitable remainder unitrust, with an
income payment of 10% of the trust property's net fair market
value.
i)
In the second year of the trust, the income generated equals
only seven percent of the trust property's net fair market
(a)
g.
h.
i.
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value.
The "income only" unitrust will pay only the seven percent
income generated to the income beneficiary.
iii)
In subsequent years, the trust will pay no more than 10%,
and will not be required to make up for income not paid in
prior years.
(2)
In the "income only unitrust with makeup", the income limitation may be
"made up" by excess income in future years.
(a)
Planning consideration. This unitrust benefits the income
beneficiary by ensuring that the income beneficiary receives the
same amount of income, on average, over the life of the trust.
i)
The donor who chooses to establish such a unitrust will be
more interested in the income beneficiary receiving the full
amount of income generated by the trust, as specified by
the percentage in the trust agreement, over the life of the
trust.
ii)
However, income earned in prior years cannot be used to
make up a difference in later years, so care must be taken
in the choice of investments.
(b)
Example. The transferor makes a cash charitable contribution of
$100,000 to establish a charitable remainder unitrust, with an
income payment of 10% of the trust property's fair market value.
i)
In the second year of the trust, the income generated equals
only seven percent of the trust property's net fair market
value.
ii)
The "income only unitrust with makeup" will pay only the
seven percent income generated to the income beneficiary.
iii)
In subsequent years, the trust will make up for the
difference between the income generated of seven percent
and the income required of 10% by paying any income in
excess of ten percent in any given year, to the income
beneficiary, until the deficit no longer exists.
(3)
Planning consideration. The beneficiary generally prefers the fixed
percentage variation because the beneficiary's payments are assured and the
payments can often be taxed more favorably than under either an "income
only" unitrust or an "income only unitrust with makeup."
(a)
However, one of the latter two variations may be called for if nonincome producing assets are transferred to the trust and those assets
cannot be quickly sold.
(b)
The charitable remainder person would prefer either the "income
only" unitrust or an "income only unitrust with makeup" because
the resulting corpus cannot be invaded.
A make-up provision for charitable remainder unitrusts requires that if the trust pays
less than the required percentage, the trust must make up for the lesser payments by
paying out more of the trust income than the required percentage until the deficit is
reduced. Read Reg. §1.664-3(a)(1)(b).
The charitable remainder unitrust instrument must provide for a way of handling
additional charitable contributions into the trust, made by either the transferor or
other parties. Read Reg. §1.664-3(b).
(1)
It should be noted that charitable remainder trusts allow tax-free build-up
inside of the trust. To the extent income earned by the trust exceeds the
annual unitrust or annuity trust payout, such income accumulates free of
tax.
The income payments made to the income beneficiary are taxed according to the
characteristics of the income paid in the following order. Read Reg. §1.664-1(d).
(1)
Ordinary income.
ii)
j.
k.
l.
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(2)
(3)
(4)
m.
n.
o.
p.
q.
r.
s.
Capital gain gross income.
Other income, including tax exempt income.
Principal.
(a)
Example 76. If the transferor makes a charitable contribution of
cash, securities, and state bonds, then the income generated from
those charitable contributions will be comprised of ordinary
income, capital gain gross income, and tax exempt income.
i)
The payments to the income beneficiary must first come
from the ordinary income of the trust.
ii)
After the ordinary income has been paid, and the trust still
owes the income beneficiary additional income, the next
payment will be made from capital gain gross income.
iii)
After both the ordinary income and capital gain gross
income have been paid, and the trust still owes the income
beneficiary additional income, the next payment will be
made from tax exempt income.
iv)
If the trust does not generate sufficient income to cover the
income payments, then the trustee must supplement the
income payments by taking the difference between the
income generated and income to be paid from principal.
(5)
A loss in one category cannot be used to reduce a gain in another category.
(6)
If a unitrust beneficiary receives property instead of cash for the
beneficiary's unitrust amount, the basis of the property for the recipient
would be a stepped-up basis, that is, its fair market value at the time it was
paid.
(7)
A charitable remainder unitrust may provide for an allocation of
depreciation deductions for trust property between the trustee and the
income beneficiaries as long as the trustee is not required to buy or keep
depreciable assets. Read Private Letter Ruling No. 8610067.
If there are two or more income beneficiaries, then the income is to be distributed
pro rata, from each of the four categories above. Read Reg. §1.664-1(d).
If a charitable remainder unitrust makes a distribution to charitable organization of
other than the unitrust amount, it will be first considered a distribution of corpus and
then of the three income tiers in reverse order of the four categories listed above.
Read Reg. §1.664-1(e)(1).
An early death of the income beneficiary does not cause the charitable contribution
deduction, for income tax purposes, to increase.
(1)
The value of the remainder is determined on the actual date of the charitable
contribution.
If a charitable remainder unitrust has two beneficiaries and one of those
beneficiaries dies, that portion of the unitrust interest can be paid to charitable
organization and the transferor's estate is allowed an estate tax charitable deduction
for the present value of the charitable organization's lead unitrust interest.
(1)
Litigation could have been avoided by the creation of two trusts - - - both
providing for income interests to non-charitable beneficiaries with
remainder interests to charitable organization.
The trustee may not accumulate any of the payments from a charitable remainder
unitrust. Read Reg. §1.664-1(a)(1)(iii)(c).
(1)
However, charitable remainder trusts allow tax-free build-up inside of the
trust. To the extent income earned by the trust exceeds the annual unitrust
or annuity trust payout, such income accumulates free of tax.
Remainder payments of any kind to a noncharitable income beneficiary, from the
charitable remainder unitrust, except as to the prescribed income beneficiary, will
not generate a charitable contribution deduction, for income tax purposes. Read
Reg. §1.664-1(2).
The charitable contribution to a charitable remainder unitrust may not be
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t.
u.
v.
conditioned upon the charitable organization meeting certain needs or performing
some act. Read Rev. Rul. 70-452, 1970-2 C.B. 199.
(1)
No charitable contribution deduction, for income, gift, or estate tax
purposes, is allowable unless the probability that the charitable contribution
will not be made is "so remote as to be negligible."
(a)
If the probability that the charitable contribution will not be made
is less than five percent, then the probability is considered "so
remote as to be negligible."
(2)
Example. The transferor makes a charitable contribution of stock, which
has a fair market value of $100,000, to a charitable remainder unitrust, to
benefit the local art museum.
(a)
The transferor has requested that the art museum will be entitled to
the remainder value of the unitrust if the art museum is able to
acquire a rare painting which the art museum is unlikely to and
uninterested in acquiring.
(b)
The charitable contribution deduction, for income tax purposes, for
the remainder value of the charitable remainder unitrust would be
denied to the transferor because the probability that the art museum
would acquire the painting is so remote as to be negligible.
If a charitable organization chooses to serve as trustee of the charitable
organization's charitable remainder unitrust, then the charitable organization should
be aware of potential conflict-of-interest problems arising as the charitable
organization makes its own investments. Read Rev. Rul. 83-19, 1983-1 C.B. 115.
(1)
If the charitable remainder person is also the trustee, then potential conflictof-interest can be reduced by employing an investment advisor.
(2)
Where property that goes into the trust is not easily valued, for example,
stock in closely-held corporation or real estate), the charitable organization
should not serve as the trustee.
(3)
Where the charitable remainder person serves as the trustee of a charitable
remainder unitrust and the income beneficiaries want to terminate and
partition the trust, that partition will not disqualify the trust or be treated as
a sale or other disposition of trust property.
(a)
Even though the charitable organization, as trustee, would normally
be considered a "disqualified person" in relation to the trust, Reg.
§53.4946-1(a)(8) states that a section 501(c)(3) organization is not
a disqualified person unless its also described in section 509(a)(4).
(b)
The termination will not be an act of self-dealing, if the charitable
remainder person is not described in §509(a)(4); the proposed
termination and partition isn't prohibited under state law; and in
consenting to the partition, the trustee considered relevant factors
such as the health and probable life expectancy of the income
beneficiaries.
A donor may name himself trustee of the charitable remainder unitrust he sets up
and even receive trustee fees so long as the fees are reasonable, not excessive and
are based on the amount ordinarily paid to trustees under state law.
(1)
A donor as trustee does not have the power to sprinkle unitrust payments
among the income recipients. Read Rev. Rul. 77-285, 1977-2 C.B. 213.
The trustee is not permitted to commingle the assets of a charitable remainder
unitrust with the assets of other trusts. Read Rev. Rul. 83-19, 1983-1 C.B. 115.
(1)
But, if a charitable organization is serving as trustee, then the IRS has ruled
that the assets of a charitable remainder unitrust may be invested within its
general endowment (Rev. Rul. 83-19, 1983-1 C.B. 115; Private Letter
Ruling No. 8212067) or with assets of other charitable remainder unitrusts
(Private Letter Ruling Nos. 8220120 and 8237068).
(a)
Records must be maintained by the trustee that sufficiently identify
the portion of jointly invested assets that are attributable to each
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unitrust and any income earned by that portion.
Trust assets should not be commingled unless authorized by the
trust instrument of each trust being commingled.
(c)
Even if commingling is authorized by all trusts involved, the trustee
should check whether state law will allow the commingling of trust
assets.
(2)
The trustee must have complete flexibility in investing the charitable
remainder unitrust assets.
(a)
If the trustee does not have complete flexibility, then no charitable
contribution deduction, for income tax purposes, will be allowed.
(b)
A trust will not be qualified if the trustee is restricted from
investing the trust assets in a way which has the possibility of
resulting in the annual realization of a reasonable amount of
income or gain from the sale or disposition of trust assets.
(c)
Unitrusts have been disqualified where the trustee was required to
retain the assets used to fund the trust or which required the trustee
to make specified investments.
Some, if not all, of the private foundation prohibitions apply to charitable remainder
unitrusts.
(1)
Those private foundation prohibitions include: engaging in any act of selfdealing as defined in section x 4941(d); making any taxable expenditure as
defined in section x 4945(d); retaining excess business holdings as defined
in section x 4943(c); and making any investment which jeopardizes its
purposes as defined in section x 4944.
A charitable contribution of tangible personal property to a charitable remainder
unitrust does not yield an immediate charitable contribution deduction, for income
tax purposes, if the income is payable to the transferor or the transferor's close
relative. Read section 170(a)(3), which states as follows:
Section 170. Charitable, etc., contributions and gifts
(a) Allowance of deduction
(3) Future interests in tangible personal property
For purposes of this section, payment of a charitable
contribution which consists of a future interest in tangible
personal property shall be treated as made only when all
intervening interests in, and rights to the actual possession
or enjoyment of, the property have expired or are held by
persons other than the taxpayer or those standing in a
relationship to the taxpayer described in section 267 (b) or
707 (b). For purposes of the preceding sentence, a fixture
which is intended to be severed from the real property shall
be treated as tangible personal property.
(b)
w.
x.
(1)
(2)
(3)
(4)
Because tangible personal property is generally non-income producing, the
income postponed charitable remainder unitrust should be used, unless the
charitable organization sells the property and reinvests the sale proceeds
within one year after the establishment of the trust.
The charitable contribution deduction, for income tax purposes, for a
charitable contribution of tangible personal property is the fair market value
of the property.
(a)
If the charitable organization may not use the transferred property,
then the charitable contribution deduction, for income tax purposes,
is the cost basis of such property.
Tangible personal property does not include cash, securities, buildings, or
an interest in an oil well.
A close relative includes the transferor's spouse, ancestors, lineal
descendants, and siblings. Read section 267(b) and section x 267(c)(4),
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y.
which state as follows:
Section 267. Losses, expenses, and interest with respect to transactions
between related taxpayers
(b) Relationships
The persons referred to in subsection (a) are:
(1) Members of a family, as defined in subsection (c)(4);
(2) An individual and a corporation more than 50 percent
in value of the outstanding stock of which is
owned, directly or indirectly, by or for such
individual;
(3) Two corporations which are members of the same
controlled group (as defined in subsection (f));
(4) A grantor and a fiduciary of any trust;
(5) A fiduciary of a trust and a fiduciary of another trust,
if the same person is a grantor of both trusts;
(6) A fiduciary of a trust and a beneficiary of such trust;
(7) A fiduciary of a trust and a beneficiary of another trust,
if the same person is a grantor of both trusts;
(8) A fiduciary of a trust and a corporation more than 50
percent in value of the outstanding stock of which
is owned, directly or indirectly, by or for the trust
or by or for a person who is a grantor of the trust;
(9) A person and an organization to which section 501
(relating to certain educational and charitable
organizations which are exempt from tax) applies
and which is controlled directly or indirectly by
such person or (if such person is an individual) by
members of the family of such individual;
(10) A corporation and a partnership if the same persons
own—
(A) more than 50 percent in value of the
outstanding stock of the corporation, and
(B) more than 50 percent of the capital interest, or
the profits interest, in the partnership;
(11) An S corporation and another S corporation if the
same persons own more than 50 percent in value
of the outstanding stock of each corporation;
(12) An S corporation and a C corporation, if the same
persons own more than 50 percent in value of the
outstanding stock of each corporation; or
(13) Except in the case of a sale or exchange in satisfact
ion of a pecuniary bequest, an executor of an
estate and a beneficiary of such estate.
Section 267. Losses, expenses, and interest with respect to transactions
between related taxpayers
(c) Constructive ownership of stock
For purposes of determining, in applying subsection (b),
the ownership of stock—
(4) The family of an individual shall include only his
brothers and sisters (whether by the whole or half
blood), spouse, ancestors, and lineal descendants;
and
A transfer of encumbered property to a charitable remainder unitrust raises the
following four potential income tax problems. Read Reg. §1.664-3(a)(1).
(1)
Unrelated debt-financed income (unrelated business income) will exclude
the charitable remainder unitrust from being tax exempt to the charitable
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organization for that year.
(a)
Property which is debt-financed, the income of which is not related
to the charitable organization's purpose, is unrelated business
income.
(b)
Debt-financed property does allow a charitable contribution
deduction.
(2)
Acts of self-dealing, which may result from the transferor and trustees
transacting between themselves, yield excise tax penalties.
(a)
The self-dealing prohibition should not apply to the initial transfer
of mortgaged property to a unitrust. Read Reg. §53.4941(d)-1(a).
(3)
Payments distributed to those other than the charitable organization and the
income beneficiaries are prohibited and may result in a disqualification of
the trust.
(a)
Such prohibited payments include mortgage payments.
i)
The IRS has held in a private letter ruling that no qualified
charitable remainder trust was created for transferred
mortgaged property where the trust continued to make
mortgage payments on which the donor was still liable
because the trust created was a grantor trust under section
x 677(a) and Reg. §1.677(a)-(1)(d). Read Private Letter
Ruling No. 9015038. Read Private Letter Rulings No.
8931023 and 9126065 for inconsistent rulings.
(4)
The transfer of encumbered property to a charitable remainder unitrust may
result in a bargain sale, with the transferor paying tax on the capital gain
gross income, as if the mortgage amount were proceeds from a sale of the
encumbered property.
(a)
The taxpayer realizes gain equal to the difference between the
outstanding liability and the taxpayer's adjusted basis, and
therefore, the gain is not limited by the property's fair market value.
(5)
Planning consideration. Instead of transferring mortgaged property to a
charitable remainder unitrust, the donor could form a corporation, transfer
the mortgaged property to the corporation and then give the stock to
charitable organization.
(a)
The stock is not debt-financed property because the stock itself is
not subject to any indebtedness.
i)
Dividends, therefore, paid on the stock, would not be
unrelated business taxable income.
(b)
The donor must have a valid business purpose for forming the
corporation and should wait a reasonable period before transferring
the stock.
z.
Examples of language for the charitable remainder unitrust.
(1)
Read appendix b for Revenue Procedures 89-20, 90-30 and 90-31.
aa.
The trust itself is exempt from federal income tax except when the following occurs:
(1)
It receives unrelated business taxable income. Read sections 512-513; Reg.
§1.664-1©. Sections 512 and 513 state as follows:
Section 512. Unrelated business taxable income
(a) Definition
For purposes of this title—
(1) General rule
Except as otherwise provided in this subsection, the term
“unrelated business taxable income” means the gross income
derived by any organization from any unrelated trade or business
(as defined in section 513) regularly carried on by it, less the
deductions allowed by this chapter which are directly connected
with the carrying on of such trade or business, both computed with
the modifications provided in subsection (b).
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(2) Special rule for foreign organizations
In the case of an organization described in section 511 which is a
foreign organization, the unrelated business taxable income shall
be—
(A) its unrelated business taxable income which is derived
from sources within the United States and which
is not effectively connected with the conduct of a
trade or business within the United States, plus
(B) its unrelated business taxable income which is
effectively connected with the conduct of a trade or
business within the United States.
(3) Special rules applicable to organizations described in paragraph (7), (9),
(17), or (20) of section 501 (c)
(A) General rule
In the case of an organization described in paragraph (7),
(9), (17), or (20) of section 501 (c), the term “unrelated
business taxable income” means the gross income
(excluding any exempt function income), less the
deductions allowed by this chapter which are directly
connected with the production of the gross income
(excluding exempt function income), both computed with
the modifications provided in paragraphs (6), (10), (11),
and (12) of subsection (b). For purposes of the preceding
sentence, the deductions provided by sections 243, 244,
and 245 (relating to dividends received by corporations)
shall be treated as not directly connected with the
production of gross income.
(B) Exempt function income
For purposes of subparagraph (A), the term “exempt
function income” means the gross income from dues, fees,
charges, or similar amounts paid by members of the
organization as consideration for providing such members
or their dependents or guests goods, facilities, or services
in furtherance of the purposes constituting the basis for the
exemption of the organization to which such income is
paid. Such term also means all income (other than an
amount equal to the gross income derived from any
unrelated trade or business regularly carried on by such
organization computed as if the organization were subject
to paragraph (1)), which is set aside—
(i) for a purpose specified in section 170 (c)(4), or
(ii) in the case of an organization described in paragraph
(9), (17), or (20) of section 501 (c), to provide for the
payment of life, sick, accident, or other benefits,
including reasonable costs of administration
directly connected with a purpose described in
clause (i) or (ii). If during the taxable year, an
amount which is attributable to income so set
aside is used for a purpose other than that
described in clause (i) or (ii), such amount shall be
included, under subparagraph (A), in unrelated
business taxable income for the taxable year.
(C) Applicability to certain corporations described in section 501
(c)(2)
In the case of a corporation described in section 501 (c)(2),
the income of which is payable to an organization
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described in paragraph (7), (9), (17), or (20) of section 501
(c), subparagraph (A) shall apply as if such corporation
were the organization to which the income is payable. For
purposes of the preceding sentence, such corporation shall
be treated as having exempt function income for a taxable
year only if it files a consolidated return with such
organization for such year.
(D) Nonrecognition of gain
If property used directly in the performance of the exempt
function of an organization described in paragraph (7), (9),
(17), or (20) of section 501 (c) is sold by such
organization, and within a period beginning 1 year before
the date of such sale, and ending 3 years after such date,
other property is purchased and used by such organization
directly in the performance of its exempt function, gain (if
any) from such sale shall be recognized only to the extent
that such organization’s sales price of the old property
exceeds the organization’s cost of purchasing the other
property. For purposes of this subparagraph, the
destruction in whole or in part, theft, seizure, requisition,
or condemnation of property, shall be treated as the sale of
such property, and rules similar to the rules provided by
subsections (b), (c), (e), and (j) of section 1034 (as in effect
on the day before the date of the enactment of the
Taxpayer Relief Act of 1997) shall apply.
(E) Limitation on amount of setaside in the case of organizations
described in paragraph (9), (17), or (20) of section 501 (c)
(i) In general In the case of any organization described in
paragraph (9), (17), or (20) of section 501 (c), a
set-aside for any purpose specified in clause (ii) of
subparagraph (B) may be taken into account under
subparagraph (B) only to the extent that such
set-aside does not result in an amount of assets set
aside for such purpose in excess of the account
limit determined under section 419A (without
regard to subsection (f)(6) thereof) for the taxable
year (not taking into account any reserve
described in section 419A (c)(2)(A) for
post-retirement medical benefits).
(ii) Treatment of existing reserves for post-retirement
medical or life insurance benefits
(I) Clause (i) shall not apply to any income
attributable to an existing reserve for
post-retirement medical or life insurance
benefits.
(II) For purposes of subclause (I), the term
“reserve for post-retirement medical or
life insurance benefits” means the greater
of the amount of assets set aside for
purposes of post-retirement medical or
life insurance benefits to be provided to
covered employees as of the close of the
last plan year ending before the date of
the enactment of the Tax Reform Act of
1984 or on July 18, 1984.
(III) All payments during plan years ending on or
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after the date of the enactment of the Tax
Reform Act of 1984 of post-retirement
medical benefits or life insurance benefits
shall be charged against the reserve
referred to in subclause (II). Except to the
extent provided in regulations prescribed
by the Secretary, all plans of an employer
shall be treated as 1 plan for purposes of
the preceding sentence.
(iii) Treatment of tax exempt organizations This
subparagraph shall not apply to any organization
if substantially all of the contributions to such
organization are made by employers who were
exempt from tax under this chapter throughout the
5-taxable year period ending with the taxable year
in which the contributions are made.
(4) Special rule applicable to organizations described in section 501 (c)(19)
In the case of an organization described in section 501 (c)(19), the
term “unrelated business taxable income” does not include any
amount attributable to payments for life, sick, accident, or health
insurance with respect to members of such organizations or their
dependents which is set aside for the purpose of providing for the
payment of insurance benefits or for a purpose specified in section
170 (c)(4). If an amount set aside under the preceding sentence is
used during the taxable year for a purpose other than a purpose
described in the preceding sentence, such amount shall be included,
under paragraph (1), in unrelated business taxable income for the
taxable year.
(5) Definition of payments with respect to securities loans
(A) The term “payments with respect to securities loans” includes
all amounts received in respect of a security (as defined in
section 1236 (c)) transferred by the owner to another
person in a transaction to which section 1058 applies
(whether or not title to the security remains in the name of
the lender) including—
(i) amounts in respect of dividends, interest, or other
distributions,
(ii) fees computed by reference to the period beginning
with the transfer of securities by the owner and
ending with the transfer of identical securities
back to the transferor by the transferee and the fair
market value of the security during such period,
(iii) income from collateral security for such loan, and
(iv) income from the investment of collateral security.
(B) Subparagraph (A) shall apply only with respect to securities
transferred pursuant to an agreement between the
transferor and the transferee which provides for—
(i) reasonable procedures to implement the obligation of
the transferee to furnish to the transferor, for each
business day during such period, collateral with a
fair market value not less than the fair market
value of the security at the close of business on the
preceding business day,
(ii) termination of the loan by the transferor upon notice of
not more than 5 business days, and
(iii) return to the transferor of securities identical to the
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transferred securities upon termination of the loan.
Section 513. Unrelated trade or business
(a) General rule
The term “unrelated trade or business” means, in the case of any
organization subject to the tax imposed by section 511, any trade or
business the conduct of which is not substantially related (aside from the
need of such organization for income or funds or the use it makes of the
profits derived) to the exercise or performance by such organization of its
charitable, educational, or other purpose or function constituting the basis
for its exemption under section 501 (or, in the case of an organization
described in section 511 (a)(2)(B), to the exercise or performance of any
purpose or function described in section 501 (c)(3)), except that such term
does not include any trade or business—
(1) in which substantially all the work in carrying on such trade or business
is performed for the organization without compensation; or
(2) which is carried on, in the case of an organization described in section
501 (c)(3) or in the case of a college or university described in
section 511 (a)(2)(B), by the organization primarily for the
convenience of its members, students, patients, officers, or
employees, or, in the case of a local association of employees
described in section 501 (c)(4) organized before May 27, 1969,
which is the selling by the organization of items of work-related
clothes and equipment and items normally sold through vending
machines, through food dispensing facilities, or by snack bars, for
the convenience of its members at their usual places of
employment; or
(3) which is the selling of merchandise, substantially all of which has been
received by the organization as gifts or contributions.
(2)
It has debt-financed income. Read sections 512 and 513; Reg. §1.664-1(c).
(3)
It fails to pay the unitrust amount to the beneficiary within the time required
to file the trust's form 5227 for the year (including extensions). Read Reg.
§1.664-3(a)(1)(i)(a).
(4)
It does not pay real property taxes or assessments by the due date. Read
section 514(c)(2)(C), which states as follows:
Section 514. Unrelated debt-financed income
(c) Acquisition indebtedness
(2) Property acquired subject to mortgage, etc.
For purposes of this subsection—
(C) Liens for taxes or assessments
Where State law provides that—
(i) a lien for taxes, or
(ii) a lien for assessments,
made by a State or a political
subdivision thereof attaches to
property prior to the time when
such taxes or assessments
become due and payable, then
such lien shall be treated as
similar to a mortgage (within the
meaning of subparagraph (A))
but only after such taxes or
assessments become due and
payable and the organization has
had an opportunity to pay such
taxes or assessments in
accordance with State law.
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(5)
bb.
It has mortgaged property. Read section 514(c)(2)(a), (b), which states as
follows:
Section 514. Unrelated debt-financed income
(c) Acquisition indebtedness
(2) Property acquired subject to mortgage, etc.
For purposes of this subsection—
(A) General rule
Where property (no matter how acquired)
is acquired subject to a mortgage or other
similar lien, the amount of the
indebtedness secured by such mortgage or
lien shall be considered as an
indebtedness of the organization incurred
in acquiring such property even though
the organization did not assume or agree
to pay such indebtedness.
(B) Exceptions
Where property subject to a mortgage is
acquired by an organization by bequest or
devise, the indebtedness secured by the
mortgage shall not be treated as
acquisition indebtedness during a period
of 10 years following the date of the
acquisition. If an organization acquires
property by gift subject to a mortgage
which was placed on the property more
than 5 years before the gift, which
property was held by the donor more than
5 years before the gift, the indebtedness
secured by such mortgage shall not be
treated as acquisition indebtedness during
a period of 10 years following the date of
such gift. This subparagraph shall not
apply if the organization, in order to
acquire the equity in the property by
bequest, devise, or gift, assumes and
agrees to pay the indebtedness secured by
the mortgage, or if the organization makes
any payment for the equity in the property
owned by the decedent or the donor.
(a)
An exception is made when the property was mortgaged more than
five years before the inter vivos transfer to the trust and the donor
owned the property more than fives years before the transfer to the
trust.
(b)
As a result, the trust should not be deemed to have an acquisition
indebtedness during the ten years following the transfer to the trust.
(c)
This exception does not apply if the mortgaged property was
transferred to the trust by the donor's will.
Charitable remainder unitrusts can benefit the remainder person immediately by
letting the charitable organization use the assets as collateral. Read Private Letter
Ruling Nos. 8807082 & 88223057.
(1)
College pledged its securities by placing them in a special account where
no trading was allowed with the income from the securities flowing to the
unitrust to allow it to make payments to the noncharitable income
beneficiaries.
(a)
The trustees, the charitable remaindermen and the income
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(b)
CC.
beneficiaries were to be made parties to any loan agreement.
The IRS approved collateral clause in the trust instrument provided
that in the event of default by one of the remaindermen, the trustees
had the discretion to severe the pledged assets from the trust estate
and deliver them to the creditors on behalf of the remainder person
in return for a note from the remainder person evidencing an
obligation to pay the unitrust the amount equal to the value of the
severed assets.
Charitable lead trusts.
1.
A charitable lead trust generates income interest which is payable to a charitable organization
for a term of years specified by the transferor after which the principal reverts to the
transferor or to others designated by the transferor. Read Reg. §1.170a-6(c)(2).
a.
The term may also be measured by the life or lives of a beneficiary or beneficiaries
living at the date of transfer, plus a term of years.
b.
Example. John establishes a charitable lead trust benefitting Indiana University.
The trust's income, which will be paid directly to the Indiana University, is $10,000
annually. John and Indiana University establish the following terms of the
charitable lead trust.
(1)
The trust will generate income interest to benefit the local university for
fifteen years.
(2)
At the termination of the charitable lead trust, the principal will revert to the
transferor's son.
(3)
The transferor may also assign, as the term of years for the existence of the
charitable lead trust, the life of transferor or the transferor's spouse.
(4)
In this example, at the death of the transferor or the transferor's spouse, the
principal would revert to the remainder beneficiary.
c.
From a planning standpoint, the charitable lead trust resembles a private foundation,
providing ongoing support for one or more charitable organizations.
d.
When the charitable lead trust is used to make a charitable contribution, a charitable
contribution deduction, for income tax purposes, is allowable for the present value
of the income interest transferred to the charitable organization. Read Reg.
§1.170a-6(c)(2)(i)(c).
e.
In order to qualify for a charitable contribution deduction, for income tax purposes,
under section x 170, for the amounts paid to the charitable organization, the income
interest must be in the form of either a "guaranteed annuity interest", or a "unitrust
interest", and the transferor must be treated as the owner of the interest for the
purpose of applying the transferor trust rules under section x 671. Read Reg.
§1.170a-6(c).
(1)
A "guaranteed annuity interest" is an irrevocable right, stated in the
governing instrument, to receive an amount specified at the time of transfer
to be paid at least annually.
(a)
Example. Peter who establishes a guaranteed annuity interest would
make a charitable contribution of a specific dollar amount each year
to the income beneficiary of the charitable lead trust. If the trust's
fair market value is $100,000 in the first year, and the specific
dollar amount agreed to was $10,000, then the charitable
organization would receive $10,000. If the trust's fair market value
is $120,000 in the third year, then the charitable organization will
still receive the annual annuity in the amount of $10,000.
(2)
A "unitrust interest", is an irrevocable right, stated in the governing
instrument, to receive payment of a fixed percentage of the new fair market
value of the trust assets determined each year and to be paid not less often
than annually.
(a)
Example. The transferor who establishes a unitrust interest would
make a charitable contribution of a specific percentage of the
charitable lead trust's fair market value, such value to be re-
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f.
evaluated on an annual basis.
i)
If the trust's fair market value is $100,000 in the first year,
and the specific percentage, as agreed to when the trust
was established, is nine percent, then the charitable
organization will receive $9,000 in the first year.
ii)
If the trust's fair market value is $120,000, in the third
year, after the annual re-evaluation, then the charitable
organization will receive $10,800 (nine percent x
$120,000).
There are basically two types of qualified charitable lead trusts. Read section
170(f)(2)(b), which states as follows:
Section 170. Charitable, etc., contributions and gifts
(f) Disallowance of deduction in certain cases and special rules
(2) Contributions of property placed in trust
(B) Income interests, etc.
No deduction shall be allowed under this
section for the value of any interest in
property (other than a remainder interest)
transferred in trust unless the interest is in
the form of a guaranteed annuity or the
trust instrument specifies that the interest
is a fixed percentage distributed yearly of
the fair market value of the trust property
(to be determined yearly) and the grantor
is treated as the owner of such interest for
purposes of applying section 671. If the
donor ceases to be treated as the owner of
such an interest for purposes of applying
section 671, at the time the donor ceases
to be so treated, the donor shall for
purposes of this chapter be considered as
having received an amount of income
equal to the amount of any deduction he
received under this section for the
contribution reduced by the discounted
value of all amounts of income earned by
the trust and taxable to him before the
time at which he ceases to be treated as
the owner of the interest. Such amounts of
income shall be discounted to the date of
the contribution. The Secretary shall
prescribe such regulations as may be
necessary to carry out the purposes of this
subparagraph.
(1)
The transferor can get a charitable contribution deduction, for income tax
purposes, for the present value of the income earned and paid to the
charitable organization, at the cost of the transferor being taxed on the trust
income as the income is earned.
(a)
This is called a "grantor, qualified charitable lead trust".
(b)
Example 81. John makes a charitable contribution to the local art
museum of a charitable lead trust, for a term of 15 years. The
charitable lead trust will generate $10,000 annually to the art
museum. If John has a "grantor, qualified charitable lead trust,"
then John will be able to take a charitable contribution deduction,
for income tax purposes, for the $10,000 annual income payment
to the art museum, but John will be taxed, for income tax purposes,
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(2)
(3)
(4)
(5)
(6)
(7)
(8)
on the $10,000 income interest generated by the charitable lead
trust.
The transferor can forego the charitable contribution deduction, for income
tax purpose, for the present value of the income earned and paid to the
charitable organization, and in turn, the transferor will not be taxed on the
subsequent income earned by the trust.
(a)
This is called a "non-grantor, qualified charitable lead trust".
(b)
Example 82. Mary makes a charitable contribution to the local art
museum of a charitable lead trust, for a term of fifteen years. The
charitable lead trust will generate $10,000 annually to the art
museum. If the grantor has a non-grantor, qualified charitable lead
trust, then Mary will not be able to take a charitable contribution
deduction, for income tax purposes, for the $10,000 annual income
payment to the art museum, but Mary will not be taxed, for income
purposes, on the $10,000 income interest generated by the
charitable lead trust.
The creation of a charitable lead trust can yield a charitable contribution of
an income interest to the charitable organization and a charitable
contribution of the remainder interest in the trust principal.
(a)
The income interest must be in the form of either a guaranteed
annuity or a unitrust interest.
(b)
The remainder interest must be assigned irrevocably and the value
determined by the present value of the remainder interest, valued
at the time the charitable contribution is made.
Charitable lead trusts are used extensively in order to reduce the transfer
tax.
(a)
The assets of the trust are transferred to a non-charitable
beneficiary by using a non-grantor qualified charitable lead trust,
thereby reducing the gift or estate tax.
i)
The transferor, and the transferor's estate, is entitled to a
charitable contribution deduction, for estate or gift tax
purposes, for the charitable lead interest that offsets the
taxable value of the remainder interest.
(b)
However, the transferor must be willing to accept a significant time
delay before the transferor's individual beneficiaries receive the
transferred property.
For a charitable lead trust created at death, it must be a qualified trust in
order for the charitable contribution to qualify for a charitable contribution
deduction, for estate tax purposes.
The IRC allows a charitable lead to be established outside of a trust as long
as the unitrust or annuity interest requirements are met and as long as the
interest is to be paid by an insurance company or other organization which
regularly issues annuity contracts or unitrust interests. Read Reg. §202055-2(e)(2)(v)(c).
There is no minimum or maximum annuity or unitrust amount which must
be paid to the charitable organization income beneficiary.
The guaranteed annuity interest is irrevocable, and pays a specific amount,
to the recipient charitable organization income beneficiary, for a specific
term of years or for the life or lives of beneficiaries, living and ascertainable
at the time the interest is transferred. Read Reg. §1.170a-6(c)(2)(i)(a).
(a)
The annuity amount may be expressed in terms of a fraction or a
percentage of an index, at the time the charitable contribution is
transferred.
(b)
The charitable annuity interest income will not qualify as a
guaranteed annuity interest if it is expressed in terms of the lesser
of a sum certain or a fixed percentage.
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(c)
(9)
(10)
The trust instrument creating the guaranteed annuity interest must
specify that if the trust income is insufficient, in any given year, to
meet the annuity payments, the difference must be paid from the
trust principal.
The unitrust interest is irrevocable, and gives the recipient charitable
organization income beneficiary a right to receive payment of a fixed
percentage of the fair market value of the trust assets. Read Reg. §1.170a6(c)(2)(ii)(a).
(a)
The fair market value of the trust assets is determined annually, on
a valuation date specified in the trust instrument.
(b)
The unitrust interest may be for a specific term of years or for the
life or lives of individuals, living and ascertainable at the time the
interest is transferred.
(c)
The charitable unitrust interest income will not qualify as a unitrust
interest if the interest is expressed in terms of the lesser of a sum
certain or a unitrust amount.
(d)
Unlike the guaranteed annuity interest, additional charitable
contributions may be made to the unitrust interest.
The governing instrument of the qualified charitable lead trust must
specifically prohibit self-dealing and any taxable expenditures. Read
section 508(a), which states as follows:
Section 508. Special rules with respect to section 501 (c)(3) organizations
(a) New organizations must notify Secretary that they are applying
for recognition of section 501 (c)(3) status
Except as provided in subsection (c), an organization
organized after October 9, 1969, shall not be treated as an
organization described in section 501 (c)(3)—
(1) unless it has given notice to the Secretary in such
manner as the Secretary may by regulations prescribe, that
it is applying for recognition of such status, or
(2) for any period before the giving of such notice, if such
notice is given after the time prescribed by the
Secretary by regulations for giving notice under
this subsection.
(a)
Additional prohibitions, such as those specified in section x 4943
(against excess business holdings) and in section x 4944 (against
risky investments), do not apply to a charitable lead trust unless the
total amount of all charitably deductible assets, for income tax
purposes, in the trust equal more than 60% of the fair market value
of the total assets in the charitable lead trust. Read section
4947(b)(3)(A), which states as follows:
Section 4947. Application of taxes to certain nonexempt trusts
(b) Special rules
(3) Sections 4943 and 4944
Sections 4943 and 4944 shall not apply to
a trust which is described in subsection
(a)(2) if—
(A) all the income interest (and
none of the remainder interest) of
such trust is devoted solely to one
or more of the purposes described
in section 170 (c)(2)(B), and all
amounts in such trust for which a
deduction was allowed under
section 170, 545 (b)(2), 642 (c),
2055, 2106 (a)(2), or 2522 have
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(11)
(12)
an aggregate value not more than
60 percent of the aggregate fair
market value of all amounts in
such trusts, or
i)
The excess business holdings and risky investments
prohibitions create the greatest concern for charitable lead
trusts funded with closely held stock.
ii)
If the charitable lead trust, in conjunction with the
transferor, the trustee and members of the transferor's and
trustee's families, own more than 20% of the voting stock
of a corporation, then the charitable lead trust will be
required to dispose of the stock within five years of the
establishment of the charitable lead trust.
iii)
If the charitable lead trust is funded with risky investments,
then the charitable lead trust will be required to dispose of
the stock immediately.
(b)
If the charitable lead trust is funded with closely held stock, then
the transferor can avoid the 60% rule, noted above, by determining
a specific annuity amount as a percent of the initial fair market
value of the charitable lead trust property. Read Reg. §1.170a6(c)(2)(ii)(d).
If the transferor establishes a testamentary charitable lead trust, then the
assets are to be valued at the fair market value at the date of death, and not
the date when the asset was transferred into the trust.
In order for the transferor to receive a charitable contribution deduction, for
income tax purposes, for income generated by the charitable lead trust, the
transferor must be treated as owning the trust by complying with one of the
following requirements. Read section 170(f)(2)(b), which states as follows:
170(f)(2)(b), which states as follows:
Section 170. Charitable, etc., contributions and gifts
(f) Disallowance of deduction in certain cases and special rules
(2) Contributions of property placed in trust
(B) Income interests, etc.
No deduction shall be allowed under this
section for the value of any interest in
property (other than a remainder interest)
transferred in trust unless the interest is in
the form of a guaranteed annuity or the
trust instrument specifies that the interest
is a fixed percentage distributed yearly of
the fair market value of the trust property
(to be determined yearly) and the grantor
is treated as the owner of such interest for
purposes of applying section 671. If the
donor ceases to be treated as the owner of
such an interest for purposes of applying
section 671, at the time the donor ceases
to be so treated, the donor shall for
purposes of this chapter be considered as
having received an amount of income
equal to the amount of any deduction he
received under this section for the
contribution reduced by the discounted
value of all amounts of income earned by
the trust and taxable to him before the
time at which he ceases to be treated as
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(a)
(b)
(c)
the owner of the interest. Such amounts of
income shall be discounted to the date of
the contribution. The Secretary shall
prescribe such regulations as may be
necessary to carry out the purposes of this
subparagraph.
The transferor retains a reversionary interest in the charitable lead
trust principal or income, or an amount equal to or greater than five
percent of the actuarial value of the charitable lead trust principal.
Read section 673(a), which states as follows:
Section 673. Reversionary interests
(a) General rule
The grantor shall be treated as the owner of any
portion of a trust in which he has a reversionary
interest in either the corpus or the income
therefrom, if, as of the inception of that portion of
the trust, the value of such interest exceeds 5
percent of the value of such portion.
The transferor, or a non-adverse party, retains control over the
beneficial enjoyment of the charitable lead trust's income or
principal. Read section 674(a), which states as follows:
Section 674. Power to control beneficial enjoyment
(a) General rule
The grantor shall be treated as the owner of any
portion of a trust in respect of which the beneficial
enjoyment of the corpus or the income therefrom
is subject to a power of disposition, exercisable by
the grantor or a nonadverse party, or both, without
the approval or consent of any adverse party.
i)
A non-adverse party is one who does not have a substantial
interest in the party which would be adversely affected by
the exercise or nonexercise of such control.
The transferor retains certain administrative powers over the
charitable lead trust which the transferor could exercise for the
benefit of self. Read section 675, which states as follows:
Section 675. Administrative powers
The grantor shall be treated as the owner of any portion of a trust
in respect of which—
(1) Power to deal for less than adequate and full
consideration A power exercisable by the grantor or a
nonadverse party, or both, without the approval or consent
of any adverse party enables the grantor or any person to
purchase, exchange, or otherwise deal with or dispose of
the corpus or the income therefrom for less than an
adequate consideration in money or money’s worth.
(2) Power to borrow without adequate interest or security
A power exercisable by the grantor or a
nonadverse party, or both, enables the grantor to
borrow the corpus or income, directly or
indirectly, without adequate interest or without
adequate security except where a trustee (other
than the grantor) is authorized under a general
lending power to make loans to any person
without regard to interest or security.
(3) Borrowing of the trust funds
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(d)
(e)
The grantor has directly or indirectly borrowed the
corpus or income and has not completely repaid
the loan, including any interest, before the
beginning of the taxable year. The preceding
sentence shall not apply to a loan which provides
for adequate interest and adequate security, if such
loan is made by a trustee other than the grantor
and other than a related or subordinate trustee
subservient to the grantor. For periods during
which an individual is the spouse of the grantor
(within the meaning of section 672 (e)(2)), any
reference in this paragraph to the grantor shall be
treated as including a reference to such individual.
(4) General powers of administration
A power of administration is exercisable in a
nonfiduciary capacity by any person without the
approval or consent of any person in a fiduciary
capacity. For purposes of this paragraph, the term
“power of administration” means any one or more
of the following powers:
(A) a power to vote or direct the voting of stock or
other securities of a corporation in which
the holdings of the grantor and the trust
are significant from the viewpoint of
voting control;
(B) a power to control the investment of the trust
funds either by directing investments or
reinvestments, or by vetoing proposed
investments or reinvestments, to the
extent that the trust funds consist of
stocks or securities of corporations in
which the holdings of the grantor and the
trust are significant from the viewpoint of
voting control; or
(C) a power to reacquire the trust corpus by
substituting other property of an equivalent value.
The transferor, or a non-adverse party, has the power to regain title
to the charitable lead trust remainder or income interest for the
benefit of self. Read section 676(a), which states as follows:
Section 676. Power to revoke
(a) General rule
The grantor shall be treated as the owner of any portion of
a trust, whether or not he is treated as such owner under
any other provision of this part, where at any time the
power to revest in the grantor title to such portion is
exercisable by the grantor or a non-adverse party, or both.
The transferor, or a non-adverse party, has the power to distribute
charitable lead trust income for the benefit of self. Read section
677(a), which states as follows:
Section 677. Income for benefit of grantor
(a) General rule
The grantor shall be treated as the owner of any
portion of a trust, whether or not he is treated as
such owner under section 674, whose income
without the approval or consent of any adverse
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(13)
(14)
party is, or, in the discretion of the grantor or a
nonadverse party, or both, may be—
(1) distributed to the grantor or the grantor’s
spouse;
(2) held or accumulated for future distribution to
the grantor or the grantor’s spouse; or
(3) applied to the payment of premiums on
policies of insurance on the life of the grantor or
the grantor’s spouse (except policies of insurance
irrevocably payable for a purpose specified in
section 170 (c) (relating to definition of charitable
contributions)).
This subsection shall not apply to a power the exercise of
which can only affect the beneficial enjoyment of the
income for a period commencing after the occurrence of an
event such that the grantor would not be treated as the
owner under section 673 if the power were a reversionary
interest; but the grantor may be treated as the owner after
the occurrence of the event unless the power is
relinquished.
(f)
The transferor's spouse has any of these five powers noted above,
and the transferor and transferor's spouse were living together at the
time the power was created. Read section 672(e), which states as
follows:
Section 672. Definitions and rules
(e) Grantor treated as holding any power or interest of
grantor’s spouse
(1) In general
For purposes of this subpart, a grantor
shall be treated as holding any power or
interest held by—
(A) any individual who was the spouse of
the grantor at the time of the
creation of such power or
interest, or
(B) any individual who became the
spouse of the grantor after the creation of
such power or interest, but only with
respect to periods after such individual
became the spouse of the grantor.
(2) Marital status
For purposes of paragraph (1)(A), an
individual legally separated from his
spouse under a decree of divorce or of
separate maintenance shall not be
considered as married.
If the transferor ceases to be treated as the owner of a charitable lead trust,
before the charitable lead trust interest expires, then the transferor must
recapture a portion of the charitable contribution deduction, for income tax
purposes, taken for the income interest of the charitable lead trust. Read
Reg. §20-2031-7(f).
If the transferor of a charitable lead trust does not choose to take a
charitable contribution deduction, for income tax purposes, for the present
value of the charitable lead trust's income interest, then the transferor can
still create a non-grantor qualified charitable lead trust to get a charitable
contribution deduction, for gift or estate tax purposes, for the charitable lead
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trust's creation.
(a)
A testamentary non-grantor qualified charitable lead trust will
reduce estate taxes while an inter vivos non-grantor qualified
charitable lead trust will reduce gift taxes.
g.
The transferor of a qualified charitable lead trust is allowed a charitable contribution
deduction, for income tax purposes, for the present value of the charitable lead
trust's interest at its creation.
(1)
The charitable contribution deduction, for income tax purposes, allowed for
a guaranteed annuity interest is the present fair market value of such
guaranteed annuity interest at the charitable lead trust's creation.
(2)
The charitable contribution deduction, for income tax purposes, allowed for
a unitrust interest is the excess of the fair market value of the property
transferred into the charitable lead trust over the present value of the
nonunitrust interests in the property transferred into the charitable lead trust.
(3)
Example 83. The transferor makes a charitable contribution of a charitable
lead trust to the local university.
(a)
The trust, which will generate $25,000 annually, will enable the
transferor to take a charitable contribution deduction, for income
tax purposes, for the present value of the charitable lead trust's
interest at the time of the creation of the trust.
h.
The creation and funding of a qualified testamentary charitable lead trust allows the
estate to take a charitable contribution deduction, for estate tax purposes, for the
present value of the charitable annuity or unitrust interest.
i.
A non-qualified charitable lead trust, which does not comply with the requirements
for a qualified charitable lead trust will not yield any charitable contribution
deduction, for income, gift, or estate tax purposes, to the transferor. Read Reg.
§1.170-6(d)(3).
(1)
The transferor may make a charitable contribution of the lead interest, but
the charitable contribution must be made annually after the lead trust
income has been generated and distributed.
j.
A charitable lead trust is best for an individual whose annual charitable contributions
are greater than the maximum annual charitable contribution deduction, for income
tax purposes, allowed.
(1)
If the remainder passes to someone other than the transferor or the grantor's
spouse, then the transferor will be making a charitable contribution with
before-tax dollars rather than after-tax dollars.
k.
The charitable lead trust is considered to be a charitable contribution for the use of
the charitable organization.
(1)
The transferor is, therefore, permitted a 30% charitable contribution
deduction, for income tax purposes. Read section 170(b)(1)(b), which
states as follows:
Section 170. Charitable, etc., contributions and gifts
(b) Percentage limitations
(1) Individuals
In the case of an individual, the deduction provided in subsection
(a) shall be limited as provided in the succeeding subparagraphs.
(B) Other contributions
Any charitable contribution other than a charitable
contribution to which subparagraph (A) applies shall be
allowed to the extent that the aggregate of such
contributions does not exceed the lesser of—
(i) 30 percent of the taxpayer’s contribution base for the
taxable year, or
(ii) the excess of 50 percent of the taxpayer’s contribution
base for the taxable year over the amount of
charitable contributions allowable under
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l.
m.
n.
o.
subparagraph (A) (determined without regard to
subparagraph (C)).
If the aggregate of such contributions exceeds the
limitation of the preceding sentence, such excess
shall be treated (in a manner consistent with the
rules of subsection (d)(1)) as a charitable
contribution (to which subparagraph (A) does not
apply) in each of the 5 succeeding taxable years in
order of time.
(2)
Example 84. Because the charitable lead trust will yield cash charitable
contributions to the charitable organization, cash charitable contributions
are considered to be for the use of the charitable organization.
The charitable lead trust can be used to generate advantages, for income tax
purposes, by funding the trust with tax exempt bonds.
(1)
When the trust principal reverts back to the transferor, or the transferor's
spouse or another beneficiary, no income tax will be due on the gain.
There is no minimum requirement for the percentage or monetary payout as with the
charitable remainder unitrust or annuity trust.
When the charitable lead trust terminates, the remainder interest may either revert
back to the transferor or the transferor's spouse (reverter trust), or to another
beneficiary as designated by the transferor (non-reverter trust).
(1)
With a reverter trust, the transferor is taxed on the income generated.
(2)
With a non-reverter trust, the transferor is not taxed on the income
generated.
If the transferor irrevocably assigns the charitable lead trust remainder interest to
another charitable organization after the charitable income interest has expired, then
the transferor makes a completed charitable contribution of the future interest in the
charitable lead trust's principal.
(1)
For a guaranteed annuity, the value of the charitable lead trust remainder
interest equals the fair market value of the property transferred into the
charitable lead trust, less the present value of the charitable annuity interest.
Read section 7520(a), which states as follows:
Section 7520. Valuation tables
(a) General rule
For purposes of this title, the value of any annuity, any
interest for life or a term of years, or any remainder or
reversionary interest shall be determined—
(1) under tables prescribed by the Secretary, and
(2) by using an interest rate (rounded to the nearest 2/10ths
of 1 percent) equal to 120 percent of the Federal
midterm rate in effect under section 1274 (d)(1)
for the month in which the valuation date falls.
If an income, estate, or gift tax charitable
contribution is allowable for any part of the
property transferred, the taxpayer may elect to use
such Federal midterm rate for either of the 2
months preceding the month in which the
valuation date falls for purposes of paragraph (2).
In the case of transfers of more than 1 interest in
the same property with respect to which the
taxpayer may use the same rate under paragraph
(2), the taxpayer shall use the same rate with
respect to each such interest.
(2)
For a unitrust interest, the value of the remainder interest equals the fair
market value of the property transferred into the charitable lead trust, times
the interest factor representing the present value of the right to receive the
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p.
remainder in the future. Read section 7520(a), which states as follows:
Section 7520. Valuation tables
(a) General rule
For purposes of this title, the value of any annuity, any
interest for life or a term of years, or any remainder or
reversionary interest shall be determined—
(1) under tables prescribed by the Secretary, and
(2) by using an interest rate (rounded to the nearest 2/10ths
of 1 percent) equal to 120 percent of the Federal
midterm rate in effect under section 1274 (d)(1)
for the month in which the valuation date falls.
If an income, estate, or gift tax charitable
contribution is allowable for any part of the
property transferred, the taxpayer may elect to use
such Federal midterm rate for either of the 2
months preceding the month in which the
valuation date falls for purposes of paragraph (2).
In the case of transfers of more than 1 interest in
the same property with respect to which the
taxpayer may use the same rate under paragraph
(2), the taxpayer shall use the same rate with
respect to each such interest.
If the transferor funds the charitable lead trust with appreciated property, then the
transferor must be aware that if the trustee sells the property at a gain, within two
years after the trust's creation, the gain will be taxed at the transferor's income tax
rate. Read section 644(a), which states as follows:
Section 644. Taxable year of trusts
(a) In general
For purposes of this subtitle, the taxable year of any trust shall be
the calendar year.
(b) Exception for trusts exempt from tax and charitable trusts
Subsection (a) shall not apply to a trust exempt from taxation under
section 501 (a) or to a trust described in section 4947 (a)(1).
(1)
If the transferor or the transferor's spouse has a remainder interest in the
charitable lead trust, created before March 2, 1986, then the capital gain
gross income is allocated to the principal, and the transferor must include
the gains in the transferor's taxable income. Read section 677(a), which
states as follows:
Section 677. Income for benefit of grantor
(a) General rule
The grantor shall be treated as the owner of any portion of
a trust, whether or not he is treated as such owner under
section 674, whose income without the approval or consent
of any adverse party is, or, in the discretion of the grantor
or a nonadverse party, or both, may be—
(1) distributed to the grantor or the grantor’s spouse;
(2) held or accumulated for future distribution to the
grantor or the grantor’s spouse; or
(3) applied to the payment of premiums on policies of
insurance on the life of the grantor or the grantor’s spouse
(except policies of insurance irrevocably payable for a
purpose specified in section 170 (c) (relating to definition
of charitable contributions)).
This subsection shall not apply to a power the
exercise of which can only affect the beneficial
enjoyment of the income for a period commencing
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q.
r.
after the occurrence of an event such that the
grantor would not be treated as the owner under
section 673 if the power were a reversionary
interest; but the grantor may be treated as the
owner after the occurrence of the event unless the
power is relinquished.
(2)
If the transferor or the transferor's spouse has a remainder interest in the
charitable lead trust, created on or after March 2, 1986, then the transferor
will be treated as the owner of the charitable lead trust, and will be taxed on
all gains along with the other charitable lead trust income.
If the charitable lead trust is funded with appreciated property other than securities,
then the transferor will get a charitable contribution deduction, for income tax
purposes, only for the cost basis of the property attributed to the charitable
organization's interest.
(1)
Example 85. The transferor makes a charitable contribution of a charitable
lead trust funded with securities the transferor has held for 13 years.
(a)
The transferor purchased the securities for $5,000, and the present
fair market value of the securities is $30,000.
(b)
The transferor may take a charitable contribution deduction, for
income tax purposes, for the cost basis of the property contributed
to fund the charitable lead trust, or $5,000.
Potential problems with charitable lead trusts
(1)
Using a charitable lead trust for income tax deductions may cause cash flow
restrictions if the trust assets are invested in non tax-free investment.
(2)
Also, alternative minimum tax problems may arise as a result of receiving
tax-free income.
(3)
The transferor's death during the trust terms may cause estate tax problems
because the value of the transferor's reversionary interest would be included
in the transferor's taxable estate.
(4)
The transferor's allocation of the transferor's generation-skipping tax
exemption may be too little or too much at the time of termination because
the generation-skipping transfer exemption is adjusted at the interest rate
applicable at the time of the gift.
Read section 2642(e), which states as follows:
Section 2642. Inclusion ratio
(e) Special rules for charitable lead annuity trusts
(1) In general
For purposes of determining the inclusion ratio for
any charitable lead annuity trust, the applicable
fraction shall be a fraction—
(A) the numerator of which is the adjusted GST
exemption, and
(B) the denominator of which is the value of all of
the property in such trust immediately
after the termination of the charitable lead
annuity.
(2) Adjusted GST exemption
For purposes of paragraph (1), the adjusted GST
exemption is an amount equal to the GST
exemption allocated to the trust increased by
interest determined—
(A) at the interest rate used in determining the
amount of the deduction under section 2055 or
2522 (as the case may be) for the charitable lead
annuity, and
(B) for the actual period of the charitable lead
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(5)
DD.
annuity.
(3) Definitions
For purposes of this subsection—
(A) Charitable lead annuity trust
The term “charitable lead annuity trust”
means any trust in which there is a
charitable lead annuity.
(B) Charitable lead annuity
The term “charitable lead annuity” means
any interest in the form of a guaranteed
annuity with respect to which a deduction
was allowed under section 2055 or 2522
(as the case may be).
(4) Coordination with subsection (d)
Under regulations, appropriate
adjustments shall be made in the
application of subsection (d) to take into
account the provisions of this subsection.
Current IRS tables may make it necessary to consume corpus to make the
lead payment, thereby reducing the amount of property to pass upon
termination to the non-charitable beneficiaries.
Pooled income funds.
1.
A trust to which each transferor transfers property, contributing an irrevocable remainder
interest in such property to or for the use of a charitable organization and retaining an income
interest for the life of one or more beneficiaries living at the time the property was
transferred. Read Reg. §1.642(c)-5(b)(1).
a.
Only the following charitable organizations are qualified to be remainder men of
pooled income funds: those described in clause (i), (ii), (iii), (iv), (v) or (vi) of
section x 170(b)(1)(a).
b.
The term "one or more beneficiaries" includes members of a named class who are
alive and can be ascertained when property is transferred to the pooled fund.
c.
A corporation may be a donor to a pooled income fund, but not an income
beneficiary. Read Rev. Rul. 85-69, 1985-1 C.B. 183.
d.
All property transferred by the transferors is commingled. Read Reg. §1.642(c)5(b)(3).
e.
The charitable organization receiving the remainder interest must "maintain" the
fund. Read Reg. §1.642(c)-5(b)(5).
f.
The income paid from the pooled income fund is all ordinary income, and must be
included in the beneficiary's taxable income. Read Reg. §1.642(c)-5(b)(7).
g.
The charitable contribution deduction, for income tax purposes, for a charitable
contribution to a pooled income fund is determined by the present value of the
remainder interest in the property. Read Reg. §1.642(c)-5(a)(4).
(1)
The present value of the property is determined by reducing the fair market
value of the property transferred into the pooled income fund on the date of
transfer, by the present value of the life income interests as of the date of
transfer.
(2)
The present value of the life interest is determined by the use of a
computation involving the IRS, the age of the beneficiary and anticipated
rate of return from the pooled income fund.
h.
The amount of the charitable contribution allowed by reason of a transfer of
property to a pooled income fund, is to be the highest rate of return earned by the
fund for any of the three taxable years immediately preceding the taxable year in
which the charitable contribution was made. Read Reg. §1.642(c)-6(b).
i.
In exchange for a charitable contribution of cash or securities, the transferor is
assigned units of participation. Read Reg. §1.642(c)-5(c)(2).
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(1)
j.
k.
l.
m.
n.
o.
p.
The number of units assigned is determined by the value of the cash or
securities at the time of the charitable contribution, and the value of the
units, within the fund, then outstanding.
(2)
Example 86. The transferor makes a cash charitable contribution of
$10,000 to the local art museum.
(a)
The transferor selects the pooled income fund because the amount
of money the transferor is contributing is more easily managed in
a pooled income fund, than in a charitable remainder or lead trust.
(b)
The transferor is able to obtain 40 units for the $10,000 charitable
contribution, each unit having a value of $250.
(c)
The transferor may take a charitable contribution deduction, for
income tax purposes, for the present value of the remainder interest
in the property at the transferor's death.
(d)
The present value of the remainder interest is determined by the use
of a computation involving the IRS, the age of the beneficiary and
the anticipated rate of return of the pooled income fund.
A transferor may not make a charitable contribution of tax exempt securities to a
pooled income fund. Read Reg. §1.642(c)-5(b)(4).
A transferor should consider donating only one of two types of property to a pooled
income fund.
(1)
Income producing property.
(2)
Property which can be easily sold and converted into income producing
property.
(3)
Therefore, investments in mutual funds, real estate investment trusts, and
depreciable real property.
All long term capital gains of a pooled income fund must be allocated to corpus and
all short term capital gains may be available to distribute to a pooled income fund's
income beneficiaries. Read section 642(c)(3); Reg. §1.642(c)-2(c); Private Letter
Ruling No. 8404039.
The pooled income fund cannot invest in tax exempt securities. Read Reg.
§1.642(c)-5(b)(4).
The pooled income fund is directed primarily to transferors who have a smaller
amount of money or securities to donate. It allows these modest donors to receive
the same benefits that sizable donors receive through the use of charitable remainder
trusts and unitrusts.
If the income beneficiary is someone other than the transferor, then the current value
of the income beneficiary's interest is considered a gift, for gift tax purposes.
(1)
If the transferor retains a power to revoke the charitable contribution to the
pooled income fund, then the charitable contribution is valued by measuring
the joint life expectancy of the transferor and the income beneficiary.
(a)
A testamentary power to revoke the charitable contribution can
reduce the amount of the completed charitable contribution.
(b)
If the income beneficiary survives the transferor, then the present
value of the charitable contribution is includible in the transferor's
estate, and may immediately take a charitable contribution
deduction, for income tax purposes.
(2)
If the transferor designates the charitable organization who is managing the
pooled income fund as the income beneficiary, then the transferor is entitled
to a charitable contribution deduction, for income tax purposes, of the full
fair market value of the life income interest on the date of the charitable
contribution as well as a deduction for the remainder interest.
If the transferor retains any interest in the pooled income fund, through either an
income interest or a power to revoke, then the fair market value of the property
transferred, along with any gift taxes paid, are included in the transferor's gross
estate.
(1)
A charitable contribution deduction, for estate tax purposes, is allowed for
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the value of the property transferred and the gift taxes paid.
A pooled income fund donor or beneficiary may not also serve as the trustee
of the fund and this prohibition must be cited in the governing instrument
of the pooled income fund.
(a)
For example, board members of a charitable organization who are
beneficiaries and donors of its pooled income fund may not
participate in any way in the management, investment or
maintenance of the fund.
(3)
Example. The transferor makes a cash charitable contribution of $10,000
to a pooled income fund, and designates the transferor as the income
beneficiary of the interest generated.
(a)
At the death of the transferor, the charitable contribution of
$10,000 will come back into the transferor's gross estate.
(b)
The transferor will receive a charitable contribution deduction, for
estate tax purposes, for the $10,000 contribution to the pooled
income fund.
(c)
If there were any gift taxes paid as a result of the income payments
being designated to another non-charitable beneficiary, such as the
transferor's son, then the transferor would also be entitled to a
charitable contribution deduction, for gift tax purposes, for those
gift taxes paid as a result of having made a gift.
A testamentary charitable contribution may be made to a pooled income fund, with
the income interest reserved for a specified beneficiary.
(1)
A charitable contribution deduction, for estate tax purposes, is allowable for
the remainder interest in the testamentary transfer.
(2)
The interest of the transferor's spouse, in a pooled income fund, qualifies for
a marital deduction for estate tax purposes.
The yearly rate of return from the pooled income fund is determined by dividing the
annual income earned by the pooled income fund by an amount equal to the average
fair market value of the fund property for the year less the corrective term
adjustment. Read Reg. §1.642(c)-6(c).
(1)
Yearly rate of return = fund's annual income average fair market value corrective term adjustment
(2)
The corrective term adjustment is the sum of the products obtained by
multiplying each income payment from the fund during the tax year by the
percentage in column two below, corresponding to the period within the tax
year during which the payment was made.
% of payment
(3)
Payment period
Last week of 4th quarter
0%
Balance of 4th quarter
25%
Last week of 3rd quarter
25%
Balance of 3rd quarter
50%
Last week of 2nd quarter
50%
Balance of 2nd quarter
75%
Last week of 1st quarter
75%
Balance of 1st quarter
100%
Pooled income funds are not tax exempt, but the funds do not pay income tax due
to two specific deductions, for income tax purposes, in computing the fund's taxable
income.
(1)
Deduction for amounts required to be distributed annually. Read
(2)
661(a), which states as follows:
Section 661. Deduction for estates and trusts accumulating income or
distributing corpus
(a) Deduction
In any taxable year there shall be allowed as a deduction in
computing the taxable income of an estate or trust (other than a
(2)
q.
r.
s.
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2.
trust to which subpart B applies), the sum of—
(1) any amount of income for such taxable year required to be
distributed currently (including any amount required to be
distributed which may be paid out of income or corpus to
the extent such amount is paid out of income for such
taxable year); and
(2) any other amounts properly paid or credited or required to be
distributed for such taxable year;
but such deduction shall not exceed the distributable net
income of the estate or trust.
(3)
Deduction for amounts permanently set aside for the charitable
organization. Read section 642(c)(1), which states as follows:
Section 642. Special rules for credits and deductions
(c) Deduction for amounts paid or permanently set aside for a charitable purpose
(1) General rule
In the case of an estate or trust (other then [1] a trust meeting the
specifications of subpart B), there shall be allowed as a deduction
in computing its taxable income (in lieu of the deduction allowed
by section 170 (a), relating to deduction for charitable, etc.,
contributions and gifts) any amount of the gross income, without
limitation, which pursuant to the terms of the governing instrument
is, during the taxable year, paid for a purpose specified in section
170 (c) (determined without regard to section 170 (c)(2)(A)). If a
charitable contribution is paid after the close of such taxable year
and on or before the last day of the year following the close of such
taxable year, then the trustee or administrator may elect to treat
such contribution as paid during such taxable year. The election
shall be made at such time and in such manner as the Secretary
prescribes by regulations.
t.
For the year when an income beneficiary dies, the beneficiary's income will either
be pro rated to the date of death or will terminate with the final regular payment of
income made prior to the beneficiary's death.
u.
Some, if not all, of the private foundation prohibitions apply to pooled income
funds.
(1)
Those private foundation prohibitions include: engaging in any act of selfdealing as defined in section x 4941(d); making any taxable expenditure as
defined in section x 4945(d); retaining excess business holdings as defined
in section x 4943(c); and making any investment which jeopardizes its
purposes as defined in section x 4944.
v.
According to a 1983 general counsel's memorandum, a pooled income fund on a
limited basis can pass depreciation and investment credits on the fund's property
through to the income beneficiaries in proportion to their income interests in the
fund. Read G.C.M. 39076.
The charitable gift annuity is an irrevocable charitable contribution of property or money
made by a transferor to a charitable organization in exchange for a promise to pay a fixed
sum of money for a specified period of time to the transferor or another person.
a.
A charitable organization should only accept cash or easily valued assets for a
charitable gift annuity because once the charitable organization does agree to pay
an annuity, it is prohibited from adjusting the payments to reflect a subsequent sale
by it of the property at a price below the value placed on the property when the
annuity was agreed upon.
b.
Planning consideration. Charitable gift annuities may now be the most attractive life
income arrangement for individuals who wish to make a more modest contribution
than normally made to pooled income funds or charitable remainder trusts.
c.
A charitable gift annuity has two elements, a charitable contribution and an annuity
purchase.
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(1)
(2)
d.
e.
f.
g.
h.
i.
The transferor transfers real property to a charitable organization.
The charitable organization agrees to make payments to the transferor for
the transferor's life.
(3)
Example. The transferor makes a cash charitable contribution of $25,000
to the local university in exchange for a charitable gift annuity.
(a)
The local university and the transferor agree upon the following
terms of the charitable gift annuity.
(b)
The charitable organization will pay $2,500 annually to the
transferor for the life of the transferor.
(c)
The charitable organization guarantees, with the assets of the
charitable organization, the annual payments to the transferor for
the life of the transferor.
(d)
Regardless of whether the university is able to earn more than
$2,500 each year or less than $2,500 each year, the transferor will
always receive the same amount annually.
The charitable gift annuities are guaranteed by the entire assets of the charitable
organization.
(1)
The transferor does not retain an interest in the property transferred.
(2)
However, unlike a charitable remainder annuity trust, a charitable gift
annuity's trust payments are made only as long as the trust has sufficient
assets.
The charitable contribution deduction, for income tax purposes, is equal to the
excess of the fair market value of the property transferred over the cost of a
comparable commercial annuity. Read Reg. §1.170a-1(d)(1).
Charitable gift annuities are valued by referencing the tables provided in the estate
and gift tax regulations for valuing the annuities, life estates and remainder interests.
(1)
The annuity tables change every quarter, thus, before referencing an annuity
table, be sure it is the most recent version.
(2)
The annuity tables do not distinguish between men and women and are
based on a 10% rate of interest.
The rates for charitable gift annuities are reset every three years by the committee
on gift annuities.
(1)
The rates are based on an annual interest rate of six and 50% percent
compounded annually, and a unisex mortality basis from 1983 table a,
female mortality assumptions.
The rates are generally higher than rates of insurance companies, and the immediate
charitable contribution deduction, for income tax purposes, received as resulting
from a charitable gift annuity should be treated as a trade-off for those lower rates.
The amount of the charitable contribution deduction, for income tax purposes,
allowed is the excess of the fair market value of the property transferred over the
value of the annuity at the date of the purchase. Read Reg. §1.170a-1(d)(1).
(1)
If the charitable gift annuity is purchased with appreciated property, then
the transferor may realize gain, as under the bargain sale rules.
(2)
If there is no excess, then there will be no charitable contribution.
(3)
If the transferor retains the power to require a repayment of the amount
transferred, before the conclusion date, then the charitable gift annuity will
not be a charitable contribution until the power lapses.
(4)
Example. The transferor makes a charitable contribution of securities
which have a fair market value of $25,000 to the local university in
exchange for a charitable gift annuity.
(a)
The value of the annuity purchased in exchange for the $25,000 in
securities is $21,000.
(b)
The transferor may take a charitable contribution deduction, for
income tax purposes, in the amount of $4,000. ($25,000 (fair
market value of the securities) - $21,000 (value of the annuity at the
date of purchase.))
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j.
k.
l.
m.
Charitable gift annuities are not issued for a specific term of years, but rather in
payment periods.
(1)
Annuitant's or transferor's life.
(2)
The joint lives of two persons, terminating on the death of the first.
(3)
The joint and survivorship lives of the annuitant transferor and another
beneficiary.
Typically, an annuity is payable beginning in the year in which the charitable
contribution was made.
(1)
A deferred payment annuity will begin payments at least one year beyond
the issuance date.
(a)
Since payments will begin at a future date, an adjustment will be
made to reflect a shorter annuity payment period and compounding
of the amount transferred.
(b)
With a deferred payment annuity, the annuitant's payments and the
donor's initial deduction are both somewhat larger.
Once the transferor acquires a charitable gift annuity, the transferor must survive for
three years from the date of acquisition. Read section 2001(b), which states as
follows:
Section 2001. Imposition and rate of tax
(b) Computation of tax
The tax imposed by this section shall be the amount equal to the
excess (if any) of—
(1) a tentative tax computed under subsection (c) on the sum of—
(A) the amount of the taxable estate, and
(B) the amount of the adjusted taxable gifts, over
(2) the aggregate amount of tax which would have been payable
under chapter 12 with respect to gifts made by the decedent after
December 31, 1976, if the provisions of subsection (c) (as in effect
at the decedent’s death) had been applicable at the time of such
gifts.
For purposes of paragraph (1)(B), the term “adjusted taxable gifts” means
the total amount of the taxable gifts (within the meaning of section 2503)
made by the decedent after December 31, 1976, other than gifts which are
includible in the gross estate of the decedent.
(1)
If the transferor dies within three years, then the fair market value of the
charitable contribution transferred will be included in the transferor's gross
estate.
(2)
The transferor's gross estate will be entitled to a charitable contribution
deduction, for estate tax purposes.
If the transferor is contributing appreciated property, then there will be some
recognized gain which must be reported. Read section 1011(b); Read Reg. §1.10112. Section 1011(b) states as follows:
Section 1011. Adjusted basis for determining gain or loss
(a) General rule
The adjusted basis for determining the gain or loss from the sale or
other disposition of property, whenever acquired, shall be the basis
(determined under section 1012 or other applicable sections of this
subchapter and subchapters C (relating to corporate distributions
and adjustments), K (relating to partners and partnerships), and P
(relating to capital gains and losses)), adjusted as provided in
section 1016.
(1)
To compute the gains, the transferor must divide the actuarial value of the
charitable contribution by the property's fair market value times the total
gain.
(2)
The reported gain can be spread out over the life of the annuitant or the
remaining life expectancy.
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(3)
3.
The charitable contribution deduction, for income tax purposes, is up to
30% or 50% of the transferor's adjusted gross income and can be carried
forward, and deducted, for income tax purposes, until used-up, for five
consecutive years.
n.
Because annuity payments are made from the charitable organization's existing
assets, one of which might be the property charitably contributed to create the
charitable gift annuity, the resulting payments to the annuitant are composed of both
tax-free and taxed income. Read Reg. §1.72-4(a)(4).
(1)
The formula for determining the amount of tax-free income is: annuity
payment x exclusion ratio
(2)
The exclusion ratio is equal to the annuitant's investment in the annuity
contract divided by the expected annual return.
o.
A survivorship interest in a spouse will qualify for the marital deduction if no
benefits are provided to persons other than the spouse. Read Reg. §20.2056(b)-1(g),
example 3.
In general, a charitable contribution can be in the form of an irrevocable conveyance, not in
trust, of a remainder interest in a personal residence or farm. Read Reg. §1.170a-7(b)(3) &
(4).
a.
The residence does not need to be the transferor's principal residence. Read Reg.
§1.170a-7(b)(3).
b.
Any property used by its owner as a personal residence, but not necessarily as the
owner's principal residence, qualifies as a charitable contribution deduction, for
income tax purposes, if transferred to a qualified charitable organization. Read Reg.
§1.170a-7(b)(3).
(1)
Example. A personal residence includes a vacation home, stock owned in
a cooperative housing corporation or a yacht, so long as all are used by the
owner as a residence under normal conditions.
(a)
A personal residence does not include household furnishings or
other tangible personal property, and therefore, no charitable
contribution deduction, for income tax purposes, is allowed for
transfers of a remainder interest in such property.
c.
A charitable contribution of a remainder interest in a personal residence or farm
must be in the residence or farm itself and not in the proceeds from the sale of the
property, unless by the terms of the agreement, the sale of the transferor's personal
residence or farm was required upon the death of the life tenant, with the sale
proceeds paid to the charitable organization. Read Reg. §1.170a-7(b)(3) & (4).
d.
A transferor may designate that the remainder interest in a personal residence or
farm be shared between two beneficiaries, as tenants in common. Read Reg.
§1.170a-7(b)(3) &(4).
(1)
A charitable contribution deduction, for income tax purposes, is allowed
only for the value donated to a qualified charitable organization.
e.
A charitable contribution of a remainder interest in a personal residence or farm
must be an irrevocable contribution of the residence itself. Read Reg. §1.170a7(b)(3) & (4).
(1)
A condition imposed on a charitable contribution of a remainder interest in
a personal residence may result in the disallowance of the charitable
contribution deduction, for income tax purposes, unless the possibility that
the condition could defeat the charitable organization's interest is so remote
as to be negligible.
(2)
A contingency imposed on a charitable contribution of a remainder interest
in a personal residence may result in the disallowance of the charitable
contribution deduction, for income, gift and estate tax purposes, unless the
probability that the contingency will occur is so remote as to be negligible.
f.
Any land used by its owner for the production of crops, fruit or other agricultural
products, or for the raising of livestock (including cattle, hogs, horses, mules,
donkeys, sheep, goats, captive fur-bearing animals, chickens, turkeys pigeons, and
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4.
other poultry), qualifies as a charitable contribution deduction, for income tax
purposes, if transferred to a qualified charitable organization.
g.
A donor of a charitable contribution of a remainder interest in a personal residence
or farm will be entitled to additional deductions upon making subsequent capital
improvements, such as installing a new heating and air conditioning system. Read
Private Letter Ruling No. 8529014.
h.
A donor in need of immediate income may contribute the donor's remainder interest
in the donor's residence or farm through the use of a bargain sale of a remainder
interest either for cash or for a gift annuity.
(1)
Both income and gift tax charitable deductions are allowable for this
amount.
(2)
A bargain sale of a remainder interest results in capital gain gross income
to the donor; however, with an annuity, that gain is spread out over the
donor's life expectancy.
To qualify a terminable interest as "qualified terminable interest property", the following
conditions must be met. Read section 2056(b)(7)(B), which states as follows:
Section 2056. Bequests, etc., to surviving spouse
(b) Limitation in the case of life estate or other terminable interest
(7) Election with respect to life estate for surviving spouse
(B) Qualified terminable interest property defined
For purposes of this paragraph—
(i) In general The term “qualified terminable interest
property” means property—
(I) which passes from the decedent,
(II) in which the surviving spouse has a qualifying
income interest for life, and
(III) to which an election under this paragraph
applies.
(ii) Qualifying income interest for life The surviving
spouse has a qualifying income interest for life if—
(I) the surviving spouse is entitled to all the
income from the property, payable annually or at
more frequent intervals, or has a usufruct interest
for life in the property, and
(II) no person has a power to appoint any part of
the property to any person other than the
surviving spouse.
Subclause (II) shall not apply to a power
exercisable only at or after the death of
the surviving spouse. To the extent
provided in regulations, an annuity shall
be treated in a manner similar to an
income interest in property (regardless of
whether the property from which the
annuity is payable can be separately
identified).
(iii) Property includes interest therein The term “property”
includes an interest in property.
(iv) Specific portion treated as separate prop-erty A
specific portion of property shall be treated as
separate property.
(v) Election An election under this paragraph with respect
to any property shall be made by the executor on
the return of tax imposed by section 2001. Such an
election, once made, shall be irrevocable.
a.
The property interest must pass from the transferor to the surviving spouse.
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b.
c.
The surviving spouse must have a qualifying income interest for life.
The executor must elect to qualify the interest for the marital deduction, for estate
tax purposes.
d.
If the transferor creates a qtip trust for the spouse and names a charitable
organization as the remainder beneficiary, then the entire value of the property will
qualify for the marital deduction, for estate tax purposes.
e.
Upon the death of the spouse, the property will be included in the spouse's estate but
will also qualify for a full charitable contribution deduction, for estate tax purposes,
thus yielding a tax result identical to that of a charitable remainder trust.
5.
A contribution of an undivided portion of the taxpayer's entire interest in property qualifies
for charitable deductions for income tax (Read section 170(f)(3)(b)(ii)), estate tax (Read
section 2055(e)(2)), and for gift tax (Read section 2522(c)(2)) purposes, which state as
follows:
Section 170. Charitable, etc., contributions and gifts
(f) Disallowance of deduction in certain cases and special rules
(3) Denial of deduction in case of certain contributions of partial interests
in property
(B) Exceptions
Subparagraph (A) shall not apply to—
(ii) a contribution of an undivided portion of the taxpayer’s
entire interest in property, and
Section 2055. Transfers for public, charitable, and religious uses
(e) Disallowance of deductions in certain cases
(2) Where an interest in property (other than an interest described in section
170 (f)(3)(B)) passes or has passed from the decedent to a person,
or for a use, described in subsection (a), and an interest (other than
an interest which is extinguished upon the decedent’s death) in the
same property passes or has passed (for less than an adequate and
full consideration in money or money’s worth) from the decedent
to a person, or for a use, not described in subsection (a), no
deduction shall be allowed under this section for the interest which
passes or has passed to the person, or for the use, described in
subsection (a) unless—
(A) in the case of a remainder interest, such interest is in a trust
which is a charitable remainder annuity trust or a charitable
remainder unitrust (described in section 664) or a pooled income
fund (described in section 642 (c)(5)), or
(B) in the case of any other interest, such interest is in the form of
a guaranteed annuity or is a fixed percentage distributed
yearly of the fair market value of the property (to be
determined yearly).
Section 2522. Charitable and similar gifts
(c) Disallowance of deductions in certain cases
(2) Where a donor transfers an interest in property (other than an interest
described in section 170 (f)(3)(B)) to a person, or for a use, described in
subsection (a) or (b) and an interest in the same property is retained by the
donor, or is transferred or has been transferred (for less than an adequate
and full consideration in money or money’s worth) from the donor to a
person, or for a use, not described in subsection (a) or (b), no deduction
shall be allowed under this section for the interest which is, or has been
transferred to the person, or for the use, described in subsection (a) or (b),
unless—
(A) in the case of a remainder interest, such interest is in a trust
which is a charitable remainder annuity trust or a charitable
remainder unitrust (described in section 664) or a pooled income
fund (described in section 642 (c)(5)), or
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a.
b.
XIX.
(B) in the case of any other interest, such interest is in the form of
a guaranteed annuity or is a fixed percentage distributed
yearly of the fair market value of the property (to be
determined yearly).
To qualify for a deduction, the charitable organization donee must receive over the
entire term of the donor's interest a fraction or percentage of each and every
substantial interest or right owned by the donor.
(1)
That interest must extend to other property into which the donor's property
is converted.
(2)
The result is that the charitable organization is made in effect a con-tenant
or co-owner of the property.
(3)
Example. Donor, with a life estate in a lake resort, contributes to a
charitable organization a 20% undivided interest in the donor's life estate in
the lake resort.
(a)
Donor's contribution is deductible.
(b)
If the donor contributed to the charitable organization a life estate
in a lake resort owned by him, the contribution would not be
deductible as it is not an undivided portion of the donor's entire
interest in the resort.
Generally, allocation of possession based on time is necessary. Read Reg. §1.170a7(b)(1)(i); PLR No. 7733075.
(1)
Used widely as a means of sharing artworks or similar property.
(2)
Example. Donor gives an art museum an undivided 33% interest in a
painting valued at $100,000. Normally this will produce a $20,000
deduction and the museum will be entitled for four months (33%) of each
year to the unrestricted use and possession of the sculpture.
Transactions involving bonds - sections 1012, 165, 171, 454, 1271, and 1273. Read sections 1012, 165(a),
171(a), 454(a), 1271(a), and 1273(a), which state as follows:
Section 1012. Basis of property—cost
The basis of property shall be the cost of such property, except as otherwise
provided in this subchapter and subchapters C (relating to corporate distributions
and adjustments), K (relating to partners and partnerships), and P (relating to capital
gains and losses). The cost of real property shall not include any amount in respect
of real property taxes which are treated under section 164 (d) as imposed on the
taxpayer.
Section 165. Losses
(a) General rule
There shall be allowed as a deduction any loss sustained during the
taxable year and not compensated for by insurance or otherwise.
Section 171. Amortizable bond premium
(a) General rule
In the case of any bond, as defined in subsection (d), the following rules
shall apply to the amortizable bond premium (determined under subsection
(b)) on the bond:
(1) Taxable bonds
In the case of a bond (other than a bond the interest on which is
excludable from gross income), the amount of the amortizable bond
premium for the taxable year shall be allowed as a deduction.
(2) Tax-exempt bonds
In the case of any bond the interest on which is excludable from
gross income, no deduction shall be allowed for the amortizable
bond premium for the taxable year.
(3) Cross reference
For adjustment to basis on account of amortizable bond premium,
see section 1016 (a)(5).
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Section 454. Obligations issued at discount
(a) Non-interest-bearing obligations issued at a discount
If, in the case of a taxpayer owning any non-interest-bearing obligation
issued at a discount and redeemable for fixed amounts increasing at stated
intervals or owning an obligation described in paragraph (2) of subsection
(c), the increase in the redemption price of such obligation occurring in the
taxable year does not (under the method of accounting used in computing
his taxable income) constitute income to him in such year, such taxpayer
may, at his election made in his return for any taxable year, treat such
increase as income received in such taxable year. If any such election is
made with respect to any such obligation, it shall apply also to all such
obligations owned by the taxpayer at the beginning of the first taxable year
to which it applies and to all such obligations thereafter acquired by him
and shall be binding for all subsequent taxable years, unless on application
by the taxpayer the Secretary permits him, subject to such conditions as the
Secretary deems necessary, to change to a different method. In the case of
any such obligations owned by the taxpayer at the beginning of the first
taxable year to which his election applies, the increase in the redemption
price of such obligations occurring between the date of acquisition (or, in
the case of an obligation described in paragraph (2) of subsection (c), the
date of acquisition of the series E bond involved) and the first day of such
taxable year shall also be treated as income received in such taxable year.
Section 1271. Treatment of amounts received on retirement or sale or exchange of debt
instruments
(a) General rule
For purposes of this title—
(1) Retirement
Amounts received by the holder on retirement of any debt
instrument shall be considered as amounts received in exchange
therefor.
(2) Ordinary income on sale or exchange where intention to call before
maturity
(A) In general
If at the time of original issue there was an intention to call
a debt instrument before maturity, any gain realized on the
sale or exchange thereof which does not exceed an amount
equal to—
(i) the original issue discount, reduced by
(ii) the portion of original issue discount previously
includible in the gross income of any holder (without
regard to subsection (a)(7) or (b)(4) of section 1272 (or the
corresponding provisions of prior law)),
shall be treated as ordinary income.
(B) Exceptions
This paragraph (and paragraph (2) of subsection (c)) shall
not apply to—
(i) any tax-exempt obligation, or
(ii) any holder who has purchased the debt instrument at a
premium.
(3) Certain short-term Government obligations
(A) In general
On the sale or exchange of any short-term Government
obligation, any gain realized which does not exceed an
amount equal to the ratable share of the acquisition
discount shall be treated as ordinary income.
(B) Short-term Government obligation
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For purposes of this paragraph, the term “short-term
Government obligation” means any obligation of the
United States or any of its possessions, or of a State or any
political subdivision thereof, or of the District of
Columbia, which has a fixed maturity date not more than
1 year from the date of issue. Such term does not include
any tax-exempt obligation.
(C) Acquisition discount
For purposes of this paragraph, the term “acquisition
discount” means the excess of the stated redemption price
at maturity over the taxpayer’s basis for the obligation.
(D) Ratable share
For purposes of this paragraph, except as provided in
subparagraph (E), the ratable share of the acquisition
discount is an amount which bears the same ratio to such
discount as—
(i) the number of days which the taxpayer held the
obligation, bears to
(ii) the number of days after the date the taxpayer acquired
the obligation and up to (and including) the date of
its maturity.
(E) Election of accrual on basis of constant interest rate
At the election of the taxpayer with respect to any
obligation, the ratable share of the acquisition discount is
the portion of the acquisition discount accruing while the
taxpayer held the obligation determined (under regulations
prescribed by the Secretary) on the basis of—
(i) the taxpayer’s yield to maturity based on the taxpayer’s
cost of acquiring the obligation, and
(ii) compounding daily.
An election under this subparagraph, once made
with respect to any obligation, shall be
irrevocable.
(4) Certain short-term nongovernment obligations
(A) In general
On the sale or exchange of any short-term nongovernment
obligation, any gain realized which does not exceed an
amount equal to the ratable share of the original issue
discount shall be treated as ordinary income.
(B) Short-term nongovernment obligation
For purposes of this paragraph, the term “short-term
nongovernment obligation” means any obligation which—
(i) has a fixed maturity date not more than 1 year from the
date of the issue, and
(ii) is not a short-term Government obligation (as defined
in paragraph (3)(B) without regard to the last
sentence thereof).
(C) Ratable share
For purposes of this paragraph, except as provided in
subparagraph (D), the ratable share of the original issue
discount is an amount which bears the same ratio to such
discount as—
(i) the number of days which the taxpayer held the
obligation, bears to
(ii) the number of days after the date of original issue and
up to (and including) the date of its maturity.
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(D) Election of accrual on basis of constant interest rate
At the election of the taxpayer with respect to any
obligation, the ratable share of the original issue discount
is the portion of the original issue discount accruing while
the taxpayer held the obligation determined (under
regulations prescribed by the Secretary) on the basis of—
(i) the yield to maturity based on the issue price of the
obligation, and
(ii) compounding daily.
Any election under this subparagraph, once made
with respect to any obligation, shall be
irrevocable.
Section 1273. Determination of amount of original issue discount
(a) General rule
For purposes of this subpart—
(1) In general
The term “original issue discount” means the excess (if any) of—
(A) the stated redemption price at maturity, over
(B) the issue price.
(2) Stated redemption price at maturity
The term “stated redemption price at maturity” means the amount
fixed by the last modification of the purchase agreement and
includes interest and other amounts payable at that time (other than
any interest based on a fixed rate, and payable unconditionally at
fixed periodic intervals of 1 year or less during the entire term of
the debt instrument).
(3) 1/4 of 1 percent de minimis rule
If the original issue discount determined under paragraph (1) is less
than—
(A) 1/4 of 1 percent of the stated redemption price at maturity,
multiplied by
(B) the number of complete years to maturity,
then the original issue discount shall be treated as zero.
A.
Transactions involving bonds generation involve the following types of transactions.
1.
Purchase of the bonds - generally, a cost basis and maybe an allocation of the cost between
the bond interest and the bond principal. Read section 1012, which states as follows:
Section 1012. Basis of property—cost
The basis of property shall be the cost of such property, except as otherwise
provided in this subchapter and subchapters C (relating to corporate distributions
and adjustments), K (relating to partners and partnerships), and P (relating to capital
gains and losses). The cost of real property shall not include any amount in respect
of real property taxes which are treated under section 164 (d) as imposed on the
taxpayer.
2.
Determining the amount of the bond interest each year. Read section 1016(a), which states
as follows:
Section 1016. Adjustments to basis
(a) General rule
Proper adjustment in respect of the property shall in all cases be made—
(1) for expenditures, receipts, losses, or other items, properly chargeable to
capital account, but no such adjustment shall be made—
(A) for taxes or other carrying charges described in section 266, or
(B) for expenditures described in section 173 (relating to
circulation expenditures),
for which deductions have been taken by the taxpayer in
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determining taxable income for the taxable year or prior
taxable years;
(2) in respect of any period since February 28, 1913, for exhaustion, wear
and tear, obsolescence, amortization, and depletion, to the extent of
the amount—
(A) allowed as deductions in computing taxable income under this
subtitle or prior income tax laws, and
(B) resulting (by reason of the deductions so allowed) in a
reduction for any taxable year of the taxpayer’s taxes under this
subtitle (other than chapter 2, relating to tax on self-employment
income), or prior income, war-profits, or excess-profits tax laws,
but not less than the amount allowable under this subtitle
or prior income tax laws. Where no method has been
adopted under section 167 (relating to depreciation
deduction), the amount allowable shall be determined
under the straight line method. Subparagraph (B) of this
paragraph shall not apply in respect of any period since
February 28, 1913, and before January 1, 1952, unless an
election has been made under section 1020 (as in effect
before the date of the enactment of the Tax Reform Act of
1976). Where for any taxable year before the taxable year
1932 the depletion allowance was based on discovery
value or a percentage of income, then the adjustment for
depletion for such year shall be based on the depletion
which would have been allowable for such year if
computed without reference to discovery value or a
percentage of income;
(3) in respect of any period—
(A) before March 1, 1913,
(B) since February 28, 1913, during which such property was held
by a person or an organization not subject to income
taxation under this chapter or prior income tax laws,
(C) since February 28, 1913, and before January 1, 1958, during
which such property was held by a person subject to tax
under part I of subchapter L (or the corresponding
provisions of prior income tax laws), to the extent that
paragraph (2) does not apply, and
(D) since February 28, 1913, during which such property was held
by a person subject to tax under part II [1] of subchapter L
(or the corresponding provisions of prior income tax laws),
to the extent that paragraph (2) does not apply,
for exhaustion, wear and tear, obsolescence, amortization,
and depletion, to the extent sustained;
(4) in the case of stock (to the extent not provided for in the foregoing
paragraphs) for the amount of distributions previously made which,
under the law applicable to the year in which the distribution was
made, either were tax-free or were applicable in reduction of basis
(not including distributions made by a corporation which was
classified as a personal service corporation under the provisions of
the Revenue Act of 1918 (40 Stat. 1057), or the Revenue Act of
1921 (42 Stat. 227), out of its earnings or profits which were
taxable in accordance with the provisions of section 218 of the
Revenue Act of 1918 or 1921);
(5) in the case of any bond (as defined in section 171 (d)) the interest on
which is wholly exempt from the tax imposed by this subtitle, to
the extent of the amortizable bond premium disallowable as a
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deduction pursuant to section 171 (a)(2), and in the case of any
other bond (as defined in section 171 (d)) to the extent of the
deductions allowable pursuant to section 171 (a)(1) (or the amount
applied to reduce interest payments under section 171 (e)(2)) with
respect thereto;
(6) in the case of any municipal bond (as defined in section 75 (b)), to the
extent provided in section 75 (a)(2);
(7) in the case of a residence the acquisition of which resulted, under
section 1034 (as in effect on the day before the date of the
enactment of the Taxpayer Relief Act of 1997), in the
nonrecognition of any part of the gain realized on the sale,
exchange, or involuntary conversion of another residence, to the
extent provided in section 1034 (e) (as so in effect);
(8) in the case of property pledged to the Commodity Credit Corporation,
to the extent of the amount received as a loan from the Commodity
Credit Corporation and treated by the taxpayer as income for the
year in which received pursuant to section 77, and to the extent of
any deficiency on such loan with respect to which the taxpayer has
been relieved from liability;
(9) for amounts allowed as deductions as deferred expenses under section
616 (b) (relating to certain expenditures in the development of
mines) and resulting in a reduction of the taxpayer’s taxes under
this subtitle, but not less than the amounts allowable under such
section for the taxable year and prior years;
[(10) Repealed. Pub. L. 94–455, title XIX, § 1901(b)(21)(G), Oct. 4, 1976,
90 Stat. 1798]
(11) for deductions to the extent disallowed under section 268 (relating to
sale of land with unharvested crops), notwithstanding the
provisions of any other paragraph of this subsection;
(12) to the extent provided in section 28(h) of the Internal Revenue Code
of 1939 in the case of amounts specified in a shareholder’s consent
made under section 28 of such code;
[(13) Repealed. Pub. L. 108–357, title IV, § 413(c)(19), Oct. 22, 2004, 118
Stat. 1509]
(14) for amounts allowed as deductions as deferred expenses under section
174 (b)(1) (relating to research and experimental expenditures) and
resulting in a reduction of the taxpayers’ taxes under this subtitle,
but not less than the amounts allowable under such section for the
taxable year and prior years;
(15) for deductions to the extent disallowed under section 272 (relating to
disposal of coal or domestic iron ore), notwithstanding the
provisions of any other paragraph of this subsection;
(16) in the case of any evidence of indebtedness referred to in section 811
(b) (relating to amortization of premium and accrual of discount in
the case of life insurance companies), to the extent of the
adjustments required under section 811 (b) (or the corresponding
provisions of prior income tax laws) for the taxable year and all
prior taxable years;
(17) to the extent provided in section 1367 in the case of stock of, and
indebtedness owed to, shareholders of an S corporation;
(18) to the extent provided in section 961 in the case of stock in controlled
foreign corporations (or foreign corporations which were controlled
foreign corporations) and of property by reason of which a person
is considered as owning such stock;
(19) to the extent provided in section 50 (c), in the case of expenditures with
respect to which a credit has been allowed under section 38;
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3.
(20) for amounts allowed as deductions under section 59 (e) (relating to
optional 10-year writeoff of certain tax preferences);
(21) to the extent provided in section 1059 (relating to reduction in basis for
extraordinary dividends);
(22) in the case of qualified replacement property the acquisition of which
resulted under section 1042 in the nonrecognition of any part of the
gain realized on the sale or exchange of any property, to the extent
provided in section 1042 (d),[2]
(23) in the case of property the acquisition of which resulted under section
1043, 1044, 1045, or 1397B in the nonrecognition of any part of
the gain realized on the sale of other property, to the extent
provided in section 1043 (c), 1044 (d), 1045 (b)(3), or 1397B
(b)(4), as the case may be,[2]
(24) to the extent provided in section 179A (e)(6)(A),[2]
(25) to the extent provided in section 30 (d)(1),[2]
(26) to the extent provided in sections 23 (g) and 137 (e),[2]
(27) in the case of a residence with respect to which a credit was allowed
under section 1400C, to the extent provided in section 1400C
(h),[2]
(28) in the case of a facility with respect to which a credit was allowed
under section 45F, to the extent provided in section 45F (f)(1),[2]
(29) in the case of railroad track with respect to which a credit was allowed
under section 45G, to the extent provided in section 45G (e)(3),[2]
(30) to the extent provided in section 179B (c),[2]
(31) in the case of a facility with respect to which a credit was allowed
under section 45H, to the extent provided in section 45H (d),[2]
(32) to the extent provided in section 179D (e),[2]
(33) to the extent provided in section 45L (e), in the case of amounts with
respect to which a credit has been allowed under section 45L,[2]
(34) to the extent provided in section 25C (e), in the case of amounts with
respect to which a credit has been allowed under section 25C,[2]
(35) to the extent provided in section 25D (f), in the case of amounts with
respect to which a credit has been allowed under section 25D,[2]
(36) to the extent provided in section 30B (h)(4),[2] and
(37) to the extent provided in section 30C (f).
Determining the difference in treatment of taxable bond interest and excludable bond
interest. Read section 103(a) and section 1016(a), which state as follows:
Section 103. Interest on State and local bonds
(a) Exclusion
Except as provided in subsection (b), gross income does not include interest
on any State or local bond.
Section 1016. Adjustments to basis
(a) General rule
Proper adjustment in respect of the property shall in all cases be made—
(1) for expenditures, receipts, losses, or other items, properly chargeable to
capital account, but no such adjustment shall be made—
(A) for taxes or other carrying charges described in section 266, or
(B) for expenditures described in section 173 (relating to
circulation expenditures),
for which deductions have been taken by the taxpayer in
determining taxable income for the taxable year or prior
taxable years;
(2) in respect of any period since February 28, 1913, for exhaustion, wear
and tear, obsolescence, amortization, and depletion, to the extent of
the amount—
(A) allowed as deductions in computing taxable income under this
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subtitle or prior income tax laws, and
(B) resulting (by reason of the deductions so allowed) in a
reduction for any taxable year of the taxpayer’s taxes
under this subtitle (other than chapter 2, relating to tax on
self-employment income), or prior income, war-profits, or
excess-profits tax laws,
but not less than the amount allowable under this subtitle
or prior income tax laws. Where no method has been
adopted under section 167 (relating to depreciation
deduction), the amount allowable shall be determined
under the straight line method. Subparagraph (B) of this
paragraph shall not apply in respect of any period since
February 28, 1913, and before January 1, 1952, unless an
election has been made under section 1020 (as in effect
before the date of the enactment of the Tax Reform Act of
1976). Where for any taxable year before the taxable year
1932 the depletion allowance was based on discovery
value or a percentage of income, then the adjustment for
depletion for such year shall be based on the depletion
which would have been allowable for such year if
computed without reference to discovery value or a
percentage of income;
(3) in respect of any period—
(A) before March 1, 1913,
(B) since February 28, 1913, during which such property was held
by a person or an organization not subject to income
taxation under this chapter or prior income tax laws,
(C) since February 28, 1913, and before January 1, 1958, during
which such property was held by a person subject to tax under part
I of subchapter L (or the corresponding provisions of prior income
tax laws), to the extent that paragraph (2) does not apply, and
(D) since February 28, 1913, during which such property was held
by a person subject to tax under part II [1] of subchapter L
(or the corresponding provisions of prior income tax laws),
to the extent that paragraph (2) does not apply,
for exhaustion, wear and tear, obsolescence, amortization,
and depletion, to the extent sustained;
(4) in the case of stock (to the extent not provided for in the foregoing
paragraphs) for the amount of distributions previously made which,
under the law applicable to the year in which the distribution was
made, either were tax-free or were applicable in reduction of basis
(not including distributions made by a corporation which was
classified as a personal service corporation under the provisions of
the Revenue Act of 1918 (40 Stat. 1057), or the Revenue Act of
1921 (42 Stat. 227), out of its earnings or profits which were
taxable in accordance with the provisions of section 218 of the
Revenue Act of 1918 or 1921);
(5) in the case of any bond (as defined in section 171 (d)) the interest on
which is wholly exempt from the tax imposed by this subtitle, to
the extent of the amortizable bond premium disallowable as a
deduction pursuant to section 171 (a)(2), and in the case of any
other bond (as defined in section 171 (d)) to the extent of the
deductions allowable pursuant to section 171 (a)(1) (or the amount
applied to reduce interest payments under section 171 (e)(2)) with
respect thereto;
(6) in the case of any municipal bond (as defined in section 75 (b)), to the
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extent provided in section 75 (a)(2);
(7) in the case of a residence the acquisition of which resulted, under
section 1034 (as in effect on the day before the date of the
enactment of the Taxpayer Relief Act of 1997), in the
nonrecognition of any part of the gain realized on the sale,
exchange, or involuntary conversion of another residence, to the
extent provided in section 1034 (e) (as so in effect);
(8) in the case of property pledged to the Commodity Credit Corporation,
to the extent of the amount received as a loan from the Commodity
Credit Corporation and treated by the taxpayer as income for the
year in which received pursuant to section 77, and to the extent of
any deficiency on such loan with respect to which the taxpayer has
been relieved from liability;
(9) for amounts allowed as deductions as deferred expenses under section
616 (b) (relating to certain expenditures in the development of
mines) and resulting in a reduction of the taxpayer’s taxes under
this subtitle, but not less than the amounts allowable under such
section for the taxable year and prior years;
[(10) Repealed. Pub. L. 94–455, title XIX, § 1901(b)(21)(G), Oct. 4, 1976,
90 Stat. 1798]
(11) for deductions to the extent disallowed under section 268 (relating to
sale of land with unharvested crops), notwithstanding the
provisions of any other paragraph of this subsection;
(12) to the extent provided in section 28(h) of the Internal Revenue Code
of 1939 in the case of amounts specified in a shareholder’s consent
made under section 28 of such code;
[(13) Repealed. Pub. L. 108–357, title IV, § 413(c)(19), Oct. 22, 2004, 118
Stat. 1509]
(14) for amounts allowed as deductions as deferred expenses under section
174 (b)(1) (relating to research and experimental expenditures) and
resulting in a reduction of the taxpayers’ taxes under this subtitle,
but not less than the amounts allowable under such section for the
taxable year and prior years;
(15) for deductions to the extent disallowed under section 272 (relating to
disposal of coal or domestic iron ore), notwithstanding the
provisions of any other paragraph of this subsection;
(16) in the case of any evidence of indebtedness referred to in section 811
(b) (relating to amortization of premium and accrual of discount in
the case of life insurance companies), to the extent of the
adjustments required under section 811 (b) (or the corresponding
provisions of prior income tax laws) for the taxable year and all
prior taxable years;
(17) to the extent provided in section 1367 in the case of stock of, and
indebtedness owed to, shareholders of an S corporation;
(18) to the extent provided in section 961 in the case of stock in controlled
foreign corporations (or foreign corporations which were controlled
foreign corporations) and of property by reason of which a person
is considered as owning such stock;
(19) to the extent provided in section 50 (c), in the case of expenditures with
respect to which a credit has been allowed under section 38;
(20) for amounts allowed as deductions under section 59 (e) (relating to
optional 10-year writeoff of certain tax preferences);
(21) to the extent provided in section 1059 (relating to reduction in basis for
extraordinary dividends);
(22) in the case of qualified replacement property the acquisition of which
resulted under section 1042 in the nonrecognition of any part of the
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4.
gain realized on the sale or exchange of any property, to the extent
provided in section 1042 (d),[2]
(23) in the case of property the acquisition of which resulted under section
1043, 1044, 1045, or 1397B in the nonrecognition of any part of
the gain realized on the sale of other property, to the extent
provided in section 1043 (c), 1044 (d), 1045 (b)(3), or 1397B
(b)(4), as the case may be,[2]
(24) to the extent provided in section 179A (e)(6)(A),[2]
(25) to the extent provided in section 30 (d)(1),[2]
(26) to the extent provided in sections 23 (g) and 137 (e),[2]
(27) in the case of a residence with respect to which a credit was allowed
under section 1400C, to the extent provided in section 1400C
(h),[2]
(28) in the case of a facility with respect to which a credit was allowed
under section 45F, to the extent provided in section 45F (f)(1),[2]
(29) in the case of railroad track with respect to which a credit was allowed
under section 45G, to the extent provided in section 45G (e)(3),[2]
(30) to the extent provided in section 179B (c),[2]
(31) in the case of a facility with respect to which a credit was allowed
under section 45H, to the extent provided in section 45H (d),[2]
(32) to the extent provided in section 179D (e),[2]
(33) to the extent provided in section 45L (e), in the case of amounts with
respect to which a credit has been allowed under section 45L,[2]
(34) to the extent provided in section 25C (e), in the case of amounts with
respect to which a credit has been allowed under section 25C,[2]
(35) to the extent provided in section 25D (f), in the case of amounts with
respect to which a credit has been allowed under section 25D,[2]
(36) to the extent provided in section 30B (h)(4),[2] and
(37) to the extent provided in section 30C (f).
Determining the amount of bond premium and the amount of amortizable bond premium.
Read section 171(a) and section 1, which state as follows:
Section 171. Amortizable bond premium
(a) General rule
In the case of any bond, as defined in subsection (d), the following rules
shall apply to the amortizable bond premium (determined under subsection
(b)) on the bond:
(1) Taxable bonds
In the case of a bond (other than a bond the interest on which is
excludable from gross income), the amount of the amortizable bond
premium for the taxable year shall be allowed as a deduction.
(2) Tax-exempt bonds
In the case of any bond the interest on which is excludable from
gross income, no deduction shall be allowed for the amortizable
bond premium for the taxable year.
(3) Cross reference
For adjustment to basis on account of amortizable bond premium,
see section 1016 (a)(5).
Section 1. Tax imposed
(a) Married individuals filing joint returns and surviving spouses
There is hereby imposed on the taxable income of—
(1) every married individual (as defined in section 7703) who makes a
single return jointly with his spouse under section 6013, and
(2) every surviving spouse (as defined in section 2 (a)),
a tax determined in accordance with the following table:
If taxable income is: The tax is:
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5.
6.
Not over $36,900 15% of taxable income.
Over $36,900 but not over $89,150 $5,535, plus 28% of the excess
over $36,900.
Over $89,150 but not over $140,000 $20,165, plus 31% of the
excess over $89,150.
Over $140,000 but not over $250,000 $35,928.50, plus 36% of the
excess over $140,000.
Over $250,000 $75,528.50, plus 39.6% of the excess over
250,000.
Determining the amount of original issue discount and the amount of accruable bond
discount. Read section 1273(a) and section 454(a), which state as follows:
Section 1273. Determination of amount of original issue discount
(a) General rule
For purposes of this subpart—
(1) In general
The term “original issue discount” means the excess (if any) of—
(A) the stated redemption price at maturity, over
(B) the issue price.
(2) Stated redemption price at maturity
The term “stated redemption price at maturity” means the
amount fixed by the last modification of the purchase
agreement and includes interest and other amounts payable
at that time (other than any interest based on a fixed rate,
and payable unconditionally at fixed periodic intervals of
1 year or less during the entire term of the debt
instrument).
(3) 1/4 of 1 percent de minimis rule
If the original issue discount determined under paragraph
(1) is less than—
(A) 1/4 of 1 percent of the stated redemption price at maturity,
multiplied by
(B) the number of complete years to maturity,
then the original issue discount shall be treated as zero.
Section 454. Obligations issued at discount
(a) Non-interest-bearing obligations issued at a discount
If, in the case of a taxpayer owning any non-interest-bearing obligation
issued at a discount and redeemable for fixed amounts increasing at stated
intervals or owning an obligation described in paragraph (2) of subsection
(c), the increase in the redemption price of such obligation occurring in the
taxable year does not (under the method of accounting used in computing
his taxable income) constitute income to him in such year, such taxpayer
may, at his election made in his return for any taxable year, treat such
increase as income received in such taxable year. If any such election is
made with respect to any such obligation, it shall apply also to all such
obligations owned by the taxpayer at the beginning of the first taxable year
to which it applies and to all such obligations thereafter acquired by him
and shall be binding for all subsequent taxable years, unless on application
by the taxpayer the Secretary permits him, subject to such conditions as the
Secretary deems necessary, to change to a different method. In the case of
any such obligations owned by the taxpayer at the beginning of the first
taxable year to which his election applies, the increase in the redemption
price of such obligations occurring between the date of acquisition (or, in
the case of an obligation described in paragraph (2) of subsection (c), the
date of acquisition of the series E bond involved) and the first day of such
taxable year shall also be treated as income received in such taxable year.
Determining the gain or loss from the sale or exchange of the bond.
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7.
Determining the gain or loss from the redemption of the bond.
Read section 1271(a) and section 1273(a), which state as follows:
Section 1271. Treatment of amounts received on retirement or sale or exchange of debt
instruments
(a) General rule
For purposes of this title—
(1) Retirement
Amounts received by the holder on retirement of any debt
instrument shall be considered as amounts received in exchange
therefor.
(2) Ordinary income on sale or exchange where intention to call before
maturity
(A) In general
If at the time of original issue there was an intention to call
a debt instrument before maturity, any gain realized on the
sale or exchange thereof which does not exceed an amount
equal to—
(i) the original issue discount, reduced by
(ii) the portion of original issue discount previously
includible in the gross income of any holder (without
regard to subsection (a)(7) or (b)(4) of section 1272 (or the
corresponding provisions of prior law)),
shall be treated as ordinary income.
(B) Exceptions
This paragraph (and paragraph (2) of subsection (c)) shall
not apply to—
(i) any tax-exempt obligation, or
(ii) any holder who has purchased the debt instrument at a
premium.
(3) Certain short-term Government obligations
(A) In general
On the sale or exchange of any short-term Government
obligation, any gain realized which does not exceed an
amount equal to the ratable share of the acquisition
discount shall be treated as ordinary income.
(B) Short-term Government obligation
For purposes of this paragraph, the term “short-term
Government obligation” means any obligation of the
United States or any of its possessions, or of a State or any
political subdivision thereof, or of the District of
Columbia, which has a fixed maturity date not more than
1 year from the date of issue. Such term does not include
any tax-exempt obligation.
(C) Acquisition discount
For purposes of this paragraph, the term “acquisition
discount” means the excess of the stated redemption price
at maturity over the taxpayer’s basis for the obligation.
(D) Ratable share
For purposes of this paragraph, except as provided in
subparagraph (E), the ratable share of the acquisition
discount is an amount which bears the same ratio to such
discount as—
(i) the number of days which the taxpayer held the
obligation, bears to
(ii) the number of days after the date the taxpayer acquired
the obligation and up to (and including) the date of
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its maturity.
(E) Election of accrual on basis of constant interest rate
At the election of the taxpayer with respect to any
obligation, the ratable share of the acquisition discount is
the portion of the acquisition discount accruing while the
taxpayer held the obligation determined (under regulations
prescribed by the Secretary) on the basis of—
(i) the taxpayer’s yield to maturity based on the taxpayer’s
cost of acquiring the obligation, and
(ii) compounding daily.
An election under this subparagraph, once made
with respect to any obligation, shall be
irrevocable.
(4) Certain short-term nongovernment obligations
(A) In general
On the sale or exchange of any short-term nongovernment
obligation, any gain realized which does not exceed an
amount equal to the ratable share of the original issue
discount shall be treated as ordinary income.
(B) Short-term nongovernment obligation
For purposes of this paragraph, the term “short-term
nongovernment obligation” means any obligation which—
(i) has a fixed maturity date not more than 1 year from the
date of the issue, and
(ii) is not a short-term Government obligation (as defined
in paragraph (3)(B) without regard to the last
sentence thereof).
(C) Ratable share
For purposes of this paragraph, except as provided in
subparagraph (D), the ratable share of the original issue
discount is an amount which bears the same ratio to such
discount as—
(i) the number of days which the taxpayer held the
obligation, bears to
(ii) the number of days after the date of original issue and
up to (and including) the date of its maturity.
(D) Election of accrual on basis of constant interest rate
At the election of the taxpayer with respect to any
obligation, the ratable share of the original issue discount
is the portion of the original issue discount accruing while
the taxpayer held the obligation determined (under
regulations prescribed by the Secretary) on the basis of—
(i) the yield to maturity based on the issue price of the
obligation, and
(ii) compounding daily.
Any election under this subparagraph, once made
with respect to any obligation, shall be
irrevocable.
Section 1273. Determination of amount of original issue discount
(a) General rule
For purposes of this subpart—
(1) In general
The term “original issue discount” means the excess (if any) of—
(A) the stated redemption price at maturity, over
(B) the issue price.
(2) Stated redemption price at maturity
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8.
B.
The term “stated redemption price at maturity” means the amount
fixed by the last modification of the purchase agreement and
includes interest and other amounts payable at that time (other than
any interest based on a fixed rate, and payable unconditionally at
fixed periodic intervals of 1 year or less during the entire term of
the debt instrument).
(3) 1/4 of 1 percent de minimis rule
If the original issue discount determined under paragraph (1) is less
than—
(A) 1/4 of 1 percent of the stated redemption price at maturity,
multiplied by
(B) the number of complete years to maturity,
then the original issue discount shall be treated as zero.
Determining the amount of loss from a worthless bond. Read section 165(g).
Section 165. Losses
(g) Worthless securities
(1) General rule
If any security which is a capital asset becomes worthless during
the taxable year, the loss resulting therefrom shall, for purposes of
this subtitle, be treated as a loss from the sale or exchange, on the
last day of the taxable year, of a capital asset.
(2) Security defined
For purposes of this subsection, the term “security” means—
(A) a share of stock in a corporation;
(B) a right to subscribe for, or to receive, a share of stock in a
corporation; or
(C) a bond, debenture, note, or certificate, or other evidence of
indebtedness, issued by a corporation or by a government or
political subdivision thereof, with interest coupons or in registered
form.
(3) Securities in affiliated corporation
For purposes of paragraph (1), any security in a corporation
affiliated with a taxpayer which is a domestic corporation shall not
be treated as a capital asset. For purposes of the preceding sentence,
a corporation shall be treated as affiliated with the taxpayer only
if—
(A) the taxpayer owns directly stock in such corporation meeting
the requirements of section 1504 (a)(2), and
(B) more than 90 percent of the aggregate of its gross receipts for
all taxable years has been from sources other than
royalties, rents (except rents derived from rental of
properties to employees of the corporation in the ordinary
course of its operating business), dividends, interest
(except interest received on deferred purchase price of
operating assets sold), annuities, and gains from sales or
exchanges of stocks and securities.
In computing gross receipts for purposes of the preceding sentence, gross receipts
from sales or exchanges of stocks and securities shall be taken into account only to
the extent of gains therefrom.
In general, bonds may be purchased in the following amounts.
1.
At par value. The par value of a bond has two functions.
a.
The par value of a bond is the amount that will be repaid by the debtor when the
bond is redeemed.
2.
At a premium. If a lender purchase a bond for more than the par value of the bond, then the
lender has paid more for the bond than the par value.
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3.
At a discount. If a lender purchase a bond for less than the par value of the bond, then the
lender has paid less for the bond than the par value.
C.
A bond's par value has two functions.
1.
One is that the par value is the amount on which the stated interest rate is based.
a.
Therefore, if a bond has a par value of $10,000 and the stated interest rate is 5%,
then the corporation issuing the bond is to pay interest of $500 each year with
respect to the bond regardless of the bond's fair market value - - - even if the bond
were purchased at a discount or at a premium.
b.
“Stated interest” is the amount of interest which the issuing corporation states that
such corporation will pay to the bond holder each year.
2.
In addition, par value is the amount which the issuing corporation is to repay when the bond
is redeemed by the corporation. This is true whether or not the bond is issued at a premium
or a discount.
a.
A bond is issued at a premium if the bond is issued at a price which is greater than
the par value of the bond.
b.
A bond is issued at a discount if the bond is issued at a price which is less than the
par value of the bond.
D.
Bond premium.
1.
Because of the volatility of the credit markets, a taxpayer may pay more for a bond than the
bonds face amount. This excess amount is known as a “bond premium”.
a.
Payments on the bond, as an economic matter, are not all interest; some of such
payments represent return of the taxpayer's bond premium.
b.
In recognition of this, the taxpayer is allowed to amortize the bond premium over
the life of the bond.
Read section 171, which states as follows:
Section 171. Amortizable bond premium
(a) General rule. In the case of any bond, as defined in subsection (d), the
following rules shall apply to the amortizable bond premium
(determined under subsection (b)) on the bond:
(1) Taxable bonds
In the case of a bond (other than a bond the interest on
which is excludable from gross income), the amount of the
amortizable bond premium for the taxable year shall be
allowed as a deduction.
(2) Tax-exempt bonds
In the case of any bond the interest on which is excludable
from gross income, no deduction shall be allowed for the
amortizable bond premium for the taxable year.
(3) Cross reference
For adjustment to basis on account of amortizable bond
premium, see section 1016 (a)(5).
c.
In the absence of such treatment, the taxpayer with a bond premium would report
too much interest income and then take a capital loss when the bond is paid off.
2.
“Amortization” is the expensing or "writing off" the cost of intangible assets. Amortization
is the writing off of an amount already spent for a capital item of a definite duration, similar
to the depreciation write off on depreciable property.
Read sections 167(a), 171(a), and 197(a), which states as follows:
Section 167. Depreciation
(a) General rule. There shall be allowed as a depreciation deduction a reasonable
allowance for the exhaustion, wear and tear (including a reasonable allowance for
obsolescence)—
(1) of property used in the trade or business, or
(2) of property held for the production of income.
Section 171. Amortizable bond premium
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(a) General rule. In the case of any bond, as defined in subsection (d), the following
rules shall apply to the amortizable bond premium (determined under
subsection (b)) on the bond:
(1) Taxable bonds
In the case of a bond (other than a bond the interest on which is
excludable from gross income), the amount of the amortizable bond
premium for the taxable year shall be allowed as a deduction.
(2) Tax-exempt bonds
In the case of any bond the interest on which is excludable from
gross income, no deduction shall be allowed for the amortizable
bond premium for the taxable year.
(3) Cross reference
For adjustment to basis on account of amortizable bond premium,
see section 1016 (a)(5).
Section 197. Amortization of goodwill and certain other intangibles
(a) General rule.A taxpayer shall be entitled to an amortization deduction with
respect to any amortizable section 197 intangible. The amount of such deduction
shall be determined by amortizing the adjusted basis (for purposes of determining
gain) of such intangible ratably over the 15-year period beginning with the month
in which such intangible was acquired.
a.
“Amortization” is the income tax recovery of the cost or other adjusted basis of an
intangible asset through deductions over its useful life in the hands of the owner.
Amortizable items include business start-up expenditures.
Read section 248(a), which states as follows:
Section 248. Organizational expenditures
(a) Election to deduct
If a corporation elects the application of this subsection (in
accordance with regulations prescribed by the Secretary) with
respect to any organizational expenditures—
(1) the corporation shall be allowed a deduction for the taxable year
in which the corporation begins business in an amount
equal to the lesser of—
(A) the amount of organizational expenditures with respect
to the taxpayer, or
(B) $5,000, reduced (but not below zero) by the amount by
which such organizational expenditures exceed
$50,000, and
(2) the remainder of such organizational expenditures shall be
allowed as a deduction ratably over the 180-month period
beginning with the month in which the corporation begins business.
3.
4.
5.
b.
Amortization is computed by using the straight-line method only.
If a bond is issued at a premium, then the purchaser of the bond pays more money for the
bond than the purchaser is to receive when the bond is redeemed by the issuing corporation.
Thus, premium is an adjustment to the effective interest rate because even though a holder
of a bond may be receiving interest, for example, of 5% based on the par value of the bond,
the holder of the bond has paid more than the par value of the bond and, therefore, is not
receiving an effect rate of interest of 5%, and therefore, is receiving an effective rate of
interest of less than 5%.
Bond premium may be amortized by the holder of the bond over the life of the bond.
Therefore, in general, a holder of a bond may treat the bond premium in one of two ways.
a.
The holder of the bond may do nothing with respect to the premium, then, when the
bond is redeemed at the bond's par value by the issuing corporation, the holder of
the bond will have a capital loss to the extent of the difference between the
redemption payment by the issuing corporation (the par value of the bond) and the
holder's adjusted basis, which would be the amount which the purchaser paid for the
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bond (including the bond premium).
The second way is for the holder of the bond to amortize the bond premium over the
life of the bond and take deductions for this amortization.
(1)
If an investor of a bond amortizes the bond premium, then the amortized
bond premium is deductible as an itemized deduction which itemized
deduction is not included in the two percent test.
Example. On January 1 of the current year, Mary, who was not a dealer, purchased a Ford
Motor Company bond for $6,000 when the bond was issued. The bond matures in ten years
from the bond's issue date, has a par value of $5,000, and pays stated interest of 6% per year.
Mary took all of the income tax deductions (or gross income reductions) indicated by these
facts.
a.
The amount of any income tax deduction or reduction to which Mary is entitled for
the current year with respect to these facts is as follows.
(1)
Mary bought the Ford bond for $6,000 and its fair market value at maturity
is $5,000, therefore Mary bought the bond at a premium (paying more for
the bond's maturity value). Bond premiums are to be amortized and then
deducted over the life of the bond. The premium is $1,000 ($6,000 $5,000). $1,000/10 years = 100 per year. The deduction is from adjusted
gross income but it is not subject to the two percent test. Therefore, the
answer is $100.
b.
The amount of the bond's adjusted basis to Mary at the end of the current year is as
follows. The bonds original basis to Mary is the cost, $6,000. Each year when
Mary takes a deduction of $100, the bond's adjusted basis will be reduced by $100.
At maturity, the adjusted basis of the bond will be the maturity value, thus no gain
or loss will be recognized when Ford redeems the bond. Here, $6,000 - $100 =
$5,900. Therefore, the answer is $5,900.
The amount of the amortizable bond premium for the taxable year is allowable as a
deduction to the owner of the bond.
The adjusted basis of goodwill and certain other intangibles are amortizable over a 15 year
period beginning with the month in which the intangible was acquired.
Read section 197(a), which states as follows:
Section 197. Amortization of goodwill and certain other intangibles
(a) General rule. A taxpayer shall be entitled to an amortization deduction with
respect to any amortizable section 197 intangible. The amount of such deduction
shall be determined by amortizing the adjusted basis (for purposes of determining
gain) of such intangible ratably over the 15-year period beginning with the month
in which such intangible was acquired.
a.
Section 197 intangibles include among other things: goodwill, customer lists,
covenants not to compete, going concern value, and copyrights.
A taxpayer may treat the organizational expenditures of forming a new corporation as
deferred expenses and deduct them ratably over a five year period.
Read section 248(a), which states as follows:
Section 248. Organizational expenditures
(a) Election to deduct
If a corporation elects the application of this subsection (in accordance with
regulations prescribed by the Secretary) with respect to any organizational
expenditures—
(1) the corporation shall be allowed a deduction for the taxable year in
which the corporation begins business in an amount equal to the lesser of—
(A) the amount of organizational expenditures with respect to the
taxpayer, or
(B) $5,000, reduced (but not below zero) by the amount by which
such organizational expenditures exceed $50,000, and
(2) the remainder of such organizational expenditures shall be allowed as
a deduction ratably over the 180-month period beginning with the
month in which the corporation begins business.
b.
6.
7.
8.
9.
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10.
11.
12.
13.
14.
15.
Section 171 provides that a lender’s may elect to amortize the premium on a bond, the
interest of which is includible in the lender’s gross income.
If the amortizable bond premium election is made, then the bond premium is to be amortized
over the period for which the bond has been issued.
To repeat. If the face amount of the bond is $10,000, then the par value of the bond is
$10,000.
a.
If the bond is issued for $10,000, then the bond is said to be issued at par value.
(1)
The par value of bonds and stock has two main purposes.
(a)
It is the amount which will be repaid to the bond owner by the
debtor and the time when the bond is redeemed.
(b)
It is the amount on which stated interest is computed.
b.
If the bond is issued for $11,000, then the bond is issued at a premium.
c.
If the bond issued for $9,000, then the bond is issued at a discount.
The amortization of bond premium with respect to a bond, the interest on which is gross
income to the lender, is elective.
a.
The amortization of bond premium is to be done by days, but for the purposes of this
document, should amortization should be done by months.
The amortization of bond premium with respect to a bond, the interest on which is excluded
from the gross income of the lender, is mandatory.
Read section 171(a), which states as follows:
Section 171. Amortizable bond premium
(a) General rule. In the case of any bond, as defined in subsection (d), the following
rules shall apply to the amortizable bond premium (determined under
subsection (b)) on the bond:
(1) Taxable bonds
In the case of a bond (other than a bond the interest on which is
excludable from gross income), the amount of the amortizable bond
premium for the taxable year shall be allowed as a deduction.
(2) Tax-exempt bonds
In the case of any bond the interest on which is excludable from
gross income, no deduction shall be allowed for the amortizable
bond premium for the taxable year.
(3) Cross reference
For adjustment to basis on account of amortizable bond premium,
see section 1016 (a)(5).
a.
The amortization of bond premium is to be done by days, but for the purposes of this
document, amortization should be done by months.
The accrual of bond discount with respect to a bond, the interest on which is gross income
to the lender, or with respect to a bond, the interest on which is excluded from the gross
income of the lender, is mandatory. Read section 454(a), which states as follows:
Section 454. Obligations issued at discount
(a) Non-interest-bearing obligations issued at a discount
If, in the case of a taxpayer owning any non-interest-bearing obligation
issued at a discount and redeemable for fixed amounts increasing at stated
intervals or owning an obligation described in paragraph (2) of subsection
(c), the increase in the redemption price of such obligation occurring in the
taxable year does not (under the method of accounting used in computing
his taxable income) constitute income to him in such year, such taxpayer
may, at his election made in his return for any taxable year, treat such
increase as income received in such taxable year. If any such election is
made with respect to any such obligation, it shall apply also to all such
obligations owned by the taxpayer at the beginning of the first taxable year
to which it applies and to all such obligations thereafter acquired by him
and shall be binding for all subsequent taxable years, unless on application
by the taxpayer the Secretary permits him, subject to such conditions as the
Secretary deems necessary, to change to a different method. In the case of
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16.
17.
any such obligations owned by the taxpayer at the beginning of the first
taxable year to which his election applies, the increase in the redemption
price of such obligations occurring between the date of acquisition (or, in
the case of an obligation described in paragraph (2) of subsection (c), the
date of acquisition of the series E bond involved) and the first day of such
taxable year shall also be treated as income received in such taxable year.
a.
The accrual of bond discount is to be done by days, but for the purposes of this
document, amortization should be done by months.
The amortization of bond premium results in deductions to the bond owner for each of the
amortization periods.
a.
If the bond is held for investment purposes, then these deductions are below the line,
but not included of the 2% test.
Example. If a $10,000, ten year bond ,is issued for $10,000 (issued at par) and if the bond
has a stated interest rate of 6%, then every year, for ten years, the bond owner will receive
$600 of interest income and the par value of the bond will stay the same throughout the life
of the bond and when the bond is redeemed at the end of ten years, the bond owner will be
paid $10,000 and the bond owner will not had any gain.
a.
If the bond owner purchased the bond for $11,000 and the bond owner elected to
amortize the bond premium of $1,000 for ten years at the rate of $100 per year, then
after the first year, the bond owner would have an adjusted basis for the bond of
$10,900 (11,000 - 100) and that the end of the ten years, the bond owner’s adjusted
basis for the bond would be $10,000 and the bond owner would be paid $10,000 and
have no gain or loss.
b.
Each year that the owner of the bond amortized the premium (once started it may
not be stopped), the bond owner could offset the $100 of premium against the $600
of stated interest and report $500 of bond interest gross income.
c.
If the bond owner did not elect to amortize the bond premium, then the bond
owner’s basis for the bond on the day of purchasing the bond would be $11,000 and
it would also be $11,000 when the bond owner cash in the bond and the bond holder
would have a capital loss of $1,000.
d.
Why would the bond owner not have an ordinary loss due to the no “sale or
exchange” concept? Read section 1271(a), which states as follows:
Section 1271. Treatment of amounts received on retirement or sale or exchange of
debt instruments
(a) General rule
For purposes of this title—
(1) Retirement
Amounts received by the holder on retirement of any debt
instrument shall be considered as amounts received in
exchange therefor.
(2) Ordinary income on sale or exchange where intention to call
before maturity
(A) In general
If at the time of original issue there was an
intention to call a debt instrument before maturity,
any gain realized on the sale or exchange thereof
which does not exceed an amount equal to—
(i) the original issue discount, reduced by
(ii) the portion of original issue discount
previously includible in the gross income of any
holder (without regard to subsection (a)(7) or
(b)(4) of section 1272 (or the corresponding
provisions of prior law)),
shall be treated as ordinary income.
(B) Exceptions
This paragraph (and paragraph (2) of subsection
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(c)) shall not apply to—
(i) any tax-exempt obligation, or
(ii) any holder who has purchased the debt
instrument at a premium.
(3) Certain short-term Government obligations
(A) In general
On the sale or exchange of any short-term
Government obligation, any gain realized which
does not exceed an amount equal to the ratable
share of the acquisition discount shall be treated as
ordinary income.
(B) Short-term Government obligation
For purposes of this paragraph, the term
“short-term Government obligation” means any
obligation of the United States or any of its
possessions, or of a State or any political
subdivision thereof, or of the District of Columbia,
which has a fixed maturity date not more than 1
year from the date of issue. Such term does not
include any tax-exempt obligation.
(C) Acquisition discount
For purposes of this paragraph, the term
“acquisition discount” means the excess of the
stated redemption price at maturity over the
taxpayer’s basis for the obligation.
(D) Ratable share
For purposes of this paragraph, except as provided
in subparagraph (E), the ratable share of the
acquisition discount is an amount which bears the
same ratio to such discount as—
(i) the number of days which the taxpayer held the
obligation, bears to
(ii) the number of days after the date the taxpayer
acquired the obligation and up to (and
including) the date of its maturity.
(E) Election of accrual on basis of constant interest rate
At the election of the taxpayer with respect to any
obligation, the ratable share of the acquisition
discount is the portion of the acquisition discount
accruing while the taxpayer held the obligation
determined (under regulations prescribed by the
Secretary) on the basis of—
(i) the taxpayer’s yield to maturity based on the
taxpayer’s cost of acquiring the obligation, and
(ii) compounding daily.
An election under this subparagraph, once
made with respect to any obligation, shall
be irrevocable.
(4) Certain short-term nongovernment obligations
(A) In general
On the sale or exchange of any short-term
nongovernment obligation, any gain realized
which does not exceed an amount equal to the
ratable share of the original issue discount shall be
treated as ordinary income.
(B) Short-term nongovernment obligation
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(1)
E.
For purposes of this paragraph, the term
“short-term nongovernment obligation” means any
obligation which—
(i) has a fixed maturity date not more than 1 year
from the date of the issue, and
(ii) is not a short-term Government obligation (as
defined in paragraph (3)(B) without
regard to the last sentence thereof).
(C) Ratable share
For purposes of this paragraph, except as provided
in subparagraph (D), the ratable share of the
original issue discount is an amount which bears
the same ratio to such discount as—
(i) the number of days which the taxpayer held the
obligation, bears to
(ii) the number of days after the date of original
issue and up to (and including) the date of its
maturity.
(D) Election of accrual on basis of constant interest rate
At the election of the taxpayer with respect to any
obligation, the ratable share of the original issue
discount is the portion of the original issue
discount accruing while the taxpayer held the
obligation determined (under regulations
prescribed by the Secretary) on the basis of—
(i) the yield to maturity based on the issue price of
the obligation, and
(ii) compounding daily.
Any election under this subparagraph,
once made with respect to any obligation,
shall be irrevocable.
Amounts received by the holder on retirement of any debt instrument shall
be considered as amounts received in exchange therefor.
Accrual of bond discount.
1.
Section 454 provides as follows with respect to non-interest-bearing obligations which are
issued at a discount.
a.
The accrual of discount results in addition income to the bond owner.
2.
If, in the case of a taxpayer owning any non-interest-bearing obligation issued at a discount
and redeemable for fixed amounts increasing at stated intervals or owning an obligation
described in paragraph (2) of subsection (c), the increase in the redemption price of such
obligation occurring in the taxable year does not (under the method of accounting used in
computing his taxable income) constitute income to him in such year, such taxpayer may, at
his election made in his return for any taxable year, treat such increase as income received in
such taxable year.
a.
If any such election is made with respect to any such obligation, it shall apply also
to all such obligations owned by the taxpayer at the beginning of the first taxable year
to which it applies and to all such obligations thereafter acquired by him and shall be
binding for all subsequent taxable years, unless on application by the taxpayer the
Secretary permits him, subject to such conditions as the Secretary deems necessary,
to change to a different method. In the case of any such obligations owned by the
taxpayer at the beginning of the first taxable year to which his election applies, the
increase in the redemption price of such obligations occurring between the date of
acquisition (or, in the case of an obligation described in paragraph (2) of subsection
(c), the date of acquisition of the series E bond involved) and the first day of such
taxable year shall also be treated as income received in such taxable year.
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3.
F.
As previously stated, in general, all bond discounts are required to be accrued by the holder
of the bond, and thus, the holder of the bond will not have any capital gain gross income when
the bond is redeemed, assuming that the discount is fully accrued at the time of the
redemption of the bond.
4.
One exception to this is certain United States Treasury bonds, which allow the holder of the
bond to either accrue the discount or to not accrue the discount, at the holder's election.
Read section 454(a), which states as follows:
Section 454. Obligations issued at discount
(a) Non-interest-bearing obligations issued at a discount
If, in the case of a taxpayer owning any non-interest-bearing obligation
issued at a discount and redeemable for fixed amounts increasing at stated
intervals or owning an obligation described in paragraph (2) of subsection
(c), the increase in the redemption price of such obligation occurring in the
taxable year does not (under the method of accounting used in computing his
taxable income) constitute income to him in such year, such taxpayer may,
at his election made in his return for any taxable year, treat such increase as
income received in such taxable year. If any such election is made with
respect to any such obligation, it shall apply also to all such obligations
owned by the taxpayer at the beginning of the first taxable year to which it
applies and to all such obligations thereafter acquired by him and shall be
binding for all subsequent taxable years, unless on application by the
taxpayer the Secretary permits him, subject to such conditions as the
Secretary deems necessary, to change to a different method. In the case of
any such obligations owned by the taxpayer at the beginning of the first
taxable year to which his election applies, the increase in the redemption
price of such obligations occurring between the date of acquisition (or, in the
case of an obligation described in paragraph (2) of subsection (c), the date
of acquisition of the series E bond involved) and the first day of such taxable
year shall also be treated as income received in such taxable year.
State and local bonds.
1.
In the case of state and local bonds, section 171 requires the holder of the bond to amortize
the bond premium, but in so doing, the bond premium is not deductible, because the bond
premium is nothing more than an adjustment of effective interest and the interest on state and
local bonds is excludable from gross income under section 103.
2.
An allocable portion of the premium, however, must be applied each year to reduce the
taxpayer's adjusted basis for the state or local bond to reflect the fact that the premium is
recovered in annual installments as the interest accrues or is received. Read section
1016(a)(5) and section 171(b), which states as follows:
Section 1016. Adjustments to basis
(a) General rule
Proper adjustment in respect of the property shall in all cases be made—
(5) in the case of any bond (as defined in section 171 (d))
the interest on which is wholly exempt from the tax imposed by this
subtitle, to the extent of the amortizable bond premium disallowable
as a deduction pursuant to section 171 (a)(2), and in the case of any
other bond (as defined in section 171 (d)) to the extent of the
deductions allowable pursuant to section 171 (a)(1) (or the amount
applied to reduce interest payments under section 171 (e)(2)) with
respect thereto;
Section 171. Amortizable bond premium
(b) Amortizable bond premium
(1) Amount of bond premium
For purposes of paragraph (2), the amount of bond premium, in the
case of the holder of any bond, shall be determined—
(A) with reference to the amount of the basis (for determining loss
on sale or exchange) of such bond,
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(B)
(i) with reference to the amount payable on maturity or on
earlier call date, in the case of any bond other than
a bond to which clause (ii) applies, or and [1]
(ii) with reference to the amount payable on maturity (or if
it results in a smaller amortizable bond premium
attributable to the period to earlier call date, with
reference to the amount payable on earlier call
date), in the case of any bond described in
subsection (a)(1) which is acquired after December
31, 1957, and
(C) with adjustments proper to reflect unamortized bond premium,
with respect to the bond, for the period before the date as of
which subsection (a) becomes applicable with respect to the
taxpayer with respect to such bond.
In no case shall the amount of bond premium on a convertible bond
include any amount attributable to the conversion features of the
bond.
(2) Amount amortizable
The amortizable bond premium of the taxable year shall be the
amount of the bond premium attributable to such year. In the case of
a bond to which paragraph (1)(B)(ii) applies and which has a call
date, the amount of bond premium attributable to the taxable year in
which the bond is called shall include an amount equal to the excess
of the amount of the adjusted basis (for determining loss on sale or
exchange) of such bond as of the beginning of the taxable year over
the amount received on redemption of the bond or (if greater) the
amount payable on maturity.
(3) Method of determination
(A) In general
Except as provided in regulations prescribed by the
Secretary, the determinations required under paragraphs (1)
and (2) shall be made on the basis of the taxpayer’s yield to
maturity determined by—
(i) using the taxpayer’s basis (for purposes of determining
loss on sale or exchange) of the obligation, and
(ii) compounding at the close of each accrual period (as
defined in section 1272 (a)(5)).
(B) Special rule where earlier call date is used
For purposes of subparagraph (A), if the amount payable on
an earlier call date is used under paragraph (1)(B)(ii) in
determining the amortizable bond premium attributable to
the period before the earlier call date, such bond shall be
treated as maturing on such date for the amount so payable
and then reissued on such date for the amount so payable.
(4) Treatment of certain bonds acquired in exchange for other property
(A) In general
If—
(i) a bond is acquired by any person in exchange for other
property, and
(ii) the basis of such bond is determined (in whole or in
part) by reference to the basis of such other
property, for purposes of applying this subsection
to such bond while held by such person, the basis
of such bond shall not exceed its fair market value
immediately after the exchange. A similar rule shall
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3.
G.
apply in the case of such bond while held by any
other person whose basis is determined (in whole or
in part) by reference to the basis in the hands of the
person referred to in clause (i).
(B) Special rule where bond exchanged in reorganization
Subparagraph (A) shall not apply to an exchange by the
taxpayer of a bond for another bond if such exchange is a
part of a reorganization (as defined in section 368). If any
portion of the basis of the taxpayer in a bond transferred in
such an exchange is not taken into account in determining
bond premium by reason of this paragraph, such portion
shall not be taken into account in determining the amount of
bond premium on any bond received in the exchange.
With respect to state and local bonds issued at a discount, the accrued discount is not
includible in the holder's gross income, because the bond discount is nothing more than an
adjustment of interest and interest from state and local bonds is excluded from gross income
under section 103.
Adjustments to the basis of the bonds.
1.
For taxable and non-taxable bonds, amortization of premiums results in a reduction in
adjusted basis. Read section 1016(a)(5), which states as follows:
Section 1016. Adjustments to basis
(a) General rule
Proper adjustment in respect of the property shall in all cases be made—
(5) in the case of any bond (as defined in section 171 (d)) the interest on
which is wholly exempt from the tax imposed by this subtitle, to the
extent of the amortizable bond premium disallowable as a deduction
pursuant to section 171 (a)(2), and in the case of any other bond (as
defined in section 171 (d)) to the extent of the deductions allowable
pursuant to section 171 (a)(1) (or the amount applied to reduce
interest payments under section 171 (e)(2)) with respect thereto;
2.
For bonds, the interest on which is taxable (but not with respect to tax-exempt bonds),
amortization also results in a deduction in computing taxable income, for the amount of
amortizable bond premium attributable to the tax year. Read Reg. §1.171-1(b)(2).
3.
The deduction is used to offset the interest paid on the bond. Read Reg. §1.171-1(a)(1).
4.
The amount of amortizable premium for any bond is the excess of the adjusted basis of the
bond (for determining loss on sale) over the amount payable at maturity. Read section
171(b)(1), which states as follows:
Section 171. Amortizable bond premium
(b) Amortizable bond premium
(1) Amount of bond premium
For purposes of paragraph (2), the amount of bond premium, in the
case of the holder of any bond, shall be determined—
(A) with reference to the amount of the basis (for determining loss
on sale or exchange) of such bond,
(B)
(i) with reference to the amount payable on maturity or on
earlier call date, in the case of any bond other than
a bond to which clause (ii) applies, or and [1]
(ii) with reference to the amount payable on maturity (or if
it results in a smaller amortizable bond premium
attributable to the period to earlier call date, with
reference to the amount payable on earlier call
date), in the case of any bond described in
subsection (a)(1) which is acquired after December
31, 1957, and
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5.
H.
(C) with adjustments proper to reflect unamortized bond premium,
with respect to the bond, for the period before the date as of
which subsection (a) becomes applicable with respect to the
taxpayer with respect to such bond.
In no case shall the amount of bond premium on a convertible bond include
any amount attributable to the conversion features of the bond.
In the case of accruals of bond discount, the accruals result in gross income to the owner of
the bond and the basis of the bond is increased by the amount of each accrual which results
in gross income to the owner of the bond.
Disposition of bonds.
1.
If the bond holder disposes of the bond prior to its maturity, the periodic original issue
discount allocations of income and expenditure continue to apply to the new holder and to the
bond issuer. Read section 1272(d)(2), which states as follows:
Section 1272. Current inclusion in income of original issue discount
(d) Definition and special rule
(2) Basis adjustment
The basis of any debt instrument in the hands of the holder thereof
shall be increased by the amount included in his gross income
pursuant to this section.
a.
Thus, the new holder will recognize income for each such original issue discount
allocation, and the debtor will continue to treat each such allocation as an interest
expenditure.
2.
If, however, the amount paid by the purchase of the bond is greater than the sum of the issue
price of the bond and the aggregate original issue discount previously included in the gross
income of the previous holder, the daily original issue discount allocation that is treated as
income to that purchaser will be reduced by an allocated portion of that excess (the
purchaser's "acquisition premium"). Read section 1272(a)(7), which states as follows:
Section 1272. Current inclusion in income of original issue discount
(a) Original issue discount on debt instruments issued after July 1, 1982, included in
income on basis of constant interest rate
(7) Reduction where subsequent holder pays acquisition premium
(A) Reduction
For purposes of this subsection, in the case of any purchase
after its original issue of a debt instrument to which this
subsection applies, the daily portion for any day shall be
reduced by an amount equal to the amount which would be
the daily portion for such day (without regard to this
paragraph) multiplied by the fraction determined under
subparagraph (B).
(B) Determination of fraction
For purposes of subparagraph (A), the fraction determined
under this subparagraph is a fraction—
(i) the numerator of which is the excess (if any) of—
(I) the cost of such debt instrument incurred by the
purchaser, over
(II) the issue price of such debt instrument,
increased by the portion of original issue
discount previously includible in the gross
income of any holder (computed without
regard to this paragraph), and
(ii) the denominator of which is the sum of the daily
portions for such debt instrument for all days after
the date of such purchase and ending on the stated
maturity date (computed without regard to this
paragraph).
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a.
3.
4.
5.
I.
A holder will not recognize any original issue discount as income if he purchased the
bond at a premium. Read section 1272(c)(1), which states as follows:
Section 1272. Current inclusion in income of original issue discount
(c) Exceptions
This section shall not apply to any holder—
(1) who has purchased the debt instrument at a premium, or
The sale of the bond (for a premium or otherwise) has no effect on the amount of deduction
that continues to be allowable to the issuer of the bond; only the holder's income can be
affected. A change in the issuer's deduction allowance would place a great administrative
burden on the issuer.
Amounts received on retirement of a corporate or governmental bond are treated as having
been received in exchange thereof. Read section 1271(a)(1), which states as follows:
Section 1272. Current inclusion in income of original issue discount
(a) Original issue discount on debt instruments issued after July 1, 1982, included in
income on basis of constant interest rate
(1) General rule
For purposes of this title, there shall be included in the gross income
of the holder of any debt instrument having original issue discount
issued after July 1, 1982, an amount equal to the sum of the daily
portions of the original issue discount for each day during the
taxable year on which such holder held such debt instrument.
In general, the gain from the sale or exchange of a bond will be ordinary income to the extent
that the gain represents previously unreported original issue discount.
Original issue discount. If a bond is acquired from an issuer for an amount that is less than the amount
the issuer will have to pay the holder when the bond matures (for example, the bond is purchased at
a discount), the difference is the original issue discount.
Read section 1273(a), which states as follows:
Section 1273. Determination of amount of original issue discount
(a) General rule
For purposes of this subpart—
(1) In general
The term “original issue discount” means the excess (if any) of—
(A) the stated redemption price at maturity, over
(B) the issue price.
1.
When a debt obligation such as a bond is issued at a discount, the amount of the discount
represents additional interest on the obligation.
2.
The total amount of original issue discount on a bond is the excess of the bond's "stated
redemption price" at maturity over the bond's "issue price."
Read section 1273(a)(1), which states as follows:
Section 1273. Determination of amount of original issue discount
(a) General rule
For purposes of this subpart—
(1) In general
The term “original issue discount” means the excess (if any) of—
(A) the stated redemption price at maturity, over
(B) the issue price.
a.
The original issue discount represents additional interest that effectively is payable
by the bond issuer (debtor) over the period of the bond (loan).
b.
Regardless of the method of accounting, the holder must report a part of the original
issue discount as interest income in each tax year the bond is held, even though the
original issue discount will not be paid to the holder until the bond matures. Read
section 1272, which states as follows:
Section 1272(a). Current inclusion in income of original issue discount
(a) Original issue discount on debt instruments issued after July 1, 1982,
included in income on basis of constant interest rate
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(1) General rule
For purposes of this title, there shall be included in the gross
income of the holder of any debt instrument having original
issue discount issued after July 1, 1982, an amount equal to
the sum of the daily portions of the original issue discount
for each day during the taxable year on which such holder
held such debt instrument.
(2) Exceptions
Paragraph (1) shall not apply to—
(A) Tax-exempt obligations
Any tax-exempt obligation.
(B) United States savings bonds
Any United States savings bond.
(C) Short-term obligations
Any debt instrument which has a fixed maturity
date not more than 1 year from the date of issue.
(D) Obligations issued by natural persons before March 2,
1984
Any obligation issued by a natural person before
March 2, 1984.
(E) Loans between natural persons
(i) In general Any loan made by a natural person to
another natural person if—
(I) such loan is not made in the course of a
trade or business of the lender, and
(II) the amount of such loan (when
increased by the outstanding
amount of prior loans by such
natural person to such other
natural person) does not exceed
$10,000.
(ii) Clause (i) not to apply where tax avoidance a
principal purpose Clause (i) shall not apply
if the loan has as 1 of its principal purposes
the avoidance of any Federal tax.
(iii) Treatment of husband and wife For purposes of
this subparagraph, a husband and wife
shall be treated as 1 person. The preceding
sentence shall not apply where the spouses
lived apart at all times during the taxable
year in which the loan is made.
(3) Determination of daily portions
For purposes of paragraph (1), the daily portion of the
original issue discount on any debt instrument shall be
determined by allocating to each day in any accrual period
its ratable portion of the increase during such accrual period
in the adjusted issue price of the debt instrument. For
purposes of the preceding sentence, the increase in the
adjusted issue price for any accrual period shall be an
amount equal to the excess (if any) of—
(A) the product of—
(i) the adjusted issue price of the debt instrument at
the beginning of such accrual period, and
(ii) the yield to maturity (determined on the basis of
compounding at the close of each accrual
period and properly adjusted for the length
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of the accrual period), over
(B) the sum of the amounts payable as interest on such debt
instrument during such accrual period.
(4) Adjusted issue price
For purposes of this subsection, the adjusted issue price of
any debt instrument at the beginning of any accrual period
is the sum of—
(A) the issue price of such debt instrument, plus
(B) the adjustments under this subsection to such issue price
for all periods before the first day of such accrual
period.
(5) Accrual period
Except as otherwise provided in regulations prescribed by
the Secretary, the term “accrual period” means a 6-month
period (or shorter period from the date of original issue of
the debt instrument) which ends on a day in the calendar
year corresponding to the maturity date of the debt
instrument or the date 6 months before such maturity date.
(6) Determination of daily portions where principal subject to
acceleration
(A) In general
In the case of any debt instrument to which this
paragraph applies, the daily portion of the original
issue discount shall be determined by allocating to
each day in any accrual period its ratable portion of
the excess (if any) of—
(i) the sum of
(I) the present value determined under
subparagraph (B) of all remaining
payments under the debt
instrument as of the close of such
period, and
(II) the payments during the accrual period
of amounts included in the stated
redemption price of the debt
instrument, over
(ii) the adjusted issue price of such debt instrument
at the beginning of such period.
(B) Determination of present value
For purposes of subparagraph (A), the present
value shall be determined on the basis of—
(i) the original yield to maturity (determined on the
basis of compounding at the close of each
accrual period and properly adjusted for
the length of the accrual period),
(ii) events which have occurred before the close of
the accrual period, and
(iii) a prepayment assumption determined in the
manner prescribed by regulations.
(C) Debt instruments to which paragraph applies
This paragraph applies to—
(i) any regular interest in a REMIC or qualified
mortgage held by a REMIC,
(ii) any other debt instrument if payments under
such debt instrument may be accelerated
by reason of prepayments of other
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3.
obligations securing such debt instrument
(or, to the extent provided in regulations,
by reason of other events), or
(iii) any pool of debt instruments the yield on
which may be affected by reason of
prepayments (or to the extent provided in
regulations, by reason of other events).
To the extent provided in regulations
prescribed by the Secretary, in the case of
a small business engaged in the trade or
business of selling tangible personal
property at retail, clause (iii) shall not
apply to debt instruments incurred in the
ordinary course of such trade or business
while held by such business.
(7) Reduction where subsequent holder pays acquisition premium
(A) Reduction
For purposes of this subsection, in the case of any
purchase after its original issue of a debt instrument
to which this subsection applies, the daily portion
for any day shall be reduced by an amount equal to
the amount which would be the daily portion for
such day (without regard to this paragraph)
multiplied by the fraction determined under
subparagraph (B).
(B) Determination of fraction
For purposes of subparagraph (A), the fraction
determined under this subparagraph is a fraction—
(i) the numerator of which is the excess (if any)
of—
(I) the cost of such debt instrument
incurred by the purchaser, over
(II) the issue price of such debt instrument,
increased by the portion of
original issue discount previously
includible in the gross income of
any holder (computed without
regard to this paragraph), and
(ii) the denominator of which is the sum of the
daily portions for such debt instrument for
all days after the date of such purchase and
ending on the stated maturity date
(computed without regard to this
paragraph).
A portion of the original issue discount is allocated on a daily basis over the remaining term
of the bond and accrued as income to the holder of the bond and an expenditure of