Federal Income Tax
(Professor Peroni)
Fall 2021
Power Point Slides—Unit 1-Part (3)*
*Copyright © 2013-2021 by Robert J. Peroni. All rights reserved
Part (3)—Importance of Personal v. Business or
Investment Borderline in Tax Law (1)
• In Part (2) of Unit 1, we explored how the tax law distinguishes between trade
or business activities v. non-trade or business income-producing investment
activities and what the consequences are of that distinction.
• In this Part (3) of Unit 1, we now look at how the tax law distinguishes
between expenses that are treated as personal consumption items and those
that are deductible as trade or business or non-trade or business incomeproducing investment expenses. In other words, we are looking at the
personal v. business/investment borderline.
• This is an important issue in an income tax system following either HaigSimons or the ability-to-pay concept because personal consumption is a key
part of the tax base for individual taxpayers—remember an income tax base
includes both consumption plus savings. It is as an important or more
important issue in a cash flow consumption tax system because personal
consumption is the entire tax base.
Part (3)—Importance of Personal v. Business or
Investment Borderline in Tax Law (2)
• Notice that as we go through these problems, the tax law uses various
approaches to trying to sort out the personal consumption component
versus the business or investment component of various types of
expenses:
• (1) In some cases, an all surrounding facts and circumstances approach is
used.
• (2) In some cases, a flat disallowance of some of these expenditures is used
because the personal consumption component predominates.
• (3) In other cases, the tax law uses a percentage disallowance that is
supposed to reflect in some general sense the personal consumption
component of the expense that should be disallowed as a deduction.
• (4) In still other cases, the tax law allows a complete deduction for the
expense because the business or investment component predominates and
the personal consumption component is thought to be incidental.
Part (3)(a)—Helen the Management
Consultant-Sole Proprietor (1)
• First, note that Helen’s sole proprietorship management consulting
business is a trade or business for § 162 purposes.
• Second, she has $350,000 of fees from clients that are includible in gross
income under § 61(a)(1) and, like all service income, are ordinary
income, not capital gain, because there is no sale or exchange of
property within the meaning of §§ 1221 and 1222.
• Third, she has $50,000 of deductible ordinary and necessary business
expenses under § 162, which is an ordinary deduction, so her net
income from this business is $300,000, before taking into account the
rent and meals. She is carrying on the business and, as a cash method
taxpayer, has paid them during the taxable year.
• This § 162 deduction is above the line under § 62(a)(1).
Part (3)(a)—Helen the Management
Consultant-Sole Proprietor (2)
• Fourth, even if we concluded somehow that her $40,000 of rent and
$20,000 of meals are fully deductible (not the case, of course, in Part
(3)(a)), her pre-§ 199A taxable income for 2021 would be $227,450 (i.e.,
$350,000 - $50,000 - $40,000 - $20,000 - $12,550 SD).
• Because management consulting is a “specified service trade or
business’ for § 199A purposes under §§ 199A(d)(2)(A) and 1202(e)(3)(A)
and her pre-§ 199A taxable income exceeds the threshold amount (for
2021) of $164,900, plus $50,000, or $214,900, the exception in §
199A(d)(3) does not apply. Thus, she does not have a “qualified
business” for § 199A purposes for 2021, § 199(d)(1)(A), and, thus, she
cannot take a § 199A deduction.
Part (3)(a)—Helen the Management
Consultant-Sole Proprietor (3)
• Fifth, the rent and meals in Part (3)(a) have no real connection to either her
management consulting business or any other income-producing activity. So,
there is no Code section that authorizes a deduction for these personal
consumption expenditures and, thus, of course, they are NOT deductible.
• Moreover, a specific disallowance rule, § 262(a), provides that “Except as
otherwise expressly provided . . . , no deduction shall be allowed for personal,
living, or family expenses.” Personal rent and personal meals are
quintessential personal and living expenses, so clearly no deduction for them
and § 262(a) specifically disallows any deduction for them.
• This makes sense because these personal consumption items should clearly
be part of any sensible income or even cash flow consumption tax base, once
you account for any subsistence allowance through a standard deduction.
• Note that the standard deduction in § 63(c) is one of those exceptions to §
262(a) that Congress has specifically authorized.
Part (3)(b)—Helen the Management Consultant-Sole
Proprietor with Business Rent (1)
• Here, we have a change in the facts. The expenses for rent and meals
now have a definite connection/nexus with Helen’s management
consulting business and the question is whether that connection is
substantial enough to merit a deduction for some or all of these
expenses under § 162(a) and to what extent § 274 will disallow all or
some portion of these expenses.
• The $40,000 business rent seems to meet the “necessary” requirement
(it is appropriate and helpful to her business) and both “ordinary”
requirements of § 162—this expense is common and accepted for this
type of business and it is a current, annual expense that does not
provide significant future benefits (i.e., it is not a “capital expenditure”).
She has paid it during the current taxable year as a cash method
taxpayer and she is already carrying on the business (i.e., it is not a
startup expense).
Part (3)(b)—Helen the Management Consultant-Sole
Proprietor with Business Rent (2)
• So, the business rent seems to meet all the requirements of § 162(a).
• However, business rent must also meet an additional requirement in §
162(a)(3) in order to be deductible. The rent payment must not provide the
payor with title to the property or an equity interest in the property.
• This provision is designed to disallow rental deductions for what are in
substance really installment payments for the purchase of the property. In
other words, the issue is whether this transaction in substance is a lease or a
sale for federal income tax purposes. If it is really a sale, then the “rental”
payments will be disallowed as a current deduction and the payments will be
treated as part of the payor’s purchase price for the property.
• Courts and the IRS look at all the surrounding facts and circumstances in making this
determination, including whether the lease contains a purchase option that at the
outset of the lease is likely to be exercised by the lessee.
Part (3)(b)—Helen the Management Consultant-Sole
Proprietor with Business Rent (3)
• Note that in the federal tax law, courts and the IRS will often treat the economic substance of a
transaction as controlling over its form, unless Congress has made it clear that it wants form to
control in the particular matter.
• There are different labels put on this doctrine—economic substance, business purpose, sham
transaction, and substance over form.
• The economic substance doctrine is now codified in the Code in § 7701(o).
• Notice that this doctrine can generally only be used by a court or the IRS to argue that substance
should control over the form of a taxpayer’s transaction, but taxpayers will generally not be
allowed to disavow the form of transaction that they have chosen (with certain exceptions).
• However, there are no facts to indicate that Helen’s business lease here gives her any
disqualifying equity interest in the property.
• So, she should be able to take an ordinary deduction under § 162(a) and § 162(a)(3) for this
$40,000 of business rent.
• It is an above the line deduction under § 62(a)(1).
• It is not an itemized deduction and so it cannot be an MID for § 67 purposes.
Part (3)(b)—Helen the Management Consultant-Sole
Proprietor with Business Meals (1)
• Now, let’s turn to Helen’s business meals of $20,000 and to what extent they may be
deductible.
• First, we note that business meals by their nature obviously have both a personal
consumption component and business component to them and the question is how do
we sort that out and determine the proper amount of the business expense deduction
for these meals.
• Because these business meals have so much of a potential personal consumption
component, they have to go through many hurdles before they can be deducted.
• First, let’s posit that they probably are appropriate and helpful to Helen’s business so
they meet the “necessary” requirement of § 162.
• Second, they probably are common and accepted for this type of business and are
current expense that do not provide significant future benefits (i.e., they are not “capital
expenditures”) so they meet both “ordinary” requirements of § 162.
• Third, as a cash method taxpayer, she has paid the expenses during the year and she is
carrying on the business (i.e., these are not startup expenses).
Part (3)(b)—Helen the Management Consultant-Sole
Proprietor with Business Meals (2)
• Fourth, court decisions such as the Seventh Circuit’s decision in
Moss v. Comm’r (1985), at p. 272 of the casebook demonstrate
how courts will police the business deduction to make sure that
the business nexus is sufficiently strong to justify the deduction
under § 162(a).
• In that case, the members of a small law firm in Chicago met
daily for lunch at which they discussed firm business. They ate a
restaurant near the firm, which they picked in part because they
liked the food.
• Judge Posner disallowed the business meal deduction on the
grounds that the taxpayers had not established the business
necessity of these meals.
Part (3)(b)—Helen the Management Consultant-Sole
Proprietor with Business Meals (3)
• Among the factors that caused Judge Posner to disallow the deduction
are the following:
• (1) the frequency of the meals—they met and ate together every day—this is
abusive and makes it harder to demonstrate that this any different than the
meal they would have otherwise had every day for personal purposes;
• (2) these were not meals with clients, but instead with members of the same
firm. It is generally easier to demonstrate a business necessity for the
business meals when the meals are with a client.
• (3) they did not show that the meals were an organic part of the business
meeting, i.e., did the lawyers’ business objective in meeting together require
sharing a meal?
• (4) these taxpayers picked a normal kind of restaurant they would have eaten
at if they were not at a supposed business meal. It is easier to justify a
deduction when the taxpayer picks a restaurant that is especially appropriate
for the business meeting aspect of the meal.
Part (3)(b)—Helen the Management Consultant-Sole
Proprietor with Business Meals (3)
• There are no facts to indicate that Helen’s meal expenses would flunk any of these
factors in Moss.
• So, it looks like she has a $20,000 potential deduction under § 162(a).
• Fifth, however, with many § 162 deductions, such as business meals and travel expenses,
you then have to go through the specific disallowance provisions of § 274.
• One important requirement under § 274(d) is that the expenses must be properly
substantiated by receipts or other records that show the amount of the expense, that it
was fully paid, the date it was incurred, all the attendees at the meal, and the business
reason for the meal. § 274(d) overturned the “reasonable approximation” standard
of the Cohan case (2d Cir. 1930) under pre-§ 274(d) case law.
• To the extent that the substantiation requirements of § 274(d) are not met, the
expenses subject to this requirement will NOT be deductible, no matter how closely
connected they are with the business.
• Let’s assume that all of Helen’s business meals meet this requirement.
Part (3)(b)—Helen the Management Consultant-Sole
Proprietor with Business Meals (4)
• § 274(c) has special limitations on the deduction of foreign travel expenses and § 274(h)
has special limitations on the deduction of expenses for conventions that are held
outside the North American area. § 274(m) has some additional limitations on the
deduction of certain travel expenses, including those on luxury water transportation (i.e.,
cruise ships). We are not covering these provisions this semester or the basic rules for
deducting travel expenses under § 162(a) and the special additional rules in § 162(a)(2).
In any event, these rules have nothing to do with Helen’s business meals in this problem.
• § 274(j) has special limitations on the deduction of employee achievement awards. We
are not going to cover these this semester and they have nothing to do with Helen’s
business meals in this problem.
• § 274(k)(1)(A) disallows any deduction for food or beverage if the expense is lavish or
extravagant under the circumstances. This seems somewhat redundant of the
“ordinary” requirement of § 162(a). In any event, let’s assume that all of Helen’s
business meals meet this requirement.
• § 274(k)(1)(B) requires that the taxpayer or an employee of the taxpayer is present at the
furnishing of the meal or beverage. Let’s assume that all of Helen’s business meals meet
this requirement.
Part (3)(b)—Helen the Management Consultant-Sole
Proprietor with Business Meals (5)
• That brings us to § 274(n)(1), which will disallow 50% of Helen’s otherwise deductible business meals
of $20,000, except for a temporary suspension of that limitation in § 274(n)(2)(D) for restaurant food or
beverages paid or incurred in 2021 and 2022.
• § 274(n) was first enacted in 1986, when it disallowed only 20% of the business meals; the 50%
disallowance came into the law in 1993.
• The theory is “rough justice” for business meals—the disallowed portion is the personal consumption
portion; the remaining portion is the business portion. Of course, this is an arbitrary, bright line rule
that is undoubtedly overly generous in many situations and overly harsh in some situations.
• Note that the business meal deduction, even as limited by § 274(n), is probably too generous to be consistent
with either Haig-Simons or the ability-to-pay concept.
• So that leaves all $20,000 of business meals as Helen’s deduction for the taxable year, which meet all
of the requirements of §§ 162 and 274, including § 274(n)(2)(D), if these business meals take place in
2021 or 2022. See Notice 2021-25.
• This is an ordinary deduction and is above the line under § 62(a)(1).
• Because it is not an itemized deduction, it cannot be an MID and § 67 does not apply to it.
Part (3)(b)—Helen the Management Consultant-Sole
Proprietor with Business Meals (6)
• The regulations have a special exception to the § 274(n)(1) 50% disallowance rule
for any food or beverage provided by a taxpayer for “a recreational, social, or
similar activity, primarily for the benefit of taxpayer’s employees (other than
employees who are highly compensated employees . . . .).” See Treas. Reg. §
1.274-12(c)(2)(iii)(A).
• This exception applies to events such as holiday parties, annual picnics, or
summer outings, but probably not to events that would be considered
“entertainment activities” subject to the disallowance rules of § 274(a)(1)(A),
such as concerts and sporting events—see below.
• It is not clear why the Treasury and IRS provided this special rule and it has been
criticized by some tax policy commentators.
Part (3)(b)—Helen the Management Consultant-Sole
Proprietor with Business Meals (7)
• If the holiday party, annual picnic, or other activity is made primarily for the
benefit of the taxpayer’s highly compensated employees, then this exception
does not apply and the 50% disallowance rule in § 274(n)(1) will apply to the food
and beverages provided at the event.
• This exception also does not apply to free coffee, donuts, and snacks provided in
a break room for all employees, because this is not considered to be a
“recreational, social, or similar activity.” See Treas. Reg. § 1.274-12(c)(2)(iii)(B)(3),
Ex. 3. So, as we determined in Part (2)(d)(vii) of the problem, § 274(n)(1) applies
in this situation to disallow 50% of the employer’s deduction of the cost of the
beverages and food provided.
• If, as is likely, these are not food or beverages provided by a restaurant, the temporary
suspension of the 50% limitation for 2021 and 2022 in § 274(n)(2)(D) would not apply.
Part (3)(b)—Helen the Employee with A Business Meal
Reimbursement (1)
• Suppose that Helen were an employee working for a corporation engaged in
the management consulting business and she is reimbursed in the amount of
$120 for taking a firm client out to a restaurant business meal. How should
Helen and the firm treat that reimbursement under §§ 162 and 274(n)?
• In the case of a reimbursed employee business meal, § 274(n) only applies
once to the ultimate payor, normally the employer. So, here, as long as the
reimbursement is made under a proper reimbursement or other expense
reimbursement arrangement, the employee leaves the reimbursement and
the deduction for the business meals off her tax return.
• In this situation, § 274(n) disallows 50% of the $120 to the employer and so
the employer will be able to deduct only $60, if all the requirements of §§ 162
and 274 are met. See Treas. Reg. § 1.274-12(c)(2)(ii)(B)(2). However, if this
restaurant meal takes place in 2021 or 2022, § 274(n)(2)(D) will allow the
employer to deduct the entire $120. See Notice 2021-25.
Part (3)(b)—Helen the Employee with A Business Meal
Reimbursement (2)
• The employer can change this result by treating the reimbursement as compensation
income to the employee, Helen, instead of as a reimbursed employee business meal. In
that case, the reimbursement of $120 is treated as additional ordinary compensation
income to Helen under § 61(a)(1) and she will have to run the $120 business meal
expense through all the requirements of §§ 162 and 274. In this situation, § 274(n)
would disallow 50% of her potential business meal deduction (unless the business meal
takes place in 2021 or 2022). See Treas. Reg. § 1.274-12(c)(2)(ii)(B)(1).
• Worse, in this situation, the $120 business meal expense probably would be treated
as an unreimbursed employee business expense, which is an MID subject to § 67.
Thus, for taxable years 2018-2025, the deduction for such a business meal would be
completely disallowed by § 67(g). This is a terrible tax result for the employee.
• In this situation, the employer is not subject to § 274(n) and can treat the entire
$120 as deductible employee compensation provided that it meets all the
requirements of § 162, including the reasonableness limit of § 162(a)(1). This is a
great tax result for the employer.
Part (3)(b)—Helen the Management Consultant-Sole
Proprietor with Business Entertainment (1)
• As the casebook discusses, Congress over the years has increasingly made the
rules for deducting business entertainment more restrictive. And, immediately
before enactment of the 2017 Act, even if a taxpayer satisfied all of the
requirements of both § 162 and pre-2017 Act § 274(a), 50% of the otherwise
deductible business entertainment costs were disallowed by § 274(n).
• The theory is that these expenditures contain a heavy element of personal
consumption and it is administratively difficult to sort out the personal
consumption component from the business component of the expenditures.
• Under current law, § 274(a)(1)(A), added to the Code by the 2017 Act, completely
disallows any deduction for “business entertainment.” This applies to activities,
for example, such as taking clients to concerts, sporting events, and theatre
performances. The deduction is disallowed even if the taxpayer can show that
business was discussed before, during, and after the entertainment activity.
• This is a “permanent” change to the Code and is consistent with both HaigSimons and the ability-to-pay concept.
Part (3)(b)—Helen the Management Consultant-Sole
Proprietor with Business Entertainment (2)
• Any beverages or meals that are part of the business entertainment
activity are disallowed under this rule unless the taxpayer pays for them
separately or they are separately stated on the invoice for the business
entertainment activity. See Treas. Reg. § 1.274-11.
• The regulations use an “objective” test in determining whether an
activity is an “entertainment activity.” But the taxpayer’s trade or
business is considered in making this determination. See Treas. Reg. §
1.274-11(b)(1)(iii).
• So, while attending a theatre performance is generally considered an
entertainment activity, it is not an entertainment activity for a theatre critic
attending in a professional capacity.
• So § 274(a)(1)(A) of current law would completely disallow any
deduction to Helen for the $15,000 of business entertainment expenses.
Part (3)(b) Hypothetical—
Business Entertainment Rules (1)
• Helen takes one of her most lucrative management consulting clients to a
football game at which they will discuss business before, during, and after the
game. Can Helen deduct all or any of the cost of this event as a business
expense under §§ 162 and 274? Consider the following alternatives:
• (a) She pays $500 for each football ticket and also pays $50 total for food and
drink that she buys at a concession stand at the stadium.
• The $1,000 spent by Helen for the two football tickets is “business
entertainment” disallowed by § 274(a)(1)(A).
• The $50 spent separately by Helen on food and drink is a “business meal,” not
“business entertainment.” § 274(n) will disallow 50% of it so she will be able
to deduct $25 under §§ 162 and 274, if all the requirements are met of both
provisions. The deduction will be above-the-line under § 62(a)(1).
• If the concession stand is considered a “restaurant” and this business meal takes place in
2021 or 2022, § 274(n)(2)(D) should allow Helen to deduct the entire meal expense of $50.
Part (3)(b) Hypothetical—
Business Entertainment Rules (2)
• (b) She instead pays $1,000 for each football ticket to attend the
game in a suite, where they have access to food and beverages.
The cost of the food and beverages is not separately stated on
the invoice.
• All $1,000 of the cost of the football ticket ($2,000 for both
tickets) is treated as “business entertainment” that is completely
disallowed under § 274(a)(1)(A). See Treas. Reg. § 1.274-11(d)(3),
Ex. 3.
• Helen should have asked in advance that the stadium operators
separately state the meals and beverage portion of the cost on the
invoice so she could probably deduct 50% of the meals portion under §
274(n) (or, possibly, 100% for the meals portion in 2021 or 2022 if the
stadium suite is considered a “restaurant”).
Part (3)(b) Hypothetical—
Business Entertainment Rules (3)
• (c) Same as (b), except the invoice separately states that $80 of the cost of each
ticket is for food and beverages and reflects the stadium’s usual selling price for
the food and beverages if they were purchased separately.
• $920 of each football ticket (or a total of $1,840) is “business entertainment”
disallowed by § 274(a)(1)(A).
• $80 of each football ticket is treated as a “business meal,” of which 50% ($40)
(i.e., $80 total) is disallowed by § 274(n) and the other 50% ($40) (i.e., $80 total)
is probably deductible by Helen under §§ 162(a) and 274, assuming that all of the
requirements of both provisions are met. See Treas. Reg. § 1.274-11(d)(4), Ex. 4.
This deduction is above the line under § 62(a)(1).
• If the stadium suite is considered a “restaurant,” § 274(n)(2)(D) should allow Helen to deduct the entire $80
business meals portion of the ticket cost if this takes place in 2021 or 2022. See Notice 2021-25.
Part (3)(c)(i)—State and Local Taxes (1)
• Let’s start with considering the possible deduction of Helen’s state and local
real estate taxes of $15,000 and her state and local income taxes of $15,000.
• § 164(a) allows a deduction for (1) state, local, and foreign real property taxes;
(2) state and local personal property taxes; and (3) state, local, and foreign
income taxes.
• The policy of this deduction provision is that the federal government is
providing revenue sharing to state and local governments through the federal
income tax system.
• There is some disagreement about whether this deduction for state and local
income taxes or for state and local property or personal property taxes on
personal use property, such as a personal residence, is consistent with HaigSimons, but it arguably is consistent with the ability-to pay concept.
Part (3)(c)(i)—State and Local Taxes (2)
• The § 164 deduction is an ordinary deduction, not a capital loss, because there is no
sale or exchange of property involved within the meaning of §§ 1221 and 1222.
• In the case of the § 164(a)(3) deduction for Helen’s state and local income taxes of
$15,000, the deduction is considered to be a personal deduction that is below the
line and itemized. It does not matter whether the taxes are imposed on business
income or investment income, you cannot disaggregate the state and local income
tax deduction in deciding whether it is above the line or below the line. It is
considered in its unitary whole to be a below the line, itemized deduction, as
decided by the courts in a number of cases.
• In the case of the § 164(a)(1) deduction for Helen’s state and local real property
taxes on her personal residence of $15,000, it also considered to be a personal
deduction and is a below the line, itemized deduction, if the real property taxes are
on a personal residence, as they are in this part of the problem.
• This is one of the tax benefits accorded home ownership and is one of the ways that the
federal income tax system favors home ownership over renting an apartment as one’s
home.
Part (3)(c)(i)—State and Local Taxes (3)
• Note that the § 164 deduction is NOT an MID, so § 67 does not apply to it. See § 67(b)(2).
• The 2017 Act temporarily imposed a special $10,000 limitation on the total deduction of
state and local real property, personal property, and income taxes for the taxable years 20182025. See § 164(b)(6). The $10,000 limitation is the same for both single taxpayers and a
married couple filing a joint return (it is a $5,000 limitation in the case of a married taxpayer
filing a separate return).
• Note that this limitation has the effect of undercutting one of the tax benefits of home
ownership—the deduction for state and local real property taxes on a home under §
164(a)(1).
• There is no discernable policy rationale for this limitation, other than it is a way to partially
pay for the other tax cuts in the 2017 Act. The $10,000 limitation amount is arbitrary and it is
unclear why Congress provided the same limitation for a single taxpayer and a married
couple filing a joint return. All of this seems rather “random,” except for the revenue dollars
it raises to absorb other favored tax cuts.
Part (3)(c)(i)—State and Local Taxes (4)
• Note that a taxpayer whose total potentially deductible state and local
taxes exceed the $10,000 limitation can choose which taxes he or she is
choosing to deduct. Here, Helen would choose to deduct $10,000 of the
state and local property taxes on her residence, because those are less
likely to be refunded later by the state and local government than are the
state and local income taxes.
• Individual taxpayers often receive partial refunds of state and local income
taxes and those refunds create potential “tax benefit rule” income in the
later year on the taxpayer’s federal income tax return. See Problem 4, Part
(14).
• So let’s assume here that Helen applies the $10,000 limitation and deducts
$10,000 of her state and local real property taxes. The other $5,000 of real
property taxes and the entire $15,000 of state and local income taxes are
disallowed by the $10,000 limitation in § 164(b)(6).
Part (3)(c)(i)—Maintenance Expenses on the Home
• As we will already seen with the § 164(a)(1) deduction for real property taxes on
a personal residence and as we will see soon further below, the federal income
tax system definitely favors home ownership over rental of one’s home residence
by providing a number of tax benefits for home ownership.
• However, there is one item of expense related to a personal residence that is not
allowed as a deduction. Helen’s maintenance expenses of $4,000 are viewed as
personal consumption since they are a cost of maintaining her personal residence
as shelter. No Code section allows a deduction for these maintenance expenses
and § 262 specifically disallows any deduction for personal, living expenses.
• So, the $4,000 of maintenance expenses on the home are NOT deductible by
Helen.
• This is consistent with both Haig-Simons and the ability-to-pay concept.
Part (3)(c)(i)—Home Mortgage Interest (1)
• The deduction for home mortgage interest, even with all of its limitations, is a major tax benefit,
which is a major way the federal tax system favors home ownership over renting one’s home.
• Other tax benefits for home ownership that we will look at later is the § 121 exclusion for up to $250,000 of
gain ($500,000 of gain for a married couple filing a joint return) from the sale of the taxpayer’s principal
residence (which we will cover in Unit 2); and the fact that we do not tax the imputed rental value of home
ownership to the homeowner (which we will cover in Unit 4).
• The United States is one of the few countries to have this tax benefit. Since it provides a tax
subsidy for home ownership, a form of personal consumption, it is inconsistent with both HaigSimons and the ability-to-pay concept.
• There is a serious question in the tax policy literature about whether the benefit of this deduction
gets capitalized into the price of personal residences (i.e., it results in an increased price for the
residence), so that the benefit inures largely to the seller of the home and not the buyer.
• The home mortgage interest deduction (called “qualified residence interest” in the statute) is one
of the exceptions to the general rule that the interest expense of individuals is nondeductible
personal interest that is disallowed by § 163(h)(1). See § 163(h)(2)(D), (h)(3), (h)(4).
• The deduction for qualified residence interest is a below the line, itemized deduction, but not an
MID, so § 67 does not apply. See § 67(b)(1). It is an ordinary deduction, not a capital loss.
Part (3)(c)(i)—Home Mortgage Interest (2)
• For taxable years before 2018 and after 2025, there are two types of
qualified residence interest: (1) qualified residence interest on acquisition
indebtedness; and (2) qualified residence interest on home equity
indebtedness.
• The 2017 Act has suspended any deduction for interest on home equity indebtedness for
taxable years 2018-2025. § 163(h)(3)(F)(i)(I).
• Home equity indebtedness is limited to the lesser of (1) $100,000 or (2) the fair market value
of the qualified residence minus the acquisition indebtedness. § 163(h)(3)(C).
• Home equity indebtedness has to be secured by a mortgage on a qualified residence but the
loan proceeds from it do not have to be used to purchase, construct, or substantially improve
a qualified residence. § 163(h)(3)(C). So this provision is a potential end-run around the
personal interest disallowance rule in § 163(h)(1).
• Acquisition indebtedness is debt that is secured by a mortgage on a
qualified residence and the loan proceeds of which are used to acquire,
construct, or substantially improve a qualified residence. § 163(h)(3)(B).
Part (3)(c)(i)—Home Mortgage Interest (3)
• “Qualified residence” means the taxpayer’s principal residence plus one other residence
selected by the taxpayer (if the taxpayer has more than one residence). § 163(h)(4)(A).
• The total amount treated as acquisition indebtedness for any taxable year cannot exceed
$1,000,000 (if the taxpayer has more than one qualified residence, the total acquisition
indebtedness on both of them together cannot exceed $1,000,000). § 163(h)(3)(B)(ii).
• For taxable years 2018-2025, the $1,000,000 limitation on acquisition indebtedness is
reduced to $750,000. § 163(h)(3)(F)(i)(II).
• Helen’s home mortgage interest seems to meet all the requirements to be deductible as
“qualified residence interest.” However, since she took out this loan after 2017, she is
subject to a $750,000 limit on acquisition indebtedness for taxable years 2018-2025.
• So, applying that limitation, she can deduct only $30,000 of the $40,000 as “qualified
residence interest” under § 163(h)(2)(D) and (h)(3):
• $750,000
$1,000,000
×
$40,000
=
$30,000
Part (3)(c)(i)—Helen’s Gross Income, Adjusted Gross
Income, and Taxable Income
• To summarize, Helen would be able to deduct only $30,000 of home
mortgage interest and $10,000 of real property taxes.
• Thus, her total below the line, itemized deductions are $40,000, which
exceeds her standard deduction of $12,550 for 2021, so she would elect to
itemize deductions.
• Her gross income, adjusted gross income, and taxable income will be:
• Gross Income =
$350,000 § 61(a)(1)
•
- $50,000 §§ 162, 62(a)(1)
• Adjusted Gross Income =
$300,000
•
- $40,000 Total Itemized Deductions (Greater than SD of
$12,550)
• Taxable Income =
$260,000
Part (3)(c)(ii)—Home Mortgage Qualifying for
Grandfathering Rule
• If Helen had taken out the home mortgage loan in February 2017, she would qualify for
the grandfathering rule in § 163(h)(3)(F), which provides that the change in the limit on
home mortgage acquisition debt from $1,000,000 to $750,000 does not apply.
• So she would be able to deduct all $40,000 of the interest on her home mortgage
acquisition debt of $1,000,000. Her total below the line, itemized deductions will now
be $50,000 ($40,000 of home mortgage interest and $10,000 of real estate taxes on her
home), which exceed her standard deduction for 2021 of $12,550, so she would elect to
itemize deductions.
• Her gross income, adjusted gross income, and taxable income will be:
• Gross Income =
•
• Adjusted Gross Income =
•
• Taxable Income =
$350,000 § 61(a)(1)
- $50,000 §§ 162, 62(a)(1)
$300,000
- $50,000 Total Itemized Deductions (Greater than SD of $12,550)
$250,000
Part (3)(c)(iii)—Real Property is Actively Managed Real
Estate Instead of a Personal Residence (1)
• Here, the facts are changed and the $40,000 of mortgage interest, $15,000 of real
property taxes, and $4,000 of maintenance expenses are paid with respect to
actively managed real estate, instead of a personal residence.
• Thus, now the question is whether one actively managed real property is a trade
or business or an income-producing investment activity.
• As we previously discussed, in connection with other Code sections, the answer is
not clear but there is authority under § 1231 v. §§ 1221/1222 that one active
rental is enough for this activity to be treated as a trade or business.
• There is a good argument that this authority applies to other areas of the Code,
as we discussed.
• So, for purposes of this problem, let’s assume that one active rental is sufficient
for this to be a trade or business for § 162 purposes and for purposes of § 163
(which means that it is not “investment interest” subject to the limitation on the
deduction of investment interest in § 163(d)(1)—see below).
Part (3)(c)(iii)—Real Property is Actively Managed Real
Estate Instead of a Personal Residence (2)
• Note that regardless of whether the actively managed real estate is treated
as a trade or business or non-trade or business income-producing
investment activity, the $15,000 of real property taxes on the property are
deductible in full. The $10,000 limitation on the state and local tax
deduction in § 164(b)(6) (for taxable years 2018-2025) does not apply to
state and local real property taxes or personal property taxes which are
paid or incurred in carrying out a trade or business or an investment
activity described in § 212 (see the second sentence in § 164(b)(6)).
• Note that she now will be able to use the $10,000 limitation in § 164(b)(6) to deduct
$10,000 of the $15,000 state and local income taxes. This $10,000 deduction will be
a below the line, itemized deduction, but not an MID, so § 67 will not apply. See §
67(b)(2).
Part (3)(c)(iii)—Real Property is Actively Managed Real
Estate Instead of a Personal Residence (3)
• The $15,000 state and local property tax deduction under § 164(a)(1) will be above the line under
either § 62(a)(1) (if the real property activity is treated as a trade or business) or § 62(a)(4) (if the
real property activity is treated as an income-producing investment activity).
• The $4,000 of maintenance expenses will be deductible under § 162 (if the real property activity
is treated as a trade or business) or § 212(2) (if the real property activity is treated as an incomeproducing investment activity), assuming all the requirements of those alternative provisions are
met, which seems to be the case here.
• The maintenance expense deduction of $4,000 will be above the line under § 62(a)(1) (if the real
property activity is treated as a trade or business) or under § 62(a)(4) (if the real property activity
is treated as an investment activity).
• Regardless of whether the actively managed real estate is treated as a trade or business or an
income-producing investment activity, the full $40,000 of mortgage interest is potentially
deductible under § 163. The $750,000 (or $1,000,000) limitation on home mortgage acquisition
debt does not apply, since is no longer mortgage debt on a personal home. Moreover, in any
event, the $40,000 interest deduction under § 163 will be above the line under either § 62(a)(1)
(if the actively managed real estate activity is treated as a trade or business) or § 62(a)(4) (if the
real estate activity is treated as an income-producing investment activity).
Part (3)(c)(iii)—Real Property is Actively Managed Real
Estate Instead of a Personal Residence (4)
• So, what difference does it make whether the actively managed real estate is treated as a trade or
business or income-producing investment activity?
• If it is treated as a trade or business, the mortgage interest is deductible as “business interest”
under § 163(a) and § 163(h)(2)(A). Therefore, it will not be subject to the investment interest
limitation in § 163(d).
• The somewhat complex limitation on “business interest” in § 163(j), enacted as part of the 2017 Act, would
not apply to Helen because there is an exception for “small businesses” whose average annual gross receipts
for the three prior taxable years does not exceed $25,000,000 ($26,000,000, as indexed for inflation for 2021).
§ 163(j)(3).
• There is also an elective exception for an “electing real property trade or business.” § 163(j)(7)(A)(ii), (B).
• If it is treated as an income-producing investment activity, the $40,000 of mortgage interest will
be treated as “Investment interest” under § 163(d)(3)(A) and subject to the investment interest
limitation in § 163(d)(1).
• Under that limitation, she can deduct the investment interest expense only to the extent she has
“net investment income” during the taxable year under § 163(d)(4).
Part (3)(c)(iii)—Real Property is Actively Managed Real
Estate Instead of a Personal Residence (5)
• “Net investment income” is gross income from property held for investment, such
as interest, dividends, and non-business rents and royalties, minus the deductible
expenses allocable to such income.
• Helen does not have any net investment income stated in this problem, which is
unrealistic because the rental property would probably generate rental income.
• In any event, investment interest expense disallowed under § 163(d)(1) is carried
forward under § 163(d)(2) to subsequent taxable years indefinitely until it is used
in a later year or the taxpayer dies.
• Finally, because the deductions from this rental activity exceed the income from
the activity, this may be a passive loss subject to the passive loss limitation in §
469, regardless of whether the rental activity is treated as a trade or business or
investment activity. See § 469(c)(2). We are not going to cover the details of this
provision but will discuss its basic purpose and operation in Unit 5.
Part (3)(d)—Nondeductible Clothing Costs (1)
• The most likely result here is that Valerie will not be able to deduct her
clothing cost of $5,000 under either § 162 or as a depreciable expense under
§§ 167/168. These types of clothing expenditures are generally viewed as
nondeductible personal consumption expenditures. No Code section allows
them as a deduction and § 262 disallows them as a personal, living expense.
• The case law and the revenue rulings issued by the IRS make it very difficult
for an individual taxpayer to deduct the costs of clothing, even if they
subjectively can show they would normally not buy the clothes in question
but for their jobs.
• The thought is that the personal consumption component predominates and
so tough standards for deductibility that are tantamount to a complete
disallowance rule in most cases are appropriate.
Part (3)(d)—Nondeductible Clothing Costs (2)
• Rev. Rul. 70-474, discussed at p. 271 of the casebook, provides that the costs of work clothing
will be nondeductible personal expenses, unless three requirements are all met:
• (1) the clothing is of a type specifically required as a condition of employment;
• (2) the clothing is not adaptable to general usage as ordinary clothing; and
• (3) the clothing is not in fact worn by the taxpayer outside of the work setting.
• See also Pevsner (5th Cir. 1980)—the court disallowed a § 162 deduction for the costs of
expensive clothing by the taxpayer who was a manager of an upscale clothing boutique. The
taxpayer’s employer required her to buy and wear expensive clothing on her job and she
subjectively did not wear this type of expensive clothing outside of work, so she met two of
the three requirements in Rev. Rul. 70-474. However, the clothing was adaptable for general
usage outside the job, so that the taxpayer failed to meet the second requirement above,
which is an objective, not subjective, standard.
Part (3)(d)—Nondeductible Clothing Costs (3)
• In our problem, the facts say that Valerie probably meets the third requirement
above in Rev. Rul. 70-474, but definitely flunks the second requirement, because
these suits objectively are adaptable for wear as ordinary clothing outside the job.
Moreover, in today’s law firm world (even before Covid 19), it is not clear that these
suits meet the first requirement above. So clearly no deduction here for Valerie.
• Examples of clothing that might meet the three requirements of Rev. Rul. 70-474 are
some types of uniforms that have the name and other information of the employer
embossed on them and are not supposed to be worn outside the job, military
uniforms that can be worn only while on active duty, and military swords. See Treas.
Reg. § 1.262-1(b)(8), although the cited regulation suggests that the IRS would
disallow a deduction for the cost of military uniforms if they “merely take the place
of articles required in civilian life.”
Part (3)(d)—Nondeductible Clothing Costs (4)
• Query whether clothing that does meet the three requirements of Rev. Rul. 70474 should often properly be treated as “capital expenditures” providing
significant future benefits (i.e., having a life extending substantially beyond the
year in which they are paid or incurred). If so, they would have to be deducted
over time under §§ 167 and 168.
• However, as a practical matter, in the limited number of cases in which a taxpayer
is able to meet the three requirements of Rev. Rul. 70-474, courts and the IRS
seem to allow a current deduction under § 162 for the costs of the work clothing.
• These very tough rules for deducting clothing expense under § 162 are arguably
consistent with both Haig-Simons and the ability-to-pay concept because these
expenses are viewed as primarily personal consumption expenditures.
Part (3)(e)—Personal Commuting Costs NOT Deductible
(1)
• Valerie’s cost of going from home to work and back from work to home are
personal commuting costs, not deductible trade or business expenses under §
162. No Code section allows them as a deduction and § 262 disallows them as
a personal expense. See Treas. Reg. §§ 1.162-2(e); 1.262-1(b)(5).
• The thought is that the personal consumption element predominates, and, in
any event, there is no administrable or practical way to sort out the personal
and business components of these expenses. So, the courts and the IRS apply
a full disallowance rule to these expenses.
• This disallowance rule is consistent with both Haig-Simons and the ability-topay concept because these commuting expenses are viewed as personal
consumption expenditures.
Part (3)(e)—Personal Commuting Costs NOT Deductible
(2)
• So, the Supreme Court decision in Flowers (1946), on p. 269 of the casebook,
makes clear that if you choose to live in Jackson, MS, and travel to Mobile, AL,
those transportation costs are nondeductible personal commuting costs, not
deductible business transportation expenses under § 162, because it is a
personal consumption choice to live in place not near your work location.
• The same result for a bi-coastal couple, where one member of the couple lives
in California and the other member of the couple lives in NYC and on alternate
weekends, they travel and incur costs to visit each other. Each taxpayer has
chosen to live in a different place than his or her life partner/spouse—thus,
the courts and the IRS view these expenses as nondeductible personal
consumption expenditures, not business transportation expenses. See Daly v.
Comm’r (4th Cir. 1981), cited at p. 298 of the casebook.
Part (3)(f)—”Heavy Tool” Exception to Personal
Commuting Cost Disallowance Rule (1)
• No change here regarding the $1,000 of basic personal commuting costs.
Those are considered “personal consumption expenditures” that are not
deductible under any Code section and are disallowed by § 262.
• The $500 of extra expense to transport the tractor or other heavy work tools
is not considered a personal commuting cost under an exception, sometimes
called the “heavy tool” exception, if the taxpayer can show the added costs of
transporting the work equipment—see the Supreme Court’s decision in
Fausner (1973) and Rev. Rul. 75-380 (which is the IRS’s acceptance of this
exception)—see p. 287 of the casebook.
• Thus, this extra $500 of business transportation expense is deductible under §
162(a), provided that it meets all the requirements of that provision, which
seems to be the case here.
Part (3)(f)—”Heavy Tool” Exception to Personal
Commuting Cost Disallowance Rule (2)
• If Valerie were in her own trade or business, this $500 § 162 deduction would be
above the line under § 62(a)(1).
• However, because her trade or business in this problem appears to be that of
being an employee, these expenses, although deductible under § 162(a), are
MIDs because they are unreimbursed employee business expenses, not within
any exception in § 67(b). So, for taxable years 2018-2025, § 67(g) completely
disallows any deduction for MIDs.
• Although it is not raised by this problem set, note the other exception to the
nondeductible personal computing rule for the taxpayer’s costs of going from his
or her residence to a “temporary work location” outside the metropolitan area
where the taxpayer lives and normally works. See Rev. Rul. 99-7, at p. 289 of the
casebook.
Part (3)(g)—Deduction for
Business Transportation Expenses (1)
• The costs of going from one business location to another business location are business
transportation expenses, not personal commuting costs.
• So, this $500 of business transportation expense is deductible by Valerie under § 162(a),
provided that she meets all of the requirements of that provision, which seems to be the
case here.
• Thus, this $500 of business transportation expense is not within the personal commuting
expense disallowance rule.
• Note also that these are not “traveling expenses” within the meaning of § 162(a)(2), because
they do not involve any travel away from her tax home. § 162(a)(2) typically applies to
overnight travel on business, such as travel to an out-of-town meeting with a client or to
attend an out-of-town business convention (such as ABA or AMA meetings).
• So, this $500 of business transportation expense only has to meet the requirements of §
162(a), not the additional requirements in § 162(a)(2).
Part (3)(g)—Deduction for
Business Transportation Expenses (2)
• If Valerie is in her own trade or business of being a lawyer as a sole
proprietor or as a partner in a law firm, this $500 § 162 deduction
would be above the line under § 62(a)(1).
• If Valerie is an employee of the law firm, this $500 § 162 deduction
will be a below the line, itemized deduction.
• If she is an employee, the deduction is also an MID because it is an
unreimbursed employee business expense not within any of the
exceptions in § 67(b).
• For taxable years 2018-2025, § 67(g) completely disallows any
deduction for MIDs.
Part (3)(h)—No Deduction for Country Club Dues (1)
• This is another area where Congress has decided to apply a complete
disallowance rule, because the personal consumption component
predominates and various “facts and circumstances” tests used in prior law
were not working properly on this issue (in the view of Congress).
• So, regardless of whether Valerie can make a strong argument that these
dues in her particular case have a strong business nexus and meet all the
requirements of § 162(a), § 274(a)(3), enacted in 1993, completely
disallows Valerie’s deduction for the $5,000 of country club dues.
• § 274(a)(3) disallows any amounts paid or incurred “for membership in any
club organized for business, pleasure, recreation, or other social purpose.”
Part (3)(h)—No Deduction for Country Club Dues (2)
• Treas. Reg. § 1.274-2(a)(2)(iii)(a) provides that clubs coming within this
disallowance rule include “any membership organization if a principal purpose of
the organization is to conduct entertainment activities for members of the
organization or their guests or to provide members or their guests with access to
entertainment facilities . . . .”
• The regulations make clear that this disallowance rule generally does not apply
to dues for professional associations (such as the ABA, AMA, and state bar or
medical associations), chambers of congress, real estate boards, boards of trade,
or trade associations, unless a principal purpose of the organization is to conduct
entertainment activities or provide access to entertainment activities. See Treas.
Reg. § 1.274-2(a)(2)(iii)(b).
• It does apply to dues for country clubs, golf and athletic clubs, hotel clubs, airline
clubs, and “clubs operated to provide meals under circumstances generally
conducive to business discussions.” See Treas. Reg. § 1.274-2(a)(2)(iii)(a).
Part (3)(i)—Limitations on the
Deduction of Personal Interest
• “Interest” is compensation for the use or forbearance of money. Think of it as kind of a
rental charge by a creditor for allowing the debtor to use the creditor’s money.
• It is gross income to the recipient-creditor under § 61(a)(4) and it is ordinary income.
• The basic deduction provision is in § 163(a), but the Tax Reform Act of 1986 enacted the
serious limitations on the deduction of “personal interest” expense by individual
taxpayers in § 163(h)(1).
• § 163(h)(2) defines “personal interest” as any interest, except the six listed categories of
interest in (A) through (F) that are potentially deductible.
• If an individual taxpayer’s interest expense does not fall within one of these six
categories, it is nondeductible personal interest under § 163(h)(1).
• To determine whether interest expense may fall within one of these deductible
categories, Temp. Treas. Reg. § 1.163-8T(a)(3) provides that you generally trace the
interest expense to a loan and trace the loan proceeds to what expenditures they are
used for in determining what category the interest expense may potentially fall within.
Part (3)(i)(1)—Limitations on the
Deduction of Personal Interest—Credit Card Interest
• Valerie’s $500 of credit card interest for amounts charged to the credit card for
personal consumption expenditures does not fall within any of the deductible
categories in § 163(h)(2).
• So, this is classic nondeductible personal interest under § 163(h)(1).
• This type of interest was one of the principal targets of the disallowance rules in §
163(h). Congress was concerned that the prior law rules that allowed most
personal interest expense to be deductible encouraged taxpayers to take on too
much debt.
• The prior law deduction for personal interest also was inconsistent with HaigSimons and the ability-to-pay concept because it provided a tax subsidy for
interest on debt used for personal consumption purposes. The current general
rule of nondeductibility of personal interest is consistent with Haig-Simons and
the ability-to-pay concept.
Part (3)(i)(2)—Limitations on the
Deduction of Personal Interest—Nondeductible Trade or
Business Interest
• Valerie’s $500 of interest on a loan used to purchase equipment and
supplies for the trade or business of being an employee does not fall within
any of the deductible categories of interest expense in § 163(h)(2).
• Note that § 163(h)(2)(A) does not apply because it applies only to interest
properly allocable to a trade or business other than the trade or business
of being an employee.
• So, Valerie’s employee trade or business interest is nondeductible personal
interest under § 163(h)(1).
• This is yet another example of Congress treating the employee trade or
business less favorably than other trades or businesses. It is arguably
inconsistent with Haig-Simons and the ability-to-pay concept because it is
disallowing a deduction for a cost of earning income.
Part (3)(i)(3)—Limitations on the
Deduction of Personal Interest—Deductible
Trade or Business Interest
• Valerie has a second trade or business of tutoring as a sole proprietor that
is a trade or business for § 162 and § 163 purposes.
• Valerie’s $500 of interest on a loan used to purchase equipment and
supplies for the trade or business of being a tutor as a sole proprietor is
deductible trade or business interest under § 163(h)(2)(A).
• So, her $500 of business interest here is deductible under § 163(a)
• Valerie’s business interest of $500 is not subject to the Section 163(j) limitation on
excess business interest because she qualifies for the “small business” exception.
• This is an ordinary deduction, not a capital loss, and it is an above the line
deduction under § 62(a)(1).
• This is consistent with Haig-Simons and the ability-to-pay concept because
this interest expense is a cost of earning income and should be allowed as a
deduction.
Part (3)(i)(4)—Limitations on the
Deduction of Personal Interest—Educational Loan Interest (1)
• Before the Tax Reform Act of 1986, educational loan interest, like
most interest expense of individuals, was fully deductible.
• The Tax Reform Act of 1986 pretty much eliminated any deduction for
educational loan interest, treating it as nondeductible “personal
interest” under § 163(h)(1).
• In 1997, Congress added §§ 163(h)(2)(F) and 221 to the Code, which
contain a limited deduction for educational loan interest.
• Any educational loan interest deductible under § 221 is above the line
under § 62(a)(17).
• However, the § 221 deduction is limited to $2,500 per taxable year
and this amount is not adjusted for inflation. See § 221(b)(1).
Part (3)(i)(4)—Limitations on the
Deduction of Personal Interest—Educational Loan Interest (2)
• Also, the $2,500 limit on the deduction begins to be phased out for single taxpayers with modified AGIs
more than $50,000 ($100,000 for a married couple filing a joint return) and is completely phased out
and reduced to 0 if a single taxpayer’s modified AGI is $65,000 or more ($130,000 or more for a
married couple filing a joint return). See § 221(b)(2).
• For 2021, these amounts are adjusted for inflation so that the deduction begins to be phased out
for single taxpayers with modified AGIs more than $70,000 ($140,000 for a married couple filing a
joint return) and is completely phased out and reduced to 0 if a single taxpayer’s modified AGI is
$85,000 or more ($170,000 or more for a married couple filing a joint return).
• So, no deduction for Valerie here, as a single taxpayer, because her AGI and modified AGI are both
$119,500 ( i.e., $100,000 + $20,000 - $500 trade or business interest), so the 221 deduction is fully
phased out. (Notice that this part of the Problem does not include the facts in Part (3)(i)(5).)
• It is not clear whether this treatment of educational loan interest is consistent with Haig-Simons or the
ability-to-pay concept. It depends on how you characterize educational expense—is it personal
consumption or a cost of (eventually) earning income?
Part (3)(i)(5)—Limitations on the
Deduction of Personal Interest—Investment Interest Expense (1)
• Valerie is clearly an investor in stock and her interest on the loan used to purchase the
investment stock is “investment interest” within the meaning of § 163(d)(3) and (d)(5).
• Investment interest is one of the categories of deductible interest in § 163(h)(2)(B), but
only to the extent allowed under the investment interest limitation in § 163(d).
• The theory is that many of these investments for which the loan proceeds are used receive
favorable treatment in the tax system by reason of both the realization requirement and the
capital gains tax preference in § 1(h). So, the taxpayer should not get a current ordinary deduction
for the investment interest unless he or she has net investment income for the year.
• As we discussed earlier, § 163(d)(1) allows a taxpayer to deduct investment interest only
to the extent of “net investment income,” as defined in § 163(d)(4).
• Here, Valerie’s only “net investment income” is the $100 of interest income on the
savings account.
• So, § 163(d)(1) (and § 163(h)(2)(B)) would allow Valerie to deduct under § 163(a) only
$100 of the investment interest in 2021.
Part (3)(i)(5)—Limitations on the
Deduction of Personal Interest—Investment Interest Expense (2)
• Valerie’s $100 deduction is an ordinary deduction, not a capital loss,
and it is a below the line, itemized deduction, but is not an MID. See
§ 67(b)(1). So § 67 does not apply to it.
• However, if, as is likely under these facts, she uses the standard deduction for
the tax year, she will get no tax benefit from this deduction.
• The remaining $900 of investment interest would be disallowed for
this year and carried forward under § 163(d)(2) to future years
indefinitely until she either is able to deduct it in a future year or any
remaining undeducted amount expires when she dies.
• This carryover provision is another statutory exception to the
“integrity of the taxable year” concept.
Part (3)(i)(5)—Limitations on the
Deduction of Personal Interest—Investment Interest Expense (3)
• Note that §§ 163(d)(4)(B)(iii) and 1(h)(2) exclude long-term capital gains from the
sale of investment assets from being included in “net investment income,” unless
the taxpayer affirmatively elects to forego the preferential capital gains rates on
such income.
• The theory is that a taxpayer should not be able to have the long-term capital
gain taxed at a preferential rate and still have it be part of net investment
income that allows a deduction of the investment interest expense.
• So, the taxpayer has to choose whether to have the gain taxed as long-term
capital gain or have it treated as investment income for purposes of the § 163(d)
limitation.
• Bottom line policy point: By deferring the deduction of an expense relating to the
production of income, this limitation is arguably inconsistent with both HaigSimons and the ability-to-pay concept.
Part (3)(i)—§ 199A Deduction for Valerie?
• Valerie’s business of being an employee of a corporation is not a qualified trade or
business for § 199A purposes. § 199A(d)(1)(B). So, no § 199A deduction for her
employee income of $100,000.
• However, her tutoring business as a sole proprietorship is a qualified trade or
business for § 199A purposes. It is a service business, but it is not a “specified
service trade or business” within the meaning of §§ 199A(d)(2) and 1202(e)(3)(A).
• So, she would get a $3,900 § 199A deduction for 20% of her net income from the
tutoring business (i.e., 20% × [$20,000 - $500 interest deduction under §§ 163(a) and
(h)(2)(A)] = $3,900)—§ 199A(b)(2)(A) and (a)(1).
• This amount is less than 20% × her pre-§ 199A taxable income of $107,050
[$120,000 - $500 + $100 – SD of $12,550 for 2021], or $21,410—§ 199A(a)(2).