Module 27
Nonbusiness Deductions
and Exemptions
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Classification of deductible expenses
Deductions for adjusted gross income
Standard deduction and itemized deductions
Personal and dependency exemptions
Phaseout of exemptions
Reduction of itemized deductions
Classification of Deductible
Expenses
Key Learning Objectives
Allowable deductions of individual taxpayers
 Order of deductions
 Relationship of deductions


For AGI and
From AGI
AGI &
Deductions From AGI

Itemized deductions reduced by AGI




Medical--7.5%
Miscellaneous--2%
Casualty--10%
Charitable--total deduction limited by AGI
§162
Trade or Business Expenses
Generally deductible
 Must be

 Ordinary


Necessary
Reasonable
§162
Trade or Business Expenses

If self-employed


Deductible for AGI
If employee
 Deductible from AGI if unreimbursed


Reimbursed--non-accountable plan
Subject to 2% floor
§212 Expenses for
Production of Income
Generally deductible
 Must be

 Ordinary


Necessary
Reasonable
§212 Expenses for
Production of Income
For production/collection of income
 For property held for production of income



Management/conservation/maintenance
Determination/collection/refund of any tax
§212 Expenses for
Production of Income

For AGI


Rental and royalty expenses on Sch E
From AGI



Most investment related items
Except taxes, interest expense
Miscellaneous 2%
§262
Personal Expenses
Generally not deductible
 Exceptions for certain itemized deductions

Deductions for Personal Items
“Otherwise Allowable”
Interest expense
 Charitable contributions
 Taxes
 Medical expenses
 Casualty losses

AGI Limitations
Medical--7.5% AGI offset
 Misc..-- 2% - 2% AGI offset
 Overall--3% AGI offset

AMT Add-Backs
100% of taxes
 100% of misc.... 2%
 Additional 2.5% AGI offset on medical
 Equity interest expense

Deductions for
Adjusted Gross Income
Key Learning Objectives

Introduction to deductions for AGI
 Moving expenses--covered in Mod 25
Alimony payments covered in Mod 25
 Penalty on early withdrawal of savings
 Health insurance costs for self-employed
taxpayers
 Interest on certain student loans

Standard &
Itemized Deductions
Key Learning Objectives (1)
Standard deduction
 Itemized deductions

 Medical expenses

Taxes
Standard Deduction 2000
Married, Joint--------------- 7,350
 Married, Separate-----------3,675
 Head of Household---------6,450
 Single-------------------------4,400
 If dependent-- at least 700 increased by

 earned
income plus 250
 but not to exceed 4,400

Note: several special rules for this group
Standard Deduction Add On
Blind and/or over 65
 Taxpayer and/or spouse only



Could be 4 add-ons per married, joint return
2000 amounts


Married -- $850
Single and head of household -- $1,100
Medical Expenses
Qualified expenses paid in tax year
 For self, spouse, dependents
 Also for would be dependent


Who has too much gross income
Qualified Medical Expenses
Only prescription medicine
 Limited weight loss
 Not cosmetic surgery after 1990

Medical Expenses
Capital Expenditures

Qualified expense for


Cost more than the increase in FMV
Meet strict requirements as to need
Medical Expenses
Institutionalized Care
Nursing home only if medical care is
primary purpose
 Special schools--blind etc....


If special facilities are
primary purpose
Medical Expenses
Reductions to Amount Spent
Reduce by insurance proceeds
 Reduce by 7.5% of AGI
 Reimbursements generally not income


Include in income if tax benefit in prior year
Income Taxes

All deductible


Except U.S. Federal
Optional credit treatment for foreign
taxes
Property Taxes
Ad Valorem

Real estate taxes (RE)

Prorate RE tax when property sold
Other taxes if assessed on value
 Not assessment for improvements

Standard Deductions and
Itemized Deductions
Key Learning Objectives (2)

Itemized deductions
 Interest expense



Charitable contributions
Casualty and theft loss deductions
for personal use property--on last test only
Miscellaneous itemized deductions
Interest Expense Categories
Active T/B
 Qualified residence interest
 Investment interest
 Tax exempt investments--N/A
 Consumer interest--N/A after 1990
 Passive T/B--follow PAL rules

To carry passive investment
 To run passive T/B

General Limitations on Interest
Deduction
Payer must be obligated on debt
 Can't deduct prepaid interest

Interest Expense
“Follow the Money”
Must track borrowing to show how money
was used
 Interest expense limitations based on how
funds spent

Interest Expense Limitations
Active T/B--no limits to deductibility
 Investment interest

 Current deduction limited


To net investment income
Excess carries over indefinitely
Investment Income
 Investment
income
interest
dividends
Overpaid,
refundable taxes
Interest on the refund
net capital gain
 if
you give up special tax rates
Investment Expense
 Investment
all
expenses
related expenses
 real
estate taxes on investment property
 management fees
 safety deposit box fees
 magazine subscriptions
if
subject to 2% limit, only that left in
excess of the limitation
Net Investment Income
 the
excess of investment income over
 investment expenses
Example 1: Deductible
investment interest expense
No deductions relating to investments
 $20,000
of interest expense on
funds borrowed to buy stock
 Taxable income:
$100,000
$
8,500
W2 wages
interest income
Example 1: Deductible
investment interest expense
No deductions relating to investments
 Investment
income
_______
 Related expenses
_______
 Net investment income _______
 Investment interest deduction
_______
Example 1: Deductible
investment interest expense
No deductions relating to investments
 Investment
income
 Related expenses
 Net investment income
 Investment interest
Deduction
 Carryover
$8,500
0
8,500
8,500
11,500
Example 2: Deductible
investment interest expense

Deductions relating to investments
RE
taxes of $2,000
$20,000 of interest expense on funds
borrowed to buy stock
 Taxable income:
$100,000 W2 wages
$ 8,500
interest income

Example 2: Deductible
investment interest expense
 RE
taxes are fully deductible on
Schedule A, so
 Investment income
_______
 Related expenses
_______
 Net investment income _______
 Investment interest deduction
_______
Example 2: Deductible
investment interest expense
 Investment
income
 Related expenses
 Net investment income
 Investment interest
Deduction
 Carryover
$8,500
2,000
6,500
6,500
13,500
Example 3: Deductible
investment interest expense

Deductions relating to investments

Management fees of $2,000
$20,000 of interest expense on funds
borrowed to buy stock
 Taxable income:
$100,000 W2 wages
$ 8,500 interest income

Example 3: Deductible
investment interest expense
 Mgt
fees are deductible only if in
excess of 2% of AGI
 Here AGI = $108,500
 2% = $2,170
 Since mgt fee was only $2,000 and
no other misc 2% deductions,
deduction = 0
Example 3: Deductible
investment interest expense
 Investment
income
_______
 Related expenses
_______
 Net investment income _______
 Investment interest
deduction
_______
Example 3: Deductible
investment interest expense
 Investment
income
 Related expenses
 Net investment income
 Investment interest
Deduction
 Carryover
$8,500
0
8,500
8,500
11,500
Example 4: Deductible
investment interest expense

Deductions relating to investments

Management fees of $8,000
$20,000 of interest expense on funds
borrowed to buy stock
 Taxable income:
$100,000 W2 wages
$ 8,500
interest income

Example 4: Deductible
investment interest expense
 Management
fees are deductible
only if in excess of 2% of AGI
 Here AGI = $108,500
 2% = $2,170
 Since management fee is $8,000
and no other misc 2% deductions,
deduction = $5,830
Example 4: Deductible
investment interest expense
 Investment
income
_______
 Related expenses
_______
 Net investment income _______
 Investment interest
deduction
_______
Example 4: Deductible
investment interest expense
 Investment
income
 Related expenses
 Net investment income
 Investment interest
Deduction
Carryover
$8,500
5,830
2,670
2,670
17,330
Special Rules for
Qualified Residence Interest
(QRI)
Only 2 principal residences
 1 million total acquisition indebtedness
 Plus 100,000 equity indebtedness

Acquisition Indebtedness
(ACQ)
Loan secured by property
 Funds used to build/improve etc....
 Limited to 1 million if after 10/16/89
 Outstanding loans at 10/17/89



Grandfathered-in as QRI
No limit as long as secured by property
Equity indebtedness
Excess of FMV over ACQ debt
 Funds can use for anything
 Must be secured by property
 Limited to 100,000 debt
 AMT add back

Points Paid

Points on acquisition of debt deductible if
 Purchase of principal personal residence



Not borrowed from lender
OK if paid by seller
Points N/D if rental or if refinancing
 Amortize over life of loan
Charitable Contributions

To qualified charitable organization
 Not individual


Not foreign
Not political organization
Charitable Contributions
Money
 Not value of services
 Related out of pocket costs OK

Charitable Contributions
Gifts of Property

Ordinary income property
 Inventory


Other held < 1 year
Deduction limited to adjusted basis
 Unless FMV is smaller

Generally subject to 50% of AGI limit
Charitable Contributions
Gifts of Property
Long term capital gain property (CG)
 Deduction generally FMV if > basis
 Gift of tangible property limited to basis if




Unrelated use by charitable organization
Contributed to nonoperating private foundation
Can deduct basis to avoid 30% limit
Check List for Gift of
Appreciated Property
Ordinary income or “capital gains”
property?
 If ordinary use lower of adjusted basis
(AB) or FMV.
 If capital gains property

Is
charity’s use “related?”
If yes use higher of AB or FMV
If no use AB unless < FMV.
Example 1:
Gift of Appreciated Property
 Artwork
is given to the local boy
scouts for annual auction.
Cost
$ 9,000
FMV $11,000
 Held
as investment since 1994
 What is taxpayer’s deduction
Example 1:
Gift of Appreciated Property
 Here
gift is for public auction, so can’t
be related use
 Deduct lower of AB and FMV
 ANSWER: $9,000
Example 2:
Gift of Appreciated Property
 Boat
is given to the local boy
scouts for summer camp.
Cost
$ 9,000
FMV $11,000
 Used
personally since 1994
 What is taxpayer’s deduction
Example 2:
Gift of Appreciated Property
 Here
gift is for use in summer camp, so
should be related use
 Deduct FMV
 ANSWER: $11,000
Charitable Contributions
Limitations on Current Deduction
Overall--50% of AGI
 Appreciated CG property




30% of AGI if deduction is FMV
50% if elect adjusted basis
To private foundation--20% AGI
Charitable Contributions
Excess Contributions
Carry over for next 5 years
 Retain character as to AGI limits
 No carry back available

Charitable Contributions
Documentation for Cash
Over $250 charity must substantiate
 Charity must disclose value of
goods/services received in exchange if
FMV > $75

Charitable Contributions
Documentation for Property
FMV > 500--attach Form 8283
 FMV > 5,000 need formal, written appraisal
 Cost of appraisal is misc..... 2% deduction

Casualty and Theft Losses
Sudden, Unexpected, Unusual
Loss on disposal of personal-use asset is
generally not allowed
 Casualty loss is exception
 Use lower of basis or decline in FMV to
determine loss

Casualty and Theft Losses
Insurance Claims
Adjust for actual or expected insurance
reimbursement
 Gain could result if insurance > basis



See involuntary conversion rules
Insurance claim must be filed to deduct loss
Casualty and Theft Loss
Personal-Use Property
Each casualty loss reduced by $100
 Net casualty gains and losses
 Net gain for the year is capital gain
 Net loss for the year is ordinary loss



Reduce by 10% of AGI floor
Deduction from AGI
Casualty and Theft Events
Business or Investment Asset
Return of capital doctrine
 Partial destruction



Complete destruction


Use lower of basis or decline in FMV
Use basis
Adjust for actual or expected insurance
Casualty and Theft Events
Business or Investment Asset
Business losses deductible for AGI
 Net loss for the year is ordinary loss



No 100 or 10% floor
Net gain for the year is



§1231 gain or
Ordinary gain
Depending on holding period
Miscellaneous Itemized
Deductions

Employee business expenses

§212 expenses except



Rents
Royalties
Total is reduced by 2% of AGI
Employee Business Expenses

Being an employee (em’e) is a recognized
T/B

T/B not that of job, but being em'e
Must distinguish between personal and T/B
expenses
 Statutory em'e--expenses for AGI
 Performing artist--may be for AGI

Employee Business Expenses
All others--deductions from AGI
 Included with other misc..... 2% items
 Exception if em’e reimbursed AND
 Em'e accounts to em'r



Then em'r does not report in W2
Em’e does not report on tax return
Miscellaneous Itemized
Deductions

Add together
Meals & entertainment--reduced by 50%
 Other employee business expenses
 All §212 expenses except rent/royalty

Reduce by 2% of AGI
 This is the amount deduct from AGI


If itemized > standard deduction
In Class Exercise: Calculate the
Miscellaneous 2% Amount
Valid business entertainment
 Employee business expenses
 Tax Preparation fee
 Management fee on
mutual stock fund
1,900
 Total
 Calculate final deduction if


AGI = 100,000 OR 500,000
8,000
7,500
250
17,650
Solution: In Class Exercise: The
Miscellaneous 2% Amount
If AGI = 100,000
 Final deduction = 11,650
 Reduce entertainment by 50%
 Deductions before 2% = 13,650
 2% of AGI = 2,000
 13,650 reduced to 11,650

In Class Exercise: Calculate the
Miscellaneous 2% Amount
If AGI = 500,000
 Final deduction = 3,650
 2% of AGI = 10,000



Reduce entertainment by 50%
Deductions before 2% = 13,650
13,650 reduced to 3,650
 Use standard deduction if no other
deductions from AGI

Personal and Dependency
Exemptions
Key Learning Objectives
Personal exemptions
 Dependency exemptions

Personal Exemptions

2,800 per allowance--2000--for
 Taxpayer


And spouse if joint return
N/A if dependent on another's return
Dependency Exemptions
2,800 per allowance -- 2000
 Meet all of 5 of following tests

 Support




Gross income
Relationship
Joint return test
Citizenship/residency
Multiple Support Agreements
No One Provides > 50% Support
Group, not individual, gives >50% of total
support
 Group can decide who gets exemption
 Taxpayer getting deduction must have
contributed at least 10% of total support

Multiple Support Agreements
No One Provides > 50% Support
Individual being claimed must not
 Have too much gross income or
 Fail to meet

 Joint return test

Citizenship/residency test
Multiple Support Agreements
No One Provides > 50% Support

Members of groups must meet relationship
test
 Relative or

Non-relative dependent lives with
In Class Exercise: Who Can
Claim D? (1)
D, age 15, parents deceased, lives with
Grandparents
 D's support this year was provided as
follows:
 Interest income--D’s account
1,000
 Social security survivor's benefits
2,000
 Grandparents
3,000
6,000

Solution--In Class Exercise:
Who Can Claim D? (1)
D would claim self since no one provides
more than 50 of D’s support
 Note that most of D’s exemption is wasted
since D’s income is only 1,000
 Grandparents would have to spend an extra
dollar to claim D

In Class Exercise
Who Can Claim D? (2)
D, age 15, parents deceased, lives with
Grandparents. D's support this year was
provided as follows:
 Interest income D’s account
1,000
 Social security survivor's benefits
2,000
 Contributions by mother’s friend
500
 Grandparents
3,000
6,500

Solution--In Class Exercise:
Who Can Claim D? (2)
D would claim self since no one provides
more than 50% of D’s support
 Since D lives with grandparents, friend
cannot meet relationship test, so not part of
group
 Grandparents now need to spend $501 to
get exemption

In Class Exercise
Who Can Claim D? (3)
D, age 15, parents deceased, lives with
Grandparents. D's support this year was
provided as follows:
 Interest income D’s account
1,000
 Social security survivor's benefits
2,000
 Uncle Joe
500
 Grandparents
3,000
6,500

Solution--In Class Exercise:
Who Can Claim D? (3)
Only the grandparents
 Grandparents and Uncle Joe are group since
they meet relationship test
 Uncle Joe doesn’t meet the 10% test

In Class Exercise
Who Can Claim D? (4)

D, age 15, parents deceased, lives with
Grandparents. D's support this year was
provided as follows:
Interest income, D’s account
 Uncle Joe
 Grandparents

3,000
1,000
3,000
7,000
Solution--In Class Exercise:
Who Can Claim D? (4)
Now either grandparents or Uncle Joe
 Group must decide who gets exemption
 The other members of the group must sign
written waiver agreeing to not take
exemption

 Form
2120
Phaseout of Exemptions and
Reduction of Itemized Deductions
Key Learning Objectives
Phaseout of exemptions
 Reduction of itemized deductions

Phase Out of Exemptions
The Steps To Follow
Calculate AGI, if < threshold stop
 Calculate excess AGI

 AGI

- Threshold
Divide by 2,500
 Round up for any fraction
Multiply by 2%--this is the amount lost
 1 - % = amount of exemptions allowed

Threshold Amounts 2000
Single
 Head of household
 Married, joint
 Married, separate

128,950
161,150
193,400
96,700
In Class Exercise:
Phaseout of Exemptions
Part 1: Calculate AGI
W2
 Bank interest
 State bond interest


Alimony paid
170,000
5,900
4,500
5,000
Solution--In Class Exercise
Part 1: Calculate AGI
AGI = 170,900 [170,000 + 5,900 - 5,000]
 State bond interest excluded
 Alimony paid is deduction for AGI
 Now calculate taxable income IF
 Single
 Married,
joint
 Head of Household

In each case, taxpayer gets two exemptions
Solution: In Class Exercise
Single, Exemption Phaseout
AGI
 THRESHOLD
 EXCESS

170,900
(128,950)
41,950
÷2,500

16.78 -> 17
 17 times 2% = loss amount (34%)
 1 - .34 = deduction amount (66%)


Exemptions = 2,800 x 2 x .66 = 3,696
Solution: In Class Exercise
Single, Taxable Income
AGI 170,900
 SD
(4,400)
 EXS
(3,696)


TI
162,804
2,800 x 2 x .66
Solution: In Class Exercise
Married, Exemption Phaseout
AGI
 THRESHOLD
 EXCESS


170,900
(193,400)
N/A
Exemptions = 2,800 x 2 = 5,600
Solution: In Class Exercise
Married, Taxable Income

AGI
 SD
170,900
(7,350)
EXS
 TI
(5,600)
157,950

2,800 x 2
Solution: In Class Exercise
Head, Exemption Phaseout
AGI
 THRESHOLD
 EXCESS


170,900
(161,150)
9,750
÷ 2,500

3.9 = 4
 4 times 2% = loss amount ( 8%)
 1 - .08= deduction amount (92%)

Exemptions = 2,800 x 2 x .92 = 5,152
Solution: In Class Exercise
Head, Taxable Income
AGI
 STD
170,900
(6,450)
EXS
(5,152)


 TI
159,298
2,800 x 2 x .92
3% of AGI Reduction
All Itemized Deductions Except
Medical
 Casualty
 Investment interest expense
 Gambling losses

3% of AGI Reduction
Threshold is same as the exemption
phaseout for single filers
 For 2000, threshold is 128,950
 Know which deduction it applies to


Know how to calculate
3% Reduction
Never Reduces to Zero

Taxpayer always gets the largest of
(1) Limited - offset + unlimited
(2) 20% of limited + unlimited
(3) Standard deduction
In Class Exercise:
Itemized Deduction Phaseout (1)
AGI 200,000
 Mortgage interest paid = 10,000
 What is the deduction from AGI?
 Apply all other limits first

 Reduce entertainment by 50% of cost



Reduce medical by 7.5% of AGI
Reduce miscellaneous by 2% of AGI
Reduce casualty loss by 10% of AGI
Solution: In Class Exercise:
Itemized Deduction Phaseout (1)
(1) Calculate the 3% Reduction
AGI
 Threshold
 Excess



Reduction
200,000
128,950 --> same for all
71,050
x .03
2,132
Solution: In Class Exercise:
Itemized Deduction Phaseout (1)
(2) Compare the 3 Limits

Taxpayer gets the largest of
(1) 10,000 - 2,132
(2) 20% of 10,000
(3) Standard deduction

7,868
2,000
7,868 > all standard deductions, so all filers
would use 7,868
In Class Exercise:
Itemized Deduction Phaseout (2)
AGI 200,000
 Medical expenses paid 20,000
 What is the deduction from AGI?
 Remember to apply all other limits before
3% reduction
 Medical reduced by 7.5% of AGI

Solution: In Class Exercise:
Itemized Deduction Phaseout (2)
(1) Calculate the 7.5% Reduction




Reduction = 200,000 x 0.075 = 15,000
Medical
Reduction
Deductible
20,000
(15,000)
5,000
Solution: In Class Exercise:
Itemized Deduction Phaseout (2)
(2) Calculate the 3% Reduction
Medical is not 3% limited, SO
 Taxpayer gets >

(1) 5,000
(2) Standard deduction

Only single/married separate use 5,000

Others would use standard deduction
In Class Exercise:
Itemized Deduction Phaseout (3)

AGI 200,000
Medical expenses paid
20,000
 Mortgage interest paid
10,000
 What is the deduction from AGI?
 Remember to apply all other limits before
3% reduction

 Medical
reduced by 7.5% of AGI
Solution: In Class Exercise:
Itemized Deduction Phaseout (3)

This is a combination of first two cases.
Here taxpayer gets largest of
(1) 7,868 + 5,000 = 12,868
(2) 2,000 + 5,000 = 7,000
(3) Standard deduction
12 ,868 > all standard deductions
 All filers would use 12 ,868

In Class Exercise:
Itemized Deduction Phaseout (4)
AGI 200,000
 Business Entertainment 52,000
 What is the deduction from AGI ?
 Remember to apply all other limits before
3% reduction
 Entertainment reduced by

 50% of each dollar

2% of AGI
Solution: In Class Exercise:
Itemized Deduction Phaseout (4)
(1) Reduce Entertainment by Limits

Reduce entertainment by 50%
52,000 x .5 = 26,000

Reduced entertainment by 2% of AGI
26,000 - [200,000 x .02] = 22,000
Solution: In Class Exercise:
Itemized Deduction Phaseout (4)
(2) Apply 3% Offset Rules
3% reduction is still 2,132
 Taxpayer gets the largest of
(1) 22,000 - 2,132 = 19,868

(2) 22,000 x .20 = 4,400
(3) Standard deduction

19,868 is > all standard deductionsAll filers
would use 19,868