Chapter 6
Individual For AGI Deductions
McGraw-Hill Education
Copyright © 2016 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written
consent of McGraw-Hill Education.
Learning objectives
1.
2.
3.
Identify the for AGI deductions directly
related to business activities
Describe the loss limitation rules for passive
activities, the rental use of a home, and
home office deductions
Explain the for AGI deductions indirectly
related to business activities and for AGI
deductions that subsidize specific activities
2
Deductions for AGI

Three categories of deductions for AGI



Directly related to business activities
Indirectly related to business activities
Deductions subsidizing specific activities
3
Deductions for AGI
Directly Related to Business Activities




Taxpayers are allowed to deduct expenses
incurred to generate business income
For tax purposes activities are either
profit-motivated or
motivated by personal objectives
Profit-motivated activities are classified as
1.
2.
business activities (called “trade or business”) or
investment activities
4
Deductions for AGI

Although both are motivated primarily by profit,
business activities are distinguished from
investment activities:


Trade or Business activities require a relatively high
involvement or effort from the taxpayer where as
investment activities don’t require
Investment activities involve investing in property for
appreciation or for income payments
5
Deductions for AGI
6
Deductions for AGI

Trade or Business Expenses must be:




directly connected to the business activity
ordinary and necessary for the activity (e.g.,
appropriate and helpful for generating a profit)
reasonable in amount (not extravagant)
Expenses are claimed on Schedule C


Revenues from the same activity are also reported on
the same Schedule C
The net income or loss from Schedule C is transferred
to Form 1040 (page 1) on line 12
7
Deductions for AGI

Rental & Royalty Expenses




Claimed above the line (for AGI)
Could either be an investment activity or a trade
activity depending on facts
Taxpayers report expenses and revenue on Schedule
E and transfer the net income or loss from Schedule E
to Form 1040 (page 1), line 17
Flow-through Entities

Expenses and losses incurred by a flow-through entity
pass through to the entity owners who typically report
these amounts on Schedule E and Line 17
8
Deductions for AGI

Losses




Taxpayers disposing of trade or business assets at a
loss are allowed to deduct the loss for AGI
Losses from investment assets (called capital assets)
are offset against capital gains
If capital losses exceed capital gains, this is called a
net capital loss
A net capital loss is deducted for AGI but limited to
$3,000. Losses in excess of the $3,000 limit are
carried forward indefinitely to subsequent years
9
Deductions for AGI

Flow-through entities


Income, expenses, and losses from flow-through
entities pass through to their owners.
Expenses and losses from flow-through entities are
subject to certain restrictions (basis, at-risk, and
passive loss rules)
10
Tax Basis Limitation


Losses may not exceed an investor’s tax basis in
the activity. Excess loss carried over until event
occurs to create more tax basis.
Increases to tax basis




Cash invested
Share of undistributed income
Share of debt
Decreases to tax basis


Cash distributions
Prior year losses
11-11
At-Risk Limitation

Losses may not exceed an investor’s amount atrisk in the activity.


Excess loss carried forward until event occurs to create
additional amount at-risk.
At-risk amount calculated like tax basis except:

The types of debt that increase a taxpayer’s at-risk
amount is more restrictive than the types of debt that
increase tax basis.
11-12
Tax Basis and At-Risk Limitation
Question



Lon purchased an interest in a limited liability
company (LLC) for $50,000 and the LLC has no
debt. Lon’s share of the loss for the current year is
$70,000.
How much of the loss is limited by his tax basis?
How much of the loss is limited by his at-risk
amount?
11-13
Tax Basis and At-Risk Limitation
Solution


Lon’s tax basis before the loss is $50,000, which
equals his $50,000 investment. As a result, $50,000
of his $70,000 loss is not limited by his tax basis and
$20,000 of his loss is limited by his tax basis.
His at-risk amount is also $50,000 because the LLC
does not have any debt. Thus, there is no additional
loss limited by Lon’s at risk amount – i.e., the
$50,000 of the loss that was not limited by his basis
is also not limited by his at risk.
11-14
Passive Activity Limitation



Applied after tax basis and at-risk limitations.
Losses from “passive activities” may only be
deducted to the extent the taxpayer has income
from passive activities or when the passive
activity is sold.
A passive activity is a trade or business or rental
activity in which the taxpayer does not materially
participate.



Participants in rental real estate and limited partners
without management rights are generally considered to
be passive participants
All other participants are considered to be passive
unless their involvement is “regular continuous and
substantial”
Seven factors for testing material participation
11-15
Testing for Material
Participation
11-16
Passive Activity Loss Limitation
Question



In addition to his interest in the LLC, Lon
owns a rental property that produced $5,000
of rental income during the year.
How much of Lon’s remaining $50,000 loss
(after applying the tax basis and at-risk
limitations) can he deduct currently?
What happens to any portion of the loss he
can’t deduct?
11-17
Passive Activity Loss Limitation
Solution




Generally, income from rental real estate is considered
to come from a passive activity.
Lon may use $5,000 of his passive activity loss from the
LLC to offset his $5,000 of passive income from his
rental real estate.
He must carry forward the remaining $45,000 passive
activity loss until he either receives more passive income
or until he sells his interest in the LLC.
At the end of the day, Lon is able to deduct $5,000 of his
loss from the LLC currently. In addition, he has a
$20,000 loss carryforward limited by his tax basis (and
at-risk) and a $45,000 passive activity loss carryforward.
11-18
Mom and Pop Exception for
Rental Estate


Mom and Pop own a home they rent out to students
at the local university. Pop approves new tenants
and makes repairs when needed. Their AGI before
considering any income or loss from the rental
property is $90,000. Their loss from the rental
property for the current year is $16,000.
If Mom and Pop have no other sources of passive
income, how much of the passive loss from the
rental home can they deduct currently?
11-19
Mom and Pop Exception for
Rental Estate Solution



Taxpayers like Mom and Pop may currently deduct
up to $25,000 of losses from rental real estate even
if they don’t have passive income from other
sources.
However, their ability to deduct these losses phases
out by 50 cents for every dollar of AGI they earn
above $100,000. Once their AGI hits $150,000 they
will no longer be able to deduct the loss from their
rental property unless they have passive income
from another source.
Because their AGI is less than $100,000, Mom and
Pop may deduct all $16,000 of loss from their rental
property.
11-20
Loss Limitations - Rental Use
of Home

Three types of classifications for second home:




Residence with minimal rental use (rents for 14 or
fewer days)
Residence with significant rental use (rents home for
15 or more days)
Nonresidence
A property is a residence if the taxpayer uses
the home for personal purposes for more than
the greater of 14 days or 10 percent of the rental
days during the year
Residence with Minimal Rental
Use



The taxpayer must live in the home for at
least 15 days and rent it out for 14 days or
less
Rental income can be excluded
No rental expenses except those that are
personal itemized deductions (home
mortgage interest and real estate taxes)
Residence with Significant
Rental Use (Vacation home)


Rent home for 15 days or more
Personal use, greater of



15 days
More than 10% of the total FMV rented days.
Include rental revenues in gross income and
allocate expenses between personal use and
rental use.
Residence with Significant Rental
Use Expense Allocation

Expenses allocated to personal use are not deductible
unless deductible under other provisions (generally
mortgage interest and real estate taxes)

Expenses to acquire tenants deductible in full

Expenses allocated to rental use deductible only to the
extent of gross rental income after deducting expenses
to acquire tenants (generally no losses for a vacation
home)

Expenses must be deducted in a specific order.
Residence with Significant
Rental Use Expense Allocation

Three categories or “tiers” of expenses:




Tier 1: expenses that are deductible without regard to
rental activity (interest/real estate taxes/expenses to
acquire tenants)
Tier 2: all other expenses except for depreciation
Tier 3: depreciation
Generally expenses allocated based on # of days
used for each activity/total days used.

Exception for tier 1 expenses which can be allocated based
on total days in the year instead of days used (called the
“Tax Court” or “Bolton” method)
Residence with Significant Rental
Use Expense Allocation Example
At the beginning of year 1, Courtney purchased a
vacation home in Scottsdale, Arizona, for $400,000.
She paid $100,000 down and financed the remaining
$300,000 with a 6 percent mortgage secured by the
home. During the year, Courtney used the home for
personal purposes for 30 days and rented the home
for 200 days, receiving $37,500 of rental income and
incurred $500 of rental advertising expense. How are
her expenses allocated to the rental use under the IRS
and Tax Court methods?
Vacation Home Rental Expense
Allocation Example Solution
Nonresidence (Rental Property)

The taxpayer includes all income and
deducts all rental expenses.



However, if the property is used for even a day of
personal use the expenses must be allocated.
Taxpayer not allowed to deduct the personal use
portion of tier 1 interest expenses because the
property doesn’t qualify as a residence.
Personal use portion of tier 1 real property taxes
are deductible as an (from AGI) itemized
deduction
Rental Home Example

Assume Courtney did not use the home at all
for personal purposes. She received $37,500
in gross rental income and incurred $50,439
of expenses relating to the property. How
much of these expenses can the Courtney
deduct?
Rental Home Example Solution

All $50,439. This generates a $12,939 loss
on the property. The loss may be limited by
the passive activity loss limitations.
Business Use of The Home:
Home Office Expense Deduction

To qualify for a “home office” deduction, a
taxpayer must use her home or part of her
home exclusively and regularly as either:


The principal place of business for any of the
taxpayer’s trade/business
A place to meet with patients/clients in the normal
course of business
Home Office Expense Deduction


If employee, deducted as unreimbursed
employee business expense
If self-employed, deducted for AGI but
deduction limited to business income before
the deduction
Home Office Expense Deduction

Must allocate expenses between personal
and business use of home



Direct vs. indirect expenses
Indirect expenses allocated based on square
footage
Limitations on deductibility of expenses


If employee, deductions are miscellaneous
itemized deductions subject to two percent floor
If self-employed, deduct for AGI
Home Office Expense Deduction

Deduction is limited to gross income derived from
business use of home.


Deduct using same tier 1 – 3 sequence used for vacation
homes
Depreciation expense
 Reduces basis in home
 Gain on sale due to depreciation is ineligible for exclusion
 Gain is taxed at a maximum 25 percent rate as
unrecaptured §1250 gain
Deductions Indirectly Related
to Business Activities





Individual Retirement Accounts
Moving Expenses
Health Insurance Deduction by SelfEmployed Taxpayers
Penalty for Early Withdrawal of Savings
Self-Employment Tax Deduction
35
Individual Retirement
Accounts (IRAs)

For AGI deduction for contributions


Generally not allowed if participant in employersponsored plan unless
For single taxpayers Taxpayer is single, deduction
allowed if participate in employer plan but income is
below certain thresholds
 In 2015, lesser of $5,500 or earned income
 If 50 years or older at end of year limit is $6,500

Additional “catch-up” contribution
Individual Retirement
Accounts (IRAs)

For AGI deduction for contributions


Generally, not allowed if participant in employersponsored plan unless
For married taxpayers deduction is allowed if
participate in employer plan but income is below
certain thresholds
 In 2015, lesser of $5,500 or earned income of both
spouses reduced by other spouse’s contributions to
IRA or Roth IRA
 If 50 years or older at end of year limit is $6,500

Additional “catch-up” contribution
Individual Retirement
Accounts (IRAs)

May make nondeductible contributions


Deductible + nondeductible cannot exceed
$5,500 for one taxpayer (plus catch-up)
Must contribute by April 15th of
subsequent year
Individual Retirement
Accounts (IRAs)

Distributions taxed as ordinary income


10% penalty if before 59 ½
Certain exceptions



Medical expenses, insurance premiums, first
home
Same minimum distributions apply as to
qualified contribution plans
nontaxable percentage = nondeductible
contributions divided by balance of account
Roth IRAs


Nondeductible contributions
Contributions to a Roth IRA


Same $5,500 limit ($6,500 if 50 or older at year
end)
Phase-out based on AGI
Roth IRAs

Distributions from a Roth


Distributions of contributions never taxed
Qualified distributions of earnings from Roth not taxed
 Account must be open for five years before can receive
qualified distributions and





Taxpayer must be at least 59 ½ to receive qualified distribution or
Distributions on death of taxpayer or
Taxpayer is disabled or
First home (limited to $10,000)
No minimum distribution requirements
Roth IRAs

Rollover from traditional to Roth


Tax consequences
Why roll over?


Marginal tax rates
Contribution limits to Roth are effectively higher

$5,500 limit of after tax vs. before-tax dollars
Rollover from Traditional to
Roth IRA Example
Assume Courtney made a fully deductible
$4,000 contribution to a traditional IRA account.
This year, when her marginal tax rate is 25
percent, Courtney withdraws the $5,000
balance in the account and contributed (rolled
over) $3,750 to a Roth IRA. What amount of
taxes and penalty is she required to pay on the
rollover?
Rollover from Traditional to
Roth IRA Example Solution
She must pay a $1,250 in taxes (25% ×
$5,000) and $125 penalty. The penalty is 10
percent of the $1,250 that she withdrew from
the IRA and did not contribute to the Roth IRA
($5,000 - $3,750).
Moving Expenses


The cost of moving personal possessions is
not a direct cost of doing business or being
employed
Moving Expenses are deductible for AGI if
the move meets two tests
1.
2.
A distance test
A time test associated with a move
45
Moving Expenses

Distance test – the new job site must extend existing
commute by 50 miles



A new job site is required, but a new employer is not
essential
Time test - Taxpayer must be employed at least 39 of
52 weeks or be self-employed for 78 of the 104 weeks
following the move
Taxpayers are allowed to deduct a mileage rate in lieu
of the actual costs of driving their personal
automobiles during the move (23 cents per mile in
2015)
46
Deductions Indirectly Related to
Business Activities

Health Insurance deduction by Self-Employed
Taxpayers



Deduction provides equity with employees who
receive health insurance as a qualified fringe benefit
Insurance must be provided for taxpayer or
dependents who are not eligible for employerprovided health insurance
Penalty for early withdrawals of savings

Reduces the taxpayer’s net interest income to the
amount actually received
47
Self-Employment Tax Deduction




Employer and employees each pay the
employee’s Social Security tax
Employers deduct the portion of Social Security
taxes they pay for employees
Self-employed individuals are required to pay SE
tax in lieu of Social Security tax
Self-employed tax payers are allowed to deduct
the employer portion of the SE tax they pay to
compensate for employers deducting their portion
of Social Security
48
Deductions Subsidizing
Specific Activities



Alimony payments are deductible for AGI to
maintain equity
Interest expense on qualified educational
loans
Qualified educational expenses
49
Deduction for Education
Interest

Deduction for Interest expense on loans used to
fund qualified educational expenses



Up to $2,500 of interest on education loans is
deductible for AGI
The interest deduction is phased-out for taxpayers
with AGI exceeding $65,000 ($130,000 filing joint)
The deduction is eliminated for taxpayers with AGI
exceeding $80,000 ($160,000 filing joint)
50
Deduction for Education
Interest
51
Deduction for Qualified
Education Expenses
52