Chapter 3

Income Tax Fundamentals 2010 edition Gerald E. Whittenburg

Martha Altus-Buller

2010 Cengage Learning

Net Rental Income/Loss is part of gross income

◦ Report on Schedule E - Part I

Vacation Homes

◦ If both personal and rental use of residence, must allocate expenses

◦ Deductions limited based on period of time residence used for personal vs. rental


Three Categories – different tax treatment for each◦ Category I: Primarily personal use

Rented for less than 15 days◦ Category II: Primarily rental use

Rented more than or equal to 15 days and personal use does not exceed greater of 14 days or 10% of rental days

◦ Category III: Rental/personal (dual use) of property Rented more than or equal to 15 days and personal use

exceeds greater of 14 days or 10% of rental days

See following screens for tax treatment for each scenario


Treated as a personal residence Rental period is disregarded

◦ Rental income is not taxable◦ Mortgage interest/taxes reported on Schedule A

(itemized deductions)◦ Other expenses are personal and nondeductible


Must allocate expenses between rental and personal use – calculated as follows:◦ Rental days / Total days used = Rental % ◦ Expenses x Rental % = Rental deductions◦ Personal days / Total days used = Personal %

If rental deductions exceed rental income, can deduct against other income, subject to passive loss rules

Personal % of mortgage interest & real estate taxes reported on Schedule A


Allocate expenses between rental and personal based on same allocation formulas as prior screen

Rental deductions can be taken up to amount of rental income only, in order, as follows◦ Taxes and interest (can take into loss situation)◦ Utilities/maintenance (only up to remaining rental

income)◦ Depreciation (only up to remaining rental income)

Personal % of mortgage interest & real estate taxes reported on Schedule A


Example

The Prebena family owns a ski condo in Alta, UT; in the current year personal use = 25 days and rental use = 50 days. Data pertaining to the rental follows; what amounts will be reported on Schedules E and A for the current year?

Rental income $10,000 Taxes $ 1,500 Interest $ 3,000 Utilities $ 2,000 Insurance $ 1,500 Snow removal $ 2,500 Depreciation $12,000



Example The Prebena family owns a ski condo in Alta, UT; in the current year personal use = 25 days and rental use = 50 days. Data pertaining to the rental follows; what amounts will be reported on Schedules E and A for the current year?

Rental income $10,000Taxes $ 1,500 Interest $ 3,000 Utilities $ 2,000Insurance

$ 1,500Snow removal $ 2,500Depreciation $12,000

SolutionStep 1: Personal use is > 14 days or 10% of rental (5 days); therefore, does exceed the greater number and this is dual use property

Step 2: Taxes/interest = $4,500 x 50/75 = $3,000 deduction on E

Step 3: Other expenses = $6,000 x 50/75 = $4,000 deduction on E

Step 4: Depreciation = $12,000 x 50/75 = $8,000 but limited to $3,000 (remaining income) because dual use property can’t create a loss

Step 5: = What amount goes to Schedule A? ($4,500 taxes/interest – $3,000 rental = $1,500)

Step 6: = What is the loss carry forward? $8,000 – 3,000 = $5,000

IRS requires that dual use of rental property allocation is based on total days of use

U.S. Tax Court has allowed allocation of interest and taxes using 365 as denominator◦ This allows more interest/taxes to be deducted on

Schedule A, creating greater potential to take other expenses on the Schedule E

This controversy between IRS and Tax Court is still not resolved


Passive loss rule - When taxpayer has minimal or no involvement in an activity, generated losses are considered “passive” and may not be deducted in excess of passive gains, however:◦ Loss can be carried forward and deducted in future

years or◦ Can be deducted when investment is sold

Examples of passive activities

◦ Limited partnerships

◦ Rental real estate


Passive Losses Rules Require income and losses to be separated

into three categories:◦ Active◦ Portfolio◦ Passive

Generally, disallow the deduction of passive losses against active or portfolio income

Passive Losses Rules In general, passive losses can only offset

passive income Passive losses are also subject to the at-risk

rules◦ Designed to prevent taxpayers from deducting losses

in excess of their economic investment in an activity

At Risk Limits At-risk defined

◦ The amount of a taxpayer’s economic investment in an activity Amount of cash and adjusted basis of property

contributed to the activity plus amounts borrowed for which taxpayer is personally liable (recourse debt)

At Risk Limits At-risk defined

◦ At-risk amount does not include nonrecourse debt unless the activity involves real estate For real estate activities, qualified nonrecourse debt

is included in determining at-risk limitation

At Risk Limits At-risk limitation

◦ Can deduct losses from activity only to extent taxpayer is at-risk

◦ Any losses disallowed due to at-risk limitation are carried forward until at-risk amount is increased

◦ Previously allowed losses must be recaptured to the extent the at-risk amount is reduced below zero

◦ At-risk limitations must be computed for each activity of the taxpayer separately

At Risk Limits Interaction of at-risk rules with passive loss

rules◦ At-risk limitation is applied FIRST to each activity

to determine maximum amount of loss allowed for year

◦ THEN, passive loss limitation applied to ALL losses from ALL passive activities to determine actual amount of loss deductible for year

Calculation of At-Risk Amount

Increases to a taxpayer’s at-risk amount:◦ Cash and the adjusted basis

of property contributed to the activity

◦ Amounts borrowed for use in the activity for which the taxpayer is personally liable or has pledged as security property not used in the activity

◦ Taxpayer’s share of amounts borrowed for use in the activity that are qualified nonrecourse financing

◦ Taxpayer’s share of the activity’s income

Decreases to a taxpayer’s at-risk amount:◦ Withdrawals from the activity◦ Taxpayer’s share of the

activity’s loss◦ Taxpayer’s share of any

reductions of debt for which recourse against the taxpayer exists or reductions of qualified nonrecourse debt

Passive Loss Limits Active income

◦ Wages, salary, and other payments for services rendered

◦ Profit from trade or business activity in which taxpayer materially participates

◦ Gain from sale or disposition of assets used in an active trade or business

◦ Income from intangible property created by taxpayer

PASSIVE LOSS LIMITS Portfolio income

◦ Interest, dividends, annuities, and certain royalties not derived in the ordinary course of business

◦ Gains/losses from disposition of assets that produce portfolio income or held for investment

PASSIVE LOSS LIMITS Passive losses defined

◦ Losses from trade or business activities in which taxpayer does not materially participate, and

◦ Certain rental activities

Passive Loss Limits Limitations on passive losses

◦ Generally, passive losses can only offset passive income, i.e., they cannot reduce active or portfolio income

◦ Disallowed losses are suspended and carried forward Suspended losses must be allocated to specific

activities

Passive Loss Limits Suspended losses are deductible in year

related activity is disposed of in a fully taxable transaction

Passive Loss Limits Passive credits

◦ Credits from passive activities are subject to loss limitation

◦ Utilize passive credits to the extent of tax attributable to passive income

◦ Credits disallowed are suspended and carried forward similar to losses Suspended credits can be used to offset tax from

disposition of activity but any credits left after activity is disposed of are lost forever

Passive Loss Limits Taxpayers subject to rules

◦ Individuals, estates, trusts, personal service corporations

◦ Closely-held corporations Can deduct passive losses against active income

◦ S Corp and partnership passive losses flow through to owners and limits applied at the owner level

Passive Loss Issues Passive losses are losses from trade or

business activities in which taxpayer does not materially participate and certain rental activities

What constitutes an activity? What is “material participation"? When is an activity a rental activity?

Identification of Activities Taxpayers with complex business operations

must determine if segments of their business are separate activities or entire business is treated as a single activity

Identification of Activities Regs allow grouping multiple trade or

businesses if they form an appropriate economic unit for measuring gain or loss◦ Once activities are grouped, can’t regroup unless:

Original groups were clearly inappropriate, or Material change in circumstances

Identification of Activities Factors given greatest weight in

determining an appropriate economic unit include:◦ Similarities and differences in types of businesses◦ Extent of common control and ownership◦ Geographic location of different units◦ Interdependencies among the activities

Material Participation Tests

An activity is treated as active rather than passive (thus, not subject to the passive loss limits) if taxpayer meets one of 7 material participation tests

Participation is generally defined as work performed by an owner


Test 1◦ Taxpayer participates in the activity more than

500 hours during the year


Test 2◦ Taxpayer’s participation in the activity is

substantially all of the participation in the activity of all individuals for the year


Test 3◦ Taxpayer participates in the activity more than

100 hours during the year and not less than the participation of any other individual in the activity


Test 4◦ Taxpayer’s participation in the activity is

significant and taxpayer’s aggregate participation in all significant participation activities during the year exceeds 500 hours

◦ Significant participation is more than 100 hours


Test 5◦ Taxpayer materially participated in the activity for

any 5 years during the last 10 year period


Test 6◦ The activity is a personal service activity in which

the taxpayer materially participated for any 3 preceding years


Test 7◦ Based on the facts and circumstances, taxpayer

participated in the activity on a regular, continuous, and substantial basis Regular, continuous, and substantial are not

specifically defined in the Regulations

Rental property is specifically designated as passive, even if taxpayer actively manages

However, individual taxpayers◦ May take up to $25,000 of rental loss (even though

considered passive) against ordinary income

◦ The $25,000 loss capability is reduced by 50¢ for each $1 modified AGI (MAGI) > $100,000*

*Therefore, no deduction for rental losses exist for MAGI reaches $150,000


If taxpayer if heavily involved in real estate rental activities, may be considered to have an active business

Requirements are◦ 50% or more of individual’s personal service

during year is performed in real property trade and

◦ More than 750 hours of service performed Then taxpayer may be able to deduct

entire loss on real estate business



ExampleBobbi Jo is single and owns one rental duplex that showed a loss of $20,000. Her modified AGI before the loss is $118,000. What amount of the rental loss can be claimed?


ExampleBobbi Jo is single and owns one rental duplex that showed a loss of $20,000. Her modified AGI before the loss is $118,000. What amount of the rental loss can be claimed?

SolutionStep 1 Modified AGI exceeds $100,000 (therefore,

$25,000 allowable loss may be reduced)

Step 2 $118,000 - $100,000 = $18,000 excess, $25,000 - ($18,000 x 50%) = $16,000

Only $16,000 of the rental loss can be deducted

Bad debts arise when taxpayer sells good/services on credit and accounts receivable later becomes uncollectible◦ Deduction for bad debts allowed up to amount

previously included in income - cash basis taxpayers cannot take bad debts expense

◦ As they never reported original income Must use specific charge-off method

◦ IRS requires proof of worthlessness


Two types of bad debts Business bad debts are ordinary deductions

◦ Those that arise from trade/business ◦ These are deductible

Non-business bad debts are short-term capital losses, which are netted against other capital gains and losses ◦ Report on Schedule D◦ Subject to $3,000/year loss limitation (discussed in

Chapter 8 in more detail)


ExampleKeiko (a dentist) loans her friend, Lars, $20,000 to

start an upholstery business. Subsequently, Lars cannot repay Keiko; is this a business or a non-business bad debt and how much may Keiko deduct in the current year?


ExampleKeiko (a dentist) loans her friend, Lars, $20,000 to start

an upholstery business. Subsequently, Lars cannot repay Keiko; is this a business or a non-business bad debt and how much may Keiko deduct in the current year?

SolutionThis is a non-business bad debt as Keiko is not in the

business of loaning money. It is a short-term capital loss (limited to $3,000 of deduction against ordinary income in any one year). She may carry forward the balance of the capital loss to future years.


Cost of goods sold (COGS) is a significant deduction for many retail businesses◦ Cost of beginning and ending inventory

crucial to calculation of deduction◦ LIFO and FIFO most commonly used

methods of costing inventory

If LIFO is used for tax, it must also be used for financial statement purposes

◦ Form 970 used to elect LIFO


NOLs are losses resulting from business and casualty items only

First, carry it back two years and then forward twenty◦ File amendments for prior years (1040X) or◦ 1045 (for quick claim for refund)

or May make an irrevocable election to forego carry back,

then carry forward◦ But must elect this in year of loss

American Recovery & Reinvestment Act provides relief for businesses that incurred an NOL in 2008. It allows them to elect to carry back the NOL to the most beneficial year between 2003 and 2006 (or carry it forward and forego carry back).


Traditional IRA

◦ Deduction for AGI if certain conditions met

◦ Distributions in retirement are taxable

Roth IRA

◦ No current deduction

◦ Distributions in retirement are nontaxable


Roth or traditional IRA contribution limited to lesser of:

◦ 100% of earned income

or

◦ $5,000 Spouse with no earned income will be able to

contribute up to $5,000 For 2009, taxpayers and spouses age 50 and over

can contribute an additional $1,000/year (called “catch-up provision”)


Can make contributions up through April 15, 2010 for 2009

Roth IRA contribution maximum is reduced for all taxpayers over certain income levels

◦ Phase-out for contribution is reflected in table on page 3-15

If taxpayer contributes to both a traditional and Roth IRA, combined amount cannot exceed $5,000 ($6,000 if 50 or over)


Traditional IRA deduction is dependent on AGI and active participation in another qualified retirement plan

◦ Single taxpayers – see table on top of page 3-16

◦ MFJ taxpayers – see table, phase-outs based on if one, both or neither spouse is an active participant

Note: if only one spouse is in a qualified plan, phase out for the non-active participant spouse begins when married filing joint couple’s AGI > $166,000


ExampleOwen is 42, single, and wants to contribute the

maximum to his Roth IRA. His AGI = $105,000, so his contribution will be limited. Please calculate how much of IRA contribution is allowed. How would that change if Owen were 62?


Example

Owen is 42, single, and wants to contribute the maximum to his Roth IRA. His AGI = $110,000, so his contribution will be limited. How much of IRA contribution is allowed? How would that change if Owen were 62?

Solution

Look at the phase-out chart on p. 3-15. The denominator to the calculation is the range of the phase-out amounts.

($120,000 – $110,000)/$15,000 x $5,000 = $3,333 Roth IRA contribution

If he were 62:

($120,000 – $110,000)/$15,000 x $6,000 = $4,000 Roth IRA contribution


$120,000 - $105,000

ExampleLiza and Mikal (both 41) filed married filing jointly.

Liza is covered by a 401(k) plan at work and earns $96,000. Mikal is not covered by a plan at work and earns $30,000. How much can each of them contribute to a traditional IRA?


Example

Liza and Mikal (both 41) are MFJ; Liza is covered by a 401(k) plan at work and earns $96,000. Mikal is not covered by a plan at work and earns $30,000. How much can each of them contribute to a traditional IRA?

Solution

Their combined AGI = $126,000. Their AGI exceeds the top end of the phase-out range for MFJ for ‘active participant spouse’, per Note 1 on the table on page 3-16.

Since Liza is the active plan participant, she may not make a deductible contribution to a traditional IRA. She could, however, make a $5,000 contribution to a Roth IRA, since their AGI is not in the Roth phase-out range (see table page 3-15).

Mikal can make the full $5,000 traditional IRA contribution since the AGI phase-out for the spouse that is not in an active plan does not kick in until $166,000.


Distribution taxed as ordinary income ◦ Must begin taking distributions by age 70.5

◦ There’s a 10% penalty if you take distribution before age 59.5 plus tax

◦ Penalty-free withdrawals from IRAs may be made by taxpayers who are:

Disabled

Using special level payment option

Purchasing a home for the first time (up to $10,000)

Paying higher education expenses

Paying medical expenses > 7.5% of AGI or medical insurance premiums for dependents and on unemployment at least 12 weeks

Note: in order to offer relief to retirees after stock market drop, minimum distribution requirements suspended for 2009 only


Qualified distributions are tax free as long as Roth IRA was open for five years

and◦ Distribution is made on/after age 59.5 ◦ Distribution is made due to a disability◦ Distribution is made on/after participant’s death◦ Distribution is used for first time home-buyer’s

expenses


Participants must meet minimum age and years of service requirements

Retirement plan geared towards self-employed individuals

Tax free contributions are limited to lesser of 20% of net earned income (before Keogh deduction) or $49,000

◦ Net earned income includes business profits if significantly generated from taxpayer’s personal services

◦ Must reduce net earned income by ½ self-employment tax for contribution calculation


Same dollar limits as Keogh plans, but contributions made to SEP-IRA◦ IRA account with higher funding limits

Participants must meet minimum age and years of service requirements

Pay early withdrawal penalty if receive distributions prior to age 59.5

Must start drawing by age 70.5


Contributions by an employer to qualified retirement plans are tax deductible◦ Employee contributions are pre-tax ◦ Tax on earnings is deferred

To achieve qualified plan status, an employer-sponsored retirement plan must◦ Be for exclusive benefit of employees ◦ Be nondiscriminatory◦ Have certain participation and coverage requirements ◦ Comply with minimum vesting requirements ◦ Meet uniform distribution rules

Limitations on contributions to/benefits from qualified plans◦ Defined contribution – annual addition to employee’s account can’t exceed

lesser of 25% of compensation or $49,000◦ Defined benefit – annual benefit can’t exceed lesser of $195,000 or average

compensation for the highest three consecutive years


§401(k) ◦ Employee chooses to defer some compensation into

plan Defer means to forego current compensation - the

reduction goes into a qualified retirement plan Employees choose % of wages to contribute to plan Not to exceed $16,500/year for all salary reduction plans

$22,000/year if 50 or older

◦ An employer may match to encourage participation, this is excludable from income

◦ When distributions occur, contributions/earnings taxable


Beginning in 2006, employers allowed to set up Roth §401(k) plan◦ Employees may defer same annual amount as

traditional 401(k), but with no reduction in current taxable income

◦ Withdrawals/earnings generally tax free upon distribution

Expected to be popular with high income taxpayers because no AGI phase-out and much higher annual contribution than a Roth IRA


Credit to encourage low-income taxpayer participation in retirement savings

Tax credit for percentage of retirement plan contribution based upon AGI

◦ Credit equal to 50%, 20% or 10% of contribution

◦ See chart on page 3-22

◦ Credit is direct deduction from income taxes payable


Plan 1 Plan 2

Taxpayer instructs trustee of plan to directly transfer assets to trustee of another plan

No backup tax withholding necessary because $ goes right from one plan to another

Unlimited number of direct transfers per year


Taxpayer

Plan 1 Taxpayer Plan 2 Taxpayer receives assets from fund, and then has 60 days to

get 100% of the $ from one plan to another to avoid penalties

◦ Or 120 days if first-time homebuyer, waived in other situations

20% federal backup tax withholding is mandatory

◦ So taxpayer must make up the 20% withholding and then wait until year-end to get refund!! Also if under 59.5 years old, portion of plan distribution not transferred subject to 10% penalty

◦ IRA distributions not subject to mandatory withholding


80% of $

ExampleTheo is 54 and instructs her employer, Ecotrek LLP, to

distribute $250,000 of her non-IRA retirement account to her. How much must the trustee of the fund withhold and what must Theo do to avoid taxes and penalties on the distribution in the current year?


Example

Theo is 54 and instructs her employer, Ecotrek LLP, to distribute $250,000 of her non IRA retirement accountto her. How much must the trustee of the fund withhold and what must Theo do to avoid taxes and penalties on the distribution in the current year?

Solution

The trustee must withhold 20%; therefore, Theo will receive $200,000 ($250,000 less withholding of $50,000). To avoid taxes she must contribute $250,000 to a new fund within 60 days. If Theo does not have the extra $50,000 to contribute, that portion of the distribution will be included in her taxable income and she will be subject to a 10% penalty. If she can contribute the full $250,000; the amount withheld will be accounted for on her annual tax return.


Designed for use by employers with less than 100 employees

SIMPLE-IRA◦ Employees can defer up to $11,500 per year into SIMPLE-IRA

or $14,000 if 50 or older

Employer must either:◦ Match employees’ contributions dollar for dollar up to 3% of

gross wagesor

◦ Contribute 2% of gross wages of all employees who make over $5,000 per year (even if they don’t elect salary deferral)

Contributions are fully vested when made; first 2 years early withdrawals are subject to 25% penalty


Example Sue, age 39, earns $70,000 and chooses

8% salary deferral to a SIMPLE IRA. How much is her contribution and what is the employer matching (assuming the 3% provision)?


Example Sue, age 39, earns $70,000 and chooses 8%

salary deferral to a SIMPLE IRA. How much is her contribution and what is the employer matching (assuming the 3% provision)?

SolutionSue contributes $5,600 to the plan and her employer matches $2,100 (dollar for dollar up to 3% maximum match ($70,000 x 3%)).


Example John, age 43, works for a computer software design business and has a salary of $500,000; John chooses 10% salary deferral (not to exceed maximum allowable by law). How much is his contribution and what is the employer matching (assuming the 2% provision)?


Example John, age 43, works for a computer software design business and has a salary of $500,000; John chooses 10% salary deferral (not to exceed maximum allowable by law). How much is his contribution and what is the employer matching (assuming the 2% provision])

SolutionJohn contributes $13,000 to the plan [since $500,000 x

10% exceeds the maximum, he is only allowed $11,500]. His employer matches $10,000 (dollar for dollar up to 2% maximum match ($500,000 x 2%)).



Date post:	13-Jan-2015
Category:	Documents
Upload:	dphil002
View:	1,114 times
Download:	6 times

Chapter 3

Documents