Chapter 6

• Vacation Homes• Hobby Losses• Losses on Transactions between Related Parties• Deduction Related to Illegal Business Operations• Prepaid Expenses by Cash Basis Taxpayer• Expenses related to Investigating a Business• Expenses Related to Tax Exempt Income• Reasonable Compensation• Expenses that go against Public Policy

Vacation Homes

• Let’s look at the two extremes:• We do not rent the vacation home at all during the

year …….. what are the tax consequences?

• We rent the house for the entire year and do not use the house for personal use …… tax consequences?

• The Middle Ground ………….•If we rent for 14 days or less, considered

“primarily” personal. Not required to recognize income.

•If we use personally for 14 days or less, primarily “trade or business”.

Vacation House (con’t)

• Combination of Personal and Rental use:• Pick up all the rental income for tax purposes

• Pro rate the expenses between personal and rental

• How do we pro rate the expenses related to a vacation house?

• Mtg interest and property taxes are pro rated evenly throughout the year …….. pro rated over 365 days.

• All other expenses are pro rated based on the number of days the house is used (not the # of days in the year).

Why the difference??

Vacation House (con’t)

• Where does the vacation house go on the tax return? what schedule??

• When the house is used for both personal and rental use, income may be offset but no loss may be taken on the tax return.

• There is an ordering of expenses when pro rating the business and personal expenses:

• Use mortgage interest and property tax first

• Use all other expenses second

• Use depreciation third

Problem 6-51

Rental Income $ 7,000

I. Property Tax (45/365 X $2,500) -308Mortgage Interest (45/365 X $9,000) -1,110

II. Utilities (45/65 X $2,400) -1,662Repairs (45/65 X $1,000) -692

III. Depreciation (45/65 X $7,000) -3,228

Net Rental Income $ 0

Property tax of $2,192 ($2,500 –308) and Mtg Interest of $7,890 ($9,000 – 1,110) can be taken as itemized deductions.

a.

Problem 6-51

Rental Income $ 7,000

I. Property Tax (45/65 X $2,500) -1,521Mortgage Interest (45/65 X $9,000) -5,479

II. Utilities (45/65 X $2,400) 0Repairs (45/65 X $1,000) 0

III. Depreciation (45/65 X $7,000) 0

Net Rental Income $ 0

Property tax of $979 ($2,500 –1,521) and Mtg Interest of $3,521 ($9,000 – 5,479) can be taken as itemized deductions.

b.

Transactions between Related Parties

• Losses – losses are disallowed from transactions between related parties.

• When property is subsequently sold, the previously disallowed loss may be used to reduce the recognized gain.

• Who is a related party?• Brothers and sisters, parents and grandparents, children

and grandchildren, spouses

• Corporation and a 50% shareholder

• Two corporations that are members of a controlled group.

Transactions between Related Parties (con’t)

• When we have two related taxpayers, one being cash basis and the other accrual basis, Section 267 IRC requires a matching of any deduction with the recognition of income.

• Example: Loan between related parties. The borrower cannot deduct the interest currently while the lender defers recognition of income until cash is received.

Expenses related to Tax Exempt Income

• Interest (or other expenses) on indebtedness used to purchase tax exempt obligations is disallowed (since the income earned on the bonds is tax exempt).

• Same principle for life insurance premiums ……… not deductible since the proceeds received upon death would be tax exempt.

Legal Expenses

• Expenses related to personal expenses are not deductible

• Legal fees relating to a divorce

• Legal fees relating to a PTI charge

• Legal fees relating to a parking ticket

• Legal expenses related to trade or business issues, tax planning or matters of income could be deductible.

Hobby Losses

• A business activity must be operated for “profit” …….. It must have a profit motive. Losses are fully deductible for activities engaged in for profit.

• Business activities that lack a profit motive are considered “hobbies”. Hobby expenses are deductible, but only to the extent of income. Revenue can be offset, but no loss can be taken on a hobby.

Hobby Losses (con’t)

• Presumption of Profit Motive (section 183, IRC)

The activity shows a profit for 3 of the previous five years (consecutive years).

• There is an ordering of deductions:• Mtg. Interest and Property Tax

• Other deductions related to the activity

• Depreciation (also amortization)

Problem 6-48

Remainder

Income from Hobby 18,000

Itemized Ded Mortgage Interest N/A

Schedule A Property Taxes -3,000 -3,000 15,000

Materials and Supplies -4,500

Misc. Deductions Utilities -2,000

Schedule A Advertising -5,000 -12,250 2,750

Insurance -750

Depreciation -4,000 -2,750 0

Net Income from Hobby 0

Problem 6-48

Alex's Tax Return Net Effect

on Taxable Income

AGI 42,000

Income from Hobby Activity 18,000 18,000

New AGI 60,000

Property Tax - Hobby -3,000 -3,000

Miscellaneous Deductions 15,000

less: 2% Haircut ($60,000 x 2%) -1,200

Deductible Misc. Deductions 13,800 -13,800 -13,800

Taxable Income before Exemptions 43,200 1,200

Taxable Income is $39,900 ….. $43,200 less $3,300 exemption.

Trade or Business Expenses

• Ordinary and Necessary expenses paid in carrying out a Trade or Business are deductible.

• Expenses, and particularly compensation, must be reasonable. Any excess amount is not deductible.

Cash Basis

• For cash basis taxpayers, expenses must be paid in order to be deductible.

• Capital expenditures are not currently deductible …… they are deducted through depreciation or amortization.

• An expenditure that creates an asset having a useful life that extends substantially beyond the end of the year should be capitalized.

Accrual Basis

• Deduction is allowed when:• All events have occurred that created the liability,

and

• The amount of the liability can be determined with reasonable accuracy.

Expenditures Contrary to Public Policy

• Not deductible for tax purposes• Bribes and Kickbacks

• Fines and penalties paid to a government regulatory agency

• Legal Expenses – generally, not deductible . However, if taxpayer can show that the legal expenses are directly related to a trade or business, or to an income producing activity, or for a tax related matter, then legal expense would be deductible.

Illegal Businesses

• Usual expenses that are related to an illegal business would be deductible against the income of the illegal business.

• Salaries, insurance, supplies, utitities

• Kickbacks or payoffs would not be deductible

• Drug dealers are not allowed a deduction for the ordinary and necessary business expenses related to that activity. However, cost of goods sold can be netted against gross revenues.

Political Contributions / Lobbying

• Not deductible

• Exception for:• Local legislation (still must be business related)

• Activities devoted to monitoring legislation (as opposed to influencing legislation)

• $2,000 de minimis amount for in-house expenditures

Investigating a Business

• Investigation Fees – • Same or Similar Business - Deductible if the

taxpayer is in the same or similar business regardless of whether the investigation expenses are fruitful or not.

• Not in the Same or Similar Business – if business is not acquired, all investigation expenses are not deductible. If business is acquired, then investigation expenses must be capitalized and amortized over 180 months, beginning in the month the business started.

Expense paid for another Taxpayer

• A tax deduction may not be claimed for the payment of expenses for another individual.

• Interest on a mortgage paid for a relative

• Property tax paid for another individual

Helen has a livestock business on the side that has been previously classified as a hobby by the IRS. Helen raises and breeds horses for sale. Aside from the Hobby activity, her AGI is $88,000 for 2004. She provides her CPA with the following information:

HobbyIncome 12,000Mortgage Interest Expense 2,000Rent 4,000Feed / Supplies 3,200Vetinary 1,000Depreciation 2,400