1. ©2003 South-Western College Publishing, Cincinnati, Ohio CHAPTER 5 Itemized Deductions and Other Incentives

2. © 2003 South-Western College PublishingTransparency 5-2 Objective Understand the nature and treatment of itemized deductions

3. © 2003 South-Western College PublishingTransparency 5-3 Itemized Deductions (Schedule A) rItemized deductions are generally personal expenses <If itemized deductions exceed standard deductions, use that number <Itemized deductions are phased out if AGI is over threshold amounts rTypes of itemized deductions (Separate sections of of Schedule A) Medical Expenses Charitable Contributions Taxes Employee Employee Business Expenses Interest Other Casualty/Theft

4. © 2003 South-Western College PublishingTransparency 5-4 Medical Expenses rTaxpayers are allowed deductions for medical expenses for spouse, self and dependents (in excess of reimbursements) but only if the total exceeds 7.5% of AGI <Prepaids are generally not deductible but credit card charges are deductible in year charged <Prescription medication is allowed <$.13/mile transport for medical care and $50/night lodging for each individual (person needing attention plus one caregiver) rCapital purchases deductible all in one year (only in excess of value increase of home, for example wheelchair ramps and bathroom fixtures)

5. © 2003 South-Western College PublishingTransparency 5-5 Medical Expenses (continued) rHealth, dental and optical insurance premiums <Health insurance for self employed is split: Ù70% is deductible for AGI Ù30% is deductible on Schedule A <Long term care insurance premiums also deductible <Medicare A premiums not deductible, but Medicare B (supplemental) are deductible (SS Statement designates) rPsychiatric care, drug/alcohol treatment deductible, but not marriage counseling or smoking cessation rNursing home costs (if entirely for medical benefit) deductible

6. © 2003 South-Western College PublishingTransparency 5-6 Medical Savings Accounts (MSA) rMSAs are designed to help employees of small businesses with high deductible health insurance plans meet uncovered costs <Also available to self-employed taxpayers rEmployees can contribute 65% of annual deductible (if single) or 75% (family) as a deduction for AGI <“High deductible” plan means deductible of $1,650-$2,500 for individual or $3,300-$4,950 for family ÙOut of pocket expenses cannot exceed $3,300 ($6,500 for a family) <If employer contributes to MSA, not includable in income <Earnings and distributions from MSA are then nontaxable if used for medical expenses (15% penalty if used for other purposes)

7. © 2003 South-Western College PublishingTransparency 5-7 Taxes rTaxes are imposed by a government to raise revenue for general public purposes; a fee is a charge with a direct benefit to the person paying. <Taxes are deductible, fees not deductible. rExamples of deductible taxes <State and local income taxes <Real estate taxes <Personal property taxes rExample of nondeductible taxes <Sales tax <Estate tax <Social Security taxes <Any federal tax

8. © 2003 South-Western College PublishingTransparency 5-8 State Income Tax Deductibility rAmount paid in current year is deductible. For example: What is deductible in following scenario? <Amend 2001 state tax return and pay additional $843 ($93 in penalties/interest + $750 tax) <State Income Tax (SIT) withholding for the current year is $660 <Paid quarterly SIT estimates as follows: Ù4/15, 6/15, and 9/15 of current year and 1/15 of next year ($200/each) Ù1/15 of current year paid fourth quarterly estimate from prior year of $155 rAnswer: Deductible amount is $750 + $660 + $200 + $200 + $200 + $155 = $2,165 rIf taxpayer receives refund of SIT that was deducted in prior year, that refund is taxable income in year it is received. <Report on Form 1040

9. © 2003 South-Western College PublishingTransparency 5-9 Real Estate Taxes rProperty taxes on real estate are deductible (even on second home); however, rental property real estate taxes are reported on Schedule E <If paid into escrow, taxes are deductible when paid <If taxpayer pays real estate taxes twice per year, doesn’t matter which year it pertains to - deduct using cash method rWhen selling property, need to allocate based on number of days each owned; this is reported on closing documents <Seller deducts taxes paid up to, but not including, date of sale rAssessments add to basis of property and are not deductible

10. © 2003 South-Western College PublishingTransparency 5-10 Personal Property Taxes rTax on personal property (such as autos, boats, trailer, etc.) are deductible, but only if ad valorem (amount that is based on the property’s value)

11. © 2003 South-Western College PublishingTransparency 5-11 Interest rExamples of deductible interest include <Qualified residence interest and points <Amortized points on refinanced mortgage <Investment interest, such as margin interest <Student loan interest Ùup to $2,500 per year Ùthis deduction phases out when AGI > $50,000 (S) and when AGI > $100,000 (MFJ) ÙLoan must be used for qualified expenses including tuition, room and board, and related expenses.

12. © 2003 South-Western College PublishingTransparency 5-12 Mortgage Interest rQualified residence interest is interest on debt used to secure/construct principal and second residence <limited to acquisition indebtedness (up to $1,000,000) <home equity loans (even if loan is for personal use) up to $100,000 rLoan origination fees and discount points (these are quoted as a percentage of principal) <Refinancing points must be capitalized & amortized (deducted) over life of loan (reported on 4562 and carries to A or E) <Other closing costs such as appraisal, title search, etc. are nondeductible, but are added to the property’s basis

13. © 2003 South-Western College PublishingTransparency 5-13 Interest Limitations rTo be deductible, interest paid or accrued within tax year must result from true debtor-creditor relationship <Promissory note, market rate of interest rInvestment interest (debt to purchase investment property, such as margin interest, but not if belongs on C or E) <Can only deduct up to the amount of net investment income Ùcarry forward to next year on 4952 any unused investment interest expense rNot allowed to deduct <Investment interest on tax-exempt securities <Interest on loans to pay life insurance premiums <Consumer interest or prepaid interest

14. © 2003 South-Western College PublishingTransparency 5-14 Charitable Contributions rDeductions limited by type of donee organization and type of contribution made rExample of organizations that qualify for 50% AGI deductions: <Churches and educational institutions <Hospital and medical research organizations <Private operating foundations (defined as receiving 1/3 or more of operating funds from grants) <Private non-operating foundations if all contributions distributed to public charities in the same year rExamples of organizations that qualify for 30% AGI deductions: <Private non-operating foundations <War veterans’ associations and fraternal societies

15. © 2003 South-Western College PublishingTransparency 5-15 Charitable Contributions (continued) rCan contribute cash or property rIf contribute appreciated long term capital gain (LTCG) property (such as appreciated stock) <To a 50% organization Ùcan deduct appreciated value, but subject to 30% AGI limitation, or deduct the basis instead and then can take up to 50% AGI <to a 30% organization Ùcan deduct appreciated value but subject to 20% AGI limitation, or deduct the basis instead and then can take up to 30% AGI rIf the LTCG property donated is tangible personal property that is used for unrelated purpose, can only deduct FMV less potential LTCG

16. © 2003 South-Western College PublishingTransparency 5-16 Charitable Contributions (continued) 50% Organization Cash 50% LTCG property, see rules on prior screen STCG or ordinary income property. Can deduct FMV less amount of gain that would’ve been recognized (i.e., the basis), then limited to 50% of AGI

17. © 2003 South-Western College PublishingTransparency 5-17 30% Organization Cash 30% LTCG property, see rules on prior screen STCG or ordinary income property, can deduct FMV less amount of gain that would’ve been recognized, then limited to 30% of AGI Charitable Contributions (continued)

18. © 2003 South-Western College PublishingTransparency 5-18 Order of charitable contribution deductions: 1. Deduct 50% contributions 2. Deduct 30% contributions 3. Deduct 20% contributions 4. Any contributions not currently deductible, can carry over for 5 years, subject to the same ceilings Total of all 3 types of deductions still limited to AGI x 50% Charitable Contributions (continued)

19. © 2003 South-Western College PublishingTransparency 5-19 Charitable Contributions (continued) rAllowed $.14/miles for mileage deduction rIf purchase event tickets, can only deduct amount paid in excess of value of event rCan’t deduct <If influences legislation <Free use of property (for example, donate use of ski condo to church youth group) rNon-cash contributions <If more than $250 - need written acknowledgement <If more than $500, complete 8283 Section A <If more than $5,000, complete 8283 Section B and need appraisal

20. © 2003 South-Western College PublishingTransparency 5-20 Fill out Form 4684, then Personal or Business Casualty and Theft rTo be classified as casualty loss, needs to be “sudden” <if theft, need to prove (for example, by police report) rEither business or non-business casualty loss can result in NOL rBusiness casualty losses are fully deductible on 4684 Section B rPersonal casualty losses are subject to $100 floor per event and then only if total exceeds 10% of AGI To Schedule A To Schedule C

21. © 2003 South-Western College PublishingTransparency 5-21 Casualty and Theft (continued) rAmount to deduct on 4684 is lesser of: Difference in FMV before and after casualty, or Adjusted basis Minus:Any reimbursement rCasualty gains can occur if reimbursed more than decrease in FMV

22. © 2003 South-Western College PublishingTransparency 5-22 Miscellaneous Deductions rCategory 1: limited to total amount over 2% AGI <unreimbursed employee expenses (Form 2106) <union dues <tax prep fees <safety deposit box <journals/subscriptions <investment expenses <job hunting fees

23. © 2003 South-Western College PublishingTransparency 5-23 Miscellaneous Deductions rCategory 2: no AGI limitations <Handicapped individual’s attendant care cost <Estate tax on income of decedent <Gambling losses to extent of gambling winnings <Terminated annuity payments

24. © 2003 South-Western College PublishingTransparency 5-24 Objective Understand the special rules applicable to moving expenses

25. © 2003 South-Western College PublishingTransparency 5-25 Moving Expenses rCan use if employee or self employed rTo qualify for deductible moving expense <Travel from new job site to old residence must be longer by at least 50 miles than distance from old job site to old residence <Must work 39 weeks in the next 12 months; if self-employed, must work 78 weeks in the next 24 months <Must change job sites. ÙMove can be with new or existing company rDeduct expenses of moving self and family, if related to starting work in new location <Cost of moving personal goods <Travel and lodging included, but not meals <.13/mile for personal car

26. © 2003 South-Western College PublishingTransparency 5-26 Objective Know the factors used to determine whether an activity is a hobby, and understand the tax treatment of hobby losses

27. © 2003 South-Western College PublishingTransparency 5-27 Hobby Losses rMust show business intent to be able to deduct all losses <IRS will look at the facts of each case rIf a “hobby”, can only deduct hobby expenses as miscellaneous itemized deductions <No expenses in excess of hobby income, i.e., cannot create a loss <Must deduct in specific order: ÙExpenses otherwise deductible on Schedule A (home mortgage interest, taxes, etc.) ÙOther expenses rIncome reported on 1040 “other income”

28. © 2003 South-Western College PublishingTransparency 5-28 Objective Know the tax implications of using educational savings accounts and qualified tuition programs

29. © 2003 South-Western College PublishingTransparency 5-29 Qualified Tuition Programs (Section 529 plans) rAllow taxpayer to <Buy in-kind tuition credits or certificates to cover higher education expenses <Contribute to an account established to meet qualified higher education expenses rDistributions are generally not taxed if funds used for higher education (tuition, fees, books, supplies, equipment) <Reasonable amount can be used for room and board rIf not used for higher education, distributions are taxable rNo limit on contribution amount, but contribution is not deductible <10% penalty if funds not used for qualified expenses or early withdrawal

30. © 2003 South-Western College PublishingTransparency 5-30 Educational IRAs (Education Savings Accounts) rAn educational IRA is a trust or custodial account created to pay qualified higher education expenses rCan contribute until beneficiary reaches 18 <$2,000/year per child non-deductible contribution <Becomes tax free distribution if used for higher education rIncome phase-outs begin at $190,000 for joint filers and $95,000 for single rCan roll over from one child to another

31. © 2003 South-Western College PublishingTransparency 5-31 Higher Education Expense Deduction rAllowed deduction for qualified tuition and related expenses incurred during tax year. $65,000 (S); $130,000 (MFJ) <Must be enrolled at an institution of higher education <Taken in year paid rReduce by <Interest excluded from education savings bonds <Excluded distributions from state tuition plans <Excluded distributions from Education Savings Accounts (IRAs)

32. © 2003 South-Western College PublishingTransparency 5-32 End of Chapter 5