McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 06 Individual Deductions

6-2 3 Types of Taxpayer Activities Business ActivitiesInvestment ActivitiesPersonal Activities Profit Motive No Profit Motive High degree of involvement Low degree of involvement Taxable Income For AGI expense deductions From AGI (i.e. itemized) expense deductions Limited from AGI (i.e. itemized) expense deductions Exception: Unreimbursed employee business expenses are a from AGI (itemized) deduction Exception: Rent and royalty expenses are for AGI deductions

6-3 Deductions for AGI – directly related to business activities Business (trade) expenses must be: directly connected to the business activity ordinary and necessary for the activity reasonable in amount Business expenses directly reduce income (i.e. “net” business income is gross income) Sole Proprietorship – income reported on schedule C and reported on line 12 of Form 1040 Flow-through entities (partnerships or s corporations), rent, royalty - income reported on schedule E and reported on line 17 of Form 1040

6-4 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 in any single tax year. Losses in excess of the $3,000 limit are carried forward indefinitely to subsequent years

6-5 The rest of the for AGI deductions … For AGI/above-the-line deductions Indirectly related to business activities Educator expenses ($250 maximum) *Unreimbursed moving expenses *Health insurance for self-employed *Self-employment tax Personal Penalty for early withdrawal of savings Alimony *Education-related deductions

6-6 Deductions for AGI – indirectly related to business activities Unreimbursed moving expenses Move must by motivated by a change in the location of employment (not necessarily a change in employer) Two tests must be met 1. A distance test – must increase commute by 50 miles 2. A business test  Employee: must be employed for 39 of the first 52 weeks after the move  Self-employed: double these numbers Qualified expenses include cost of moving belongings, actual costs of driving (.23/mile for 2012;.24/mile in 2013), lodging (cost of meals are specifically excluded) Problem 35

6-7 Deductions for AGI – indirectly related to business activities Health insurance deduction for self-employed Why? Many employees receive health insurance as a qualified (i.e. nontaxable) fringe benefit. This deduction provides equity for the self-employed. 100% deduction for premiums paid to insure taxpayer(s) and family Not available to self-employed who have access to an employer-sponsored plan

6-8 Deductions for AGI – indirectly related to business activities Self-employment (SE) Tax Deduction Why? To provide equity for the self-employed. Recall that the employer and employee share in the payment of the employee’s FICA (Social Security and Medicare) tax. 5.65% % = 13.3% (of first $110,100 in 2012) The employer-paid portion (7.65%) is a deductible business expense for employers. Self-employed individuals are required to pay SE tax of 13.3% (of first $110,100) in lieu of FICA. Self-employed can deduct the 7.65% portion of SE for AGI to reduce AGI similar to deduction allowed to employers.

6-9 Deductions for AGI – to subsidize personal activities Education-related 1.Interest on qualified educational loans Taxpayer, taxpayer’s spouse, and/or dependents Loan proceeds can be used to pay for ALL educational expenses Maximum $2,500 deduction with phase-out based on modified AGI  Modified AGI: AGI before interest and educational expense deductions Not available to married taxpayers filing separately (MFS)

6-10 Deductions for AGI – to subsidize personal activities Education-related 2.Qualified Educational expenses ONLY tuition and fees paid by the taxpayer Phase-out based on modified AGI  Modified AGI - AGI after student loan interest deduction but before this deduction Married taxpayers filing separately are not eligible for this deduction. This deduction was set to expire on 12/31/2011 but it was extended through 12/31/2013 earlier this year. Problem 39

6-11 Deductions from AGI Medical expenses Taxes Interest Charitable contributions Casualty losses Miscellaneous itemized deductions subject to 2% AGI threshold Miscellaneous itemized deductions not subject to any AGI threshold

6-12 Deductions from AGI: Itemized Deductions Medical Expenses Taxpayer, spouse, and dependents Qualifying medical expenses include unreimbursed payments for qualified medical and dental expenses Qualified expenses include prescriptions, medical or dental care costs, long-term care expenses, health and long-term care insurance premiums (paid by taxpayer with after-tax dollars!), and transportation Transportation: actual cost (or 23.5 cents/mile for 2012; 24 cents/mile in 2013) of using personal automobile for medical transportation purposes Subject to 7.5% of AGI floor!!! Problem 45

6-13 Taxes Individuals may deduct itemized deductions payments for following taxes State and local OR sales tax  Sales tax “standard deduction” based on AGI Foreign income taxes Real estate taxes on property held for personal or investment purposes Personal property taxes that are assessed on the value of the specific property Deductions from AGI: Itemized Deductions

6-14 Deductions from AGI: Itemized Deductions 2 types of deductible interest 1.Investment interest expense Deduction of investment interest is limited to a taxpayer’s net investment income (reported on line 8a) with carryforward provision 2.Home mortgage interest expense One personal residence plus one other home Two types of interest mortgage interest  Acquisition debt limit: $1 million  Home equity debt limit: $100K  No restriction based on how funds are used! Note: Credit card and personal loan interest is not deductible! - Problem 51

6-15 Charitable Contributions Contribution must be made to a qualified charity Valuation of contribution and deductible limit depends of type of property contributed Cash – deduction limited to 50% of AGI Capital gain property – valued at FMV, deduction limited to 30% of AGI Ordinary income property – Valued at lesser of 1) FMV or 2) adjusted tax basis, deduction limited to 50% of AGI Note: Political contributions are not deductible! Deductions from AGI: Itemized Deductions

6-16 Deductions from AGI: Itemized Deductions Casualty and theft losses on personal-use assets Amount of loss Damaged property - decline in value Destroyed property - taxpayer’s tax basis Amount of deduction Each loss is subject to a $100 floor Sum of all losses (after subtracting $100 floor) is subject to a 10% of AGI threshold Problem 56

6-17 Deductions from AGI: Itemized Deductions Misc Itemized Deductions Subject to AGI Floor Unreimbursed employee business expenses Appropriate and helpful for employee’s work (i.e. uniforms, union dues, subscriptions to professional publications, etc.) Investment expenses, tax preparation fees Hobby expenses Activity considered a hobby if it has not generated a profit in at least 3 of the past 5 years Hobby income reported on line 21 Total miscellaneous itemized deductions are subject to a 2% of AGI floor Problem 58 (maybe)

6-18 Deductions from AGI: Itemized Deductions Misc Itemized Deductions Not Subject to AGI Floor Gambling losses (not to exceed gambling income reported on line 21) Tax Planning Technique Bunching of itemized deductions

6-19 The Standard Deduction Standard deduction amounts for 2012 Filing status Standard deduction Additional standard deduction (age or blindness) Married filing jointly $11,900$1,150 Head of household8,7001,450 Single5,9501,450 Married filing separately 5,9501,150 The taxpayer deducts the greater of 1) the sum of the itemized deductions or 2) the standard deduction.

6-20 Standard Deductions & Exemptions Deduction for Personal and Dependency Exemptions $3,800 each in 2012 Taxpayer who is also a dependent on someone else’s tax return Limited standard deduction and no exemption Problem 61

6-21 Chapter 6

6-22 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. business activities (called “trade or business”) or 2. investment activities

6-23 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

6-24 Deductions for AGI

6-25 Deductions for AGI – directly related to business 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

6-26 Deductions for AGI 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 Business 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 (19 cents per mile in 2011)

6-27 Deductions for AGI 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 $60,000 ($120,000 filing joint) The deduction is eliminated for taxpayers with AGI exceeding $75,000 ($150,000 filing joint)

6-28 Deductions for AGI

6-29 Deductions from AGI: Itemized Deductions Hospitals and Long-term Care Facilities Taxpayers may deduct the costs of actual medical care whether the care is provided at hospitals or other long-term care facilities Medical Expenses Deduction Limitation It is limited to the amount of unreimbursed qualifying medical expenses paid during the year which is reduced by 7.5% of the taxpayers AGI

6-30 Deductions from AGI: Itemized Deductions Charitable Contribution Deduction Limitations for property donations Apply the AGI limitations in the following sequence  Step 1: Determine limitation for the 50% contributions  Step 2: Apply limitation to 30% contributions, which is the lesser of (a) AGI × 30% or (b) AGI × 50% minus the contributions subject to 50% limit  Step 3: Apply limitation to 20% contributions, which is the lesser of (a) AGI × 20%, (b) AGI × 30% minus the contributions subject to 30% limit, or (c) AGI x 50% minus the contributions subject to the 50% limit and the contributions subject to the 30% limit

6-31 Deductions from AGI: Itemized Deductions

6-32 Deductions from AGI: Itemized Deductions Casualty Loss Deduction Floor Limitations It must exceed two separate floor limitations to qualify as itemized deductions  $100 for each casualty during the year  10 percent of AGI floor limit applied to the sum of all casualty losses for the year (after applying the $100 floor) In other words, the itemized deduction is the aggregate amount of casualty losses that exceeds 10 percent of AGI

6-33 Standard Deductions & Exemptions Bunching Itemized Deductions Tax benefit can be gained by implementing simple timing tax-planning strategy Taxpayers with itemized deductions that fall just short of the standard deduction amount These itemized deductions do not produce any tax benefit Rather than deduct the standard deduction every year time deductions (when possible) to bunch together in one year