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Unformatted text preview: chapter 6 Individual Deductions Learning Objectives Upon completing this chapter, you should be able to: LO 6-1 Identify the common deductions necessary for calculating adjusted gross income (AGI). LO 6-2 Describe the different types of itemized deductions available to individuals. LO 6-3 Determine the standard deduction available to individuals. LO 6-4 Calculate the deduction for qualified business income. Storyline Summary Taxpayers: Courtney Wilson, age 40 Courtney’s mother, Dorothy “Gram” Weiss, age 70 Family description: Courtney is divorced with a son, Deron, age 10, and a daughter, Ellen, age 20. Gram is currently residing with Courtney. Ellen is currently a full-time student. Location: Kansas City, Missouri Employment status: Courtney works as an architect for EWD. Gram is retired. Filing status: Courtney files as a head of household. Gram files as a single taxpayer. Current situation: Courtney and Gram are trying to determine their allowable deductions and compute taxable income. deductions. She incurred some extra medical expenses to treat a broken wrist from a mountain biking accident and had additional state income taxes withheld from her paycheck. Courtney paid real estate taxes for her personal residence and investment property and interest expense on loans secured by ©Image Source N her new home. She also donated (cash and property) the expenditures she believes to be deductible. Be- penses and donated money to her local church. sides expenses associated with her weekend consult- Gram is a little frustrated because she doesn’t ing work and rental property, Courtney incurred incur enough itemized deductions to exceed the some significant costs moving from Cincinnati to standard deduction amount. Gram recently heard Kansas City. She also paid self-employment taxes on that she might be able to save taxes by “bunching” her consulting income. Courtney is confident some her itemized deductions into one year. She’s of these items are deductible, but she isn’t quite sure hoping to learn a little bit more about this tech- which items are deductible and how much. nique. In any event, Gram didn’t pay any taxes ow that Courtney has determined her to her favorite charities. gross income, she still must determine her Gram wasn’t as busy as Courtney this year. deductions to compute taxable income. Gram paid a penalty for cashing in her certificate Fortunately, Courtney keeps detailed records of all of deposit early. She also paid some medical ex- Based on her review of prior-year tax returns, Courtney has a pretty good handle on her itemized during the year and she wants to learn how much she’s going to owe. ■ 6-1 6-2 CHAPTER 6 Individual Deductions In the previous chapter, we determined gross income for both Courtney and Gram. To compute their taxable income, however, we need to identify their deductions. As emphasized previously, taxpayers are not allowed to deduct expenditures unless there is a specific tax law authorizing the deductions. And as we learn in this chapter, Congress grants many deductions for taxpayers for a variety of reasons. As we discussed in the Individual Income Tax Overview, Dependents, and Filing Status chapter, deductions appear in one of two places in the individual income tax formula. Deductions “for AGI” (also called deductions “above the line”) are subtracted directly from gross income. 1 Next, deductions “from AGI” (also called deductions “below the line”) are subtracted directly from AGI, resulting in taxable income. Deductions for AGI are generally preferred over deductions from AGI because deductions above the line reduce taxable income dollar for dollar. In contrast, deductions from AGI sometimes have no effect on taxable income. Further, because many of the limitations on tax benefits for higher income taxpayers are based upon AGI, deductions for AGI often reduce these limitations, thereby increasing potential tax benefits. Thus, it’s important to determine both the amount of the deduction and whether it’s a deduction for AGI or from AGI. We begin our discussion of deductions by describing deductions for AGI, and we conclude by tackling itemized deductions, the standard deduction, and the deduction for qualified business income. LO 6-1 DEDUCTIONS FOR AGI Congress allows taxpayers to claim a variety of deductions for AGI.2 To provide an overview, we select a cross-section of deductions for AGI and classify them into three categories: 1. Deductions directly related to business activities. 2. Deductions indirectly related to business activities. 3. Deductions subsidizing specific activities. We’ve organized our discussion around these categories to illustrate the variety of deductions for AGI and explain why Congress provides preferential treatment for certain deductions. Deductions Directly Related to Business Activities As a matter of equity, Congress allows taxpayers involved in business activities to deduct expenses incurred to generate business income. That is, because taxpayers include the revenue they receive from doing business in gross income, they should be allowed to deduct against gross income the expenses they incur to generate those revenues. To begin, we must define “business activities” and, for reasons we discuss below, we must distinguish business activities from investment activities. In general, for tax purposes, activities are either profit-motivated or motivated by personal objectives. Profit-motivated activities are, in turn, classified as either (1) business activities or (2) investment activities. Business activities are sometimes referred to as a trade or business, and these activities require a relatively high level of involvement or effort. Most, but not all, deductions for AGI appear on lines 23 through 35 on page 1 of Form 1040. The term “above the line” refers to the placement of deductions for AGI before the last line of the first page of Form 1040. This last line is the taxpayer’s AGI. 2 §62 identifies deductions for AGI. 1 CHAPTER 6 Individual Deductions 6-3 For example, if an individual is a full-time employee, the individual is in the business of being an employee. Self-employed individuals are also engaged in business activities. Unlike business activities, investment activities are profit-motivated activities that don’t require a high degree of involvement or effort.3 Instead, investment activities involve investing in property for appreciation or for income payments. An individual who occasionally buys land or stock in anticipation of appreciation or dividend payments is engaged in an investment activity. Example 6-1 Suppose that Courtney purchased a parcel of land for its appreciation potential. Would her ownership in the land be considered a business or investment activity? Answer: Courtney’s activity would most likely be considered an investment activity, because she acquired the land for its appreciation potential and she does not plan to exercise any special effort to develop the property or to become actively involved in other real estate speculation. What if: Suppose that Courtney frequently buys and sells land or develops land to sell in small parcels to those wanting to build homes. Would Courtney’s activity be considered a business or investment activity? Answer: Courtney’s activity would most likely be considered a business activity because she is actively involved in generating profits from the land by developing it rather than simply holding the land for appreciation. The distinction between business and investment activities is critical for determining whether a deduction associated with the activity is above or below the line or even deductible. With one exception, business expenses are deducted for AGI. The lone exception is unreimbursed employee business expenses, which, unfortunately, are not deductible for years beginning after 2017.4 In contrast, investment-related expenses, if deductible at all, are deductible as itemized deductions with one exception. Expenses associated with rental and royalty activities are deductible for AGI regardless of whether the activity qualifies as an investment or a business. Exhibit 6-1 summarizes the rules for classifying business and investment-related expenses as for AGI deductions, from AGI deductions, or not deductible. EXHIBIT 6-1 Individual Business and Investment-Related Expense Deductions for AGI, from AGI, and Not Deductible Deduction Type Activity Type Deduction for AGI Deduction from AGI (itemized deduction) Business activities Self-employed business expenses N/A Unreimbursed employee business expenses Investment activities Rental and royalty expenses Investment interest expense Other investment expenses §162 generally authorizes trade or business expense deductions, while §212 generally authorizes deductions for investment activities. The distinction between these activities is discussed in the Business Income, Deductions, and Accounting Methods chapter. 4 Prior to 2018, both unreimbursed employee business expenses and other investment expenses were deductible from AGI as miscellaneous itemized deductions subject to a 2 percent of AGI floor. 3 Not Deductible 6-4 CHAPTER 6 Individual Deductions Trade or Business Expenses Congress limits business deductions to expenses diOMB No. 1545-0074 SCHEDULE C to the business activity rectly related those are ordinary and necessary for the Profit orand Loss Fromthat Business (Form 1040) (Sole Proprietorship) 5 2017 This means that deductible expenses must be appropriate and helpful for generactivity. Go to for instructions and the latest information. Department of the Treasury Attachment Internal Revenue Service (99) Attachbusiness to Form 1040, 1040NR, or 1041; partnerships mustmost file Formcommon 1065. Sequence No. 09 ating a profit. Although deductions are onegenerally of the deductions for Name of proprietor Social security number (SSN) AGI, they are not readily visible on the front page of Form 1040. Instead, these deducB Enter code from instructions A Principal business or profession, including product or service (see instructions) tions are reported with business revenues on Schedule C of Form 1040. Schedule C, presented in name. Exhibit 6-2,business is essentially business that identiD Employer ID number (EIN) (see instr.) C Business If no separate name, leave blank.an income statement for the fiesE typical ordinary and necessary business expenses. Taxpayers transfer the net income Business address (including suite or room no.) or loss from C and to ZIP Form City, townSchedule or post office, state, code 1040 (page 1), line 12. F G Accounting method: (1) Cash (2) Accrual (3) Other (specify) Did you “materially participate” in the operation of this business during 2017? If “No,” see instructions for limit on losses H If you started or acquired this business during 2017, check here . . . . . . . . . . . . . . . . . Yes I Did you make6-2 any payments in 2017Ithat would to file Form(s) 1099? (see instructions) . . from . . .Business . . . EXHIBIT Parts and IIrequire fromyouSchedule C Profit or Loss J If "Yes," did you or will you file required Forms 1099? Part I Income . . . . . . . . . . . . . . . . 2 3 Gross receipts or sales. See instructions for line 1 and check the box if this income was reported to you on Form W-2 and the “Statutory employee” box on that form was checked . . . . . . . . . Returns and allowances . . . . . . . . . . . . . . . . . . . . . . . . . Subtract line 2 from line 1 . . . . . . . . . . . . . . . . . . . . . . . . 4 5 6 Cost of goods sold (from line 42) . . . . . . . . . . . . . . . . . . . Gross profit. Subtract line 4 from line 3 . . . . . . . . . . . . . . . . . Other income, including federal and state gasoline or fuel tax credit or refund (see instructions) . . . . . . . 7 Gross income. Add lines 5 and 6 . . . 8 Advertising . 9 Car and truck expenses (see instructions) . . . . . Commissions and fees . 1 Part II 10 11 12 13 14 15 16 a b 17 . . . . . . . . . . . . . . . . Expenses. Enter expenses for business use of your home only on line 30. . . . . 8 9 10 13 Employee benefit programs (other than on line 19) . . Insurance (other than health) 14 15 Interest: Mortgage (paid to banks, etc.) Other . . . . . . Legal and professional services 19 20a Other business property . . . Repairs and maintenance . . . Supplies (not included in Part III) . 20b 21 22 Taxes and licenses . . . . . Travel, meals, and entertainment: Travel . . . . . . . . . 23 24a 25 Deductible meals and entertainment (see instructions) . Utilities . . . . . . . . 24b 25 26 27a b Wages (less employment credits) . Other expenses (from line 48) . . Reserved for future use . . . 26 27a 27b b 17 28 Total expenses before expenses for business use of home. Add lines 8 through 27a . . . . . . 29 30 Tentative profit or (loss). Subtract line 28 from line 7 . . . . . . . . . . . . . . . . . . Use the Simplified . . . . . . . Net profit or (loss). Subtract line 30 from line 29. If a profit, enter on both Form 1040, line 12 (or Form 1040NR, line 13) and on Schedule SE, line 2. (If you checked the box on line 1, see instructions). Estates and trusts, enter on Form 1041, line 3. must go to line 32. 32 28 . 29 Expenses for business use of your home. Do not report these expenses elsewhere. Attach Form 8829 unless using the simplified method (see instructions). Simplified method filers only: enter the total square footage of: (a) your home: and (b) the part of your home used for business: Method Worksheet in the instructions to figure the amount to enter on line 30 31 . No No 7 Pension and profit-sharing plans . Rent or lease (see instructions): Vehicles, machinery, and equipment a . 4 5 6 19 20 23 24 . 2 3 18 21 22 . Yes Yes 1 Office expense (see instructions) b 16a 16b . . 18 a 11 12 Contract labor (see instructions) Depletion . . . . . Depreciation and section 179 expense deduction (not included in Part III) (see instructions) . . . . . . . . . . No . If you have a loss, check the box that describes your investment in this activity (see instructions). If you checked 32a, enter the loss on both Form 1040, line 12, (or Form 1040NR, line 13) and on Schedule SE, line 2. (If you checked the box on line 1, see the line 31 instructions). Estates and trusts, enter on Form 1041, line 3. must attach Form 6198. Your loss may be limited. For Paperwork Reduction Act Notice, see the separate instructions. Cat. No. 11334P } } 30 31 32a 32b All investment is at risk. Some investment is not at risk. Schedule C (Form 1040) 2017 Source: Form1040 Example 6-2 Besides being employed by EWD, Courtney is also a self-employed architectural consultant (a business activity). This year her consulting activity generated $19,500 of revenue and incurred $1,500 in expenses (primarily travel and transportation expenses). How does she report the revenue and deductions from the activity? Answer: Courtney reports the $19,500 of revenue and deducts the $1,500 of business expenses for AGI on her Schedule C. Her net income of $18,000 from her consulting activities is included on the front page (line 12) of her individual tax return. §162. In the Business Income, Deductions, and Accounting Methods chapter, we address the requirements for deductible business expenses in detail. 5 CHAPTER 6 Rental and Royalty Expenses Taxpayers are allowed to deduct their expenses associated with generating rental or royalty income for AGI.6 Like business expenses, rental and royalty expenses do not appear directly on the front page of Form 1040. Instead, rental and royalty deductions are reported with rental and royalty revenues on Schedule E of Form 1040.7 Schedule E, presented in Exhibit 6-3, is essentially an income statement for the taxpayer’s rental or royalty activities. Taxpayers transfer the net income OMB No. 1545-0074 SCHEDULE E Supplemental Income and17. Loss or loss E to Form 1040 (page 1), line (Form from 1040) Schedule (From rental real estate, royalties, partnerships, S corporations, estates, trusts, REMICs, etc.) 2017activiRental and royalty endeavorsAttach aretomost commonly to be investment Form 1040, 1040NR, or Formconsidered 1041. Department of the Treasury Attachment Go to for instructions and the latest information. Internal Revenue Service (99) Sequence No. 13 ties, but like trade or business expenses, rental and royalty deductions are claimed Your social security number above Name(s) shown on return the line.8 Perhaps rental and royalty expenses are deductible for AGI because Congress Income or Loss From Rental Real Estate and Royalties Note: If you are in the business of renting personal property, use Part I believed that these activities usually taxpayer involvement Schedule C or C-EZ (see instructions). If you arerequire an individual,more report farm rental income or loss from Form 4835than on page other 2, line 40. types A Did you make any payments in 2017 that would this require preferential you to file Form(s) 1099? (see instructions) . . . . Yes of No of investment activities. Despite treatment, the . deductibility rental B If “Yes,” did you or will you file required Forms 1099? . . . . . . . . . . . . . . . . . . . Yes No losses expenses exceed income) is code) subject to limitations (basis, at-risk, passive 1a (where Physical address of each property (street, city, state, ZIP loss,BAand excess business loss rules). We discuss the excess business loss rules later in this chapter and the basis, at-risk, and passive loss rules in the Investments chapter when we C Fair Rental Personal Use 2 For each rental real estate property listed 1b Type of Property QJV discuss similar limitations that apply to ofinvestments in flow-through entities. above, report the number fair rental and Days Days (from list below) personal use days. Check the QJV box A A only if you meet the requirements to file as a qualified joint venture. See instructions. B B C C Type of Property: 3 Vacation/Short-Term RentalE 5Rental Land 7 Self-Rental 1 Single Family Residence Page 1 of Schedule or Royalty Income 2 Multi-Family Residence 4 Commercial 6 Royalties 8 Other (describe) Income: Properties: A B 3 Rents received . . . . . . . . . . . . . 3 4 4 Royalties received . . . . . . . . . . . . Expenses: 5 Advertising . . . . . . . . . . . . . . 5 6 Auto and travel (see instructions) . . . . . . . 6 7 Cleaning and maintenance . . . . . . . . . 7 8 Commissions. . . . . . . . . . . . . . 8 9 Insurance . . . . . . . . . . . . . . . 9 10 Legal and other professional fees . . . . . . . 10 11 Management fees . . . . . . . . . . . . 11 12 Mortgage interest paid to banks, etc. (see instructions) 12 13 Other interest. . . . . . . . . . . . . . 13 14 Repairs. . . . . . . . . . . . . . . . 14 15 Supplies . . . . . . . . . . . . . . . 15 16 Taxes . . . . . . . . . . . . . . . . 16 17 Utilities . . . . . . . . . . . . . . . . 17 18 Depreciation expense or depletion . . . . . . 18 Other (list) 19 19 20 Total expenses. Add lines 5 through 19 . . . . . 20 EXHIBIT 6-3 Subtract line 20 from line 3 (rents) and/or 4 (royalties). If result is a (loss), see instructions to find out if you must file Form 6198 . . . . . . . . . . . . . 21 Deductible rental real estate loss after limitation, if any, 22 )( on Form 8582 (see instructions) . . . . . . . 22 ( 23a Total of all amounts reported on line 3 for all rental properties . . . . 23a b Total of all amounts reported on line 4 for all royalty properties . . . . 23b c Total of all amounts reported on line 12 for all properties . . . . . . 23c d Total of all amounts reported on line 18 for all properties . . . . . . 23d e Total of all amounts reported on line 20 for all properties . . . . . . 23e 24 Income. Add positive amounts shown on line 21. Do not include any losses . . . . . . . 25 Losses. Add royalty losses from line 21 and rental real estate losses from line 22. Enter total losses here . C 21 26 Total rental real estate and royalty income or (loss). Combine lines 24...
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