Essentials of federal taxation 3rd edition spilker solutions manual 1 by karen.bowles485

Essentials of Federal Taxation 3rd Edition Spilker

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Chapter 6

Individual for AGI Deductions

SOLUTIONS MANUAL

Discussion Questions

1. [LO 1] It has been suggested that tax policy favors deductions for AGI compared to itemized deductions. Describe two ways in which deductions for AGI are treated more favorably than itemized deductions.

Itemized deductions must exceed the standard deduction before taxpayers receive any tax benefit from the deductions (this is equivalent to an overall floor limit). In contrast, business deductions that are deductible for AGI (above the line) reduce taxable income without being subject to an overall floor limit. Also, itemized deductions are subject to many mechanical limitations including ceilings, floors, and phase-outs whereas business deductions are generally not subject to these limits (there are limits on certain specific deductions, but this will be described in greater detail in chapter9).

2. [LO 1] How is a business activity distinguished from an investment activity? Why is this distinction important for the purpose of calculating federal income taxes?

2015

Both business and investment activities are motivated primarily by profit intent, but they can be distinguished by the level of profit-seeking activity. A business activity is commonly described as a sustained, continuous, high level of profit-seeking activity, whereas investment activities don’t require a high level of involvement. The distinction can be important for the location of deductions, because business deductions are claimed above the line (for AGI on Schedule C) while investment deductions are generally itemized or from AGI deductions (with the exception of rent and royalty expenses which are deductible for AGI on Schedule E).

3. [LO 2] Describe how a business element is reflected in the requirements to deduct moving expenses and how Congress limited this deduction to substantial moves.

A business element is reflected in both the distance test and time test associated with the move. To satisfy the distance test, the distance from the taxpayer’s old residence to the new place of work (business element) must be at least 50 miles more than the distance from the old residence to the old place of work (business element). The time test for a moving expense deduction requires the taxpayer to be employed full time 39 of the first 52 weeks (or self-employed for 78 of the first 104 weeks) after the move (obviously reflecting a business element).

4. [LO 2] What types of losses may potentially be characterized as passive losses?

Losses from limited partnerships, and from rental activities, including rental real estate, are generally considered passive losses. In addition, losses from any other activity involving the conduct of a trade or business in which the taxpayer does not materially participate are also treated as passive losses. Material participation is defined as “regular, continuous, and substantial.”

5. [LO 2] What are the implications of treating losses as passive?

Passive losses may not be used to offset portfolio income or active income. Passive losses can only be used to offset passive income. Passes losses that are limited will be suspended until taxpayers have passive income or until the activity producing the passive loss is sold.

6 [LO 2] What tests are applied to determine if losses should be characterized as passive?

In general, losses are from trade or business activities are passive unless individuals are material participants in the activity. Regulations provide seven separate tests for material participation, and individuals can be classified as material participants by meeting any one of the seven tests. The seven tests are as follows:

1. The individual participates in the activity more than 500 hours during the year.

2. The individual’s activity constitutes substantially all of the participation in such activity by the individuals including non-owners.

3. The individual participates more than 100 hours during the year, and the individual’s participation is not less than any other individual’s participation in the activity.

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4. The activity qualifies as a “significant participation activity” (more than 100 hours spent during the year) and the aggregate of all “significant participation activities” is greater than 500 hours for the year.

5. The individual materially participated in the activity for any five of the preceding 10 taxable years.

6. The individual materially participated for any three preceding years in any personal service activity (personal services in health, law, accounting, architecture, etc.)

7. Taking into account all the facts and circumstances, the individual participates on a regular, continuous, and substantial basis during the year.

7 [LO 2] {Planning} All else being equal, would a taxpayer with passive losses rather have wage income or passive income?

A taxpayer in this situation would prefer passive income because the taxpayer’s passive losses could be applied currently against the passive income to reduce the amount of tax paid currently. If the taxpayer had received wage income, the passive losses would have been suspended, and the tax benefits associated with the passive losses would be deferred.

8 [LO 2] {Planning} Is it possible for a taxpayer to receive rental income that is not subject to taxation? Explain.

Yes. A taxpayer (owner) who lives in a home for at least 15 days and rents it out for 14 days or less (residence with minimal rental use) is not required to include the gross receipts in rental income but is not allowed to deduct any expenses related to the rental.

9. [LO 2] Halle just acquired a vacation home. She plans on spending several months each year vacationing in the home and on renting the property for the rest of the year. She is projecting tax losses on the rental portion of the property for the year. She is not too concerned about the losses because she is confident she will be able to use the losses to offset her income from other sources. Is her confidence misplaced? Explain.

Because Halle will be living in the home for several months, the home will be considered a residence with significant rental use. Consequently, she may deduct expenses to obtain tenants (direct rental expenses such as advertising and realtor commissions) and mortgage interest and real property taxes allocated to the rental use of the home. To the extent that these expenses exceed gross rental income she may deduct the loss (the passive loss rules do not apply). However, the remaining expenses allocated to the rental use of the home may only be deducted to the extent of the net rental income after deducting the direct rental expenses and rental mortgage interest and real property taxes allocated to the property. This limitation reduces her ability to deduct a rental loss from the home.

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10. [LO 2] {Planning} A taxpayer stays in a second home for the entire month of September. He would like the home to fall into the residence with significant rental use category for tax purposes. What is the maximum number of days he can rent out the home and have it qualify?

To qualify for the residence with significant rental use category, the taxpayer must have used the home for personal purposes more than the greater of (1) 14 days or (2) 10% of the total days it is rented out during the tax year and rented the house for more than 14 days. In this situation, the taxpayer used the second home for personal purposes for 30 days (the entire month of September). To qualify, the 30 days of personal use must be greater than 10% of the number of days the property is rented out. If the taxpayer rents the property out for 300 days, the number of personal use days will be exactly 10% of the number of rental days, and the property would not qualify as residence. However, if the taxpayer rents out the property for 299 days, the 30 days of personal use will be greater than 10% of the number of rental days, so the property would qualify as a residence with significant rental use. So, the maximum number of days the taxpayer can rent out the home and have it qualify as a residence with significant rental use is 299 days. Anything more than that and the property would be considered a nonresidence with rental use.

11 [LO 2] Compare and contrast the IRS method and the Tax Court method for allocating expenses between personal use and rental use for vacation homes. Include the Tax Court’s justification for departing from the IRS method in your answer.

The IRS method of allocating deductions between personal and rental use allocates the deductions based on a fraction with the number of days the property was used for rental property in the numerator and the number of days the property was used for any reason during the year in the denominator. Each expense relating to the home is multiplied by this fraction to determine the amount allocable to rental use. Subject to the gross rental income limitation, tier 1 expenses are deducted first, followed by tier 2 expenses, and then tier 3 expenses.

The Tax Court and the IRS method of allocating deductions are identical except for the allocation of the tier 1 expenses of interest and real property taxes. Under the Tax Court approach, interest and taxes are allocated to rental use based on the fraction of days that the property was rented over the number of days in the year (not the number of days the property was used for any purpose during the year). The Tax Court justifies this approach by pointing out that interest expense and property taxes accrue over the entire year regardless of the level of personal or rental use. The Tax Court method is generally taxpayer favorable because it tends to allocate less interest and real property taxes to the rental use which allows more tier 2 and tier 3 expenses to be deducted when the gross income limitation applies. The taxpayer does not lose deductions for the interest and property taxes allocated to personal use and not to the rental activity because these expenses are deductible anyway as itemized deductions.

12. [LO 2] In what circumstances is the IRS method for allocating expenses between personal use and rental use for second homes more beneficial to a taxpayer than the Tax Court method?

The IRS method is generally more beneficial than the Tax Court method when the property is considered to be a nonresidence with rental use. When the property is not a residence, the interest allocated to personal use is not deductible. Thus, under these circumstances, the taxpayer is better off by allocating as little interest as possible to personal use. The IRS method accomplishes this by allocating interest (a tier 1 expense) to rental use by dividing the total rental days by the total days used and allocating the remainder to personal use. The Tax Court method would allocate less

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interest to rental use because the denominator is the number of days in the year, rather than total days used.

13 [LO 2] Under what circumstances would a taxpayer who generates a loss from renting a home that is not a residence be able to fully deduct the loss? What potential limitations apply?

By definition, a rental activity is considered to be a passive activity. Because they are passive losses, losses from rental property are generally not allowed to offset other ordinary or investment type income.

However, the loss from a rental activity may be deductible under two circumstances. First, a taxpayer who is an active participant in the rental activity may be allowed to deduct up to $25,000 of the rental loss against other types of income (subject to phase-out beginning at $100,000 AGI). Second, the taxpayer may offset the passive loss from the rental activity against other sources of passive income.

14 [LO 2] Describe the circumstances in which a taxpayer acquires a home and rents it out and is not allowed to deduct a portion of the interest expense on the loan the taxpayer used to acquire the home.

When a rental home is not a residence, the interest allocable to any personal-use days is nondeductible.

15 [LO 2] Is it possible for a rental property to generate a positive annual cash flow and at the same time produce a loss for tax purposes? Explain.

Yes. A taxpayer is able to have a positive cash flow and at the same time produce a loss for tax purposes. This outcome is possible due to depreciation expense that is deductible for tax purposes but does not require an annual cash outflow. A rental property could provide a positive cash flow (gross receipts greater than cash expense for the year) but generate a tax loss when depreciation expense is deducted.

16. [LO 2] How are the tax issues associated with home offices and vacation homes used as rentals similar? How are the tax issues or requirements dissimilar?

The tax issues facing renters of second homes are similar in a lot of ways with tax issues facing taxpayers qualifying for home office deductions. Both taxpayers with home offices and taxpayers with vacation homes are allowed to deduct business or rental expenses not associated with the use of the home as for AGI deductions without income limitations. Taxpayers with home offices allocate expenses of the entire home between personal use of the home and business use of the home. In a similar way, renters of second homes generally allocate expenses of the second home between personal use of the home and rental use of the home. Taxpayers with home offices and vacation homes may deduct mortgage interest and real property taxes allocated to the business or rental use of the home as for AGI deductions without income limitations. Further, the non mortgage interest and non real property tax expenses allocated to business use of the home and

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rental use of a residence with significant rental use may be limited by the income generated by the property (after deducting business and rental expenses unrelated to the home and after deducting mortgage interest and real property taxes allocated to the business or rental use of the home). Disallowed expenses are carried over and treated as incurred in the next year.

The treatment of home offices and vacation homes are also dissimilar. By definition, a home office is located in the taxpayer’s “home” and the home office must be used exclusively for business purposes. In contrast, the tax consequences of owning a second home depend on the extent to which the property is used for personal and for rental purposes. Personal use of a rental property is allowed. This is not the case for home offices.

17 [LO 2] Are employees or self-employed taxpayers more likely to qualify for the home office deduction? Explain.

Self-employed taxpayers are more likely to qualify for the home office deduction. Both must meet the requirement of using the home office as either (1) the principal place of business for any of the taxpayer’s trade or businesses or (2) as a place to meet with patients, clients, or customers in the normal course of business. However, an employee must meet the additional requirement of using the home office for the convenience of the employer. Thus, self-employed taxpayers are more likely to qualify for the home office deduction.

18. [LO 2] Compare and contrast the manner in which employees and employers report home office deductions on their tax returns.

Both employees and employers will determine the amount of their eligible home office expenses in the same manner. However, each is subject to different limitations and reports the deduction in different places on the tax return. An employer reports his home office deduction on Schedule C of his 1040 and is limited to his Schedule C net income before deducting the home office expense. Thus, an employer’s home office deduction is a for AGI deduction.

An employee will report his home office expenses as unreimbursed employee business expenses that are itemized deductions subject to the 2% of AGI floor. Thus, an employee’s home office deduction is a from AGI deduction.

19 [LO 2] For taxpayers qualifying for home office deductions, what are considered to be indirect expenses of maintaining the home? How are these expenses allocated to personal and home office use?

Indirect expenses are expenses incurred in maintaining and using the home. Indirect expenses include insurance, utilities, interest, real property taxes, general repairs, and depreciation on the home as if it were used entirely for business purposes. Only indirect expenses allocated to the home office space, however, are deductible. If the rooms in the home are roughly of equal size, the taxpayer may allocate the indirect expenses to the business portion of the home based on the number of rooms. Alternatively, the taxpayer may allocate indirect expenses based on the amount of the space or square footage of the business-use room relative to the total square footage in the home.

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20 [LO 2] What limitations exist for self-employed taxpayers in deducting home office expenses, and how does the taxpayer determine which deductions are deductible and which are not in situations when the overall amount of the home office deduction is limited?

The total home office deductions other than mortgage interest and real property taxes allocated to business use of the home allowable for the taxpayer in any given year is limited to a taxpayer’s Schedule C net income (without any home office expense deductions) minus mortgage interest and real property taxes allocated to business use of the home. Thus, home office deductions other than mortgage interest and real property taxes cannot either create or increase a loss on the taxpayer’s Schedule C. Amounts that are not deducted in the current year are carried over and deducted in the next year subject to the same Schedule C limitation.

The sequence of deductions for the home office follows the exact same sequence of deductions for homes with significant personal use and significant rental use. Tier 1-type expenses that would be deductible as itemized deductions (interest and taxes) are deducted first (and deducted in full regardless of income). Tier 2-type expenses are deducted second, and Tier 3-type expense (depreciation) is deducted last.

21. [LO 3] What are the primary tax differences between traditional IRAs and Roth IRAs?

Traditional IRA contributions are deductible and distributions when received are taxable. Roth IRA contributions are not deductible and distributions when received are not taxable.

22 [LO 3] Describe the circumstances in which it would be more favorable for a taxpayer to contribute to a traditional IRA rather than a Roth IRA and vice versa.

In general, a traditional IRA will typically provide a better after-tax rate of return when tax rates are expected to decline in the future. A Roth IRA will generally provide a better after-tax rate of return when tax rates are expected to increase in the future. If the tax rates are expected to remain the same, the after-tax rate of return will be the same for both types of IRAs.

23 [LO 3] What are the requirements for a taxpayer to make a deductible contribution to a traditional IRA? Why do the tax laws impose these restrictions?

To make a deductible contribution to a traditional IRA the taxpayer must (1) not be a participant in an employer sponsored retirement plan or (2) if they are participating in an employee sponsored retirement plan, they must have income below a certain threshold. IRAs are meant to help persons that are unable to participate in an employer sponsored program or that have relatively low levels of income.

24. [LO 3] What is the limitation on a deductible IRA contribution for 2014?

For those not already participating in an employer sponsored retirement plan, deductible contributions to an IRA are limited to $5,500 a year or earned income if it is less. Taxpayers who have reached the age of 50 are able to contribute an additional $1,000. A taxpayer already participating in an employer sponsored program may also make deductible contributions of the

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same amount if her AGI falls below a certain threshold. The $5,500 (or $6,500) deductible amount is phased out for taxpayers whose AGI exceeds the threshold amount.

25. [LO 3] Compare the minimum distribution requirements for traditional IRAs to those of Roth IRAs.

In regards to traditional IRAs, taxpayers are subject to the same minimum distribution requirements as traditional 401(k) plans. They must begin receiving distribution by the later of April 1 of the year after the year in which the taxpayer turns 70 ½ or when she retires. The minimum amount of the distribution is determined by using a table provided by the IRS and is based upon the taxpayer’s age and account balance.

Taxpayer’s are not ever required to make minimum distributions from Roth IRAs.

26 [LO 3] How are qualified distributions from Roth IRAs taxed? How are nonqualified distributions taxed?

Qualifying distributions from a Roth IRA are not taxable. Nonqualified distributions are taxed and penalized to the extent that they are made from the earnings of the IRA. Contributions to a Roth IRA are from after-tax dollars (non-deductible) and can always be recovered tax free. Nonqualified distributions are considered to first come from contributions and then earnings.

27. [LO 3] Explain when a taxpayer will be subject to the 10 percent penalty when receiving distributions from a Roth IRA.

Only nonqualified distributions made from the earnings of a Roth IRA are subject to ordinary taxes and a 10% penalty. Nonqualified distributions are any distributions if the taxpayer has not had the Roth IRA account open for at least five years.1 If the Roth account has been open for five years, all distributions other than distributions (1) made on or after the date the taxpayer reaches 59 ½ years of age, (2) made to a beneficiary (or to the estate of the taxpayer) on or after the death of the taxpayer, (3) attributable to the taxpayer being disabled, or (4) used to pay qualified acquisition costs for first-time homebuyers (limited to $10,000) are considered to be disqualified distributions.

28 [LO 3] Is a taxpayer who contributed to a traditional IRA able to transfer or “roll over” the money into a Roth IRA? If yes, explain the tax consequences of the transfer.

Taxpayers are able to roll over (transfer) funds from a traditional IRA to a Roth IRA. The entire amount taken from the traditional IRA is taxed at ordinary rates but is not subject to the 10% penalty so long as the taxpayer contributes the full amount taken out of the traditional IRA to a Roth IRA.

29. [LO 3] Assume a taxpayer makes a nondeductible contribution to a traditional IRA. How does the taxpayer determine the taxability of distributions from the IRA on reaching retirement?

1 The five year period starts on January 1 of the year in which the contribution was made and ends on the last day of the fifth taxable year.

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When a taxpayer receives a partial distribution from an IRA containing both deductible and nondeductible contributions, the nontaxable portion of the distribution is determined by multiplying the ratio of the nondeductible contribution over the entire balance in the account (nondeductible contributions / entire account balance) by the amount of the distribution.

30 [LO 3] When a taxpayer takes a nonqualified distribution from a Roth IRA, is the entire amount of the distribution treated as taxable income?

Only the portion of a nonqualified distribution attributable to the earnings from contributions is taxable (this portion is also penalized at a 10% rate). Distributions are considered to come first from contributions and then from earnings.

31. [LO 3] Explain why Congress allows self-employed taxpayers to deduct the cost of health insurance above the line (for AGI) when employees can only itemize this cost as a medical expense. Would a self-employed taxpayer ever prefer to claim health insurance premiums as an itemized deductions rather than a deduction for AGI? Explain.

This deduction provides a measure of equity between employees and the self-employed. The cost of health insurance is essentially a personal expense. However, employees typically aren’t required to pay insurance premiums because their employers pay the premiums for them as a form of compensation. The employer is allowed to deduct the premium as a compensation expense, and the employee is allowed to exclude from taxable income the value of the premiums paid on his behalf. Thus, from the employee’s perspective, this arrangement has the same effect as if (1) the employer pays the employee cash compensation in the amount of the premium and (2) the employee pays the premium and deducts the expense for AGI (completely offsetting the compensation income). In contrast to employees, self-employed taxpayers pay their own health insurance costs, because they don’t have an employer to pay these costs for them. Absent a rule to the contrary, self-employed taxpayers would deduct their medical expenses as itemized deductions subject to strict limitations, because the cost of the health insurance is a personal expense rather than a business expense. To treat employees and self-employed taxpayers similarly, Congress allows self-employed taxpayers to deduct personal health insurance premiums as for AGI rather than itemized deductions. Thus, selfemployed taxpayers are able to (1) receive business income and (2) use the business income to pay their health insurance premiums and deduct the premiums as a for AGI deduction (completely offsetting the business income they used to pay the premium). Given the preferential treatment of for AGI deductions relative to itemized deductions, a self-employed taxpayer should never prefer to claim health insurance premiums as an itemized deduction rather than a deduction for AGI.

32. [LO 3] Explain why Congress allows self-employed taxpayers to deduct the employer portion of their self-employment tax.

To put self-employed individuals on somewhat equal footing with other employers that are allowed to deduct the employer’s share of the social security tax. Hence, self-employed taxpayers are allowed to deduct the employer portion of the self-employment tax.

33 [LO 3] {Research} Using the Internal Revenue Code, describe two deductions for AGI that are not discussed in this chapter?

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§62 is the quickest way to identify deductions for AGI, but several can also be identified from the front of form 1040. Examples include the performing artist deduction, deductions of business expenses for state and local officials, reforestation expenses, and remitted jury duty pay.

34 [LO 3] Explain why Congress allows taxpayers to deduct interest forfeited as a penalty on the premature withdrawal from a certificate of deposit.

The full amount of the interest income is included in gross income, and this deduction reduces the net interest income to the amount actually received by the individual.

35 [LO 3] Describe the mechanical limitation on the deduction for interest on qualified educational loans.

The maximum deduction for interest expense on qualified education loans is the amount of interest expense paid up to $2,500. However, the deduction is reduced (phased-out) for taxpayers depending on the taxpayer’s filing status and modified AGI. Specifically, the deduction for interest on educational loans is subject to proportional phase-out over a range of $15,000 ($30,000 for married filing jointly). The range begins for taxpayers at $65,000 of modified AGI ($130,000 for MFJ) and ends at $80,000 of modified AGI ($160,000 for married filing jointly). Modified AGI for this purpose is AGI before deducting interest expense on the qualified education loans and before deducting qualified education expenses. Married individuals who file separately are not allowed to deduct this expense under any circumstance.

Problems

36. [LO 1] {Tax Forms} Betty operates a beauty salon as a sole proprietorship. Betty also owns and rents an apartment building. This year Betty had the following income and expenses. Determine Betty’s AGI and complete page 1 of Form 1040 for Betty. You may assume that Betty will owe $2,502 in self-employment tax on her salon income.

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Interest income $ 11,255 Salon sales and revenue 86,360 Salaries paid to beauticians 45,250 Beauty salon supplies 23,400 Alimony paid to her ex-husband, Rocky 6,000 Rental revenue from apartment building 31,220 Depreciation on apartment building 12,900 Real estate taxes paid on apartment building 11,100 Real estate taxes paid on personal residence 6,241 Contributions to charity 4,237

The beauty parlor salaries and expenses are deductible on Schedule C as business expenses and the depreciation and real estate taxes for the apartment building are deductible for AGI as rental/royalty related deductions. The interest income is included in AGI, and the alimony expense is deductible for AGI. Note that this solution assumes that the apartment building amounts represent Betty’s interest and not the total. The residential real estate taxes and the charitable contributions are itemized deductions.

*Betty would owe $2,502 in self-employment tax ($17,710 salon income x 92.35% x 15.3% = $2,502).

Of the $2,502, $1,251 ($17,710 x 92.35% x 7.65%) would be deductible as a for AGI deduction.

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Interest income $ 11,255 Salon revenue $

Less: Salaries -

Supplies - 23,400 Operating income from salon 17,710 Apartment building revenue $ 31,220 Less: Depreciation -

Taxes on apartment building - 11,100 Apartment building income 7,220 Less: Employer share of self-employment taxes* -1,251 Alimony deduction -6,000 AGI $ 28,934

86,360

45,250

12,900

Solutions Manual – McGraw-Hill’s Taxation, by Spilker et al. 6-12 Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

37. [LO 2] Larry recently invested $20,000 (tax basis) in purchasing a limited partnership interest in which he will have no management rights in the company. His at-risk amount is also $20,000. In addition, Larry’s share of the limited partnership loss for the year is $2,000, his share of income from a different limited partnership was $1,000, and he had $3,000 of dividend income from the stock he owns. How much of Larry’s $2,000 loss from the limited partnership can he deduct in the current year?

Before considering his $2,000 loss, Larry’s tax basis is $20,000 and his at-risk amount is $20,000. Therefore the basis and at-risk hurdles do not apply. However, Larry still may not deduct $1,000 of the $2,000 loss because he only has $1,000 of passive income for the year. Therefore, Larry has a $1,000 passive activity loss carryover.

38 [LO 2] Rubio recently invested $20,000 (tax basis) in purchasing a limited partnership interest in which he will have no management rights in the company. His at-risk amount is $15,000. In addition, Rubio’s share of the limited partnership loss for the year is $22,000, his share of income from a different limited partnership was $5,000, and he had $40,000 in wage income and $10,000 in long-term capital gains.

a. How much of Rubio’s $22,000 loss can he deduct considering only the tax basis limitation?

b. How much of the loss from part a. can Rubio deduct under the at-risk limitations?

c. How much of Rubio’s $22,000 loss from the limited partnership can he deduct in the current year considering all limitations?

a. Rubio’s initial tax basis in the limited partnership is $20,000. Rubio’s $22,000 loss reduces his tax basis to zero leaving him with a $2,000 loss carryover because of the tax basis loss limitation.

b. Rubio’s initial at-risk amount in the limited partnership is $15,000. Rubio’s $22,000 loss reduces his at-risk amount to zero leaving him with a $5,000 at-risk carryover ($20,000 loss allowed under the tax basis limitation less the $15,000 amount Rubio has at risk).

c. After applying the tax basis and at-risk limitations, Rubio can potentially deduct $15,000 of loss. However, because Rubio is a limited partner this loss is considered a passive loss. Therefore, Rubio may only deduct this loss in the current year to the extent he has passive income. Because Rubio has only passive income of $5,000 (from another limited partnership), he may only deduct $5,000 of the $15,000 loss leaving him with a $10,000 passive activity loss that can be carried forward indefinitely.

39 [LO 2] Anwar owns a rental home and is involved in maintaining it and approving renters. During the year he has a net loss of $8,000 from renting the home. His other sources of income during the year were a salary of $111,000 and $34,000 of long-term capital gains. How much of Anwar’s $8,000 rental loss can he deduct currently if he has no sources of passive income?

Because Anwar meets the definition of an “active participant” and has adjusted gross income of less than $150,000, before considering his rental loss, he may deduct $2,500 of the loss against his other income. His $2,500 deduction is computed as follows:

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(1) Maximum deduction available before phase-out $25,000

(2) Phase-out of maximum deduction $22,500 [($145,000 AGI –100,000) x .5]

(3) Maximum deduction in current year $2,500 (1) – (2)

(4) Rental loss in current year $8,000

(5) Rental loss deductible in current year $2,500 Lesser of (3) or (4) Passive loss carry forward $5,500 (3) – (4)

40. [LO 2] Dillon rented his personal residence at Lake Tahoe for 14 days while he was vacationing in Ireland. He resided in the home for the remainder of the year. Rental income from the property was $6,500. Expenses associated with use of the home for the entire year were as follows:

a. What effect does the rental have on Dillon’s AGI?

b. What effect does the rental have on Dillon’s itemized deductions?

a. Since Dillon resided in his home for at least 15 days during the year and rented the home for fewer than 15 days, he excludes the rental income from taxable income and does not deduct the associated rental expenses. So, the rental has no effect on Dillon’s AGI.

b. He will be allowed to deduct the real property taxes of $3,100 and mortgage interest of $12,000 as itemized deductions

Use the following facts to answer problems 41 and 42.

Natalie owns a condominium near Cocoa Beach in Florida. This year, she incurs the following expenses in connection with her condo:

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Description Amount Explanation

Real property taxes $ 3,100 Mortgage interest 12,000 Repairs 1,500 Insurance 1,500 Utilities 3,900 Depreciation 13,000

Insurance $1,000 Advertising expense 500 Mortgage interest 3,500 Property taxes 900 Repairs & maintenance 650

Utilities 950 Depreciation 8,500

During the year, Natalie rented out the condo for 75 days, receiving $10,000 of gross income. She personally used the condo for 35 days during her vacation. Assume there are 365 days in the year.

41 [LO 2] Assume Natalie uses the IRS method of allocating expenses to rental use of the property.

a. What is the total amount of for AGI (rental) deductions Natalie may deduct in the current year related to the condo?

b. What is the total amount of itemized deductions Natalie may deduct in the current year related to the condo?

c. If Natalie’s basis in the condo at the beginning of the year was $150,000, what is her basis in the condo at the end of the year?

d. Assume that gross rental revenue was $1,000 (rather than $10,000), what amount of for AGI deductions may Natalie deduct in the current year related to the condo?

Note that the home falls into the residence with significant rental use category.

a. $10,000, calculated as follows:

2015

expense = $500

interest = (75/110) × $3,500=$2,386

taxes= (75/110) × $900=$614

= (75/110) × $1,000=$682 Repairs & Maintenance = (75/110) × $650=$443

(75/110) × $950=$648

Solutions Manual – McGraw-Hill’s Taxation, by Spilker et al. 6-15

Gross rental income $10,000 Tier

Advertising

Mortgage

Less:

expenses (3,500) Balance $6,500 Tier 2 expenses: Insurance

Utilities=

Less:

(1,773) Balance $4,727

1 expenses:

Property

total Tier 1

total Tier 2 expenses

Tier 3 expenses:

Depreciation (75/110) × $8,500= $5,795, but the deduction is limited to the remaining income (4,727)

Balance $0

Total “For AGI” deductions ($3,500 + $1,773 + $4,727) $10,000

b. Natalie may deduct the personal-use portion of the mortgage interest and property taxes since they are deductible without regard to rental income. Her deductions for these items are computed as follows:

Mortgage interest [(35/110) × $3,500] $1,114

Real property taxes [(35/110) × $900] 286

Total “from AGI” deductions $1,400

c. $145,273, calculated as follows:

Beginning basis $150,000

Less: depreciation actually deducted (4,727)

Adjusted basis $145,273

d. $3,500. Even though it creates a loss ($2,000 - $3,500), Natalie is allowed to deduct all of the advertising expense and the portion of the mortgage interest expense and real property taxes allocated to the rental use of the home as for AGI deductions (these deductions are not limited to rental revenue). The loss is not subject to the passive loss rule limitations.

42. [LO 2] Assume Natalie uses the Tax Court method of allocating expenses to rental use of the property.

a. What is the total amount of for AGI (rental) deductions Natalie may deduct in the current year related to the condo?

b. What is the total amount of itemized deductions Natalie may deduct in the current year related to the condo?

c. If Natalie’s basis in the condo at the beginning of the year was $150,000, what is her basis in the condo at the end of the year?

Solutions Manual – McGraw-Hill’s Taxation, by Spilker et al. 6-16

d. Assume that gross rental revenue was $2,000 (rather than $10,000), what amount of for AGI deductions may Natalie deduct in the current year related to the condo?

Note that the home falls into the residence with significant rental use category.

a. $8,972, calculated as follows:

Gross rental income $10,000 Tier 1 expenses:

Advertising expense = $500

Mortgage interest = (75/365) × $3,500=$719

Property taxes= (75/365) × $900=$185

Less: total Tier 1 expenses

Tier 2 expenses: Insurance = (75/110) × $1,000=$682

Repairs & Maintenance = (75/110) × $650=$443 Utilities= (75/110) × $950=$648

Less: total Tier 2 expenses

c. $144,205, calculated as follows:

Beginning basis $150,000

Less: depreciation actually deducted (5,795)

d. $2,000. Natalie is allowed to deduct all $1,404 of the advertising expense and the portion of the mortgage interest expense and real property taxes allocated to the rental use of the home as for AGI deductions (these deductions would not be limited to rental revenue even if it created a loss). Natalie is also able to deduct $596 of

Solutions Manual – McGraw-Hill’s Taxation, by Spilker et al. 6-17

(1,404) Balance

$8,596

(1,773) Balance

Total

$6,823 Tier 3 expenses: Depreciation (75/110) × $8,500= $5,795 (5,795) Balance net income from rental of condo $1,028

“For AGI” deductions ($1,404 + $1,773 + $5,795) $8,972

$2,781 Real

Total

$3,496

Mortgage interest [(290/365) × $3,500]

property taxes [(290/365) × $900] $715

"from AGI" deductions

Adjusted basis $144,205

the tier two expenses. In total, she will deduct $2,000 of rental related expenses leaving her with $0 net income from the property.

Use the following facts to answer problems 43-45. Alexa owns a condominium near Cocoa Beach in Florida. This year, she incurs the following expenses in connection with her condo:

During the year, Alexa rented out the condo for 100 days. She did not use the condo at all for personal purposes during the year. Alexa’s AGI from all sources other than the rental property is $200,000. Unless otherwise specified, Alexa has no sources of passive income.

43. [LO 2] Assume Alexa receives $30,000 in gross rental receipts.

a. What effect do the expenses associated with the property have on her AGI?

b. What effect do the expenses associated with the property have on her itemized deductions?

a. Expenses reduce AGI by $28,900. Alexa’s property is treated as a nonresidence with rental use property because she rented it for 100 days and did not use it all for personal purposes. The rental deductions are fully deductible for AGI. Thus, the expenses reduce Alexa’s AGI by $28,900 and the gross rental income increases the AGI by $30,000. Overall, Alexa’s AGI will be increased by the rental net income of $1,100, calculated as follows:

b. Because Alexa did not use the rental property for personal purposes, all expenses associated with the property were allocated to rental use and were deducted for AGI. Thus, the expenses associated with the property have no effect on her itemized deductions.

Solutions Manual – McGraw-Hill’s Taxation, by Spilker et al. 6-18

Insurance $2,000 Mortgage interest 6,500 Property taxes 2,000 Repairs & maintenance 1,400 Utilities 2,500 Depreciation 14,500

Gross rental income $30,000 Expenses: Insurance Mortgage interest Property taxes Repairs & maintenance Utilities Depreciation Less: total expenses (2,000) (6,500) (2,000) (1,400) (2,500) (14,500) (28,900) Balance net rental income $1,100

44 [LO 2] Assuming Alexa receives $20,000 in gross rental receipts, answer the following questions:

a. What effect does the rental activity have on her AGI for the year?

b. Assuming that Alexa’s AGI from other sources is $90,000, what effect does the rental activity have on Alexa’s AGI? Alexa makes all decisions with respect to the property.

c. Assuming that Alexa’s AGI from other sources is $120,000, what effect does the rental activity have on Alexa’s AGI? Alexa makes all decisions with respect to the property.

d. Assume that Alexa’s AGI from other sources is $200,000. This consists of $150,000 salary, $10,000 of dividends, and $25,000 of long-term capital gain, and net rental income from another rental property in the amount of $15,000. What effect does the Cocoa Beach Condo rental activity have on Alexa’s AGI?

Note that the property is a nonresidence with rental use property

a. Alexa’s AGI will be reduced by $0, calculated as follows:

By definition, a rental activity [unless it is a residence with significant rental use (a vacation home rental)], is considered to be a passive activity. Consequently, losses from rental property are not allowed to offset other ordinary or investment type income. As a result, Alexa will include $20,000 of rental income in gross income. She will also get to deduct $20,000 of expenses related to the rental property. The remaining $8,900 of expenses (the rental loss) is not deductible this year because (1) the rental activity is a passive activity, (2) Alexa has no passive income from other sources, and (3) Alexa’s AGI is above the phase-out range ($100,000 - $150,000) so she is not allowed to deduct any of the loss under the rental real estate exception to the passive loss rules. She may, however, carry the loss forward to future years in which she has passive income to offset.

b. Reduction of $8,900.

Under a rental real estate exception, a taxpayer who is an “active” participant in the rental activity may be allowed to deduct up to $25,000 of the rental loss against other types of income. To be considered an active participant, the taxpayer must (1) own at least 10% of the rental property and (2) participate in the process of making management decisions such as approving new tenants, deciding on rental terms, and approving repairs and capital expenditures. Since Alexa owns 100% of the property, and she makes

Solutions Manual – McGraw-Hill’s Taxation, by Spilker et al. 6-19

Gross rental income $20,000 Expenses: Insurance Mortgage interest Property taxes Repairs & maintenance Utilities Depreciation Less: total expenses (2,000) (6,500) (2,000) (1,400) (2,500) (14,500) (28,900) Balance net rental loss ($8,900)

all decisions with respect to the property, she is an active participant in the rental activity. Thus, she meets the rental real estate exception, and, because her AGI is below $100,000 she is eligible to deduct up to $25,000 of the loss against other types of income. In this case, she may deduct the entire $8,900 loss as an ordinary deduction in the current year.

c. Reduction of $8,900. Under a rental real estate exception, a taxpayer who is an “active” participant in the rental activity may be allowed to deduct up to $25,000 of the rental loss against other types of income. To be considered an active participant, the taxpayer must (1) own at least 10% of the rental property and (2) participate in the process of making management decisions such as approving new tenants, deciding on rental terms, and approving repairs and capital expenditures. The $25,000 maximum exception amount is phased out by 50 cents for every dollar the taxpayer’s adjusted gross income exceeds $100,000. Consequently, the entire $25,000 is phased-out when the taxpayer’s adjusted gross income reaches $150,000.

Since, Alexa owns 100% of the property, and she makes all decisions with respect to the property, she is an active participant in the rental activity. Thus, she meets the rental real estate exception, and she may potentially deduct the rental loss as an ordinary deduction in the current year. However, because her AGI exceeds $100,000, part of the exception amount is phased out as follows:

Phase-out = [AGI - $100,000] × $.50 = [$120,000 - $100,000] × $.50 = $10,000

Exception amount = $25,000 (maximum) - $10,000 (phase-out) = $15,000

Since Alexa’s rental loss of $8,900 is less than the exception amount of $15,000, she can deduct the entire $8,900 as an ordinary deduction in the current year.

d. The rental activity reduces her AGI by $8,900. (All transactions described in the problem increase her AGI by $191,100.)

Since Alexa has passive income (the rental income from another property), she can deduct the loss against this passive income. Thus, her net passive income is $6,100 ($15,000 rental income - $8,900 rental loss). In summary, she will include $150,000 salary, $10,000 dividends, $25,000 LTCG, and $35,000 rental income ($15,000 + $20,000) in gross income. She will also be able to deduct all of the expenses related to the rental property ($28,900) from the income in arriving at AGI. The $8,900 loss from the rental property reduces her AGI by $8,900.

45. [LO 2] {Planning Assume that in addition to renting the condo for 100 days, Alexa uses the condo for eight days of personal use. Also assume that Alexa receives $30,000 of gross rental receipts. Answer the following questions:

Solutions Manual – McGraw-Hill’s Taxation, by Spilker et al. 6-20

a. What is the total amount of for AGI deductions relating to the condo that Alexa may deduct in the current year? Assume she uses the IRS method of allocating expenses between rental and personal days.

b. What is the total amount of from AGI deductions relating to the condo that Alexa may deduct in the current year? Assume she uses the IRS method of allocating expenses between rental and personal days.

c. Would Alexa be better or worse off after taxes if she uses the Tax Court method of allocating expenses?

a. $26,760.

Since Alexa used the condo personally for 8 days, she must allocate the expenses between personal use and rental use days. As illustrated below, the portion attributable to the rental days are deductible as “for AGI” deductions.

Gross rental income $30,000

Expenses:

Insurance [100/108] × $2,000

Mortgage interest [100/108] × $6,500

Property taxes [100/108] × $2,000

Repairs & maintenance [100/108] × $1,400

Utilities [100/108] × $2,500

Depreciation [100/108] × $14,500

Less:

b. Alexa may deduct the personal-use portion of property taxes since they are deductible without regard to rental income. However, she is not allowed to deduct the mortgage interest related to personal-use days because the property no longer qualifies as a personal residence. Her deduction for the property taxes is calculated as follows:

Real property taxes = (8/108) × $2,000 = $148. Note that Alexa would be able to deduct the taxes whether she itemized or not (as an increase to her basic standard deduction).

c. The Tax Court method is less favorable in this circumstance because it allocates less interest expense to the rental activity and more to personal use. The interest expense allocated to personal use, however, does not qualify for an interest deduction because the taxpayer does not meet the minimum amount of personal use required for the deduction. By using the Tax Court method, any mortgage interest allocated to the personal-use days generates no tax benefit. Also, since this is primarily rental property, the taxpayer may deduct expenses in excess of income from the property. So, the taxpayer may not be as concerned about allocating more taxes to the rental property because doing so does not limit the taxpayer’s ability to deduct other expenses, as it might with mixed-use property. Note however, that a loss may not be immediately deductible due to the passive activity rules.

Solutions Manual – McGraw-Hill’s Taxation, by Spilker et al. 6-21

total expenses (1,852) (6,019) (1,852) (1,296) (2,315) (13,426) (26,760) Balance net rental income $3,240 Total “for AGI” deductions $26,760

46. [LO 2] {Forms} Brooke owns a sole proprietorship in which she works as a management consultant. She maintains an office in her home where she meets with clients, prepares bills, and performs other work-related tasks. The home office is 300 square feet and the entire house is 4,500 square feet. Brooke incurred the following home-related expenses during the year. Unless indicated otherwise, assume Brooke uses the actual expense method to compute home office expenses.

a. What amount of each of these expenses is allocated to the home office? The expenses are allocated to the home office as follows:

b. What are the total amounts of tier 1, tier 2, and tier 3 expenses allocated to the home office?

• Tier 1 expenses: $1,173 ($240 real property + $933 interest on home mortgage).

• Tier 2 expenses: $333 (operating expenses of the home)

• Tier 3 expense: $800 depreciation.

c. If Brooke reported $2,000 of Schedule C income before the home office expense deduction, what is the amount of her home office expense deduction and what home office expenses, if any, would she carry over to next year?

$2,000 home office expense in total and $306 depreciation expense carryover to next year. She would subtract all $1,173 of the tier 1 expenses and all $333 of the tier 2 expenses from her $2,000 of Schedule C income. This leaves $494 ($2,000 - $1,173 – 333) of net income before depreciation (tier 3 expense). Because the home office expense deduction can reduce

Solutions Manual – McGraw-Hill’s Taxation, by Spilker et al. 6-22 Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Real property taxes $ 3,600 Interest on home mortgage 14,000 Operating expenses of home 5,000 Depreciation 12,000 Repairs to home theater room 1,000

Expense Amount Type Allocated to home office 6.667% of indirect (300/4,500 sq. ft) Real property taxes $3,600 Indirect $240 Interest on home mortgage 14,000 Indirect 933 Operating expenses of home 5,000 Indirect 333 Depreciation 12,000 Indirect 800 Repairs to home theater room 1,000 Unrelated 0 Total expenses $35,600 $2,306

net income to $0 but not below, Brook may deduct $494 of depreciation expense and carry the remaining $306 over to next year.

d. Assuming Brooke reported $2,000 of Schedule C income before the home office expense deduction, complete Form 8829 for Brooks home office expense deduction. Also assume the value of the home is $500,000 and the adjusted basis of the home (exclusive of land) is $468,019.

Solutions Manual – McGraw-Hill’s Taxation, by Spilker et al. 6-23

Solutions Manual – McGraw-Hill’s Taxation, by Spilker et al. 6-24 Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

e. Assume that Brooke uses the simplified method for computing home office expenses. If Brooke reported $2,000 of Schedule C net income before the home office expense deduction, what is the amount of her home office expense deduction and what home office expenses, if any, would she carry over to next year?

Home office expense deduction is $1,500 (300 square feet × $5.00 per square foot) with zero carryover. The gross income limit does not apply here because the Schedule C net income before the home office expense deduction ($2,000) exceeds the home office expenses of $1,500. Note that taxpayers cannot carryforward expenses calculated using the simplified method to the next year even when the gross income limits the amount of the home office expense deduction.

Use the following facts to answer problems 47 – 48. Rita owns a sole proprietorship in which she works as a management consultant. She maintains an office in her home (500 square feet) where she meets with clients, prepares bills, and performs other work-related tasks. Her business expenses, other than home office expenses, total $5,600. The following home-related expenses have been allocated to her home office under the actual expense method for calculating home office expenses.

Also, assume that not counting the sole proprietorship, Rita’s AGI is $60,000.

47. [LO 2] {Tax planning} Assume Rita’s consulting business generated $15,000 in gross income.

a. What is Rita’s home office deduction for the current year? (Answer for both the actual expense method and the simplified method).

b. What would Rita’s home office deduction for the current year be if her business generated $10,000 of gross income instead of $15,000? (Answer for both the actual expense method and the simplified method).

c. Given the original facts, what is Rita’s AGI for the year?

d. Given the original facts, what types and amounts of expenses will she carry over to next year?

a. Rita’s home office deduction is $9,100 using the actual expense method calculated as follows:

Solutions Manual – McGraw-Hill’s Taxation, by Spilker et al. 6-25

without the prior written consent of McGraw-Hill Education.

Real property taxes $1,600 Interest on home mortgage 5,100 Operating expenses of home 800 Depreciation 1,600

Gross Income $15,000 Less: business expenses (5,600) Balance $9,400 Less: Tier 1 expenses (interest

taxes) (6,700) Balance after tier 1 expenses $2,700 Less Tier 2 expenses (operating expenses) (800) Balance after tier 2 expenses 1,900

$5,100 + $1,600

Less Tier 3 expenses (depreciation) (1,600)

Rita is allowed to deduct all expenses allocated to the home office ($6,700 interest and taxes + 800 home operating expenses + depreciation 1,600).

Under the optional method, Rita’s home office deduction would have been limited to $1,500 (300 square feet × $5 application rate). However, she also would have been able to deduct all of the $6,700 for interest and taxes as itemized deductions. This would have provided her with $1,500 + $6,700 = $8,200 of deductions, but this is still less than the $9,100 in deductions under the actual method

b. Under the actual expense method, she would deduct $6,700 for the home office expense deduction.

Less: Tier 1 expenses (interest $5,100 + $1,600

Rita is allowed to deduct only the mortgage interest and real property taxes allocated to the business use of the home. The remaining expenses (tier 2 and tier 3) are suspended and carried over to next year.

Under the simplified method, Rita would be limited to a home office expense deduction of $1,500 (300 square feet x $5 application rate), but she would have $6,700 more for itemized deductions for mortgage interest and taxes.

c. Rita’s AGI is $60,300 for the year. This is her AGI without the sole proprietorship plus the net income from the business ($60,000 + $300).

d. None. Because Rita is allowed to deduct all of the expenses this year, she does not carry any over to next year.

48. [LO 2] Assume Rita’s consulting business generated $13,000 in gross income for the current year. Further, assume Rita uses the actual expense method for computing her home office expense deduction.

a. What is Rita’s home office deduction for the current year?

Solutions Manual – McGraw-Hill’s Taxation, by Spilker et al. 6-26

Net income from business $300

Gross Income $10,000 Less: business expenses (5,600) Balance $4,400

taxes) (6,700) Loss after tier 1 expenses ($2,300) Less Tier 2 expenses (operating expenses) 0 Loss after tier 2 expenses ($2,300) Less Tier 3 expenses (depreciation) 0 Net loss from business ($2,300)

b. What is Rita’s AGI for the year?

c. Assume the original facts, except that Rita is an employee, and not self-employed (she uses the home office for the convenience of the employer). Consequently, she does not receive any gross income from the (sole proprietorship) business and she does not incur any business expenses unrelated to the home office. Finally, her AGI is $60,000 consisting of salary from her work as an employee. What effect do her home office expenses have on her itemized deductions?

d. Assuming the original facts, what types and amounts of expenses will she carry over to next year?

a. $7,400, calculated as follows:

Less: Tier 1 expenses (interest $5,100 + $1,600 taxes) (6,700)

Balance after tier 1 expenses $700

Less: Tier 2 expenses (operating expenses $800 before limit) (700)

Balance after tier 2 expenses 0 Less Tier 3 expenses (depreciation $1,600 before limit) (0)

Rita is allowed to deduct a total of $7,400 in home office expenses ($6,700 in interest and taxes and $700 of home operating expenses).

b. $60,000. This is the $60,000 of AGI without the sole proprietorship plus $0 net income from the home business.

c. Because the home office deduction is deductible from AGI for employees, Rita’s AGI is unchanged by her home office expenses. Employees who may deduct home office expenses do so as itemized deductions subject to the 2% AGI floor. Thus, Rita’s $9,100 of home office expenses are reduced by $1,200 ($60,000 × 2%) and she may deduct $7,900 as an itemized deduction.

d. Rita will carry over $100 of tier 2 expenses (operating expenses) and $1,600 of tier 3 expenses (depreciation expense) to next year.

49. [LO 2] {Research } Boodeesh is contemplating running a consulting business out of her home. She has a large garage apartment in her backyard that would be perfect for her business. Given that the garage apartment is separate from her house (about 30 feet behind her house) would the office be considered part of her home for purposes of the home office rules?

Solutions Manual – McGraw-Hill’s Taxation, by Spilker et al. 6-27

Gross Income $13,000 Less: business expenses (5,600) Balance $7,400

Net

income from business $0

Yes, the garage apartment is likely to be considered a part of the home as it would be considered appurtenant to Boodeesh’s dwelling unit. IRC Sec. 280A(f)(1) defines a dwelling unit to include a house, apartment, condominium, mobile home, boat, or similar property, and all structures or other property appurtenant to such dwelling unit. See Charles Scott, 84 TC 683 (1985) for a discussion of when a structure is appurtenant to a dwelling unit.

50. [LO 3] Clem is married and is a skilled carpenter. Clem’s wife, Wanda, works part-time as a substitute grade school teacher. Determine the amount of Clem’s expenses that are deductible for AGI this year (if any) under the following independent circumstances:

a. Clem is self-employed and this year he incurred $525 for tools and supplies related to his job. Since neither were covered by a qualified health plan, Wanda paid health insurance premiums of $3,600 to provide coverage for herself and Clem (not through an exchange).

b. Clem and Wanda own a garage downtown that they rent to a local business for storage. This year they incurred $1,250 in utilities and depreciation of $780.

c. Clem paid self-employment tax of $15,300 (the employer portion is $7,650) and Wanda had $3,000 of Social Security taxes withheld from her pay.

d. Clem paid $45 to rent a safe deposit box to store his coin collection. Clem has collected coins intermittently since he was a boy and he expects to sell his collection when he retires.

a. $4,125 – The tools and supplies and the health insurance are deductible for AGI.

b. $2,040 – The utilities and depreciation are deductible for AGI (rental activity).

c. $7,650 –The employer portion of the self-employment tax is deductible for AGI, but the Social Security tax is not deductible.

d. $0 – The safe deposit fee is an itemized deduction (it appears that Clem is investing in rare coins rather than a dealer in coins – a business).

51 [LO 3] Clyde currently commutes 55 miles to work in the city. He is considering a new assignment in the suburbs on the other side of the city that would increase his commute considerably. He would like to accept the assignment, but he thinks it might require that he move to the other side of the city. Assume that Clyde is employed for 39 of the next 52 weeks. Determine if Clyde’s move qualifies for a moving expense deduction and calculate the amount (if any) under the following circumstances:

a. Clyde estimates that unless he moves across town, his new commute would be almost 70 miles. He also estimates the costs of a move as follows:

Lodging while searching for an apartment

$ 125

Transportation – auto (100 miles @ 23.5 cents/mile, rounded) 24

fee (furniture and possessions) 1,500

while en route 35

Solutions Manual – McGraw-Hill’s Taxation, by Spilker et al. 6-28

Mover’s

Meals

b. Same as (a.) above, except Clyde estimates that unless he moves across town, his new commute would be almost 115 miles.

c. Same as (a.) above, except Clyde’s new commute would be almost 150 miles and the mover’s intend to impose a $450 surcharge on the moving fee for the additional distance.

a. Zero. Clyde would not qualify for a moving expense deduction. To qualify for a moving expense deduction the new commute from Clyde’s current residence would need to be a minimum of 105 miles. That is, his commute from his old residence to the new job must be more than 50 miles longer than his current commute

b. Clyde now qualifies for a moving expense deduction (assuming he is employed for 39 of the next 52 weeks). Estimated costs of $1,524 (mover’s fee of $1,500 + $24 of mileage) are deductible for AGI. This excludes the cost for lodging while searching for an apartment and the meals en route.

c. Clyde qualifies for a moving expense deduction (assuming he is employed for 39 of the next 52 weeks). Estimated costs of moving increase to $1,974, and this total is deductible for AGI.

52. [LO 3] Smithers is a self-employed individual who earns $30,000 per year in self-employment income. Smithers pays $2,200 in annual health insurance premiums (not through an exchange) for his own medical care. In each of the following situations, determine the amount of the deductible health insurance premium for Smithers.

a. Smithers is single, and the self-employment income is his only source of income.

b. Smithers is single, but besides being self-employed, Smithers is also employed part-time by SF Power Corporation. This year Smithers elected not to participate in SF’s health plan.

c. Smithers is self-employed, and he is also married. Smithers’ spouse, Samantha, is employed fulltime by SF Power Corporation and is covered by SF’s health plan. Smithers is not eligible to participate in SF’s health plan.

d. Smithers is self-employed, and he is also married. Smithers’ spouse, Samantha, is employed fulltime by SF Power Corporation and is covered by SF’s health plan. Smithers elected not to participate in SF’s health plan.

a. Smithers can deduct $2,200 either as a deduction for AGI or claim $2,200 as an itemized medical expense.

b. Smithers can claim only $2,200 as an itemized medical expense. Even though he is self-employed, he is not eligible to deduct the health insurance premiums as a for AGI deduction because he is eligible to participate in his employer’s plan (even though he did not actually participate).

c. Smithers can deduct $2,200 either as a deduction for AGI or claim $2,200 as an itemized medical expense.

Solutions Manual – McGraw-Hill’s Taxation, by Spilker et al. 6-29

d. Smithers can claim only $2,200 as an itemized medical expense. Even though he is self-employed, he is not eligible to deduct the health insurance premiums as a for AGI deduction because he is eligible to participate in his spouse’s employer’s plan (even though he did not actually participate in her plan).

53 [LO 3] Hardaway earned $100,000 of compensation this year. He also paid (or had paid for him) $3,000 of health insurance (not through an exchange). What is Hardaway’s AGI in each of the following situations (ignore the effects of Social Security and self-employment taxes)?

a. Hardaway is an employee, and his employer paid Hardaway’s $3,000 of health insurance for him as a nontaxable fringe benefit. Consequently, Hardaway received $97,000 of taxable compensation and $3,000 of nontaxable compensation.

b. Hardaway is a self-employed taxpayer, and he paid $3,000 of health insurance himself. He is not eligible to participate in an employer-sponsored plan.

a. Hardaway’s AGI is $97,000, consisting of the $97,000 of taxable compensation he received from his employer.

b. Hardaway’s AGI is $97,000 (the same as in part a), consisting of $100,000 of taxable earnings minus $3,000 for AGI deduction for the health insurance.

54. [LO 3] John (age 51 and single) has earned income of $3,000. He has $30,000 of unearned (capital gain) income.

a. If he does not participate in an employer-sponsored plan, what is the maximum deductible IRA contribution John can make in 2014?

b. If he does participate in an employer-sponsored plan, what is the maximum deductible IRA contribution John can make in 2014?

c. If he does not participate in an employer-sponsored plan, what is the maximum deductible IRA contribution John can make in 2014 if he has earned income of $10,000?

a. $3,000. Deductible contributions to an IRA account are limited to the lesser of $5,500 or earned income. If the individual is at least 50 years old by the end of the year, he/she may make a contribution of up to the lesser of $6,500 or earned income. In this case, John’s deductible contribution is the lesser of (1) his earned income of $3,000 or (2) the maximum deductible amount of $6,500. So his deductible contribution is $3,000.

b. $3,000. Taxpayers who are participants in an employer sponsored retirement plan are allowed to make deductible contributions to an IRA account as long as they meet certain AGI restrictions. In 2014, the deductibility of IRA contributions is phased-out proportionally for AGI between $60,000 and $70,000. John’s AGI of $33,000 (3,000 earned income + 30,000 capital gain) falls below the $60,000 AGI phase-out threshold. Thus, John is allowed to make a contribution equal to the lesser of $6,500 or earned income (The $6,500 = $5,500 standard limit + $1,000 catch-up contribution for taxpayers age 50 and over). So, he is allowed to deduct $3,000.

Solutions Manual – McGraw-Hill’s Taxation, by Spilker et al. 6-30

c. $6,500. Deductible contributions are limited to the lesser of $5,500 or earned income. The $5,500 limit is increased to $6,500 for taxpayers who have reached the age of 50 by the end of the year (taxpayers age 50 or older at the end of the year are allowed to make an additional $1,000 catch up contribution). Thus, John may make a total deductible contribution equal to the lesser of $6,500 (5,500 + 1,000) or earned income ($10,000). So, he is allowed to deduct $6,500.

55. [LO 3] William is a single writer (age 35) who recently decided that he needs to save more for retirement. His 2014 AGI is $64,000 (all earned income).

a. If he does not participate in an employer-sponsored plan, what is the maximum deductible IRA contribution William can make in 2014?

b. If he does participate in an employer-sponsored plan, what is the maximum deductible IRA contribution William can make in 2014?

c. Assuming the same facts as in b. except his AGI is $75,000, what is the maximum deductible IRA contribution William can make in 2014?

a. $5,500. Because William is not covered by an employer provided retirement plan, his deductible contribution is not limited by AGI. Also, because he is under 50 years of age at the end of the year, his maximum deductible IRA contribution for the year is $5,500.

b. $3,300. Because William is under 50 years of age at the end of the year, his maximum deductible contribution (before phase-out) is $5,500. However, because he is covered by an employer sponsored plan as a single taxpayer, William’s maximum deductible contribution is phased out proportionally for AGI between $60,000 and $70,000. William’s AGI of $64,000 is 40% of the way through the $10,000 phase-out range [($64,000 - $60,000)/$70,000 - $60,000)] so he is not allowed to deduct 40% of the $5,500 maximum deductible contribution. But he is allowed to deduct 60% of his maximum deductible contribution of $5,500 which is $3,300.

c. The maximum deductible IRA contribution that William can contribute in 2014 is $0. Because he is covered by an employer provided plan, the maximum deductible contribution for unmarried taxpayers phases out between $60,000 and $70,000. Because William’s AGI exceeds $70,000, he cannot make a deductible IRA contribution.

56 [LO 3] In 2014, Susan (44 years old) is a highly successful architect and is covered by an employee-sponsored plan. Her husband, Dan (47 years old), however, is a Ph.D. student and is unemployed. Compute the maximum deductible IRA contribution for each spouse in the following alternative situations.

a. Susan’s salary and the couple’s AGI is $200,000. The couple files a joint tax return.

b. Susan’s salary and the couple’s AGI is $120,000. The couple files a joint tax return.

c. Susan’s salary and the couple’s AGI is $80,000. The couple files a joint tax return.

d. Susan’s salary and her AGI is $80,000. Dan reports $5,000 of AGI (earned income). The couple files separate tax returns.

Solutions Manual – McGraw-Hill’s Taxation, by Spilker et al. 6-31

a. Susan’s maximum deductible contribution is $0. Dan’s maximum deductible contribution is also $0. Susan’s maximum deductible contribution is $0 because she is an active participant in an employer’s retirement plan and the AGI on the couple’s joint return exceeds $116,000, so her deductible contribution is entirely phased out. Dan’s maximum deductible contribution is also $0 even though he is not an active participant in an employer’s plan. Because Susan is an active participant and the couple’s AGI exceeds $191,000 Dan’s deductible contribution is fully phased out.

b. Susan’s maximum deductible contribution is $0. Because she is an active participant in an employer’s plan and the couple’s AGI exceeds $116,000 her deductible contribution is entirely phased out. Dan’s maximum deductible contribution is $5,500. This is the lesser of (1) $5,500 or (2) $114,500, which is the couple’s earned income ($120,000) minus Susan’s deductible contribution ($5,500). Dan is able to contribute $5,500 even though he doesn’t have any earned income because the couple has earned income and the couple’s AGI is less than $181,000.

c. Susan’s maximum deductible contribution is $5,500, and Dan’s maximum deductible contribution is $5,500. Even though Susan is an active participant in an employer’s retirement plan she is able to make a deductible contribution because the couple’s AGI is less than $96,000. Dan is able to make a $5,500 deductible contribution which is the lesser of (1) $5,500 or (2) $74,500 ($80,000 minus $5,500) which is the couple’s earned income minus Susan’s deductible contribution.

d. Susan’s maximum deductible contribution is $0 because she is filing separately and her AGI exceeds $10,000. Dan is able to make a $2,750 deductible contribution. His maximum deductible contribution before phase out is $5,500. Because he is filing a separate return, his maximum contribution phases out proportionally between $0 and $10,000 of AGI. Here his $5,000 AGI is 50% of the way through the phase out range so he loses 50% of his otherwise deductible contribution.

57. [LO 3] {Forms } In 2014, Rashaun (62 years old) retired and planned on immediately receiving distributions (making withdrawals) from his traditional IRA account. The current balance of his IRA account is $160,000. Over the years, Rashaun has contributed $40,000 to the IRA. Of his $40,000 contributions, $30,000 was nondeductible and $10,000 was deductible

a. If Rashaun currently withdraws $20,000 from the IRA, how much tax will he be required to pay on the withdrawal if his marginal tax rate is 20 percent?

b. If Rashaun currently withdraws $70,000 from the IRA, how much tax will he be required to pay on the withdrawal if his marginal tax rate is 30 percent?

c. Usingtheinformationprovidedinpart b,completeForm8606,Part Itoreportthetaxableportion of the $70,000 distribution (withdrawal). Use 2013 forms if 2014 forms are unavailable.

a. Because Rashaun has made both deductible and nondeductible contributions to his IRA, he needs to allocate the distribution between taxable amounts and amounts that are a return of his nondeductible contribution. To do this, he first has to determine the ratio of nondeductible contributions to the value of the IRA at the time of the distribution. In this case the ratio is $30,000/$160,000 or 18.75%. Consequently, $3,750 (20,000 × 18.75%) is not taxable and the remaining $16,250 is taxed at Rashaun’s marginal tax rate of 20%. Thus, Rashaun must pay

Solutions Manual – McGraw-Hill’s Taxation, by Spilker et al. 6-32

$3,250 in taxes and the overall amount he receives after taxes is $16,750 [3,750 + (16,250 × (1.2)].

b. Again, because Rashaun has made both deductible and nondeductible contributions, he needs to allocate the distribution between taxable amounts and amounts that are a return of his nondeductible contributions. His ratio of nondeductible contributions to the value of the IRA is 30,000/160,000 or 18.75%. Consequently, $13,125 (70,000 × 18.75%) is not taxable and the remaining $56,875 (70,000 – 13,125) is taxed at his marginal tax rate of 30% for taxes of $17,063 ($56,875 × 30%). After taxes Rashaun receives $52,937 [13,125 + (56,875 – 17,063]).

Solutions Manual – McGraw-Hill’s Taxation, by Spilker et al. 6-33

58. [LO 3] Brooklyn has been contributing to a traditional IRA for seven years (all deductible contributions) and has a total of $30,000 in the account. In 2014, she is 39 years old and has decided that she wants to get a new car. She withdraws $20,000 from the IRA to help pay for the car. She is currently in the 25 percent marginal tax bracket. What amount of the withdrawal, after tax considerations, will Brooklyn have available to purchase the car?

Solutions Manual – McGraw-Hill’s Taxation, by Spilker et al. 6-34

Brooklyn will be taxed at 25% on the $20,000 withdrawal. Consequently, she will pay $5,000 in taxes (20,000 × 25%). In addition, she must pay a 10% early distribution penalty on the $20,000 withdrawal ($20,000 × 10% = $2,000 penalty). This leaves her with $13,000 after taxes ($20,000 – 5,000 taxes – 2,000 penalties) to purchase the car.

59 [LO 3] Jackson and Ashley Turner (both 45 years old) are married and want to contribute to a Roth IRA for Ashley. In 2014, their AGI is $170,000. Jackson and Ashley each earned half of the income.

a. How much can Ashley contribute to her Roth IRA if they file a joint return?

b. How much can Ashley contribute if she files a separate return?

a. Individuals are allowed to contribute to a Roth IRA as long as their AGI falls below certain threshold limits. The AGI threshold limits for married individuals filing jointly is between $181,000 and $191,000. Because Jackson and Ashley’s AGI is below these threshold limits, Ashley can contribute $5,500, the maximum contribution for taxpayers under age 50 at the end of the year.

b. The AGI threshold limits for married individuals filing separately is between $0 and $10,000. Thus, if they filed separately, Ashley would not be able to contribute to a Roth IRA.

60. [LO 3] Harriet and Harry Combs (both 37 years old) are married and both want to contribute to a Roth IRA. In 2014, their AGI is $50,000. Harriet earned $46,000 and Harry earned $4,000.

a. How much can Harriet contribute to her Roth IRA if they file a joint return?

b. How much can Harriet contribute if she files a separate return?

c. How much can Harry contribute to his Roth IRA if they file separately?

a. Individuals are allowed to contribute to a Roth IRA as long as their AGI falls below certain threshold limits. The AGI threshold limits for married individuals filing jointly is between $181,000 and $191,000. Because Harriet and Harry’s AGI is below these threshold limits, Harriet can contribute $5,500, the maximum contribution for taxpayers under age 50 at the end of the year.

b. The AGI threshold limits for married individuals filing separately is between $0 and $10,000. Thus, if Harriet files separately, she would not be allowed to contribute to Roth IRA because her AGI is $46,000.

c. $3,300 ($5,500 × 60%). Since Harry’s AGI is 40% of the way between $0 and $10,000 [($4,000 – 0)/(10,000 – 0)], Harry is only allowed to contribute 60% (100% - 40% disallowed percentage) of the $5,500 maximum contribution for tax payers under 50 years of age at year end.

61. [LO 3] George (age 42 at year-end) has been contributing to a traditional IRA for years (all deductible contributions) and his IRA is now worth $25,000. He is planning on transferring (or rolling over) the entire balance into a Roth IRA account. George’s marginal tax rate is 25 percent.

a. What are the tax consequences to George if he takes $25,000 out of the traditional IRA and puts the entire amount into a Roth IRA?

Solutions Manual – McGraw-Hill’s Taxation, by Spilker et al. 6-35

b. What are the tax consequences to George if he takes $25,000 out of the traditional IRA, pays the taxes due from the IRA distribution, and contributes the remaining distribution to the Roth IRA?

c. What are the tax consequences to George if he takes $25,000 out of the traditional IRA, keeps $10,000 to pay taxes and to make a down payment on a new car, and contributes the remaining distribution to the Roth IRA?

a. George will have to pay taxes of $6,250 (25% × 25,000) for taking the $25,000 out of the IRA. However, he will not have to pay the 10% penalty tax because he deposited the entire $25,000 (the entire amount of the withdrawal) into a Roth IRA.

b. George will have to pay taxes of $6,250 for taking the $25,000 out of the IRA. After taxes, this leaves $18,750 ($25,000 – 6,250) for George to contribute to the Roth IRA. However, because he doesn’t contribute (roll over) $25,000 (the full amount that was withdrawn from the traditional IRA), he will also have to pay the 10% penalty tax on the $6,250 that he did not contribute or roll over. Therefore, he will have to pay a penalty of $625 ($6,250 x 10%). In total he will pay taxes of $6,875 ($6,250 + 625) on the transaction.

c. George will have to pay taxes of $6,250 for taking the $25,000 out of the IRA. After taxes, this leaves him with $18,750 ($25,000 – 6,250). Because George only contributes $15,000 to the Roth IRA he must pay a 10% penalty tax on the $10,000 that he took out of the traditional IRA and did not contribute or roll over to a Roth IRA. Consequently, he pays a $1,000 penalty ($10,000 × 10%). In total, George must pay $7,250 ($1,000 penalty + $6,250 tax) in taxes on the distribution.

62 [LO 3] Jimmer has contributed $15,000 to his Roth IRA and the balance in the account is $18,000. In the current year, Jimmer withdrew $17,000 from the Roth IRA to pay for a new car. If Jimmer’s marginal ordinary income tax rate is 25 percent, what amount of tax and penalty, if any, is Jimmer required to pay on the withdrawal in each of the following alternative situations?

a. Jimmer opened the Roth account 44 months before he withdrew the $17,000 and Jimmer is 62 years of age.

b. Jimmer opened the Roth account 44 months before he withdrew the $17,000 and Jimmer is age 53.

c. Jimmer opened the Roth account 76 months before he withdrew the $17,000 and Jimmer is age 62.

d. Jimmer opened the Roth account 76 months before he withdrew the $17,000 and Jimmer is age 53.

a. $500 tax and $200 penalty. Because the Roth account has not been open for five years at the time of the distribution), this is a nonqualified distribution. Because Jimmer contributed $15,000, he is allowed to receive $15,000 in distributions from the account without paying tax or penalty. However, because it is a nonqualified distribution, he must pay tax ($2,000 x 25%) and penalty ($2,000 × 10%) on the $2,000 earnings that Jimmer received in the distribution.

b. $500 tax and $200 penalty. Because the Roth account has not been open for five years (and Jimmer has not reached age 59 ½ by the time of the distribution), this is a nonqualified distribution. Because Jimmer contributed $15,000, he is allowed to receive $15,000 in distributions from the account without paying tax or penalty. However, because it is a nonqualified distribution, he must pay tax ($2,000 × 25%) and penalty ($2,000 × 10%) on the $2,000 earnings that Jimmer received in the distribution.

Solutions Manual – McGraw-Hill’s Taxation, by Spilker et al. 6-36

c. $0 tax and $0 penalty. Because this is a qualified distribution (distribution is after Jimmer has attained 59 ½ years of age and the Roth account has been open for more than five years) the distribution is not subject to tax or penalty.

d. $500 tax and $200 penalty. Because Jimmer has not reached age 59 ½ by the time of the distribution, this is a nonqualified distribution. Because Jimmer contributed $15,000, he is allowed to receive $15,000 in distributions from the account without paying tax or penalty. However, because it is a nonqualified distribution, he must pay tax ($2,000 × 25%) and penalty ($2,000 × 10%) on the $2,000 earnings that Jimmer received in the distribution.

63 [LO 3] Over the past three years, Sherry has contributed a total of $12,000 to a Roth IRA account ($4,000 a year). The current value of the Roth IRA is $16,300. In the current year, Sherry withdraws $14,000 of the account balance to purchase a car. Assuming Sherry is in a 25 percent marginal tax bracket, how much of the $14,000 withdrawal will she retain after taxes to fund her car purchase?

Because Sherry has made a withdrawal from her Roth IRA within five years of opening it, she has received a nonqualified distribution. Nonqualified distributions are non taxable to the extent they are attributable to contributions; the earnings made on such contributions are taxed as ordinary income and subject to a 10% penalty. In this instance, Sherry has withdrawn $2,000 of earnings (14,000 withdrawal – 12,000 contributions) and will pay taxes of $500 (25% × 2,000) and a penalty of $200 (10% × 2,000). Of the $14,000 withdrawn, Sherry will retain after-taxes $13,300 ($14,000 withdrawal – 500 taxes – 200 penalty).

64 [LO 3] Seven years ago, Halle (currently age 41) contributed $4,000 to a Roth IRA account. The current value of the Roth IRA is $9,000. In the current year Halle withdraws $8,000 of the account balance to use as a down payment on her first home. Assuming Halle is in a 25 percent marginal tax bracket, how much of the $8,000 withdrawal will she retain after taxes to fund her house down payment?

All $8,000. Because Halle has had her Roth IRA open for at least five years and she used the distribution proceeds as a down payment on her first home, the entire distribution is considered a qualified distribution and is not taxable.

65 [LO 3] {Research } Sarah was contemplating making a contribution to her traditional individual retirement account for 2014. She determined that she would contribute $5,000 to her IRA and she deducted $5,000 for the contribution when she completed and filed her 2014 tax return on February 15, 2015. Two months later, on April 15, Sarah realized that she had not yet actually contributed the funds to her IRA. On April 15, she went to the post office and mailed a $5,000 check to the bank holding her IRA. The bank received the payment on April 18. In which year is Sarah’s $5,000 contribution deductible?

Sarah is allowed to deduct $5,000 in 2014

Solutions Manual – McGraw-Hill’s Taxation, by Spilker et al. 6-37

According to Rev. Rul. 84-18, an individual may deduct a contribution to an IRA (under §219) even though the contribution is made after the individual’s tax return is filed, as long as the contribution is made before the due date of the return.

The next issue is whether Sarah’s contribution was made by the due date of her return

According to IRS Letter Ruling 8536085, June 14, 1985, contributions mailed by a taxpayer on or before the tax return deadline are considered as though they were timely made.

66. [LO 3] Lionel is an unmarried law student at State University Law School, a qualified educational institution. This year Lionel borrowed $24,000 from Counti Bank and paid interest of $1,440. Lionel used the loan proceeds to pay his law school tuition. Calculate the amounts Lionel can deduct for interest on higher education loans under the following circumstances (assume the 2013 rules apply for purposes of the qualified education expense deduction):

a. The maximum interest deduction is the amount paid up to $2,500. The deduction is phased out as AGI exceeds $65,000 (before applying the interest deduction). Consequently, because his AGI is below the trigger amount for the phase-out, Lionel can deduct $1,440, which is the lesser of (1) $2,500 or (2) $1,440 (the amount of interest expense he paid). Lionel paid $24,000 of qualified educational expenses. Because his modified AGI ($50,000 - $1,440 deduction for interest on higher education loan = $48,560) is less than the trigger for the deduction for qualified education expense phase-out ($65,000), Lionel can deduct $4,000 for qualified education expenses, which is the lesser of (1) $4,000 or (2) $24,000 (qualified education expenses paid).

b. Lionel can deduct $576 of qualified educational interest expense computed as follows:

Since Lionel’s modified AGI (($74,000 - $576 deduction for interest on higher education loan = $73,424) exceeds $65,000 but is less than or equal to $80,000, Lionel can also deduct $2,000 of qualified education expenses, which is the lesser of (1) $2,000 or (2) $24,000 (qualified education expenses paid).

Solutions Manual – McGraw-Hill’s Taxation, by Spilker et al. 6-38

Description Amount Explanation (1) Modified AGI $74,000 (2) Amount of interest paid up to $2,500 1,440 Lesser of amount paid or $2,500 (3) Phase-out (reduction) percentage 60% [(1) – 65,000] / 15,000, limited to 100 percent (4) Phase-out amount (reduction in maximum) 864 (2) x (3) Deductible interest expense $576 (2) – (4)

c. Lionel is not allowed to deduct any qualified educational interest expense computed as follows: Description

(1) Modified AGI $90,000

(2) Amount of interest paid up to $2,500 1,440 Lesser of amount paid or $2,500

(3) Phase-out (reduction) percentage 100% [(1) – 65,000] / 15,000, limited to 100 percent

(4) Phase-out amount (reduction in maximum) 1,440 (2) x (3)

Deductible interest expense $0 (2) – (4)

Lionel is also not allowed to deduct any qualified education expenses because his modified AGI ($90,000) exceeds $80,000.

67 [LO 3] This year Jack intends to file a married-joint return with two dependents. Jack received $162,500 of salary, and paid $5,000 of interest on loans used to pay qualified tuition costs for his dependent daughter, Deb. This year Jack has also paid qualified moving expenses of $4,300 and $24,000 of alimony.

a. What is Jack’s adjusted gross income? Assume that Jack will opt to treat tax items in a manner to minimize his AGI.

b. Suppose that Jack also reported income of $8,800 from a half share of profits from a partnership. What AGI would Jack report under these circumstances? Again, assume that Jack will opt to treat tax items in a manner to minimize his AGI.

Solutions Manual – McGraw-Hill’s Taxation, by Spilker et al. 6-39

Amount Explanation

a. AGI is $132,050. Jack’s modified AGI calculated without adjustment for educational interest expense is 134,200. He is allowed to deduct part of his student loan interest because his modified AGI is not above $160,000. Jack’s maximum deduction before the phase-out is $2,500 (the amount of interest paid up to $2,500). The maximum deduction of $2,500 is phased-out ratably over a $30,000 range beginning with modified AGI over $130,000. Consequently, Jack’s education interest expense deduction is $2,150 = ($2,500 - $2,500 * [($134,200130,000)/30,000]).Jack’s AGI is computed as follows;

Salary and gross income

$ 162,500

Less: Alimony - 24,000

Moving Expense Deduction - 4,300

Modified AGI $ 134,200

Student Loan Interest Deduction - 2,150

AGI $ 132,050

b. AGI is $141,583. Jack’s modified AGI calculated without adjustment for educational interest expense is 143,000. He is allowed to deduct part of his student loan interest because his modified AGI is not above $160,000. Jack’s maximum deduction before the phase-out is $2,500 (the amount of interest paid up to $2,500). The maximum deduction of $2,500 is phased-out ratably over a $30,000 range beginning with modified AGI over $130,000. Consequently, Jack’s education interest expense deduction is $1,417 = ($2,500 - $2,500 * [($143,000-130,000)/30,000]).

Jack’s AGI is computed as follows:

Salary $ 162,500

Partnership income + 8,800

Less: Alimony - 24,000 Moving Expense Deduction

4,300

Modified AGI

AGI

Comprehensive Problems

1,417

143,000 Student Loan Interest Deduction

141,583

68. Read the following letter and help Shady Slim with his tax situation. Please assume that gross income is $172,900 for purposes of this problem.

December 31, 2014

To the friendly student tax preparer:

Hi, it’s Shady Slim again. I’m told that you need some more information from me in order to complete my tax return. I’m an open book! I’ll tell you whatever I think you need to know.

Solutions Manual – McGraw-Hill’s Taxation, by Spilker et al. 6-40

I had to move this year after getting my job at Roca Cola. We moved on February 3 of this year, and I worked my job at Roca Cola for the rest of the year. I still live in the same state, but I moved 500 miles away from my old house. I left a little bit early to go on a house-hunting trip that cost me a total of $450. I hired a moving company to move our stuff at a cost of $2,300. Junior and I got a hotel room along the way that cost us $42 (I love Super 8!). We spent $35 on meals on the way to our new home. Oh yeah, I took Junior to a movie on the way and that cost $20.

Can you believe I’m still paying off my student loans, even after 15 years? I paid a total of $900 in interest on my old student loans this year.

Since Roca Coca (my employer) never started a retirement plan, I decided I should probably start saving for my golden years. I contributed $3,000 to what the bank referred to as a regular IRA (or was it a REM?). Oh yeah. I also did a little investing this year. I bought a limited partnership interest in Duds, Ltd. for $10,000. I thought it was going to be a real winner, but this year they took a bath. My portion of the loss was $8,000. Well, at least I did not actually do any work for Duds, and I get the tax deductionright?

That should be all the information you need right now. Please calculate my adjusted gross income and complete page 1 of Form 1040 You’re still doing this for free, right?

Adjusted gross income is $167,440, computed as follows:

Notes:

1. Duds, Ltd. Loss is not deductible because it is a passive activity for Shady.

2. House-hunting trip, meals, and movie are not deductible moving expenses.

3. Student loan interest is not deductible because AGI exceeds the threshold amount of income.

2015

Solutions Manual – McGraw-Hill’s Taxation, by Spilker et al. 6-41

Gross Income $ 172,900 Less: Duds, Ltd Loss Deduction $ 0 Moving Expenses: Mileage (500 x 23.5¢) 118 Moving company 2,300 Lodging 42 IRA Deduction 3,000 - 5,460 AGI $ 167,440

Solutions Manual – McGraw-Hill’s Taxation, by Spilker et al. 6-42 Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

69. Jeremy and Alyssa Johnson have been married for five years and do not have any children. Jeremy was married previously and has one child from the prior marriage. He is self-employed and operates his own computer repair store. For the first two months of this year, Alyssa worked for Staples, Inc. as an employee. In March, Alyssa accepted a new job with Super Toys, Inc. (ST) where she worked for the remainder of the year. This year the Johnsons received $255,000 of gross income. Determine the Johnson’s AGI given the following information (assume the 2013 rules apply for purposes of the qualified education expense deduction):

a. Expenses associated with Jeremy’s store include $40,000 in salary (and employment taxes) to employees, $45,000 of supplies, and $18,000 in rent and other administrative expenses.

b. Alyssa contributed $5,000 to a regular IRA. She did not participate in an employer-provided retirement plan. Jeremy currently is not saving for his retirement

c. The Johnsons own a piece of investment real estate. They paid $500 of real property taxes on the property and they incurred $200 of expenses in travel costs to see the property and to evaluate other similar potential investment properties.

d. The Johnsons own a rental home. They incurred $8,500 of expenses associated with the property.

e. The Johnson’s home was only five miles from the Staples store where Alyssa worked in January and February. The ST store was 60 miles from their home, so the Johnsons decided to move to make the commute easier for Alyssa. The Johnson’s new home was only ten miles from the ST store. However, it was 50 miles from their former residence. The Johnsons paid a moving company $2,000 to move their possessions to the new location. They also drove the 50 miles to their new residence. They stopped along the way for lunch and spent $60 eating at Denny’s. None of the moving expenses were reimbursed by ST.

f. Jeremy paid $4,500 for health insurance coverage for himself (not through an exchange). Alyssa was covered by health plans provided by her employer, but Jeremy is not eligible for the plan until next year.

g. Jeremy paid $2,500 in self-employment taxes ($1,250 represents the employer portion of the self-employment taxes).

h. Jeremy paid $5,000 in alimony and $3,000 in child support from his prior marriage.

i. Alyssa paid $3,100 of tuition and fees to attend night classes at a local university. The Johnsons would like to deduct as much of this expenditure as possible rather than claim a credit.

Answer: $122,638, computed as follows: Johnson’s

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AGI Description Amount Explanation Gross income $255,000

a Ordinary and necessary business expenses

b Unreimbursed employment expenses

c Real property taxes and investment expenses.

d Rental expenses

e Moving expenses

103,000 Ordinary expenses associated with Jeremy’s business

- Unreimbursed employee business expenses are deductible from AGI not for AGI

- Taxes and investment expenses are deductible from AGI not for AGI.

8,500 Rental expenses are deductible for AGI even though they are technically investment or “production of income expenses.”

2,012 Her old residence to new place of employment is more than 50 miles farther than her old residence to her old place of employment (60 – 5 = 55). The location of her new residence is irrelevant. The Johnsons are allowed to deduct costs of moving ($2,000 movers including 23.5 cents a mile for driving themselves (50 x 23.5¢ =$12, rounded). Meals are an indirect cost of moving and are not deductible.

f Self-employed health insurance

g Self-employment taxes

4,500 Jeremy may deduct all the costs of his health insurance because he is not eligible for ST’s health plan.

1,250 The employer portion of self-employment taxes are allowed as for AGI deduction

Note A: Qualifying education expenses are deductible up to a maximum of $4,000. Since the Johnson’s modified AGI of $125,738 (AGI without deducting education expenses) does not exceed $130,000, the Johnsons are allowed to deduct the lesser of their actual qualified expenditures of $3,100 or $4,000.

Solutions Manual – McGraw-Hill’s Taxation, by Spilker et al. 6-44

Education expenses 3,100 See Note A below Total for AGI deductions 132,362 AGI $122,638 AGI

h Alimony 5,000 Alimony allowed as for AGI deduction i IRA Deduction 5,000 Fully deductible since Alyssa did not participate in an employer retirement plan. i

70. Joe and Jessie are married and have one dependent child, Lizzie. Lizzie is currently in college at State University. Joe works as a design engineer for a manufacturing firm while Jessie runs a craft business from their home. Jessie’s craft business consists of making craft items for sale at craft shows that are held periodically at various locations. Jessie spends considerable time and effort on her craft business and it has been consistently profitable over the years. Joe and Jessie pay interest on a personal loan to pay for Lizzie’s college expenses (balance of $35,000).

Based on their estimates, determine Joe and Jessie’s AGI and complete page 1 of Form 1040. Assume the 2013 rules apply for purposes of the qualified education expense deduction and that the employer portion of the self-employment tax on Jessie’s income is $808. Joe and Jessie have summarized the income and expenses they expect to report this year as follows:

Solutions Manual – McGraw-Hill’s Taxation, by Spilker et al. 6-45

Income: Joe’s salary $ 119,100 Jessie’s craft sales 18,400 Interest from certificate of deposit 1,650 Interest from Treasury bond funds 727 Interest from municipal bond funds 920 Income from renting out their personal residence for 10 days during a local golf tournament 800 Expenditures: Social Security tax withheld from Joe’s wages 7,482 Cost of Jessie’s craft supplies 4,260 Postage for mailing crafts 145 Travel and lodging for craft shows 2,230 Meals during craft shows 670 Self-employment tax on Jessie’s craft income 1,615 College tuition paid for Lizzie 5,780 Interest on loans to pay Lizzie’s tuition 3,200 Lizzie’s room and board at college 12,620 Cleaning fees and advertising expense associated with renting their residence during local golf tournament 600