Fundamentals of Taxation 2016 Edition
9th Edition by Cruz ISBN 1259534820
9781259534829
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CHAPTER 8 – SOLUTIONS END OF CHAPTER MATERIAL
Discussion Questions
1. Can the owner of rental property be treated as conducting a trade or business with respect to the rental property? If so, what must the taxpayer do for it to be considered a trade or business?
Answer:
The taxpayer must differentiate between rental property and a trade or business involving rental property. Generally, if the taxpayer materially participates in the rental activity and provides significant services to the renter such as maid services, and is considered a real estate professional, then the rental activity should be reported on Schedule C as a trade or business. A taxpayer materially participates in the rental activity if he or she works on a regular, continuous, and substantial basis in the operation of the rental.
Learning Objective: 08-01
Topic: Rental Property Income and Expenses
Difficulty: 1 Easy
EA: No
2. For rental expenses to be deductible, what criteria must be met? For this question, assume no personal use of the rental property.
Answer:
Generally, the same rules apply for rental property as for business expenses – ordinary, necessary, and reasonable. Deductible expenses include advertising, depreciation, repair and maintenance, interest, taxes, management fees, and travel expenses. General repairs and maintenance are deductible from gross rental income. However, no deduction is allowed for amounts that are “capital improvements.”
Learning Objective: 08-01
Topic: Rental Property Income and Expenses
Difficulty: 1 Easy
EA: Yes
3. What is the difference between a deductible repair expense and a capital improvement of a rental property?
Answer:
Allowable repairs are expenditures that neither materially add to the value of the property nor appreciably prolong the property’s life. Any repairs in the nature of a replacement are capitalized and depreciated over the appropriate depreciable life. Repairs are allowed as an immediate expense deduction, but capital improvements are added to the value of the property and are depreciated over 27 ½ years (residential) or 39 years (nonresidential).
Learning Objective: 08-01
Topic: Rental Property Income and Expenses
Difficulty: 1 Easy
EA: Yes
4 When depreciation is deducted on a rental property, why is it beneficial for the taxpayer to allocate the cost of the property to other assets (furniture, appliances, etc.) connected with the property, rather than allocating the entire lump sum to the building itself?
Answer:
To accelerate the tax deduction, the taxpayer should allocate the purchase price to the structure and to furniture, appliances, carpet, as well as to shrubbery or fences. These assets are depreciated over 5 to 15 years. Without the allocation, the lump sum of the rental property is depreciated over 27 ½ (or 39 years), thus delaying depreciation.
Learning Objective: 08-01
Topic: Rental Property Income and Expenses
Difficulty: 2 Medium
EA: Yes
5. Can travel expenses to and from rental property be deducted? If so, what are the rules concerning the deductibility of travel, and how is the deduction calculated? (Hint: You may need to review Chapter 6 to help with this answer.)
Answer:
Travel costs from the taxpayer’s home to a rental property are deductible if the travel is for business purposes, for example, to conduct repairs or attend a condo association meeting. The standard mileage rate for business travel is used in calculating any travel expenses concerning rental property.
Learning Objective: 08-02
Topic: Personal Use of Rental Property
Difficulty: 1 Easy
EA: Yes
6 Les’s personal residence is in uptown New Orleans. Every year during Mardi Gras, Les rents his house for 10 days to a large corporation that uses it to entertain clients. How does Les treat the rental income? Explain.
Answer:
If a residence is rented for less than 15 days, the property is considered “primarily personal” property. When property is rented for less than 15 days, none of the rental income derived is included in gross income, and no deduction is allowed for rental expenses, other than the mortgage interest and property taxes that are usually allowed as itemized deductions.
Learning Objective: 08-02
Topic: Personal Use of Rental Property
Difficulty: 1 Easy
EA: Yes
7. Two methods are used to allocate expenses between personal and rental uses of property. Explain the Tax Court method and the IRS method. Which method is more beneficial to the taxpayer?
Answer:
The two methods used are the IRS method and the Tax Court method. Using the IRS method, expenses are allocated based on the ratio of total rental days to total days used. The rest of the expenses are allocated to personal use. Using the Tax Court method, interest and taxes are allocated by the ratio of total rental days to the days in the entire year (365 days if held for the full year). This method yields a smaller percentage of the interest and taxes
allocated to rental income. This allows a larger portion of other rental expenses to be used to offset rental income. The interest and taxes are deducted on Schedule A anyway. The Tax Court method is generally more beneficial to the taxpayer because less interest expense and real property taxes are allocated to the rental use which allows more of the remaining expenses to be deducted when the gross income limitation applies.
Learning Objective: 08-02
Topic: Personal Use of Rental Property
Difficulty: 2 Medium
EA: Yes
8. Discuss the three categories of vacation home rentals. Include in your discussion how personal use of the property affects the reporting of income and losses of vacation homes
Answer:
Vacation rental property can be classified as primarily rental use, primarily personal use, and personal/rental use. The category depends on the number of total rental days to total personal use days the rental property is used. When property is rented for less than 15 days, none of the rental income derived from the short rental period is included in gross income, and no deduction is allowed for rental expenses. If the property is used personally for more than the greater of 14 days or 10 percent of the number of rental days during the year and rented for 15 days or more, expenses are allowed only to the extent that there is income, disallowing losses. A property that is rented for 15 days or more and used personally for no more than the greater of 14 days or 10 percent of the total days the property is rented is considered primarily rental, and losses may be allowed subject to passive loss rules. Passive loss rules, without income limitations, allow losses from rental properties up to $25,000.
Learning Objective: 08-02
Topic: Personal Use of Rental Property
Difficulty: 2 Medium
EA: No
9. What is considered personal use of a vacation rental property?
Answer:
Personal use includes use of the property by the taxpayer (unless he is working on the property) or his family or non-family’s use of the rental property free of a rental charge. If any family member uses the rental property, the days are considered personal use days, even if they paid fair market value for the rental.
Learning Objective: 08-02
Topic: Personal Use of Rental Property
Difficulty: 1 Easy
EA: No
10. Jake has a vacation rental house at the beach. During the tax year, he and his immediate family used the house for 12 days for a personal vacation. Jake and his son spent two more weekends (4 days) repairing steps from the property to the beach. The beach house was rented for 100 days. How is the beach house categorized this year? Explain your answer.
Answer:
The house is categorized as primarily rental since the personal use of the property was 12 days. If rental property is used for no more than 14 days for personal purposes, it is considered “primarily rental” property. Days spent working on the house are not considered personal days.
Learning Objective: 08-02
Topic: Personal Use of Rental Property
Difficulty: 2 Medium
EA: No
11 Would your answer to Question 10 change if Jake also rented his house (at fair market value) to his brother and his family for 7 days?
Answer:
Yes, because then the property would be used for more than 15 days for personal use – to a total of 19 days. Rental by family members still counts as personal use even if it is rented for the fair market value.
Learning Objective: 08-02
Topic: Personal Use of Rental Property
Difficulty: 2 Medium
EA: No
12. What is royalty income, and which forms are used to report it? What factors determine which forms should be used?
Answer:
A royalty is a payment for the right to use intangible property. Royalties may be received from books, stories, plays, copyrights, trademarks, formulas, patents, and from the exploitation of natural resources such as coal, gas, or timber. When royalties are received, the payer is required to send the recipient a 1099-MISC. If the royalty is a result of a trade or business, the taxpayer should report the royalty on Schedule C. If the royalty income is produced by a non-trade or business activity (such as an investment) then the income should be reported on Schedule E.
Learning Objective: 08-03
Topic: Royalty Income
Difficulty: 2 Medium
EA: Yes
13 Briefly describe the types of income that are reported on a Schedule E
Answer:
Income and expenses associated with rental, royalty, and flow-through entities are the types of items known as “for the production of income” property and are reported on Schedule E of Form 1040. Income and expenses from rentals and royalties are reported in Part I of Schedule E, and certain items from flow-through entities such as partnerships, LLCs, S corporations, and estates and trusts, are reported in Part II and Part III of Schedule E.
Learning Objective: 08-01
Learning Objective: 08-02
Learning Objective: 08-03
Learning Objective: 08-04
Topic: Royalty Income
Difficulty: 2 Medium
EA: Yes
14. What is meant by the term flow-through entity? Give some examples.
Answer:
Flow-through entities are given this name because they do not pay income taxes. Instead, the net share of income or loss from the entities flows-through to the tax returns of its partners/shareholders/owners. These parties then pay the tax on their share of the flow-through entity’s income. Common flow-through entities are partnerships, S corporations, LLCs, estates, and trusts.
Learning Objective: 08-04
Topic: Flow-through Entity
Difficulty: 1 Easy
EA: No
15. How are the income and losses from a flow-through entity reported to the taxpayer (partner, shareholder or owner)? Are all of the items from the flow-through entity reported on the same form? Explain.
Answer:
The flow-through entity must supply each taxpayer a Schedule K-1, indicating the taxpayer’s share of income, expenses, or losses. The taxpayer’s share is then reported on various places on Form 1040. In the
case of a partnership, the K-1 reports the partner’s share of ordinary income from the partnership and other separately stated items.
Separately stated items are not included in the income or expenses of the partnership but are, instead, allocated separately to each of the partners.
Learning Objective: 08-04
Topic: Flow-through Entity
Difficulty: 1 Easy
EA: Yes
16. Why are the income and losses (or expenses) separately stated to the partner, shareholder or owner, and on what form(s) are they reported?
Answer:
Separately stated items are reported on the K-1. All items that can have different tax treatment for different types of partners are separately stated. For example, a corporate partner cannot deduct net capital losses, whereas an individual partner can deduct up to $3,000 of capital losses against ordinary income.
Learning Objective: 08-04
Topic: Flow-through Entity
Difficulty: 2 Medium
EA: No
17. Why are charitable contributions stated separately on the K-1 but not deducted on a partnership return?
Answer:
For most individual taxpayers, charitable deductions are limited to 50% of AGI. The limit occurs at the individual level and could result in a different outcome depending on the individual taxpayer’s tax situation.
Learning Objective: 08-04
Topic: Flow-through Entity
Difficulty: 2 Medium
EA: No
Multiple Choice
18. On August 1 of the current year, Jennifer and Tyler purchased a cabin for $950,000. Of that amount, $500,000 was for the land. How much depreciation deduction can Jennifer and Tyler take in the current year assuming that the cabin was rented starting on the purchase date? (You may need to refer to the depreciation tables in Chapter 6.)
a. $0.
b. $6,138.
c. $8,865
d. $16,364.
Answer: b
Feedback: ($950,000 - $500,000)=$450,000 x 1.364%=$6,138.
Learning Objective: 08-01
Topic: Rental Property Income and Expenses
Difficulty: 2 Medium
EA: Yes
19. Jermaine owns a rental home in Lake Tahoe and traveled there from his home in San Francisco for maintenance and repairs three times this year. The round trip from San Francisco to Lake Tahoe is approximately 167 miles. How much travel cost can Jermaine deduct for the current year related to the rental home in Lake Tahoe?
a. $0
b. $96.
c $288
d. $305.
Answer: c
Feedback: 167 miles x 3 x 57.5 cents = $288.
Learning Objective: 08-01
Topic: Rental Property Income and Expenses
Difficulty: 2 Medium
EA: Yes
20. Dennis receives $11,100 during the current tax year from Blanca for some office space in Anaheim, California. The rent covers eight months, from August 1 of the current year to March 31 of the following year. The amount also includes a security deposit of $1,500. How much should Dennis report as rental income in the current tax year?
a. $1,200.
b. $6,000.
c. $9,600
d. $11,100.
Answer: c
Feedback: $11,100 - $1,500 = $9,600.
Learning Objective: 08-01
Topic: Rental Property Income and Expenses
Difficulty: 2 Medium
EA: Yes
21. Ginny owns a house in northern Wisconsin that she rents for $1,600 per month. Ginny does not use the property personally. While she was in Europe for Christmas, the water heater on the property failed, and her tenants repaired it for $1,200. For the following month’s rent (January), her tenants paid her $400 for rent ($1,600 - $1,200). What amounts should Ginny include for rental income and repair expense, respectively, for January?
a. $400; $0.
b. $1,200; $400.
c. $1,600; $400
d. $1,600; $1,200.
Answer: d
Feedback: Report gross rent and all expenses.
Learning Objective: 08-01
Topic: Rental Property Income and Expenses
Difficulty: 2 Medium
EA: Yes
22. James owns a home in Lake Tahoe, Nevada, that he rented for $1,600 for two weeks during the summer. He lived there for a total of 120 days, and the rest of the year the house was vacant. The expenses for the home included $6,000 in mortgage interest, $900 in property taxes, $1,300 in maintenance and utilities, and $2,500 in depreciation. How much rental income from the Lake Tahoe home would James report for the current year?
a. $0
b. $567.
c. $1,600.
d. $9,100.
Answer: a
Feedback: $0 income is reported since the property is categorized as primarily personal.
Learning Objective: 08-02
Topic: Personal Use of Rental Property
Difficulty: 3 Hard
EA: Yes
23. Assume the same facts as Question 22, except that James rented the Lake Tahoe home for 40 days for $4,600. What is his net income or loss from the rental of his home (without considering the passive loss limitation)? Use the IRS method for allocation of expenses.
a. $0.
b. $1,925 net income
c. $4,600 net income.
d. $6,100 net loss
Answer: b
Feedback: $4,600 – [40/160($6,000+$900+$1,300+$2,500)] = $1,925 net income.
Learning Objective: 08-02
Topic: Personal Use of Rental Property
Difficulty: 3 Hard
EA: Yes
24. Which of the following items is not deductible as rental expense?
a. Advertising
b. Repairs and maintenance
Cruz et al. Fundamentals of Taxation 2016 8-10
© 2016 McGraw-Hill Education
c. New bathroom addition.
d. Insurance.
Answer: c
Feedback: New bathroom addition would be considered a capital improvement and therefore capitalized and depreciated and not deductible as rental expense.
Learning Objective: 08-02
Topic: Personal Use of Rental Property
Difficulty: 2 Medium
EA: Yes
25. Darren and Nikki own a cabin in Mammoth, California. During the year, they rented it for 45 days for $9,000 and used it for 12 days for personal use. The house remained vacant for the remainder of the year. The expenses for the house included $8,000 in mortgage interest, $2,000 in property taxes, $1,200 in utilities, $750 in maintenance, and $4,000 in depreciation. What is their net income or loss from their cabin rental (without considering the passive loss limitation)? Use the IRS method for allocation of expenses.
a. $0.
b. $3,592 net loss
c. $6,950 net loss.
d. $9,000 net income.
Answer: b
Feedback: $9,000 – [45/57($8,000+$2,000+$1,200+$750+$4,000)] =$3,592 net loss.
Learning Objective: 08-02
Topic: Personal Use of Rental Property
Difficulty: 3 Hard
EA: Yes
26. Sean and Jenny own a home in Boulder City, Nevada, near Lake Mead. During the year, they rented the house for 40 days for $3,000 and used it for personal use for 18 days. The house remained vacant for the remainder of the year. The expenses for the house included $14,000 in mortgage interest, $3,500 in property taxes, $1,100 in utilities, $1,300 in maintenance, and $10,900 in depreciation. What is the deductible net loss for the rental of their home (without considering the passive loss limitation)? Use the Tax Court method for allocation of expenses.
a. $0.
b. $388
c. $8,090.
d. $27,800.
Answer: a
Feedback: No net loss deduction is allowed for personal/rental properties.
Learning Objective: 08-02
Topic: Personal Use of Rental Property
Difficulty: 2 Medium
EA: Yes
27. Nicolette and Brady own a cabin in Lake Arrowhead, California that they rent out during the winter and use the rest of the year. The rental property is categorized as personal/rental property, and their personal use is determined to be 68% (based on the IRS method). They had the following income and expenses for the year (after allocation):
How much can Nicolette and Brady deduct for depreciation expense related to this property for this year on their tax return?
a. $0.
b. $1,000.
c. $4,300.
d. Answer cannot be determined.
Answer: b
Feedback: $9,500-$6,000-$2,500=$1,000; only $1,000 is left to offset depreciation expense since no loss is allowed for personal/rental properties.
Learning Objective: 08-02
Topic: Personal Use of Rental Property
Difficulty: 3 Hard
EA: Yes
28. Colin is a high school chemistry teacher who owns some land in Oklahoma that produces oil from its small oil reserve. On what schedule should Colin report the royalty income he receives?
a. Schedule A.
b. Schedule C.
c. Schedule E.
d. Schedule SE.
Answer: c
Feedback: Schedule E is used to report royalty income from investments.
Learning Objective: 08-03
Topic: Royalty Income
Difficulty: 1 Easy
EA: Yes
© 2016 McGraw-Hill
29. Sally is a full-time author and recently published her third mystery novel. The royalty income she receives from the publisher this year should be reported on what schedule?
a. Schedule E.
b. Schedule D
c. Schedule A.
d. Schedule C
Answer: d
Feedback: Schedule C is used to report income earned from a trade or a business.
Learning Objective: 08-03
Topic: Royalty Income
Difficulty: 1 Easy
EA: Yes
30. What is the maximum amount of passive losses from a rental activity that a taxpayer can deduct against active and portfolio income per year (assuming no passive loss limitation due to AGI or personal use of the property)?
a. $0.
b. $15,000.
c. $25,000.
d. $50,000.
Answer: c
Feedback: Passive losses from rental activity are limited to $25,000 per year before AGI limitations apply.
Learning Objective: 08-04
Topic: Flow-through Entity
Difficulty: 2 Medium
EA: No
31. Which of the following entity (ies) is (are) considered flow-through?
a. Partnership.
b. S Corporation
c. LLC.
d. All are considered flow-through entities.
Answer: d
Feedback: Partnership, limited liability company (LLC), S Corporations, and certain types of trusts and estates are considered flow-through entities.
Learning Objective: 08-04
Topic: Flow-through Entity
Difficulty: 2 Medium
EA: No
32 From which of the following flow-through entities is ordinary income (K-1) considered self-employment income?
a. Partnership.
b. S Corporation
c. Trusts.
d. Estates
Answer: a
Feedback: Ordinary income from partnerships is considered self-employment income.
Learning Objective: 08-04
Topic: Flow-through Entity
Difficulty: 2 Medium
EA: No
Problems
33 Ramone is a tax attorney and he owns an office building that he rents for $8,500/month. He is responsible for paying all taxes and expenses relating to the building’s operation and maintenance. Is Ramone engaged in the trade or business of renting real estate?
Answer:
No, the office building would be treated as rental property and not a trade or business. The general rule is that Ramone must materially participate in the rental activity and provide substantial services to the rental property. Additionally, Ramone must be considered a real estate professional if the activity is to be treated as a trade or business.
Learning Objective: 08-01
Topic: Rental Property Income and Expenses
Difficulty: 2 Medium
EA: No
34. Kelvin owns and lives in a duplex. He rents the other unit for $750 per month. He incurs the following expenses during the current year for the entire property:
How are the above income and expenses reported on Kelvin’s tax return? On what tax form(s) are these amounts reported? Answer:
Learning Objective: 08-01
Learning Objective: 08-02
Topic: Rental Property Income and Expenses
Difficulty: 3 Hard
EA: Yes
The $4,750 of personal expenses for taxes and interest is deductible as various itemized deductions (see Chapter 5). The other personal expenses are non-deductible. The rental loss of $1,650 is deductible subject to the passive loss rules (Chapter 13).
35. In the current year, Sandra rented her vacation home for 75 days, used it for personal use for 22 days, and left it vacant for the remainder of the year. Her income and expenses before allocation are as follows:
What is Sandra’s net income or loss from the rental of her vacation home? Use the Tax Court method.
Cruz et al. Fundamentals of Taxation 2016 8-15
© 2016 McGraw-Hill Education
Learning Objective: 08-02
Topic: Personal Use of Rental Property
Difficulty: 3 Hard
EA: Yes
36 Alice rented her personal residence for 13 days to summer vacationers for $4,500. She has AGI of $105,000, before the rental income. Related expenses for the year include the following:
Calculate the effect of the rental on Alice’s AGI. Explain your rationale, citing tax authority.
Answer:
Since the rental days are 14 days or less, none of the income and rental expenses are reported (IRC §280(A)(g)). Alice’s income remains unchanged at $105,000. The mortgage interest and property taxes are deductible on Schedule A as itemized deductions.
Learning Objective: 08-02
Topic: Personal Use of Rental Property
Difficulty: 3 Hard
EA: Yes
37. Matt and Marie own a vacation home at the beach. During the year, they rented the house for 42 days (6 weeks) at $890 per week and used it for personal use for 58 days. The total costs of maintaining the home are as follows:
a. What is the proper tax treatment of this information on their tax return using the Tax Court method?
b. Are there options available for how to allocate the expense between personal and rental use? Explain.
c. What is the proper tax treatment of the rental income and expenses if Matt and Marie rented the house for only 14 days?
Answer:
a. The proper tax treatment is to allocate the expenses between personal and rental expenses. Schedule E would show $0 net income for this property and remaining taxes and interest would be deducted on Schedule A.
b. The taxpayer can use the Tax Court method or the IRS method to allocate expenses. The Tax Court method allows for an overall larger deduction. However, the IRS has maintained it will continue to fight the Tax Court method.
c. In this case, the property would be primarily personal; and none of the income would be included and only the interest and taxes would be deductible on Schedule A.
Learning Objective: 08-02
Topic: Personal Use of Rental Property Difficulty: 3 Hard EA: Yes
38 Janet owns a home at the lake. She incurs the following expenses:
What is the proper treatment of these rental income and expenses in each of the following cases? Use the Tax Court allocation method, if applicable.
*For less than 15 days rental, there is no income or rental expense reported. Interest and taxes are deducted on Schedule A.
Learning Objective: 08-02
Topic: Personal Use of Rental Property
Difficulty: 3 Hard
EA: Yes
39. Randolph and Tammy own a second home. They spent 45 days there and rented it for 88 days at $150 per day during the year. The total costs relating to the home include the following:
What is the proper treatment of these items relating to the second home? Would you use the Tax Court allocation or the IRS allocation? Explain.
The IRS method produces the least amount of net rental income for Randolph and Tammy and would be the preferable allocation of expenses for them. Net rental income reported using the Tax Court method is $2,397 greater than they are under the IRS method. Itemized deductions however, are $2,397 greater under the Tax Court method.
Learning Objective: 08-02
Topic: Personal Use of Rental Property
Difficulty: 3 Hard
EA: Yes
40. Mabel, Loretta, and Margaret are equal partners in a local restaurant. The restaurant reports the following items for the current year:
Each partner receives a Schedule K-1 with one-third of the preceding items reported to her. How must each individual report these results on her Form 1040?
Net short-term capital loss ($56,000)
($157,000 - $213,000) x 1/3
Schedule D ($18,666)
The loss is netted against other short-term and long-term capital gains.
Learning Objective: 08-04
Topic: Flow-through Entity
Difficulty: 3 Hard
EA: Yes
41 Nicole and Mohammad (married taxpayers filing jointly) are equal owners in an S corporation. The company reported sales revenue of $450,000 and expenses of $310,000. The corporation also earned $20,000 in taxable interest and dividend income and had $15,000 investment interest expense. How are these amounts treated for tax purposes? Answer:
Interest and dividends of $20,000 are reported as interest and dividends separately on Schedule B, Form 1040. The investment interest expense is an itemized deduction on Schedule A.
Learning Objective: 08-04
Topic: Flow-through Entity
Difficulty: 2 Medium
EA: Yes
42 Dominique and Terrell are joint owners of a bookstore. The business operates as an S corporation. Dominique owns 65%, and Terrell owns 35%. The business has the following results in the current year:
How do Dominique and Terrell report these items for tax purposes?
Answer:
Learning Objective: 08-04
Topic: Flow-through Entity
Difficulty: 3 Hard
EA: Yes
43 Shirelle and Newman are each 50% partners of a business that operates as a partnership. The business reports the following results:
How do Shirelle and Newman report these items for tax purposes?
Learning Objective: 08-04
Topic: Flow-through Entity
Difficulty: 3 Hard
EA: Yes
Tax Return Problems
The solutions to the chapter tax return problems can be found on the online learning center: www.mhhe.com/cruz2016