Material current through July 2019 exam cycle

Income Tax Table of Contents

Lesson 1 Income tax law fundamentals / Tax compliance

– Tax law doctrines
– Filing requirements
– Penalties

Lesson 2 Income tax fundamentals and calculations

– Front of 1040 / Filing status / Gross income / AGI
– Back of 1040 / Standard deduction / Itemized deduction / Exemptions
– Qualified residence interest rules / Investment interest deduction / Casualty losses/Kiddie tax
– Self-employment tax / Entertainment / Tax credits

Lesson 3 Tax accounting

– Accounting methods / Investment sales/ Inventory methods
– Net operation loss (NOL)

Lesson 4 Characteristics and income taxation of business entities

Lesson 5 Income taxation of trusts and estates

– Grantor trusts (defective)
– Simple versus complex trusts
– Distributed net income (DNI)

Lesson 6 Basis / Depreciation / Cost recovery concepts

– Basis of gifts / Inheritances
– MACRS / Cost recovery deductions (CRD) / Section 179

Lesson 7 Tax consequences of like-kind exchanges/ Tax consequences of disposition of property

– Like-kind exchanges / Boot
– Capital gains and losses/ Sale of residence
– Depreciation recapture (1245 property)

Lesson 8 Alternative minimum tax (AMT)

Lesson 9 Passive activity / Tax implications of special circumstances

– Nonpublicly traded and publicly traded partnerships
– Real estate exceptions (active/rental)
– Divorce rules

Lesson 10 Charitable contributions and deductions

– Qualified entities / Deduction limitations
– Appreciated property

Income Tax Planning

 Material current through July 2019 exam cycle

Income tax law fundamentals / Tax compliance

Lesson 1 Income tax fundamentals
A. Types of authority
– Internal Revenue Code – primary source of all tax law
– Treasury regulations – a source for all tax law
– Revenue rulings and Revenue procedures – administrative interpretation / may be cited
as a precedent
– Congressional Committee reports – indicate the intent of Congress / may not be cited
as precedent
– Private letter rulings – apply to a specific taxpayer in a particular situation
– Judicial sources – court decisions interpret law and/or facts
Practice question
Which is the primary source of all tax law?
A. Treasury regulations D. Supreme Court decisions
B. Revenue rulings E. Internal Revenue Code
C. Private letter rulings
Answer: E Federal tax law means the Internal Revenue Code.
While Treasury regulations carry as great authority as
the government's explanation of the law in the code,
they are not laws in and of themselves.
Tax law doctrines (definition and examples)
Step transaction – Ignore the individual transactions and instead tax the
ultimate transaction
Example of step transaction
The XYZ corporation sells property to an unrelated purchaser who subsequently resells the
property to a wholly owned subsidiary of XYZ.

Sham transaction – This transaction lacks a business purpose, and

economic substance will be ignored for tax purposes.

Example of sham transaction

A sale by XYZ to ABC when both XYZ and ABC are owned by the same person.
Substance over form – The substance of a transaction and not merely its form
governs its tax consequences.
Example of substance over form
The president of XYZ has the company lend him money. There is no written loan agreement. He
never intends to repay the loan or take a salary. The loan is taxed to president.
Assignment of income – Income is taxed to the "tree that grows the fruit" although
it may be assigned to another prior to receipt.
Example of assignment of income
Mr. T owns XYZ, an S corporation. He directs that all income be paid to his son. Mr. T
reports no income. The income is taxed to Mr. T .

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Practice questions
Match the following doctrines to the situations below. Doctrines
may be used more than once or not at all. (Very difficult)
A. Step transaction D. Substance over form
B. Constructive receipt E. Assignment of interest
C. Assignment of income
1. ____ The IRS ignores legal formalities to determine the economic
outcome of a transaction.
2. ____ The transactions are so obviously interdependent that the
parties involved will not complete the first transaction
without anticipating that the whole series of transactions
will take place.
3. ____ A father (37% tax bracket) detaches negotiable interest
coupons from corporate bonds and gives the coupons to his
son. The son in 12% tax bracket collects the interest and
reports it on his own tax return.
4. ____ Pam has a life insurance policy with dividends accumulating
with interest. Pam leaves the dividends and interest in the
policy.
Answers: 1-D, 2-A, 3-C (very close to a gift transaction), 4-B

Hobby loss
Under hobby loss rules, income is reportable. The Tax Cuts and Jobs Act (TCJA)
eliminated miscellaneous itemized deductions and the opportunity to deduct hobby
related expenses. The tax law establishes a presumption that any activity generating net
income (profit) in three out of five consecutive years is a business (not a hobby). For
horses, profit is necessary in only two out of seven consecutive years.
Practice question
Dr. Johnson (salary $500,000) races stockcars on weekends. Each year
he earns about $30,000 from racing but has about $40,000 of related
expenses. Which of the following is true?
A. The $40,000 of expenses are deductible against personal income.
B. There must be a profit in three out of the last seven years to
be a business, not a hobby.
C. The $30,000 of income must be reported as miscellaneous taxable
income on the front of the 1040.

Answer: C The $30,000 of income is miscellaneous income.

B. Research sources
The major tax services are Federal Tax Coordinator published by the Research Institute
of America (RIA) and Federal Tax Service published by Commerce Clearing House
Incorporated (CCH).

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C. Filing requirements
Not every taxpayer who receives income must file an income tax return. There are five
basic categories of taxpayers who may be required to file.
– Individuals (U.S. citizens)
– Dependents
– Children under age 24 (the kiddie tax rules)
– Self employed
– Aliens
Practice question
Grady performs odd jobs for Tom Baker. Tom sends Grady a 1099 Misc.
form showing earned income of $500. If Grady has no other income,
does he have to file an income tax return?
A. Yes C. Maybe
B. No
Answer: A An individual is required to file if his net earnings
from self-employment are at least $400.
Dates for paying estimated taxes are April 15th (1), June 15th (+2), September 15th (+3),
and January 15th (+4). Later installments may be used to amend earlier ones.
Extension of time for filing individual tax returns is six months for filing (until October
15th). The form must show the full amount estimated as the tax for the year, but it need
not be accompanied by payment of the balance of the tax estimated to be due. An
individual is subject to penalty if additional payments are due.
The IRS checks every return for math errors. If a taxpayer makes a computation error
resulting in an underpayment of tax, the IRS sends a computation and a demand of any
balance due. (This does not entitle the taxpayer to go to tax court.)

Practice questions
1. A person wanting to file an amended return uses which of the
following forms?
A. 1040 C. 1040X E. 1040A
B. 1041 D. Schedule A
Answer: C The 1041 is for estates and trusts. The 1040A
used to report simple income (salaries, interest,
dividends etc.) has only certain adjustments to
income, doesn't itemize, etc.

D. Representation
Who can represent the taxpayer? Formally, a taxpayer may be represented by any
attorney, CPA, enrolled agent, enrolled actuary, or any other person permitted to
represent a taxpayer before the IRS. A CFP Certificant is generally not classified as an
audit representative.

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Practice question
Who can represent the taxpayer at an IRS audit?
I. Attorney IV. Enrolled actuary
II. CPA V. Any permissible designee
III. Enrolled agent
A. All of the above D. I, II
B. I, II, III, IV E. II, III, IV
C. I, II, IV

Answer: A

E. Penalties
Frivolous return -$5,000
A frivolous return is one that omits information necessary to determine the taxpayer's tax
liability, shows a substantially incorrect tax, or is based on the taxpayer's desire to
impede the collection of tax.
Negligence
The "accuracy-related" penalty is imposed if underpayment of tax is due either to
negligence or to disregard of rules or regulations but without intent to defraud.
The penalty is 20% of the underpayment attributed to negligence. Negligence includes
any failure to make a reasonable attempt to comply with the law or to exercise ordinary
and reasonable care in preparing a tax return, as well as failure to keep adequate books
and records or to substantiate items properly.
Fraud
Fraud indicates the intent to cheat the government by deliberately understating tax
liability. Fraud implies the systematic omission of substantial amounts of income from
the tax return or by the deduction of non-existent expenses or losses. The penalty is 75%
of the portion of a tax underpayment attributable to fraud.

NOTE: The CFP Board Examination is probably more interested in the penalty amount
rather than the definition of frivolous, negligence, or fraud.

Failure to pay: The penalty is .5% per month the tax is unpaid with a maximum of 25%.
Failure to file: The amount of the penalty is 5% of the tax due each month with a
maximum of 25%.

Example
The client owes $9,000 for the current year and does not have the money to pay the IRS. If she
files her return by April 15th and sends no money, the IRS will send a bill. If the client pays 3
months late, the bill would be $9,000 plus approximately $135 in late-payment fees and interest
(pay 3 x .5% = 1.5%).

But if the client delays filing until she can raise the money 3 months later, the bill
could be $9,000 plus approximately $1,350 (pay 5% x 3 = 15%).

NOTE: The best scenario is to file. The penalties for failure to pay and failure to file coordinate
with each other for the first five months, but both can be applied.

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Practice question
A taxpayer is faced with a tax deficiency of $10,000, along with an
interest deficiency of $4,200; the entire deficiency is the result of
fraud from the taxpayer's 2017 return. What is the amount of the
penalty?
A. $2,000 B. $2,840 C. $7,500 D. $10,650

Answer: C $10,000 x 75% = $7,500 (75% of the tax deficiency

only, not the interest deficiency)

Estimated tax
To avoid the penalty for 2019, pay the lesser of the following.
1. 90% of the current's year tax liability or
2. 100% of the prior year's liability (or 110% if the prior year’s adjusted gross
income exceeded $150,000)
Practice questions
1. Tony Carter filed a federal tax return on which he reported
self-employment income ($80,000) as dividends and crossed off
“penalty of perjury” language above the signature line. He will
be subject to which of the following penalties?
I. Frivolous return III. Fraud
II. Negligence IV. Estimated tax
A. I, II, IV D. I, III
B. I, IV E. II, III
C. I, II

Answer: D The crossing off of “penalty of perjury”

constitutes a frivolous return. It is also both
frivolous and fraud when he shows that self-
employment income is unearned-income (dividends).
Not enough information is given to determine
whether he will be responsible for an
estimated penalty.
2. Sara filed an extension on April 15. On June 1, she filed her
tax return and owed an additional $400 on a tax liability of
$4,100. Which of the following will apply?
A. Failure to file on a timely basis
B. Failure to pay the total amount due
C. No penalty because of prepayment of over 90% of liability
D. Penalty on $400
E. Penalty and interest on $400
Answer: C 90% of $4,100 is $3,690. She actually paid
$3,700. The $3,700 comes from the data given
($4,100 - $400). There is no failure to pay the
total amount due because she fulfilled the 90%
rule by paying slightly more than 90%. There is
no penalty, but interest may be due.

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3. A client has an AGI of $200,000. What choice does he or she have

to avoid the underpayment penalty?
A. To deposit 90% of last year’s estimated tax liability
B. To deposit 100% of last year’s estimated tax liability
C. To deposit 110% of last year’s tax liability
D. To deposit 110% of this year’s tax liability
Answer: C The AGI exceeds $150,000. The client’s best
choice is to deposit the lesser of 90% of this year’s
tax liability or 110% of last year’s.
Match the following amounts or percentages to the tax penalty.
Answers may be used more than once.
A. Fraud
B. Negligence
C. Frivolous return
1. _____ $5,000
2. _____ 20% of the underpayment
3. _____ 75% of the underpayment

Answers:
1. C
2. B
3. A

Practice questions: Case / Evaluation

1. Mr. Davis owns 100% of Davis, Inc. The business operates as an S
corporation. It is profitable. Mr. Davis took about $100,000 in
salary, but he will get another tax-related form from the
company, a K-1. He expects the K-1 to report an additional
$250,000 (unearned income from an S corporation). He expects
the additional taxes due will amount to $60,000 to $70,000.
What should he do?
A. Direct the K-1 to be shown in his son’s name. His son
is in college and needs the income.
B. Have the corporation file for an extension until September
15th.
C. Pay the tax when due
D. File for a personal extension and hope to come up with the
taxes due by October 15th

Answer: C If he does not file that will cost him 5% per

month with a maximum of 25%, whereas, as failure to
pay will only cost him .5% per month. Answer A is
“assignment of income”. Even if he does Answer B, his
estimate tax payment is due 4/15. So, Answer B and D
created the same problem, failure to pay.

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2. Bob Smith owns a small car repair shop. He is marginally

successful ($150,000 income – Schedule C). Since he is not busy
every day, he has 2 cars that he maintains for weekend racing at
the local raceway. Even after not expensing his time to work on
the cars through his business, he loses money each year. His
accountant lists his earnings from the races on the front of his
1040. He feels he never comes out ahead financially. What can
he do?
A. Tell the accountant to add the racing income and expenses
on his Schedule C.
B. Give racing up and concentrate on his business
C. Make more income from racing than expenses for 3 years
D. Start a separate business for racing.

Answer: C If he does Answer C the racing expense will

become a business expense (profit for 3 out of 5
years) and cease being a hobby. The auto racing is a
hobby not a business. His accountant will treat it as
such. Nothing indicates that Bob wishes to give up
racing. Answers A and D are not the answer because he
has a hobby.

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Income tax fundamentals and calculations

Income tax fundamentals and calculations

A. Filing status
Every individual who is either a citizen or permanent resident of the United States may
be required to file an income tax return. There are five filing statuses: Single, Married
filing separately, Head of household, Married filing jointly, and Qualifying widow(er).

Examples
Mr. and Mrs. Apple are legally separated and live apart. Mrs. Apple suspects Mr. Apple is
evading taxes. By filing separately, she should avoid any liability or IRS audits. She would
also avoid liability under the innocent spouse rules.
Mrs. Baker divorced Mr. Baker toward the end of the year. She maintains the principal
residence and provides more than 50% of her child’s support. She can file as head of household.
Mr. Carter's wife died this year. He maintains a home for his dependent child. He can file as
married filing jointly in the year she died and then as a qualifying widower for the two years
after her death as long as he had a qualifying child and does not remarry.

–
Gross Income

less adjustments/ above the line /for AGI

Adjusted Gross Income

less deductions/ below the line /from AGI

Taxable Income

times appropriate tax rates

Taxable Calculation

less credits plus other taxes

Tax Liability

less quarterly payments and witholding

Net Tax Due/Refund

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B. Gross income (Top front of 1040)

1) Inclusions
– Ordinary dividends - Schedule B – Wages, salaries, tips
– Taxable interest – Schedule B – IRA distributions
– Business income (and losses) – Schedule C – Pensions and annuities
– Capital gains (and losses) – Schedule D – Certain alimony received
– Real estate - Schedule E – Unemployment income
– Punitive damages (except wrongful death) – Taxable Social Security

2) Exclusions
– Gifts – Municipal bond income
– Inheritances – Workers' compensation payments
– Child support – Compensatory damages
Practice questions
1. Jeff Munroe (annual salary of $40,000) had the following
financial events during the current tax year.
• received a $100,000 inheritance due to the
death of his brother
• received qualified dividends of $2,000
• had a Schedule C loss of $10,000 (assume material
participation)
What is Jeff's total (gross) income for the current tax year?
A. $30,000 D. $140,000
B. $32,000 E. $142,000
C. $42,000

Answer: B The $40,000 salary is reduced by the $10,000

Schedule C loss.
NOTE: Qualified dividends are treated for AGI
purposes the same as ordinary dividends, but they
are taxed differently. The same applies to
LTCGs.

2. Which of the following may be excluded from income?

A. Private purpose municipal bond interest
B. RMDs from a pension plan
C. Qualifying dividends
D. Schedule C net income

Answer: A Private purpose muni bond income is always

excluded from income but it is subject to AMT.
RMDs are required minimum distributions.
Schedule C income is business income.

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3. Your son, Jeff (age 18), is beginning college this year. He

receives a full scholarship of $20,000. He plans to use $12,000
for tuition, $1,000 for books, and the remainder towards the
cost of room and board. Which of the following is true?
A. He can no longer be claimed as a dependent.
B. $12,000 will be excluded from income.
C. $7,000 will be additional taxable income to you.
D. $7,000 will be taxable income to Jeff.
E. $8,000 will be taxable income to Jeff.

Answer: D Scholarships for tuition and books are excluded

from income, but portions attributable to room
and board is taxable income. Because the
scholarship is paid to Jeff, it is income to him
[$20,000 – ($12,000 + $1,000)]. He will get a
standard deduction.

Fringe benefits – tax free

– Premiums your employer pays to a health plan for you, your spouse, or your
dependents
– Insurance premiums your employer pays on a group life policy of up to $50,000 on
your life
– Company car for business purposes
– Commuter highway vehicle and transit pass ($265/month cap – 2019)
– The employee may exclude up to $5,000 paid or incurred by the employer for
dependent care assistance provided during a tax year ($2,500 married filing separately)
– An exclusion from gross income for employer – provided education assistance in an
aggregate amount of up to $5,250 per year.
– An exclusion from gross income for employer – assistance programs (and the adoption
credit) for qualified adoption expenses of amounts up to $10,000.
– Employer-provided parking spots or subsidized parking ($265/month cap - 2019)
– Value of discounts on company products if it does not exceed the employer's gross
profit percentage
– Occasional overtime meal money, cab fare, theater or sporting event tickets
– Discounts on services are limited to 20% of the selling price charged customers

Fringe benefits – taxable

– Health insurance premiums paid for self-employed, partners, and more than 2% owners
of an S corporation are taxable income. 100% is deductible as an adjustment to income
on the front of the 1040 to the extent that such costs do not exceed the net income from
the business (for self-employment). This can include all types of health insurance
programs like medical, dental, and long-term care. Be careful. This area is heavily
tested.
– Insurance premiums your employer pays on a group life policy in excess of $50,000 of
death benefit if the plan is nondiscriminatory are taxable (per Table I).

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Practice question
Dr. Hill (a dentist) has given you a list of employee benefits he is
considering. Which of the following can he provide tax-free to his
employees?
I. $220 per month for parking (Office is in a downtown building.)
II. Occasional theater tickets
III. 50% off on dental work
IV. $100,000 group life
V. Group disability insurance premiums for benefits of up to 50% of
salary
A. I, II, IV, V C. II, III E. V
B. I, II, V D. III, V
Answer: B The IRS says the excludable amount with respect to
services is limited to 20% of the price at which the
employer offers services to nonemployee customers.
The group disability benefits would be taxable.
C. Adjustments (Bottom front of 1040)
The second step in the 1040 calculation is determining adjusted gross income. AGI is
total income (or gross income) less adjustments to income. The main adjustments or
deductions to income are the following.
– IRA contributions* – 100% self-employment health insurance*
– Student loan interest – Keogh or SEP*
– Medical savings account (MSA) – Penalty for early withdrawal of savings
– Moving expenses (active military only) – Health saving account (HSA)
– Self-employment tax (.07065)* – Certain alimony paid **
– $4,000 educational expense (AGI limits apply)
(Alternative to American Opportunity Credit)

* Important deductions
The .07065 is the factor for the adjustment to gross income. The factor is ½ of the self-
employment tax. The factor calculation is 7.65% x .9235 (1-7.65%) or ½ of 14.13%.
The 14.13% is the self-employment tax rate.

** Alimony is generally non-deductible for divorces settled after December 31, 2018.
Practice questions
1. Bob has paid $5,000 of student loan interest. He is eligible to
itemize deductions. How much of the loan interest can he deduct?
A. Consumer interest is no longer deductible.
B. $5,000 can be deducted as interest paid on the Schedule A.
C. $2,500 of interest paid may be deducted as an above-the-
line deduction.
D. $3,000 of interest paid may be deducted on the Schedule D.

Answer: C Qualifying individuals may claim an above-the-line

deduction (adjustment to income – limited to $2,500)
on the front of Form 1040. Even if you don’t know the
dollar amount, you should know that it is deductible
on the front of the 1040. That is what is important.

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2. Alice is a single mother with three children. She has provided

you with the following information.
Salary $80,000
Qualified Dividends $ 4,000
Long-term capital gains $10,000
Short-term capital losses $ 5,000
IRA contribution $ 5,000
Municipal bond interest $ 3,000
Based on the data given, what is Alice’s adjusted gross income?
A. $80,000 C. $85,000
B. $84,000 D. $88,000

Answer: B Salary $80,000

Dividends $ 4,000*
Net capital gains $ 5,000*
IRA contribution -$ 5,000 **
AGI $84,000
* Although taxed differently, they are still part of AGI.
* It doesn’t indicate she is an active participant in a
workplace retirement plan. There is no phase out.

3. Richard and Susan have provided you with the following data.
– Salaries $670,000 – Municipal interest $ 8,000
– Capital gains $ 8,000 – Alimony paid $60,000
– Qualified Dividends $ 4,000 – Keogh contribution $80,000
– Interest $ 12,000 (Defined Benefit Plan)
– Self-employment tax AGI deduction $ 20,000**
Richard started paying alimony to his ex-wife in 2014. Based on
the information given, what is Richard and Susan's adjusted
gross income?
A. $534,000 C. $554,000
B. $544,000 D. $694,000
Answer: A Salaries $670,000
Capital gains 8,000*
Dividends 4,000*
Interest 12,000
Total income $694,000
Alimony Paid - 60,000
Keogh - 80,000
Self-employment tax - 20,000
AGI $534,000
* Although taxed differently, they are still part of AGI.

Deductions on the front page of the 1040 are "deductions for AGI," or above-
the-line deductions. As we go to the back of the 1040, these deductions are called
"deductions from AGI" or below-the-line deductions.
AGI Front of 1040 - deductions for AGI / above-the-line
Back of 1040 - deductions from AGI / below-the-line

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D. Standard / itemized deductions (2019)

The AGI is reduced by the greater of the standard deduction or allowable itemized
deductions. Standard deductions will be given. You should not memorize.
Single $12,200 Head of household $18,350
Married filing jointly $24,400* Elderly or blind $1,300**
Married filing separately $12,200* Child unearned $1,100
* The standard deduction for a married couple filing a joint return is twice the basic
standard deduction for an unmarried individual filing a single return or married filing
separately.
** The extra standard deduction for each spouse married filing jointly age 65 or older or
blind is $1,300, and it is $1,650 for single. Blindness has no age requirement.
Example
Tom, age 68, is married to Sara, age 63. Sara is blind. What is their standard deduction for
2019? Married filing jointly $24,400
Tom (68) 1,300
Sara (blind) 1,300
$27,000
Practice question
What is the standard deduction (2019) for a married couple who are
both over age 65 and the husband is blind?
A. $24,400 C. $27,000
B. $25,700 D. $28,300
Answer: D A married couple who are both over 65 receives $24,400
plus an additional $1,300 (per spouse) and $1,300
blind standard deduction.
1) Itemized deductions (2019) (Schedule A)
– Medical, dental, & qualified LTC expenses (>10% ) – Home mortgage interest
– State and local; sales tax (limited)* – Charitable gifts
– Personal property tax (limited)* – Investment interest
– Real estate taxes (limited)* – Casualty losses**
– Mortgage insurance qualified residence (<$100,000 AGI)

*State, local, sales, real estate and personal property taxes limited to $10,000.
**Must be from a federally declared disaster area

2) Itemized deduction limitations (repealed)

The 2017 Tax Act repeals phaseout of itemized deductions through tax year 2025.

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Practice question
Which of the following are deductions for calculating taxable income?
I. Capital losses IV. Home mortgage interest
II. IRA contributions V. Personal property taxes
III. Alimony paid (divorced 2015)

A. I, II, III, IV, V C. III, IV

B. II, III, V D. IV
Answer: A All items shown are deductible on some part of the
1040 (front and back) to calculate taxable income.
It is not asking about AGI.
Qualified residence interest rules
After December 15, 2017, if the proceeds of a mortgage loan are used to buy, build, or
improve a taxpayer’s home and these mortgages combined with any others taken out total
more than $750,000 ($375,000 if married filing separately), only interest paid on the first
$750,000 is deductible. The $750,000 includes principle mortgage and up to $100,000 of
a home equity loan. Primary mortgages up to $1M taken out before 12/15/17 are
grandfathered.

Unless the proceeds of such mortgage loans are used for purposes other than buying,
building, or improving the taxpayer's home the TCJA suspends the deduction for such
interest through 2025. For a home equity loan to qualify for deduction, it must be used
for acquiring, constructing or improving your primary residence and be secured by your
home.

Examples of this type of mortgage loan not qualifying for the mortgage deduction:
-- a refinanced mortgage loan where the amount borrowed exceeds the amount of debt
immediately prior to the refinancing and
-- a home equity loan used to pay off credit card bills, buy a car, or pay tuition
Investment interest deduction
Investment interest is interest paid on indebtedness for property held for investment
(example: margin account interest). The maximum deduction allowed for interest
incurred on investment indebtedness is limited to the taxpayer's net investment income.
Ordinary dividends/qualified dividends
Qualified dividends as defined by the code are ordinary dividends taxed at the lower
long-term capital gains rate rather than at the higher rate for an individual’s ordinary
income tax bracket.

What qualifies as investment income?

Investment income includes interest, dividends, royalties, and short-term gains. A
qualified dividend will qualify as investment income only if the taxpayer elects not to use
the reduced tax rates (uses ordinary income rates). This means the dividend will have to
be treated as ordinary income. Long-term gains are included only if the taxpayer elects
out of long-term rates. In other words, the investor must elect out of qualifying rates (0%,
15% or 20%). Instead, the taxpayer elects short-term capital gains treatment. NOTE:
Unless it says qualified dividend, treat it as an ordinary dividend.

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Example
Tom has a $50,000 AGI. Over the course of the year, he is assessed margin interest of
$30,000. Tom earns $20,000 in dividends (treated as ordinary income) and $5,000 in
interest. How much margin interest can he deduct?
Up to net investment income – $25,000 (Dividend can count as investment income.)
What happens to $5,000 difference? It is carried forward forever until used.
Practice questions
1. Mr. and Mrs. Apple have active income of $100,000. They have
portfolio income of $5,000 (interest), $7,500 (qualified
dividends), and $22,500 (short-term gains). They have been
margining their portfolio and have incurred $40,000 of
investment interest expense. How much can they deduct?
A. $12,500 C. $27,500
B. $22,500 D. $30,000

Answer: C Nothing indicates that the dividends will be

treated as ordinary income. Thus, the $7,500
does not count as investment income. The
difference, $12,500 ($40,000 - $27,500), will be
carried forward.

2. Tommy, a CPA, has $60,000 of earned income, $2,000 of interest

from CDs, long-term capital gains of $3,000, and $4,000 of
margin interest. How much of the margin interest is deductible?
A. -0- C. $3,000 E. $5,000
B. $2,000 D. $4,000
Answer: B $2,000 (from his CDs) unless the question says he
“opted out” of long-term capital gains treatment.
Then the answer becomes $4,000.

Prior to the enactment of the 2017 Tax Cuts and Jobs Act, the investment interest deduction had to be
reduced by amounts of deductible investment advisor fees. The TCJA suspend itemized miscellaneous
deductions which included investment advisor fees.

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 Material current through July 2019 exam cycle

Practice Questions
1. You are Barbara’s registered representative. Your firm has
given her two bills.
– $5,000 for margin interest
– $8,000 for investment adviser fees
She asks you how much investment interest she can deduct. You
ask her for additional information. She responds by saying she
has the following.
– $150,000 of earned income
– $ 5,000 of commissions paid to your firm
– $ 10,000 of short-term gains on the margin account
What will be your answer if she has an AGI of $155,000?

A. She can deduct $5,000 of margin interest and $8,000 of

investment adviser fees.
B. She can deduct $1,900 of margin interest, $5,000 of
commissions, and $4,900 of investment adviser fees.
C. She can deduct $5,000 of commissions and $8,000 of
investment adviser fees.
D. She can deduct $5,000 of margin interest. However, the
advisor fees are not deductible.

Answer: D Commissions are not deductible. They affect the

basis of the stock bought and sold. They are
reflected in the short-term gains. She can also
deduct $5,000 of margin interest on Schedule A
because her net investment income is $10,000 in
STCG (greater than $5,000 of margin interest).

Investment income (short-term gains) $10,000

4. Can you buy municipal bonds on margin and claim an investment

interest deduction?
A. Yes, if you itemize
B. Yes, if you have net investment income
C. No
D. Maybe

Answer: C No deduction is allowed for interest paid on debt

incurred in order to purchase or carry tax-exempt
bonds.

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Casualty and theft losses (Schedule A)

Under the Jobs Act casualty loss deductions may only be claimed for unreimbursed losses from a
presidentially declared “national disaster.” A casualty is the complete or partial destruction of
property resulting from an identifiable event of a sudden, unexpected, or unusual nature - not
termite damage. Progressive deterioration of a steadily used piece of property isn't a casualty.
Fire, hurricane and earthquake are now examples of casualty and theft losses. A casualty or theft
loss is reduced by any insurance proceeds received by the owner. Thus, only the un-reimbursed
loss is deductible. This is true only if a timely insurance claim is filed for the loss presuming that
they have insurance. Furthermore, the loss attributable to each casualty or theft is reduced by a
$100 floor. Finally, only the aggregate loss in excess of 10% of AGI is deductible. The
calculation of a deductible loss is done as follows.

Calculation of a deductible loss

First: Use the lesser of basis or FMV
Second: Subtract any insurance coverage
Third: Subtract $100 (floor)
Fourth: Subtract 10% of AGI

Miscellaneous deductions (Schedule A) (repealed)

All itemized miscellaneous deductions are suspended from tax years 2018 through 2025.

Home office deduction for employees (suspended)

Before the TCJA, an employee could claim a home office deduction as an itemized
miscellaneous deduction. The Act has suspended such deductions. However, you can
deduct home office expenses if you are self-employed and meet the qualifying rules.
To deduct home office expenses if self-employed, a taxpayer must prove that you use the
home area exclusively and on a regular basis.
– The home office must be used by the taxpayer to conduct administrative or
management activities of a trade or business, and
– there must be no other fixed location of the trade or business where the taxpayer
conducts substantial administrative or management activities of the trade or business.

Gross income limit

The deduction is limited to the gross income derived from the activity reduced by all
other deductible expenses. However, statutory employees, such as a full-time life
insurance sales person, and self-employed individuals can claim their allowable home
office deductions on Schedule C.
Example
Cathy Adams, self-employed, operates her business from her home. Her gross income is
$50,000. Expenses associated with her business are $45,000. If she has $10,000 of home
expenses, then she can deduct only $5,000. An office in a home cannot create a loss.

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Additional example
Loretta Swit, self-employed, meets the requirement for deducting expenses for business use of
her home. She uses her home office for her business. Below are the facts.
Gross income from the business $20,000
Business supplies, phones, etc. $12,000
Depreciation, home maintenance, etc. $10,000 (attributable to business use)
How much of depreciation, home maintenance can she deduct?

Answer: $8,000. You cannot create a loss with a home-office deduction.

($20,000 - $12,000) = $8,000

Practice question
1. Mr. and Mrs. Jacob have the following miscellaneous expenses.
Fee to their investment counselor $10,000
Tax preparation fee $ 2,000
Safety-deposit box $ 200
Educational costs (for job) $ 5,000
They have an AGI of $100,000. What is the amount of deductible
miscellaneous expenses?
A. $0 C. $15,200
B. $13,200 D. $21,200
Answer: A For 2018 forward, miscellaneous deductions are
repealed.
Meals and Entertainment Expense
The Tax Cuts and Jobs Act allows for stricter limits on the deductibility of business meals and
entertainment expenses. Under the Act, entertainment expenses incurred or paid after December 31,
2017 are nondeductible unless they fall under the specific exception. Meals for entertaining clients and
wooing prospects may be deductible if business is conducted, the taxpayer is present and such meals are
not “lavish or extravagant.”

However, one noteworthy exception is for “expenses for recreation, social, or similar activities primarily
for the benefit of the taxpayers employees, other than highly compensated employees” (i.e. office parties
are still deductible). Business meals provided for the convenience of the employer are now only 50%
deductible whereas before the Act they were fully deductible. Meals for employees while traveling are
deductible at 50%.

Tickets to sporting and cultural events are no longer deductible after 2017.

The TCJA regards this as a permanent change.

E. Personal and dependency exemptions (suspended)

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Practice questions
1. How many exemptions may a married couple, who are both age 65,
claim?
A. 0 B. 2 C. 4
Answer: A Personal exemptions are suspended after 2017.
2. Mr. Samuels, age 65, and Mrs. Samuels, age 63, have no dependent
children. Mrs. Samuels is blind. How many exemptions do they
get?
A. 0 C. 4
B. 3 D. 5
Answer: A Personal exemptions are suspended after 2017.
E. Tax liability
1) Rate schedule – Do not memorize schedules as they will be given.
The tax liability on individual taxable income is computed under a rate schedule
determined by the taxpayer’s filing status. The 2018 schedules are as follows.
Single Married (JT) Heads of
Households
The 10% rate begins for the $0 $0 $0
following amounts.
The 12% rate begins for the $9,700 $19,400 $13,850
following amounts.
The 22% rate begins for the $39.475 $78,950 $52,850
following amounts.
The 24% rate is effective for $84,200 $168,400 $84,200
incomes exceeding.
The 32% rate is effective for $160,725 $321,450 $160,700
incomes exceeding.
The 35% rate is effective for $204,100 $408,200 $204,100
incomes exceeding.
The 37% is effective for incomes $510,300 $612,350 $510,300
exceeding.
Marginal tax rate
The marginal tax rate is the percentage applying to the last dollar of taxable income. We
do not believe that all the percentages will be tested.

Other US Tax Changes Effective January 1, 2013

Effective January 1, 2013, the Medicare tax rate applicable to wages in excess of $200,000 ($250,000
for married individuals filing jointly; $125,000 for married individuals filing separately) will increase to
2.35% (1.45% + .9%). Employers are required to withhold and report Medicare tax at the 2.35% rate on
all wages over $200,000 with respect to their employees. The Medicare tax on wages of $200,000 or less
will remain at the 1.45% rate.

Also effective January 1, 2013, an additional 3.8% Medicare tax (in addition to the capital gain rates
already in effect, see above) will be applied to investment income for taxpayers with annual income of
more than $200,000 or $250,000 for joint filers.

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 Material current through July 2019 exam cycle

Examples
Mr. Pete, single, has taxable income of $250,000. What is his marginal tax bracket ? 35%
Paul and Joan, married and filing jointly, have taxable income of $110,000. What is their
marginal tax bracket? 22%

NOTE: If CFP Board tested, tax tables will be given.

Qualifying Dividends and Long Term Capital Gains (2019)

Use 0% if the taxpayer is in the 0-12% bracket. Use 15% if taxpayer in the 22%-35%
bracket (up to $488,850 MFJ). Use 20% when the taxpayer is in the 35%-37% bracket
(over $488,850 MFJ) Use same rates for LTCGs.

2019 Trust Rates on Qualified Dividends & Long-Term Capital Gains

$0 to $2,650 0%
$2,650 to $12,950 15%
$12,950 and over 20%

2) Kiddie tax
The 1986 tax act includes several provisions designed to discourage the shifting of
income to lower-bracket taxpayers as a tax-avoidance technique. One of these is the so-
called kiddie tax.
Accordingly, all net unearned income of a child who has not attained age 18 (or age 24 if
a student) and who has at least one parent alive is taxed at the highly compressed
fiduciary rates. This applies to all net unearned income, regardless of the source of the
assets creating the income or the date the income-producing property was transferred.
However, children under age 18 are entitled (2019) to a standard deduction amount
($1,100), and an additional $1,100 of unearned income will be taxed at the child’s
marginal rate (10% - $110). Unearned income in excess of $2,200 is the child’s “net
unearned income.”

Child 18 and older

The Small Business and Work Opportunity Act (5/12/07) further expands the kiddie tax
to reach certain children up to age 23. The new law does not change the kiddie tax rules
for all children under age 18. However, it does expand the kiddie tax rules to apply in
the following circumstances.
– Where the child turns 18 or turns 19-23 if a full-time student before the end of the tax
year
– Where the child has earned income for the tax year of one-half or less of his or her
support
– Where the child has a certain amount of unearned income ($2,200 in 2019) and
– Where the child has at least one living parent at the end of the tax year

The parents’ marginal income tax rate is no longer factored into the Kiddie Tax. Instead,
investment earnings in excess of $2,200 will be taxed at the (fiduciary) rates that apply to
trusts and estates. The applicable threshold of $2,200 on the child’s investment income is
still in effect. This means that the child’s investment income will be subject to the Kiddie

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 Material current through July 2019 exam cycle

Tax for investment income only in excess of $2,200. The fiduciary tax rates on ordinary
income for 2019 are:

Up to $2,600 10%
$2,600 to $9,300 24%
$9,300 to $12,750 35%
Over $12,750 37%

Practice questions
1. Mr. and Mrs. Baker transfer $20,000 to their granddaughter. The
Bakers are in a 35% marginal tax bracket. Their granddaughter,
Bess age 9, receives $4,200 of unearned income from the
securities. Bess’s parents’ marginal tax bracket is 24%. What
is Bess’s tax liability?
A. $110.00 C. $665.00
B. $310.00 D. $840.00

Answer: B Income $4,100

less standard deduction -1,100
less taxed at her rate -1,100 @ 10% = $
110.00
remainder $2,000 @ 10% = 200.00
Bess’s tax liability $ 310.00
This is an income tax question, not a gift tax question. There
is no taxable gift. They can give $15,000 each (split gift).

2. Mr. Ulmerton, with his wife’s consent, transfers $28,000 to his

grandson’s UTMA account. Mr. Ulmerton is the custodian of the
account. Mr. Ulmerton likes to trade stocks. At year-end, he has
generated $1,500 of short-term capital gains. What is his
grandson’s tax liability?
A. Grandson has no tax liability because his grandfather is
responsible for the tax.
B. Since we do not know the grandfather’s marginal tax bracket,
there is no solution.
C. Since we do not know the parent’s marginal tax bracket,
there is no solution.
D. $40.00
E. $1,500.00

Answer: D As long as the gain is short-term gain (ordinary

income) and the gain is less than $2,200, the tax
is 10% of $400 ($1,500 - $1,100). It is not
necessary to know the trust tax rate. This is
only true if the grandson had unearned income
under $2,200.

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 Material current through July 2019 exam cycle

3. Mr. and Mrs. P (in a 35% tax bracket) want to gift to their only
child, Sara. Sara is age 17. She has an UTMA account. The
UTMA already has $350 of unearned income. Mr. and Mrs. P want
to gift 2,000 shares of stock they bought for $5. The stock has
a value of $22 per share. The stock is yielding 6%. What would
you recommend?
A. Give 1,000 shares by 12/31 and 1,000 shares on January 2nd
of next year
B. Give 2,000 shares this year
C. Give 1,000 shares on January 2nd of next year and then
another 1,000 shares the following year
D. Wait until Sara goes to college

Answer: A If they gift 1,000 shares at $22 per share, the

$22,000 will pay $1,320 of income. There should
be no kiddie tax this year.

Calculation of the standard deduction for a child with both earned and unearned income
Life gets more complicated when the child has both earned and unearned income.
The standard deduction is the greater of $1,100 unearned income or earned income plus
$350 but no more than the single person standard deduction ($12,200 – 2019).
Examples
Jackie, age 15, has earned income of $250 and interest income of $500. She would elect the
standard deduction of $1,100 (unearned). Her earned deduction is $600 ($250 + $350).
Jackie, age 15, has earned income of $2,000 and interest income of $500. Her standard
deduction (earned) is $2,350 ($2,000 + $350) whereas her standard deduction (unearned) is
only $1,100.

Practice questions
1. Johnny Thornton, age 12, has interest and dividend income of
$800. He also has earned income of $4,350 from a paper route and
odd jobs. Johnny is eligible to be claimed as a dependent on
his parents’ return. What is the amount of Johnny’s standard
deduction for 2019?
A. $1,050 C. $4,700 E. $24,400
B. $4,350 D. $12,200

Answer: C The dependent standard deduction is the greater

of the limited deduction of $1,100 or the amount
of earned income ($4,350 plus $350), not to
exceed the full standard deduction amount of
$12,200.

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 Material current through July 2019 exam cycle

2. Jenny is an enterprising young girl (age 13). Her babysitting

service will generate $2,000 this year. She has her prior
earnings ($5,000) invested in a convertible bond fund that will
generate 5% interest and 6% capital gains this year. How much of
her income is taxable?
A. $200 C. $300
B. $250 D. $550
Answer: AThe question is asking about the amount subject
to tax, not the amount of tax.
Total unearned $ 550 *
Earned income +2,000
$2,550
Less standard deduction -2,350 (earned)
Taxable income $ 200
NOTE: When a child has both earned and unearned income, the CFP
Board Examination may ask you to calculate the taxable income
but not the tax. The tax calculation is too difficult.
*5% of $5,000 = $250, and 6% of $5,000 = $300 or a total of $550

3) Self-employment tax
Self-employed persons pay Social Security and Medicare taxes for themselves as part of
their income tax. This self-employment tax is based on net earnings from self-
employment, not on taxable income. Self-employment income doesn’t include the
following.
– Dividends or interest on investments
– Gains (or deductions for losses) from property, securities, or commodities
– Real estate income or rents paid
– Distributive share of income or loss of a limited partner
– Wages from an S corporation
– Distributions (K-1 income) from an S corporation
Self-employment income does include the following.
– Net schedule C income – Board of directors fees
– General partnership income (K-1 income) – Part-time earnings (1099)
Practice question
Which of the following person and/or income is/are subject to self-
employment tax?
I. Wages from an S corporation
II. K-1 distributions from an S corporation
III. K-1 distributions from a general partnership
IV. Board of directors fees
A. All of the above C. III, IV E. IV
B. II, III, IV D. I, II
Answer: C Any distribution from an S corporations is not self-
employed income.

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 Material current through July 2019 exam cycle

Calculation – keys for year 2019

The taxable wage base given in test questions will not exceed $132,900. If you added up
the self-employment income and it exceeded $132,900, you did something wrong.
Why? The calculation above $132,900 is for Medicare only.
Follow these steps:
– 1st calculate the total self-employment income
– 2nd subtract 7.65% or multiply by .9235 (1 - .0765)
– 3rd multiply remainder by 15.3% (7.65% + 7.65%)
Recommended Shortcut – combine steps two and three by multiplying step one by .1413
and round up.
Practice questions
1. Michelle has the following income:
– Net Schedule C income of $40,000
– Travel and entertainment expenses of $10,000
– K-1 income from a general partnership of $5,858
– K-1 income from an S corporation of $20,000 (distributed)
What amount of self-employment tax must Michelle pay?
A. $3,240 C. $6,480 E. $9,305
B. $5,632 D. $7,016
Answer: C $45,858 x .9235 x 15.3% = $6,479.53 or
Shortcut $45,858 x .1413 = $6,479.73
The question says net Schedule C that means the
travel and entertainment has already been
deducted. This is only true to $132,900. There
should be no questions with income exceeding
$132,900.

NOTE: Then subtracting ½ on the front of the 1040 will work this
year.
The 1040 subtraction is as follows.
45,858 x .9235 x .0765 = $3,239.76 or
45,858 x ½ (.1413) = $3,239.86 or $45,858 x. 07065(1/2 of .1413)

2. Mel has the following income:

– Net schedule C income $50,000
– K-1 income from a general partnership $20,000
– K-1 income from a S corporation $15,000
– Interest $ 2,000
– Dividends $ 3,000
What amount of self-employment tax must Mel pay?
A. $8,596 C. $10,710
B. $9,891 D. $12,010
Answer: B Shortcut $70,000 x .1413 = $9,891

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3. What happens to the $9,891 of self-employment tax?

Answer: It is added as an additional tax due. Then ½ is

subtracted on the front of the 1040 or $4,945.50.
You can use .07065 or 1/2 of 14.13% ($70,000 x .07065
= $4,945.50)

4. Tom, age 61, is self-employed. He has no employees. He is

paying $3,600 for medical, $1,200 for dental, and $2,000 for LTC
insurance. His Schedule C net income is $90,000. What is his
AGI?
A. $76,841 C. $79,674 E. $84,474
B. $77,674 D. $83,200

Answer: A Net Schedule C income $90,000.00

less self-employment tax adjustment* - 6,358.50
less insurance premiums** - 6,800.00
AGI $76,841.50
* $90,000 x .07065 = $6,358
** Maximum LTC at age 61 is $3,720. ($2,000 LTC premium is
under the phaseout/threshold.) Premium equals $3,600 +
1,200 + 2,000 = $6,800 It is deductible on the front of
the 1040.
NOTE: We do not expect any questions above $132,900 (OASDI portion is exceeded and only the
Medicare tax applies) when the tax is just the Medicare Tax (1.45%). Obamacare will impose a 0.9%
Medicare Tax on individuals earning more than $200,000 and couples earning more than $250,000.

H. Credits
Credit for child and dependent care expenses (until age 13)
The credit is a percentage of expenses paid for care of a dependent to allow the taxpayer
to work and earn income. In figuring the credit, qualifying expenses are limited to
$3,000 for one dependent or $6,000 for two or more dependents. Depending on income,
a credit percentage of 20% to 35% applies. 35% applies to AGI under $15,000; 20%
applies to AGI above $43,000. Use 20% for the exam.
Example
Paula, a single mother, works full time (AGI $70,000). Her two children are in day care ($600 a
month). Her credit is $6,000 (max) x 20% = $1,200 credit.

Child tax credit

Individuals may claim a child tax credit of $2,000 (2019) for each qualifying child under
age 17. The credit is for a son, daughter, stepchild, or foster child. The amount of the
credit is reduced by $50 for each $1,000 above $400,000 MAGI for married filing jointly
and $200,000 MAGI for unmarried individuals. Up to $1,400 per child is a refundable tax
credit.
In addition, the 2017 TCJA created a $500 “family” credit for each dependent that is not
a qualifying child. This non-refundable credit applies to children age 17 or older, elderly
parents, disabled adult child, etc. that you provide more than 50% of their support. It
uses the same phase out thresholds as the child tax credit.
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Practice questions
1. Sally, a single mother, has three children under age 13. Her
child care expenses are $8,000. Her taxable income is $61,000.
How much child care credit can she use?
A. $1,200 C. $3,000
B. $1,800 D. $6,000
Answer: A The maximum usable expense is $6,000 x 20% =
$1,200. The question is asking about the child
care credit, not the child credit ($2,000 x 3).

NOTE: Per the TCJA the Child Tax Credit may be treated as a
refundable credit up to $1,400 per child.
2. Lenny received the following this year.
– Wages $50,000
– Money won at weekly poker games $1,000
– Christmas ham $33
– Corporate dependent care benefits of $2,000
– Spent $3,000 for dependent care
– Group term insurance ($40,000 death benefit) $50 premium
How much income must be reported by Lenny for the year?
A. $50,000 C. $50,800
B. $50,022 D. $51,000
Answer: D The question is asking about gross income not
taxes due. Wages and gambling winnings are
income. Up to $5,000 is tax-free. The dependent
care ($3,000 - $2,000 received) will produce a
credit of $200 (20%), but the question is asking
about income – not income taxes. The group term
insurance is less than $50,000, and there is no
indication of a discriminatory plan.
3. Mr. and Mrs. Sikes both work. Their two children (ages 3 and 4)
are in day care (cost $6,000). If their MAGI is $90,000, what
amount of child tax credit will they get in 2018?
A. $1,000 C. $2,000
B. $1,200 D. $4,000
Answer: D The question only asked for child tax credit (2 x
$2,000).
4. Sally is single with 2 children under 17 and a MAGI of $115,000.
How much is her child tax credit in 2018?
A. $-0- C. $1,200
B. $1,000 D. $4,000

Answer: D Because Sally’s income is under $200,000, she may

claim a child tax credit of $2,000 for each child
for a total of $4,000.

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Foreign tax credit

U.S. taxpayers who pay income taxes to a foreign government may deduct those taxes for
U.S. tax purposes or may credit them dollar-for-dollar against their income tax liability.

Adoption credit
To qualify for the adoption tax credit: One, you have adopted a child and paid out-of-
pocket expenses relating to the adoption. Then, the amount of the tax credit you qualify
for is directly related to how much money you spent on adoption-related expenses. If you
adopt a special needs child, however, you are entitled to claim the full amount of the
adoption credit, even if your out-of-pocket expenses are less than the tax credit amount.

An individual is allowed an income tax credit for qualified adoption expenses. Qualified
adoption expenses include adoption fees, court costs, attorney fees, and the cost to adopt
a foreign child (including travel to a foreign country). Qualifying expenses do not
include costs of a surrogate parenting arrangement or for adopting your spouse’s child.
The maximum credit is $14,080 (2019) per eligible child, including both special needs
and non-special needs children. Furthermore, the act provides that the $14,080 credit can
be claimed in the year a special needs adoption is finalized even if the taxpayer does not
have any qualified adoption expenses. The adoption credit is phased out ratably for
taxpayers with MAGI between $211,160 and $251,160 (2019).

When to Claim the Adoption Credit

What year you can claim the adoption credit depends on when the adoption was finalized
and whether the adopted child is a U.S. citizen, resident alien, or foreign national. If the
child is a foreign national, then you take the adoption credit only in the year when the
adoption becomes final. Any expenses paid in the year after the adoption is finalized,
you can take a credit for those expenses in the year that you paid them.
Credit for the elderly and the permanently and totally disabled
The credit is available to an individual who (1) reaches 65 or (2) is under 65, is retired
with a permanent and total disability, and receives disability income.
American Opportunity Credit and Lifetime Learning Credit
Review General Principles Lesson 6
Special tax credits for real estate investments
See Income Tax Lesson 9 for low-income housing and rehabilitation credit programs

Earned income credit (refundable)

Tax credit is for certain people who work and have earned income under certain amounts.

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Tax deduction versus tax credit examples

Joan made a $3,000 deductible IRA contribution. What is its equivalent tax credit if she
is in a 35% tax bracket?

Deduction x tax bracket = equivalent tax credit

$3,000 x 35% = $1,050 In essence, she saved $1,050.
Joan claimed a $2,000 child care credit. What is its equivalent deduction if she is in a
35% tax bracket?

Tax credit = Deduction $2,000 = $5,714.29

Tax bracket .35

A deduction is worth more to a high-bracket taxpayer and that a credit is worth more to a
low-bracket taxpayer. If Joan were in a 12% bracket, the following would apply.
IRA $3,000 x .12 = $360 The deduction is worth less in a lower tax bracket.
Child care $2,000 = $16,667 The credit is worth more if she is in a lower tax
bracket. .12

Practice questions
1. Which has more beneficial impact?
I. A deduction to a lower bracket taxpayer
II. A deduction to a higher bracket taxpayer
III. A credit to a lower bracket taxpayer
IV. A credit to a higher bracket taxpayer
A. I, III C. II, III
B. I, IV D. II, IV
Answer: C See next question/example
2. Which has a more beneficial impact to a taxpayer in a 12%
bracket?
A. A $3,000 IRA deduction
B. A $2,000 child tax credit
Answer: B The $3,000 IRA creates a $360 credit
($3,000 x 12%). The credit is more beneficial.

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Practice questions: Case / Evaluation

1. Sara Kimball is single, age 35. She is a very successful sales
manager. Her income with bonus was $350,000 last year and she
expects more this year. She is enrolled in the companies MSA
and had almost no claims for medical expense. She rents a car
(uses a taxi service). What can she do to save on income taxes?
I. Enroll in the company’s FSA
II. Buy a condo near the office
III. Invest in public purpose muni bonds instead of CDs
IV. Start a Keogh or SEP plan
A. I, II, IV C. II, III
B. I, III, IV D. II, IV

Answer: C Buying the condominium should produce deductions

for property tax up to certain limits and
mortgage interest. Given Sara’s 35% marginal
income tax bracket, investing in tax exempt bonds
makes sense. The problem with the FSA is use it
or lose it. With no medical expenses and no
information on dental or vision savings, there is
no tax benefit. Keogh’s and SEPs are for self-
employed persons. With the roman numerals, only
C is a good answer.

2. Bob Tuttle works for a large company. He is being considered

for a new executive position along with a substantial raise or
slightly lesser raise and more benefits. He is married (stay-
at-home mom) with two children (6 and 8). He and his family are
in good health but between medical, dental, vision expenses he
usually claims almost all of the $2,650 FSA medical plan. The
company benefits that are offered are as follows. Which one is
best for him if he elects the benefits in lieu of salary?
A. $10,000 into a combination of excess group life,
section 162 individual disability plan and subsidized
covered parking ($1,000 per month).
B. $10,000 paid directly into an IRA for him and his wife
C. $10,000 placed into a deferred compensation plan
D. $10,000 paid directly into an annuity which will be owned
by him.

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Answer: C A deferred compensation arrangement makes the

most sense for Bob. Answers A, B and D will all
generate taxable events. In Answer A, excessive
group life, the premium paid for the disability
insurance is taxable compensation (a bonus), and
the parking fees are taxable. The employer would
typically not provide an IRA contribution for an
employee or spouse as an employee benefit. The
annuity contribution will be taxable.

The child support only lasts for 4 years (Answer D). Answer C in the
long run is better than Answer A. It does not matter if you used 25%
or 28%.

3. Mr. Cain owns a small software firm. It operates as a regular

corporation. Recently, his specialized software has pushed him
well into the 35% tax bracket. His son is eager to learn what
the firm is doing. At age 13, what do you suggest Mr. Cain
should do regarding his son?
A. Make him a shareholder and pay him qualified dividends.
B. Employ him as part-time worker and pay him $10 per hour
(about $5,000 per year)
C. Pay him for time worked but issue him a 1099 at $12 per
hour(about 500 hours per year)
D. Let him observe on an unpaid basis.
Answer: C The son can be paid as a 1099 “consultant.” As a
1099 worker, Mr. Cain’s company is not required
to pay or withhold income or FICA tax. Answer A,
produces unearned income subject to kiddie tax
(qualified dividends). But all shareholders would
also have to be paid qualified dividends. Using
Answer B, the firm would also have to pay 7.65%
in FICA taxes. His son would also have to pay
7.65% FICA tax.
Answer B calculation
500 x 10 = $5,000.00
Less his FICA 7.65%* -382.50
Net $4,617.50

Answer C calculation
500 x 12 = $6,000.00
Less self-employment @.1413 -847.80 *
Net $5,152.20

*In this answer, his son would not have to pay self-
employment tax, but he would not net more. The firm would
not have to pay 7.65%.

NOTE: However, either way he does not have to pay income

tax. His standard deduction is $12,200 (2019).

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Tax accounting
Lesson 3 Tax accounting
A. Accounting periods
Taxable income is computed for a period called a tax year. This period is usually a
calendar year or a fiscal year. A calendar year is a period of twelve months ending on
December 31. A fiscal year is a period of 12 months ending on the last day of any
month other than December or a 52-53 week tax year. A new taxpayer may adopt
either a calendar or a fiscal year for the first return.

B. Accounting methods
After establishing its taxable year, a firm must assign the items of income and deduction
to a method of accounting.

1) Cash receipts and disbursements

Under the cash method of accounting, firms realize revenue from services performed in
the year the payment is received (constructive receipt), regardless of when the services
were performed. Firms then match expenses against revenues in the year the expense is
paid, regardless of when the firm incurred the liability for the expense.

Under the TCJA, most businesses having no more than $25 million in average revenues
will now use the cash method of accounting.

Practice question
On average, Compuchat produces $15 million in annual revenues.
Identify the easiest accounting method it may elect.
A. Cash C. Hybrid
B. Accrual D. LIFO

Answer: A The cash method is now available with annual average

revenues not exceeding $25 million. It is the easiest
accounting method to maintain.
2) Accrual method
Under the accrual method of accounting, firms realize revenue when the earnings process
with goods or services is complete, regardless of when payment for those goods and
services is received. Under the accrual method, firms match expenses against revenues in
the year the firm incurs the liability for the expense, regardless of when the expense is
paid.
The accrual method is no longer mandatory for purchases and sales where there are
inventories (when merchandise is an income-producing factor) unless the corporation or
other business averaged over $25 million in revenues during the prior three years.

3) Hybrid method
Taxpayers may use any combination of the cash, accrual, and specifically permitted
methods of accounting if the combination clearly reflects income and is consistently
used.

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4) Change of accounting method

As a general rule, a taxpayer may not change the method of accounting without advance
permission from the IRS.
C. Long-term contracts
A long-term contract is any contract for the manufacture, building, installation, or
construction of property if not completed in the tax year in which entered into. Long-
term contracts use percentage-of-completion method of accounting.
Examples: Building of a bridge, highway, or skyscraper
Practice questions
1. Which of the following will increase cash flow?
A. Collecting an account receivable faster
B. Paying an account payable off faster
Answer: A When a company collects the revenues it is
owed, its cash flow increases.
D. Installment sales
When some or all of the amount realized on the sale of property consists of the buyer's
note (a debt obligation to pay cash at some future date,) the seller (individual or business)
may be entitled to use a special method of accounting for the gain realized on the
transaction. The installment method provides that the realized gain is not recognized in
the year of sale. Instead, the gain recognized is spread over the life of the note.
Exceptions
– If all payments received are in the year of sale
– If property is publicly-traded securities
– If property is sold at a loss
– If property is sold to a related party (son, daughter, etc.) who in turn sells the property
within two years of the original purchase date

Example
You buy a parcel of land for $100,000. You sell it to your daughter for $1,000,000, and she pays
you $100,000 per year for 10 years. That is an installment sale; taxation of gain is prorated and
deferred. However, if she sells the property within two years of the original purchase date, the
installment sale collapses (for tax purposes), and you have a capital gain of $900,000 in the first
year. This is true even if she continues to make the installment payments of $100,000 per year
based on the original installment contract with you.
Calculation of gain
Under the installment sale method, the seller determines the gain recognized in the year
of sale and each subsequent year by multiplying the cash received each year by a gross
profit percentage. This percentage is calculated by dividing the gain realized on the sale
by the total contract price.
____Profit _ = Gross profit percentage
Total contract price

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Example
Harold sells land with a basis of $100,000 for $400,000. The purchaser pays $40,000 down and
a note to pay $40,000 plus interest for nine more years. How much gain must Harold recognize
for the current year?
____Profit = $300,000 = 75% Gross profit percentage
Total contract price $400,000
Installment ($40,000) x Gross Profit percentage (75%) = $30,000 gain
The gain is capital gain. It can be long-term (normally), but it can be short-term depending on
how long the property was held prior to the sale.

Practice question
Tom Price purchases a parcel of land for investment for $150,000. He
sells the land for $600,000 in an installment sale, receiving $60,000
as the first year payment. How much gain must Tom recognize for the
current year?
A. $15,000 C. $60,000
B. $45,000 D. $450,000
Answer: B Gross profit percentage: $450,000 : $600,000 = 75%
$60,000 x 75% = $45,000

E. Inventory valuation and flow methods

The two most commonly used costing conventions are FIFO (first-in, first-out) and LIFO
(last-in, first-out). A firm's selection of an inventory costing convention may have a
substantial impact on the taxable income recognized each year. During a period of rising
prices (typical), it is generally to a firm's advantage to adopt LIFO. The recently acquired
goods are the most expensive. The firm, therefore, maximizes the cost of goods sold and
minimizes the cost of ending inventory (understates it). While LIFO diminishes taxable
income and reduces taxes, it is mirrored by a reduction in accounting income and
earnings per share reported to the firm's investors. NOTE: Another method is specific
identification much like selling stock or mutual funds.
The following chart graphically illustrates the key components of FIFO and LIFO.

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Practice questions
1. During an inflationary period, Company A is using the LIFO form
of inventory control. If it changes to FIFO, which of the
following will be true?
A. Net business income will be higher.
B. Net business income will be lower.
C. Tax liability will be lower.
D. Inventory cost will be understated.

Answer: A FIFO indicates that Company A sell its lowest

cost goods first. Thus its income would increase.
Answers B, C, and D would be true if Company A
changed from FIFO to LIFO.

3. Due to inflation, inventory costs have risen. Jack LaRue

wants to sell LaRue, Inc for the best possible price. He wants
profits to look as strong as possible. What should he do if he
is currently valuating inventory using LIFO?
A. Stay with LIFO
B. Change to FIFO
C. Use a weight average of LIFO or FIFO
D. Use specific identification

Answer: D As an alternative to FIFO or LIFO, businesses may

value inventory under a specific identification
method. If a taxpayer can specifically identify
what to sell he can create a gain, a loss, or
neutralize the gain or loss. By doing this, he
could create the best profit. If he changed to
FIFO, that would increase his earnings.

F. Net operating losses

If a firm's business operations for a taxable year result in an excess of deductible
expenses over gross income, this excess is labeled a net operating loss (NOL) and is
reported as such on its tax return. If it reports no taxable income, the firm
obviously incurs no current year tax cost. If this were the case, the losses would be
suspended. It isn't allowed to partnerships or S corporations.

The NOL deduction

An NOL sustained in one year may be used to reduce the taxable income for another
year.
Tax Cuts and Jobs Act (TCJA) limits the amount of net operating losses (NOLs) that can
be utilized in a given tax year while allowing for an indefinite carryforward. Beginning in
the 2018 tax year, a business can only use an NOL carryforward for up to 80 percent of
computed taxable income. Not only does the TCJA change the NOL rules, it also imposes
loss limitation rules on noncorporate taxpayers.

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The rules for NOLs arising in tax years beginning after Dec. 31, 2017, state that a
corporation’s NOL carryover can only offset 80 percent of taxable income. However,
these NOLs can now be carried forward indefinitely instead of limiting to 20 years.
Carrybacks of these losses are no longer permitted.

NOL limitations for pre-2018 losses. Rules for existing NOLs remain the same. These
losses can be carried back two years and forward 20 years. There is no taxable income
limit to usage of pre-2018 losses.

NOL computations must now address both old and new rules.

Example.
ABS Corporation has a $2 million NOL from 2017. In 2018 ABC generated a $15 million NOL.
Its 2019 taxable income is forecast to be $15 million. ABC can use its entire $2 million pre-2018
NOL and $12 million of the 2018 NOL (80 percent multiplied by the assumed pre-NOL income
of $15 million). As a result, 2019 taxable income would be $1 million with a $3 million NOL
carryforward. There is no time limit on the carryforward.

Practice questions
1. An NOL cannot be used by which of the following entities?
A. Trusts
B. Regular C corporations
C. S Corporations
D. Self-employed persons
Answer: C S-corps and partnerships cannot use NOLs.

3. Why is NOL important?

Answer: Corporations can utilize losses from prior years to

offset current year income.

Practice questions:
1. Tina Adams owns a consignment shop. She operates her business
as an S Corporation. Typical annual revenues are $750,000. She
takes in all kinds of inventory and the turnover based on good
pricing and sales keeps her profitable month after month. What
type of tax accounting does she use?
A. Conduit
B. Cash
C. Accrual
D. Hybrid
E. FIFO
Answer: B Tina’s S Corporation may implement the cash
method of accounting. The cash method would be
the easiest to maintain. FIFO is an inventory
valuation method.

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2. Three years ago Mr. Kane bought land at bargain price of

$50,000. Now he realizes that the land will be the site of an
interstate exit next year. He has had two inquiries regarding
the purchase of the land from major hotel chains. He feels that
he could justify selling the land to his son today for $500,000
and use a 10 year installment sale. After he sells it he tells
his son not to sell it for at least two years. After he sells
the land, he and his wife have to gift the son $30,000 so he can
make the first installment. In less than a year, construction
starts on the interstate. His son gets an offer for $1,500,000
and sells the land. What is the result?

I. Mr. Kane will have to report a $450,000 long-term capital

gain even if his son only makes the first $50,000 payment
II. Mr. Kane will have to report $1,450,000 long-term capital
gain because two years did not pass.
III. His son will have a $1,450,000 long-term capital gain.
IV. His son will have a $1,000,000 short-term capital gain.
V. This whole transaction is illegal due to the gift

A. I, III D. II, III

B. I, IV E. V
C. II, IV
Answer: B Mr. Kane will have to report the gain ($500,000 –
50,000). His holding period was long-term. The
son held the property for less than one year, but
he will pay $500,000 for it. The gift of the
money should not defeat the sale.

3. ABC Corporation had an unprofitable year in 2015 losing $5

million. Prior to 2015, the company was marginally profitable.
In 2016, the corporation broke even. With the development of a
new product in 2017, the company made $10 million. How much NOL
can the company use?
A. None, ABC is an S corporation
B. Zero, the company is profitable in 2017.
C. $5 million this year
D. $10 million this year

Answer: C Presuming ABC is an a regular corporation, 2017

NOL rules allow a company to carry back a loss 2
years. The 2017 loss also can be carried forward
for 20 years. The 2015 loss ($5 million) can be
used in 2017 against the $10 million gain.

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4. NOL would generally be important to a sole proprietor who just

started a business because of which of the following reasons?
(Presume tax year 2018)
I. Losses from the business can be claimed on his/her 1040.
II. Losses in his/her business in excess of taxable income may
be carried back two years to recover tax paid in those
prior years.

A. I only C. I and II
B. II only D. Neither I or II
Answer: A Schedule C losses attributable to a sole
proprietorship may be claimed on that
proprietor’s personal 1040 and thus reduce AGI
and ultimately taxable income. Regarding
statement II, the TCJA eliminates NOL carrybacks
for business losses incurred in tax years 2018
and beyond.

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Characteristics and income taxation of business entities

Lesson 4 Characteristics and income taxation of business entities
A. Entity types
1) Sole proprietorship
The owner is generally responsible for operating the business on a day-to-day basis. The
business operations are undistinguished from the owner's personal affairs.
Advantages of sole proprietorships
– Availability of pension plans (Keogh, SEP)
– 100% of medical insurance premiums deductible by owner
– No legal formalities
– Conduit of income or losses to owner (files on a Schedule C)
Disadvantages of sole proprietorships
– Unlimited liability
– Business dies with owner.
– Capital structure depends on resources of owner.
2) Partnerships (general partnership)
An association of two or more owners to carry on the business for profit
Advantages of partnerships
– Availability of pension plans (Keogh, SEP)
– 100% medical insurance premiums deductible by partners
– Partnership agreement can be oral (written preferable).
– Conduit of income or losses to owner
Disadvantages of partnerships
– Unlimited personal liability for acts of the partnership or a partner acting on behalf of
the partnership (joint and several liability)
– Partnerships dissolve upon the death, bankruptcy, or incapacity of a partner.
– Capital structure depends on resources of partners.
3) Limited liability company
An LLC may be classified for Federal income tax purposes either as a partnership or a
corporation. It is classified as a partnership if it has no more than two of the following
corporate characteristics.
– Centralization of management – Limited liability
– Continuity of life – Free transferability of interests
NOTE: Ownership interests, the disbursement of funds, capital structure, and most
other financial items are governed by a contract among the LLC owners and governed by
state law.

The LLC may operate like a general partnership, thus members can be involved in daily
operations without losing their limited liability status. In an LLC, every member has
limited liability for all debts or claims against the business.

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The Tax Cuts and Jobs Act (TCJA) created a new tax deduction of up to 20 percent of income
from partnerships, sole proprietorships, and other pass-through businesses.

The Taxpayer Must Have Qualified Business Income.

Individuals who earn income through pass-through businesses may qualify to deduct up to 20%
of their “qualified business income” (“QBI”) from each pass-through business they own. QBI is
the net income (profit) from a pass-through business. QBI generally includes rental income
presuming the rental activity qualifies as a business. It also includes income from publicly traded
partnerships and REITs.

QBI is determined by each separate business that the taxpayer owns. If one of a taxpayer’s
business loses money, that loss can be deducted from the QBI of the profitable businesses. If net
QBI is zero or less then no pass through deduction is available for that tax year. However any
loss may be carried forward to the next year and is deducted against any QBI for that year.

For example, assume that during the 2019 year, Steve earned $20,000 in QBI from his cubic
zirconium mining business and he had a $50,000 loss from his printing business. Both businesses
are pass-through entities. He nets a $30,000 qualified business loss, so no pass-through deduction
may be claimed for 2019. The $30,000 loss may be carried forward and deducted from Steve’s
QBI for 2019 and perhaps beyond.

TCJA divides pass-through businesses into two classes: Those that provide certain personal
services, such as law firms, medical practices, consulting firms, firms where revenues come from
the talents of entertainers and athletes (so called personal service firms); and all other businesses.

Then, it divides the business owners into three tiers based on taxable income as follows:

Tier 1.

Single taxpayers making less than $160,700 or joint filers making less than $321,400 in total
taxable income may claim the full 20 percent deduction on their pass-through income. For these
individuals, it does not matter whether their business is a personal service firm or not.

Tier 2.

Single filers with more than $210,700 or couples making more than $421,400 in taxable income
are allowed no deduction whatsoever if their pass-through business is a personal service firm.
However, if they own any other pass-through business, they may still get a deduction, but it will
be limited (and possibly eliminated) based on the amount of wages their business pays and the
property it owns.

Tier 3.

Those with incomes between these thresholds are eligible for a partial tax benefit. It is available
no matter the nature of their business, but the amount of business income eligible for the
deduction phases out for personal service firms.

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How does the limitation work? First, the taxpayer calculates Qualified Business Income (QBI).
This is, generally, the business’s net income. Joint filers making less than $321,400 in total
taxable income can deduct 20 percent of their QBI.

If the taxpayer owns a personal service business (specified service business), the QBI is phased-
out pro rata until it disappears once joint total taxable income hits $421,400.

In addition, for all pass-through businesses, whether they are a personal service firm or not, the
deduction may be limited based on a complicated schedule which factors employee wages.

The following model will present three examples. Each shows both a personal service business
and a business not subject to special personal service rules. The examples show joint filers. The
main variable in each example is total taxable income.

Example 1.

Peter and Henrietta Barnett, who file jointly have a taxable income of $150,000, half of which is
Schedule C net profits from Peter’s sole proprietorship. He is a self-employed electrician (hence
the Schedule C income) and Henrietta works as a copy editor for a textbook publisher. The
Barnett’s may claim a deduction for the full 20 percent of the $75,000 in business income from
Peter’s electrical business, ($75,000 x .20 = $15,000).

Example 2.

Saul and Ava Morgan, a married couple who file jointly have a total taxable income of $400,000.
Ava files a Schedule C for her consulting business which nets $75,000 in pass-through income.
The Morgans end up in the phase-out range where they lose some of their deduction. However,
the amount of the deduction could vary substantially depending on the nature of their business.

Example 3.

Dan and Pat Dunn, a married couple who file jointly have total taxable income of $575,000. Dan
is a high level executive with a nationally recognized pharmaceutical manufacturer. His current
year compensation will be $500,000. Pat is raising their children but is also a part-time financial
adviser (a personal service business owner) who will net $75,000 for the current tax year.
Because their total income exceeds the $415,000 limit, they are not eligible for the 20 percent
pass-through deduction. Assume instead that Pat owns and operates a small dressmaking shop
(not a personal service business), nets the same $75,000. In this case, the allowable deduction is
$15,000.

Limited Liability Partnership (LLP)

An LLP is a partnership in which the general partners are not personally liable for
malpractice-related claims arising from the professional misconduct of another general
partner. An LLP is useful for a partnership that wants to convert from an entity where
one or more partners have unlimited liability. Rather than having to redo all the
paperwork, some states allow the partnership to convert to an LLC-type organization (an
LLP). Since under these conversion state statutes the entity is still technically a
partnership, it is called an LLP. In general, when forming a new entity, the flexibility of
an LLC generally makes it preferable to an LLP.
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4) Corporations
Regular C corporation
This is a separate tax entity. If a corporation distributes after-tax earnings to its owners,
the distributed income is taxed a second time at the owner level (double taxation).

The TCJA taxes corporation profits at a flat rate of 21%. The graduated rates no longer
apply. The Corporate AMT has also been eliminated.
Advantages of regular C corporation
– Separate tax entity – Limited liability
– Sale of stock to an unlimited number of investors – Continuity of life
– Dividend-received deduction (50% rule - see below)

Disadvantages
– Corporate formalities
– Dividends paid (after-tax)
– Accumulated earnings beyond certain limits are subject to double taxation (page 4-10).

Dividend received deduction

Corporate shareholders are allowed a deduction for dividends received.
– 50% of dividends received from qualifying corporation may be excluded from income
of recipient corporation if recipient corporation owns 20% or less of distributing
corporation.
– 65% exclusion if ownership is between 20% and 80%
– 100% exclusion if ownership is greater than 80%

Practice question
Mr. X owns 100% of X Plus, Inc. X Plus, Inc. is holding a
substantial amount (40%) of stock in another corporation called PQ.
PQ is paying dividends. X Plus, Inc. would enjoy a tax benefit if it
were which of the following?
A. An LLC D. A sole proprietorship
B. A corporation E. A limited partnership
C. An S corporation
Answer: B X Plus, Inc. (owning 40% of PQ) could claim the 65%
dividend exclusion.
NOTE: Only C corporations (referred to as a
corporation) can claim this exclusion.
Section 1244 qualified small business stock – what is it?
- A Section 1244 business is a corporation (C or S) that was initially capitalized with
no more than $1 million.
- Loss of $100,000 per year on a joint return ($50,000 otherwise) considered ordinary,
not capital loss

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Example
Bob (married) starts a business (a corporation using 1244) and loses $150,000. If he closes the business,
what kind of losses can he take? He can take a 1244 loss of $100,000 and a $3,000 capital loss.
Without 1244, he can take a $3,000 capital loss and a $147,000 carry forward.

Personal service corporation (PSC)

A closely held C corporation that is owned by certain individuals who perform services
is denied the progressivity of the corporate rate schedule. Any income retained by a
PSC is taxed at a flat 21% not the previous 35%.
Businesses that are classified as a PSC are the following:
H Health (doctors, dentists, etc.)
A Accounting, Architectural, Actors
L Law
E Engineering

Practice question
Dr. Smith sets up his Professional Association (PA) as a regular
corporation. Dr. Smith realizes the IRS classifies the PA as a
personal service corporation. Jack, his attorney, tells Dr. Smith
that his corporation has the following disadvantages. Which of the
following statements made by Jack are true?
I. One disadvantage of classifying a C corporation as a personal
service corporation is that employee fringe benefits are
disallowed.
II. The dividend-received deduction is lost because of the
personal service classification.
III. Any earned income that remains at year-end will be taxed by
a 21% flat tax.
IV. The advantage of being a separate tax entity is lost due to
the flat tax.
A. I, III D. II, III, IV
B. II, III E. IV
C. III, IV
Answer: C Income retained by a PSC is taxed at 21%. I is
wrong because employee fringe benefits are
allowed. A PSC does enjoy the dividend
exclusion.

Subchapter S corporations
The corporation elects a special tax treatment and is a conduit for items of income,
deductions, and tax credits. An eligible corporation becomes an S corporation by
unanimous election of its shareholders. The election is immediately terminated if the
corporation loses its eligibility. The S corporation files its taxes on Form 1120 S.

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Eligibility
– The number of shareholders is limited to one hundred.
– The corporation can issue only a single class of outstanding common stock (no
preferred), but the common stock can be voting and/or nonvoting.
– Must be a domestic corporation
– Only individuals, estates, and certain trusts may be shareholders (Persons must be U.S.
citizens or permanent resident aliens.)
Advantages of S corporations
-- Limited liability
-- Conduit of income or loss to owner but limited losses up to basis.
-- Basis equals cash plus direct loans made by the shareholder to the corporation.
Disadvantages of S corporations
-- Corporate formalities
-- Sale of stock limited by eligibility standards

Practice question
What is the advantage of establishing an S corporation versus a
regular (C) corporation?
A. The ability to issue preferred stock
B. The ability to provide a defined benefit plan
C. The ability to issue voting and nonvoting common stock
D. The ability of an owner to take excessive compensation and not
have it classified as dividends
Answer: D A high salary paid to the owner(s) does not affect S
corporations. The IRS would not reclassify salary as
dividends (conduit theory) but may try to reclassify
excessive compensation in a regular corporation. S
corporations cannot issue preferred stock
(disadvantage). Both S and regular corporations can do
answer B and C.
Limited partnership
Virtually any business can be a limited partnership. Limited partnerships must have at
least one general partner. The limited partners are liable for partnership debt only to the
extent of their capital contributions to the partnership (conduit taxation). A limited
partner's role is restricted to that of a passive investor. If a limited partner is an active
participant, he/she forfeits limited liability for partnership debt.
Business organization chart
The following flow chart outlines the key factors in deciding the type of business
organization the client should adopt.

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Business entities
Business is profitable.

C Corporation keys
1. Separate tax entity
2. Dividend-received deduction

Personal Service Corporation (PSC)

(Flat tax at 21%)

Business has losses.

risk-free entity risky entity (needs limited liability)

Sole Proprietorship keys S Corporation keys

1. Pension plan (Keogh) 1. Pension plan
2. 100% of medical, dental, & LTC 2. 100% of medical, dental, & LTC
insurance deductible for owner insurance deductible for > 2%
3. Lack of continuity owner
3. Losses up to basis
4. Special requirements
- no more than 100 shareholders
- only one class of stock
Partnership keys - must be a domestic corporation
1. Pension plan (Keogh) - Shareholders must be U.S.
2. 100% of medical, dental, & LTC citizens or residents.
insurance deductible for owner - All shareholders must consent to
3. Lack of continuity the election.
4. Losses up to basis

Limited Liability Company keys

1. Limited liability
(like a corporation)
2. Losses up to basis
(like a partnership)

Limited Partnership keys

1. Limited partners cannot
actively participate in business.
2. Losses up to basis

Risk-free versus risky entity: In a risk free entity, little or no liability exists or is connected with the
business. Either the nature of the business entails no liability exposure or the business is covered by
adequate insurance.

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Practice questions
1. Tory starts a small financial planning practice. The business is
a sole proprietorship. Tory anticipates taking a regular
salary. As a result, she anticipates marginal profits or losses
for the next several years. She wants to establish a family
business so that her daughter and son can join her in future
operations after they graduate from college. What is the most
appropriate business form for Tory's practice?
A. Remain as a sole proprietorship for the time being
B. Change to a partnership and issue limited partnership
interests
C. Change to an S corporation and issue both voting and
nonvoting stock
D. Change to a corporation

Answer: C The S Corporation will enable Tory to claim

losses from her business. As limited partners,
her son and daughter cannot actively participate
in the business. A regular corporation does not
enable Tory to claim the business losses on her
personal 1040. The solution is somewhat
subjective. Answer A, although acceptable, is
not the best choice.
2. Mel runs a business as a sole proprietor. The business is mature
and successful. Every year he has profits. His wife has a
successful business of her own. Mel would like to bring in
additional investors and expand his business. Which is the most
appropriate business form for Mel?
A. An S corporation
B. A corporation
C. A limited partnership with Mel as the general partner
D. A partnership
Answer: B A (regular) corporation can be owned by an
unlimited number of stockholders with no
eligibility requirements. The corporation may
also allow Mel to retain profits as a separate
tax entity. Retained earnings are not
immediately taxable to Mel. If Mel chooses a
limited partnership, he can bring in additional
investors. But the excess income is still
taxable to him and he has unlimited liability
exposure as a general partner.

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3. Alan is buying a business that was in receivership (chapter 7).

He anticipates business difficulties and potential losses before
the business becomes profitable. What do you suggest Alan do?
A. Establish the new business as a sole proprietorship
B. Establish the new business as a regular corporation
C. Establish the new business as an S-corporation
D. Establish the new business as a limited partnership
Answer: C The business is risky so Alan needs limited
liability. The S Corporation provides both
limited liability and the pass through of losses.

4. David Leonard, a successful CPA, is going to merge his practice

with John Murphy. John is also a successful CPA. Which would be
the most appropriate business form for David and John?
A. A corporation
B. An S corporation
C. A partnership
D. A limited partnership (LP)
E. A limited liability partnership (LLP)

Answer: E The LLP offers limited liability for the practice

and no liability to one partner for the
professional acts of the other. A corporation
would be classified as a PSC subjecting any
retained earnings to a 21% tax rate. A
partnership increases the professional liability
to each partner (the acts of the partnership and
the partners). A limited partnership only works
for passive investors. If an LLP was not offered
as an answer, the best answer becomes an S
corporation.

B. Taxation at entity and owner level

1) Formation
A variety of tax and nontax factors must be considered when choosing a business form.
At formation, the entity can be tax-neutral. Participants can transfer assets to either a
corporation or a partnership entity in exchange for an ownership interest in the entity
without recognition of gain.

2) Flow through of income and losses

Conduit entities - sole proprietorships
The taxable income (or loss) is reported on Schedule C (Profit and Loss From Business).
This schedule is essentially the proprietorship's income statement for the current year.
If the sole proprietorship operated at a loss, the loss carries to the first page of the 1040.
If the business loss exceeds other income, certain taxpayers can carry the excess loss
forward indefinitely as an NOL (like corporations). If an individual borrows money for
business purposes relating to his/her sole proprietorship, the interest paid (without limit)
on the debt is deductible on Schedule C.

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Practice question
Which of the following provides unlimited interest deductibility on a
personal tax return?
A. Business investment interest paid (or "expensed")
B. Mortgage interest on a primary residence
C. Margin account investment interest
D. Personal loan interest
Answer: A Deductions for mortgage interest and margin interest
are limited. This was explained in Lesson 2. Personal
loan interest isn't deductible. Business interest is
unlimited.

Conduit entities - partnerships

A partnership is an unincorporated association of two or more persons to conduct
business as co-owners. A partnership must file a tax return (Form 1065), but it is for
information purposes only. Each partner includes in his/her return the distributed share
of the partnership income or loss items.
– Losses up to basis – Basis equals 1) cash contributed by the partner, 2) direct loans
made to the partnership by the partner, and loans made to the partnership – not the
partner (share of partnership debt for which the partner may ultimately be held
responsible).
Conduit entities - S corporations
– Losses up to basis – Basis equals 1) cash contributed by the shareholder plus 2) direct
loans made by the shareholder to the S-corporation. No bank loans.
NOTE: When an S corporation incurs debt, shareholders typically do not have personal
liability for the debt. Therefore, S corporation debt is NOT included in the shareholders’
basis. However, even if the shareholders have personally guaranteed the debt, the debt
does not increase the shareholders’ basis!
Examples of partnerships versus S corporations
Ted and Jack plan to open a restaurant. They will put up a limited amount of cash. They
plan to borrow the remainder. If they form a partnership, what will be their basis?
Answer: Cash plus partnership debt
If they form an S corporation, what will be their basis?
Answer: Up to cash contributed, not debt

Why is this important?

Answer:
Shareholders can take losses up to basis. If the S corporation shareholder contributes
$50,000 of cash, that's the shareholder's basis for the S corporation ($50,000). If the S
corporation borrows $450,000 from a third-party, the shareholder's basis remains unchanged. If
a partner contributes $50,000 of cash and the partnership borrows $450,000 from a third-party,
then the basis for the partnership is $500,000. This is a meaningful difference in basis between
an S corporation and a partnership. If the business develops large losses and if the client wants
to take losses against income, a partnership is a more opportune business entity.
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Conduit entities - Limited liability corporations

Regardless of number of members, if the entity is treated as a partnership, only an
“information” return is filed. The income subject to tax will pass through to the
individual members. If the entity makes a corporate election, the business itself is a
taxable entity and normally files using a Form 1120 or 1120s.

Conduit example
Jim and George are going to buy a hotel for $10 million. They plan to contribute $1,000,000
each in cash and have the business borrow $8 million from a bank. What will be their basis?

(No third party loans)

Partnership and LLC basis-$10 million ($5 million each)

S corporation basis-$ 2 million ($1 million each)
3) Special taxes
Corporate accumulated earnings tax
Unless specifically exempt, a corporation that accumulates earnings and profits to avoid
income tax to its shareholders is subject to an annual accumulated earnings (penalty) tax
equal to 20% of its "accumulated taxable income" for the year. The tax is in addition to
the regular corporate tax. A regular corporation can generally accumulate $250,000
($150,000 for Personal Service Corporations) without establishing a business need. The
tax is intended to coerce corporations to pay dividends. A bona fide business need allows
corporations to avoid the tax above $250,000/$150,000.

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Practice question
Q Corporation has the following items of income and expense.
Taxable income $200,000
Federal income tax paid $ 75,000
Dividends paid $ 25,000
Accumulated earnings & profits at the end of the prior year $200,000
Q Corporation is not a personal service corporation. What amount,
if any, of accumulated earnings tax is due?
A. -0- C. $10,500
B. $10,000 D. $21,000
Answer: B Prior accumulated earnings $200,000
Income $200,000
Tax paid - 75,000
Dividends paid - 25,000
This year's earnings $100,000
Total accumulated earnings $300,000
Less credit -250,000
Accumulated taxable income $ 50,000
Tax rate 20%
Tax due $ 10,000

4) Distributions
Corporate stockholders may receive a return on their investment as a dividend.
Corporations cannot deduct a dividend payment. The business profit flowing through to
investors as dividends is taxed both at the corporate level and again to the shareholders.
This is double taxation. S corporations, LLCs, and sole proprietors are conduit entities
(pass-through entities). These entities avoid double taxation.
Example
Corporation X wants to pay a $1 per share dividend. First, the corporation will have to retain at least
$1.27 per share and pay taxes at 21% (leaving $1.00). Then the $1 per share dividend paid to the
shareholder is taxed a second time as a qualified dividend.
Practice questions
1. On what tax forms are S corporation distributions normally
received by individuals?
A. Schedule K-1 of the 1041 D. 1099
B. Schedule K-1 from Form 1065 E. Schedule E
C. Schedule K-1 of 1120S

Answer: C K-1 of 1120S is for S corporation distributions.

K-1 of the 1041 is for trusts and estates. 1099
is for self-employed income. K-1 of the 1065 is
for partnerships. Schedule E is for the
reporting of K-1 income from real estate.

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2. Bobbie was an employee of XYZ, an S corporation. He stills owns

stock. Which of the following tax reporting forms will he
receive?
A. W-9 C. Schedule K-1
B. W-2 D. 1099-Misc.
Answer: C The form K-1 reflects Bobbie’s unearned income;
W-2 and a K-1 would apply if he was still
employed.

Summary of tax forms used by different business entities

Corporation Self employed Partnership S Corporation
Filing 1120 Schedule C 1065 1120S
Employee W-2 Schedule C W-2 W-2
Distributions 1099 (dividends) ------------- K-1 K-1 (unearned)

K-1 of 1120S is for S corporation distributions.

K-1 of the 1041 is for trusts and estates. 1099
is for self-employed income. K-1 of the 1065 is
for partnerships. Schedule E is for the reporting
of K-1 income.

Practice questions:
1. Tim Terrific starts T2 Inc. He is very successful. He starts
accumulating money in the corporation. After a few years, he has
$1,000,000 in excess funds. If he invests the excess funds in a
dividend paying stock paying a 4% dividends (50% exclusion
rule), how much income tax will the corporation pay if they
corporation also has $30,000 of other taxable income?
A. $6,000 C. $9,500
B. $6,300 D. $10,500

Answer: D
$1,000,000
x 4%
$40,000
50% excluded x 50%
Using dividend rec’d deduction $20,000
Plus corporation income 30,000
Taxable income $50,000
Multiply corporation tax rate X21%
$10,500

NOTE: The corporation does not appear to be subject to the corporate

accumulations tax.

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2. A CPA starts out in practice. She is reasonably successful

during the first years using an S corporation entity. Due to
retaining a large client she expects her income from the
corporation to double this year. What should she do with her
business entity?
A. Stay as an S corporation
B. Convert to a regular C corporation
C. Form a limited partnership
D. Stay as an S corporation and issue preferred shares so she
can qualify for the preferred dividend tax rates.

Answer: A If she converts to a regular C corporation she

becomes a PSC. PSC profits are subject to a flat
tax 21%. As an S owner the excess income above
salary just flows through to her at her personal
tax bracket (unearned K-1 income). She cannot be
a limited partner because she is active. S
corporations cannot issue preferred shares.

3. Is there an advantage between taking excessive income as a

stockholder from a corporation or an S corporation if the
company is very profitable?
A. Taking earned income as compensation from a corporation
will qualify the stockholder to ultimately get more Social
Security benefits.
B. Taking earned income as compensation from a corporation
will qualify the stockholder to ultimately qualify for a
large retirement contributions.
C. Taking limited income from an S corporation will reduce
FICA and FUTA taxes because the remainder of income will be
unearned income.
D. Taking limited earned income from an S corporation and the
remainder as unearned income will reduce corporate taxes.

Answer: C In answer A and B there are salary caps that

limit what qualifies for Social Security benefits
and retirement contributions. But compensation
from a regular corporation is subject to
unlimited Medicare taxes. That is why an S
corporation (Answer C) is a better answer.
Unearned is not subject to Medicare tax. Answer D
is incorrect, an S corporation has conduit
income. No taxes are paid by the corporation.

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4. Bill Bradley and Alice Cates are going to buy a $20 million
dollar hotel together. The hotel needs a substantial upgrade
but the price is a bargain. They plan to put up $4 million in
cash ($2 million each). The remaining $16 million, is coming
from a bank loan. The bank is requiring a personal endorsement
by Bill and Alice to make the loan. If the hotel must have
major changes which will require floors to be shut down, they
feel losses could total $10 million in the first year. Which
entity should they elect to cover them for conduit of losses and
liability protection?
A. Partnership
B. C Corporation
C. S Corporation
D. LLP/LLC

Answer: D Answer A subjects them to tremendous liability

exposure. The C Corporation will not allow conduit of
losses. The S Corporation has a limit of losses of $4
million (bank debt does not increase their basis).
The LLP provides for both of their needs.

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Income taxation of trusts and estates

Lesson 5 Income taxation of trusts and estates
A. General issues
There are similarities and differences between trusts and estates. The personal
representative of an estate has duties and responsibilities similar to those of the trustee of
a trust.

Similarities:
– Both have beneficiaries.
– Both decedents and grantors are responsible for the creation of the estate or trust.
– Both transfer property.
– Both administer property in a fiduciary capacity (trustee and executor).
– Both are distinct tax entities.

However, there are differences between estates and trusts.

– An estate comes into existence involuntarily by operation of law upon the decedent’s
death. A living trust is created intentionally and voluntarily during the grantor’s
lifetime.
– Estates operate for a limited period. Trusts generally operate for many years.
– The estate moves property to the beneficiaries. The trust may retain property.
– The estate is supervised by the court whereas the trustee operates under a private
arrangement.

Example
An estate continues until all the assets have been transferred to the beneficiaries and debts and
taxes have been paid. A trust may benefit several generations of family members. It may operate
for centuries.

1) Filing requirements
Estates file on Form 1041, known as the Fiduciary Income Tax Return. Because the
estate is a separate entity, it also is entitled to certain deductions. Therefore, the estate
may deduct administration costs, accounting and attorney fees, and expenses of preparing
the estate's return. Some of these expenses may be taken on either the income tax return
(1041) or as deductions from the gross estate (706). The deduction should be claimed on
the return that provides the most tax advantage.

Trusts file on Form 1041. The beneficiary's share of income is reported on Schedule K-1
(Form 1041).

2) Deadlines
The Form 1041 is due on the 15th day of the fourth month after the entity's year ends. A
fiduciary must file a return for the estate or trust if the following exists.
– any taxable income for the year
– gross income of $600 or more, or
– a beneficiary who is a nonresident alien

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3) Choice of taxable year

In filing its first return, an estate may choose the same accounting period as the decedent,
or it may choose a calendar tax year or any fiscal year it chooses. If it chooses the
decedent's accounting period, its first return will generally be for a short period to cover
the unexpired term of the decedent's regular tax year. Although estates may select or
retain any tax year, all trusts [except 501(a) or charitable] must use a calendar year.
NOTE: An exemption of $600 is allowed on a short-period return.
Practice question
Which type of trust does not have to use a calendar year to file tax
returns?
A. Charitable trust C. Revocable living trust
B. Testamentary trust D. Irrevocable
Answer: A All trusts [except 501(a) or charitable] must use a
calendar year. Trusts (other than trusts exempt from
tax under Code Section 501 and wholly charitable
trusts must adopt a calendar tax year).
4) Tax treatment of distributions to beneficiaries
Generally, the beneficiaries are taxed on the part of the income currently distributed and
the estate or trust is then taxed on the portion that it has accumulated. If the estate or trust
must distribute all of its current income, the beneficiary must report his or her share of
distributed net income, whether or not that beneficiary actually receives it in a particular
tax year.
Example
The beneficiary has received a Schedule K-1 reporting $1,000 of interest income. However, the
beneficiary has not received the $1,000 distribution yet the $1,000 must be reported on the
Schedule B of the beneficiary's Form 1040.
Current income not required to be distributed
If the trustee or fiduciary has a choice of whether to distribute all or part of the current
income, the beneficiary must report the following.
– all income that is required to be distributed, whether or not it is actually distributed,
and
– all amounts actually paid or credited up to the amount of the beneficiary's distributed
net income
5) 2019 Trust/Estate Rate structure*

The 2017 Tax Cuts and Jobs Act made significant changes to the tax brackets for estate and trusts. These
rates apply to income that is not distributed to beneficiaries. Beginning in the 2018 tax year there are
only four brackets. Taxable income up to $2,600 is taxed at 10 percent. Taxable income over this
amount but not over $9,300 is taxed at 24 percent. Taxable income over $9,300 but not over $12,750 is
taxed at 35 percent. And taxable income over $12,750 is taxed at 37 percent.

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Taxable Income (TI) % payable on excess

$0 to $2,600 10%
Over $2,600 to $9,300 24% of excess over $2,600
Over $9,300 to $12,750 35% of excess over $9,300
Over $12,750 37% of excess over $12,750

These rates are significantly more compressed than individual tax rates. They mainly
affect trust accumulated taxable income. There are no calculations in the material nor
expected on exam.

B. Grantor/Non-grantor trusts
In a grantor trust, the maker holds too much control or "strings" over the property for tax
purposes. Whether the arrangement is classified as a grantor trust will depend on
whether the individual is calculating income or estate tax liability (or both). The other
trusts are called non-grantor trusts.
Grantor trust rules (also known as defective or tainted trusts)
The Internal Revenue Code governs the income taxation of trusts.
The code provides that a grantor of the trust (rather than the trust itself
or the beneficiary) will be taxed on the income produced by the trust. These trusts
are defective or “tainted.” The following violations create a defective trust for income
tax purposes (but do not collapse the trust).

– Trust income is, or may be, distributed or accumulated for later distribution to either the
grantor or the grantor's spouse.
– Trust income is, or may be, used to discharge any legal obligation of the grantor.
– Trust income actually is used to discharge a legal support obligation of the grantor.
– The power to control the beneficial enjoyment of the trust principal or income is
held by either the grantor or grantor's spouse (e.g., retaining the right to decide
who will receive and/or when a beneficiary will receive trust income or principal).
– Trust income is, or may be, used to pay premiums on life insurance on the life of either
the grantor or the grantor's spouse.

In the unfunded ILIT, the yearly gift pays the life insurance premium (not income taxable
to the grantor). In the funded ILIT, the investment income from the trust pays the
insurance premium (taxable to the grantor). NOTE: Only the amount of the actual
premium paid is taxable to the grantor. The remainder is taxed to the trust, if
accumulated, or to the beneficiaries, if distributed. In this situation, the trust is only
subject to income tax, not estate tax.

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– A reversionary interest that exceeds 5% of the trust value at the time of creation is
retained by the grantor.
Example
A grandfather (grantor) transfers $500,000 into a trust for his granddaughter. The income
is paid to his granddaughter. After 10 years, the $500,000 reverts to the grantor or the
grantor's spouse. The income paid to the granddaughter is taxable to the grantor (the
grandfather).

– Administrative power is held by either the grantor or the grantor's spouse to deal with
the trust property for less than full consideration, to borrow from the trust without
adequate interest or security, or the right to vote the stock held in the trust corpus.
A trust may also be defective or tainted for estate tax purposes if the grantor retains the
following.
– A right to income or the right to use or enjoy trust property (beneficial enjoyment)
– A reversionary interest that exceeds 5% measured at the time of death
Practice questions
1. Mrs. Bell, a grandmother, transferred $1.5 million to an
irrevocable trust seventeen years ago. She died this year.
Under what circumstance will this trust not be part of her gross
estate?
A. She had the power to specify the amount of income and the
beneficiary of the trust each year.
B. She had the power to specify whether income should be
accumulated or disbursed annually.
C. She received income from the trust for life. After death
it will go to her children.
D. She received income from the trust for 15 years. Now the
income goes to her children.
Answer: D Mrs. Bells right to income had expired (or
lapsed), and she has no beneficial enjoyment at
death. Answers A and B are subject to beneficial
enjoyment exposure (tainted trust rules). Under
Answer C, she had a right to income. She retained
that income interest at death.
2. Tony creates an irrevocable life insurance trust. Tony
transfers $500,000 of high yield bonds to the trust. The income
from the bonds will be used to pay the premiums on a policy on
his life owned by the trust. Which of the following is correct?
I. During Tony's lifetime, the income of the trust will be
taxable to Tony.
II. During Tony's lifetime, income from the trust will be
taxable at the trust rates.
A. I
B. II
C. Neither I or II

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Answer: A Grantor trust rules apply. Trust income is, or

may be, used to pay premiums on life insurance on
the life of either the grantor or the grantor's
spouse. This funded irrevocable life insurance
trust (ILIT) is a classic example of a grantor
trust.

3. A grandfather creates a trust to benefit his grandson. He

transfers a million dollars into the trust. The trust pays the
grandson income for eleven years, and then the trust corpus is
returned to the grandfather's wife (the grandson's grandmother).
This
arrangement is which of the following?
A. A gift of corpus to the grandson
B. A remainder interest
C. A reversionary interest
D. A reverse gift

Answer: C Any power or interest held by the spouse is

treated as if that interest was held by the
grantor. Therefore, it will be treated as if it
will revert to the grantor. Because of that
revisionary interest the trust income will be
taxable to the grantor.

C. Simple/Complex trusts
Trust - simple (uses conduit principle for distributions)
A simple trust (or estate) is considered merely a "conduit" for forwarding income to the
beneficiaries. The trust (or estate) passes its income (and deductions) through to the
beneficiaries who then report the income with the same character that it had for the trust.
The beneficiaries pay taxes on it at their own marginal tax brackets [distributable net
income (DNI)]. The trust is a separate tax entity but operates as a tax conduit.
Trust - complex (taxed as a separate tax entity)
A trust is taxed as a distinct entity for income tax purposes if it meets two requirements.
– It is irrevocable, and the grantor has not retained any "control", and
. – income is accumulated (either because the trust document requires accumulation or the
trustee has the discretion to accumulate income).
NOTE: An irrevocable trust is often, but not always, a complex trust.

Differences between simple versus complex trusts

Income is distributed. Income must or may be accumulated.
Income taxed to the beneficiary Income accumulated is taxed to the trust.
Income distributed is taxed to the beneficiary.
Normally no distribution of corpus Corpus can be distributed.
No charitable gifts May make charitable gifts

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Practice questions
1. Which of the following is a complex trust?
A. A trust that may distribute income
B. A trust that must distribute income
C. A trust that is required to distribute all of its income
D. A revocable trust
Answer: A The key word is "may." A complex trust may
accumulate income is accumulated, or the trustee
has the discretion to accumulate income. A
complex trust must be irrevocable.
2. Which of the following statements concerning a simple trust is
incorrect?
A. Accumulation of trust income is not allowed.
B. The trust is treated as a separate tax entity.
C. Beneficiaries are never taxed on distributed income.
D. A simple trust can never make distributions of principal or
have a charitable beneficiary.

Answer: C A simple trust generally must obtain a federal ID

number because it must file a tax return. All
trust income must be distributed. The trust is
treated as a tax entity only subject to a $300
personal exemption. Principal may not be
distributed, and no charitable gifts can be made.

D. Revocable/Irrevocable trusts
Revocable living trusts (also known as inter vivos or grantor trusts)
The more popular alternative to probate for many estate planning clients is a revocable
living trust. Most grantors name themselves trustee of their living trust for life.
At the trustor's death, the revocable trust becomes irrevocable and either terminates with
the corpus distributed to the remainderman or continues until a later date.
A revocable trust has no gift tax consequence during the grantor's lifetime. A
transfer of property to it does not constitute a taxable gift since the transfer is not
complete. And under the grantor trust rules, all income earned by a revocable trust is
taxable to the grantor.

Irrevocable trusts
With an irrevocable trust the grantor gives up all rights in the property transferred to the
trust. At that point, the grantor can no longer revoke, terminate, or modify the trust in
any material way. It becomes a non-grantor trust.

E. Trust income

1) Trust accounting income

Revocable trust
A revocable living trust is a grantor trust. As the owner of the property, the grantor of a
revocable trust will be responsible for any income tax liability.

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Irrevocable trust
An irrevocable trust, that is not a grantor trust (non-grantor), can be taxed as a simple or a
complex trust depending on whether all income is (or is not) distributed in a specific tax
year.
2) Trust taxable income
Certain deductions are available to a trust. They are similar to the deductions an
individual can elect. However, there are some exceptions.
– A charitable deduction is only allowed for complex trusts.
– Depreciation, cost recovery, and depletion are calculated in the same manner as for
individuals. If income is distributed, it must be allocated between the trust and the
beneficiaries.
– Net operating carryforwards are allowed.
– Administration expenses are allowed.
–The trust is allowed a deduction for all income that it is required to distribute
It does not matter whether or not that income is actually distributed. The trust is still
allowed a corresponding deduction.

Exemption
A complex trust that is required to distribute all of its income has an exemption of $300.
For a complex trust that is not required to distribute income, the exemption is $100.
Practice question
An estate is entitled to an income tax exemption amount of which of
the following?
A. $600 C. $100
B. $300 D. $4,050
Answer: A Estates receive an income tax exemption of $600.

3) Distributable net income (DNI)

Distributable net income (DNI) limits the amount that trust (or estate) beneficiaries must
report as gross income for income tax purposes. DNI rules allow the trust (or estate) to:
– claim a deduction for the amount distributed,
– limit the portion of the distribution that is taxable to the beneficiaries, and
– ensure that the character of the distributions remains the same for the beneficiary as it
was to the trust
There is no double taxation of trust income because the trust receives a deduction (the
"distribution deduction") on the income that is distributed to its beneficiaries. This
deduction is equal to the lesser of the amount distributed to the beneficiaries or the
DNI.
Example
The trust has DNI of $30,000. Distributions for the year are $45,000. The income distribution
deduction is $30,000 (the lesser of the two numbers).

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 Material current through July 2019 exam cycle

Practice question
Mr. Pierce is considering transferring $5,000,000 to a revocable
trust or $5,000,000 to an irrevocable trust for his own benefit.
Which of the following would be true?
I. If income is distributed from the irrevocable trust to him, it
will be taxed as DNI.
II. If income is accumulated in the irrevocable trust, the income is
taxed at trust tax rates, not personal tax rates.
III. If income is accumulated in the irrevocable trust, the income
will be taxed to Mr. Pierce.
IV. The income from the revocable trust will be taxed to Mr. Pierce.
A. I, II, IV C. II, IV E. IV
B. I, III, IV D. III, IV
Answer: B Because the trust was established to benefit its
grantor (Mr. Pierce) it is classified as a grantor
trust for income tax purposes. The Internal Revenue
Code deems this trust to be “tainted” because the
trust does not pay tax on its own income. Grantor
trust income will be taxed to the grantor. The income
distributed is at the discretion of the grantor
without the consent of an adverse party.

Practice questions:
1. Mr. Rich wants to establish an irrevocable trust to benefit his
daughter. He wants to deposit $1,000,000 into the trust with
income accumulating until she is age 40 (10 years from now). He
has spoken with one aggressive manager who feels he can generate
6% taxable income and a 6% growth rate. But another manager who
is being considered is suggesting low risk municipal bonds
yielding 4%. What do you suggest the client do if most of his
personal investments are with the aggressive manager?
A. Hire the aggressive manager to get more equity in the
trust.
B. Hire the municipal bond manager to get more equity in
the trust.
C. Split the money between the aggressive manager and the
municipal bond manager to get more equity into the trust
than either Answer A or B alone.
D. Only give the aggressive manager $200,000 to control trust
taxation and the remainder to the municipal bond manager.

Answer: A Although the 6% would produce a substantial income

taxed at 37%, the other 6% is deferred (growth).
$60,000 of income is far above the 37% trust threshold
of $12,500. This net of tax income plus 6% growth
would be substantially better than the other choices.

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 Material current through July 2019 exam cycle

2. Mrs. P establishes an irrevocable trust for her son. She

transfers $500,000 to the trust. The trust principal is placed
with a money manager generating 6% taxable income. The trust
applied for a whole life policy on her life. The trust will own
and be the beneficiary of the policy. The premium of the whole
life policy is $13,000 per year. The trust will pay the
premium. The remaining income will accumulate in the trust.
How will the income be taxed?
A. $13,000 as a taxable gift to Mrs. P and $17,000 as taxable
income to the trust
B. $13,000 as taxable income to Mrs. P and $17,000 as taxable
income to the trust.
C. $30,000 as taxable income to Mrs. P
D. $30,000 as taxable income the trust.

Answer: B This is a tainted irrevocable trust. Only the life

insurance premium is taxable to Mrs. P (the grantor).
The remaining income is taxable to the trust.

3. A client should never establish an irrevocable trust that is

tainted for both income and estate tax purposes?
A. Correct
B. Incorrect, there are usually exceptions
C. Maybe
D. Always

Answer: A Tainting an irrevocable trust for both income tax and

estate tax serves no purpose. The grantor might as
well kept the assets in his or her name. The trust
would also cost attorney and accounting fees.
4. Mr. Smith worries about his 12-year old son. Although he says
he will behave himself and plans to go to college, Mr. Smith is
doubtful. After reviewing 529 investment elections, he feels he
can earn substantially more by investing the assets himself. He
is considering contributing to an UTMA or creating an
irrevocable trust. Which of the following is true?
A. His son will be able to take the irrevocable trust
assets at any time.
B. The UTMA will be subject to the kiddie tax rules.
C. The trust will pay the income tax due under DNI if he is
the trustee.
D. If he is the grantor and the trustee of the trust, the
assets will not be included in his estate.

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 Material current through July 2019 exam cycle

Answer: B Income on an UTMA is subject to the kiddie tax rules.

Answer A is wrong because the trustee controls the
assets of the trust. Answers C and D will cause both
the income to be taxed to Mr. Smith and the assets of
the trust to be included in his estate. This would be
caused by his control of the (his) property. He has a
retained interest because he controls the beneficial
enjoyment of the property. This would also be true if
he was the donor-custodian of the UTMA (beneficial
enjoyment also).

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 Material current through July 2019 exam cycle

Basis / Depreciation/cost recovery concepts

Lesson 6 Basis
A. Original basis
Basis is a taxpayer's investment in any asset or property right. It is a measure of
unrecovered dollars. Basis is increased by legal fees, commissions, sales tax, freight, and
improvements but not repairs, real estate taxes, or normal business expenses. When the
basis is increased by these incidental costs, it becomes the cost basis.
Improvements must be capitalized; therefore, they increase the basis of the property.
Examples
– replace roof – replace air-conditioning system
– add a fence – replace plumbing
– pave a driveway – add a room
– incur an assessment for building improvements
(e.g., Condo elevator is replaced.)
Repairs are typically deducted as expenses; therefore, they never affect basis.
Examples
– repair roof – repair air-conditioning system
– pay property tax – pay for lawn service
– pay liability insurance – pay for property management
– patch holes in driveway – repair a fence
B. Adjusted basis

Cost basis less cost recovery (deductions) is adjusted basis. Cost recovery produces a
deduction for depreciation. The deduction generates a tax savings and reduces the basis
of the asset.
Practice questions
1. What is cost basis?
A. The original investment plus improvements
B. The selling price less purchase price
C. The purchase price less selling price
D. The cost basis less cost recovery deductions
Answer: A Cost basis reflects the amount of the initial
investment plus improvements. Answer B refers to
gain (loss).
2. Five years ago, Jackie Martin purchased a warehouse for her
business at a cost of $190,000. She paid $4,000 in legal fees
associated with the acquisition. She paid $12,500 to improve
the dock area. She has taken $25,000 in cost recovery
deductions. She has paid $13,000 for property taxes and $17,000
for utilities over the five years. What is Jackie's current
adjusted basis in the warehouse?
A. $165,000 C. $181,500 E. $211,500
B. $177,500 D. $206,500

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 Material current through July 2019 exam cycle

Answer: C The $190,000 basis is increased by the capitalized

costs: legal fees of $4,000 and improvements of
$12,500 (cost basis $206,500). The cost recovery
deductions ($25,000)reduce the adjusted basis to
$181,500. Property taxes and utilities are currently
deductible and, therefore, do not affect basis.

C. Amortization and accretion

Amortization
A business may own a variety of assets with no physical substance. However, the assets
represent a valuable property right or economic attribute. An example is goodwill. The
tax basis in such intangible assets may be recoverable. Intangibles are generally
amortized under Section 197 intangibles rules. The recovery method is similar to straight-
line depreciation.
Accretion
At issue a bond is discounted from par value. For example, a bond may be issued at $500
instead of $1,000 (par). The discount on the bond must be accreted over the bond's life.
Each year the portion of the discount that has been "earned" is included as taxable interest
income, and the bond's basis is increased. Because the accretion creates no current year
cash it becomes phantom income.
D. Basis of property received by gift and in nontaxable transactions
The value of the gift for gift tax purposes is its fair market value at the date of gift. The
basis for income tax purposes is more complicated.
– If the FMV on the date of the gift is greater than the donor's adjusted basis, then use the
donor's adjusted basis.
Practice questions
1. Mrs. Black gifts to her daughter, Jane, a stock worth $212,000.
Mrs. Black bought the stock for $20,000 some years ago. What is
Jane's adjusted basis for income tax purposes?
A. $20,000 C. $200,000
B. $32,000 D. $212,000
Answer: A Gifts of appreciated property carry the donor’s
basis over to the donee.
2. Mr. Eden gifts to his son, John, a stock worth $1,015,000.
Mr. Eden bought the stock for $200,000 many years ago. What is
John's adjusted basis for income tax purposes?
A. $15,000 C. $200,000
B. $185,000 D. $1,015,000
Answer: C Mr. Eden's basis carries over to Jane.

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 Material current through July 2019 exam cycle

Loss Gift Basis

– If the FMV on the date of the gift is less than the donor's adjusted basis in the gift, then the
following occurs.
1. A loss is measured using the FMV on the date of the gift.
2. A gain is measured using the donor's basis.
3. If the sale price of the gift is between the donor's basis and the FMV on the date of
the gift, no gain or loss is recognized.

Practice questions
1. Mrs. Falk purchased stock for $50,000. At the time of the gift
of stock to her daughter, the stock had a FMV of $25,000. What
are the income tax implications to the daughter when she sells
it for $70,000 three years later?
A. -0- C. $35,000 LTCG
B. $20,000 LTCG D. $45,000 LTCG
Answer: B A gain is measured by the donor's basis
($50,000). A loss is measured by the date of gift fair
market value. When the gift is "loss" property,
draw a chart like below. The chart will help you
get the correct answer every time.

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 Material current through July 2019 exam cycle

2. Your aunt gives you property with a basis of $1,200,000 (her

purchase price) but a FMV of only $660,000. What are the income
tax implications to you if you sell the property for $600,000 a
year later?
A. -0- C. $60,000 LTCL E. $600,000 LTCL
B. $50,000 LTCL D. $590,000 LTCL
Answer: C The loss is determined by the lesser of date
of gift FMV ($660,000) or the substituted basis
($1,200,000). See the chart below.

E. Basis of inherited property (community and noncommunity)

The basis of property acquired by inheritance is the fair market value on the date of the
decedent's death or the alternate valuation date if so elected. In community property
states, property gets a full step-up in basis if at least one-half of the whole property is
includible in the deceased spouse's gross estate. In noncommunity property states,
property only gets a half-step up in basis.
Practice questions
1. A widow inherits stock with a date of death FMV of $70,000.
She and her husband held the stock jointly before his death
(basis $20,000). She and her husband always lived in a common
law state. She sells it nine months later for $80,000. What is
the amount of capital gain?
A. $10,000 LTCG C. $35,000 LTCG E. $45,000 LTCG
B. $35,000 STCG D. $45,000 STCG
Answer: C The basis for her half of the jointly held
stock is $10,000, and she gets a step-up in
basis on his half to $35,000 ($45,000 total).
The holding period for property acquired from a
decedent is long-term, regardless of the actual
holding period.
2. What is the answer if the property was held as community
property?

Answer: A The property gets a full step-up in basis to

$70,000.

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 Material current through July 2019 exam cycle

3. Mrs. Boone bought the following XYZ mutual fund shares in the
past.

– $12,000 of XYZ one year

– $ 8,000 of XYZ another year
– $10,000 of XYZ another year

She let all the dividends ($2,000) and capital gains ($3,000)
accumulate in the fund. When she died, the value of the shares
was $48,000. Her son inherited the XYZ shares and has been
adding $1,000 per year for the past three years to the XYZ fund.
In addition, XYZ has paid out $500 in dividends and $300 in
capital gains (which her son reinvested in XYZ). If he now has
2,208 shares, what is his average cost per share?

A. $16.667 C. $22.554
B. $17.572 D. $23.460
Answer: D Ignore all of her purchases, dividends, and
capital gains. The shares got a step-up in basis
at her death.

Stepped up basis at mother's death = $48,000

Plus son's investments (3 years @ $1,000) + 3,000
Plus son's dividends and capital gains + 800
$51,800

$51,800 ÷ 2,208 shares = $23.46 per share

Depreciation/cost-recovery concepts
Cost-recovery deductions are an allowance for the exhaustion and wear and tear of
property used in a trade or business or held for the production of income.
A. Modified accelerated cost recovery system (MACRS)
The modified accelerated cost recovery system (MACRS) applies to all recovery
property (not land or intangibles) placed in service after 1986. Prior to 1986, ACRS was
used. Straight-line is an option under MACRS; but, half-year convention must be used.
Special note: If more than 40% of the depreciable property (non-real-estate) is placed in service
during the last three months of the year, the firm must use a mid-quarter convention.

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 Material current through July 2019 exam cycle

Practice question
Which of the following is true about the MACRS system of
depreciation?
I. It is used to depreciate nonresidential real property.
II. It can't be used for fixed assets.
III. It requires the half-year convention for the year of
acquisition.
IV. It requires mid-quarter convention if > 40% of the depreciable
property is put into service by the business during the
fourth quarter of its tax year.
A. I, III C. I, III, IV
B. I, II D. All of the above
Answer: C Fixed assets describe tangible property used in the
operation of a business. Examples include a plant,
machinery, and equipment. MACRS is used to recover
costs of (depreciate) these fixed assets.
Nonresidental real property can be recovered under
MACRS. Land is not depreciable.
Property classes -- must know
5-year computers, autos and light duty trucks (1245 property)
7-year office furniture and fixtures (1245 property)
27-1/2 year residential rental property (1250 property)
39-year nonresidential real property (1250 property)
MACRS Tables
MACRS Straight-line
Recovery year 5-year 7-year 5-year 7-year
1 20% 14.29% | 10% 7.14%
2 32% 24.49% | 20% 14.29%

Examples
1. MACRS Cost of computer: $5,000
First year cost recovery deduction: 20% of $5,000 = $1,000
2. Straight-line Cost of computer: $5,000
First year cost recovery deduction: 10% of $5,000 = $500
Why 10%? 1/5 of 100% is 20%, but you must use half-year convention
with straight-line. ½ of 20% = 10%.

NOTE: You may have to calculate the first and second year using either MACRS or straight-line. Use
MACRS unless the question says to use straight-line depreciation. Use cost basis to make the
calculation.

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 Material current through July 2019 exam cycle

Practice questions
1. Sara purchases new office equipment for $9,500. Sara pays $500
in sales tax. Assuming she uses MACRS, what is the cost
recovery deduction for the first year?
A. $ 714.50 C. $1,429.00
B. $1,000.00 D. $2,000.00
Answer: C $10,000 x 14.29% (seven-year property)
2. If Sara had used straight-line depreciation, what would have
been the correct answer?

Answer: A $10,000 x 7.145% (100% : 7 : 2 = 7.145%

is the half-year calculation for seven year
property.)
3. Cheryl purchases new office furniture. She pays $10,000 for the
furniture. The sales tax is $700, and the shipping cost is
$300. She spends $3,000 to improve her office. What is the
cost recovery deduction she can claim for the new furniture in
the first year?
A. $1,429.00 C. $1,571.90 E. $2,200.00
B. $1,529.03 D. $2,000.60
Answer: C The office furniture is seven-year property.
$11,000 x 14.29% = $1,571.90. The question asks
only about the furniture – nothing else!
4. Larry bought a light-duty truck for his business. The cost was
$15,000. What cost recovery deductions can he take in the second
year (MACRS)?
A. $2,143.50 C. $3,673.50
B. $3,000.00 D. $4,800.00
Answer: D The truck is 5-year property ($15,000 x 32%).

5. Art is a sole proprietor. He bought a commercial building

several years ago. He made a down payment of $20,000 in cash and
assumed a mortgage of $100,000. After he pays off the mortgage,
Art sells the building for $180,000. He uses straight line
depreciation. The amount of depreciation taken by the date of
sale is $18,000. What is the total gain on the sale?
A. $60,000 C. $80,000 E. $160,000
B. $78,000 D. $82,000

Answer: B His gain is $180,000 less the adjusted basis of

$102,000 or $78,000.
Cash $ 20,000
Mortgage assumption 100,000
Less depreciation - 18,000
Adjusted basis $102,000
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 Material current through July 2019 exam cycle

B. Expensing policy
The tax law allows businesses to expense (rather than capitalize) a limited dollar amount
of tangible property during a taxable year under Section 179.
C. §179 deduction
Under the TCJA a business may expense up to $1,020,000 of qualifying property in the
year of acquisition. Qualifying property is generally tangible personal property (1245
property) purchased for use in a trade or business. The maximum cost that can be
annually expensed is reduced dollar-for-dollar by the cost of qualifying property (placed
in service during the taxable year) that exceeds $2,550,000 (2019).

The amount of expense deduction is further limited to the taxable income derived from
the active conduct by the taxpayer of any trade or business. You cannot create a loss with
Section 179.
However, the 179 deduction not allowed for any year because of this limitation can be
carried over to the next year.

Practice questions
1. In January of this year, Adam, a sole proprietor, purchases
equipment (5-year property) for $600,000 for use in his
business. Assume he elects and qualifies for the maximum
Section 179 deduction and uses MACRS. What is the maximum
current-year deduction that Adam can claim with respect to the
equipment?
A. $25,000 C. $520,000
B. $510,000 D. $600,000

Answer: D Adam’s business may claim the entire $600,000.

2. This year, Frank Phillips purchased several items of

depreciable, tangible personality with a total cost of $41,000
(5-year property) for use in his business. Frank has taxable
(earned) income from his business of $11,000 (without regard to
the Section 179 expense). He also has 1099 income from a part-
time job of $13,000. What is the maximum amount of Section 179
expense that Frank may deduct in the current year?
A. $11,000 C. $24,000 E. $41,000
B. $13,000 D. $25,000
Answer: C The Section 179 election is subject to a taxable
(earned) income limitation. For this purpose,
part-time wages received are considered to be
from the active conduct of a trade or business.
Frank’s business income $11,000 plus part-time
income of $13,000 equals $24,000 of taxable
income. The 179 deduction may not create a net
operating loss (NOL).

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 Material current through July 2019 exam cycle

4. Which of the following property is eligible for a 179 election?

A. Rental real estate purchased for $200,000
B. Commercial real estate purchased for $200,000
C. A franchise purchased for $200,000
D. A computer purchased for $200,000

Answer: D Section 1245 business personal property qualifies

for the Section 179 election. Real estate is 1250
property. 1250 property is real, not personal,
property. A franchise is intangible property.

By making a Section 179 election, many small firms can more easily deduct the cost of
new assets and avoid the burden of maintaining MACRS depreciation schedules.

D. Amortization
Amortization is the recovery of certain capital expenditures that are not ordinarily
deductible in a manner that is similar to straight-line.

Example
Amounts paid to acquire membership in a trade association can be amortized over a fifteen-year
period using the straight-line method.

Practice questions:
1. Tom Jones owns TJ, Inc. The company typically sells unwanted
inventory of other stores. TJ is very popular due to its low
prices. Business profits should total $600,000 after all
expenses. Tom feels the business computer cannot handle the
increasing volume of transactions effectively. What should he
do if he buys a new piece of computer equipment for $25,000?
A. He cannot do anything because his business profits are
$600,000.
B. Expense it under Section 197 rules
C. Expense it under Section 179 rules
D. Depreciate it under MACRS rules
E. Depreciate it under straight line rules

Answer: C With a Section 179 election he can now expense up

to $600,000 the cost of the computer directly
against the profits of the company this year.
Under MACRS, he could depreciate it over 5+
years, but future depreciation is not as cost
effective as a current deduction.

2. Which of the following business transactions will trigger an

immediate tax deduction for a business?
A. Purchase of 1250 property
B. Purchase of land
C. Repair to 1250 property
D. Depreciation of 1245 property
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 Material current through July 2019 exam cycle

Answer: C Repairs are treated as expenses which are fully

deductible in the current tax year. 1245 property
is equipment and has a shorter depreciation
schedule. But, it is not expensed immediately.
1245 property could be expensed immediately under
Section 179.

3. Lewis was a seasoned stock trader. Just before his death, he

purchased 100 shares of Electrifying Software, Inc. at $100 per
share. His nephew inherited the stock at his uncle’s death. The
date of death value of the stock was $150 per share. Two months
later the stock split 2 for 1 valued at at $300 per share. If
the nephew sells the stock at $150 per share, what will be his
tax effect?
A. $0
B. $15,000 STCG
C. $15,000 LTCGs
D. $20,000 STCGs

Answer: C Lewis’s basis was $100, but the nephew

inherited it with a step-up in basis to $150.

After the split he has 200 shares, he inherited

100 shares.

Split $150 x 200 = $30,000 (post split = 200 shares)

Basis $150 x 100 = 15,000 (inherited)
Gain $15,000

Sales of inherited stock produce LTCGs regardless

of how long the heir holds the shares.

4. Mrs. Yates bought a Florida investment condo for $600,000. Five

years later she has an offer from an interested buyer for
$300,000. However, her son wants the condo for his personal
use. What should she do if the adjusted basis of the condo is
$500,000.
A. Sell it and take a $300,000 LTCL
B. Sell it and take a $200,000 LTCL
C. Gift it to her son at FMV
D. Gift it to her son at her basis

Answer: B Mrs. Yates should sell the property to realize the

long-term loss. She can then gift the proceeds to her
son to buy a similar condominium. The gift would be
valued at date of gift FMV rather than at basis.

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 Material current through July 2019 exam cycle

Tax consequences of like-kind exchanges /

Tax consequences of disposition of property
Lesson 7 Tax consequences of like-kind exchanges
A. Reporting requirements
The like-kind exchange provisions have the effect of deferring, but not necessarily
completely eliminating, unrecognized gain or loss because a substitute basis rule applies
to the properties involved in the exchange.

Under Code Section 1031, no gain or loss will be recognized on the exchange of certain
properties held either for an investment or for productive use in a trade or business.
These exchanges are "like-kind" exchanges.
Example
A taxpayer uses an exchange to continue an investment in a specific type of income-producing
property (example: rental apartments) but needs a different location. Continuing to own what is
essentially the same investment in the same type ("like kind") of property should not give rise to
a taxable event under Section 1031.

B. Qualifying property
Property eligible for like-kind exchange treatment includes real estate only. The TCJA
eliminated the use of personal property exchanges.
Like-kind Property
Properties are of like-kind, if they are of the same nature, even if they differ in grade or
quality. Real properties generally are of like-kind, regardless of whether the properties
are improved or unimproved. However, real property in the United States and real
property outside the United States are not like-kind properties.

In order to qualify:
1. The exchange properties must be “like kind” (rental property for rental property).
2. The taxpayer must use the acquired property in a trade on business.
Examples
– Apartment complex for shopping center (real estate)
Non-qualifying property
– Inventory of a business
– Principal residence
– Tangible personal property (not allowed starting in 2018)

C. Liabilities
If the taxpayer assumes and is relieved of a mortgage, only the net debt relief is
considered boot.
D. Boot
Because it is unlikely that the two properties to be exchanged have the same value, the
party with the lower valued property must add consideration in addition to the swapped
property. In a like-kind exchange, often cash or other (non-like-kind) property will be
involved in the exchange (along with the like-kind property). In such an exchange, the

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 Material current through July 2019 exam cycle

cash or other property that is not property of like-kind is called "boot." Boot does not
disqualify the entire exchange. Instead, the party receiving the boot must recognize a
portion of the realized gain equal to the lesser of the boot or the realized gain.

No matter how many numbers are given in an exam question, use only three.
1. FMV of property received (see box #1 below)
2. Adjusted basis of property given up (see box #2 below)
3. Boot (anything that is not qualified or like-kind - see box 3A or 3B but not both)

Example
Mr. X is going to exchange vacant land for Mr. Swapper’s parcel of land. Mr. X's vacant land is
Worth $100,000 and has an adjusted basis of $10,000 (Box #2). The land Mr. X wants to
acquire has a fair market value of $75,000 (Box #1), and its owner has an adjusted basis of
$15,000. Mr. X is also to receive $15,000 in cash and a computer system with fair market value
of 10,000.

Always
Solve for
Received Liability Boot FMV #1
Mr. X Assumed by received $75,000
$100,000 other party $25,000 A.B. Never
#3A Used

FMV - Boot Given Liability Given

Never Used Assumed by
-10,000 $10,000 -0- other party
A.B. #2 #3B

What is the amount of gain

realized by Mr. X in the $ 90,000 Step #1 [this step shows the realized gain]
exchange? $90,000

What is the amount of gain

recognized by Mr. X in the - 25,000 Step #2 The lesser of boot received $25,000 or
realized exchange? $25,000 the realized gain ($90,000) – [this step
shows recognized gain]

$ 65,000 Step #3 [this step is step #1 minus step #2]

Step #4 is the FMV of the property received less

Step #3

FMV of property received $75,000

What is Mr. X’s substitute basis less Step #3 - 65,000
in the acquired land? $10,000 Adjusted basis of new property $10,000

NOTE: If Mr. X sold this land outright, he would have to recognize (for tax purposes) a capital gain of
90,000. In lieu of that, he has to recognize only the boot amount, namely $25,000 (the cash and
computer), and he defers $65,000 of gain.
Realized gain = economic or inherent gain at the time of the transaction.
Recognized gain = the part of the realized gain that is immediately taxable.

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 Material current through July 2019 exam cycle

Practice question
Judy wants to exchange her boat slip which she currently rents out
for chartered cruises for a larger boat slip which will be used for
the same purpose. In the exchange Judy is contemplating, she will
receive $9,000 in cash(boot). Additional facts about the exchange
include the following.
– Judy's boat slip has a fair market value of $27,000.
– Judy's adjusted basis in the old boat slip is $26,000.
– The new boat slip has a fair market value of $18,000.
What will be Judy's substituted basis in the new boat slip?
A. $12,000 D. $20,000
B. $16,000 E. $27,000
C. $18,000

Answer: C In a like-kind exchange, the substitute basis of the

acquired asset is the fair market value of the asset
less any gain realized but not recognized. In Judy’s
situation, the fair market value of the acquired asset
is $18,000. There is no gain realized but not
recognized; therefore, the $18,000 is the substitute
basis in the acquired asset. This is true because the
realized gain ($1,000) becomes the recognized gain. No
gain was deferred.(suspended)

Always
Solve for
Liability Boot FMV
Received Assumed by received $18,000
Judy other party $ 9,000 A.B. Never
$ 27,000 Used

FMV - Boot Given Liability

Never Used Assumed by
Given
$26,000 -0- other party
-26,000 A.B.

$ 1,000 Step #1 [this step shows the realized gain]

- 1,000 Step #2 The lesser of boot received $9,000 or

the realized gain ($1,000) – [this step
shows recognized gain]

$ -0- Step #3 [this step is step #1 minus step #2]

Step #4 is the FMV of the property received less

Step #3

FMV of property received $18,000

less Step #3 - -0-
Adjusted basis of new property $18,000

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 Material current through July 2019 exam cycle

Time limit on like-kind exchanges

Like-kind treatment is barred if the property to be received is not identified on or before
forty-five days after the transfer and/or isn't received within 180 days after the transfer.

E. Related-party transactions
When a taxpayer exchanges like-kind property with a related taxpayer and within two
years the related party disposes of the property, the gain not recognized in the exchange is
recognized on the date of the sale. The like-kind exchange collapses.
Tax consequences of the disposition of property
A. Capital assets (§1221)
B. Holding period
Capital gains and losses
The main features of the income tax treatment of capital gains and losses are the
following.
– Short-term capital gains and short-term losses are netted; long-term capital gains and
long- term losses are netted.
– If any gains and any losses remain, they are again netted.
– If a loss remains after netting capital gains and losses, only $3,000 of net losses can be
used to offset ordinary income in a single year.

Example #1
Bobby completed several security transactions in the current tax year that produced the
following: long-term capital gain - $4,150; long-term capital loss - $1,200; short-term capital
gain - $6,905; short-term capital loss - $2,770. What will be the result?
Answer: Bobby will recognize $2,950 of long-term capital gain and $4,135 of short-term
capital gain. NOTE: These remain separate due to the differing tax treatment.
LTCG $4,150 STCG $6,905
LTCL -1,200 STCL -2,770
net LTCG $2,950 net STCG $4,135

Example #2
Sandra completed several security transactions this year that produced the following: long-term
capital gain – $5,000; long-term capital loss – $3,000; short-term capital gain – $4,000; short-
term capital loss – $9,500. What will be the result?
Answer: Sandra will recognize $3,500 of net short-term capital loss.
LTCG $5,000 STCG $4,000
LTCL -3,000 STCL -9,500
LTCG $2,000 STCL $5,500
What happens to the $3,500 net short-term loss?

Answer: In one tax year, a maximum loss of $3,000 may be taken against ordinary income.
Sandra will have $500 of short-term loss to carry forward.

Updated by Brett Danko Income Tax 7-4

 Material current through July 2019 exam cycle

Rates and Brackets for Long-Term Gains and Qualified Dividends After the TCJA
Prior to the enactment of the 2017 Tax Cuts and Jobs Act, long-term capital gains and qualified
dividend tax rates were pegged to the investor’s marginal income tax bracket.

The TCJA retains the 0%, 15%, and 20% rates on LTCGs and qualified dividends. However for
2018-2025, these rates have their own brackets that are no longer tied to the taxpayer’s ordinary
income brackets.

2019 brackets for LTCGs and dividends

Single Joint Head of Household

0% tax bracket $0-$39,375 $0-$78,750 $0-$52,750
Beginning of 15% tax bracket $39,375 $78,750 $52,750
Beginning of 20% tax bracket $434,550 $488,850 $461,700

After 2018, these brackets will be indexed for inflation.

2019 Tax Rates and Brackets for Short-Term Capital Gains

As under prior law, the TCJA taxes short-term capital gains recognized by individual taxpayers
at the regular ordinary income rates.

The 3.8% net investment income tax that applies to certain high earners did not change with the TCJA,
with the exact same income thresholds. This is part of the Affordable Care Act.

-- Short-term gains are taxed at ordinary income rates.

-- Long-term collectible gains are subject to a tax rate of 28% for all tax brackets.
-- Real property (1250) long-term gains are subject to capital gains tax rates. A special 25%
depreciation “recapture” rate is applied when the property is sold.

Example
Polly Andrews (single) purchased rental property for $100,000 some years ago. Through the
years she took depreciation of $25,000 (adjusted basis $75,000). She just sold the property for
$140,000. How much tax will she have to pay on the $65,000 gain ($140,000 - $75,000) if her
2018 AGI is $150,000?

Answer: $12,250 ($25,000 recapture at 25% or $6,250 and $40,000 gain at 15% or $6,000)

Updated by Brett Danko Income Tax 7-5

 Material current through July 2019 exam cycle

Practice questions
1. During the current tax year, Ken Brandt sold several securities
that left him with the following types of gains and losses:
long-term capital gain–$6,700; short-term capital gain–$7,000;
long-term capital loss–$1,900; and short-term capital loss–
$9,200. What is the net capital gain or loss on Ken's security
sales?
A. Net short-term loss of $2,500 and net long-term gain of
$5,100
B. Net short-term gain of $2,600
C. Net long-term gain of $2,600
D. Net long-term gain of $4,800 and net short-term loss
of $2,200
Answer: C The long-term items are netted, leaving a long-
term capital gain of $4,800. The short-term
items are netted, leaving a short-term capital
loss of $2,200. These are netted, leaving a net
long-term capital gain of $2,600.

2. Your client purchased 1,000 shares of ABC, Inc. for $20/share.

At the end of six years, your client sells the stock for
$32/share. The stock pays the following dividends at the end of
each period.
Dividends Stock Price
Year 1 $600 $22
Year 2 $660 $24
Year 3 $720 $26
Year 4 $780 $28
Year 5 $900 $30
Year 6 $990 $32
The dividends are reinvested at the end of periods 1, 3, and 5.
The dividends received in cash for periods 2, 4, and 6. What
is the taxable gain on the shares sold if the sale takes place
immediately after the 6th year dividend is paid?
A. $12,000.88 LTCG, plus $2,200 ordinary income
B. $12,498.88 LTCG
C. $17,498.88 LTCG
D. $13,498.88 LTCG

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 Material current through July 2019 exam cycle

Answer: B $ Amount # of shares

Initial Purchase $20,000 1,000.000
Year 1 $ 600 27.273
Year 3 $ 720 27.692
Year 5 $ 900 30.000
Basis $22,220 1,084.965

The question asks about taxable gain on the

shares sold. The client sold 1,084.965 shares @
$32 = $34,718.88 Gain $34,718.88 - $22,220 =
$12,498.88 LTCG (the last purchase with
reinvested dividends was at end of year 5. The
sale took place immediately after end of year 6.)
3. From question 2, how much phantom income did the client have to
report for the entire holding period?
A. $0 C. $4,650
B. $2,220 D. $12,499
Answer: B The reinvested dividends are phantom income
[year 1 ($600), year 3 ($720), year 5 ($900)]
4. What is the IRR of ABC, Inc.?
A. 8.24% C. 11.13%
B. 10.19% D. 13.49%

Answer: C The dividends paid in cash are a positive. (The

client received them.) The dividends reinvested
increased his basis (phantom income). You must
enter a zero for those years.

10BII 12C 17BII+

20,000,±,CFj 20,000,CHS,g,Cfo CFLO,clear data,yes,#T
0,CFj 0,g,CFj Flow 0=20,000,±,Input
660,CFj 660,g,CFj 0,Input
0,CFj 0,g,CFj 660,Input
780,CFj 780,g,CFj 0,Input
0,CFj 0,g,CFj 780,Input
35,708.88,CFj 35,708.88,g,CFj 0,Input
gold,IRR/YR=11.13% f,IRR=11.13% 35,708.88,Input,Exit,calc.,IRR
$34,718.88 (sold) + $990 (dividend) = $35,708.88
Years 1, 3, and 5 produce phantom income which is taxable but
produces no cash flow. They are reinvested. They affect the
number of shares held and the future value.

Updated by Brett Danko Income Tax 7-7

 Material current through July 2019 exam cycle

5. Charles completed several security transactions this year that

produced the following: long-term capital gain – $8,000; long-
term capital loss – $3,000; short-term capital gain – $4,000;
short-term capital loss – $6,500. What will be the current year
tax result?
A. $2,500 of short-term losses and $5,000 of long-term gains
B. $2,500 of short-term losses
C. $2,500 of long-term gains
D. $1,500 of long-term gains

Answer: C Charles will recognize $2,500 of net long-term

capital gain. Net the losses against the gains.
LTCG $8,000 STCG $4,000
LTCL -3,000 STCL -6,500
LTCG $5,000 STCL $2,500
LTCG = LTCG $5,000 - STCL $2,500 = $2,500 LTCG

6. Mr. Lowe (single taxpayer) died this year. He has a $9,000

carryforward capital loss from the prior year. How will his
carryforward loss be treated?
A. $3,000 can be deducted on the estate's 1041 tax return.
B. $3,000 can be deducted on the estate's 1041 tax return; the
remaining loss is carried forward to next year.
C. $9,000 can be deducted in full on the final estate tax
return (1041).
D. No capital loss deduction can be claimed after death.
Answer: A The loss can be used in the year of death.
However, any unused carryforward losses are
lost after the year of death.

Mini case questions

Your CPA asks you to assist him on a case with a wealthy client. The
client has asked your CPA some difficult questions. The client is in
a 32% marginal income tax bracket. He has the following investments.
–$100,000 in a money market earning 5%
–$100,000 in treasuries purchased some years ago (coupon 11%)
now worth $140,000
–$100,000 in an S&P 500 mutual fund purchased 12/31/12
that is now worth $160,000
–$100,000 in an aggressive growth stock purchased 12/31/12
now worth $300,000

Updated by Brett Danko Income Tax 7-8

 Material current through July 2019 exam cycle

1. The client wants to sell the S&P mutual fund in 2018 paying
capital gains (15%), and buy treasuries similar to the ones
purchased years ago. How much after-tax income will he get from
these new treasuries if he sells the S&P mutual fund in 2018?
A. $8,024 C. $8,653
B. $8,068 D. $11,865
Answer: B The S&P mutual fund is subject to LTCG at 15%.
Current value $160,000
Basis -100,000 ----–––––>$100,000
Gain $ 60,000 -15% –> 51,000
Investable value $151,000
Subtract the basis first. Basis is not taxed. However, the 11%
treasuries now take $140,000 to purchase,or $11,000 of income
takes $140,000 of principal.
$11,000 x $151,000 = $11,864.60
$140,000
Then $11,864 x .68* = $8,068
*32% is his tax bracket.

2. The client wants to margin the aggressive growth stock and

purchase the following investments. Which of the following will
allow for an investment interest tax deduction?
I. Purchase various treasuries, GNMAs, zeros, etc.
II. Purchase municipal bonds
III. Purchase a residence
IV. Purchase a home mortgage
V. Purchase a trade or business
A. All of the above C. I, V E. IV, V
B. I, III, IV, V D. I, IV

Answer: D Investment interest paid for or accrued

on indebtedness property held for investment
(purchase a home mortgage). Investment interest
does not include interest on funds borrowed in
connection with a trade or business. It also
does not include a personal residence or
municipal bonds interest.

Tax implication of the sale of mutual fund shares

Sales of mutual fund shares create taxable gains or losses as measured by the difference
between sales price and basis; basis may be determined by several methods.
– The first-in, first-out method treats those shares acquired first as being sold first.
– The specific identification method requires the seller of the shares to identify the
shares of the fund that are sold.
– The average cost method allows the investor to divide the total cost of all shares held
by the number of shares held.

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 Material current through July 2019 exam cycle

Example
A client owns 400 shares in a mutual fund that he/she bought at different times and prices.
2014 100 @ $20 = $ 2,000
2015 100 @ $28 = 2,800
2016 100 @ $32 = 3,200
2017 100 @ $36 = 3,600
400 shares = $11,600
Average cost $11,600 = $29 per share
400
If the client redeems 100 shares in 2018, netting $26 per share, the three ways that taxable gain
can be calculated are the following.
FIFO Specific Shares Average Cost
Proceeds $2,600 $2,600 $2,600
Cost -2,000 - 3,600 * 2,900
$ 600 gain $1,000 loss $ 300 loss
* Specific shares allow the investor to maximize gain, neutralize gain, or maximize loss.

Practice questions
1. Patsy is going to sell some of the shares of her mutual
fund. Which statement(s) is/are incorrect?
A. The taxable gain may be based on an average cost per share.
B. The client may choose which shares to sell, thereby
controlling the taxable gain under specific identification.
C. To minimize taxable gain, the client would normally use the
specific identification method.
D. To maximize taxable gain, the client should always use the
first in, first out method.
Answer: D The clearly incorrect answer is to set basis
using FIFO. If the first shares acquired were
priced near current FMV the gain may be small.

C. Sale of residence (Code Section 121)

If certain requirements are satisfied, Section 121 of the Internal Revenue Code enables
taxpayers to exclude from income substantial amounts of capital gain on the sales of their
homes. For married taxpayers filing jointly, the maximum amount of realized gain that
may be excluded from gross income is $500,000 ($250,000 unmarried or single). To
claim the exclusion, the taxpayer must have owned and used the home as a principal
residence for an aggregate time period of two years out of the 5-year period immediately
preceding the home's date of sale. If the home-sale gain is entirely excluded, the
transaction is not reported on the taxpayer's return at all.

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 Material current through July 2019 exam cycle

Example
Fifteen years ago Dave paid $50,000 for his house. He sold his house this year for $400,000
and bought a condo for $400,000. What is the maximum amount of gain he must report?
His selling price $400,000
Less his basis - 50,000
Realized gain $350,000
Less exclusion (single) -250,000
Recognized gain $100,000
NOTE: The subsequent purchase of the condo does not affect the outcome. That once was true
under prior tax law. The recognized gain is reported on the Schedule D as capital gain.
The tax code also includes exceptions that allow home sellers who don't meet the
minimum two-year residency requirement to (still) qualify for a partial exclusion.
Taxpayers may be eligible for a partial exclusion when a move is required by a
change of employment, health reasons, or "unforeseen circumstances." The rules for
unforeseen circumstances include the following.
– Divorce, legal separation, or death of a spouse
– Becoming eligible for unemployment compensation
– A change in employment that makes it impossible to pay the mortgage or basic living
expense
– Multiple births resulting from the same pregnancy
– Damage to the home from a natural disaster, an act of war, or terrorism
– Condemnation, seizure, or involuntary conversion of the property such as
foreclosure
– A job-related move would qualify for a home-sale exception if the taxpayer's new job
is more than fifty miles farther away from the old home than the old workplace.
The size of the deduction depends on how long the seller lived in the house during the
five years before the sale. A taxpayer who lived in a house for a year – or 50 percent of
the two-year requirement – is entitled to a 50% exclusion. That would allow home-sale
profit of $125,000 per person or $250,000 per couple to be sheltered from capital gains
tax.
Example
If Larry owned and lived in his home for one year before selling it to take a new job, he is
entitled to 50% of the regular deduction (12 months ÷ 24 months = .50). Normally the question
will be in ¼, ½, or one year periods. See practice question 5. (New place of employment must
be at least 50 miles farther from your old home than the old place of employment.)

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 Material current through July 2019 exam cycle

Practice questions
1. Mr. and Mrs. Patrick purchased a home some years ago for
$100,000. They sold the home in the current year for $750,000.
They used the money to buy a smaller home for $250,000. What is
the maximum amount of gain they must recognize?
A. -0- C. $250,000
B. $150,000 D. $650,000
Answer: B Selling price $ 750,000
Less basis - 100,000
Realized gain 650,000
Less exclusion (married) - 500,000
Recognized gain $ 150,000
2. If you and your spouse live in a house for two years and then
rent it for three years, can you sell it and get the $500,000
exclusion?
A. No, you must live in the house for five years.
B. No, you must live in the house at least three of the five
years.
C. Yes, you can sell it and get the $500,000 exclusion.
D. Yes, as long as you do not live in another house you own
during the other three years, you can sell it and get the
$500,000 exclusion.
Answer: C To claim the exclusion, both spouses must have
lived in the house for at least two years. The
other three years the home can be rental
property.
3. Dale and June were recently married. Dale moved into June’s
house right after the wedding. She owned the home for seven
years. The original purchase price was $160,000. They want to
put the house up for sale and move to a bigger home. Since they
live in a “hot” real estate market area, they expect to sell the
house very quickly. If the home is sold immediately for
$660,000, how much may be excluded from taxation?
A. $0 C. $160,000
B. $250,000 D. $500,000
Answer: B Only June qualifies for the $250,000 exclusion
since she lived in and owned the home for the
last seven years. Dale did not own or live in the
home long enough to qualify for the exclusion.

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 Material current through July 2019 exam cycle

4. Edie bought a home for $150,000 one year ago. Due to a job
change, she had to move several thousand miles away. She was
lucky enough to find a buyer quickly and sell the home for
$160,000, but she incurred a 6% brokerage commission and $3,000
of selling expenses. What is the tax result of the sale of the
home?
A. She will have to report a $10,000 gain.
B. She will not have to report the $10,000 gain due to her
change of place of employment.
C. She will not have to report the $400 gain due to her change
of place of employment.
D. She will not have to report a gain.
Answer: D Edie will not realize a gain but a loss
of $2,600 [$160,000 - ($9,600 + 3,000)= 147,400
basis]. $150,000 – 147,400= $2,600 loss There is
no deduction for loss on a home sale. Selling
expenses (like commissions, title search and doc
stamps) are generally deductible.
5. What would have been the result if Edie had sold the home for
$200,000 after living in it for six months?
A. She would have received an exclusion of up to $62,500 in
gains.
B. She would have received an exclusion of up to $125,000 in
gains.
C. She would have received an exclusion of up to $250,000 in
gains.
Answer: A She is single. $250,000 x .25* = $62,500
* 6 months divided by 24 months
6. Mr. and Mrs. Littletown purchased a house together for $100,000
many years ago. When Mr. Littletown died, the house was worth
$600,000. Mrs. Littletown sold the home for $700,000 three years
later. How much gain must she realize?
A. $100,000 C. $350,000
B. $250,000 D. $500,000
Answer: C The house would get a half step-up in basis.
His $50,000 basis is now $300,000
Her $50,000 basis remains unchanged + 50,000
New basis $350,000

$700,000 - 350,000 = $350,000 realized gain

The house only gets a ½ step-up in basis at his death
(not community property). $50,000 was her basis and ½
of 600,000 was his step-up or (total of $350,000).
The question asked for the realized gain. Given the
Section 121 exclusion, she will recognize only 100,000
(Answer A). If she sold the house within 2 years of
death, she would get the full $500,000 exclusion.

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 Material current through July 2019 exam cycle

7. What would the answer to Question #6 be if they had lived in a

community property state?
A. $0 C. $75,000 E. $250,000
B. $50,000 D. $100,000
Answer: D The house would get a full step-up to $600,000.
Her realized gain would be $100,000. The
recognized gain is $0 (answer A).

Like kind exchange example with a residence

Bob is a single taxpayer. He buys a house for $210,000 that he uses as his principal residence
from 2013 to 2016 (3 years). After 2016, he rents the house for 2 years to tenants and claims
depreciation deductions of $20,000. In 2019, Bob exchanges the house for a condo with a fair
market value of $460,000. He intends to rent the condo to tenants.
Bob can claim Section 121. Bob owned and used the home as his principal residence for at
least two years during the 5-year period prior to the exchange. In addition, because the
property was investment property (2-year rule), Bob can defer gain under section 1031 (like-
kind).
Amount realized $460,000 ($460,000)
less adjusted basis -190,000 ($210,000 - $20,000)
Realized gain $270,000
less Section 121 -250,000 (121 is applied first)
Gain to be deferred $ 20,000 (1031 is applied next)

To exclude gain, a taxpayer must both own and use the home as a principal residence for two of
the five years before the sale. The ownership and use periods need not be concurrent.

An owner only gets a percentage of the exclusion based on a ratio of how long the property is their
primary residence divided by how long they owned the property. This prevents people from moving into
vacation homes or rental units for two years and then claiming the entire exclusion. Question on the
exam - Can certain taxpayers do both the 121 exclusion and 1031 like-kind exchange? Yes, if the
requirements are satisfied.

D. Depreciation recapture
1245 property
Depreciation recapture may apply to all MACRS property (mainly equipment) other than
residential real property (27.5-year class) and nonresidential (39-year class) When a
business purchases equipment and takes depreciation (cost recovery deduction), the
CRDs offset the business's ordinary income. When the business sells the equipment for a
gain, the business must do the following.
1st look back and recapture the lesser of total CRDs taken or the gain
realized as 1245 gain (ordinary income)
nd
2 recover any excess gain as 1231 gain (capital gain)

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 Material current through July 2019 exam cycle

Practice questions
1. Two years ago, Morton Anderson purchased equipment (7-year
property) for use in his business at a cost of $12,000. Cost
recovery deductions total $7,392. The equipment is sold for
$13,000. What is the amount of cost recovery deductions that
must be recaptured as 1245 gain?
A. $1,000 C. $4,608 E. $8,392
B. $1,392 D. $7,392
2. What is the amount of Section 1231 gain?
A. $1,000 C. $4,608 E. $8,392
B. $1,392 D. $7,392
Answers: 1-D, 2-A
Original cost $12,000 Sells $13,000
-CRD - 7,392 -Basis - 4,608
Basis $ 4,608 Gain $ 8,392

look
back 1245 $ 7,392 (OI)
excess(if any) 1231 $ 1,000 (CG
1231 property – includes depreciable tangible and intangible personal property and
real property, whether or not depreciable

3. Mr. Barnes operates a business as a sole proprietor. He

purchased office equipment a few years ago at a cost of $4,500
to use in his business. He claimed $3,295 in cost recovery
deductions. This year he sells the office equipment for $3,000.
What are the amount and nature (character) of the gain/loss
resulting from this disposition?
A. $1,205 of 1245 gain C. $1,205 of 1231 gain
B. $1,795 of 1245 gain D. $1,795 of 1231 gain

Answer: B Original Cost $4,500 Sells $3,000

-CRD -3,295 -Basis -1,205
Basis $1,205 Gain $1,795

look
back 1245 $1,795 (OI)
4. Two years ago, Maxine purchased a computer for use in her
business at a cost of $10,000. She took cost recovery deductions
of $5,200. Due to her business expanding, she needs a faster
more powerful computer. She sells the original computer for
$4,000. What is her gain or loss on the sale of the computer?
A. 1245 gain of $ 800 C. Ordinary loss of $1,200
B. 1231 gain of $1,200 D. Ordinary loss of $ 800

Answer: D The sale creates an ordinary loss. Her basis is

$4,800. The $4,000 in sales proceeds less $4,800
basis equals an $800 loss.
Updated by Brett Danko Income Tax 7-15
 Material current through July 2019 exam cycle

NOTE: When the amount realized is less than the adjusted

basis, the resulting loss is treated as an ordinary loss.
Installment sale recapture
If you make an installment sale of tangible personal property, all depreciation recapture
must be reported as income in the year of disposition. This is a serious disadvantage.
Example
Mr. Thomas sells a large dredge for $800,000 on an installment note and receives $80,000 this
year. He originally purchased the property for $400,000 and took $300,000 in cost recovery
deductions. What amount is subject to recapture in the year of sale? Mr. Thomas must pay taxes
on $300,000 of the gain at ordinary income rates. The remainder of the gain ($400,000) is
subject to the installment sale rules over the ten years.
Mr. Thomas “realizes” a gain of $700,000. Although he only receives $80,000 this
year, the recapture is $300,000. This can cause serious cash flow problems.
Original cost $400,000 Sells for $800,000
Cost recovery deductions -300,000 Adjusted basis -100,000
Adjusted basis $100,000 Gain $700,000

Look back $300,000

Gain $400,000

Practice questions
1. Dan sells a classic automobile to his brother-in-law under the
following terms:
– The selling price is $25,000.
– Dan’s purchase price was $15,000.
– Dan’s brother-in-law will pay five annual installments of
$5,000 plus accrued interest.
Ignoring interest income, what amount of gain will Dan recognize
for the current year?
A. $2,000 C. $ 5,000
B. $3,000 D. $10,000
Answer: A Dan’s gross profit percentage is 40% (profit
$10,000 : contract price $25,000). ($5,000 x
40% = $2,000). There is no recapture because he
never depreciated the car.
2. Mike sells a car he used 100% in business. He bought the car for
$30,000. He took cost recovery deductions of $15,000. He sells
the car to his brother-in-law for $18,000. Mike’s brother-in-law
will pay three annual installments of $6,000 plus accrued
interest. Ignoring interest income, what amount of gain will Dan
recognize for the current year?
A. $-0- D. $15,000
B. $1,000 E. $18,000
C. $3,000

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 Material current through July 2019 exam cycle

Answer: C Mike sold the car for $18,000. $18,000 less the
adjusted basis of $15,000 equals gain of $3,000.
The $3,000 gain is subject to recapture in the
year of sale. The recapture up to the amount of
cost recovery deductions claimed applies up to
the gain realized. If any excess gain remains,
it is subject to the installment sale rules. In
this case nothing remains.
3. This year, Paul Green sells a business automobile to Ken Meyer
on the following terms:
– The price is $6,000, equal to the car's fair market value.
– Paul’s basis in the auto is zero; the cost of $14,000 had been
fully recovered using straight-line depreciation.
– Ken will pay in six annual installments of $1,000 plus
accrued interest.
– There is no down payment.
Ken makes the first installment payment this year. Ignoring
interest income, what amount of gain will Paul recognize for the
current year?
A. $429 D. $2,000
B. $571 E. $6,000
C. $1,000

Answer: E Paul must recover any gain as ordinary income

first (depreciation recapture). He has fully
depreciated the property (zero basis). Therefore,
all gain ($6,000)is recovered in current year as
ordinary income.

E. Related parties
Like-kind exchanges and installment sales are subject to the related party rules. When a
taxpayer exchanges like-kind property with a related taxpayer and within two years the
related party disposes of the property, any gain not recognized in the exchange is
recognized on the date of the sale.
F. Wash sale rule
No loss deduction is allowed for any loss or other disposition of stock or securities if
within a period beginning 30 days before and ending 30 days after the sale the taxpayer
acquires substantially identical stock or securities.
Example
6/15/2018 Buys 100 shares of XYZ $100/share
12/1/2018 Buys 100 shares of XYZ $50/share
12/15/2018 Sells 100 shares of XYZ, purchased 6/15/2018 $55/share
Result: No loss deduction is allowed for any loss within a period of 11/15/2018 to 1/14/2019 (30
days before or after the date of sale) if the taxpayer acquires substantially identical stock or
securities (which he did on 12/1/2018). The basis of the 12/1/2018 shares is increased by the
amount of the disallowed loss. ($50 basis is increased by $45 loss – new basis $95. The $45
loss comes from $100 - $55.)
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G. Charitable Bargain sales

If a charitable deduction is available, the basis of the property sold to the charity for less
than fair market value must be allocated between the portion of the property "sold" and
the portion "given" to charity, based on the fair market value of each portion.
Practice question
Bob sells land with FMV of $500,000 to a local charity for $300,000.
His basis in the land is $100,000. What is his taxable gain?
A. $0 D. $300,000
B. $100,000 E. $500,000
C. $240,000
Answer: C $300,000 (realized) x $100,000 (basis) = $60,000
$500,000 (FMV)
$300,000 (sale) - $60,000 (adjusted basis) = $240,000
Bob’s basis is adjusted because he claimed a $200,000
charitable tax deduction. If the basis wasn’t
adjusted he would benefit disproportionally.

Practice questions: Case / Evaluation

1. Mrs. Tuttle is about to retire. At retirement (NRA) she will get
$1,500 per month from Social Security and $1,000 per month from
her employer’s retirement plan. She feels she needs to
reposition her assets to produce more income. She is currently
in a 24% tax bracket, but when she retires she will drop into a
10-12 bracket. What should she sell and when?
A. She has a $10,000 loss in Global Tele with a current FMV
$50,000. She should sell and take the loss this year.
B. She has a $10,000 gain in municipal bond fund with a
current yield of 3.5%. Comparable AAA bonds are paying 6%.
She should sell next year.
C. She has no gain in A REIT worth $40,000 with a current
yield of 5.5%. She should sell this year and buy AAA
bonds.
D. She has a $20,000 gain in a Growth and Income fund worth
$40,000. She should sell next year.

Answer: B The lower the marginal income tax bracket, the

less advantageous the tax exempt income becomes.
If she sells the municipal bond next year, her
capital gains tax will be zero. The TEY of the
AAA in her future tax bracket will be superior to
the muni TEY. Answer A is wrong because she can
only take a loss of $3,000 this year. Selling
the other funds is not particularly tax
effective.

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 Material current through July 2019 exam cycle

2. If Mrs. Tuttle from the prior question would also like to sell
her home with a $300,000 gain to relocate to Florida this year,
which of the prior answers would you suggest?
A. Global Tele
B. Municipal bond
C. REIT
D. Growth and Income
E. None, she can use Section 121 to offset the gain.

Answer: A There is nothing to indicate that she is actually

married. Just because it says Mrs. Tuttle does
not mean she is married. The question says “she”.
There is never any mention of spousal income.
Her exemption is only $250,000. She will have a
capital gain of $50,000. The Global loss could
be used against the gain.

3. Tom and his wife want to sell their ranch in Florida (FMV
$1,500,000/basis $500,000) and move to Montana. While looking
for land in Montana they met with a rancher who wants to move to
Florida. He owns land with a FMV of $1,000,000 and a basis of
$100,000. Tom and his wife told him it was not an acceptable
exchange. He has countered by adding cattle worth $500,000. If
they accept his offer, how much recognized gain will they be
taxed on?
A. $0 D. $1,000,000
B. $500,000 E. $1,500,000
C. $900,000

Answer: B The boot is $500,000 (cattle – not like kind)

Receives land $1,000,000 plus cattle $1,500,000

Gives up land with a basis 500,000
Realized Gain $1,000,000

NOTE: The recognized gain is the lesser of the boot $500,000

($500,000) or realized gain. ($1,000,000)

4. Ted has owned a real estate property which has a fair market
value of $1,000,000, an adjusted basis of $200,000. The
property has a $500,000 loan against it. He wants to exchange
it for a parcel of land worth $100,000 (FMV). But as part of
the exchange the person will assume his loan (his liability).
How much gain will he have to recognize?
A. $100,000 D. $400,000
B. $200,000 E. $500,000
C. $300,000

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 Material current through July 2019 exam cycle

Answer: D

Fair market value of the property received $100,000

Liability assumed by purchaser $500,000
Total $600,000
Less adjusted basis of Ted’s real estate 200,000
Realized Gain $400,000

NOTE: The recognized gain is the lesser of the boot received

($500,000 liability assumed-same as cash) or realized gain.
($400,000)

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 Material current through July 2019 exam cycle

Alternative minimum tax (AMT)

Lesson 8 Alternative minimum tax (AMT)
A. Mechanics
The alternative minimum tax, or AMT, is a separate method of calculating income tax
liability. It applies in cases where the calculation of the AMT results in a higher tax
liability than the calculation of the regular income tax. The purpose of the AMT is to
prevent the taxpayer from reducing his or her tax liability below reasonable levels.
Therefore, in calculating the AMT, certain tax benefits available under the regular tax
rules are limited or lost.
The Tax Cuts and Jobs Act of 2017 retained the Individual AMT (while it repealed the
corporate AMT). According to the Tax Institute, only about 200,000 tax filers are
expected to owe the AMT in 2018, dramatically fewer than the 5.25 million who likely
would have under the old tax law. However for tax years 2018 through 2025 it provides
temporary increases in both the exemption amount and the phaseout threshold. These
changes will temporarily reduce AMT liability relative to 2017 rules but still require
taxpayers to calculate both traditional 1040 tax liability and tax liability factoring the
AMT.

The maximum AMT rate is “only” 28% versus the 37% regular tax maximum rate that
applies for 2018-2025 under the TCJA.

Exemptions Increase
The amount of income automatically exempt from the AMT calculation has been
increased to $111,700 for joint filers and to $71,700 for individual filers..

The TCJA increases the exemption phaseout level – which is the income level above
which the taxpayer gradually lose you’re the exemption, until it phases out completely.
The phaseout levels were raised to $1,020,600 for joint filers and to $510,300 for
individuals

Historically the AMT is generally applied for filers claiming substantial exemptions,
credits and deductions that are not allowed under AMT rules.

However, the Jobs Act eliminates many of those breaks (such as personal exemptions)
and it has limited the value of others, such as the state and local tax deduction.

The estimated 200,000 filers who will continue to face AMT exposure are likely to be
very high-income households claiming large, less-than-typical tax breaks such as tax-
exempt interest on private activity bonds.

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 Material current through July 2019 exam cycle

AMT calculation
– Start with regular post-deduction 1040 income (if itemizing) or AGI (for standard
deduction)
– Add back any item that was deductible for the 1040 but not for AMT (see AMT
deduction)
– Add preference items
– Result equals AMT base
– Subtract exemptions
– Result equals AMTI (Alternative minimum taxable income)
– Then calculate AMT (26% and 28% tax rates)

B. Preference items (only the important ones are listed) IPOD

– Private-activity municipal bond
– Oil and gas percentage depletion / Excess Intangible drilling costs (IDC)
Percentage depletion is the excess depletion over the property’s adjusted basis.
– Depreciation (ACRS / MACRS) – but not straight-line

Depletion is an allowable deduction which is allowed in determining taxable income from

natural resources. The deduction is similar to depreciation in that it allows the taxpayer to
recover the cost of an asset over the resource’s productive life. Percentage depletion typically
triggers AMT because it is accelerated. Cost depletion is not an AMT preference item.
C. Exclusion items vs. deferral items
Some itemized deductions are not allowable deductions for calculation of the AMT
which are called add back items.

Property, state, city/income and sales taxes Add Back Item

(Now limited to $10,000/year)
Incentive stock option bargain element Add Back Item
("Bargain element" is the excess of the fair market value at the exercise date
over the option price.)

Other itemized deductions such as medical expenses, qualified residence interest, investment
interest, charitable deductions and casualty and gambling losses are not add back items. In
addition, the standard deduction is deductible. The personal exemption is no longer available for
the regular tax computation – or AMT.

Practice questions
1. Which itemized deduction is not added back to calculate the AMT?
A. Real estate taxes C. State income taxes
B. Charitable giving D. Financial planning fees
Answer: B
2. Which of the following is (are) AMT preference item(s)?
A. Cost depletion in excess of adjusted basis
B. Municipal bond interest (public purpose)
C. Personal exemption
D. MACRS
E. Standard deduction
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 Material current through July 2019 exam cycle

Answer: D MACRS depreciation is a preference item.

Percentage depletion is an AMT preference item,
but cost depletion is not. Private activity bond
interest is an AMT preference item, but interest
on public purpose municipal bonds is not. It
must say private activity. Personal exemptions
have been suspended. Standard deductions are not
part of the calculation (not usable). Add back
items are not preference items.
3. Which of the following are preference items or adjustments for
purposes of the alternative minimum tax?
I. Qualified housing interest
II. Investment interest expense in excess of net investment
income
III. Qualified private activity municipal bond interest
IV. The excess of depletion over the properties adjusted basis
A. All of the above C. II, III E. I, IV
B. I, III, IV D. III, IV
Answer: D Private activity municipal bond interest and
percentage depletion are preference items.
Answer IV describes percentage depletion. Answer
I is neither a preference item nor an add back
item. The same is true with Answer II.
D. Credit, operation, usage, and limitations
Instead of a standard deduction, an individual return has an AMT exemption. The
applicable exemption amount is determined by the taxpayer's filing status and is phased
out for upper income taxpayers. It may phase out entirely.
AMT Rules and examples - 1040 – alternative minimum tax (AMT)
The tentative minimum tax is compared to the regular tax (1040).
– If the regular tax after credits equals or exceeds the tentative alternative minimum tax amount,
then no AMT payment is required.
Example 1
If the regular tax is $125,000 and the tentative alternative minimum tax is $119,000, no AMT is
due.
– If the regular tax is less than the alternative minimum tax amount, then the difference is the
AMT payable.
Example 2
If the regular tax is $125,000 and the alternative minimum tax is $140,000, then the AMT
payable is $15,000.

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 Material current through July 2019 exam cycle

Practice question
What is the alternative minimum tax payable for the following
situation? Bill and Linda Sanders are married and file a joint
income tax return. They have estimated their regular tax to be
$23,500 for the current year. What is their alternative minimum tax
payable based on the following information?
Adjusted gross income $150,150
Excess intangible drilling costs $ 22,000
Percentage depletion in excess of adjusted basis $ 14,250
Home mortgage note interest $ 11,500
AMT $ 33,384

A. $7,394 C. $33,384
B. $9,884 D. $40,778

Answer: B The difference between the AMT ($33,384) and the

regular tax ($23,500) is the AMT payable ($9,884). The
AMT ($33,384) is not the additional tax due.

E. Application to businesses and trusts

C corporations are no longer subject to the AMT. However, certain smaller corporations
are exempt from the application of the AMT.

F. Planning strategies
Can the AMT be postponed or avoided?

Answer: Yes, the AMT can be postponed or avoided by reviewing income and
expenses. It may entail increasing regular income tax liability.
How?
– By accelerating the receipt of taxable income or deferring payment of property
taxes, state income taxes, deductible medical expenses, or charitable giving, the regular
tax (1040) may exceed the AMT payable (more taxable income).
– By deferring the exercise of an incentive stock option (add back item) to a later date
or disqualifying the ISO so it becomes a nonqualified stock option (income taxable)
– By purchasing public purpose municipal bonds (instead of private activity bonds)
Practice questions
1. Which one of the following helps a taxpayer avoid paying AMT?
A. Increase the amount of charitable gifting this year
B. Exercise nonqualified stock options this year
C. Buy a larger home with more property taxes (pay the
property tax this year)
D. Buy a larger home with a maximum mortgage
Answer: B Exercising nonqualified stock options (NSOs)
increases taxable income. Any tax item that
increases the regular tax is correct for
minimizing the AMT. Answers A, C, and D decrease
regular taxable income and thus increase the
exposure to paying AMT.

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 Material current through July 2019 exam cycle

2. Which one of the following activities helps a taxpayer

avoid paying AMT?
A. Earning more commissions
B. Increasing charitable deducations
C. Exercising ISOs this year
D. Buying an oil and gas partnership
Answer: A Commissions increase regular income and tax.
Charitable deductions reduce regular income tax.
Exercising ISOs increases AMT exposure.

Practice questions: Case / Evaluation

1. Mr. Terry has a taxable income of $200,000 (32% marginal
bracket). He lives in New York paying high real estate taxes,
high state and local taxes. As a result, he is always hit with
a sizable tentative minimum tax (AMT). What could he do to
reduce his AMT?
A. Move out of New York
B. Sell his home
C. Increase his taxable income by earning more income or
reducing itemized deductions
D. Reduce his taxable income
Answer: C If Mr. Terry increases his regular income tax
liability, he decreases his AMT exposure. Yes, if
he sells his house his real estate taxes will
disappear and he may still have add back items
which are creating his AMT exposure.

2. Mr. and Mrs. Fair have been informed by their CPA that they are
going to have to pay $28,000 of tentative minimum tax (AMT). Of
the following, what activity could have caused the AMT?
A. They purchased a large amount of public purpose municipal
bonds.
B. They purchased a large amount of a S&P 500 mutual fund.
C. They donated a large amount of money to a public charity.
D. They sold their house (gain $500,000) after living in it
for 10 years. They invested the proceeds in balanced mutual
funds.
Answer: C The substantial charitable donation reduces their
regular income tax, thus increasing AMT exposure.
Neither A or B affect AMT. Answer A is public
Purpose. The S&P fund is tax efficient.
Since they sold their house they are not
itemizing and that reduces AMT.

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 Material current through July 2019 exam cycle

3. Mr. and Mrs. Lein want to lower their federal income tax
exposure. Both of them work and their earned income is close to
$200,000 after their 401(k) contributions. To reduce their tax
liability they bought a large house with a substantial mortgage.
They pay real estate taxes and local taxes. They donate
generously to various charities. They cannot deduct for medical
or dental expenses because of their AGI. As a result, their
marginal tax bracket is 24%. When they got their 1040, they had
an AMT hit of extra taxes at 26%. Most likely, what caused the
AMT?
I. Real estate taxes
II. Mortgage interest
III. Local taxes
IV. Charitable giving
V. AGI

A. All of the above D. IV

B. I, II, III E. V
C. I, III
Answer: A AMT is calculated based on AGI. The itemized
deductions reduce the regular taxes (interest and
charitable donations). Indirectly they trigger an AMT
tax because they reduce the regular tax. Some items
are added back (taxes). The answer to AMT reduction
is generally to pay more regular tax.

4. Harry and Bev Latel both are earning high levels of

compensation. As a result, they are high up in the 37% bracket.
They pay a regular tax of around $325,000. They save regularly
because they want to retire early. They currently rent a 1,500
square foot condo in a downtown building. They drive their cars
for 6-7 years. They only give a limited amount to various
charities. However, they are not itemizing. They are claiming a
standard deduction. They say they are aggressive investors, but
mainly invest in low turnover growth funds. Do they appear to
have an AMT problem?
A. Yes, their income levels will trigger AMT.
B. Yes, without being able to itemize their AMT will be
excessive.
C. No, without itemizing their AMT will not be a factor.
D. No, saving and investing their income will reduce their
AMT.
Answer: C Because they are not itemizing and there are no
AMT preference or add-back items, they would
have an AMT problem when they are in the 37%
bracket. The AMT maximum tax is 28%.

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Passive activity / Tax implications of special circumstances

Lesson 9 Passive activity and at-risk rules
A. Definitions
A "passive activity" generally means a trade or business in which the taxpayer does
not "materially participate." The general rule is that losses from passive activities may
only offset profits from other passive activities.
A passive activity loss may generally not be used by a taxpayer to reduce portfolio
income, compensation, or business income. The 1986 tax act separated earned
investment and passive income, active income (wages, commissions), portfolio income
(dividends, interest, capital gains), and passive income (nonpublic limited partnerships).
Losses from these nonpublic traded limited partnerships (called passive activity losses or
PALs) Non-publicly traded partnerships (referred to as RELPs – real estate limited
partnerships) can only be used to offset income from nonpublic limited partnerships
(called passive income generators or PIGs). The PALs and PIGs are on the right side.
The netting process is done on a Schedule E. Active participation (gains and losses) is
also on the Schedule E. Active participation (Schedule E) affects some questions in this
lesson.
Investment in passive activities
Individuals may own equity interests in business enterprises without rendering any
personal service to the business (not materially participating). Many partners and
shareholders have no involvement in the business activity of these enterprises, yet such
owners are allocated a share of operating income and losses. This income or loss is
considered passive.
Example
Paul Murphy owns and operates PM, Inc., an S corporation. He materially participates.
Janet Murphy, his daughter, owns some shares of PM, Inc., but she works for another company
full-time. She does not materially participate. Her unearned income will be passive income.
The owner of the passive activity (the limited partner) can only deduct the loss to the
extent of income generated by another passive activity.
There are two kinds of passive activities.
1. Rentals, including both equipment and rental real estate (exception: active
participation) and royalty income (oil royalties)
2. Businesses in which the taxpayer does not materially participate include the following.
– Limited partnerships (with some exceptions)
– Partnerships, S-corporations (with some exceptions), and limited liability companies
in which the taxpayer does not materially participate
Publicly traded partnership (PTP) rules
These are also known as master limited partnerships (MLPs). A partnership is publicly
traded if the interests in such partnership are traded on an established securities market.
Income from a PTP may not be sheltered by passive losses from any other source. PTP
income is portfolio income (like dividends) and is shown on Schedule B.
Losses from a PTP may not be used to offset passive income from other sources. Net
loss from a PTP must be carried forward and used only against the future income from
that same partnership. This is shown using circles. The loss in the top PTP cannot

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 Material current through July 2019 exam cycle

escape the circle. The loss is carried forward until it can be offset against income in that
same partnership or until the partnership is sold. The income in the bottom PTP is
investment income.

B. Computations

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 Material current through July 2019 exam cycle

Practice question
Alice has furnished the following information to her financial
planner. How much income must she report, and how much of the losses
can she use against income?
Income from ABC
(a publicly traded limited partnership) $10,000
Loss from DEF
(a publicly traded limited partnership) $11,000
Income from RST
(a non-publicly traded limited partnership) $13,000
Loss from XYZ
(a non-publicly traded limited partnership) $19,000
A. $23,000 income/$30,000 losses
B. $10,000 income/$19,000 losses
C. $10,000 income/$13,000 losses
D. $13,000 income/$13,000 losses

Answer: C She must report the income ($10,000) from the publicly
traded partnership. She can offset the non-publicly
traded partnership income (PIG $13,000) against losses
from the non-publicly traded partnership (PAL $19,000)
using $13,000 of losses. (C answers the question.)

Practice questions
1. Which of the following could be a passive activity?
I. 30% ownership in XYZ, Inc., an S corporation
II. 25% ownership in ABC, a partnership
(materially participates/makes management decisions)
III. 0.8% ownership in a real estate limited partnership
IV. Active participation in rental real estate
A. I, II, IV C. I, III
B. I, II D. III, IV

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 Material current through July 2019 exam cycle

Answer: C A limited partner is normally a passive

investor. S corporations can produce passive
income to investors who do not materially
participate. It doesn't indicate material
participation. In Answer II the investor
materially participates. Answer IV is an
exception to the passive activity rules. Since
III is positive and II and IV are not, then the
answer is C.
2. In 2014, Paul purchased an interest in a non-publicly traded
partnership. He has carried forward a passive loss of $5,000.
What can he do to deduct the loss?
A. Buy an interest in a publicly traded partnership that will
generate $5,000 of income
B. Buy an interest in an S Corporation that will generate
$5,000 of income (material participation).
C. Sell the non-publicly traded partnership interest
D. Sell common stock with a gain of $5,000
Answer: C Publicly traded partnerships produce portfolio
income. If Paul is a material participant the S
corporation is active income. The sale of stock
for a gain is “portfolio gain” (reported on
Schedule D) whereas a passive loss is reported on
Schedule E. To realize the passive loss, Paul
must sell the partnership interest.
C. Treatment of disallowed losses
Disallowed losses are carried forward (suspended losses) until the taxpayer can dispose
of the interest. For passive investments, there is no $3,000 per year loss allowed per year
(like capital loss).
D. Disposition of passive activities
The passive activity loss limitation is not a permanent disallowance. The partnership can
make income that can be offset by its loss. When an investor disposes of his/her entire
interest in a passive activity in a taxable transaction (generally a sale of all the
properties), any suspended losses with respect to the interest are fully deductible in the
year of disposition. The partnership can be sold for a loss. Lastly, the investor can buy a
non-publicly traded partnership that makes income (PIG).
Miscellaneous - Phantom income
Phantom income may occur in a tax shelter created prior to the 1986 Act where real
estate properties, having declined in market value, are refinanced or the debt is forgiven.
Income arises from portions of debt that are forgiven. There are also other forms of
phantom income like zero bonds, S corporation K-1s with no cash distributed, etc.

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Practice question
Which of the following type of income is not phantom income?
A. Limited partnership income that arises from debt restructuring,
creating taxability without generating cash flow
B. Imputed interest from zero coupon bonds
C. A life policy, with a taxable gain and a maximum loan, which
lapses
D. K-1 income from an S corporation with no corresponding check
issued
E. EE bond interest
Answer: E The EE interest is deferred unless the owner elected
to have the interest taxed each year. This rarely
occurs. Imputed interest (interest not actually paid)
is still taxable.
E. Passive Loss Exceptions for Real Estate
Material participation
A taxpayer will be treated as materially participating in an activity only if the taxpayer is
involved in the operation of the activity on a regular, continuous, and substantial basis.
Generally, no limited partner is treated as materially participating in the partnership's
activity.
Active participation
Active participation is a less stringent standard than material participation. Although
passive, it is an exception to the passive loss rules. It merely requires bona fide
involvement in management decisions. A limited partner may never be an active
participant. To qualify, the taxpayer must own at least a 10% interest in the property.

NOTE: Active participation in residential real estate can produce profit (income) or loss. The
income or loss is shown on Schedule E.
Example
Lucy owns a small apartment complex. She decides on rental terms, arranges for repairs, etc.
Does she actively participate?
Yes, she need not have regular, continuous, and substantial involvement in operations. However,
a merely formal and nominal participation in management, without a genuine exercise of
independent discretion and judgment, is insufficient. The “active investor” has to be the
“decider.”
$25,000 loss
Qualifying taxpayers may deduct up to $25,000 per year of net losses from the real estate
activity. This deduction (up to $25,000) is phased out for taxpayers with AGIs between
$100,000 and $150,000 on a 2-for-1 basis. The deduction can offset their active or
portfolio income.
Example
John owns an apartment building that he manages himself. This year his adjusted gross income
is $110,000. His building generates tax losses of $28,000. $5,000 of his
special $25,000 will be disallowed ($10,000 x .50). Therefore, John is entitled to deduct $20,000
from his AGI. The remaining $8,000 will be subject to passive loss rules.
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Practice questions
1. Bob owns a 4-unit apartment complex. Because of rehabilitation
construction costs, the complex generates current year losses of
$27,000.
If he has $62,000 of W-2 employment income, what is his AGI?
A. $35,000 C. $49,500
B. $37,000 D. $62,000
Answer: B ($62,000 - $25,000 = $37,000) Up to $25,000
2. Hal owns a small apartment complex. The complex generates
$27,000 of losses. If he has $57,000 of W-2 income, what
amount of the losses can Hal deduct?
A. $0 C. $27,000
B. $25,000 D. $57,000
Answer: B He can deduct up to $25,000. His AGI will be
$32,000 ($57,000 - $25,000).
3. Mr. Litell earns $90,000 a year as a salesman. He also owns
a duplex that he rents out on a regular basis. Due to unforeseen
circumstances, the duplex creates $30,000 in losses. If he is
eligible to itemize, can he deduct the losses?
A. No, losses on real estate property cannot be itemized
deductions.
B. Yes, he can take the $30,000 real estate losses because
he has active income.
C. He can only deduct losses up to basis.
D. Yes, he can claim $25,000 of losses.
E. He can only deduct up to $3,000 unless he has
capital gains to offset the losses.
Answer: D A real estate owner who is an active participant
can deduct up to $25,000 if his AGI is less than
$100,000. The losses are reported on the
Schedule E and then on the front of the 1040.
There is no $3,000 limitation. Losses
exceeding $25,000 can be carried forward.
Rental of the principal residence (Not a passive activity)
The simplest tax treatment of a home results when the taxpayer rents his/her home for
less than fifteen days during the taxable year. In such cases, the rental income is
excludible from the taxpayer's gross income, but no deductions attributable to the rental
use are allowed. The amount of the rental income is not important but the number of
rental days is.

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Practice question
Rudy rents his beachfront home out to fraternity brothers during
Florida spring break for $4,000/week (to cover damages). The rental
period is 14 days. What is Rudy's tax consequence?
A. Rudy can write off the repairs against income.
B. Rudy doesn't have to report income.
C. The repairs are deductible, but Rudy cannot show a loss.
D. In addition to deductible repairs, Rudy can deduct an allocated
portion of real estate taxes, depreciation, and other expenses.
Answer: B A home can be rented for up to 15 days during the year
with no tax consequence.
Renting your vacation home (Normally a business)
A home is treated as a residence in any tax year in which the owner's use of the unit for
personal purposes exceeds the longer of (1) 14 days or (2) 10% of the period of rental
use.
Example
Mr. and Mrs. Pool use their beachfront condo twenty-nine days a year. The condo usually rents
for 300 days a year. Therefore, the condo will still be treated as rental property for tax purpose,
and deductions attributable to rental use may be allowed.

Practice question
Loretta owns a rental home in the mountains. The normal rental period
is at least 180 days a year. How many days can Loretta use the
vacation home and not lose its rental characteristics?
A. 14 days C. 180 days
B. 18 days D. 185 days
Answer: B The longer of fourteen days or 10% of the rental
period (eighteen days)
Low income housing credit
Low income housing programs that are held as a passive activity may generate a
deduction-equivalent tax credit up to $25,000. There is no phaseout.
How does the deduction-equivalent tax credit work?
Calculate your tax to determine the maximum marginal tax bracket. If it is 37%, for
example, then multiply $25,000 times 37% for a credit of $9,250.
NOTE: The Historical Rehabilitation Credit is still available, but often not a productive deduction. It
phases out at $200,000 AGI. So for example, Client’s tax rate is only 25%, then the credit is only
$25,000 x 25% or $6,250. The credit amount is important. These programs depend on credits, not
returns, to make them worthwhile investments.

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Practice questions
1. Ronald has carryover losses (Schedule E) from non-publicly
traded partnerships of $20,000. He still owns the partnerships.
What can he do to use the losses?
I. Sell the partnerships
II. Buy a publicly traded partnership
III. Buy a non-publicly traded partnership
IV. Buy a duplex that produces income (active participation)
A. I, II C. I, IV E. IV
B. I, III D. III
Answer: C Ronald can realize the losses by selling the
partnerships. He can also seek passive income
that can be offset by his passive losses. Answer
III is wrong because it does not say it will
produce income (Schedule E). It is an exception
to the nonpublicly traded rules because losses by
active participation are considered passive.

2. Sam is single. His AGI usually ranges from $200,000 to

$250,000. He would like to reduce his AGI and his taxes if
possible. What do you suggest?
A. He should consider buying a small apartment complex that he
could oversee.
B. He should consider buying into a historical rehabilitation
program that generates losses.
C. He should get married.
D. He should consider buying a low income housing that
generates losses and credits.

Answer: D Investing in low income housing is likely to

produce losses and the credits Sam is seeking to
reduce his AGI and tax liability. If answer A did
generate losses, he would not be able to use them
because he would be above phaseout ($150,000).
Answer B is wrong because he is above phaseout
($200,000 - $250,000). Answer C may reduce taxes,
but it doesn’t answer the whole question.
Marriage doesn't reduce AGI. It could reduce his
taxes due to a higher standard deduction
Oil and gas working interests
Oil and gas working interests are not passive forms of participation and thus are
exempted from PAL rules. Losses from oil and gas working interests (general partner)
for which the taxpayer is personally liable are deductible against active or portfolio
income without limits and without respect to the taxpayer's AGI. To qualify as a working
interest, the form of ownership may not limit the taxpayer's personal liability. If you are
a limited partner, you cannot take the loss. The loss becomes a passive loss. Percentage
depletion triggers AMT. Cost depletion is not an AMT preference item.

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Equipment leasing
A closely held C corporation that is not a personal service corporation may use passive
losses to offset active, but not portfolio, income. This is an exception for closely held C
corporations only; it is not available to S corporations.
Example
ABC Inc., a closely held C corporation, owns an equipment leasing partnership (as a limited
partner). ABC Inc. invested $50,000 (cash) and is at-risk for $60,000 (direct loan). Z Inc. may
deduct up to $110,000 (basis) of loss.
Tax implications of special circumstances
A. Married/widowed
1) Filing status
For the taxable year in which a married person dies, the widow or widower can file a
joint return "with" the deceased individual. The executor generally signs the return on
behalf of the decedent. If the widow or widower maintains a home for a dependent child,
he or she qualifies as a surviving spouse for the two taxable years following the year of
death. As such, the individual can use the married filing jointly rates for these two years.

Example
Mr. Smith died on January 10, 2018, and Mrs. Smith has not remarried. The couple had two
dependent children, who live with their mother. Because Mrs. Smith meets the definition of
surviving spouse, she will be entitled to compute her tax liability for 2018 (the year of her
husband’s death) and 2019/2020 (two years following) using married filing jointly rates.

2) Children
Dependency exemptions
For 2018-2025, the new law eliminates personal and dependent exemption deductions,
which would have been $4,150 each for 2018 under prior law.

However, for various tax provisions that make reference to persons for whom dependent
exemption deductions are allowed (such as eligible rules for head of household filing
status, the child and dependent care tax credit, education tax credits, and certain child-
related tax breaks for non-custodial parents after divorce, the dependent exemption
deduction is still deemed to exist for 2018-2025. However, it is valued at $0. This is an
odd quirk in the tax code.

1. Under age 24 as of the end of the year if they are full-time students, and
2. Under age 19 as of the end of the year, whether or not they are students

NOTE: Such children may earn any amount and still be claimed as your dependents,
provided they meet the support test (50% of total support).

3) Community and noncommunity property

If separate returns are filed by a married couple in a community property state, one-half
of the community income must be reported by each spouse. In Idaho, Louisiana, Texas,
and Wisconsin, income from separate property is community income, with one-half being
allocable to each spouse. In the other community property states, income from separate
property is treated as separate income.

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Example
Jack and Jill Hill live in California, a community property state. Jack has earned income of
$100,000, and Jill has earned income of $75,000. In addition, Jack has $50,000 of unearned
income from a separately owned asset. If they file separately, how much income must Jack or
Jill claim?
Jack - ½($100,000 + 75,000) + $50,000 = $137,500
Jill - ½($100,000 + 75,000) = $87,500

B. Divorce
1) Alimony requirements
The 2017 Tax Cuts and Jobs Act changes the tax implications related to alimony. The
new rule does not go into effect until 2019, and only for divorces finalized or modified
after 2018. For divorces after December 31, 2018, alimony payments are no longer
deductible nor must the recipient declare the amount as taxable income. The law
does allow ex-spouses to modify an earlier divorce agreement to adopt the new rule after
2018. Both ex-spouses must agree to the change.

If a pre-2019 divorce is not modified, the old rules apply: the payer can deduct the
payments and the recipient must pay tax on them.

Alimony is deductible by payor and taxable to payee if the following requirements are
met.
– The divorce was finalized before December 31, 2018.
–The taxpayers cannot file a joint tax return or live together at the time of payment.
– Payments must be made in cash.
– Payments must be received by or for the benefit of the payee spouse
(i.e., not child support).
– The payments cannot extend beyond the death of the recipient spouse.

Alimony test for deductibility - cash payments

-- Transfers of noncash items including services, property or the use of property,
or promissory notes will not qualify as alimony.
-- Cash payments to third parties can qualify if made pursuant to the divorce
Payor Taxes/ instrument for an obligation of the spouse, such as payments of the spouse's
Interest rent, mortgage, tax, or tuition liabilities.
Payee owns
-- Any payments to maintain property owned by the payor spouse and used by the
payee spouse (including mortgage payments, real estate taxes, and insurance
Payor premiums) will not qualify as payments made on behalf of a spouse and will
not be alimony, even if required under the terms of the divorce instrument.
Taxes /
Interest Payor owns -- If the payee spouse owns the life insurance policy on the life of the payor, the
policy payments made by the payor will qualify as alimony if the payments are
made under the divorce instrument.

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Practice questions
1. Which of the following expenses qualify as an alimony payment to
a spouse if made pursuant to a divorce instrument?
A. Payment of the payor-spouse’s mortgage
B. Payment of $3,000 into the payee spouse’s IRA
C. Payment of child support by the payor spouse
D. Payment of the premium on a life insurance policy on the
life of payor paid by the payee spouse
Answer: B Answer A is wrong. It is the payee’s mortgage
that qualifies as alimony. Child support is never
deductible alimony (covered next). Answer D would
have been correct if it were paid by the payor
spouse.
2. Which of the following items qualify as alimony payments to a
spouse if pursuant to a divorce instrument?
I. Mortgage payments for property owned by the payor spouse
but used by the payee spouse
II. Payment of the payee spouse's rent by payor spouse
III. Life insurance premiums on payee spouse
IV. Payments which continue beyond the payee spouse's death
with the children as named beneficiaries
V. Payment of payee spouse's tuition to State College to
become a CFP® practitioner per divorce decree
A. All of the above C. II, III, V E. III
B. I, II, IV, V D. II, V
Answer: D Tuition payments can qualify if made pursuant to
the divorce instrument. Payment of the payee’s
rent by the payor spouse is clearly alimony.
Payments made to maintain property owned by the
payor are not alimony. Only life insurance on
the payor spouse qualifies as alimony. The policy
must be owned by the payee spouse. Payments that
continue beyond the payee spouse's death are
considered child support.
Recapture rules -- excess front-loading of alimony
If a payor makes "excess" alimony payments, a special rule applies. The calculation is
based on the relative amounts of payments made during the first three post-separation
years. The Internal Revenue Code says if the alimony decreases too fast, it really is a
disguised property settlement. As a result, alimony paid (and deducted) will be recaptured
as ordinary income.
The easiest calculation reflects no alimony paid in the third year. Add what was paid in
the first two years, and subtract $37,500. The number comes from the first three years
[$15,000 year 2-3 and $15,000 + $7,500 from year 1-2].

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Example
Steve makes alimony payments of $82,000 in the first post-separation year, payments of $42,000
in the second year, and none in the third year. What is the amount of recapture?
1st year alimony $ 82,000
2nd year alimony + 42,000
Total $124,000
less constant - 37,500
Recapture $ 86,500

Practice questions
1. Betsy divorces Arthur. She is required to pay alimony to him.
Arthur wants the majority of the alimony quickly. He asks for
$70,000 in the first year, $50,000 in the second year, and then
nothing. How much of the alimony that Betsy pays is subject to
recapture?
A. $20,000 C. $62,500
B. $37,500 D. $82,500

Answer: D 1st year alimony $ 70,000

2nd year alimony 50,000
Total $120,000
less constant - 37,500
Recapture $ 82,500
2. What happens if Betsy (from the question above) pays $10,000 in
the third year?

Answer: C Double the 3rd year alimony payment ($10,000 x 2 =

$20,000), then add it to the constant $37,500.
The constant becomes $37,500 + $20,000 = $57,500.
Only use the first two years and subtract the
constant [$120,000 – (37,500 + 20,000)] = $62,500
recaptured.
2) Child support
– Child support payments are nontaxable to the payee and nondeductible by the payor.
– Any amount tied to a contingency or occurrence of an event relating to a child is
considered to be child support and not alimony.
Example
Patsy and John’s divorce instrument provides that alimony payments will be reduced by $1,000
when a child reaches age eighteen. Under these circumstances, $1,000 of each payment is
treated as child support.

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Practice question
1. In 2016, Keith Pierce was divorced from his wife, Barbara.
Barbara received custody of their two children. Keith was
ordered to pay $1,000 per month to Barbara until the youngest
child reaches age 18. At that time, the payments are to
decrease to $400 per month. What portion, if any, is deductible
by Keith as qualifying alimony?
A. -0- B. $400 C. $600 D. $1,000
Answer: B The $600 is tied to an occurrence related to a
Minor child (the child reaching age 18). Only
$400 is treated as alimony.
2. Harry divorces Gloria. Harry's mother gave him IBM shares 60+
years ago. His 10,000 shares are worth $1,000,000 with a basis
of $5,000. Gloria sues to get the shares as part of the
property settlement and is granted the stock. What is Gloria's
basis if she sells them?
A. $5,000 C. $502,500
B. $500,000 D. $1,000,000
Answer: A Gloria assumes the original cost basis of the
stock. No step up in basis applies in a divorce
related transfer.

3. Tess and Richard Carpenter bought shares of Microsoft many years

ago for $5,000 held JTWROS. The stock has split many times and
is now worth $100,000. Tess and Richard are now getting
divorced. She wants the Microsoft stock. What amount will her
basis be?
A. $ 5,000
B. $ 52,500 (her basis plus a $50,000 half step-up in basis)
C. $ 50,000 (split ownership)
D. $100,000

Answer: A Tess assumes the original cost basis. Answer

B would be correct if she kills Richard
prior to the divorce (but that would create
other nontax problems).

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Practice questions: Case / Evaluation

1. Harry is about to retire. He has worked as a handyman at a
small hotel for the past 10 years. There is nothing he cannot
repair. He is age 60 and has decided to wait as long as
possible to apply for Social Security benefits. Through various
employers he will be getting retirement benefits of $1,000 per
month. He has accumulated about $1,000,000 of investments that
normally generate 5% taxable income. He is considering buying a
small triplex at a distressed property sale. It needs
substantial work and repair. He estimates the improvements
(like new A/C) will cost $50,000. In addition, he feels it will
also produce a net loss of $20,000 the first year if the
property costs $100,000. Should he buy it if will return a net
taxable income of $22,000 per year?
A. Yes, because he can use an active participation loss of
$25,000
B. Yes, because he can use an active participation loss of
$22,000 in future years.
C. Yes, because the return will be better than his current
investments
D. No, he should not invest the money.
Answer: C His investment is $150,000 (includes
improvements). Ultimately he will get a 14.67%
return($22,000 divided by $150,000). His AGI is
below $100,000 so he can take an active
participation loss of $20,000 in the first year.
Sounds like a good investment for him in
retirement. He needs to keep busy after he
retires.

2. Sam Snead was talked into a poor investment many years ago.
This non-publicly traded partnership struggled through the
years. Now the properties are beginning to rise in value. Sam
has a carry forward loss of $50,000 on his Schedule E. The
partnership is not trading. The remaining investors are holding
their interest hoping the partnership will sell the properties
and dissolve. Sam has been offered $100,000 or more for his
interest in the partnership. The sale would be a private
transaction. He wants to know is there any way to take the
loss?
A. Yes, buy a PTP generating $50,000 of income.
B. Yes, buy options that will generate $50,000 of income.
C. Yes, sell it for $100,000 to the interested buyer.
D. No, there is no way to take the loss until the partnership
is dissolved.
Answer: C When Sam sells his partnership interest he can
realize the loss. Answers A and B produce
portfolio income. Then Answer D is wrong. The
non-publicly traded partnership is a security,
but not traded.
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3. Jim Jones bought an interest in a limited partnership (LP

Properties) that invested in a large rental type property in
Florida. As an accredited investor, he bought a $250,000
interest. LP purchased the property with cash of $10,000,000
and a bank loan of $90,000,000. Due to a real estate crash, the
property is only worth $75,000,000. LP Properties told the bank
that LP would default on the loan unless the bank renegotiated
the loan balance for $75,000,000 (current mortgage principal
$85,000,000). The bank agreed. What will happen at year end
when LP, Inc. sends a K-1?
A. Nothing, Jim Jones is a limited partner.
B. He will be able to take his proportionate share of loss
($250,000 divided by $10,000,000)
C. He will be charged with his proportional share of phantom
income due to mortgage relief.
D. His limited partnership interest will be reduced by the
amount of mortgage relief.
Answer: C The Internal Revenue Code treats debt relief as
if the taxpayer received income. With no cash
received now this becomes phantom income. The
bank will charge LP, Inc. with $10,000,000 of
income. The bank has to write the loss off.

4. Mr. Hardy bought an interest in a non-publicly traded

partnership(RELP) in 1985. It produced a series of initially
large losses and is breaking even today. Through the years the
$50,000 investment has produced a $20,000 loss with very limited
cash flow. What is the tax result with the loss?
A. He already wrote it off at $3,000 per year.
B. The loss has been carried forward and the only way he can
take it if the partnership ceases or he sells the
partnership
C. He could use the loss against investment income.
D. He could use the loss against income produced by a publicly
traded partnership.
Answer: B To realize the passive loss, Mr. Hardy must
dispose of his partnership interest. The losses
go on a Schedule E and can only be offset by
passive income. He cannot use the losses against
Answer C or D. If he bought a non-publicly
traded partnership (RELP) that produced income,
then he could use the losses. His only choice is
Answer B.

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5. Mr. and Mrs. Jones divorced in December of last year. As part

of the divorce, she gets the home which they owned and lived in
for 5 years. In March of this year, she sells it for a $400,000
gain. As part of the divorce settlement she agreed to split the
proceeds including the gain. How much of the gain is subject to
tax?
A. $0, they will get the $500,000 exclusion because they
agreed to split the proceeds
B. $150,000 ($250,000 exclusion applies)
C. $400,000, she only owned the home for 4 months
D. Without knowing the basis of the house, you cannot answer
the question.
Answer: A Although, she was single at the time of sale.
This situation falls under “unforeseen
circumstances”. She can qualify for the $500,000
exclusion for capital gains (Section 121). She
can count the years of ownership with her ex-
spouse to qualify for the exclusion. She will
have to make a “gift” of ½ the value of house,
not just the gain.

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Charitable contributions and deductions

Lesson 10 Charitable contributions and deductions
A. Qualified entities
1) Public charities - 50% organizations
– All churches, schools, and hospitals
– All organizations organized and operated for charitable, religious, educational,
or literary purposes or for the prevention of cruelty to children or animals
(United Way, Red Cross, Humane Society, etc.)

2) Private charities - 30% organizations

– Private nonoperating foundations – Fraternal orders
– War veterans' organizations

B. Deduction limitations
It takes more than ten pages in CCH to cover charitable giving. The rules are very
complex. This is an attempt to simplify them.

First - calculate the maximum deductible.

You cannot deduct more than 60% of AGI for cash gifts to a public charity. Any
contribution in excess of such limit is carried forward as an itemized deduction for five
years, or if sooner, death.

Simple example
Mr. and Mrs. C. contribute $60,000 of cash to charitable organizations. Their AGI is
$100,000. Their charitable deduction is limited to $60,000.

Second - calculate the eligible amounts given to 50% organizations (public charities).

Third - calculate the eligible amounts given to 30% organizations (private charities).

Example
In the tax year 2018, Mr. and Mrs. Daniels contribute $60,000 in cash to the United Way, a
public charity and $30,000 to the American Legion, which is a private charity. Their AGI is
$120,000. Their 2018 charitable deduction is calculated as follows:

Maximum 60% of AGI $72,000

Gift to public charity $60,000

Remaining for private charity (2018) $12,000

The remaining $18,000 may not be deducted on the Daniels’ current 2018 return.

C. Carryover periods
The unused charitable deduction amount may be carried forward for the next 5 years or
the taxpayer’s death, if sooner. With the five year carryover and the year of the
contribution, the actual deduction window is six years. The ceiling percentages remain in
force when the deduction is carried forward into future years.
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D. Appreciated property
Types of property - appreciated
The prime area of difficulty is a gift of appreciated property. An individual's deduction
ceiling for gifts of appreciated long-term capital gains property to 50% organizations is
30% of AGI unless he/she elects to use the property's basis rather than fair market
value (FMV). If the individual uses basis, he/she can deduct up to 50% of AGI.

Example
Sue purchased 1,000 shares of stock for $60,000. It is now worth $75,000 (LTCG). If she gives
it to a 50% organization and her AGI is $150,000, how do the appreciated property rules work?

If Sue uses fair market value, she can deduct $45,000 this year and carry forward $30,000.
$150,000 x 30% = $45,000 limitation

If she uses basis, she can deduct the whole $60,000 but loses the extra $15,000 (FMV) as a
deduction. $150,000 x 50% = $75,000 limitation

NOTE: It is rarely to the individual's advantage to use basis.

Practice questions
Jim Corley is planning to make a charitable contribution to a local
university, a qualifying charitable organization. He is going to
contribute a piece of real estate that he has owned for six years.
The fair market value of the property is $80,000, and the basis is
$35,000. He has an AGI of $120,000.

1. What is the maximum charitable contribution deduction that Jim

may claim in the current year for the gift of real estate?
A. $35,000 C. $40,000 E. $80,000
B. $36,000 D. $60,000

Answer: B The gift of long-term capital gains (LTCG)

property is based on the fair market value of the
property. The university is a 50% organization.
LTCG property contributed to a 50% organization
involves a 30% of AGI limitation. 30% of
$120,000 is $36,000. If he used basis, the
deduction would have been $35,000. It is rarely
to the individual's advantage to use basis except
when the basis is very close to the FMV.
2. What amount of the gift (Question #1) is carried forward until
next year?
A. -0- B. $20,000 C. $44,000 D. $45,000

Answer: C $80,000 (FMV) less $36,000 deduction this year

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Types of property - ordinary income

Ordinary income property, is property that, if sold, would produce ordinary income, not
capital gains. The deduction is limited to basis. Types of ordinary income property
include the following.
– Inventory – A work of art created by the taxpayer
– A copyright – Short-term capital gains property
– Use-unrelated property

NOTE: Stock and real estate are always use-related.

Practice questions
1. Mildred, a widow age 79, wants to donate $20,000 cash and
antiques with a FMV of $40,000 to Mercy Hospital. Mildred
bought the antiques for $3,000 some years ago. Since she spent
some time in the hospital, she feels the antiques will help the
appearance of the lobby area. Her AGI is $50,000. What is the
maximum allowable charitable deduction in the current year?
A. $50,000 C. $25,000 E. $18,000
B. $30,000 D. $23,000

Answer: DMaximum allowable 60% of AGI = $30,000

Up to 60% of AGI for cash = $20,000
Use unrelated* but limited to basis= $ 3,000
Total $23,000
*The hospital may have no use for the antiques and sell them.

2. Kate ($200,000 of AGI) is considering giving a painting to a

private university. Kate’s mother bought the painting for
$10,000 many years ago. When Kate’s mother died, Kate inherited
the painting which was then worth $50,000. It is now worth
$100,000. What is the maximum allowable charitable deduction
Kate can take in the current year?
A. $10,000 C. $60,000 E. $200,000
B. $50,000 D. $100,000
Answer: B Art objects – FMV can be used only if the charity
can use the art object in its charitable
activity. Otherwise, use basis (the inherited
value). There is no implication that the art is
use related.
3. From question 2, what happens if the private university has an
Art museum on campus?
Answer: C If the university can use the painting in its
museum, use FMV (limited to 30% of AGI).
Answer C is $60,000 (30% of AGI).

Updated by Brett Danko Income Tax 10-3

 Material current through July 2019 exam cycle

Example
Luke Wells has an adjusted gross income of $100,000. He made charitable contributions of
$4,000 in cash and $60,000 of appreciated real estate (held more than one year) to Northwestern
University (a private university classified as a public charity). In addition, Luke made a gift of
$31,000 in cash to the Preservation Foundation. Luke is entitled to the following deduction.
Step 1 First, calculate the maximum amount deductible
60% of AGI $60,000
Step 2 Calculate the amount to public charities (50% organizations)
(This includes all churches, schools, and hospitals.)
Up to 60% of AGI for cash donations $ 4,000
Up to 30% of AGI for LTCG property $30,000
(plus $30,000* to be carried forward)
Up to 50% of AGI but using
basis for inventory/works of art
basis for STCG property
basis for use unrelated property
basis for LTCG property _______
Subtotal $34,000
Step 3 Calculate the amount to private charities (30% organizations)
Up to 30% of AGI for cash donations $26,000**
(plus $5,000* to be carried forward)
Up to 20% of AGI for LTCG property
Up to 30% of AGI but using
basis for inventory/works of art/ use-unrelated
basis for STCG and LTCG property
_______
Subtotal $26,000
Step 2 plus step 3 is limited to a deduction of 60% of AGI. $60,000
* The $30,000 remaining of the appreciated real estate and the $5,000 of the cash to the 30%
organization is carried forward for five years or until Luke's death if sooner.
** This is a result of Step 1 (maximum amount deductible - 60% of AGI) less Step 2
$60,000 - 34,000 = $26,000 This is the maximum for Step 3.
The chart is more useable because Step 3 is removed.
Step 1 First calculate the maximum amount deductible
60% of AGI ________
Step 2 Calculate the amount to public charities (50% organizations)
(This includes all churches, schools, and hospitals.)
Up to 60% of AGI for cash donations ________
Up to 30% of AGI for LTCG property ________
Up to 50% of AGI but using
basis for inventory/works of art ________
basis for STCG property ________
basis for use unrelated property ________

Subtotal
Updated by Brett Danko Income Tax 10-4
 Material current through July 2019 exam cycle

Practice questions
1. Margaret donates stock she bought six months ago to the State
University. She purchased the stock for $50,000. The current
fair market value is $60,000. Margaret's AGI is $150,000.
What is her maximum allowable charitable deduction in the
current year?
A. $45,000 B. $50,000 C. $60,000 D. $75,000

Answer: B The charitable deduction for gifts of short-term

Capital gains property is limited to basis and
50% of AGI.

2. Mrs. Peters (AGI $130,000) would like to give one of the

following stocks to the United Way(a public charity). Which one
would produce the highest overall income tax deduction?
A. Stock A purchased this year for $90,000, now worth $60,000
B. Stock B purchased two years ago for $50,000, now worth
$80,000
C. Stock C purchased this year for $65,000, now worth $90,000
Answer: B Stock B has a basis of $50,000 but a
FMV of $80,000. At 30% of AGI, she could deduct
$39,000 (30% of $130,000) this year and $41,000
either next year or after using FMV. Stock A is loss
property. The charitable deduction is limited to its
current FMV ($60,000). Answer B is the highest overall
deduction ($80,000). Stock C is STCG and is limited to
basis($65,000).
NOTE: Stock and real estate are not subject to use-unrelated rules.
3. Mrs. Thomas contributed $20,000 cash and $50,000 in LTCG stock
(basis $10,000) to a public charity. Her AGI is $120,000. What
is the charitable deduction she can take this year?
A. $30,000 C. $60,000
B. $56,000 D. $70,000

Answer: B $20,000 cash and $36,000 LTGC property (30% of

AGI) does not exceed the overall 60% of AGI.
E. Nondeductible contributions
Non-itemizers
The 1986 tax act eliminated a non-itemizer (claims the standard deduction) from taking a
charitable deduction. A taxpayer must itemize to take a charitable deduction. A taxpayer
would logically take the greater of the itemized deductions or the standard deduction.
Because the TCJA increased the standard deduction substantially, claims for charitable
deductions may decline.

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 Material current through July 2019 exam cycle

Example #1 of itemized versus standard deductions

Mr. and Mrs. Winslow are both over 65. They rent a condo. If their only deductions are $10,000
to charity and $3,000 of sales tax, should they itemize? Their 2019 joint filing standard
deduction ($24,400 + $1,300 + $1,300 = $27,000) is substantially higher, than itemizing
($13,000). Sales tax may or may not be deductible in 2019 but it doesn’t affect the answer.

Example #2
Lilly is age 70. She lives with her daughter. She pays $12,000 per year in rent to her daughter.
She gives $10,000 to her church (substantiated). Her AGI is $50,000. Should she itemize? No,
her charitable gift ($10,000) will not be greater than her standard deduction ($12,200 + $1,650 =
$13,850).
Example #3
John and Jane Donner (married filing jointly) have an AGI of $150,000. Both are under age 65.
If they have the following expenses, should they itemize?
Answer: No, the joint standard deduction is $24,400.

Medical expenses not reimbursed $ 8,000

Property taxes $ 7,500
Casualty loss uninsured (due to a fire) $10,000
Charitable contributions $ 6,000
Medical expenses less 10% AGI $ -0-
Property taxes 7,500
Casualty loss less 10% of AGI -0- (no natural disaster implied)
Charitable contributions 6,000
Itemized total $ 13,500
G. Substantiating requirements
A charitable deduction is not allowed unless the taxpayer can prove the right to it. No
charitable deduction is allowed for any (cash or property) contribution of $250 or more
unless the taxpayer substantiates it by contemporaneous written acknowledgment (not
just a cancelled check) from the donee organization.
Substantiating Vehicle Donations
A charitable deduction will be denied to any taxpayer who fails to obtain a
contemporaneous written acknowledgement for any “qualified vehicle” donation if the
claimed value of the vehicle exceeds $500. If the donee organization sells the qualified
vehicle without any significant intervening use or material improvement, the maximum
deduction the taxpayer will be allowed is equal to the gross proceeds received by the
donee organization from the sale of that vehicle.
Example
Bill has a 2000 Ford. The “Blue Book” value is $2,000. But Bill knows that the car needs some
extensive repairs. If he donates the car to a qualified charity, what is the amount of the charitable
deduction? If the value is over $500, he must receive a written acknowledgment from the
charity. If the charity sells the car without putting it to significant use or improving it, Bill’s
deduction is limited to the gross proceeds from the sale. The IRS uses another definition: the
price a willing buyer and a willing seller agree to when neither party is compelled to buy or sell
and both parties have reasonable knowledge of the facts.

Updated by Brett Danko Income Tax 10-6

 Material current through July 2019 exam cycle

H. Charitable contributions by business entities

The deduction of a corporation for a contribution or gift to a charitable organization is
limited to 10% of its taxable income.
Contribution of inventory
If a corporation (other than an S corporation) makes a gift of inventory, it can deduct its
basis for the property plus one-half of the property's unrealized appreciation. However,
the claimed deduction may not exceed twice the basis of the property. In addition, the
inventory must be for the ill, needy, or care of infants.
Practice Question
Bob Patterson, a health professional, donated 40 hours of his time to
a public charity. If his time was worth $200 per hour and he also
wrote a check to the charity for $2,000 out of his business account,
how much could he deduct as a gift to charity?
A. $2,000 on his Schedule C (self-employed)
B. $2,000 on his Schedule A (itemized deduction)
C. $10,000 on his Schedule C (self-employed)
D. $10,000 on his Schedule A (itemized deduction)
E. $10,000 on his 1020 (corporate tax return)

Answer: B As an individual “sole proprietor”, any charitable

contribution made through his/her business is
considered by the IRS as being made by the person, not
the business. Bob’s time is not deductible (answers C
and D). Nothing indicates a corporation.

Practice questions:
1. Mrs. Substantial, age 80, is in poor health. She has given away
to family and friends about $10 million and paid gift taxes.
She is considering gifting a large sum to charities for an
income tax deduction. The assets she wants to contribute have a
very low basis (inherited 50 years ago). The assets have a
basis of $500,000 and are worth $10 million. If her AGI is
$500,000, which of the following are true?
I. She can only deduct $500,000 per year.
II. She should use basis to get a 50% of AGI deduction.
III. If she dies shortly, most of the income deduction will be
lost.
IV. The gift will reduce her estate by $10 million.

A. I, II, III, IV D. III, IV

B. II, III, IV E. III
C. II, IV

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 Material current through July 2019 exam cycle

Answer: D The donated property will be removed from her

estate. If she does not live five years more some
of the carryover may be lost. Given the very low
basis, she should value the charitable gift at
FMV. Her current year income tax deduction would
be 30% of AGI. She can only deduct 50% of her AGI
($250,000), if she uses basis. But, the basis is
very low. She should use FMV. Then she could
deduct 30% of AGI. Answer III and IV are true.
At death the deduction stops for income tax
purposes.

NOTE: For income tax purposes the maximum deduction for income
tax is 6 years (first year plus 5) or 6 x $250,000. However,
her estate would be reduced by $10 million.

2. Mrs. Adams, a recent widow, has decided to move to Arizona to be

closer to her sister. She sold her house without having to
recognize capital gain. Her sister lives in an upscale condo.
A condo is for sale in the same building where her sister lives
but it costs more money than her house sale. She would need to
sell investments to get the extra money. She is thinking also
about just renting. She gets her husband’s pension and Social
Security that plus investment income puts her in a 25% tax
bracket. She is very charitable to her church and various
organizations. What should she do?
A. Rent, her home sale proceeds can be invested to provide more
income
B. Rent, then if this does not work out she can move away.
C. Buy the condo then take out a mortgage to make up the
difference between her home sale proceeds and the condo price.
D. Buy, using her investable assets to make up the difference
between her home sale proceeds and the condo price.

Answer: C To be eligible for the charitable deduction, she

will have to itemize. Without real estate taxes
and mortgage interest that is difficult.

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 Material current through July 2019 exam cycle

3. Sue Slater, age 30, just inherited a painting from her mother.
Her mother purchased it 30 years ago for $10,000. The painting
has been appraised at $100,000 in her mother’s estate. Sue, a
graduate of University of Miami, knows the university has an art
museum. She hates the painting. She also inherited all her
mother’s assets and her mother’s “B” Trust assets. Sue’s AGI
will go from $75,000 to $750,000. What should Sue do?
A. Sell the painting for $100,000 and pay the gains (LTCGs) on
$90,000 at 15%.
B. Sell the painting for $100,000 and donate the proceeds to the
university (cash).
C. Gift the painting to the university to get a 30% of AGI
deduction.
D. Gift the painting to the university to get an overall
deduction of $100,000 (appraised value).

Answer: D Given that the painting is use related (Art

museum) Sue can value her charitable gift at
$100,000 (FMV), claiming an overall deduction for
that amount. Answer A is wrong. There is no gain.
Answer C is also wrong. The maximum is $100,000
not 30% of AGI. Answer B entails cost
commissions to sell the painting.

4. Mr. and Mrs. Owens want to make a gift to a private university.

Their AGI is $300,000. They own a variety of assets. Which
asset would produce the largest income tax deduction this year?
A. Stock bought two years ago for $130,000 now worth $150,000.
B. A painting bought five years ago for $50,000, now worth
$150,000.
C. Stock bought six years ago for $30,000, now worth $150,000
D. Stock bought two years ago for $180,000, now worth $100,000

Answer: A The question is asking for the largest

income tax deduction this year. If they value
the donated stock at basis, they can deduct
$130,000. In regards to the painting, they must
valuate at basis ($50,000 use unrelated). Answer
C produces a deduction of $90,000 (30% of AGI).
Answer D is loss property. They should sell it
and take the loss.

Updated by Brett Danko Income Tax 10-9