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Chapter 06

Chapter 06. Individual Deductions. 3 Types of Taxpayer Activities. Deductions for AGI – directly related to business activities. Business (trade) expenses must be: directly connected to the business activity ordinary and necessary for the activity reasonable in amount

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Chapter 06

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  1. Chapter 06 Individual Deductions

  2. 3 Types of Taxpayer Activities

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

  4. Deductions for AGI • Losses • Taxpayers disposing of trade or business assets at a loss are allowed to deduct the loss for AGI • Losses from investment assets (called capital assets) are offset against capital gains • If capital losses exceed capital gains, this is called a net capital loss • A net capital loss is deducted for AGI but limited to $3,000 in any single tax year. Losses in excess of the $3,000 limit are carried forward indefinitely to subsequent years

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

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

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

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

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

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

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

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

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

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

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

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

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

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

  19. The Standard Deduction The taxpayer deducts the greater of 1) the sum of the itemized deductions or 2) the standard deduction.

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

  21. Chapter 6

  22. Deductions for AGI • Directly Related to Business Activities • Taxpayers are allowed to deduct expenses incurred to generate business income • For tax purposes activities are either profit-motivated or motivated by personal objectives • Profit-motivated activities are classified as • business activities (called “trade or business”) or • investment activities

  23. Deductions for AGI • Although both are motivated primarily by profit, business activities are distinguished from investment activities: • Trade or Business activities require a relatively high involvement or effort from the taxpayer where as investment activities don’t require • Investment activities involve investing in property for appreciation or for income payments

  24. Deductions for AGI

  25. Deductions for AGI – directly related to business • Rental & Royalty Expenses • Claimed above the line (for AGI) • Could either be an investment activity or a trade activity depending on facts • Taxpayers report expenses and revenue on Schedule E and transfer the net income or loss from Schedule E to Form 1040 (page 1), line 17 • Flow-through Entities • Expenses and losses incurred by a flow-through entity pass through to the entity owners who typically report these amounts on Schedule E and Line 17

  26. Deductions for AGI • Distance test – the new job site must extend existing commute by 50 miles • A new job site is required, but a new employer is not essential • Business test - Taxpayer must be employed at least 39 of 52 weeks or be self-employed for 78 of the 104 weeks following the move • Taxpayers are allowed to deduct a mileage rate in lieu of the actual costs of driving their personal automobiles during the move (19 cents per mile in 2011)

  27. Deductions for AGI • Deduction for Interest expense on loans used to fund qualified educational expenses • Up to $2,500 of interest on education loans is deductible for AGI • The interest deduction is phased-out for taxpayers with AGI exceeding $60,000 ($120,000 filing joint) • The deduction is eliminated for taxpayers with AGI exceeding $75,000 ($150,000 filing joint)

  28. Deductions for AGI

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

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

  31. Deductions from AGI: Itemized Deductions

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

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

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