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Chapter 10

Chapter 10. Deductions and Losses: Certain Itemized Deductions. The Big Picture (slide 1 of 3). John and Susan Williamson have been renting an apartment since they were married. They now want to purchase their own home. Their current monthly rent is $2,000.

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Chapter 10

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  1. Chapter 10 Deductions and Losses: Certain Itemized Deductions

  2. The Big Picture (slide 1 of 3) John and Susan Williamson have been renting an apartment since they were married. They now want to purchase their own home. Their current monthly rent is $2,000. They are willing to spend $2,500 per month on an after-tax basis if necessary to purchase their first home. 2

  3. The Big Picture (slide 2 of 3) After months of house hunting, they have found the perfect home, but they fear it may be too expensive. Using a standard mortgage to finance the purchase, the total cash outlay during the first year of ownership would be as follows. Principal payments $ 2,000 Interest payments 37,000 Real estate taxes 3,000 Total cash outlay $42,000 Monthly cost ($42,000 ÷ 12) = $ 3,500 3

  4. The Big Picture (slide 3 of 3) Alternatively, if they use investments to secure financing, they could qualify for a lower interest rate. Reduces the interest charge from $37,000 to $35,000. Their Federal taxable income will be between $160,000 and $185,000 for the year. They do not itemized their deductions. The state they live in imposes an income tax at a flat rate of 6%. Can John and Susan Williamson afford to pursue their dream of home ownership? Read the chapter and formulate your response. 4

  5. Itemized Deductions(slide 1 of 2) Personal expenditures that are deductible from AGI as itemized deductions include: Medical expenses Certain taxes Mortgage and investment interest Charitable Contributions Miscellaneous itemized deductions 5

  6. Itemized Deductions(slide 2 of 2) • Itemized deductions provide a tax benefit only to extent that, in total, they exceed the standard deduction amount for the taxpayer

  7. The Big Picture - Example 1Allowable Itemized Deductions Return to the facts of The Big Picture on p. 10-2. With the purchase of a home, John and Susan will be able to itemize their deductions for the first time instead of claiming the standard deduction. Assuming the home mortgage interest expense and real estate taxes meet the requirements discussed in this chapter, they will be deducted from AGI. Their total itemized deductions will exceed the amount of their allowable standard deduction. Further, other qualifying expenditures (e.g., state income taxes and charitable contributions) likewise will be deductible as itemized deductions, providing an explicit tax benefit to the Williamsons. 7

  8. Medical Expenses (slide 1 of 6) • Medical expenses are deductible to the extent unreimbursed medical expenses, in total, exceed 7.5% of AGI

  9. Medical Expenses (slide 2 of 6) • Example of medical expense deduction limitation: • Amy has AGI of $10,000 and medical expenses of $1,000 • Amy’s medical expense deduction = $250 [$1,000 – ($10,000 × 7.5%)]

  10. Medical Expenses (slide 3 of 6) • Example of medical expense deduction limitation: • Bob has AGI of $4,000 and medical expenses of $1,000 • Bob’s medical expense deduction = $700 [$1,000 – ($4,000 × 7.5%)]

  11. Medical Expenses (slide 4 of 6) • Expenditures for: • The diagnosis, cure, mitigation, treatment, prevention of disease, or • The purpose of affecting any structure or function of the body of the taxpayer, spouse, or dependents • Includes prescription drugs and insulin

  12. Medical Expenses (slide 5 of 6) • Does not include the cost of items such as : • Unnecessary cosmetic surgery • General health items • Nonprescription drugs • If cosmetic surgery is deemed necessary, it is deductible as a medical expense • Cosmetic surgery is necessary when it ameliorates • A deformity arising from a congenital abnormality • A personal injury, or • A disfiguring disease

  13. Medical Expenses (slide 6 of 6) • Medical expenditures are deductible in year paid • Includes payment by check or credit card

  14. Nursing Home Expenditures • If primary reason for being in nursing home is medical, costs (including meals and lodging) qualify • If primary purpose of placement in home is personal, only specific medical costs qualify (no meals or lodging)

  15. Special School Expenditures • Medical expense deduction may include the expenses of a special school for a mentally or physically handicapped individual • Deduction is allowed if a principal reason for sending the individual to the school is the school’s special resources for alleviating the infirmities • In this case, the cost of meals and lodging, in addition to the tuition, is a proper medical expense deduction

  16. Capital Medical Expenditures • May include a pool, air conditioners if they do not become permanent improvements, dust elimination systems, elevators, etc. • Must be medical necessity, advised by a physician, used primarily by patient, and expense is reasonable • Full amount of cost is medical expense in year paid • Maintenance on capital expenditures also medical expense

  17. Capital Improvement to Home • Deductible medical expense only to extent cost exceeds increase in value of home • Appraisal costs related to capital improvements are also deductible, but not as medical expenses • Exception: removal of structural barriers to home of handicapped are deemed to add no value to home • Thus, full amount is a medical expense

  18. Medical Care of Spouse and Dependents • Taxpayer may deduct cost of medical care for spouse and dependents • Dependents need not meet gross income or joint return tests • Medical expenses of children of divorced parents can be deducted by non-custodial parent even though child is claimed as dependent of custodial parent

  19. Medical Transportation and Lodging • Transportation costs to and from medical care are deductible • Mileage allowance of 19 cents per mile (in 2011) may be used instead of actual out-of-pocket automobile expenses • Lodging while away from home for medical care • Allowable amount is $50 per person per night • If parent and/or aide needs to accompany patient, their expenses are also deductible

  20. Medical Insurance Premiums(slide 1 of 2) • Premiums paid for medical care insurance are deductible medical expenses • If employer pays all or part of taxpayer’s medical insurance premiums the amount paid by employer is • Not included in gross income by employee • Not deductible by the employee as medical expense

  21. Medical Insurance Premiums(slide 2 of 2) For self-employed, 100% of insurance premiums are deductible for AGI Includes amounts paid for taxpayer’s spouse and dependents Not allowed if taxpayer is eligible to participate in a subsidized health plan maintained by any employer of the taxpayer or the taxpayer’s spouse Premiums paid for qualified long-term care insurance are deductible medical expenses Subject to limitations based on age of the insured 21

  22. Reimbursement by Medical Insurance • If reimbursed in same year as expense paid: • Reimbursement offsets medical expense • Amount deductible is excess of expenses over reimbursement • If reimbursed in the year after medical expenses were paid: • Reimbursement is income only to extent medical deduction was taken by taxpayer (tax benefit rule) • If standard deduction was taken in year expenses were paid, none of the reimbursement is included in income

  23. Example of Medical Reimbursements (slide 1 of 2) • In 2011, taxpayer paid medical expenses = $1,200; In 2011, reimbursed $800 by insurance company • For 2011, deductible medical expense is $400 – (7.5% × AGI)

  24. Example of Medical Reimbursements (slide 2 of 2) • In 2011, taxpayer paid medical expenses of $1,200; In 2012, reimbursed $800 by insurance company • For 2011, deductible medical expense is $1,200 – (7.5% × AGI) • For 2012, reimbursement is income to extent taxpayer received a tax benefit from medical expense deduction in 2011

  25. Health Savings Accounts • Used in conjunction with a high deductible medical insurance policy • Employee contributions to HSA are deductible for AGI and earnings on funds in account are not taxable • Deductible contributions are limited to the sum of the monthly limitations. The monthly deductible amount is limited to the lesser of one twelfth of: • The annual deductible under a high deductible plan or • $3,050 for self-only ($6,150 for family coverage) in 2011 • Withdrawals from HSA are excludible to the extent used for qualified medical expenses

  26. Taxes (slide 1 of 4) • State, local, and foreign income and real property taxes are deductible in the year paid • Real property taxes do not include taxes assessed for local benefits • e.g., Special assessments for streets, sidewalks, curbing, and other similar improvements • State and local personal property taxes based on value (ad valorem) are deductible in the year paid

  27. Taxes (slide 2 of 4) • Other taxes such as FICA, excise, etc., are not deductible • May be deductible if incurred in business or production of income activity • Fees are not deductible as tax

  28. Taxes (slide 3 of 4) • Real estate taxes for year property is sold must be apportioned between the buyer and the seller • Failure to correctly apportion requires offsetting adjustments to seller’s amount realized and buyer’s adjusted basis

  29. Taxes (slide 4 of 4) • Can elect to deduct either state & local income taxes or sales/use taxes • For state and local income taxes, deduct amounts paid during year: • Amounts withheld • Estimated tax payments • Amounts paid in current year for prior year’s liability • For sales/use taxes, deduct either: • Actual sales/use tax payments or • Amount from an IRS table • Table amount may be increased by sales tax paid on certain specific items (e.g., Purchase of motor vehicles, boats, etc.)

  30. The Big Picture - Example 16Deductible Property Taxes Return to the facts of The Big Picture on p. 10-2. If the Williamsons purchase their home, the real estate taxes they pay will be deductible from AGI as an itemized deduction. If they also pay personal property tax on their car, the payment may be only partially deductible. In their state, the motor vehicle registration tax is 4% of the value of the vehicle plus 40 cents per hundredweight. The Williamsons car is valued at $20,000 and weighs 3,000 lbs. Their annual registration fee is $812. $800 (4% of $20,000) is deductible as a personal property tax. The remaining $12, based on the weight of the car, is not deductible. 30

  31. Interest Expense • Deduction of interest expense is limited to: • Interest on qualified student loans • Investment interest • Qualified residence (home mortgage) interest • Business interest • Personal interest expense is not deductible

  32. Interest on Qualified Student Loans • Deductible for AGI, subject to limits • Maximum deduction is $2,500 per year • Deduction is phased out for taxpayers with modified AGI (MAGI) between $60,000 and $75,000 ($120,000 and $150,000 on joint returns) • Not allowed for those claimed as a dependent or for married filing separate returns

  33. Investment Interest • Investment interest on loans whose proceeds are used to purchase investment property may be deductible • e.g., Investment property may include stock, bonds, and land held for investment • Deduction of investment interest expense is limited to net investment income

  34. Qualified Residence Interest (slide 1 of 4) • Interest on indebtedness secured by the principal residence and one other residence (qualified residences) • Interest must be on acquisition indebtedness or home equity loans

  35. Qualified Residence Interest (slide 2 of 4) • Acquisition indebtedness: amounts incurred to acquire, construct, or substantially improve the qualified residences • Interest paid on aggregate acquisition indebtedness of $1 million or less ($500,000 for married, filing separately) is deductible as qualified residence interest

  36. Qualified Residence Interest (slide 3 of 4) • Home equity indebtedness: loans secured by qualified residences • Interest is deductible only on portion of home equity loan that does not exceed the lesser of: • $100,000 ($50,000 for married, filing separate), or • FMV of home – acquisition indebtedness

  37. Qualified Residence Interest (slide 4 of 4) • Thus, maximum loans on qualified residences that will produce qualified residence interest is $1.1 million • Interest on mortgage debt exceeding $1.1 million or on mortgage debt relating to nonqualified residence (e.g., second vacation home) is nondeductible personal interest

  38. The Big Picture - Example 22Acquisition Indebtedness Return to the facts of The Big Picture on p. 10-2. John and Susan will need to borrow at least a portion of the purchase price of their new home A standard mortgage likely will qualify as acquisition indebtedness. However, the interest on the acquisition indebtedness will be fully deductible only if The amount of the mortgage is $1 million or less (assuming they file a joint return), and The mortgage is secured by the home. Recall that they are also considering what appears to be a less expensive route of using their investments to secure the debt. If they choose this alternative, the interest will not be deductible as qualified residence interest because the loan would not be acquisition indebtedness. 38

  39. Interest Paid For Services (slide 1 of 2) • “Points” paid for the use or forbearance of money qualify as deductible interest • Cannot be a service charge if they are to qualify as deductible interest • Points generally must be capitalized and amortized over the life of loan

  40. Interest Paid For Services (slide 2 of 2) • Exception: Points paid in the acquisition or improvement of principal residence • Entire amount of such points are deductible in the year paid • Points paid to refinance an existing home mortgage must be capitalized and amortized over the life of the new loan

  41. Mortgage Insurance Payments • Mortgage insurance premiums are deductible as interest if they relate to a qualified residence of the taxpayer • The deduction begins to phase out for taxpayers with AGI in excess of $100,000 ($50,000 for married taxpayers filing separately)

  42. Classification of Interest Expense • Whether interest is deductible for AGI or as an itemized deduction (from AGI) depends on purpose of indebtedness • If related to a business or the production of rent or royalty income • Interest is deductible for AGI • If incurred for personal use, such as qualified residence interest • Deduction is reported on Schedule A, Form 1040 if taxpayer itemizes • However, interest on a student loan is a deduction for AGI • If the taxpayer incurs debt in relation to his or her employment • Interest is considered to be personal, or consumer, interest

  43. Charitable Contributions(slide 1 of 2) • Individuals and corporations may deduct contributions made to qualified domestic organizations • Contributor must have donative intent and expect nothing in return • If contributor receives tangible benefit, the FMV of such benefit reduces the amount of the charitable contribution deduction

  44. Charitable Contributions(slide 2 of 2) • Exception to tangible benefit rule • Allows deduction of 80% of amount paid for the right to purchase athletic tickets from colleges and universities

  45. Contribution of Services • No deduction is allowed for the contribution of services • Unreimbursed expenses related to the services are deductible • Out-of-pocket transportation costs or a standard mileage rate of 14 cents per mile are deductible • Deductions are also permitted for transportation, reasonable expenses for lodging, and the cost of meals while away from home incurred in performing the donated services

  46. Nondeductible Items • The following items may not be deducted as charitable contributions: • Dues, fees, or bills paid to country clubs, lodges, fraternal orders, or similar groups • Cost of raffle, bingo, or lottery tickets • Cost of tuition • Value of blood given to a blood bank • Donations to homeowners associations • Gifts to individuals • Rental value of property used by a qualified charity

  47. Qualified Organizations • To be deductible, contributions must be to a qualified domestic nonprofit organization or state or possession of U.S. or any subdivisions thereof • Many (but not all) qualified domestic charities are listed in IRS Publication #78

  48. Record-Keeping Requirements • No deduction is allowed for charitable contributions unless the taxpayer has appropriate documentation and substantiation • The specific type of documentation required depends on the amount of the contribution and whether the contribution is made in cash or noncash property • Special rules may apply to gifts of certain types of property (e.g., used automobiles) where Congress has noted taxpayer abuse in the past

  49. Ordinary Income Property • Defined: assets that would produce ordinary income or short-term capital gain if sold • Contribution amount • FMV of asset less ordinary income (or STCG) potential; generally the lower of adjusted basis or FMV

  50. Capital Gain Property • Defined: assets that would produce long-term capital gain or Section 1231 gain if sold • Contribution amount • Generally FMV of asset

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