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Chapter 17. Tax Consequences of Personal Activities. Objectives. Taxable and nontaxable gratuitous receipts Divorce, alimony, child support Taxation of Social Security benefits Itemized deductions for medical, taxes, charity Casualty and theft Hobby income and expenses

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chapter 17

Chapter 17

Tax Consequences of Personal Activities

  • Taxable and nontaxable gratuitous receipts
  • Divorce, alimony, child support
  • Taxation of Social Security benefits
  • Itemized deductions for medical, taxes, charity
  • Casualty and theft
  • Hobby income and expenses
  • Tax benefits of home ownership
  • AMT
gross income
Gross Income
  • Sec. 61 of IRC states that gross income means all income from whatever source derived – even income from personal activities
gratuitous receipts
Gratuitous Receipts
  • Prizes and awards are taxable
    • Some exceptions to taxability if awards are given to charity
  • Scholarships are excluded to the extent spent on
    • Tuition, books, fees, equipment required by institution
  • Gifts, inheritances, and life insurance death benefits are excluded from gross income
legal settlements and government payments
Legal Settlements and Government Payments
  • Legal settlements are taxable unless they represent compensation for physical injury or illness
  • Workers’ compensation payments are nontaxable
  • Unemployment compensation payments are taxable
  • Need-based payments like welfare and food stamps are nontaxable
  • Social security is nontaxable or taxed on 50% or 85% depending on income level
application problem 1
Application Problem 1
  • Marcy Tucker received the following items this year. Determine to what extent each item is included in her AGI.
    • A $25,000 cash gift from her parents
    • A $500 cash award from the local Chamber of Commerce for her winning entry in a contest to name a new public park
    • $8,000 alimony from her former husband
    • $3,700 unemployment compensation from the state of Michigan
  • Property settlements are nontaxable - like gifts
    • The transferred property takes on a carryover basis
  • Alimony is taxable to the recipient, deductible for AGI by the payer
  • Child support is not taxable nor deductible
divorce example
Divorce Example
  • Ted and Alice divorced on July 1, 2007. As part of the property settlement, Ted transferred ½ ownership of the house (FMV $250,000) to Alice. In addition, he agrees to pay $450 per month alimony and $800 per month child support. What is the taxable effect of the divorce on Ted?
    • Ted receives no deduction for the transfer of the house or payment of child support. He does have a deduction for AGI of $2,700 ($450 x 6 months) for alimony paid.
  • What is the taxable effect of the divorce on Alice?
    • Alice derives no income from the child support or transfer of the home. However, she must report taxable income from receipt of alimony of $2,700.
personal use assets and personal expenses
Personal Use Assets and Personal Expenses
  • Personal use assets may not be depreciated
  • The sale of personal use assets usually results in losses which are not deductible
  • Gains from the sale of personal use assets are generally capital in nature
  • No deduction is allowed for personal, living, or family expenses except for
    • Medical expenses
    • Local, state, and foreign income tax payments
    • Home mortgage interest
    • Charitable contributions
personal expenses medical
Personal Expenses - Medical
  • Taxpayers may deduct the excess of unreimbursed expenses over 7.5% of AGI as an itemized deduction
  • Qualifying medical expenses include
    • Doctors, dentists, chiropractors
    • Clinics, hospitals, long-term care facilities
    • Medical aids (e.g., hearing aids, crutches)
    • Prescription drugs
    • Medical insurance premiums
medical expenses example
Medical Expenses Example
  • Sam incurred the following expenses during the current year
    • Heath Insurance Premiums $2,200
    • Prescription Drugs 600
    • Hospital Bills 2,000
    • Wheel Chair 100
    • Diet food and pills, non Rx 250
  • If Sam’s AGI is $55,000, what is the amount of his medical expense deduction?
    • [$4,900 – ($55,000 x .075)] = $775
personal expenses taxes
Personal Expenses - Taxes
  • Individuals may deduct real or personal property taxes paid on personal assets
  • Individuals may elect to deduct either state and local sales taxes or state and local income taxes
  • Costs of tax compliance (e.g. tax preparation fees) are miscellaneous expenses deductible if > 2% AGI in aggregate
  • Common taxes NOT deductible include
    • Gift and estate taxes
    • Employee payroll taxes
    • Employment taxes paid for household employees
personal expenses charitable contributions
Personal Expenses – Charitable Contributions
  • General limit - deduct up to 50% of AGI for cash donation (less for capital assets)
    • Carryover excess as an itemized deduction for 5 years
  • Deduction amount
    • LT capital assets = FMV of property
    • Other property = lesser of FMV or basis
charitable contribution example
Charitable Contribution Example
  • Mrs. Bates gave the following items to charity during the current year
    • Antiques, owned 15 years, cost of $50,000; FMV of $125,000
    • Painting, owned 9 months, cost of $25,000; FMV of $27,000
  • What is the amount of Mrs. Bates’ itemized deduction for charitable contributions before considering any AGI limitation?
    • $125,000 (FMV of antiques) + $25,000 (basis of painting) = $150,000
tax subsidies for education
Tax Subsidies for Education
  • EE Savings Bonds - interest excluded to the extent used for tuition and fees; phase out for higher-income individuals
  • Deduct $4,000 qualified tuition and fees expense if AGI < $130,000 (MFJ), $65,000 (S, HOH)
  • Qualified educational loan interest is deductible for first 60 months of payments - max $2,500 per year. Phase out for high income individuals
  • Hope scholarship credit – Available for first 2 years of college. Max $1,500 per year per student based on tuition/fees; phase out for higher-income individuals
tax subsidies for education1
Tax Subsidies for Education
  • Lifetime learning credit – Equal to 20% of tuition/fees; $2,000 credit max per year per tax return; phase out for higher-income individuals
  • Education savings account (Coverdell plan or section 529 state-sponsored plan) - withdrawals spent on education are tax-free
personal losses
Personal Losses
  • Recall that losses on disposition of personal assets are not deductible, while the gains on disposition of personal assets are taxable
  • Casualty and theft losses
    • Loss = lesser of (adjusted basis or decline in FMV) - insurance proceeds
    • Deduction = Loss - $100 per casualty - 10% AGI
casualty loss example
Casualty Loss Example
  • Cheryl’s home (basis of $275,000) was damaged in a fire. $100,000 of damage was incurred and the insurance company reimbursed Cheryl $75,000 for the loss. If Cheryl’s AGI was $125,000, what was the amount of her casualty loss?
    • [$100,000 (decline in FMV) - $75,000 (insurance proceeds) - $100 - $12,500 (10% of AGI)] = $12,400
personal losses1
Personal Losses
  • Hobby income is taxable
  • Hobby deductions (to the extent that miscellaneous deductions exceed 2% of AGI) are limited to the amount of hobby income
  • If the activity generates a profit in 3 of 5 years, the IRS presumes it is a business and occasional losses are fully deductible
  • Gambling losses are treated very much like hobbies, except that gambling losses are not subject to the 2% of AGI limitation
home ownership
Home Ownership
  • The following types of qualified residence interest are deductible as an itemized deduction
    • Interest on acquisition debt up to $1 million
    • Interest on home equity debt up to $100,000
  • The deduction is available for the principal residence and one other personal residence (not a primary rental property)
home mortgage interest example
Home Mortgage Interest Example
  • Mr. and Mrs. Wimple have incurred $48,000 of interest on $1,200,000 of acquisition debt related to their principal residence. In addition, they incurred $4,720 of interest on an $80,000 home equity line of credit. What amount of home mortgage interest can they deduct?
    • Acquisition debt (limited) $1,000,000
    • Home equity debt 80,000


Qualified home interest:

$1,080,000 x $52,720 = $44,482.50


home ownership1
Home Ownership
  • Vacation home rental activity
    • Deductions related to a house are treated as for a vacation home (as opposed to a rental house) if the personal use exceeds the greater of 14 days or 10% of rental days
    • Deductions (based on the number of days of rental usage) are limited to gross rents less any mortgage interest or property taxes allocable to the rental period
      • Thus, vacation rental deductions cannot generate a net rental loss
    • Carry forward excess rental deductions
gain on sale of principal residence
Gain on Sale of Principal Residence
  • Exclude $250,000 of gain on sale if home is principal residence 2 years out of 5 years ending on date of sale
  • Exclude only one gain every 2 years
  • The maximum exclusion is doubled (to $500,000) for MFJ if either spouse meets the 2 of 5 year ownership requirement and both spouses meet the 2 of 5 year use requirement
gain exclusion example
Gain Exclusion Example
  • Bill purchased a house in April of 2003. On March 15, 2005, Sue moved into the house and on July 4, 2006 they were married. They sold the house on August 7, 2007 generating a $270,000 gain. How much of the gain may be excluded?
  • $270,000; Bill meets the 2 year ownership requirement and bothBill and Sue meet the 2 year use requirement
itemized deductions as amt adjustments
Itemized Deductions as AMT Adjustments
  • Medical deductions are allowed only to the extent they exceed 10% AGI (not the usual 7.5%)
  • State and Local tax payment deductions are disallowed
  • Miscellaneous itemized deductions (including investment and employment-related deductions) are disallowed
  • Interest on home equity debt is disallowed