Chap006

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 06

Individual Deductions

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Learning objectives

1. Identify the common deductions necessary for calculating adjusted gross income (AGI)

2. Describe the different types of itemized deductions available to individuals and compute itemized deductions

3. Explain the operation of the standard deduction, determine the deduction for personal and dependency exemptions, and compute taxable income

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Deductions for AGI

Three categories of deductions for AGI Directly related to business activities Indirectly related to business activities Deductions subsidizing specific activities

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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 1. business activities (called “trade or business”) or 2. investment activities

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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

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Deductions for AGI

Trade or Business Expenses must be: directly connected to the business activity ordinary and necessary for the activity (e.g.,

appropriate and helpful for generating a profit) reasonable in amount (not extravagant)

Expenses are claimed on Schedule C Revenues from the same activity are also reported on

the same Schedule C The net income or loss from Schedule C is transferred

to Form 1040 (page 1) on line 12

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Deductions for AGI

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

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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. Losses in excess of the $3,000 limit are carried forward indefinitely to subsequent years

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Deductions for AGI Deductions indirectly Related to Business

Activities The cost of moving personal possessions is not

a direct cost of doing business or being employed

Moving Expenses are deductible for AGI if the move meets two tests

1. A distance test

2. A business test associated with a move

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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)

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Deductions for AGI

Health Insurance deduction by Self-Employed Taxpayers Deduction provides equity with employees who

receive health insurance as a qualified fringe benefit Insurance must be provided for taxpayer or

dependents who are not eligible for employer-provided health insurance

Penalty for early withdrawals of savings Reduces the taxpayer’s net interest income to the

amount actually received

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Deductions for AGI

SE Tax Deduction Employer and employees each pay one-half of

employee’s Social Security tax Employers deduct the portion of Social Security taxes

they pay for employees Self-employed individuals are required to pay SE tax

in lieu of Social Security tax Self-employed tax payers are allowed to deduct one-

half of the SE tax they pay to compensate for employers deducting their portion of Social Security

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Deductions for AGI

Alimony payments are deductible for AGI to maintain equity

Contributions to a qualified retirement account are deductible for AGI to encourage savings

Interest expense on qualified educational loans

Qualified educational expenses

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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)

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Deductions from AGI: Itemized Deductions

Medical Expenses Taxpayers may deduct medical expenses incurred to

treat themselves, their spouse, and their dependents Qualifying medical expenses include unreimbursed

payments for care, prevention, diagnosis or cure of injury, disease, or bodily function

Taxpayers using personal automobiles for medical transportation purposes may deduct a standard mileage allowance (19 cents per mile in 2011) in lieu of actual costs

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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

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Taxes Individuals may deduct itemized deductions

payments for following taxes State, local, and 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

Sales Tax deduction State and local sales taxes can be deducted in lieu

of state and local income taxes


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Interest Two itemized deductions for interest expense:

Deduction of investment interest is limited to a taxpayer’s net investment income

Any investment interest in excess of the net investment income limitation carries forward to the subsequent year

Home mortgage interest Interest on acquisition indebtedness of $1million Interest on home equity debt of $100K

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Charitable Contributions Contribution of money or property must be made

to a qualified charity

Special rules apply to charitable contributions of property depending on the type of property: Capital gain property Ordinary income property


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Casualty and theft losses on personal-use assets

The amount of the tax loss from any specific casualty event (including theft) is the lesser of

decline in value of the property caused by the casualty or

taxpayer’s tax basis in the damaged or stolen asset

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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

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Miscellaneous Itemized Deductions Subject to AGI Floor Employee Business Expenses

Travel and transportation Employee expense reimbursements

Investment Expenses Tax Preparation Fees Hobby losses Total miscellaneous itemized deductions are

subject to a 2 percent of AGI floor limit

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Itemized Deductions and the Standard Deduction

Miscellaneous Itemized Deductions Not Subject to AGI Floor Individuals include all gambling winnings for the

year in gross income and deduct gambling losses to the extent of gambling winnings for the year

Standard Deductions Taxpayers generally deduct the greater of their

standard deduction or their itemized deductions

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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