McGraw-Hill/Irwin © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter 1 Chapter 17 Tax Consequences of Personal Activities McGraw-Hill/Irwin.

McGraw-Hill/Irwin © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved.

Chapter 1Chapter 17

Tax Consequences of

Personal Activities

McGraw-Hill/Irwin Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.

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ObjectivesObjectives

• Identify personal receipts that are taxable income• Describe the tax consequences of divorce settlements• Identify personal expenses and losses that result in itemized

deductions• Describe the tax treatment of revenues and expenses from a

hobby• Compute the itemized deduction for home mortgage interest• Describe the preferential treatment of gain from the sale of a

personal residence• Identify itemized deductions that are limited or disallowed for

AMT purposes

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Gross IncomeGross Income

• Section 61 states that gross income means all income from whatever source derived – even income from personal activities

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Gratuitous ReceiptsGratuitous Receipts

• Prizes and awards are included in gross income

• 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

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Legal Settlements and Government PaymentsLegal Settlements and Government Payments

• Legal settlements are included in gross income unless compensation for physical injury or illness

• Workers’ compensation payments are excluded• Unemployment compensation payments are included• Need-based payments such as welfare and food stamps

are excluded• Social security:

• 85%, 50%, or 0% included in gross income depending on income level

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Application Problem 1Application Problem 1

• Marcy Tucker received the following items this year. Determine to what extent each item is included in gross income.• $25,000 cash gift from her parents• $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• $100,000 cash inheritance from her grandfather

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DivorceDivorce

• Property settlements are nontaxable• Transferred property

takes a carryover basis

• Alimony is taxable to the recipient, deductible above-the line by the payer

• Child support is neither taxable nor deductible

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Divorce ExampleDivorce Example

• Ted and Alice divorced on July 1. In the property settlement, Ted transferred one-half ownership of their home (FMV $250,000) to Alice. Ted will pay $450 per month alimony and $800 per month child support

• What are the tax consequences to Ted?• Ted has no deduction for the property transfer or payment of child

support. He has a $2,700 ($450 x 6 months) above-the-line deduction for payment of alimony

• What are the tax consequences to Alice?• Alice has no income from the receipt of property or child support.

She recognizes $2,700 ordinary income from the receipt of alimony

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Personal Use Assets and Personal Use Assets and Personal ExpensesPersonal Expenses

• Personal use assets• Personal use assets may not be depreciated• Gains on sale are generally capital gain• Losses on sale are not deductible

• 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

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Personal Expenses - MedicalPersonal Expenses - Medical

• Taxpayers may deduct the excess of unreimbursed expenses over 10% of AGI as an itemized deduction• 10% decreased to 7.5% for taxpayer age 65 or older

• Qualifying medical expenses include:• Clinics, hospitals, long-term care facilities• Medical aids (e.g., hearing aids, crutches)• Prescription drugs• Medical insurance premiums• Doctors, dentists, chiropractors

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Medical Expenses ExampleMedical Expenses Example

• Sam, age 42, incurred the following unreimbursed expenses

• Health insurance premiums $2,200• Prescription drugs 600• Hospital bills 2,000• Doctor bills 900• Wheelchair 100• Diet food and pills, non Rx 250

• If Sam’s AGI is $55,000, compute his medical expense deduction• $5,800 – ($55,000 x 10%) = $300

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Personal Expenses - TaxesPersonal Expenses - Taxes

• Individuals are allowed an itemized deduction for:• Real or personal property taxes paid on nonbusiness

assets• Either state and local sales taxes or state and local

income taxes

• Costs of tax compliance (e.g. tax preparation fees) are miscellaneous itemized deductions

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Personal Expenses – Charitable ContributionsPersonal Expenses – Charitable Contributions

• General limit – Itemized deduction limited 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

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Charitable Contribution ExampleCharitable Contribution Example

• Mrs. Bain gave the following to charity this year• Antiques (owned 15 years; cost $50,000; FMV $125,000)• Painting (owned 9 months; cost $25,000; FMV $27,000)

• Compute Mrs. Bain’s itemized deduction for charitable contributions before considering any AGI limitation• $125,000 (FMV of antiques) + $25,000 (basis of painting)

= $150,000 deduction

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Tax Subsidies for EducationTax Subsidies for Education

• EE Savings Bonds• Deduction for qualified tuition and fees • Deduction for interest on qualified education loans• American Opportunity Credit• Lifetime Learning Credit• Coverdell education savings accounts• Qualified tuition programs

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Casualty LossesCasualty Losses

• Casualty and theft losses• Loss equals lesser of adjusted basis or

decline in FMV of property resulting from casualty or theft• Loss reduced by insurance

reimbursement

• Loss in excess of $100 floor per casualty is deductible

• Deduction limited to excess of aggregate losses over 10% AGI

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Hobby and Gambling LossesHobby and Gambling Losses

• Activity not entered into for profit (hobby)• Revenue is included in gross income• Expenses are miscellaneous itemized deductions

limited to the amount of revenue from hobby• If the activity generates a profit in 3 of 5 years, the IRS

presumes it is a business and losses are deductible

• Gambling losses• Itemized deduction but not miscellaneous• Limited to gambling winnings

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Home Mortgage InterestHome Mortgage Interest

• Qualified residence interest is an itemized deduction• Interest on acquisition debt up to $1 million • Interest on home equity debt up to $100,000

• Deduction is available for mortgage on principal residence and one other personal residence

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Vacation Home RentalVacation Home Rental

• Residence is subject to vacation home rules if the owner’s days of personal use exceed the greater of 14 days or 10% of rental days

• Expenses attributable to rental days are deductible to the extent of rental revenues• Vacation home rental can’t generate a net loss deductible

against other income • Nondeductible loss carries forward

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Gain on Sale of Principal ResidenceGain on Sale of Principal Residence

• $250,000 exclusion of gain on sale of home• Owner must have used the home as a principal residence for two

years out of the five years ending on date of sale• Exclusion doubled to $500,000 for MFJ

• Exclusion applies to only one sale in a two-year period

• Owners who sell a home but don’t satisfy the above requirements may be eligible for a reduced exclusion if the sale was necessitated by:• Change of employment• Health reasons• Unforeseen circumstances

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Itemized Deductions as AMT AdjustmentsItemized Deductions as AMT Adjustments

• Medical deductions are allowed only to the extent they exceed 10% AGI

• Deductions for state and local taxes are disallowed • Miscellaneous itemized deductions are disallowed• Interest on home equity debt is disallowed

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