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ITEMIZED DEDUCTIONS

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					                               ITEMIZED DEDUCTIONS

After reviewing this chapter, you should be able to:
        1.     Determine when to use the standard deduction and when to itemize
               deductions
        2.     Discuss the deductions from adjusted gross income for specifically
               allowed personal expenditures and explain the requirements for deduction
               and applicable limitations

Reference Materials: IRS Publication 17—Your Federal Income Tax (2006)
                     IRS Publication 553—Highlights of 2005 Tax Changes (Mar.
                           2006)
                     IRS Publication 600—State and Local Sales Taxes

          Individuals are allowed to deduct certain personal expenditures as deductions
from adjusted gross income in lieu of the standard deduction. Taxpayers itemize
deductions only when the sum of their allowable deductions exceeds their standard
deduction (Pub. 17, page 131, “Who should Itemize”). In allowing certain personal
expenditures to be deducted, Congress has exercised its power, under the legislative grace
concept, to restrict the amount of deductible expenditures. These restrictions limit
deductions to amounts exceeding a stated percentage of the taxpayer’s adjusted gross
income. Only amounts in excess of the limit are deductible. Restricting these deductions
provides an element of administrative convenience. That is, with these limitations, many
taxpayers will not have sufficient amounts of deductions to itemize and instead use the
standard deduction amount. The use of the standard deduction lowers compliance costs,
both for the taxpayer and for the government.
          Individuals are allowed a deduction for their unreimbursed medical costs as well
as those of their spouse and any dependents (Pub. 17, page 133). An individual does not
have to meet the gross income test or the joint return test to qualify for medical expense
purposes. A person who meets the support, relative, and residency tests is considered a
dependent for purposes of the medical expense deduction (Pub. 17, page 133). This
treatment recognizes situations in which taxpayers are expending significant amounts on
behalf of relatives who, because they earn too much money or are married, are not
technically dependents.



Revised February 2007                        Page 1
          Medical expenses are defined as those expenditures incurred for “diagnosis, cure,
mitigation, treatment, or prevention of disease,” as well as those that are incurred because
of problems “affecting any structure or function of the body.” This definition
encompasses most costs we usually think of as medical expenses: doctor bills, dentistry,
surgery, medicine and prescribed drugs, and hospital charges (Pub. 17, Table 21-1, page
134). Over-the-counter drugs purchased without a prescription are not deductible.
However, if the costs of over-the-counter drugs are reimbursed through an employer
health flexible-spending plan, the reimbursement is not taxable to the employee (Rev.
Rul. 2003-102). (Dietary supplements that are not prescribed are still not deductible or
excludable from income under an employer reimbursement plan). Weight loss program
costs, according to IRS Rev. Ruling 2002-19, are deductible as long as a physician has
diagnosed obesity. In addition to these typical costs, taxpayers can deduct the cost of
health and accident insurance premiums and transportation costs of 18 cents per mile in
2006 (20 cents per mile in 2007) for travel to and from the place of medical care (Pub.
17, page 136). Unreimbursed medical costs are deductible only to the extent that they
exceed 7.5% of adjusted gross income (Pub. 17, page 133). Medical costs below the
7.5% limit are effectively disallowed. This limitation severely restricts the benefit of the
medical expense deduction for taxpayers with high incomes and/or those covered by
medical insurance. Although low-income taxpayers are more likely to have medical
expenses that exceed the 7.5% limitation, most low-income taxpayers use the standard
deduction and therefore receive no tax benefit for the medical expenses they incur.
          Deductions are allowed for amounts paid for state and local income taxes, real
estate taxes, sales tax (in lieu of income tax), and other personal property taxes (Pub. 17,
page 138). Because most individuals are cash basis taxpayers, the deduction allowed is
for taxes paid during the year, not the total of the tax imposed. Taxpayers who itemize
deductions normally have an adjustment for state and local taxes paid in the year
following the deduction. If the taxpayer obtains a state or local tax refund, the tax benefit
rule requires that person to include the refund in the subsequent year’s taxable income
Similarly, if the taxpayer pays additional taxes, these are added to the tax paid for the
subsequent year to determine that year’s deduction. To be deductible, personal property
taxes must be ad valorem, that is, based on the value of the property being taxed (Pub. 17,



Revised February 2007                        Page 2
page 141). An individual cannot use any of the following in calculating itemized tax
deductions: federal taxes, including income and Social Security taxes; water use and
sewer taxes; excise taxes on alcohol, tobacco, or firearms; gasoline taxes; utility taxes; or
assessments for local benefits such as sidewalks (Pub. 17, Table 21-1, page 140).
Assessments for local benefits are not considered taxes; instead, these are added to the
basis of the property. It should be stressed that although these taxes are not deductible by
individuals as itemized deductions, they may be deductible or capitalized as part of the
cost when incurred in a trade or business.
          As of 2004, you can elect to deduct state and local general sales taxes in lieu of
state and local income taxes. You can deduct either your actual expenses or an amount
computed by using the optional sales tax tables found in IRS Publication 600. This
deduction originally was scheduled to expire at the close of 2005. However, it was
extended retroactively by Congress at the close of 2006. The state and local sales tax
deduction is now scheduled to expire at the end of 2007.
          Itemized deductions for interest payments have been severely restricted in recent
years. Personal interest (credit card interest and auto loans) is specifically disallowed
(Pub. 17, page 142). The only interest deductible, as an itemized deduction, is qualified
home mortgage interest (Pub. 17, page 142) and investment interest (Pub. 17, page 147).
Each type of deductible interest is subject to restrictions.
          Only interest on debt that is secured by the taxpayer’s principal residence and one
other residence is deductible as qualified home mortgage interest. The second residence
either must qualify as a vacation home if it is rented out during the year or is not rented at
all during the year to qualify as a second residence. If a second home is considered rental
property, the portion of the interest expense attributable to the personal use of the home is
considered personal interest and is not deductible, unless the property is used personally
more than 14 days or 10% of the total days rented during the year. A residence includes
a house, cooperative apartments, condominiums, and mobile homes and boats that have
living accommodations. Qualified home mortgage interest includes both acquisition debt
and home equity debt.
          Acquisition debt is any debt incurred to acquire, construct, or substantially
improve a qualified residence of the taxpayer. Home equity debt is any debt that is



Revised February 2007                         Page 3
secured by a personal residence that is not acquisition debt. There is a cap on the level of
indebtedness for each type of qualified home mortgage interest.
          Interest paid on acquisition debt of $1 million or less is deductible. Interest on
debt in excess of $1 million is considered personal interest and is not deductible. Interest
paid on home equity debt of $100,000 or less is also deductible. However, total debt
(acquisition plus home equity) cannot exceed the fair market value of the property.
Home equity debt is any debt, other than acquisition debt, which is secured by the
residence. The proceeds of home equity debt can be used for any purpose.
          Points are prepaid interest amounts that must be paid to acquire financing (Pub.
17, page 143). They are expressed as a percentage of the value of the loan and paid at
loan acquisition. They represent prepaid interest, which usually is capitalized and
amortized over the term of the loan. A special provision in the tax law allows points paid
to acquire an initial mortgage, on a taxpayer’s principal residence, to be deducted in the
year the points are paid. Points paid to refinance an existing mortgage must be
capitalized and amortized as interest expense over the term of the loan (Pub. 17, Figure
23-D, page 145). Loan origination fees that replace charges for services in obtaining the
loan are not deductible as points. Prepayment penalties for the early payment of a
mortgage are also deductible as qualified home mortgage interest.
          Interest paid on debt used to purchase portfolio investments is deductible (Pub.
17, page 147). Interest paid on an investment in a passive activity is not included in the
investment interest deduction. Expenses related to passive activities are subject to the
passive activity rules and are not included in the investment interest calculation. Interest
paid to produce tax-exempt income is not deductible and therefore is not part of the
investment interest deduction. The deduction for investment interest is limited to the net
investment income of the taxpayer for the year. Any interest not currently deductible
because of this limitation may be carried forward indefinitely and applied to future years.
          Net investment income equals the excess of investment income over investment
expenses (other than interest expense). Included in investment income is property held for
investment (such as interest, dividends, annuities, and royalties) and capital gains, if
elected (Pub. 17, page 147). Investment income does not include dividend income subject
to capital gain rates, unless the taxpayer elects to treat dividend income as investment



Revised February 2007                         Page 4
income. In order to include long-term capital gain or qualified dividend income eligible
for the 15% maximum tax rate, an election must be made to treat all or part of net capital
gain and/or qualified dividend income as investment income. Once this election is made,
the taxpayer must reduce the amount eligible for the lower tax rates. The election is made
on Form 4952, Investment Interest Expense Deduction (Pub. 17, page 147).
          An election is also available to capitalize taxes and interest on vacant land rather
than taking a current tax deduction for the expense. This election must be made by filing a
statement with the original return for the year the election is made. The election is
effective only for the year for which it is made and is useful when a taxpayer does not
benefit from deducting the expense, such as when itemized deductions do not exceed the
standard deduction or when investment interest expense is limited by investment income.
          Individuals are allowed to deduct contributions to organizations that are organized
for religious, charitable, educational, scientific, or literary purposes (Pub. 17, page 149).
Deductions are allowed for contributions to organizations that work to prevent cruelty to
animals or children and for contributions to government units. Most charitable
contributions are made in cash or are out-of-pocket costs for performing charitable work.
Examples of these expenses include the cost of uniforms and mileage at 14 cents per mile
(Pub. 17, Car Expenses, page 152). Special rates are temporarily in effect for the cost of
operating a vehicle for providing charitable services solely related to Hurricane Katrina.
These charitable contributions do not generally present valuation problems. However,
when a taxpayer contributes property to a charitable organization, the type of property
determines the amount of the contribution (Pub. 17, page 153). The deduction for
property of a type that would produce ordinary income or short-term capital gain, if it
were sold, is limited to the lesser of the fair market value of the property on the date of the
contribution or the adjusted basis of the property. This limitation makes it an unwise tax-
planning strategy to donate ordinary income property with a fair market value that is less
than the adjusted basis (Pub. 17, page 155). Taxpayers can deduct the fair market value of
contributions of property that would result in a long-term capital gain if the property were
sold. Long-term gain property includes property held more than 12 months and
collectibles gain property held more than 12 months. There are three major limitations on
the deductible amount of charitable contributions (Pub. 17, page 155). First, the overall



Revised February 2007                         Page 5
amount of the charitable contribution deduction cannot exceed 50% of the taxpayer’s
adjusted gross income. Second, contributions of capital gain property deducted at fair
market value cannot exceed 30% of adjusted gross income. But a taxpayer who is willing
to give up the deduction related to the property’s appreciation (use the adjusted basis as
the deductible amount) is not subject to the 30% limit. Third, any contributions in excess
of the limitations are carried forward for deduction for five years (Pub. 17, page 156).
Deductions for contribution should be supported by contemporaneous receipts and
documentation.
          Miscellaneous itemized deductions include amounts expended for unreimbursed
employee business expenses, investment expenses (other than investment interest), hobby-
related deductions, and gambling losses to the extent of gambling winnings. In addition to
the limitations imposed on specific types of deductions in this category, some of these
expenditures are fully deductible, whereas others are subject to an annual limitation of 2%
of adjusted gross income (Pub. 17, page 193). Gambling losses, impairment-related work
expenses of a disabled person, and the unrecovered investment in an annuity contract,
when the annuity ceases because of death, are deductible without regard to the annual
limitation imposed on other types of miscellaneous expenses (Pub. 17, page 193).
          It is important to segregate these expenditures from the other allowable
miscellaneous deductions. Unreimbursed employee business expenses, investment
expenses (other than interest), fees for tax advice and preparation, and hobby-related
deductions are deductible only to the extent that the total expenditures in this category
exceed 2% of the taxpayer’s adjusted gross income. The 2% limitation is an annual
limitation that is imposed after any specific limitations imposed on each category of
expenditure. For example, unreimbursed employee meals and entertainment are subject to
the 50% limitation on meals and entertainment before the 2% annual limitation is applied
(Pub. 17, page 187). In addition, hobby expenses are limited to hobby income before
application of the 2% annual limitation (Pub. 17, page 189).
          In regard to the limitation on investment interest discussed earlier, investment
expenses are determined after applying the 2% annual limitation. However, any other
miscellaneous itemized deductions are applied against the 2% limitation before investment
expenses are reduced for the purpose of the investment interest limitation.



Revised February 2007                         Page 6
          The tax law requires high-income taxpayers to reduce the amount of their
allowable itemized deductions and personal and dependency exemption amounts. In
general, taxpayers in 2006 with adjusted gross incomes in excess of $150,500 ($72,500 for
married individuals filing separate returns) must reduce their allowable itemized
deductions by 3% of adjusted gross income in excess of the phase-out amount. In making
this reduction to account for the itemized deduction phase-out, allowable deductions for
medical expenses, investment interest, gambling losses, and casualty and theft losses are
not subject to reduction. In addition, deductions subject to the 3% reduction rule may not
be reduced by more than 80% of the allowable amount. The phase-out level for itemized
deductions has been increased by an inflation adjustment for 2007 to $156,400 ($78,200
for married individuals filing separate returns) (Pub. 17, page 193).
          High-income taxpayers also must reduce their exemption deductions. The basic
reduction is 2% of the allowable exemption amount for each $2,500 ($1,250 for married
filing separately), or portion thereof, in adjusted gross income in excess of the threshold
amount and is known as the exemption deduction phase-out (Pub. 17, page 34, “Phase-out
of Exemptions”). The threshold amount varies by filing status.
          Filing Status           2006 Threshold Amount        2007 Threshold Amount

                    Single                   $150,500                    $156,400
                    Head of Household         188,150                     195,500
                    Married, joint            225,750                     234,600
                    Married, separately       112,875                     117,300
                    Surviving spouse          225,750                     234,600

          Two aspects to note in calculating the exemption phase-out are that the total
exemption amount (not each individual exemption) is subject to the phase-out. Therefore,
high-income taxpayers with larger numbers of exemptions lose more than taxpayers with
the equivalent income but fewer exemptions. Second, each portion of a $2,500 increment
results in a 2% reduction.
          In tax years beginning in 2006 and 2007, the amount of the exemption phase-out
reduction that would otherwise apply is reduced by one-third. The phase-out is repealed
for tax years beginning after 2009. As of 2006, you can lose no more than 2/3 of the dollar
amount of each exemption. Each exemption cannot be reduced to less than $1,100 (Pub.
17, page 34).


Revised February 2007                        Page 7
Revised February 2007   Page 8
                                     REVIEW QUESTIONS
                                   ITEMIZED DEDUCTIONS

1.        Samantha incurs the following medical expenses for the current year:

                    Face-lift for cosmetic purposes          $800
                    Dentist fees                              500
                    Doctor’s fees for Samantha’s daughter     400

          How much may Samantha include as qualified medical expenses on her current
          tax return before any limitation?
          a.      $ 400
          b.      $ 500
          c.      $ 900
          d.      $1,300


2.        Which of the following qualify for the medical expense deduction?

                    I.     insulin
                    II.    general purpose vitamins

          a.        Only statement I is correct.
          b.        Only statement II is correct.
          c.        Both statements are correct.
          d.        Neither statement is correct.


3.        Which of the following qualify for the medical expense deduction?

                    I.     life insurance premiums
                    II.    chiropractic treatments

          a.        Only statement I is correct.
          b.        Only statement II is correct.
          c.        Both statements are correct.
          d.        Neither statement is correct.




Revised February 2007                           Page 9
4.        Phil incurs the following medical expenses during the current year:

                    Surgeon’s fees                       $1,200
                    Medical insurance premiums              600
                    Hospital fees                           800
                    Prescription drugs                      310
                    Wheelchair                              200

          Phil’s adjusted gross income for the year is $32,000. He receives a $500
          reimbursement from his insurance company. Determine the amount of his
          medical expense deduction for the current year.

          a.        $ -0-
          b.        $ 210
          c.        $2,310
          d.        $2,410


5.        Maureen is single and her adjusted gross income is $25,000. In addition, she pays
          the following expenses during the year:

                    Psychiatrist’s fees                  $ 300
                    Hospital bill                         1,200
                    Transportation to/from hospital          30
                    Prescription drugs                      100
                    Over-the-counter vitamins               125
                    Chiropractor’s fees                     350

          Maureen pays $600 for medical insurance premiums and receives a
          reimbursement of $400 from the insurance company for her medical expenses.
          Compute her medical deduction.

          a.        $ -0-
          b.        $ 305
          c.        $ 405
          d.        $1,875




Revised February 2007                          Page 10
6.        Randy is a single individual who receives a salary of $30,000. During 20X1, he
          has $7,000 withheld for payment of his federal income taxes and $2,500 for his
          state income taxes. In 20X2, he receives a $50 refund after filing his state tax
          return for 20X1.

                    I.     Randy is allowed a deduction for the $7,000 of federal taxes
                           withheld from his salary on his federal tax return for 20X1.
                    II.    If Randy had total itemized deductions of $6,000 on his federal tax
                           return for 20X1, he must include the $50 state refund in his gross
                           income when filing his return for 20X2.

          a.        Only statement I is correct.
          b.        Only statement II is correct.
          c.        Both statements are correct.
          d.        Neither statement is correct.


7.        Rhonda is a single individual who receives a salary of $30,000. During 20X1, she
          had $2,900 withheld for her state income taxes. In 20X2 she receives a $250
          refund after filing her state tax return.

                    I.     If Rhonda has total itemized deductions of $5,200 on her federal
                           tax return for 20X1, she must include the $250 state refund in her
                           gross income for 20X2.
                    II.    If Rhonda uses the standard deduction for 20X1 (assume $5150) in
                           filing her 20X1 income tax return, none of the $250 refund would
                           be taxable in 20X2.

          a.        Only statement I is correct.
          b.        Only statement II is correct.
          c.        Both statements are correct.
          d.        Neither statement is correct.


8.        Callie receives a state income tax refund of $550 in May 20X2. When she filed
          her federal income tax return for 20X1, she used the standard deduction amount.
          Although the all-inclusive income concept would require Callie to report the $550
          in her federal gross income for 20X2, The Internal Revenue Code does not require
          her to do so. The refund is excluded. What tax concept explains why the
          exclusion is permitted in this case?

          a.        wherewithal to pay
          b.        tax benefit rule
          c.        ability to pay
          d.        administrative convenience



Revised February 2007                           Page 11
9.        Jackson is a single individual who has total itemized deductions in 20X1 of
          $5,250. Assume the standard deduction for this year was $5,150. Jackson’s
          itemized deductions include $2,000 for state income taxes. After filing his state
          income tax return for 20X1, he received a refund of $275 in 20X2.

          a.        Jackson must include $275 as income on his federal income tax return for
                    20X2.
          b.        Jackson must amend his federal tax return for 20X1 to reflect the correct
                    state income taxes paid of $1,725 ($2000 - $275).
          c.        If Jackson itemizes his tax return in 20X2, he must reduce his state tax
                    deduction by $275.
          d.        Jackson must include income of $100 on his 20X2 federal income tax
                    return.


10.       Richard pays his personal property tax on his car in July of the current year. He
          wrote a check for $350. The $350 represented a $10 registration fee, a $140
          charge based on the weight of the car, and a $200 charge based on the value of the
          car. How much of the $350 can Richard deduct on his current-year tax return?

          a.        $-0-
          b.        $ 10
          c.        $140
          d.        $200


11.       During the current year, Pierre and Anne Gardenia pay the following taxes:

                    State income tax (balance due last year)           $1,000
                    Estimated state income tax                          2,400
                    Estimated federal income tax                        3,250
                    Sales tax on new car (75% business use)               600
                    State gift tax                                        500
                    Property tax                                        2,450
                    Real estate tax on condominium in Taos, NM          1,100

          What amount can Pierre and Anne claim as an itemized deduction for taxes on
          their federal income tax return for the year?
          a.      $ 6,950
          b.      $ 5,850
          c.      $10,250
          d.      $11,350




Revised February 2007                          Page 12
12.       Christopher pays the following taxes during the year:

                    Real estate taxes on his personal residence          $2,500
                    Real estate taxes on rental property                  2,000
                    State sales taxes                                       600
                    State income taxes                                    4,000
                    City income taxes                                     1,000
                    Federal income taxes                                  5,400

          What is the amount Christopher can deduct for taxes as an itemized deduction for
          the year?
          a.     $ -0-
          b.     $15,500
          c.     $ 7,500
          d.     $12,900


13.       Which of the following taxes is deductible from adjusted gross income when paid
          by an individual taxpayer?

                    I.     state income tax
                    II.    local property tax on business use property

          a.        Only statement I is correct.
          b.        Only statement II is correct.
          c.        Both statements are correct.
          d.        Neither statement is correct.


14.       Which of the following taxes is deductible from adjusted gross income when paid
          by an individual taxpayer?

                    I.     state sales tax
                    II.    federal income tax

          a.        Only statement I is correct.
          b.        Only statement II is correct.
          c.        Both statements are correct.
          d.        Neither statement is correct.




Revised February 2007                           Page 13
15.       Gerald purchases a new home on June 30, 20X1. During January 20X2, he
          receives his real estate tax statement for calendar year 20X1, showing $1,800 tax
          payable. Gerald pays the $1,800 on March 1, 20X2. The seller of the residence is
          properly allocated her share of the property taxes at closing. What is the amount
          of real estate taxes that Gerald may claim as an itemized deduction for 20X2?

          a.        $ -0-
          b.        $1,800
          c.        $ 900
          d.        $ 450


16.       J.C. purchases a new principal residence in the current year for $185,000. She
          borrows $110,000 from a local mortgage company and pays loan origination fees
          of $1,500 and points of $2,200 based upon 2% of the amount borrowed. During
          the year, J.C. pays $7,000 of interest on the loan. What is J.C.’s allowable interest
          deduction for the year?

          a.        $    -0-
          b.        $ 7,000
          c.        $10,500
          d.        $ 9,200


17.       Chin purchases a new home during the year, borrowing $900,000 from Third
          National Bank to finance the purchase. He also pays $9,000 in points based on
          1% of the amount borrowed and $5,500 in loan origination fees for miscellaneous
          charges in processing the loan. During the year he pays interest of $72,000 on the
          loan. What is Chin’s allowable interest deduction?

          a.        $    -0-
          b.        $72,000
          c.        $81,000
          d.        $86,500


18.       Bonita and Ken refinance their personal residence during 20X1. They borrow
          $96,000 over a 20-year period and paid points of $1,800. For 20X2, what amount
          of the $1,800 in points is deductible?

          a.        $1,500
          b.        $ 900
          c.        $ 150
          d.        $ 90




Revised February 2007                        Page 14
19.       Trine purchases a new personal residence for $165,000. He makes a down
          payment of $15,000 and finances the balance at a very favorable interest rate. To
          obtain the favorable rate, points equal to 2% of the loan balance are paid at the
          closing. What amount of the points can Trine deduct in the current year?

          a.        $ -0-
          b.        $2,000
          c.        $3,000
          d.        $1,500


20.       Certain interest expense can be carried forward if not deductible in the current
          year. Which of the following can be carried forward and deducted in a future
          year?

          a.        credit card interest
          b.        personal car loan interest
          c.        interest on a loan to buy common stock
          d.        home equity loan interest


21.       Benny incurs $950 interest on his General Motors automobile loan, $150 interest
          on a loan with Computer Express to buy a multimedia-equipped computer
          (personal use), $500 interest on his credit cards, and $1,000 investment interest.
          Benny’s net investment income is $650. Benny’s deductible interest amount is:

          a.        $ -0-
          b.        $ 350
          c.        $ 650
          e.        $1,950


22.       Bob borrows $100,000 from his uncle’s bank and invests the proceeds in various
          common stocks. He pays $9,000 in interest on the loan during the current year.
          The stocks produce $7,200 of qualified dividend income. Bob reports adjusted
          gross income of $100,000 in the current year and used the 15% tax rate on his
          dividends. If the dividend income is his only investment income, how much of
          the interest expense is deductible by Bob?

          a.        $9,000
          b.        $7,200
          c.        $7,000
          d.        None of the interest is deductible.




Revised February 2007                           Page 15
23.       Laurie, age 29, is single and makes an annual contribution to her church of
          $2,000. Laurie always uses the standard deduction when filing her income tax
          return. Determine the amount of Laurie’s deduction for charitable contributions.

          a.        $ -0-
          b.        $2,000
          c.        $1,000
          d.        $ 560


24.       Charlene makes the following contributions during the current year:

                    Purchase of raffle ticket from church                $ 50
                    Cash given to church                                  200
                    Chamber of Commerce dues                              500
                    Stock acquired in 1999 donated to State University
                           (Cost = $1,000; FMV = $1,800)
                    Clothing donated to Goodwill
                           (Cost = $800; FMV = $200)
                    Volunteer work at local hospital prior to August, 2005
                           (300 miles at $.14 cents per mile)
                           (Candy-striper uniform @ $40)

          If Charlene’s gross income is $35,000, what is her allowable charitable
          contribution?
          a.     $2,282
          b.     $1,442
          c.     $2,202
          d.     $1,482


25.       Kirk has AGI of $80,000 and makes the following charitable contributions early
          in 20X1.

                    $20,000 cash to the American Red Cross
                    $ 7,000 cash to St. Peter’s church
                    $24,000 worth of IBM stock acquired in 1999 with a basis of $10,000 to
                    Small State University

          What is Kirk’s maximum charitable deduction in the current year?
          a.     $24,000
          b.     $36,000
          c.     $40,000
          d.     $41,000




Revised February 2007                          Page 16
26.       Alex has AGI of $41,500 and makes the following donations in the current year:

                        $1,000 cash to the United Way
                        100 hours contributed to the Red Cross to help Hurricane victims
                        (Alex’s normal billing rate is $40 per hour in his consulting business)
                        15 old dress shirts to the Good Will Industries Foundation (original
                        cost $300; FMV $45)

          What is Alex’s charitable contribution deduction for the current year?
          a.     $5,300
          b.     $1,045
          c.     $5,045
          d.     $1,000


27.       Bergman has AGI of $60,000 in 20X1 and 20X2. She makes cash contributions
          to the United Way of $33,000 in 20X1 and $34,000 in July 20X2. Bergman’s
          charitable contribution carryover from 20X2 is:

          a.        $ -0-
          b.        $3,000
          c.        $4,000
          d.        $7,000


28.       Gable, who is employed as a college instructor, pays the following expenses
          during the current year:

                    Subscription to Golf magazine                        $ 80
                    Dues paid to professional organizations               300
                    Attorney’s fees for tax advice                        200
                    Life insurance premiums                               600
                    Valid business entertainment                          500
                    Fees for business investment advice (taxable)         300

          If Gable itemizes his deductions and his adjusted gross income is $25,000, what is
          his allowable deduction for the above expenses?
          a.      $ -0-
          b.      $ 550
          c.      $ 700
          d.      $1,050




Revised February 2007                           Page 17
29.       Vernon is an employee of a large consulting firm. During the year he incurs the
          following expenses in his job, none of which are reimbursed by his employer.
          Vernon’s adjusted gross income is $100,000 before considering these expenses.

                    Commuting between his home and his office               $3,000
                    Local travel to and from his office to visit clients     4,000
                    Legitimate business entertainment of clients             8,000
                    Hotel accommodations while on business travel            3,000
                    Meals while away from home on business                   2,000
                    Subscription fees directly related to employment         1,000
                    Cost of professional wardrobe                            7,000

          What amount can Vernon deduct as miscellaneous itemized deductions?
          a.    $22,000
          b.    $20,000
          c.    $13,000
          d.    $11,000


30.       Nicholas is single, with no dependents, and has adjusted gross income of
          $148,000. His itemized deductions total $21,000 and consist of $9,650 of interest
          expense, $6,450 of taxes, $3,700 of charitable contributions, and $1,200 of
          unreimbursed business expenses (after 2% reduction). What is his 20X1 taxable
          income?

          a.        $117,561.50
          b.        $117,573.50
          c.        $117,500.50
          d.        $120,550.50




Revised February 2007                            Page 18
Revised February 2007   Page 19
                REVIEW QUESTION SOLUTIONS AND EXPLANATIONS
                           ITEMIZED DEDUCTIONS


          1. The correct answer is C, $900. A taxpayer may deduct his or her own
             medical expenses and those of his spouse and dependents if the status as
             spouse, etc., exists either when the medical care is rendered or when the
             expenses were paid (Publ. 17, page 133). Deductible medical expenses are
             amounts paid for the diagnosis, mitigation, treatment, or prevention of disease
             or for a purpose affecting any structure or function of the body. A deduction
             is not allowed for cosmetic surgery or similar procedures unless the surgery is
             to ameliorate a deformity arising from or directly related to a congenital
             abnormality, a personal injury resulting from an accident or trauma, or a
             disfiguring disease (for additional information, see IRS Publ. 502, Medical
             and Dental Expenses.

          2. The correct answer is A, only statement I is correct. The only payments for
             drugs that count as medical expenses are those for prescribed drugs and
             insulin. Expenses merely beneficial to the individual’s general health aren’t
             deductible as costs for medical care (Pub. 17, page 133 and Table 22-1, on
             page 134).

          3. The correct answer is B, only statement II is correct. The cost of insurance
             that’s deductible as a medical expense is limited to amounts paid for insurance
             that covers medical care (Pub. 17, page 135, “Insurance Premiums”).
             Deductible medical expenses are amounts paid for the diagnosis, mitigation,
             treatment, or prevention of disease or for a purpose affecting any structure or
             function of the body (Pub. 17, page 133).

          4. The correct answer is B, $210. The question wants the medical expense for
             the current year. Deductible medical expenses are amounts paid for the
             diagnosis, mitigation, treatment, or prevention of disease or for the purpose of
             affecting any structure or function of the body (Pub. 17, page 133). The cost
             of insurance that’s deductible as a medical expense is limited to amounts paid
             for insurance that covers medical care. The cost of in-patient care, including
             meals and lodging furnished by a hospital, is a deductible medical expense
             (Pub. 17, Table 22-1, page 134). The only payments for drugs that count as
             medical expenses are those for prescribed drugs and insulin. The amount of
             medical expenses an individual may deduct on Schedule A of Form 1040 in a
             tax year is the amount by which his or her unreimbursed payments for those
             expenses exceed 7.5% of his or her adjusted gross income for the year (Pub.
             17. page 137). The total medical expense includes all costs that add up to
             $3,110 minus the $500 reimbursement, leaving $2,610; minus $2,400 (7.5%
             of the AGI of $32,000) leaves $210 deductible.




Revised February 2007                        Page 20
          5. The correct answer is B, $305. The costs of transportation primarily for and
             essential to medical care qualify as medical expenses, including food and
             lodging expenses while en route to the place of medical treatment as well as
             train, taxi, plane, bus, and ambulance fares and cost (Publ. 17, Table 22-1,
             page 134). All the amounts are deductible save the $125 for over-the-counter
             vitamins, including the medical insurance of $600. The total medical expense
             includes all costs that add up to $2,580 minus the $400 reimbursement (Pub.
             17, page 136), leaving $2,180; minus $1,875 (7.5% of the AGI of $25,000)
             leaves $305 deductible.

          6. The correct answer is B, only statement II is correct. The recovery of an
             amount deducted or credited in an earlier tax year is included in a taxpayer’s
             income in the current or recovery year, to the extent the deduction or credit
             reduced federal income tax or alternative minimum tax (Pub. 17, Recoveries,
             page 82). Deductible state, local, and foreign taxes include state, local, and
             foreign income, war profits, and excess profits taxes (Pub. 17, page 138 and
             following). Taxes not deductible as taxes, expenses, or otherwise include
             federal income taxes, including amounts withheld from wages, interest, etc.;
             and alternative minimum tax (Pub. 17, Table 22-1, page 140). The standard
             deduction for a single individual was $5,150 in the question. The $7,000 in
             itemized deductions exceeded the standard deduction; therefore, the refund of
             $50 must be included in income in the year 20X2.

          7. The correct answer is B, only statement II is correct. See #6 above for
             further explanation. The standard deduction for a single individual was
             assumed to be $5,150 for 20X1 in the question. The itemized deductions for
             20X1 of $5,200 exceed this standard deduction for individual filers by $50;
             therefore, $50 must be included on the 20X2 income tax return. In statement
             II, the taxpayer used the standard deduction, and none of the state taxes were
             deducted in the previous year; therefore, under the tax benefit rule, no amount
             of state refund need be picked up as income on the 20X2 tax return (Pub. 17,
             Recoveries, page 82).

          8. The correct answer is B, tax benefit rule. The recovery of an amount
             deducted or credited in an earlier tax year is included in a taxpayer’s income
             in the current or recovery year, except to the extent the deduction or credit did
             not reduce federal income tax or alternative minimum tax, but not the
             accumulated earnings or personal holding company penalty taxes imposed in
             the earlier year (Pub. 17, Chapter 12, “Other Income – Recoveries,” page 82).
             This is called the tax benefit rule. The wherewithal-to-pay rule recognizes the
             inequity of taxing a transaction when the taxpayer lacks the means with which
             to pay the tax. Under this rule, there is a correlation between the imposition
             of the tax and the ability to pay the tax . The other two do not appear to be
             rules of any kind.

          9. The correct answer is D, Jackson must include $100 as income on his federal
             income tax return for 20X2. The itemized deductions of $5,250 claimed on


Revised February 2007                        Page 21
               the 20X1 return exceeded the $5,150 standard deduction for individual filers
               by $100; therefore, Jackson has received a tax benefit and the $100 must be
               included on the 20X2 income tax return. It is the lesser of the income or the
               amount that benefited the taxpayer under the tax benefit rule (Pub. 17, page
               82).

          10. The correct answer is D, $200. Personal property taxes imposed by a state
              or local government are deductible. The tax must be imposed annually on
              personal property, on an ad valorem (meaning according to the value of the
              property) basis. The amount of the tax based upon the value of the property is
              separately stated as $200, and this is the amount you can deduct (Pub. 17,
              Chapter 22, “Taxes – Personal Property Taxes,” page 141).

          11. The correct answer is A, $6,950. See above questions for explanation. State
              or local sales or use taxes paid or incurred in connection with the acquisition
              or disposition of property can be deducted. However, a taxpayer must choose
              between a deduction of sales tax or state income tax. In this instance the state
              income tax exceeds the sales tax by a substantial amount (Pub. 600, State and
              Local Sales Taxes). A cash basis taxpayer may deduct an advance payment of
              tax in the year of payment as long as it’s an actual good faith payment and not
              a mere deposit (estimated and prepaid taxes). Deductible state, local, and
              foreign taxes include state, local, and foreign real estate taxes. Estate,
              inheritance, legacy, succession, and gift taxes, whether state, Federal, or
              foreign, are not deductible, save for some special exceptions, where income
              distributions are involved (Pub. 17, page 142). Federal income taxes,
              including amounts withheld from wages, etc., are not deductible (Pub.17, page
              142). Sum up the $1,000 state income tax, $2,400 estimated state income tax,
              $2,450 property tax, and $1,100 foreign real estate tax, for a total of $6,950.

          12. The correct answer is C, $7,500. The real estate taxes on rental property
              belong on the Schedule E of Form 1040. See above questions for explanation
              of the treatment of state sales taxes. Sum up $2,500 personal residence real
              estate taxes, $4,000 state income taxes, and $1,000 city income taxes, for a
              total of $7,500. Federal income taxes are not deductible (Pub. 17, page 142).

          13. The correct answer is A, only statement I is correct. See above questions for
              explanation. State and local property tax on business property belongs on the
              appropriate business form, i.e., Schedule C of Form 1040.

          14. The correct answer is A, only statement I is correct. State or local sales or
              use taxes paid can be elected to be deducted in lieu of state income taxes, as of
              2004. These taxes when paid by an individual are deducted as an itemized
              deduction. (Note: This deduction had expired but was extended retroactively.
              It is not discussed in Publ. 17. See IRS Pub. 600, State and Local Sales
              Taxes). They are not deductible by an individual to arrive at AGI. Federal
              income taxes, including amounts withheld from wages, etc., are not deductible
              (Pub. 17, page 142).


Revised February 2007                         Page 22
          15. The correct answer is C, $900. The real estate tax bill is for 20X1. The
              seller of the home has already reimbursed the taxpayer buyer of the home for
              half of the real estate taxes at the June 30, 20X1 settlement. The $1,800 paid
              is for the entire calendar year of 20X1. Therefore, the taxpayer is entitled to 6
              months out of the 12 months of real estate tax paid (one-half), or $900 (Pub.
              17, Chapter 24, “Real Estate Taxes,” pages 189 and 190).

          16. The correct answer is D, $9,200. You must assume that the loan origination
              fees are not points unless they are based upon a percentage of the amount
              borrowed. Points, including loan origination fees, loan processing fees, loan
              discount fees, etc., that are a specific percentage of the amount borrowed, paid
              by the borrower, out of his own funds, to a lender, in order to obtain a
              mortgage loan, are deductible as interest if they are solely for the use or
              forbearance of money and not a charge for services (Pub. 17, Interest Expense
              – Points, page 143). Several code sections apply to qualified residence interest
              that is deductible (Pub. 17, pages 142-149; see Figure 23-A on page 144). .

          17. The correct answer is C, $81,000. See question #16 for explanation. If the
              loan origination fees are based upon a percentage of the amount borrowed,
              you must assume they are paid for the use of money. The total amount
              deductible for qualified residence interest on the principal residence is the
              points of $9,000 and the interest of $72,000, for a total of $81,000 (Pub. 17,
              Interest Expense – Points, page 143). Loan origination fees paid for
              processing loan documents and miscellaneous expenses are not deductible.

          18. The correct answer is D, $90. Points paid to refinance an existing mortgage
              are deductible only ratably over the loan term. Where the refinancing is
              incurred for home improvements, points paid from separate funds may be
              deductible currently. The points on a refinance are amortized according to
              number of months in the year that the loan was outstanding; since the
              refinance occurred in the prior year, we may assume payments were made for
              twelve months in the current year. Divide $1,800 by 20 years to get $90 per
              year (Pub. 17, Interest Expense – Refinancing, page 146).

          19. The correct answer is C, $3,000. This question expects us to compute the
              amount of the points. The cost of the home of $165,000 minus the down
              payment of $15,000, giving a loan balance of $150,000; multiplied by 2%,
              this gives $3,000 in points. Points on acquisition loans, not refinance, are
              deductible in the year of purchase of the principal residence (Pub. 17, Interest
              Expense – Points, page 143, and Figure 23-B on page 145).

          20. The correct answer is C, interest on a loan to buy common stock.
              Investment interest is interest paid or accrued on indebtedness properly
              allocatable to property held for investment (Pub. 17, Investment Interest, page
              147). The amount of investment interest that may be deducted in any tax year
              by a noncorporate taxpayer generally is limited to the taxpayer’s net
              investment income for the year (code sec. 163(d)(1); 163(d)(4)(a)). Interest


Revised February 2007                         Page 23
               that is disallowed because of the net investment income limit can be carried
               over and deducted in later years, subject to the later years’ investment income
               limit. Personal credit card interest and personal car loan interest are not
               deductible (Pub. 17, Items You Cannot Deduct, page 148). Home equity
               indebtedness is any debt other than acquisition indebtedness secured by the
               taxpayer’s qualified residence to the extent the aggregate amount of the
               indebtedness does not exceed the fair market value of the residence, as
               reduced by the acquisition indebtedness on it.

          21. The correct answer is C, $650 (see #20 above). The amount of investment
              interest that may be deducted in any tax year by a noncorporate taxpayer
              generally is limited to the taxpayer’s net investment income for the year (Pub.
              17, page 147). Personal interest is not deductible (Pub. 17, pages 142 and
              148). Only the $1,000 investment interest loan is deductible to the extent of
              the $650 investment income, while the remaining $350 carries over to be
              deducted against investment income earned in the future.

          22. The correct answer is D, None of the interest is deductible. The amount of
              investment interest that may be deducted in any tax year by a noncorporate
              taxpayer generally is limited to the taxpayer’s net investment income for the
              year (Pub. 17, page 147). Qualified dividends are not included in investment
              income unless the taxpayer elects to include them. Electing to include
              qualified dividends as investment income would result in the taxpayer
              forgoing the 15% tax rate on qualified dividends. The $9,000 of investment
              interest is deductible to the extent of the investment income; the interest that
              was not deducted would carry over to be deducted against investment income
              earned in the future (see Questions 20 and 21).

          23. The correct answer is A, $-0-. If you use the standard deduction, you are not
              entitled to any deduction for charitable contributions, since these contributions
              are deducted on Schedule A of Form 1040, which is not filed when taking the
              standard deduction. For individuals, charitable contributions are deductible
              only as an itemized deduction on Schedule A, Form 1040 (Pub. 17, Who
              Should Itemize, page 131).

          24. The correct answer is A, $2,282. The amounts paid for raffle tickets, to play
              bingo, etc., are not contributions, but they may qualify as a gambling loss if
              there are gambling winnings reported elsewhere on the return. A gift of
              property to a qualified charitable donee is a charitable contribution to the
              extent of the property’s fair market value (FMV) at the time of the gift,
              whether or not it has appreciated (Pub. 17, pages 150, 154, and 155). A
              taxpayer is allowed a charitable deduction for his or her unreimbursed out-of-
              pocket expenses necessarily incurred in the performance of services free for a
              charity (Pub. 17, page 157, Out of Pocket Expenses). This includes 14 cents
              per mile for car expenses traveling to perform the services and costs for
              uniforms, choir robes, or like supplies. A charity will not qualify if a
              substantial part of its activities include lobbying, or if it participates in any


Revised February 2007                         Page 24
               political campaigns. Sum up the $200 cash given the church, $1,800 FMV of
               stock given to the university, $200 of clothing donated to Goodwill, $42 (14
               cents times 300 miles) for transportation, and $40 for uniform to give a total
               of $2,282.

          25. The correct answer is C, $40,000. There is an overall ceiling of 50% of
              adjusted gross income for contributions to charities for the year (Pub. 17, Page
              155). Fifty-percent charities include churches, tax-exempt educational
              institutions, tax-exempt hospitals and research organizations, and others. The
              maximum contribution would be the lesser of the amount given of $51,000 or
              $40,000 (50% of $80,000 adjusted gross income). A special overall ceiling
              was in effect from August 27, 2005, to January 1, 2006, for contributions
              made by cash or check to 50%-limit organizations. The question indicates that
              the contributions were made early in 2005; thus the special overall ceiling
              would not apply.

          26. The correct answer is B, $1,045. See above for reference and explanation.
              Sum up the $1,000 cash given to United Way and the $45 FMV given to
              Goodwill, for a total of $1,045. No charitable deduction is allowed for the
              value of services the taxpayer renders to charity (Pub. 17, Chapter 17, “Value
              of Time and Services,” page 174).

          27. The correct answer is D, $7,000. There is an overall ceiling of 50% of
              adjusted gross income for contributions to charities for the year (Pub. 17, page
              155). If an individual’s charitable gifts for a tax year exceed the percentage
              ceilings for the year, the excess may be carried forward and deducted for up to
              five years A statement must be filed with the return for the year the carryover
              is utilized. The percent limitation for the taxpayer is equal to 50% times the
              $60,000 adjusted gross income, for a total limitation of $30,000 for both years
              20X1 and 20X2. The contributions in 20X1 of $33,000 created a $3,000
              carryover, and the contributions in 20X2 of $34,000 created a $4,000
              carryover, making the carryover to 20X3 equal to the sum of the prior
              carryovers of $7,000.

          28. The correct answer is B, $550. The life insurance premiums and the
              subscription to the golf magazine are not deductible (Pub. 17, page 191).
              Professionals can deduct expenses peculiar to their professions such as dues to
              professional associations (Pub. 17, page 192). A taxpayer may deduct a wide
              variety of expenses related to his investments if they are ordinary and
              necessary for the production or collection of income or for the management,
              conservation, or maintenance of property held for the production of income
              (IRC sec. 212). Individuals may also deduct all the ordinary and necessary
              expenses incurred in connection with the determination, collection, or refund
              of any tax. Miscellaneous itemized deductions are allowed only to the extent
              that they, in the aggregate, exceed 2% of adjusted gross income. Costs
              incurred for entertainment that are otherwise allowable are reduced by 50%
              (Pub. 17, page 169). Summing up the deductions of $300 for dues, $200 for


Revised February 2007                         Page 25
               tax advice, $300 for investment advice, and $250 for entertainment (50%
               times $500 spent) gives us $1,050 total, minus the 2% of $25,000 AGI floor
               of $500, leaving the $550 deduction.

          29. The correct answer is D, $11,000. Expenses of commuting between a
              taxpayer’s residence and his regular business location, wherever situated, are
              not deductible (Pub. 17, page 172). In order to be deducted, work clothes
              must not be suitable for general wear and must be worn as a condition of your
              employment. The cost of a professional wardrobe would appear to be a
              personal expense (Pub. 17, page 188). A deduction may be claimed for
              unreimbursed daily transportation expenses incurred in going between
              taxpayer’s residence and temporary work locations within the same
              metropolitan area; this is business transportation if either the taxpayer has one
              or more regular work locations away from the taxpayer’s residence or the
              taxpayer’s residence is the taxpayer’s principal place of business (Pub. 17,
              page 165). Ordinary and necessary expenses, including meals and lodging,
              incurred while traveling away from home in pursuit of a trade or business are
              deductible; however, the meal portion of the expense must be reduced by 50%
              (Pub. 17, pages 167 and 169). Costs incurred for business entertainment that is
              otherwise allowable are reduced by 50% (Pub. 17, page 169). Miscellaneous
              itemized deductions are allowed only to the extent that they, in the aggregate,
              exceed 2% of adjusted gross income. Sum up the deductions of $4,000 for
              local travel, $4,000 for legitimate business entertainment of clients ($8,000
              reduced by 50%), $3,000 for hotel accommodations while on business travel,
              $1,000 for meals while away from home on business ($2,000 reduced by
              50%), and $1,000 for subscription fees directly related to employment. The
              total of allowable expenses is $13,000, which must be reduced by $2,000 (2%
              of the AGI ), giving us $11,000.

          30. The correct answer is B, $117,573.50. The amount of the personal
              exemption is $3,200 for 2005. The deduction for exemptions may be reduced
              or eliminated for high-income taxpayers (IRC. 151); over a threshold amount
              the exemption phases out. The threshold is $145,950 in 2005 for single
              taxpayers. The exemption is phased out by 2% for each $2,500 of income that
              exceeds the threshold (Pub. 17, page 25). Also, if an individual’s adjusted
              gross income exceeds the applicable amount, certain otherwise allowable
              itemized deductions are reduced by the lesser of 3% of the excess adjusted
              gross income over the applicable amount or 80% of the itemized deductions
              otherwise allowable for the tax year (IRC sec. 68). The limit on itemized
              deductions threshold amount is $145,950 for single taxpayers for 2005 (Pub.
              17, page 142 and page 182). The $148,000 AGI exceeds the $145,950
              threshold by $2,050. The personal exemption is reduced by $62 ($148,000
              less the base amount of $145,950 equals $2,050; $2,050 divided by $2,500
              equals .82, which rounds up to 1, times 2% equals 2%, which is multiplied by
              the exemption amount [$3,200] to get $62). The itemized deductions are
              reduced by $61.50. This is 3% of the difference between the AGI of $148,000
              less the threshold amount of $145,950. The $148,000 AGI less $20,938.50


Revised February 2007                        Page 26
               allowable itemized deductions equals $120,611.50, less the allowable personal
               exemption of $3,138 equals $117,573.50 taxable income.




Revised February 2007                        Page 27
Revised February 2007   Page 28

				
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