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GROSS INCOME
I. GROSS INCOME
A. IRC § 61 (a) – Gross income includes all income from whatever source derived including:
1. Compensation for services 8. Dividends
2. Fringe benefits 9. Alimony & separate maintenance payments
3. Gross income 10. Annuities
4. Gains fr. prop. dealings 11. Income fr. life insurance & endowment contracts
5. Interest 12. Pensions
6. Rents 13. Income from discharge of indebtedness
7. Royalties
B. To be included as income, there must be a realization of the wealth.
1. Undeniable ascensions to wealth, clearly realized, and over which the taxpayer has complete
dominion will be counted as income.1 Source does not matter.
2. Discovery of value does not constitute income. (i.e. discovering worth of painting after
purchase – not recognized as income until sold)
3. Inducing a third party to pay taxes for TP will constitute income.2
Key: Is it a gift or compensation for duties or position? Look to see if third
person is unrelated or is receiving some type of benefit in return.
4. Frequent flyer miles, even if gained by employer-paid business flights, not GI unless
converted into cash.
5. Loans not taxable income, because they do not increase TP’s net wealth. Payments received
by bank not taxable, either, b/c are return of capital, but interest is taxable.
6. Any Economic Benefit except
a. Return on capital
b. Imputed income
c. Contemporaneous obligation to repay
d. Statutory exclusions
C. Glenshaw Glass Test for economic accretion.
“Economic Accretion” includes any financial benefit that is:
a. Not a return of capital
b. Not accompanied by a contemporaneously acknowledged obligation to repay.
c. Excluded by a specific statutory provision.
3
D. Treasure
1
Comm. v. Glenshaw Glass Co. – Two Ps received damages in the form of punitive and treble damges. Neither included it as
income. Held: Since the income was realized and was not a gift, it was to be included as taxable income. The law that applies is
the law at the time the taxable income occurs.
2
Old Colony Trust Co v. Comm.—TP received salary from company. In his compensation package the company included paying
for his income taxes. Issue: Did the payment by the employer of the income taxes constitute additional taxable income to the
employee? Held: Yes, TP could not pass on his duty to pay taxes. It was as if he had received the money himself from a 3P.
They were paying his taxes in consideration for his services. It was not a gift. There was a discharge of a 3P (employer) to the
government which was in consideration for services performed. It is equivalent to receipt by the person taxed.
3
Cesarini v. U.S. -- P bought piano and found 4K in cash inside the piano. Included the amount in his tax return as gross income.
Later attempted to amend his return to not and include the amount and demanded a return of the tax upon the amount. Is the
money included as income? Held: The discovery of cash was realization of wealth & was thus taxable as income.
1. Reg 1.61-1.4 – “The finder of treasure trove is in receipt of taxable income, for Fed income
tax purposes, for the taxable yr in which it is reduced to undisputed possession.
2. Found money is taxable in the year that it is discovered.
3. Unsolicited items are not income.
E. Property
1. Property or money obtained illegally must be included in GI.
2. H/e, property only GI in year ownership actually vested in TP.
a. §83(a) Included as GI when rights to property are transferable or are not subject to a
substantial risk of forfeiture.
b. §83(b) Can elect to include in GI in yr of transfer, but risky b/c no deduction if
forfeiture occurs. (30 days to choose) – Transferror employer would get to make the
deduction that year.
c. Good idea to use early election when stock price likely to rise. Otherwise, income
recognized when vested at a possibly higher valuation (more taxes).
3. A (value of property) – B (what taxpayer paid for it) = GI
4. Stock is property. With stock options, only GI when exercised.
II. IMPUTED INCOME
A. The value of self-provided services & the annual fair-rental value of consumer assets.
B. Not taxable income.
C. Homeowner does not have to include the fair rental value of his house that he lives in as income or
the value to him of doing his own taxes.4
D. DIY No GI.
III. BARGAINING
A. Reg. § 1.61-2(d)(1) – If services are paid for other than in money, the fair market value of the
property or services taken in payment must be included in income. 5
B. If the services were rendered at a stipulated price, the price will be presumed to be the FMV of the
services performed unless there is evidence to the contrary.
C. Same result if property exchanged.
THE EXCLUSION OF GIFTS AND INHERITANCES
I. GIFTS
A. IRC § 102– Gross income does not include property acquired by gift, bequest, devise, or inheritance.
1. This does not exclude from gross income:
a. income from any property received by gift, bequest or inheritance; or
b. if derived form the property if it is income producing property.
B. Duberstein Test
4
Helvering v. Independent Life Ins. Co.—A TP does not have to include as GI the rental value of a building owned & occupied
by the TP. Not income under 16th amendement.
5
Dean v. Comm.—Deans owned a house and they transfer the house to a C in which they were the sole SH of. They lived in the
house for free or were not charged rent by the C. The government said the Deans had to be taxed on the fair market rental value
of the house. This is different because C file their own income taxes. The C is a different entity or cash payer from the
shareholders, thus the Deans were receiving income form the C. This was a form of compensation to the Deans. Treating the
Deans as SH living in the house rent free was like a dividend.
1. Must have donative intent; if not, then GI.
2. Property Gifts: Determine FMV as gain for later tax upon realization at sale
3. FMV = arms length transaction between competent buyer and seller under no compulsion and
with competent knowledge.
4. Employee Gifts: If it is consideration, it is income. Even if given to spouse.
C. A gift in the statutory sense proceeds from a detached and disinterested generosity out of affection,
respect, admiration, charity or like impulses, the most critical consideration is the transferor’s
intention.6
Look for voluntary transfer of property without consideration.
D. Factors to determine if gift or income:
Familial relationship; size or type of gift; services performed; employment status
(preacher?)
II. EMPLOYEE GIFTS
A. IRC § 102(c) – Gifts issued to employees by an employer are NOT excludable from income unless
they are an employee achievement award OR a de minimis fringe.
B. Employee Benefits Not Included in Gross Income:
1. Reg . § 102-1(f)(2) -- for “extraordinary transfers to the natural objects of an employer’s
bounty” if the employee can show that transfer was not made in recognition of employee’s
employment
i.e. like son getting color TV.
2. § 74(c) – Gross income does not include the value of an employee achievement award if the
cost to the employer of the award does not exceed the amount allowable as a deduction to the
employer for the cost of the award.
If it is a length of stay award, it can only be given after employee’s first 5 years.
III. BEQUESTS, DEVISES AND INHERITANCES
A. Property left by will, bequest or devise is not included as gross income.
1. If property is left as repayment for something it could be considered income – analyze facts.
2. The true test of a gift is whether it is done disinterestedly or done in connection with
something else.
B. Settlements from will contests are inheritance and are excluded under GI.7
C. H/e, if legacy in will left in consideration/compensation of past services, generally include in GI, esp.
if no familial relationship. 8 In this situation, look to gift rules.
6
Comm. v. Duberstein -- Dub received a car from a business associate. The business associate said it was a gift for his help. The
business associate deducted it from his taxes which alerted the IRS. The IRS said that Dub owed income tax on that the car. Tax
court said that it was income and court of appeal reversed.
7
Lyeth v. Hoey -- TP contests will of his grandmother, receives a settlement. Does not report the settlement money as income.
IRS says it is income because it wasn’t the direct result of an inheritance. Held: Because the settlement came as a result of an
inheritance, it fit the mechanism for the exclusion. If it had been a successful will contest, would have been treated as an
inheritance, so this is close enough. Not income. Settlements from will contests are inheritances, & are excluded from GI. Policy
reasoning: Lack of uniformity if based on individ state inheritance law.
8
Wolder v. Comm.—Atty made agreement (contract) with client to perform legal services, & he would be paid through her will.
She died, & atty was given stock of 15K. He cashed in stock and tried to exclude stock from gross income under 102(a). Held:
The true test of a gift is whether it is done disinterestedly or done in connection with something else. Same policy reasoning as in
Lyeth, but w. diff. results based on characterization of the prop as gift for Fed Income Tax vs state law’s interpretation of it as a
bequest. Contract is what killed it for Wolder.
AWARDS
I. PRIZES
A. IRC § 74(a) – Generally GI includes amounts received from awards and prizes.
B. Exceptions – IRC § 74(b) Gross income does not include amounts rec’d as prizes and awards made
primarily in recognition of religious, charitable, scientific, educational, artistic, literary, or civic
achievement, but only if—
1. The recipient was selected without any action on his part to enter the contest or proceeding;
2. The recipient is not required to render substantial future services as a condition to receiving
the prize or award; and
3. The prize or award is transferred directly by the payor to a §170(c) governmental unit/org
pursuant to designation made by the recipient.
II. SCHOLARSHIPS AND FELLOWSHIPS
A. IRC § 117 – Gross income does not include any amount received as a qualified scholarship.
1. Scholarship or grant must be used for tuition or related expense.
—tuition & fees required for the enrollment or attendance of a student at an
educational organization; fees, books, supplies, and equipment required for courses
of instruction at such an educational org
2. Tution Reduction §117(d)
a. The amount of any reduction in tuition provided to an employee of an educational
organization for the sub-graduate education at such organization or another
educational organization under §170(b)(1)(A)(ii).
b. Excluded from gross income.
c. BUT no exclusion for graduate school, unless engaged in teaching or research.
d. Employee includes a §132(h) employee:
i. Retired or disabled employees & surviving spouse.
ii. Spouse & dependent children.
e. Must be non-discriminatory.
B. Limitations on Exclusion §117(c)
1. Any amount received which represents payment for teaching, research, or other services by
the student required as a condition for receiving the qualified scholarship or qualified
tuition reduction must be included in GI.
2. Scholarship cannot include (as amount will be included in GI):
a. Requirement for future services, even if also required of all students, including non-
scholarship/fellowship, pursuing the degree. §1.117-6(d)(1)
b. Amounts reserved for housing, food, or other spending.
3. Athletic Scholarships excludable if participation expected but not required; the scholarship
is not cancelled if recipient can’t/doesn’t participate; and, participant not expected to perform
other services if not participating.
C. Reconciliation of §117(c) and §117(d)
1. §117(c) – Scholarships received subject to this exclusion are conditioned upon required
services by graduate students and must be included in GI. The scholarship is seen as
payment for services rendered.
2. §117(d) – Tuition reductions under this subsection are not conditioned upon required
services but are awarded to employees of the institution.
3. Example 1: A graduate student/assistant must grade papers for x hours. The value of the
services is included in GI. The rest of the scholarship/tuition reduction, if any, is excluded.
4. Example 2: A professor’s child receives a tuition reduction. Neither are required to perform
special services. The entire amount is excluded from GI.
III. OTHER HIGHER EDUCATION BENEFITS AND EXCLUSIONS
A. Qualified Tuition and Related Expenses §25A(f)(1), cited by §222(d)(1)
1. Costs of enrollment/attendance at eligible educational institution of higher education for a
student who is the TP/spouse/deductible dependent of the TP.
2. Costs DO NOT INCLUDE: books, housing, student/sports activities unrelated to academic
instruction, hobby/sports courses unless part of student’s degree program.
3. Rejects expenses funded by amounts excluded by GI (§117/§127), except for §102 gifts.
4. QTRE is reduced by §117/§127 amounts.
B. §222 – TP is allowed an Above the Line Deduction for QTRE paid by TP.
1. No deduction if §25A tax credit is elected.
2. No double deduction for QTRE deducted under other provision (e.g. §162).
3. No deduction if married TP does not file joint return.
4. Ceilings: $4000 max if AGI under $65K(DiM); $2000 max if AGI under $80K(DiM)
5. No deduction for taxable years beginning after end of 2007?
C. §221 – TP allowed a deduction for amount = interest paid on Qualified Education Loan.
1. Loan must have been for QTRE.
2. $2500 max.
3. Limitation based on modified AGI, phasing at $50K(DiM)-$65K(DiM)
4. No double benefit.
5. If married, must file joint return.
D. Hope and Lifetime Learning Credits (§25A)—TP allowed a credit against the tax imposed by this
chapter for the taxable year the amount equal to the sum of the Hope Scholarship Credit plus the
Lifetime Learning Credit.
1. §25A Tax Credits Generally:
a. Nonrefundable—Can’t directly generate tax refund but may increase amount of
refund by reducing tax liability. §26(a)
b. May only select one type of credit each year! No combining Hope & LtL! Unless
multiple students (1 might qualify for Hope, 1 for LtL; can combine).
c. Same expenses can’t be both a credit & an exclusion/deduction
i. If there was a §127 employer educational grant or a §117 scholarship, no
credit.
ii. BUT, if educational expenses funded by gifts excluded from GI under §102,
tax credit allowed.
2. Hope Scholarship
a. Per student credit – i.e, if parent has 2 eligible children, may claim TC for each.
i. 100% of the first $1000, and 50% of the second $1000.
ii. Max of $1500. Total applicable expenses are $2000 (must spend at least that
much to get max tax credit).
b. Limitations
i. Can’t be applied for more than 2 taxable years.
ii. Student must be at least ½ time; for first $1000, must be eligible for at least
one academic period for that year.
iii. Only allowed for first 2 years of post-secondary.
iv. No felony drug offenders.
3. Lifetime Learning Credit
a. Per taxpayer credit (i.e., if parent has 2 kids in college, only 1 TC)
i. 20% of education expenses up to $10K.
ii. $2000 max.
b. For any year of post-secondary.
c. Phases out
i. Begins at $40K MAGI for single TP (DiM)
ii. Fully phased out at $50K MAGI for single TP (DiM)
iii. TC * [MAGI-40K]/(10K); if married, 80K/20K.
E. §127 EMPLOYER EDUCATIONAL ASSISTANCE PROGRAMS
1. Allowed GI exclusion of up to $5,250.
2. Must be part of written plan.
3. §127 Employee:
a. Current/retired/disabled/on leave employee (mil.?).
b. Not dependents/spouses.
4. Nondiscriminatory
a. Not only for highly compensated employees.
b. Less than 5% of payments to more than 5% owners or their spouses/dependents.
5. Can’t be offered other benefits as alternative (no cafeteria plan).
F. §135 Savings Bond Income used to pay higher education tuition and fees:
1. Exclusion from GI for gain (interest) on redemption of qualified U.S. savings bonds if used
for higher education expenses.
a. Proceeds includes original cost of bond + interest generated.
b. If proceeds exceed QTRE, only fraction = to (proceeds/expenses) is excludable.
2. Qualified U.S. Savings Bond – Issued at a discount to individual 24yrs or older. Not eligible
if bought by a parent in the name of the child or bought by the child.
3. Qualified higher education expenses – Tuition & fees for TP/spouse/deductible dependent.
4. Phase-out begins at MAGI of $40K ($60K J), ends at MAGI +55K ($90K J).
5. Marrieds must file joint returns.
IV. EMPLOYEE ACHIEVEMENT AWARDS § 74(c)
A. In general.--Gross income shall not include the value of an employee achievement award received by
the taxpayer if the cost to the employer of the employee achievement award does not exceed the
amount allowable as a deduction to the employer for the cost of the employee achievement award.9
9
Allen J. McDonell— Allen’s name was randomly selected from a hat, to avoid image of favoritism, by his employer. He was to
chaperone a trip to Hawaii, with his wife, that was to reward salesmen. He was told to consider it an assignment, not a vacation, &
he had no time to swim or shop, as scheduled biz. activities & requirement to stay with winners took up substantially all of their
time. IRS wanted entire cost of trip to be included in GI, & Allen wanted refund of $600 estimated cost of bringing wife that he’d
already paid. Held: That co. used random drawing and sent them to resort does not make it a taxable prize, even if it was
enjoyable. Also, persons chosen one year to go were not excluded from going in following years. They were “expected to go as an
Must be an item of tangible personal prop.
B. Excess deduction award: If the cost to the employer of the employee achievement award received by
the TP exceeds the amount allowable as a deduction to the employerGI includes the greater of—
1. an amount equal to the portion of the cost to the employer of the award that is not allowable
as a deduction to the employer (but not in excess of the value of the award), or
2. the amount by which the value of the award exceeds the amount allowable as a deduction to
the employer.
C. The remaining portion of the value of such award shall not be included in the gross income of the
recipient.
D. Qualified plan award: §274(j)
1. $1600/emp deduction.
2. Nondiscrim., est’d written plan/program
E. Unqualified plan award: $400/emp deduction (averaged)–§274(j)
F. Length of Service Award
1. More than 5 yrs employment
2. No more than once in a 4yr prd
G. Safety Achievement awards
1. No more than 10% of workforce.
2. Blue collar only.
EMPLOYEE BENEFITS
I. §132 FRINGE BENEFITS: EXLUSIONS FROM GROSS INCOME
A. Employee (under No-Additional Cost Service & Qualified Employee Discount) includes:
1. Retired or disabled employees & surviving spouse.
2. Spouse & dependent children. §132(h)
B. § 414(q) – Highly Compensated Employee is any employee who
1. Was a 5% owner at any time during the year or the preceding year, or
2. For the preceding year—
a. Had compensation > $80,000, and
b. (If the employer elects this clause) was in the top-paid 20%.
C. § 132(b) – No additional cost service which means any service offered by an employer to employee if:
1. The service is offered for sale to customers in the ordinary course of line of business and;
2. The employer incurs no substantial additional cost in providing such service to the employee.
a. This includes forgone revenue: Revenue that was lost b.c the service was rendered to an
employee rather than a customer.
b. Excess Capacity Services
1) Ex: hotel accomodations, seats on mass trasports, phone service.
2) If non-excess capacity services are received, employees are still eligible for 20%
discount. § 1.132-2(a)(2)
c. This applies to family members as well.
essential part of Allen’s employment” & were busy with employment-related activities. Allen received return of $600 for his
wife, since co. didn’t want stag men chaperoning, and the cost of trip was excludable from GI.
3. Also, if reciprocal agreement with other co., excludable as long as same-line-of-business &
written agreement. E.g. stewardesses
4. Special Rule – Only apply to officers if no discrimination exists.
D. § 132(c) – Qualified employee discounts As long as the discount is:
1. Property, and the discount does not exceed the gross profit percentage of the price at which the
property is being offered or;
2. Services, 20% of the price at which the services are being offered.
3. Must be in line of business
4. Special Rule – Only apply to officers if no discrimination exists.
E. § 132(d) – Working condition fringe
1. Not income if employer pays for a business expense that would otherwise be deductible by the TP
2. Examples: co. car/plane for biz purposes, biz periodicals, bodyguard, OTJ training.
3. Use fraction for miles on co. vehicles q. are also used for personal benefit.
F. § 132(e) – De minimis fringe benefits
1. Includes:
a. Secretary typing letters, picnics, occasional events tickets, etc.
b. Eating facility for employees if 1) the facility is on or near workplace and; 2) revenue
produced at the facility normally equals or exceeds the direct operating cost of the facility
2. But not: Season tickets, auto for more than 1 day a month,or membership to country club.
G. § 132(f) – Qualified transportation fringe (1. + 2. ≤ $100/mo)
1. Commuter highway vehicle if used to travel between residence and place of employment -- 80%
for employee transport, ½/+ seats by employees.
2. Any transit pass.
3. Qualified parking – $175/mo – Must be on/near business place of employer or where employee
commutes to work. (Not near where employee lives). Excess included in GI.
4. Non-discrimination rule does not apply here.
H. § 132(j)(4) On-premises athletic facility operated by employer, at which substantially all the use is by
132(h) employees.
I. § 132(g) – Moving expense reimbursement fringe
J. § 132(m) – Qualified retirement planning services
II. MEALS AND LODGING
A. IRC § 119 -- Meals and Lodging can be excluded from gross income but only if:
1. Meals – 1) on Employer’s Business Premises and 2) For Convenience of Employer
a. If employee is required to pay charge for such meals, they are deductible under
§119(b)(3).
b. Irrelevant for convenience test that employee may accept/decline meal.
c. Does not apply for spouses & dependents.
d. §1.119-1(a)(ii)(d) – Restaurant or Food-Service employees may exclude meals
immediately before & after business hours, as well as during business hours.
2. Lodging – 1) Employer’s Business Premises; 2) For Convenience of Employer and 3) as a
Condition of Employment
a. Employer premises = on or adjacent to (2 blocks away would not count)
b. If required to live on employer premises for job, then do not have to include value in
GI.10
c. Clause in contract “requiring” the employee to live on the business premises is not
determinative for the Condition of Employment test. §119(b)(1)
d. Includes spouses & dependents.
e. §107 – Ministers may exclude from GI rental value of church-provided home or
rental allowance (even to pay mortgage), so long as both are meant as compensation.
Reasoning: House is often used for church functions. Under §265, may deduct
interest & property taxes on parsonage allowance.
3. Both must be offered for non-compensatory purpose.
III. §79 GROUP-TERM LIFE INSURANCE
A. Only included in gross income if the cost exceeds the sum of:
1. Cost of $50,000 of such insurance, and
2. The amount paid by the employee toward the purchase of the insurance.
B. If company is beneficiary, no inclusion in gross income of employee.
C. Non-discrimination requirements
1. 70% or more of employees must benefit.
2. 85% of participants must be non-key employees.
3. All benefits must be available to employees.
4. <3 years service & part-timers can be excluded.
5. Uniform relationships to compensation okay.
GAINS FROM DEALINGS IN PROPERTY
IV. §1001 – 1012 FACTORS IN DETERMINING GAIN
A. Gain = Amount Realized – Adjusted Basis (§1001)
B. Loss = AB – AR
C. §1.61-6: When a part of a larger property is sold, the cost/other basis of the entire property shall be
equitably apportioned among the several parts.
D. The cost basis of the property received in a taxable exchange is the FMV of the property
received in exchange.11 NOT the FMV of what was exchanged – avoid double taxation.
E. Gain from Exchange of Property 1 for Property 2 = FMV Property 2 – AB Property 1
1. Property 1 AB = $6000 and FMV=$9000
2. Property 2 AB = $8000 and FMV=$10000
10
Herbert v. Hatt – TP corp. president had to live at funeral home. Held: The “condition of his employment” test & “convenience
of his employer” test of §119 are similar. Convenience for employee doesn’t disqualify for exclusion if tests are met. Funeral
business is such that someone important be on hand to meet with family members of deceased. IRS was concerned that, as corp.
president, could write a contract for himself “requiring” him to live there—extra scrutiny. Ct. also looked to local custom; locals
expected someone to be available at all times at funeral homes. One factor: custom.
11
Philadelphia Park Amusements Co. v. U.S. -- Facts: TP gave bridge to city for 10 year extension to franchise agreement.
Subsequently TP abandoned the 10 year extension with three years left on the contract. TP asserted a deprcision based upon the
cost of the bridge and the loss they took by abandoning the franchise. TP needs to basis of the 10 year extension to figure out
what their extension is. IRS said they did not have a basis in the extension. Issue: What is the basis of the cost of the 10 year
extension? Held: TP did have a basis in the extension. TP said franchise was not of any worth. People were no longer using it.
The basis of property acquired in an exchange is its fair market value, unless otherwise provided in the Code or regulations. This
case is asking how to determine the cost basis of an asset when TP doesn’t pay cash to receive an asset. Rule: The basis of
property received in an exchange is its fair market value at the time of receipt. If TP cannot value that asset, then look to the value
of the asset given in exchange for the asset received.
3. Gain for TP 1 (exchanged 1 for 2): $4000; TP 1 Cost Basis: $10000
4. Gain for TP 1(exchanged 2 for 1): $1000; TP 2 Cost Basis: $9000
F. If difficult to ascertain the cost basis, use value of either item exchanged IF it was an arms-length
transaction, since that is the presumption.
Arms length –transaction b/w a willing buyer and seller where neither party is under any real
pressure to make transaction. Would expect what is given up = what is received.
V. ADJUSTED BASIS §1016
A. Proper adjustment in respect of the property shall in all cases be made for:
1. Expenditures, recipts, losses, or other items properly chargeable to capital account…
2. Exhaustion, wear & tear, obsolescence, amortization, & depletion to the extent of the amount:
a. Allowed as deductions, and
b. Resulting in a reduction for any taxable year of the TP’s taxes…
c. But not less than the amount allowable under this subtitle.
B. Depreciation Recap
1. Depreciation deductions reduce AB.
2. BUT, declining to take depreciation deductions or taking a lower depreciation deduction still
reduces AB if depreciation did occur. So if TPs do not use the deductions, they lose them.
C. Tax Benefit Rule
1. If a taxpayer recovers an amount that was deducted or credited against tax in a previous year,
the recovery must be included in income to the extent that the deduction or credit reduced the
tax liability in the earlier year. If no tax benefit was derived from a prior-year deduction or
credit, the recovery does not have to be included in income. But see depreciation exception.
2. If a taxpayer repays an amount that was previously included in taxable income, the repayment
can be deducted in the year in which it is repaid.
VI. PROPERTY ACQUIRED BY GIFT
A. IRC § 1015 (Deferral) – Donee gets the donor’s basis12 UNLESS donor’s basis is greater than
FMV of the prop at time of the gift, then for purposes of determining loss the basis is the FMV.
1. BUT when final sale price of gifted property is less than original owner’s basis and more than
the FMV at time of gift, no gain recognized.
a. Ex. 10,000 original basis
8,000 mkt value on gift
8,000 is new basis
9,000 donee sells
Therefore no gain or loss under this section.
2. Gift Tax: Adjusted basis is increased by amount of gift tax paid.
a. GT Adjustment = Gift Tax Paid * Net Appreciation in Value of Gift/Amount (FMV)
of Gift.
b. Net appreciation = FMV - Donor’s AB
B. Transfers Part-Gift and Part-Sale
1. Transferror – Only has gain to the extent the AR exceeds his AB. No loss is realized if AR is
below AB. §1.1001-11(e)
2. Purchaser/Donee:
a. AB is greater of either:
(1) The amount paid for the property.
(2) Transferror’s AB at time of transfer. §1.1015-4
12
Taft v. Bowers—Father buys stock at $1000. Gives them to daughter Elizabeth Taft when FMV is $2000. She later sells them
for $5000. IRS wants tax on gain of $4000. She states that taxes should only be $3000. Held: Donee gets donor’s basis under
these circumstances. Father’s basis was $1000, so that is her basis as donee, and taxes are owed on the $4000 gain from the sale.
b. To determine loss, if AB>FMV at time of gift, then loss basis = FMV at time of gift.
C. Farid-Es-Sultaneh standard for determining gift under §1015.13
D. §1011 – If §170 charitable deduction allowable by reason of a sale, then the AB for determining gain
is [AB(total property) * AR/FMV]= AB(gain) or Donor’s Basis * AR/FMV=Gain Basis
VII. PROPERTY ACQUIRED BY BETWEEN SPOUSES OR INCIDENT TO DIVORCE
A. IRC § 1041 – Non Recognition Rule: Generally no gain or loss on a transfer of property from an
individual to either:
1. A spouse, or;
2. A former spouse, BUT only if the transfer is incident to divorce.
a. A transfer is incident to divorce if:
(1) Occurs within 1 year on which the date the marriage stops, or
(2) Is related to the cessation of the marriage
i. Pursuant to divorce/separation instrument
ii. Within 6 years of finalization
b. Does not apply to agreements or transfers that are entered into before marriage. If
agreement was entered into before marriage but property was transferred only after
marriage it would apply.
c. Rebuttable presumption for post-6 years
(1) Factors hampered an earlier transfer, and
(2) Is effected promptly after impediment removed.
B. Rule: Transferred Basis
1. Transferee keeps Transferor’s AB.
2. Gift rules for determining loss dna §1015(e).
VIII. PROPERTY ACQUIRED FROM A DECEDENT
A. IRC § 1014 – Generally property acquired from a decedent (even if transferred before death if the
value of the property must be included in the gross estate for fed estate tax) receives an AB equal to
the FMV of the property on the date of the death of the decedent OR at the time of a gift (in the case
of a transfer in trust during decedent’s lifetime) Stepped Up Basis
1. Property Acquired from a Decedent (§1.1014-2):
a. By bequest, devise, or inheritance, or by decedent’s estate from decedent.
b. By trust established by decedent during his lifetime, w. power to alter/amend/term.
c. By property passed w.o full & adequate consideration under general power of
appointment thru will.
d. By community property representing surviving spouse’s ½ share, if ½ remainder was
includable in valuing gross estate.
2. Appreciated Property: if FMV at transfer > AB.
a. Applies to property acquired by gift within 1 year of death.
13
Farid-Es-Sultaneh v. Comm.—Husband-to-be gave wife-to-be stock during their engagement in case he died before their
marriage. The ante-nup said all the shares were a gift, and she waived her right to later claim alimony, division of property, etc.
At the time of the “gift,” the stock was valued at $787,500. They later divorced, and she sold her stock. Note: To determine
whether a transfer is a gift, the IRS and courts will focus on the substance of the transaction, not just the form or the label given
by the parties. Reasoning – Just because it’s a gift for gift tax purposes doesn’t mean it is for income tax purposes. IRS only sees
it as a gift if it meets Duberstein test (based on generosity), but she received the stock in exchange for the ante-nup, so it wasn’t a
gift. Held: It was not a gift, so her basis is FMV at time of transfer (when the prenup was signed), not his basis.
b. 1014(e) if a TP gives away property and then gets it back within 1 year from a
decedent, no stepped up basis. Prevents TPng persons giving property to elderly
relatives to get stepped-up basis upon the relative’s death.
IX. THE AMOUNT REALIZED
A. IRC § 1001(b) – The amount realized is the amount from the sale or disposition received PLUS the
FMV of the property (other than money) received. 14
Key Case: International Freighting When TP uses appreciated property to discharge
an obligation, TP recognizes gain to the extent the FMV exceeds the adjusted basis.
B. Rules from Crane15 and Tufts16 §1.1001-2
1. The amount of a mortgage is to be included in basis when the mortgage is used to acquire the
property.
2. AR includes amount of liabilities fr. which transferror is discharged.
a. Nonrecourse debt: foreclosure of prop is sale or exchange w. NR debt part of AR;
treated like capital gain/loss. One-step.
b. Recourse debt: foreclosure transaction is broken into two parts, capital gains & COD
income:
(1) First, owner sells property, [FMV-AB] and
(2) Second, seller pays imaginary cash to lender. Amt q. lender accepts less than
$ of debt is COD under §61 & §108. When the property is sold, the seller
must treat the amount of the mortgage as AR. [Unpaid Mortgage - FMV]
3. If the value of the property falls below the amount of the mortgage, it dn matter.
4. If TP took out a second mortgage on his home or a home equity loan, the amount of the loan
would be added to his AB in his property if he spent the money on his home.
5. SUM: Non-recourse loans treated as recourse loan for basis purposes on sale of property, but
treated as non-recourse for purposes of capital gains vs. income.
LIFE INSURANCE PROCEEDS AND ANNUITIES
14
International Freighting Corp. v. Comm. – TP gave stock to some of its employees, but the stock was of another company
(DuPont). These stock transfers were more like bonuses, given to those employees who performed well. The stock that was
transferred to the employees was worth 25K at the time is was transferred. The stock cost the TP 16K. 1) Whether business may
deduct FMV of the stock. Held 1): Bonuses are a form of salaries, so TP gets to deduct the FMV of the stock because the transfer
depleted his assets & was made in compensation for services. 2) Whether the TP had to recognize gain (which would be 16K to
25K). Held 2): Yes. They had a gain of 9K. When a TP uses appreciated property to discharge an obligation (pay employees) he
recognizes gain to the extent the FMV exceeds the adjusted basis.
15
Crane v. Comm.—Crane inherits property from her husband, worth $262K when he died, subject to a mortgage (plus arrearage
of interest) resulting in an equity of $0. She “sells” property for $3,000 less expenses ($2,500 cash + $500 expenses). Buyer also
took over the mortgage. Crane says she had a gain of $2,500 (AR of $2,500 – AB of $0, where equity=AB). IRS says taxable
gain was $23,767.03, b.c original basis was $262K (FMV at time of death), less allowable depreciation of $28K (even though she
claimed less than this) AB of $179K. AR=Net Cash+mortgage principal=$256,500. AR-AB=$23,767.03. Held: Crane’s AB is
$262K, the FMV at the time she received the property from the decedent. AR is mortgage principal + sale proceeds. Rule 1)
Depreciation deductions allowed and reduce basis even when TP paid no $ down & pays no principal on loan. [Tax Shelter!]
Rule 2) When selling property to buyer who assumes mortgage, AR is the principal of the mortgage PLUS what else buyer paid.
16
Comm. v. Tufts—Whether the same rule in Crane applies when the unpaid amount of the nonrecourse mortgage exceeds the
FMV of the property sold. Held: The amount of the mortgage is still part of the AR even if the person leaves the home w/o
paying off the remaining part of the mortgage. The FMV of the property is irrelevant in computing the gain or loss. Thus, the
gain/loss is still computed by taking the AR less the AB; equity is NOT part of this analysis. O’Connor: Treat NR & R equally;
depreciation as COD to elim tax shelter.
I. IRC § 101 – INSURANCE PROCEEDS
A. Generally GI excludes amounts from life insurance proceeds by received by reason of death of the
insured. (Paragraph 1)
1. If TP cashes out early this does not apply.
2. Accelerated Death Benefits Exception: Terminally/Chronically ill patients who need to pay
for medical expenses may cash out to viatical settlement providers (who then record gross
income based on transfer-for-value rule) without having to include the proceeds as gross
income. They are treated as being already dead, as far as Paragraph 1 goes.
a. Terminally ill: Physician certifies that person can be reasonably be expected to die in
24 months or less due to illness or physical condition.
b. Chronically ill: Physician certifies that person is unable to perform at least 2 activities
of daily living for at least 90 days due to loss of functional capacity; or has a level of
disability similar to this requirement; or requires substantial supervision due to
threats to health|safety b.c of severe cognitive impairment.
c. Viatical Settlement Provider: 1) Must be licensed as such in insured’s state; if no
licensing there, must meet requirements of the code with regards to patient being
terminal/chronic; 2) and be regularly engaged in the business of.
B. Transfer for Valuable Consideration(Transfer for Value Rule): The amount excluded from gross
income by paragraph (1) shall not exceed an amount equal to sum of actual value of such
consideration and premiums and other amounts subsequently paid by the transferee. (cost basis)
1. This does not apply (in other words, none of it is taxed as income) if transfer was to:
a. Anyone whose basis is det’d by ref. to the orig. transferor’s basis (gift/part-gift);
b. The insured (or insured’s spouse/ex-spouse, if incident to a divorce)
c. A partner of the insured; a PS in which the insured is a partner; a C in which the
insured is a shareholder or officer.
2. Only the principle is excludable, not interest payments.
C. Payment at a Date Later than Death
1. If payments are to made over term of years, whatever was due upon death would be
excludable; the rest would be included as gross income.
a. If beneficiary lives beyond life expectancy, amount is still pro-rated. §1.101-4(c)
b. If beneficiary dies prior to end of life expectancy, no deduction for unrecovered
proceeds.
2. If TP leaves the balance & only takes the interest, the interest is fully included in GI.
II. IRC § 72 ANNUITY PAYMENTS
A. Gross income includes any amount received from an annuity
1. Gross income does not include the amount determined by the exclusion ratio.
2. Exclusion Ratio
a. Exclusion cannot exceed the amount invested in the annuity. So if TP outlives life
expectancy, entire amount received in after-life expectancy year is included.
b. The way that it is not taxed is the exclusion tax ratio under 72(b).
c. Expected return is years of life remaining * annual return.
d. Estate allowed a deduction if entire amount of investment not recovered (i.e., dies too
soon), based on .
DISCHARGE OF INDEBTEDNESS
I. § 61a(12) GENERALLY DISCHARGE OF INDEBTEDNESS IS INCLUDED IN GI.
A. Indebtedness = taxpayer is personally liable for debt.
B. Gift discharges are subject to §102 & are excluded.
C. If the discharge is compensation, subject to those rules.
D. §385 Corporate Interests as Debt or Stock
If it is debt, repurchase of it at less than issuing price/face value is GI to the extent that the
issuing price/face value exceeds the repurchase price. 17
II. EXCEPTIONS § 108:
A. Not included in gross income if discharge of indebtedness…
1. Occurs in a Title 11 bankruptcy;
2. [Insolvency] Occurs while TP is insolvent
a. Insolvent: Liabilities exceed FMV of assets even after discharge.
b. Amount excluded is limited to extent of insolvency.
3. Is qualified farm indebtedness;
4. Is qualified real property business indebtedness of a non-C TP;
a. Qualified Real Property Business Indebtedness:
i. Incurred/assumed in connection w. RP used in a trade/business & is secured
by such RP, &,
ii. if incurred/assumed post-1993, is Qualified Acquisition Indebtedness—
incurred/assumed to acquire/construct/reconstruct/or substantially improve
such real property.
b. Exclusion from GI shall not exceed:
i. the outstanding principal – [the FMV of property – (any other loans secured
by it)] AND
ii. the aggregate ABs of all depreciable RP held by taxpayer immediately before
discharge.
5. Is qualified principal residence indebtedness pre-2010.
B. Precedence Rules
1. Title 11 then insolvency.
2. Principal residence then insolvency unless elected otherwise.
3. Farm exclusion and qualified real property dna if TP insolvent.
C. Contested Liability Doctrine—if a TP in good faith disputes the amount of a debt, a subsequent
settlement of the dispute would be treated as the amount of debt recognizable for tax purposes.18
D. BUT: If both parties agree on a debt amount and subsequently reach a payment agreement for a lesser
amount, the remainder will be included as income.
17
U.S. v. Kirby Lumber – If a corporation purchases and retires any of its bonds at a price less than the issuing price or face
value, the excess of the issuing price or face value is gain or income.
18
Zarin v. Commissioner – TP was a gambler. Casino extended him credit way beyond what the law allowed. Casino was later
reprimanded. TP argued he did not have to pay entire debt based upon wrongfulness of Casino. TP made an agreement with
Casino to reduce debt amount to 500K. Commissioner tried to argue that amount discharged was gross income pursuant to §
61(a)(12). Held: The Contested Liability Doctrine (Disputed Debt Doctrine) holds that if a taxpayer in good faith disputes the
amount of a debt, a subsequent settlement of the dispute would be treated as the amount of debt recognizable for tax purposes. TP
not liable for debt b.c unenforceable under NJ law, so doesn’t fit 108(d)(1). Notes: Contested liability only applicable if amount is
in dispute, not liability for the amount. And why use 108, since this case doesn’t fit exceptions? Should have only used 61(a)(12).
E. Purchase Price Debt Reduction: If the debt discharge is between the seller of property (discharger)
and the buyer (dischargee) of property, then it shall be treated as a price adjustment, not income.
1. But remember Tax Benefit Rule.
2. Treat as a repurchase and then re-calc depreciation/other deductions related to purchase.
III. §1017 and §108(b) REDUCTION IN BASIS AND TAX ATTRIBUTES
A. In QRPBI & QPRI, amount excluded from GI is subtracted from basis of depreciable real property.
B. In title 11, insolvency, or farm indebtedness, tax attributes are reduced first, then basis:
1. Net Operating Loss
2. General Business Credit
3. Minimum Tax Credit
4. Capital Loss Carryovers
5. Basis
a. For farm indebtedness, basis reduction after 1-4 is to be applied on qualified
depreciable property, then farmland, then other qualified property.
b. TP may elect to apply this first, but basis reduction limitation DNA.
C. Basis Reduction Limitation
1. For title 11 or insolvency, basis reduction not to exceed, after discharge, agg bases – agg
liabilities.
2. BUT if TP elected to apply reduction before 1-4, this basis reduction limitation DNA.
Instead, limitation is the entire agg adjusted bases of depreciable property.
DAMAGES AND RELATED RECEIPTS
I. DAMAGES GENERALLY
A. Generally are includable in gross income under §61.
B. Loss treated as forced sale to D. Apply gain/loss rules.
C. §186 Antitrust Damages
1. Not necessarily includable, see in lieu of.
2. But if included in GI, deduction allowed for lesser of:
a. The amount of the compensatory amount, or
b. The amount of unrecovered losses sustained.
II. DAMAGES IN LIEU OF: 19
A. Lost profitstaxed, unless result of physical injury.
B. Lost goodwill not taxed.
C. Return of capital not taxed
D. Interest taxed
E. Punitive damages taxed, unless
1. Wrongful death action, and,
2. State law only awards punitive damages for such actions.
F. Recovery of basis not taxed (beyond basis is taxed)
19
Raytheon v. Comm. – Raytheon (TP) recovered damages in anti-trust action. Wanted recovery to be seen as a return of
capital, rather than reimbursement for lost profits, which are taxable since the lost income they represent are taxable. Test: In lieu
of what were the damages awarded? Held: The allegation was that RCA(D) destroyed TP’s goodwill. The profits evidence was
to determine the value of the business & good will. Only the portion of compensation for the loss of goodwill that exceeds its cost
is gross income. The rest is a return of capital.
III. DAMAGES AND OTHER RECOVERIES OF PERSONAL INJURIES
A. IRC § 104 – GI does not include amounts received on behalf of:
1. Workers Compensation: The death/injury must be job-related.
2. Damages for personal injury or sickness20
a. As long as damages flow from physical injury then they are excludable21 this
includes lost wages.
b. Damages for a non-physical injury (including emotional distress) are included in GI
unless they are for resulting medical expenses.
3. Accident or health insurance for personal injuries or sickness;
4. A pension, annuity, or similar allowance for personal injuries or sickness resulting from
active service in the armed forces of any country;
5. Amounts received by an individual as disability income attributable to injuries incurred as a
direct result of a terroristic or military action.
6. Exception: §213 Amounts attributable to 7.5% AGI uncompensated medical expenses.
Application of tax benefit rule.
B. IRC §105 – If an employer directly/indirectly reimburses an employee for expenses of medical care
for the employee or the employee’s spouse or dependents, the amount rec’d is excluded from gross
income.
1. Otherwise, general rule is that amounts a) attributable to employer contributions not included
in GI, or b) are paid by employer, are taxable.
2. Permanent loss injuries must be computed in reference to nature of injury rather than absence
from work.
C. IRC § 106(a) – GI excludes payment made by an employer for employee health insurance coverage.
1. Exception: Flexible spending arrangement for long-term care services.
2. Health savings accounts are excluded as employer-provided coverage.
IV. CALCULATING RECOVERY
A. Loss of a capital asset is treated as a forced sale when calculating taxation on recovery.
1. AR(damages) – AB = Taxable Amount.
2. Reduce basis of asset by loss sustained.
3. OR
4. Treat as partial forced sale.**
B. Personal + Employer-Provided Policies: Under 104(a)(3), policies from TP’s own policy are
excluded, but 105(b) limits exclusion for employer-provided policy to amounts q. reimburse.
1. Amount of medical expense to be considered paid by ea. policy is proportionate to the
benefits received from each policy.
2.
3. Ex: $900 expenses; $800 fr. employer +$400 fr. personal=$1200 total.
20
Rev. Rul. 79-313: TP sustained severe & perm personal injuries fr. being hit by car. Brought action v. X, owner-operator of car,
who had liability ins w. M. M prop’d settlement q. TP accepted. 50 consec annual payments. Amount of ea. to be +ed by 5% over
previous year. No accelerating or +/- amount of annual payments. Held: All payments are excludable under 104(a)(2), as part of a
settlement agreement. TP d.n have the benefit of the of the present value, so just b.c amounts increase d.n make any of it taxable.
21
X got in car crash; resulting ED which woud be excludable. Damages for ED alone would not be excludable dn flow from PI.
$800/$1200, or 2/3, is medical expense paid for by employer.
2/3 * $900 = $600 is considered paid for out of proceeds of employer policy.
Only $600 is excluded as reimburssement.
$200 is included in gross income.
C. Tax Benefit Rule Applies. If TP deducted but later recovered, no exclusion for that amount!
D. Rev. Rul. 85-98: IRS will allocate settlement proceeds between compensatory damages (amount
prayed for) & punitive damages to determine taxation. Courts are divided on this, as in some states
punitive damages are limited, & the “punitive” damages allocated by the IRS would be unrecoverable
as such. But IRS does not take parties’ determination of the damages since it is against their own
respective interests to allocate any to punitive damages.
SEPARATION AND DIVORCE
I. ALIMONY
A. IRC § 71 – Alimony must be included in GI by the PAYEE and may be deducted by the PAYOR.
1. §71 = include in GI of payee
2. §215 = deduct from GI of payor
B. Requirements under § 71
1. Payments in cash: Not a promissory note or other forms of property.
2. Received on behalf of spouse under divorce or separation instrument:
a. Decree of divorce/separate maintainance;
b. Written separation agreement; or,
c. Decree requiring spousal support/maintenance payments.
3. The divorce/separation agreement does not designate the payments as non-alimony.
a. This allows parties to shift tax burden as part of dissolution.
b. For Transferror to deduct, must be alimony. For Transferee to not have income, must
be non-alimony.
4. No liability after Payee’s death.22
a. Payments must cease on death. Add this clause.
b. If payments are not to cease on death, entire amount is not alimony.
No good reason for this. Why not allow to be alimony up to substitute
payments?
5. Must not be members of same household.
a. Only in the case of divorce or legal separation.
b. If there is just a written separation agreement they can continue to live together.
c. One month to get out!
6. Payment is not for child support.
7. No joint returns, or §71 & §215 dna.
C. §71(f) FRONT-LOADING & THE RECAPTURE PROVISION
1. Reasoning: Most front-loading (paying large amounts in early years) of alimony is a
disguised cash settlement. Cash settlement could be in the form of a lump sum or in large
early amounts. But it d.n get alimony treatment, so no tax shelter for payor spouse. Strangely,
rear-loading is not penalized (larger amount in year 3 than in years 1 & 2).
22
If TP made a provision that the payments are to be made for 10 years after divorce, then it would not count.
Recapture: When inordinately large amounts of alimony/support are paid in the 1st/2nd year
2.
in relation to year 3, an amount is recaptured in year 3.
a. An amount is included in payor spouse’s GI for year three offsetting prior
deductions, AND
b. A deduction is made by recipient spouse offsetting priod inclusions.
3. Calculating Steps: (Note—Deductions resulting are above the line)
a. Second Year: If payments in 2nd year > 3rd year by +15K, recapture excess over
15K. Y2-(Y3+15K)
b. First Year: If payments in 1st year > avg payments in 2nd & 3rd year (after reducing
2nd year excess payments), by +15K, recapture excess over 15K.
Y1-((Avg (Y2-R2) & Y3)+15K)
4. Exceptions:
a. No reduction taken into account if it was b.c spouse died/payee married.
b. (b)(2)(C) decree payments (since that’s decided by a judge).
c. If contingent payments based on fixed portion of income fr. biz/prop/employment it
to be made for at least 3 years, no recapture b.c subject to fluctuations beyond control
of payor.
D. INDIRECT PAYMENTS
1. Rule: Indirect payments must be received by or on behalf of a spouse. 23
a. Payments to maintain property owned by Payor & used by Payee not alimony.
b. Payments in satisfaction of a legal obligation of the Payee’s are alimony.
c. For insurance, Payee must own policy.
2. As Capital Expenditures: Payee spouse is seen to have received it & used it thus.
a. Do not increase basis on property.
b. Do increase basis on life insurance.
II. §1041 & §1015(e) PROPERTY SETTLEMENTS, SUPRA
III. CHILD SUPPORT
A. Not gross income, not deductible.
B. Amount Fixed as Child Support
1. If amount in §71 divorce/separation instrument is reduced on a child attaining a specified age,
marrying, dying, leaving school, or upon a similar contingency, or at a time which can clearly
be associated with such a contingency, then the amount of reduction is treated as an amount
fixed as child support. §71(b)(2)
2. Result: If it’s disguised child support & can be proven by the above, no deduction for Payor,
and that amount is excluded from GI of Payee.
IV. COMMUNITY PROPERTY (CI)
23
I.TP. 4001—Whether premiums paid by a H on (1) a life insurance policy assigned to his former W and w. respect to which
she is the irrevocable beneficiary, and (2) a life insurance policy not assigned to the W and w. respect to which she is only the
contingent beneficiary, are includible in the gross income of the W and deductible by the H? Held: (1) is includible gross income
for W and deductible to H. (2) are neither includible in the gross income of the W nor deductible by the H. Rule: Indirect
payments must be received by or on behalf of a spouse. Cash payments to a third party (such as LL) would be an example, if they
are pursuant to a divorce/separation agreement.
A. Ea. spouse in a community state is personally liable for income tax out of their own separate
ownership of other spouse’s income. But if §66 applies, §879 removes that personal liability for the
“innocent” nonearning spouse, under some circumstances.
B. Bagur v. Commissioner
C. §66 Treatment of Community Income
1. If 2 individuals are married to ea. other;
a. Live apart at all times during calendar year; &
b. Do not file a joint return (6013);
c. One or both have earned income q. is community income; &
d. No portion of such earned income is transferred bw. them
2. Then any community income is treated in accordance with §879(a).
D. §879(a) [CI in case of Nonresident Aliens, but title d.n matter here]
1. Earned income24 is treated as the income of the spouse who rendered the personal services.
2. Other CI q. is derived fr the sep. property of one spouse is treated as the income of q. spouse.
3. All other CI shall be treated as provided in the applicable community property law.
OTHER EXCLUSIONS FROM GROSS INCOME
I. §121 EXCLUSION OF GAIN FROM SALE OF PRINCIPAL RESIDENCE
A. Gain from sale/exchange excluded from gross income if during 5 year period ending on date of
sale/exchange, such property has been owned and used by the TP as the TP’s principal residence for
periods aggregating 2/+ years.
B. Limitations
1. Amount of gain excluded not to exceed $250K;
2. For married joint returns: (generally only benefits if it is separate property)
a. excluded amount not to exceed $500K;
b. both spouses meet use requirements; &
c. neither spouse ineligible based on application restriction.
d. If reqs not met, limitation is sum of limitations q. ea. would get had they not married,
and ea. spouse seen as owning prop. during any period q. other spouse did.
3. Application Restriction: No more than 1 sale/exchange every 2 years.
4. Nonqualified Use:
a. No exclusion to so much of gain from sale/exchange as is allocated to periods of
nonqualified use.
b. Gain Allocated to Periods of NonQualified Use Ratio:
c. Period of Nonqualified Use:
i. Any period post 01-Jan-2009 during which the property is not used as the
principal residence of TP/TP’s spouse/ex-spouse.
ii. Doesn’t include:
1) Qualified official extended duty periods (up to 10 years,
TP/spouse)
2) Period after use as principal residence b.c. of sale/exchange
3) Temp absence <2 agg years b.c of change of employment, health
conds, or unforeseen circs specified by Secretary.
C. Exclusion for TPs who Fail Ownership/Application/Use Requirements
1. Applies only to those who—
a. Fail because of 2 agg years/application restriction; and
b. Moved b.c of change in place of employment, health, unforeseen circs (in regs).
24
Other than trade or business income and a partner's distributive share of partnership income; 1402(a)(2))
i. New place of employment must be at least 50 miles farther from residence
sold/exchanged than previous place of employment, or, if unemployed, is at
least 50 miles away from residence sold/exchanged.
ii. For health, more than just beneficial (no moving to Arizona for “better air”).
Must be like going to Houston for cancer treatments.And physician should
deem necessary for treatment.
2. Ratio
a. Shorter of
i. aggregate periods during 5 year period ending on sale/exchange q. property
has been owned and used as TP’s principal residence; or
ii. period after date of most recent prior sale/exchange by TP to which PR
exclusion applied & before sale/exchange
b. Divided by 2 Years; and
c. Multiplied by otherwise unexcludable amount (of gain).
D. Principal Residence Factors
1. Mainly where TP spends most time; but
2. Place of employment, DL, car & voter reg, mailing address for correspondence/tax return,
etc, might also be looked at.
E. Depreciation Recapture
1. Basically, the person was able to take depreciation deductions, and gain resulting from that
(b.c. of change in basis) is not excluded.
2. For Nonqualified Use situation, apply this to periods of Nonqualified Use; and
3. Do not apply to result from gain allocation equation.
4. Depreciation only applies if rented/used as business at any time.
F. TP may elect not to use exclusion. Good idea if buying home that is expected to rapidly gain value,
while TP’s old home resulted in little gain.
G. Out of Residence Care counts towards PR time.
II. §911 INCOME EARNED ABROAD
A. Elective exclusion for foreign earned income and the housing cost amount of a qualified
citizen/resident living abroad.
B. Must 1) be a bona fide resident of foreign country or, 2) be present there for at least 350 days in a 12
month period.
C. Foreign Earned Income [Income from a Foreign Source]: Amount received from sources within a
foreign countr(y/ies) which would be earned income attributable to services performed by such
individual.
1. Not: Pension/annuities/402 or 403 trust GI
2. Not: Payment by US/US agency to employee
3. Not: Amount received after taxable year’s close following taxable year services performed.
D. Maximum: $80K
E. Housing Cost Limitations:
1. Exclusion up to 16% of Maximum if paid for by employer. ($12800)
2. Deduction for AGI if not paid for by employer, limited to (FEI - excluded FEI).
F. Housing Expenses: Reasonable amounts paid for housing (including utility bills & insurance) in a
foreign country for the TP & family members if they live together.
G. No exclusion for travel-restricted countries.
H. Once election made, remains in effect until revoked.
BUSINESS DEDUCTIONS
I. INTRODUCTION TO BUSINESS DEDUCTIONS
A. IRC §162(a) Deductions of business expenses are allowed if:
1. Must be ordinary and necessary25:
a. An ordinary expense is not one that is habitual, but rather one that is common in the
taxpayer’s particular industry or business. More objective.
b. Necessary: Appropriate and helpful. More subjective—view of TP.
2. Incurred or paid during the taxable year
3. Incurred in carrying on a trade or business26
B. Trade or business expenses deductions include:
1. A reasonable allowance for salaries or other compensation for personal services actually
rendered;
a. Contingent Compensation27
i. if greater than amount ordinarily paid, must be paid pursant to a “free
bargain” bw. the ER and EE; and,
ii. Must be reasonable under the circumstances existing at date of K for services
made.
b. Multi-Factor Test (Majority)
i. Type & extent of services rendered
ii. Scarcity of qualified EEs
iii. Qualifications & prior earning capacity of EE
iv. Contributions of EE to business venture
v. Net earnings of ER
vi. Prevailing compensation paid to EEs w. comparable jobs
vii. Peculiar characteristics of the ER’s business.
c. Independent Investor Test (Exacto Spring Corp. v. Comm.) (Minority)
i. Abandoned multi-factor test, although most App. Cts kept it.
ii. Where, because of EE’s (CEO) efforts, notwithstanding exorbitant salary,
investors are obtaining a far higher return than they had any reason to expect,
his salary is presumptively reasonable.
iii. Can be rebutted when not due to EE’s efforts. E.g., found oil on property.
d. §162(m) Excessive Employee Remuneration: Publicly held corporations can’t
deduct applicable EE remuneration > $1M for covered employees.
i. Covered Employee: CEO, or EE whose total compensation is required to be
reported to SHs b.c one of 4 highest compensated officers (SEC law).
ii. Publicly held: Registered with SEC.
iii. Applicable EE Remuneration
1) Includes compensation otherwise deductible.
25
Welch v. Helvering —H was the secretary for the W co. This was a corporate office q. he held but it was his father that was
calling the shots. The business went bankrupt. Son starts K with Kellog and decides he wants to pay off his debt to help his
future business and develop clients. The Comm. said that the payments made to pay off debts were not ordinary and necessary
but rather capital expenditures. Held: Paying debts without legal obligation was extraordinary. Necessary but not ordinary.
26
Morton Frank v. Comm.—Travel fees incurred by TPs in trying to locate a radio or newspaper enterprise to purchase are not
deductible, as they are not connected with the carrying on of or engagement in a trade or business. Now, this would be covered
under §195 start-up expenditures.
27
Harolds Club v. Comm.— Where the compensation of non S/H F employed by sons (ER) based on net profits, no deduction for
excess above reasonable amount where sons (ER) were unduly controlled by him since he was the “brains of the business,” as
compensation was not pursuant to a “free bargain.” Bad case: F was not S/H, so public policy vs reducing net income of corp. for
closely helds not an issue here. Dn. own business & was not trying to sell it. If he dominated them & bullied them, should be
deductible extortion expense. 1.162-7(a), (b)(2). Advice: Prove negotation from the start.
2) Dn include compensation payable on commission basis derived
soley from income generated directly by the individual
performance of the EE.
3) Performance-Based Compensation not included if determined by
compensation committee of BOD comprised soley of 2/+ outside
directors; material terms are disclosed to & voted upon by S/Hs in
separate vote; & compensation committee must certify q.
performance goals were met.
2. Traveling expenses (including meals and lodging that are not lavish or extravagant under the
circumstances) while away from home in the pursuit of a trade or business; AND
3. Rentals or other payments to be made as a condition to the continued use or possession, for
purposes of trade or business, of property to which the taxpayer is not or has not taken title or
in which he has no equity
II. CAPITAL EXPENDITURES V. EXPENSES
A. IRC § 263 – No deduction shall be allowed for:
1. Any amount paid out for new buildings or for permanent improvements or betterments made
to increase the value of any property or estate.
2. Any amount expended in restoring property or in making good the exhaustion thereof for
which an allowance is or has been made.
B. Cost of acquiring/creating capital asset is treated like a capital expenditure.
28
C. The cost of repairs is deductible.
1. Can’t be problem created by the taxpayer.
2. Shouldn’t be a problem known from beginning (that cost should be included in overall cost of
acquiring capital asset).
D. Need to draw line b/w cost related to tangible prop that are incurred as repairs (currently deductible
expenses) and expenditures that are improvements to prop (amounts required to be capitalized)
Midland.
E. Question of capitalization of costs related to the acquisition or creation of various types of intangible
assets INDOPCO29
F. Key Questions:
1. Is it a repair?
2. Is it a capital improvement or asset?
3. Should it have been figured into cost of capital asset?
G. Substance is more important than form. K might state a lease, but IRS may look at practical effects to
determine whether is a deductible rental expense or a capital expenditure that would only allow
depreciation deductions. Starr’s Estate v. Comm.
III. CARRYING ON BUSINESS
A. § 195 Generally there is no deduction allowed for start-up expenditures but…
28
Midland Empire Packing v. Comm. — TP installed floor lining to factory to protect against leakage from neighboring plant. Is
this deductible or capital expenditure? Held: It is deductible because it is a repair. Ordinary b.c such payments to protect vs
attack are common & accepted. It’s normal to do so. No enlargement, no increase in expected life, & didn’t make more useful b.c
prior to leak everything had been fine.
29
INDOPCO, Inc. v. Comm.—Friendly takeover. The TP at the time of the takeover was known as National Starch, and after it
was changed to INDOPCO. The acquiring company was called Unileaver. Incurred professional expenses in course of takeover.
Issue: Are these expenses deductible, or should they be capitalized? Held: TP will have future benefit. Rule: Deductions are the
exception to income tax rule. So instead of deducting, general rule is to capitalize. Result: Capitalize.
B. § 195(b)(1) …TP may deduct for the taxable year in which the business begins an amount equal
to the lesser of: 1) the amount of start-up expenditures, or 2) 5K – ( the amount by which such
start-up expenditures > 50k ). (Phase-out)
1. The remainder can be amortized over the next 180 month period.
2. If the business stops before the amortization period, TP can deduct the rest of the expenses in
that year as long as they comply with §165.
3. Remember half-year convention (7/01/xx)
C. Start-up expenditure means any amount paid in connection with:
1. Investigating the creation or acquisition of a business or trade;
2. Creating an active trade or business;
3. Any activity engaged in for profit and for production of income before the day on which the
active trade or business begins, in anticipation of such activity becoming an active trade or
business. (anticipatory expenditures)
D. Rules:
1. When taxpayer reaches the transactional stage, amounts paid to complete the transaction
generally must be capitalized.
2. To get §195 deductions, TP must actually enter the business.
3. Expenditures must be of the type that are allowed on an existing business
4. Revenue Ruling 75-120.
5. Job hunting is below the line as misc. expenses.
E. Process:
1. Step 1 – is the person “carrying on”?
a. If no, no deduction under 162, but TP can get start-up costs for 195.
2. Step 2 – If yes, how much start-up costs did TP spend?
a. If less than 50K, 5K in first year and rest amortized over next 15 years.
b. If over 50K, 5k reduced by the amount that is over 50K, amortize over 15 years.
IV. TRAVEL AWAY FROM HOME
A. IRC §162(a)(2) – Generally TP can deduct traveling expenses (including amounts expended for
meals and lodging other than amounts which are lavish or extravagant under the circumstances) while
away from home in the pursuit of a trade or business.
B. Limitations
1. Living expenses paid by a single taxpayer who has no home and is continuously employed on
the road may not be deducted in computing net income. 30 This is b.c expenses must be
duplicated.
2. A TP can have only one home for purposes of deducting travel expenses under § 162(a)(2).
3. Living expenses duplicated due to business necessity are deductible, whereas those resulting
from a personal choice are not. 31
C. Rules:
30
Rosenspan v. U.S.—TP is trying to deduct the cost of hotels and meals he uses and/or stays in every night. He does not have a
home and is a traveling salesman. § 162(a)(2) allows deductions for traveling expenses while away from home. Issue: What is
TP’s home or did TP need to have a home? TP’s base was NY where he kept a room (kind of) at his brother’s house (stored his
things there, but d.n want to impose). Court ruled that since TP did not have a home the deduction could not apply.
31
Andrews v. Comm.—TP owned two homes and ran two businesses. Spent 6 months w. one business & 6 months w. other.
Chose one as home and wanted to deduct other. Held: Duplicated living expenses due to business are deductible. To determine
principal business: Time; Intensity of Business; Compensation.
1. TP cost of going between residence and place of work are dedutible in 3 cases:
a. TP may deduct daily transportation expenses incurred in going b/w the TP’s
residence and temporary work location outside the metropolitan area where TP
lives and normally works.
b. If a TP has one or more regular work locations away from the TP’s residence, the TP
may deduct daily transportation expenses incurred in going b/w the TP’s residence
and a temporary work location in the same trade or business, regardless of the
distance.
c. If TP’s residence is the TP’s principal place of business, the TP may deduct daily
transportation expenses incurred in going b/w the residence and another work
location in the same trade or business, regardless of whether the other work location
is regular or temporary and regardless of the distance.
2. Revenue Ruling 99-7: What is Temporary?
a. If employment is realistically expected to last (and does in fact last) for 1 yr or less,
the employment is temporary32
b. If employment at a work location is realistically expected to last for more than 1 yr or
there is no realistic expectation that the employment will last for 1 yr or less, the
employment is not temporary, regardless of whether it actually exceeds 1 yr.
c. If employment initially is realistically expected to last for 1 yr or less, but at some
later date the employment is realistically expected to exceed 1 yr, that employment
will be treated as temporary until the date that the TP’s realistic expectation changes,
and will be treated as not temporary after that date.
3. Other
a. If TP is self-employed, the transportation expense deduction is above the line (above
AGI).
b. If TP is an employee, the transportation expense is below the line (below AGI –
usually part of itemized deductions).
c. Transportation between 2 business locations = deductible.
d. Going to and from a non-regular place of business is deductible.
e. Commuters’ fare nondeductible (§1.162-2(e)).
f. For meals to be deductible, TP must stay overnight.
V. EXPENSES OF EDUCATION
A. IRC § 162 – Can be deductible if carrying on trade or business.
B. Reg § 1.162-5(a)
1. Education expenses incurred to fulfill requirements of a taxpayer’s employment or profession
are deductible as necessary and ordinary business expenses.33
2. A taxpayer may deduct education expenses incurred in maintaining or improving his
professional skills.34
32
Peurifoy Case — Construction workers were employed at a site in Kingston N.C. and they lived elsewhere in NC. Issue:
Whether they may deduct the cost of housing and meals at the Kingston job site. If they could establish that the work was temp.
rather than indefinite, they received the deduction. Congress codified the results in this case in § 162(a). § 162(a) – “A taxpayer
shall not be treated as being temporarily away from home during any period of employment if such period exceeds 1 year.”
33
Hill v. Comm. — Hill was teacher in Va. She had been teaching for 25 years. She had to take classes to renew her credentials.
She also had the option of reading books and taking tests on those books. She chose the classes. IRS concerned that this was not
necessary since she could have stayed in Va. and read the books. She did get the deductions.
34
Coughlin v. Commissioner—TP did not need to take course he took. He was not taking it for credit. It was a one week tax
course that exists today. He had to stay up on tax matters so he could better serve his firm. Held: This was a 162(a) deduction.
C. Exceptions
1. New Hires: Meeting minimum education requirements of potential employer are
nondeductible.
2. Cannot Qualify TP for New Education or Trade:
a. Law school always qualifies TP for a new trade/business—the practice of law. Not
even if were a teacher & planned on becoming a law professor.
b. Not even if already a lawyer & want to practice in another state. Cost of materials &
exams nondeductible b.c it is the new trade/busines of practicing law in another state.
c. If not previously working as a lawyer and get an LLM, new trade/business!
d. Also, cost of education not a start-up cost.
3. § 274(m)(2) – No deduction for travel as a form of education.
D. If TP gets a deduction for education & they have to travel, they can get a deduction for travel, meals
and lodging.
VI. MISCELLANEOUS BUSINESS DEDUCTIONS
A. IRC § 274 Activity not deductible unless it is “directly related” OR “associated with” business.
1. “Directly related to” – requires that business go on during the entertainment for which an
expense deduction is claimed.
2. “Associated w.” – requires that the entertainment have a business purpose and either
immediately precede or follow a bona fide business discussion.
a. For meals, travel, gifts, etc. to get the deduction TP must have substantial records.
b. If $75+, substantial records.
B. (K) -- Business Meals – No deduction unless:
1. It is not lavish or extravagant (1st class not lavish per se);
2. The TP/EE is present;
3. Actual business must be discussed—can’t just touch base; and,
4. Deduct ONLY 50% of meals.
C. (a)(1)(B) Facilities – § 274) precludes entertainment facilities deductions (yachts; summer
homes; club dues for business, pleasure, recreation, or other social purpose.
1. Expenses of facilities to the extent used in business for non-entertainment purposes are
deductible (airplane for business travel)
2. Although expenditures for entertainment facilities are not deductible, nevertheless
entertainment activities related to the use of such facilities remain 50% deductible if the rules
for deduction of entertainment activity expenditures are satisfied.
D. (l)(1) -- Entertainment Tickets –
1. Limited to 50% of the face value of the ticket
2. Only 50% of meals and entertainment is allowed.
E. Advertising –
1. Generally deductible in the year the expenses occurs even if benefits go beyond a year.
2. BUT can be a capital expenditure if something is purchased, like a billboard.
F. (a)(2)(3) Dues –
1. Dues paid to one’s business are deductible.
2. Dues to a contry club are not; expenses at the country club could be.
G. Reimbursed Expenses – TP does not have to cut in half. They are a wash.
H. Uniforms – Deductions for uniforms allowed only if “(1) the uniforms are specifically required as a
condition of employment, & (2) are not adaptable to general or continued usage to the extent that they
take the place of ordinary clothing.” Upkeep costs (dry cleaning/laundry) also deductible.
I. Lobbying Expenses – Generally not deductible for influencing legislation, participation in or
opposition to the political campaign for any candidate for public office, etc.
Limitation not applicable to bus related costs incurred in influencing legis at the local
level, in-house lobbying expenses if don’t exceed $2k, and lobbying expenses incurred
by professional lobbyist directly on behalf of another person.
J. (h)(1) -- Conventions – No deduction unless done for trade or business.
K. Outside of U.S.: 25% Rule: Only 25% of time can be personal/pleasure if more than week.
1. Transportation days are business days unless TP takes indirect route.
2. Sat. and Sun. are business days.
VII. LOSSES
A. IRC § 165(a) – Generally any loss sustained during the year is deductible as long as it is not
compensated by insurance or otherwise.
B. Individuals can only collect losses on:
1. (c)(1)--The loss incurred in a trade or business.
2. (c)(2)--The loss incurred in any transaction for profit, though not connected with a trade or
business. Look for reasonable expectation for profit.
3. (c)(3)--Losses from fire, storm, casualty, or theft.
C. NOTE If a individual is trying to take a personal loss, it might not be deductible.
D. Amount Deductible – In the case of any casualty loss, whether or not incurred in a trade or business
or in any transaction entered into for profit, the amount of loss to be taken into account for purposes
of § 165(a) shall be the lesser of either:
1. The amount which is equal to the FMV of the prop immediately before the casualty, reduced
by the FMV of the prop immediately after the casualty; or,
2. The amount of the AB prescribed in § 1.1011-1 for determining the loss from the sale or
other disposition of the prop involved.
E. Determining Loss Reg. § 1.165-7(b)(1)
1. If the property is damaged – Loss is the difference between the FMV before and the FMV
after, limited by the AB.
2. If the property is destroyed:
a. For income producing property or property used in a trade or business if the FMV
is below the AB, TP takes the AB.
b. For all other property Use the AB.
3. Only realized losses taken into account.
a. Must be evidenced by a closed and completed transaction, such as a sale, or fixed by
an identifiable event.
VIII. DEPRECIATION
A. IRC § 167 – There shall be allowed as a depreciation deduction a reasonable allowance for the
exhaustion, wear and tear of:
1. (a)(1) --Property used in a trade or business or;
2. (a)(2) -- Property held for the production of income
B. The Relationship of Depreciation to Basis
When a TP claims depreciation on prop, the deduction is attended by a commensurate
reduction in the basis for the prop – the downward adjustment required is at least the amount
of depreciation deduction permitted (allowable) under the depreciation method employed by
the TP.
C. Straight Line Depreciation -- cost or other basis of the prop, less its estimated salvage value, is
deducted in equal annual installments over the period of its estimated useful life.
DEDUCTIONS FOR PROFIT-MAKING NONBUSINESS
ACTIVITIES
I. SECTION 212 EXPENSES
A. IRC § 212 – General rule is that TP can deduct all the ordinary and necessary expenses incurred for
the management, consveration or maintenance of property held for the production of income or in the
connection with the determination, collection, or refund of any tax. 35
B. Rules
1. Expenses must be Ordinary and Necessary36: Do not have to show proximate relationship.
a. Revenue Ruling 64-236: Held: Proxy fight expenditures are deductible by a
stockholder under § 212, if such expenditures are proximately related to either the
production or collection of income or to the management, conservation, or
maintenance of prop held for the production of income.
b. Make sure TP capitalizes if TP cannot deduct, such as attorney’s fees being part of
the cost
c. If something is viewed as being part of the cost, then capitalize it and reduce the AB
2. §274 – No deductions for attending convention, seminars, or meetings, etc.
C. Legal Expenses
1. Legal fees that are NOT deductible:
a. Expenses incurred in defending income. 37
b. Divorce expenses
c. Defending antinumptual agreement
2. Legal fees that ARE deductible:
a. Tax advice (Carpenter Case)
b. Alimony agreements (to set up or seek to profit by attacking or asserting)
35
Higgins v. Comm. — Case Prior to §212 which led Congress to adopt this section. TP had a “business” which was comprised
of offices of people managing his portfolio on a regular basis. IRS conceded that it was for production of income, but… Ct. held
expenses non-deductible b.c this “managing of his affairs” was not “carrying on a business.” Rule: Holding property for
production of income is not a trade or business.
36
Surasky v. United States – TP bought stock in company at the suggestion of Wolfson. W wanted to make some changes to the
C as a stock holder. Created proxy sub-committee with a goal to implement those actions through voting. P gave 17K to help
fund the committee’s goal. It worked and created greater profit for her initial investment. Issue: is the 17K deductible? Held: .
Showing of proximate relationship b/w nonbusiness expenses and producing or managing income producing prop is not necessary
to claim nonbusiness deduction so long as expenses are ordinary and necessary.
37
Bowers v. Lumpkin – P bought stock from trustees. Attorney general took issue with the sale and challenged it. She had to
incur expenses in fighting the litigation. She had to hire a lawyer to defend against suit, in which she was successful. Issue: can
she deduct expenses for legal fees? Held: Not deductible. Nonbusiness expenses incurred for production or collection of income
must meet restrictions applicable to business expenses in order to be deductiblePay attention to this case. He argued that hey
should have capitalized meaning it would have reduced the AB down. This would not also be then deductible.
II. CHARGES ARISING OUT OF TRANSACTIONS ENTERED INTO FOR PROFIT
A. IRC §121(a) – GI does not include gain from sale of principle residence if it is held for more than 2
years within the 5 year period ending on the date of sale
1. 121(b)(2)(A) --Excluded Gain Limitations:
a. 500K for married; 250K single
2. Exception: Does not apply if the gain does not exceed the depreciation38
B. 3 Possible Deductions
1. § 165 – Losses sustained, not compensated by ins.
a. Can be for profit although not connected with trade.
2. § 167 – Depreciation of property held for production of income
3. § 212 – Ordinary and necessary expenses (production, maintenance, etc.)
C. Rule: Deductions for depreciation and maintenance are allowed when property is held for production
of income, BUT a loss is not allowed unless the property constitutes a transaction entered into for
profit.
D. Rule: Generally, when prop has been used as a personal residence, it must be converted to a
transaction entered into for profit. To show such a conversion, the owner must do more than abandon
the prop and try to rent or sell it. 39
E. Rule: Deductions for depreciation and maintenance are allowed when prop is held for production of
income, but a loss is not allowed unless the prop constitutes a transaction entered into for profit
F. Losses on Sale of Real Property (Reg. § 1.165-9)
1. Property used for personal use no loss deduction under § 165.
2. Property converted from personal use (rental) loss on sale is deductible
a. AB is the lesser of either:
i. FMV at time of conversion
ii. AB at time of conversion subject to 1.1011-1
G. Rule: In determining whether a property has been converted look at all factors, not just if it was up for
rent. 40
H. Exceptions to 2 year requirement:
1. If the sale or exchange is the result of either 1) change in employment; 2) health; or 3)
unforeseen circumstances, the amount will be excluded on an amortized basis.
a. i.e. if a single taxpayer is at a house for 1 year and moves because of job, he will get
½ of the possible deduction = ½ of 250K. if he were married it would be ½ of 500.
b. Unforseen events include Involuntary conversion of property; death; divorce; natural
or manmade disaster.
38
I.e. 100K home. Depreciated 20K. Sold for 100K. Must count 20K as GI.
39
Horrmann v. Comm. – Inherits house from mom at a basis of 60K w. 9k in cap expenses which gives him an AR of 69K. He
moves in, later abandons. He decided to rent it when the FMV is worth 45K. He ends up putting it on the market, & it’s never
rented. Sells for 20K. He wants to deduct 1) cost of maintenance from time of conversion to the time of sale & 2) losses on the
sale. He gets to depreciate under 167(a)(2), & the maintenance cost under 212(2). He does not get to deduct loss on sale b.c it
was not covered as a transaction entered into for profit. At the time he moved out of the house and put it up for sale, he could not
have received a profit b.c the market was so low that it couldn’t have been a transaction entered into for profit. Rule: Generally,
when prop has been used as a personal residence, it must be converted to a transaction entered into for profit.
40
Lowry v. U.S. – L was trying to deduct cost of maintence of his vacation home when it was up for sale. The problem was that
he never put the property up for rent. If he had there would not be must of an issue. Thus the issue is whether TP can deduct
maintenance expenses under 212 if TP never put the property up for rent after living in it? Court held yes. whether a personal
residence has been converted into income-producing prop is not determine by whether or not it was rented before sold, but rather
by looking at all of the relevant facts and circumstances, including whether the taxpayer had an expectation of profit.
DEDUCTIONS NOT LIMITED TO BUSINESS OR PROFIT-
SEEKING ACTIVITIES
I. INTEREST
A. IRC § 163(a) – All interest paid or accrued during taxable year is deductible on indebtedness
B. 163(h)(1) – No personal interest is deductible.
1. Exceptions to personal interest: § 163--
a. (h)(2)(A) -- Interest paid or accrued on indebtedness properly allocable to a trade or
business (NOT for employees)
b. (h)(2)(B) – Any investment interest
c. (h)(2)(D)* -- Any qualified residence interest
d. (h)(2)(F) – Educational loan interest
i. loan incurred by TP solely to pay for the qualified higher education expenses
of a student who is the TP, the TP’s spouse, or a dependent of the TP if the
student is at least a ½ time student
ii. amount of qualified expenses is reduced by any amounts excluded from gross
income
iii. interest is not deductible if loan is made by a related person
iv. Phase Out - amount of deduction is phased out ratably for single TPs w/
mAGI of b/w $50k - $65k (100k – 130k for couple)
v. Limited to $2,500.
C. Qualified Residence Interest
1. 163(h)(2) – QRI includes any interest paid on:
a. Acquisition indebtedness or;
i. (h)(3)(B)(i)(I)-(II) -- acquisition indebtedness includes any debt incurred: in
acquiring, constructing, or substantially improving any qualified residence of
TP or 2) is secured by such residence.
1) Includes refinancing, if original loan met requirements.
2) Can’t exceed $1,000,000.00 or $500,000 in the case of married
individual filing separate tax return, total, for the taxable year. This
is NOT for each house, but total QRI under AI.
b. Home equity indebtedness
i. (h)(3)(C)(i)(I)-(II) -- HEI means any debt secured by residence that does not
exceed the FMV reduced by debt.
1) 100K limitation or 50K for married person filing separately.
2) Can’t exceed equity in the home.
2. Revenue Ruling 69-188: Fees associated with the use or forbearance of money are deductible
as interest.41
a. Cannot be payment for services such as closing costs or security investigation.
b. Points received on behalf of loan are amortized over life of loan.
c. It is sufficient that the payment be prerequisite to obtaining borrowed capital, even if
there is no loan yet.
41
Rev. Ruling 69-188 -- TP borrows money, must pay loan processing fee – is this fee interest (and deductible)? YES, b/c TP
was able to establish that fee was paid as compensation to the lender solely for the use or forbearance of money, and b/c he did
not initially obtain the funds to pay this fee from the lender points are deductible.
D. Interest on Investment Income
1. IRC § 163(d) imposes a limit on the deductibility of investment interest by noncorp
taxpayers.
a. Only deductible to the extent that the TP has net investment income
b. Investment interest – interest paid or accrued on indebtedness incurred to purchase or
carry prop held for investment
c. Net investment income – excess of investment income over investment expenses
d. Investment income – gross income from prop held for investment plus some gains on
the sale of such prop, but only if the prop is not a part of a trade or business, or an
activity subject to the passive activity rules, or does not qualify for preferential net
capital gain treatment under § 1(h) either on the sale of investment prop or as
qualified dividend income.
E. Interest on Education Loans: IRC § 221 – TP can deduct interest of qualified education loan. Above
the line.
II. TAXES
A. IRC § 164 Deductions on the following taxes shall be allowed:
1. State, local and foreign real property taxes
2. State and local personal property taxes
3. State, local, and foreign income and excess property taxes.
B. Tax deductions not allowed:
1. Taxes assessed against local benefit to increase value of property
a. NOTE – this does not apply to maintenance or interest charges
2. Taxes on real property assessed to another taxpayer.
a. § 164(d)(1) -- Taxes on real estate sold within a given year will be divided pro rata.
3. Federal income taxes (§ 275).
4. Estate, inheritance, legacy, succession, and gift taxes (§275)
5. State sales tax. See §164(b)(5)
C. Taxes on Real Estate
1. Must be owner or on the deed.
2. No deduction if someone else is the owner but TP is paying the taxes. Does not matter what
each agreed to pay. (Cramer v. Comm.)(§1.164-1A)
P512
III. §183 Hobby Loss Deductions: If activity by individual or S corporation is not engaged in for profit. Severely
limits deductions that TP may claim for expenses incurred. Hobby expenses only deductible if can itemize
miscellaneous deductions.
A. Only deductions allowed are those otherwise allowable; and 2) Deductions that would have applied,
but only up to amount of gain derived from that activity. In other words, can’t use to offset other
income for tax purposes.
B. Presumption that if gross income exceeds attributable deductions for 3 of 5 years (without regard to
whether/not engaged in for profit), then it is presumed activity engaged in for profit.
C. Activity not engaged in for profit: any activity other than those that would have expenses allowed
as a "trade or business" (§ 162) or an "investment" (§ 212).
1. See 1.183-2—Relevant Factors:
a. All those to determine profit objective (Facts and Circumstances)
b. Manner in which TP carries on activity
c. Expertise of TP
d. Time & Effort expended
e. Expecation that assets used in activity may appreciate in value
f. Past Success
g. History of income/loss re the activity
h. Amount of occasional profits earned
i. Financial Status of TP (if substantial income fr. other sources, not good)
j. Elements of Personal Pleasure or Recreation
280A Rental Use of Home (Principal Residence)
Must use for personal use for more than (greater of) 14 days or 10% of days of rented at fair rental value.
If does not meet personal use, expense deductions limited.
Expenses: Prorate for rented period.
If rental period less than 15 days, don’t bother including in gross income. (“Take the money and run.”)
Fall back—183.
P514 restrictions on deductions of homes
1.183-2
280A Home Office Rule
Home offices - § 280A
o Must be principal place of business OR place where taxpayer regularly meets with patients, clients or
customers
o Can only deduct portion of expenses allocable to activity
can’t deduct in excess of gross income – nonbusiness deductions + bus. deductions not related to
use of property
o can deduct utilities, repairs, etc. and take depreciation
Vacation rental homes - § 280A
o If used as a “residence”, then must divide expenses based on the # of days used as a residence and as a
rental. § 280A
All rental expenses & personal deductions (home mortgage interest etc) & business
deductions (home business) are capped at income from rental. § 280A(c)(5)
o Can’t exceed (total expenses x (# days rented / # days used))
o can take depreciation
DEDUCTIONS FOR INDIVIDUALS ONLY
I. IRC § 62 Adjusted Gross Income equals GI minus the following (Above the Line) deductions:
A. (a)(1) – Trade and Business Deductions
1. must be carried on by the TP
2. trade or business cannot consist of performance of services by TP as employee
3. KEY Covers person who is sole proprietor but not employee.
a. Person who owns the business but the employees get below the line.
B. (a)(2) Certain Trade and Business deductions
1. (A) – Reimbursed expenses of employees. Does not count if:
a. such arrangement does not require the employee to substantiate the expenses covered
by the arrangement to the person providing the reimbursement, or;
b. such arrangement provides the employee the right to retain any amount in excess of
the substantiated expenses covered under the arrangement
2. (B) – Certain expenses of performing artists
3. (C) – Certain expenses of officials
4. (D) – Certain expenses of elementary and secondary school teachers (limit to $250)
C. (a)(3) – Losses from sale or exchange of property
D. (a)(4) – Deductions attributable to rents and royalties
E. (these are 212 deductions or deductions involved with property held for the production of income)
F. (a)(5) – Certain deductions for life tenants and income bfs of property
G. (a)(6) – Pension, profit sharing, and annuity plans for self employed individuals
H. (a)(7) – Retirement savings
I. (a)(10) – Alimony
J. (a)(15) – Moving expenses
K. (a)(17) – Interest on education loans
L. (a)(18) – Higher education expenses
M. (a)(19) – Health savings account
N. (a)(20) – Costs involving discrimination suits
II. MOVING EXPENSES (ABOVE THE LINE)
A. IRC § 217(a) -- There shall be allowed as a deduction moving expenses paid/incurred in connection
w/ commencement of work by TP as an employee or as a self-employed individual at a new principal
place of work.
B. § 217(b) – Definition of moving expenses:
1. moving of household goods and personal effects from one house to another
2. of traveling, including lodging, to new place (does not include meals)
3. Requirements – 217(c)
a. Distance -- Allowed only if the distance b/w TP’s former residence and new principal
place of work is at least 50 miles farther than the distance b/w TP’s former residence
and former principal place of business. (c)(1)(A)
b. If starting a new job for first time, like a law student, then it must be 50 miles away.
i. FORMULA: (Distance from TPr old home to new job) – (Distance of TPr
old home to old job) 50
c. Time – (c)(2)(A)
i. Full Time: 39 weeks of the 12 months
ii. Self-employed: 39 weeks of first 12 months AND 78 weeks of 24 months
overall.
iii. In the case of a full-time employee who suffers involuntary separation from
employment or who is transferred by an employer, the time requirement is
waived if the employee could reasonably have been expected to satisfy the
time requirement if there had been no separation or transfer
d. Timing
i. In general a deduction may be taken only in a yr in which an expense is paid
or accrued. This poses a dilemma for the deduction of moving expenses b/c
the expense will frequently be paid or accrued in a yr prior to satisfaction of
the time requirement
ii. In order to bring the deduction in line w/ the yr an expenses is paid or
accrued, a deduction is allowed for the earlier yr, if at the time for filing an
income tax return it is possible that the TP may still satisfy the time
requirement even though she has not yet done so
iii. If subsequently fail to meet requirement, TP may either include the amount
previously deducted in gross income for the 1st subsequent yr in which the
deduction was taken
III. EXTRAORDINARY MEDICAL EXPENSES (BELOW THE LINE)
A. IRC § 213 -- There shall be allowed as a deduction the expenses paid during the taxable year, not
compensated for by insurance or otherwise, for medical care of the taxpayer, his spouse, or a
dependent, to the extent that such expenses exceed 7.5 percent of adjusted gross income.
1. (b) – Medicine and drugs are only deductible if they are prescribed by a doctor or insulin.
2. Lodging is paid for if:
a. Not lavish or extravagant
b. Required by a physician
c. Not for pleasure
d. Can’t exceed $50 per night per person.
3. ½ of meals
4. Transportation costs are included.
5. Long term care insurance costs.
6. Cosmetic surgery does not count as medical care.
7. Rule: If medical care is for permanent addition to TP’s home, it can only be deductible under
213 if it does not increase the FMV. If cost of treatment exceeds value to home then the part
exceeding value to home is deductible.
8. Rev. Ruling 2002-19 – An expense that is merely beneficial to general health is not
deductible.
9. Food is never deductible even if prescribed by doctor.
IV. PERSONAL AND DEPENDENCY EXEMPTIONS
A. IRC § 151: Everyone who is alive gets a deduction
B. When TP files, he can combine deductions (i.e. include dependents).
V. THE STANDARD DEDUCTION
A. IRC § 63 – Standard deduction is made up of basic standard deduction plus an additional deduction:
1. 63(b)(2)(C) – Every person get to deduct 3K (6K for married filing jointly; or surviving
spouse).
2. (b)(2)(B) – Head of household gets $4,400
a. Head of Household is a single person (not a surviving spouse) living in one house for
more than half the year and has a child.
3. Limitation:A married person cannot take the SD by filing separately if spouse itemized.
B. Public Policy Extras to Standard Deductions
1. If over the age of 65 before close of taxable year he gets and additional $600 (works for
spouse also).
2. Same deal applies for blind (if TP is blind or TP spouse is blind get $600).
3. If individuals are not married and not surviving spouse, they get $750 instead of $600 in
above two categories.
VI. Itemized Deductions (below the line deductions)
A. Misc deductions – deducted only so much that exceeds 2% of adjusted gross income
B. Non-misc. deductions – listed in 67 – 100% deductible. THEY INLUCDE (IRC § 67):
1. § 163 (interest)
2. § 164 (taxes)
3. § 165(a) (casualty or theft)
4. §170 (charitable contributions)
5. § 213 (medical expenses)
6. etc.
C. PROCESS
1. Step 1: Figure out TP’s gross income.
2. Step 2: Calculate and subtract “above the line” deductions to get AGI
3. Step 3: Figure out TP’s itemized deduction
a. Itemized deductions = misc. (only amount over 2% AGI) + 100% non-misc
deductions.
4. Step 4: Figure out TP’s standard deduction
a. 3K for single, 6K for married.
5. Step 5: Compare ID and SD and deduct the greater from AGI.
a. Add non-mic and misc that exceed 2% of AGI deductions together. If they are
over the standard deduction itemize
6. Step 6: Subtract Personal deduction and itemized/standard deduction from AGI
7. Step 7: TAXABLE INCOME
