1 - Belk College Of Business

					37.1. [LO 1] Steve and Stephanie Pratt purchased a home in Spokane, Washington for           Formatted: Bullets and Numbering
   $400,000. They moved into the home on February 1, of year 1. They lived in the
   home as their primary residence until November 1 of year 1 when they sold the home
   for $500,000. The Pratts’ marginal tax rate is 34 percent.
       a. Assume that the Pratts sold their home and moved because they don’t like their
       neighbors. How much gain will the Pratts recognize on their home sale? At what
       rate, if any, will the gain be taxed?
       b. Assume the Pratts sell the home because Stephanie’s employer transfers her to
       an office in Utah. How much gain will the Pratts recognize on their home sale?
       c. Assume the same facts as in (b), except that the Pratts sell their home for
       $700,000. How much gain will the Pratts recognize on the home sale?
       d. Assume the same facts as (b), except that on December 1 of year 0 the Pratts
       sold their home in Seattle and excluded the $300,000 gain from income on their
       year 0 tax return. How much gain will the Pratts recognize on the sale of their
       Spokane home?

   a. $100,000.
      Amount realized from the sale         $500,000
      Adjusted basis                         400,000
      Gain realized                         $100,000

       The Pratts owned and used the Spokane home for only 9 months (February 1 to
       November 1 of year 1), and so they fail the ownership and use tests required to
       qualify for the exclusion. They also don’t qualify for the hardship exception
       because disliking one’s neighbors does not meet the “unusual circumstances”
       test. Thus the entire $100,000 gain is recognized. The gain is taxed at the Pratts’
       ordinary income rate of 34% because they did not hold the home (a capital asset)
       for more than one year, so the gain is a short-term capital gain, subject to
       ordinary income rates (note that this assumes that they did not have any capital
       losses).
b. $0.
   A change in employment qualifies as “unusual circumstances,” so the Pratts
   won’t be disqualified for the exclusion. However, the maximum available
   exclusion must be reduced to reflect the amount of time the Pratts owned and used
   the Spokane home relative to the two year ownership and use requirements as
   follows:

   Maximum exclusion × number of months taxpayers met the use and ownership
   tests
                                             24 months

   $500,000 × 9 months = $187,500
             24 months

   The Pratt’s can exclude up to $187,500 of gain on the sale. Because they realized
   a gain of only $100,000 ($500,000 – 400,000) they are able to exclude the entire
   gain from taxable income. Consequently, the Pratts are not required to pay any
   taxes on the gain on the sale of the home.

c. $112,500.
   A change in employment qualifies as “unusual circumstances,” so the Pratts
   won’t be disqualified for the exclusion. However, the maximum available
   exclusion must be reduced to reflect the amount of time the Pratts owned and used
   the Spokane home relative to the two year ownership and use requirements as
   follows:

   Maximum exclusion × number of months taxpayers met the use and ownership
   tests
                                             24 months

   $500,000 × 9 months = $187,500
             24 months

   The Pratt’s can exclude up to $187,500 of gain on the sale. Because they realized
   a gain of only $300,000 ($700,000 – 400,000) they are able to exclude $187,500
   of the gain from income but they must include $112,500 in their income. The gain
   is taxed at the Pratts’ ordinary tax rate because they did not own the home (a
   capital asset) for more than a year before they sold it.

d. $0.
   Same answer as b. The rule that prohibits taxpayers from claiming an exclusion
   more than once every two years does not apply to taxpayers who are selling
   homes under the hardship circumstances.
41.2. [LO 2] Javier and Anita Sanchez purchased a home on January 1, 2010 for,                     Formatted: Bullets and Numbering
   $500,000 by paying $200,000 down and borrowing the remaining $300,000 with a 7
   percent loan secured by the home. The loan requires interest-only payments for the
   first five years. The Sanchezes would itemize deductions even if they did not have
   any deductible interest. The Sanchezes’ marginal tax rate is 30 percent.
        a. What is the after-tax cost of the interest expense to the Sanchezes in 2010?
        b. Assume the original facts, except that the Sanchezes rent a home and pay
        $21,000 in rent during the year. What is the after-tax cost of their rental payments
        in 2010?
        c. Assuming the interest expense is their only itemized deduction for the year and
        that Javier and Anita file a joint return, have great eyesight, and are under 60
        years of age, what is the after-tax cost of their 2010 interest expense?
   a. $14,700.
        The $300,000 loan is treated as acquisition indebtedness, since it was to initially
        acquire the home. Interest on up to $1,000,000 of acquisition indebtedness is
        deductible as an itemized deduction. Since the $300,000 loan principal is less
        than the limit, all of the interest associated with the loan is deductible. The after-
        tax cost of the interest expense is calculated as follows:

         Description                                 Amount       Explanation
         (1) Before-tax interest expense               $21,000    $300,000 × 7%. All deductible.
         (2) Marginal tax rate                        × 30%
         (3) Tax savings from interest expense          $6,300    (1) × (2)
         After-tax cost of interest expense            $14,700    (1) – (3)

   b. $21,000.
       Because rental payments are not deductible, they do not generate any tax
      savings, so the before- and after-tax cost of the rental payments is the same.

   c. $18,120.
      Because the Sanchezes had no other itemized deductions, their interest expense
      only produces a benefit to them to the extent that it exceeds the standard
      deduction, calculated as follows:

         Description                                 Amount       Explanation
         (1) Before-tax interest expense              $21,000     $300,000 × 7%. All deductible.
         (2) Standard deduction                        11,400     MFJ
         (3) Interest in excess of standard            $9,600     (1) – (2)
         deduction
         (4) Marginal tax rate                        ×   30%
         (5) Tax savings from interest expense          $2,880 (3) × (4)
         After-tax cost of interest expense            $18,120 (1) – (5)
49.3. [LO 2] {Planning} Rajiv and Laurie Amin are recent college graduates looking to          Formatted: Bullets and Numbering
   purchase a new home. They are purchasing a $200,000 home by paying $20,000
   down and borrowing the other $180,000 with a 30-year loan secured by the home.
   The Amins have the option of (1) paying no discount points on the loan and paying
   interest at 8 percent or (2) paying one discount point on the loan and paying interest
   of 7.5 percent. Both loans require the Amins to make interest-only payments for the
   first five years. Unless otherwise stated, the Amins itemize deductions irrespective of
   the amount of interest expense. The Amins are in the 25 percent marginal ordinary
   income tax bracket.
        a. Assuming the Amins do not itemize deductions, what is the break-even point
        for paying the point to get a lower interest rate?
        b. Assuming the Amins do itemize deductions, what is the break-even point for
        paying the point to get a lower interest rate?
        c. Assume the original facts except that the amount of the loan is $300,000.
        What is the break-even point for the Amins for paying the point to get a lower
        interest rate?
        d. Assume the original facts except that the $180,000 loan is a refinance instead of
        an original loan. What is the break-even point for paying the point to get a lower
        interest rate?
        e. Assume the original facts except that the amount of the loan is $300,000 and
        the loan is a refinance and not an original loan. What is the break-even point for
        paying the point to get a lower interest rate?
   a. 2 years.

       Cost of paying 1 point= loan principal × 1%
                             =$180,000 × 1%
                             =$1,800

       Because the Amins do not itemize deductions, they will receive no tax benefit from
       the deduction for the points paid. Consequently, the after-tax cost of the point is
       the same as the before-tax cost of the point—$1,800. The Amins need to
       determine how long it will take them to recoup this cost due to a lower interest
       rate. To do this, they should divide the after-tax cost of paying the point by the
       yearly after-tax interest savings from the point. The after-tax cost of paying the
       point is $1,800. The after-tax savings due to a lower interest rate is $900
       calculated as follows:

       Before-tax savings due to a lower interest rate= $180,000 loan × (8%-7.5%)
                                                        = $900

       Because the Amins are not itemizing deductions, additional interest payments do
       not generate any tax savings, therefore the after-tax savings from the lower
       interest rate is the same as the before-tax savings of $900.

       The break-even period, then, is 2 years ($1,800 after-tax cost of the point/$900
       after-tax annual savings from the lower interest rate).
b. 2 years.
    Loan summary: $180,000; 8% rate with no
    points. 7.5% rate with 1 point. The Amins pay
    only interest for the first five years.
    Description                                          Amounts        Calculation
    (1)Initial cash outflow from paying 1 point           ($1,800) $180,000 × 1%
    (2) Tax benefit from deducting points                 + $450   (1) × 25%
    (3) After-tax cost of points                          ($1,350) (1) + (2)
    (4) Before-tax savings per year from 7.5% vs.            $900  [$180,000 × (8% –
    8% interest rate                                               7.5%)]
    (5) Forgone tax benefit per year of higher              ($225) (4) × 25%
    interest rate
    (6) After-tax savings per year of 7.5% vs. 8%            $675 (4) + (5)
    interest rate
    Break-even point in years                              2 years (3) / (6)

   The break even period is 2 years. This is the same break even point for the Amins
   even if they don’t itemize deductions.

c. 2 years.

    Loan summary: $300,000; 8% rate with no
    points. 7.5% rate with 1 point. The Amins pay
    only interest for the first five years.
    Description                                          Amounts        Calculation
    (1)Initial cash outflow from paying 1 point           ($3,000) $300,000 x 1%
    (2) Tax benefit from deducting points                 + $750   (1) × 25%
    (3) After-tax cost of points                          ($2,250) (1) + (2)
    (4) Before-tax savings per year from 7.5% vs.           $1,500 [$300,000 x (8% -
    8% interest rate                                               7.5%)]
    (5) Forgone tax benefit per year of higher              ($375) (4) × 25%
    interest rate
    (6) After-tax savings per year of 7.5% vs. 8%           $1,125 (4) + (5)
    interest rate
    Break-even point in years                              2 years (3) / (6)

d. 2.6 years.

    Loan summary: $180,000; 8% rate with no
    points. 7.5% rate with 1 point. The Amins pay
    interest only for the first 5 years. 30-year loan.

    Description
                                                          Points       Calculation
    (1) Initial cash outflow from paying points           ($1,800) $180,000 × 1%
    (2) Tax benefit from deducting points                        0
    (3) After-tax cost of points                          ($1,800) (1) + (2)
    (4) Before-tax savings per year from 7.5% vs.                  [$180,000 × (8% -
    8% interest rate                                          $900 7.5%)]
    (5) Foregone tax benefit per year of higher                    (4) × 25%
    interest payments                                       ($225)
    (6) After-tax savings per year of 7.5% vs. 8%             $675 (4) + (5)
    interest rate
    (7) Annual tax savings from amortizing points              $15 (1) / 30 years × 25%
    (8) Annual after-tax cash flow benefit of paying          $690 (6) + (7)
    points
    Break-even point in years                             2.6 years (3) / (8)

   Because this is a refinance, the $1,800 paid for the point is not immediately
   deductible. Consequently, the after-tax cost of the point is $1,800. The $1,800 is
   amortized over 30 years, generating a $60 deduction each year. The $60
   deduction will save the Amins $15 in taxes each year ($60 × 25%).

e. 2.6 years.

    Loan summary: $300,000; 8% rate with no
    points. 7.5% rate with 1 point. The Amins pay
    interest only for the first 5 years. 30-year loan.

    Description
                                                          Points           Notes
    (1) Initial cash outflow from paying points           ($3,000) $300,000 × 1%
    (2) Tax benefit from deducting points                        0
    (3) After-tax cost of points                          ($3,000) (1) + (2)
    (4) Before-tax savings per year from 7.5% vs.                  [$300,000 × (8% -
    8% interest rate                                        $1,500 7.5%)]
    (5) Foregone tax benefit per year of higher                    (4) × 25%
    interest payments                                       ($375)
    (6) After-tax savings per year of 7.5% vs. 8%           $1,125 (4) + (5)
    interest rate
    (7) Annual tax savings from amortizing points              $25 (1) / 30 years × 25%
    (8) Annual after-tax cash flow benefit of paying        $1,150 (6) + (7)
    points
    Break-even point in years                             2.6 years (3) /(8)

   Because this is a refinance, the $3,000 paid for the point is not immediately
   deductible. Consequently, the after-tax cost of the point is $3,000. The $3,000 is
   amortized over 30 years, generating a $100 deduction each year. The $100
   deduction will save the Amins $25 in taxes each year ($100 × 25%).
52.4. [LO 3] Kirk and Lorna Newbold purchased a new home on August 1 of year 1 for           Formatted: Bullets and Numbering
   $300,000. At the time of the purchase, it was estimated that the real property tax rate
   for the year would be .5 percent of the property’s value. Because the taxing
   jurisdiction collects taxes on a July 1 year-end, it was estimated that the Newbolds
   would be required to pay $1,375 in property taxes for the property tax year relating to
   August through June of year 2 ($300,000 × .005 × 11/12). The seller would be
   required to pay the $125 for July of year 1. Along with their monthly payment of
   principal and interest, the Newbolds paid $125 to the mortgage company to cover the
   property taxes. The mortgage company placed the money in escrow and used the
   funds in the escrow account to pay the property tax bill in July of year 2. The
   Newbolds’ itemized deductions exceed the standard deduction before considering
   property taxes.
       a. How much in property taxes can the Newbolds deduct for year 1?
       b. How much in property taxes can the Newbolds deduct for year 2?
       c. Assume the original facts except that the Newbolds were not able to collect
       $125 from the Seller for the property taxes for July of year 1. How much in
       property taxes can the Newbolds deduct for year 1 and year 2?
       d. Assume the original facts except that the tax bill for July 1 of year 1 through
       June 30 of year 2 turned out to be $1,200 instead of $1,500. How much in
       property taxes can the Newbolds deduct in year 1 and year 2?
   a. $0. Homeowners are allowed to deduct property taxes when the actual taxes are
       paid to the taxing jurisdiction and not when they make payments for taxes to the
       escrow account. Consequently, the Newbolds will deduct their share of the
       property taxes when the taxes are actually paid in year 2. They are not allowed
       to deduct any property taxes in year 1 because they did not pay any taxes to the
       taxing jurisdiction during year 1.
   b. For tax purposes, it doesn’t matter who actually pays the tax. Assuming the taxes
      are paid, the tax deduction is based on the relative amount of time each party held
      the property during the year. Thus, the Newbold’s tax deduction is $1,375,
      calculated as follows:

       Tax deduction = $300,000 × 0.005 × 11/12 (since they held the property for 11
       months               of the property tax year)
                     = $1,375

   c. For tax purposes, it doesn’t matter who actually pays the tax. Thus, it doesn’t
      matter that the Newbolds were unable to collect $125 from the seller for property
      taxes. Assuming the taxes are paid, the tax deduction is based on the relative
      amount of time each party held the property during the year. Since no taxes were
      paid during year 1, no deduction is allowed for year one. The Newbold’s tax
      deduction for year 2 is still $1,375, calculated as follows:

       Tax deduction = $300,000 × 0.005 × 11/12 (since they held the property for 11
       months               of the property tax year)
                     = $1,375

   d. Since no taxes were paid during year 1, the Newbolds don’t deduct any property
      taxes for year one. However, the Newbold’s tax deduction for year 2 is $1,100
      calculated as follows:

       Tax deduction = $1,200 (total tax liability) × 11/12 (number of months property
       was held by the Newbolds) = $1,100


58.5. [LO 4] Dillon rented his personal residence at Lake Tahoe for 14 days while he        Formatted: Bullets and Numbering
   was vacationing in Ireland. He resided in the home for the remainder of the year.
   Rental income from the property was $6,500. Expenses associated with use of the
   home for the entire year were as follows:
              Real property taxes                    $3,100
              Mortgage interest                      12,000
              Repairs                                 1,500
              Insurance                               1,500
              Utilities                               3,900
              Depreciation                           13,000

      a. What effect does the rental have on Dillon’s AGI?
      b. What effect does the rental have on Dillon’s itemized deductions?
   a. Since Dillon resided in his home for at least 15 days during the year and rented
      the home for fewer than 15 days, he excludes the rental income from taxable
      income and does not deduct the associated rental expenses. So, the rental has no
      effect on Dillon’s AGI.
   b. He will be allowed to deduct the real property taxes of $3,100 and mortgage
      interest of $12,000 as itemized deductions.



                 Use the following facts to answer problems 65 – 66.
   Rita owns a sole proprietorship in which she works as a management consultant. She
   maintains an office in her home where she meets with clients, prepares bills, and
   performs other work-related tasks. Her business expenses, other than home office
   expenses, total $5,600. The following home-related expenses have been allocated to
   her home office.

           Real property taxes                             $1,600
           Interest on home mortgage                        5,100
           Operating expenses of home                         800
           Depreciation                                     1,600

   Also, assume that not counting the sole proprietorship, Rita’s AGI is $60,000.
6. [LO 5] Assume Rita’s consulting business generated $15,000 in gross income.
      a. What is Rita’s home office deduction for the current year?
      b. What would Rita’s home office deduction for the current year be if her business
      generated $10,000 of gross income instead of $15,000?
      c. What is Rita’s AGI for the year?
      d. What types and amounts of expenses will she carry over to next year?
   a. $9,100, calculated as follows:

            Gross Income                                          $15,000
            Less: business expenses                               (5,600)
            Balance                                               $9,400
        Less: Tier 1 expenses (interest $5,100 + $1,600
        taxes)                                                  (6,700)
        Balance after tier 1 expenses                           $2,700
        Less Tier 2 expenses (operating expenses)                (800)
        Balance after tier 2 expenses                            1,900
        Less Tier 3 expenses (depreciation)                     (1,600)
        Net income from business                                 $300

Rita is allowed to deduct all expenses allocated to the home office ($6,700 interest
and taxes + 800 home operating expenses + depreciation 1,600).

b.

          Gross Income                                         $10,000
          Less: business expenses                               (5,600)
          Balance                                               $4,400
          Less: Tier 1 expenses (interest $5,100 + $1,600
          taxes)                                                (6,700)
          Loss after tier 1 expenses                           ($2,300)
          Less Tier 2 expenses (operating expenses)                0
          Loss after tier 2 expenses                           ($2,300)
          Less Tier 3 expenses (depreciation)                      0
          Net loss from business                               ($2,300)
Rita is allowed to deduct only the mortgage interest and real property taxes allocated
to the business use of the home. The remaining expenses (tier 2 and tier 3) are
suspended and carried over to next year.


c. Rita’s AGI is $60,300 for the year. This is her AGI without the sole
   proprietorship plus the net income from the business ($60,000 + $300).

d. None. Because Rita is allowed to deduct all of the expenses this year, she does not
   carry any over to next year.

            Use the following facts to answer problems 59 and 60.
Natalie owns a condominium near Cocoa Beach in Florida. This year, she incurs the
following expenses in connection with her condo:
           Insurance                           $1,000
           Advertising expense                     500
           Mortgage interest                     3,500
           Property taxes                          900
           Repairs & maintenance                   650
           Utilities                               950
           Depreciation                          8,500
   During the year, Natalie rented out the condo for 75 days, receiving $10,000 of gross
   income. She personally used the condo for 35 days during her vacation.

59.7. [LO 4] Assume Natalie uses the IRS method of allocating expenses to rental use        Formatted: Bullets and Numbering
   of the property.
       a. What is the total amount of for AGI (rental) deductions Natalie may deduct in
       the current year related to the condo?
       b. What is the total amount of itemized deductions Natalie may deduct in the
       current year related to the condo?
       c. If Natalie’s basis in the condo at the beginning of the year was $150,000, what
       is her basis in the condo at the end of the year?
       d. Assume that gross rental revenue was $1,000 (rather than $10,000), what
       amount of for AGI deductions may Natalie deduct in the current year related to
       the condo?


   Note that the home falls into the residence with significant rental use category.

   a. $10,000, calculated as follows:


       Gross rental income                                              $10,000
       Tier 1 expenses:
               Advertising expense = $500
               Mortgage interest = (75/110) × $3,500=$2,386
               Property taxes= (75/110) × $900=$614
       Less: total Tier 1 expenses                                      (3,500)
       Balance                                                          $6,500
       Tier 2 expenses:
               Insurance = (75/110) × $1,000=$682
               Repairs & Maintenance = (75/110) × $650=$443
               Utilities= (75/110) × $950=$648
       Less: total Tier 2 expenses                                      (1,773)
       Balance                                                          $4,727
       Tier 3 expenses:
               Depreciation (75/110) × $8,500= $5,795, but the
               deduction is limited to the remaining income             (4,727)
       Balance                                                             $0
       Total “For AGI” deductions ($3,500 + $1,773 + $4,727)            $10,000

   b. Natalie may deduct the personal-use portion of the mortgage interest and
      property taxes since they are deductible without regard to rental income. Her
      deductions for these items are computed as follows:

               Mortgage interest [(35/110) × $3,500]          $1,114
               Real property taxes [(35/110) × $900]             286
               Total “from AGI” deductions                    $1,400

   c. $145,273, calculated as follows:

               Beginning basis                              $150,000
               Less: depreciation actually deducted           (4,727)
               Adjusted basis                               $145,273

   d. $3,500. Even though it creates a loss ($1,000 - $3,500), Natalie is allowed to
      deduct all of the advertising expense and the portion of the mortgage interest
      expense and real property taxes allocated to the rental use of the home as for AGI
      deductions (these deductions are not limited to rental revenue). The loss is not
      subject to the passive loss rule limitations.



60.8. [LO 4] Assume Natalie uses the Tax Court method of allocating expenses to             Formatted: Bullets and Numbering
   rental use of the property.
       a. What is the total amount of for AGI (rental) deductions Natalie may deduct in
       the current year related to the condo?
       b. What is the total amount of itemized deductions Natalie may deduct in the
       current year related to the condo?
       c. If Natalie’s basis in the condo at the beginning of the year was $150,000, what
       is her basis in the condo at the end of the year?
       d. Assume that gross rental revenue was $2,000 (rather than $10,000), what
       amount of for AGI deductions may Natalie deduct in the current year related to
       the condo?
   Note that the home falls into the residence with significant rental use category.

a. $8,972, calculated as follows:

      Gross rental income                                           $10,000
      Tier 1 expenses:
              Advertising expense = $500
              Mortgage interest = (75/365) × $3,500=$719
              Property taxes= (75/365) × $900=$185
      Less: total Tier 1 expenses
                                                                     (1,404)
      Balance                                                        $8,596
      Tier 2 expenses:
              Insurance = (75/110) × $1,000=$682
              Repairs & Maintenance = (75/110) × $650=$443
              Utilities= (75/110) × $950=$648
      Less: total Tier 2 expenses                                    (1,773)
      Balance                                                        $6,823
      Tier 3 expenses:
              Depreciation (75/110) × $8,500= $5,795                (5,795)
      Balance—net income from rental of condo                        $1,028
      Total “For AGI” deductions ($1,404 + $1,773 + $5,795)          $8,972

b. Natalie may deduct the personal-use portion of the mortgage interest and
   property taxes since they are deductible without regard to rental income. Her
   deductions for these items are computed as follows:

           Mortgage interest [(290/365) × $3,500]       $2,781
           Real property taxes [(290/365) × $900]        $715
           Total "from AGI" deductions                  $3,496

c. $144,205, calculated as follows:

           Beginning basis                              $150,000
           Less: depreciation actually deducted           (5,795)
           Adjusted basis                               $144,205

d. $1,404. Even though it creates a loss ($1,000 - $1,404), Natalie is allowed to
   deduct all of the advertising expense and the portion of the mortgage interest
   expense and real property taxes allocated to the rental use of the home as for AGI
   deductions (these deductions are not limited to rental revenue). The loss is not
   subject to the passive loss rule limitations.

				
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