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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