PART 2 — ACQUISITION AND DISPOSITION OF PROPERTY Gain or Loss on the Sale or Exchange of Property 12 LEARNING OBJECTIVES amount realized is simply the total money received. For an exchange, the amount realized is the fair market value This chapter was prepared to enable participants to learn of the property received. If the taxpayer received both about taxable and tax-free exchanges of property. More money and property in exchange, the amount realized specifically, upon completion, you will be able to: is the sum of the money plus the fair market value of Distinguish between taxable and tax-free exchanges. the property received. Report like-kind exchanges on the return. Identify other types of tax-free exchanges. EXAMPLE: Tirrell Jones exchanges his car for a motorcycle worth $500, plus $1,200 in cash. The ¶1201 Introduction (Sec. 1001) amount realized is $1,700 ($1,200 cash plus $500, the value of the cycle received). Gross income includes profit from the sale or exchange of property. Likewise, one of the items that may be deducted from gross income in computing adjusted gross If the taxpayer incurred selling expenses connected with income is a loss on the sale or exchange of property. the sale or exchange, the amount realized is the money and/or fair market value received less selling expenses, The mere fluctuation in the value of property does not such as commissions, advertising expenditures, legal result in a gain or loss—some action must be taken, such fees, and other expenses directly related and attributable as selling the property. Thus, “paper” gains from stock to the sale of the property. Thus, if Tirrell had accom- market increases in a stock’s value are not a gain for tax plished the exchange through placing a newspaper ad purposes. The mere fact that taxpayers realize gain or for $10, the amount realized would have been $1,690 sustain a loss in selling or exchanging their property ($1,700 - $10). does not necessarily mean that the gain is taxable or that the loss is deductible. The law provides that only a Naturally, the entire amount realized by the seller is not recognized gain or loss can be considered for tax purposes. all profit or gain. First, the cost or basis of the property Recognizing a gain or loss means using the gain or loss sold or given in exchange is subtracted from the amount to determine income subject to tax. In other words, a received (usually the sales price). Basis, in simple lan- gain is taxable only if it is recognized and, by the same guage, means the cost of the property sold or given in token, a loss is deductible only if it is recognized. exchange. Frequently, a gain or loss is recognized in part. Obvi- EXAMPLE: Assume that in the previous example, ously, in such a case, the gain or loss will be taxable or Tirrell had originally paid $1,500 for his automobile. deductible only to the extent recognized. This chapter The basis of the car would be $1,500. is devoted to a discussion of which gains and losses are recognized and which are not. However, the determination of the basis is not always that simple. For this reason, it will be discussed further It is necessary to define the following terms that will in Chapter 15. be encountered repeatedly throughout the next few chapters: “amount realized,” “basis,” “realized gain,” Realized gain is the excess of the amount realized over the and “realized loss.” basis of the property sold or given in exchange. Amount realized is the value received when an asset is sold Realized loss is the excess of the basis of the property sold or exchanged for another asset. In the case of a sale, the or given in exchange over the amount realized. ¶1201 170 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E In other words, taxpayers have a realized gain if the Property held for sale in the ordinary course amount realized on the transaction is greater than the of the taxpayer’s trade or business. This would basis of the property they sold or exchanged. Conversely, include items such as a storekeeper’s merchandise, if the basis is greater than the amount realized, they have crops grown for sale by a farmer, and similar items. a realized loss. Also included in this group are inventory items, such as a manufacturer’s stock of raw material and EXAMPLE: Continuing with our previous examples, unfinished goods. it is clear that Tirrell has a realized gain of $200 (the It is not the physical nature of the property that deter- excess of the amount realized [$1,700] over the mines its classification, but its use or the purpose for basis of his car [$1,500]). However, the realized gain would have been only $190 if Tirrell had incurred the which it was acquired or held. For instance, a taxpayer’s $10 selling expense mentioned previously ($1,690 household furniture is considered “personal” property. If amount realized less $1,500 basis). the taxpayer sells it to a furniture dealer for resale, it will become merchandise inventory in the dealer’s hands. If the dealer uses it to furnish his own office, it will become EXAMPLE: Assume the same facts as in the previous “property held for productive use in the taxpayer’s trade examples, except that Tirrell originally paid $2,200 or business.” for his car and its basis is now $2,200. Therefore, Tirrell has a realized loss of $500 (excess of $2,200 ¶1203 Sales and Exchanges of basis over $1,700 amount realized). If the $10 sell- “Personal” Property ing expenses were incurred, the realized loss would be $510. Normally, if taxpayers sell or exchange property held for personal use at a gain, they must include the entire After determining the amount of gain or loss realized on gain in their gross income. In other words, the entire a transaction, determine whether, or to what extent, the realized gain on the sale of the personal property is rec- gain or loss is recognized for tax purposes. Sometimes the ognized. (The few exceptions to this rule are explained entire realized gain or loss may be recognized, at other in ¶1209.) times only a portion is recognized, and at still other times the entire gain or loss is not recognized. EXAMPLE: If Mark Diamond sells a car for $1,700 and the basis of the car is $1,500, Mark has a recognized ¶1202 Determination of the Transaction’s gain of $200 on the sale of his car. Tax Treatment The tax treatment or recognition of gains and losses No loss is recognized on the sale or exchange of property on the sale or exchange of property depends in part on held for personal use. the purpose for which the item sold or exchanged was used or held. EXAMPLE: Assume that Mark sells his car for $1,200. Most items can be classified as being held or used for The basis was $1,700. Although Mark has a realized one of the following purposes: loss of $500, no part of the loss is recognized. So far as Mark’s tax return is concerned, the loss on the Property held for personal use. This includes items sale of his personal car is not recognized. such as the taxpayer’s personal residence, personal jewelry, or pleasure car. Business or investment property. This clas- PITFALL: Loss on the sale of a personal residence sification may consist of either property held for is nondeductible. productive use in the taxpayer’s trade or business, such as machinery, delivery trucks, a factory build- ing owned by a manufacturer, or property held for Individuals must limit loss deductions to losses incurred investment (e.g., stocks and bonds or an apartment in a trade or business, incurred in transactions entered house held for rental income). into for profit, or arising from casualty or theft. ¶1202 PA R T 2 — C H A P T E R 1 2 — G a i n o r L o s s o n t h e S a l e o r E x c h a n g e o f P r o p e r t y 171 STUDY QUESTION EXAMPLE: Assume the same facts as in the previous example, except that the value of the truck received 1. Sharon James sells a car for $3,800 for which she in exchange was only $1,000. Martin then realizes a paid $12,000. Her selling expenses to advertise nonrecognized loss of $200. the car are $100. Which statement best describes her tax consequences? a. She has an $8,200 loss that can be It is most important to remember that this special non- recognized. recognition rule applies only to an exchange, not to a sale. b. She has an $8,300 loss that can be A “sale” is defined as a transfer of property for money recognized. or for a promise to pay money (such as a mortgage or c. She has an $8,300 loss that cannot be promissory note). An “exchange” is a transfer of property recognized. in return for other property or for services. EXAMPLE: Assume that Martin, in the first example NOTE: Answers to Study Questions, with feedback above, sells his original truck for $1,400 in cash. to both the correct and incorrect responses, are Even if he immediately reinvests the entire $1,400 provided in Chapter 35, beginning with ¶3512. in another truck, the $200 gain will be recog- nized because it was realized on a sale, not on an exchange. By the same token, referring again to the ¶1204 Sales and Exchanges of first previous example, if Martin had sold his truck for Business and Investment Property: $1,000, instead of exchanging it, his $200 loss would have been recognized. Again, it makes no difference General Rule (Sec. 1031) whether he reinvests his money in another truck. In the case of personal-use property, it makes no differ- ence whether the gain or loss came about through a sale To qualify as a tax-free exchange, both the property given or through an exchange. However, if a taxpayer disposes and the property taken in exchange must be held for busi- of business or investment property at a gain or loss, it ness or investment purposes—not for personal use. may make a great deal of difference whether the transac- tion was a sale or an exchange. The provisions for nonrecognition of gain or loss do not apply to property held for sale in the ordinary course of a In general, if a taxpayer sells business or investment taxpayer’s trade or business or to inventory items. Thus, property, both gain and loss are recognized. if an automobile dealer exchanges one of his cars held for sale to a customer for another automobile, the full Under a special rule, if gain or loss is realized on an amount of gain or loss realized will be recognized by the exchange of business or investment property for other dealer for tax purposes. The same is true if a dealer in real business or investment property, neither the gain nor estate exchanges one real estate property (if held for sale the loss will be recognized, provided that the property to customers) for another piece of real estate. taken in the exchange is of like-kind. The reason for nonrecognition of a like-kind transaction is that the If not for this restriction, storekeepers, dealers, and other new property is considered as being merely a replace- sellers of merchandise could simply trade or barter their ment or continuation of the old property; therefore, goods, instead of selling them outright, in order to avoid no real change in the taxpayer’s financial position has paying taxes on their profits. taken place. ¶1205 What Is a Like-Kind Exchange? EXAMPLE: Martin Lord, a grocer, trades his delivery The provision for nonrecognition of gain or loss on the truck, which has a basis of $1,200, for another truck, exchange of business or investment property applies only which has a fair market value of $1,400. Because the if the property given and the property taken in exchange amount realized ($1,400) exceeds the basis of his old are of like kind. However, the definition of “like-kind” truck ($1,200) by $200, Martin has a realized gain of is quite liberal. It refers to the nature or character of $200. However, because this is a like-kind exchange, the property, not its grade or quality. Thus, an exchange the gain is not recognized, and he need not include of real estate property for real estate property, and the it in gross income. exchange of personal property (i.e., non–real estate) for ¶1205 172 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E personal property are exchanges of like property. This (but not later than the due date, including extensions, means that the exchange of an apartment house for for the transferor’s return for the tax year in which the a factory building, or of improved land for an unim- relinquished property’s transfer occurred) and (2) to be proved piece of land, would qualify because both are real treated as like-kind property, the property to be received estate properties used in trade, business, or investment. must be identified within 45 days after the date on Exchanges of shares in certain mutual ditch, reservoir, which the taxpayer transfers the property given up in or irrigation companies after May 22, 2008, qualify as the exchange. like-kind. An example of such a tax-free exchange is an exchange of a business car for a new delivery truck. Parking transactions. If replacement property is not readily available, an accommodation party can be used. Foreign realty cannot be treated as like-kind property. Simi- This is called a qualified exchange accommodation larly, personal property used predominantly in the United arrangement (QEAA). States can be exchanged only for other like-kind property in a similar location. Exchanges of personal property must be Sometimes this arrangement is used in reverse: the “similar in location of use,” which means property located replacement property is parked with the accommodation in the United States. For example, a computer used within party until such time as the transfer of the relinquished the United States exchanged for a computer used in Canada party can be arranged. This arrangement is referred does not qualify for like-kind treatment. to as a reverse-Starker exchange (named after the case that permitted it). However, the IRS will not allow the Time limit on like-kind exchanges. For transfers to reverse of a parking transaction to be used if replacement qualify as like-kind exchanges, a 180-day time limit is property is owned by the taxpayer within 180 days that imposed for completing the exchange. Also, the prop- it is transferred to the exchange accommodation party erty to be received in the exchange must be identified (effective for transfers on or after July 20, 2004). within 45 days after the original property transfer. Iden- tification means delivering to the other party involved Like-kind exchanges are reported on Form 8824, Like- in the exchange a written description of the property. Kind Exchanges. ¶1205 PA R T 2 — C H A P T E R 1 2 — G a i n o r L o s s o n t h e S a l e o r E x c h a n g e o f P r o p e r t y 173 Like-Kind Exchanges OMB No. 1545-1190 Form 8824 (and section 1043 conflict-of-interest sales) 2008 Department of the Treasury Attachment Internal Revenue Service Attach to your tax return. Sequence No. 109 Name(s) shown on tax return Identifying number Part I Information on the Like-Kind Exchange Note: If the property described on line 1 or line 2 is real or personal property located outside the United States, indicate the country. 1 Description of like-kind property given up: 2 Description of like-kind property received: DRAFT AS OF 3 Date like-kind property given up was originally acquired (month, day, year) . 4 Date you actually transferred your property to other party (month, day, year) . . . . . . . . . . . . 3 4 MM/DD/YYYY MM/DD/YYYY August 6, 2008 5 Date like-kind property you received was identified by written notice to another party (month, day, year). See instructions for 45-day written notice requirement . . . . . . . . . . 6 Date you actually received the like-kind property from other party (month, day, year). See instructions 5 6 MM/DD/YYYY MM/DD/YYYY 7 Was the exchange of the property given up or received made with a related party, either directly or indirectly (such as through an intermediary)? See instructions. If “Yes,” complete Part II. If “No,” go to Part III . . . . Yes No Part II Related Party Exchange Information 8 Name of related party Relationship to you Related party’s identifying number Address (no., street, and apt., room, or suite no., city or town, state, and ZIP code) 9 During this tax year (and before the date that is 2 years after the last transfer of property that was part of the exchange), did the related party sell or dispose of any part of the like-kind property received from you (or an intermediary) in the exchange or transfer property into the exchange, directly or indirectly (such as through an intermediary), that became your replacement property? . . . . . . . . . . . . . . . . . . Yes No 10 During this tax year (and before the date that is 2 years after the last transfer of property that was part of the exchange), did you sell or dispose of any part of the like-kind property you received? . . . . . . . . Yes No If both lines 9 and 10 are “No” and this is the year of the exchange, go to Part III. If both lines 9 and 10 are “No” and this is not the year of the exchange, stop here. If either line 9 or line 10 is “Yes,” complete Part III and report on this year’s tax return the deferred gain or (loss) from line 24 unless one of the exceptions on line 11 applies. 11 If one of the exceptions below applies to the disposition, check the applicable box: a The disposition was after the death of either of the related parties. b The disposition was an involuntary conversion, and the threat of conversion occurred after the exchange. c You can establish to the satisfaction of the IRS that neither the exchange nor the disposition had tax avoidance as one of its principal purposes. If this box is checked, attach an explanation (see instructions). For Paperwork Reduction Act Notice, see page 5. Cat. No. 12311A Form 8824 (2008) ¶1205 174 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E Form 8824 (2008) Page 2 Name(s) shown on tax return. Do not enter name and social security number if shown on other side. Your social security number Part III Realized Gain or (Loss), Recognized Gain, and Basis of Like-Kind Property Received Caution: If you transferred and received (a) more than one group of like-kind properties or (b) cash or other (not like-kind) property, see Reporting of multi-asset exchanges in the instructions. Note: Complete lines 12 through 14 only if you gave up property that was not like-kind. Otherwise, go to line 15. 12 Fair market value (FMV) of other property given up . . . . . . 12 13 Adjusted basis of other property given up . . . . . . . . . 13 14 Gain or (loss) recognized on other property given up. Subtract line 13 from line 12. Report the gain or (loss) in the same manner as if the exchange had been a sale . . . . . . . . . . . 14 Caution: If the property given up was used previously or partly as a home, see Property used as home in the instructions. 15 Cash received, FMV of other property received, plus net liabilities assumed by other party, reduced DRAFT AS OF (but not below zero) by any exchange expenses you incurred (see instructions) . . . . . . 16 FMV of like-kind property you received . . . . . . . . . . . . . . . . . . . . 17 Add lines 15 and 16 . . . . . . . . . . . . . . . . . . . . . . . . . . 18 Adjusted basis of like-kind property you gave up, net amounts paid to other party, plus any 15 16 17 exchange expenses not used on line 15 (see instructions) . . . . . . . . . . . . . 18 August 6, 2008 19 Realized gain or (loss). Subtract line 18 from line 17 . . . . . . . . . . . . . . . 20 Enter the smaller of line 15 or line 19, but not less than zero . . . . . . . . . . . . . 21 Ordinary income under recapture rules. Enter here and on Form 4797, line 16 (see instructions) . . . 22 Subtract line 21 from line 20. If zero or less, enter -0-. If more than zero, enter here and on 19 20 21 Schedule D or Form 4797, unless the installment method applies (see instructions) . . . . . 22 23 Recognized gain. Add lines 21 and 22 . . . . . . . . . . . . . . . . . . . 23 24 Deferred gain or (loss). Subtract line 23 from line 19. If a related party exchange, see instructions . . 24 25 Basis of like-kind property received. Subtract line 15 from the sum of lines 18 and 23 . . . 25 Part IV Deferral of Gain From Section 1043 Conflict-of-Interest Sales Note: This part is to be used only by officers or employees of the executive branch of the Federal Government or judicial officers of the Federal Government for reporting nonrecognition of gain under section 1043 on the sale of property to comply with the conflict-of-interest requirements. This part can be used only if the cost of the replacement property is more than the basis of the divested property. 26 Enter the number from the upper right corner of your certificate of divestiture. ( Do not attach a copy of your certificate. Keep the certificate with your records.) . . . . . . . . . . . – 27 Description of divested property 28 Description of replacement property 29 Date divested property was sold (month, day, year) . . . . . . . . . . . . . . . . 29 MM/DD/YYYY 30 Sales price of divested property (see instructions) . . . . . . 30 31 Basis of divested property . . . . . . . . . . . . . . 31 32 Realized gain. Subtract line 31 from line 30 . . . . . . . . . . . . . . . . . . 32 33 Cost of replacement property purchased within 60 days after date of sale . . . . . . . . . . . . . . . . . . . . . 33 34 Subtract line 33 from line 30. If zero or less, enter -0- . . . . . . . . . . . . . . . 34 35 Ordinary income under recapture rules. Enter here and on Form 4797, line 10 (see instructions) . 35 36 Subtract line 35 from line 34. If zero or less, enter -0-. If more than zero, enter here and on Schedule D or Form 4797 (see instructions) . . . . . . . . . . . . . . . . . . 36 37 Deferred gain. Subtract the sum of lines 35 and 36 from line 32 . . . . . . . . . . . 37 38 Basis of replacement property. Subtract line 37 from line 33 . . . . . . . . . . . . 38 Form 8824 (2008) ¶1205 PA R T 2 — C H A P T E R 1 2 — G a i n o r L o s s o n t h e S a l e o r E x c h a n g e o f P r o p e r t y 175 ¶1205A Trade or Exchange Involving Both Property and Money EXAMPLE: Kevin Cleaver, a butcher, trades in his refrigerator, which has a basis of $600, and receives Frequently, a taxpayer will pay or receive money in addi- in return $150 in cash plus a meat-cutting machine tion to the property traded or received in trade. Also, with a fair market value of $700. Kevin realizes a gain at times, several items of property are involved in one of $250 on this transaction ($850 amount realized [$700 $150], less the basis of property traded in combined transaction. The money and other unlike [$600] $250). Because both the refrigerator and property received are generally referred to as “boot.” the meat-cutting machine are items held for pro- ductive use in the taxpayer’s trade or business, the To simplify the provisions dealing with these situations, exchange is tax free. However, because the taxpayer we have condensed them into a few short rules, each of also received cash, the gain is recognized, but only to which is fully explained and illustrated below. Rules 1 to the extent of the money received. Thus, the amount 3 cover situations wherein the taxpayer realized a gain; of the recognized gain is $150, which was the amount Rule 4 deals with the treatment of a loss. received in cash. Rule 1. No gain is recognized on a like-kind exchange Realized gain = $250 ($850 $600) of business or investment property, even if the taxpayer Recognized gain = $150 (limited to the pays money (so-called boot) in addition to the property amount of boot received) given in the trade. Gain is recognized to the extent of boot received. EXAMPLE: Jan Gutenberg, a printer, trades in his old printing press, which has a basis of $3,400, for a new press that costs $5,600. He is given a trade-in EXAMPLE: Gloria Star exchanges a machine with a allowance of $3,600 and pays $2,000 “boot” in cash basis of $350 for another machine worth $250 and to make up the difference. The amount realized is $150 in cash, realizing a gain of $50. The entire gain $5,600 (the value of the new press). Because the total is recognized because it does not exceed the amount basis of the assets given up is only $5,400 ($3,400, of cash received. the basis of the old press, plus $2,000 cash), the printer realizes a gain of $200. However, because the press is held for productive use in a trade or Rule 3. If a taxpayer, in exchange for property, receives business, the gain is not recognized. both like-kind property and property that is not like- Realized gain = $200 ($5,600 $5,400) kind (other property), the fair market value of the other Recognized gain = 0 property is treated as cash. This means that a gain, if any, is recognized only to the extent of the fair market value of the other property received. If the above-mentioned taxpayer had sold his original press for $3,600 and then added $2,000 to purchase the new machine for $5,600, the $200 gain would have EXAMPLE: Assume that in the previous example been recognized, because it would have been realized on Gloria had received, instead of $150 cash, a necklace a sale, not an exchange. worth the same amount. The necklace is not like-kind property because it is not used in the taxpayer’s trade Rule 2. If a taxpayer receives property, plus money, in or business or for investment. Therefore, its $150 exchange for property and realizes a gain, the gain is rec- value is treated as cash. Hence, the entire $50 gain ognized, but only to the extent of the money received. In will be recognized. other words, the taxpayer must report either the gain real- ized or the amount of money received, whichever is less. ¶1205A 176 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E The only way to tell whether nonrecognition in a given EXAMPLE: Judith Kohl, an investor, exchanges farm situation is desirable is to project the taxpayer’s future property having a basis of $35,000 for a vacant building lot worth $36,000, an automobile worth income and tax picture. If it appears that nonrecogni- $2,000, and a diamond ring worth $500. The amount tion would not benefit the taxpayer, it may be possible to realized is $36,000 plus $2,000 plus $500, a total sidestep the nonrecognition provisions by arranging of $38,500. Consequently, Judith realizes a gain of the transaction in the form of a sale rather than as an $3,500. The farm and the lot are like-kind property, exchange. However, bear in mind that simply terming but the automobile and the ring are other kinds of a true exchange as a “sale” will not do. Thus, if a tax- property and, hence, the gain will be recognized to payer sold old equipment used in his trade or business the extent of $2,500, the sum of the fair market value to a dealer and purchased new equipment of like kind of the automobile and the ring. from the dealer, the transaction would be an exchange, “even though the sale and purchase are accomplished Obviously, if the taxpayer receives both cash and other by separately executed contracts and are treated as unre- property in addition to like-kind property, the gain, if lated transactions by the taxpayer for record-keeping any, would be recognized to the extent of the sum of the purposes.” If losses on tax-free exchanges are involved, fair market value of the other property, plus the cash. most taxpayers will want to claim the loss. Wherever possible, arrange a bona fide sale instead of an exchange EXAMPLE: Assume that in the previous example in such cases so that the loss can be recognized. On the Judith had also received $1,000 in cash. The realized other hand, if nonrecognition of the loss is deemed gain is now $4,500, of which $3,500 (the sum of the more desirable, an exchange type of transaction should fair market value of the automobile and the ring, plus be arranged if at all possible. the cash) is recognized. Rule 4. A loss is never recognized on the exchange STUDY QUESTIONS of like-kind property held for productive use in trade 2. Which of the following does not qualify for a like- or business, even though other property or money is kind exchange? received or paid in addition to the exchange. a. U.S. realty for foreign realty b. An apartment building for a factory EXAMPLE: Daryl Oates, a farmer, exchanges a c. Unimproved land for a shopping center combine with a basis of $15,000 for a tractor worth $10,000, a parcel of land worth $2,000, and $1,000 3. For like-kind exchange treatment to apply, replace- cash. The amount realized is $13,000, and the real- ment property must be received within: ized loss is, therefore, $2,000, no part of which is a. 45 days recognized. b. 180 days c. Before the end of the tax year Where the exchange involves related parties (spouse, siblings, descendants, ancestors, or controlled entities) and property is disposed of within 2 years of that exchange, gain on the ¶1206 Exchange of Securities (Sec. 1036) original exchange is triggered. Exceptions apply to disposi- Although corporate stocks (shares) are usually held for tions because of death or involuntary conversion. investment, an exchange of stock for stock is not a tax- free, like-kind exchange, except if the stock is exchanged PRACTICE POINTER: The nonrecognition of gain for the same class of stock in the same corporation. on a like-kind transaction is a two-edged sword. On the one hand, it defers the immediate recognition This means that the exchange of stock in one corpora- (and tax) of the taxpayer’s gain, which is gener- tion for stock in another corporation or the exchange ally beneficial to the taxpayer. On the other hand, of common stock for preferred stock in the same cor- it reduces the taxpayer’s basis and increases the poration, or of stocks for bonds or vice versa, is not a taxpayer’s gain in the event of a future taxable disposition as explained at ¶1208. like-kind exchange. Any gain or loss is therefore fully recognized. ¶1206 PA R T 2 — C H A P T E R 1 2 — G a i n o r L o s s o n t h e S a l e o r E x c h a n g e o f P r o p e r t y 177 STUDY QUESTION EXAMPLE: Jim Turner trades 100 shares of Corporation A stock having a per-share basis of $100 for 100 shares 4. An annuity contract can be exchanged tax-free for: of Corporation B stock, which has a market value of $95 per share. The total loss of $500 is recognized. a. A life insurance policy b. An endowment policy c. Another annuity contract As stated above, if stock in a corporation is exchanged for the same class of stock in the same corporation, it is ¶1208 How Nonrecognition of Gain or Loss considered a like-kind exchange and no gain or loss is Affects Basis (Sec. 1031) recognized. It makes no difference whether the exchange is between two stockholders or between a stockholder The basis of the property that a taxpayer receives in a fully and the corporation. or partially tax-free exchange must be reduced by the amount of any gain that was realized but not recognized. EXAMPLE: Corporation X common stock sells for $300 a share. On July 1, the corporation offers to EXAMPLE: Jim Davis had a nonrecognized gain of issue three new shares of common stock for each $1,400 on the exchange of his truck, which had a old share turned in (this is called a stock split). basis of $12,600, for another truck worth $14,000. This is a like-kind exchange. No gain or loss is The basis of the new truck would be $12,600 recognized, regardless of the market value of the ($14,000 less the $1,400 nonrecognized gain). new shares. If a like-kind exchange results in a loss (which, of course, ¶1207 Exchanges of Insurance Policies is not recognized), the basis of the property received (Sec. 1035) in exchange would be increased by the amount of the No gain or loss is recognized if a taxpayer exchanges a nonrecognized loss. life insurance policy for another life insurance policy, an endowment, or an annuity contract. This is so even EXAMPLE: John Gilbert had a $2,000 nonrecognized if there is an outstanding loan on the policy, as long as loss on the trade of his truck, which had a basis of the new policy has similar loan provisions. The same $12,000, for another truck worth $10,000. The basis rule applies when one annuity contract is exchanged for of the new truck will accordingly be $12,000 ($10,000 increased by the $2,000 nonrecognized loss). If he another annuity contract, so long as the insured (the sells the new truck immediately for $10,000, he will annuitant) remains the same. Where one endowment then have a recognized loss of $2,000. policy is exchanged for another endowment policy, no gain or loss is recognized if the beginning date under the new contract is no later than the beginning date under the The exchange, being a like-kind one, is tax-free or old contract. Nonrecognition also applies to the exchange ignored for tax purposes, and the basis of the old truck of an endowment policy for an annuity contract. is simply transferred to the new one. The above examples also illustrate why the nonrecog- PITFALL: The exchange of an annuity contract for a nition of gain or loss on such transactions is, in most life insurance policy or an endowment policy does cases, no more than a postponement of the gain or loss not fall under this tax-free exchange rule. to the time when the new asset is ultimately disposed of by sale or taxable exchange. (Of course, if the taxpayer again trades the new property in a tax-free exchange, NEW FOR 2010: Annuities with a rider for long-term the recognition of the gain or loss may be postponed care qualify for tax-free exchange treatment. again and again, and go on indefinitely. If the person holds the replacement property until death, the deferred If the insurance company is financially troubled (i.e., in gain is never taxed; the heirs get a stepped-up basis to rehabilitation, insolvency, conservatorship, or other state the value of the property at the time of death.) The proceeding), a policy holder can surrender the policy and impact of an exchange on depreciation of the replace- make a tax-free reinvestment of the proceeds in a new ment property is discussed in ¶2103. policy if the transfer is completed within 60 days. ¶1208 178 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E ¶1209 Special Provisions ¶1210 Recent Developments Affecting Sale or Exchange of Property Congress is aware that, under certain conditions, the recognition of a gain would be extremely burdensome Like-kind exchange treatment is extended to exchanges or unfair to some taxpayers. For this reason, there are of certain mutual ditch, reservoir, or irrigation compa- exceptions in the Tax Code that permit certain gains to nies after May 22, 2008 (Heartland, Habitat, Harvest, be deferred or completely tax-free. and Horticulture Act of 2008, P.L. 110-248). These provisions apply to: Final regulations have been issued on the taxation of escrow accounts used to facilitate like-kind exchanges Gain on the sale of a taxpayer’s principal residence up (T.D. 9413, 7/9/08). to $250,000 ($500,000 on a joint return) Gain on an involuntary conversion if the proceeds Starting in 2009, gain from the sale of a principal are reinvested in similar property residence that is allocable to periods where neither the Gain on the transfer of property to a spouse or an taxpayer, the taxpayer’s spouse, nor the taxpayer’s for- ex-spouse incident to divorce or legal separation mer spouse used the property as a principal residence (rental, etc.) is included in the taxpayer’s income. These special rules are discussed in detail in Chapters (Housing Assistance Tax Act of 2008). 13 and 14. A sale of a vacation home to an escrow agent and the The rules governing the recognition of gains and losses purchase of another did not qualify as a like-kind can be briefly summarized as follows: exchange because the properties were not held for Gains on the sale of property are always recognized in business or investment purposes (Moore, TC Memo full (except in the case of an involuntary conversion or 2007-134). sale of a residence, where part or all of the gain may An amount received by an investor as a settlement be nonrecognized). of his claim against a brokerage firm for mismanage- Losses on the sale of property (except property held ment could be treated as capital gain (Letter Ruling for personal use) are fully recognized. 200724012). No gain or loss is recognized on a like-kind exchange of property held for productive use in trade or business, Cashing out a commercial annuity and investing the or for investment (so-called tax-free exchanges). proceeds in another annuity does not qualify as a tax-free No gain or loss is recognized on a tax-free exchange, exchange (Rev. Rul. 2007-24, IRB 2007-21, 1282). even though the taxpayer gives “boot” in addition to property (so-called trade-in). A multiparty exchange qualified for like-kind treat- If a taxpayer in a tax-free exchange also receives, in addi- ment even though two parties were related; the actual tion to like-kind property, cash or other property, exchange involved an unrelated third party (Letter Rul- Gain is recognized, but not to exceed the sum ing 200712013). of the cash and fair market value of the other Tax deferral on the exchange of property for a private property received. annuity no longer applies; the transaction is treated No loss is recognized. (No loss is ever recognized as if the property were sold, with proceeds used to on the sale or exchange of property held for purchase the annuity [Prop. Reg. §1.72-6(e) and personal use.) §1.1001-1(j)]. The nonrecognition of gain or loss rules applicable to like-kind exchanges will not apply to deferred like- kind exchanges if the time limit rules are not met. For further information, see IRS Publication 544, Sales and Other Dispositions of Assets, and IRS Publication 551, Basis of Assets. ¶1209 PART 2 — ACQUISITION AND DISPOSITION OF PROPERTY Exclusion for Gain on the Sale of a Principal Residence 13 LEARNING OBJECTIVES PRACTICE POINTER: The exclusion can be used This chapter was prepared to enable participants to learn even though the old $125,000 has already been used, the rules for the home sale exclusion. More specifically, for sales prior to May 7, 1997, as long as the 2-year upon completion, you will be able to: test is satisfied. Figure gain or loss on the sale of a principal residence. Use of the home for purposes of the 2-year requirement Determine the basis of the home. need not be consecutive. Ownership and use need not Know how to treat a loss on the sale of a residence. be simultaneous (all that is required is that each satisfy NEW THIS YEAR the 2-year test). Ownership and use for the 2-year test is based on 24 months or 730 days during a 5-year period ending on the date of sale. Temporary absences (such Sale by surviving spouse. The sale of a residence previously owned and occupied jointly by a surviving as vacations) are not taken into account in determining spouse and deceased spouse within 2 years after whether the 2-year test has been met. the death of the deceased spouse qualifies for the $500,000 exclusion. See ¶1301. NEW FOR 2009: Gain from the sale or exchange of a Suspension of 5-year test period. Intelligence principal residence allocated to periods of nonqualified community employees and Peace Corps volunteers use is not excludable. “Nonqualified use” means any can opt to suspend the test period for up to 10 period during which the property is not used by the years. See ¶1301. home owner, the home owner’s spouse, or the home Gain on home sales. For sales of homes after owner’s former spouse as a principal residence (other December 31, 2008, gain from the sale of a prin- than temporary absences or vacancies). cipal residence that is allocable to periods where neither the taxpayer, the taxpayer’s spouse, nor Even if a home owner meets the 2-year test, the exclusion the taxpayer’s former spouse used the property does not apply if the sale occurs within 5 years of acquiring as a principal residence is not excluded from the taxpayer’s income. See ¶1301. the home in a tax-free exchange. In this case, the home must be owned as a main home for a full 5 years. This additional limit applies to sales after October 22, 2004. ¶1301 Basic Requirements for the Exclusion (Code Sec. 121) Residence. The term “residence,” in addition to the usual one-family house, includes shares of stock in Individuals who owned and lived in their main homes cooperative housing; an apartment in a condominium; for at least 2 of the 5 years preceding the date of sale a houseboat or mobile home, provided that it is the can exclude up to $250,000 of gain ($500,000 on a owner’s principal residence; and a multifamily house (for joint return or by a surviving spouse within 2 years of the residential portion only). When a taxpayer has two the death of the deceased spouse if the home had been homes, generally the one in which he spends more time jointly owned and occupied). This exclusion can be used each year is considered the principal residence. every 2 years. There is no age requirement. ¶1301 180 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E Unforeseen circumstances affecting the home owner or PRACTICE POINTER: Although the exclusion is members of the household include the following: designed to eliminate recordkeeping for most home owners (on the theory that the exclusion is sufficient Moving after being mugged in the neighborhood. to offset gain without having to increase basis by Needing different housing to accommodate a parent’s home improvements), it is still advisable to save records of home improvements. This will help reduce disability by a child who is caring for the parent. gain in excess of the exclusion. Moving from a senior community after taking in a child and grandchild who do not meet the commu- nity’s age restrictions. Special marital situations. Married couples who have a Destruction of the home through acts of war or title to the home in the name of one spouse can use the terrorism. $500,000 exclusion on a joint return if they both lived The home owner becomes unable to pay housing in the house for 2 years (and neither spouse is ineligible costs and basic living expenses due to a change in for the exclusion because of selling a home within the employment or self-employment status. past 2 years). A widow(er) can include the period of Divorce or legal separation. ownership of the deceased spouse in his own period of Multiple births resulting from the same pregnancy. ownership. If, incident to divorce, an individual receives Being forced from the home by pressure or hostility the marital residence in a property settlement, that person from neighbors. can include the former spouse’s period of ownership in his Being required to have larger space when adopting own period of ownership. Where the spouse who moves a child. from the home continues to hold title to it, that spouse Airport noise that was not disclosed by the seller. can treat the other spouse’s period of use as his own for Needing more space for a new blended family. purposes of the 2-year test. Relocating out of fear of drug dealers (in the case of Exceptions to the 2-year test. If a home owner becomes a police officer). incapable of self-care because of a physical or mental con- Suspension of the 5-year test period. Military person- dition and moves to a nursing home after living in the nel, Foreign Service personnel, Peace Corps volunteers residence for at least 1 year, then the time in the nursing (sales after December 31, 2007), and intelligence com- home is treated as occupancy of the personal residence. munity employees (sales after June 17, 2008) can suspend For example, after 1 year, a home owner suffers a stroke the 5-year period for up to 10 years if they are on official that requires him to be placed in a nursing home. After extended duty that is 50 miles or more away from home 1 year in the nursing home, the home owner is treated or living in compulsory government-furnished housing. as satisfying the 2-year requirement. Business use of a home. Claiming a home office deduc- If an individual moves before meeting the 2-year require- tion does not bar the use of the home sale exclusion for ment because of change in the place of employment, gain on the entire home; no apportionment of the gain health, or other unforeseen circumstance, then the is required for the business use of the home if the office exclusion is prorated on the basis of the period that the is within the dwelling unit. However, any depreciation individual qualifies. claimed on the home office after May 6, 1997, is recap- tured at the rate of 25% for taxpayers in a tax bracket EXAMPLE: Ken Marker, a single individual, bought higher than 25%. The same rule applies if a home owner a home on July 1, 2007, and relocated across the rents out a room within the home; the exclusion applies country for employment purposes on July 1, 2008, to the entire gain, but any depreciation claimed on the selling his home for a profit of $80,000 at that time. rental portion is recaptured. The applicable exclusion in this case is $125,000 (50% of $250,000 because the individual met the Reporting home sales. Gain or loss and the applicable requirements for 1 out of 2 years). Thus, all of the exclusion, if any, are figured on a worksheet contained gain is excluded. in IRS Publication 523, Selling Your Home. ¶1301 PA R T 2 — C H A P T E R 1 3 — E x c l u s i o n f o r G a i n o n t h e S a l e o f a P r i n c i p a l R e s i d e n c e 181 Worksheet 1. Adjusted Basis of Home Sold Keep for Your Records Caution: See the Worksheet 1 Instructions before you use this worksheet. 1. Enter the purchase price of the home sold. (If you filed Form 2119 when you originally acquired that home to postpone gain on the sale of a previous home before May 7, 1997, enter the adjusted basis of f the new home from that Form 2119.) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1. o 2. Seller-paid points for home bought after 1990 (see Seller-paid points). Do not include any seller-paid points you already subtracted to arrive at the amount entered on line 1 . . . . . . . . . . . . . . . . . . . . . . . . 2. as 08 3. Subtract line 2 from line 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3. 4. Settlement fees or closing costs (see Settlement fees or closing costs). If line 1 includes the adjusted basis of the new home from Form 2119, skip lines 4a – 4g and 5; go to line 6. ft 20 a. Abstract and recording fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4a. ra 5/ b. Legal fees (including fees for title search and preparing documents) . . . . . . . . . . . . . . 4b. c. Survey fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4c. d. Title insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4d. e. f. D /2 Transfer or stamp taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Amounts that the seller owed that you agreed to pay (back taxes or interest, recording or mortgage fees, and sales commissions) . . . . . . . . . . . . . . . . . . . . . . . . . 4e. 4f. 08 g. Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4g. 5. Add lines 4a through 4g . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5. 6. Cost of additions and improvements. Do not include any additions and improvements included on line 1 6. 7. Special tax assessments paid for local improvements, such as streets and sidewalks . . . . . . . . . . . . . . 7. 8. Other increases to basis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8. 9. Add lines 3, 5, 6, 7, and 8 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9. 10. Depreciation allowed or allowable, related to the business use or rental of the home . . . 10. 11. Other decreases to basis (see Decreases to basis) . . . . . . . . . . . . . . . . . . . . . . . . . . 11. 12. Add lines 10 and 11 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12. 13. Adjusted basis of home sold. Subtract line 12 from line 9. Enter here and on Worksheet 2, line 4 . . . . . 13. Worksheet 2. Gain or (Loss), Exclusion, and Taxable Gain on Sale of Home Keep for Your Records Part 1: Gain or (Loss) on Sale 1. Selling price of home . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1. 2. 3. 4. o f Selling expenses (including commissions, advertising and legal fees, and seller-paid loan charges) . . . . . . . . . Subtract line 2 from line 1. This is the amount realized . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Adjusted basis of home sold (from Worksheet 1, line 13) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2. 3. 4. as 08 5. Gain or (loss) on the sale. Subtract line 4 from line 3. If this is a loss, stop here . . . . . . . . . . . . . . . . . . . . . . 5. Part 2: Exclusion and Taxable Gain ft 20 6. Enter any depreciation allowed or allowable on the property for periods after May 6, 1997. If none, enter -0-. . . 6. ra 5/ 7. Subtract line 6 from line 5. If the result is less than zero, enter -0-. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7. 8. If you qualify to exclude gain on the sale, enter your maximum exclusion (see Maximum Exclusion). If you qualify for a reduced maximum exclusion, enter the amount from Worksheet 3, line 7. If you do not qualify to D /2 exclude gain, enter -0- . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8. 9. Exclusion. Enter the smaller of line 7 or line 8 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9. 10. Taxable gain. Subtract line 9 from line 5. Report your taxable gain as described under Reporting the Sale. If the amount on this line is zero, do not report the sale or exclusion on your tax return. If the amount on 08 line 6 is more than zero, complete line 11 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10. 11. Enter the smaller of line 6 or line 10. Enter this amount on line 12 of the Unrecaptured Section 1250 Gain Worksheet in the instructions for Schedule D (Form 1040) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11. ¶1301 182 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E If all of the gain is excluded, or if a loss results, the The home sale is not reported to the IRS if the seller sale is not reported on Form 1040. completes a written certification like the following sample indicating that the full amount of the gain Gain on the sale of a home in excess of the exclusion qualifies for the exclusion. amount, if any, is reported on Schedule D in the same way as gain from any other asset. Use the information in ¶1302 to determine the basis of the residence for figuring gain or loss on its sale. Part I. Seller Information 1. Name _______________________________________________________________________________________________________ 2. Address or legal description (including city, state, and ZIP code) of residence being sold or exchanged _____________________________________________________________________________________________________________ _____________________________________________________________________________________________________________ 3. Taxpayer Identification Number (TIN) ____________________________________________________________________________ Part II. Seller Assurance Check “yes” or “no” for assurances (1) through (4) Yes No (1) I owned and used the residence as my principal residence for periods aggregating 2 years or more during the 5-year period ending on the date of the sale or exchange of the residence. (2) I have not sold or exchanged another principal residence during the 2-year period ending on the date of the sale or exchange of the residence (not taking into account any sale or exchange before May 7, 1997). (3) No portion of the residence has been used for business or rental purposes by me (or my spouse if I am married) after May 6, 1997. (4) At least one of the following three statements applies: The sale or exchange is of the entire residence for $250,000 or less. OR I am married, the sale or exchange is of the entire residence for $500,000 or less, and the gain on the sale or exchange of the entire residence is $250,000 or less. OR I am married, the sale or exchange is of the entire residence for $500,000 or less, and (a) I intend to file a joint return for the year of the sale or exchange, (b) my spouse also used the residence as his or her principal residence for periods aggregating 2 years or more during the 5-year period ending on the date of the sale or exchange of the residence, and (c) my spouse also has not sold or exchanged another principal residence dur- ing the 2-year period ending on the date of the sale or exchange of the residence (not taking into account any sale or exchange before May 7, 1997). Part III. Seller Certification Under penalties of perjury, I certify that all the above information is true as of the end of the day of the sale or exchange. ________________________________________________ _________________________________ Signature of Seller Date ¶1301 PA R T 2 — C H A P T E R 1 3 — E x c l u s i o n f o r G a i n o n t h e S a l e o f a P r i n c i p a l R e s i d e n c e 183 Examples of Expenditures That May Be PRACTICE POINTER: It is advisable for the seller to Includible in Tax Basis of Personal Residence notify the IRS of a change of address. This is done by filing Form 8822, Change of Address, directly OUTSIDE ADDITIONS AND IMPROVEMENTS with the IRS. This form is not filed with the income Additions to buildings: tax return. Aluminum siding Porch Breezeway Work shed or other outbuildings Garage Cement staircase STUDY QUESTIONS Driveway (blacktopping, gravel, paving) Fences and gates 1. Which of the following is not a requirement to Gutters, leaders, drainpipes claiming the home sale exclusion? Lamppost a. Owning the home for 2 out of 5 years preced- Mailbox ing the date of sale Retaining walls b. Attaining age 55 by the date of sale Roofing additions or replacements c. Using the home as a principal residence for 2 Screens and screen doors out of 5 years preceding the date of sale Septic tank or cesspool Storm doors 2. Joe and Natalie Smith owned and lived in their Swimming pool home for 10 years. The basis in the home is Terraces and patios $100,000. On June 1, 2008, they sell the home Waterproofing for $400,000. On a joint return, the couple can LAWN AND GROUNDS exclude: Additional acreage or lots a. $250,000 Grading b. $300,000 Landscaping materials, such as stone, etc. c. $500,000 Sprinkler system Shrubs, bushes, vines Topsoil and fill Trees NOTE: Answers to Study Questions, with feedback Water well and pump to both the correct and incorrect responses, are HEATING AND AIR-CONDITIONING provided in Chapter 35, beginning with ¶3513. Air-conditioning Attic fan Boiler Circulating system ¶1302 Basis of Residence Cooling equipment Basis in the residence can be increased by capital Fireplace heater improvements. Basis cannot be increased by ordinary Furnace and appurtenances repairs to the home, such as painting a room or repair- Hot water heater Radiators and valves ing a leaking faucet. Warm air grills and registers Additions to basis. The following checklist will help INTERIOR IMPROVEMENTS Bathroom: to remind home owners of items they may have omit- Bathtub sliding doors Shower controls ted in determining the basis of the residence. Note Medicine cabinet Towel racks that the answer to the question of whether a particular Mirrors Tub expenditure is a part of the cost or basis of real estate Kitchen: depends on the law of the particular state in which the Countertops Refrigerator property is located (i.e., whether or not the law classifies Dishwasher Sinks the improvement as a so-called fixture). For this reason, Garbage disposal Ventilator the following list should not be considered definitive. Range It is merely designed to indicate those items that would Laundry room: be classified as improvements to real estate in the great Dryer Supply cabinets Linen chute Ventilator majority of states. Sinks Washing machine Bookcases and other built-in furniture ¶1302 184 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E INTERIOR IMPROVEMENTS, cont’d Subtractions from basis. The basis of the residence Cabinets, closet shelves, etc. must be decreased by: Carpeting and padding Ceilings (acoustical) Any depreciation taken on a portion of the residence Closets used for business (e.g., a home office) Communication: Casualty deductions Call bells or chimes Residential energy credits claimed between 1978 and Fire or burglar alarm system 1985, and in 2006, 2007, and 2008 Intercommunication system District of Columbia first-time home buyer credit Telephone raceways Conversion of basement or attic into STUDY QUESTION recreation room or bedroom Fireplace mantel 3. All of the following expenses can increase the basis Flooring—wood, tile, etc. of a home except: Inside walls: a. Painting the exterior of the home Altering and plastering b. Adding vinyl siding Wall tiles c. Adding a retaining wall Wood paneling Electricity and lighting (circuit breakers, fuse boxes, ¶1303 Mixed Use of Residence lightning rods, TV antenna and wiring, wiring system) Hardware, fixtures, and locks for closets, curtains, If a residence is used partly as the taxpayer’s principal doors, windows residence and partly rented or used for business pur- Replacement or addition of stairs poses and the business portion is separate from the Room dividers and partitions dwelling unit, only the portion used as a residence Ventilators qualifies for nonrecognition of gain. For example, Window seats apportionment is required for a multifamily apart- Windows (replacement screens, venetian blinds, weather stripping, window shades) ment house where the owner lives in one unit, for a Plumbing store where the owner lives above it, and for a sepa- Cold and hot water pipes and tanks rate portion of a home that is rented out, such as a Copper tubing detached garage or cottage on the property. In this Floor drains case, the property is treated as if it consisted of two Pumps separate houses; the gain or loss is computed separately Septic system on each. In most cases, the apportionment between Traps the residential and the nonresidential part is made on Vent pipe the basis of space occupied for each business. However, Water supply system other methods of apportionment, such as comparative INSULATION rental value and so forth, may also be used, so long as Ceilings the apportionment is realistic. Floors Pipe and duct If, prior to a sale in 2008, the business use ceases so Roof that personal use satisfies the 2-year test, then the entire Walls property is treated as a personal residence. For example, a MISCELLANEOUS home owner rented out the basement, for which deduc- Acquisition costs: tions were claimed. Several years ago, that basement Appraisal fees ceased to be used as such and again became part of the Broker’s commission residence. No apportionment is required in this case. Closing costs However, it should be noted that any depreciation Legal fees claimed with respect to the basement will be used to Recording of deed and mortgage reduce basis (and thereby increase gain) on the sale of Survey the residence and any post–May 6, 1997, depreciation Title search and insurance is taxed at 25%. ¶1303 PA R T 2 — C H A P T E R 1 3 — E x c l u s i o n f o r G a i n o n t h e S a l e o f a P r i n c i p a l R e s i d e n c e 185 ¶1304 Loss on the Sale of a Residence filing separately; the credit generally must be repaid over 15 years starting in the second year after the year Loss on the sale of a personal residence is nondeduct- of the credit (Housing Assistance Act of 2008, P.L. ible. In a declining real estate market, future losses can 110-289). be made deductible by converting the residence to an income-producing activity, such as rental property. The $500,000 home sale exclusion can be claimed by surviving spouses under certain conditions (Mortgage There are no established time minimums for proving Forgiveness Debt Relief Act of 2007, P.L. 110-142). that a residence has been converted to rental property. In one case, a court held that a period of a few months of a Casualty damage to a principal residence can result in month-to-month rental was not sufficient to convert the sale treatment (with gain excludable) if the home is use of the property from personal to income-producing. damaged to such an extent that the remaining structure cannot be used to advantage in restoring the property to At the time of conversion, the property basis must be fixed. its pre-casualty condition (Chief Counsel Advice (ILM) Basis in this instance is the lower of (1) the original basis plus 200734021). any adjustments or (2) the current fair market value of the property. This value is established by obtaining appraisals. Victims of Hurricanes Katrina, Rita, or Wilma have This new basis is used only for figuring depreciation. an additional year in which to sell vacant land in order to qualify it as part of their home sale exclusion (the STUDY QUESTION usual 2-year period has been extended for 1 more year) (IR-2007-134, 7/31/07). 4. Veronica Marks, a single taxpayer, uses one room in her home as a deductible home office for her A home owner in a blended family that needed more freelance business. (Assume the office is 10% of space for their five children from previous marriages the home space.) She sells her home for a gain could claim a partial home sale exclusion; the marriage of $200,000. She had claimed depreciation after and the need for larger quarters were unforeseen circum- May 6, 1997, totaling $2,800. Which statement is stances (Letter Ruling 200725018). correct? a. She can exclude all of her gain and there is A settlement against a home seller for failing to dis- no depreciation recapture. close airport noise that forced the buyer to sell at a b. She can exclude 90% of her gain and must loss after 20 months of living in the home qualified as recapture $2,800 depreciation at 25%. sales proceeds that could be excluded under a prorated c. She can exclude all of her gain, but $2,800 exclusion; this qualified as an unforeseen circumstance depreciation is taxed at 25%. (Letter Ruling 200702032). ¶1305 Recent Developments Affecting Exclusion A narcotics police officer and his spouse were allowed to for Gain on the Sale of a Residence take a reduced maximum exclusion of the gain on a prin- cipal residence that had not been owned or lived in for Extreme bullying experienced by a home owner’s the requisite 2-year period because he had been involved daughter was an unforeseen circumstance that entitled in a highly publicized arrest of an alleged drug dealer the home owner to a partial home sale exclusion (Letter and feared for his life; these facts qualified as unforeseen Ruling 200820016). circumstances (IRS Letter Ruling 200615011). The 5-year test period can be suspended for up to 10 years by Peace Corps volunteers and intelligence com- For further information on home sales, see IRS Publication 523, Selling Your Home; IRS Pub- munity employees (Heroes Earnings Assistance and lication 544, Sales and Other Dispositions of Relief Tax Act of 2008, P.L. 110-245). Assets; and IRS Publication 552, Recordkeeping for Individuals. First-time homebuyers may be eligible for a refundable credit of up to $7,500 ($3,750 for married persons ¶1305 14 PART 2 — ACQUISITION AND DISPOSITION OF PROPERTY Involuntary Conversions LEARNING OBJECTIVES EXAMPLE: John Carter’s house, which had a basis of This chapter was prepared to enable participants to learn $65,000, was condemned by the city for the building about involuntary conversions. More specifically, upon of a new road. He received a condemnation award of completion, you will be able to: $85,000. The gain of $20,000 is recognized just as in any other sale. Properly defer gain on an involuntary conversion. Correctly treat severance damages. However, suppose taxpayers take the money they Recognize and use the special rules for disaster losses. received and buy other property to replace property that was condemned, destroyed, or otherwise involuntarily NEW THIS YEAR converted. Frequently, the new property will cost them as much as they received or even more. In this situation, Disaster areas. A list of places designated as they have no real profit because they are in the same disaster areas can be found at www.fema.gov/news/ position as before. Obviously, it would be unfair to tax disasters.fema. See ¶1408. them on such a compulsory “gain.” Disaster relief. For victims of the Greensburg, Kansas storm, the 2008 Midwest floods, and Hur- For this reason, the law provides that if taxpayers reinvest ricane Ike, a 5-year replacement period applies to the entire proceeds in other property “similar or related in involuntary conversions resulting from these events. use,” they may elect to have the gain not recognized. See ¶1402. EXAMPLE: Assume that Reggie Jones’s house, which had an adjusted basis of $65,000, was con- ¶1401 Introduction demned. The state made an award of $85,000. Reggie then acquired similar property for $90,000. The Code provides for the nonrecognition of gain on Because Reggie reinvested his entire proceeds, he involuntary conversions under certain conditions. may, at his option, not recognize the gain. An involuntary conversion takes place when a taxpayer’s property is stolen, seized, destroyed, condemned, or What happens if taxpayers reinvest part, but not all, of threatened with condemnation and when the taxpayer the proceeds in similar property? They must report as receives some form of compensation either from insur- gain the portion of the proceeds that was not reinvested. ance, from condemnation awards, or from other sources. For the portion of the proceeds that was reinvested, they The compensation may be in the form of money, or it may elect nonrecognition treatment. can be in the form of other property. In other words, the taxpayer’s original property may be involuntarily EXAMPLE: Assume that Reggie from the previous converted either into money or into other property. example acquires a new building for $70,000. He must report $15,000 of the gain; he may elect to have Ordinarily (unless the tax-free exchange provisions dis- the remaining $5,000 not recognized. cussed in Chapter 12 apply), the conversion is treated as a sale, and any gain is therefore recognized. ¶1402 Replacement Period It is not necessary that the actual money received from insurance or condemnation proceeds be used or ear- marked for the acquisition of new property. However, ¶1402 188 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E the replacement must take place within a certain time on or after September 23, 2005, by reason of Hurricane limit or replacement period if the taxpayer desires to Rita; or on or after October 23, 2005, by reason of elect nonrecognition. That is, the new property must Hurricane Wilma. The same 5-year period applies to be acquired no later than 2 years (3 years in the case victims of the Greensburg, Kansas disaster, the 2008 of real property held for productive use in a trade or Midwest storms, and Hurricane Ike. business for condemnation proceedings) after the close of the first tax year in which any part of the gain is Livestock sales due to weather. Farmers may be realized. Where the taxpayer for good reason is unable forced to sell livestock due to weather-related condi- to replace the property within the required period, tions. The replacement period in this case is 4 years. the taxpayer should write to and request permission The IRS has authority to extend this 4-year period from the IRS. and has done so for tax years ending after September 25, 2006 (Notice 2006-82, IRB 2006-39, 529). It has ruled that the period is extended until the end of the EXAMPLE: Bill Baxter’s warehouse with an adjusted taxpayer’s first year ending after the first “drought-free basis of $3,000,000 was destroyed by fire on August year” for the applicable year. The first drought-free year 15, 2006. He settled with his insurance company for for a particular region is the first 12-month period that $5,000,000, of which he receives $3,500,000 in Septem- meets all of these tests: ber 2007 and $1,500,000 in January 2008. If Bill replaces the building and elects nonrecognition treatment, he must Ends on August 31; acquire the replacement building no later than December Ends in or after the last year of the taxpayer’s 4-year 31, 2009, the end of the second year following the year in which he realized the first part of his gain. replacement period; and Does not include any weekly period for which excep- Bill could have added another year to the replacement period by requesting the insurance company to pay him tional, extreme, or severe drought is reported for any no more than $3,000,000 in 2007. In that case, he first location in the region. would have realized a gain in 2008, and the replacement period would have ended December 31, 2010. If it is not feasible to reinvest proceeds in property similar or related in use to the livestock that was converted, the proceeds can be reinvested in other farm property. Understandably, if the new property was acquired before the fire or other casualty or theft occurred, it would not ¶1403 What Qualifies as Replacement Property? be considered as replacement property. However, for A taxpayer may elect nonrecognition of gain on an invol- condemnations, the replacement period begins on the untary conversion only if the new property is “similar earliest date of threat or imminence of the property’s or related in service or use” to the property condemned, condemnation or requisition, provided that the replace- destroyed, stolen, et cetera. There are two tests to deter- ment property is still held by the taxpayer at the time mine whether the replacement property qualifies. These the condemnation, requisition, or sale on the threat of tests are the previously defined like-kind test and the condemnation actually takes place. functional-use test. EXAMPLE: On June 1, 2008, Joe Caldwell was notified This does not mean that the new property must be by his county authorities that the county was planning to identical to the old. What matters is that the use or func- buy or, if necessary, condemn his farm in order to build tion of the two properties is similar. Thus, if a taxpayer a school on the land. The negotiations were completed replaced two buildings that were destroyed by fire with in February 2009, and the county took title on March one building to be operated for the same purpose, the 1. Meanwhile, Joe had bought similar farm property in taxpayer would be entitled to elect nonrecognition. November 2008. The new property qualifies as replace- ment property because it was acquired after the first On the other hand, if an owner operates a manufacturing date of threat or imminence of condemnation. plant on property that is destroyed and replaces the plant with a building to be used as a wholesale grocery warehouse, Hurricane victims. The replacement period is extended the replacement would not qualify. However, if the taxpayer, to 5 years for property involuntarily converted on or instead of operating the property, merely rented out the after August 25, 2005, by reason of Hurricane Katrina; original property for use as a manufacturing plant and then ¶1403 PA R T 2 — C H A P T E R 1 4 — I n v o l u n t a r y C o n v e r s i o n s 189 rented out the replacement property for use as a wholesale of compensation for the value of the property taken grocery warehouse, the replacement would qualify, because, plus an amount (“severance damages”) to compensate as far as the owner is concerned, the use of both properties the taxpayer for the loss in value or use of the remaining is “similar.” Both are held for rental; the end use to which property. Only the portion specified as compensation the tenant puts the property is immaterial. for the property taken is considered in determining gain. Severance damages are completely tax-exempt, except Replacement of farmland with other farmland will to the extent they exceed the basis of the remaining qualify, even though the crop or usage differs. Thus, the property. Net severance damages (severance damages court has held that apricot, prune, and walnut orchards less expenses in obtaining them) reduce the basis of the were “similar” to a truck and cattle farm that they retained property. replaced. However, livestock involuntarily converted must be replaced with the same kind of animals held ¶1404 Property Replaced in Kind for the same purpose. Thus, horses held for breeding Sometimes in an involuntary conversion the taxpayer purposes must be replaced with horses also to be used is compensated with similar property instead of with for breeding purposes. cash. In such cases, gain is never recognized so long as More liberal rules apply in the case of real estate held for the property given in exchange is similar or related in productive use in trade, business, or investment that is use to the property converted. condemned or converted because of threat of condem- nation. In such case, the new property will qualify as EXAMPLE: The township condemned Paul Dobson’s replacement property so long as it is of like-kind. land, which had a basis of $30,000, to build a new road. As compensation, Paul received another parcel of land with a fair market value of $60,000. No gain EXAMPLE: Stu Barber owned an urban building lot is recognized. that was condemned. He reinvested the proceeds in a ranch. The replacement qualifies because both are like-kind properties, even though they are not STUDY QUESTIONS “similar or related in use.” 1. To defer gain on an involuntary conversion, the Any tangible property acquired and held for productive ordinary replacement period is: use in a business is treated as similar or related in service a. 2 years or use to property that was held for investment or produc- b. 3 years tive use in a business and that was involuntarily converted c. 5 years as a result of a presidentially declared disaster. 2. What type of property qualifies as replacement property for purposes of deferring gain on an EXAMPLE: In August 2008, James Brown’s spare involuntary conversion? delivery truck was destroyed by a hurricane in Coco City, an area declared by the president to be eligible a. Like-kind property for federal disaster relief. James used insurance b. Property that is similar or related in service or proceeds received in October 2008 to buy a new use telephone system for his office. Gain in this case is c. Any type of property eligible for deferral. Property acquired from a related person (a close relative NOTE: Answers to Study Questions, with feedback or a business controlled by the taxpayer) is not treated to both the correct and incorrect responses, are pro- as qualified replacement property unless gain on the vided in Chapter 35, beginning with ¶3514. involuntary conversion is less than $100,000. ¶1405 Other Examples of ¶1403A Severance Damages Involuntary Conversion When a public authority condemns a portion of prop- On occasion, property may be considered as “involun- erty for public use (e.g., to widen a road or build a tarily” converted, even though it was sold by the tax- school), the condemnation award customarily consists payer voluntarily. For instance, a portion of a taxpayer’s ¶1405 190 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E property may be condemned or destroyed, impairing STATEMENT ELECTING the usefulness of the remaining portion. If the taxpayer NONRECOGNITION OF GAIN subsequently sells the remainder in order to buy a larger (To accompany tax return) unit, the sale will be viewed as “involuntary” because it was forced upon the taxpayer as a result of the condem- Mary and John Jones, SSN 123-45-6789 Taxable Year 2008 nation or destruction. On June 30, 2008, a warehouse owned by taxpayers was Also, if livestock is destroyed by a taxpayer because of totally destroyed by fire. It had been constructed at a total disease or exposure to disease, or is sold or exchanged cost of $1,000,000 and, after its original construction, by the taxpayer for that reason, the destruction or sale no capital improvements were made. The building was is treated as an involuntary conversion. If livestock being depreciated on the basis of a 25-year useful life. (other than poultry) held for draft, breeding, or dairy Total depreciation claimed prior to this taxable year was purposes is sold or exchanged solely on account of $380,000. Additional depreciation on the building for the drought, it will be considered an involuntary conver- portion of this year prior to its destruction was $20,000. sion. However, only the number of animals that are sold The building was insured by the ABC Casualty Corpo- in excess of those that normally would have been sold ration. Taxpayers received $1,300,000 in full payment of their loss on the building on October 1, 2008. On by the taxpayer will be considered disposed of solely October 15, 2008, taxpayers entered into a construc- because of drought. tion contract with the XYZ Corporation to build a new building at a cost of $1,300,000. Construction was completed February 15, 2009, and the new building ¶1406 How the Nonrecognition has been occupied since that date by the taxpayers. Election Is Made The taxpayers hereby elect, in accordance with the The nonrecognition of a gain on an involuntary conver- provisions of Code Sec. 1033(a)(2), not to have any sion is optional. Thus, if no election is made, gain will gain recognized with respect to the insurance proceeds received on account of their destroyed building, and in be recognized. their depreciation schedule attached to this return have To make the election, taxpayers should attach to the stated their basis in the new building to be $600,000. return for the first year in which a gain was realized a full explanation of the conversion and replacement STUDY QUESTION of the property (or intention to replace, if replace- ment has not yet been made). A similar explanation 3. Deferring gain on an involuntary conversion is auto- should be attached for each subsequent year in which matic if qualified replacement property is timely the gain is realized. However, even if no explanation received. True or False? is attached, the mere failure to report the gain on the return will be considered a nonrecognition election. ¶1407 Taxpayer’s Residence If taxpayers make the election because they intend to If a taxpayer’s principal residence is involuntarily con- replace the property and later change their minds or verted through condemnation, threat, or imminence of otherwise fail to do so (or replace the property at a lower condemnation, seizure, or requisition, the involuntary cost), they must file an amended return for the year in conversion rules apply. which the gain was realized. If a residence is completely destroyed, both the home sale exclusion (¶1301) and the involuntary conversion rules PRACTICE POINTER: On involuntary conversions, as can apply. A complete destruction is deemed to occur for tax-free like-kind exchanges, any nonrecognized when the remaining structure cannot be used to advan- gain reduces the basis of the replacement property. tage in restoring the home to its pre-casualty condition For this reason, it is sometimes to the taxpayer’s or when the cost of repair substantially exceeds the fair advantage to recognize the gain. market value of the home prior to the event (i.e., it is not economically feasible to repair the damaged home). ¶1406 PA R T 2 — C H A P T E R 1 4 — I n v o l u n t a r y C o n v e r s i o n s 191 Special rules for disaster losses. If a principal residence ¶1409 Involuntary Conversion Rules Summary (or any of its contents) is compulsorily or involuntarily An involuntary conversion is a forced disposition of converted because of a disaster, any gain resulting from property for money or other property. The most frequent the receipt of insurance proceeds for personal property examples are destruction by fire, theft, and condemna- that was part of the contents of the residence but was tion by federal, state, or local governments. The law not scheduled property for insurance purposes will not mitigates the tax effects of any gains realized on such be recognized. Also, the insurance proceeds for both the conversions by providing that if the proceeds are rein- home and the contents can be treated as a common pool vested in property similar or related in service or use to of funds for purposes of replacement. the original property at the taxpayer’s option: No gain is recognized if the cost of the replacement EXAMPLE: Antoine Brown’s home is destroyed in a disaster, and he receives a check from the insur- property equals or exceeds the proceeds. ance company for $200,000 ($140,000 for the home Gain is recognized only to the extent of the excess if the and $60,000 for the contents). Antoine can elect to proceeds exceed the cost of the replacement property. defer tax on any gain from receipt of the insurance proceeds if he buys a new home for $170,000 and STUDY QUESTION contents for $30,000. He is not limited to the original 70%/30% allocation of insurance proceeds. 4. Which statement regarding disaster losses is not correct? A “disaster” for purposes of this rule is an involuntary con- a. A disaster is an involuntary conversion in an version in an area declared by the president to be an area area declared by the president to qualify for warranting assistance by the federal government under federal disaster assistance relief. the Disaster Relief and Emergency Assistance Act. b. The replacement period for a personal resi- dence and its contents in a disaster area is 4 The replacement period for a personal residence and years. its contents in a disaster area is extended to 4 years c. The rules apply only to home owners and not to renters. (instead of the usual 2 years) after the close of the first taxable year in which any part of the gain upon conver- sion is realized. ¶1410 Recent Developments Affecting These rules apply to both home owners and renters. Involuntary Conversions ¶1408 Losses on Involuntary Conversions Under certain conditions, a complete destruction of a The special rules for involuntary conversion apply only principal residence can qualify for both the home sale to gains. A loss on an involuntary conversion is treated exclusion and involuntary conversion treatment (Chief as any other loss on a sale or exchange. Thus, a loss on Counsel Advice (ILM) 200734021) and to victims of the involuntary conversion of business or investment the 2008 Midwest floods and Hurricane Ike (Emergency property is fully recognized unless the taxpayer received Economic Stabilization Act of 2008, P.L. 110-343). replacement property in exchange, in which case the like- The same disaster relief created for victims of Hurricane kind exchange rules will apply. In the case of personal-use Katrina also applies to victims of the Greensburg, Kansas property, the loss is recognized only if it qualifies as a disaster (Heartland, Habitat, Harvest, and Horticulture “casualty” loss (see Chapter 23). Act of 2008, P.L. 110-248). PITFALL: Losses of personal-use property arising For further information, see IRS Publication 547, out of condemnations are not deductible. Disasters, Casualties, and Thefts (Business and Non- business); IRS Publication 2194, Disaster Losses Kit for Individuals; and IRS Publication 1600, Disaster Special rules apply to disaster losses. These rules are Losses: Help from the IRS. explained in ¶2314. ¶1410 15 PART 2 — ACQUISITION AND DISPOSITION OF PROPERTY Basis LEARNING OBJECTIVES EXAMPLE: Earl Elkins paid $9,000 for an automobile This chapter was prepared to enable participants to gain he uses entirely in his business. He took a depreciation an understanding of the rules on basis of property. More deduction of $3,000 per year. At the end of 2 years he has specifically, upon completion, you will be able to: charged off $6,000. The basis is adjusted for the deprecia- tion, and the adjusted basis of the car is $3,000. Know how to figure the basis of property acquired by purchase. Determine the basis of property acquired by gift or PITFALL: Proving basis is the taxpayer’s responsibility. inheritance. Where basis cannot be proven, a zero basis may apply. Use special rules affecting basis. ¶1502 Basis of Property Received in Exchange ¶1501 Introduction for Services or Property (Sec. 1012) To compute the amount of gain or loss on a sale or If property is received in exchange for services rendered, exchange of property, a taxpayer must know the basis its basis is the fair market value of the property at the of the property that was sold or exchanged. The deter- time the services are rendered. mination of basis is also necessary for computing the depreciation deduction (discussed in Chapter 21). In most cases, the basis is the cost or purchase price of the EXAMPLE: Alonzo Ames painted Mike Brown’s house, in payment for which Mike gave Alonzo an automobile property. The cost of the property acquired is the amount worth $450. Alonzo has income of $450. The basis of paid for it in cash or other property. This is called the the automobile to Alonzo is $450. This transaction is “cost basis.” treated as if Alonzo had received $450 in cash from Mike and had used the money to purchase the car. However, the property may have been acquired by gift or in some other way by which gain or loss is not recognized on the exchange. In that case, the property received by Similarly, if property is traded for other property in a taxable taxpayers has what is called a “substituted basis.” This exchange, the basis of the new property is its fair market is either the basis taxpayers had for the property they value at the time of the exchange (except if the property was relinquished in the exchange or the basis the transferor received in a nontaxable exchange, as discussed below). or donor had for the particular property. EXAMPLE: Gus Payton traded a fur coat, which cost In addition, it is frequently necessary to adjust basis $1,500, for an automobile having a fair market value for depreciation, additions or dispositions of property, of $1,700. Because the value of the automobile is casualty losses, and similar items. This results in what is $1,700, Gus realizes a taxable gain of $200 on the known as an “adjusted basis.” transaction. If he later sells the automobile for $1,750, he will have another taxable gain of $50. EXAMPLE: Jason Dailey bought a one-family home in 1996 for $162,000. He immediately added “Fair market value” is the price that would be agreed upon another room at a cost of $5,000. The cost basis on by a seller willing, but under no compulsion, to sell and December 31, 1996, was $167,000. In November a buyer willing, but under no compulsion, to buy. In the 2008, a fire damaged Jason’s garage, resulting in a usual case, the market value of the property given and loss of $2,000. The adjusted basis on December 31, the market value of the property received will be approxi- 2008, was $165,000 ($167,000 $2,000). mately equal. The fair market value of both properties will usually be determined by reference to the property whose value is most easily determinable. ¶1502 194 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E For securities traded on the open market, stock exchange If the cost of the new replacement property is more than quotations provide conclusive evidence of fair market the proceeds of the conversion, its basis is the cost of the value. In the case of real estate, leaseholds, patents, new property less the gain not recognized. machinery, and equipment, it is frequently necessary to secure an expert appraisal at the time the exchange is EXAMPLE: Assume the same facts as above, except made to avoid later disputes. that the new truck costs $13,500. If Wayne elects to have the gain not recognized, the basis of the new STUDY QUESTION truck will be $12,500, figured as follows: Realized gain . . . . . . . . . . . . . . . . . . . . . . . . . $1,000 1. Ed Jenkins trades in a tractor having an adjusted Recognized gain. . . . . . . . . . . . . . . . . . . . . . . 0 basis of $20,000, plus $20,000 cash from his Gain not recognized . . . . . . . . . . . . . . . . . . . . $1,000 pocket, to acquire a new tractor having a value of $50,000. The basis of the new tractor is: Cost of new truck . . . . . . . . . . . . . . . . . . . . . . $13,500 a. $20,000 Less: Gain not recognized . . . . . . . . . . . . . . . 1,000 b. $40,000 Basis of new truck . . . . . . . . . . . . . . . . . . . . . $12,500 c. $50,000 NOTE: Answers to Study Questions, with feedback If the taxpayer elects to report the entire gain or if the to both the correct and incorrect responses, are conversion results in a loss, the basis of the replacement provided in Chapter 35, beginning with ¶3515. property is its cost. ¶1504 Basis of Property Acquired through ¶1503 Basis for Involuntary Conversion of Tax-Free Exchanges (Sec. 1031) Property (Sec. 1033) The general rule is that when a taxable exchange of If property is involuntarily converted into similar prop- property takes place, the basis of the new property is its erty (as, for example, by its destruction, theft, condem- fair market value at the time of the exchange. However, nation, or threat of condemnation), the taxpayer may if all or part of the gain or loss on the exchange is not elect, under certain circumstances, not to have all or recognized, certain adjustments must be made to the part of the gain recognized. In such cases, the cost of the basis of the new property. replacement property must be decreased by the amount of gain not recognized upon the conversion. The same rule applies if gain or loss is not recognized (or only partially recognized) in an exchange of business or Basis of replacement Cost of replacement property property less gain not recognized investment property. Here, the basis of the new property will be determined as follows: EXAMPLE: Wayne Posey’s truck, having an adjusted Basis of Property Acquired in an Exchange basis of $10,000, was completely destroyed by fire. Basis of new property Basis of old property He received $11,000 in insurance proceeds. Wayne gain recognized had a gain of $1,000 because the insurance proceeds boot received exceeded the adjusted basis of the destroyed truck. boot paid loss recognized However, Wayne used $10,800 of the proceeds to buy a replacement truck. He may therefore elect to This, in effect, gives the new property a substituted basis, report the gain only to the extent of the unexpended which is determined not only by the cost or value of the portion of the proceeds ($200). The basis of the new property acquired but also by the basis of the property truck remains at $10,000, figured as follows: given in exchange. Realized gain . . . . . . . . . . . . . . . . . . . . . . $1,000 Recognized gain . . . . . . . . . . . . . . . . . . . 200 Gain not recognized . . . . . . . . . . . . . . . . $800 Cost of new truck . . . . . . . . . . . . . . . . . . $10,800 Less: Gain not recognized . . . . . . . . . . . . 800 Basis of new truck . . . . . . . . . . . . . . . . . . $10,000 ¶1503 PA R T 2 — C H A P T E R 1 5 — B a s i s 195 individual items. Thus, if some of the items are later sold, EXAMPLE: Three years ago, Farmer Andy McDaniel the sale of each part is treated as a separate transaction, bought a tractor for $60,000. This year, after hav- ing charged off $15,000 for depreciation, Andy and gain or loss must be computed separately on each exchanges it for a new model costing $65,000. Andy portion. Allocation is generally made in proportion to is given a trade-in allowance of $48,000 and pays the the fair market value of the different items on the date difference, $17,000, in cash. The adjusted basis of of acquisition. the tractor at the time of the exchange was $45,000 ($60,000 less $15,000 depreciation), and the actual gain was thus $3,000. However, because the property EXAMPLE: Ed Carrol purchases, for $25,000, prop- exchanged was “held for productive use in trade or erty consisting of a used car lot and an adjoining business,” the gain is not recognized but instead is filling station. At the time of the purchase, the fair deducted from the basis of the new tractor. The new market value of the filling station is $15,000 and of the tractor acquires a substituted basis of $62,000. This, used car lot, $10,000. Ed, after charging off a $500 of course, will increase any taxable gain or decrease yearly depreciation deduction on the filling station any loss on a subsequent sale. for 4 years, sells the station for $20,000. His gain Basis of old property . . . . . . . . . . . . . . . . $45,000 on the sale is $7,000 because the adjusted basis of Gain or loss recognized . . . . . . . . . . . . . 0 the filling station at the time of the sale was $13,000 Plus: Boot paid . . . . . . . . . . . . . . . . . . . . 17,000 ($15,000 minus $2,000 depreciation). Basis of new property . . . . . . . . . . . . . . $62,000 The above example illustrates that gain or loss must be determined at the time of sale of each part. It EXAMPLE: Wade Wright, an investor, exchanged a cannot be deferred until the entire property has been building lot with a basis of $4,000,000 for an apart- disposed of. ment house worth $2,800,000. The $1,200,000 loss is not recognized. The basis of the apartment house If a taxpayer purchases a large parcel of land, later subdi- would be $4,000,000, figured as follows: vides it into separate lots, and then sells them, the basis of each lot is allocated in proportion to its respective Basis of old property . . . . . . . . . . . . . $4,000,000 Gain or loss recognized . . . . . . . . . . . 0 value when acquired. Boot paid or received . . . . . . . . . . . . . 0 Basis of new property . . . . . . . . . . . . $4,000,000 ¶1506 Purchase and Sale of a In this example, Wade would have been better off Going Business (Sec. 1060) selling the building lot, taking the loss, and then buying the apartment house. But then there would Frequently, taxpayers sell the assets of an entire business have been a lower basis in the apartment house for for a lump sum. If the business is a sole proprietorship depreciation purposes. (as opposed to a partnership or a corporation), it is necessary to apportion the sales price and allocate it to However, if the investor exchanges real estate for a truck, the the various items involved, such as inventories, accounts exchange is not covered by this section because the proper- receivable, notes receivable, real estate, machinery and ties are not of like kind. Similarly, even on an exchange that fixtures, and other physical assets. The gain or loss on would ordinarily be taxable, no gain or loss is recognized if each individual component must then be separately the property received in exchange has no ascertainable fair computed and reported. (Apportionment is also required market value. The new property acquires the basis of the when there is an asset purchase of a corporation or old. However, only rarely would the property be deemed other business.) not to have any fair market value. If taxpayers buy a going business for a lump sum, any ¶1505 Basis of Property Acquired part of the purchase price over and above the total value of the physical assets is treated as payment for by a Lump-Sum Purchase “goodwill.” In a subsequent sale of the business, they If various kinds of property are purchased together for a are entitled to recover tax-free the goodwill for which lump sum, it is necessary to allocate the basis among the they paid. ¶1506 196 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E hands of the donor (subject to an adjustment, discussed EXAMPLE: In 1997, Derek Brown purchased a gro- below, for gift tax paid on the gift). If the donor also cery store for $350,000. The purchase price at the time was allocated as follows: real estate, $160,000; received the property by gift, then the basis is the same equipment and fixtures, $30,000; inventory, $80,000; as that in the hands of the last preceding owner who did goodwill, $80,000. In 2008, he sold the business for not acquire it by gift. $500,000. The physical assets of the business at the time of the sale had a fair market value of $390,000. In the absence of any specific allocation of the EXAMPLE: In 2006, Arnold Golden gave shares of sales price, it will be assumed that Derek received stock worth $400 to Mitch Bolton. The stock had $110,000 ($500,000 - $390,000) for goodwill, result- cost Arnold $600. This year, Mitch sells the stock for ing in a gain of $30,000 on the goodwill. This, of $750. Because the sale resulted in a gain, the basis is course, is in addition to any gain he may realize on $600 (the same as in the hands of the donor). Mitch the other assets involved. realizes a recognized gain of $150. The allocation of the sales price to the assets involved is made on Form 8594, Asset Acquisition Statement, which EXAMPLE: In 1996, Lamar Ackley purchased is attached to the return for the year of sale. securities for $2,000. In 1997, when the securities had a fair market value of $3,000, he gave them PRACTICE POINTER: Typically the buyer wants to to his brother, Bob. In 2001, when the stock had allocate as much as possible to depreciable assets a fair market value of $5,500, Bob gave them to (to maximize future deductions), whereas the seller his son, Charles. Charles sold them in 2008 for wants to allocate as much as possible to assets $7,000. Because Bob acquired the securities by gift, producing capital gains (to minimize tax on the Charles’s basis would be $2,000, the same as in the sale). The buyer’s and seller’s interests may be at hands of Ackley, and Charles will have to report a odds and must be resolved through negotiation to gain of $5,000. complete the sale. ¶1509 Loss on Property Acquired by Gift PITFALL: The allocation made on Form 8594 is bind- ing on the parties to the sale. The IRS, however, is The basis for determining loss on gifts is either the not bound by this allocation. same as it was in the hands of the donor (or of the last preceding owner who did not acquire it by gift) or the fair market value of the property at the time of the gift, ¶1507 Basis of Property Acquired by Gift whichever is lower. (Sec. 1015) The items discussed up to now were acquired either EXAMPLE: In 2005, Aaron Small gave shares of by purchase or by exchange. Hence, their basis (before stock, which cost him $550, to Ben Pruett. At the adjustments) is normally what the taxpayer paid for time of the gift they were worth $400. Ben sold the them, either in cash or in property given in exchange. shares in 2008 for $300. Because the sale resulted If the taxpayer received property as a gift, having paid in a loss, the basis would be $400 (the fair market neither money nor other property for it, the cost basis is value on the date of the gift). Of course, this amount is less than the basis in the hands of the donor ($550). not applicable, and the taxpayer must assign a substituted Ben will incur a recognized loss of $100. basis to the property. Substituted basis, like cost basis, may have to be adjusted for such items as depreciation, improvements, and casualty losses. EXAMPLE: In 2005, Aaron gave securities that had The basis of property acquired depends on whether the cost him $100,000 to Ben. At the time of the gift the property was disposed of at a gain or at a loss. fair market value was $90,000. Ben sold the securi- ties in 2008 for $95,000. In such case, there is no ¶1508 Gain on Property Acquired by Gift gain or loss. Because the basis for determining loss is $90,000, there is no loss or gain, because the basis The general rule is that the basis for determining gain on for determining gain is $100,000. property received by gift is the same as the basis in the ¶1507 PA R T 2 — C H A P T E R 1 5 — B a s i s 197 The purpose of this special provision is to prevent taxpay- STUDY QUESTIONS ers from gaining a tax benefit by transferring property to persons who can take advantage of tax losses. 2. In 1994, a father purchased 1,000 shares of X Cor- poration for $10,000. In 1998, when the stock had a fair market value of $9,000, he gave the shares ¶1510 Adjustments for Gift Taxes Paid to his son. The stock is worth $15,000 in 2008 and The receipt of a gift does not constitute income; therefore, the son sells it. The basis of the stock to the son no income tax is payable on it by the recipient. However, is: on certain larger gifts of money or property (those in a. $9,000 excess of the $12,000 annual gift tax exclusion in 2008 b. $10,000 c. $15,000 and the applicable lifetime gift tax exemption amount of $1 million), a federal gift tax may be payable by the 3. Assume the same facts as above, except the stock individual making the gift. This tax is in the nature of an sold for $8,000. The basis of the stock to the son excise tax for the privilege of transferring property by gift. is: It is not an income tax. If any gift tax was paid at the time a. $9,000 the gift was made, it will increase the basis of the property b. $10,000 by the amount of the tax. In no event can the basis be c. $15,000 increased to more than the property’s fair market value at the time of the gift. For gifts made after 1976, the increase in basis of property is limited to an amount that bears the ¶1511 Basis of Home Acquired under same ratio to the gift tax paid as the net appreciation in the Old Deferral Rules (Sec. 1034) the value of the gift bears to the taxable gift. If a home was sold before May 7, 1997 (or within a transition period), and gain was deferred by buying or EXAMPLE: In 1985, Josh Adams purchased a busi- building a replacement home within 2 years of the sale, ness building at a cost of $120,000. In 1995, when the then the basis of the replacement home is the cost of property (because of depreciation) had an adjusted the home minus any gain not recognized on the sale of basis of $60,000 in Adams’s hands, he gave the the old home. property to his nephew, Bill Barker. Josh paid a gift tax in the amount of $7,500. The fair market value of the property at the time of the gift was $65,000. Thus, net appreciation is $5,000 ($65,000 value of EXAMPLE: On May 1, 1997, Mabel Black sold her gift $60,000 donor’s basis). home for a gain of $80,000. Within the month, she had purchased a new home for $175,000 and quali- The basis of the property to Bill is $60,577 ($60,000 fied to defer her entire gain under the old home sale $7,500 gift tax [$5,000 appreciation $65,000 deferral rules. Her basis in the new home is $95,000 taxable gift]). The annual exclusion was not used. ($175,000 cost of the new home less $80,000 gain not recognized on the sale of the old home). Summary. Basis of property acquired by gift: For Gain. Donor’s basis increased by the amount of The basis of a home sold under the current home sale gift tax paid with respect to the gift. However, the exclusion rules may be found in ¶1302. increase is made only to the extent that the total basis will not exceed fair market value of the property at the time of the gift. For gifts made after 1976, the ¶1512 Securities Acquired at Different Prices increase in basis of property is limited to the gift tax Taxpayers frequently purchase different quantities of the attributable to the net appreciation at the time of same stocks or bonds at different costs before figuring the gift. the adjusted basis when less than the entire holdings of For Loss. Basis is the lower of: a particular stock or mutual fund are sold. For stock, Fair market value at the time of the gift, or there is the specific identification method or first-in Donor’s basis increased by the gift tax (limited to first-out (FIFO). For mutual fund shares, there is the gift tax on appreciation only for gifts made after specific identification method, FIFO, or the average- 1976). cost method. ¶1512 198 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E Specific share identification. If a taxpayer has good EXAMPLE: Sam Madison bought the following shares records, the adjusted basis of shares acquired in different in the XYZ Mutual Fund: 100 shares in 2003 at $10 lots at various prices and times can be used for determin- per share; 100 shares in 2005 at $12 per share; and ing gain or loss provided: 100 shares in 2007 at $26 per share. On July 1, 2008, Sam sold 150 shares. The basis of the shares sold The identity of the shares to be sold or transferred using the single-category method is $2,400, figured are specified to the broker or other agent at the time as follows: of the sale or transfer; and Total cost ($1,000 + $1,200 Confirmation of these specifications is received from + $2,600) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,800 the broker or other agent in writing within a reason- Average cost per share able time. ($4,800 ÷ 300 shares) . . . . . . . . . . . . . . . . . . . $16 Basis of shares sold ($16 × 150 sold) . . . . . . . $2,400 PITFALL: Taxpayers who trade online may have difficulty obtaining confirmation of their trade order Double-category method. Shares are divided into required for the specific identification method. The IRS has not indicated how to overcome this two categories: those held 1 year or less and those problem. held more than 1 year. Then follow the single-cat- egory method for finding the average cost of shares in each category. FIFO. If the shares cannot be identified, then the taxpayer is treated as selling or transferring the shares acquired first. PRACTICE POINTER: The choice of the average- basis method must be clearly indicated on the tax return and cannot be changed without IRS approval. EXAMPLE: Chad Jones purchased 100 shares of Once the average-basis method is elected, it must be XYZ stock in 1998 for $10,000. In February 2000, he used for all accounts in the same fund. See ¶1608A bought another 200 shares for $22,000. In October for more details. 2000, he gave his son 50 shares, and, in June 2003, he purchased another 100 shares for $9,000. This year he sold 130 shares for $13,650. ¶1513 Basis of Inherited Property (Sec. 1014) The shares he gave his son have a basis of $5,000 (50/100 of $10,000, the cost of the first lot bought). If property was obtained by inheritance, bequest, or The basis of the stock sold this year is computed devise, its basis is normally the fair market value at the as follows: date of the decedent’s death. This is referred to as a 50 shares (balance of stock “stepped-up basis.” However, if a federal estate tax return purchased in 1998) . . . . . . . . . . . . . $ 5,000 80 shares (80/200 of $22,000 was required to be filed, the basis is the same as the value February 2000 purchase) . . . . . . . . 8,800 used for estate tax purposes. An election can be made to Total basis of 130 shares sold . . . . . . $13,800 use an “alternate valuation date,” that is, to value the gross estate for estate tax purposes at a date 6 months after the decedent’s death or, if earlier, the date of disposition of Average-cost method. The average-basis method for the property. The election to use the alternate valuation mutual fund shares can be chosen to figure gain or loss date can be made only when the election will reduce both when selling or transferring shares if they were acquired the value of the decedent’s gross estate and the federal at different times and prices, and the shares were left estate tax liability. on deposit in an account handled by a custodian or agent who acquires or redeems these shares. There are two average-basis methods: single-category method and PRACTICE POINTER: The estate tax valuation pro- double-category method. vides only a rebuttable presumption of the basis of inherited property. The beneficiary is free to establish Single-category method. Find the average of all shares a more accurate basis of the inherited property for owned at the time of disposition, regardless of how long income tax purposes. they were owned. ¶1513 PA R T 2 — C H A P T E R 1 5 — B a s i s 199 Estate tax, like gift tax, is in the nature of an excise tax Summary of Rules on Basis and has no direct connection to income tax. How Property Basis for Basis for Obtained Determining Gain Determining Loss In cases where no federal estate tax return is required Gift. Same as in hands of Same as in hands to be filed, but a state inheritance or transmission tax donor (plus gift tax of donor plus gift is assessed against the estate, the basis of the property paid) but not more tax paid* or fair than market value at market value at will generally be the appraised value used for state tax the time of gift.* date of gift, which- purposes. ever is lower. Property Fair market value Same as for gain. acquired from at date of death, or a decedent. value 6 months after EXAMPLE: Adam Manning owned stock in Corpora- death or at disposi- tion A that cost him $10,000 and had a fair market tion within 6 months after death, if alter- value of $50,000 at the time of his death. His legatee nate valuation date or distributee (or his estate) would have a new basis was elected. of $50,000 for the stock. The $40,000 appreciation in Nontaxable Basis of property Same as for gain. value (up to the time of Adam’s death) would never exchange. acquired is basis of become subject to income tax. property exchanged plus any recognized gain and less any boot received. Spouse of a decedent who died after 1981. For A residence Cost less gain not Same as for gain, acquired recognized on sale of but loss not rec- property owned as tenants by the entirety or joint ten- replacing old old residence. ognized. ants with rights of survivorship, the surviving spouse’s residence basis is composed of two parts: one-half is the surviving with gain not recognized.** spouse’s own cost basis; the other half is the estate tax value for that half (the value of that half on the date * Limited to gift tax on appreciation for gifts made after 1976. of the decedent’s death or alternate valuation date). ** Prior to May 7, 1997, or August 5, 1997, under certain conditions. However, use the estate’s value for the entire property where it was acquired by the couple before 1977 if the STUDY QUESTION decedent paid for it. 4. In 1989, a grandmother purchases a pearl neck- lace for $3,000. In 2008, when it is worth $10,000, she dies and leaves it to her granddaughter. EXAMPLE: In 1976, a couple, Ray and Elaine Joseph, The value of the necklace as reported on the estate purchased a residence for $50,000 (the husband paid tax return is $10,000. The necklace is not to the for the home), taking title as joint tenants with right granddaughter’s taste, so she immediately sells it of survivorship. Ray dies in 2008 when the home is and receives $9,800. For purposes of determining worth $500,000. For income tax purposes, the wife’s the granddaughter’s gain or loss, her basis is: basis is $500,000, the estate tax value of the entire property. If the home had been purchased in, say, a. $3,000 1980, Elaine’s basis would be $275,000 (1/2 of estate b. $9,800 tax value and 1/2 of original cost basis). c. $10,000 ¶1514 Basis of Intangible Assets NEW FOR 2010: A modified carryover basis rule is The basis of intangible assets, such as patents, copy- set to replace the stepped-up basis rule for property rights, trademarks, trade names, and so on is ordinarily inherited after 2009, unless Congress changes the determined in the same manner as the basis of tangible law before then. assets. Thus, the basis of a patent obtained directly by the taxpayer from the government is the cost of patent A summary of the basis rules appears in the following and attorney fees, drawings, and similar expenditures. chart: The costs of developing the patent, such as research and ¶1514 200 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E experimental expenditures, are also added to the basis EXAMPLE: Assume that instead of purchasing two unless these costs are deducted as current expenses at the houses, Bill from the previous example purchased time they are incurred. If the patent is acquired by pur- a two-family house for $200,000, one-half of which chase, its basis is the amount the taxpayer paid for it. he occupied himself and the other half of which he rented out. He took a $5,000 yearly depreciation Furthermore, the basis of a purchased copyright is the deduction on the rented portion. Assume further amount paid for it, whereas, in the case of a copyright that, at the end of 2008, he sold the entire house for secured directly by the taxpayer, the basis is the total of $212,000. He will compute his basis and gain in the all costs involved, including the cost of producing the following manner: work. The same rules apply to the basis of trademarks Residence Rented and trade names. In no event can the value of the inven- Portion Portion Cost $100,000 $100,000 tor’s or author’s time be included in the basis of a patent Less: Depreciation (4 years × or copyright to the inventor or author. $5,000 on rented portion only) . . . 20,000 Adjusted basis . . . . . . . . . . . . . $100,000 $80,000 ¶1515 Basis of Property Held for Personal Use Amount realized . . . . . . . . . . . . . . . . $106,000 In general, as far as the determination of basis is con- $106,000 0 cerned, there is no difference between property held for Less: Basis . . . . . . . . . . . . . . . . . . . . 100,000 80,000 business and investment purposes and property held for Gain. . . . . . . . . . . . . . . . . . . . . . $6,000 $26,000 personal use. Total gain ($6,000 + $26,000) . . . . . . $32,000 The basis of a personal residence for which a residential energy credit is claimed must be reduced by the amount The computations in the above two examples are identi- of the credit. cal, except that “residence portion” and “rented portion” However, if the property is subject to a depreciation allow- have been substituted for House 1 and House 2. ance, its basis must be reduced by the amount of deprecia- tion allowed or allowable. Obviously, this adjustment does PRACTICE POINTER: Because a loss on the sale of not apply to property held for personal use, because no personal property is not deductible, taxpayers who depreciation may be taken on personal-use property. want to sell a residence that is declining in value (e.g., if it is located in a deteriorating neighborhood) would EXAMPLE: On January 2, 2005, Bill Beane purchased be wise to move out and rent the property (or use it two one-family houses for $100,000 each. House 1 was for other income-producing purposes) until they are used as his personal residence; House 2 was rented to able to sell it. This strategy will enable them to deduct a tenant, and Bill deducted depreciation on it at the rate any loss in value between the date of conversion and of $5,000 per year. Bill subsequently decides to move the date of sale. into a hotel, and, on December 31, 2008, he sells both houses for $106,000 each. The basis and the gain on each house will be computed as follows: The “conversion date” is the date on which the property becomes available for rent, not the date it was actually House 1 House 2 rented. The courts have held that if the taxpayer actively Cost (unadjusted basis) . . . . . . . . . . . $100,000 $100,000 demonstrated a desire to put the property to profitable Less: Depreciation (4 years $5,000 on rented house only) . . . . . . . . . . . 20,000 use (e.g., listing it with real estate agents, advertising it Adjusted basis . . . . . . . . . . . . . . . $100,000 $80,000 for rent), it is considered as “being held for productive use in business or for investment.” Amount realized . . . . . . . . . . . . . . . . . $106,000 $106,000 Less: Basis . . . . . . . . . . . . . . . . . . . . . 100,000 80,000 ¶1516 Basis of Property Converted Gain . . . . . . . . . . . . . . . . . . . . . . . . $6,000 $26,000 to Business Use Total gain ($6,000 + $26,000) . . . . . . . $32,000 If a taxpayer holds property for personal use and then converts it to business use, its basis for determining If property is held partly for business and partly for gain is the cost or other basis of the property, less personal use, the same rules apply. We simply consider depreciation allowed or allowable during the time that it consisted of two distinct parts and compute the the property was held for business use to arrive at the basis of each separately. adjusted basis. ¶1515 PA R T 2 — C H A P T E R 1 5 — B a s i s 201 The basis for loss is either the basis of the property at the stock is allocated between the stock and the rights in time of conversion or the fair market value at the time the ratio of the fair market value of each to the total fair of conversion, whichever is less, reduced by depreciation market value of both at the time of distribution. If less and any other applicable adjustments after the conver- than 15%, the basis for the rights is zero unless an elec- sion dates to arrive at the adjusted basis. tion is made on the return for the taxable year of receipt of the rights to allocate a portion of the basis of the old EXAMPLE: In 1993, Eric Moore purchased a house stock to the rights. to be used as his personal residence at a cost of $60,000. He resided in it until January 1, 2005, at When rights are exercised, the basis of the new stock is which time its fair market value was $57,000. He its cost plus the basis of the rights exercised. The hold- then rented the property from January 1, 2005, to ing period of the new stock begins on the date the rights January 1, 2008, at which time he sold it for $50,000. are exercised. He deducted depreciation at the rate of $2,000 per year during the 3 years the house was rented. EXAMPLE: Assume Toby Cooper owns 100 shares The basis and the recognized loss will be computed of XYZ Company stock, which cost $22 per share. as follows: The XYZ Company offers 10 stock rights that allow Basis of property at time of conversion the taxpayer to purchase 10 additional shares of for determining loss (the lesser of $60,000 stock at $26 per share. At the time the rights were cost or $57,000 value) . . . . . . . . . . . . . . . . . . . $57,000 distributed, the stock had a market value of $30, Less: Depreciation allowable ex-rights, and each right had a market value of $3. during rented period . . . . . . . . . . . . . . . . . . . 6,000 Toby elects to allocate a portion of the basis of the Adjusted basis . . . . . . . . . . . . . . . . . . . . . . . . . . . $51,000 Less: Amount realized on sale . . . . . . . . . . . 50,000 stock to the rights. The basis of the rights and of the Recognized loss . . . . . . . . . . . . . . . . . . . . . . . . . . $1,000 old and new stock is computed as follows: 100 shares $22 $2,200, cost of old stock for which rights were acquired 100 shares $30 $3,000, market value of old stock EXAMPLE: Assume the same facts as above, except 10 rights $3 $30, market value of rights that the fair market value on January 1, 2005, was 3,000 $2,178.22, cost of old stock $65,000. The loss will be computed as follows: $2,200 3,030 apportioned to such stock Basis at time of conversion for purposes of determining loss (the lesser of $60,000 30 $21.78, cost of old stock $2,200 cost or $65,000 value) . . . . . . . . . . . . . . . . . . . $60,000 3,030 apportioned to rights Less: Depreciation . . . . . . . . . . . . . . . . . . . . 6,000 $21.78 10 stock rights $2.178 per right Adjusted basis . . . . . . . . . . . . . . . . . . . . . . . . . . . $54,000 Less: Amount realized on sale . . . . . . . . . . . 50,000 If the rights are sold, the basis for determining gain or Recognized loss . . . . . . . . . . . . . . . . . . . . . . . . . . $4,000 loss is $2.178 per right. If the rights are exercised, the basis of the new stock acquired is the subscription price paid ($26) plus the basis of the rights exercised ($2.178 each), or $28.178 per share. The remaining basis of PRACTICE POINTER: When a portion of a home is the 100 shares of old stock for determining gain or loss converted to business use (i.e., a home office), the on a later sale is $2,178.22, or $21.782 per share. The basis for purposes of depreciating the home office is holding period of nontaxable stock rights to the owner the lower of the adjusted basis or fair market value of the underlying stock begins at the time the underlying of the portion of the home used for business on the date of conversion. stock is acquired. ¶1518 Property Settlements (Sec. 1041) ¶1517 Stock Rights (Secs. 305 and 307) Gain on property transferred incident to divorce is not Stock rights are rarely taxable on receipt. If a taxpayer immediately taxable. Instead, the basis of the property in exercises or sells nontaxable stock rights and if, at the the hands of the transferor carries over to the transferee. time of distribution by the corporation, the rights had Transfers subject to this rule include transfers within a fair market value of 15% or more of the fair market 1 year after the date on which the marriage ceases or value of the underlying stock, the adjusted basis of the transfers related to the cessation of the marriage. ¶1518 202 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E ¶1519 Summary of Basis Rules for Gain or Loss ¶1520 Recent Developments Affecting Basis Type of Acquisition Basis for Gain or Loss Wrap fees on brokerage accounts cannot be added to the Accounts receivable basis of securities; they are investment expenses currently Accrual-basis taxpayer . . . . . Face value deductible as a miscellaneous itemized deduction (CCA Cash-basis taxpayer . . . . . . . Zero 200721015). Bequest . . . . . . . . . . . . . . . . . . . Estate tax value Cash purchase . . . . . . . . . . . . . . Cost Shares from demutualized insurance companies have a Mortgage also assumed, higher basis than zero; the court rejected the IRS view or property taken subject to mortgage . . . . . . . . . . . . . . Full price, including mortgage that the shares were a windfall with a zero basis (Fisher, Community property Ct. Fed. Cl., 2008-2 USTC ¶50,481). Survivor (death after 1947) . . . Estate tax value for full property Gift property . . . . . . . . . . . . . . . . Gain: Donor’s basis plus gift tax A couple could not value inherited art differently than it times net appreciation over tax- was reported on the estate tax return because they did not able gift challenge the accuracy of the method used for estate tax Loss: Limited to lesser of donor’s basis or FMV valuation, which is their income tax basis (Janis, CA-2, at time of gift 2007-1 USTC ¶50,210). Inherited property . . . . . . . . . . . . Estate tax value Inventory goods . . . . . . . . . . . . . Last inventory value Joint tenancy The basis of a car for which business mileage was deducted between spouses . . . . . . . . . . . . One-half survivor’s cost basis using the standard mileage rate must be reduced by a plus one-half estate tax value (full estate tax value for deemed depreciation rate. For business mileage in 2005, pre-1977 property purchased by the rate is 17 cents per mile (Rev. Proc. 2004-64, 2004-2 the decedent) Joint tenancy in general CB 898); the same rate (17 cents per mile) applies for After death of one tenant 2006 (Rev. Proc. 2005-78, IRB 2005-51, 1177); the rate after 1953 . . . . . . . . . . . . . . . . . Estate tax value for portion is 20 cents per mile for 2007 (Rev. Proc. 2006-49, IRB included in estate After death of one tenant 2006-47, 936); the rate is 19 cents per mile for the first before 1954 . . . . . . . . . . . . . . . Original cost to joint tenants six months of 2008 and 27 cents per mile for the second Life estate. . . . . . . . . . . . . . . . . . Zero if disposed of after October 9, 1969 six months of 2008 (Rev. Proc. 2007-70, IRB 2007-50, Livestock 1162; Announcement 2008-63, IRB 2008-28, 114). Inventoried . . . . . . . . . . . . . . . . Last inventory value Purchased . . . . . . . . . . . . . . . . Cost Raised by For further information on basis, see IRS Publica- accrual-basis farmer. . . . . . . . . Cost of raising tion 551, Basis of Assets. Raised by cash-basis farmer. . . . . . . . . . . Zero if costs expensed Property settlements Transferor’s basis Repossessed property after installment sale Personal property . . . . . . . . . . . Fair market value Real property reacquired Adjusted basis of indebtedness to satisfy purchaser’s plus gain resulting from indebtedness secured reacquisition and acquisition by property . . . . . . . . . . . . . . . . costs Residence after sale of old residence without recognition of gain (prior to August 5, 1997) . . . . . . . . . . . Cost less gain not recognized on old residence Stock Acquired in wash sale . . . . . . . Cost of acquired stock plus loss not recognized Nontaxable stock dividend. . . . Allocable share of basis of stock on which declared Received for services . . . . . . . . Amount reported in income plus cash paid Stock rights Nontaxable . . . . . . . . . . . . . . . . Allocable share of basis of stock unless rights value is less than 15% of stock value Taxable . . . . . . . . . . . . . . . . . . . Fair market value when issued Tenancy by the entirety (see Joint tenancy between spouses, above) ¶1519 16 PART 2 — ACQUISITION AND DISPOSITION OF PROPERTY Capital Gains and Losses LEARNING OBJECTIVES The purpose of holding an asset, rather than the form of the asset, determines whether or not it is a capital asset. This chapter was prepared to enable participants to gain For instance, a government bond held by an investor is a a general understanding of capital gains and losses. More capital asset, whereas the same bond purchased by a bond specifically, upon completion, you will be able to: dealer today, with the hope of selling it tomorrow at a Know what a capital asset is. profit, would be part of the stock-in-trade and, hence, an Understand how capital gains are taxed. ordinary asset. While this definition is adequate for most Apply the limits on capital losses. purposes, the legal definition is somewhat broader. Figure Section 1231 gains and losses. Under the Code, all property is classified as capital assets except: NEW THIS YEAR Stock in trade and similar property held primarily Zero tax rate for certain taxpayers. Taxpayers for sale to customers in the ordinary course of the in the 10% or 15% tax bracket pay 0% tax on net taxpayer’s business capital gains for tax years beginning after December Property includible in taxpayer’s inventory 31, 2007. See ¶1602. Accounts or notes receivable acquired in the ordinary course of a trade or business Depreciable property used in the taxpayer’s trade or ¶1601 Introduction business (Section 1231) Although recognized gains on the sale or exchange of Real property used in the taxpayer’s trade or business property are taxable and recognized losses are deduct- (Section 1231) ible, before such gains and losses are reported, we must A copyright, a literary or artistic composition, or determine whether the property involved is a capital asset similar property held by the creator of the property or an ordinary (noncapital) asset. or other person who obtained the property from the creator in a tax-free exchange or as a gift (other than The distinction between capital and ordinary assets is self-created musical compositions for which the cre- important because capital gains and losses are reported ator has chosen capital gain treatment) differently from ordinary gains and losses, and the deduc- A letter or memorandum, or similar property held tion of capital losses is sharply limited. by a person for whom such property was prepared ¶1602 What Are Capital Assets? (Sec. 1221) or produced or held by a taxpayer whose basis is determined by reference to such person’s basis “Capital assets” are assets held for personal use or invest- A franchise, trademark, or trade name whose seller ment, whereas ordinary assets are principally business (franchisor) retains any significant rights or interest assets held for sale or exchange in the ordinary course in the franchise, trademark, or trade name of the taxpayer’s business (e.g., inventory). Certain U.S. government publications received free or for-less-than-public sales price EXAMPLE: Ron Timmons, a furniture manufacturer, A commodities derivative financial instrument sold, within a tax year, his pleasure automobile, his A hedging transaction clearly identified as such before personal residence, and 100 shares of stock in the the close of the day X Corporation. In the course of his business, he sold Supplies of a type used or consumed in the ordinary $250,000 worth of furniture. The automobile, residence, and securities are capital assets, whereas the furniture course of a trade or business (the taxpayer’s stock-in-trade) is an ordinary asset. ¶1602 204 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E The fourth and fifth items are so-called “Section 1231” EXAMPLE: Cathy Wright owns rental property that assets, which are treated under a special set of rules dis- she bought for $80,000 and on which she claimed cussed later in this chapter. $50,000 depreciation over the years. Cathy sells the property on December 1, 2008, for $200,000. Cathy’s Musical compositions. Composers can elect capital gain gain of $170,000 ($200,000 less $30,000 basis) is treatment for their compositions. This is done simply by taxed as follows: $50,000 (the unrecaptured depre- treating gain as capital gain (i.e., reporting it on Schedule ciation) at 25% and $120,000 at 15%. D). A separate election is required for each composition. ¶1603 General Treatment of Capital Gains PRACTICE POINTER: The 25% and 28% tax rates and Losses (Sec. 61) apply to taxpayers in tax brackets above these rates. Gains. All recognized gains from the sale or exchange of property, whether capital assets or ordinary assets, are included in gross income. A special tax break is extended In order to determine the amount of gain subject to this to certain gains: special tax treatment, gains and losses are segregated as capital gains and losses and as long-term and short-term Sales of assets held 1 year or less at a profit are short- capital gains and losses. Schedule D is used for reporting term capital gains taxed at ordinary income rates. capital gains and losses. The schedule is broken down Sales or exchanges of assets held more than 1 year at into Part I—Short-term gains and losses and Part II— a profit are long-term capital gains taxed at 15% (0% Long-term gains and losses. for those in the 10% or 15% tax bracket). Reporting gains and losses. Gains and losses are PRACTICE POINTER: Installment payments received entered on Schedule D. See ¶1606. If there are more in 2008 on sales prior to May 6, 2003, qualify for the transactions than can fit on the lines provided on Sched- lower capital gains tax rates. ule D, use Schedule D Continuation Sheet, the total of which is carried over to Schedule D. Exceptions to the 15% rate. Even if a taxpayer meets Taxpayers with net capital gains (defined in ¶1609) the long-term holding period, the gain may not be eli- figure their tax liability on the Qualifying Dividends and gible for the 15% rate (depending on the date of sale). Capital Gains Worksheet to ensure that gains are taxed Four exceptions apply: at the appropriate rate. However, if taxpayers have any 25% or 28% gains, they must complete Schedule D Tax Collectibles (such as art works, gems, stamps, most Worksheet instead. coins, antiques, rugs, metals, alcohol, and guns) held long-term are taxed at the maximum rate of 28%. Losses. All deductible losses from the sale or exchange Small business stock eligible for the 50% exclusion is of property are subtracted from gross income in comput- taxed at 28% [so the effective tax rate is 14% (50% ing adjusted gross income. However, not all losses are of 28%)]. This is called Section 1202 gain. deductible. Losses on the sale of personal use property Qualified community business property is fully (such as a principal residence) are never deductible. excludable; no gain is taxed. Only property acquired after 2001 and before 2010 in a renewal community While ordinary losses are deductible in full, the deduc- (a distressed area certified as a qualified community) tion of capital losses is restricted. Capital losses are held more than 5 years is treated as qualified commu- allowed in full against capital gains. Schedule D dictates nity property. The same exclusion applies to DC Zone how losses are to be used to offset gains at the different property (property within the District of Columbia tax rates. Losses first offset gains in their appropri- Enterprise Zone acquired after 1997). ate category (e.g., short-term losses offset short-term Depreciation on rental or business property is taxed gains). Excess losses are then used to offset gains starting at a 25% rate (if it is not otherwise treated as ordinary with gains taxed at the highest rate. If losses are more income). So, if the taxpayer claimed straight line than gains, only up to $3,000 ($1,500, if married fil- depreciation, there is no ordinary income recapture, ing separately) of the excess loss is deductible against but the depreciation is called “unrecaptured deprecia- ordinary income. tion” and is taxed at 25%. ¶1603 PA R T 2 — C H A P T E R 1 6 — C a p i t a l G a i n s a n d L o s s e s 205 Capital losses in excess of the amount of the allowable PRACTICE POINTER: Married couples can claim the loss may be carried over and used in later years. There $100,000 on a joint return even if the stock is held is no limit to the number of years the losses can be car- only in the name of one spouse. ried forward. To be treated as Section 1244 stock eligible for ordinary EXAMPLE: Dan and Helen Wayne sold stock in 2008. The sale resulted in a capital loss of $10,000. The loss treatment, certain requirements apply: Waynes had $40,000 of ordinary income and no other The corporation’s equity cannot exceed $1 million at capital transactions. On their joint return for 2008, the time of stock issuance. the Waynes can deduct $3,000. The unused loss of $7,000 ($10,000 - $3,000), can be carried over to The stock must be issued for money or property other 2009. If the Waynes’ capital loss had been $1,000, than stock and securities. their capital loss deduction would have been $1,000 In the 5 years preceding the loss, the stock must have (lower of $3,000 or $1,000). They would have no derived more than half of its gross receipts from busi- carryover to 2008. ness operations (and not simply from investments). The loss is reported on Form 4797, Sales of Business For more details on the capital loss carryover, see Property. ¶1608. Taxpayers must maintain records to support their deduc- STUDY QUESTIONS tion. These records must show that the corporation was a small business corporation when the stock was issued, that the taxpayers were the original holders, and that the 1. Which of the following property is not a capital asset? stock was issued for money or property (not for services). These records must be available in case the IRS questions a. A personal car b. A painting held by the artist who created it the deduction. c. Stock in IBM ¶1605 Exclusion and Rollover of Gain for Small 2. A taxpayer in the 35% tax bracket sells his coin Business Stock (Sec. 1045 and 1202) collection that he held for more than 25 years. The tax rate on the sale is: 50% of the gain on small business stock held for more than 5 years is excludable from gross income. Small a. 15% b. 25% business stock is stock issued after August 10, 1993, by c. 28% a domestic corporation that is an active business with d. 35% gross assets not exceeding $50 million. The gain not excluded, called Section 1202 gain, is taxed at 28% for an effective rate of 14% (50% 28%). NOTE: Answers to Study Questions, with feedback Limitation. A per-issuer limit restricts the amount of gain to both the correct and incorrect responses, are that can be taken into account in any 1 year. Eligible provided in Chapter 35, beginning with ¶3516. gain cannot exceed the greater of $10 million reduced by the aggregate amount of gain taken into account in ¶1604 Section 1244 Stock prior years or 10 times the adjusted basis of all quali- fied stock of the issuer that an individual disposed of in Losses on stock generally are treated as capital losses. the year (excluding additions to basis after issuance). However, if the stock is small business stock under Code Section 1244, it is eligible for ordinary loss treatment. Married persons filing separately each have a $5 million Under this section, up to $50,000 ($100,000 for married limit. Also, for purposes of the per-issuer limit in later persons filing jointly) can be claimed. Losses in excess years, gain excluded on earlier joint returns is allocated of the dollar limit can still be claimed as capital losses equally between spouses, regardless of whether only one (as discussed above). spouse qualified for the exclusion. If the small business stock is held by a pass-through entity (e.g., partnership or S corporation), then each owner can exclude 50% of the gain on his allocable share of gain ¶1605 206 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E from the pass-through entity. The entity must hold the Gain from the sale or exchange of a capital asset is not stock for more than 5 years. considered long-term unless the asset has been held for more than 1 year. Long-term gains are generally taxed at Rollover option. Gain can be entirely deferred (instead 15%, but gains can be taxed at as high as 28% (or not of taking the exclusion). All of the proceeds from the sale taxed at all for taxpayers in the 10% or 15% tax bracket). must be used to purchase other small business stock (that Consider the netting process involved in Section 1231 continues to be an active business for at least 6 months transactions. See ¶1609. after the rollover) within 60 days of the date of sale. If only some of the proceeds are used for this purpose, then If the taxpayer had long-term gains or losses from the the gain related to the part of the proceeds not rolled sale or exchange of several assets, the total losses are over must be recognized. In effect, gain is recognized to subtracted from the total gains to arrive at the net long- the extent that the amount realized on the sale is more term capital gain or loss. than the cost of the replacement stock. The basis of the replacement stock must be reduced by the amount of EXAMPLE: Curtis Bell, during March 2008, sold gain not recognized (deferred). shares of A stock for $600 and B stock for $950. ¶1605A Rollover of Gain to Specialized The stock had cost him $450 and $700, respectively. Assuming that he had held both stocks long-term, Small Business Investment Companies he had a total long-term capital gain of $400 ($150 (Sec. 1044) on A stock and $250 on B stock). Let us further assume that on April 1, 2008, he sold shares of C Recognition of gain on the sale of publicly traded securi- stock (also held long-term), which had cost him ties can be deferred if the sales proceeds are rolled over $1,200, for $1,075, resulting in a long-term loss of within 60 days to purchase common stock or a partner- $125. Subtracting the loss from the total gain, he has ship interest in a specialized small business investment a net long-term gain of $275. company (SSBIC). If sales proceeds exceed the cost of SSBIC common stock or partnership interest, gain is currently recognized. Gains and losses on the sale or exchange of capital assets held 12 months or less are called “short-term” capital Limitations. For an individual, this rollover option is gains and losses. Again, it is necessary to total all short- limited to the lesser of $50,000 or $500,000, reduced term gains and losses and to subtract one from the other by any gain previously excluded under this rollover rule. to arrive at the net short-term capital gain or loss. In the case of married persons filing separately, the limit is $25,000 and $250,000, respectively. EXAMPLE: Assume that Curtis in August 2008 made, Basis reduction. Any gain not recognized because of in addition to his net long-term gain of $275, the fol- this rollover rule reduces the basis of the SSBIC com- lowing additional sales of stock, all of which were mon stock or partnership interest. However, there is no held short-term: reduction for purposes of calculating the 50% exclusion X stock (cost $500) sold for $600 . . . . . . . . $100 gain on small business stock. See ¶1605. Y stock (cost $200) sold for $150 . . . . . . . . 50 loss Z stock (cost $425) sold for $300 . . . . . . . . 125 loss An SSBIC is a corporation or partnership licensed by the Small Business Administration under Section 301(d) of the Small Business Investment Act of 1958 as in effect on Subtracting the total losses ($175) from the gain ($100), May 13, 1993 (e.g., investment companies that finance we arrive at a net short-term loss of $75. The excess, if any, small businesses owned by disadvantaged taxpayers). of net long-term capital gain over net short-term capital loss is the net capital gain. It is this net capital gain that ¶1606 Long-Term and Short-Term Gains and enjoys the special tax rate. Losses (Sec. 1223) Capital gain distributions. Capital gain distributions are On the sale or exchange of ordinary assets, it makes no reported in Part II of Schedule D. However, if a taxpayer difference how long the asset was held by the taxpayer has no other capital gain transactions, then capital gain before the transaction occurred. However, in the case distributions are reported directly on Form 1040. of capital assets, the Code makes a distinction between long-term capital gains and losses and short-term capital Capital gains and losses are reported on Schedule D, gains and losses. shown on the following two pages. ¶1605A PA R T 2 — C H A P T E R 1 6 — C a p i t a l G a i n s a n d L o s s e s 207 OMB No. 1545-0074 SCHEDULE D Capital Gains and Losses (Form 1040) 2008 f Attach to Form 1040 or Form 1040NR. See Instructions for Schedule D (Form 1040). Department of the Treasury Attachment Use Schedule D-1 to list additional transactions for lines 1 and 8. 12 o Internal Revenue Service (99) Sequence No. Name(s) shown on return Your social security number Part I s 8 Short-Term Capital Gains and Losses—Assets Held One Year or Less a 0 (b) Date (d) Sales price (e) Cost or other basis ft 20 (a) Description of property (c) Date sold (f) Gain or (loss) acquired (see page D-7 of (see page D-7 of (Example: 100 sh. XYZ Co.) (Mo., day, yr.) (Mo., day, yr.) the instructions) the instructions) Subtract (e) from (d) 1 ra 2/ D /0 2 06 Enter your short-term totals, if any, from Schedule D-1, line 2 2 3 Total short-term sales price amounts. Add lines 1 and 2 in column (d) 3 4 Short-term gain from Form 6252 and short-term gain or (loss) from Forms 4684, 6781, and 8824 4 5 Net short-term gain or (loss) from partnerships, S corporations, estates, and trusts from Schedule(s) K-1 5 6 Short-term capital loss carryover. Enter the amount, if any, from line 10 of your Capital Loss Carryover Worksheet on page D-7 of the instructions 6 ( ) 7 Net short-term capital gain or (loss). Combine lines 1 through 6 in column (f) 7 Part II Long-Term Capital Gains and Losses—Assets Held More Than One Year (a) Description of property (b) Date (c) Date sold (d) Sales price (e) Cost or other basis (f) Gain or (loss) acquired (see page D-7 of (see page D-7 of (Example: 100 sh. XYZ Co.) (Mo., day, yr.) (Mo., day, yr.) the instructions) the instructions) Subtract (e) from (d) 8 9 Enter your long-term totals, if any, from Schedule D-1, line 9 9 10 Total long-term sales price amounts. Add lines 8 and 9 in column (d) 10 11 Gain from Form 4797, Part I; long-term gain from Forms 2439 and 6252; and long-term gain or (loss) from Forms 4684, 6781, and 8824 11 12 Net long-term gain or (loss) from partnerships, S corporations, estates, and trusts from Schedule(s) K-1 12 13 Capital gain distributions. See page D-2 of the instructions 13 14 Long-term capital loss carryover. Enter the amount, if any, from line 15 of your Capital Loss Carryover Worksheet on page D-7 of the instructions 14 ( ) 15 Net long-term capital gain or (loss). Combine lines 8 through 14 in column (f). Then go to Part III on the back 15 For Paperwork Reduction Act Notice, see Form 1040 or Form 1040NR instructions. Cat. No. 11338H Schedule D (Form 1040) 2008 ¶1606 208 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E Schedule D (Form 1040) 2008 Page 2 Part III Summary 16 Combine lines 7 and 15 and enter the result o f 16 as 08 If line 16 is: ● A gain, enter the amount from line 16 on Form 1040, line 13, or Form 1040NR, line 14. Then ft 20 go to line 17 below. ● A loss, skip lines 17 through 20 below. Then go to line 21. Also be sure to complete line 22. ● Zero, skip lines 17 through 21 below and enter -0- on Form 1040, line 13, or Form 1040NR, ra 2/ line 14. Then go to line 22. D /0 17 Are lines 15 and 16 both gains? Yes. Go to line 18. No. Skip lines 18 through 21, and go to line 22. 18 19 Enter the amount, if any, from line 7 of the 28% Rate Gain Worksheet on page D-8 of the instructions Enter the amount, if any, from line 18 of the Unrecaptured Section 1250 Gain Worksheet on page D-9 of the instructions 06 18 19 20 Are lines 18 and 19 both zero or blank? Yes. Complete Form 1040 through line 43, or Form 1040NR through line 40. Then complete the Qualified Dividends and Capital Gain Tax Worksheet on page 35 of the Instructions for Form 1040 (or in the Instructions for Form 1040NR). Do not complete lines 21 and 22 below. No. Complete Form 1040 through line 43, or Form 1040NR through line 40. Then complete the Schedule D Tax Worksheet on page D-10 of the instructions. Do not complete lines 21 and 22 below. 21 If line 16 is a loss, enter here and on Form 1040, line 13, or Form 1040NR, line 14, the smaller of: ● The loss on line 16 or 21 ( ) ● ($3,000), or if married filing separately, ($1,500) Note. When figuring which amount is smaller, treat both amounts as positive numbers. 22 Do you have qualified dividends on Form 1040, line 9b, or Form 1040NR, line 10b? Yes. Complete Form 1040 through line 43, or Form 1040NR through line 40. Then complete the Qualified Dividends and Capital Gain Tax Worksheet on page 35 of the Instructions for Form 1040 (or in the Instructions for Form 1040NR). No. Complete the rest of Form 1040 or Form 1040NR. Schedule D (Form 1040) 2008 ¶1606 PA R T 2 — C H A P T E R 1 6 — C a p i t a l G a i n s a n d L o s s e s 209 ¶1607 Holding Period Involuntary conversions. For an involuntary conversion (Sec. 1014, 1015, and 1223) of property in which the taxpayer elects not to have all or part of the gain recognized, the holding period of the In determining how long an asset has been held, a tax- new property begins with the date of acquisition of the payer excludes the day the property was acquired and old property. includes the day of sale or disposition. Home sales. The holding period of a new residence EXAMPLE: On June 25, 2008, Jean Greene bought acquired under the old deferred rules includes the hold- some jewelry, which she now has an opportunity ing period of the old residence if all or part of the gain to sell at a profit. If she wishes to have a long-term is not recognized on the sale of the old residence under capital gain, she must wait until June 26, 2009, before those rules. concluding the sale. Related party transactions. The holding period carries over from the original property when there is a nonrec- PRACTICE POINTER: When selling stocks, bonds, ognized loss on “related party” transactions. and other capital assets that may qualify for the 15% capital gain rate, be sure to hold the assets for more ¶1608 Capital Loss Carryover (Sec. 1212) than 1 year. As previously mentioned, that portion of net capital loss that is not deductible in the current year because For securities traded on stock exchanges, two dates of the capital loss limitation may be “carried over” to appear on the broker’s advice slips: a “trade” date and a the next taxable year, subject to certain limitations. “settlement” date. To determine the holding period of The amount carried forward is determined under a such securities, the trade date governs. complicated formula (incorporated into the Capital Loss Carryover Worksheet in the instructions to Gifts. In the case of property acquired by gift, the hold- Schedule D) that takes into account taxable income ing period generally begins with the date the property is (which may be a negative number for this purpose acquired by the donor. However, if the sale results in a loss where deductions exceed gross income), the capital loss and the property has a value lower than cost at the date of deduction in excess of capital gains, and the deduction the gift, the holding period begins at the date of the gift. for personal exemptions. This means that a net short- Inheritances. Property acquired from a decedent and term loss and a net long-term loss sustained this year disposed of within 1 year of death is automatically treated will be treated, respectively, as a short-term loss and a as being held long-term. This rule applies regardless of long-term loss in the following year. Any part of the how long the decedent owned the property or how long loss that is not deducted in the next year may be car- the recipient holds it before a disposition. ried over to the following year, and so on indefinitely, until fully wiped out. Tax-free exchanges. If the taxpayer makes a tax-free “like-kind” exchange, the holding period of the old prop- PITFALL: Losses carried forward cannot be used erty is transferred (tacked on) to the new property. after an individual dies. So, for example, if a spouse has a capital loss carryfoward and dies, the surviv- EXAMPLE: On September 25, 2008, Evan Boros ing spouse cannot use the loss after the year of the exchanges his dump truck used in his construction decedent’s death on a final joint return. business, which he had purchased on September 15, 2007, and which had a basis of $15,000, for a cement mixer worth $20,000. Seven months later, he sells the cement mixer for $21,500. Because the dump truck- cement mixer transaction is a tax-free exchange of depreciable property used in trade or business, the latter is considered as having been acquired on Sep- tember 15, 2007, and, thus, held long-term. ¶1608 210 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E STUDY QUESTIONS PITFALL: It is not clear how to comply with the rules for using the specific identification method for online 3. Edith Edwards purchases a corporate bond on May sales of shares since the seller is not dealing with an 4, 2007, and sells it on May 4, 2008. The holding individual broker who will necessarily respond to a period is: request for confirmation of an order to sell specific a. Short-term shares. b. Long-term c. Depends on whether a gain or loss results Other methods for determining which shares are being sold 4. Which statement regarding capital losses is not in mutual fund transactions are explained in ¶1512. correct? ¶1609 Gains and Losses on a. Losses that cannot be deducted currently can Business Property (Sec. 1231) be carried forward for up to 5 years. b. Losses that cannot be deducted currently can Section 1231 of the Internal Revenue Code establishes be carried forward indefinitely. a third category of assets (the so-called Section 1231 c. They can offset ordinary income to the assets), with respect to which net gain is entitled to the extent of $3,000 (after offsetting any capital gains). advantages of capital gain treatment. However, a net loss on this asset category is treated as an ordinary, rather than a capital, loss. ¶1608A Identifying Shares in Stock The following are Section 1231 items if the assets have and Mutual Fund Transactions been held for more than 1 year: If a taxpayer holds shares of stock in the same company or mutual fund shares that were bought at different times, Gain or loss on real estate used in business then there are different holding periods and bases to con- Gain or loss on depreciable property used in business sider. The size of the gain or loss and its characterization (machinery, fixtures, automobiles, and trucks, etc.) as long-term or short-term depends on which shares are Gain on capital assets involuntarily converted into treated as having been sold. other property or money through condemnation, casualty, or theft If no identification is made. If a taxpayer does not identify the specific shares to be sold, then the IRS treats NOTE: Gains and losses from personal casualties the first shares purchased as having been sold. In other and thefts are not subject to the netting treatment words, it applies a FIFO (first in, first out) rule. of Section 1231. Instead, gains and losses from personal casualties and thefts are to be separately Adequate identification. A taxpayer is permitted to netted. See ¶2306. choose the specific shares to be sold. According to regulations, shares are considered to be adequately To determine whether there was a gain or loss on the identified if the taxpayer specifies the shares to be sale or exchange of Section 1231 assets, it is necessary sold at the time of sale and the broker confirms these to lump the Section 1231 transactions together. If the instructions in writing. According to the Tax Court, overall result is a gain, the gains (net of any depreciation the regulations are a safe-harbor method of identifica- recapture or losses) are reported together with the other tion; other methods are also permissible. For example, capital gains and losses on the return. (The depreciation a standing order to a broker to always sell the highest recapture rules are discussed in Chapter 21.) cost basis shares first was considered to be adequate identification. (Concord Instruments Corp., TC Gains and losses on business property are reported on Form Memo 1994-248) 4797, Sales of Business Property, shown on the next pages. ¶1608A PA R T 2 — C H A P T E R 1 6 — C a p i t a l G a i n s a n d L o s s e s 211 4797 OMB No. 1545-0184 Sales of Business Property Form (Also Involuntary Conversions and Recapture Amounts 2008 f Under Sections 179 and 280F(b)(2)) Department of the Treasury Attachment Attach to your tax return. See separate instructions. 27 o Internal Revenue Service (99) Sequence No. Name(s) shown on return Identifying number 1 Part I s 8 Enter the gross proceeds from sales or exchanges reported to you for 2008 on Form(s) 1099-B or 1099-S (or substitute a 0 statement) that you are including on line 2, 10, or 20 (see instructions) Sales or Exchanges of Property Used in a Trade or Business and Involuntary Conversions From Other 1 ft 20 Than Casualty or Theft—Most Property Held More Than 1 Year (see instructions) (e) Depreciation (f) Cost or other ra 4/ (g) Gain or (loss) (a) Description (b) Date acquired (c) Date sold (d) Gross allowed or basis, plus Subtract (f) from the of property (mo., day, yr.) (mo., day, yr.) sales price allowable since improvements and acquisition expense of sale sum of (d) and (e) D /2 2 6 3 Gain, if any, from Form 4684, line 39 3 0 4 Section 1231 gain from installment sales from Form 6252, line 26 or 37 4 5 Section 1231 gain or (loss) from like-kind exchanges from Form 8824 5 6 Gain, if any, from line 32, from other than casualty or theft 6 7 Combine lines 2 through 6. Enter the gain or (loss) here and on the appropriate line as follows: 7 Partnerships (except electing large partnerships) and S corporations. Report the gain or (loss) following the instructions for Form 1065, Schedule K, line 10, or Form 1120S, Schedule K, line 9. Skip lines 8, 9, 11, and 12 below. Individuals, partners, S corporation shareholders, and all others. If line 7 is zero or a loss, enter the amount from line 7 on line 11 below and skip lines 8 and 9. If line 7 is a gain and you did not have any prior year section 1231 losses, or they were recaptured in an earlier year, enter the gain from line 7 as a long-term capital gain on the Schedule D filed with your return and skip lines 8, 9, 11, and 12 below. 8 Nonrecaptured net section 1231 losses from prior years (see instructions) 8 9 Subtract line 8 from line 7. If zero or less, enter -0-. If line 9 is zero, enter the gain from line 7 on line 12 below. If line 9 is more than zero, enter the amount from line 8 on line 12 below and enter the gain from line 9 as a long-term capital gain on the Schedule D filed with your return (see instructions) 9 Part II Ordinary Gains and Losses (see instructions) 10 Ordinary gains and losses not included on lines 11 through 16 (include property held 1 year or less): 11 Loss, if any, from line 7 11 ( ) 12 Gain, if any, from line 7 or amount from line 8, if applicable 12 13 Gain, if any, from line 31 13 14 Net gain or (loss) from Form 4684, lines 31 and 38a 14 15 Ordinary gain from installment sales from Form 6252, line 25 or 36 15 16 Ordinary gain or (loss) from like-kind exchanges from Form 8824 16 17 Combine lines 10 through 16 17 18 For all except individual returns, enter the amount from line 17 on the appropriate line of your return and skip lines a and b below. For individual returns, complete lines a and b below: a If the loss on line 11 includes a loss from Form 4684, line 35, column (b)(ii), enter that part of the loss here. Enter the part of the loss from income-producing property on Schedule A (Form 1040), line 28, and the part of the loss from property used as an employee on Schedule A (Form 1040), line 23. Identify as from “Form 4797, line 18a.” See instructions 18a b Redetermine the gain or (loss) on line 17 excluding the loss, if any, on line 18a. Enter here and on Form 1040, line 14 18b For Paperwork Reduction Act Notice, see separate instructions. Cat. No. 13086I Form 4797 (2008) ¶1609 212 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E Form 4797 (2008) Page 2 Part III Gain From Disposition of Property Under Sections 1245, 1250, 1252, 1254, and 1255 f (see instructions) o (b) Date acquired (c) Date sold 19 (a) Description of section 1245, 1250, 1252, 1254, or 1255 property: (mo., day, yr.) (mo., day, yr.) A B C s 8 a 0 ft 20 D These columns relate to the properties on lines 19A through 19D. Property A Property B Property C Property D ra 4/ 20 Gross sales price (Note: See line 1 before completing.) 20 21 Cost or other basis plus expense of sale 21 D /2 22 Depreciation (or depletion) allowed or allowable 22 23 Adjusted basis. Subtract line 22 from line 21 23 24 Total gain. Subtract line 23 from line 20 24 6 25 If section 1245 property: 0 a Depreciation allowed or allowable from line 22 25a b Enter the smaller of line 24 or 25a 25b 26 If section 1250 property: If straight line depreciation was used, enter -0- on line 26g, except for a corporation subject to section 291. a Additional depreciation after 1975 (see instructions) 26a b Applicable percentage multiplied by the smaller of line 24 or line 26a (see instructions) 26b c Subtract line 26a from line 24. If residential rental property or line 24 is not more than line 26a, skip lines 26d and 26e 26c d Additional depreciation after 1969 and before 1976 26d e Enter the smaller of line 26c or 26d 26e f Section 291 amount (corporations only) 26f g Add lines 26b, 26e, and 26f 26g 27 If section 1252 property: Skip this section if you did not dispose of farmland or if this form is being completed for a partnership (other than an electing large partnership). a Soil, water, and land clearing expenses 27a b Line 27a multiplied by applicable percentage (see instructions) 27b c Enter the smaller of line 24 or 27b 27c 28 If section 1254 property: a Intangible drilling and development costs, expenditures for development of mines and other natural deposits, and mining exploration costs (see instructions) 28a b Enter the smaller of line 24 or 28a 28b 29 If section 1255 property: a Applicable percentage of payments excluded from income under section 126 (see instructions) 29a b Enter the smaller of line 24 or 29a (see instructions) 29b Summary of Part III Gains. Complete property columns A through D through line 29b before going to line 30. 30 Total gains for all properties. Add property columns A through D, line 24 30 31 Add property columns A through D, lines 25b, 26g, 27c, 28b, and 29b. Enter here and on line 13 31 32 Subtract line 31 from line 30. Enter the portion from casualty or theft on Form 4684, line 33. Enter the portion from other than casualty or theft on Form 4797, line 6 32 Part IV Recapture Amounts Under Sections 179 and 280F(b)(2) When Business Use Drops to 50% or Less (see instructions) (a) Section (b) Section 179 280F(b)(2) 33 Section 179 expense deduction or depreciation allowable in prior years 33 34 Recomputed depreciation (see instructions) 34 35 Recapture amount. Subtract line 34 from line 33. See the instructions for where to report 35 ¶1609 PA R T 2 — C H A P T E R 1 6 — C a p i t a l G a i n s a n d L o s s e s 213 Gain from the sale or exchange of a capital asset is not It can be seen from the previous example that the net considered long-term unless the asset has been held for gain from an involuntary conversion (the condemnation more than 1 year. The results of the netting process award) is considered a Section 1231 item. However, if the described above determine if a taxpayer has an ordinary involuntary conversion results in a loss (or the taxpayer loss deduction or a capital loss carryover. Thus, the hold- has several involuntary conversions and the net result is ing period can be an important factor. a loss), that loss is not considered a Section 1231 item and does not enter into the computation. EXAMPLE: In June 2008, Dan Behr sold for $2,400 a business parking lot that he had held long-term. There is a special recapture rule that transforms what It then had an adjusted basis of $2,100. He sold a would otherwise have been treated as Section 1231 capi- machine in August 2008, used in his business, which tal gain into ordinary income. The amount recharacter- had been held long-term, at a recognized loss of ized as such is the amount needed to offset net Section $100. Both the business parking lot and the machine 1231 losses incurred within the past 5 years that have are Section 1231 assets. They are reported on Form not already been “recaptured.” 4797. In addition, he had a long-term gain of $400 on the sale of some stock. Because the Section 1231 assets were held long-term and the gain ($300) PRACTICE POINTER: Keep a running record of exceeded the loss ($100), both transactions would Section 1231 gains and losses to determine recap- be treated as sales and exchanges of capital assets ture requirements. and would be reported as follows: Gain on sale of parking lot . . . . . . . . . . . . . . . . . . . . $300 The application of Section 1231 has been limited by the Gain on sale of stocks . . . . . . . . . . . . . . . . . . . . . . . 400 recapture provisions of Sections 1245 and 1250, both of $700 which are explained in Chapter 21. See ¶2115–2118. Less: Loss on sale of machine . . . . . . . . . . . . . . . . . (100) Net long-term capital gain . . . . . . . . . . . . . . $600 ¶1610 Lump-Sum Distributions from Qualified Employee Plans (Sec. 401–405) If the overall result of the netting of Section 1231 transac- If an individual who was over age 50 on January 1, 1986, tions is a net loss, then the gains and losses are considered receives a lump-sum distribution from a qualified retire- as ordinary gains and losses. ment plan, the tax on the distribution can be figured on Form 4972, Tax on Lump-Sum Distributions, using EXAMPLE: Jeremy Harper sold his factory building a special 10-year averaging method. This method allows (a Section 1231 asset) in May 2008 at a recognized the ordinary income part of the lump sum to be taxed loss of $16,000. His business showed a net profit as if received in equal parts over 10 years using the tax of $20,000 for the year. He had no other income rates for singles in 1986, regardless of the individual’s or business deductions. Because the total Section 1231 losses ($16,000) exceed the Section 1231 actual filing status then or now. Those born after 1935 gains (none), the loss is treated as an ordinary loss do not qualify for averaging. The form is shown on the not subject to the capital loss limitations. Hence, the following page. entire amount will be deducted from Jeremy’s gross income, leaving an adjusted gross income of $4,000 ($20,000 - $16,000). EXAMPLE: Assume the same facts as in the previous example, but that, in addition, Jeremy’s residence, which he had occupied for 30 years, was condemned by the city for a street-widening project. The con- demnation award he received in July 2008 left him with a recognized gain of $18,000. Now the Section 1231 gain ($18,000) exceeds the Section 1231 loss ($16,000); the net gain is treated as a long-term capital gain. Accordingly, Jeremy will show adjusted gross income of $22,000 ($20,000 ordinary income plus $2,000 net long-term capital gain). ¶1610 214 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E OMB No. 1545-0193 Form 4972 Tax on Lump-Sum Distributions 2008 f (From Qualified Plans of Participants Born Before January 2, 1936) Department of the Treasury Attachment (99) Attach to Form 1040, Form 1040NR, or Form 1041. 28 o Internal Revenue Service Sequence No. Name of recipient of distribution Identifying number Part I 1 s 8 Complete this part to see if you can use Form 4972 a 0 Was this a distribution of a plan participant’s entire balance (excluding deductible voluntary employee Yes No ft 20 contributions and certain forfeited amounts) from all of an employer’s qualified plans of one kind (pension, profit-sharing, or stock bonus)? If “No,” do not use this form 1 2 Did you roll over any part of the distribution? If “Yes,” do not use this form 2 ra 5/ 3 Was this distribution paid to you as a beneficiary of a plan participant who was born before January 2, 1936? 3 D /0 4 Were you (a) a plan participant who received this distribution, (b) born before January 2, 1936, and (c) a participant in the plan for at least 5 years before the year of the distribution? 4 If you answered “No” to both questions 3 and 4, do not use this form. 5a Did you use Form 4972 after 1986 for a previous distribution from your own plan? If “Yes,” do not use this 6 form for a 2008 distribution from your own plan 5a 0 b If you are receiving this distribution as a beneficiary of a plan participant who died, did you use Form 4972 for a previous distribution received for that participant after 1986? If “Yes,” do not use the form for this distribution 5b Part II Complete this part to choose the 20% capital gain election (see instructions) 6 Capital gain part from Form 1099-R, box 3 6 7 Multiply line 6 by 20% (.20) 7 If you also choose to use Part III, go to line 8. Otherwise, include the amount from line 7 in the total on Form 1040, line 44, Form 1040NR, line 41, or Form 1041, Schedule G, line 1b, whichever applies. Part III Complete this part to choose the 10-year tax option (see instructions) 8 Ordinary income from Form 1099-R, box 2a minus box 3. If you did not complete Part II, enter the taxable amount from Form 1099-R, box 2a 8 9 Death benefit exclusion for a beneficiary of a plan participant who died before August 21, 1996 9 10 Total taxable amount. Subtract line 9 from line 8 10 11 Current actuarial value of annuity from Form 1099-R, box 8. If none, enter -0- 11 12 Adjusted total taxable amount. Add lines 10 and 11. If this amount is $70,000 or more, skip lines 13 through 16, enter this amount on line 17, and go to line 18 12 13 Multiply line 12 by 50% (.50), but do not enter more than $10,000 13 14 Subtract $20,000 from line 12. If line 12 is $20,000 or less, enter -0- 14 15 Multiply line 14 by 20% (.20) 15 16 Minimum distribution allowance. Subtract line 15 from line 13 16 17 Subtract line 16 from line 12 17 18 Federal estate tax attributable to lump-sum distribution 18 19 Subtract line 18 from line 17. If line 11 is zero, skip lines 20 through 22 and go to line 23 19 20 Divide line 11 by line 12 and enter the result as a decimal (rounded to at least three places) 20 . 21 Multiply line 16 by the decimal on line 20 21 22 Subtract line 21 from line 11 22 23 Multiply line 19 by 10% (.10) 23 24 Tax on amount on line 23. Use the Tax Rate Schedule in the instructions 24 25 Multiply line 24 by ten (10). If line 11 is zero, skip lines 26 through 28, enter this amount on line 29, and go to line 30 25 26 Multiply line 22 by 10% (.10) 26 27 Tax on amount on line 26. Use the Tax Rate Schedule in the instructions 27 28 Multiply line 27 by ten (10) 28 29 Subtract line 28 from line 25. Multiple recipients, see instructions 29 30 Tax on lump-sum distribution. Add lines 7 and 29. Also include this amount in the total on Form 1040, line 44, Form 1040NR, line 41, or Form 1041, Schedule G, line 1b, whichever applies 30 For Paperwork Reduction Act Notice, see instructions. Cat. No. 13187U Form 4972 (2008) ¶1610 PA R T 2 — C H A P T E R 1 6 — C a p i t a l G a i n s a n d L o s s e s 215 If an individual had been covered by his employer’s PRACTICE POINTER: States are not permitted to tax retirement plan before 1974, the part of a distribution pensions payable to nonresidents. from the plan that applies to the pre-1974 coverage is treated as long-term capital gain if such individual was born before 1936 and an election is made. This portion ¶1611 Wash Sales (Sec. 1091) is then taxed at a rate of 20% (the 15% capital gain rate A former common practice of taxpayers whose stocks applicable to other gains does not apply here). had declined in value was to sell such shares at a loss and Definition of “lump-sum distribution.” A “lump-sum immediately thereafter buy the same stock in the hope distribution” is a distribution made within 1 tax year that its value would again increase. This enabled taxpay- of an employee’s entire account balance from all of ers to claim the loss on their income tax returns and, in the employer’s qualified pension, stock bonus, or prof- effect, hold on to the stock. Moreover, if the stock then it-sharing plans. Also, the distribution must be paid on appreciated, the gain was usually taxable as a long-term account of separation from service, death, disability, or capital gain. Congress closed this loophole with a special attaining age 59½. In the case of a self-employed person provision prohibiting the deduction of a loss incurred in who receives a distribution, it must be paid on account a “wash sale.” A wash sale occurs when, within 30 days of death, disability, or attaining age 59½. before or after the sale of stock, stock options, or secu- rities at a loss, a taxpayer (or the taxpayer’s spouse or a Lump-sum treatment applies only to an employee who corporation controlled by them) contracts to buy, or has been a plan participant for 5 years or more before buys, substantially identical stock or securities. the tax year in which the payment is made. However, the 5-year plan participation requirement does not require PITFALL: The wash sale rule applies when a security 5 full years. The requirement is satisfied if there is any in a taxable portfolio is sold at a loss and, within the participation within the 5 years. wash sale period, the taxpayer causes his tax-deferred account (e.g., a traditional IRA) to acquire a substan- If an employee receives a lump-sum distribution that tially identical security. Furthermore, the individual’s includes securities in the employer’s company, these basis in the IRA or Roth IRA will not be increased. securities may have increased in value while in trust. The employee is not taxed on the increase at the time Substantially identical securities. Shares of stock in the securities are distributed, but rather when they are the same company are treated as “substantially identi- exchanged or sold. cal securities.” Thus, for example, a sale and a purchase of IBM stock are considered substantially identical PRACTICE POINTER: Tax on receipt of a lump-sum securities; a sale of IBM stock and a purchase of Apple distribution need not be paid immediately. It can be stock are not. Bonds of the same obligor are treated as deferred by making a rollover to an IRA within 60 days substantially similar securities only if they carry the same of receipt of the distribution. See ¶2909. However, a distribution not rolled over directly to another qualified interest rate. Different maturity dates make securities plan or IRA is subject to a 20% withholding rate. not substantially similar only if they have economic significance. For example, a difference of several years may be viewed as being economically significant. PITFALL: If part of a lump-sum distribution is rolled If the wash sale rules apply, the nonrecognized loss is over to an IRA, the remaining portion does not qualify added to the basis of the newly acquired stock or securi- for special averaging. ties and will thus reduce any taxable gain (or will increase any loss) on a subsequent sale. Distributions from retroactively disqualified plans. The tax status of the plan at the time of distribution governs the tax treatment of the distribution. If the plan is disqualified retroactively, then all of the distribution is treated as coming from a nonqualified plan (i.e., all of the distribution is currently taxable; there is no special treatment). ¶1611 216 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E EXAMPLE: Jim Abbott owns 100 shares of ABC EXAMPLE: In June 2007, Frank O’Brien contracts stock, for which he originally paid $5,000, but which to sell “short” 100 shares of XYZ stock at $50 per is now worth considerably less. On February 1, he share. Because he owns no XYZ stock, he borrows sells the stock at $2,000 and, believing that it will it from his broker. In July 2008, when the price of increase again in value, he repurchases identical XYZ has fallen to $40, he purchases 100 shares and stock on February 20 for $1,850. The $3,000 loss on immediately delivers them to his broker to repay his the sale is not deductible but will increase the basis debt, thereby closing out the short sale. His gain of of the new stock from $1,850 to $4,850 ($1,850 $10 per share (minus expenses) is a short-term capi- $3,000). Hence, if he later sells this stock for $6,000, tal gain because the holding period of the delivered his taxable gain would only be $1,150 ($6,000 property does not exceed 12 months. $4,850), even though he actually paid $1,850. The following rules apply when property substantially identical to that sold short (1) has been held by the PRACTICE POINTER: Remember that this “wash taxpayer on the date of the short sale for 12 months or sale” rule applies only to stock and securities less or (2) is acquired by the taxpayer after the short sale transactions resulting in a loss. Any gain on such a and/or before the date of the closing: transaction is fully recognized. Substantially identi- cal securities can be acquired immediately without Rule 1. Any gain on the closing of a short sale is con- affecting tax treatment of the gain. sidered a short-term capital gain. In line with the reasoning that the new securities are Rule 2. The holding period of substantially identical merely an identical replacement of the old, the holding property begins with the date of closing a short sale. period of the new securities includes the holding period Constructive sale treatment on appreciated financial of the old securities. positions. Sales of certain financial positions (such The wash sale rules do not apply to securities dealers as “selling short against the box” and other hedging or floor traders who trade for their own accounts. The positions) on or after June 8, 1997, may be treated as wash sale rules apply to all nondealers even if the loss constructive sales. These rules are highly complex and is from a transaction made in the ordinary course of a beyond the scope of this book. No losses can be recog- trade or business. nized on these positions. ¶1612 Short Sales (Sec. 1233) ¶1613 Options Purchased as an Exchange (Sec. 1234) A short sale occurs when the seller borrows the property (usually securities) delivered to the purchaser and later Income from the lapse of an option is treated as a short- either purchases substantially identical securities and term capital gain, except for options written by taxpayers delivers them to the lender or makes delivery out of such in the ordinary course of their trade or business. In the securities held by the seller at the time of the sale. latter case, the gain will be treated as ordinary income. A short sale is not considered as closed until the EXAMPLE: Nick Bronson purchases 100 shares of “borrowed” securities are repaid. Thus, the holding stock at $200 per share as an investment and writes a period is normally determined by the length of time that call on the stock at that price in return for a premium the seller holds the securities delivered to the lender in of $1,000. The stock declines, and the call purchaser closing the sale. lets his option lapse because it is worthless. The call writer will have a short-term capital gain of $1,000 on the lapsed option and, if he sells his stock at $190 per share, he will have a capital loss of $1,000 on that transaction. Employee stock options are discussed in ¶602A. ¶1612 PA R T 2 — C H A P T E R 1 6 — C a p i t a l G a i n s a n d L o s s e s 217 ¶1614 Cancellation or Sale of Leases Temporary regulations detail how to elect capital gain (Sec. 1241) treatment for self-created musical works (T.D. 9379, 02/07/2008). Payments received by a landlord for cancellation of a lease are treated as ordinary income, not as capital gains. Under final regulations, loss on the abandonment of securities is a capital loss and not an ordinary loss; the Treatment of payments received by a tenant for the sale loss is treated as occurring on the last day of the year if of a lease depends on the type of lease in question. If the proposed amendments to regulations are adopted (T.D. lease is used in the tenant’s trade or business, the gain or 9386 3/11/08, corrected 3/24/08). loss would be treated under Section 1231. If the lease is for the tenant’s home, a gain would be taxed as a capital Stock-trading losses were deductible only as short-term gain, but any loss would not be deductible. capital losses (not ordinary losses) because the taxpayers were investors (Acharya, CA-7, 2007-1 USTC ¶50,300; ¶1615 Recent Developments Affecting see also Jaime, TC Memo 2007-22). Capital Gains and Losses The wash sale rule applies if replacement securi- For further information on capital gains and losses, ties are bought in an IRA (Rev. Rul. 2008-5, IRB see IRS Publication 544, Sales and Other Disposi- 2008-3, 271). tions of Assets. ¶1615 PART 3 Deductions for Business and Other Special Deduction Rules 17 PART 3 — DEDUCTIONS FOR BUSINESS AND OTHER SPECIAL DEDUCTION RULES Business Deductions LEARNING OBJECTIVES C, if they meet certain requirements. To use this form, the taxpayer must: This chapter was prepared to enable participants to gain a general understanding of reporting business Have business expenses of $5,000 or less deductions. More specifically, upon completion, you Use the cash method of accounting will be able to: Not have any inventory or employees Not have a net loss from the business Complete Schedule C or C-EZ. Have had only the single business Understand the deduction for domestic production Not be required to file Form 4562, Depreciation and activities. Amortization Understand the vacation home rules. Not deduct expenses for business use of home Not have prior year disallowed passive activity losses NEW THIS YEAR Family businesses. Spouses who file jointly, co-own Election to amortize organizational costs. The a business, and each work in it can choose not to file IRS no longer requires taxpayers to attach a a partnership return, Form 1065, and two Schedule statement to tax returns for the election to deduct $5,000 in organizational costs or start-up costs K-1s. Instead, they each file a separate Schedule C and and amortize the excess costs to be effective. report their shares of net earnings for self-employment This new rule is in place for costs incurred after tax purposes. September 8, 2008. See ¶1705 and ¶2207. To determine net profit, all receipts from sales, fees, or other sources should be totaled. Then, all allowable ¶1701 Trade and Business: General Rule expenses and other deductions are deducted from that total. To be deductible, expenses must be “ordinary and Taxpayers engaged in a trade, business, or profession necessary” to carry on the trade or business. The expenses must include in adjusted gross income any net profit must be directly related to, or connected with, the trade, (or loss) derived from operating that trade, business, or business, or profession, and must have been paid (if the profession. Schedule C is filed by sole proprietorships, taxpayer is on the cash basis) or incurred (if the taxpayer spouses in a family business (see below), and one-member is on the accrual basis) during the taxable year. limited liability companies that have not elected to be taxed as corporations. The net profit is computed on The timing of when to claim a deduction depends on a Schedule C (shown on the following pages), which is taxpayer’s method of accounting. See ¶2803–2809. attached to the taxpayer’s Form 1040. Net profit not only is the amount of earnings included Taxpayers who operate a business or practice a profes- in gross income. It is also the figure used to determine sion as a sole proprietorship may file Schedule C-EZ self-employment tax (see Chapter 26). (shown on the following pages), rather than Schedule ¶1701 222 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E OMB No. 1545-0074 SCHEDULE C Profit or Loss From Business (Form 1040) (Sole Proprietorship) 2008 f Partnerships, joint ventures, etc., generally must file Form 1065 or 1065-B. Department of the Treasury Attachment Attach to Form 1040, 1040NR, or 1041. See Instructions for Schedule C (Form 1040). 09 o Internal Revenue Service (99) Sequence No. Name of proprietor Social security number (SSN) A C s 8 Principal business or profession, including product or service (see page C-2 of the instructions) a 0 Business name. If no separate business name, leave blank. B Enter code from pages C-8, 9, & 10 D Employer ID number (EIN), if any E F Business address (including suite or room no.) City, town or post office, state, and ZIP code Accounting method: (1) Cash ft 20 ra 0/ (2) Accrual (3) Other (specify) D /1 G Did you “materially participate” in the operation of this business during 2008? If “No,” see page C-3 for limit on losses Yes No H If you started or acquired this business during 2008, check here Part I Income 1 Gross receipts or sales. Caution. See page C-3 and check the box if: 2 was checked, or subject to self-employment tax Returns and allowances 06 ● This income was reported to you on Form W-2 and the “Statutory employee” box on that form ● You are a member of a qualified joint venture reporting only rental real estate income not 1 2 3 3 Subtract line 2 from line 1 4 Cost of goods sold (from line 42 on page 2) 4 5 Gross profit. Subtract line 4 from line 3 5 6 Other income, including federal and state gasoline or fuel tax credit or refund (see page C-3) 6 7 Gross income. Add lines 5 and 6 7 Part II Expenses. Enter expenses for business use of your home only on line 30. 8 Advertising 8 18 Office expense 18 9 Car and truck expenses (see 19 Pension and profit-sharing plans 19 page C-4) 9 20 Rent or lease (see page C-5): 10 Commissions and fees 10 a Vehicles, machinery, and equipment 20a 11 Contract labor (see page C-4) 11 b Other business property 20b 12 Depletion 12 21 Repairs and maintenance 21 22 Supplies (not included in Part III) 22 13 Depreciation and section 179 23 Taxes and licenses 23 expense deduction (not included in Part III) (see page 24 Travel, meals, and entertainment: C-4) 13 a Travel 24a 14 Employee benefit programs b Deductible meals and (other than on line 19) 14 entertainment (see page C-6) 24b 15 Insurance (other than health) 15 25 Utilities 25 16 Interest: 26 Wages (less employment credits) 26 a Mortgage (paid to banks, etc.) 16a 27 Other expenses (from line 48 on b Other 16b page 2) 27 17 Legal and professional services 17 28 Total expenses before expenses for business use of home. Add lines 8 through 27 28 29 Tentative profit or (loss). Subtract line 28 from line 7 29 30 Expenses for business use of your home. Attach Form 8829 30 31 Net profit or (loss). Subtract line 30 from line 29. ● If a profit, enter on both Form 1040, line 12, and Schedule SE, line 2, or on Form 1040NR, line 13 (if you checked the box on line 1, see page C-7). Estates and trusts, enter on Form 1041, 31 line 3. ● If a loss, you must go to line 32. 32 If you have a loss, check the box that describes your investment in this activity (see page C-7). ● If you checked 32a, enter the loss on both Form 1040, line 12, and Schedule SE, line 2, or on 32a All investment is at risk. Form 1040NR, line 13 (if you checked the box on line 1, see page C-7). Estates and trusts, enter 32b Some investment is not on Form 1041, line 3. at risk. ● If you checked 32b, you must attach Form 6198. Your loss may be limited. For Paperwork Reduction Act Notice, see page C-8 of the instructions. Cat. No. 11334P Schedule C (Form 1040) 2008 ¶1701 PA R T 3 — C H A P T E R 1 7 — B u s i n e s s D e d u c t i o n s 223 Schedule C (Form 1040) 2008 Page 2 Part III Cost of Goods Sold (see page C-7) 33 Method(s) used to value closing inventory: a Cost o f b Lower of cost or market c Other (attach explanation) as 08 34 Was there any change in determining quantities, costs, or valuations between opening and closing inventory? If “Yes,” attach explanation Yes No ft 20 35 Inventory at beginning of year. If different from last year’s closing inventory, attach explanation 35 36 ra 0/ 36 Purchases less cost of items withdrawn for personal use 37 Cost of labor. Do not include any amounts paid to yourself 37 38 39 Materials and supplies Other costs D /1 38 39 40 41 42 Add lines 35 through 39 Inventory at end of year 06 Cost of goods sold. Subtract line 41 from line 40. Enter the result here and on page 1, line 4 40 41 42 Part IV Information on Your Vehicle. Complete this part only if you are claiming car or truck expenses on line 9 and are not required to file Form 4562 for this business. See the instructions for line 13 on page C-4 to find out if you must file Form 4562. 43 When did you place your vehicle in service for business purposes? (month, day, year) / / 44 Of the total number of miles you drove your vehicle during 2008, enter the number of miles you used your vehicle for: a Business b Commuting (see instructions) c Other 45 Was your vehicle available for personal use during off-duty hours? Yes No 46 Do you (or your spouse) have another vehicle available for personal use? Yes No 47a Do you have evidence to support your deduction? Yes No b If “Yes,” is the evidence written? Yes No Part V Other Expenses. List below business expenses not included on lines 8–26 or line 30. 48 Total other expenses. Enter here and on page 1, line 27 48 Printed on recycled paper Schedule C (Form 1040) 2008 ¶1701 224 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E OMB No. 1545-0074 SCHEDULE C-EZ Net Profit From Business (Form 1040) (Sole Proprietorship) 2008 f Partnerships, joint ventures, etc., generally must file Form 1065 or 1065-B. Department of the Treasury Attachment Attach to Form 1040, 1040NR, or 1041. See instructions on back. 09A o Internal Revenue Service (99) Sequence No. Name of proprietor Social security number (SSN) Part I General Information s 8 a 0 ft 20 ● Had business expenses of $5,000 or ● Had no employees during the year. less. ● Are not required to file Form 4562, ra 0/ You May Use Depreciation and Amortization, for ● Use the cash method of accounting. Schedule C-EZ this business. See the instructions Instead of ● Did not have an inventory at any for Schedule C, line 13, on page D /1 Schedule C time during the year. C-4 to find out if you must file. And You: Only If You: ● Did not have a net loss from your ● Do not deduct expenses for business. business use of your home. ● Had only one business as either a ● Do not have prior year unallowed 6 sole proprietor, qualified joint passive activity losses from this venture, or statutory employee. business. A C 0 Principal business or profession, including product or service Business name. If no separate business name, leave blank. B Enter code from pages C-8, 9, & 10 D Employer ID number (EIN), if any E Business address (including suite or room no.). Address not required if same as on page 1 of your tax return. City, town or post office, state, and ZIP code Part II Figure Your Net Profit 1 Gross receipts. Caution. See the instructions for Schedule C, line 1, on page C-3 and check the box if: ● This income was reported to you on Form W-2 and the “Statutory employee” box on that form was checked, or ● You are a member of a qualified joint venture reporting only rental real estate income not subject to self-employment tax 1 2 Total expenses (see instructions on page 2). If more than $5,000, you must use Schedule C 2 3 Net profit. Subtract line 2 from line 1. If less than zero, you must use Schedule C. Enter on both Form 1040, line 12, and Schedule SE, line 2, or on Form 1040NR, line 13. (If you checked the box on line 1, do not report the amount from line 3 on Schedule SE, line 2.) Estates and trusts, enter on Form 1041, line 3 3 Part III Information on Your Vehicle. Complete this part only if you are claiming car or truck expenses on line 2. 4 When did you place your vehicle in service for business purposes? (month, day, year) / / . 5 Of the total number of miles you drove your vehicle during 2008, enter the number of miles you used your vehicle for: a Business b Commuting (see instructions) c Other 6 Was your vehicle available for personal use during off-duty hours? Yes No 7 Do you (or your spouse) have another vehicle available for personal use? Yes No 8a Do you have evidence to support your deduction? Yes No b If “Yes,” is the evidence written? Yes No For Paperwork Reduction Act Notice, see page 2. Cat. No. 14374D Schedule C-EZ (Form 1040) 2008 ¶1701 PA R T 3 — C H A P T E R 1 7 — B u s i n e s s D e d u c t i o n s 225 STUDY QUESTION who devotes a substantial part of his time to it. Thus, an individual can be engaged in more than one trade 1. Which of the following is not a requirement for or business at the same time. On the other hand, if a using Schedule C-EZ instead of Schedule C? taxpayer merely holds securities or other property for a. Filed Schedule C-EZ in the prior year investment purposes, although he devotes some time b. Have no employees to their management, the taxpayer is not considered c. Have business expenses of $5,000 or less as being engaged in a trade or business. In some cases, the ownership and management of rental property can be considered a trade or business. Expenses incurred in NOTE: Answers to Study Questions, with feedback to connection with mere investment activities are deduct- both the correct and incorrect responses, are provided ible only as itemized deductions. in Chapter 35, beginning with ¶3517. ¶1705 Examples of Common Ordinary and ¶1702 Ordinary and Necessary Necessary Business Expenses Unless otherwise covered by a specific section of the Tax The following is a list of some of the most common Code, a business expense is deductible if it is “ordinary allowable business expenses. Bear in mind that this listing and necessary.” An expense is considered “ordinary” if is merely intended as a guide to what type of expense incurring it is a common and accepted practice in the is deductible: taxpayer’s field of business. It is considered “necessary” if Wages and salaries it is appropriate and helpful in developing and maintain- Repairs ing the trade or business. Thus, an expense need not be Rents paid essential or indispensable in order to be deductible. Traveling expenses ¶1703 Reasonableness of Salaries Meals, entertainment, and business gifts Advertising In addition to being ordinary and necessary, the amount Insurance premiums expended for salaries must be reasonable in relation to the Cost of prizes awarded in contests services performed. The courts have disallowed excessive Commissions paid compensation paid to members of a taxpayer’s family, con- Dues to business or professional organizations sidering this a mere device to spread taxable income among Expenses incurred in attending business conventions many people. The regulations define “reasonable compen- Accounting and bookkeeping fees (including return pre- sation” as an amount that would ordinarily be paid for like parer fees allocable to Schedule C or Schedule C-EZ) services by like enterprises under like circumstances. Legal fees In determining whether salaries are reasonable, many fac- Bank, merchant authorization, credit card discounts, tors are taken into account, the most important of which and PayPal fees are the nature of the services rendered, the salaries paid in Bad debts from reported sales or services (accrual prior years for the same type of work, whether the salary is taxpayers only) on a contingent basis (a larger amount may be reasonable Employee benefit programs if the compensation is contingent), and the amount the Postage and freight charges employee would have obtained from another employer Cost of moving business to a new location for the same work. Courts have also used a “hypothetical Stationery and printing investor” test to decide if compensation is reasonable, that Licenses and regulatory fees is, whether an investor in the company thinks the payment Penalties for nonperformance of a contract is reasonable, allowing for a return to the investor. Heat, light, power, telephone, Internet access, and other utility costs ¶1704 What Constitutes a Trade or Business? Depreciation A taxpayer is considered as being “engaged in a trade or Start-up expenses. Expenses incurred to decide whether to business” if the activity is one entered into with at least go into business and which business to enter can be expensed the expectation of making a profit and the taxpayer up to $5,000; the balance is amortized over a period of devotes a substantial part of his business time to it, or if 180 months. If the start-up expenses exceed $50,000, the the taxpayer operates it through an agent or employee immediate deduction is reduced dollar for dollar, so that no ¶1705 226 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E immediate deduction can be claimed if start-up costs exceed Fines and penalties for violating the law, such as traffic $55,000. Start-up costs incurred before October 23, 2004, fines or penalties for building violations, are nonde- continue to be amortized over a period of 60 months if an ductible even where incurred in connection with the amortization election was made. See ¶2207. taxpayer’s trade or business, and even though the viola- tion was inadvertent. Lobbying expenses incurred to appear before congressional or legislative committees, or before senators, congressmen, or Home phone service. A taxpayer who uses the tele- state legislators, or to submit statements are not deductible. phone in his residence for business or income produc- However, a deduction is allowed for in-house expenditures tion purposes may not deduct the base charge for local not exceeding $2,000. In-house expenditures are expen- telephone service (e.g., charges required to be paid to ditures paid or incurred to influence legislation, or direct obtain local telephone service for the first telephone line communications with a covered executive branch official in in the taxpayer’s residence). an attempt to influence the official’s actions or positions. Interest on tax deficiencies. Interest on a tax deficiency Advertising expenses are deductible if they are reason- related to business income and expenses reported on able and bear a reasonable relationship to the taxpayer’s Schedule C, E, or F is not deductible. business activities. Such expenses are not deductible if made to promote or defeat legislation. Expenditures Commercial landlord. An owner of a commercial for “institutional” or “goodwill” advertising to keep the building can deduct $1.80 per square foot (or 60¢ taxpayer’s name before the public are generally deductible per square foot) for meeting certain energy standards as ordinary and necessary business expenses. through 2013. Donations to business organizations, as well as advertise- ments in charity-sponsored journals, newspapers, and so on, ¶1705A Current Expenses Versus Capital are deductible as business expenses if made with reasonable Expenses (Sec. 162 and Sec. 263) expectation of financial return commensurate with the It is necessary to distinguish between capital expenditures amount of the donation. Donations to tax-exempt organiza- and current expenses because capital expenditures are not tions that are made with no expectation of financial return deductible but may be recovered through depreciation are an owner’s personal charitable contributions claimed on over a period of years. his Schedule A to the extent allowed there. A capital expenditure represents an investment of capital Bribes and kickbacks. No deduction may be claimed either to acquire property having a useful life of more for any payment, direct or indirect, to a person if the than 1 year or to increase the value of such property or to payment is an illegal bribe or an illegal kickback under prolong its life. Examples of capital expenditures include a U.S. law or any state law that is generally enforced. the costs of acquiring a plant or production, building an To be “illegal,” it must subject a taxpayer to a criminal addition to an existing structure, installing a new roof, penalty or the loss of a license, but it is not necessary installing a new heating system, and installing new eleva- that criminal prosecution or license loss actually occur. tors. Commissions and legal fees incurred in buying or The IRS has the burden of proving that the challenged constructing property are also capital expenditures. payment is an illegal bribe or kickback. The area in which the distinction between capital and There is no deduction for Medicare kickbacks, but here current expenses is of particular importance is where illegality is not relevant, and the IRS has no special money is expended on repairs, replacements, or improve- burden of proof. ments. The latter two are capital expenditures that can be recovered (if at all) only through depreciation, while PRACTICE POINTER: The legality of certain pay- the former is an expense that entitles the taxpayer to a ments made to foreign government officials is deter- full current deduction. mined solely under the Foreign Corrupt Practices Act. Thus, a payment that is not prohibited by FCPA, but A “repair” is defined as an expenditure made to main- is classified as illegal under another federal law, is tain the taxpayer’s business property in an ordinary, deductible as a business expense. efficient operating condition, whereas an improvement materially adds to the value or utility of the property ¶1705A PA R T 3 — C H A P T E R 1 7 — B u s i n e s s D e d u c t i o n s 227 or appreciably prolongs its useful life. Examples of must be applied to all expenditures for that particular repairs are patching and repairing floors, repainting the research project unless permission to change the method insides and outsides of buildings, repairing roofs and is obtained. gutters, and mending leaks. This special provision does not apply to land or to depre- Expenditures for replacements of parts of a machine, ciable property used for research or development work. merely to maintain it in efficient operating condition, are deductible as repairs. However, if the machine is EXAMPLE: In the current year, the XYZ Company extensively overhauled, it is considered an improvement builds and equips a research laboratory at a cost and should be capitalized. Other examples of capital of $150,000. The operating and other expenses, items are new electric wiring, new roofs, new floors, new including depreciation, amount to $60,000. Only the plumbing, and lighting improvements. $60,000 is deductible in the current year. The cost of the laboratory must be capitalized and can be The IRS warns that taxpayers who make both repairs recovered only through amortization. and improvements at the same time should segregate the repair and improvement items; otherwise, capitalization of the entire cost may be required. Instead of deducting research costs, the taxpayer may claim a research credit for 2008. See ¶1111. Environmental cleanup. It is not always easy to deter- mine whether the cost of environmental cleanup is ¶1707 Carrying Charges, Interest, currently deductible or must be capitalized. Generally, and Taxes on Real Estate (Sec. 266) when the cost is to restore the property to its pre- Landowners have the option to capitalize real estate contamination condition, those restoration costs can be taxes, mortgage interest, and deductible carrying charges expensed; otherwise, they must be capitalized. on unimproved and unproductive real estate, instead Under a special rule in effect for expenses paid or of currently deducting these expenses. This election is incurred in 2008 and 2009, a business can elect to made each year. expense the cost of environmental remediation. This Taxpayers engaged in real estate development or the con- election applies only to certain hazardous substances struction business usually must capitalize loan interest, and requires that the state environmental agency must carrying charges and taxes, such as federal and state unem- certify the need for cleanup. Petroleum products are ployment and Social Security taxes on the wages of their treated as hazardous substances. employees, as well as state and local sales taxes. However, capitalization may be made only for those expenses paid NOTE: The expensing option for environmental or incurred up to the time the work was completed. cleanup costs expires at the end of 2009 unless Congress extends it. ¶1708 Income and Expenses Attributable to Rents and Royalties If a taxpayer derives income from rents and royalties, ¶1706 Research and Development all gross rents or gross royalties received are includible Expenditures (Sec. 174) in gross income, and all expenses incurred in connec- If taxpayers incur research and development expenses tion with earning the rents and royalties are deductible (R & D) in connection with their trade or business, from gross income in computing adjusted gross income the question of whether such expenditures should be (above-the-line expenses). Such expenses are deductible deducted or capitalized is presented. Because of the diffi- from gross income, even though the taxpayer is not in the culties sometimes involved in making this determination, trade or business of renting property. This constitutes one and also as a means of encouraging research, Congress of the few exceptions to the rule that only trade or busi- has enacted a special provision permitting the taxpayer ness expenses may be deducted from gross income. to elect either to deduct research and development costs currently or to amortize the cost over a period of 60 months or more. Whichever method the taxpayer elects ¶1708 228 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E If any part of the expenditures is made solely for the EXAMPLE: Bruce Jenkins received $1,200 monthly benefit of the tenants, that amount is, of course, entirely from the rental of a one-family home. His deductions in connection with the rented house were as follows: deductible. taxes, $4,800; mortgage interest, $7,200; repairs, $450; depreciation, $1,540; and miscellaneous EXAMPLE: Assume the same facts as in the previous expenses, $250. Assuming that he earned $36,500 example, except that Fred, in addition to the above in salary, his adjusted gross income is computed as expenses, pays $3,000 for having the outside of the follows: apartment painted. The income would be computed Salary . . . . . . . . . . . . . . . . . . . . . . . . . . . . as follows: $36,500 Rental income . . . . . . . . . . . . . . . . . . . . . $14,400 Salary . . . . . . . . . . . . . . . . . . . . $30,000 Less: Expenses incurred Gross income from rents . . . . . $26,000 in producing the rental income. . . . . . $14,240 Allocable expenses . . . . . . . . . $32,000 Net income from rents . . . . . . . . . . . . . . . 160 Less ¼ for personal use. . . . 8,000 Adjusted gross income. . . . . . . . . . . . $36,660 $24,000 Painting expense . . . . . . . . . . . 3,000 The gross income in the above case is $50,900 Total amount deductible ($36,500 salary plus $14,400 gross rent). from gross income . . . . . . . . . . 27,000 Net income from rents (loss) . . (1,000) Adjusted gross income . . . . $29,000 However, expenses in excess of rental income may not be currently deductible under the passive loss limitation rules. See ¶709A. Note from the above example that, just as a net profit from rents is added to other income in computing If part of the income-producing property is occupied adjusted gross income, a net loss is deducted and will thus by the taxpayers for their personal residence, only a reduce the adjusted gross income (if the loss is allowable proportionate part of the expenses may be deducted. As under the passive loss rules). previously discussed, an allocation may be made under any one of several methods. PITFALL: Rental expenses may not be currently deductible. Rental losses are limited by the passive loss rules. See ¶709 and ¶709A. EXAMPLE: Fred Barton earns a $30,000 annual sal- ary. He owns a four-family house, where he occupies one apartment and rents out the other three at a PRACTICE POINTER: Taxpayers who actively par- total yearly rental of $26,000. All apartments are ticipate in a rental real estate activity may be able to of approximately equal size and rental value. His deduct losses in excess of income, up to a maximum expenditures for interest, taxes, heat, repairs, depre- of $25,000. However, the allowance is phased out ciation, etc. amounted to $32,000. The net income for adjusted gross income over $100,000 and is from rents and the adjusted gross income would be completely lost when adjusted gross income exceeds determined as follows: $150,000. Married couples must file jointly to claim the $25,000 allowance. Salary . . . . . . . . . . . . . . . . . . . . . $30,000 Gross rents . . . . . . . . . . . . . . . . . $26,000 Rental income and expenses generally are reported on Total deductions . . . . . . . . . . . . $32,000 Schedule E. However, if rental activities constitute a trade Less ¼ for personal use . . . . 8,000 or business, then income and expenses are reported on Amount deductible Schedule C or Schedule C-EZ. Similarly, royalties and from gross income . . . . . . . . . . . 24,000 Net income from rents . . . . . . . . related expenses generally are reported on Schedule E. 2,000 Adjusted gross income . . . . . However, royalties related to a trade or business, and oil $32,000 and gas working interests are reported on Schedule C or Schedule C-EZ. For example, an investor reports oil and gas royalties on Schedule E, but a freelance writer reports royalties from book sales on Schedule C (or C-EZ). ¶1708 PA R T 3 — C H A P T E R 1 7 — B u s i n e s s D e d u c t i o n s 229 ¶1708A Domestic Production Activities Engineering and architectural services relating to a Deduction (Sec. 199) construction project performed in the U.S. Software developed in the U.S., regardless of whether it is Effective for tax years beginning after December 31, purchased off-the-shelf or downloaded from the Internet. 2004, the domestic production activities deduction (or The term “software” includes video games. But, with the manufacturer’s deduction) is a deductible expense some de minimis exceptions, the term does not include that is designed to encourage domestic production activi- fees for online use of software, fees for customer support, ties and is expected to save businesses $76 billion in tax and fees for playing computer games online. dollars from its onset in 2005 through 2014. Like depre- ciation, it is a non-cash outlay (no actual expenditure is The deduction is limited to activities that are in whole required in order to qualify for the deduction). or “significant part” in the U.S. Under a safe harbor, labor and overhead costs incurred in the U.S. for the PRACTICE POINTER: The deduction applies for both manufacture, production, growth, and extraction of regular and alternative minimum tax purposes, so the property are at least 20% of the total cost of goods claiming it will not trigger or increase AMT liability. sold of the property. Even if a taxpayer fails to meet this safe harbor, the taxpayer can still demonstrate that the activity is “in significant part” a U.S. activity based on Eligibility. A taxpayer must be a “qualified producer” to all the facts and circumstances. claim this deduction. This includes a business engaged in any of the following activities: Figuring the deduction. For 2007, 2008, and 2009, the deduction is 6% of the lesser of the taxpayer’s tax- Selling, leasing, or licensing items manufactured, able income or qualified production activities income produced, grown, or extracted in the U.S. in whole or (QPAI). Income for this purpose is gross receipts reduced significant part (safe harbor discussed below). by certain expenses (the deduction had been 3% in Selling, leasing, or licensing films produced in the U.S. 2005 and 2006). Starting in 2010, deduction is 9% of Construction in the U.S. including both erection the lesser of the taxpayer’s taxable income or QPAI (the and substantial renovation of residential and com- 6% deduction continues to apply to oil and gas produc- mercial buildings (but not cosmetic activities, such tion). The deduction is figured on Form 8903, Domestic as painting). Production Activities Deduction. ¶1708A 230 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E Form 8903 Domestic Production Activities Deduction OMB No. 1545-1984 Department of the Treasury 2008 Attachment Internal Revenue Service Attach to your tax return. See separate instructions. Sequence No. 143 f Name(s) as shown on return Identifying number 1 2 o s 8 Domestic production gross receipts (DPGR) Allocable cost of goods sold. If you are using the small business 1 3 a 0 simplified overall method, skip lines 2 and 3 ft 20 If you are using the section 861 method, enter deductions and losses allocable to DPGR. All others, see instructions 2 3 ra 1/ 4 If you are using the small business simplified overall method, enter the amount of cost of goods sold and other deductions or losses you ratably apportion to DPGR. All others, skip line 4 4 5 6 Add lines 2 through 4 D /0 Subtract line 5 from line 1 5 6 7 8 07 Qualified production activities income from estates, trusts, and certain partnerships and S corporations (see instructions) Add lines 6 and 7. Estates and trusts, go to line 9, all others, skip line 9 and go to line 10 7 8 9 9 Amount allocated to beneficiaries of the estate or trust (see instructions) 10 Qualified production activities income. Estates and trusts, subtract line 9 from line 8, all others, enter amount from line 8. If zero or less, enter -0- here, skip lines 11 through 19, and enter -0- on line 20 10 11 Income limitation (see instructions): ● Individuals, estates, and trusts. Enter your adjusted gross income figured without the domestic production activities deduction 11 ● All others. Enter your taxable income figured without the domestic production activities deduction (tax-exempt organizations, see instructions) 12 Enter the smaller of line 10 or line 11. If zero or less, enter -0- here, skip lines 13 through 19, and enter -0- on line 20 12 13 Enter 6% of line 12 13 14 Form W-2 wages (see instructions) 14 15 Form W-2 wages from estates, trusts, and certain partnerships and S corporations (see instructions) 15 16 Add lines 14 and 15. Estates and trusts, go to line 17, all others, skip line 17 and go to line 18 16 17 Amount allocated to beneficiaries of the estate or trust (see instructions) 17 18 Estates and trusts, subtract line 17 from line 16, all others, enter amount from line 16 18 19 Form W-2 wage limitation. Enter 50% of line 18 19 20 Enter the smaller of line 13 or line 19 20 21 Domestic production activities deduction from cooperatives. Enter deduction from Form 1099-PATR, box 6 21 22 Expanded affiliated group allocation (see instructions) 22 23 Domestic production activities deduction. Combine lines 20 through 22 and enter the result here and on Form 1040, line 35; Form 1120, line 25; or the applicable line of your return 23 For Paperwork Reduction Act Notice, see separate instructions. Cat. No. 37712F Form 8903 (2008) Printed on Recycled Paper ¶1708A PA R T 3 — C H A P T E R 1 7 — B u s i n e s s D e d u c t i o n s 231 To figure the deduction, the taxpayer starts with gross the business must allocate gross receipts, cost of goods receipts from qualified domestic production activities. If sold, and related expenses from qualified production the business is entirely domestic, then all gross receipts are activities to the owners so they can claim the deduction taken into account. If the business has both domestic and on their personal returns. foreign activities, use any reasonable method to allocate gross receipts to qualified domestic activities. However, A special allocation rule applies for purposes of the 50%- under a de minimis rule, if less than 5% of total gross of-W-2 wages limitation. The allocation of this amount receipts is derived from nonqualified domestic produc- is the lower of the owner’s allocable share of wages or two tion activities, the business does not have to make any times 6% of production activities income for 2008. allocation and can treat all gross receipts as attributable Owners of pass-through entities pick up their share of to qualified domestic production activities. the deduction from Schedule K-1. Reduce these gross receipts by the cost of goods sold and related expenses. Related expenses include direct costs STUDY QUESTIONS of production, plus a portion of indirect expenses. The 2. Which of the following expenses is a deductible allocation is based on the taxpayer’s books and records business expense? if possible, or if not, on any reasonable method. Small a. Basic service charge for the first telephone businesses (those with average annual gross receipts line to a taxpayer’s home even if the phone is of $25 million or less) can use a simplified method to used in a deductible home office. allocate deductions on relative gross receipts. b. Interest on a tax deficiency related to Schedule C. Limitations on the deduction. The deduction is subject c. Business gifts (within limits). to two limitations: 3. Which costs are not currently deductible? It cannot exceed adjusted gross income for sole pro- a. Repairs prietors and owners of partnerships, limited liability b. Advertising expenses companies, or S corporations. c. Capital improvements It cannot exceed 50% of W-2 wages. W-2 wages includes both taxable compensation and elective defer- rals [e.g., employee contributions to 401(k) plans]. ¶1709 Vacation Home Rules (Sec. 280A) For purposes of the W-2 wage limitation, only wages If a taxpayer owns and rents out a vacation home or other allocable to domestic production activities are taken into dwelling unit that is also used as a residence, certain account when applying this limitation. Partners, LLC restrictions apply to rental expenses. Expenses must be members, and more-than-2% S corporation shareholders allocated between the rental use and the personal use. are allocated wages paid to determine qualified domestic For purposes of allocating expenses, any day that the unit production activities income. There are three methods is rented at a fair rental value is a day of rental use, even provided for determining W-2 income. One method if the taxpayer has personally used the unit for that day. looks to the lesser of Box 1 or Box 5 of Form W-2; the A unit is not considered used for rental during the time other alternatives are more complex. that it was held out for rent. A taxpayer is considered to use a dwelling unit as a PRACTICE POINTER: Partnerships and S corpora- residence during the tax year if he used it for personal tions can figure W-2 wages at the entity level and then allocate this to owners under certain conditions. purposes more than 14 days or more than 10% of the number of days during the tax year it is rented at a fair rental, whichever is greater. PITFALL: For S corporation shareholders, “wages” means those allocated based on shareholder owner- EXAMPLE: Vicki Ames owns a beach house. She ship and not actual wages paid to a shareholder. rented it during June and July (61 days) and used it herself in August (31 days). Vicki used the home as a residence because she used it for personal purposes Pass-through entities. For partnerships, limited liabil- for more than 14 days and more than 10% of the ity companies, and S corporations, the deduction is number of days it was rented. applied at the owner (not entity) level. This means that ¶1709 232 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E If the residence is not used for personal purposes (i.e., STUDY QUESTION personal use does not exceed the greater of 14 days or 10% of rental) but it is rented out for 15 days or more 4. With respect to the vacation home rules, which during the year, then rental expenses fall within the pas- statement is not correct? sive loss rules. See ¶709A. a. A home owner who rents out the home for less than 15 days has to report the income. Rental for less than 15 days. If a taxpayer uses the b. A home owner who rents out the home for unit as a residence and rents it for less than 15 days less than 15 days cannot deduct any mainte- during the year, no rental expenses can be deducted. nance or depreciation on the home. However, if the taxpayer itemizes deductions, he can c. A home owner who rents out a home for 15 deduct mortgage interest on a second home, taxes, and days or more and uses the home for more than 14 days or 10% of the rental period can casualty and theft losses. No rental income is included deduct expenses (other than mortgage inter- in gross income in this case. est, real estate taxes, and casualty losses) only to the extent of rental income. Deducting expenses where personal use exceeds the greater of 14 days or 10% of rental and rental is 15 days or more. Deductions (other than mortgage ¶1710 Recent Developments Affecting Business interest, property taxes, and casualty losses) cannot Deductions and Vacation Home Rules exceed rental income. A taxpayer must deduct rental expenses in the following order: (1) mortgage interest, Final regulations explain that no separate form is required real estate taxes, and casualty losses that are for rental to make the election to deduct $5,000 of start-up expenses use; (2) operating expenses, except depreciation and and organizational costs incurred after September 8, 2008, other basis adjustments; and (3) depreciation and other and to amortize excess costs (T.D. 9411, 7/7/08). basis adjustments. Comprehensive re-proposed regulations clarify when Category (1) expenses are deductible whether or not amounts to improve tangible property must be capi- there is any rental income and, thus, can produce talized (NPRM REG-168745-03, 3/10/08 (corrected a loss. Category (2) expenses are deductible only 4/9/08); IR-2008-35, 3/7/08). to the extent that rental income exceeds category Under certain conditions, partnerships and S corpora- (1) expenses. Category (2) expenses cannot produce tions can figure QPAI and W-2 wages at the entity level a loss. Category (3) expenses can be deducted only to and then allocate them to owners (Rev. Proc. 2007-23, the extent that rental income exceeds both category IRB 2007-23, 1). (1) and category (2) expenses; excess expenses cannot be deducted as a loss. The IRS has ruled that the extraction and processing of minerals is a qualified domestic production activity (Rev. Rental income and all the expenses for rental use are Rul. 2007-30, IRB 2007-21, 1277). reported on Schedule E of Form 1040. Where the vacation home expenses are subject to the passive Final regulations prevent the use of the domestic pro- loss rules, Form 8582 must also be completed. Inter- duction activities deduction for most online (“hosted”) est, taxes, and casualty and theft losses for personal computer software (T.D. 9317, 3/19/07). use of the property are deducted on Schedule A of Reimbursement by a sole proprietor of a spouse’s medical Form 1040. costs was not a deductible business expense where the Deducting expenses where personal use does not amount made the spouse’s compensation unreasonable exceed the greater of 14 days or 10% of rental days. (Francis, TC Memo 2007-33). In this situation, the vacation home rules do not apply. If the home is rented out, then expenses may be deductible For further information on business deductions, see IRS Publication 334, Tax Guide for Small Business; IRS under ordinary rental rules. See ¶1708. Publication 527, Residential Rental Property (Includ- ing Rental of Vacation Homes); IRS Publication 535, Business Expenses; IRS Publication 544, Sales and Other Dispositions of Assets; IRS Publication 583, Starting a Business and Keeping Records; and IRS Publication 587, Business Use of Your Home. ¶1710 PART 3 — DEDUCTIONS FOR BUSINESS AND OTHER SPECIAL DEDUCTION RULES Travel and Entertainment Expenses 18 LEARNING OBJECTIVES Employees. The treatment of travel and entertainment expenses by employees depends on the arrangement they have This chapter was prepared to enable participants to with their employers. If they are solely responsible for such learn the rules on deducting travel and entertainment expenses, then they are deducted as an unreimbursed busi- expenses. More specifically, upon completion, you will ness expense. Unreimbursed business expenses, along with be able to: other miscellaneous expenses, are deductible as an itemized Report deductions for travel-away-from-home costs. deduction on Schedule A only to the extent that they exceed Figure meal and entertainment deductions, including 2% of adjusted gross income. If the employer advances or applicable limitations. reimburses an employee for such expenses, then it is necessary Calculate deductions for business car use. to determine the type of arrangement involved. PITFALL: The IRS has noted that improper use of NEW THIS YEAR Schedule C by employees (other than statutory employees) to report business expenses is one of Standard mileage allowance. The IRS standard the most common errors made on individual income mileage rate for business use of a car is 50.5¢ per tax returns. mile for the first half of 2008 and 58.5¢ per mile for the second half of 2008. See ¶1806. If there is an “accountable plan” with an employer, Per diem rates. The per diem rates for certain then advances and reimburses are not includible in travel expenses, which can be used to ease sub- stantiation requirements, have changed for 2008. gross income, and expenses need not be deducted. If, See ¶1809. however, the plan is a “nonaccountable plan,” then First-year dollar limit for purchased business advances and reimbursements are includible, and gross cars, trucks, and vans. The limits reflect bonus income and expenses can be deducted as miscellaneous depreciation for 2008. See ¶1805. itemized expenses (subject to the 2%-of-adjusted- Meal limit for DOT workers. DOT workers can gross-income floor). deduct 80% of the cost of meals. See ¶1807. Accountable plans. An accountable plan is one where an employer advances or reimburses an employee for ¶1801 Deducting Travel and business expenses and: Entertainment Expenses The expenses have a business connection (there must be a Travel and entertainment expenses generally are a nexus between an employer’s “advance” and the business deductible cost of doing business. However, the way in expense that the employee is anticipated to incur); which the deduction is handled depends on a taxpayer’s The employee must substantiate reimbursed expenses employment status and, if employed, expense arrange- within a reasonable period of time; and ments with an employer. The employee must return any excess reimbursement to the employer within a reasonable time. Self-employed persons. Self-employed individuals deduct the cost of business travel and entertainment The IRS has provided safe harbor rules for determining directly from gross income. More specifically, such when returns of excess payments under reimburse- expenses are entered directly on Schedule C or Schedule ment arrangements have been made within a “reason- C-EZ and offset self-employment income. able time”: (1) advances are made within 30 days of the expense, substantiation within 60 days, and the ¶1801 234 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E return of excess advances within 120 days; or (2) at lodging, and other expenses incurred during the pleasure least quarterly, the company provides a statement of portion of the trip are nondeductible. amounts paid in excess of those substantiated, and returns are made by employees within 120 days of EXAMPLE: David Green, a school administrator, receipt of the statement. travels from New York to Miami to attend a 4-day meeting of the National Education Association. ¶1801A Travel and Transportation Expenses While there, he takes a 3-day sightseeing trip to (Sec. 162) the Everglades. The cost of his New York–Miami round trip transportation, his food and lodging, and Traveling expenses include not only the cost of trans- other incidental expenses during the 4 days spent portation (automobile, bus, cab, train, and plane fares, in Miami on business are deductible. The cost of the etc.) but also the cost of meals and lodging, as well as sightseeing trip and the food and lodging expenses other expenses incidental to the trip, such as the cost of during the other 3 days are not deductible. sample rooms, telephone, telegraph, public stenogra- phers, laundry, and cleaning. If the taxpayer travels to a destination outside the United While the cost of business travel is always deduct- States for business purposes and engages in both business ible, other travel expenses (meals and lodging, etc.) and personal activities, the transportation expenses to are deductible only if incurred while the taxpayer the destination must be allocated in proportion to the is “away from home.” The Treasury has consistently time spent for business purposes. maintained that this means away from home at least overnight and, after years of litigation, this requirement EXAMPLE: Travis Blue, an advertising copywriter, has been upheld by the Supreme Court. A taxpayer flies to Vancouver to attend a 5-day convention of cannot deduct the cost of meals on daily trips that the Direct Mail Association. After the convention do not require “sleep or rest.” Thus, an executive or is over, he takes a 10-day vacation trip throughout business owner who travels to a neighboring city and British Columbia. Assuming that he would not have returns the same evening would be entitled to deduct taken the vacation if not for the convention, he can deduct 5/15 of his New York to Vancouver round-trip only the cost of transportation, not the cost of meals transportation expenses and all expenses incurred or other traveling expenses. during the 5-day stay in Vancouver. The rest of the expenses are nondeductible. Like all other business expenses, the cost of travel is deductible only if it constitutes an “ordinary and nec- essary” business expense. Travel expenses incurred in Note, however, that the rule requiring allocation of attending a trade, business, or professional convention business expenses for part-business, part-pleasure trips or meeting are deductible if there is a sufficient rela- outside of the United States applies only to managing tionship between the taxpayer’s trade or business and executives and self-employed individuals and only if his attendance at the convention or other meeting, so (1) the trip lasted a week or less or (2) the trip lasted that the taxpayer is benefiting or advancing the inter- more than 1 week and 25% or more of the total time est of his trade or business by such attendance. The was spent on personal matters. fact that attendance is voluntary and not required by the taxpayer’s employer will not disallow the deduc- tion. If the convention is for political, social, or other EXAMPLE: Art Vance, an exporter, takes a 21-day purposes unrelated to the taxpayer’s trade or business, trip to Europe. He spends 17 days on business and 4 days on personal matters. All his traveling expenses, the expenses are not deductible. It makes no difference with the exception of those incurred during the 4 days whether the taxpayer is a self-employed individual or he spent on nonbusiness matters, are deductible an employee. because less than 25% of the time was devoted to personal matters. Part business, part personal. If the trip is part busi- ness and part pleasure, the traveling expenses will still be allowable if the trip is entirely within the United States Per diem rates for lodging, meals and incidental expenses and it can be shown that the primary purpose for the for travel are found in IRS Publication 1542, Per Diem trip was to transact business. However, the cost of meals, Rates, or at www.gsa.gov (click on “per diem rates”). ¶1801A PA R T 3 — C H A P T E R 1 8 — Tr a v e l a n d E n t e r t a i n m e n t E x p e n s e s 235 Cruise ships. A limited deduction is allowed for conven- EXAMPLE: Paul Green makes a business trip by tions held on U.S. cruise ships. The deduction is limited ship from New York to England. Assuming that the voyage takes 4 days and that the highest per diem is to $2,000 per individual each year. $200, Paul’s deduction cannot exceed $1,600 ($400 per day × 4 days). ¶1803 Temporary Jobs Away from Home The deduction for traveling expenses while away from Spouse or other travel companion. If a taxpayer’s spouse home applies only if taxpayers are away temporarily. (or other family member or companion) accompanies Thus, if they are employed at a location away from the taxpayer on a business trip, expenses attributable to home permanently, or for an indefinite period of the spouse’s travel are not deductible unless the spouse time, the IRS considers the place of their employment is also an employee of the same employer and it can be (or business) as their tax “home” and, therefore, they adequately shown that the spouse’s presence on the trip are not considered to be away from home. In other has a bona fide business purpose. The spouse’s perfor- words, “home,” for tax purposes, means the place of mance of some incidental services does not cause his the taxpayer’s principal business or employment, not expenses to qualify as deductible business expenses. where he resides. Travel expenses for a spouse, dependent, or other On the other hand, if taxpayers are on a temporary assign- person are no longer deductible unless that person is ment, or have taken temporary employment away from an employee of the person paying or reimbursing the home, their travel and living expenses at their temporary expenses, the travel is for a bona fide business purpose, place of employment (or business) are deductible. and the travel expenses of that person would otherwise be deductible. EXAMPLE: Carlos Batista has a seasonal job in New York for 8 months of the year and earns $12,000. Investment seminars. The costs of attending conven- From January through April, he holds a seasonal job tions or seminars for investment purposes are not deduct- in Florida, where he earns $5,000. Because his tax ible. Also, the deduction for expenses of travel by cruise “home” is New York, he can deduct his transportation ship or other luxury water transportation is limited to to and from Florida, as well as his living expenses twice the highest per diem generally allowed employees while there. of the federal government for travel in the United States, times the number of days in transit. If taxpayers return home from their temporary jobs or places of business during weekends, holidays, or vaca- ¶1802 Foreign Conventions [Sec. 274(h)] tion, they may deduct their traveling expenses (including Business owners and professionals may not deduct meals and lodging en route) to the extent that these do expenses for attending conventions, seminars, or not exceed the amount they would have spent for meals similar meetings held outside the North American and lodging had they stayed. area unless they establish that (1) the meetings are directly related to the active conduct of their trade or Regardless of the guidelines discussed above, no stay business or to their income-producing activity and is considered “temporary” if it extends beyond 1 year. (2) it is as reasonable for the meetings to be held out- The IRS has indicated that a break in an assignment side the North American area as within it. The North of 3 weeks or less is not a significant break that would American area means the United States, its possessions, stop the running of the 1-year period. However, a break Puerto Rico, the Trust Territory of the Pacific Islands, of 7 months or more would be considered significant. Canada, and Mexico. Also, separate infrequent or sporadic assignments may be aggregated into a single assignment for purposes of the 1-year rule under certain circumstances. Again, NOTE: The “North American area” also includes the IRS has indicated that work of no more than 35 Antigua and Barbuda, Aruba, Bahamas, Barbados, days (or part days) at a temporary location within the Bermuda, Costa Rica, Dominica, Dominican Republic, Grenada, Guyana, Honduras, Jamaica, Netherlands year would not be aggregated into a single assignment Antilles, and Trinidad and Tobago. and would be considered temporary even if the overall assignment lasts more than 1 year. ¶1803 236 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E EXAMPLE: Harry Morgan is assigned to two work EXAMPLE: Kendra McAllister, a doctor, travels projects, both of which are expected to last for between her home and her medical office, clin- 18 months. He’s required to visit one project once ics, and hospitals at which she works or performs a week (52 times a year) and the other project once services on a regular basis. Such transportation is a month (12 times a year). The assignment to the considered nondeductible commuting. However, first project is not temporary because he must travel between her office and the clinics and the spend more than 35 days there within the year and hospitals is deductible. Also, if the doctor stops off the overall assignment is more than 1 year. But the to see patients before going to her office, clinics, or second assignment is “temporary,” so travel costs hospitals, then such transportation is deductible. to and from there are deductible. If it is necessary for taxpayers to carry heavy or bulky ¶1804 Commuting Expenses tools or instruments to their jobs or businesses, the IRS The costs that taxpayers incur in commuting from their permits deduction of their automobile expenses, but only homes to their jobs or businesses are considered personal if they would not have otherwise used their autos. expenses and generally are not deductible. However, if ¶1805 Deducting Automobile Expenses they have two jobs or two places of business, they are considered, for this purpose, to be in a trade or busi- If taxpayers use their automobiles in connection with ness. The cost of traveling from the first to the second their trade or business, on behalf of their employers, or job is deductible. in connection with any other income-producing activity, all expenses incurred (including oil, gas, tires, repairs, PRACTICE POINTER: Individuals who claim home depreciation, etc.) are deductible. In many cases, however, office deductions for a home-based business activity passenger automobiles are used both for business and for (see ¶1905) can deduct the cost of going from home pleasure. If so, only a proportionate part of the expenses is to another business location (and back) because the deductible. The deductible portion is determined on the home is also a business location. basis of mileage for which the car was used for business pur- poses. Alternatively, instead of deducting actual expenses, If, for personal reasons, a taxpayer does not go directly a standard mileage rate can be used. See ¶1806. from one location to the other, he may deduct only the amount it would have cost to go directly from the first Taxpayers using actual expenses for an automobile can claim to the second job. depreciation (see ¶2104 et seq.), but special dollar limits apply to so-called luxury cars weighing no more than 6,000 pounds. The dollar limits on cars placed in service during EXAMPLE: John Buxton, a teacher, has a morning job 2008 are $10,960 if bonus depreciation is used or $2,960 in School A (15 miles from his home) and an afternoon job in School B (10 miles from A and 20 miles from if bonus depreciation is not used for year one, $4,800 for his home). Even if he stops off at home on the way year two, $2,850 for year three, and $1,775 for each year to School B, he can only deduct the transportation thereafter. Bonus depreciation cannot be used for the pur- cost attributable to the 10 miles between Schools chase of a used (“pre-owned”) vehicle, so the lower dollar A and B. limit applies to the purchase of such a vehicle. The following is the maximum depreciation that may be claimed in 2008 Commuting costs may also be deductible where a work (assuming the car is used 100% for business): location is temporary and is located outside the metro- Year Car Placed in Service 2008 Dollar Limit politan area where the taxpayer lives and usually works or 2008 $10,960/$2,960 where commuting is to a job location that is “temporary” 2007 4,800 (i.e., expected to last for less than 1 year and in fact lasts 2006 2,850 for less than 1 year). However, transportation costs of 2005 1,775 military reservists for trips from home to regular service meetings are not deductible. The first-year expensing limit under Code Section 179 on vehicles weighing over 6,000 pounds but no more than 14,000 pounds is fixed at $25,000. For dollar limits on cars placed in service before 2004, see ¶2106. ¶1804 PA R T 3 — C H A P T E R 1 8 — Tr a v e l a n d E n t e r t a i n m e n t E x p e n s e s 237 PITFALL: The IRS has noted that claiming deprecia- PITFALL: The standard mileage rate merely relieves tion for a car in excess of the dollar limit is one of taxpayers of having to record automobile expenses the most common errors made on individual income and substantiate them if the return is audited. It is still tax returns. necessary to keep an accurate record of business mileage (including the miles, time, place, and business purpose for the travel). Special limits for light trucks and vans. Trucks and vans weighing no more than 6,000 pounds are also sub- In many cases, the standard mileage rate provides a ject to dollar limits. The first-year limits for such vehicles greater deduction than the taxpayer’s actual expenses, first placed in service in 2008 are $11,160 if bonus especially where mileage is high. However, in some depreciation is used or $3,160 if bonus depreciation is instances the actual cost method produces a greater not used for year one, $5,100 for year two, $3,050 for deduction. This is particularly true when a large propor- year three and $1,875 for each succeeding year. tion of the car usage is for business purposes, but the Nonpersonal use vehicles. There is no dollar limit on total mileage is low. a truck or van that has been modified to enable only de The standard mileage rate may not be used in the fol- minimis personal use. For example, if a van has only a lowing situations: seat for the driver or the driver and a person in a jump seat, permanent shelving, or a painting sign on the exte- Modified Accelerated Cost Recovery System (MACRS) rior, these would qualify a truck or van as a nonpersonal or first-year expensing was used for the car. use vehicle. The cost of such vehicle could be expensed The car is used for hire (e.g., taxicabs). up to the full limit and is not subject to the dollar limits Four or more cars are used for business simultaneously applicable to passenger vehicles. (e.g., a fleet operation). ¶1806 Standard Mileage Deduction Changing write-off methods. A taxpayer may change from the standard mileage rate to the actual cost method. Self-employed taxpayers or employees who use their cars However, depreciation is then limited to straight line for business may, instead of computing their actual car (provided the car has not already been fully depreciated). expenses, take a flat deduction for each mile the car is A taxpayer who has used the actual cost method and used for business. The standard mileage rate for busi- claimed first-year expensing or accelerated depreciation ness use of a vehicle is 50.5¢ per mile for the first half of cannot change to the standard mileage rate for that car. 2008 and 58.5¢ per mile for the second half of 2008 (it had been 48.5¢ per mile for all of 2007). This standard Rural letter carriers. Reimbursements by the U.S. rate is in lieu of all expenses such as gasoline (including Postal Service up to the carrier’s actual costs are not tax thereon), oil, repairs, license plates, insurance, and taxable to the carrier, nor deductible by the carrier. If depreciation if the car is owned or lease payments if the reimbursements are less than the carrier’s actual costs, car is leased. However, the following items are deductible excess costs are deductible as a miscellaneous itemized in addition to the mileage rate: parking fees and tolls deduction subject to the 2%-of-AGI floor. attributable to business use, interest, and state and local taxes incurred in purchasing the car. EXAMPLE: Barbara Porter, a salesperson, buys a new car on January 4 and drives it 36,000 miles a year for business (3,000 miles a month). Her actual costs for using the car for business are $18,875 a year. Her deduction under the standard mileage rate is $19,620 (18,000 miles 50.5¢ + 18,000 58.5¢). Because the standard mileage rate provides the larger deduction, she uses the standard mileage rate in lieu of deducting actual costs. ¶1806 238 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E STUDY QUESTIONS Sample Inclusion Amounts FMV of Car Tax Year During Lease 1. Ed Aikins regularly works in one city. His family 5th lives in another city in the home he owns. For tax Not and Over Over 1st 2nd 3rd 4th Later purposes, which city is his “home?” $18,500 $19,000 $20 $42 $62 $73 $84 a. The city in which he works 20,000 20,500 27 58 87 102 117 b. The city in which his family lives 25,000 26,000 53 115 172 204 235 c. The taxpayer may elect which city to call his 30,000 31,000 78 170 151 301 347 tax home 40,000 41,000 128 279 413 495 571 50,000 51,000 177 388 575 689 794 2. The standard mileage rate for business use of a 60,000 62,000 229 502 746 892 1,029 car in 2008 is: a. 14¢ per mile ¶1807 Meals and Entertainment Expenses b. 48.5¢ per mile (Sec. 162 and 274) c. 50.5¢ per mile for the first half of the year and 58.5¢ per mile for the second half of the year The cost of entertaining customers (or prospective customers), employees, business associates, and so on has long been held to be an ordinary and neces- sary business expense. However, due to large and NOTE: Answers to Study Questions, with feedback widespread abuses, such as the deduction of lavish to both the correct and incorrect responses, are entertainment expenses by taxpayers on practically provided in Chapter 35, beginning with ¶3518. unlimited expense accounts, Congress severely limited the allowance of deductions for entertainment and similar expenditures. ¶1806A Deducting the Costs of a Leased Car No deduction for entertainment expenses is allowed The expenses of using a leased car for business can be unless taxpayers establish that the expenditure was deducted using the standard mileage rate or the actual directly related to or associated with the active con- expense method. See ¶1806. However, the depreciation duct of their trade or business (or employment). deduction limits on “luxury cars” cannot be avoided Thus, the regulations require that the taxpayer have by leasing rather than buying. A taxpayer who leases a a definite expectation of deriving some income or luxury car (one valued at an inflation-adjusted amount of other specific trade or business benefit (not merely $18,500) is limited to deductions that are “substantially the goodwill of the person or persons entertained) at equivalent” to the limits on depreciation deductions some future time. imposed on car owners. Control over a lessee’s deduc- tions is achieved by adding an “inclusion amount” to the Club dues. Dues paid for membership in social, athletic, lessee’s gross income. This is done directly in Section C or sporting clubs (such as airline clubs) are not deduct- of Part II of Form 2106. In effect, the inclusion amount ible. However, dues to professional (e.g., bar association), offsets rental deductions when the actual expense method business (e.g., chamber of commerce), and civic (e.g., is used. Rotary or Lions) organizations are deductible. The inclusion amount is based on the fair market value The deduction for entertainment expenses is limited to of the car on the first day of the lease. This determines an 50% of the amount otherwise allowable as a deduction. inclusion amount shown on an IRS table. The amount is prorated for the number of days of the lease term included The 50% limitation is applied after determining the in the tax year. Finally, the prorated amount is multiplied amount of otherwise allowable deductions under the by the percentage of business use by the taxpayer. “ordinary and necessary” standard and other rules that disallow certain entertainment expenses (such as the For cars (that are not trucks or vans) first leased in 2008, “lavish and extravagant” rule). below is a table of sample ranges of fair market value. For other fair market values, see Rev. Proc. 2008-22, IRB EXAMPLE: Larry Alexander spends $1,000 for quali- 2008-12, 658. For inclusion amounts for cars leased in fied entertainment. Result: His deduction is limited prior years, see Appendix B of IRS Publication 463, Travel, to $500 (50% of $1,000). Entertainment, Gift, and Car Expenses. ¶1806A PA R T 3 — C H A P T E R 1 8 — Tr a v e l a n d E n t e r t a i n m e n t E x p e n s e s 239 Business meals. The deduction for meals is subject to To qualify, a charitable sporting event must (1) be orga- the same requirements that apply to other entertain- nized for the primary purpose of benefiting a tax-exempt ment expenses. This means that a business meal, like organization, (2) contribute 100% of its net proceeds to business entertainment, is deductible (subject to the this organization, and (3) use volunteers for substantially 50% limitation rule) only if the meal is directly related all work performed in carrying out the event. to or associated with the active conduct of a taxpayer’s trade or business. Entertainment tickets. The amount of a deduction for a ticket to an entertainment event is limited to the Business meal expenses generally are not deductible ticket’s face value (before applying the 50% limitation unless there is a substantial and bona fide business dis- rule). Tickets bought for a charitable fund-raiser are not cussion before, during, or after the meal. limited by this rule. PRACTICE POINTER: An individual away from home PITFALL: This rule bars excess payments to “scalpers” overnight on business automatically qualifies for the and even to legitimate ticket agencies. “directly related” requirement. Skyboxes. A deduction is disallowed for renting a Special limit for certain workers. Employees and luxury “skybox” for multiple events. The disallowance independent contractors whose hours are governed by is the excess over the cost of a regular box seat. A luxury Department of Transportation hours of service limita- “skybox” is any private luxury box or other facility at a tions (such as interstate truck drivers) can deduct 80% sports arena that is separated from other seating and that of their meal costs in 2008. is available at a higher price than the price generally appli- cable to other seating. For this rule, a single game or other Exceptions to the “50% limitation” rule. The 50% limit performance counts as one event. If this disallowance does not apply if any of the following exceptions applies: rule applies, two types of expenses related to the skybox An employer’s expenses for meals and entertainment still may be deductible, subject to the 50% limitation if treated by the employer as compensation to the rule, if they meet the generally applicable requirements employee on the employer’s tax return and as wages for deducting business entertainment expenses: for withholding purposes An amount not exceeding the face values of the Expenses for meals and entertainment includible highest-price nonluxury box seats generally held for in the gross income of the recipient, who is not an sale to the public on an event-by-event basis, multi- employee of the taxpayer, as compensation for services plied by the number of seats in the skybox (subject rendered or as a prize or award, and included by the to the 50% limitation rule) taxpayer on Form 1099 issued to the recipient The deductibility of separately stated charges for Expenses for recreational, social, or similar activities food or beverages, as determined under the rules (including facilities primarily for employees’ benefit) generally applying to business meals (including the other than certain highly compensated employees 50% limitation rule and the disallowance of lavish Expenses for meals and entertainment, including or extravagant expenditures) using facilities, made available by the taxpayer to the general public, such as a free concert ¶1808 Business Gifts (Sec. 274) Expenses for meals or entertainment sold by the taxpayer in a bona fide transaction for adequate and The law limits deductions for business gifts to $25 per full consideration individual per year, the same limit that applied more An expense for food or beverage (but not entertain- than half a century ago. Any amount in excess of $25 ment) that is excludable from the recipient’s gross given to one individual during a year is not deductible. income under the de minimis rule Gifts made to an individual’s spouse will be considered The price of tickets to certain charitable sporting as having been made to the individual, unless the spouse events (including amounts in excess of face value), has a separate business connection with the individual provided the expense is covered by a ticket package making the gift. that includes admission to the event ¶1808 240 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E adequate records the amount, time, and place of travel PRACTICE POINTER: In some cases, an expense or entertainment, or date and description of the gift, may be a business gift (subject to the $25 limit) or an entertainment expense (subject to the 50% limit). For and the business purpose of the travel or the business example, theater tickets for a client or customer can relationship to the taxpayer of each person entertained be treated as either type of expense as long as the tax- or receiving a gift. payer does not attend the performance. If the taxpayer accompanies the client or customer, the expense is The most common method of meeting the “adequate only an entertainment expense. record” requirement is by keeping a diary or account book in which all deductible expenses, together with the Advertising giveaways costing less than $4 and on necessary explanatory details, are recorded at or near the which the donor’s name is permanently imprinted are time of the expenditure. not included in the $25 limitation. Also excluded from Each separate payment is usually considered a separate the definition of “gifts” are signs, display racks, and expenditure and must be separately recorded. Thus, other promotional materials to be used by the recipient if a taxpayer entertains a customer or client at dinner on his business premises. The employer can exclude and then takes the customer to the theater, the dinner an employee achievement award from the employee’s expense and the cost of the theater tickets are separate income only if the employer can deduct the award. To expenditures. be deductible, the award must be: In recording various expenditures, such items as cab Made for length-of-service or safety achievement, fares, phone calls, meals, gas and oil, and other incidental Tangible personal property, traveling expenses may be aggregated, and the daily total Awarded as part of a meaningful presentation, and of each category listed in the taxpayer’s account book, Awarded under conditions and circumstances that do diary, or personal digital assistant (PDA). not create a significant likelihood of the payment of disguised compensation. For most items, notations in an account book, diary, or PDA are sufficient. However, documentary evidence, The total of all nonqualified plan awards made to any such as receipts, paid bills, or similar evidence, is not one employee during the tax year may not exceed $400. required for any expenditure (other than lodging) of The total of all awards (including both qualified and less than $75. (Transportation charges for which docu- nonqualified plan awards) made to any one employee mentary evidence is not readily available are exempted during the tax year may not exceed $1,600. from this requirement.) If the cost of the award is more than the amount the employer can deduct, the employer must include in the PRACTICE POINTER: Remember, the diary and employee’s income the greater of (1) the excess of cost documentary evidence should not be submitted over the employer’s deduction (but not more than the with the return, but should be readily available if the award’s value) or (2) the amount by which the award’s return is questioned. value exceeds the amount the employer is allowed to deduct. NOTE: It is important to maintain accurate records A qualified plan award is one awarded as part of an as far as an auto’s business use. Cars are not eligible established written plan by the employer that does not for accelerated depreciation unless the “more than discriminate in favor of highly compensated employees. 50% business use” applies. See ¶2105. Form 2106 An award will not be considered a qualified plan award contains specific questions with regard to an auto’s if the average cost of all employee achievement awards business use. given by the employer during the tax year exceeds $400. In determining average cost, awards of very small value Per diem allowances. Where an employer reimburses are not considered. an employee for automobile use at the standard mileage ¶1809 Substantiation of Travel and rate (50.5¢ per mile for the first half of 2008 and 58.5¢ per mile for the second half of 2008) or for travel using a Entertainment Expenses per diem rate, substantiation requirements are simplified. No deduction for travel, entertainment, or gifts is Amounts reimbursed under a per diem arrangement are allowed unless the taxpayer can clearly substantiate by deemed substantiated when they do not exceed the appli- ¶1809 PA R T 3 — C H A P T E R 1 8 — Tr a v e l a n d E n t e r t a i n m e n t E x p e n s e s 241 cable federal rate, which varies from locality to locality. Incidental expenses include only fees and tips to por- The per diem rate can be used for lodging, meals, and ters, baggage carriers, bellhops, hotel maids, stewards incidental expenses or for meals and incidental expenses and stewardesses. However, if no expenses for meals are with separate reimbursement for actual lodging costs. incurred, incidental expenses can be separately substanti- ated by a per diem rate of $3. Instead of using the federal per diem rate for lodging, meals, and incidental expenses in a particular locality, there is an even simpler option for travel within the STUDY QUESTION continental United States. Under a so-called “high-low” method, several high-cost areas (such as New York, Los 3. To be deductible, a gift to a customer may not Angeles, Washington, D.C., Atlanta, Chicago, Boston, exceed: and Philadelphia) have a per diem rate (beginning a. $25 per year October 1, 2007) of $237. All other areas within the b. $400 per year c. Any reasonable amount continental U.S. are assigned a low per diem rate of $152. The M&IE rate for high-cost areas is $58 ($45 for all other areas). The rates for October 1, 2008, through September 30, 2009, are $256 for high-cost areas and ¶1810 Reporting Employee Business Expenses $158 for all other areas within the continental U.S. The Employees claim unreimbursed employee business M&IE rates remain unchanged. expenses, including car expenses, as itemized deductions on Schedule A. However, these expenses must first be PRACTICE POINTER: Employers may choose to use listed on Form 2106, Employee Business Expenses, or on a the old or new listing of high-cost areas for the fourth simplified version of the form, Form 2106-EZ, Unreim- quarter of 2008. bursed Employee Business Expenses. These forms are used to report car expenses, meals and entertainment, travel costs away from home, parking, tolls, and local trans- portation costs, business gifts, and other unreimbursed employee business expenses. ¶1810 242 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E 2106 OMB No. 1545-0074 Employee Business Expenses Form 2008 f See separate instructions. Department of the Treasury Attachment Attach to Form 1040 or Form 1040NR. 54 o Internal Revenue Service (99) Sequence No. Your name Occupation in which you incurred expenses Social security number Part I Employee Business Expenses and Reimbursements s 8 a 0 ft 20 Column A Column B Step 1 Enter Your Expenses Other Than Meals Meals and and Entertainment Entertainment 1 2 3 instructions.) ra 1/ Vehicle expense from line 22c or line 29. (Rural mail carriers: See D /2 Parking fees, tolls, and transportation, including train, bus, etc., that did not involve overnight travel or commuting to and from work Travel expense while away from home overnight, including lodging, 1 2 7 airplane, car rental, etc. Do not include meals and entertainment 3 0 4 Business expenses not included on lines 1 through 3. Do not include meals and entertainment 4 5 Meals and entertainment expenses (see instructions) 5 6 Total expenses. In Column A, add lines 1 through 4 and enter the result. In Column B, enter the amount from line 5 6 Note: If you were not reimbursed for any expenses in Step 1, skip line 7 and enter the amount from line 6 on line 8. Step 2 Enter Reimbursements Received From Your Employer for Expenses Listed in Step 1 7 Enter reimbursements received from your employer that were not reported to you in box 1 of Form W-2. Include any reimbursements reported under code “L” in box 12 of your Form W-2 (see instructions) 7 Step 3 Figure Expenses To Deduct on Schedule A (Form 1040 or Form 1040NR) 8 Subtract line 7 from line 6. If zero or less, enter -0-. However, if line 7 is greater than line 6 in Column A, report the excess as income on Form 1040, line 7 (or on Form 1040NR, line 8) 8 Note: If both columns of line 8 are zero, you cannot deduct employee business expenses. Stop here and attach Form 2106 to your return. 9 In Column A, enter the amount from line 8. In Column B, multiply line 8 by 50% (.50). (Employees subject to Department of Transportation (DOT) hours of service limits: Multiply meal expenses incurred while away from home on business by 80% (.80) instead of 50%. For details, see instructions.) 9 10 Add the amounts on line 9 of both columns and enter the total here. Also, enter the total on Schedule A (Form 1040), line 21 (or on Schedule A (Form 1040NR), line 9). (Reservists, qualified performing artists, fee-basis state or local government officials, and individuals with disabilities: See the instructions for special rules on where to enter the total.) 10 For Paperwork Reduction Act Notice, see instructions. Cat. No. 11700N Form 2106 (2008) ¶1810 PA R T 3 — C H A P T E R 1 8 — Tr a v e l a n d E n t e r t a i n m e n t E x p e n s e s 243 Form 2106 (2008) Page 2 Part II Vehicle Expenses f Section A—General Information (You must complete this section if you (a) Vehicle 1 (b) Vehicle 2 are claiming vehicle expenses.) 11 12 13 Enter the date the vehicle was placed in service Total miles the vehicle was driven during 2008 Business miles included on line 12 o s 8 11 12 13 / / miles miles / / miles miles a 0 14 Percent of business use. Divide line 13 by line 12 14 % % ft 20 15 Average daily roundtrip commuting distance 15 miles miles 16 Commuting miles included on line 12 16 miles miles 17 Other miles. Add lines 13 and 16 and subtract the total from line 12 17 miles miles ra 1/ 18 Was your vehicle available for personal use during off-duty hours? Yes No 19 Do you (or your spouse) have another vehicle available for personal use? Yes No D /2 20 Do you have evidence to support your deduction? Yes No 21 If “Yes,” is the evidence written? Yes No Section B—Standard Mileage Rate (See the instructions for Part II to find out whether to complete this section or Section C.) 22a Multiply business miles driven before July 1, 2008, by 50.5¢ (.505) 22a 7 b Multiply business miles driven after June 30, 2008, by 58.5¢ (.585) 22b c Add lines 22a and 22b. Enter the result here and on line 1 22c Section C—Actual Expenses 23 Gasoline, oil, repairs, vehicle insurance, etc. 24a Vehicle rentals b Inclusion amount (see instructions) 23 24a 24b 0 (a) Vehicle 1 (b) Vehicle 2 c Subtract line 24b from line 24a 24c 25 Value of employer-provided vehicle (applies only if 100% of annual lease value was included on Form W-2—see instructions) 25 26 Add lines 23, 24c, and 25 26 27 Multiply line 26 by the percentage on line 14 27 28 Depreciation (see instructions) 28 29 Add lines 27 and 28. Enter total here and on line 1 29 Section D—Depreciation of Vehicles (Use this section only if you owned the vehicle and are completing Section C for the vehicle.) (a) Vehicle 1 (b) Vehicle 2 30 Enter cost or other basis (see instructions) 30 31 Enter section 179 deduction and special allowance (see instructions) 31 32 Multiply line 30 by line 14 (see instructions if you claimed the section 179 deduction or special allowance) 32 33 Enter depreciation method and percentage (see instructions) 33 34 Multiply line 32 by the percentage on line 33 (see instructions) 34 35 Add lines 31 and 34 35 36 Enter the applicable limit explained in the line 36 instructions 36 37 Multiply line 36 by the percentage on line 14 37 38 Enter the smaller of line 35 or line 37. If you skipped lines 36 and 37, enter the amount from line 35. Also enter this amount on line 28 above 38 Printed on Recycled Paper Form 2106 (2008) ¶1810 244 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E Form 2106-EZ can be used only if an employee with for 2008 (and also used it for the year the car was first unreimbursed business expenses that include car placed in service). expenses owns his car and uses the standard mileage rate OMB No. 1545-0074 Form 2106-EZ Unreimbursed Employee Business Expenses 2008 Department of the Treasury Internal Revenue Service (99) Your name o f Attach to Form 1040 or Form 1040NR. Occupation in which you incurred expenses Attachment Sequence No. 54A Social security number You May Use This Form Only if All of the Following Apply. s 8 a 0 ● You are an employee deducting ordinary and necessary expenses attributable to your job. An ordinary expense is one that is ft 20 common and accepted in your field of trade, business, or profession. A necessary expense is one that is helpful and appropriate for your business. An expense does not have to be required to be considered necessary. ● You do not get reimbursed by your employer for any expenses (amounts your employer included in box 1 of your Form W-2 are ra 5/ not considered reimbursements for this purpose). ● If you are claiming vehicle expense, you are using the standard mileage rate for 2008. Caution: You can use the standard mileage rate for 2008 only if: (a) you owned the vehicle and used the standard mileage rate for the first year D /2 you placed the vehicle in service, or (b) you leased the vehicle and used the standard mileage rate for the portion of the lease period after 1997. Part I Figure Your Expenses 07 1 Vehicle expense using the standard mileage rate. Complete Part II and then go to line 1a below. a Multiply business miles driven before July 1, 2008, by 50.5¢ (.505) 1a b Multiply business miles driven after June 30, 2008, by 58.5¢ (.585) 1b c Add lines 1a and 1b 1c 2 Parking fees, tolls, and transportation, including train, bus, etc., that did not involve overnight travel or commuting to and from work 2 3 Travel expense while away from home overnight, including lodging, airplane, car rental, etc. Do not include meals and entertainment 3 4 Business expenses not included on lines 1c through 3. Do not include meals and entertainment 4 5 Meals and entertainment expenses: $ × 50% (.50). (Employees subject to Department of Transportation (DOT) hours of service limits: Multiply meal expenses incurred while away from home on business by 80% (.80) instead of 50%. For details, see instructions.) 5 6 Total expenses. Add lines 1c through 5. Enter here and on Schedule A (Form 1040), line 21 (or on Schedule A (Form 1040NR, line 9)). (Armed Forces reservists, fee-basis state or local government officials, qualified performing artists, and individuals with disabilities: See the instructions for special rules on where to enter this amount.) 6 Part II Information on Your Vehicle. Complete this part only if you are claiming vehicle expense on line 1. 7 When did you place your vehicle in service for business use? (month, day, year) / / 8 Of the total number of miles you drove your vehicle during 2008, enter the number of miles you used your vehicle for: a Business b Commuting (see instructions) c Other 9 Was your vehicle available for personal use during off-duty hours? Yes No 10 Do you (or your spouse) have another vehicle available for personal use? Yes No 11a Do you have evidence to support your deduction? Yes No b If “Yes,” is the evidence written? Yes No For Paperwork Reduction Act Notice, see page 4. Cat. No. 20604Q Form 2106-EZ (2008) ¶1810 PA R T 3 — C H A P T E R 1 8 — Tr a v e l a n d E n t e r t a i n m e n t E x p e n s e s 245 ¶1811 Recent Developments Affecting Travel if employees also substantiate the time, place, mileage, and Entertainment Expenses and business purpose of the trip (Rev. Proc. 2007-70, IRB 2007-50, 1162; Announcement 2008-63, IRB Airline pilots “bumped” to different airports because of 2008-28, 114). seniority rules were not “away from home” because they no longer had an anchor airport (tax home) (Wasik, For the period from October 1, 2007, through Stockwell, Bogue, Farran, Wilbert, Riley, TC Memo September 30, 2008, the per diem rates are $237, of 2007-148 through 2007-152). which $58 is for meals, for high cost areas, and $152, of which $45 is for meals, for all other areas (Rev. Proc. The IRS will allow a deduction for local lodging (i.e., in 2007-63, IRB 2007-42, 809); for the period from Octo- the same town as the employer) where lodging is necessary ber 1, 2008, through September 30, 2009, the rates are for the employee to take part in a meeting or function of $256, of which $58 is for meals, for high cost areas; and the employer (Notice 2007-47, IRB 2007-24, 1393). $158, of which $45 is for meals, for all other areas (Rev. The list of countries within the “North American area” Proc. 2008-59, IRB 2008-41, 857). has been expanded (Rev. Rul. 2007-28, IRB 2007-18, New depreciation limits for cars placed in service in 2008 1039). and income inclusion amounts for cars leased in 2008 are Employers reimbursing employees for business travel set forth (Rev. Proc. 2008-22, IRB 2008-12, 658). under their reimbursement plans may use 50.5¢ per mile for business travel in the first half of 2008 and For further information on travel and entertainment 58.5¢ per mile for the second half of 2008. When this expenses, see IRS Publication 463, Travel, Enter- rate is used, substantiation requirements are satisfied tainment, Gift, and Car Expenses; and IRS Publica- tion 1542, Per Diem Rates (For Travel within the Continental United States). ¶1811 PART 3 — DEDUCTIONS FOR BUSINESS AND OTHER SPECIAL DEDUCTION RULES Other Business, Job-Related, and Investment Expenses 19 LEARNING OBJECTIVES for the production of income are deductible only as miscellaneous itemized expenses, subject to the 2%-of- This chapter was prepared to enable participants to adjusted-gross-income floor. learn about various business, job-related, and investment expenses. More specifically, upon completion, you will Jury duty pay. If employees must give jury duty pay be able to: to their employer because their employer continues to pay their salary while they serve on a jury, they can Figure the home office deduction. deduct the amount turned over to the employer as an Determine deductible expenses in connection with adjustment to gross income. investments and income-producing activities. Claim a deduction for work-related education ¶1902 “Statutory Employee” Business expenses. Expenses (Sec. 62) ¶1901 Deducting Other Business, Job-Related, Certain individuals may be treated as statutory employ- and Investment Expenses ees whose business expenses are deductible without regard to the 2% floor. Statutory employees are those Business, job-related, and investment expenses generally who are treated as employees for FICA tax purposes are deductible. However, the way in which the deduction but who are not traditional common-law employees. is handled varies greatly. They include: Self-employed persons. Self-employed individuals Full-time life insurance salespersons whose entire or deduct business expenses from gross income. Specifically, principal activity is devoted to the solicitation of life such expenses are entered directly on Schedule C and insurance, annuity contracts, or both, primarily for offset self-employment income. one life insurance company Agent-driver or commission driver Statutory employees. Outside salespersons, certain Home workers insurance agents and others defined under the Internal Traveling or city salespersons Revenue Code as “statutory employees” may deduct busi- ness expenses in the same way in which self-employed Individuals need not make the determination of whether individuals handle these expenses. Such expenses are they are statutory employees. Statutory employee status entered directly on Schedule C and are not limited by is reflected on Form W-2, on which their wages for adjusted gross income. the year are reported. Employees. Job-related expenses that are not reimbursed Statutory employees list their business expenses on by employers under an accountable plan (see ¶1801) are Schedule C or Schedule C-EZ. deductible only as miscellaneous expenses on Schedule A. These are deductible only to the extent that they exceed ¶1903 Employee Business Expenses (Sec. 62) 2% of adjusted gross income. However, special rules apply to qualified performing artists, who can deduct Form 2106 is used to detail the amount of the employee expenses directly from gross income. business expenses that must be entered on Schedule A of Form 1040 and claimed as a miscellaneous item- Investment expenses. Expenses incurred for the man- ized deduction (assuming the employee itemizes agement, conservation, or maintenance of property held deductions). ¶1903 248 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E ¶1904 Employees’ Expenses in Connection with Their Employment NOTE: Answers to Study Questions, with feedback to both the correct and incorrect responses, are Unreimbursed employees’ business expenses are miscel- provided in Chapter 35, beginning with ¶3519. laneous itemized deductions and are deductible from adjusted gross income, together with other itemized deductions. Again, the expenses must be “ordinary and ¶1905 Home Office Expenses (Sec. 280A) necessary” and “reasonable” in amount. Such expenses A deduction for the business use of a personal residence include the following: is allowed only if the space is used exclusively and on a Union and trade-organization dues and convention regular basis as any of the following: expenses The principal place of any business in which the tax- Work clothes, including cleaning and laundry payer engages. A home is treated as a principal place Small tools (if useful life is less than 1 year; otherwise, of business if it is used for substantial administrative a depreciation deduction is available) or managerial activities and there is no other fixed Subscription to trade and technical journals and location for the performance of these activities. newspapers A place of business used for meeting clients, custom- Hiring of assistants and substitutes (if not paid for ers, or patients. by employer) In connection with the taxpayer’s trade or business if The cost of work clothes and uniforms, including laun- the taxpayer is using a separate structure that is not dry or cleaning, is deductible if the taxpayer’s occupation attached to the dwelling. is one that specifically requires special clothing that is not Additionally, if the taxpayer is an employee, the business use adaptable to general usage. The IRS lists the following of the home must be for the convenience of the employer. as specifically deductible: Special uniforms and/or equipment required by PITFALL: The home office deduction of an employee ballplayers, fire fighters, police officers, letter carriers, is a miscellaneous itemized deduction subject to the nurses, and civilian faculty members of military 2% of AGI limitation. schools Theatrical clothes and accessories used by professional musicians and entertainers, if used solely in the course of their trade or employment NOTE: Congress may add a standard deduction for Uniforms of air, rail, bus, and other transportation home office expenses in lieu of deducting actual costs. employees, if used solely in the course of employ- ment If the space is in a separate building, not attached to the The cost of protective clothing, including safety shoes taxpayer’s residence, it will qualify so long as it is used and helmets, work gloves, oilskins, rubber boots, etc. exclusively and on a regular basis for business purposes. Fees paid to employment agencies for seeking or securing Business expenses related to space in a home used a job in the same line of business are deductible, as are regularly (even if not exclusively) as a storage unit for expenses for drafting and printing of job resumes and inventory or sample items (or both) are deductible if the traveling to job interviews. home is the sole fixed location of the business. STUDY QUESTION One exception to the exclusive use test is if the residence is the only fixed location of a trade or business engaged 1. Which expense may be deductible from gross in selling products at retail or wholesale, provided a income? separate, identifiable portion of the residence is regularly a. Unreimbursed employee business expenses used for inventory storage. Thus, where a part of a base- b. Investment expenses ment is used for this purpose, the proportionate part of c. Jury duty pay that must be given to an the expenses will qualify, even though the basement is employer who continues an employee’s sal- used for other purposes as well. ary while serving on a jury ¶1904 PA R T 3 — C H A P T E R 1 9 — O t h e r B u s i n e s s , J o b - R e l a t e d , a n d I n v e s t m e n t E x p e n s e s 249 Another exception is where a residence is used to provide The allocation, however, can be based on the number of day care services to children, handicapped individuals, rooms if the rooms are all of approximately equal size. and the elderly on a regular basis. Part II of Form 8829, Expenses for Business Use of Your Home office deductions by self-employed individuals Home, is used for figuring allowable deductions. The are first figured on Form 8829, Expenses for Business form distinguishes between direct and indirect expenses. Use of Your Home, and then entered on Schedule C. Direct expenses are those solely connected with a home (Employees claiming home office expenses figure deduc- office. Indirect expenses are those applicable to the entire tions on Form 2106.) Form 8829 consists of four parts. residence, such as mortgage interest on a loan for the entire Part I is used for figuring the portion of the home used residence and real property taxes. Indirect expenses are first for business. Generally, this is figured by dividing the listed and then the percentage of business use is applied to area used for business by the total area in the home to arrive at the deductible portion. No deduction, direct or arrive at a “business percentage.” indirect, is allowed for the cost of landscaping the home. Depreciation is figured in Part III of Form 8829. Again, EXAMPLE: Sue Brandt uses 500 sq. ft. of her 2,000 it is figured on the business portion of the home. Usually, sq. ft. house as a home office. Her business percent- age is 25% (500 sq. ft. 2,000 sq. ft). a home office is treated as nonresidential realty, with a 39-year recovery period. ¶1905 250 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E OMB No. 1545-0074 Form 8829 Expenses for Business Use of Your Home File only with Schedule C (Form 1040). Use a separate Form 8829 for each 2008 f home you used for business during the year. Department of the Treasury Attachment See separate instructions. Sequence No. 66 o Internal Revenue Service (99) Name(s) of proprietor(s) Your social security number Part I 1 Part of Your Home Used for Business s 8 a 0 Area used regularly and exclusively for business, regularly for daycare, or for storage of inventory ft 20 or product samples (see instructions) 1 2 Total area of home 2 3 Divide line 1 by line 2. Enter the result as a percentage 3 % ra 9/ For daycare facilities not used exclusively for business, go to line 4. All others go to line 7. 4 Multiply days used for daycare during year by hours used per day 4 hr. D /1 5 Total hours available for use during the year (366 days 24 hours) (see instructions) 5 8,784 hr. 6 Divide line 4 by line 5. Enter the result as a decimal amount 6 . 7 Business percentage. For daycare facilities not used exclusively for business, multiply line 6 by line 3 (enter the result as a percentage). All others, enter the amount from line 3 7 % 6 Part II Figure Your Allowable Deduction 0 8 Enter the amount from Schedule C, line 29, plus any net gain or (loss) derived from the business use of your home and shown on Schedule D or Form 4797. If more than one place of business, see instructions 8 See instructions for columns (a) and (b) before (a) Direct expenses (b) Indirect expenses completing lines 9–21. 9 Casualty losses (see instructions) 9 10 Deductible mortgage interest (see instructions) 10 11 Real estate taxes (see instructions) 11 12 Add lines 9, 10, and 11 12 13 Multiply line 12, column (b) by line 7 13 14 Add line 12, column (a) and line 13 14 15 Subtract line 14 from line 8. If zero or less, enter -0- 15 16 Excess mortgage interest (see instructions) 16 17 Insurance 17 18 Rent 18 19 Repairs and maintenance 19 20 Utilities 20 21 Other expenses (see instructions) 21 22 Add lines 16 through 21 22 23 Multiply line 22, column (b) by line 7 23 24 Carryover of operating expenses from 2007 Form 8829, line 42 24 25 Add line 22 in column (a), line 23, and line 24 25 26 Allowable operating expenses. Enter the smaller of line 15 or line 25 26 27 Limit on excess casualty losses and depreciation. Subtract line 26 from line 15 27 28 Excess casualty losses (see instructions) 28 29 Depreciation of your home from Part III below 29 30 Carryover of excess casualty losses and depreciation from 2007 Form 8829, line 43 30 31 Add lines 28 through 30 31 32 Allowable excess casualty losses and depreciation. Enter the smaller of line 27 or line 31 32 33 Add lines 14, 26, and 32 33 34 Casualty loss portion, if any, from lines 14 and 32. Carry amount to Form 4684, Section B 34 35 Allowable expenses for business use of your home. Subtract line 34 from line 33. Enter here and on Schedule C, line 30. If your home was used for more than one business, see instructions 35 Part III Depreciation of Your Home 36 Enter the smaller of your home’s adjusted basis or its fair market value (see instructions) 36 37 Value of land included on line 36 37 38 Basis of building. Subtract line 37 from line 36 38 39 Business basis of building. Multiply line 38 by line 7 39 40 Depreciation percentage (see instructions) 40 % 41 Depreciation allowable (see instructions). Multiply line 39 by line 40. Enter here and on line 29 above 41 Part IV Carryover of Unallowed Expenses to 2009 42 Operating expenses. Subtract line 26 from line 25. If less than zero, enter -0- 42 43 Excess casualty losses and depreciation. Subtract line 32 from line 31. If less than zero, enter -0- 43 For Paperwork Reduction Act Notice, see page 4 of separate instructions. Cat. No. 13232M Form 8829 (2008) ¶1905 PA R T 3 — C H A P T E R 1 9 — O t h e r B u s i n e s s , J o b - R e l a t e d , a n d I n v e s t m e n t E x p e n s e s 251 Telephone. The cost of basic charges of a first phone PITFALL: Any depreciation taken on a home office after line in a home is not deductible. Other charges, such as May 6, 1997, is “recaptured” as ordinary income at the rate of 25%. However, the home sale exclusion can long distance calls, call waiting, and equipment rentals, be claimed for the home office portion as long as the continue to be deductible. office is part of the dwelling unit (no allocation of gain is required for the business portion of the home). STUDY QUESTION Gross income limit. The deduction for home office 2. Which indirect expense related to a home office is not part of a home office deduction? expenses is limited to the gross income from the business use of the home less the sum of (1) business percentage a. Mortgage interest b. Landscaping of the mortgage interest, real estate taxes, and casualty c. Real estate taxes losses and (2) business expenses other than those related to the business use of a home. Therefore, the deduction is limited to a modified net income from the business ¶1906 Expenses in Connection with Investment use of a home, that is, the net income of the business and Other Income-Producing Activities without including the home expenses (other than the (Sec. 212) business percentage of mortgage interest, real estate taxes, and casualty losses). Thus, a deduction for the Section 212 of the Code allows taxpayers to deduct expenses business use of a home will not create a business loss or “incurred for the management, conservation, or mainte- increase a net loss from a business. The gross income nance of property held for the production of income.” limitation is built into Part III of Form 8829. This section authorizes the deduction from adjusted gross Disallowed home office deductions can be carried forward income (as an itemized deduction) of business expenses to later years, subject to the income limitations in those years incurred in connection with investments or other income- from the business activity. The carryover of unallowed producing activities that are not in the taxpayer’s trade or expenses to 2009 is figured in Part IV of Form 8829. business (so-called nontrade or nonbusiness expenses). An exception is expenses that are attributable to property held for production of rents or royalties that are deductible EXAMPLE: Bob Brown operates a retail sales busi- from gross income as “above-the-line” deductions. ness from his home. He uses 20% of his home for this business. In 2008, his gross income, expenses Typical examples of these “nonbusiness” expenses are for the business, and computation of the deduction investment counsel fees, cost of financial periodicals for the business use of his home are as follows: and advisory services, safe deposit box rentals (if the Gross income . . . . . . . . . . . . . . . . . . . . . $12,000 box is used for safe-keeping of securities or property Less: Inventory, supplies, etc. . . . . . . . . . $9,000 held for production of income), state and local transfer Business percentage of tax, collection charges and commissions, cost of secre- mortgage interest and tarial services, telephone, postage, and so on, and office real estate taxes . . . . . . . . . . . . . . . . 2,000 11,000 Modified net income—deduction limit . . . (including a pro rata share of home office) expense. $ 1,000 Business use of home expenses— The expenses in connection with investment and other indirect expenses . . . . . . . . . . . . . . . . . . income-producing activities are deductible as miscella- Maintenance, insurance, neous itemized deductions only to the extent that they utilities (20%) . . . . . . . . . . . . . . . . . . $ 800 Depreciation (20%). . . . . . . . . . . . . . . exceed 2% of adjusted gross income. 1,600 Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,400 No deduction is allowed for the cost of travel to invest- Deduction limited to modified net income . . . . . . . . . . . . . . . . . . . . . . 1,000 ment seminars. Carryover expenses to 2009 (subject to income limitation in 2009). . . . . . . . . $ 1,400 ¶1907 Educational Expenses (Sec. 162) Taxpayers may deduct educational expenses, such as the No deduction (other than deductible expenses such as cost of special training programs or courses (including real estate taxes and mortgage interest) is allowed for a correspondence courses and research activities) under- home office leased to an employer. taken for the purpose of: ¶1907 252 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E Maintaining or improving skills required in the tax- EXAMPLE: Olivia Delgado, an individual employed payer’s present trade, business, or employment; or as a patent attorney, is required by her employer Meeting the requirements of the taxpayer’s present employer to go to engineering school and obtain a degree in as a condition of present employment or salary. engineering to improve her skills as a patent attor- ney. The educational expenses are not deductible Deductible expenses include tuition, books, and other because they qualify her for a new trade or business supplies as well as the cost of travel, board, and lodging, (as an engineer), even though she does not intend if the training is away from home. to go into this field. PRACTICE POINTER: Instead of deducting education EXAMPLE: Bernard Robinson, a self-employed psy- expenses, a taxpayer may qualify for education tax chiatrist, undertakes a program of study and training credits. The credit may produce a greater tax benefit as a psychoanalyst at a psychoanalytic institute. than the deduction. See ¶1105. The course will enable him to qualify as a practic- ing psychoanalyst. His expenditures are deductible because his study and training maintain or improve Whether or not the education meets the above require- skills required for his profession and do not qualify ments depends on the facts of each case. Thus, if it is him for a new trade or business. customary for other individuals in the taxpayer’s trade, business, or profession to undertake such education, the In the case of an employee, a change of duties does not expenses would ordinarily be deductible. constitute a “new trade or business,” if the new duties In the case of expenditures for education required by involve the same general type of work the individual is the taxpayer’s employer, the expenses are deductible presently doing. only if the requirement was imposed primarily for the An employee is eligible to exclude certain educational employer’s bona fide business purposes and the expenses assistance provided by an employer if it qualifies as a were not intended primarily for the taxpayer’s benefit. working condition fringe benefit or if it is received under an educational assistance plan. See ¶611. An employee EXAMPLE: Phil Jones, a high school teacher, is can exclude up to $5,250 of employer-provided educa- required by his employer (or by state law) either to tional assistance. read a list of books or to take certain courses giving 6 hours of academic credit every 2 years in order to The regulations give special tax consideration to teachers retain his position as a teacher. Phil fulfills his require- by providing that all teaching and related duties should ments by taking the courses. Because his purpose in be considered as involving the same general type of work. taking the courses is to fulfill his employer’s educa- Thus, the cost of training undertaken by an elementary tional requirements, his expenses for such education school teacher to become a high school teacher, by a math and transportation and meals and lodging while away teacher to become a science teacher, or by a teacher to from home are deductible. qualify as a principal is deductible. Likewise, if the purpose of the education is to meet EXAMPLE: John Blalock, a tax practitioner, annually the minimum requirements of the taxpayer’s present takes a brush-up course to review new tax develop- employer, such expenses are not deductible, even though ments and refresh his tax knowledge. His expenses are the taxpayer is already employed in the field. deductible because the training is undertaken to main- tain or improve skills required in his trade or business. (The expenses are deductible, regardless of whether EXAMPLE: To become a permanent teacher, Kristin the individual is self-employed or employed, and even Nelson is required to have a bachelor’s degree. In the if the training is not required by his employer.) meantime, she obtains a provisional teacher’s certifi- cate, renewable on condition that she go to college and show progress toward obtaining the degree. Because However, a deduction for educational expenses is not her educational expenses are incurred primarily to permitted if the education or training qualifies (or helps meet the minimum requirements or qualifications as a qualify) the taxpayer for a new trade or business. permanent teacher, they are not deductible. ¶1907 PA R T 3 — C H A P T E R 1 9 — O t h e r B u s i n e s s , J o b - R e l a t e d , a n d I n v e s t m e n t E x p e n s e s 253 If the taxpayer has met the minimum requirements for General Rules for Deducting obtaining a position but the employer subsequently Work-Related Education Expenses increases the requirements, necessitating further study Type of Expense Deductible by the employee, the expenses are deductible. Education that is necessary to meet the mini- No mum requirements of the taxpayer’s present occupation, trade, or business. EXAMPLE: Donna Bird is a seventh grade teacher. She has 4 years of college education, which is Education that qualifies the taxpayer for a No new occupation, trade, or business. (Note: the minimum required by the state in which she is For employees, new duties involving the employed for her continuing certification to teach this same general type of work they are now grade. The state recently changed its requirements, performing do not constitute a new occu- and now seventh grade teachers must have 5 years pation.) of college education. Donna is entitled to deduct expenses incurred in obtaining the additional year If the taxpayer’s education expenses are not disallowed of college required by her employer. by the foregoing tests, then the education is qualifying work-related education if one of the following require- No deduction is allowed for costs of travel that would be ments is met: deductible only on the ground that the travel itself is a form of education. For example, when a teacher of French travels Type of Expense Deductible to France to maintain a general familiarity with the French Education that maintains or Yes language and culture, the travel is not deductible. improves skills required by the taxpayer in his occupation. For persons engaged in a trade or business, the allowable Education that is needed to Yes education expenses are deducted from gross income, along meet the express requirements with all other business expenses as adjustments to gross of the taxpayer’s employer or of applicable law or regula- income. Education expenses of an employee are considered tions imposed as a condition to miscellaneous deductions subject to the 2%-of-adjusted- the taxpayer’s retention of his gross-income rule. See ¶910. However, if the taxpayer’s AGI present employment, status, or is below a set limit, higher education tuition and fees up compensation. to $4,000 are deductible as an above-the-line deduction whether or not job-related. See ¶910. Excess tuition and Deductibility of Work-Related fees, plus transportation and other work-related education Education Expenses—Examples costs, can then be claimed as a miscellaneous itemized deduction if job-related. Occupation Education Expense Deductible Teacher Advanced courses to qualify Yes (elementary school) as high school instructor PRACTICE POINTER: A taxpayer may be eligible for Teacher (math) Courses to qualify in another Yes an education credit for higher education courses if subject (e.g., science) modified adjusted gross income is below set limits, Teacher Courses to qualify as guidance Yes which are more modest than the limits for the above- counselor and/or principal the-line deduction for tuition and fees. See ¶1105. Accountant Classes to obtain law degree No Accountant Review course to qualify as No STUDY QUESTION a certified public accountant (CPA) Engineer Classes to obtain law degree No 3. Which taxpayer cannot deduct educational costs? Engineer Pilot’s license No Doctor (general Courses in recent develop- Yes a. A teacher who takes courses to become a practitioner) ments for specialized fields principal of medicine b. An accountant who takes classes at night to Doctor Courses to study and train Yes obtain a law degree (psychiatrist) in psychoanalysis c. An engineer who takes classes toward a master’s degree in engineering ¶1907 254 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E Note that travel expenses away from home incurred engineering skills, because it led to his commercial pilot primarily to obtain education, the expenses of which are certificate (a new trade or business) (Thompson, TC deductible, are deductible to the extent that they are not Memo 2007-174). related to personal activities. For further information on a number of business ¶1908 Recent Developments Affecting expenses, see IRS Publication 508, Tax Benefits Other Business, Job-Related, for Work-Related Education; IRS Publication 529, and Investments Expenses Miscellaneous Deductions; IRS Publication 535, Business Expenses; and IRS Publication 587, Busi- An aeronautical engineer with NASA could not deduct ness Use of Your Home. the cost of flight school, even though helpful for his ¶1908 20 20 PART 3 — DEDUCTIONS FOR BUSINESS AND OTHER SPECIAL DEDUCTION RULES Moving Expense Deduction LEARNING OBJECTIVES Only certain expenses are eligible for deduction. The new residence must be a minimum distance This chapter was prepared to enable participants to beyond the old residence (“distance test”). learn the rules for the moving expense deduction. More The taxpayer must be employed in the new loca- specifically, upon completion, you will be able to: tion or be self-employed for a certain length of time Determine eligibility for deducting expenses. (“time test”). Understand how employer-paid expenses are treated. Moving expense reimbursements from an employer for Complete Form 3903. moves that would not entitle the employee to a moving expense deduction (e.g., a move of less than 50 miles) NEW THIS YEAR are reported as income. These reimbursements generally are reported on Form W-2. Standard mileage rate. The mileage rate for car travel in a move is 19¢ per mile for the first half of Moving expenses are reported on Form 3903, Moving 2008 and 27¢ per mile for the second half of 2008. Expenses, which is attached to the return. The deductible See ¶2002. amount is an adjustment to gross income claimed on page 1 of Form 1040. Both forms follow. ¶2001 In General (Sec. 217) Employees or self-employed persons who incur moving PRACTICE POINTER: Notify the IRS of a new address on Form 8822, Change of Address. Form 8822 is expenses during the year in connection with their jobs or shown on the following pages. businesses are entitled to a deduction for these expenses, provided that certain requirements are met: 23 Educator expenses (see page 27) 23 Adjusted 24 Certain business expenses of reservists, performing artists, and Gross fee-basis government officials. Attach Form 2106 or 2106-EZ 24 Income 25 Health savings account deduction. Attach Form 8889 25 26 Moving expenses. Attach Form 3903 26 27 One-half of self-employment tax. Attach Schedule SE 27 28 Self-employed SEP, SIMPLE, and qualified plans 28 29 Self-employed health insurance deduction (see page 26) 29 30 Penalty on early withdrawal of savings 30 31a Alimony paid b Recipient’s SSN 31a 32 IRA deduction (see page 27) 32 33 Student loan interest deduction (see page 30) 33 34 Tuition and fees deduction. Attach Form 8917 34 35 Domestic production activities deduction. Attach Form 8903 35 36 Add lines 23 through 31a and 32 through 35 36 37 Subtract line 36 from line 22. This is your adjusted gross income 37 For Disclosure, Privacy Act, and Paperwork Reduction Act Notice, see page 83. Cat. No. 11320B Form 1040 (2008) ¶2001 256 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E 3903 OMB No. 1545-0074 Moving Expenses Form 2008 Department of the Treasury Internal Revenue Service (99) Name(s) shown on return o f Attach to Form 1040 or Form 1040NR. Attachment Sequence No. 62 Your social security number Before you begin: s 8 See the Distance Test and Time Test in the instructions to find out if you can deduct your moving expenses. a 0 See Members of the Armed Forces on the back, if applicable. 1 2 the cost of meals ft 20 Transportation and storage of household goods and personal effects (see instructions) ra 3/ Travel (including lodging) from your old home to your new home (see instructions). Do not include 1 2 3 4 Add lines 1 and 2 D /0 Enter the total amount your employer paid you for the expenses listed on lines 1 and 2 that is 3 5 6 not included in box 1 of your Form W-2 (wages). This amount should be shown in box 12 of your Form W-2 with code P Is line 3 more than line 4? 0 4 No. You cannot deduct your moving expenses. If line 3 is less than line 4, subtract line 3 from line 4 and include the result on Form 1040, line 7, or Form 1040NR, line 8. Yes. Subtract line 4 from line 3. Enter the result here and on Form 1040, line 26, or Form 1040NR, line 26. This is your moving expense deduction 5 Moving Expenses You Can Members of the Armed Forces General Instructions may not have to meet the Deduct TIP distance and time tests. See What’s New instructions on the back. You can deduct the reasonable expenses For 2008, the standard mileage rate for of moving your household goods and using your vehicle to move to a new home personal effects and of traveling from your Distance Test is 19 cents a mile. old home to your new home. Reasonable expenses can include the cost of lodging Your new principal workplace must be at Purpose of Form (but not meals) while traveling to your new least 50 miles farther from your old home home. You cannot deduct the cost of than your old workplace was. For example, Use Form 3903 to figure your moving sightseeing trips. if your old workplace was 3 miles from expense deduction for a move related to your old home, your new workplace must the start of work at a new principal place be at least 53 miles from that home. If you of work (workplace). If the new workplace Who Can Deduct Moving did not have an old workplace, your new is outside the United States or its Expenses workplace must be at least 50 miles from possessions, you must be a U.S. citizen or your old home. The distance between the resident alien to deduct your expenses. If you move to a new home because of a two points is the shortest of the more new principal workplace, you may be able commonly traveled routes between them. If you qualify to deduct expenses for more than one move, use a separate Form to deduct your moving expenses whether you are self-employed or an employee. But To see if you meet the 3903 for each move. distance test, you can you must meet both the distance test and TIP For more details, see Pub. 521, Moving time test that follow. use the worksheet Expenses. below. Distance Test Worksheet Keep a Copy for Your Records 1. Number of miles from your old home to your new workplace 1. miles 2. Number of miles from your old home to your old workplace 2. miles 3. Subtract line 2 from line 1. If zero or less, enter -0- 3. miles Is line 3 at least 50 miles? Yes. You meet this test. No. You do not meet this test. You cannot deduct your moving expenses. Do not complete Form 3903. For Paperwork Reduction Act Notice, see back of form. Cat. No. 12490K Form 3903 (2008) ¶2001 PA R T 3 — C H A P T E R 2 0 — M o v i n g E x p e n s e D e d u c t i o n 257 Form 8822 Change of Address OMB No. 1545-1163 f (Rev. December 2008) Please type or print. Department of the Treasury See instructions on back. Do not attach this form to your return. o Internal Revenue Service Part I Complete This Part To Change Your Home Mailing Address s 8 Check all boxes this change affects: 1 Individual income tax returns (Forms 1040, 1040A, 1040EZ, 1040NR, etc.) 2 a 0 If your last return was a joint return and you are now establishing a residence separate ft 20 from the spouse with whom you filed that return, check here Gift, estate, or generation-skipping transfer tax returns (Forms 706, 709, etc.) ra 5/ For Forms 706 and 706-NA, enter the decedent’s name and social security number below. Decedent’s name Social security number 3a Your name (first name, initial, and last name) D /1 3b Your social security number 9 4a Spouse’s name (first name, initial, and last name) 4b Spouse’s social security number 5 6a Prior name(s). See instructions. 0 Old address (no., street, city or town, state, and ZIP code). If a P.O. box or foreign address, see instructions. Apt. no. 6b Spouse’s old address, if different from line 6a (no., street, city or town, state, and ZIP code). If a P.O. box or foreign address, see instructions. Apt. no. 7 New address (no., street, city or town, state, and ZIP code). If a P.O. box or foreign address, see instructions. Apt. no. Part II Complete This Part To Change Your Business Mailing Address or Business Location Check all boxes this change affects: 8 Employment, excise, income, and other business returns (Forms 720, 940, 940-EZ, 941, 990, 1041, 1065, 1120, etc.) 9 Employee plan returns (Forms 5500, 5500-EZ, etc.) 10 Business location 11a Business name 11b Employer identification number 12 Old mailing address (no., street, city or town, state, and ZIP code). If a P.O. box or foreign address, see instructions. Room or suite no. 13 New mailing address (no., street, city or town, state, and ZIP code). If a P.O. box or foreign address, see instructions. Room or suite no. 14 New business location (no., street, city or town, state, and ZIP code). If a foreign address, see instructions. Room or suite no. Part III Signature Daytime telephone number of person to contact (optional) ( ) Sign Here Your signature Date If Part II completed, signature of owner, officer, or representative Date If joint return, spouse’s signature Date Title For Privacy Act and Paperwork Reduction Act Notice, see back of form. Cat. No. 12081V Form 8822 (Rev. 12-2008) ¶2001 258 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E ¶2002 Eligible Expenses NOTE: Answers to Study Questions, with feedback Only certain types of expenses qualify for deduction. to both the correct and incorrect responses, are These include the reasonable cost of moving household provided in Chapter 35, beginning with ¶3520. goods and personal effects from the former residence to the new residence. This includes the costs of packing, ¶2003 What Move Qualifies for Deduction- crating, and in-transit storage. Mileage Limitations: Mileage Test Also deductible is the cost of traveling from the To qualify for the moving expense deduction, the new former residence to the new residence. This means place of work or business must be at least 50 miles farther the cost of transportation and lodging en route. from the old residence than was the taxpayer’s previous However, the cost of meals in transit is not deduct- job or business location. If the taxpayer had no previous ible. Also nondeductible are the costs of travel for job or business, the taxpayer will be permitted a deduc- house-hunting purposes. tion if the new job or business is at least 50 miles from If taxpayers use their cars for moving their families and his previous residence. household effects, they may use a flat mileage rate of 19¢ per mile for the first half of 2008 and 27¢ per mile for EXAMPLE: The distance from Bruce Buckley’s old the second half of 2008 instead of computing actual car residence to his old job is 10 miles and from his old expenses. Parking fees and tolls are deductible in addition residence to his new job is 65 miles. He qualifies for to the flat mileage rate. the deduction because the new job is at least 50 miles farther from his old home than the old job was. Expenses related to someone other than the taxpayer are deductible only if that other person has both the same old residence and same new residence as the EXAMPLE: Assume that the distance from Bruce’s taxpayer. Thus, the cost of moving the toys and cloth- old residence to the old job is 10 miles and from the ing of the taxpayer’s child who lives with the taxpayer old residence to the new job is 55 miles. Here, Bruce would be deductible. does not qualify for the deduction because the new job is only 45 miles farther from his old residence than the old job. STUDY QUESTIONS 1. All of the following are deductible expenses for pur- The law does not contain any specific requirements as poses of the moving expense deduction except: to the location of the new residence. The IRS, however, a. The cost of lodging for the family during the takes the position that, if the new residence is farther move from the new place of work than the old residence was, b. Meals that the family eats during the move the moving expense deduction will generally be denied, c. The cost of packing and crating household even if the 50-mile distance requirement is met. There goods are two exceptions. The moving expense deduction will not be denied if the taxpayer must reside at the new 2. The standard mileage rate for use of a car during a deductible move in 2008 is: residence as a condition of employment. Nor will it be denied if the taxpayer’s residency results in an actual a. 14¢ per mile b. 19¢ per mile for the first half of 2008 and 27¢ decrease in commuting time or expense. per mile for the second half of 2008 Special rules apply to moves abroad that are covered in c. 50.5¢ per mile for the first half of 2008 and 58.5¢ per mile for the second half of 2008 IRS Publication 521, Moving Expenses. ¶2002 PA R T 3 — C H A P T E R 2 0 — M o v i n g E x p e n s e D e d u c t i o n 259 STUDY QUESTION ¶2007 When to Claim the Deduction The moving expense deduction must be claimed for 3. In order to satisfy the mileage test for the mov- the year in which the expenses were paid or incurred. If ing expense deduction, the new place of work or the 39-week or 78-week requirement has not been met business must be at least how many miles farther from the old residence than was the previous job by the time the return is due but a sufficient portion of or business? the 12-month or 24-month period remains so that it is a. 10 miles possible to satisfy the applicable requirement, the taxpayer b. 35 miles may claim the moving expense deduction on the return. c. 50 miles Subsequently, if the taxpayer does not meet the applicable requirement (and the automatic waiver provisions do not apply), he will have to report the amount deducted on ¶2004 Time Requirements the return for the taxable year in which he is no longer To be eligible for the moving expense deduction, the able to satisfy the requirement. taxpayer (if an employee) must work in the new location (but not necessarily for the same employer) on a full- EXAMPLE: Steve Smith moves to his new place time basis for at least 39 weeks in the 12-month period of employment on November 5, 2008, and begins following the moving date. working November 8. His allowable moving expenses come to $500. Although he cannot meet the 39-week This provision is obviously designed to prevent the requirement until August 2009, he may deduct his deduction of moving expenses by an individual who moving expenses on his 2009 return. continuously moves from one location to another or who wants to move to another city and temporarily goes to work there in order to deduct his moving expenses. EXAMPLE: Assume that Steve quits his job in July The “full-time” work requirement bars a moving expense 2009 and has no other employment during the rest deduction for semi-retired persons, part-time students, of the year. He must report the $500 he deducted in 2008 as income on his 2009 income tax return. or those who work only a few hours each week. In the case of self-employed individuals, the definition of “full-time” depends upon the customary practice of the If the taxpayer prefers, he may instead file a return taxpayer’s occupation. without the moving expense deduction and then file an amended return on which these expenses are ¶2005 Self-Employed Persons deducted after the taxpayer has satisfied the 39-week If self-employed, taxpayers must perform full-time or 78-week requirement. services in their trade or business for at least 78 weeks during the 24-month period following the moving date (and 39 weeks in the first 12 months). EXAMPLE: Assume that Steve chose to file his 2008 return without claiming the moving expense deduc- ¶2006 Waiver Rules tion. During or after August 2009, when he has met the 39-week requirement, he can file an amended There will be occasions when a taxpayer cannot, for rea- return for 2008, taking the deduction for his moving sons beyond his control, fulfill the 39-week or 78-week expenses. He will then receive a refund for the dif- work requirement. In these situations, the 39-week or ference between the tax as originally computed and 78-week test will be automatically waived if the taxpayer as computed on the amended return. cannot fulfill it because of death or disability, loss of his job (if not for willful misconduct), or retransfer by the Similarly, if the taxpayer claims a moving expense employer for the employer’s benefit (provided that the deduction for 1 year, and discovers in a later year that employee had reasonably expected to remain at his job he cannot meet the 39- or 78-week requirement, the for the required period). taxpayer can file an amended return for the year in which the deduction was claimed in order to eliminate that deduction. If the taxpayer files an amended return, ¶2007 260 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E he is not required to include the amount originally Moving expenses that do not qualify as a fringe benefit deducted in his return for the later year. are includible in gross income. This would include an employer’s payment or reimbursement of expenses ¶2008 Employer Reimbursements deducted by an employee in a prior year. Moving expenses that are paid for or reimbursed by an A move paid for by the armed services is tax-free. employer can be treated as a nontaxable fringe benefit if the expenses would have been deductible had they been paid by the employee. Moving expenses that are treated as a fringe For further information on moving expenses, see IRS benefit are not includible in the employee’s gross income. Publication 521, Moving Expenses. They are not reported on the employee’s Form W-2. ¶2008 21 PART 3 — DEDUCTIONS FOR BUSINESS AND OTHER SPECIAL DEDUCTION RULES Depreciation LEARNING OBJECTIVES depreciation allowance may be taken on property held primarily for sale to customers, such as stock in trade This chapter was prepared to enable participants to gain and merchandise inventory. an understanding of the rules on depreciation. More specifically, upon completion, you will be able to: If property is used for both business and personal pur- poses, only that part of the depreciation allocable to Understand what property is depreciable. business use may be deducted. Figure first-year expensing. Report depreciation recapture. EXAMPLE: Frank Conner owns a two-family house; NEW THIS YEAR he resides in one apartment and rents the other. Depreciation is allowed on the portion rented, usually based on the number of rooms. First-year expensing. The dollar limit increased to $250,000 and the phase-out starting point increased to $800,000. See ¶2107. Bonus depreciation. 50% bonus depreciation can NOTE: Certain property used only partly for busi- be claimed for qualified property placed in service ness will be affected by the “mixed-use” rule. This in 2008. See ¶2104A. involves passenger cars and other so-called listed Luxury cars and trucks. New dollar limits apply property. See ¶2106. to depreciation claimed on luxury cars and trucks placed in service in 2008. See ¶2106. There are various methods to use in claiming deprecia- tion. The appropriate method depends on the type of ¶2101 Introduction (Sec. 167 and 168) asset involved (e.g., machinery or real estate) and when Taxpayers who acquire machinery, equipment, trucks, the asset is first used in the business or income-producing office furniture, buildings, or other property used in a activity. This time is referred to as the date the asset is trade, business, or other income-producing activity can “placed in service.” It is not the date on which the asset recover the cost over a period of time by means of tax was purchased, but rather the date it was put to use. deductions (depreciation). MACRS. Assets placed in service in 2008 generally are Depreciation is viewed as a deduction for the wear and depreciated under the Modified Accelerated Cost Recov- tear on property. Thus, antiques generally are not depre- ery System (MACRS). This method applies to property ciable (although two musicians convinced courts that placed in service after December 31, 1986, and to prop- their antique instruments were depreciable because they erty placed in service after July 31, 1986, for which an were subject to wear and tear—Simon, CA-2, 95-2 USTC election was made to have MACRS apply. See ¶2104. ¶50,552; Liddle, CA-3, 95-2 USTC ¶50,488). Because land ACRS. The Accelerated Cost Recovery System (ACRS) is not subject to the same wear and tear as other property, generally applies to property placed in service after 1980 it is generally not depreciable. and before 1987. To be eligible for a depreciation deduction, the property Old methods. Property placed in service before 1981 must be used in the taxpayer’s trade or business or be that has not yet been fully depreciated continues to be held for the production of income. No depreciation depreciated under the old rules in effect before ACRS. may be taken on a taxpayer’s private residence, pleasure This usually means under the “Asset Depreciation automobile, home furnishings, and so on. Also, no ¶2101 262 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E Range” (ADR) system or as determined by the facts and vehicle placed in service in a prior year; simply figure the circumstances pertaining to each asset. depreciation and enter the amount on the appropriate form or schedule. Self-employed persons can use Part IV Reporting. Depreciation is claimed on Form 4562, of Schedule C to figure depreciation on a business car Depreciation and Amortization. However, according to or truck if they are not otherwise required to file Form instructions to the form, it need not be filed with non- 4562. Employees claiming depreciation on cars must corporate (other than Form 1120S) returns if no new complete Form 2106, Employee Business Expenses, which property is placed in service in 2008, no amortization is appears at ¶1810. being claimed, and no depreciation is being claimed on a ¶2101 PA R T 3 — C H A P T E R 2 1 — D e p r e c i a t i o n 263 Depreciation and Amortization Form 4562 (Including Information on Listed Property) OMB No. 1545-0172 2008 f Department of the Treasury Internal Revenue Service Attachment See separate instructions. Attach to your tax return. 67 o (99) Sequence No. Name(s) shown on return Business or activity to which this form relates Identifying number Part I Election To Expense Certain Property Under Section 179 s 8 a 0 Note: If you have any listed property, complete Part V before you complete Part I. $250,000 ft 20 1 Maximum amount. See the instructions for a higher limit for certain businesses 1 2 Total cost of section 179 property placed in service (see instructions) 2 3 Threshold cost of section 179 property before reduction in limitation (see instructions) 3 $800,000 ra 1/ 4 Reduction in limitation. Subtract line 3 from line 2. If zero or less, enter -0- 4 5 Dollar limitation for tax year. Subtract line 4 from line 1. If zero or less, enter -0-. If married filing separately, see instructions D /1 5 (a) Description of property (b) Cost (business use only) (c) Elected cost 6 6 7 Listed property. Enter the amount from line 29 7 8 0 8 Total elected cost of section 179 property. Add amounts in column (c), lines 6 and 7 9 Tentative deduction. Enter the smaller of line 5 or line 8 9 10 Carryover of disallowed deduction from line 13 of your 2007 Form 4562 10 11 Business income limitation. Enter the smaller of business income (not less than zero) or line 5 (see instructions) 11 12 Section 179 expense deduction. Add lines 9 and 10, but do not enter more than line 11 12 13 Carryover of disallowed deduction to 2009. Add lines 9 and 10, less line 12 13 Note: Do not use Part II or Part III below for listed property. Instead, use Part V. Part II Special Depreciation Allowance and Other Depreciation (Do not include listed property.) (See instructions.) 14 Special depreciation allowance for qualified property (other than listed property) placed in service during the tax year (see instructions) 14 15 Property subject to section 168(f)(1) election 15 16 Other depreciation (including ACRS) 16 Part III MACRS Depreciation (Do not include listed property.) (See instructions.) Section A 17 MACRS deductions for assets placed in service in tax years beginning before 2008 17 18 If you are electing to group any assets placed in service during the tax year into one or more general asset accounts, check here Section B—Assets Placed in Service During 2008 Tax Year Using the General Depreciation System (b) Month and (c) Basis for depreciation (d) Recovery (a) Classification of property year placed in (business/investment use (e) Convention (f) Method (g) Depreciation deduction period service only—see instructions) 19a 3-year property b 5-year property c 7-year property d 10-year property e 15-year property f 20-year property g 25-year property 25 yrs. S/L h Residential rental 27.5 yrs. MM S/L property 27.5 yrs. MM S/L i Nonresidential real 39 yrs. MM S/L property MM S/L Section C—Assets Placed in Service During 2008 Tax Year Using the Alternative Depreciation System 20a Class life S/L b 12-year 12 yrs. S/L c 40-year 40 yrs. MM S/L Part IV Summary (See instructions.) 21 Listed property. Enter amount from line 28 21 22 Total. Add amounts from line 12, lines 14 through 17, lines 19 and 20 in column (g), and line 21. Enter here and on the appropriate lines of your return. Partnerships and S corporations—see instr. 22 23 For assets shown above and placed in service during the current year, enter the portion of the basis attributable to section 263A costs 23 For Paperwork Reduction Act Notice, see separate instructions. Cat. No. 12906N Form 4562 (2008) ¶2101 264 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E Form 4562 (2008) Page 2 Part V Listed Property (Include automobiles, certain other vehicles, cellular telephones, certain computers, and f property used for entertainment, recreation, or amusement.) Note: For any vehicle for which you are using the standard mileage rate or deducting lease expense, complete only o 24a, 24b, columns (a) through (c) of Section A, all of Section B, and Section C if applicable. Section A—Depreciation and Other Information (Caution: See the instructions for limits for passenger automobiles.) s 8 24a Do you have evidence to support the business/investment use claimed? Yes No 24b If “Yes,” is the evidence written? Yes No a 0 (c) (e) (i) (a) (b) Business/ (d) (f) (g) (h) investment Basis for depreciation Elected ft 20 Type of property (list Date placed in Cost or other Recovery Method/ Depreciation use (business/investment section 179 vehicles first) service basis period Convention deduction percentage use only) cost 25 Special depreciation allowance for qualified listed property placed in service during the tax ra 1/ year and used more than 50% in a qualified business use (see instructions) 25 26 Property used more than 50% in a qualified business use: D /1 % % % 27 Property used 50% or less in a qualified business use: 6 % S/L – % S/L – 28 29 % 0 Add amounts in column (h), lines 25 through 27. Enter here and on line 21, page 1 Add amounts in column (i), line 26. Enter here and on line 7, page 1 Section B—Information on Use of Vehicles S/L – 28 Complete this section for vehicles used by a sole proprietor, partner, or other “more than 5% owner,” or related person. 29 If you provided vehicles to your employees, first answer the questions in Section C to see if you meet an exception to completing this section for those vehicles. (a) (b) (c) (d) (e) (f) 30 Total business/investment miles driven Vehicle 1 Vehicle 2 Vehicle 3 Vehicle 4 Vehicle 5 Vehicle 6 during the year (do not include commuting miles) 31 Total commuting miles driven during the year 32 Total other personal (noncommuting) miles driven 33 Total miles driven during the year. Add lines 30 through 32 34 Was the vehicle available for personal Yes No Yes No Yes No Yes No Yes No Yes No use during off-duty hours? 35 Was the vehicle used primarily by a more than 5% owner or related person? 36 Is another vehicle available for personal use? Section C—Questions for Employers Who Provide Vehicles for Use by Their Employees Answer these questions to determine if you meet an exception to completing Section B for vehicles used by employees who are not more than 5% owners or related persons (see instructions). 37 Do you maintain a written policy statement that prohibits all personal use of vehicles, including commuting, Yes No by your employees? 38 Do you maintain a written policy statement that prohibits personal use of vehicles, except commuting, by your employees? See the instructions for vehicles used by corporate officers, directors, or 1% or more owners 39 Do you treat all use of vehicles by employees as personal use? 40 Do you provide more than five vehicles to your employees, obtain information from your employees about the use of the vehicles, and retain the information received? 41 Do you meet the requirements concerning qualified automobile demonstration use? (See instructions.) Note: If your answer to 37, 38, 39, 40, or 41 is “Yes,” do not complete Section B for the covered vehicles. Part VI Amortization (d) (e) (b) (c) (f) (a) Amortization Date amortization Amortizable Code Amortization for Description of costs period or begins amount section this year percentage 42 Amortization of costs that begins during your 2008 tax year (see instructions): 43 Amortization of costs that began before your 2008 tax year 43 44 Total. Add amounts in column (f). See the instructions for where to report 44 Form 4562 (2008) ¶2101 PA R T 3 — C H A P T E R 2 1 — D e p r e c i a t i o n 265 ¶2102 Failure to Take Depreciation (Sec. 1016) EXAMPLE: Assume that John, in the above example, Taxpayers should claim the proper amount of the allowed had invested only $8,500 in his property, the balance or allowable depreciation deduction for each year of being secured by a mortgage. He is still entitled to a eligibility. This includes the bonus depreciation allow- depreciation deduction on the entire $262,500. ance, where applicable, unless the taxpayer elects not to deduct it. DEPRECIATION UNDER MODIFIED ACCELERATED COST RECOVERY PITFALL: If taxpayers fail to deduct the allowable SYSTEM (MACRS) amount in 1 year, they may not generally deduct the unclaimed depreciation in a later year (except on an ¶2104 In General amended return). Still, the unclaimed depreciation (the amount that had been allowed) reduces the basis Under MACRS, the classes of property are 3-, 5-, 7-, of the property for purposes of determining gain or 10-, 15-, and 20-year property. Different classes apply loss on a disposition. to Indian reservation property (discussed on next page). In addition, most real property is classified as residential ¶2103 Basis for Determining Depreciation rental or nonresidential real property. See ¶2109 for (Sec. 167 and 168) depreciating real property. Generally, the basis for depreciation is the same as that PRACTICE POINTER: MACRS is not used for certain used for determining gain if the property is sold. For this property. For example, the income forecast method purpose, the basis is usually the property’s cost increased is used for film, videotape, sound recordings, copy- by improvements and decreased by any depreciation pre- rights, books, patents, and other similar property. viously deducted (see Chapter 15). Under MACRS, the However, the income forecast method cannot be property’s unrecovered basis is used (that is, generally the used for consumer durables subject to rent-to-own cost or other basis adjusted for depreciation previously contracts placed in service after August 5, 1997. allowed or allowable and for all other applicable adjust- Rent-to-own property placed in service after this ments). Under the Accelerated Cost Recovery System, date is 3-year property. the unadjusted basis is used. The class to which property is assigned is determined If a nonbusiness asset is converted to business use, by its class life. The class life of an item of property depreciation is allowable from the date of its conversion, determines its recovery period, the method of deprecia- and its basis is the lower of the fair market value or the tion used, and the applicable convention. (Declining adjusted basis. balance, straight-line, and other depreciation methods are defined at ¶2111.) EXAMPLE: In 1998, John Grey purchased as his residence a one-family home for $271,000, of which The class life of an item of property is the asset guideline $10,000 represented the cost of the land. In 1999, period that would apply to the property on January 1, he finished his basement at a cost of $1,500. On 1986, if an election had been made to use the asset July 1, 2008, he vacated the house and began rent- depreciation range (ADR) system prior to 1986. ing it. The fair market value of the house in July 2008 was $365,000 (excluding the land). John’s basis for Under MACRS, property other than residential rental computing depreciation is $262,500, the adjusted or nonresidential real property that the taxpayer places basis at the time of the conversion, because it is in service after 1986 (or after July 31, 1986, if elected) less than fair market value. Land is not depreciable will fall into one of the following classes: for tax purposes. Three-year property. This class includes property Remember that depreciation is computed on the full with a class life of 4 years or less, such as tractor cost or other basis of the property (other than land), units for use over the road, breeding hogs, and, as even if the property is mortgaged or subject to other designated, any race horse that is over 2 years old indebtedness. when placed in service and any other horse that is over 12 years old when placed in service. This class also includes rent-to-own property placed in service after August 5, 1997. Computer software generally ¶2104 266 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E is 3-year property unless it has a shorter life (e.g., it Property Class Recovery Period is the type that is replaced each year). 3-year property 2 years 5-year property 3 years NEW FOR 2009: For race horses age 2 years or 7-year property 4 years younger, when placed in service after December 10-year property 6 years 31, 2008, and before January 1, 2014, the recovery 15-year property 9 years period is 3 years (down from 7 years). 20-year property 12 years Five-year property. This class includes property with a class life of more than 4 years but less than 10 years, such NOTE: Motion picture films and videotapes cannot be as breeding sheep and goats; breeding and dairy cattle; depreciated using MACRS. Their costs must be recov- heavy, general-purpose trucks, computers and peripheral ered on the straight-line or income forecast method. equipment; office machinery (fax machines, calculators, and typewriters); carpet, appliances, and furniture used For property in the 3-, 5-, 7-, or 10-year class, the 200% in residential rental realty; and, as designated, any auto declining balance method over 3, 5, 7, or 10 years and a or light, general-purpose truck. Leasehold improvements half-year convention is used. For property in the 15- or to property used by a business in the New York Liberty 20-year class, the 150% declining balance method over Zone are also treated as 5-year property. 15 or 20 years and a half-year convention is used. The applicable depreciation rate (in percentage terms) is NOTE: There is a dollar limit on the depreciation determined by dividing the specified declining balance deduction for an auto. See ¶2106. percentage (150% or 200%) by the applicable recovery period. This applicable depreciation rate is constant for each tax year in which the declining balance method is NEW FOR 2009: Most farm equipment and machin- used and is applied to the property’s unrecovered basis ery is five-year property. (that is, generally, the cost or other basis adjusted for depreciation previously allowed or allowable and for all Seven-year property. This class includes property with other applicable adjustments). a class life of 10 years or more but less than 16 years, such as farm machinery and equipment; office furniture (e.g., desks, files, and safes) and fixtures; breeding and NOTE: The 200% declining balance method applied work horses 12 years old or less when placed in service; to property with a 5-year recovery period results in an applicable depreciation rate of 40% (200 ÷ 5) and, as designated, any single-purpose agricultural or in each full tax year. The 150% declining balance horticultural structure. This class also includes any method applied to property with a 7-year recovery property that does not have a class life and that has not period results in a depreciation rate of 21.43% (150 been designated by law as being in any other class. ÷ 7) in each full tax year. Ten-year property. This class includes property with a class life of 16 years or more but less than 20 years. Fifteen-year property. This class includes property with The tables automatically change to the straight-line a class life of 20 years or more but less than 25 years. method for the first tax year in which use of this method Twenty-year property. This class includes property yields an allowance equal to or greater than the allowance with a class life of 25 years or more, such as farm yielded by using the declining balance method. Also, the buildings. taxpayer must use the straight-line method for nonresi- Twenty-five-year property. This class includes water dential real property, residential rental property, and any utility property. other class of property for which the taxpayer elects to Indian reservation property. Property placed in use it. For all classes, salvage value is treated as zero. service after 1993 used predominantly in the active conduct of a trade or business on an Indian reservation PRACTICE POINTER: Recovery periods for MACRS (for purposes other than gaming) has special recovery assets are in IRS Publication 946, How to Depreciate periods, as listed below. In addition, the recovery Property. period for nonresidential real property is 22 years. ¶2104 PA R T 3 — C H A P T E R 2 1 — D e p r e c i a t i o n 267 Half-year convention. Under MACRS, the half-year each tax year. If a taxpayer uses a table to compute the convention treats all property placed in service, or annual allowance for any item of property, the taxpayer disposed of, during a tax year as placed in service, or must use the table to compute the annual depreciation disposed of, on the midpoint of that tax year. Thus, as a allowances for the entire recovery period of such prop- practical matter, 5-year property will be depreciated over erty. However, a taxpayer may not continue to use a period of 6 years. The following example is based on the table if there are any adjustments to the property’s depreciation rates found in Table 1, which follows. basis for reasons other than (1) depreciation allowed or allowable or (2) an addition or an improvement to such Table 1: General Depreciation System property that is subject to depreciation as a separate Applicable Depreciation Method: 200 or 150% item of property. Taxpayers use the appropriate table for Declining Balance Switching to Straight-line any property based on the depreciation system, the Applicable Recovery Periods: 3, 5, 7, 10, 15, 20 years applicable depreciation method, the applicable recovery Applicable Convention: Half-year period, and the applicable convention. The tables list If the the percentage depreciation rates to be applied to the Recovery Year Is: And the Recovery Period Is: property’s unadjusted basis in each tax year (Rev. Proc. 3-year 5-year 7-year 10-year 15-year 20-year 87-57, 1987-2 CB 117). The Depreciation Rate Is: 1 . . . . . . . 33.33 20.00 14.29 10.00 5.00 3.750 Mid-quarter convention. If, during any tax year, the 2 . . . . . . . 44.45 32.00 24.49 18.00 9.50 7.219 aggregate bases of MACRS property that is placed in 3 . . . . . . . 14.81 19.20 17.49 14.40 8.55 6.677 service during the last 3 months of that tax year exceed 4....... 7.41 11.52 12.49 11.52 7.70 6.177 5.............. 11.52 8.93 9.22 6.93 5.713 40% of the aggregate bases of all property placed in 6.............. 5.76 8.92 7.37 6.23 5.285 service during that tax year, a mid-quarter convention 7..................... 8.93 6.55 5.90 4.888 is used instead of a half-year convention. In determining 8..................... 4.46 6.55 5.90 4.522 9............................ 6.56 5.91 4.462 the aggregate bases of MACRS property, the following 10 . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.55 5.90 4.461 property is not taken into account: 11 . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.28 5.91 4.462 12 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.90 4.461 Residential rental or nonresidential property 13 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.91 4.462 14 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.90 4.461 Property depreciated under another method pursuant 15 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.91 4.462 to an election (e.g., unit of production method or 16 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.95 4.461 other method not expressed in a term of years other 17 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.462 18 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.461 than the retirement-replacement-betterment method 19 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.462 or similar method) 20 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.461 Public utility property 21 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.231 Films and videotapes Sound recordings EXAMPLE: On February 1, 2008, David Greenwood Property placed in service for the purpose of secur- placed in service 5-year property costing $10,000. ing accelerated depreciation (i.e., property placed in His allowances are as follows: service in churning transactions) 2008 .............. $2,000 (20% of $10,000) Short-term property (property placed in service and 2009 .............. $3,200 (32% of $10,000) disposed of within the same year) 2010 .............. $1,920 (19.2% of $10,000) 2011 .............. $1,152 (11.52% of $10,000) In a mid-quarter convention, all property placed in 2012 .............. $1,152 (11.52% of $10,000) service, or disposed of, during any quarter of a tax year 2013 .............. $576 (5.76% of $10,000) is treated as placed in service, or disposed of, at the quarter’s midpoint. Optional tables. Optional tables can be used by certain Property placed in service and disposed of within the taxpayers in computing annual depreciation allowances. same tax year is disregarded in making the 40% deter- These tables specify schedules of annual depreciation mination. rates to be applied to the property’s unadjusted basis in ¶2104 268 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E Table 2: General Depreciation System Table 4: General Depreciation System Applicable Depreciation Method: 200 or 150% Applicable Depreciation Method: 200 or 150% Declining Balance Switching to Straight-line Declining Balance Switching to Straight-line Applicable Recovery Periods: 3, 5, 7, 10, 15, 20 years Applicable Recovery Periods: 3, 5, 7, 10, 15, 20 years Applicable Convention: Mid-quarter Applicable Convention: Mid-quarter (Property Placed in Service in First Quarter) (Property Placed in Service in Third Quarter) If the Recovery If the Year Is: And the Recovery Period Is: Recovery Year Is: And the Recovery Period Is: 3-year 5-year 7-year 10-year 15-year 20-year 3-year 5-year 7-year 10-year 15-year 20-year The Depreciation Rate Is: The Depreciation Rate Is: 1 . . . . . . . 25.00 15.00 10.71 7.50 3.75 2.813 1....... 58.33 35.00 25.00 17.50 8.75 6.563 2 . . . . . . . 50.00 34.00 25.51 18.50 9.63 7.289 2....... 27.78 26.00 21.43 16.50 9.13 7.000 3 . . . . . . . 16.67 20.40 18.22 14.80 8.66 6.742 3....... 12.35 15.60 15.31 13.20 8.21 6.482 4....... 8.33 12.24 13.02 11.84 7.80 6.237 4....... 1.54 11.01 10.93 10.56 7.39 5.996 5 . . . . . . . . . . . . . . 11.30 9.30 9.47 7.02 5.769 5.............. 11.01 8.75 8.45 6.65 5.546 6.............. 7.06 8.85 7.58 6.31 5.336 6.............. 1.38 8.74 6.76 5.99 5.130 7..................... 8.86 6.55 5.90 4.936 7..................... 8.75 6.55 5.90 4.746 8..................... 5.53 6.55 5.90 4.566 8..................... 1.09 6.55 5.91 4.459 9............................ 6.56 5.91 4.460 9............................ 6.56 5.90 4.459 10 . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.55 5.90 4.460 10 . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.55 5.91 4.459 11 . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.10 5.91 4.460 11 . . . . . . . . . . . . . . . . . . . . . . . . . . . 0.82 5.90 4.459 12 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.90 4.460 12 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.91 4.460 13 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.91 4.461 13 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.90 4.459 14 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.90 4.460 14 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.91 4.460 15 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.91 4.461 15 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.90 4.459 16 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.69 4.460 16 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0.74 4.460 17 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.461 17 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.459 18 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.460 18 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.460 19 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.461 19 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.459 20 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.460 20 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.460 21 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.788 21 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0.557 Table 5: General Depreciation System Table 3: General Depreciation System Applicable Depreciation Method: 200 or 150% Declining Balance Switching to Straight-line Applicable Depreciation Method: 200 or 150% Applicable Recovery Periods: 3, 5, 7, 10, 15, 20 years Declining Balance Switching to Straight-line Applicable Convention: Mid-quarter Applicable Recovery Periods: 3, 5, 7, 10, 15, 20 years (Property Placed in Service in Fourth Quarter) Applicable Convention: Mid-quarter (Property Placed in Service in Second Quarter) If the Recovery If the Year Is: And the Recovery Period Is: Recovery 3-year 5-year 7-year 10-year 15-year 20-year Year Is: And the Recovery Period Is: The Depreciation Rate Is: 3-year 5-year 7-year 10-year 15-year 20-year 1....... 8.33 5.00 3.57 2.50 1.25 0.938 The Depreciation Rate Is: 2....... 61.11 38.00 27.55 19.50 9.88 7.430 1....... 41.67 25.00 17.85 12.50 6.25 4.688 3....... 20.37 22.80 19.68 15.60 8.89 6.872 2....... 38.89 30.00 23.47 17.50 9.38 7.148 4....... 10.19 13.68 14.06 12.48 8.00 6.357 3....... 14.14 18.00 16.76 14.00 8.44 6.612 5.............. 10.94 10.04 9.98 7.20 5.880 4....... 5.30 11.37 11.97 11.20 7.59 6.116 6.............. 9.58 8.73 7.99 6.48 5.439 5.............. 11.37 8.87 8.96 6.83 5.658 7..................... 8.73 6.55 5.90 5.031 6.............. 4.26 8.87 7.17 6.15 5.233 8..................... 7.64 6.55 5.90 4.654 7..................... 8.87 6.55 5.91 4.841 9............................ 6.56 5.90 4.458 8..................... 3.33 6.55 5.90 4.478 10 . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.55 5.91 4.458 9............................ 6.56 5.91 4.463 11 . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.74 5.90 4.458 10 . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.55 5.90 4.463 12 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.91 4.458 11 . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.46 5.91 4.463 13 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.90 4.458 12 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.90 4.463 14 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.91 4.458 13 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.91 4.463 15 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.90 4.458 14 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.90 4.463 16 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.17 4.458 15 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.91 4.462 17 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.458 16 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.21 4.463 18 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.459 17 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.462 19 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.458 18 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.463 20 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.459 19 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.462 21 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.901 20 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.463 21 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.673 ¶2104 PA R T 3 — C H A P T E R 2 1 — D e p r e c i a t i o n 269 Real property. Nonresidential real property includes to calculate energy savings. Qualified software is listed any real property that is not residential rental property at the U.S. Department of Energy’s Energy Efficiency and property with a class life of 27.5 years or more. This and Renewable Energy Agency at www.eere.energy.gov/ includes factories, storefronts, office buildings, and a buildings/info/qualified_software. home office in a taxpayer’s residence. This property is depreciated over 39 years using the straight-line method Residential rental property is a rental building or struc- and a mid-month convention (31.5 years for property ture for which 80% or more of the gross rental income placed in service before May 13, 1993). Nonresidential for the tax year is rental income from dwelling units. real property placed in service after 1993 and used This property is depreciated over 27.5 years using the predominantly in the active conduct of a trade or busi- straight-line method and mid-month convention. ness on an Indian reservation (for other than gaming purposes) has a 22-year recovery period. PRACTICE POINTER: Building components, such as special wiring, can be depreciated separately For improvements to leaseholds and restaurant property from the building itself over their shorter recovery placed in service before 2010, costs can be deducted period. For example, the IRS had allowed separate ratably over 15 years (rather than depreciated over depreciation of special flooring installed over wiring. 39 years). See ¶2202. However, the IRS has revised its opinion and may require components to be depreciated as part of the building (i.e., over the building’s recovery period). NOTE: The 15-year recovery period for qualified leasehold and restaurant improvements applies only to property placed in service before 2010, unless PRACTICE POINTER: Property acquired in a like-kind Congress extends this rule. For such property placed exchange can be depreciated over the remaining in service in 2010 or after, the recovery period reverts recovery period of the old property. For example, if to 39 years, unless Congress extends the break. there were 12 years remaining on the recovery period of the old building, the newly acquired building can be depreciated over those 12 years. Commercial buildings that achieve a 50% energy sav- ings target can deduct $1.80 per square foot of building Mid-month convention. Under a mid-month conven- floor area (60¢ per square foot for more modest energy tion, all property placed in service, or disposed of, during savings). Before claiming the deduction, the owner any month is treated as placed in service, or disposed of, must self-certify that the required energy savings will be on the midpoint of that month. achieved, which is done by using IRS-approved software ¶2104 270 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E Table 6: General Depreciation System Applicable Depreciation Method: Straight-line Applicable Recovery Period: 27.5 years Applicable Convention: Mid-month If the Recovery And the Month in the First Recovery Year Year Is: the Property Is Placed in Service Is: 1 2 3 4 5 6 7 8 9 10 11 12 The Depreciation Rate Is: 1............ 3.485 3.182 2.879 2.576 2.273 1.970 1.667 1.364 1.061 0.758 0.455 0.152 2............ 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3............ 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 4............ 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 5............ 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 6............ 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 7............ 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 8............ 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 9............ 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 10 . . . . . . . . . . . 3.637 3.637 3.637 3.637 3.637 3.637 3.636 3.636 3.636 3.636 3.636 3.636 11 . . . . . . . . . . . 3.636 3.636 3.636 3.636 3.636 3.636 3.637 3.637 3.637 3.637 3.637 3.637 12 . . . . . . . . . . . 3.637 3.637 3.637 3.637 3.637 3.637 3.636 3.636 3.636 3.636 3.636 3.636 13 . . . . . . . . . . . 3.636 3.636 3.636 3.636 3.636 3.636 3.637 3.637 3.637 3.637 3.637 3.637 14 . . . . . . . . . . . 3.637 3.637 3.637 3.637 3.637 3.637 3.636 3.636 3.636 3.636 3.636 3.636 15 . . . . . . . . . . . 3.636 3.636 3.636 3.636 3.636 3.636 3.637 3.637 3.637 3.637 3.637 3.637 16 . . . . . . . . . . . 3.637 3.637 3.637 3.637 3.637 3.637 3.636 3.636 3.636 3.636 3.636 3.636 17 . . . . . . . . . . . 3.636 3.636 3.636 3.636 3.636 3.636 3.637 3.637 3.637 3.637 3.637 3.637 18 . . . . . . . . . . . 3.637 3.637 3.637 3.637 3.637 3.637 3.636 3.636 3.636 3.636 3.636 3.636 19 . . . . . . . . . . . 3.636 3.636 3.636 3.636 3.636 3.636 3.637 3.637 3.637 3.637 3.637 3.637 20 . . . . . . . . . . . 3.637 3.637 3.637 3.637 3.637 3.637 3.636 3.636 3.636 3.636 3.636 3.636 21 . . . . . . . . . . . 3.636 3.636 3.636 3.636 3.636 3.636 3.637 3.637 3.637 3.637 3.637 3.637 22 . . . . . . . . . . . 3.637 3.637 3.637 3.637 3.637 3.637 3.636 3.636 3.636 3.636 3.636 3.636 23 . . . . . . . . . . . 3.636 3.636 3.636 3.636 3.636 3.636 3.637 3.637 3.637 3.637 3.637 3.637 24 . . . . . . . . . . . 3.637 3.637 3.637 3.637 3.637 3.637 3.636 3.636 3.636 3.636 3.636 3.636 25 . . . . . . . . . . . 3.636 3.636 3.636 3.636 3.636 3.636 3.637 3.637 3.637 3.637 3.637 3.637 26 . . . . . . . . . . . 3.637 3.637 3.637 3.637 3.637 3.637 3.636 3.636 3.636 3.636 3.636 3.636 27 . . . . . . . . . . . 3.636 3.636 3.636 3.636 3.636 3.636 3.637 3.637 3.637 3.637 3.637 3.637 28 . . . . . . . . . . . 1.970 2.273 2.576 2.879 3.182 3.485 3.636 3.636 3.636 3.636 3.636 3.636 29 . . . . . . . . . . . 0.000 0.000 0.000 0.000 0.000 0.000 0.152 0.455 0.758 1.061 1.364 1.667 ¶2104 PA R T 3 — C H A P T E R 2 1 — D e p r e c i a t i o n 271 Table 7: General Depreciation System Applicable Depreciation Method: Straight-line Applicable Recovery Period: 31.5 years Applicable Convention: Mid-month If the Recovery And the Month in the First Recovery Year Year Is: the Property Is Placed in Service Is: 1 2 3 4 5 6 7 8 9 10 11 12 the Depreciation Rate is: 1............ 3.042 2.778 2.513 2.249 1.984 1.720 1.455 1.190 0.926 0.661 0.397 0.132 2............ 3.175 3.175 3.175 3.175 3.175 3.175 3.175 3.175 3.175 3.175 3.175 3.175 3............ 3.175 3.175 3.175 3.175 3.175 3.175 3.175 3.175 3.175 3.175 3.175 3.175 4............ 3.175 3.175 3.175 3.175 3.175 3.175 3.175 3.175 3.175 3.175 3.175 3.175 5............ 3.175 3.175 3.175 3.175 3.175 3.175 3.175 3.175 3.175 3.175 3.175 3.175 6............ 3.175 3.175 3.175 3.175 3.175 3.175 3.175 3.175 3.175 3.175 3.175 3.175 7............ 3.175 3.175 3.175 3.175 3.175 3.175 3.175 3.175 3.175 3.175 3.175 3.175 8............ 3.175 3.174 3.175 3.174 3.175 3.174 3.175 3.175 3.175 3.175 3.175 3.175 9............ 3.174 3.175 3.174 3.175 3.174 3.175 3.174 3.175 3.174 3.175 3.174 3.175 10 . . . . . . . . . . . 3.175 3.174 3.175 3.174 3.175 3.174 3.175 3.175 3.175 3.175 3.175 3.175 11 . . . . . . . . . . . 3.174 3.175 3.174 3.175 3.174 3.175 3.174 3.175 3.174 3.175 3.174 3.175 12 . . . . . . . . . . . 3.175 3.174 3.175 3.174 3.175 3.174 3.175 3.174 3.175 3.174 3.175 3.174 13 . . . . . . . . . . . 3.174 3.175 3.174 3.175 3.174 3.175 3.174 3.175 3.174 3.175 3.174 3.175 14 . . . . . . . . . . . 3.175 3.174 3.175 3.174 3.175 3.174 3.175 3.174 3.175 3.174 3.175 3.174 15 . . . . . . . . . . . 3.174 3.175 3.174 3.175 3.174 3.175 3.174 3.175 3.174 3.175 3.174 3.175 16 . . . . . . . . . . . 3.175 3.174 3.175 3.174 3.175 3.174 3.175 3.174 3.175 3.174 3.175 3.174 17 . . . . . . . . . . . 3.174 3.175 3.174 3.175 3.174 3.175 3.174 3.175 3.174 3.175 3.174 3.175 18 . . . . . . . . . . . 3.175 3.174 3.175 3.174 3.175 3.174 3.175 3.174 3.175 3.174 3.175 3.174 19 . . . . . . . . . . . 3.174 3.175 3.174 3.175 3.174 3.175 3.174 3.175 3.174 3.175 3.174 3.175 20 . . . . . . . . . . . 3.175 3.174 3.175 3.174 3.175 3.174 3.175 3.174 3.175 3.174 3.175 3.174 21 . . . . . . . . . . . 3.174 3.175 3.174 3.175 3.174 3.175 3.174 3.175 3.174 3.175 3.174 3.175 22 . . . . . . . . . . . 3.175 3.174 3.175 3.174 3.175 3.174 3.175 3.174 3.175 3.174 3.175 3.174 23 . . . . . . . . . . . 3.174 3.175 3.174 3.175 3.174 3.175 3.174 3.175 3.174 3.175 3.174 3.175 24 . . . . . . . . . . . 3.175 3.174 3.175 3.174 3.175 3.174 3.175 3.174 3.175 3.174 3.175 3.174 25 . . . . . . . . . . . 3.174 3.175 3.174 3.175 3.174 3.175 3.174 3.175 3.174 3.175 3.174 3.175 26 . . . . . . . . . . . 3.175 3.174 3.175 3.174 3.175 3.174 3.175 3.174 3.175 3.174 3.175 3.174 27 . . . . . . . . . . . 3.174 3.175 3.174 3.175 3.174 3.175 3.174 3.175 3.174 3.175 3.174 3.175 28 . . . . . . . . . . . 3.175 3.174 3.175 3.174 3.175 3.174 3.175 3.174 3.175 3.174 3.175 3.174 29 . . . . . . . . . . . 3.174 3.175 3.174 3.175 3.174 3.175 3.174 3.175 3.174 3.175 3.174 3.175 30 . . . . . . . . . . . 3.175 3.174 3.175 3.174 3.175 3.174 3.175 3.174 3.175 3.174 3.175 3.174 31 . . . . . . . . . . . 3.174 3.175 3.174 3.175 3.174 3.175 3.174 3.175 3.174 3.175 3.174 3.175 32 . . . . . . . . . . . 1.720 1.984 2.249 2.513 2.778 3.042 3.175 3.174 3.175 3.174 3.175 3.174 33 . . . . . . . . . . . 0.000 0.000 0.000 0.000 0.000 0.000 0.132 0.397 0.661 0.926 1.190 1.455 ¶2104 272 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E Table 8: General Depreciation System Applicable Depreciation Method: Straight-line Applicable Recovery Period: 39 years Applicable Convention: Mid-month If the Recovery and the Month in the First Recovery Year Year Is: the Property Is Placed in Service Is: 1 2 3 4 5 6 7 8 9 10 11 12 the Depreciation Rate is: 1.............. 2.461 2.247 2.033 1.819 1.605 1.391 1.177 0.963 0.749 0.535 0.321 0.107 2–39 . . . . . . . . . . . 2.564 2.564 2.564 2.564 2.564 2.564 2.564 2.564 2.564 2.564 2.564 2.564 40 . . . . . . . . . . . . . 0.107 0.321 0.535 0.749 0.963 1.177 1.391 1.605 1.819 2.033 2.247 2.461 ¶2104A Bonus Depreciation erty’s basis whether or not a deduction is taken), a taxpayer There is an additional first-year depreciation allowance of may opt out of using bonus depreciation. If no election is 50% of the adjusted basis of qualified property that can be made in Part II of Form 4562, then bonus depreciation claimed for qualified property placed in service in 2008. automatically applies to all eligible property. If an election Bonus depreciation applies in addition to any first-year is desired, it must be made on a per-asset class basis. expensing (Section 179) that may be claimed, although the basis of the property is first reduced by the expensing deduc- PRACTICE POINTER: Consider opting out of using tion before figuring bonus depreciation (see ¶2107). bonus depreciation if the taxpayer’s business has little or no current business income against which to use the write-off but expects to have higher income EXAMPLE: In June 2008, Herman Perez buys two semi- in future years. trucks for $350,000. He claims first-year (Section 179) expensing of $250,000. His bonus depreciation is $50,000 (50% of $100,000). Assuming the truck is 7-year property, ¶2105 Alternative Depreciation System he can claim regular depreciation of $7,145 (14.29% of $350,000 – [$250,000 + $50,000]). His total write-off for Instead of claiming accelerated depreciation over the 2008 is $307,145 ($250,000 + $50,000 + $7,145), which is applicable recovery period for personal property and the 88% of his total cost. (14.29% is the rate from Table 1.) applicable recovery period for real property as described in ¶2104, different recovery periods (and methods) can be Bonus depreciation is not taken into account in deter- used under the alternative depreciation system (ADS). For mining the basis of property for purposes of the mid- example, an election can be made to depreciate equipment quarter convention. In effect, the basis of property placed over its applicable recovery period using the straight-line in service in the last quarter of the year is determined method instead of accelerated depreciation. without regard to bonus depreciation. EXAMPLE: Office furniture, which has a seven-year Eligible property. Bonus depreciation applies to any recovery period, normally is depreciated using the 200% property with a recovery period of 20 years or less, declining balance method. Under ADS, such furniture computer software (other than a Section 197 intan- can be depreciated using the straight-line method. gible as explained in ¶2205), and qualified leasehold improvements. It does not apply to property that must For real property (both residential and nonresidential), an be depreciated under ADS (see ¶ 2105), such as listed election can be made to use a 40-year recovery period. property used less than 50% for business. PRACTICE POINTER: Electing to use ADS may be PITFALL: Bonus depreciation cannot be claimed for desirable to avoid adjustments for alternative minimum used property; the use of the property must begin tax (AMT) purposes. For example, under ADS an AMT with the taxpayer. depreciation adjustment is required if real property is depreciated over any period other than 40 years. Election out of bonus depreciation. Unlike regular depre- ciation that effectively must be claimed (it reduces the prop- ¶2104A PA R T 3 — C H A P T E R 2 1 — D e p r e c i a t i o n 273 ¶2106 Limits on Depreciation for was placed in service, many of these limits no longer Mixed-Use Property (Sec. 280F) apply because the applicable years have passed. The dollar limits for these cars are: Limits are placed on the depreciation deductions allowed for cars, cellular phones, computers, and other “listed Car Placed Later property.” in Service 1st year 2nd year 3rd year Years 2004 10,610* 4,800 2,850 1,675 PRACTICE POINTER: A computer used in a home 2005 2,960 4,700 2,850 1,675 office, the expenses of which are deductible, is pre- sumed to be used entirely for business. No records 2006 2,960 4,800 2,850 1,775 proving business use are required. 2007 3,060 4,900 2,850 1,775 2008 10,960* 4,800 2,850 1,775 Property not predominantly used in business. “Listed * $2,960 for cars not eligible for bonus depreciation. property” not used more than 50% in a qualified busi- These limits are reduced when the percentage of business ness use is limited to depreciation on a straight-line basis. use is less than 100%. The property’s life is based on one used for computing earnings and profits (“E & P”) of a corporation. The following recovery periods are prescribed for making the EXAMPLE: Al Winslow places in service in April 2008 straight-line depreciation computation unless a longer a pre-owned car used 75% for business. His first-year dollar limit on depreciation is $2,220 (75% of $2,960). period was elected under the ACRS optional straight-line method for regular tax purposes: In the Case of: E & P Recovery Period PITFALL: The IRS has noted that claiming depreciation 3-year property 5 years for a car in excess of the dollar limit is one of the 5-year property 12 years most common errors made on individual income 10-year property 25 years tax returns. 15-year real property 35 years 18-year real property 35 or 40 years Heavy SUVs. Vehicles weighing over 6,000 pounds but 19-year real property 40 years not over 14,000 pounds are not subject to the dollar 15-year public utility property 35 years limits. However, these vehicles have a first-year expens- ing limit of $25,000 (if the SUV cost more than this Where business use exceeds 50%, then investment-related amount). Excess cost can be depreciated under regular use can be added to arrive at a final percentage. This is the depreciation rules. percentage of the otherwise allowable deduction that can be claimed for listed property. For example, if business use Light trucks and vans. The limit for such vehicles of a car is 80% and the deduction otherwise allowable for placed in service in 2008 is $11,160 for vehicles using such car is $1,000, the deduction is limited to $800. bonus depreciation and $3,160 for vehicles not using bonus depreciation. The second-year limit is $5,100; All taxpayers claiming either a depreciation or lease the third-year limit is $3,050; and the limit for each payment deduction for autos or other listed property, succeeding year is $1,875. regardless of the tax year in which this property was placed in service, must provide certain information to the IRS. Form 4562 is used for this purpose, regardless of NOTE: There are no longer any special limits on depreciating electric vehicles. the year in which the property was placed in service. Nonpersonal use trucks and vans. Vehicles modified PRACTICE POINTER: For mixed-use property, keep to permit only de minimis personal use are not subject to a log or diary in which business and personal use is noted. This documentary evidence will help support dollar limits. Modifications qualifying vehicles as non- a claim that business use exceeded 50%. personal use vehicles include special seating, permanent shelving, and signs painted on the exterior. Special dollar limits restrict write-offs for so-called luxury cars used for business. Depending on the year the vehicle ¶2106 274 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E ¶2107 Expensing in Lieu of from the active conduct of a trade or business. However, Depreciation (Sec. 179) any deduction disallowed as a result of this limitation can be carried forward and deducted in a subsequent year Taxpayers can elect to treat a qualifying property’s cost, (assuming there is sufficient taxable income in that year). up to a limited amount, as a current expense. The dollar limit for 2008 generally is $250,000. The costs for which For a partnership and an S corporation, both the entity the election is made are allowed as a deduction for the and each owner are subject to the annual dollar limita- tax year in which the qualifying property is placed in tion, as well as the taxable income limitation. service and are deducted currently instead of employing a MACRS deduction regarding the costs expensed. PITFALL: Owners of fiscal-year partnerships or S corporations may not enjoy the increased dollar limit LOOKING AHEAD: In 2009, the expensing limit will for 2008. For example, an entity with a fiscal year revert to the $125,000 limit (adjusted for inflation). In ending June 30, 2009, could use the $250,000 limit 2011, the dollar limit is set to decrease to $25,000 (the limit in effect on July 1, 2008, the start of its tax unless Congress again extends the law. year). But the calendar-year owner must use the limit in effect for the start of his or her tax year (January 1, 2009). The owner’s dollar limit is $125,000 (as Qualifying property. Personal property that is recovery adjusted for inflation). property and qualified for the investment credit is eligible for the expensing election. It must be property acquired for use in a trade or business. Off-the-shelf computer Expensing is not allowed for (1) property acquired from software now qualifies for expensing. a related party, (2) property acquired by a component member of a controlled group from another member of PRACTICE POINTER: Expensing can be used for the same group, (3) property held for the production of both new and used property. income, (4) autos on which the standard mileage rate is used, or (5) property the basis of which is determined in whole or in part (a) by reference to the transferor’s A $250,000 ceiling for expensing is provided where adjusted basis or (b) under the stepped-up basis rules for the total investment in tangible personal property is property acquired from a decedent. It is also not allowed $800,000 or less. The $250,000 ceiling is reduced by $1 for heating and air-conditioning units. for every dollar of investment in excess of $800,000. Limits on mixed-use property. For passenger cars and EXAMPLE: In 2008, Nate Arnold places in service other “listed property,” limits are placed on the depre- equipment costing $900,000. Nate’s first-year ciation deductions allowed for this property placed in expense deduction is limited to $150,000 [$250,000 service (¶2106). less $100,000 (the amount exceeding $800,000)]. PITFALL: The expensing deduction is recaptured For equipment placed in service by a trade or business in when property is not predominantly used in a trade an enterprise zone (designated by HUD), in addition to or business at any time before the end of the recov- the $250,000 expense limitation, there is an additional ery period. Thus, in the tax year that the property is $35,000 limit for a maximum first-year expense deduction not used predominantly in a trade or business, the of $285,000. For equipment placed in service in a Gulf taxpayer must include in income the “tax benefit” Opportunity Zone, Greensburg, Kansas, and certain areas derived from the expensing deduction. impacted by the 2008 Midwest floods or Hurricane Ike, there is an additional $100,000 limit for certain property Election. A taxpayer makes the election to expense prop- (most qualifying property ceased at the end of 2007), so that erty under Section 179 on Form 4562 and must specify the maximum deduction in 2008 is $350,000 ($250,000 the items of property to which the election applies and $100,000). The first-year expensing deduction for prop- the part of the cost of each of these items to be deducted erty in these special disaster areas starts to phase out when currently. The election must be made on an original property placed in service exceeds $1,400,000. return (including a late-filed original return) for the year that the property is placed in service. Through 2009, an Taxable income limitation. An additional limitation is election can be made if it was not done so on an original imposed on first-year expensing. The amount allowed as an return or revoked if the election was made on an original expense deduction cannot exceed taxable income derived ¶2107 PA R T 3 — C H A P T E R 2 1 — D e p r e c i a t i o n 275 return without IRS consent. The change is made by filing The optional recovery periods under the straight-line an amended return, but once this is done, it cannot be ACRS election for 15-year real property are 15, 35, and 45 changed again without IRS consent. years. For 18-year real property and low-income housing, the optional recovery periods are 18, 35, and 45 years. For STUDY QUESTION 19-year recovery property and low-income housing, the optional recovery periods are 19, 35, and 45 years. 1. The maximum first-year expensing deduction for 2008 generally is: Under ACRS, equal depreciation is required for the entire structure other than those components that a a. $25,000 b. $125,000 taxpayer properly elects to amortize (such as low-income c. $250,000 rehabilitation expenditures). Thus, the same recovery period and method, in general, must be used for each component, such as plumbing, wiring, and so on. NOTE: Answers to Study Questions, with feedback When a taxpayer makes a substantial improvement to a to both the correct and incorrect responses, are building, it is treated as a separate building rather than provided in Chapter 35, beginning with ¶3521. as one or more components. Thus, the taxpayer may use the regular ACRS deduction for the substantial improvement, or he may elect the straight-line ACRS DEPRECIATION UNDER ACCELERATED deduction over the regular or a longer recovery period, COST RECOVERY SYSTEM (ACRS) regardless of the ACRS method or recovery period that ¶2108 Accelerated Cost Recovery System is used for the rest of the building. An improvement is (ACRS) for Personal Property substantial if (1) the amounts added to the building’s capital account over a 2-year period are at least 25% of The annual deduction for property placed in service after the building’s adjusted basis (disregarding depreciation 1980 and before 1987 was found by applying the appro- and amortization adjustments) as of the first day of that priate percentage to the property’s unadjusted basis. This period and (2) the improvement is made at least 3 years applicable percentage depended on the class of property. after the building was placed in service. The only property (other than real estate) still being depre- ciated under ACRS is 15-year public utility property. Real property (other than low-income housing). Prop- erty placed in service after March 15, 1984, and before ¶2109 Real Property May 9, 1985, had an 18-year recovery period applied. Buildings placed in service after May 8, 1985, and before Property placed in service after May 8, 1985, and before 1987 have a 19-year recovery period (buildings placed in January 1, 1987, had a 19-year recovery period. service after March 15, 1984, and before May 9, 1985, had an 18-year recovery period). Different recovery DEPRECIATION NOT UNDER MACRS periods apply to low-income housing and to other realty ¶2110 In General placed in service before January 1, 1987. Note that low- income housing placed in service before May 9, 1985, The cost or other basis of property not eligible for which had been subject to a 15-year recovery period, has MACRS is depreciated over the asset’s estimated useful now been fully depreciated. life. The estimated useful life refers to the period of years during which the asset may be expected to be useful to NOTE: The first-year percentages are based on the num- taxpayers in their trade or business. ber of months the realty is in service in the year it is placed So-called non-MACRS property means (1) property in service. Real property placed in service after March 15, 1984, and before May 9, 1985, had an 18-year recovery placed in service before 1981; (2) property not depreci- period. Recovery property placed in service after May ated in terms of years; (e.g., motion pictures and video 8, 1985, had a 19-year recovery period. Low-income cassettes) (3) certain intangible property (for example, housing retains the 15-year recovery period. Transitional patents or copyrights) (see ¶2104); or (4) certain property rules applied to property placed in service after May 8, acquired in a “churning” transaction. 1985, and before January 1, 1987, when there is a binding contract to acquire or construct the property. ¶2110 276 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E For used residential rental property with a remaining useful PRACTICE POINTER: As a practical matter, most life of at least 20 years, the taxpayer may use either the straight- property placed in service before 1981, other than real estate, has already been fully depreciated. line method or the declining balance method, but the latter is limited to a maximum of 125% of the straight-line rate. All other used real estate is restricted to the straight-line method ¶2111 Special Limitations on only; no accelerated depreciation method can be used. Depreciation of Real Estate There are some special restrictions that apply only to accel- STUDY QUESTION erated depreciation on real estate. The restrictions do not apply to real estate owned before July 25, 1969. Likewise, 2. In 2008, a taxpayer begins to use a room in his the restrictions do not apply if a taxpayer had either begun one-family home that qualifies for home office deductions. He can depreciate the basis of the construction or entered into a binding contract to acquire room over what period? or construct such property before July 25, 1969. a. 27.5 years Also, the special restrictions do not apply to new “resi- b. 31.5 years dential” property, such as apartment buildings and rental c. 39 years housing developments, regardless of when acquired. Thus, on new residential rental property the 200% declining ¶2112 Change of Depreciation Methods balance method, as well as the sum-of-the-years-digits method, is permitted. Property held for mixed residen- Taxpayers may use different depreciation methods for dif- tial and commercial use (such as apartment buildings ferent assets; thus, they may use the straight-line method containing stores) will be considered “residential” if 80% for one asset or group of assets, and the declining balance or more of the gross rental income stems from dwelling method for other assets. However, once they have begun units. A hotel, motel, or other establishment in which to use a particular depreciation method for any asset or more than half of the units are used on a transient basis assets, they cannot change to another method without is not considered residential property for this purpose. obtaining prior IRS approval. An exception to this rule is that, if taxpayers are using the declining balance method, On all other new real estate property, the taxpayer may they may change to the straight-line method at any time use either the straight-line method or the declining bal- without obtaining prior approval. ance method, but at a rate not to exceed 150% of the straight-line rate. The IRS has procedures under which a number of changes in depreciation method can be made—with approval For any year in which the 80% test is not met, the 150% considered to have been given—if specified rules are fol- declining balance rate for new nonresidential property lowed. File Form 3115, Application for Change in Account- can be used. A shift to or from the 150% rate by reason ing Method, with the Service Center where the taxpayer of the 80% test does not require IRS consent. filed his return during the year of change. Approval is automatic if the taxpayer files on time and furnishes all of the information required (refer to IRS Publication 538, EXAMPLE: Mark Reid built an apartment building in 1980, Accounting Periods and Methods, for details). but rented the first floor to commercial tenants. Rents from dwelling units total $75,000, while rents from commer- cial tenants total $25,000. Because rents from dwelling PRACTICE POINTER: The IRS has provided a sim- units are only 75% of the gross rents, Mark cannot use a plified procedure for obtaining automatic consent method faster than that applicable to new nonresidential to change an accounting method to claim under- property (that is, the 150% declining balance). depreciation when the taxpayer still owns the prop- erty. No user fee is required. See Rev. Proc. 2008-52 for details. EXAMPLE: Assume that in 2008 rents from dwelling units rise to $125,000 while rents from commercial ¶2113 Deduction for Obsolescence tenants are still $25,000. The 80% test is met (83.3%) for 2008, so the 200% declining balance or sum-of-the- It frequently happens that an item of machinery or years-digits method may now be used. IRS consent is equipment becomes outdated (or “obsolete”) because of not necessary for a change to either method. technological advances or sudden economic changes long ¶2111 PA R T 3 — C H A P T E R 2 1 — D e p r e c i a t i o n 277 before the physical usefulness of the item is exhausted. half of the year and no depreciation for those assets put Thus, if it becomes clear that an asset that has a useful in service during the last half of the year. life of 10 years has to be discarded after 2 years, the taxpayer may take an additional depreciation deduction Asset Depreciation Range System guidelines. A as a result of obsolescence. complete table with guideline lives can be found in Rev. Proc. 83-35, 1983-1 CB 745. ¶2114 The ADR Depreciation System The Asset Depreciation Range (ADR) System was NOTE: The above revenue procedure sets out the asset guideline classes, asset guideline periods and terminated for property placed in service after 1980. It ranges, and annual asset guideline repair allowance is generally replaced by the Accelerated Cost Recovery percentages for the Class Life Asset Depreciation System (ACRS) and the Modified Accelerated Cost Range System. The asset guideline periods (midpoint Recovery System (MACRS). However, post-1980 ADR class lives) set out in Rev. Proc. 83-35 are also used depreciation may continue to be claimed on pre-1981 in defining the classes of recovery property under assets for which the ADR election was made. ACRS. This revenue procedure remains effective for property subject to depreciation under those systems. Most types of assets are encompassed in the list of eligible Rev. Proc. 83-35 is obsoleted for property subject to MACRS. (Rev. Proc. 87-56, 1987-2 CB 27) assets under ADR. Further, subsidiary assets (dies, tools, returnable containers, glassware, and silverware) can be depreciated as a separate class as set up by the IRS using their own useful lives. DEPRECIATION RECAPTURE ¶2115 In General (Sec. 1245 and 1250) ADR permits taxpayers to decrease the estimated useful life of eligible assets by as much as 20% less than the use- Until 1962, some taxpayers who had disposed of depre- ful life specified in the Treasury Depreciation Guidelines ciable property at a gain had a unique tax advantage. (see below) and, thus, increase their annual depreciation In many cases, as a result of accelerated depreciation deduction by as much as 25%. deductions, the basis of the property was less than the actual decline in its value. Thus, when the property was Salvage value. The annual depreciation deduction under sold, there was a taxable gain. Under previous law, this ADR is computed without taking salvage value into gain was taxed at capital gain rates (no more than half consideration. No matter what method of depreciation is of the regular tax rates), even though the depreciation used—straight-line, sum-of-the-years-digits, or declining deduction was a deduction against ordinary income. balance—the total depreciation taken cannot reduce the Hence, a taxpayer who utilized accelerated depreciation basis of the asset below estimated salvage value. However, deductions on an asset and then sold the asset had, in the amount of salvage value not in excess of 10% of the effect, converted ordinary income into a capital gain. cost of the property can be disregarded. Additionally, under ADR, if there is a dispute between the taxpayer and the In 1962, Congress plugged part of this loophole by Treasury, the taxpayer’s estimate will not be disturbed if the enacting Code Section 1245, which provided for the difference is not more than 10% of the item’s cost. This, “recapture” of certain depreciation deducted on most in effect, would allow depreciation of the entire cost even depreciable property with the exception of real estate. In though salvage value is as much as 20%. However, this extra 1964, Congress enacted Code Section 1250, which par- leeway will not be allowed if the taxpayer makes a regular tially extended the same rules to depreciable real estate. practice of underestimating salvage value. Code Section 1250 was further amended by the Tax Reform Act of 1969 and the Tax Reform Act of 1976. First-year convention. Under ADR, taxpayers can elect a half-year’s depreciation for all property placed in The effect of the recapture provision is to treat the gain service during the year. They therefore can treat all assets (or that part of it) that resulted from the depreciation as placed in service in the middle of the year (i.e., July 1 deduction as ordinary income, rather than as a capital for a calendar-year taxpayer). gain. Depreciation recapture is reported in Part III of Form In the alternative, a taxpayer may elect a full year’s 4797, Sales of Business Property. depreciation for assets placed in service during the first ¶2115 278 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E 4797 OMB No. 1545-0184 Sales of Business Property Form (Also Involuntary Conversions and Recapture Amounts 2008 f Under Sections 179 and 280F(b)(2)) Department of the Treasury Attachment Attach to your tax return. See separate instructions. 27 o Internal Revenue Service (99) Sequence No. Name(s) shown on return Identifying number 1 Part I s 8 Enter the gross proceeds from sales or exchanges reported to you for 2008 on Form(s) 1099-B or 1099-S (or substitute a 0 statement) that you are including on line 2, 10, or 20 (see instructions) Sales or Exchanges of Property Used in a Trade or Business and Involuntary Conversions From Other 1 ft 20 Than Casualty or Theft—Most Property Held More Than 1 Year (see instructions) (e) Depreciation (f) Cost or other ra 4/ (g) Gain or (loss) (a) Description (b) Date acquired (c) Date sold (d) Gross allowed or basis, plus Subtract (f) from the of property (mo., day, yr.) (mo., day, yr.) sales price allowable since improvements and acquisition expense of sale sum of (d) and (e) D /2 2 6 3 Gain, if any, from Form 4684, line 39 3 0 4 Section 1231 gain from installment sales from Form 6252, line 26 or 37 4 5 Section 1231 gain or (loss) from like-kind exchanges from Form 8824 5 6 Gain, if any, from line 32, from other than casualty or theft 6 7 Combine lines 2 through 6. Enter the gain or (loss) here and on the appropriate line as follows: 7 Partnerships (except electing large partnerships) and S corporations. Report the gain or (loss) following the instructions for Form 1065, Schedule K, line 10, or Form 1120S, Schedule K, line 9. Skip lines 8, 9, 11, and 12 below. Individuals, partners, S corporation shareholders, and all others. If line 7 is zero or a loss, enter the amount from line 7 on line 11 below and skip lines 8 and 9. If line 7 is a gain and you did not have any prior year section 1231 losses, or they were recaptured in an earlier year, enter the gain from line 7 as a long-term capital gain on the Schedule D filed with your return and skip lines 8, 9, 11, and 12 below. 8 Nonrecaptured net section 1231 losses from prior years (see instructions) 8 9 Subtract line 8 from line 7. If zero or less, enter -0-. If line 9 is zero, enter the gain from line 7 on line 12 below. If line 9 is more than zero, enter the amount from line 8 on line 12 below and enter the gain from line 9 as a long-term capital gain on the Schedule D filed with your return (see instructions) 9 Part II Ordinary Gains and Losses (see instructions) 10 Ordinary gains and losses not included on lines 11 through 16 (include property held 1 year or less): 11 Loss, if any, from line 7 11 ( ) 12 Gain, if any, from line 7 or amount from line 8, if applicable 12 13 Gain, if any, from line 31 13 14 Net gain or (loss) from Form 4684, lines 31 and 38a 14 15 Ordinary gain from installment sales from Form 6252, line 25 or 36 15 16 Ordinary gain or (loss) from like-kind exchanges from Form 8824 16 17 Combine lines 10 through 16 17 18 For all except individual returns, enter the amount from line 17 on the appropriate line of your return and skip lines a and b below. For individual returns, complete lines a and b below: a If the loss on line 11 includes a loss from Form 4684, line 35, column (b)(ii), enter that part of the loss here. Enter the part of the loss from income-producing property on Schedule A (Form 1040), line 28, and the part of the loss from property used as an employee on Schedule A (Form 1040), line 23. Identify as from “Form 4797, line 18a.” See instructions 18a b Redetermine the gain or (loss) on line 17 excluding the loss, if any, on line 18a. Enter here and on Form 1040, line 14 18b For Paperwork Reduction Act Notice, see separate instructions. Cat. No. 13086I Form 4797 (2008) ¶2115 PA R T 3 — C H A P T E R 2 1 — D e p r e c i a t i o n 279 Form 4797 (2008) Page 2 Part III Gain From Disposition of Property Under Sections 1245, 1250, 1252, 1254, and 1255 f (see instructions) o (b) Date acquired (c) Date sold 19 (a) Description of section 1245, 1250, 1252, 1254, or 1255 property: (mo., day, yr.) (mo., day, yr.) A B C s 8 a 0 ft 20 D These columns relate to the properties on lines 19A through 19D. Property A Property B Property C Property D ra 4/ 20 Gross sales price (Note: See line 1 before completing.) 20 21 Cost or other basis plus expense of sale 21 D /2 22 Depreciation (or depletion) allowed or allowable 22 23 Adjusted basis. Subtract line 22 from line 21 23 24 Total gain. Subtract line 23 from line 20 24 06 25 If section 1245 property: a Depreciation allowed or allowable from line 22 25a b Enter the smaller of line 24 or 25a 25b 26 If section 1250 property: If straight line depreciation was used, enter -0- on line 26g, except for a corporation subject to section 291. a Additional depreciation after 1975 (see instructions) 26a b Applicable percentage multiplied by the smaller of line 24 or line 26a (see instructions) 26b c Subtract line 26a from line 24. If residential rental property or line 24 is not more than line 26a, skip lines 26d and 26e 26c d Additional depreciation after 1969 and before 1976 26d e Enter the smaller of line 26c or 26d 26e f Section 291 amount (corporations only) 26f g Add lines 26b, 26e, and 26f 26g 27 If section 1252 property: Skip this section if you did not dispose of farmland or if this form is being completed for a partnership (other than an electing large partnership). a Soil, water, and land clearing expenses 27a b Line 27a multiplied by applicable percentage (see instructions) 27b c Enter the smaller of line 24 or 27b 27c 28 If section 1254 property: a Intangible drilling and development costs, expenditures for development of mines and other natural deposits, and mining exploration costs (see instructions) 28a b Enter the smaller of line 24 or 28a 28b 29 If section 1255 property: a Applicable percentage of payments excluded from income under section 126 (see instructions) 29a b Enter the smaller of line 24 or 29a (see instructions) 29b Summary of Part III Gains. Complete property columns A through D through line 29b before going to line 30. 30 Total gains for all properties. Add property columns A through D, line 24 30 31 Add property columns A through D, lines 25b, 26g, 27c, 28b, and 29b. Enter here and on line 13 31 32 Subtract line 31 from line 30. Enter the portion from casualty or theft on Form 4684, line 33. Enter the portion from other than casualty or theft on Form 4797, line 6 32 Part IV Recapture Amounts Under Sections 179 and 280F(b)(2) When Business Use Drops to 50% or Less (see instructions) (a) Section (b) Section 179 280F(b)(2) 33 Section 179 expense deduction or depreciation allowable in prior years 33 34 Recomputed depreciation (see instructions) 34 35 Recapture amount. Subtract line 34 from line 33. See the instructions for where to report 35 Form 4797 (2008) ¶2115 280 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E ¶2116 Depreciation Recapture on A conversion of business property to personal use is Personal Property (Sec. 1245) treated as a disposition, but no depreciation recapture is recognized on the conversion. Under Section 1245, any gain on the sale or exchange of depreciable personal property is treated as ordinary Section 1245 recovery property. Gain recognized on a income (instead of as a Section 1231 gain) to the extent post-1980 disposition of Section 1245 recovery property is of depreciation deducted (called Section 1245 gain). The ordinary income to the extent of prior ACRS deductions. remainder of the gain, if any, is treated as Section 1231 gain and, thus, may qualify for capital gain treatment. A first-year expense deduction (¶2107) is treated as a depreciated deduction for purposes of Section 1245 depreciation recapture. Thus, if property that was EXAMPLE: Ralph Collins installed equipment on January 5, 1998, for $5,600. On January 5, 2008, expensed ceases to be predominantly used in a trade or when the adjusted basis of the equipment was business (more than 50% business use), then recapture $3,528 ($5,600 less $2,072 depreciation), he sold it results. If property that was expensed is sold through the for $6,400, resulting in a recognized gain of $2,872. installment method, the expense deduction is subject to Post-1961 depreciation is $2,072. A portion of this immediate recapture. gain is Section 1245 income, computed as follows: Amount realized from sale . . . . . . . . . . . . . . . . . . $6,400 Installment sales. Section 1245 recapture is reported in Adjusted basis . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,528 the year of disposition, even if no payments are received Realized gain. . . . . . . . . . . . . . . . . . . . . . . . . $2,872 in that year. The taxpayer’s adjusted basis in the prop- erty disposed of is treated as including the amount of Ordinary income (Sec. 1245) . . . . . . . . . . . . . . . . $2,072 depreciation recapture income. Eligible for capital gain (Sec. 1231) . . . . . . . . . . . $800 Any “listed property” that was used more than 50% in In the example above, the Section 1245 income is equal a trade or business in the year it was placed in service, to the total depreciation deducted. Obviously, if the sell- but in the current tax year is used 50% or less, is subject ing price produced a gain less than the depreciation, the to depreciation recapture. See also ¶2106. Section 1245 income will be limited to the actual gain. Under MACRS, depreciation recapture on personal property has not changed. EXAMPLE: Assume that, in the above example, Ralph had sold the machine for $5,600 (instead of ¶2117 Charitable Contributions $6,400), resulting in a recognized gain of $2,072. The of Section 1245 Property entire gain is Section 1245 ordinary income. If taxpayers contribute property to a qualifying charitable organization, they are generally entitled to a deduction If a taxpayer transfers Section 1245 property to another (from adjusted gross income) equal to the fair market value person by gift and the recipient later sells the property at of the contributed property, subject to applicable limita- a gain, the taxpayer must take into account any deprecia- tions. However, if the contributed property consists of tion deducted by the donor in computing his Section Section 1245 property, the contribution deduction must 1245 income. be reduced by the amount that would have been treated as Section 1245 gain if the property had been sold at its EXAMPLE: Aaron Small purchased Section 1245 prop- fair market value instead of contributed to the charity. erty on January 1, 2006, for $10,000. Aaron claimed depreciation deductions of $2,000 before gifting the property to his son, Ben. Under the rules previously dis- EXAMPLE: Dennis Rudolph donates depreciable cussed, Ben’s adjusted basis in the property is $8,000, property to a charity with an adjusted basis of the same as in his father’s hands. Assume further that $10,000 and a fair market value of $17,000. Depre- Ben subsequently claims another $1,000 depreciation ciation was $4,000. If Dennis had sold the property on the property (reducing his adjusted basis to $7,000) for $17,000, he would have had a Section 1245 gain and then sells it for $10,500, realizing a recognized of $4,000. Hence, the amount of the contribution gain of $3,500. Of the gain, $3,000 would be treated deduction would be limited to $13,000 ($17,000 as Section 1245 ordinary income. The remainder of the - $4,000). gain, $500, is treated as a Section 1231 gain. ¶2116 PA R T 3 — C H A P T E R 2 1 — D e p r e c i a t i o n 281 ¶2118 Depreciation Recapture STUDY QUESTION on Real Estate (Sec. 1250) There are now two different sets of rules for figuring 3. Unrecaptured depreciation means that all deprecia- tion claimed after May 6, 1997, is taxed at a 25% depreciation recapture on real estate. rate when property is disposed of (assuming the Residential real property. For residential real property, taxpayer is in a tax bracket at or above this rate). there is the complete recapture of all post-1975 excess True or False? depreciation. This rule already applies to post-1969 excess depreciation on commercial property. ¶2119 Recent Developments Affecting Depreciation All of the depreciation taken, including straight-line, is recaptured if the property is disposed of within 12 The IRS has updated its guidance for an automatic months. This has been the rule and remains unchanged. change of accounting with respect to underdepreciation Here is how the amount of recapture on a sale of resi- (Rev. Proc. 2008-52, IRB 2008-36, 587, clarifying, dential rental housing is now computed: modifying, amplifying, and revoking Rev. Proc. 2002-9, 2002-1 CB 327). Post-1975. All excess depreciation (depreciation in excess of straight-line) attributable to periods after The IRS has provided guidance on claiming first-year December 31, 1975, is recaptured, regardless of when expensing for owners of fiscal-year pass-through enti- the property was placed in service. ties, which states that the dollar limit applicable to the entity and owner is the one in effect at the start of the Unrecaptured depreciation. Under MACRS, there is no entity’s and owner’s tax years (Rev. Proc. 2008-54, IRB recapture for all residential rental or nonresidential real 2008-38, 722). property since they are subject to straight-line depre- ciation. However, on sales of such property on or after The Economic Stimulus Act of 2008 increased the Sec- May 7, 1997, there may be “unrecaptured depreciation.” tion 179 deduction for 2008 to $250,000 (it had been This is the total of all depreciation taken on such prop- set to be $128,000) and raised the threshold for annual erty not otherwise recaptured as ordinary income, and it purchases to $800,000 (it had been set to be $532,000), is taxed at a maximum rate of 25% if the balance of the and re-introduced 50% bonus depreciation for 2008 gain is subject to the 15% capital gains tax rate. (P.L. 110-185). Installment sales. The amount of gain representing The ceilings for luxury cars placed in service in 2008 unrecaptured depreciation is treated as reported first and are $10,960 if bonus depreciation is used or $2,960 if subject to the 25% tax rate. Once all such unrecaptured bonus depreciation is not used for first year; $4,800 for depreciation has been reported, further gain is taxed at the second year; $2,850 for the third year; and $1,775 for the 15% rate. each year thereafter (Rev. Proc. 2008-22. IRB 2008-12, 658). EXAMPLE: Property purchased for $100,000 is sold The Cohan rule does not apply for depreciation, which on the installment method for $130,000 in five equal can only be based on the adjusted basis of property (with annual installments. The property had been depre- proof of adjusted basis) (Tyson Foods, Inc., TC Memo ciated to $80,000, resulting in a gain on the sale of $50,000 ($130,000 amount realized less $80,000 2007-188). basis). The gain represents $20,000 depreciation recapture, plus $30,000 long-term capital gain. Of For the IRS explanation of depreciation, see: IRS each payment of $26,000, $10,000 represents gain. Publication 534: Depreciating Property Placed in So gain in the first two payments is taxed at 25% (rep- Service Before 1987 and IRS Publication 946: How resenting a total of $20,000 Section 1250 gain), while to Depreciate Property. gain on the final three payments is taxed at 15%. ¶2119 22 PART 3 — DEDUCTIONS FOR BUSINESS AND OTHER SPECIAL DEDUCTION RULES Amortization and Depletion LEARNING OBJECTIVES In determining whether a leasehold improvement that is recovery property will be amortized over the term of This chapter was prepared to enable participants to gain the lease, the recovery period of such property is used an understanding of amortization and depletion. More instead of its useful life. specifically, upon completion, you will be able to: Where, under the terms of the lease, lessees have options Identify expenses subject to amortization. to renew the lease, the renewal period or periods must Figure depletion deductions. be taken into account in determining the period in which amortization is allowed, but only if the remaining ¶2201 Amortization unexpired term of the lease (not counting the renewal period) is less than 60% of the useful life of the improve- The deduction for amortization is similar to depre- ments. ciation in that the taxpayer is permitted to write off or “amortize” certain expenses over a given period of time. Unlike depreciation, amortization is always computed PRACTICE POINTER: If lessees can show that, as of on a straight-line basis. Amortization, like depreciation, the close of their tax year, it is more probable that the lease will not be renewed, the renewal period does is deductible from gross income in computing adjusted not have to be taken into account. gross income. Form 4562, Depreciation and Amortiza- tion, is used to report amortization deductions. See Form 4562 at ¶2101. No amortization deduction is permitted if the lessee and lessor are related persons at any time during the tax year. In such a case, the cost of the improvements must be ¶2202 Amortization of Improvements depreciated over the estimated useful life. “Related per- Made by Lessee or Lessor sons” are husband and wife, parents and children, grand- Lessees. Lessees or tenants of business or income- parents and grandchildren, and so on, or an individual producing property frequently make alterations or other and a corporation in which the former owns (directly or improvements to make the leased premises or property indirectly) 80% or more of the outstanding stock. suitable for their needs. The question then often arises on Under MACRS, the lessee is treated the same as any how lessees deduct the amounts spent on the improve- owner-taxpayer for determining MACRS allowances ments. Lessees must use MACRS real estate rates for as to improvements by the lessee placed in service after leasehold improvements after 1986. 1986. This means that the allowances are found without For pre-1987 improvements, if the useful life of the regard to the lease term, but rather with regard to the improvements is equal to or less than the remaining period underlying property. of the lease, taxpayers can simply recover their expendi- Lessors. Lessors who make leasehold improvements to tures by way of the regular depreciation deduction. On rental property recover the cost of those improvements the other hand, if the life of the improvements is expected over the term applicable to the underlying building. to last longer than the remaining period of the lease (and Thus, the same term is used for both the building and the assuming the improved property will revert to the owner improvements. However, the improvements are treated at the end of the lease without compensation to the lessee), as separate items whose depreciation begins on the date a depreciation deduction would not permit taxpayers to they are placed in service. recover their entire cost. For this reason, the law permits taxpayers to “amortize” or write off their costs over the A lessor who disposes of leasehold improvements made remaining period of the lease. for a lessee upon the lessee’s termination of the lease ¶2202 284 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E may use the adjusted basis of the improvements for PRACTICE POINTER: If the taxpayer can show that purposes of determining gain or loss. Thus, the lessor the lease will probably not be renewed, the renewal may recover the adjusted basis at that time (rather than period need not be taken into account. Likewise, if at the end of the lease term) for improvements disposed the lease is actually renewed or it is reasonably cer- of or abandoned after June 12, 1996. tain that it will be renewed, the renewal period must be taken into consideration in any event. Leasehold and restaurant improvements after October 22, 2004, and before January 1, 2010. Non- residential real property-related improvements placed NOTE: For property placed in service after 1986, the in service during this period can qualify for a 15-year term of a lease is determined by including all renewal recovery period, using straight-line depreciation, instead options as well as any other period for which the par- of being required to be depreciated over 39 years or ties reasonably expect the lease to be renewed. amortized over the term of the lease. The 15-year recovery period applies to qualified restau- ¶2204 Rehabilitation Outlays for Low-Income rant property. This is property placed in service more Rental Housing (Sec. 167) than 3 years after the building was placed in service. Rehabilitation expenditures generally are depreciated The restaurant must use more than half of the build- over the life of the building. In the past, a special rule ing’s square footage for the preparation of meals and allowed for amortization of certain expenditures over a on-premises consumption of meals. 60-month period. The rule applied to property placed in service before January 1, 1987. For low-income housing property placed in service after December 31, NOTE: The break for leasehold and restaurant improvements applies only through 2009 unless 1986 (other than grandfathered property), a low-income Congress extends it. housing credit replaces the amortization of rehabilitation expenditures. ¶2203 Cost of Acquiring a Lease (Sec. 178) ¶2205 Amortization of Intangibles (Sec. 177 and 197) When a taxpayer incurs expenses in acquiring a lease on business or income-producing property, that cost may be Acquired intangibles. Goodwill and other intangibles amortized over the period or remaining period of the lease. If acquired after August 10, 1993 (or after July 25, 1991, the lease contains a renewal option, the renewal period must for which a special election was made) and used in a trade be taken into account if less than 75% of the cost is attribut- or business or an activity engaged in for the production able to the portion of the term of the lease (not counting the of income may be amortized over a period of 15 years, renewal period) remaining on the date of its acquisition. beginning in the month of acquisition. These assets are called “Section 197 intangibles.” The amortizable basis is generally the asset’s cost basis. If intangibles are acquired EXAMPLE: Ellen Hughes paid a previous tenant as part of the sale of a business, the residual method must $10,000 for transferring to her the lease in a desir- be used to figure the allocated basis of intangibles. able office building. The remaining unexpired period of the lease was 5 years, and the lease contained a Section 197 intangibles include goodwill; going-concern 5-year renewal clause. value; workforce in place; information base; know-how; any Obviously, part of the amount paid for the lease customer-based intangible; any supplier-based intangible; was for its unexpired portion and part was for the any governmental unit or agency license, permit, or other option to renew the lease. If the amount attribut- right; covenant not to compete; and any franchise (other able to the unexpired term is less than $7,500 (75% than a sports franchise), trademark, or trade name. of $10,000), the renewal period must be taken into consideration. Therefore, the cost can be amortized Section 197 intangibles do not include self-created only over 10 years (5 years remaining plus the 5-year intangibles; interests in a corporation, partnership, trust, renewal period). If $7,500 or more is attributable to the remaining term of the current lease, the renewal or estate; interests under certain financial contracts; period need not be taken into consideration, and the interests in land; certain computer software; certain $10,000 may be amortized over 5 years. separately acquired rights and interests; interests under existing leases of tangible property; interests under exist- ¶2203 PA R T 3 — C H A P T E R 2 2 — A m o r t i z a t i o n a n d D e p l e t i o n 285 ing indebtedness; certain residential mortgage servicing the 5-year period. The balance may be recovered through rights; and certain corporate transaction costs. the regular depreciation allowance. Amortization of trademark expenditures. Expenses incurred in the registration, protection, or defense of a ¶2207 Amortization of Business Start-Up trademark or trade name would normally be treated as Expenditures (Sec. 195) capital expenses that can be amortized over their useful The tax treatment of start-up costs in 2008 depends on life. However, a trademark or trade name is a Section when the costs are incurred. One rule applies to post– 197 intangible acquired with the purchase of a business October 22, 2004, costs, while another rule applies to and can be amortized only over a 15-year period. pre–October 23, 2004, costs. STUDY QUESTIONS Start-up costs after October 22, 2004. A deduction of up to $5,000 can be claimed for start-up costs in 1. In January 2008, Amy Peterson, boutique owner, the year in which the business begins. Any start-up costs enters into a 10-year lease for her store, with a not deductible under this rule can be amortized ratably 5-year renewal option. To make the store more over a period of 180 months (15 years). This amortiza- suitable for her purposes, she makes extensive tion period mirrors the write-off for acquired intangibles improvements (assume the improvements have under Code Section 197. See ¶2205. a 39-year recovery period). She can amortize the improvements over: a. 10 years The $5,000 limit is reduced by one dollar for each b. 15 years dollar of costs exceeding $50,000, so that no first-year c. 39 years deduction is allowed if start-up or organizational costs exceed $55,000. 2. In 2008, Guy Edmonds buys a local stationery store. A portion of the purchase price is allocated Organizational costs. The same rules for start-up costs to goodwill. He can amortize the goodwill over: apply to organizational costs. a. A period of at least 60 months b. 15 years c. 39 years PRACTICE POINTER: To elect the current deduction and amortization of costs over $5,000, simply report the deduction on the return (called a deemed election). No special statement or attachment explaining the deduction is NOTE: Answers to Study Questions, with feedback to required for expenses incurred after September 8, 2008. both the correct and incorrect responses, are pro- vided in Chapter 35, beginning with ¶3522. Start-up costs before October 23, 2004. Taxpayers can elect to amortize start-up expenditures over a period ¶2206 Special Amortization for Pollution of not less than 60 months. Start-up expenditures are Control Facilities (Sec. 169) amounts (1) paid or incurred in connection with inves- To encourage owners and operators of plants causing air tigating the creation or acquisition of an active trade or water pollution to invest in pollution control devices, or business or with creating an active trade or business the Code permits an accelerated write-off for expenditures and (2) which, if paid or incurred in connection with made or incurred for that purpose. To qualify, the pollution the expansion of an existing trade or business, would be control device or facility must be certified by the state air or deductible for the tax year. In other words, start-up costs water pollution control agency as suitable for the specific are those incurred to determine whether to buy or start control task. The device must have been placed into service a business and which business to buy or start. after 1975 and must have been added to, or been installed at, a plant that was in operation before 1976. If the trade or business is disposed of completely by the taxpayer before the end of the 60-month (or longer) If the facility has a useful life of 15 years or less, the entire period, the deferred expenses may be deducted to the cost can be amortized over a 5-year period. If the useful extent allowed by Code Section 165. The definition of life is more than 15 years, only that portion of the cost “start-up expenditures” is expanded to include amounts attributable to the first 15 years can be amortized over incurred or paid before, and in anticipation of, the start ¶2207 286 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E of the business in an activity for profit or production of Adjusted basis Depletion ——————————— = income, but does not include any amount with respect No. of units remaining as per unit to which a deduction is allowable under Code Section of the beginning of the 163(a), 164, or 174. taxable year ¶2207A Optional 10-Year Amortization of EXAMPLE: Mel Houston owns an oil well with an Certain Preferences [Sec. 59(e)] estimated recoverable reserve of 50,000 barrels. The adjusted basis is $10,000. During the year, he Individuals can elect to amortize certain tax preferences sold and received payment for 8,000 barrels. Using over a 10-year period. These preferences include min- the cost depletion method, he will claim a depletion ing exploration and development costs, research and allowance of $1,600 ($10,000 50,000 20¢ per experimental expenditures, and intangible drilling costs. barrel. 8,000 barrels 20 cents $1,600). A 3-year period applies to circulation expenditures. When the amortization is elected, individuals do not have prefer- ¶2210 Percentage Depletion (Sec. 613) ences for the alternative minimum tax. See also ¶2503. Under this method, the taxpayer may deduct a certain percentage of gross income from the resource during PRACTICE POINTER: The election is made on a each year, but the deduction in any year may generally statement attached to the original (or amended) not exceed 50% of the taxable income from the prop- return for the year in which amortization begins. A erty, computed without the deduction for depletion. In separate election is required for each project or activ- ity. The statement must contain specified information no event, however, may the deduction be less than the (see proposed amendments to Reg. §1.59-1). amount available if computed on the cost basis. Note that timber is excluded from this method. The major depletion percentages are as follows: ¶2208 Depletion (Sec. 611–613) Sulfur and uranium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22% Taxpayers who own mineral deposits, oil and gas wells, Gold, silver, copper, iron ore, and oil shale (with some exceptions) if from mines standing timber, or other so-called wasting assets are or deposits in the United States. . . . . . . . . . . . . . . . . 15% permitted to take a “depletion” deduction to make allow- Coal and sodium chloride . . . . . . . . . . . . . . . . . . . . . . . . . 10% ances for reduction in the remaining assets as resources Gravel, peat, and pumice sand . . . . . . . . . . . . . . . . . . . . . 5% are diminished. In other words, depletion is a form of Asbestos, bauxite, graphite, lead, mica, nickel, “depreciation” of natural resources. platinum, zinc, and most other minerals and metals if from mines or deposits There are two methods of computing depletion: cost in the United States.. . . . . . . . . . . . . . . . . . . . . . . . . . 22% depletion and percentage depletion. Cost depletion Gold, silver, copper, iron ore, and most other minerals and metals extracted from may be used for all assets subject to depletion; percent- non-U.S. mines or deposits . . . . . . . . . . . . . . . . . . . . 14% age depletion may be used for most, but not all, assets (except by the larger oil and gas producers). Oil and gas. There is no oil and gas percentage depletion allowance for larger companies. ¶2209 Cost Depletion (Sec. 611 and 612) It is important to note that taxpayers may continue to In general, cost depletion is calculated by dividing take allowances for percentage depletion even after they the adjusted basis of the property (cost minus prior- have recovered their cost or other basis. This provision year depletion allowances, cost, or percentage) by the was designed to encourage the exploration of natural total of estimated recoverable units (tons, barrels, etc. resources through granting producers a singular tax as determined in accordance with prevailing meth- advantage not enjoyed by other taxpayers. For the same ods in the respective industry) in the mine, well, or reason, the depletion deduction may generally be taken deposit. The resulting figure is “depletion per unit” only during the period the natural resources are actually and is multiplied by the number of units for which being extracted from the property. payment is received during the tax year (if on the Taxpayers engaged in the development and explora- cash basis) or by the number of units sold (if on the tion of geothermal resources are eligible for a depletion accrual basis). allowance of 15%. A 10% depletion allowance will ¶2207A PA R T 3 — C H A P T E R 2 2 — A m o r t i z a t i o n a n d D e p l e t i o n 287 be permitted for natural gas from geo-pressured brine ¶2212 Who Is Entitled to from wells drilled in the United States or its possessions the Depletion Deduction? if drilling began after September 30, 1978, and before Anyone who owns or has an “economic interest” in an January 1, 1984. oil or gas well, mine, timber, or other resource property Where taxpayers, as is frequently the case, lease wells subject to depletion is entitled to the depletion allow- or mines in return for royalties to be received for each ance. The Supreme Court has ruled that any person unit removed, their gross income from the property is entitled to a share of oil and gas in place, or who has a ordinarily the sum of the royalties received from the lease right to a share of production, has an “economic inter- (including any bonus, but excluding rentals). est” and is therefore entitled to the allowance. Thus, the owner of ocean shore property that provided the If owners (or lessors) of resource property receive from only available site from which to drill oil from adjacent lessees minimum royalties, which are payable even if submerged coastal lands and who received a share of the the oil, gas, or minerals are not extracted, they are still profits for permitting use of the land was held entitled entitled to the depletion allowance. However, no further to the depletion allowance, even though the actual oil deduction is allowed if and when the extraction actually deposit was not located on the property. takes place. If the lease is ended before all the minerals paid for by the minimum royalties have been extracted, ¶2213 Recent Developments Affecting the depletion allowance taken for those minerals paid Amortization and Depletion for but not removed must be included in income. Of Final regulations detail amortization rules for start-up and course, the basis of the property would be increased by organizational expenses, including how to make a deemed the same amount since that portion of the depletion is, election (T.D. 9411, 7/7/08). in effect, nullified. Expenses for the production of income from a horse board- Just as in the case of depreciation, the amount of deple- ing and training facility were deductible as investment tion allowed (or allowable, even though not actually expenses and were not subject to the amortization rules taken) reduces the basis of the property. The depletion for business start-up costs; the expenses here were incurred “allowable” is the greater of cost or percentage depletion, after the income-producing activity had begun and were regardless of which method was actually used. not start-up costs [Toth, 128 TC 1 (2007)]. ¶2211 Percentage Depletion as a STUDY QUESTION Tax Preference The amount by which percentage depletion deductions 3. With respect to percentage depletion, which state- taken exceed the basis of the resource property (not ment is not correct? counting any depletion in the tax year) is a tax preference. a. It may not be used after the taxpayer has (Tax preferences are discussed in Chapter 25.) No tax recovered his basis in the property. b. It cannot exceed 50% of taxable income from preference arises until total percentage depletion on the the property. property over the years equals the basis of the property. c. It may give rise to a tax preference item. After the year that total percentage depletion equals the property’s basis, every dollar of percentage depletion is a dollar of tax preference. For further information on amortization and deple- tion, see IRS Publication 534, Depreciating Property NOTE: The tax preference is not necessarily the Placed in Service Before 1987, and IRS Publication difference between percentage depletion and cost 946, How to Depreciate Property. depletion. ¶2213 23 PART 3 — DEDUCTIONS FOR BUSINESS AND OTHER SPECIAL DEDUCTION RULES Business and Casualty Losses LEARNING OBJECTIVES As previously explained, “trade or business” generally refers to an occupation or profession to which the tax- This chapter was prepared to enable participants to payer devotes a substantial part of his time. A taxpayer understand the rules on business and casualty losses. More may have several trades or businesses; therefore, if one specifically, upon completion, you will be able to: business operates at a loss, he may deduct this loss from Apply the limits on trade or business losses. the profit realized on the others. Figure the amount of casualty and theft losses that can be deducted. A loss by sale or otherwise (except through casualty or theft) Determine net operating losses. of tangible personal property not connected with either the taxpayer’s trade or business or arising from any other ¶2301 Introduction (Sec. 165) transaction entered into for profit is never deductible. Thus, Section 165 of the Code permits taxpayers to deduct a tailor who buys a used sewing machine for $100 and certain losses for which they are not compensated by shortly thereafter determines that it is worthless and sells insurance or otherwise, either from gross income or from it for scrap can deduct the amount of the loss. If the same adjusted gross income, depending upon the nature of the thing happens to a homemaker who uses the machine for loss. Only the following types of losses are deductible: her own purposes only, the loss is not deductible. Losses incurred in a trade or business Trade and business losses, as explained in Chapter Losses incurred in any transaction entered into for 16, generally qualify either as ordinary or as Section profit, not in the taxpayer’s regular course of business 1231 losses. Losses incurred as the result of casualty or theft ¶2303 Loss on Transactions As indicated above, the first two types of losses must Entered into for Profit (Sec. 165) be associated with a business or other income-producing activity. On the other hand, casualty losses, in connection In addition to losses from a trade or business, taxpay- with strictly personal use property can be deductible. ers may deduct from gross income any loss incurred in a transaction entered into with the expectation of Losses on the sale or exchange of business or income- a profit, even though the transaction is not connected producing property were covered in Chapter 12. Also, as with their trade or business. Thus, losses on the sale of explained in Chapter 16, a recognized loss may be treated stocks, bonds, or other securities are deductible, since as an ordinary loss, a capital loss, or a Section 1231 loss, the taxpayer presumably invested in them out of a desire depending on the type of property involved. for profit. A majority of these losses are treated as capital ¶2302 Trade or Business Losses (Sec. 165) losses and are subject to the capital loss limitations that were previously discussed in ¶1603. A loss incurred in the taxpayer’s trade or business is deductible from gross income in computing adjusted Abandonment of assets. If, due to some unforeseen gross income. Thus, a person selling his delivery truck change in business conditions, taxpayers must suddenly at a loss can deduct the amount of this loss from gross and prematurely abandon their assets permanently, they income. Further, if the operation of a trade or business can claim a deduction for their loss. The amount of the itself results in a loss for the year, the loss is deductible. deductible loss is the adjusted basis of the asset. ¶2303 290 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E EXAMPLE: Five years ago, Jack Snow bought a spe- EXAMPLE: Mike Arroyo discovers that securities he cial machine for $11,000, which he depreciated at the still owns became worthless in 2000. He has until rate of $1,000 a year. Because of changed business April 15, 2008 (7 years from the due date of the conditions, the product for which the machine was 2000 return) to file an amended return to make a designed is no longer profitable to manufacture and refund claim. Jack is forced to abandon it. He may deduct a loss of $6,000 ($11,000 cost less $5,000 depreciation deductions). ¶2304 Hobby Losses (Activities Not Engaged in for Profit) (Sec. 183) Note that there must be a definite and permanent aban- There is a “hobby loss” rule that limits deductions donment before a loss can be claimed. Mere nonuse is attributable to an activity not engaged in for profit. If not sufficient. Also, it is important to understand that the activity is not engaged in for profit, the taxpayer may this loss deduction does not apply to merchandise or deduct, in the following order: other items included in a taxpayer’s inventory, because any such loss will automatically be taken into account Those items whose deductibility does not depend on through a reduction in inventory values. As Schedule C, a profit motive, such as interest, property taxes, and Profit or Loss from Business, shows, opening and closing casualty losses inventories are taken into account in computing profit or Items deductible only if the activity is engaged in for loss; thus, any decrease in inventory value will decrease profit (other than depreciation), but only to the extent profit (or increase loss) by the same amount. that the gross income from the activity exceeds the deductions allowed in 1, above Demolition of buildings. When a building is bought Depreciation with the intention of demolishing it to use the land, the costs of demolition are not deductible but must In other words, if the activity is not engaged in for profit, be added to the basis of the land, unless the following a deduction is allowed to the extent of (1) the income exception applies. from the activity or (2) the amount of deductions allow- able, regardless of profit motive, whichever is larger. EXCEPTION: Demolition costs are currently deduct- ible if both 75% or more of the existing external walls EXAMPLE: Clarence Clements collects paintings and 75% or more of the existing internal framework as a hobby, and not for profit. His expenses con- are retained. nected with this activity, which would be deductible, regardless of profit motive (interest and personal Worthless stocks. If stocks or bonds become worthless property taxes, etc.), total $1,200. He may deduct during the year, they are treated as if they had been sold this amount. Assume that he derived income of $2,000 from this activity and assume further that on the last day of the year, with the owner entitled to he incurs maintenance expenses, insurance, and a capital loss deduction (as explained in Chapter 16). shipping costs connected with his paintings totaling However, the securities must be entirely worthless before $1,500 in addition to his $1,200 in deductions. These a loss can be claimed. If they retain any value at all, expenses would be deductible in full if the activity the only way to establish a loss is through a sale. The was engaged in for profit. But, since it is a hobby, he sale must be bona fide, not a sham. However, the fact may deduct only $2,000, consisting of the amount that the sole purpose of the sale was to establish a tax allowable regardless of profit motive ($1,200), plus $800 of the $1,500 of other costs. loss does not disqualify the deduction. In view of the difficulty in ascertaining precisely if and when securities become worthless, there is an extended PITFALL: The IRS has noted that claiming losses time for claiming the loss deduction. Generally, there is a from hobby activities in excess of income from those 3-year period for amending returns to claim deductions activities is one of the most common errors made omitted from the original return. In the case of worthless on individual income tax returns. securities, there is a 7-year period. ¶2304 PA R T 3 — C H A P T E R 2 3 — B u s i n e s s a n d C a s u a l t y L o s s e s 291 If the activity is a “hobby,” then income is reported on STUDY QUESTION page 1 of Form 1040 as “other income” and expenses are reported as miscellaneous itemized deductions on 1. To rely on a presumption that an activity (other Schedule A (subject to the 2%-of-AGI limit). than a horse-related activity) has a profit motive in order to avoid the hobby loss rules, a taxpayer must show a profit in how many years? PITFALL: Hobby activity expenses are not deductible a. 2 out of 5 years for AMT purposes (since they are treated as miscel- b. 3 out of 5 years laneous itemized deductions). c. 2 out of 7 years Presumption of profit motive. A taxpayer will be presumed to engage in a profitable activity if, in any 3 NOTE: Answers to Study Questions, with feedback out of 5 consecutive years ending with the current year, to both the correct and incorrect responses, are the activity produces a profit, or, in the case of breed- provided in Chapter 35, beginning with ¶3523. ing, training, showing, or racing horses, in 2 out of 7 consecutive taxable years. The IRS can overcome this ¶2305 Casualty and Theft Losses (Sec. 165) presumption, however. Taxpayers are permitted a deduction for casualty losses, A taxpayer who suffers losses in the first couple of years whether on business or personal property. A casualty loss and who wants to rely on the presumption can file an is the complete or partial loss or destruction of property as election to do so on Form 5213, Election to Postpone the result of a sudden, unexpected, or unusual destructive Determination. In effect, this keeps the IRS from chal- force, such as an automobile collision, a fire, flood, storm, lenging a profit motive until the end of the 5-year drought, shipwreck, explosion, hurricane, or other simi- testing period. lar event, or through theft, robbery, vandalism, or riot. Progressive deteriorations of property through a steadily EXAMPLE: Rick Johnson starts a dog-breeding operating cause or damage from a normal process are business in 2008 and incurs losses with very little not casualty losses. The steady weakening of a building income. He can file Form 5213 to prevent the IRS brought on by normal or ordinary wind or weather con- from questioning losses from this activity until after ditions is not a casualty loss. Moth and termite damage 2012. is not normally a casualty loss. However, where it can be proven that property was suddenly infested and damaged The election must be made within 3 years of the due by termites, the loss may be held deductible. date of the return for the first year of the activity. In the The cost of repairing damage to a taxpayer’s automobile example above, the election must be made by April 15, from collision (even if resulting from his own faulty driv- 2012 (within 3 years from April 15, 2009, the due date ing) is deductible, provided that it was not caused by a for the 2008 return, the year in which the dog-breeding willful act or negligence (e.g., drunk driving). activity started). If the IRS questions any deductions before the end of this 3-year period and an election has Theft losses are deductible if the taking constitutes a theft not yet been made, an election can still be put into effect. under state law. Losses from embezzlement are classed The election must be made within 60 days of receiving a as thefts and, therefore, are deductible. For example, deficiency notice from the IRS. when a contractor disappeared after collecting a down payment for construction of a residence, the taxpayer PITFALL: It is not advisable in most cases to make was permitted a deduction. the election to postpone determination of profit Loss incurred through misplacement or disappearance of motive on Form 5213. Doing so virtually guarantees that the IRS will look at affected returns, and the an item is not deductible. Consequently, a theft deduction election extends the statute of limitations for all items will be allowed only if the taxpayer can submit some reason- on the return related to the activity. able evidence that the loss was due to theft. In questionable cases, the police record will frequently be decisive. ¶2305 292 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E The cost of repairs to damaged property is also accept- PRACTICE POINTER: It is important that the tax- able as proof of the amount of the loss, provided that payer notify the police immediately when theft or suspected theft occurs, if only to substantiate a tax the repairs do no more than restore the property to its deduction. The taxpayer should also file an insur- condition immediately before the casualty and that the ance claim to confirm the theft and to help fix the amount spent for such repairs is not excessive. The cost amount of loss. of clearing the property of debris is also deductible. For rules on when to deduct losses, see ¶2313. ¶2306 Amount of Loss ¶2308 Limitations on Personal Casualty Losses The amount deductible depends on whether the loss incurred is a business casualty loss or a personal casualty Personal casualty losses generally are deductible only to loss. Regardless of the nature of the loss, the taxpayer the extent that the loss exceeds 10% of adjusted gross must reduce the deduction by any insurance, or other income. In addition, each separate casualty loss must be compensation, recovered or recoverable. reduced by $100. A “business” casualty loss is a loss sustained on property EXAMPLE: Referring to the previous example, used in the taxpayer’s trade or business, or held for invest- assuming that Adam’s adjusted gross income is ment or the production of income, even though not in $15,000, his casualty loss deduction is $1,400 the taxpayer’s trade or business. [$2,900 ($3,000 - $100) - $1,500 (10% of AGI)]. ¶2307 Personal Casualty Losses Where nonbusiness or personal property has been dam- EXAMPLE: Assume that on the same day that Adam’s aged or destroyed, the loss is the difference between the fair home burned down, a pickpocket stole his wallet con- market value of the property immediately before and the taining $300. Because two separate acts of casualty are fair market value immediately after the casualty. However, involved, he must reduce each loss deduction by $100 the recognized loss cannot be greater than the adjusted before applying the 10%-of-adjusted-gross-income basis of the property. The deduction must be reduced by limit. Accordingly, his total casualty loss deduction would be $1,600 [$300 $100 $3,000 $100 any salvage or insurance proceeds obtained. $3,100 $1,500 (10% of AGI)]. EXAMPLE: Adam Sanderson’s residence, which cost When the taxpayer suffers two or more losses as the him $112,000 in 1998, was partially destroyed by fire during the taxable year. The value of the home result of one casualty act, or when the events causing immediately before the fire was $188,000 and the the casualty losses are closely related in origin, the result- value immediately after was $175,000. He collected ing losses are considered as a single casualty and, thus, $10,000 from his insurance company. The amount of subject to only one $100 reduction. For example, if a the casualty loss is computed as follows: storm damages a taxpayer’s residence and also damages Value before fire . . . . . . . . . . . . . . . . . . . . . . . . . . $188,000 his automobile parked in the driveway, it is considered Value after fire. . . . . . . . . . . . . . . . . . . . . . . . . . . . 175,000 as a single casualty. Similarly, if a hurricane causes both Decrease in value . . . . . . . . . . . . . . . . . . . . . $13,000 wind and flood damage to a taxpayer’s summer residence, Adjusted basis (cost in this case) . . . . . . . . . . . . . $112,000 a single casualty is involved. In addition to the $100 floor Loss (lesser of decrease in value for each separate casualty, losses are deductible only when or adjusted basis) . . . . . . . . . . . . . . . . . . . $13,000 they exceed 10% of adjusted gross income. Less insurance recovery . . . . . . . . . . . . 10,000 Loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,000 For purposes of applying the limitations, a husband and wife filing a joint return are treated as one individual. To accurately determine the difference in the fair market If a husband and wife file a joint return, only one $100 value of the property immediately before and after the floor applies to each casualty, regardless of whether loss, a competent appraiser should be employed. the property on which the loss was sustained is owned ¶2306 PA R T 3 — C H A P T E R 2 3 — B u s i n e s s a n d C a s u a l t y L o s s e s 293 jointly or separately. Also, the overall 10%-of-adjusted- PRACTICE POINTER: The $100/10% limits do not gross-income limitation applies. By the same token, if apply to victims of certain disasters, such as Hur- a husband and wife file separate returns, each is subject ricanes Katrina, Rita and Wilma, the Greensburg, to the $100 floor for each casualty, and the 10% of AGI Kansas storm, the 2008 Midwest floods, and Hur- limit applies on each of their returns. ricane Ike.. Individual taxpayers, other than husband and wife, are subject to a separate $100 floor for each casualty or theft, ¶2309 Reporting of Personal Casualty even though the property of other persons is damaged Gains and Losses or destroyed by the same disaster. For example, if a fire Form 4684, Casualties and Thefts, is used to figure the damages the house and household goods of one indi- gain or loss from casualties and thefts (shown on the next vidual, as well as the property of a visiting nephew, the two pages). Section A of Form 4684 is used to make this home owner is subject to one $100 reduction and the determination for personal use property. The $100 floor nephew to a separate $100 reduction. is applied to each casualty or theft event. ¶2309 294 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E OMB No. 1545-0177 Form 4684 Casualties and Thefts See separate instructions. 2008 f Attach to your tax return. Department of the Treasury Attachment Use a separate Form 4684 for each casualty or theft. 26 o Internal Revenue Service Sequence No. Name(s) shown on tax return Identifying number s 8 SECTION A—Personal Use Property (Use this section to report casualties and thefts of property not used in a trade or business or for income-producing purposes.) a 0 ft 20 1 Description of properties (show type, location, and date acquired for each property). Use a separate line for each property lost or damaged from the same casualty or theft. ra 5/ Property A Property B Property C D /0 Property D Properties A B C D 06 2 Cost or other basis of each property 2 3 Insurance or other reimbursement (whether or not you filed a claim) (see instructions) 3 Note: If line 2 is more than line 3, skip line 4. 4 Gain from casualty or theft. If line 3 is more than line 2, enter the difference here and skip lines 5 through 9 for that column. See instructions if line 3 includes in- surance or other reimbursement you did not claim, or you received payment for your loss in a later tax year 4 5 Fair market value before casualty or theft 5 6 Fair market value after casualty or theft 6 7 Subtract line 6 from line 5 7 8 Enter the smaller of line 2 or line 7 8 9 Subtract line 3 from line 8. If zero or less, enter -0- 9 10 Casualty or theft loss. Add the amounts on line 9 in columns A through D 10 11 Enter the smaller of line 10 or $100 11 12 Subtract line 11 from line 10 12 Caution: Use only one Form 4684 for lines 13 through 18. 13 Add the amounts on line 12 of all Forms 4684 13 14 Add the amounts on line 4 of all Forms 4684 14 15 ● If line 14 is more than line 13, enter the difference here and on Schedule D. Do not complete the rest of this section (see instructions). 15 ● If line 14 is less than line 13, enter -0- here and go to line 16. ● If line 14 is equal to line 13, enter -0- here. Do not complete the rest of this section. 16 If line 14 is less than line 13, enter the difference 16 17 Enter 10% of your adjusted gross income from Form 1040, line 38, or Form 1040NR, line 36. Estates and trusts, see instructions 17 18 Subtract line 17 from line 16. If zero or less, enter -0-. Also enter the result on Schedule A (Form 1040), line 20, or Schedule A (Form 1040NR), line 8. Estates and trusts, enter the result on the “Other deductions” line of your tax return 18 For Paperwork Reduction Act Notice, see page 4 of the instructions. Cat. No. 12997O Form 4684 (2008) ¶2309 PA R T 3 — C H A P T E R 2 3 — B u s i n e s s a n d C a s u a l t y L o s s e s 295 Form 4684 (2008) Attachment Sequence No. 26 Page 2 Name(s) shown on tax return. Do not enter name and identifying number if shown on other side. Identifying number SECTION B—Business and Income-Producing Property o f Part I Casualty or Theft Gain or Loss (Use a separate Part l for each casualty or theft.) s 8 19 Description of properties (show type, location, and date acquired for each property). Use a separate line for each property lost or dam- aged from the same casualty or theft. Property Property Property A B C a 0 ft 20 ra 5/ Property D Properties A B C D D /0 20 Cost or adjusted basis of each property 20 21 Insurance or other reimbursement (whether or not you filed a claim). See the instructions for line 3 21 Note: If line 20 is more than line 21, skip line 22. 06 22 Gain from casualty or theft. If line 21 is more than line 20, enter the difference here and on line 29 or line 34, column (c), except as provided in the instructions for line 33. Also, skip lines 23 through 27 for that column. See the instructions for line 4 if line 21 includes insurance or other reimbursement you did not claim, or you received payment for your loss in a later tax year 22 23 Fair market value before casualty or theft 23 24 Fair market value after casualty or theft 24 25 Subtract line 24 from line 23 25 26 Enter the smaller of line 20 or line 25 26 Note: If the property was totally destroyed by casualty or lost from theft, enter on line 26 the amount from line 20. 27 Subtract line 21 from line 26. If zero or less, enter -0- 27 28 Casualty or theft loss. Add the amounts on line 27. Enter the total here and on line 29 or line 34 (see instructions) 28 Part II Summary of Gains and Losses (from separate Parts l) (b) Losses from casualties or thefts (c) Gains from (i) Trade, business, (ii) Income- casualties or thefts (a) Identify casualty or theft rental or royalty producing and includible in income property employee property Casualty or Theft of Property Held One Year or Less 29 ( ) ( ) ( ) ( ) 30 Totals. Add the amounts on line 29 30 ( ) ( ) 31 Combine line 30, columns (b)(i) and (c). Enter the net gain or (loss) here and on Form 4797, line 14. If Form 4797 is not otherwise required, see instructions 31 32 Enter the amount from line 30, column (b)(ii) here. Individuals, enter the amount from income-producing property on Schedule A (Form 1040), line 28, or Schedule A (Form 1040NR), line 16, and enter the amount from property used as an employee on Schedule A (Form 1040), line 23, or Schedule A (Form 1040NR), line 11. Estates and trusts, partnerships, and S corporations, see instructions 32 Casualty or Theft of Property Held More Than One Year 33 Casualty or theft gains from Form 4797, line 32 33 34 ( ) ( ) ( ) ( ) 35 Total losses. Add amounts on line 34, columns (b)(i) and (b)(ii) 35 ( ) ( ) 36 Total gains. Add lines 33 and 34, column (c) 36 37 Add amounts on line 35, columns (b)(i) and (b)(ii) 37 38 If the loss on line 37 is more than the gain on line 36: a Combine line 35, column (b)(i) and line 36, and enter the net gain or (loss) here. Partnerships (except electing large partnerships) and S corporations, see the note below. All others, enter this amount on Form 4797, line 14. If Form 4797 is not otherwise required, see instructions 38a b Enter the amount from line 35, column (b)(ii) here. Individuals, enter the amount from income-producing property on Schedule A (Form 1040), line 28, or Schedule A (Form 1040NR), line 16, and enter the amount from property used as an employee on Schedule A (Form 1040), line 23 or Schedule A (Form 1040NR), line 11. Estates and trusts, enter on the “Other deductions” line of your tax return. Partnerships (except electing large partnerships) and S corporations, see the note below. Electing large partnerships, enter on Form 1065-B, Part II, line 11 38b 39 If the loss on line 37 is less than or equal to the gain on line 36, combine lines 36 and 37 and enter here. Partnerships (except electing large partnerships), see the note below. All others, enter this amount on Form 4797, line 3 39 Note: Partnerships, enter the amount from line 38a, 38b, or line 39 on Form 1065, Schedule K, line 11. S corporations, enter the amount from line 38a or 38b on Form 1120S, Schedule K, line 10. Form 4684 (2008) ¶2309 296 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E If the net result of these events is a gain because of insur- Casualty losses of business property are deductible from ance or other reimbursements, it is entered on Schedule D. gross income in computing adjusted gross income. The If the net result of these events is a loss, then the loss must same applies to casualty losses of property held for the be reduced by the 10%-of-adjusted-gross-income floor. production of rents and royalties. The reduced loss is then entered on Schedule A. If the property is held partly for business purposes STUDY QUESTION and partly for personal purposes, the casualty or theft loss deduction must be computed as though two sepa- rate pieces of property had been stolen, damaged, or 2. A personal casualty loss from a house fire in destroyed—one business and the other nonbusiness. Denver is deductible only to the extent it exceeds what percentage of adjusted gross income? For a casualty loss of property used partially for business a. 2.5% and partially for personal purposes, the $100 floor and b. 7.5% the 10%-of-adjusted-gross-income limit apply only to c. 10% the net loss attributable to the part used for personal purposes. ¶2310 Business Casualty Losses If business property or property held for the production EXAMPLE: A collision caused $1,000 in damage to Rose Karl’s automobile. It has an adjusted basis of income is completely destroyed, the deductible loss is of $2,000 and is used 50% for business and 50% the adjusted basis of the property, less any salvage value for personal reasons. Rose collected $900 from her and any insurance or other compensation received or insurance company, with a net loss to her of $100. recoverable. The loss is deductible in full; the $100 floor Half the loss ($50) is considered a business loss and and the 10%-of-adjusted-gross-income limit apply only is fully deductible. The remaining $50 is personal and to nonbusiness casualty losses. is nondeductible because it does not exceed $100. Assuming the loss was larger, the 10% AGI limit would apply only to the personal use portion. EXAMPLE: Tom Harding owns a building, which cost him $130,000. He uses it for rental purposes. It was completely destroyed by a tornado. The total ¶2311 Insurance or Other Compensation depreciation allowable up to the time of the loss was $26,000, and his insurance and salvage recovery As stated before, the casualty loss deduction must was $100,000. He would compute his casualty loss be reduced by any insurance or other compensation as follows: received. This includes amounts received from disaster Cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $130,000 relief agencies (such as FEMA or the Red Cross) or other Less Depreciation . . . . . . . . . . . . . . . . . . . . . 26,000 sources to restore or rehabilitate lost or damaged prop- Adjusted basis. . . . . . . . . . . . . . . . . . . . . . . . $104,000 erty. Food, medical supplies, and other forms of subsis- Less Salvage and insurance recovery . . . . . . . . . 100,000 tence received are not replacements of lost or destroyed Total loss deductible. . . . . . . . . . . . . . . . . . . . . . . $4,000 property and do not reduce the deduction. A taxpayer is not allowed to deduct a personal casualty loss If business property is partially destroyed, the deduct- unless the taxpayer files a timely insurance claim for damage ible loss is (1) the decrease in value due to the casualty to that property. This rule applies to the extent any insur- or (2) the adjusted basis of the property damaged, ance policy would provide reimbursement for a loss. whichever is smaller, reduced by insurance or other compensation received. ¶2312 How Casualty Losses Are Deducted All business casualty losses must be grouped together to EXAMPLE: Assume that Tom’s building was only determine if there is a net gain or net loss. If a net gain partially destroyed by the storm, and that the actual results, all such casualty gains and losses are combined value of the building was $120,000 immediately or “netted” with any regular noncasualty, Section 1231 before the storm and $85,000 immediately after. The loss is the decrease in value, $35,000, since this is gains and losses to determine if there is a net gain on less than the adjusted basis of $104,000. Section 1231 assets; such gain would be taxed as long- term capital gain. If a net loss results from casualties, it does not come under Section 1231, and the loss is ¶2310 PA R T 3 — C H A P T E R 2 3 — B u s i n e s s a n d C a s u a l t y L o s s e s 297 therefore fully deductible as an ordinary loss. The netting EXAMPLE: Steve Candler owned business property is done on Form 4684, Casualties and Thefts. with an adjusted basis of $10,000 that is completely destroyed by fire in 2008. Steve’s only claim for reim- EXAMPLE: Oliver Jones had an uninsured loss of bursement consists of an insurance claim for $8,000, $5,000 resulting from the destruction by fire of which is settled in 2008. Steve sustained a loss of property he used in his business. He also had a rec- $2,000 in 2008 and should claim it in that year. ognized gain of $3,000 resulting from an insurance recovery on business property used in his business, which was destroyed by a tornado. Because his PRACTICE POINTER: If a loss is claimed and an losses exceed his gains, neither is subject to Sec- tion 1231. The net effect is an ordinary loss deduc- unexpected insurance recovery is later received, tion of $2,000. the amount of the loss must be reported as income in the year of the insurance recovery. The return for the loss year is not amended, even if that year is still Business casualty loss rules can be summarized as follows: otherwise available for making amendments. Step 1. Casualty and theft gains and losses are net- ted. ¶2314 Special Rule for Disaster Losses Step 2. If a net loss results, take it as an ordinary [Sec. 165(h)] deduction. Step 3. If a net gain results, take it into account under A special rule permits quick tax relief for casualty losses Section 1231 gains and losses. If the total is a gain, suffered by individuals residing in disaster areas. Under Section 1231 is applicable. If the total is a loss, all this rule, any such losses sustained during the current gains and losses are ordinary. tax year may be deducted on the tax return filed for the previous tax year. The disaster area must be so designated ¶2313 When to Deduct a Casualty Loss by the President. The taxpayer has the choice of elect- In general, casualty losses are deductible only in the ing to take advantage of this provision or deferring the tax year in which the casualty occurs. This is true even deduction until the return for the tax year. though the property may not be repaired or replaced until a later year. However, theft and embezzlement losses EXAMPLE: Norm Wallace’s home was severely are deductible only in the year the loss is discovered, not damaged by a flood in May 2008, and the area was in the year the theft or embezzlement occurred unless subsequently declared a disaster area. Therefore, that is also the year in which the loss is discovered. Norm may elect to claim the loss on his income tax return for either 2007 or 2008. If the amount of the loss sustained cannot be determined before the due date for filing the return, the taxpayer can file Form 4868 to obtain the automatic 6-month Disaster loss treatment is extended when a disaster extension of time to file. See ¶3203. has rendered a personal residence unsafe (though still habitable) and the taxpayer has been ordered by state If the taxpayer reasonably expects to receive insurance or local officials, within 120 days of the designation of or other compensation, but has not received it by the the locality as a disaster area, to demolish or move the end of the year in which the casualty occurred, the loss residence. deduction must be reduced by the estimated amount of insurance or other compensation to be received. If If the casualty occurs after the return for the preced- the taxpayer subsequently receives less than the amount ing year has been filed, the taxpayer may file an amended originally estimated, he is entitled to an additional loss return in order to claim the loss. deduction in the year the claim is settled. ¶2314 298 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E Defined simply, a net operating loss is the excess PITFALL: In the event that individuals elect to take of allowable deductions over gross income after into account a personal disaster loss for the tax year immediately preceding the tax year in which the certain adjustments described below are applied to disaster occurred, they must use their adjusted gross that excess. income for such prior year in determining the extent ¶2317 How the Net Operating Loss to which the loss is deductible. Is Computed A net operating loss is computed in the same way as PRACTICE POINTER: Taxpayers who are in taxable gross income less deductions, with the following presidentially declared disaster areas gain automatic post- exceptions: ponement for certain tax acts, such as filing returns. Capital losses may not exceed capital gains. Fur- thermore, nonbusiness capital losses may not exceed ¶2315 Gambling Losses [Sec. 165(d)] nonbusiness capital gains, even though the taxpayer’s Taxpayers who are engaged (legally or illegally) in the capital gains derived from business activities exceed business of wagering or gambling may deduct such losses his business capital losses. from gross income to the extent that they report their The deduction for personal and dependency exemp- gambling gains as income. A net loss from gambling is not tions is disregarded. deductible. A person who is not engaged in gambling as a Nonbusiness deductions may not exceed nonbusi- business may deduct such losses, along with other item- ness income. ized deductions, from adjusted gross income, but only to No net operating loss carryovers or carrybacks from the extent that the gambling income was reported. other years are considered. EXAMPLE: Joe Redfield, an unmarried store clerk, PRACTICE POINTER: No special form is used to earned a $7,000 annual salary in 2008. He is an figure the net operating loss. Instead, attach a ardent racing fan and had total winnings of $1,800 statement to the return that shows how the net and total losses of $3,000 resulting from betting on operating loss deduction was figured. Schedule A the horses. Although Joe’s wagering losses totaled of Form 1045, Application for Tentative Refund, can $3,000, he can deduct only $1,800, his losses to the be used as a guideline to determining current year extent of his winnings. The $1,200 losses in excess net operating loss. of gains are not deductible and cannot be carried over to another year. ¶2318 Business or Nonbusiness Where a husband and wife file a joint return, their Income and Expenses combined gambling losses are allowable as itemized Because nonbusiness deductions may be claimed only to the deductions to the extent that their combined winnings extent of nonbusiness income in computing a net operat- from such transactions were included in income. ing loss, it is necessary to distinguish between business and nonbusiness income and expenses. For purposes of the net NOTE: While certain miscellaneous itemized deduc- operating loss computation, salaries and wages are considered tions are subject to a 2%-of-adjusted-gross-income as trade or business income. Also, loss sustained in the opera- floor (see ¶910), this floor does not apply to gambling tion of rental property is considered a business loss. Losses losses, which are deductible in full to the extent of on Section 1244 stock and the taxpayer’s pro rata share of gambling winnings. losses from an S corporation or partnership are allowable as business losses in computing the net operating loss. Any gain ¶2316 Net Operating Losses (Sec. 172) or loss on the sale or other disposition of real or depreciable If taxpayers sustain a net loss in the operation of their trade, property used in a trade or business is included at 100%. business, or profession, or from casualty or theft, and such Casualty and theft losses, including those losses incurred on loss or losses exceed their income from other sources, they property used for personal purposes, are treated as attribut- have a net operating loss that may be used to reduce their able to a trade or business in computing the net operating income subject to tax (as adjusted) for other years or to loss. However, a personal casualty loss is subject to the 10%- entitle them to a refund of income tax previously paid. of-adjusted-gross-income limit and the $100 floor. ¶2315 PA R T 3 — C H A P T E R 2 3 — B u s i n e s s a n d C a s u a l t y L o s s e s 299 However, a small business net operating loss from a presi- EXAMPLE: Carolyn Evans, a single taxpayer, began dentially declared disaster and an individual net operating operation of a retail business in 2007 and had a net operating loss of $185 for the year. She had no income loss from a casualty or theft have a 3-year carryback in lieu subject to tax in 2006. During 2008, she had the fol- of an applicable 2-year period. Farmers and ranchers and lowing income and deductions: taxpayers affected by Hurricanes Katrina, Rita, and Wilma, as well as victims of the Greensburg, Kansas, disaster, the INCOME Salary earned as part-time helper in 2008 Midwest floods, and Hurricane Ike, can claim a gas station (salary is business income) . . . . . . . . $875 5-year carryback for all their net operating losses, regardless Interest on savings. . . . . . . . . . . . . . . . . . . . . . . . 1,425 of year (unless they elect to forego the 5-year period). Net long-term capital gain on sale of real estate used in business. . . . . . . . . . . . . . . . . 1,000 Total income. . . . . . . . . . . . . . . . . . . . . . . . . . $3,300 PRACTICE POINTER: Taxpayers must keep track of net operating losses from each year separately so that DEDUCTIONS the appropriate carryback and carryover period can Net operating loss carryover from 2007 . . . . . . . $185 Net loss from business (gross receipts of be used. Schedule A of Form 1045, Application for $67,000 minus expenses of $72,000) . . . . . . . 5,000 Tentative Refund, is a worksheet that can be used to Net short-term capital loss on sale of stock . . . . 500 compute net operating loss on a year-by-year basis. Net loss from rental property . . . . . . . . . . . . . . . . 900 Casualty loss short-term on business property. . . . . . . . . . . . . . . . . . . . . . . 200 Foregoing the carryback. A taxpayer can elect to forego Itemized deductions. . . . . . . . . . . . . . . . . . . . . . . 8,410 the carryback and simply carry the loss forward for the Total deductions . . . . . . . . . . . . . . . . . . . . . . $15,195 applicable number of years. For purposes of the 5-year Deductions exceed income (loss) . . . . . . . . . . . . . ($11,895) carryback period, a taxpayer can forego this period in favor of a 2-year period or forego the carryback entirely. To determine net operating loss, The election is made on a statement attached to the the following adjustments must be made: return for the year of the loss. The election cannot be Deductions in excess of income (loss) . . . . . . . . ($11,895) made after the due date for filing the return (including 1. Eliminate net operating extensions). The election is irrevocable. loss carryover from 2007. . . . . . . . $185 2. Eliminate net nonbusiness short-term capital loss . . . . . . . . . 500 3. Eliminate the excess of PRACTICE POINTER: The election to forego the car- nonbusiness deductions ryback should be considered where there is concern (itemized deductions, $8,410) of an audit for the earlier years. over nonbusiness income (interest, $1,425) . . . . . . . . . . . . . . 6,985 Before computing the net operating loss deduction for Total adjustments to net loss . . . . . . . . . . . . . . . . 7,670 the year, it must be determined what part of any oper- Net operating loss for 2008 . . . . . . . . . . . . . . . . . ($4,225) ating losses for any preceding or succeeding tax years represents carryovers or carrybacks to the tax year under consideration. The sum of the net operating loss car- ¶2319 Loss Carrybacks and Carryovers rybacks and carryovers, then, is the net operating loss The carryback and carryover periods for net operating losses deduction for the tax year. depend on the year in which the net operating loss arose. The net operating loss is carried back to the second For losses arising in 2001 and 2002, the carryback period tax year preceding the year in which it is sustained. Any is 5 years and the carryforward period is 20 years. amount of the loss not used to offset income subject to tax For losses arising in tax years beginning after (adjusted, as explained below) for the third preceding year August 5, 1997 (other than in 2001 and 2002), the is carried to the second preceding year. Any amount of the carryback period is 2 years and the carryforward loss not used to offset income subject to tax (adjusted) for period is 20 years. the third and second preceding years must be carried to For losses arising tax years beginning before August 6, the first preceding year. If the loss is not entirely used to 1997, the carryback period is 3 years and the carry- offset income subject to tax (adjusted) in the 3 preceding forward period is 15 years. years, the balance may be carried forward to the twentieth succeeding year in the order of their occurrence. ¶2319 300 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E EXAMPLE: Ruben Jones started a business in January 2004 and had a $42,000 net operating loss for the year. Before 2004, his income consisted of wages. His income subject to tax (after necessary adjustments) in the other years to which the loss may be carried back or forward is as follows: Adjusted Unused Carryback or Income Carryback or Year Carryover Subject to Tax Carryover 2002—2nd preceding year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $42,000 $2,000 $40,000 2003—1st preceding year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000 3,000 37,000 2004—net operating loss year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2005—1st succeeding year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37,000 5,500 31,500 2006—2nd succeeding year. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31,500 7,000 24,500 2007—3rd succeeding year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,500 3,800 20,700 2008—4th succeeding year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,700 10,700 10,000 The $10,000 loss carryover remaining at the end of 2008 may be used, if needed, up to the year 2024. If the taxpayer has more than one net operating loss to STUDY QUESTION be carried to the same tax year, the loss from the earli- est year is applied first. 3. The ordinary net operating loss carryback for losses arising in 2008 is: EXAMPLE: Art Becker had net operating losses of a. 2 years $10,000 and $15,000, respectively, in the years 2007 b. 3 years and 2008. His income subject to tax (adjusted) was c. 5 years $2,500 in 2005 and $14,000 in 2006. He carried back a $10,000 loss from 2007 to 2005, leaving an unused loss of $7,500 to be used in 2006. The $15,000 loss ¶2320 Recomputing Tax Liability for from 2008 is used to offset $6,500 in 2006. The Year to Which a Loss Is Carried remainder of the loss ($8,500) may be carried forward to future years up to 2028. In recomputing the tax liability to determine the amount of refund for the year to which the loss is car- In making a claim for a net operating loss deduction, ried back, the deduction for charitable contributions the taxpayer must file with his return for the year of the is determined without regard to any carryback. Any deduction a concise statement setting forth all related other deduction (such as medical expenses) based on, facts, including a detailed schedule showing how the or limited to, a percentage of adjusted gross income deduction was computed. Schedule A of Form 1045, or income subject to tax must be recomputed on the Application for Tentative Refund, can be used to calculate basis of the adjusted gross income or income subject to current year net operating loss. The net operating loss tax, as the case may be, determined after applying the deduction is claimed on page 1 of Form 1040 as a nega- carryback. Also, any credits based on or limited by the tive entry under “other income.” tax must be recomputed on the basis of the tax liability after application of the carryback. PRACTICE POINTER: The net operating loss car- ¶2321 Effect on Self-Employment Tax ryback and carryforward will not change the self- employment tax due for the carryover year. In computing net earnings from self-employment, the net operating loss deduction is not to be considered. An election to relinquish the net operating loss car- ¶2322 Carrying the Loss to More Than 1 Year ryback for regular tax purposes applies for alternative minimum tax purposes as well. Inconsistent elections The net operating loss is carried back to the oldest appli- are not permitted. Thus, in order to relinquish the cable preceding year. However, if the loss exceeds the carryback for alternative minimum tax purposes, it must income subject to tax in the year to which it is carried, be relinquished for regular tax purposes. certain adjustments must be made to the income subject ¶2320 PA R T 3 — C H A P T E R 2 3 — B u s i n e s s a n d C a s u a l t y L o s s e s 301 to tax of that year to determine the unused portion of the Quick refunds. To simplify and accelerate the filing and loss that may be carried to another year. The amount of the processing of carryback refunds, the IRS has provided loss that may be carried to another year, after applying it a special form, Form 1045, Application for Tentative to an earlier year or years, is the excess of the net operating Refund. This form, used by the great majority of taxpay- loss over the income subject to tax of the earlier year or ers entitled to a refund, furnishes detailed instructions years, computed with the following modifications: and schedules for computing the carryback and will normally be acted upon by the IRS within 90 days from The deduction for capital losses may not exceed the the date it is filed. capital gains included in gross income. Income subject to tax is determined without regard to Form 1045 must be filed on or after the date of filing the the particular net operating loss being carried back or return for the tax year in which the loss was sustained and forward, or to any later net operating loss. Any earlier may not be filed later than 12 months from the end of net operating losses being carried back or over from that tax year. Thus, a taxpayer entitled to a 2006 carryback other years may be taken into account. refund as a result of a 2008 net operating loss must file The taxpayer may not claim any personal exemptions Form 1045 at any time between January 1 and December or exemptions for dependents. 31, 2009. After that date, the taxpayer can still file a refund Any deductions claimed, except charitable contribu- claim, but he must use Form 1040X. See ¶3203. tions, which are based on or limited to a percentage ¶2324 Recent Developments Affecting of adjusted gross income or income subject to tax (such as medical expenses), must be recomputed Business and Casualty Losses on the basis of the adjusted gross or income subject Victims of the 2008 Midwest floods and Hurricane Ike to tax after applying adjustments 1, 2, and 3, above. have the same casualty loss rules that are accorded to The deduction for charitable contributions is deter- victims of Hurricane Katrina (Emergency Economic mined by using the same adjustments, except that Stabilization Act of 2008, P.L. 110-343) any net operating losses being carried back are not considered. Victims of the Greensburg, Kansas, tornados have the same casualty loss rules accorded to victims of Hurricane The income subject to tax so computed is not to be Katrina (Heartland, Habitat, Harvest, and Horticulture reduced to less than zero. Act of 2008, P.L. 110-248). ¶2323 How to Claim a Carryback Refund No casualty loss deduction is allowed if the home owner Where the taxpayer is entitled to a refund of income tax fails to prove evidence of the value of the home or its previously paid as a result of a net operating loss car- adjusted basis (Lockett, TC Memo 2008-5). ryback, the taxpayer can obtain the refund by filing an A theft loss deduction is allowed for a portion of $37 amended return on Form 1040X. The Form 1040X may million involving a series of fraudulent transactions also be used to correct a return filed in an earlier year. In with gems and jewelry in the year in which a recovery either case, the form must be filed on or before the 15th will not be received and the amount can be determined day of the 40th month following the close of the year in with reasonable accuracy (Johnson, Fed. Cl., 2008-1 which the net operating loss was sustained. USTC ¶50,142). EXAMPLE: Derek Brown sustained a net operating Losses related to tournament sport fishing are nonde- loss in 2008, which he carried back to 2006. It entitles ductible hobby losses because the taxpayer made no him to a refund for that year. He must file Form 1040X effort to minimize losses and engaged in the activity only on or before April 15, 2012. on the weekends during 4 months of the year (Follum, TC Memo 2007-164). The amended return should show a detailed computa- The IRS has issued guidance for victims of Hurri- tion of the net operating loss deduction and the recom- canes Katrina, Rita, and Wilma who realized losses to putation of the carryback year’s tax. their residences and personal belongings (Rev. Proc. ¶2324 302 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E 2006-32, IRB 2006-28, 61); they have an extra year to sell vacant land as part of the home sale exclusion For further information on business and casualty losses, see IRS Publication 536, Net Operating Losses (IR-2007-134, 7/31/07). for Individuals, Estates and Trusts; IRS Publication The IRS has extended the disaster-related provisions 544, Sales and Other Dispositions of Assets; IRS Pub- lication 547, Casualties, Disasters, and Thefts; IRS discussed under ¶2314 of this chapter to those affected Publication 584, Nonbusiness Disaster, Casualty, and by Hurricane Gustav (IR-2008-100, 9/4/08). Theft Loss Workbook; IRS Publication 2194, Disaster Losses Kit for Individuals; and IRS Publication 2194B, Disaster Losses Kit for Businesses. ¶2324 24 PART 3 — DEDUCTIONS FOR BUSINESS AND OTHER SPECIAL DEDUCTION RULES Bad Debts LEARNING OBJECTIVES the corporation has thin capitalization (little equity as compared with debt) and where the corporation This chapter was prepared to enable participants to learn does not treat the advance as a loan (it agrees to make the rules on deducting bad debts. More specifically, upon repayment only if there are profits, it does not enter completion, you will be able to: the advance as a loan on its books, and it does not Determine whether a debt is a business or nonbusi- make payments of interest and principal). ness bad debt. ¶2402 The Debt Must Be Worthless Determine whether a nonbusiness bad debt is deductible. A debt must be uncollectible, both now and in the future, Understand the statute of limitations on bad debts. before it can be charged off as a bad debt. Taxpayers must also show that they have taken reasonable steps to collect ¶2401 Introduction (Sec. 166) the debt, unless circumstances clearly indicate that no If money is owed to a taxpayer and the debt becomes likelihood of recovery exists. Thus, the debtor’s bank- uncollectible, he may claim a “bad debt” deduction. The ruptcy or disappearance generally is sufficient evidence debt must be valid, legally enforceable, and in a fixed of the debt’s worthlessness. Legal action on the part of amount to be deductible. For instance, in most states a the creditor is not necessary if it can otherwise be shown gambling debt cannot be enforced and, therefore, will that a judgment would be worthless. not qualify for a bad debt deduction. If the taxpayer endorsed or guaranteed someone else’s Where debts are owed to the taxpayer by his relatives, noncorporate obligation and is later required to pay the the question arises as to whether it is a bona fide loan or obligation, the taxpayer may take a bad debt deduction merely a gift. If the circumstances indicate that the loan if unable to collect from the borrower. Debts owed by was made with a definite expectation of repayment, the political parties are generally considered campaign con- deduction will be permitted. Otherwise, the deduction tributions and are not deductible. will be denied on the grounds that the taxpayer was really making a gift, not a loan. PITFALL: Cash-basis taxpayers may not claim a bad debt deduction for uncollectible interest, salary, rents, or fees, since they did not report these items EXAMPLE: Danielle Morris loaned money to her as income. son-in-law to go into a new business venture. She did not investigate whether the venture was sound or practical, and the son-in-law had no means to secure If taxpayers are on the accrual basis and have reported the debt. The venture subsequently failed, and the the rents, fees, interest, or other accounts receivable as son-in-law was unable to repay the debt. No bad income when the amounts became due, they may claim debt deduction is permitted because Danielle, by all indications, did not seriously expect repayment. them as bad debts when the debts later turn out to be uncollectible. In particular, when loans are made to a taxpayer’s children, ¶2403 Amount of Deduction the IRS will assume they are gifts unless the taxpayer is able to show convincing evidence to the contrary. The amount of the bad debt deduction is determined by the basis the debt would have had if it had been sold Advances by a shareholder to a corporation may be at a loss. Thus, it is not necessarily the face amount of capital contributions, not loans. This is so where the debt. ¶2403 304 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E such losses are deductible, regardless of whether the EXAMPLE: Andre Anderson sold $5,000 worth of taxpayer itemizes or not. merchandise to Bob Baxter and received Bob’s note in return. Andre then sells the note to Carl Caruthers for $4,500. Subsequently, Bob goes bankrupt, and PITFALL: The IRS has noted that claiming nonbusi- the note becomes totally worthless. Carl’s bad ness bad debt deductions on Schedule C, rather than debt deduction is $4,500, the amount he paid for reporting nonbusiness bad debts on Schedule D, is the note. one of the most common errors made on individual income tax returns. The method of deducting a bad debt depends on whether the debt is a business bad debt or a nonbusiness bad No deduction may be taken for a nonbusiness bad debt debt. that becomes partially worthless. However, if part of a debt has been paid and the remainder is entirely uncol- ¶2404 Business Bad Debts (Sec. 166) lectible, this balance is wholly worthless and, thus, is A business bad debt is one that arises out of a debt that deductible. was originally created or acquired in the taxpayer’s trade or business. Such debts may be deducted in determin- The question of whether a debt is a business or a non- ing adjusted gross income if they become completely business debt depends on the facts of the particular case. worthless or if they are partially worthless, provided If the debt is created or acquired in the course of a tax- that the uncollectible portion can be determined with payer’s trade or business (including the trade or business reasonable certainty. of being an employee), it is a business bad debt, even though it has no relationship to the trade or business at the time it becomes worthless. EXAMPLE: Richard Hamilton, a jeweler reporting on the accrual basis, sold a $2,000 diamond brace- let to a customer on credit. The customer filed for EXAMPLE: In 2001, Marvin Jones, a wholesale grocer bankruptcy, and it is reasonably certain that Richard using the accrual basis, extended credit to Steve will receive no more than 50% of the amount due Smith on an open account. In 2006, Marvin sold the him. He may charge off $1,000 (50% of $2,000) as business to Bud Brown but retained the claim against a bad debt. Steve. In 2008, the claim becomes worthless. It is a business bad debt because it was acquired in the course of Marvin’s business. A deduction on account of a partially worthless debt is allowable only to the extent that the specific debt is charged off on the books during the taxable year. If no EXAMPLE: Assume the same facts as above, except charge-off is made, the entire debt is deductible when that in 2001, Marvin sold the claim against Steve to it becomes totally worthless. The deduction for business Arthur Adams (not the individual who bought the bad debts is reported on Schedule C (or Schedule F, for business). Arthur is entitled to a nonbusiness bad bad debts connected with farming). debt deduction in 2008. A taxpayer is not required to claim a partial bad debt but may wait until the total debt has become worthless. If the relationship between the taxpayer’s trade or busi- ness and the bad debt is only incidental, the taxpayer will ¶2405 Nonbusiness Bad Debts (Sec. 166) be entitled only to a nonbusiness bad debt deduction. Debts that are not originally created or acquired in a Taxpayers who are forced to make good on a loan guar- taxpayer’s trade or business and that become worthless antee and are unable to collect are treated as if they had are called “nonbusiness” bad debts and are treated as made a direct loan. Thus, if the loan guarantee arose short-term capital losses, regardless of the length of time in connection with a taxpayer’s trade or business, he is the debt was in existence. entitled to a business bad debt; otherwise it is a nonbusi- ness bad debt. Because nonbusiness bad debts are treated as short-term capital losses, they are subject to the limitations on ¶2406 Loans by Shareholder-Employees deductions for capital losses, as explained in Chapter 16, and should be reported on a separate Schedule D, Individuals who make a loan to a corporation for which together with any other capital gains and losses. Thus, they work and in which they own stock may have difficulty ¶2404 PA R T 3 — C H A P T E R 2 4 — B a d D e b t s 305 in deciding whether a bad debt is a business bad debt or a Although refund claims normally must be filed within nonbusiness bad debt. A loan by a shareholder is treated 3 years from the date the original return was due, refund as a nonbusiness bad debt made to protect an investment. claims based on bad debts or worthless securities may A loan by an employee is treated as a business bad debt be filed up to 7 years after the due date of the original made to protect a salary. Whether a loan by a shareholder- return. This gives taxpayers an opportunity to realize employee is a business or nonbusiness bad debt depends the benefit of a bad debt deduction, even though, as on the dominant motive for making the loan. frequently happens, a number of years elapse between the time the debt actually becomes worthless and the time the fact is established. EXAMPLE: Sidney Marcus, an elderly businessman, formed his own corporation when his employer EXAMPLE: In 2004, Sam Burgess loaned money to a decreased his responsibilities. He did so to obtain friend overseas. He received sporadic payments on sufficient salary income, as well as investment oppor- the loan until 2006. After the payments stopped, he tunities. He loaned money to his new corporation wrote a number of times to the debtor but received and guaranteed a line of credit on which he suffered no reply. In 2008, after engaging an attorney, he was a loss. He was actively involved in the day-to-day advised that the friend had been mentally ill since management of the company and continued to be 2007 and had no prospect of recovering. Under involved even after the sale of his controlling interest these circumstances, Sam should file an amended and after his chance for significant capital return was return for 2007 and claim a refund for that year. The lost. Therefore, the dominant motive in making the return may be filed any time up to April 15, 2015, loan was to protect his compensation as an officer 7 years from April 15, 2008, the due date of the and employee of the corporation rather than to pro- 2007 return. tect his investment as a shareholder in the company. This was a business bad debt. Completely worthless business bad debts must also be deducted in the year they become worthless. If a business bad debt becomes partially worthless, the deduction may EXAMPLE: John Carter, an independently wealthy indi- vidual, started a corporation by making an investment be taken in that year or deferred to the year when the and also loaning money to the corporation. He was not debt (or part of it) becomes completely worthless. repaid. His salary from the corporation was $30,000, while his outside income was $1 million. His dominant STUDY QUESTIONS motive was protection of his investment and not job security. This was a nonbusiness bad debt. 1. In 2006, Joseph Jones loans $1,000 to his friend who moved overseas. In 2008 he learns that his friend died in 2007 and left no assets. Joseph should: PITFALL: A shareholder-employee who has a a. Claim the loss on the 2008 return. business bad debt can deduct it only as a miscel- b. File an amended return for 2007 to claim the laneous itemized deduction, which is subject to bad debt. the 2%-of-AGI floor, and the deduction cannot be c. File an amended return for 2006 to claim the claimed for alternative minimum tax purposes. The bad debt. net result is that a shareholder-employee with a business bad debt from a loan to the corporation 2. The period during which an amended return can that went sour may not reap any tax benefit from be filed to claim a bad debt is: this financial loss. a. 3 years b. 5 years c. 7 years ¶2407 When Deductible 3. A nonbusiness bad debt from a loan made 5 years Nonbusiness bad debts must be deducted in the year ago is deducted as: they become worthless. If taxpayers first find out in a a. A short-term capital loss. later year that a debt had become worthless in a previous b. A long-term capital loss. year, they should file an amended return for that year c. An ordinary loss. and claim a refund. ¶2407 306 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E The nonaccrual-experience method may not be used for NOTE: Answers to Study Questions, with feedback amounts owed to taxpayers because they are engaged in to both the correct and incorrect responses, are provided in Chapter 35, beginning with ¶3524. activities such as (1) lending money, (2) selling goods, or (3) acquiring receivables or other rights to receive payment from other persons (including related persons), ¶2408 Recovery of Bad Debts (Sec. 111) regardless of whether those persons earned these amounts If a taxpayer deducted a bad debt from gross income and through the providing of services. later recovered all or part of it, any amount attributable Generally, the nonaccrual-experience method may not to the recovery is excluded from gross income by the be used for amounts due for which interest or a penalty amount the deduction did not reduce the amount of for late payment is required to be paid. tax in the earlier year. ¶2409 Explanation of Bad Debt ¶2411 Recent Developments Affecting Bad Deduction on Tax Return Debts A taxpayer claiming either a nonbusiness or business bad An employee’s loss on a loan to an employer is a business debt deduction must attach a statement to the return bad debt (Graves, CA-9, unpublished opinion, 2007-1 showing: USTC ¶50,252). The nature of the debt The name of the debtor and the business or family For further information about bad debts, see IRS Publication 334, Tax Guide for Small Business. relationship (if any) to the taxpayer When the debt became due What efforts were made to collect the debt How the debt was determined to be worthless CPE NOTE: When you have completed your study and review of Chapters 12–24, which comprise ¶2410 The Nonaccrual-Experience Method Quizzer Module 3, you may wish to take the Quizzer for this Module. Taxpayers who use an accrual method and qualify under CPE Quizzer instructions can be found on page the rules need not accrue (include in income) any part 473. of amounts that they receive from performing services For your convenience, you can also take this Quizzer that, on the basis of experience, will be uncollectible. online at www.cchtestingcenter.com. This is treated as a method of accounting called the “nonaccrual-experience method.” ¶2408 PA R T 7 — C H A P T E R 3 5 — A n s w e r s t o S t u d y Q u e s t i o n s 427 True. Incorrect. Although the value of a deduction c. Incorrect. The $2,000 credit limit would apply if Sue’s depends on the taxpayer’s tax bracket, the value of a modified AGI in 2008 was not over $49,000. credit does not. 7. a. Correct. Surrogate parenting costs do not qualify 2. a. Correct. The maximum dependent care credit is for the adoption credit. 20% of expenses up to $6,000, or $1,200. b. Incorrect. Adoption fees qualify for the adoption b. Incorrect. Although the maximum credit is 20%, it credit. cannot be applied to all the expenses to produce a credit c. Incorrect. Court costs qualify for the adoption of $1,500. Expenses on which the credit is figured are credit. limited to $6,000. c. Incorrect. Jane’s AGI exceeds $43,000, so she is lim- 8. a. Correct. The credit with respect to solar panels is ited to a 20% credit. The 35% credit rate applies only limited to $2,000. if AGI is not over $15,000 (which would have resulted b. Incorrect. Although the credit is 30% of eligible costs, in a $2,100 credit). it cannot exceed a fixed dollar limit. c. Incorrect. The credit is not the full cost of the expen- 3. a. Correct. The amount of eligible expenses ($3,000 diture if it exceeds the applicable dollar limit. is the maximum allowed for one child, $6,000 for two or more children) must be reduced by employer reimburse- 9. c. Correct. The credit may be claimed in addition to ment ($2,000), leaving $1,000 of expenses on which the IRA deduction. the credit is figured. a. Incorrect. Although certain personal credits may not b. Incorrect. Because the employer reimbursed $2,000, offset the alternative minimum tax, this credit can. the parent cannot figure the credit on the $3,000 regular b. Incorrect. Form 8880 is the correct form for figuring expense limit. the credit. c. Incorrect. $5,000 is the maximum child care exclusion if the employer pays for this amount. 10. b. Correct. The foreign tax credit is not part of the general business credit. 4. False. Correct. Because the credit may not be claimed a. Incorrect. The small employers pension plan startup by someone receiving even modest Social Security ben- cost credit is part of the general business credit. efits, it is intended to help those who do not receive this c. Incorrect. The low-income housing credit is part of type of income. the general business credit even though an investor may True. Incorrect. The credit is designed to assist low- not necessarily be in business. income taxpayers who receive little or no tax-exempt Social Security benefits. 11. a. Correct. $438 is the earned income credit limit in 2008 for a taxpayer with no qualifying child. 5. c. Correct. Taxpayers with modified AGI below set lev- b. Incorrect. $2,917 is the credit limit for a taxpayer els can claim a top credit of $1,000 per eligible child. with one qualifying child. a. Incorrect. $600 was the child tax credit amount before c. Incorrect. $4,824 is the credit limit for a taxpayer it was changed in 2003. with two or more qualifying children. b. Incorrect. $700 is the child tax credit amount that had been set to apply in 2005 before Congress changed ¶3512 Answers to Questions from Chapter 12 — the law. Gain or Loss on the Sale or Exchange of Property 6. a. Correct. The top credit of $2,000 must be reduced because Sue’s modified AGI is over $49,000; the reduc- 1. c. Correct. Although her loss is $8,300, she cannot tion is [$51,000 - $49,000]/$10,000, or .2, which is mul- recognize it because the car is personal property. tiplied by the maximum credit of $2,000, for a reduction a. Incorrect. Her loss is not $8,200 because this fails to of $400. The credit is $2,000 - $400 = $1,600. take the selling expense into account. b. Incorrect. $1,800 is the maximum Hope credit, but b. Incorrect. Although her loss is $8,300 ($3,800 Sue is not limited to the Hope credit and can opt for the [$12,000 + $100]), it is not recognized. lifetime learning credit. ¶3512 428 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E 2. a. Correct. U.S. realty cannot be exchanged tax free c. Incorrect. A retaining wall is a capital improvement for foreign realty. that is added to basis. b. Incorrect. Both an apartment building and a factory are considered like-kind. 4. c. Correct. She does not have to apportion her gain; c. Incorrect. Both unimproved land and a shopping it is all excludable, but she must recapture $2,800 depre- center are considered like-kind. ciation at a 25% rate. a. Incorrect. Although she can exclude all of her gain, 3. b. Correct. 180 days is the period in which property she must recapture all depreciation claimed after May 6, must be received to complete the like-kind exchange. 1997. a. Incorrect. 45 days is the period in which property to b. Incorrect. She does not have to apportion her gain and be received must be identified. so is not limited to excluding only 90% of her gain. c. Incorrect. If the 180 days exceeds the end of the year, there is no requirement to conclude the exchange before ¶3514 Answers to Questions from Chapter 14 — the end of the tax year. Involuntary Conversions 4. c. Correct. An annuity contract can be exchanged tax 1. a. Correct. The ordinary replacement period is no free for another annuity contract. later than two years after the close of the first year in a. Incorrect. Although a life insurance policy can be which any part of the gain is realized. exchanged tax free for an annuity contract, an annuity b. Incorrect. A three-year replacement period applies contract cannot be exchanged tax free for a life insur- only to condemnations of real property held for business ance policy. or investment purposes. b. Incorrect. An annuity contract cannot be exchanged c. Incorrect. A five-year period applies only to GO tax free for an endowment policy. zone property. ¶3513 Answers to Questions from Chapter 13 — 2. b. Correct. Only property that is similar or related Exclusion for Gain on the Sale of a in service or use qualifies as replacement property for Principal Residence involuntary conversion purposes. 1. b. Correct. There is no age requirement for the home a. Incorrect. Like-kind property is qualified replace- sale exclusion. ment property only for like-kind exchanges and not for a. Incorrect. To qualify for the exclusion, the taxpayer involuntary conversions. must have owned the home for two out of five years c. Incorrect. Code Sec. 1033 limits replacement prop- preceding the date of sale. erty to “similar or related” property so that not just any c. Incorrect. To qualify for the exclusion, the taxpayer property qualifies. must have used the home as a principal residence for two out of five years preceding the date of sale. 3. False. Correct. Although deferral of gain on a like- kind exchange is automatic, the same rule does not apply 2. b. Correct. They can exclude their entire gain of to an involuntary conversion. $300,000 because this is less than the maximum exclu- True. Incorrect. Taxpayers must make an affirmative sion amount of $500,000. election to defer gain on an involuntary conversion; a. Incorrect. $250,000 is the exclusion limit for single the election can be made only if certain conditions taxpayers. are met. c. Incorrect. Although the maximum exclusion on a joint return is $500,000, the actual exclusion is limited 4. c. Correct. The involuntary conversion rules apply to gain recognized. to both home owners and renters. a. Incorrect. A disaster is indeed an involuntary conver- 3. a. Correct. Although painting the exterior of the home sion in an area declared by the president to qualify for may be a costly expense, it is not a capital improvement federal disaster assistance relief. that increases the basis. b. Incorrect. Instead of the usual two-year replacement b. Incorrect. Adding vinyl siding is a capital improve- period, the replacement period for a personal residence ment that is added to basis. and its contents in a disaster area is four years. ¶3513 PA R T 7 — C H A P T E R 3 5 — A n s w e r s t o S t u d y Q u e s t i o n s 429 ¶3515 Answers to Questions from Chapter 15 — 2. c. Correct. The 28% rate applies to sales of collectibles Basis (for taxpayers in tax brackets at or above this rate). a. Incorrect. The 15% rate is the general capital gains 1. b. Correct. Basis is the basis of the old tractor plus rate for taxpayers in brackets above 15%. cash paid or $20,000 + $20,000 = $40,000. b. Incorrect. The 25% rate applies to unrecaptured a. Incorrect. Basis is not limited to cash paid, or depreciation (for taxpayers in tax brackets at or above $20,000. this rate). c. Incorrect. Basis is not the fair market value of the d. Incorrect. The 35% rate for ordinary income does not new tractor, or $50,000. apply to the capital gain from the sale of collectibles. 2. b. Correct. Because the sale results in a gain, the 3. a. Correct. Because the bond was held for only one year donor’s original basis of $10,000 is the basis for figur- (holding period starts on May 5, 2007, and ends on May ing the gain. 4, 2008), the holding period is short term. a. Incorrect. Because the sale results in a gain, the fair b. Incorrect. To be long term, the bond must have been market value of the stock at the time of the gift, or held for at least one year and a day. $9,000, is not used as the basis. c. Incorrect. Holding period does not depend on c. Incorrect. The value of the stock at the time of sale, or whether a gain or loss results. $15,000, is never used as the basis of gifted property. 4. a. Correct. There is no five-year carryforward limita- 3. a. Correct. Because the sale results in a loss, the prop- tion on losses that cannot be deducted currently. erty’s fair market value at the time of the gift, which is b. Incorrect. Losses that cannot be deducted currently $9,000, must be used because it is less than the donor’s can indeed be carried forward indefinitely. basis. c. Incorrect. Capital losses can offset ordinary income to b. Incorrect. Because the sale results in a loss, the donor’s the extent of $3,000 (after offsetting any capital gains). original basis, which is higher than the property’s fair market value at the time of the gift, cannot be used as ¶3517 Answers to Questions from Chapter 17 — the basis. Business Deductions c. Incorrect. The value of the stock at the time of sale, or 1. a. Correct. There is no requirement that the taxpayer $15,000, is never used as the basis of gifted property. must have filed Schedule C-EZ in the prior year in order to use the schedule in the current year. 4. c. Correct. For income tax purposes, the basis of b. Incorrect. Schedule C-EZ cannot be used if the pro- inherited property is usually its fair market value as prietor has any employees. reported on the estate tax return, which is $10,000 in c. Incorrect. Schedule C-EZ cannot be used if the busi- this case. ness has expenses over $5,000. a. Incorrect. For inherited property, the donor’s basis, or $3,000, does not control. 2. c. Correct. Business gifts are deductible within set b. Incorrect. The amount received for the sale generally limits. does not determine the basis of inherited property. a. Incorrect. No deduction may be claimed for the basic ¶3516 Answers to Questions from Chapter 16 — service charge for the first telephone line to a taxpayer’s Capital Gains and Losses home even if the phone is used in a deductible home office. 1. b. Correct. A self-created asset, such as a painting held b. Incorrect. No deduction can be claimed for interest by an artist, is specifically excluded from the definition on a tax deficiency related to Schedule C. of a capital asset. a. Incorrect. A personal car is a capital asset because it is 3. c. Correct. No current deduction is allowed for capital not excluded from the definition of a capital asset. improvements, although some may be depreciable. c. Incorrect. Stock in IBM is a capital asset because it is a. Incorrect. Repairs are ordinary expenses that can be not excluded from the definition of a capital asset. currently deducted and do not have to be capitalized. b. Incorrect. Advertising expenses are ordinary and necessary expenses that are currently deductible. ¶3517 430 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E 4. a. Correct. A home owner who rents out the home for a. Incorrect. The portion of mortgage interest related to less than 15 days does not have to report the income. the home office is part of the home office deduction. b. Incorrect. A home owner who rents out the home c. Incorrect. The portion of real estate taxes related to for less than 15 days is not allowed to deduct any main- the home office is part of the home office deduction. tenance or depreciation on the home. c. Incorrect. A home owner who rents out a home for 3. b. Correct. An accountant who takes classes at night 15 days or more and uses the home for more than 14 days to obtain a law degree cannot deduct the cost because or 10% of the rental period is allowed to deduct expenses the degree leads to a new trade or business (i.e., being (other than mortgage interest, real estate taxes, and casu- an attorney). alty losses) only to the extent of rental income. a. Incorrect. A teacher who takes courses to become a principal can deduct the cost because this is not treated ¶3518 Answers to Questions from Chapter 18 — as a new trade or business. Travel and Entertainment Expenses c. Incorrect. An engineer who takes classes toward a mas- 1. a. Correct. Because he regularly works in a particular ter’s degree in engineering can deduct the cost because he city, the city of his employment is his tax home. is already in the trade or business of being an engineer. b. Incorrect. The city in which his family lives is not his ¶3520 Answers to Questions from Chapter 20 — tax home because of his work location. Moving Expense Deduction c. Incorrect. Ed cannot elect which city to call his tax home. 1. b. Correct. Meals that the family eats during the move 2. c. Correct. The standard business mileage rate for are specifically nondeductible. 2008 has increased to 50.5¢ per mile for the first half of a. Incorrect. The cost of lodging for the family during 2008 and 58.5¢ per mile for the second half of 2008. the move is a deductible moving expense. a. Incorrect. The 2008 mileage rate for charitable pur- c. Incorrect. The cost of packing and crating household poses is 14¢ per mile. goods is a deductible moving expense. b. Incorrect. The standard business mileage rate was 48.5¢ per mile for all of 2007. 2. b. Correct. The mileage rate is 19¢ per mile for the first half of 2008 and 27¢ per mile for the second half of 2008. 3. a. Correct. The limit on business gifts is $25 per a. Incorrect. The mileage rate for 2008 for charitable person per year. driving is 14¢ per mile. b. Incorrect. $400 is the limit on nonqualified plan c. Incorrect. 50.5¢ per mile and 58.5¢ per mile are the awards to an employee per year. mileage rates for business use of a car in the first and c. Incorrect. Although most expenses are fully deduct- second half of 2008, and a move is not treated as a busi- ible if the amount is reasonable, the tax law limits the ness use even though the move must be business-related deductible amount of business gifts. in order to be deductible. ¶3519 Answers to Questions from Chapter 19 — 3. c. Correct. The tax law fixes the minimum distance Other Business, Job-Related, and test at 50 miles. Investment Expenses a. Incorrect. If a taxpayer moves only 10 miles, the 1. c. Correct. Jury duty pay that must be given to an moving costs will be nondeductible. employer who continues an employee’s salary while serv- b. Incorrect. If a taxpayer moves only 35 miles, the ing on a jury is an adjustment to gross income. moving costs will be nondeductible. a. Incorrect. Unreimbursed employee business expenses ¶3521 Answers to Questions from Chapter 21 — are deductible only as miscellaneous itemized deductions Depreciation subject to the 2%-of-AGI floor. b. Incorrect. Investment expenses are deductible only 1. c. Correct. Under the Economic Stimulus Act of 2008, the as miscellaneous itemized deductions subject to the maximum dollar limit on expensing in 2008 is $250,000. 2%-of-AGI floor. a. Incorrect. $25,000 is the limit that will apply after 2010 if Congress does not extend the law. 2. b. Correct. No home office deduction can be claimed b. Incorrect. $125,000 was the dollar limit in 2007. for landscaping. ¶3518 PA R T 7 — C H A P T E R 3 5 — A n s w e r s t o S t u d y Q u e s t i o n s 431 2. c. Correct. Because the home office is nonresidential c. Incorrect. Two out of sevenyears is the testing period rental property, its recovery period is 39 years. for breeding, training, showing, or racing horses. a. Incorrect. 27.5 years is the recovery period for resi- dential rental property, which a home office is not. 2. c. Correct. Only personal casualty losses in excess of b. Incorrect. 31.5 years was the recovery period for nonresi- 10% of AGI are deductible as an itemized deduction. dential property placed in service before May 13, 1993. a. Incorrect. 2.5% is the AGI threshold for miscella- neous itemized deductions. 3. True. Correct. Unrecaptured depreciation is the total b. Incorrect. 7.5% is the AGI threshold for medical amount of depreciation claimed after May 6, 1997, on expenses. property on which straight-line depreciation has been claimed. 3. a. Correct. Two years is the standard carryback period False. Incorrect. Straight-line depreciation, which is not for NOLs arising in 2008. subject to Sec. 1250 recapture, is treated as unrecaptured b. Incorrect. A three-year carryback period applies depreciation if claimed after May 6, 1997. only to NOLs resulting from a presidentially declared disaster. ¶3522 Answers to Questions from Chapter 22 — c. Incorrect. A five-year carryback period applied only Amortization and Depletion for NOLs arising in 2001 and 2002. 1. c. Correct. Improvements must use a 39-year recovery period after 1986, because the costs of improvements ¶3524 Answers to Questions from Chapter 24 — are recovered over the same period as the underlying Bad Debts real estate. 1. b. Correct. Because the debt became worthless in a. Incorrect. She cannot amortize the improvements over 2007, Joseph must claim the deduction on an amended the term of the lease, or 10 years, because this option return for 2007. applies only to pre-1987 improvements. a. Incorrect. Even though Joseph learned of the bad debt b. Incorrect. She cannot amortize the improvements over in 2008, the deduction can be claimed only in the year the term of the lease plus renewal periods, or 15 years, because in which it became worthless (2007). this option applies only to pre-1987 improvements. c. Incorrect. The bad debt was not worthless in the year in which the loan was made (2006), so no deduction can 2. b. Correct. 15 years is the amortization period for be claimed on the return for that year. Sec. 197 intangibles, which includes goodwill. a. Incorrect. A period of at least 60 months applies to business start-up costs. 2. c. Correct. The statute of limitations for filing an c. Incorrect. 39 years is the amortization period for amended return to claim a bad debt is extended to leasehold improvements. seven years. a. Incorrect. The normal statute of limitations, which is 3. a. Correct. A taxpayer may continue to use percentage three years, does not apply in the case of a bad debt. depletion, even after he or she has recovered his or her b. Incorrect. Five years is not the limitations period basis in the property. for filing an amended return to claim a bad debt b. Incorrect. It cannot exceed 50% of taxable income deduction. from the property, so this is not an incorrect statement. c. Incorrect. It may give rise to a tax preference item, 3. a. Correct. The law allows a nonbusiness bad debt to so this is not an incorrect statement. be deducted only as a short-term capital loss, regardless of when the loan was made. b. Incorrect. Even though the loan was made more than ¶3523 Answers to Questions from Chapter 23 — a year ago, the debt is not deductible as a long-term Business and Casualty Losses capital loss. 1. b. Correct. Three out of five years is the period for c. Incorrect. Only a business bad debt is deductible as determining a profit presumption under Sec. 183. an ordinary loss. a. Incorrect. Two out of five years is the testing period for the home sale exclusion of capital gains. ¶3524 1040 PREPARATION AND PLANNING GUIDE Quizzer Questions: Module 3 71. Which of the following transactions do not qualify 74. John Anderson, who is single, bought his home as a Sec. 1035 exchange? on May 1, 2007. On May 1, 2008, he sold his home because his employer relocated him across a. Life insurance contract for an endowment the country. Assume his gain is $20,000. He may contract exclude: b. Life insurance contract for another life insurance contract a. $0 c. Life insurance contract for an annuity con- b. $10,000 tract c. $20,000 d. Annuity contract for a life insurance contract 75. A married individual has owned a home in her 72. All of the following statements with regard to name since 2002. Both she and her husband have like-kind exchanges are correct except: lived in the home since the day she bought it. She sold it in 2008 for a profit of $600,000. What is a. An exchange of an apartment house for a factory her maximum home sale exclusion? can qualify as a like-kind exchange. b. Foreign realty can never be treated as like-kind a. $250,000 property. b. $500,000 c. In an otherwise qualifying like-kind exchange, c. $600,000 gain is generally recognized to the extent of “boot” received by the taxpayer. 76. In 2008, a surviving spouse sells the residence d. For transfers to qualify as like-kind exchanges, that she and her deceased husband owned lived the exchange must be completed within in since 1990. The husband died in 2007. Gain 45 days. on the sale was $300,000. What is the most gain she can exclude? 73. Which of the following is a requirement for the a. $0 $250,000/$500,000 exclusion on sale of residence b. $250,000 (assume the home was not acquired in a tax-free c. $300,000 exchange)? a. The taxpayer must be age 55 or older. 77. The basis of a primary residence can be increased b. The taxpayer must have owned and occupied by each of the following except: the residence as a principal residence for at least two of the five years before the sale (unless a. Waterproofing the basement the taxpayer is eligible to suspend the five-year b. Adding a new room period). c. Installing new countertops in the kitchen c. The taxpayer must have owned and occupied d. Painting the exterior the residence as a principal residence for at least three of the five years before the sale. d. The taxpayer must not have previously claimed any home sale exclusion. 484 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E 78. A home owner, who is single, used one bedroom 83. Harriet Nichols purchased a painting for $50 by in his residence as a home office for the past five an unknown artist 40 years ago at a tag sale. She years. Assume he owned the home for this period died in 2008, leaving the painting to her niece. as well. Which of the following statements is The value of the painting on the date of her correct? death was $5,000, and this value was reported on Harriet’s estate tax return. Eight months later, a. He can exclude all of his gain on the sale of the the unknown artist died, increasing the value of home up to $250,000. his works. The niece sold the painting at auction b. He must apportion the gain between the resi- ten months after Harriet’s death for $12,000. For dence and the home office, reporting gain with purposes of determining gain or loss, the niece’s respect to the home office. basis in the painting is: c. He can exclude all of his gain but must report any depreciation on the home office, which is a. $50 taxed at 25% b. $5,000 c. $12,000 79. Henry Davidson started his home office in 2003, using 10% of the space in his home for business. 84. Which of the following is true as to net long-term He has claimed a total of $2,000 depreciation for capital gain in 2008? the portion of his residence used as a home office. a. For taxpayers in the 10% or 15% bracket, the If he sells his home in 2008 at a gain of $80,000, rate on net long-term capital gains is 5% for which amount is taxed at 25%? sales. a. $78,000 b. For taxpayers in the 10% or 15% bracket, there b. $8,000 is no tax on net long-term capital gains for c. $2,000 sales. d. $0 c. Corporations are eligible for the special rates. 80. A business’s building in New Jersey is destroyed 85. Which of the following is true as to long-term by flooding and the owner receives an insurance capital gain? recovery. Assume that the business has a gain from a. The 15% rate applies to installment payments this involuntary conversion. What is the replace- received in 2008, on installment sales made ment period for postponing gain? before May 7, 2003. a. Two years b. The 15% rate has been made permanent for b. Three years long-term capital gains. c. Five years c. The 15% rate applies to all sales or exchanges made in 2008, even sales of collectibles and 81. The basis of property received for services per- unrecaptured depreciation. formed is equal to the: 86. Daniel Baxter purchased a building for $150,000, a. Lower-of-cost-or-market price of the property has a basis of $40,000 after several years of straight- b. Cost of the property line depreciation (totalling $110,000), and sells c. Cost of the services provided the building in August 2008 for $175,000. Gain d. Fair market value of the property is taxed in the following manner: 82. Which of the following will decrease the basis of a. $135,000 at 15% property? b. $110,000 at 25% and $25,000 at 15% c. $135,000 at 20% a. Depreciation d. $135,000 at 25% b. Return of capital c. Recognized losses on involuntary conversions d. All of the above Quizzer Questions: Module 3 485 87. Which of the following is not correct as to Sec. 92. Which of the following is not correct with regard 1202 stock? to vacation homes? a. There is a 50% gain exclusion for stock held a. Where annual rental is less than 15 days, rental more than five years. income is not reported and no deductions are b. The gain is excluded if reinvested in other allowed (other than mortgage interest and qualified small business stock within 60 days taxes). of sale. b. Where annual rental is 15 days or more and c. The AMT preference on the small business personal use exceeds the greater of 14 days stock is 50% of the excluded gain. or 10% of the rental period, deductions and d. S corporation stock is not eligible for Sec. 1202 expenses are limited to rental income. treatment. c. Where annual rental is 15 days or more and personal use does not exceed 14 days or 10% 88. All of the following statements are correct of the rental period, property is treated as rental except: property subject to the passive loss limita- tions. a. The totals for short-term capital gains and losses d. Mortgage interest and property taxes are not and the totals for long-term capital gains and deductible if expenses exceed rental income. losses must be figured separately. b. When a taxpayer carries over any capital loss, 93. What characteristic is not required for an account- its character will be long-term. able plan? c. If the total of a taxpayer’s capital gains is more than the total of capital losses, the excess is a. The purpose of the expense must be defined at taxable. the time of payment. d. The yearly limit on the amount of the capital b. The employee must provide adequate substan- loss a taxpayer can deduct in excess of capital tiation of all expenses on a timely basis. gains is $3,000 ($1,500 if married filing c. The plan must require remittance of any separately). advances or payments in excess of substantiated expenses. 89. Vince Maxwell, who is in the 28% tax bracket, d. Substantiation and remittance of excess amounts sold 10 shares of X stock for a gain on June 30, must be made on a timely basis. 2008. He had purchased the stock on April 12, 2007. The gain is taxed at: 94. Accountable plans require that: a. 15% a. Advances be made within 30 days of expense b. 18% b. Substantiation be provided to the employer c. 20% within 60 days of expense d. 28% c. Excess amounts be returned within 120 days of expense 90. Capital losses in excess of capital gains (after off- d. All of the above setting up to $3,000 of ordinary income) can be carried forward: 95. Which of the following is not deductible as an “actual car expense” by a taxpayer who uses that a. Two years method to figure the deductible cost of operating b. Five years his car for business purposes? c. Indefinitely a. Gas 91. All of the following are requirements for filing b. Depreciation Schedule C-EZ except: c. Parking fines d. Lease fees a. Gross receipts under $100,000 b. Business expenses not exceeding $5,000 c. No home office deduction d. No employees 486 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E 96. Which of the following is not a deductible trans- 100. Julio Flores pays club dues of $5,000 a year, for portation expense? which he is not reimbursed. He uses the club 75% for his business, 50% for directly related enter- a. Cost of round-trip transportation between tainment, and 25% for associated entertainment. an individual’s office and his client’s place of How much of the club dues may Julio deduct? business b. Cost of round-trip transportation between an a. $0 individual’s home and a temporary training site b. $2,000 in the same city c. $3,000 c. Cost of round-trip transportation between an d. $3,750 individual’s home and office while conducting business on his car phone 101. On deducting the cost of business gifts, which of d. Cost of round-trip transportation between an the following limitations applies? individual’s office in the home and his client’s place of business a. $25 per individual each year b. 50% of the cost of the gift c. Ordinary and necessary business expense 97. In March 2008, Mitchell Dean bought a new car used 100% for business. The car cost $36,000 and weighs less than 6,000 pounds (assume that 102. In general, square footage is used to figure the Mitchell made no other equipment purchases in percentage of business use of a home for purposes 2008). In 2008, Mitchell may deduct: of the home office deduction. True or False? a. $2,960 b. $4,800 103. In regard to education expenses, which of the fol- c. $10,960 lowing statements is correct? d. $25,000 a. Education expenses are deductible, even though they may be qualifying an individual for a new 98. Five elements must be proven with respect to trade or business, so long as they improve skills entertainment expenses. Two of the elements in a present trade or business. are the amount and the business purpose of the b. Education expenses are deductible, even though expense. Which of the following is not one of the they lead to meeting the minimum educational other three elements? requirements for employment. c. If the minimum educational requirements have a. The nature of the entertainment b. The time/date of the entertainment been met, then all additional education expenses c. The place of the entertainment are deductible in all cases. d. Education expenses are deductible as long as d. The business relationship of the person(s) being entertained the minimum educational requirements have been met, the education is not qualifying an individual for a new trade or business, and the 99. With regard to meal and entertainment expenses, all education is necessary to maintain or improve of the following statements are correct except: skills in the established trade or business. a. Country club dues are not allowed as a deduc- tion. b. An entertainment expense must meet one of the two tests: directly related test or associated test. c. The deductible limit on business entertainment expenses is 50%. d. The allowable deduction for the cost of a Super Bowl ticket is limited to twice the face value of the ticket. Quizzer Questions: Module 3 487 104. Which of the following is not deductible as an 108. An employer pays the moving cost to relocate an itemized educational expense? employee across the country. Which of the fol- lowing statements is correct? a. William Bard was employed as a patent chemist on the condition that he obtain a law degree at a. The employee must report the employer’s pay- his own expense. He enrolled in evening law ment of moving costs as income but can claim school. When he graduated from law school, an itemized deduction to offset the income. he was promoted to patent attorney with a b. The employee must report the employer’s substantial increase in salary. payment of moving costs as income but can b. Theresa Roland owns an accounting prac- deduct this amount as an adjustment to gross tice and took several courses in taxation and income. accounting. c. The employee does not have any income from c. Janice Paine, a salesperson, was required by her the employer’s payment. employer to take a public speaking course at her own expense as a condition to retain her 109. A factory building placed in service on May position. 1, 2008, is depreciated using the straight-line d. Marion Lane, an elementary school teacher, method over: took additional courses to qualify her to teach mathematics in high school. a. 27.5 years b. 39 years c. 40 years 105. Which of the following nonbusiness investment expenses is not deductible? 110. Which of the following is not listed property? a. The cost of a safe-deposit box rental b. A subscription to an investment advisory a. Cell phones letter b. Cars c. The cost of travel to attend an investment c. Computers seminar d. Office furniture 106. Susan James met all the requirements to deduct 111. Form 4562 is required to be filed in 2008 by an moving expenses when she moved from Arizona individual in business only if property is placed to Nevada. Which of the following are deductible in service in 2008 (assume no vehicle usage needs as moving expenses? to be reported). True or False? a. Costs of pre-movehouse-hunting trips b. Meal expenses 112. Edward Smith explores a business in January c. Expenses of buying or selling a home and February 2008. In May 2008, the business d. Costs of traveling to her new home begins. It has start-up expenses of $60,000, costs for acquiring Sec. 197 assets of $125,000, and 107. Mark Hanson is being permanently transferred cost for acquiring a lease of $10,000. Which of from his office in Virginia to another office the following expenses can be amortized? in Washington, D.C. His office in Virginia a. Business start-up costs is 10 miles from his home. For Mark to meet b. Acquisition of Sec. 197 assets the distance test to qualify for moving expense c. Cost of acquiring a lease deductions, how many miles must the office in d. All of the above Washington, D.C., be from his current home? a. 50 113. Deductible nonbusiness casualty losses result from b. 40 each of the following except: c. 60 a. Earthquake damage d. 10 b. Damage from sonic booms c. Termite damage d. Hurricane damage 488 1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E 114. The carryback period for an ordinary net operating 115. All of the following statements regarding bad debts loss arising in 2008 is: are correct except: a. One year a. In order to be deductible, a nonbusiness bad b. Two years debt must be entirely worthless. c. Three years b. To claim a bad debt deduction, the taxpayer d. Five years must include a statement with the tax return containing information such as when the debt became due, collection efforts, the nature of the debt, and how the taxpayer concluded the debt was worthless. c. Nonbusiness bad debts are treated as long-term capital losses. d. Nonbusiness bad debts are deductible in the year they become worthless.