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Gain or Loss on the Sale or Exchange of Property

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					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.


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      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.




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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



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      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.




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                                                                  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)




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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)




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¶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
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                                                                       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
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      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
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      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.

				
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