1040 Prep_book_06.indb by pengtt

VIEWS: 31 PAGES: 147

									                                       PART




                                       2
                             Acquisition and
                              Disposition 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                                           an exchange, the amount realized is the fair market value
                                                                               of the property received. If the taxpayer received both
                 This chapter was prepared to enable participants to learn     money and property in exchange, the amount realized
                 about taxable and free exchanges of property. More spe-       is the sum of the money plus the fair market value of
                 cifically, upon completion, you will be able to:              the property received.
                    Distinguish between taxable and tax-free exchanges.
                    Report like-kind exchanges on the return.                    EXAMPLE: Mr. Jones exchanges his car for a motor-
                    Identify other types of tax-free exchanges.                  cycle worth $500, plus $1,200 in cash. The amount
                                                                                 realized is $1,700 ($1,200 cash plus $500, the value
                 ¶1201 Introduction (Sec. 1001)                                  of the cycle received).

                 Gross income includes profit from the sale or exchange
                 of property. Likewise, one of the items that may be de-       If the taxpayer incurred selling expenses connected with
                 ducted from gross income in computing adjusted gross          the sale or exchange, the amount realized is the money
                 income is a loss on the sale or exchange of property.         and/or fair market value received less selling expenses, such
                                                                               as commissions, advertising expenditures, legal fees, and
                 The mere fluctuation in the value of property does not        other expenses directly related and attributable to the sale of
                 result in a gain or loss—some action must be taken, such      the property. Thus, if Mr. Jones had effected the exchange
                 as selling the property. Thus, “paper” gains from stock       through placing a newspaper ad for $10, the amount real-
                 market increases in a stock’s value are not a gain for tax    ized would have been $1,690 ($1,700 - $10).
                 purposes. The mere fact that taxpayers realize gain or
                 sustain a loss in selling or exchanging their property        Naturally, the entire amount realized by the seller is not all
                 does not necessarily mean that the gain is taxable or         profit or gain. First we must deduct the cost or basis of the
                 that the loss is deductible. The law provides that only a     property sold or given in exchange. Basis, in simple language,
                 recognized gain or loss can be considered for tax purposes.   means the cost of the property sold or given in exchange.
                 Recognizing a gain or loss means using the gain or loss
                 to determine income subject to tax. In other words, a           EXAMPLE: Assume that Mr. Jones in the previous
                 gain is taxable only if it is recognized and, by the same       example, above, had originally paid $1,500 for his
                 token, a loss is deductible only if it is recognized.           automobile. The basis of the car would be $1,500.

                 Frequently, a gain or loss is recognized in part. Obvi-       However, the determination of the basis is not always
                 ously, in such a case, the gain or loss will be taxable or    that simple. For this reason, it will be discussed further
                 deductible only to the extent recognized. This chapter        in chapter 15.
                 is devoted to a discussion of which gains and losses are
                 recognized and which are not.                                 Realized gain is the excess of the amount realized over the
                                                                               basis of the property sold or given in exchange.
                 Before we proceed with our discussion, it is necessary
                 to define the following terms that will be encountered        Realized loss, is the excess of the basis of the property sold
                 repeatedly throughout the next few chapters: “amount          or given in exchange over the amount realized.
                 realized,” “basis,” “realized gain,” and “realized loss.”
                                                                               In other words, taxpayers have a realized gain if the amount
                 Amount realized is the value received when an asset is sold   realized on the transaction is greater than the basis of the
                 or exchanged for another asset. In the case of a sale, the    property they sold or exchanged. Conversely, if the basis is
                 amount realized is simply the total money received. For       greater than the amount realized, they have a realized loss.

                                                                                                                                              ¶1201



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                                                                             or the purpose for which it was acquired or held. For
                 EXAMPLE: Continuing with our previous examples,
                                                                             instance, a taxpayer’s household furniture is considered as
                 it is clear that Mr. Jones has a realized gain of $200
                 (the excess of the amount realized ($1,700) over the
                                                                             “personal” property. If the taxpayer sells it to a furniture
                 basis of his car ($1,500)).                                 dealer for resale, it will become merchandise inventory in
                                                                             the dealer’s hands. If the dealer uses it to furnish his or her
                                                                             own office, it will become “property held for productive
              The realized gain would have been only $190 if Mr.
                                                                             use in the taxpayer’s trade or business.”
              Jones had incurred the $10 selling expense mentioned
              previously ($1,690 amount realized less $1,500 basis).         ¶1203 Sales and Exchanges of
                                                                                   “Personal” Property
                 EXAMPLE: Assume the same facts as in the previous
                 examples, except that Mr. Jones originally paid $2,200
                                                                             Normally, if taxpayers sell or exchange property held for
                 for his car. Its basis is now $2,200, and he, therefore,    personal use at a gain, they must include the entire gain in
                 has a realized loss of $500 (excess of $2,200 basis over    their gross income. In other words, the entire realized gain
                 $1,700 amount realized). If the $10 selling expenses        on the sale of the personal property is recognized. (The
                 were incurred, the realized loss would be $510.             few exceptions to this rule are explained in ¶1209.)

              After determining the amount of gain or loss realized on         EXAMPLE: If Mr. Jones sells a car for $1,700 and the
              a transaction, then determine whether, or to what extent,        basis of the car is $1,500, Mr. Jones has a recognized
              the gain or loss is recognized for tax purposes. Sometimes       gain of $200 on the sale of his car.
              the entire realized gain or loss may be recognized, at
              other times only a portion is recognized, and at still other   No loss is recognized on the sale or exchange of property
              times, the entire gain or loss is not recognized.              held for personal use.
              ¶1202 Determination of the Transaction’s
                                                                               EXAMPLE: Assume that Mr. Jones sells his car for
                    Tax Treatment
                                                                               $1,200. The basis was $1,700. Although Jones has a
              The tax treatment or recognition of gains and losses             realized loss of $500, no part of the loss is recognized.
              on the sale or exchange of property depends in part on           So far as Mr. Jones’s tax return is concerned, the loss
              the purpose for which the item sold or exchanged was             on the sale of his personal car is not recognized.
              used or held.
              Most items can be classified as being held or used for           PITFALL: Loss on the sale of a personal residence
              one of the following purposes:                                   is nondeductible.

                 Property held for personal use. This includes items
                 such as the taxpayer’s personal residence, personal         Individuals must limit loss deductions to losses incurred
                 jewelry, or pleasure car.                                   in a trade or business, in transactions entered into for
                 Business or investment property. This classifica-
                                                                             profit, or arising from casualty or theft.
                 tion may consist of either property held for produc-        ¶1204 Sales and Exchanges of
                 tive use in the taxpayer’s trade or business, such as             Business and Investment Property:
                 machinery, delivery trucks, a factory building owned              General Rule (Sec. 1031)
                 by a manufacturer, or property held for investment
                 (e.g., stocks and bonds or an apartment house held          In the case of personal use property it makes no difference
                 for rental income).                                         whether the gain or loss came about through a sale or
                 Property held for sale in the ordinary course of the        through an exchange. However, if a taxpayer disposes of
                 taxpayer’s trade or business. This would include            business or investment property at a gain or loss, it may
                 items such as a storekeeper’s merchandise, crops grown      make a great deal of difference whether the transaction
                 for sale by a farmer, and similar items. Also included in   was a sale or an exchange.
                 this group are inventory items, such as a manufacturer’s
                                                                             In general, if a taxpayer sells business or investment
                 stock of raw material and unfinished goods.
                                                                             property, both gain and loss are recognized.
              You will note that it is not the physical nature of the
                                                                             But under a special rule, if gain or loss is realized on an
              property that determines its classification, but its use
                                                                             exchange of business or investment property for other

    ¶1202



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                 business or investment property, neither the gain nor the                   If it were not for this restriction, storekeepers, dealers,
                 loss will be recognized, provided that the property taken                   and other sellers of merchandise could simply trade or
                 in the exchange is of like kind. The reason for nonrecog-                   barter their goods, instead of selling them outright, in
                 nition of a like-kind transaction is that the new property                  order to avoid paying taxes on their profits.
                 is considered as being merely a replacement or continua-
                 tion of the old property; therefore, no real change in the                  ¶1205 What Is a Like-Kind Exchange?
                 taxpayer’s financial position has taken place.                              The provision for nonrecognition of gain or loss on the
                                                                                             exchange of business or investment property applies only
                    EXAMPLE: Martin, a grocer, trades his delivery truck,                    if the property given and the property taken in exchange
                    which has a basis of $1,200, for another truck which                     are of like kind. However, the definition of “like-kind”
                    has a fair market value of $1,400. Since the amount real-                is quite liberal. It refers to the nature or character of the
                    ized ($1,400) exceeds the basis of his old truck ($1,200)                property, not its grade or quality. Thus, an exchange
                    by $200, Martin has a realized gain of $200. However,
                                                                                             of real estate property for real estate property, and the
                    because this is a like-kind exchange, the gain is not rec-
                    ognized, and he need not include it in gross income.                     exchange of personal property (i.e., non-real estate) for
                                                                                             personal property are exchanges of like property. This
                                                                                             means that the exchange of an apartment house for a
                                                                                             factory building, or of improved land for an unimproved
                    EXAMPLE: Assume the same facts as in the previous
                    example, except that the value of the truck received                     piece of land, would qualify because both are real estate
                    in exchange was only $1,000. Martin then realizes a                      properties used in trade, business, or investment. An
                    nonrecognized loss of $200.                                              example of such a tax-free exchange is an exchange of a
                                                                                             business car for a new delivery truck.
                 It is most important to remember that this special non-                     Foreign realty cannot be treated as like-kind property.
                 recognition rule applies only to an exchange, not to a sale.                Similarly, personal property used predominantly in the
                 A “sale” is defined as a transfer of property for money                     U.S. can be exchanged only for other like-kind property
                 or for a promise to pay money (such as a mortgage or                        in a similar location. Exchanges of personal property
                 promissory note). An “exchange” is a transfer of property                   must be “similar in location of use” which means prop-
                 in return for other property or for services.                               erty located in the U.S. So, for example, a computer
                                                                                             used within the U.S. exchanged for a computer used in
                    EXAMPLE: Assume that Martin, in the first example                        Canada does not qualify for like-kind treatment.
                    above, sells his original truck for $1,400 in cash.
                    Even if he immediately reinvests the entire $1,400 in                    Time limit on like-kind exchanges.        For transfers to
                    another truck, the $200 gain will be recognized be-                      qualify as like-kind exchanges, a 180-day time limit is
                    cause it was realized on a sale, not on an exchange.                     imposed for completing the exchange. Also, the property
                    By the same token, referring again to the first previ-                   to be received in the exchange must be identified within
                    ous example, if Martin had sold his truck for $1,000,
                    instead of exchanging it, his $200 loss would have
                                                                                             45 days after the original property transfer. Identifica-
                    been recognized. Here, again, it makes no difference                     tion means delivering to the other party involved in the
                    whether he reinvests his money in another truck.                         exchange a written description of the property. Specifi-
                                                                                             cally: (1) the property must be received by the taxpayer
                 To qualify as a tax-free exchange, both the property given                  within180 days (but not later than the due date, includ-
                 and the property taken in exchange must be held for busi-                   ing extensions, for the transferor’s return for the tax year
                 ness or investment purposes—not for personal use.                           in which the relinquished property’s transfer occurred)
                                                                                             after the date on which the taxpayer transferred property
                 The provisions for nonrecognition of gain or loss do not                    relinquished in the exchange will not be considered like-
                 apply to property held for sale in the ordinary course of a                 kind property and (2) to be treated as like-kind property,
                 taxpayer’s trade or business or to inventory items. Thus,                   the property to be received must be identified within 45
                 if an automobile dealer exchanges one of his or her cars                    days after the date on which the taxpayer transfers the
                 held for sale to a customer for another automobile, the                     property given up in the exchange.
                 full amount of gain or loss realized will be recognized by
                 the dealer for tax purposes. The same is true if a dealer in                Parking transactions.     If replacement property is not
                 real estate exchanges one real estate property (if held for                 readily available, an accommodation party can be used.
                 sale to customers) for another piece of real estate.                        This is called a qualified exchange accommodation ar-
                                                                                             rangement (QEAA).

                                                                                                                                                                               ¶1205



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              Sometimes this arrangement is used in reverse: the re-                                               reverse a parking transaction to be used if replacement
              placement property is parked with the accommodation                                                  property is owned by the taxpayer within 180 days that
              party until such time as the transfer of the relinquished                                            it is transferred to the exchange accommodation party
              party can be arranged. This arrangement is referred                                                  (effective for transfers on or after July 20, 2004).
              to as a reverse- Starker exchange (named after the case
              that permitted it). However, the IRS will not allow the                                              Like-kind exchanges are reported on Form 8824, “Like-
                                                                                                                   Kind Exchanges.”
                                                                                                                                                             OMB No. 1545-1190
                                                                                        Like-Kind Exchanges
                     Form      8824                                        (and section 1043 conflict-of-interest sales)                                        2005
                     Department of the Treasury                                                                                                              Attachment
                     Internal Revenue Service                                                  Attach to your tax return.                                    Sequence No.    109
                     Name(s) shown on tax return                                                                                                  Identifying number




                                                                      f
                      Part I            Information on the Like-Kind Exchange


                       1
                                                                    o
                               Note: If the property described on line 1 or line 2 is real or personal property located outside the United States, indicate the country.




                                                                   s 5
                               Description of like-kind property given up



                       2
                                                                  a 0
                                                                ft 20
                               Description of like-kind property received




                                                              ra 1/
                       3       Date like-kind property given up was originally acquired (month, day, year)                                        3            /         /

                                                                                                                                                  4            /         /



                                                             D /2
                       4       Date you actually transferred your property to other party (month, day, year)

                       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                                                 5            /         /




                                                              07
                       6       Date you actually received the like-kind property from other party (month, day, year). See instructions            6            /         /

                       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 directly or indirectly (such as through an intermediary) sell or dispose of any
                               part of the like-kind property received from you in the exchange?                                                                      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 its
                                   principal purpose. If this box is checked, attach an explanation (see instructions).

                     For Paperwork Reduction Act Notice, see page 4.                                                    Cat. No. 12311A                        Form    8824   (2005)




    ¶1205



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                 Form 8824 (2005)                                                                                                                                             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.




                                                             f
                        Note: Complete lines 12 through 14 only if you gave up property that was not like-kind. Otherwise, go to line 15.
                                                                                              12



                                                           o
                  12    Fair market value (FMV) of other property given up
                  13    Adjusted basis of other property given up                             13




                                                          s 5
                  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



                  15                                     a 0
                        Caution: If the property given up was used previously or partly as a home, see Property used
                        as home in the instructions.




                                                       ft 20
                        Cash received, FMV of other property received, plus net liabilities assumed by other party, reduced
                        (but not below zero) by any exchange expenses you incurred (see instructions)                                             15




                                                     ra 1/
                  16    FMV of like-kind property you received                                                                                    16
                  17    Add lines 15 and 16                                                                                                       17




                                                    D /2
                  18    Adjusted basis of like-kind property you gave up, net amounts paid to other party, plus any
                        exchange expenses not used on line 15 (see instructions)                                                                  18
                  19    Realized gain or (loss). Subtract line 18 from line 17                                                                    19
                  20    Enter the smaller of line 15 or line 19, but not less than zero                                                           20




                                                     07
                  21    Ordinary income under recapture rules. Enter here and on Form 4797, line 16 (see instructions)                            21
                  22    Subtract line 21 from line 20. If zero or less, enter -0-. If more than zero, enter here and on 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 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            /         /

                 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   (2005)


                                                                                                                                                                                         ¶1205



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              ¶1205A Trade or Exchange Involving
                     Both Property and Money                                  EXAMPLE: A butcher trades in his refrigerator, which
                                                                              has a basis of $600, and receives in return $150 in
              It frequently happens that a taxpayer will pay or receive       cash plus a meat-cutting machine with a fair market
              money in addition to the property traded or received            value of $700. He realizes a gain of $250 on this trans-
              in trade. Also, at times, several items of property are         action ($850 amount realized [$700 + $150], less the
                                                                              basis of property traded in [$600] = $250). Since both
              involved in one combined transaction. The money and             the refrigerator and the meat-cutting machine are
              other unlike property received are generally referred to        items held for productive use in the taxpayer’s trade
              as “boot.”                                                      or business, the exchange is tax free. However, due
                                                                              to the fact that the taxpayer also received cash, the
              To simplify the provisions dealing with these situations,       gain is recognized, but only to the extent of the money
              we have condensed them into a few short rules, each of          received. Thus, the amount of the recognized gain is
              which is fully explained and illustrated below. Rules 1 to      $150, which was the amount received in cash.
              3 cover situations wherein the taxpayer realized a gain;
                                                                                      Realized gain   = $250 ($850 - $600)
              Rule 4 deals with the treatment of a loss.
                                                                                      Recognized gain = $150 (limited to the
              Rule 1.  No gain is recognized on a like-kind exchange                                    amount of boot received)
              of business or investment property, even if the taxpayer
              pays money (so-called “boot”) in addition to the property     Gain is recognized to the extent of boot received.
              given in the trade.
                                                                              EXAMPLE: A taxpayer exchanges a machine with a
                 EXAMPLE: A printer trades in his old printing press,         basis of $350 for another machine worth $250 and
                 which has a basis of $3,400, for a new press that            $150 in cash, realizing a gain of $50. The entire gain
                 costs $5,600. He is given a trade-in allowance of            is recognized because it does not exceed the amount
                 $3,600 and pays $2,000 “boot” in cash to make up             of cash received.
                 the difference. The amount realized is $5,600 (the
                 value of the new press). Since the total basis of the
                 assets given up is only $5,400 ($3,400, the basis of       Rule 3.  If a taxpayer, in exchange for property, receives
                 the old press, plus $2,000 cash), the printer realizes     both like-kind property and property that is not like
                 a gain of $200. However, because the press is held         kind (other property), the fair market value of the other
                 for productive use in a trade or business, the gain        property is treated as cash. This means that a gain, if any,
                 is not recognized.                                         is recognized only to the extent of the fair market value
                              Realized gain   = $200 ($5,600 - $5,400)      of the other property received.
                              Recognized gain = 0

                                                                              EXAMPLE: Assume that in the previous example the
              If the above-mentioned taxpayer had sold his original           taxpayer had received, instead of the $150 cash,
              press for $3,600 and then added $2,000 to purchase              a necklace worth the same amount. The necklace
                                                                              is not like-kind property because it is not used in
              the new machine for $5,600, the $200 gain would have
                                                                              the taxpayer’s trade or business or for investment.
              been recognized, because it would have been realized on         Therefore, its $150 value is treated as cash. Hence,
              a sale, not an exchange.                                        the entire $50 gain will be recognized.
              Rule 2.  If a taxpayer receives property, plus money, in
              exchange for property and realizes a gain, the gain is
              recognized, but only to the extent of the money re-             EXAMPLE: An investor exchanges farm property hav-
              ceived. In other words, the taxpayer must either report         ing a basis of $35,000 for a vacant building lot worth
              the gain realized or the amount of money received,              $36,000, an automobile worth $2,000, and a diamond
                                                                              ring worth $500. The amount realized is $36,000 plus
              whichever is less.                                              $2,000 plus $500, a total of $38,500. Consequently,
                                                                              the investor realizes a gain of $3,500. The farm and
                                                                              the lot are like-kind property, but the automobile and
                                                                              ring are other kinds of property, and, hence, the gain
                                                                              will be recognized to the extent of $2,500, the sum of
                                                                              the fair market value of the automobile and ring.




    ¶1205A



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                 Obviously, if the taxpayer receives both cash and other                    If losses on tax-free exchanges are involved, most taxpay-
                 property in addition to like-kind property, the gain, if                   ers will want the loss. Wherever possible, to recognize to
                 any, would be recognized to the extent of the sum of the                   arrange a bona fide sale instead of an exchange in such
                 fair market value of the other property, plus the cash.                    cases so that the loss can be recognized. On the other
                                                                                            hand, if nonrecognition of the loss is deemed more desir-
                    EXAMPLE: Assume that in the previous example the                        able, an exchange type of transaction should be arranged
                    investor had also received $1,000 in cash. The real-                    if at all possible.
                    ized gain is now $4,500, of which $3,500 (the sum
                    of the fair market value of the automobile and ring,                    ¶1206 Exchange of Securities (Sec. 1036)
                    plus the cash) is recognized.
                                                                                            Although corporate stocks (shares) are usually held for
                                                                                            investment, an exchange of stock for stock is not a tax-
                 Rule 4.  A loss is never recognized on the exchange of                     free, like-kind exchange, except if the stock is exchanged
                 like-kind property held for productive use in trade or                     for the same class of stock in the same corporation.
                 business, even though other property or money is re-
                 ceived or paid in addition to the exchange.                                This means that the exchange of stock in one corpora-
                                                                                            tion for stock in another corporation or the exchange
                    EXAMPLE: A farmer exchanges a combine with a
                                                                                            of common stock for preferred stock in the same
                    basis of $15,000 for a tractor worth $10,000, a parcel                  corporation, or of stocks for bonds or vice versa, is
                    of land worth $2,000, and $1,000 cash. The amount                       not a like-kind exchange. Any gain or loss is therefore
                    realized is $13,000, and the realized loss is, therefore,               fully recognized.
                    $2,000, no part of which is recognized.
                                                                                               EXAMPLE: A taxpayer trades 100 shares of Cor-
                 Where the exchange involves related parties (spouse,                          poration A stock having a per share basis of $100
                 siblings, descendants, ancestors, or controlled entities)                     for 100 shares of Corporation B stock, which has a
                 and property is disposed of within two years of that                          market value of $95 per share. The total loss of $500
                 exchange, gain on the original exchange is triggered.                         is recognized.
                 Exceptions apply to dispositions because of death or
                 involuntary conversion.                                                    As stated above, if stock in a corporation is exchanged
                                                                                            for the same class of stock in the same corporation, it is
                    PRACTICE POINTER: The nonrecognition of gain on
                                                                                            considered a like-kind exchange and no gain or loss is
                    a like-kind transaction is a two-edged sword. On the                    recognized. It makes no difference whether the exchange
                    one hand, it defers the immediate recognition (and                      is between two stockholders or between a stockholder
                    tax) of the taxpayer’s gain, which, generally, is ben-                  and the corporation.
                    eficial to the taxpayer. On the other hand, it reduces
                    the taxpayer’s basis and increases the taxpayer’s
                                                                                               EXAMPLE: Corporation X common stock sells for
                    gain in the event of a future taxable disposition as
                                                                                               $300 a share. On July 1, the corporation offers to
                    explained at ¶1208.
                                                                                               issue three new shares of common stock for each
                                                                                               old share turned in (this is called a stock split). This is
                 The only way to tell whether nonrecognition in a given                        a like-kind exchange. No gain or loss is recognized,
                 situation is desirable is to project the taxpayer’s future                    regardless of the market value of the new shares.
                 income and tax picture. If it appears that nonrecognition
                 would do more harm than good, it may be possible to                        ¶1207 Exchanges of Insurance Policies
                 sidestep the nonrecognition provisions by arranging the                          (Sec. 1035)
                 transaction in the form of a sale rather than as an exchange.
                 However, bear in mind that simply terming a true exchange                  No gain or loss is recognized if a taxpayer exchanges a
                 as a “sale” will not do. Thus, if a taxpayer sold old equip-               life insurance policy for another life insurance policy,
                 ment used in his or her trade or business to a dealer and                  an endowment, or an annuity contract. This is so even
                 purchased new equipment of like kind from the dealer,                      if there is an outstanding loan on the policy, as long as
                 the transaction would be an exchange, “even though the                     the new policy has similar loan provisions. The same
                 sale and purchase are accomplished by separately executed                  rule applies when one annuity contract is exchanged
                 contracts and are treated as unrelated transactions by the                 for another annuity contract, so long as the insured
                 taxpayer for record-keeping purposes.”                                     (the annuitant) remains the same. Where one endow-


                                                                                                                                                                              ¶1207



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              ment policy is exchanged for another endowment                 by sale or taxable exchange. (Of course, if the taxpayer
              policy, no gain or loss is recognized if the beginning         again trades the new property in a tax-free exchange, the
              date under the new contract is no later than the be-           recognition of the gain or loss may be postponed again
              ginning date under the old contract. Nonrecognition            and again, and go on indefinitely.) The impact of an
              also applies to the exchange of an endowment policy            exchange on depreciation of the replacement property
              for an annuity contract.                                       is discussed in ¶2103.
                                                                             ¶1209 Special Provisions
                 PITFALL: The exchange of an annuity contract for a
                 life insurance policy or an endowment policy does           Congress is aware that, under certain conditions, the
                 not fall under this tax-free exchange rule.                 recognition of a gain would be extremely burdensome
                                                                             or unfair to some taxpayers. For this reason it has written
              If the insurance company is financially troubled (i.e., in     into the Code exceptions that permit certain gains to be
              rehabilitation, insolvency, conservatorship, or other state    deferred or completely tax free.
              proceeding), a policy holder can surrender the policy and
              make a tax-free reinvestment of the proceeds in a new          These provisions apply to:
              policy if the transfer is completed within 60 days.              Gain on the sale of a taxpayer’s principal residence up
                                                                               to $250,000 ($500,000 on a joint return) and
              ¶1208 How Nonrecognition of Gain or Loss
                                                                               Gain on an involuntary conversion if the proceeds
                    Affects Basis (Sec. 1031)
                                                                               are reinvested in similar property.
              The basis of the property that a taxpayer receives in            Gain on the transfer of property to a spouse or ex-
              a fully or partially tax-free exchange must be reduced           spouse incident to divorce or legal separation.
              by the amount of any gain that was realized but not
              recognized.                                                    These special rules are discussed in detail in chapters
                                                                             13 and 14.
                 EXAMPLE: A taxpayer had a nonrecognized gain of             The rules governing the recognition of gains and losses
                 $1,400 on the exchange of his truck, which had a ba-        can be briefly summarized as follows:
                 sis of $12,600, for another truck worth $14,000. The
                 basis of the new truck would be $12,600 ($14,000              Gains on the sale of property are always recognized in
                 less the $1,400 nonrecognized gain).                          full (except in the case of an involuntary conversion
                                                                               or sale of a residence, where part or all of the gain
              If a like-kind exchange results in a loss (which, of course,     may be nonrecognized).
              is not recognized), the basis of the property received           Losses on the sale of property (except property held
              in exchange would be increased by the amount of the              for personal use) are fully recognized.
              nonrecognized loss.                                              No gain or loss is recognized on a like-kind exchange of
                                                                               property held for productive use in trade or business,
                 EXAMPLE: A taxpayer had a $2,000 nonrecognized                or for investment (so-called tax-free exchanges).
                 loss on the trade of his truck, which had a basis of          No gain or loss is recognized on a tax-free exchange,
                 $12,000, for another truck worth $10,000. The basis           even though the taxpayer gives “boot” in addition to
                 of the new truck will accordingly be $12,000 ($10,000         property (so-called trade-in).
                 increased by the $2,000 nonrecognized loss). If he            If a taxpayer in a tax-free exchange also receives, in ad-
                 sells the new truck immediately for $10,000, he will          dition to like-kind property, cash or other property:
                 then have a recognized loss of $2,000.
                                                                                    Gain is recognized, but in an amount not exceed-
                                                                                    ing the sum of the cash and fair market value of
              The exchange, being a like-kind one, is tax free or ignored           the other property received.
              for tax purposes, and the basis of the old truck is simply            No loss is recognized (No loss is ever recognized
              transferred to the new one.                                           on the sale or exchange of property held for
              The above examples also illustrate why the nonrecog-                  personal use.).
              nition of gain or loss on such transactions is, in most          The nonrecognition of gain or loss rules applicable
              cases, no more than a postponement of the gain or loss           to like-kind exchanges will not apply to deferred like-
              to the time when the new asset is ultimately disposed of         kind exchanges if the time limit rules are not met.



    ¶1208



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                 ¶1210 Recent Developments Affecting                                         can Industry Classification System (NAICS) for
                       Sale or Exchange of Property                                          determining what properties are of like class. (T.D.
                                                                                             9151; 8/12/04)
                 A like-kind exchange of a home used partly for business
                 can qualify for the home sale exclusion as well as for the                  The IRS has limited the scope of “parking” transactions
                 deferral of gain under Sec. 1031. The basis in the replace-                 under the so-called reverse-Starker rule where replace-
                 ment property business/investment property is the basis                     ment property is parked with an accommodation party;
                 of the relinquished business/investment property plus                       like-kind exchange treatment does not apply to replace-
                 excluded gain and minus any cash received (Rev. Proc.                       ment property held by an accommodation party that
                 2005-15, IRB 2005-7l, 528).                                                 is owned by the taxpayer within 180 days ending on
                                                                                             the date that title is transferred to this party. (Rev. Proc.
                 Proposed, temporary and final regulations clarify de-
                                                                                             2004-51, IRB 2004-33, 294)
                 preciation rules for exchanged property (T.D. 9115,
                 2/27/04; NPRM REG-106590-00; NPRM REG-                                      The exchange of laid railroad track attached to the land
                 138499-02)                                                                  was not like kind to unassembled track components.
                                                                                             (TAM 200424001)
                 Regulations replace the old Standard Industrial
                 Classification (SIC) system with the North Ameri-


                 ¶1211         CHAPTER 12 STUDY QUESTIONS — Gain or Loss on the Sale or Exchange of Property

                     1.      Sharon sells a car for $3,800 for which she paid                   4.    An annuity contract can be exchanged tax free for:
                             $12,000. Her selling expenses to advertise the car                       a. A life insurance policy
                             are $100. Which statement best describes her tax                         b. An endowment policy
                             consequences?                                                            c. Another annuity contract
                             a. She has an $8,200 loss that can be recognized.
                             b. She has an $8,300 loss that can be recognized.
                             c. She has an $8,300 loss that cannot be rec-                       For further information, see: IRS Publication 544:
                                ognized.                                                         Sales and Other Dispositions of Assets and IRS
                                                                                                 Publication 551: Basis of Assets.
                     2.      Which of the following does not qualify for a like-
                             kind exchange?
                                                                                                 Answers to Study Questions, with feedback to both
                             a. U.S. realty for foreign realty
                                                                                                 the correct and incorrect resposese, are provided in
                             b. An apartment building for a factory
                                                                                                 Chapter 35, beginning with ¶3512.
                             c. Unimproved land for a shopping center

                     3.      For like-kind exchange treatment to apply, replace-
                             ment property must be received within:
                             a. 45 days
                             b. 180 days
                             c. Before the end of the tax year




                                                                                                                                                                               ¶1211



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                 PART 2 — ACQUISITION AND DISPOSITION OF PROPERTY


                 Exclusion for Gain on the Sale
                 of a Principal Residence                                                                                   13
                 LEARNING OBJECTIVES                                             owner’s principal residence; and a multifamily house (for
                                                                                 the residential portion only). When a taxpayer has two
                 This chapter was prepared to enable participants to learn       homes, generally the one in which he or she spends more
                 the rules for the home sale exclusion. More specifically,       time each year is considered the principal residence.
                 upon completion, you will be able to:
                    Figure gain or loss on the sale of a principal residence.      PRACTICE POINTER: While the exclusion is designed
                    Determine the basis of the home.                               to eliminate recordkeeping for most homeowners (on
                    Know how to treat a loss on the sale of a residence.           the theory that the exclusion is sufficient to offset
                                                                                   gain without having to increase basis by home im-
                 ¶1301 Basic Requirements                                          provements), it is still advisable to save records of
                       for the Exclusion (Code Sec. 121)                           home improvements. This will help reduce gain in
                                                                                   excess of the exclusion.
                 Individuals who owned and lived in their main homes
                 for at least two of the five years preceding the date of        Special marital situations. Married couples who have
                 sale can exclude up to $250,000 of gain ($500,000 on a          title to the home in the name of one spouse can use the
                 joint return). This exclusion can be used every two years.      $500,000 exclusion on a joint return if they both lived in
                 There is no age requirement.                                    the house for two years (and neither spouse is ineligible
                                                                                 for the exclusion because of selling a home within the past
                    PRACTICE POINTER: The exclusion can be used                  two years). A widow(er) can include the period of owner-
                    even though the old $125,000 has already been                ship of the deceased spouse in his or her own period of
                    used, for sales prior to May 7, 1997, as long as the         ownership. If, incident to divorce, an individual receives
                    two-year test is satisfied.                                  the marital residence in a property settlement, that person
                                                                                 can include the former spouse’s period of ownership in
                 Use of the home for purposes of the two-year require-           his or her own period of ownership. Where the spouse
                 ment need not be consecutive. Ownership and use need            who moves from the home continues to hold title to it,
                 not be simultaneous (all that is required is that each          that spouse can treat the other spouse’s period of use as
                 satisfy the two-year test). Ownership and use for the           his or her own for purposes of the two-year test.
                 two-year test is based on 24 months or 730 days during
                 a five-year period ending on the date of sale. Temporary        Exceptions to the two-year test.      If a homeowner be-
                 absences (such as vacations) are not taken into account in      comes incapable of self-care due to a physical or mental
                 determining whether the two-year test has been met.             condition and moves to a nursing home after living in
                                                                                 the residence for at least one year, then the time in the
                 Even if a homeowner meets the two-year test, the exclu-         nursing home is treated as occupancy of the personal resi-
                 sion does not apply if the sale occurs within five years        dence. For example, after one year, a homeowner suffers a
                 of acquiring the home in a tax-free exchange. In this           stroke that requires him to be placed in a nursing home.
                 case, the home must be owned as a main home for a               After one year in the nursing home, the homeowner is
                 full five years. This additional limit applies to sales after   treated as satisfying the two-year requirement.
                 October 22, 2004.
                                                                                 If an individual moves before meeting the two-year
                 Residence.   The term “residence,” in addition to the           requirement because of change in the place of employ-
                 usual one-family house, includes: shares of stock in            ment, health, or other unforeseen circumstance, then
                 cooperative housing; an apartment in a condominium;             the exclusion is prorated on the basis of the period that
                 a houseboat or mobile home, provided that it is the             the individual qualifies.

                                                                                                                                            ¶1301



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                                                                              or self employment that resulted in an inability to pay
                 EXAMPLE: A single individual bought a home on July
                                                                              basic reasonable living expenses for the household.
                 1, 2004, and relocated across the country for em-
                 ployment purposes on July 1, 2005, selling his home
                                                                              A homeowner whose residence was damaged by
                 for a profit of $80,000 at that time. The applicable         attacks.
                 exclusion in this case is $125,000 (50% of $250,000
                                                                            Special rules for military and Foreign Service person-
                 since the individual met the requirements for one out
                 of two years). Thus, all of the gain is excluded.          nel. These homeowners can suspend the five-year period
                                                                            for up to 10 years if they are on official extended duty
                                                                            that is 50 miles or more away from home or living in
              Unforeseen circumstances include:
                                                                            compulsory government-furnished housing.
                 Destruction of the home through acts of war or
                                                                            Business use of a home. Claiming a home office deduc-
                 terrorism.
                                                                            tion does not bar the use of the home sale exclusion for
                 The homeowner becomes unable to pay housing costs
                                                                            gain on the entire home; no apportionment of the gain
                 and basic living expenses due to a change in employ-
                                                                            is required for the business use of the home if the office
                 ment or self-employment status.
                                                                            is within the dwelling unit. However, any depreciation
                 Divorce or legal separation.
                                                                            claimed on the home office after May 6, 1997, is recap-
                 Multiple births resulting from the same pregnancy.
                                                                            tured at the rate of 25% for taxpayers in a tax bracket
                 Being forced from the home by pressure from
                                                                            higher than 25%. The same rule applies if you rent out
                 neighbors.
                                                                            a room within your home; the exclusion applies to the
              Affected taxpayers include:                                   entire gain but any depreciation claimed on the rental
                                                                            portion is recaptured.
                 A taxpayer who was the homeowner, the homeowner’s
                 spouse or a person living with the homeowner and           Reporting home sales. Gain or loss and the applicable
                 such person was killed, became eligible for unemploy-      exclusion, if any, is figured on a worksheet contained in
                 ment compensation or had a change in employment            IRS Publication 523, “Selling Your Home.”




    ¶1301



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                                                                               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   173




                   Worksheet 1. Adjusted Basis of Home Sold —
                                Illustrated Example 1 for Peter and Betty Clark
                     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 the new home
                               from that Form 2119.) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.          $40,000
                     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.
                     3.        Subtract line 2 from line 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.           40,000
                     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, go to line 6.
                           a. Abstract and recording fees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4a.
                           b. Legal fees (including title search and preparing documents) . . . . . . . . . . . . . . . . . . . . . . . . 4b.                         250
                           c. Surveys . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4c.
                           d. Title insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4d.
                           e. Transfer or stamp taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4e.
                           f. Amounts that the seller owed that you agreed to pay (back taxes or interest, recording or
                              mortgage fees, and sales commissions) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4f.
                           g. Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4g.
                     5.        Add lines 4a through 4g . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.               250
                     6.        Cost of additions and improvements. Do not include any additions and improvements included on line 1 . . . . 6.                                                2,000
                     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.           42,250
                     10.       Depreciation, related to the business use or rental of the home, claimed (or allowable) . . . . . 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.                                          $42,250



                   Worksheet 2. Gain or (Loss), Exclusion, and Taxable Gain —
                                Illustrated Example 1 for Peter and Betty Clark
                     Part 1 – Gain or (Loss) on Sale
                      1.       Selling price of home . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   1.   $395,000
                      2.       Selling expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .    2.     25,000
                      3.       Subtract line 2 from line 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .     3.    370,000
                      4.       Adjusted basis of home sold (from Worksheet 1, line 13) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                   4.     42,250
                      5.       Subtract line 4 from line 3. This is the gain or (loss) on the sale. If this is a loss, stop here . . . . . . . . . . . . . .                         5.    327,750

                     Part 2 – Exclusion and Taxable Gain
                      6.       Enter any depreciation allowed or allowable on the property for periods after May 6, 1997. If none, enter zero                                        6.            0
                      7.       Subtract line 6 from line 5. (If the result is less than zero, enter zero.) . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                 7.    327,750
                      8.       If you qualify to exclude gain on the sale, enter your maximum exclusion. (See Maximum Exclusion.) If you do
                               not qualify to exclude gain, enter -0- . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .        8.    500,000
                      9.       Enter the smaller of line 7 or line 8. This is your exclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .               9.    327,750
                     10.       Subtract line 9 from line 5. This is your taxable gain. Report it 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 line 6 is
                               more than zero, complete line 11 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10.                      0
                     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



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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




              If all of the gain is excluded, or if a loss results, the sale                  ¶1302 to determine the basis of the residence for figuring
              is not reported on Form 1040.                                                   gain or loss on its sale.
              Gain on the sale of a home in excess of the exclusion                           The home sale is not reported to the IRS if the seller
              amount, if any, is reported on Schedule D in the same                           completes a written certification like the sample provided
              way as gain from any other asset. Use the information in                        as follows that the full amount of the gain qualifies for
                                                                                              the exclusion.


                   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



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                                                                                               Additions to basis. The following checklist will help
                    PRACTICE POINTER: It is advisable for the seller to
                                                                                               to remind homeowners of items they may have omitted
                    notify the IRS of a change of address. This is done by
                    filing Form 8822, “Change of Address,” directly with the
                                                                                               in determining the basis of the residence. Note that the
                    IRS. This form is not filed with the income tax return.                    answer to the question of whether a particular expendi-
                                                                                               ture is a part of the cost or basis of real estate depends
                                                                                               on the law of the particular state in which the property
                 ¶1302 Basis of Residence                                                      is located (that is, whether or not the law classifies the
                                                                                               improvement as a so-called fixture). For this reason, the
                 Basis in the residence can be increased by capital im-                        following list should not be considered definitive. It is
                 provements. Basis cannot be increased by ordinary re-                         merely designed to indicate those items that would be
                 pairs to the home, such as painting a room or repairing                       classified as improvements to real estate in the great
                 a leaking faucet.                                                             majority of states.

                  Expenditures That May Be Includible in Tax Basis of Personal Residence
                 Outside Additions and Improvements


                     Additional acreage or lots                 Garden and grounds:                                         Play yard
                     Additions to buildings:                      Fertilizers and conditioners                              Retaining walls
                        Aluminum siding                           Grading                                                   Roofing additions or replacements
                        Breezeway                                 Grass seed                                                Screens and screen doors
                        Garage                                    Lawn sprinkler system                                     Septic tank or cesspool
                        Porch                                     Plants, bulbs, seed                                       Sewers—assessment and connection
                        Wings                                     Rototill soil                                             Storm doors
                        Work shed or other out-buildings          Shrubs, bushes, vines                                     Surveying of property
                     Barbecue pit                                 Topsoil and fill                                          Swimming pool
                     Birdbath                                     Trees                                                     Telephone outlets
                     Cement staircase                             Trellis                                                   Termite proofing
                     Driveway:                                    Water well and pump                                       Terraces and patios
                        Blacktopping                            Gutters, leaders, drainpipes,                               Walks
                        Gravel                                    and dry wells                                             Waste-collecting and burning apparatus
                        Paving                                  Lamppost                                                    Waterproofing
                     Electrical outlets                         Mailbox
                     Fences and gates                           Pathways


                 Inside Additions and Improvements and Other Costs


                     Accessories and equipment:                       Food freezer                                                 Ventilator
                       Bathrooms:                                     Garbage disposal                                             Washing machine
                           Bathtub sliding doors                      Lawn sprinkling system                                Acquisition costs:
                           Medicine cabinet                           Range                                                   Appraisal fees
                           Mirrors                                    Range hood                                              Broker’s commission
                           Shower cabinet                             Refrigerator                                            Closing costs
                           Shower controls                            Sinks                                                   Legal fees
                           Towel racks                                Ventilator                                              Recording of deed and mortgage
                           Tub                                     Laundry:                                                   Survey
                           Tub hanger                                 Dryer                                                   Title search and insurance
                           Unit heater                                Linen chute                                           Bookcases and other built-in furniture
                       Kitchen:                                       Sinks                                                 Cabinets, closet shelves, etc.
                           Countertops                                Sorting counter                                       Carpeting and padding
                           Dishwasher                                 Supply cabinets                                       Ceilings (acoustical)
                           Drainboards                                Tubs                                                  Closets




                                                                                                                                                                                     ¶1302



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              Inside Additions and Improvements and Other Costs, continued


                  Communication:                                               TV antenna and wiring                        Hot water tank
                     Call bells or chimes                                      Wiring system                                Pumps
                     Fire or burglar alarm system                           Hardware, fixtures, and locks:                  Septic system
                     Intercommunication system                                 For cabinets and closets                     Sump pump
                     Telephone raceways                                        For curtains and draperies                   Traps
                  Conversion of basement or attic into                         For doors                                    Vent pipe
                  recreation room or bedroom                                   For windows                                  Water supply system
                  Cupboards                                                    Lighting fixtures                     Miscellaneous items:
                  Fireplace mantel                                          Heating and air conditioning:              Dumbwaiter
                  Flooring—wood, tile, etc.                                    Air conditioning                        Garbage disposal
                  Inside walls:                                                Attic fan                             Other equipment:
                     Altering and plastering                                   Boiler                                  Fireplace equipment
                     Wall tiles                                                Circulating system                      Mirrors
                     Wood paneling                                             Cooling equipment                       Workshop equipment
                  Insulation:                                                  Fireplace heater                      Radiator covers
                     Ceilings                                                  Furnace and appurtenances             Replacement or addition of stairs
                     Floors                                                    Hot water heater                      Room dividers and partitions
                     Pipe and duct                                             Radiators and valves                  Ventilators
                     Roof                                                      Space heater                          Window seats
                     Walls                                                     Warm air grills and registers         Windows:
                  Linoleum                                                     Plumbing and sanitation:                Replacement screens
                  Mechanical equipment:                                        Cold water pipe                         Storm sash
                     Electricity and lighting:                                 Copper tubing                           Venetian blinds
                         Circuit breakers                                      Floor drains                            Weather stripping
                         Fuse boxes                                            Grease traps                            Window shades
                         Lightning rods                                        Hot water pipe




              Subtractions from basis. The basis of the residence                                If, prior to the sale, the business use ceases so that
              must be decreased by: (1) any depreciation taken on a                              personal use satisfies the two-year test, then the entire
              portion of the residence used for business (e.g., a home                           property is treated as a personal residence. For example,
              office), (2) casualty deductions, (3) residential energy                           a homeowner rented the basement, for which deductions
              credits claimed between 1978 and 1985 and (4) District                             were claimed. Several years ago, that basement ceased to
              of Columbia first-time homebuyer credit.                                           be used as such and again became part of the residence.
                                                                                                 No apportionment is required in this case.
              ¶1303 Mixed Use of Residence                                                       However, it should be noted that any depreciation claimed
              If a residence is used partly as the taxpayer’s principal                          with respect to the basement will be used to reduce basis
              residence and partly rented or used for business purposes                          (and thereby increase gain) on the sale of the residence and
              and the business portion is separate from the dwelling                             any post-May 6, 1997, depreciation is taxed at 25%.
              unit, only the portion used as a residence qualifies for
              nonrecognition of gain. For example, apportionment                                 ¶1304 Loss on the Sale of a Residence
              is required for a multi-family apartment house where
              the owner lives in one unit, for a store where the owner                           Loss on the sale of a personal residence is nondeduct-
              lives above it and for a separate portion of a home that                           ible. In a declining real estate market, future losses can
              is rented out, such as a detached garage or cottage on                             be made deductible by converting the residence to an
              the property. In this case, the property is treated as if                          income-producing activity, such as rental property.
              it consisted of two separate houses; the gain or loss is                           There are no established time minimums for proving
              computed separately on each. In most cases, the appor-                             that a residence has been converted to rental property. In
              tionment between the residential and nonresidential part                           one case, a court held that a period of a few months of a
              is made on the basis of space occupied for each business.                          month-to-month rental was not sufficient to convert the
              However, other methods of apportionment, such as                                   use of the property from personal to income-producing.
              comparative rental value, etc. may also be used, so long
              as the apportionment is realistic.                                                 At the time of conversion, the property basis must be fixed.
                                                                                                 Basis in this instance is the lower of (1) the original basis

    ¶1303



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                 plus any adjustments or (2) the current fair market value of                     Compensation for damage to home for faulty construc-
                 the property. This value is established by obtaining apprais-                    tion or chemical contamination is not immediately
                 als. This new basis is used only for figuring depreciation.                      taxable, but reduces the home’s basis (Chief Counsel
                                                                                                  Information Letter 2005-0013 and Letter Ruling
                 ¶1305 Recent Developments Affecting Exclusion                                    200513011).
                       for Gain on the Sale of a Residence                                        Final regulations effective August 13, 2004, create
                 A like-kind exchange of a home used partly for business                          a safe harbor for treating the sale of a residence for
                 can qualify for the home sale exclusion as well as for the                       the purposes of employment, health or unforeseen
                 deferral of gain under Sec. 1031. The basis in the replace-                      circumstances as the primary reason for the sale. They
                 ment property business/investment property is the basis                          also clarify some rules under unforeseen circumstances.
                 of the relinquished business/investment property plus                            (T.D. 9152, 8/13/04).
                 excluded gain and minus any cash received (Rev. Proc.                            Homeowners forced to sell their home before satisfying
                 2005-15, IRB 2005-7l, 528).                                                      the two-year ownership and use tests because of pres-
                 A police officer’s move to the K-9 unit, which required                          sure from neighbors to leave the neighborhood is an
                 him to maintain a dog kennel at his home, was an                                 unforeseen circumstance entitling the homeowners to a
                 unforeseen circumstance permitting a proration of the                            partial exclusion. (Letter Ruling 200403049).
                 home sale exclusion (Letter Ruling 200504012).


                 ¶1306 CHAPTER 13 STUDY QUESTIONS —
                       Exclusion of Gain on the Sale of a Principal Residence

                     1.      Which of the following is not a requirement to                         4.     Veronica, a single taxpayer, uses one room in her
                             claiming the home sale exclusion?                                             home as a deductible home office for her freelance
                             a. Owning the home for two out of five years                                  business (Assume the office is 10% of the home
                                preceding the date of sale                                                 space.) She sells her home for a gain of $200,000.
                             b. Attaining age 55 by the date of sale                                       She had claimed depreciation after May 6, 1997,
                             c. Using the home as a principal residence for two                            totaling $2,800. Which statement is correct?
                                out of five years preceding the date of sale                               a. She can exclude all of her gain and there is no
                                                                                                                 depreciation recapture.
                     2.      Mr. and Mrs. Smith owned and lived in their home                              b. She can exclude 90% of her gain and must
                             for 10 years. The basis in the home is $100,000.                                    recapture $2,800 depreciation at 25%.
                             On June 1, 2005, they sell the home for $400,000.                             c. She can exclude all of her gain, but $2,800
                             On a joint return, the couple can exclude:                                          depreciation is taxed at 25%.
                             a. $250,000
                             b. $300,000
                             c. $500,000                                                             For further information on home sales, see: IRS
                                                                                                     Publication 523: Selling Your Home; IRS Pub-
                     3.      All of the following expenses can increase the basis                    lication 544: Sales and Other Dispositions of
                             of a home except:                                                       Assets; and IRS Publication 552: Recordkeeping
                             a. Painting the exterior of the home                                    for Individuals.
                             b. Adding vinyl siding
                             c. Adding a retaining wall                                              Answers to Study Questions, with feedback to both
                                                                                                     the correct and incorrect resposese, are provided in
                                                                                                     Chapter 35, beginning with ¶3513.




                                                                                                                                                                                        ¶1306



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                                                                                                                          14
                 PART 2 — ACQUISITION AND DISPOSITION OF PROPERTY


                 Involuntary Conversions

                 LEARNING OBJECTIVES                                          However, suppose taxpayers take the money they re-
                                                                              ceived and buy other property to replace property that
                 This chapter was prepared to enable participants to learn    was condemned, destroyed, or otherwise involuntarily
                 about involuntary conversions. More specifically, upon       converted. Frequently, the new property will cost them
                 completion, you will be able to:                             as much as they received or even more. In this situation,
                    Properly defer gain on an involuntary conversion.         they have no real profit since they are in the same position
                    Correctly treat severance damages.                        as before. Obviously, it would be unfair to tax them on
                    Recognize and use the special rules for disaster          such a compulsory “gain.”
                    losses.                                                   For this reason, the law provides that, if taxpayers reinvest
                 NEW THIS YEAR                                                the entire proceeds in other property of “similar or related
                                                                              in use,” they may elect to have the gain not recognized.
                       Disaster areas. A list of places designated as
                       disaster areas can be found at www.fema.gov/news/        EXAMPLE: Assume that Mr. Jones’ house, which had
                       disasters.fema. See ¶1408.                               an adjusted basis of $65,000, was condemned. The
                                                                                state made an award of $85,000. Similar property
                       Extended replacement period for Hurricane Ka-
                                                                                is acquired at $90,000. Since Jones reinvested his
                       trina victims. These individuals have an increased
                                                                                entire proceeds, he may, at his option, not recognize
                       time to reinvest proceeds in order to postpone gain.
                                                                                the gain.
                       See ¶1402.

                                                                              What happens if taxpayers reinvest part, but not all, of
                 ¶1401 INTRODUCTION                                           the proceeds in similar property? They must report as
                                                                              gain the unexpended portion of the proceeds. For the
                 The Code provides for the nonrecognition of gain on
                                                                              portion of the proceeds that was reinvested, they may
                 involuntary conversions under certain conditions.
                                                                              elect nonrecognition.
                 An involuntary conversion takes place when a taxpayer’s
                 property is stolen, seized, destroyed, condemned, or           EXAMPLE: Assume that Mr. Jones of the previous
                 threatened with condemnation and when the taxpayer             example acquires a new building for $70,000. He
                 receives some form of compensation either from insur-          must report $15,000 of the gain; he may elect to have
                 ance, condemnation awards, or other sources. The com-          the remaining $5,000 not recognized.
                 pensation may be in the form of money or it can be in
                 the form of other property. In other words, the taxpayer’s
                                                                              ¶1402 Replacement Period
                 original property may be involuntarily converted either
                 into money or into other property.                           It is not necessary that the actual money received from
                                                                              insurance or condemnation proceeds be used or ear-
                 Ordinarily (unless the tax-free exchange provisions dis-     marked for the acquisition of new property. However,
                 cussed in chapter 12 apply), the conversion is treated as    the replacement must take place within a certain time
                 a sale, and any gain is therefore recognized.                limit or replacement period if the taxpayer desires to
                                                                              elect nonrecognition. That is, the new property must
                    EXAMPLE: Mr. Carter’s house, which had a basis of         be acquired no later than two years (three years in the
                    $65,000, was condemned by the city for the building       case of real property held for productive use in a trade or
                    of a new road. He received a condemnation award
                                                                              business for condemnation proceedings) after the close of
                    of $85,000. The gain of $20,000 is recognized just
                    as in any other sale.                                     the first tax year in which any part of the gain is realized.
                                                                              Where the taxpayer for good reason is unable to replace

                                                                                                                                           ¶1402



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              the property within the required period, the taxpayer         is authorized to extend the replacement period for ad-
              should write and request permission to the IRS.               ditional time on regional basis where weather-related
                                                                            conditions (such as drought) persist for more than three
                 EXAMPLE: A taxpayer’s warehouse with an adjusted           years. Weather-related conditions include drought, flood
                 basis of $3,000,000 was destroyed by fire on August        or other similar conditions as well as soil contamination
                 15, 2003. He settled with his insurance company            or other environmental contamination.
                 for $5,000,000, of which he receives $3,500,000 in
                 September 2004 and $1,500,000 in January 2005. If          If it is not feasible to reinvest proceeds in property similar
                 he replaces the building and elects nonrecognition,        or related in use to the livestock that was converted, the
                 he must acquire the replacement building no later          proceeds can be reinvested in other farm property.
                 than December 31, 2006, the end of the second
                 year following the year in which he realized the first
                 part of his gain.                                            PRACTICE POINTER: The four-year period for live-
                                                                              stock sales due to weather-related conditions ap-
                                                                              plies retroactively to 2003 returns and later returns,
              The taxpayer could have added another year to the replace-      so affected farmers should explore whether to file
              ment period by requesting the insurance company to pay          amended returns for 2003 if they have not already
              him no more than $3,000,000 in 2004. In that case, he           done so.
              first would have realized a gain in 2005, and the replace-
              ment period would have ended December 31, 2007.
                                                                            ¶1403 What Qualifies as Replacement Property
              Understandably, if the new property were acquired before      A taxpayer may elect nonrecognition of gain on an in-
              the fire or other casualty or theft occurred, it would not    voluntary conversion only if the new property is “similar
              be considered as replacement property. However, for           or related in service or use” to the property condemned,
              condemnations, the replacement period begins on the           destroyed, stolen, etc. There are two tests to determine
              earliest date of threat or imminence of the property’s        whether the replacement property qualifies. These tests
              condemnation or requisition, provided that the replace-       are the previously defined like-kind test and the func-
              ment property is still held by the taxpayer at the time       tional-use test.
              the condemnation, requisition, or sale on the threat of
              condemnation actually takes place.                            This does not mean that the new property must be iden-
                                                                            tical to the old. What matters is that the use or function of
                 EXAMPLE: On June 1, 2005, a taxpayer was notified          the two properties is similar. Thus, if a taxpayer replaced
                 by his county authorities that the county was plan-        two buildings that were destroyed by fire with one single
                 ning to buy or, if necessary, condemn his farm in          building to be operated for the same purpose, the tax-
                 order to build a school on the land. The negotiations      payer would be entitled to elect nonrecognition.
                 were completed in February 2006, and the county
                 took title on March 1. The taxpayer meanwhile had          On the other hand, if an owner operates a manufactur-
                 bought similar farm property in November 2005.             ing plant on property that is destroyed and replaces the
                 The new property qualifies as replacement property         plant with a building to be used as a wholesale grocery
                 because it was acquired after the first date of threat
                                                                            warehouse, the replacement would not qualify. But, if
                 or imminence of condemnation.
                                                                            the taxpayer, instead of operating the property, merely
                                                                            rented out the original property for use as a manufactur-
              New York Liberty Zone property. The replacement pe-           ing plant and then rented out the replacement property
              riod for property involuntarily converted on September        for use as a wholesale grocery warehouse, the replacement
              11, 2001, as a result of the terrorist attacks is extended    would qualify, because, as far as the owner is concerned,
              to five years.                                                the use of both properties is “similar.” Both are held for
              Hurricane Katrina victims. The replacement period             rental; the end use to which the tenant puts the property
              is extended to five years for property involuntarily          is immaterial.
              converted on or after August 25, 2005, by reason of           Replacement of farmland with other farmland will qualify,
              Hurricane Katrina.                                            even though the crop or usage differs. Thus, the court has
              Livestock sales due to weather. Farmers may be forced         held that apricot, prune, and walnut orchards were “simi-
              to sell livestock due to weather-related conditions. The      lar” to a truck and cattle farm that they replaced. However,
              replacement period in this case is four years. The IRS        livestock involuntarily converted must be replaced with


    ¶1403



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                 the same kind of animals held for the same purpose. Thus,          In such cases, gain is never recognized so long as the
                 horses held for breeding purposes must be replaced with            property given in exchange is similar or related in use
                 horses also to be used for breeding purposes.                      to the property converted.
                 More liberal rules apply in the case of real estate held for
                                                                                      EXAMPLE: The township condemned a taxpayer’s
                 productive use in trade, business, or investment that is
                                                                                      land, which had a basis of $30,000, to build a new
                 condemned or converted because of threat of condem-                  road. As compensation, the taxpayer received
                 nation. In such case, the new property will qualify as               another parcel of land with a fair market value of
                 replacement property so long as it is of like kind.                  $60,000. No gain is recognized.

                    EXAMPLE: A taxpayer owned an urban building lot
                                                                                    ¶1405 Other Examples of
                    that was condemned. He reinvested the proceeds
                    in a ranch. The replacement qualifies because both                    Involuntary Conversion
                    are like-kind properties, even though they are not
                                                                                    On occasion, property may be considered as “involun-
                    “similar or related in use.”
                                                                                    tarily” converted, even though it was sold by the tax-
                                                                                    payer voluntarily. For instance, a portion of a taxpayer’s
                 Any tangible property acquired and held for productive             property may be condemned or destroyed, impairing
                 use in a business is treated as similar or related in service or   the usefulness of the remaining portion. If the taxpayer
                 use to property that was held for investment or productive         subsequently sells the remainder in order to buy a larger
                 use in a business and that was involuntarily converted as          unit, the sale will be viewed as “involuntary” because it
                 a result of a Presidentially-declared disaster.                    was forced upon the taxpayer as a result of the condem-
                                                                                    nation or destruction.
                    EXAMPLE: In August 2005, Brown’s spare delivery
                    truck was destroyed by a hurricane in Coco City, an             Also, if livestock is destroyed by a taxpayer because of
                    area declared by the President to be eligible for federal       disease or exposure to disease, or is sold or exchanged
                    disaster relief. Brown used insurance proceeds received         by the taxpayer for that reason, the destruction or sale is
                    in October 2005 to buy a new telephone system for his           treated as an involuntary conversion. If livestock (other
                    office. Gain in this case is eligible for deferral.             than poultry) held for draft, breeding, or dairy purposes
                                                                                    is sold or exchanged solely on account of drought, it will
                 Property acquired from a related person (a close relative          be considered an involuntary conversion. However, only
                 or a business controlled by the taxpayer) is not treated           the number of animals that are sold in excess of those
                 as qualified replacement property unless gain on the               that normally would have been sold by the taxpayer will
                 involuntary conversion is less than $100,000.                      be considered disposed of solely because of drought.
                 ¶1403A       Severance Damages                                     ¶1406 How the Nonrecognition
                                                                                          Election Is Made
                 When a public authority condemns a portion of property
                 for public use (e.g., to widen a road or build a school), the      The nonrecognition of a gain on an involuntary conver-
                 condemnation award customarily consists of compensa-               sion is optional. Thus, if no election is made, gain will
                 tion for the value of the property taken plus an amount            be recognized.
                 (“severance damages”) to compensate the taxpayer for
                 the loss in value or use of the remaining property. Only           To make the election, taxpayers should attach to the
                 the portion specified as compensation for the property             return for the first year in which a gain was realized a
                 taken is considered in determining gain. Severance dam-            full explanation of the conversion and replacement of
                 ages are completely tax exempt, except to the extent they          the property (or intention to replace, if replacement
                 exceed the basis of the remaining property. Net severance          has not yet been made). A similar explanation should
                 damages (severance damages less expenses in obtaining              be attached for each subsequent year in which the gain
                 them) reduce the basis of the retained property.                   is realized. However, even if no explanation is attached,
                                                                                    the mere failure to report the gain on the return will be
                 ¶1404 Property Replaced in Kind                                    considered a nonrecognition election.
                 It sometimes happens that the taxpayer, in an involun-             If taxpayers make the election because they intend to
                 tary conversion, is compensated with similar property              replace the property and later change their minds or
                 instead of with cash.

                                                                                                                                                                    ¶1406



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              otherwise fail to do so (or replace the property at a lower   not scheduled property for insurance purposes will not
              cost), they must file an amended return for the year in       be recognized. Also, the insurance proceeds for both the
              which the gain was realized.                                  home and the contents can be treated as a common pool
                                                                            of funds for purposes of replacement.
                 PRACTICE POINTER: On involuntary conversions, as
                 for tax-free like-kind exchanges, any nonrecognized          EXAMPLE: The Browns’ home is destroyed in a di-
                 gain reduces the basis of the replacement property.          saster, and they receive a check from the insurance
                 For this reason, it is sometimes to the taxpayer’s           company for $200,000 ($140,000 for the home and
                 advantage to recognize the gain.                             $60,000 for the contents). They can elect to defer tax
                                                                              on any gain from receipt of the insurance proceeds
                                                                              if they buy a new home for $170,000 and contents
                                    STATEMENT ELECTING                        for $30,000. They are not limited to the original
                                  NONRECOGNITION OF GAIN                      70%/30% allocation of insurance proceeds.
                                       (To accompany tax return)

                                        Mary and John Jones
                                                                            A “disaster” for purposes of this rule is an involuntary
                                         Taxable Year 2005                  conversion in an area declared by the President to be an
                                                                            area warranting assistance by the federal government un-
                 On June 30, 2005, a warehouse owned by taxpayers           der the Disaster Relief and Emergency Assistance Act.
                 was totally destroyed by fire. It had been constructed
                 at a total cost of $1,000,000 and, after its original      The replacement period for a personal residence and
                 construction, no capital improvements were made.           its contents in a disaster area is extended to four years
                 The building was being depreciated on the basis            (instead of the usual two years) after the close of the
                 of a 25-year useful life. Total depreciation claimed
                                                                            first taxable year in which any part of the gain upon
                 prior to this taxable year was $380,000. Additional
                 depreciation on the building for the portion of this       conversion is realized.
                 year prior to its destruction was $20,000.
                                                                            These rules apply to both homeowners and renters.
                 The building was insured by the ABC Casualty Corpo-
                 ration. Taxpayers received $1,300,000 in full payment      ¶1408 Losses on Involuntary Conversions
                 of their loss on the building on October 1, 2005. On
                                                                            The special rules for involuntary conversion apply only
                 October 15, 2005, taxpayers entered into a construc-
                 tion contract with the XYZ Corporation to build a new      to gains. A loss on an involuntary conversion is treated
                 building at a cost of $1,300,000. Construction was         as any other loss on a sale or exchange. Thus, a loss on
                 completed February 15, 2006, and the new building          the involuntary conversion of business or investment
                 has been occupied since that date by the taxpayers.        property is fully recognized unless the taxpayer received
                 The taxpayers hereby elect, in accordance with the
                                                                            replacement property in exchange, in which case the like-
                 provisions of Code Sec. 1033(a)(2), not to have any        kind exchange rules will apply. In the case of personal-use
                 gain recognized with respect to the insurance proceeds     property, the loss is recognized only if it qualifies as a
                 received on their destroyed building, and in their de-     “casualty” loss (see chapter 23).
                 preciation schedule attached to this return have stated
                 their basis in the new building to be $600,000.
                                                                              PITFALL: Losses of personal-use property arising
                                                                              out of condemnations are not deductible.

              ¶1407 Taxpayer’s Residence
                                                                            Special rules apply to disaster losses. These rules are
              If a taxpayer’s principal residence is involuntarily con-     explained in ¶2314.
              verted through condemnation, threat, or imminence of
              condemnation, seizure, or requisition, the involuntary        ¶1409 Involuntary Conversion Rules Summary
              conversion rules apply.                                       An involuntary conversion is a forced disposition of
              Special rules for disaster losses. If a principal residence   property for money or other property. The most frequent
              (or any of its contents) is compulsorily or involuntarily     examples are destruction by fire, theft, and condemna-
              converted because of a disaster, any gain resulting from      tion by federal, state, or local governments. The law
              the receipt of insurance proceeds for personal property       mitigates the tax effects of any gains realized on such
              that was part of the contents of the residence but was        conversions by providing that if the proceeds are rein-



    ¶1407



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                 vested in property similar or related in service or use to         ¶1410 Recent Developments Affecting
                 the original property at taxpayer’s option:                              Involuntary Conversions

                    No gain is recognized if the cost of the replacement            The replacement period for gain related to property invol-
                    property equals or exceeds the proceeds.                        untarily converted on or after August 25, 2005, by reason of
                    Gain is recognized only to the extent of the excess if the      Hurricane Katrina has been extended to five years (Katrina
                    proceeds exceed the cost of the replacement property.           Emergency Tax Relief Act of 2005, P.L. 109-73).


                 ¶1411         CHAPTER 14 STUDY QUESTIONS — Involuntary Conversions


                     1.      To defer gain on an involuntary conversion, the         4.   Which statement regarding disaster losses is not
                             ordinary replacement period is:                              correct?
                             a. Two years                                                 a. A disaster is an involuntary conversion in an
                             b. Three years                                                  area declared by the President to qualify for
                             c. Five years                                                   federal disaster assistance relief.
                                                                                          b. The replacement period for a personal resi-
                     2.      What type of property qualifies as replacement                  dence and its contents in a disaster area is
                             property for purposes of deferring gain on an in-               four years.
                             voluntary conversion?                                        c. The rules apply only to homeowners and not
                             a. Like-kind property                                           to renters.
                             b. Property that is similar or related in service or
                                use
                             c. Any type of property                                  For further information, see IRS Publication 547:
                                                                                      Disasters, Casualties, and Thefts (Business and
                     3.      Deferring gain on an involuntary conversion is au-       Nonbusiness), IRS Publication 2194: Disaster
                             tomatic if qualified replacement property is timely      Losses Kit for Individuals, and IRS Publication
                             received. True or False?                                 1600, Disaster Losses: Help for the IRS.


                                                                                      Answers to Study Questions, with feedback to both
                                                                                      the correct and incorrect resposese, are provided in
                                                                                      Chapter 35, beginning with ¶3514.




                                                                                                                                                                    ¶1411



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                                                                                                                           15
                 PART 2 — ACQUISITION AND DISPOSITION OF PROPERTY


                 Basis

                 LEARNING OBJECTIVES
                                                                                 EXAMPLE: Mr. Dailey bought a one-family home in
                 This chapter was prepared to enable participants to gain        1993 for $162,000. He immediately added another
                 an understanding of the rules on basis of property. More        room at a cost of $5,000. The cost basis on Decem-
                 specifically, upon completion, you will be able to:             ber 31, 1993, was $167,000. In November 2005, a
                                                                                 fire damaged Dailey’s garage, resulting in a loss of
                    Know how to figure the basis of property acquired            $2,000. The adjusted basis on December 31, 2005,
                    by purchase.                                                 was $165,000 ($167,000 - $2,000).
                    Know how to figure the basis of property acquired
                    by gift or inheritance.
                    Use special rules affecting basis.                           EXAMPLE: Mr. Elkins paid $9,000 for an automobile
                                                                                 he uses entirely in his business. He took a depre-
                 NEW THIS YEAR                                                   ciation deduction of $3,000 per year. At the end of
                                                                                 two years he has charged off $6,000. The basis is
                                                                                 adjusted for the depreciation, and the adjusted basis
                       Car’s basis. The basis of a car which the standard
                                                                                 of the car is $3,000.
                       mileage rate is used to account for expenses is
                       reduced by a deemed depreciation rate, which is
                       17¢ per mile. See ¶1520.                                ¶1502 Basis of Property Received in Exchange
                                                                                     for Services or Property (Sec. 1012)
                 ¶1501 Introduction                                            If property is received in exchange for services rendered,
                                                                               its basis is the fair market value of the property at the
                 To compute the amount of gain or loss on a sale or ex-
                                                                               time the services are rendered.
                 change of property, a taxpayer must know the basis of the
                 property that was sold or exchanged. The determination
                 of basis is also necessary for computing the depreciation       EXAMPLE: Ames painted Brown’s house, in pay-
                                                                                 ment for which Brown gave Ames an automobile
                 deduction (discussed in chapter 21). In most cases the
                                                                                 worth $450. Ames has income of $450. The basis of
                 basis is the cost or purchase price of property. The cost       the automobile to Ames is $450. This transaction is
                 of the property acquired is the amount paid for it in cash      treated as if Ames had received from Brown $450 in
                 or other property. This is called the “cost basis.”             cash 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     Similarly, if property is traded for other property in a
                 on the exchange. In that case, the property received by       taxable exchange, the basis of the new property is its
                 taxpayers has what is called a “substituted basis.” This      fair market value at the time of the exchange (except if
                 is either the basis taxpayers had for the property they       the property was received in a nontaxable exchange, as
                 relinquished in the exchange or the basis the transferor      discussed below).
                 or donor had for the particular property.
                                                                                 EXAMPLE: A taxpayer traded a fur coat, which
                 In addition, it is frequently necessary to adjust basis         cost $1,500, for an automobile having a fair market
                 for depreciation, additions or dispositions of property,        value of $1,700. Since the value of the automobile
                 casualty losses, and similar items. This results in what is     is $1,700, he 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.




                                                                                                                                             ¶1502



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              “Fair market value” is the price that would be agreed                       If the cost of the new replacement property is more than
              upon by a seller willing, but under no compulsion, to sell                  the proceeds of the conversion, its basis is the cost of the
              and a buyer willing, but under no compulsion, to buy.                       new property less the gain not recognized.
              In the usual case, the market value of the property given
              and the property received will be approximately equal.                        EXAMPLE: Assume the same facts as above, except
              The fair market value of both properties will usually be                      that the new truck costs $13,500. If the taxpayer
              determined by reference to the property whose value is                        elects to have the gain not recognized, the basis of
              most easily determinable.                                                     the new truck will be $12,500, figured as follows:

              For securities traded on the open market, stock exchange                        Realized gain . . . . . . . . . . . . . . . . . . . . . . . . .    $1,000
                                                                                              Recognized gain. . . . . . . . . . . . . . . . . . . . . . .            0
              quotations conclusive evidence of fair market value. In
              the case of real estate, leaseholds, patents, machinery,                        Gain not recognized . . . . . . . . . . . . . . . . . . . .        $1,000
              and equipment, it is frequently necessary to secure an
                                                                                              Cost of new truck . . . . . . . . . . . . . . . . . . . . . .     $13,500
              expert appraisal at the time the exchange is made to                            Less: Gain not recognized . . . . . . . . . . . . . . .             1,000
              avoid later disputes.
                                                                                              Basis of new truck . . . . . . . . . . . . . . . . . . . . .      $12,500
              ¶1503 Basis for Involuntary Conversion of
                    Property (Sec. 1033)
                                                                                          If the taxpayer elects to report the entire gain or if the
              If property is involuntarily converted into similar prop-                   conversion results in a loss, the basis of the replacement
              erty (as, for example, by its destruction, theft, condem-                   property is its cost.
              nation, or threat of condemnation), the taxpayer may
              elect, under certain circumstances, not to have all or                      ¶1504 Basis of Property Acquired Through
              part of the gain recognized. In such cases, the cost of the                       Tax-Free Exchanges (Sec. 1031)
              replacement property must be decreased by the amount
                                                                                          The general rule is that when a taxable exchange of
              of gain not recognized upon the conversion.
                                                                                          property takes place, the basis of the new property is its
                  Basis of replacement            =     Cost of replacement property      fair market value at the time of the exchange. However,
                  property                              less gain not recognized          if all or part of the gain or loss on the exchange is not
                                                                                          recognized, certain adjustments must be made to the
                 EXAMPLE: A taxpayer’s truck, having an adjusted                          basis of the new property.
                 basis of $10,000, was completely destroyed by fire.
                 He received $11,000 in insurance proceeds. The                           The same rule applies if gain or loss is not recognized (or
                 taxpayer had a gain of $1,000 because the insur-                         only partially recognized) in an exchange of business or
                 ance proceeds exceeded the adjusted basis of the                         investment property. Here, again, the basis of the new
                 destroyed truck.                                                         property will be determined as follows:
                 However, the taxpayer used $10,800 of the proceeds                                Basis of Property Acquired in an Exchange
                 to buy a replacement truck. He may therefore elect to
                 report the gain only to the extent of the unexpended                           Basis of new property =              Basis of old property
                 portion of the proceeds ($200). The basis of the new                                                 +              gain recognized
                 truck remains at $10,000, figured as follows:                                                        -              boot received
                                                                                                                      +              boot paid
                    Realized gain . . . . . . . . . . . . . . . . . . . . . .    $1,000                               -              loss recognized
                    Recognized gain . . . . . . . . . . . . . . . . . . .           200
                                                                                          This, in effect, gives the new property a substituted basis,
                    Gain not recognized . . . . . . . . . . . . . . . .           $800    which is determined not only by the cost or value of the
                    Cost of new truck . . . . . . . . . . . . . . . . . .       $10,800   property acquired but also by the basis of the property
                    Less: Gain not recognized . . . . . . . . . . . .               800   given in exchange.
                    Basis of new truck . . . . . . . . . . . . . . . . . .      $10,000




    ¶1503



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                    EXAMPLE: Three years ago, Farmer X bought a tractor                         EXAMPLE: Mr. Carrol purchases, for $25,000, prop-
                    for $60,000. This year, after having charged off $15,000                    erty consisting of a used car lot and an adjoining
                    for depreciation, X exchanges it for a new model cost-                      filling station. At the time of the purchase, the fair
                    ing $65,000. X is given a trade-in allowance of $48,000                     market value of the filling station is $15,000 and of
                    and pays the difference, $17,000, in cash. The adjusted                     the used car lot, $10,000. Mr. Carrol, after charging
                    basis of the tractor at the time of the exchange was                        off a $500 yearly depreciation deduction on the filling
                    $45,000 ($60,000 less $15,000 depreciation), and the                        station for four years, sells the station for $20,000.
                    actual gain was thus $3,000. However, since the prop-                       His gain on the sale is $7,000 since the adjusted
                    erty exchanged was “held for productive use in trade                        basis of the filling station at the time of the sale was
                    or business,” the gain is not recognized but instead is                     $13,000 ($15,000 minus $2,000 depreciation).
                    deducted from the basis of the new tractor. The new
                    tractor acquires a substituted basis of $62,000. This,
                    of course, will increase any taxable gain or decrease
                                                                                              The above example illustrates that gain or loss must be
                    any loss on a subsequent sale.                                            determined at the time of sale of each part. It cannot be
                                                                                              deferred until the entire property has been disposed of.
                       Basis of old property . . . . . . . . . . . . . . . .       $45,000
                       Gain or loss recognized . . . . . . . . . . . . .                 0    If a taxpayer purchases a large parcel of land, later sub-
                       Plus: Boot paid . . . . . . . . . . . . . . . . . . . .      17,000    divides it into separate lots and then sells them, the basis
                       Basis of new property . . . . . . . . . . . . . .           $62,000    of each lot is allocated in proportion to its respective
                                                                                              value when acquired.
                                                                                              ¶1506 Purchase and Sale of a
                    EXAMPLE: An investor exchanged a building lot                                   Going Business (Sec. 1060)
                    with a basis of $4,000,000 for an apartment house
                    worth $2,800,000. The $1,200,000 loss is not recog-                       Frequently, taxpayers sell the assets of an entire business
                    nized. The basis of the apartment house would be                          for a lump sum. If the business is a sole proprietorship
                    $4,000,000, figured as follows:                                           (as opposed to a partnership or a corporation), it is
                       Basis of old property . . . . . . . . . . . . .           $4,000,000   necessary to apportion the sales price and allocate it to
                       Gain or loss recognized . . . . . . . . . . .                      0   the various items involved, such as inventories, accounts
                       Boot paid or received . . . . . . . . . . . . .                    0   receivable, notes receivable, real estate, machinery and
                       Basis of new property . . . . . . . . . . . .             $4,000,000   fixtures, and other physical assets. The gain or loss on
                    The investor in this example would have been better off
                                                                                              each individual component must then be separately
                    selling the building lot, taking the loss, and then buying                computed and reported. (Apportionment is also re-
                    the apartment house. But then there would have been a                     quired when there is an asset purchase of a corporation
                    lower basis in the apartment house for appreciation.                      or other business.)
                                                                                              If taxpayers buy a going business for a lump sum, any
                 However, if the investor exchanges real estate for a truck,                  part of the purchase price over and above the total value
                 the exchange is not covered by this section because the                      of the physical assets is treated as payment for “goodwill.”
                 properties are not of like kind. Similarly, even on an ex-                   In a subsequent sale of the business, they are entitled to
                 change that would ordinarily be taxable, no gain or loss                     recover tax free the goodwill for which they paid.
                 is recognized if the property received in exchange has no
                 ascertainable fair market value. The new property acquires
                 the basis of the old. However, only rarely would the prop-                     EXAMPLE: In 1994, Mr. Brown purchased a grocery
                                                                                                store for $350,000. The purchase price at the time
                 erty be deemed not to have any fair market value.                              was allocated as follows: real estate, $160,000;
                                                                                                equipment and fixtures, $30,000; inventory, $80,000;
                 ¶1505 Basis of Property Acquired
                                                                                                goodwill, $80,000. In 2005, he sold the business for
                       by a Lump-Sum Purchase                                                   $500,000. The physical assets of the business at the
                 If various kinds of property are purchased together for a                      time of the sale had a fair market value of $390,000.
                                                                                                In the absence of any specific allocation of the sales
                 lump sum, it is necessary to allocate the basis among the
                                                                                                price, it will be assumed that Mr. Brown received
                 individual items. Thus, if some of the items are later sold,                   $110,000 ($500,000 - $390,000) for goodwill, re-
                 the sale of each part is treated as a separate transaction, and                sulting in a gain of $30,000 on the goodwill. This, of
                 gain or loss must be computed separately on each portion.                      course, is in addition to any gain he may realize on
                 Allocation is generally made in proportion to the fair market                  the other assets involved.
                 value of the different items on the date of acquisition.

                                                                                                                                                               ¶1506



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              The allocation of the sales price to the assets involved
                                                                              EXAMPLE: In 1993, Ackley purchased securities for
              is made on Form 8594, “Asset Acquisition Statement,”
                                                                              $2,000. In 1994, when the securities had a fair market
              which is attached to the return for the year of sale.           value of $3,000, he gave them to his brother, Bob.
                                                                              In 1998, when the stock had a fair market value of
                 PRACTICE POINTER: Typically the buyer wants to               $5,500, Bob gave them to his son, Charles. Charles
                 allocate as much as possible to depreciable assets           sold them for $7,000. Inasmuch as Bob had ac-
                 (to maximize future deductions), while the seller            quired the securities as a gift, Charles’ basis would
                 wants to allocate as much as possible to assets              be $2,000, the same as in the hands of Ackley, and
                 producing capital gains (to minimize tax on the              Charles will have to report a gain of $5,000.
                 sale). The buyers’ and seller’s interests may be at
                 odds and must be resolved through negotiation to
                 complete the sale.                                         ¶1509 Loss on Property Acquired by Gift

                                                                            The basis for determining loss on gifts is either the
                                                                            same as it was in the hands of the donor (or of the last
                 PITFALL: The allocation made on Form 8594 is bind-         preceding owner who did not acquire it by gift), or the
                 ing on the parties to the sale. The IRS, however, is
                                                                            fair market value of the property at the time of the gift,
                 not bound by this allocation.
                                                                            whichever is lower.

              ¶1507 Basis of Property Acquired by Gift                        EXAMPLE: In 2002, Aaron gave shares of stock, which
                    (Sec. 1015)                                               cost him $550, to Ben. At the time of the gift they were
                                                                              worth $400. Ben sold the shares for $300. Since the
              The items discussed up to now were acquired either              sale resulted in a loss, the basis would be $400 (the
              by purchase or by exchange. Hence, their basis (before          fair market value on the date of the gift). Of course, this
              adjustments) is normally what the taxpayer paid for             amount is less than the basis in the hands of the donor
              them, either in cash or in property given in exchange.          ($550). Ben will incur a recognized loss of $100.
              But, if the taxpayer received property as a gift, and thus
              paid neither money nor other property for it, the cost
              basis is nil, and we must therefore assign a substituted        EXAMPLE: In 1992, Aaron gave securities that had
              basis. Substituted basis, like cost basis, may have to be       cost him $100,000 to Ben. At the time of the gift
              adjusted for such items as depreciation, improvements,          the fair market value was $90,000. Ben later sold
              and casualty losses.                                            the securities for $95,000. In such case, there is no
                                                                              gain or loss. Since the basis for determining loss is
              The basis of property acquired depends on whether the           $90,000, there is no loss, nor is there gain, because
              property was disposed of at a gain or at a loss.                the basis for determining gain is $100,000.

              ¶1508 Gain on Property Acquired by Gift                       The purpose of this special provision is to prevent taxpay-
              The general rule is that the basis for determining gain on    ers from gaining a tax benefit by transferring property to
              property received by gift is the same as the basis in the     persons who can take advantage of tax losses.
              hands of the donor (subject to an adjustment, discussed
                                                                            ¶1510 Adjustments for Gift Taxes Paid
              below, for gift tax paid on the gift). If the donor also
              received the property by gift, then the basis is the same     The receipt of a gift does not constitute income;
              as that in the hands of the last preceding owner who did      therefore, no income tax is payable on it by the re-
              not acquire it by gift.                                       cipient. However, on certain larger gifts of money or
                                                                            property (those in excess of the $11,000 annual gift
                 EXAMPLE: In 2003, Arnold gave shares of stock              tax exclusion in 2005 and the applicable lifetime gift
                 worth $400 to Bolton. The stock had cost Arnold            tax exemption amount of $1 million), a federal gift tax
                 $600. This year, Bolton sells the stock for $750. Be-      may be payable by the individual making the gift. This
                 cause the sale resulted in a gain, the basis is $600       tax is in the nature of an excise tax for the privilege of
                 (the same as in the hands of the donor). Bolton real-      transferring property by gift. It is not an income tax.
                 izes a recognized gain of $150.                            If any gift tax was paid at the time the gift was made,
                                                                            it will increase the basis of the property by the amount



    ¶1507



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                 of the tax. But in no event can the basis be increased to     ¶1512 Securities Acquired at Different Prices
                 more than the property’s fair market value at the time
                                                                               Taxpayers frequently purchase different quantities of the
                 of the gift. For gifts made after 1976, the increase in
                                                                               same stocks or bonds at different times and at different
                 basis of property is limited to an amount that bears the
                                                                               prices. There is a choice of how to figure the adjusted
                 same ratio to the gift tax paid as the net appreciation
                                                                               basis when less than the entire holdings of a particu-
                 in the value of the gift bears to the taxable gift.
                                                                               lar stock or mutual fund are sold. For stock, there is
                                                                               the specific identification method or first-in first-out
                    EXAMPLE: In 1982, Adams purchased a business               (FIFO). For mutual fund shares, there is the specific
                    building at a cost of $120,000. In 1992, when the          identification method, first-in first-out (FIFO), or the
                    property (because of depreciation) had an adjusted
                    basis of $60,000 in Adams’ hands, he gave the
                                                                               average cost method.
                    property to his nephew, Barker. Adams paid a gift          Specific share identification. If a taxpayer has good
                    tax in the amount of $7,500. The fair market value
                    of the property at the time of the gift was $65,000.
                                                                               records, the adjusted basis of shares acquired in different
                    Thus, net appreciation is $5,000 ($65,000 value of         lots at various prices and times provided can be used for
                    gift - $60,000 donor’s basis).                             determining gain or loss provided:
                    The basis of the property to Barker is $60,577               The identity of the shares to be sold or transferred
                    ($60,000 + $7,500 gift tax × ($5,000 appreciation
                    ÷ $65,000 taxable gift)). The annual exclusion was
                                                                                 are specified to the broker or other agent at the time
                    not used.                                                    of the sale or transfer, and
                                                                                 Confirmation of these specifications is received from
                                                                                 the broker or other agent in writing within a reason-
                 Summary.    Basis of property acquired by gift:                 able time.
                    For Gain. Donor’s basis increased by the amount of
                    gift tax paid with respect to the gift. But the increase     PITFALL: Taxpayers who trade online may have dif-
                    is made only to the extent that the total basis will not     ficulty obtaining confirmation of their trade order re-
                    exceed fair market value of the property at time of          quired for the specific identification method. The IRS
                                                                                 has not indicated how to overcome this problem.
                    gift. For gifts made after 1976, the increase in basis
                    of property is limited to the gift tax attributable to
                    the net appreciation at the time of the gift.              FIFO. If the shares cannot be identified, then the taxpayer is
                    For Loss. Basis is the lower of:                           treated as selling or transferring the shares acquired first.
                       Fair market value at time of gift, or
                       Donor’s basis increased by the gift tax (limited          EXAMPLE: Jones purchased 100 shares of XYZ stock
                       to gift tax on appreciation only for gifts made           in 1995 for $10,000. In February 1997, he bought
                       after 1976).                                              another 200 shares for $22,000. In October 1997,
                                                                                 he gave his son 50 shares, and, in June 2000, he
                 ¶1511 Basis of Home Acquired Under                              purchased another 100 shares for $9,000. This year
                       the Old Deferral Rules (Sec. 1034)                        he sold 130 shares for $13,650.

                 If a home was sold before May 7, 1997 (or within a              The shares he gave his son have a basis of $5,000
                                                                                 (50/100 of $10,000, the cost of the first lot bought).
                 transition period), and gain was deferred by buying or          The basis of the stock sold this year is computed
                 building a replacement home within two years of the             as follows:
                 sale, then the basis of the replacement home is the cost
                                                                                    50 shares (balance of stock
                 of the home minus any gain not recognized on the sale                purchased in 1995) . . . . . . . . . . . . .    $ 5,000
                 of the old home.                                                   80 shares (80/200 of $22,000
                                                                                      February 1997 purchase) . . . . . . . .           8,800

                    EXAMPLE: On May 1, 1997, Black sold her home                    Total basis of 130 shares sold . . . . . .       $13,800
                    for a gain of $80,000. Within the month she had
                    purchased a new home for $175,000 and qualified            Average cost method. The average basis method for
                    to defer her entire gain under the old home sale
                    deferral rules. Her basis in the new home is $95,000
                                                                               mutual fund shares can be chosen to figure gain or loss
                    ($175,000 cost of new home less $80,000 gain not           when you sell or transfer shares if you acquired them
                    recognized on the sale of the old home).                   at different times and prices, and you left the shares on
                                                                               deposit in an account handled by a custodian or agent


                                                                                                                                                      ¶1512



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              who acquires or redeems these shares. There are two aver-
                                                                                                   PRACTICE POINTER: The estate tax valuation pro-
              age basis methods: single category method and double
                                                                                                   vides only a rebuttable presumption of the basis of
              category method.                                                                     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
                                                                                                   income tax purposes.
              owned at the time of disposition, regardless of how long
              they were owned.
                                                                                                 Estate tax, like gift tax, is in the nature of an excise tax
                                                                                                 and has no direct connection to income tax.
                 EXAMPLE: Jones bought the following shares in
                 the XYZ Mutual Fund: 100 shares in 2000 at $10 per                              In cases where no federal estate tax return is required to be
                 share; 100 shares in 2002 at $12 per share; and $100                            filed, but a state inheritance or transmission tax is assessed
                 shares in 2004 at $26 per share. On July 1, 2005,
                 Jones sold 150 shares. The basis of the shares sold
                                                                                                 against the estate, the basis of the property will generally
                 using the single category method is $2,400, figured                             be the appraised value used for state tax purposes.
                 as follows:
                  Total cost ($1,000 + $1,200                                                      EXAMPLE: Mr. Adams owned stock in Corporation
                  + $2,600) . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   $4,800     A that cost him $10,000 and had a fair market value
                  Average cost per share                                                           of $50,000 at the time of his death. His legatee or
                  ($4,800 ÷ 300 shares) . . . . . . . . . . . . . . . . . . .           $   16     distributee (or his estate) would have a basis of
                  Basis of shares sold ($16 × 150 sold) . . . . . . .                   $2,400     $50,000 for the stock. The $40,000 appreciation in
                                                                                                   value (up to the time of Mr. Adams’s death) would
              Double category method. Shares are divided into two                                  never become subject to income tax.
              categories: those held one year or less and those held more
              than one year. Then follow the single category method for                          Spouse of a decedent who died after 1981. For
              finding the average cost of shares in each category.                               property owned as tenants by the entirety or joint ten-
                                                                                                 ants with rights of survivorship, the surviving spouse’s
                 PRACTICE POINTER: The choice of the average
                                                                                                 basis is comprised of two parts: one-half is the surviving
                 basis method must be clearly indicated on the tax                               spouse’s own cost basis; the other half is the estate tax
                 return and cannot be changed without IRS approval.                              value for that half (the value of that half on the date
                 Once the average basis method is elected, it must be                            of the decedent’s death or alternate valuation date).
                 used for all accounts in the same fund. See ¶1608A                              However, use the estate’s value for the entire property
                 for more details.                                                               where it was acquired by the couple before 1977 if the
                                                                                                 decedent paid for it.
              ¶1513 Basis of Inherited Property (Sec. 1014)

              If property was obtained by inheritance, bequest, or                                 EXAMPLE: In 1975, a couple purchased a resi-
                                                                                                   dence for $50,000 (the husband paid for the home).
              devise, its basis is normally the fair market value at
                                                                                                   The husband dies in 2005 when the home is worth
              the date of the decedent’s death. This is referred to as                             $500,000. For income tax purposes, the wife’s basis
              a “stepped-up basis.” However, if a federal estate tax                               is $500,000, the estate tax value of the entire prop-
              return was required to be filed, the basis is the same as                            erty. If the home had been purchased in, say, 1980,
              the value used for estate tax purposes. An election can                              the wife’s basis would be $275,000 (1/2 of estate tax
              be made to use an “alternate valuation date,” that is, to                            value and 1/2 of original cost basis).
              value the gross estate for estate tax purposes at a date
              six months after the decedent’s death or, if earlier, the
              date of disposition of the property. The election to use
              the alternate valuation date can be made only when the
              election will reduce both the value of the decedent’s gross
              estate and the federal estate tax liability.




    ¶1513



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                                                                                        Furthermore, the basis of a purchased copyright is the
                       NEW FOR 2010: A modified carryover basis rule is                 amount paid for it, while, in the case of a copyright se-
                       set to replace the stepped-up basis rule for property
                       inherited after 2009.
                                                                                        cured directly by the taxpayer, the basis is the total of all
                                                                                        costs involved, including the cost of producing the work.
                                                                                        The same rules apply to the basis of trademarks and
                 Following is a summary of the rules on basis in chart                  trade names. In no event can the value of the inventor’s
                 form.                                                                  or author’s time be included in the basis of a patent or
                 Summary of Rules 0n Basis                                              copyright to the inventor or author.

                      How Property       Basis for                Basis for             ¶1515 Basis of Property Held for Personal Use
                      Obtained           Determining Gain         Determining Loss
                      Gift.              Same as in hands of      Same as in            In general, as far as the determination of basis is con-
                                         donor (plus gift tax     hands of donor        cerned, there is no difference between property held for
                                         paid) but not more       plus gift tax paid*   business and investment purposes or property held for
                                         than market value at     or fair market
                                         the time of gift.*       value at date of      personal use.
                                                                  gift, whichever is
                                                                  lower.                However, if the property is subject to a depreciation
                      Property ac-       Fair market value        Same as for           allowance, its basis must be reduced by the amount
                      quired from a      at date of death, or     gain.
                      decedent.          value six months
                                                                                        of depreciation allowed or allowable. Obviously, this
                                         after death or at                              adjustment does not apply to property held for personal
                                         disposition within six                         use, since no depreciation may be taken on personal-
                                         months after death,
                                         if alternate valuation                         use property.
                                         date was elected.
                      Nontaxable         Basis of property        Same as for             EXAMPLE: On January 2, 2001, when he was 45
                      exchange.          acquired is basis of     gain.
                                         property exchanged                               years old, Mr. Beane purchased two one-family
                                         plus any recognized                              houses for $100,000 each. House 1 was used as his
                                         gain and less any                                personal residence; House 2 was rented to a ten-
                                         boot received.                                   ant, and Mr. Beane deducted depreciation on it at
                      A residence ac-    Cost less gain not       Same as for             the rate of $5,000 per year. Mr. Beane subsequently
                      quired replacing   recognized on sale       gain, but loss not      decides to move into a hotel, and, on December 31,
                      old residence      of old residence.        recognized.
                      with gain not                                                       2005, he sells both houses for $106,000 each. The
                      recognized.**                                                       basis and the gain on each house will be computed
                 *
                                                                                          as follows:
                 Limited to gift tax on appreciation for gifts made after 1976.
                 **
                 Prior to May 7, 1997, or August 5, 1997, under certain conditions.                                                                  House 1   House 2
                                                                                          Cost (unadjusted basis) . . . . . . . . . . . $100,000 $100,000
                 ¶1514 Basis of Intangible Assets                                         Less: Depreciation (4 years × $5,000
                                                                                            on rented house only) . . . . . . . . . . .            20,000
                 The basis of intangible assets, such as patents, copy-                       Adjusted basis . . . . . . . . . . . . . . . $100,000            $80,000
                 rights, trademarks, trade names, etc. is ordinarily de-
                                                                                          Amount realized . . . . . . . . . . . . . . . . . $106,000 $106,000
                 termined in the same manner as the basis of tangible
                                                                                          Less: Basis . . . . . . . . . . . . . . . . . . . . . 100,000 80,000
                 assets. Thus, the basis of a patent obtained directly by
                 the taxpayer from the government is the cost of patent                       Gain . . . . . . . . . . . . . . . . . . . . . . . .    $6,000   $26,000
                 and attorney fees, drawings, and similar expenditures.                   Total gain ($6,000 + $26,000) . . . . . . .                          $32,000
                 The costs of developing the patent, such as research
                 and experimental expenditures, are also added to
                 the basis unless these costs are deducted as current                   If property is held partly for business and partly for
                 expenses at the time they are incurred. If the patent                  personal use, the same rules apply. We simply consider
                 is acquired by purchase, its basis is the amount the                   that it consisted of two distinct parts and compute the
                 taxpayer paid for it.                                                  basis of each separately.




                                                                                                                                                                         ¶1515



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                                                                                                 The basis for loss is either the basis of the property at the
                 EXAMPLE: Assume that Mr. Beane, in the previous
                                                                                                 time of conversion or the fair market value at the time
                 example, had, instead of purchasing two houses,
                 purchased a two-family house for $200,000, one
                                                                                                 of conversion, whichever is less, reduced by depreciation
                 half of which he occupied himself and the other half                            and any other applicable adjustments after the conver-
                 of which he rented out. He took a $5,000 yearly de-                             sion dates to arrive at the adjusted basis.
                 preciation deduction on the rented portion. Assume
                 further that, at the end of 2005, he sold the entire                              EXAMPLE: In 1990, a taxpayer purchased a house
                 house for $212,000. He will compute his basis and                                 to be used as his personal residence at a cost of
                 gain in the following manner:                                                     $60,000. He resided in it until January 1, 2002, at
                                                                         Residence     Rented      which time its fair market value was $57,000. He
                                                                            Portion    Portion
                                                                                                   then rented the property from January 1, 2002, to
                 Cost                                                    $100,000 $100,000
                                                                                                   January 1, 2005, at which time he sold it for $50,000.
                 Less: Depreciation (4 years ×
                   $5,000 on rented portion only) . . .                                20,000      He deducted depreciation at the rate of $2,000 per
                       Adjusted basis . . . . . . . . . . . . .          $100,000     $80,000      year during the three years the house was rented.
                                                                                                   The basis and the recognized loss will be computed
                 Amount realized . . . . . . . . . . . . . . . .         $106,000 $106,000         as follows:
                 Less: Basis . . . . . . . . . . . . . . . . . . . .      100,000   80,000
                       Gain. . . . . . . . . . . . . . . . . . . . . .     $6,000     $26,000      Basis of property at time of conversion
                                                                                                     for determining loss (the lesser of $60,000
                 Total gain ($6,000 + $26,000) . . . . . .                            $32,000        cost or $57,000 value) . . . . . . . . . . . . . . . . . . .         $57,000
                                                                                                        Less: Depreciation allowable
                                                                                                        during rented period . . . . . . . . . . . . . . . . . . .          6,000
              You can see that the computations in the above two                                   Adjusted basis . . . . . . . . . . . . . . . . . . . . . . . . . . .   $51,000
              examples are identical, except that we substituted “resi-                                 Less: Amount realized on sale . . . . . . . . . . .                50,000
                                                                                                   Recognized loss . . . . . . . . . . . . . . . . . . . . . . . . . .     $1,000
              dence portion” and “rented portion” for House 1 and
              House 2.

                 PRACTICE POINTER: Since a loss on the sale of
                 personal property is not deductible, taxpayers who                                EXAMPLE: Assume the same facts as above, except
                 want to sell a residence that is declining in value (for                          that the fair market value on January 1, 2002, was
                 instance, if it is located in a deteriorating neighbor-                           $65,000. The loss will be computed as follows:
                 hood) would be wise to move out and rent the prop-
                                                                                                   Basis at time of conversion for purposes
                 erty (or use it for other income-producing purposes)                                of determining loss (the lesser of $60,000
                 until they are able to sell it. This strategy will enable                           cost or $65,000 value) . . . . . . . . . . . . . . . . . . .         $60,000
                 them to deduct any loss in value between the date                                      Less: Depreciation . . . . . . . . . . . . . . . . . . . .          6,000
                 of conversion and the date of sale.
                                                                                                   Adjusted basis . . . . . . . . . . . . . . . . . . . . . . . . . . .   $54,000
                                                                                                       Less: Amount realized on sale . . . . . . . . . . .                 50,000
              The “conversion date” is the date on which the property
                                                                                                   Recognized loss . . . . . . . . . . . . . . . . . . . . . . . . . .     $4,000
              becomes available for rent, not the date it was actually
              rented. The courts have held that if the taxpayer actively
              demonstrated a desire to put the property to profitable
              use (i.e., listing it with real estate agents, advertising it for                    PRACTICE POINTER: When a portion of a home is
              rent, etc.), it is considered as “being held for productive                          converted to business use (i.e., a home office), the
              use in business or for investment.”                                                  basis for purposes of depreciating the home office is
                                                                                                   the lower of the adjusted basis or fair market value
              ¶1516 Basis of Property Converted                                                    of the portion of the home used for business on the
                    to Business Use                                                                date of conversion.

              If a taxpayer holds property for personal use and then
              converts it to business use, its basis for determining gain                        ¶1517 Stock Rights (Secs. 305 and 307)
              is the cost or other basis of the property, less depreciation                      Stock rights are rarely taxable on receipt. If a taxpayer
              allowed or allowable during the time the property was                              exercises or sells nontaxable stock rights and if, at the
              held for business use to arrive at the adjusted basis.                             time of distribution by the corporation, the rights had a
                                                                                                 fair market value of 15% or more of the fair market value



    ¶1516



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                 of the underlying stock, the adjusted basis of the stock is        ¶1519 Summary of Basis Rules for Gain or Loss
                 allocated between the stock and the rights in the ratio of
                 the fair market value of each to the total fair market value       Type of Acquisition                             Basis for Gain or Loss
                 of both at the time of distribution. If less than 15%, the         Accounts receivable
                 basis for the rights is zero unless an election is made on the       Accrual-basis taxpayer . . . . .              Face value
                                                                                      Cash-basis taxpayer . . . . . . .             Zero
                 return for the taxable year of receipt of the rights to allocate
                                                                                    Bequest . . . . . . . . . . . . . . . . . . .   Estate tax value
                 a portion of the basis of the old stock to the rights.             Cash purchase . . . . . . . . . . . . . .       Cost
                                                                                      Mortgage also assumed,
                 When rights are exercised, the basis of the new stock is             or property taken subject
                                                                                      to mortgage . . . . . . . . . . . . . .       Full price, including mortgage
                 its cost plus the basis of the rights exercised. The hold-         Community property
                 ing period of the new stock begins on the date the rights            Survivor (death after 1947) . . .              Estate tax value for full
                 are exercised.                                                                                                      property
                                                                                    Gift property . . . . . . . . . . . . . . . . Gain: Donor’s basis plus gift tax
                                                                                                                                     times net appreciation over tax-
                                                                                                                                     able gift
                    EXAMPLE: Assume a taxpayer owns 100 shares of
                                                                                                                                     Loss: Limited to lesser
                    XYZ Company stock, which cost $22 per share. The                                                                 of donor’s basis or FMV
                    XYZ Company offers 10 stock rights that allow the                                                                at time of gift
                    taxpayer to purchase 10 additional shares of stock at           Inherited property . . . . . . . . . . . . Estate tax value
                    $26 per share. At the time the rights were distributed,         Inventory goods . . . . . . . . . . . . . Last inventory value
                    the stock had a market value of $30, ex-rights, and             Joint tenancy
                                                                                    between spouses . . . . . . . . . . . . One-half survivor’s cost basis
                    each right had a market value of $3. The taxpayer                                                                plus one-half estate tax value (full
                    elects to allocate a portion of the basis of the stock                                                           estate tax value for
                                                                                                                                     pre-1977 property purchased by
                    to the rights. The basis of the rights and of the old                                                            the decedent)
                    and new stock is computed as follows:                           Joint tenancy in general
                                                                                       After death of one tenant
                     100 shares × $22       = $2,200, cost of old stock for            after 1953 . . . . . . . . . . . . . . . . . Estate tax value for portion
                                              which rights were acquired                                                             included in estate
                     100 shares × $30       = $3,000, market value of old stock        After death of one tenant
                                                                                       before 1954 . . . . . . . . . . . . . . . Original cost to joint tenants
                     10 rights × $3         = $30, market value of rights           Life estate. . . . . . . . . . . . . . . . . . Zero if disposed of after
                                                                                                                                     October 9, 1969
                     3,000
                                            = $2,178.22, costsuch stock
                             ×                                of old stock
                                 $2,200                                             Livestock
                     3,030                    apportioned to
                                                                                       Inventoried . . . . . . . . . . . . . . . . Last inventory value
                       30                                                              Purchased . . . . . . . . . . . . . . . . Cost
                                            = $21.78, cost to rights
                             ×                             of old stock
                                 $2,200                                                Raised by
                     3,030                    apportioned
                                                                                       accrual-basis farmer. . . . . . . . . Cost of raising
                     $21.78 ÷ 10 stock rights = $2.178 per right                       Raised by
                                                                                       cash-basis farmer. . . . . . . . . . . Zero if costs expensed
                                                                                    Property settlements                             Transferor’s basis
                 If the rights are sold, the basis for determining gain or          Repossessed property
                                                                                    after installment sale
                 loss is $2.178 per right. If the rights are exercised, the            Personal property . . . . . . . . . . . Fair market value
                 basis of the new stock acquired is the subscription price             Real property reacquired                      Adjusted basis of indebtedness
                                                                                       to satisfy purchaser’s                        plus gain resulting from
                 paid ($26) plus the basis of the rights exercised ($2.178             indebtedness secured                          reacquisition and acquisition
                 each), or $28.178 per share. The remaining basis of                   by property . . . . . . . . . . . . . . . . costs
                 the 100 shares of old stock for determining gain or loss           Residence after sale of
                                                                                    old residence without
                 on a later sale is $2,178.22, or $21.782 per share. The            recognition of gain (prior
                                                                                    to August 5, 1997) . . . . . . . . . . . Cost less gain not recognized on
                 holding period of nontaxable stock rights to the owner                                                              old residence
                 of the underlying stock begins at the time the underlying          Stock
                 stock is acquired.                                                    Acquired in wash sale . . . . . . . Cost of acquired stock plus loss
                                                                                                                                     not recognized
                                                                                       Nontaxable stock dividend. . . . Allocable share of basis of stock
                 ¶1518 Property Settlements (Sec. 1041)                                                                              on which d eclared
                                                                                       Received for services . . . . . . . . Amount reported in income plus
                 Gain on property transferred incident to divorce is not                                                             cash paid
                 immediately taxable. Instead, the basis of the property in         Stock rights
                                                                                       Nontaxable . . . . . . . . . . . . . . . . Allocable share of basis of stock
                 the hands of the transferor carries over to the transferee.                                                         unless rights value is less than
                                                                                                                                     15% of stock value
                 Transfers subject to this rule include transfers within               Taxable . . . . . . . . . . . . . . . . . . . Fair market value when issued
                 one year after the date on which the marriage ceases or            Tenancy by the entirety
                                                                                    (see Joint tenancy
                 transfers related to the cessation of the marriage.                between spouses, above)



                                                                                                                                                                            ¶1519



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              ¶1520 Recent Developments Affecting Basis                          by a deemed depreciation rate. For cars placed in service
                                                                                 in 2005, the rate is 17 cents per mile (Rev. Proc. 2004-64,
              The basis of a car for which business mileage was de-
                                                                                 IRB 2004-49, 898).
              ducted using the standard mileage rate must be reduced


              ¶1521          CHAPTER 15 STUDY QUESTIONS — Basis

                  1.    A taxpayer trades in a tractor having an adjusted         4.   In 1986, a grandmother purchases a pearl neck-
                        basis of $20,000, plus $20,000 cash from his                   lace for $3,000. In 2005, when it is worth $10,000,
                        pocket, to acquire a new tractor having a value of             she dies and leaves it to her granddaughter. The
                        $50,000. The basis of the new tractor is:                      value of the necklace as reported on the estate
                        a. $20,000                                                     tax return is $10,000. The necklace is not the
                        b. $40,000                                                     granddaughter’s taste so she immediately sells it
                        c. $50,000                                                     and receives $9,800. For purposes of determining
                                                                                       the granddaughter’s gain or loss, her basis is:
                  2.    In 1991, a father purchased 1,000 shares of X Cor-             a. $3,000
                        poration for $10,000. In 1995, when the stock had              b. $9,800
                        a fair market value of $9,000, he gave the shares to           c. $10,000
                        his son. The stock is worth $15,000 in 2005 and the
                        son sells it. The basis of the stock to the son is:
                        a. $9,000                                                  For further information on basis, see IRS Publication
                        b. $10,000                                                 551: Basis of Assets.
                        c. $15,000
                                                                                   Answers to Study Questions, with feedback to both
                  3.    Assume the same facts as above, except the stock
                                                                                   the correct and incorrect resposese, are provided in
                        sold for $8,000. The basis of the stock to the son is:
                                                                                   Chapter 35, beginning with ¶3515.
                        a. $9,000
                        b. $10,000
                        c. $15,000




    ¶1521



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                                                                                                                           16
                 PART 2 — ACQUISITION AND DISPOSITION OF PROPERTY


                 Capital Gains and Losses

                 LEARNING OBJECTIVES                                            Under the Code, all property is classified as capital as-
                                                                                sets except:
                 This chapter was prepared to enable participants to gain
                 a general understanding of capital gains and losses. More        Stock in trade and similar property held primarily
                 specifically, upon completion, you will be able to:              for sale to customers in the ordinary course of the
                                                                                  taxpayer’s business
                    Know what a capital asset is.                                 Property includible in taxpayer’s inventory
                    Understand how capital gains are taxed.                       Accounts or notes receivable acquired in the ordinary
                    Apply the limits on capital losses.                           course of a trade or business
                    Figure Section 1231 gains and losses.                         Depreciable property used in the taxpayer’s trade or
                 ¶1601 Introduction                                               business (Section 1231)
                                                                                  Real property used in the taxpayer’s trade or business
                 Although recognized gains on the sale or exchange of             (Section 1231)
                 property are taxable and recognized losses are deduct-           A copyright, a literary or artistic composition, or
                 ible, before such gains and losses are reported, we must         similar property held by the creator of the property
                 determine whether the property involved is a capital asset       or other person who obtained the property from the
                 or an ordinary (noncapital) asset.                               creator in a tax-free exchange or as a gift
                                                                                  A letter or memorandum, or similar property held
                 The distinction between capital and ordinary assets is
                                                                                  by a person for whom such property was prepared
                 important because capital gains and losses are reported
                                                                                  or produced, or held by a taxpayer whose basis is
                 differently from ordinary gains and losses, and the de-
                                                                                  determined by reference to such person’s basis
                 duction of capital losses is sharply limited.
                                                                                  A franchise, trademark, or trade name whose seller
                 ¶1602 What Are Capital Assets? (Sec. 1221)                       (franchisor) retains any significant rights or interest
                                                                                  in the franchise, trademark, or trade name
                 “Capital assets” are assets held for personal use or invest-     Certain U.S. Government publications received free
                 ment, while ordinary assets are principally business assets      or for less than public sales price
                 held for sale or exchange in the ordinary course of the
                 taxpayer’s business (e.g. inventory).                          The fourth and fifth items are so-called “Section 1231”
                                                                                assets, which are treated under a special set of rules dis-
                    EXAMPLE: A furniture manufacturer sold, within a            cussed later in this chapter.
                    tax year, his pleasure automobile, his personal resi-
                    dence, and 100 shares of stock in the X Corporation.        ¶1603 General Treatment of Capital Gains
                    In the course of his business, he sold $250,000 worth             and Losses (Sec. 61)
                    of furniture. The automobile, residence, and securi-
                    ties are capital assets, whereas the furniture (the
                                                                                Gains.  All recognized gains from the sale or exchange
                    taxpayer’s stock-in-trade) is an ordinary asset.            of property, whether capital assets or ordinary assets, are
                                                                                included in gross income. A special tax break is extended
                                                                                to certain gains:
                 The purpose of holding an asset, rather than the form of
                 the asset, determines whether or not it is a capital asset.      Sales of assets held one year or less at a profit are
                 For instance, a government bond held by an investor is a         short-term capital gains taxed at ordinary income
                 capital asset, while the same bond purchased by a bond           rates.
                 dealer today, with the hope of selling it tomorrow at a          Sales or exchanges of assets held more than one year
                 profit, would be part of the stock-in-trade and, hence, an       at a profit are long-term capital gains taxed at 15%
                 ordinary asset. While this definition is adequate for most       (5% for those in the 10% or 15% tax bracket).
                 purposes, the legal definition is somewhat broader.

                                                                                                                                           ¶1603



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                                                                            at the appropriate rate. However, if taxpayers have any
                 PRACTICE POINTER: Installment payments received
                                                                            25% or 28% gains, they must complete Schedule D Tax
                 in 2005 on sales prior to May 6, 2003 qualify for the
                 lower capital gains tax rates.
                                                                            Worksheet instead.
                                                                            Losses.  All deductible losses from the sale or exchange
              Exceptions to the 15% rate.     Even if you meet the          of property are subtracted from gross income in comput-
              long-term holding period, your gain may not be eligible       ing adjusted gross income. However, not all losses are
              for the 15% rate (depending on the date of sale). Three       deductible. Losses on the sale of personal use property
              exceptions apply:                                             (such as a principal residence) are never deductible.
                 Collectibles (such as art works, gems, stamps, most        While ordinary losses are deductible in full, the deduc-
                 coins, antiques, rugs, metals, alcohol and guns) held      tion of capital losses is restricted. Capital losses are al-
                 long-term are taxed at the maximum rate of 28%.            lowed in full against capital gains. Schedule D dictates
                 Small business stock eligible for the 50% exclusion is     how losses are to be used to offset gains at the different tax
                 taxed at 28% (so the effective tax rate is 14% (50%        rates. Losses first offset gains in their appropriate category
                 of 28%). This is called Section 1202 gain.                 (e.g., short-term losses offset short-term gains). Excess
                 Depreciation on rental or business property is taxed at    losses are then used to offset gains starting with gains
                 a 25% rate (if it is not other-wise treated as ordinary    taxed at the highest rate. If losses are more than gains,
                 income). So, if you claimed straight line deprecia-        only up to $3,000 ($1,500, if married filing separately) of
                 tion, there is no ordinary income recapture, but the       the excess loss is deductible against ordinary income.
                 depreciation is called “unrecaptured depreciation”
                 and is taxed at 25%.                                       Capital losses in excess of the amount of the allowable
                                                                            loss may be carried over and used in later years. There
                                                                            is no limit to the number of years the losses can be car-
                 EXAMPLE: You own rental property that you bought
                                                                            ried forward.
                 for $80,000 and on which you claimed $50,000
                 depreciation over the years. You sell the property
                 on December 1, 2005, for $200,000. Your gain of              EXAMPLE: Dan and Helen Wayne sold stock in 2005.
                 $170,000 ($200,000 less $30,000 basis) is taxed as           The sale resulted in a capital loss of $10,000. The
                 follows: $50,000 (the unrecaptured depreciation) at          Waynes had $40,000 of ordinary income and no other
                 25% and $120,000 at 15%.                                     capital transactions. On their joint return for 2005,
                                                                              the Waynes can deduct $3,000. The unused part of
                                                                              the loss, $7,000 ($10,000 - $3,000), can be carried
                                                                              over to 2006. If the Waynes’ capital loss had been
                 PRACTICE POINTER: The 25% and 28% tax rates ap-
                                                                              $1,000, their capital loss deduction would have been
                 ply to taxpayers in tax brackets above these rates.
                                                                              $1,000 (lower of $3,000 or $1,000). They would have
                                                                              no carryover to 2006.
              In order to determine the amount of gain subject to this
              special tax treatment, gains and losses are segregated as     For more details on the capital loss carryover, see
              capital gains and losses and as long-term and short-term      ¶1608.
              capital gains and losses. Schedule D is used for report-
              ing capital gains and losses. The schedule is broken          ¶1604 Section 1244 Stock (Sec. 1244)
              down into Part I—Short-term gains and losses and Part
                                                                            Losses on stock generally are treated as capital losses. How-
              II—Long-term gains and losses.
                                                                            ever, if the stock is small business stock under Code Sec.
              Reporting gains and losses.         Gains and losses are      1244, then it is eligible for ordinary loss treatment. Under
              entered on Schedule D (see ¶1606). If there are more          this section, up to $50,000 ($100,000 for married persons
              transactions than can fit on the lines provided on Sched-     filing jointly) can be claimed. Losses in excess of the dollar
              ule D, use Schedule D Continuation Sheet, the total of        limit can still be claimed as capital losses (see above).
              which is carried over to Schedule D.
                                                                              PRACTICE POINTER: Married couples can claim the
              Taxpayers with net capital gains (defined in ¶1609) fig-        $100,000 on a joint return even if the stock is held
              ure their tax liability on the Qualifying Dividends and         only in the name of one spouse.
              Capital Gains Worksheet to ensure that gains are taxed



    ¶1604



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                 To be treated as Section 1244 stock eligible for ordinary      must be used to purchase other small business stock (that
                 loss treatment, certain requirements apply:                    continues to be an active business for at least six months
                                                                                after the rollover) within 60 days of the date of sale. If
                    The corporation’s equity cannot exceed $1 million at        only some of the proceeds are used for this purpose, then
                    the time of stock issuance.                                 the gain related to the part of the proceeds not rolled
                    The stock must be issued for money or property other        over must be recognized. In effect, gain is recognized to
                    than stock and securities.                                  the extent that the amount realized on the sale is more
                    In the five years preceding the loss, the stock must have   than the cost of the replacement stock. The basis of the
                    derived more than half of its gross receipts from busi-     replacement stock must be reduced by the amount of
                    ness operations (and not simply from investments).          gain not recognized (deferred).
                 The loss is reported on Form 4797, “Sales of Business          ¶1605A Rollover of Gain to Specialized
                 Property.”                                                            Small Business Investment Companies
                 Taxpayers must maintain records to support their de-                  (Sec. 1044)
                 duction. These records must show that the corporation          Recognition of gain on the sale of publicly traded securi-
                 was a small business corporation when the stock was            ties can be deferred if the sales proceeds are rolled over
                 issued, that the taxpayers were the original holders, and      within 60 days to purchase common stock or a partner-
                 that the stock was issued for money or property (not for       ship interest in a specialized small business investment
                 services). These records must be available in case the IRS     company (SSBIC). If sales proceeds exceed the cost of
                 questions the deduction.                                       SSBIC common stock or partnership interest, gain is
                 ¶1605 Exclusion and Rollover of Gain for Small                 currently recognized.
                       Business Stock (Secs. 1045 and 1202)                     Limitations.   For an individual, this rollover option is
                 Fifty percent of the gain on small business stock held for     limited to the lesser of $50,000 or $500,000, reduced
                 more than five years is excludable from gross income.          by any gain previously excluded under this rollover rule.
                 Small business stock is stock issued after August 10,          In the case of married persons filing separately, the limit
                 1993, by a domestic corporation that is an active business     is $25,000 and $250,000, respectively.
                 with gross assets not exceeding $50 million. The gain          Basis reduction.    Any gain not recognized because of
                 not excluded, called Section 1202 gain, is taxed at 28%        this rollover rule reduces the basis of the SSBIC com-
                 for an effective rate of 14% (50% × 28%).                      mon stock or partnership interest. However, there is no
                 Limitation. A per-issuer limit restricts the amount of gain    reduction for purposes of calculating the 50% exclusion
                 that can be taken into account in any one year. Eligible       on small business stock (see ¶1605).
                 gain cannot exceed the greater of $10 million reduced          An SSBIC is a corporation or partnership licensed by the
                 by the aggregate amount of gain taken into account in          Small Business Administration under Sec. 301(d) of the
                 prior years or 10 times the adjusted basis of all qualified    Small Business Investment Act of 1958 as in effect on
                 stock of the issuer that an individual disposed of in the      May 13, 1993 (e.g., investment companies that finance
                 year (excluding additions to basis after issuance).            small businesses owned by disadvantaged taxpayers).
                 Married persons filing separately each have a $5 million       ¶1606 Long-Term and Short-Term Gains and
                 limit. Also, for purposes of the per-issuer limit in later
                                                                                      Losses (Sec. 1223)
                 years, gain excluded on earlier joint returns is allocated
                 equally between spouses, regardless of whether only one        On the sale or exchange of ordinary assets, it makes no
                 spouse qualified for the exclusion.                            difference how long the asset was held by the taxpayer
                                                                                before the transaction occurred. However, in the case
                 If the small business stock is held by a pass-through entity   of capital assets, the Code makes a distinction between
                 (e.g., partnership or S corporation), then each owner can      long-term capital gains and losses and short-term capital
                 exclude 50% of the gain on his or her allocable share of       gains and losses.
                 gain from the pass-through entity. The entity must hold
                 the stock for more than five years.                            Gain from the sale or exchange of a capital asset is not
                                                                                considered long term unless the asset has been held for
                 Rollover option. Gain can be entirely deferred (instead
                                                                                more than one year. Long-term gains are generally taxed
                 of taking the exclusion). All of the proceeds from the sale    at 15%, but gains can be taxed at as low as 5% or as high

                                                                                                                                                            ¶1606



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              as 28%. Consider the netting process involved in Sec.
                                                                              EXAMPLE: Let us assume that Bell in August 2005
              1231 transactions. See ¶1609.
                                                                              made, in addition to his net long-term gain of $275,
              If the taxpayer had long-term gains or losses from the          the following additional sales of stock, all of which
              sale or exchange of several assets, the total losses are        were held short-term:
              subtracted from the total gains to arrive at the net long-       X stock (cost $500) sold for $600 . . . . . . . . $100   gain
              term capital gain or loss.                                       Y stock (cost $200) sold for $150 . . . . . . . .   50   loss
                                                                               Z stock (cost $425) sold for $300 . . . . . . . .  125   loss

                 EXAMPLE: Bell, during March 2005, sold shares of A
                 stock for $600 and B stock for $950. The stock had         Subtracting the total losses ($175) from the gain ($100),
                 cost him $450 and $700, respectively. Assuming that        we arrive at a net short-term loss of $75. The excess, if any,
                 he had held both stocks long term, he had a total          of net long-term capital gain over net short-term capital
                 long-term capital gain of $400 ($150 on A stock and        loss is the net capital gain. It is this net capital gain that
                 $250 on B stock). Let us further assume that on April 1,   enjoys the special tax rate.
                 2005, he sold shares of C stock (also held long term),
                 which had cost him $1,200, for $1,075, resulting in a      Capital gain distributions. Capital gain distributions
                 long-term loss of $125. Subtracting the loss from the      are reported in Part II of Schedule D. However, if a
                 total gain, he has a net long-term gain of $275.           taxpayer has no other capital gain transactions, then
                                                                            capital gain distributions are reported directly on
              Gains and losses on the sale or exchange of capital assets    Form 1040.
              held 12 months or less are called “short-term” capital
              gains and losses. Here, again, it is necessary to total all   Capital gains and losses are reported on Schedule D,
              short-term gains and losses and to subtract one from the      shown on the following two pages.
              other to arrive at the net short-term capital gain or loss.




    ¶1606



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                                                                                                                                                                         OMB No. 1545-0074
                     SCHEDULE D                                               Capital Gains and Losses
                     (Form 1040)
                     Department of the Treasury
                                                              Attach to Form 1040.               See Instructions for Schedule D (Form 1040).                              2005
                                                                                                                                                                         Attachment
                     Internal Revenue Service   (99)                Use Schedule D-1 to list additional transactions for lines 1 and 8.                                  Sequence No.   12
                     Name(s) shown on Form 1040                                                                                                              Your social security number



                      Part I

                                                           o f
                                      Short-Term Capital Gains and Losses—Assets Held One Year or Less
                                                                                 (b) Date                               (d) Sales price    (e) Cost or other basis




                                                          s 5
                                      (a) Description of property                                  (c) Date sold                                                          (f) Gain or (loss)
                                                                                 acquired                             (see page D-6 of        (see page D-6 of
                                     (Example: 100 sh. XYZ Co.)                (Mo., day, yr.)    (Mo., day, yr.)      the instructions)       the instructions)         Subtract (e) from (d)

                      1


                                                         a 0
                                                       ft 20
                                                    ra 7/
                                                   D /1
                      2

                      3

                      4
                             line 2

                             column (d)
                                                    0 5
                             Enter your short-term totals, if any, from Schedule D-1,

                             Total short-term sales price amounts. Add lines 1 and 2 in
                                                                                             2

                                                                                             3
                             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 8 of your Capital Loss
                             Carryover Worksheet on page D-6 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-6 of        (see page D-6 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-1 of the instructions                                                                    13
                     14      Long-term capital loss carryover. Enter the amount, if any, from line 13 of your Capital Loss
                             Carryover Worksheet on page D-6 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 instructions.                                   Cat. No. 11338H                   Schedule D (Form 1040) 2005


                                                                                                                                                                                                         ¶1606



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               Schedule D (Form 1040) 2005                                                                                                     Page   2
               Part III        Summary




                                             f
               16    Combine lines 7 and 15 and enter the result. If line 16 is a loss, skip lines 17 through 20, and
                     go to line 21. If a gain, enter the gain on Form 1040, line 13, and then go to line 17 below           16

               17
                                           o
                     Are lines 15 and 16 both gains?



                                          s 5
                        Yes. Go to line 18.




                                         a 0
                        No. Skip lines 18 through 21, and go to line 22.




                                       ft 20
               18    Enter the amount, if any, from line 7 of the 28% Rate Gain Worksheet on page D-7 of the
                     instructions                                                                                            18




                                    ra 7/
               19    Enter the amount, if any, from line 18 of the Unrecaptured Section 1250 Gain Worksheet on
                     page D-8 of the instructions                                                                            19

               20
                                   D /1
                     Are lines 18 and 19 both zero or blank?
                        Yes. Complete Form 1040 through line 43, and then complete the Qualified Dividends and
                        Capital Gain Tax Worksheet on page 34 of the Instructions for Form 1040. Do not complete




               21
                                      5
                        lines 21 and 22 below.



                                    0
                          No. Complete Form 1040 through line 43, and then complete the Schedule D Tax Worksheet
                          on page D-9 of the instructions. Do not complete lines 21 and 22 below.

                     If line 16 is a loss, enter here and on Form 1040, line 13, 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?
                        Yes. Complete Form 1040 through line 43, and then complete the Qualified Dividends and
                        Capital Gain Tax Worksheet on page 34 of the Instructions for Form 1040.
                        No. Complete the rest of Form 1040.

                                                                             Printed on recycled paper                    Schedule D (Form 1040) 2005




              ¶1607 Holding Period
                                                                                             PRACTICE POINTER: When selling stocks, bonds,
                    (Sec. 1014, 1015, and 1223)
                                                                                             and other capital assets that may qualify for the 15%
              In determining how long an asset has been held, we                             capital gain rate, be sure to hold the assets for more
              exclude the day the property was acquired and include                          than one year.
              the day on which it was disposed of.
                                                                                          For securities traded on stock exchanges, two dates ap-
                 EXAMPLE: On June 25, 2005, Mrs. Greene bought
                                                                                          pear on the broker’s advice slips: a “trade” date and a
                 some jewelry, which she now has an opportunity                           “settlement” date. To determine the holding period of
                 to sell at a profit. If she wishes to have a long-term                   such securities, the trade date governs.
                 capital gain, she must wait until June 26, 2006, before
                 concluding the sale.                                                     Gifts. In the case of property acquired by gift, the hold-
                                                                                          ing period generally begins with the date the property is




    ¶1607



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                 acquired by the donor. However, if the sale results in a     excess of capital gains and the deduction for personal
                 loss and the property has a value lower than cost at the     exemptions. This means that a net short-term loss
                 date of the gift, the holding period begins at the date      and a net long-term loss sustained this year will be
                 of the gift.                                                 treated, respectively, as a short-term loss and a long-
                                                                              term loss in the following year. Any part of the loss
                 Inheritances.   Property acquired from a decedent and        that is not deducted in the next year may be carried
                 disposed of within one year of death is automatically        over to the following year, and so on indefinitely, until
                 treated as being held long-term. This is regardless of how   fully wiped out.
                 long the decedent owned the property or how long the
                 heir holds it before a disposition.
                                                                                PITFALL: Losses carried forward cannot be used
                 Tax-free exchanges.      If the taxpayer makes a tax-free      after an individual dies. So, for example, if a spouse
                 “like-kind” exchange, the holding period of the old prop-      has a capital loss carryfoward and dies, the surviv-
                                                                                ing spouse cannot use the loss after the year of the
                 erty is transferred (tacked on) to the new property.
                                                                                decedent’s final return.

                    EXAMPLE: On September 25, 2005, a taxpayer
                    exchanges his office typewriter, which he had pur-        ¶1608A Identifying Shares in Stock
                    chased on September 15, 2004, and which had a                    and Mutual Fund Transactions
                    basis of $150, for a dictating machine worth $200.
                    Seven months later, he sells the dictating machine for
                                                                              If a taxpayer holds shares of stock in the same company or
                    $215. Since the typewriter-dictating machine trans-       mutual fund which were bought at different times, then
                    action is a tax-free exchange of depreciable property     there are different holding periods and bases to consider.
                    used in trade or business, the latter is considered as    The size of the gain or loss and its characterization as
                    having been acquired on September 15, 2004, and,          long-term or short-term depends on which shares are
                    thus, held long term.                                     treated as having been sold.

                 Involuntary conversions. For an involuntary conversion
                                                                              If no identification is made.       If a taxpayer does not
                 of property in which the taxpayer elects not to have all     identify the specific shares to be sold, then the IRS treats
                 or part of the gain recognized, the holding period of the    the first shares purchased as having been sold. In other
                 new property begins with the date of acquisition of the      words, it applies a FIFO (first in, first out) rule.
                 old property.                                                Adequate identification.      A taxpayer is permitted to
                 Home sales. The holding period of a new residence
                                                                              choose the specific shares to be sold. According to regula-
                 acquired under the old deferred rules include the hold-      tions, shares are considered to be adequately identified
                 ing period of the old residence if all or part of the gain   if the taxpayer specifies the shares to be sold at the time
                 is not recognized on the sale of the old residence under     of sale and the broker confirms these instructions in
                 those rules.                                                 writing. According to the Tax Court, the regulations are
                                                                              a safe-harbor method of identification; other methods
                 Related party transactions. The holding period carries       are also permissible. For example, a standing order to a
                 over from the original property when there is a nonrec-      broker to always sell the highest cost basis shares first
                 ognized loss on “related party” transactions.                was considered to be adequate identification. (Concord
                                                                              Instruments Corp., TC Memo 1994-248)
                 ¶1608 Capital Loss Carryover (Sec. 1212)

                 As previously mentioned, that portion of net capital           PITFALL: It is not clear how to comply with the rules
                 loss that is not deductible in the current year because        for using the specific identification method for online
                 of the capital loss limitation may be “carried over” to        sales of shares since the seller is not dealing with
                 the next taxable year, subject to certain limitations. The     an individual broker who will necessarily respond
                                                                                to a request for confirmation of an order to sell
                 amount carried forward is determined under a com-              specific shares.
                 plicated formula (incorporated into the Capital Loss
                 Carryover Worksheet is the instruction to Schedule D)
                 that takes into account taxable income (which may be         Other methods for determining which shares are be-
                 a negative number for this purpose where deductions          ing sold in mutual fund transactions are explained
                 exceed gross income), the capital loss deduction in          in ¶1512.



                                                                                                                                                        ¶1608A



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              ¶1609 Gains and Losses on
                    Business Property (Sec. 1231)                             NOTE: Gains and losses from personal casualties
                                                                              and thefts are not subject to the netting treatment
              Section 1231 of the Internal Revenue Code establishes           of Section 1231. Instead, gains and losses from
              a third category of assets (the so-called Section 1231          personal casualties and thefts are to be separately
              assets), with respect to which net gain is entitled to the      netted. See ¶2306.
              advantages of capital gain treatment. However, a net loss
              on this asset category is treated as an ordinary, rather      To determine whether there was a gain or loss on the
              than a capital, loss.                                         sale or exchange of Section 1231 assets, it is necessary
                                                                            to lump the Section 1231 transactions together. If the
              The following are Section 1231 items if the assets have       overall result is a gain, the gains (net of any depreciation
              been held for more than one year:                             recapture or losses) are reported together with the other
                 Gain or loss on real estate used in business               capital gains and losses on the return. (The depreciation
                 Gain or loss on depreciable property used in business      recapture rules are discussed in chapter 21.)
                 (machinery, fixtures, automobiles, and trucks, etc.)       Gains and losses on business property are reported on
                 Gain on capital assets involuntarily converted into        Form 4797, “Sales of Business Property,” shown on the
                 other property or money through condemnation,              next pages.
                 casualty, or theft




    ¶1609



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                         4797
                                                                                                                                                              OMB No. 1545-0184
                                                                        Sales of Business Property
                 Form
                                                          (Also Involuntary Conversions and Recapture Amounts
                                                                                                                                                                  2005
                                                                                  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 5
                         Enter the gross proceeds from sales or exchanges reported to you for 2005 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 /1
                  2




                                                                           0
                  3      Gain, if any, from Form 4684, line 42                                                                                           3




                                                                         1
                  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 34 and 41a                                                                             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 38, 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 27, and the part of the
                        loss from property used as an employee on Schedule A (Form 1040), line 22. 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     (2005)




                                                                                                                                                                                              ¶1609



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               Form 4797 (2005)                                                                                                                                      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




                                                                               as 05
                  B
                  C




                                                                             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 /1
               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




                                                                           10
               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 36. 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
                                                                                            Printed on recycled paper                                     Form   4797   (2005)



    ¶1609



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                 Gain from the sale or exchange of a capital asset is not                         As you can see from the previous example, the net gain
                 considered long term unless the asset has been held for                          from an involuntary conversion (the condemnation
                 more than one year. The results of the netting process                           award) is considered a Section 1231 item.
                 described above determine if a taxpayer has an ordinary
                 loss deduction or a capital loss carryover. Thus, the hold-                      However, if the involuntary conversion results in a loss (or
                 ing period can be an important factor.                                           the taxpayer has several involuntary conversions and the
                                                                                                  net result is a loss), that loss is not considered a Section
                                                                                                  1231 item and does not enter into the computation.
                    EXAMPLE: In June 2005, a taxpayer sold for $2,400 a
                    business parking lot that he had held long term. It then                      There is a special recapture rule that transforms what
                    had an adjusted basis of $2,100. He sold a machine                            would otherwise have been treated as Section 1231 capi-
                    in August 2005 used in his business, which had been
                                                                                                  tal gain into ordinary income. The amount recharacter-
                    held long term, at a recognized loss of $100. Both the
                    business parking lot and the machine are Section 1231
                                                                                                  ized as such is the amount needed to offset net Section
                    assets. They are reported on Form 4797. In addition,                          1231 losses incurred within the past five years that have
                    he had a long-term gain of $400 on the sale of some                           not already been “recaptured.”
                    stock. Since the “Section 1231” assets were held long
                    term and the gain ($300) exceeded the loss ($100), both
                                                                                                    PRACTICE POINTER: Keep a running record of Sec-
                    transactions would be treated as sales and exchanges
                                                                                                    tion 1231 gains and losses to determine recapture
                    of capital assets and would be reported as follows:
                                                                                                    requirements.
                    Gain on sale of parking lot . . . . . . . . . . . . . . . . . . . .    $300
                    Gain on sale of stocks . . . . . . . . . . . . . . . . . . . . . . .    400   The application of Section 1231 has been limited by the
                                                                                           $700
                                                                                                  recapture provisions of Sections 1245 and 1250, both of
                    Less: Loss on sale of machine . . . . . . . . . . . . . . . . .         100
                           Net long-term capital gain . . . . . . . . . . . . . .          $600   which are explained in Chapter 21 (¶2115-¶2118).
                                                                                                  ¶1610 Lump-Sum Distributions from Qualified
                 If the overall result of the netting of Section 1231 transac-                          Employee Plans (Secs. 401-405)
                 tions is a net loss, then the gains and losses are considered
                                                                                                  If an individual who was over age 50 on January 1, 1986,
                 as ordinary gains and losses.
                                                                                                  receives a lump-sum distribution from a qualified retire-
                                                                                                  ment plan, the tax on the distribution can be figured on
                    EXAMPLE: A taxpayer sold his factory building (a Sec-                         Form 4972, “Tax on Lump-Sum Distributions,” using a
                    tion 1231 asset) in May 2005 at a recognized loss of
                                                                                                  special ten-year averaging method. This method allows
                    $16,000. His business showed a net profit of $20,000
                    for the year. He had no other income or business de-
                                                                                                  the ordinary income part of the lump sum to be taxed
                    ductions. Since the total Section 1231 losses ($16,000)                       as if received in equal parts over ten years using the tax
                    exceed the Section 1231 gains (none), the loss is treat-                      rates for singles in 1986, regardless of the individual’s
                    ed as an ordinary loss not subject to the capital loss                        actual filing status then or now. Those born after 1935
                    limitations. Hence, the entire amount will be deducted                        do not qualify for averaging. The form is shown on the
                    from the taxpayer’s gross income, leaving an adjusted                         following page.
                    gross income of $4,000 ($20,000 - $16,000).



                    EXAMPLE: Assume the same facts as in the previ-
                    ous example, but that, in addition, the taxpayer’s
                    residence, which he had occupied for 30 years, was
                    condemned by the city for a street-widening project.
                    The condemnation award he received in July 2005
                    left him with a recognized gain of $18,000. Now the
                    Sec. 1231 gain ($18,000) exceeds the Sec. 1231 loss
                    ($16,000); the net gain is treated as a long-term capi-
                    tal gain. Accordingly, this taxpayer will show adjusted
                    gross income of $22,000 ($20,000 ordinary income
                    plus $2,000 net long-term capital gain).




                                                                                                                                                                              ¶1610



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                                                                                                                                     OMB No. 1545-0193

               Form    4972                                        Tax on Lump-Sum Distributions
                                                    (From Qualified Plans of Participants Born Before January 2, 1936)                  2005
               Department of the Treasury                                                                                            Attachment
               Internal Revenue Service   (99)                              Attach to Form 1040 or Form 1041.                        Sequence No.   28
               Name of recipient of distribution                                                                              Identifying number




                                f
                Part I           Complete this part to see if you can use Form 4972
                                                                                                                                                Yes No



                              o
                1     Was this a distribution of a plan participant’s entire balance (excluding deductible voluntary employee
                      contributions and certain forfeited amounts) from all of an employer’s qualified plans of one kind (pension,
                                                                                                                                          1



                             s 5
                      profit-sharing, or stock bonus)? If “No,” do not use this form
                2     Did you roll over any part of the distribution? If “Yes,” do not use this form                                      2
                3

                4           a 0
                      Was this distribution paid to you as a beneficiary of a plan participant who was born before




                          ft 20
                      January 2, 1936?
                   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?
                                                                                                                                          3

                                                                                                                                          4




                       ra 9/
                   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
                                                                                                                                         5a



                      D /0
                   form for a 2005 distribution from your own plan
                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




                         6
               Part II     Complete this part to choose the 20% capital gain election (see instructions)
                                                                                                                         6



                       0
               6 Capital gain part from Form 1099-R, box 3
               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, 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, or Form 1041, Schedule G, line 1b, whichever applies                                30
               For Paperwork Reduction Act Notice, see instructions.                                      Cat. No. 13187U               Form   4972   (2005)



    ¶1610



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                 If an individual had been covered by his or her employer’s       ¶1611 Wash Sales (Sec. 1091)
                 retirement plan before 1974, the part of a distribution
                                                                                  A former common practice of taxpayers whose stocks
                 from the plan that applies to the pre-1974 coverage is
                                                                                  had declined in value was to sell such shares at a loss
                 treated as long-term capital gain if such individual was
                                                                                  and immediately thereafter buy the same stock in the
                 born before 1936 and an election is made. This portion
                                                                                  hope that its value would again increase. This enabled
                 is then taxed at a rate of 15%.
                                                                                  taxpayers to claim the loss on their income tax returns
                 Definition of “lump-sum distribution.”     A “lump-sum           and yet, in effect, hold on to the stock. Moreover, in
                 distribution” is a distribution made within one tax year         case the stock did appreciate, the gain was usually tax-
                 of an employee’s entire account balance from all of the          able as a long-term capital gain. Congress closed this
                 employer’s qualified pension, stock bonus, or profit-            loophole with a special provision prohibiting the de-
                 sharing plans. Also, the distribution must be paid on            duction of a loss incurred in a “wash sale.” A wash sale
                 account of separation from service, death, disability, or        occurs when, within 30 days before or after the sale of
                 attaining age 59½. In the case of a self-employed person         stock, stock options, or securities at a loss, a taxpayer
                 who receives a distribution, it must be paid on account          (or his or her spouse or a corporation controlled by
                 of death, disability, or attaining age 59½.                      them) contracts to buy, or buys, substantially identical
                                                                                  stock or securities.
                 Lump-sum treatment applies only to an employee who
                 has been a plan participant for five years or more before        Substantially identical securities.      Shares of stock in
                 the tax year in which the payment is made. However, the          the same company are treated as “substantially identical
                 five-year plan participation requirement does not require        securities.” Thus, for example, a sale and a purchase of
                 five full years. The requirement is satisfied if there is any    IBM stock are considered substantially identical securi-
                 participation within the five years.                             ties; a sale of IBM stock and a purchase of Apple stock are
                                                                                  not. Bonds of the same obligor are treated as substantially
                 If an employee receives a lump-sum distribution that             similar securities only if they carry the same interest rate.
                 includes securities in the employer’s company, these             Different maturity dates make securities not substantially
                 securities may have increased in value while in trust.           similar only if they have economic significance. For
                 The employee is not taxed on the increase at the time            example, a difference of several years may be viewed as
                 the securities are distributed, but rather when they are         being economically significant.
                 exchanged or sold.
                                                                                  If the wash sale rules apply, the nonrecognized loss is
                    PRACTICE POINTER: Tax on receipt of a lump-sum
                                                                                  added to the basis of the newly acquired stock or securi-
                    distribution need not be paid immediately. It can be          ties and will thus reduce any taxable gain (or will increase
                    deferred by making a rollover to an IRA within 60 days        any loss) on a subsequent sale.
                    of receipt of the distribution (see ¶2909). However, a
                    distribution not rolled over directly to another qualified      EXAMPLE: A taxpayer owns 100 shares of ABC
                    plan or IRA is subject to a 20% withholding rate.               stock, for which he originally paid $5,000, but
                                                                                    which is now worth considerably less. On February
                                                                                    1, he sells the stock at $2,000, and, in the belief
                    PITFALL: If part of a lump-sum distribution is rolled           that it will increase again in value, he repurchases
                    over to an IRA, the remaining portion does not qualify          identical stock on February 20 for $1,850. The
                    for special averaging.                                          $3,000 loss on the sale is not deductible but will
                                                                                    increase the basis of the new stock from $1,850 to
                                                                                    $4,850 ($1,850 + $3,000). Hence, if he later sells
                 Distributions from retroactively disqualified plans. The           this stock for $6,000, his taxable gain would only
                 tax status of the plan at the time of distribution governs the     be $1,150 ($6,000 - $4,850), even though he actu-
                 tax treatment of the distribution. If the plan is disqualified     ally paid $1,850.
                 retroactively, then all of the distribution is treated as com-
                 ing from a nonqualified plan (i.e., all of the distribution is
                 currently taxable; there is no special treatment).                 PRACTICE POINTER: Remember that this “wash
                                                                                    sale” rule applies only to stock and securities
                                                                                    transactions resulting in a loss. Any gain on such a
                    PRACTICE POINTER: States are not permitted to tax
                                                                                    transaction is fully recognized.
                    pensions payable to nonresidents.



                                                                                                                                                               ¶1611



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              In line with the reasoning that the new securities are          beyond the scope of this book. No losses can be recog-
              merely an identical replacement of the old, the holding         nized on these positions.
              period of the new securities includes the holding period
              of the old securities.                                          ¶1613 Options Purchased
                                                                                    as an Exchange (Sec. 1234)
              The wash sale rules do not apply to securities dealers
              or floor traders who trade for their own accounts. The          Income from the lapse of an option is treated as a short-
              wash sale rules apply to all nondealers even if the loss        term capital gain, except for options written by taxpayers
              is from a transaction made in the ordinary course of a          in the ordinary course of their trade or business. In the
              trade or business.                                              latter case, the gain will be treated as ordinary income.

              ¶1612 Short Sales (Sec. 1233)                                     EXAMPLE: A taxpayer purchases 100 shares of stock
                                                                                at $200 per share as an investment and writes a call
              A short sale occurs when the seller borrows the property          on the stock at that price in return for a premium of
              (usually securities) delivered to the purchaser and later         $1,000. The stock declines, and the call purchaser
              either purchases substantially identical securities and           lets his option lapse because it is worthless.
              delivers them to the lender or makes delivery out of such
                                                                                The call writer will have a short-term capital gain
              securities held by the seller at the time of the sale.            of $1,000 on the lapsed option and, if he sells his
              A short sale is not considered as closed until the “borrowed”     stock at $190 per share, he will have a capital loss
                                                                                of $1,000 on that transaction.
              securities are repaid. Thus, the holding period is normally
              determined by the length of time that the seller holds the
              securities delivered to the lender in closing the sale.         Employee stock options are discussed in ¶602A.
                                                                              ¶1614 Cancellation or Sale of Leases
                 EXAMPLE: In June 2004, a taxpayer contracts to sell                (Sec. 1241)
                 “short” 100 shares of XYZ stock at $50 per share.
                 Since he owns no XYZ stock, he borrows it from his           Payments received by a landlord for cancellation of a lease
                 broker. In July 2005, when the price of XYZ has fallen       are treated as ordinary income, not as capital gains.
                 to $40, he purchases 100 shares and immediately
                 delivers them to his broker to repay his debt, thereby       Treatment of payments received by a tenant for the sale
                 closing out the short sale. His gain of $10 per share        of a lease depends on the type of lease in question. If the
                 (minus expenses) is a short-term capital gain be-            lease is used in the tenant’s trade or business, the gain or
                 cause the holding period of the delivered property           loss would be treated under Section 1231. If the lease is
                 does not exceed 12 months.
                                                                              for the tenant’s home, a gain would be taxed as a capital
                                                                              gain, but any loss would not be deductible.
              The following rules apply when property substantially
              identical to that sold short (1) has been held by the           ¶1615 Recent Developments Affecting
              taxpayer on the date of the short sale for 12 months or               Capital Gains and Losses
              less or (2) is acquired by the taxpayer after the short sale
                                                                              A couple could not claim a Section 1244 loss because
              and/or before the date of the closing:
                                                                              they failed to prove the stock was qualified small business
              Rule 1.  Any gain on the closing of a short sale is con-        stock; for the final five years of the fiberglass business,
              sidered a short-term capital gain.                              the evidence showed it was not an operating company
                                                                              (it had no operating assets and paid no sales). (Crigler,
              Rule 2. The holding period of substantially identical           TC Memo 2003-93, aff ’d per curiam in unpublished
              property begins with the date of closing a short sale.          opinion CA-4, 1/14/04).
              Constructive sale treatment on appreciated finan-               If a taxpayer is obligated to transfer stock to a broker as
              cial positions. Sales of certain financial positions (such      a result of a short sale and borrows stock from another
              as “selling short against the box” and other hedging            broker to satisfy this obligation, the transfer of stock from
              positions) on or after June 8, 1997, may be treated as          the second broker to the first broker does not close the
              constructive sales. These rules are highly complex and          short sale. (Rev. Rul. 2004-15, IRB 2004-8, 515).




    ¶1612



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                 ¶1616 CHAPTER 16 STUDY QUESTIONS — Capital Gains and Losses


                     1.      Which of the following property is not a capital      4.   Which statement regarding capital losses is not
                             asset?                                                     correct?
                             a. A personal car                                          a. Losses that cannot be deducted currently can
                             b. A painting held by an artist                                 be carried forward for up to five years.
                             c. Stock in IBM                                            b. Losses that cannot be deducted currently can
                                                                                             be carried forward indefinitely
                     2.      A taxpayer in the 35% tax bracket sells his coin           c. They can offset ordinary income to the extent
                             collection that he held for more than 25 years. The             of $3,000 (after offsetting any capital gains).
                             tax rate on the sale is:
                             a.   15%
                             b.   25%                                              For further information on capital gains and losses,
                             c.   28%                                              see IRS Publication 544: Sales and Other Disposi-
                             d.    35%                                             tions of Assets.

                     3.      A taxpayer purchases a corporate bond on May
                                                                                   Answers to Study Questions, with feedback to both
                             4, 2004 and sells it on May 4, 2005. The holding
                                                                                   the correct and incorrect resposese, are provided in
                             period is:
                                                                                   Chapter 35, beginning with ¶3516.
                             a. Short term
                             b. Long term
                             c. Depends on whether a gain or loss results




                                                                                                                                                               ¶1616



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                                               PART




                                               3
                             Deductions for Business
                                  and Other Special
                                    Deduction Rules




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                                                                                                                        17
                 PART 3 — DEDUCTIONS FOR BUSINESS AND OTHER SPECIAL DEDUCTION RULES


                 Business Deductions

                 LEARNING OBJECTIVES                                         next pages), rather than Schedule 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 deduc-          Have business expenses of $5,000 or less
                 tions. More specifically, upon completion, you will be        Use the cash method of accounting
                 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
                    activities.                                                and Amortization”
                    Understand the vacation home rules.                        Not deduct expenses for business use of home
                 NEW THIS YEAR                                                 Not have prior year unallowed passive activity losses
                                                                             To determine net profit, all receipts from sales, fees,
                       Deduction for domestic production activities.         or other sources should be totaled; then all allowable
                       Starting this year, 3% of net income from domestic    expenses and other deductions are deducted from that
                       production activities is deductible. See ¶1709.
                                                                             total. Expenses, to be deductible, must be “ordinary and
                                                                             necessary” to carry on the trade or business. The expenses
                 ¶1701 Trade and Business: General Rule                      must be directly related to, or connected with, the trade,
                                                                             business, or profession, and must have been paid (if the
                 Taxpayers engaged in a trade, business, or profession       taxpayer is on the cash basis) or incurred (if the taxpayer
                 must include in adjusted gross income any net profit        is on the accrual basis) during the taxable year.
                 (or loss) derived from operating that trade, business,
                 or profession. The net profit is computed on Schedule       The timing of when to claim a deduction depends on a
                 C (see next pages), which is attached to the taxpayer’s     taxpayer’s method of accounting (see ¶2803-¶2809).
                 Form 1040.
                                                                             Net profit not only is the amount of earnings included
                 Taxpayers who operate a business or practice a profession   in gross income. It is also the figure used to determine
                 as a sole proprietorship may file Schedule C-EZ (see        self-employment tax (see Chapter 26).




                                                                                                                                        ¶1701



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                                                                                                                                                         OMB No. 1545-0074
               SCHEDULE C                                                   Profit or Loss From Business
               (Form 1040)

               Department of the Treasury
                                                                                       (Sole Proprietorship)
                                                                 Partnerships, joint ventures, etc., must file Form 1065 or 1065-B.
                                                                                                                                                          2005
                                                                                                                                                         Attachment
               Internal Revenue Service   (99)         Attach to Form 1040 or 1041.         See Instructions for Schedule C (Form 1040).                 Sequence No.   09
               Name of proprietor                                                                                                      Social security number (SSN)




                                                               f
               A       Principal business or profession, including product or service (see page C-2 of the instructions)               B Enter code from pages C-7, 8, & 9

               C


               E                                             o
                       Business name. If no separate business name, leave blank.




                                                            s 5
                       Business address (including suite or room no.)
                                                                                                                                       D Employer ID number (EIN), if any




                                                           a 0
                       City, town or post office, state, and ZIP code




                                                         ft 20
               F       Accounting method:         (1)     Cash        (2)     Accrual      (3)     Other (specify)
               G       Did you “materially participate” in the operation of this business during 2005? If “No,” see page C-3 for limit on losses              Yes        No
               H       If you started or acquired this business during 2005, check here




                                                      ra 1/
                Part I          Income
                1      Gross receipts or sales. Caution. If this income was reported to you on Form W-2 and the “Statutory




                                                     D /3
                       employee” box on that form was checked, see page C-3 and check here                                                1
                2      Returns and allowances                                                                                             2
                3      Subtract line 2 from line 1                                                                                        3
                4      Cost of goods sold (from line 42 on page 2)                                                                        4


                5
                6

                7
               Part II
                                                      0 5
                       Gross profit. Subtract line 4 from line 3
                       Other income, including Federal and state gasoline or fuel tax credit or refund (see page C-3)

                       Gross income. Add lines 5 and 6
                                Expenses. Enter expenses for business use of your home only on line 30.
                                                                                                                                          5
                                                                                                                                          6


                                                                                                                                          7


                8      Advertising                           8                                18 Office expense                          18
                9      Car and truck expenses (see                                            19 Pension and profit-sharing plans        19
                       page C-3)                             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                                             24 Travel, meals, and entertainment:
                       page C-4)                            13                                  a Travel                                 24a
               14      Employee benefit programs                                                b Deductible meals and
                       (other than on line 19)              14                                    entertainment (see page C-5)           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 in columns                        28


               29      Tentative profit (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 Form 1040, line 12, and also on Schedule SE, line 2 (statutory employees,
                       see page C-6). Estates and trusts, enter on Form 1041, line 3.                                                    31
                       ● 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-6).
                       ● If you checked 32a, enter the loss on Form 1040, line 12, and also on Schedule SE, line 2                       32a      All investment is at risk.
                       (statutory employees, see page C-6). Estates and trusts, enter on Form 1041, line 3.                              32b      Some investment is not
                       ● If you checked 32b, you must attach Form 6198. Your loss may be limited.                                                 at risk.
               For Paperwork Reduction Act Notice, see Form 1040 instructions.                           Cat. No. 11334P                   Schedule C (Form 1040) 2005


    ¶1701



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                                                                                                                            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    215




                        Schedule C (Form 1040) 2005                                                                                                                                  Page   2
                        Part III         Cost of Goods Sold (see page C-6)
                        33       Method(s) used to
                                 value closing inventory:        a      Cost                b       Lower of cost or market                       c      Other (attach explanation)
                        34       Was there any change in determining quantities, costs, or valuations between opening and closing inventory? If
                                 “Yes,” attach explanation                                                                                                            Yes               No


                        35



                                                                    o f
                                 Inventory at beginning of year. If different from last year’s closing inventory, attach explanation                   35


                                                                                                                                                       36



                                                                   s 5
                        36       Purchases less cost of items withdrawn for personal use




                                                                  a 0
                        37       Cost of labor. Do not include any amounts paid to yourself                                                            37




                                                                ft 20
                        38       Materials and supplies                                                                                                38




                                                             ra 1/
                        39       Other costs                                                                                                           39




                                                            D /3
                        40       Add lines 35 through 39                                                                                               40


                        41       Inventory at end of year                                                                                              41




                                                               5
                        42       Cost of goods sold. Subtract line 41 from line 40. Enter the result here and on page 1, line 4                        42
                         Part IV          Information on Your Vehicle. Complete this part only if you are claiming car or truck expenses on




                        43
                                                             0
                                          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.

                                 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 2005, enter the number of miles you used your vehicle for:


                             a   Business                                b Commuting (see instructions)                                      c Other


                        45       Do you (or your spouse) have another vehicle available for personal use?                                                             Yes               No


                        46       Was your vehicle available for personal use during off-duty hours?                                                                   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) 2005


                                                                                                                                                                                                ¶1701



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    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




                                                                                                                                                      OMB No. 1545-0074
               SCHEDULE C-EZ                                                Net Profit From Business
               (Form 1040)

               Department of the Treasury
                                                                                   (Sole Proprietorship)
                                                             Partnerships, joint ventures, etc., must file Form 1065 or 1065-B.
                                                                                                                                                        2005
                                                                                                                                                      Attachment
               Internal Revenue Service                         Attach to Form 1040 or 1041.       See instructions on back.                          Sequence No.   09A
              Name of proprietor                                                                                                      Social security number (SSN)



                Part I



                              o f
                                General Information




                             s 5
                                                ● Had business expenses of $5,000 or                                    ● Had no employees during the year.
                                                  less.                                                                 ● Are not required to file Form 4562,




                            a 0
              You May Use                                                                                                 Depreciation and Amortization, for
                                                ● Use the cash method of accounting.
              Schedule C-EZ                                                                                               this business. See the instructions




                          ft 20
              Instead of                        ● Did not have an inventory at any                                        for Schedule C, line 13, on page
              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




                       ra 1/
                                                  business.                                                               business use of your home.
                                                ● Had only one business as either a                                     ● Do not have prior year unallowed
                                                  sole proprietor or statutory                                            passive activity losses from this




                      D /0                        employee.                                                               business.


                A      Principal business or profession, including product or service                                                 B Enter code from pages C-7, 8, & 9

                C

                E        6
                       Business name. If no separate business name, leave blank.



                       0
                       Business address (including suite or room no.). Address not required if same as on Form 1040, page 1.

                       City, town or post office, state, and ZIP code
                                                                                                                                      D Employer ID number (EIN), if any




               Part II          Figure Your Net Profit

                1      Gross receipts. Caution. If this income was reported to you on Form W-2 and the “Statutory
                       employee” box on that form was checked, see Statutory Employees in the instructions for
                       Schedule C, line 1, on page C-3 and check here                                                                       1

                2      Total expenses (see instructions). 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
                       Form 1040, line 12, and also on Schedule SE, line 2. (Statutory employees do not report this
                       amount 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 2005, enter the number of miles you used your vehicle for:

                  a   Business                                   b Commuting (see instructions)                             c Other


                6     Do you (or your spouse) have another vehicle available for personal use?                                                            Yes             No

                7     Was your vehicle available for personal use during off-duty hours?                                                                  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 Form 1040 instructions.                        Cat. No. 14374D               Schedule C-EZ (Form 1040) 2005




    ¶1701



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                 ¶1702 Ordinary and Necessary                                  ¶1705 Examples of Common Ordinary and
                                                                                     Necessary Business Expenses
                 An expense is considered “ordinary” if its incurring is a
                 common and accepted practice in the taxpayer’s field of       The following is a list of some of the most common al-
                 business. It is considered “necessary” if it is appropriate   lowable business expenses. Bear in mind that this listing
                 and helpful in developing and maintaining the trade           is merely intended as a guide to what type of expense
                 or business. Thus, an expense need not be essential or        is deductible:
                 indispensable in order to be deductible.
                                                                                 Wages and salaries
                 ¶1703 Reasonableness of Salaries                                Repairs
                                                                                 Rents paid
                 In addition to being ordinary and necessary, the amount
                                                                                 Traveling expenses
                 expended for salaries must be reasonable in relation
                                                                                 Meals, entertainment and business gifts
                 to the services performed. The courts have disallowed
                                                                                 Advertising
                 excessive compensation paid to members of a taxpayer’s
                                                                                 Insurance premiums
                 family, considering this a mere device to spread tax-
                                                                                 Cost of prizes awarded in contests
                 able income over many people. The regulations define
                                                                                 Commissions paid
                 “reasonable compensation” as an amount that would
                                                                                 Dues to business or professional organizations
                 ordinarily be paid for like services by like enterprises
                                                                                 Expenses incurred in attending business conventions
                 under like circumstances.
                                                                                 Accounting and bookkeeping fees (including return pre-
                 In determining whether salaries are reasonable, many            parer fees allocable to Schedule C or Schedule C-EZ)
                 factors are taken into account. Among the more impor-           Legal fees
                 tant are: the nature of the services rendered, the salaries     Bad debts from sales or services
                 paid in prior years for the same type of work, whether          Employee benefit programs
                 the salary is on a contingent basis (a larger amount may        Postage and freight charges
                 be reasonable if the compensation is contingent), and           Cost of moving business to a new location
                 the amount the employee would have obtained from                Stationery and printing
                 another employer for the same work. Courts have also            Licenses and regulatory fees
                 used a “hypothetical investor” test to decide whether           Penalties for nonperformance of a contract
                 compensation is reasonable; would an investor in the            Heat, light, power, telephone, Internet access, and
                 company think the payment is reasonable, allowing for           other utility costs
                 a return to the investor.                                       Depreciation

                 ¶1704 What Constitutes a Trade or Business?                   Start-up expenses. Expenses incurred to decide whether
                                                                               to go into business and which business to enter can be ex-
                 A taxpayer is considered as being “engaged in a trade or      pensed up to $5,000; the balance is amortized over a period
                 business” if the activity is one entered into with at least   of 180 months. But if start-up expenses exceed $50,000, the
                 the expectation of making a profit and the taxpayer           immediate deduction is reduced dollar for dollar, so that no
                 devotes a substantial part of his or her business time        immediate deduction can be claimed if start-up costs exceed
                 to it, or if the taxpayer operates it through an agent        $55,000. Start-up costs incurred before October 23, 2004,
                 or employee who devotes a substantial part of his or          continue to be amortized over a period of 60 months if an
                 her time to it. Thus, an individual can be engaged in         amortization election was made (see ¶2207).
                 more than one trade or business at the same time. On
                 the other hand, if a taxpayer merely holds securities         Lobbying expenses incurred to appear before congressional
                 or other property for investment purposes, although           or legislative committees, or before senators, congress-
                 he or she devotes some time to their management,              men, or state legislators, or to submit statements are not
                 the taxpayer is not considered as being engaged in a          deductible. However, a deduction is allowed for in-house
                 trade or business. In some cases, the ownership and           expenditures not exceeding $2,000.
                 management of rental property can be considered a
                                                                               Advertising expenses are deductible if they are reason-
                 trade or business. Expenses incurred in connection
                                                                               able and bear a reasonable relationship to the taxpayer’s
                 with mere investment activities are only deductible as
                                                                               business activities. Such expenses are not deductible if
                 itemized deductions.
                                                                               made to promote or defeat legislation. Expenditures


                                                                                                                                                          ¶1705



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              for “institutional” or “goodwill” advertising to keep the        A capital expenditure represents an investment of capital
              taxpayer’s name before the public are generally deductible       either to acquire property having a useful life of more
              as ordinary and necessary business expenses.                     than one year or to increase the value of such property
                                                                               or to prolong its life. Examples of capital expenditures
              Donations to business organizations, as well as advertise-       are the costs of acquiring a plant or production, of
              ments in charity-sponsored journals, newspapers, etc. are        building an addition to an existing structure, of install-
              deductible as business expenses if made with reasonable          ing a new roof, of installing a new heating system, and
              expectation of financial return commensurate with the            of installing new elevators. Commissions and legal fees
              amount of the donation.                                          incurred in buying or constructing property are also
              Bribes and kickbacks. No deduction may be claimed                capital expenditures.
              for any payment, direct or indirect, to a person if the          The area in which the distinction between capital and
              payment is an illegal bribe or an illegal kickback under         current expenses is of particular importance is where
              a U.S. law or any state law which is generally enforced.         money is expended on repairs, replacements, or improve-
              To be “illegal,” it must subject a taxpayer to a criminal        ments. The latter two are capital expenditures that can
              penalty or the loss of a license, but it is not necessary that   be recovered (if at all) only through depreciation, while
              criminal prosecution or license loss actually occur.             the former is an expense that entitles the taxpayer to a
              The IRS has the burden of proving that the challenged            full current deduction.
              payment is an illegal bribe or kickback.                         A “repair” is defined as an expenditure made to main-
              There is no deduction for Medicare kickbacks, but here           tain the taxpayer’s business property in an ordinary,
              illegality is not relevant, and the IRS has no special           efficient operating condition, whereas an improvement
              burden of proof.                                                 materially adds to the value or utility of the property or
                                                                               appreciably prolongs its useful life. Examples of repairs
                                                                               are patching and repairing floors, repainting the insides
                 PRACTICE POINTER: The legality of certain pay-
                 ments made to foreign government officials is de-
                                                                               and outsides of buildings, repairing roofs and gutters,
                 termined solely under the Foreign Corrupt Practices           or mending leaks.
                 Act. Thus, a payment that is not prohibited by FCPA,
                 but is classified as illegal under another federal law,
                                                                               Expenditures for replacements of parts of a machine,
                 is deductible as a business expense.                          merely to maintain it in efficient operating condition,
                                                                               are deductible as repairs. But if the machine is extensively
                                                                               overhauled, it is considered an improvement and should
              Fines and penalties for violating the law, such as traffic
                                                                               be capitalized.
              fines or penalties for building violations, are nonde-
              ductible even where incurred in connection with the              Other examples of capital items are new electric wir-
              taxpayer’s trade or business, and even though the viola-         ing, new roofs, new floors, new plumbing, and lighting
              tion was inadvertent.                                            improvements.
              Home phone service. A taxpayer who uses the telephone            The IRS warns that taxpayers who make both repairs
              in his or her residence for business or income produc-           and improvements at the same time should segregate the
              tion purposes may not deduct the base charge for local           repair and improvement items; otherwise, capitalization
              telephone service (e.g., charges required to be paid to          of the entire cost may be required.
              obtain local telephone service for the first telephone line
              in the taxpayer’s residence).                                      PRACTICE POINTER: Taxpayers may elect to take a
                                                                                 limited expense deduction (instead of depreciation)
              Interest on tax deficiencies. Interest on a tax deficiency
                                                                                 for certain depreciable property (see ¶2106).
              related to Schedule C is not deductible.
              ¶1705A Current Expenses versus Capital                           Environmental cleanup. It is not always easy to de-
                     Expenses (Secs. 162 and 263)                              termine whether the cost of environmental cleanup is
                                                                               currently deductible or must be capitalized. Generally,
              It is necessary to distinguish between capital expenditures
                                                                               when the costs restore the property to its pre-contamina-
              and current expenses because capital expenditures are
                                                                               tion condition, they can be expensed; otherwise, they
              not deductible, but they may frequently be recovered
                                                                               must be capitalized.
              through depreciation over a period of years.

    ¶1705A



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                 Under a special rule in effect for 2005, a business can       interest, carrying charges and taxes, such as federal
                 elect to expense the cost of environmental remediation.       and state unemployment and Social Security taxes on
                 This election applies only to certain hazardous substances    the wages of their employees, as well as state and local
                 and requires that the state environmental agency must         sales taxes. However, capitalization may be made only
                 certify the need for cleanup.                                 for those expenses paid or incurred up to the time the
                                                                               work was completed.
                 ¶1706 Research and Development
                       Expenditures (Sec. 174)                                 ¶1708 Income and Expenses Attributable
                                                                                     to Rents and Royalties
                 If taxpayers incur research and development expenses
                 (R & D) in connection with their trade or business,           If a taxpayer derives income from rents and royalties,
                 the question of whether such expenditures should be           all gross rents or gross royalties received are includible
                 deducted or capitalized is presented. Because of the diffi-   in gross income, and all expenses incurred in connec-
                 culties sometimes involved in making this determination,      tion with earning the rents and royalties are deductible
                 and also as a means of encouraging research, Congress         from gross income in computing adjusted gross income
                 has enacted a special provision permitting the taxpayer       (above-the-line expenses). Such expenses are deduct-
                 to elect either to deduct research and development costs      ible from gross income, even though the taxpayer is
                 currently, or to amortize the cost over a period of 60        not in the trade or business of renting property. This
                 months or more. Whichever method the taxpayer elects          constitutes one of the few exceptions to the rule that
                 must be applied to all expenditures for that particular       only trade or business expenses may be deducted from
                 research project unless permission to change the method       gross income.
                 is obtained.
                                                                                 EXAMPLE: A taxpayer received $1,200 monthly from
                 This special provision does not apply to land or to depre-
                                                                                 the rental of a one-family home. His deductions in con-
                 ciable property used for research or development work.          nection with the rented house were as follows: taxes,
                                                                                 $4,800; mortgage interest, $7,200; repairs, $450;
                    EXAMPLE: In the current year, the XYZ Company                depreciation, $1,540; and miscellaneous expenses,
                    builds and equips a research laboratory at a cost            $250. Assuming that he earned $36,500 in salary, his
                    of $150,000. The operating and other expenses,               adjusted gross income is computed as follows:
                    including depreciation, amount to $60,000. Only the
                                                                                 Salary . . . . . . . . . . . . . . . . . . . . . . . . . . . .  $36,500
                    $60,000 is deductible in the current year. The cost
                                                                                 Rental income . . . . . . . . . . . . . . . . . . . . . $14,400
                    of the laboratory must be capitalized and can only
                    be recovered through amortization.                              Less: Expenses incurred
                                                                                    in producing the rental income. . . . . . $14,240
                                                                                 Net income from rents . . . . . . . . . . . . . . .                 160
                 Taxpayers can elect a credit for certain research and               Adjusted gross income. . . . . . . . . . . .              $36,660
                 experimentation expenses incurred before December
                 31, 2005 (see ¶1111).                                           The gross income in the above case is $50,900
                                                                                 ($36,500 salary plus $14,400 gross rent).
                 ¶1707 Carrying Charges, Interest,
                       and Taxes on Real Estate (Sec. 266)
                                                                               However, expenses in excess of rental income may not
                 Landowners have the option to capitalize real estate          be currently deductible under the passive loss limitation
                 taxes, mortgage interest, and deductible carrying charges     rules (see ¶709A).
                 on unimproved and unproductive real estate, instead
                 of currently deducting these expenses. This election is       If part of the income-producing property is occupied
                 made each year.                                               by the taxpayers for their personal residence, only a
                                                                               proportionate part of the expenses may be deducted. As
                 Taxpayers engaged in real estate development or the           previously discussed, an allocation may be made under
                 construction business usually must capitalize loan            any one of several methods.




                                                                                                                                                            ¶1708



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                 EXAMPLE: A taxpayer earns a $30,000 annual sal-                                     PRACTICE POINTER: Taxpayers who actively par-
                 ary. He owns a four-family house, where he occupies                                 ticipate in a rental real estate activity may be able to
                 one apartment and rents out the other three at a                                    deduct losses in excess of income, up to a maximum
                 total yearly rental of $18,000. All apartments are                                  of $25,000. However, the allowance is phased out
                 of approximately equal size and rental value. His                                   for adjusted gross income over $100,000 and is
                 expenditures for interest, taxes, heat, repairs, depre-                             completely lost when adjusted gross income exceeds
                 ciation, etc. amounted to $32,000. The net income                                   $150,000. Married couples must file jointly to claim
                 from rents and the adjusted gross income would be                                   the $25,000 allowance.
                 determined as follows:
                                                                                                   Rental income and expenses generally are reported on
                 Salary . . . . . . . . . . . . . . . . . . . . .                       $30,000    Schedule E. However, if rental activities constitute a trade
                 Gross rents . . . . . . . . . . . . . . . . .                $18,000              or business, then income and expenses are reported on
                 Total deductions . . . . . . . . . . . . $32,000                                  Schedule C or Schedule C-EZ. Similarly, royalties and
                    Less: ¼ for personal use . . . .        8,000                                  related expenses generally are reported on Schedule E.
                 Amount deductible                                                                 However, royalties related to a trade or business are re-
                 from gross income . . . . . . . . . . .                      124,000              ported on Schedule C or Schedule C-EZ. For example,
                 Net income from rents . . . . . . . .                                    2,000    an investor reports oil and gas royalties on Schedule E
                     Adjusted gross income . . . . .                                    $32,000    but a freelance writer reports royalties from book sales
                                                                                                   on Schedule C (or C-EZ).
              If any part of the expenditures is made solely for the                               ¶1708A Domestic Production Activities
              benefit of the tenants, that amount is, of course, entirely                                 Deduction (Sec. 199)
              deductible.
                                                                                                   There is a new deduction called the domestic production
                 EXAMPLE: Assume the same facts as in the previ-
                                                                                                   activities deduction (or the manufacturer’s deduction)
                 ous example, except that the taxpayer, in addition                                that is designed to encourage domestic production ac-
                 to the above expenses, pays $3,000 for having the                                 tivities and is expected to save businesses $76 billion in
                 outside of the apartment painted. The income would                                tax dollars over the next 10 years. Like depreciation, it
                 be computed as follows:                                                           is a non-cash outlay (no actual expenditure is required
                 Salary . . . . . . . . . . . . . . . . . . . .                         $30,000
                                                                                                   in order to qualify for the deduction).
                 Gross income from rents . . . . .                            $18,000
                 Allocable expenses . . . . . . . . .               $32,000                          PRACTICE POINTER: The deduction applies for both
                    Less: ¼ for personal use . . .                    8,000                          regular and alternative minimum tax purposes, so
                                                                    $24,100                          claiming it will not trigger or increase AMT liability.
                 Painting expense . . . . . . . . . . .               3,000
                 Total amount deductible                                                           Eligibility. A taxpayer must be a “qualified producer”
                 from gross income . . . . . . . . . .                    27,000
                 Net income from rents (loss) . .                                                  to claim this credit. This includes a business engaged in
                                                                                         (9,000)
                     Adjusted gross income . . . .                                                 any of the following activities:
                                                                                        $21,000
                                                                                                     Selling, leasing or licensing items manufactured,
              Note from the above example that, just as a net profit                                 produced, grown or extracted in the U.S. in whole
              from rents is added to other income in computing ad-                                   or significant part (see safe harbor below).
              justed gross income, a net loss is deducted and will thus                              Selling, leasing or licensing films produced in the
              reduce the adjusted gross income (if the loss is allowable                             U.S.
              under the passive loss rules).                                                         Construction in the U.S. Construction includes both
                                                                                                     erection and substantial renovation of residential and
                                                                                                     commercial buildings (but not cosmetic activities,
                 PITFALL: Rental expenses may not be currently                                       such as painting).
                 deductible. Rental losses are limited by the passive
                                                                                                     Engineering and architectural services relating to a
                 loss rules (see ¶709 and ¶709A).
                                                                                                     construction project performed in the U.S.
                                                                                                     Software developed in the U.S., regardless of whether




    ¶1708A



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                    it is purchased off-the-shelf or downloaded from the       sold of the property. Even if a taxpayer fails to meet this
                    Internet. The term “software” includes video games.        safe harbor, the taxpayer can still demonstrate that the
                    But, with some de minimis exceptions, the term             activity is “in significant part” a U.S. activity based on
                    does not include fees for online use of software, fees     all the facts and circumstances.
                    for customer support and fees for playing computer
                    games online.                                              Figuring the deduction. The deduction is 3 percent
                                                                               of income from domestic production activities. In-
                 The deduction is limited to activities that are in whole      come for this purpose is gross receipts reduced by
                 or “significant part” in the U.S. Under a safe harbor,        certain expenses.
                 labor and overhead costs incurred in the U.S. for the
                 manufacture, production, growth and extraction of the         The deduction is figured on Form 8903, “Domestic
                 property are at least 20 percent of the total cost of goods   Production Activities Deduction.”




                                                                                                                                                        ¶1708A



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              Form    8903                             Domestic Production Activities Deduction
                                                                                                                                         OMB No. 1545-xxxx



              Department of the Treasury
                                                                                                                                            2005
                                                                                                                                         Attachment
              Internal Revenue Service                          Attach to your tax return.   See separate instructions.                  Sequence No. 143
               Name(s) as shown on return                                                                                    Identifying number




                1    Domestic production gross receipts                                                                       1

                2    Allocable cost of goods sold                                                 2

                3    Directly allocable deductions, expenses, or losses                           3

                4    Indirectly allocable deductions, expenses, or losses                         4

                5    Add lines 2 through 4                                                                                    5

                6    Subtract line 5 from line 1                                                                              6

                7    Qualified
                     production
                     activities
                     income
                                       If you are a—


                                       b Partner
                                                   o
                                       a Shareholder
                                                     f  Then enter the total qualified production activities income from—
                                                        Schedule K-1 (Form 1120S), box 12, code P
                                                        Schedule K-1 (Form 1065), box 13, code T




                                                 as 05
                     from pass-                                                                                               7
                     through                            Schedule K-1 (Form 1065-B), box 9, code S2
                     entities:
                8    Qualified production activities income. Add lines 6 and 7. If zero or less, enter -0- here,




                                               ft 20
                     skip lines 9 through 15, and enter -0- on line 16                                                        8




                                            ra 2/
                9    Income limitation (see instructions):
                     ● Individuals, estates, and trusts. Enter your adjusted gross income figured without the
                       domestic production activities deduction



                                           D /2
                     ● All others. Enter your taxable income figured without the domestic production
                       activities deduction (tax-exempt organizations, see instructions)                                      9




                                              8
               10    Enter the smaller of line 8 or line 9. If zero or less, enter -0- here, skip lines 11 through 15,
                     and enter -0- on line 16                                                                                10

               11

               12
                     Enter 3% of line 10




                     Form W-2
                                            0
                     Form W-2 wages (see instructions)

                                                        Then enter the total Form W-2 wages from—
                                                                                                                             11

                                                                                                                             12

               13                      If you are a—
                     wages
                     from pass-        a Shareholder    Schedule K-1 (Form 1120S), box 12, code Q
                     through           b Partner        Schedule K-1 (Form 1065), box 13, code U
                     entities:
                                                        Schedule K-1 (Form 1065-B), box 9, code S3                           13

               14    Add lines 12 and 13                                                                                     14

               15    Form W-2 wage limitation. Enter 50% of line 14                                                          15

               16    Enter the smaller of line 11 or line 15                                                                 16

               17    Domestic production activities deduction from cooperatives. Enter deduction from Form
                     1099-PATR, box 6                                                                                        17

               18    Expanded affiliated group allocation (see instructions)                                                 18

               19    Domestic production activities deduction. Combine lines 16 through 18 and enter the result
                     here and on Form 1040, line 35; Form 1120, line 25; Form 1120-A, line 21; or the applicable
                     line of your return                                                                                     19
               For Paperwork Reduction Act Notice, see separate instructions.                              Cat. No. 37712F                   Form   8903   (2005)




    ¶1708A



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                 Start with gross receipts from qualified domestic produc-         ¶1709 Vacation Home Rules (Sec. 280A)
                 tion activities. If the business is entirely domestic, then all
                                                                                   If you own and rent out a vacation home or other dwell-
                 gross receipts are taken into account. If the business has
                                                                                   ing unit that you also use as a residence, certain restric-
                 both domestic and foreign activities, use any reasonable
                                                                                   tions apply to your rental expenses. You must divide your
                 method to allocate gross receipts to qualified domestic
                                                                                   expenses between the rental use and the personal use.
                 activities. However, under a de minimis rule, if less than 5
                                                                                   For purposes of dividing your expenses, any day that the
                 percent of total gross receipts are derived from nonqualified
                                                                                   unit is rented at a fair rental value is a day of rental use,
                 domestic production activities, the business does not have
                                                                                   even if you have personally used the unit for that day.
                 to make any allocation and can treat all gross receipts as
                                                                                   A unit is not considered used for rental during the time
                 attributable to qualified domestic production activities.
                                                                                   that it was held out for rent.
                 Reduce these gross receipts by the cost of goods sold and
                                                                                   You are considered to use a dwelling unit as a residence
                 related expenses. Related expenses include direct costs
                                                                                   during the tax year if you use it for personal purposes
                 of production, plus a portion of indirect expenses. The
                                                                                   more than 14 days or more than 10% of the number
                 allocation is based on your books and records if possible,
                                                                                   of days during the tax year it is rented at a fair rental,
                 or if not, on any reasonable method. Small businesses
                                                                                   whichever is greater.
                 (those with average annual gross receipts of $25 million
                 or less) can use a simplified method to allocate deduc-
                 tions on relative gross receipts.                                   EXAMPLE: Ames owns a beach house. He rented it
                                                                                     during June and July (61 days) and used it himself
                 Limitations on the deduction. The deduction is subject              in August (31 days). Ames used the home as a resi-
                 to two limitations:                                                 dence because he used it for personal purposes for
                                                                                     more than 14 days and more than 10% of the number
                    It cannot exceed adjusted gross income for sole pro-             of days it was rented.
                    prietors and owners of partnerships, limited liability
                    companies or S corporations.                                   If the residence is not used for personal purposes (i.e.,
                    It cannot exceed 50% of W-2 wages. W-2 wages in-               personal use does not exceed the greater of 14 days or
                    cludes both taxable compensation and elective defer-           10% of rental) but it is rented out for 15 days or more
                    rals (e.g., employee contributions to 401(k) plans).           during the year, then rental expenses fall within the pas-
                                                                                   sive loss rules (see ¶709A).
                 For purposes of the W-2 wage limitation, it appears that
                 all wages of a business, not just those related to domestic       Rental for less than 15 days. If you use the unit as a
                 production, are taken into account when applying this             residence and rent it for less than 15 days during the
                 limitation. There are three methods provided for deter-           year, you cannot deduct any rental expenses. However,
                 mining W-2 income. One method looks to the lesser of              if you itemize your deductions, you can deduct mortgage
                 Box 1 or Box 5 of Form W-2--the other alternatives are            interest on a second home, taxes, and casualty and theft
                 more complex.                                                     losses. You do not have to include in your gross income
                                                                                   the rent you receive.
                 Pass-through entities.     For partnerships, limited li-
                 ability companies and S corporations, the deduction is            Deducting expenses where personal use exceeds the
                 applied at the owner (not entity) level. This means that          greater of 14 days or 10% of rental and rental is 15
                 the business must allocate gross receipts, cost of goods          days or more. Deductions (other than mortgage interest,
                 sold and related expenses from qualified production               property taxes and casualty losses) cannot exceed rental
                 activities to the owners so they can claim the deduction          income. You must deduct your rental expenses in the
                 on their personal returns.                                        following order: (1) mortgage interest, real estate taxes,
                                                                                   and casualty losses that are for rental use; (2) operating ex-
                 A special allocation rule applies for purposes of the             penses, except depreciation and other basis adjustments;
                 50-percent-of-W-2 wages limitation. The allocation of             and (3) depreciation and other basis adjustments.
                 this amount is the lower of the owner’s allocable share
                 of wages or two times 3 percent of production activities          Category (1) expenses are deductible whether or not
                 income for 2005.                                                  there is any rental income and, thus, can produce a loss.
                                                                                   Category (2) expenses are deductible only to the extent
                 Owners of pass-through entities pick up their share of            that rental income exceeds category (1) expenses. Cat-
                 the deduction from Schedule K-1.                                  egory (2) expenses cannot produce a loss. Category (3)

                                                                                                                                                               ¶1709



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              expenses can only be deducted to the extent that rental       (“parsonage allowance”) is not deductible (Young, Sum-
              income exceeds both category (1) and category (2) ex-         mary Opinion 2005-76).
              penses; excess expenses cannot be deducted as a loss.
                                                                            A bodybuilder’s special diet, that included bison meat,
              Rental income and all the expenses for rental use are re-     power shakes and vitamins, was not deductible as a
              ported on Schedule E of Form 1040. Where the vacation         business expense because a diet regime is inherently
              home expenses are subject to the passive loss rules, Form     personal in nature. But oils and lotions marketed directly
              8582 must also be completed. Interest, taxes, and casu-       to bodybuilders are deductible (Wheir, TC Summary
              alty and theft losses for personal use of the property are    Opinion 2004-117).
              deducted on Schedule A of Form 1040 if you itemize.
                                                                            Unsubstantiated business expenses may be deductible
              Deducting expenses where personal use does not                under the Cohan rule in some cases. For example, a
              exceed the greater of 14 days or 10% of rental days.          taxpayer who was both a firefighter and housing au-
              In this situation, the vacation home rules do not apply. If   thority police officer was allowed a partial deduction
              the home is rented out, then expenses may be deductible       for uniforms, cleaning, dues, firing range expenses and
              under ordinary rental rules (see ¶1708).                      gun costs totaling $1,500 (of the more than $3,700 in
                                                                            undocumented expenses originally claimed). (Jones, TC
              ¶1710 Recent Developments Affecting                           Summary Opinion 2004-76).
                    Business Deductions and Vacation
                    Home Rules                                              A deduction for “salary” to children, ages 5 and 10, of a
                                                                            self-employed taxpayer was not deductible because there
              Extensive proposed regulations explain the rules on           was no proof the money was actually paid to the children
              the domestic production activities deduction and can          (Dumond, TC Summary Opinion 2005-11).
              be relied upon until final regulations are issued (REG-
              105847-05, 10/20/05).                                         Environmental cleanup costs that relate to inventory
                                                                            must be capitalized under the UNICAP rules. (Rev. Rul.
              A minister’s business expenses are only partly deductible;    2004-18, IRB 2004-8, 502)
              the portion related to the tax-free housing allowance




    ¶1710



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                 ¶1711         CHAPTER 17 STUDY QUESTIONS — Business Deductions

                     1.      Which of the following is not a requirement for      4.   With respect to the vacation home rules, which
                             using Schedule C-EZ instead of Schedule C?                statement is incorrect?
                             a. Filed Schedule C-EZ in the prior year                  a. A homeowner who rents out the home for less
                             b. Have no employees                                         than 15 days has to report the income.
                             c. Have business expenses of $5,000 or less               b. A homeowner who rents out the home for less
                                                                                          than 15 days cannot deduct any maintenance
                     2.      Which of the following expenses is a deductible              or depreciation on the home.
                             business expense?                                         c. A homeowner who rents out a home for 15
                             a. Basic service charge for the first telephone              days or more and uses the home for more
                                 line to a taxpayer’s home even if the phone is           than 14 days or 10% of the rental period can
                                 used in a deductible home office.                        only deduct expenses (other than mort-
                             b. Interest on a tax deficiency related to                   gage interest, real estate taxes and casualty
                                 Schedule C.                                              losses) to the extent of rental income.
                             c. Business gifts (within limits).

                     3.      Which costs are not currently deductible?            For further information on business deductions, see:
                             a. Repairs                                           IRS Publication 334: Tax Guide for Small Business;
                             b. Advertising expenses                              IRS Publication 527: Residential Rental Property (In-
                             c. Capital improvements                              cluding 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.


                                                                                  Answers to Study Questions, with feedback to both
                                                                                  the correct and incorrect resposese, are provided in
                                                                                  Chapter 35, beginning with ¶3517.




                                                                                                                                                            ¶1711



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                 PART 3 — DEDUCTIONS FOR BUSINESS AND OTHER SPECIAL DEDUCTION RULES


                 Travel and
                 Entertainment Expenses                                                                                 18
                 LEARNING OBJECTIVES                                           have with their employers. If they are solely responsible
                                                                               for such expenses, then they are deducted as an unre-
                 This chapter was prepared to enable participants to           imbursed business expense. Unreimbursed business
                 learn the rules on deducting travel and entertainment         expenses, along with other miscellaneous expenses,
                 expenses. More specifically, upon completion, you will        are deductible as an itemized deduction on Schedule
                 be able to:                                                   A only to the extent that they exceed 2% of adjusted
                    Report deductions for travel-away-from-home                gross income. If the employer advances or reimburses
                    costs.                                                     an employee for such expenses, then it is necessary to
                    Figure meal and entertainment deductions, including        determine the type of arrangement involved.
                    applicable limitations.
                    Figure deductions for business car use.                      PITFALL: The IRS has noted that improper use of
                                                                                 Schedule C by employees (other than statutory
                 NEW THIS YEAR                                                   employees) to report business expenses is one of
                                                                                 the most common errors made on individual income
                                                                                 tax returns.
                       Standard mileage allowance. The IRS standard
                       mileage rate for business use of a car increased
                       to 40.5¢ per mile for the first eight months of 2005    If there is an “accountable plan” with an employer,
                       and 48.5¢ per mile for the remainder of the year.       then advances and reimburses are not includible in
                       See ¶1806.                                              gross income, and expenses need not be deducted. If,
                       Per diem rates. The per diem rates for certain travel   however, the plan is a “nonaccountable plan,” then
                       expenses, which can be used to ease substantiation      advances and reimbursements are includible, and gross
                       requirements, have changed for 2005. See ¶1809.         income and expenses can be deducted as miscellaneous
                       First-year dollar limit for purchased business          itemized expenses (subject to the 2%-of-adjusted-gross-
                       cars, trucks and vans. The limits for 2005 have         income floor).
                       decreased. See ¶1805.
                                                                               Accountable plans.  An accountable plan is one where
                 ¶1801 Deducting Travel and                                    an employer advances or reimburses an employee for
                       Entertainment Expenses                                  business expenses and:

                 Travel and entertainment expenses generally are a de-           The expenses have a business connection (there must
                 ductible cost of doing business. However, the way in            be a nexus between an employer’s “advance” and the
                 which the deduction is handled depends on a taxpayer’s          business expense that the employee is anticipated
                 employment status and, if employed, expense arrange-            to incur);
                 ments with an employer.                                         The employee must substantiate reimbursed expenses
                                                                                 within a reasonable period of time; and
                 Self-employed persons.      Self-employed individuals           The employee must return any excess reimbursement
                 deduct the cost of business travel and entertainment            to the employer within a reasonable time.
                 directly from gross income. More specifically, such ex-
                 penses are entered directly on Schedule C or Schedule         The IRS has provided safe harbor rules for determin-
                 C-EZ and offset self-employment income.                       ing when returns of excess payments under reimburse-
                                                                               ment arrangements have been made within a “reason-
                 Employees. The treatment of travel and entertainment          able time:” (1) advances are made within 30 days of
                 expenses by employees depends on the arrangement they         the expense, substantiation within 60 days, and the

                                                                                                                                        ¶1801



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              return of excess advances within 120 days or (2) the
                                                                               EXAMPLE: Mr. Green, a school administrator, travels
              company at least every quarter provides a statement
                                                                               from New York to Miami to attend a four-day meet-
              of amounts paid in excess of those substantiated, and            ing of the National Education Association. While
              returns are made by employees within 120 days of                 there, he takes a three-day sightseeing trip to the
              receipt of the statement.                                        Everglades. The cost of his New York-Miami round
                                                                               trip transportation, his food and lodging, and other
              ¶1801A Travel and Transportation Expenses                        incidental expenses during the four days spent in
                     (Sec. 162)                                                Miami on business are deductible. The cost of the
                                                                               sightseeing trip and the food and lodging expenses
              Traveling expenses include not only the cost of trans-           during the other three days are not deductible.
              portation (automobile, bus, cab, train, and plane fares,
              etc.) but also the cost of meals and lodging, as well as
                                                                             If the taxpayer travels to a destination outside the United
              other expenses incidental to the trip, such as the cost of
                                                                             States for business purposes and, while there, engages in
              sample rooms, telephone, telegraph, public stenogra-
                                                                             both business and personal activities, the transportation
              phers, laundry, and cleaning.
                                                                             expenses to the destination must be allocated in propor-
              While the cost of business travel is always deductible,        tion to the time spent for business purposes.
              the cost of other travel expenses (meals and lodging,
              etc.) are deductible only if incurred while the taxpayer         EXAMPLE: Mr. Blue, an advertising copywriter, flies
              is “away from home.” The Treasury has consistently               to Vancouver to attend a five-day convention of
              maintained that this means away from home at least               the Direct Mail Association. After the convention
              overnight, and after years of litigation, this requirement       is over, he takes a 10-day vacation trip throughout
              has been upheld by the Supreme Court. A taxpayer can-            British Columbia. Assuming that he would not have
                                                                               taken the vacation if not for the convention, he can
              not deduct the cost of meals on daily trips that do not          deduct |5/15 of his New York to Vancouver round-trip
              require “sleep or rest.” Thus, an executive or business          transportation expenses and all expenses incurred
              owner who travels to a neighboring city and returns              during the five-day stay in Vancouver. The rest of the
              the same evening would only be entitled to deduct the            expenses are nondeductible.
              cost of transportation, not the cost of meals or other
              traveling expenses.                                            Note, however, that the rule requiring allocation of
              Like all other business expenses, the cost of travel is        business expenses for part-business, part-pleasure trips
              deductible only if it constitutes an “ordinary and nec-        outside of the United States applies only to managing
              essary” business expense. Travel expenses incurred in          executives and self-employed individuals and only if (1)
              attending a trade, business, or professional convention        the trip lasted a week or less or (2) the trip lasted more
              or meeting are deductible if there is a sufficient relation-   than one week and 25% or more of the total time was
              ship between the taxpayer’s trade or business and his or       spent on personal matters.
              her attendance at the convention or other meeting, so
              that the taxpayer is benefiting or advancing the interest        EXAMPLE: An exporter takes a 21-day trip to Europe.
              of his or her trade or business by such attendance. The          He spends 17 days on business and four days on
                                                                               personal matters. All his traveling expenses, with
              fact that attendance is voluntary and not required by
                                                                               the exception of those incurred during the four days
              the taxpayer’s employer will not disallow the deduc-             he spent on nonbusiness matters, are deductible
              tion. If the convention is for political, social, or other       because less than 25% of the time was devoted to
              purposes unrelated to the taxpayer’s trade or business,          personal matters.
              the expenses are not deductible. It makes no difference
              whether the taxpayer is a self-employed individual or          Spouse or other travel companion. If a taxpayer’s spouse
              an employee.                                                   (or other family member) accompanies the taxpayer on a
              Part business, part personal. If the trip is part busi-        business trip, expenses attributable to the spouse’s travel
              ness and part pleasure, the traveling expenses will still be   are not deductible unless the spouse is also an employee
              allowable if the trip is entirely within the United States     of the same employer and it can be adequately shown
              and it can be shown that the primary purpose for the           that the spouse’s presence on the trip has a bona fide
              trip was to transact business. However, the cost of meals,     business purpose. The spouse’s performance of some
              lodging, and other expenses incurred during the pleasure       incidental services does not cause his or her expenses to
              portion of the trip are nondeductible.                         qualify as deductible business expenses.

    ¶1801A



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                 Travel expenses for a spouse, dependent, or other                 time, the IRS considers the place of their employment
                 person are no longer deductible unless that person is             (or business) as their tax “home,” and they are thus
                 an employee of the person paying or reimbursing the               not considered as being away from home. In other
                 expenses, the travel is for a bona fide business purpose,         words, “home,” for tax purposes, means the place of
                 and the travel expenses of that person would otherwise            the taxpayer’s principal business or employment, not
                 be deductible.                                                    where he or she resides.
                 Investment seminars.      The costs of attending conven-          On the other hand, if taxpayers are on a temporary assign-
                 tions or seminars for investment purposes are not deduct-         ment, or have taken temporary employment away from
                 ible. Also, the deduction for expenses of travel by cruise        home, their travel and living expenses at their temporary
                 ship or other luxury water transportation is limited to           place of employment (or business) are deductible.
                 twice the highest per diem generally allowed employees
                 of the federal government for travel in the United States,           EXAMPLE: A taxpayer has a seasonal job in New
                 times the number of days in transit. (Per diem rates are             York for eight months of the year and earns $12,000.
                 found in IRS Publication 1542 or at www.gsa.gov and                  From January through April, he holds a seasonal job
                 click on “per diem rates.)”                                          in Florida, where he earns $5,000. His tax “home” is
                                                                                      New York, and he, therefore, can deduct his trans-
                                                                                      portation to and from Florida, as well as his living
                    EXAMPLE: Paul Green makes a business trip by ship                 expenses while there.
                    from New York to England. Assuming that the voy-
                    age takes four days and that the highest per diem is
                    $200, Paul’s deduction cannot exceed $1,600 ($400              If taxpayers return home from their temporary jobs or
                    per day × four days).                                          places of business during weekends, holidays, or vaca-
                                                                                   tion, they may deduct their traveling expenses (including
                 ¶1802 Foreign Conventions (Sec. 274(h))                           meals and lodging en route) to the extent that these do
                                                                                   not exceed the amount they would have spent for meals
                 Business owners and professionals may not deduct                  and lodging had they stayed.
                 expenses for attending conventions, seminars, or
                 similar meetings held outside the North American                  No stay is considered “temporary” if it extends beyond
                 area unless they establish that (1) the meetings are              one year.
                 directly related to the active conduct of their trade
                                                                                   The IRS has indicated that a break in an assignment of
                 or business or to their income-producing activity
                                                                                   three weeks or less is not a significant break that would
                 and (2) it is as reasonable for the meetings to be held
                                                                                   stop the running of the one-year period. But a break of
                 outside the North American area as within it. The
                                                                                   seven months or more would be considered significant.
                 North American area means the United States, its
                                                                                   Also, separate infrequent or sporadic assignments may
                 possessions, Puerto Rico, the Trust Territory of the
                                                                                   be aggregated into a single assignment for purposes of
                 Pacific Islands, Canada, and Mexico.
                                                                                   the one-year rule under certain circumstances. Again,
                                                                                   the IRS has indicated that work of no more than 35
                    NOTE: The “North American area” also includes                  days (or part days) at a temporary location within the
                    Antigua and Barbuda, Barbados, Bermuda, Costa                  year would not be aggregated into a single assignment
                    Rica, Dominica, Dominican Republic, Grenada, Guy-
                    ana, Honduras, Jamaica, Saint Lucia, and Trinidad
                                                                                   and would be considered temporary even if the overall
                    and Tobago.                                                    assignment lasts more than one year.

                 Cruise ships. A limited deduction is allowed for conven-             EXAMPLE: Harry is assigned to two work projects,
                                                                                      both of which are expected to last for 18 months.
                 tions held on U.S. cruise ships. The deduction is limited
                                                                                      He’s required to visit one project once a week (52
                 to $2,000 per individual each year.                                  times a year) and the other project one a month (12
                                                                                      times a year). The assignment to the first project is
                 ¶1803 Temporary Jobs Away from Home
                                                                                      not temporary because the must spend more than 35
                 The deduction of traveling expenses while away from                  days there within the year and the overall assignment
                 home applies only if taxpayers are away temporarily.                 is more than one year. But the second assignment
                                                                                      is “temporary” so that travel costs to and from there
                 Thus, if they are employed at a location away from
                                                                                      are deductible.
                 home permanently, or for an indefinite period of


                                                                                                                                                                      ¶1803



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              ¶1804 Commuting Expenses                                       ¶1805 Deducting Automobile Expenses
              The costs that taxpayers incur in commuting from their         If taxpayers use their automobiles in connection with
              homes to their jobs or businesses are considered personal      their trade or business, on behalf of their employers, or
              expenses and generally are not deductible. However, if         in connection with any other income-producing activity,
              they have two jobs or two places of business, they are         all expenses incurred (including oil, gas, tires, repairs, de-
              considered, for this purpose, to be in a trade or busi-        preciation, etc.) are deductible. In many cases, however,
              ness. The cost of traveling from the first to the second       passenger automobiles are used not only for business
              job is deductible.                                             but also for pleasure. If so, only a proportionate part
                                                                             of the expenses is deductible. The deductible portion
                 PRACTICE POINTER: Individuals who claim home                is determined on the basis of mileage for which the car
                 office deductions for a home-based business activ-          was used for business purposes.
                 ity (see ¶1905) can deduct the cost of going from
                 home to another business location (and back) since          Instead of deducting actual expenses, a standard mileage
                 the home is also a business location.                       rate can be used (see ¶1806).
                                                                             Taxpayers using actual expenses for an automobile can
              If, for personal reasons, they do not go directly from one     claim depreciation (see ¶2104 et seq.), but special dollar
              location to the other, they may deduct only the amount         limits apply to so-called luxury cars weighing no more
              it would have cost them to go directly from the first to       than 6,000 pounds. The dollar limits on cars placed in
              the second job.                                                service during 2005 are $2,960 for year one, $4,700 for
                                                                             year two, $2,850 for year three, and $1,675 for each year
                 EXAMPLE: A teacher has a morning job in School              thereafter. The following is the maximum depreciation
                 A (15 miles from his home) and an afternoon job in          that may be claimed in 2005 (assuming the car is used
                 School B (10 miles from A and 20 miles from his             100% for business):
                 home). Even if he stops off at home on the way to
                 School B, he can only deduct the transportation              Year Car Placed in Service                2005 Dollar Limit
                 cost attributable to the 10 miles between Schools            2005                                          $2,960
                 A and B.
                                                                              2004                                            4,800
                                                                              2003                                            2,950
              Commuting costs may also be deductible where a work             2002                                            1,775
              location is temporary and is located outside the metro-
              politan area where the taxpayer lives and usually works or     The first-year expensing limit on vehicles weighing over
              where commuting is to a job location that is “temporary”       6,000 pounds but no more than 14,000 pounds is fixed
              (i.e., expected to last for less than one year and in fact     at $25,000.
              lasts for less than one year). However, transportation         For dollar limits on cars placed in service before 2002,
              costs of military reservists for trips from home to regular    see ¶2106.
              service meetings are not deductible.
                                                                               PITFALL: The IRS has noted that claiming deprecia-
                 EXAMPLE: A doctor travels between her home and                tion for a car in excess of the dollar limit is one of
                 her medical office, clinics, and hospitals at which           the most common errors made on individual income
                 she works or performs services on a regular basis.            tax returns.
                 Such transportation is considered nondeductible
                 commuting. However, travel between her office and
                 the clinics and the hospitals is deductible. Also, if the   Special rules for electric cars. For electric cars placed
                 doctor stops off to see patients before going to her        in service in 2005, the dollar limits are $8,880 for the
                 office, clinics, or hospitals, then such transportation
                                                                             first year, $14,200 for the second year, $8,450 for the
                 is deductible.
                                                                             third year, and $5,125 for each year thereafter.
              If it is necessary for taxpayers to carry heavy or bulky
                                                                               PRACTICE POINTER: Buying an electric car in 2005
              tools or instruments to their jobs or businesses, the IRS
                                                                               may result in a tax credit (see ¶1118).
              permits deduction of their automobile expenses, but only
              if they would not have otherwise used their autos.



    ¶1804



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                 Special limits for light trucks and vans. Trucks and                 actual expenses, especially where mileage is high. How-
                 vans weighing no more than 6,000 pounds are also                     ever, in some instances the actual cost method produces
                 subject to dollar limits. The first-year limit for such ve-          a greater deduction. This is particularly true when a large
                 hicles first placed in service in 2005 is $300 more than             proportion of the car usage is for business purposes, but
                 for passenger cars for the first year. The dollar limits are         the total mileage is low.
                 $3,260 for year one, $5,200 for year two, $3,150 for year
                 three and $1,875 for each succeeding year.                           The standard mileage rate may not be used in the fol-
                                                                                      lowing situations:
                 Nonpersonal use vehicles. There is no dollar limit on
                 a truck or van that has been modified to enable only de                  Modified Accelerated Cost Recovery System (MACRS)
                 minimis personal use. For example, if a van has only a                   or first-year expensing was used for the car.
                 seat for the driver or the driver and a person in a jump                 The car is used for hire (e.g., taxicabs).
                 seat, permanent shelving or a painting sign on the exte-                 Four or more cars are used for business simultaneously
                 rior, these would qualify a truck or van as a nonpersonal                (e.g., a fleet operation).
                 use vehicle. The cost of such vehicle could be expensed              Changing write-off methods. A taxpayer may change
                 up to the full limit and is not subject to the dollar limits         from the standard mileage rate to the actual cost method.
                 applicable to passenger vehicles.                                    However, depreciation is then limited to straight line
                 ¶1806 Standard Mileage Deduction
                                                                                      (provided the car has not already been fully depreci-
                                                                                      ated). A taxpayer who has used the actual cost method
                 Self-employed taxpayers or employees who use their cars              and claimed first-year expensing or accelerated depre-
                 for business may, instead of computing their actual car              ciation cannot change to the standard mileage rate for
                 expenses, take a flat deduction for each mile the car is             that car.
                 used for business. The standard mileage rate for business
                 use is 40.5¢ per mile for business travel in the first eight         Rural letter carriers. Reimbursements by the U.S.
                 months of 2005 (48.5¢ for the remainder of the year).                Postal Service up to the carrier’s actual costs are not
                 This standard rate is in lieu of all expenses such as gaso-          taxable to the carrier, nor deductible by the carrier. If
                 line (including tax thereon), oil, repairs, license plates,          reimbursements are less than the carrier’s actual costs,
                 insurance, and depreciation if the car is owned or lease             excess costs are deductible as a miscellaneous itemized
                 payments if the car is leased. However, parking fees and             deduction subject to the 2%-of-AGI floor.
                 tolls attributable to business use are deductible in addition        ¶1806A Deducting the Costs of a Leased Car
                 to the mileage rate. Also deductible separately are interest
                 and state and local taxes incurred in purchasing the car.            The expenses of using a leased car for business can be
                                                                                      deducted using the standard mileage rate or the actual
                    EXAMPLE: A salesperson buys a new car on Janu-                    expense method (see ¶1806). However, the depreciation
                    ary 4 and drives it 36,000 miles a year for business              deduction limits on “luxury cars” cannot be avoided
                    (3,000 miles a month). Her actual costs for using the             by leasing rather than buying. A taxpayer who leases a
                    car for business are $13,875 a year. Her deduction                luxury car (one valued at an inflation-adjusted amount of
                    under the standard mileage rate is $15,540 (24,000                $15,200) is limited to deductions that are “substantially
                    miles × 40.5¢ = $9,720 plus 12,000 miles × 48.5¢ =                equivalent” to the limits on depreciation deductions
                    $5,820). Since the standard mileage rate provides
                                                                                      imposed on car owners. Control over a lessee’s deduc-
                    the larger deduction, she uses the standard mileage
                    rate in lieu of deducting actual costs.
                                                                                      tions is achieved by adding an “inclusion amount” to
                                                                                      the lessee’s gross income. This is done directly in Sec-
                                                                                      tion C of Part II of Form 2106. In effect, the inclusion
                                                                                      amount offsets rental deductions when the actual expense
                    PITFALL: The standard mileage rate merely relieves
                    taxpayers of having to record automobile expenses
                                                                                      method is used.
                    and substantiate them if the return is audited. It is
                                                                                      The inclusion amount is based on the fair market value
                    still necessary to keep an accurate record of busi-
                    ness mileage (including the miles, time, place, and
                                                                                      of the car on the first day of the lease. This determines an
                    business purpose for the travel).                                 inclusion amount shown on an IRS table. The amount is
                                                                                      prorated for the number of days of the lease term included
                                                                                      in the tax year. Finally, the prorated amount is multiplied
                 In many cases, the standard mileage rate results in a
                                                                                      by the percentage of business use by the taxpayer.
                 greater deduction than that obtainable on the basis of

                                                                                                                                                                       ¶1806A



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              For cars (that are not trucks, vans or electric cars) first
                                                                                            EXAMPLE: Alexander spends $1,000 for qualified
              leased in 2005, the following is a table of sample ranges
                                                                                            entertainment. Result: his deduction is limited to
              of fair market value. For other fair market values, see                       $500 (50% of $1,000).
              Rev. Proc. 2005-13, IRB 2005-12, 759. For inclusion
              amounts for cars leased in prior years, see Appendix B
              of IRS Publication 463.                                                     Business meals.    The deduction for meals is subject
                                                                                          to the same requirements that apply to other entertain-
              Sample Inclusion Amounts                                                    ment expenses. This means that a business meal, like
                                                                                          business entertainment, is deductible (subject to the
                FMV of Car                 Tax Year During Lease
                                                                                  5th     50% limitation rule) only if the meal is directly related
                Over
                              Not
                              Over          1st       2nd        3rd        4th
                                                                                  and
                                                                                  Later
                                                                                          to or associated with the active conduct of a taxpayer’s
                $15,200      $15,500        $3         $6         $9        $11    $13    trade or business.
                 16,700       17,000         8         18         27         32     39
                 18,000      $18,500        16         35         52         63     73    Business meal expenses generally are not deductible un-
                 20,000       20,500        25         55         82         99    115    less there is a substantial and bona fide business discus-
                 25,000       26,000        49        108        161        192    223    sion before, during, or after the meal.
                 30,000       31,000        72        159        234        283    326
                 40,000       41,000       118        259        384        462    533
                 50,000       51,000       164        360        533        640    740      PRACTICE POINTER: An individual away from home
                                                                                            overnight on business automatically qualifies for the
              ¶1807 Meals and Entertainment Expenses                                        “directly related” requirement.
                    (Secs. 162 and 274)
                                                                                          Special limit for certain workers.       Employees and
              The cost of entertaining customers (or prospective cus-                     independent contractors whose hours are governed by
              tomers), employees, business associates, etc. has long                      Department of Transportation hours of service limita-
              been held to be an ordinary and necessary business                          tions (such as interstate truck drivers) can deduct 70%
              expense. However, due to large and widespread abuses,                       of their meal costs in 2005.
              such as the deduction of lavish entertainment expenses
              by taxpayers on practically unlimited expense accounts,
              Congress severely limited the allowance of deductions                         NEW FOR 2006: The limit increases to 75% (80%
                                                                                            in 2008).
              for entertainment and similar expenditures.
              No deduction for entertainment expenses is allowed un-                      Exceptions to the “50% limitation” rule.      The 50%
              less taxpayers establish that the expenditure was directly                  limit does not apply if any of the following exceptions
              related to or associated with the active conduct of their                   applies:
              trade or business (or employment). Thus, the regulations
              require that the taxpayer have a definite expectation of                      An employer’s expenses for meals and entertainment
              deriving some income or other specific trade or business                      if treated by the employer as compensation to the
              benefit (not merely the goodwill of the person or persons                     employee on the employer’s tax return and as wages
              entertained) at some future time.                                             for withholding purposes.
                                                                                            Expenses for meals and entertainment includible in
              Club dues. Dues paid for membership in social, athletic,                      the gross income of the recipient, who is not an em-
              or sporting clubs (such as airline clubs) are not deduct-                     ployee of the taxpayer, as compensation for services
              ible. However, dues to professional (e.g., bar association),                  rendered or as a prize or award, and included by the
              business (e.g., chamber of commerce), and civic (e.g.,                        taxpayer on Form 1099 issued to the recipient.
              Rotary or Lions) organizations are deductible.                                Expenses for recreational, social, or similar activities
                                                                                            (including facilities primarily for employees’ benefit,
              The deduction for entertainment expenses is limited to
                                                                                            other than certain highly compensated employees.
              50% of the amount otherwise allowable as a deduction.
                                                                                            Expenses for meals and entertainment, including
              The 50% limitation is applied after determining the                           using facilities, made available by the taxpayer to the
              amount of otherwise allowable deductions under the                            general public, such as a free concert.
              “ordinary and necessary” standard and other rules that                        Expenses for meals or entertainment sold by the
              disallow certain entertainment expenses (like the “lavish                     taxpayer in a bona fide transaction for adequate and
              and extravagant” rule).                                                       full consideration.


    ¶1807



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                    An expense for food or beverage (but not entertain-               made to an individual’s spouse will be considered as
                    ment) that is excludable from the recipient’s gross               having been made to the individual, unless the spouse
                    income under the de minimis rule.                                 has a separate business connection with the individual
                    The price of tickets to certain charitable sporting               making the gift.
                    events (including amounts in excess of face value),
                    provided the expense is covered by a ticket package                  PRACTICE POINTER: In some cases, an expense
                    that includes admission to the event.                                may be a business gift (subject to the $25 limit) or
                                                                                         an entertainment expense (subject to the 50% limit).
                 To qualify, a charitable sporting event must: (1) be orga-              For example, theater tickets for a client or customer
                 nized for the primary purpose of benefiting a tax-exempt                can be treated as either type of expense as long as
                 organization, (2) contribute 100% of its net proceeds to                the taxpayer does not attend the performance. If the
                 this organization, and (3) use volunteers for substantially             taxpayer accompanies the client or customer, the
                 all work performed in carrying out the event.                           expense is only an entertainment expense.

                 Entertainment tickets.     The amount of a deduction                 Not included in the $25 limitation are advertising
                 for a ticket to an entertainment event is limited to the             giveaways costing less than $4 and on which the donor’s
                 ticket’s face value (before applying the 50% limitation              name is permanently imprinted. Also excluded from the
                 rule). Tickets bought for a charitable fund-raiser are not           definition of “gifts” are signs, display racks, and other
                 limited by this rule.                                                promotional materials to be used by the recipient on his
                                                                                      or her business premises. The employer can only exclude
                    PITFALL: This rule bars excess payments to “scalp-                an employee achievement award from the employee’s
                    ers” and even to legitimate ticket agencies.                      income if the employer can deduct the award. To be
                                                                                      deductible, the award must be:
                 Skyboxes. A deduction is disallowed for renting a luxury
                 “skybox” for multiple events. The disallowance is the ex-                Made for length-of-service or safety achievement,
                 cess over the cost of a regular box seat. A luxury “skybox”              Tangible personal property,
                 is any private luxury box or other facility at a sports arena            Awarded as part of a meaningful presentation, and
                 that is separated from other seating and that is available               Awarded under conditions and circumstances that do
                 at a higher price than the price generally applicable to                 not create a significant likelihood of the payment of
                 other seating. For this rule, a single game or other per-                disguised compensation.
                 formance counts as one event. If this disallowance rule              The total of all nonqualified plan awards made to any
                 applies, two types of expenses related to the skybox still           one employee during the tax year may not exceed $400.
                 may be deductible, subject to the 50% limitation rule,               The total of all awards (including both qualified and
                 if they meet the generally applicable requirements for               nonqualified plan awards) made to any one employee
                 deducting business entertainment expenses:                           during the tax year may not exceed $1,600.
                    An amount not exceeding the face values of the high-              If the cost of the award is more than the amount the
                    est-price nonluxury box seats generally held for sale             employer can deduct, the employer must include in
                    to the public on an event-by-event basis, multiplied              the employee’s income the greater of: (1) the excess
                    by the number of seats in the skybox (subject to the              of cost over the employer’s deduction (but not more
                    50% limitation rule)                                              than the award’s value) or (2) the amount by which
                    The deductibility of separately stated charges for                the award’s value exceeds the amount the employer is
                    food or beverages, as determined under the rules                  allowed to deduct.
                    generally applying to business meals (including the
                    50% limitation rule and the disallowance of lavish                A qualified plan award is one awarded as part of an
                    or extravagant expenditures)                                      established written plan by the employer that does not
                                                                                      discriminate in favor of highly compensated employees.
                 ¶1808 Business Gifts (Sec. 274)                                      An award will not be considered a qualified plan award
                                                                                      if the average cost of all employee achievement awards
                 The law limits deductions for business gifts to $25 per              given by the employer during the tax year exceeds $400.
                 individual per year, the same limit that applied nearly              In determining average cost, awards of very small value
                 half a century ago. Any amount in excess of $25 given                are not considered.
                 to one individual during a year is not deductible. Gifts

                                                                                                                                                                         ¶1808



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              ¶1809 Substantiation of Travel and                             Per diem allowances. Where an employer reimburses
                    Entertainment Expenses                                   an employee for automobile use at the standard mile-
                                                                             age rate (40.5/48.5¢ per mile in 2005) or for travel
              No deduction for travel, entertainment, or gifts is al-
                                                                             using a per diem rate, substantiation requirements are
              lowed unless the taxpayer can clearly substantiate by
                                                                             simplified. Amounts reimbursed under a per diem ar-
              adequate records the amount, time, and place of travel
                                                                             rangement are deemed substantiated when they do not
              or entertainment, or date and description of the gift,
                                                                             exceed the applicable federal rate, which varies from
              and the business purpose of the travel or the business
                                                                             locality to locality. The per diem rate can be used for
              relationship to the taxpayer of each person entertained
                                                                             lodging, meals, and incidental expenses or for meals
              or receiving a gift.
                                                                             and incidental expenses with separate reimbursement
              The most common method of meeting the “adequate                for actual lodging costs.
              record” requirement is by keeping a diary or account
                                                                             Instead of using the federal per diem rate for lodging,
              book in which all deductible expenses, together with the
                                                                             meals, and incidental expenses in a particular locality,
              necessary explanatory details, are recorded at or near the
                                                                             there is an even simpler option for travel within the
              time of the expenditure.
                                                                             continental United States. Under a so-called “high-low”
              Each separate payment is usually considered a separate         method, several high-cost areas (such as New York, Los
              expenditure and must be separately recorded. Thus,             Angeles, Washington, D.C., Atlanta, Chicago, Boston,
              if a taxpayer entertains a customer or client at dinner        and Philadelphia) have a per diem rate (beginning
              and then takes the customer to the theater, the dinner         October 1, 2004) of $204. All other areas within the
              expense and the cost of the theater tickets are separate       continental U.S. are assigned a low per diem rate of
              expenditures.                                                  $129. The M&IE rate for high-cost areas is $46 ($36 for
                                                                             all other areas). The rates for October 1, 2005, through
              In recording various expenditures, such items as cab           September 30, 2006, are $226 for high-cost areas and
              fares, phone calls, meals, gas and oil, and other inciden-     $141 for all other areas.
              tal traveling expenses may be aggregated, and the daily
              total of each category listed in the taxpayer’s account
                                                                               PRACTICE POINTER: Employers may choose to use
              book or diary.                                                   the old or new listing of high-cost areas for the fourth
                                                                               quarter of 2005.
              For most items, such an account book, diary, or Palm
              Pilot notation will be sufficient. However, documentary
              evidence, such as receipts, paid bills, or similar evidence,   Incidental expenses include only fees and tips to por-
              is not required for any expenditure (other than lodging)       ters, baggage carriers, bellhops, hotel maids, stewards
              of less than $75. (Transportation charges for which docu-      and stewardesses. However, if no expenses for meals are
              mentary evidence is not readily available are exempted         incurred, incidental expenses can be separately substanti-
              from this requirement.)                                        ated by a per diem rate of $3.
                                                                             ¶1810 Reporting Employee Business Expenses
                 PRACTICE POINTER: Remember, the diary and
                 documentary evidence should not be submitted                Employees claim unreimbursed employee business ex-
                 with the return, but should be readily available if the     penses, including car expenses, as itemized deductions
                 return is questioned.                                       on Schedule A. However, these expenses must first be
                                                                             listed on Form 2106, “Employee Business Expenses,”
                                                                             or on a simplified version of the form, Form 2106-EZ,
                 NOTE: It is important to maintain accurate records          “Unreimbursed Employee Business Expenses.” These
                 as far as an auto’s business use. Cars are not eligible     forms are used to report car expenses, meals and enter-
                 for accelerated depreciation unless the “more than          tainment, travel costs away from home, parking, tolls,
                 50% business use” applies (see ¶2105). Form 2106            and local transportation costs, business gifts, and other
                 contains specific questions with regard to an auto’s
                 business use.
                                                                             unreimbursed employee business expenses.




    ¶1809



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                         2106
                                                                                                                                                        OMB No. 1545-0139
                                                                Employee Business Expenses
                 Form

                 Department of the Treasury
                                                                             See separate instructions.                                                    2005
                                                                                                                                                         Attachment
                 Internal Revenue Service (99)                                  Attach to Form 1040.                                                     Sequence No.    54
                 Your name                                                                   Occupation in which you incurred expenses         Social security number



                  Part I

                 Step 1
                                o f
                                  Employee Business Expenses and Reimbursements

                              Enter Your Expenses
                                                                                                              Column A
                                                                                                           Other Than Meals
                                                                                                                                                     Column B
                                                                                                                                                     Meals and



                               s 5
                              a 0
                                                                                                           and Entertainment                        Entertainment




                            ft 20
                   1    Vehicle expense from line 22 or line 29. (Rural mail carriers: See
                        instructions.)                                                                 1
                   2    Parking fees, tolls, and transportation, including train, bus, etc., that




                         ra 7/
                        did not involve overnight travel or commuting to and from work                 2
                   3    Travel expense while away from home overnight, including lodging,
                                                                                                       3



                        D /2
                        airplane, car rental, etc. Do not include meals and entertainment
                   4    Business expenses not included on lines 1 through 3. Do not
                        include meals and entertainment                                                4




                           4
                   5    Meals and entertainment expenses (see instructions)                            5




                         0
                   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)



                   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                                                    8
                        Note: I f 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 70% (.70)
                        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 20. (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     (2005)




                                                                                                                                                                                    ¶1810



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              Form 2106 (2005)                                                                                                             Page   2
               Part II    Vehicle Expenses
              Section A—General Information (You must complete this section if you
                                                                                                    (a) Vehicle 1          (b) Vehicle 2
              are claiming vehicle expenses.)
              11    Enter the date the vehicle was placed in service                           11      /     /                   /     /
              12    Total miles the vehicle was driven during 2005                             12                miles                      miles



                              f
              13    Business miles included on line 12                                         13                miles                      miles
                                                                                               14



                            o
              14    Percent of business use. Divide line 13 by line 12                                              %                          %
              15    Average daily roundtrip commuting distance                                 15                miles                      miles
                                                                                               16                miles                      miles




                          as 05
              16    Commuting miles included on line 12
              17    Other miles. Add lines 13 and 16 and subtract the total from line 12       17                miles                      miles
              18    Do you (or your spouse) have another vehicle available for personal use?                                 Yes             No




                        ft 20
              19    Was your vehicle available for personal use during off-duty hours?                                       Yes             No
              20    Do you have evidence to support your deduction?                                                          Yes             No
              21    If “Yes,” is the evidence written?                                                                       Yes             No




                     ra 7/
              Section B—Standard Mileage Rate (See the instructions for Part II to find out whether to complete this section or
              Section C.)
              22    Multiply line 13 by 40.5 ¢ (.405)                                                              22



                    D /2
              Section C—Actual Expenses
              23  Gasoline, oil, repairs, vehicle
                  insurance, etc.                               23
                                                                            (a) Vehicle 1                        (b) Vehicle 2




                       4
              24a Vehicle rentals                              24a
                                                               24b



                     0
                b Inclusion amount (see instructions)
                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
                     (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

                                                                                                                            Form     2106   (2005)




    ¶1810



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                 Form 2106-EZ can be used only if an employee with un-                          for 2005 (and also used it for the year the car was first
                 reimbursed business expenses that include car expenses                         placed in service).
                 owns his or her car and uses the standard mileage rate

                                                                                                                                                          OMB No. 1545-1441
                           2106-EZ
                   Form

                   Department of the Treasury
                                                     Unreimbursed Employee Business Expenses                                                                    2005
                                                                                                                                                          Attachment
                   Internal Revenue Service (99)                                  Attach to Form 1040.                                                    Sequence No.    54A
                   Your name                                                                    Occupation in which you incurred expenses           Social security number



                   You May Use This Form Only if All of the Following Apply.
                   ● You are an employee deducting ordinary and necessary expenses attributable to your job. An ordinary expense is one that is
                   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
                   not considered reimbursements for this purpose).
                   ● If you are claiming vehicle expense, you are using the standard mileage rate for 2005.
                   Caution: You can use the standard mileage rate for 2005 only if: (a) you owned the vehicle and used the standard mileage rate for the first year



                                                             f
                   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


                    1
                                    Figure Your Expenses

                                                           o
                                                          s 5
                          Vehicle expense using the standard mileage rate. Complete Part II and multiply line 8a by 40.5¢



                    2
                          (.405)

                                                         a 0
                                                       ft 20
                          Parking fees, tolls, and transportation, including train, bus, etc., that did not involve overnight
                                                                                                                                                1



                                                                                                                                                2




                                                    ra 3/
                          travel or commuting to and from work

                    3     Travel expense while away from home overnight, including lodging, airplane, car rental, etc.



                                                   D /2
                          Do not include meals and entertainment                                                                                3

                    4     Business expenses not included on lines 1 through 3. Do not include meals and entertainment                           4


                    5




                    6
                                                      5
                          Meals and entertainment expenses: $



                                                    0
                                                                             × 50% (.50) (Employees subject to
                          Department of Transportation (DOT) hours of service limits: Multiply meal expenses incurred
                          while away from home on business by 70% (.70) instead of 50%. For details, see instructions.)


                          Total expenses. Add lines 1 through 5. Enter here and on Schedule A (Form 1040), line 20.
                                                                                                                                                5



                          (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 2005, enter the number of miles you used your vehicle for:

                          a Business                             b Commuting (see instructions)                                        c Other

                    9     Do you (or your spouse) have another vehicle available for personal use?                                                                Yes         No

                   10     Was your vehicle available for personal use during off-duty hours?                                                                      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 3.                                       Cat. No. 20604Q                                 Form    2106-EZ     (2005)



                                                                                                                                                                                   ¶1810



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              ¶1811 Recent Developments Affecting Travel                     employer pays for lodging, provides it in kind or knows
                    and Entertainment Expenses                               that an employee will not incur lodging expenses, a flat
                                                                             meal rate may be used ($46 for high-cost areas) (Rev.
              Workers who are “on call” and commute to job sites
                                                                             Proc. 2005-10, IRB 2005-3,341).
              in various locations outside of the metropolitan area in
              which they live can deduct commuting costs. The IRS            For the period of October 1, 2005, through September
              attempt to define “metropolitan area” by means of the          30, 2006, one rate ($226 per day, of which $58 is for
              Census Bureau was rejected; the Tax Court views this           meals and incidentals) applies to travel in high-cost ar-
              area as the taxpayer’s normal commuting area (Wheir,           eas; other rate ($141 per day, of which $45 is for meals
              TC Summary Opinion 2004-117).                                  and incidentals) applies for all other areas within the
                                                                             continental United States. Where an employer pays for
              In 2005, employers reimbursing employees for busi-
                                                                             lodging, provides it in kind or knows that an employee
              ness travel under their reimbursement plans may use
                                                                             will not incur lodging expenses, a flat meal rate may be
              40.5/48.5¢ per mile for business travel. When this rate
                                                                             used ($58 for high-cost areas) (Rev. Proc. 2005-67, IRB
              is used, substantiation requirements are satisfied if em-
                                                                             2005-42, 729).
              ployees also substantiate the time, place, mileage, and
              business purpose for the trip (Rev. Proc. 2004-64, IRB         New depreciation limits for cars placed in service in 2005
              2004-49, 898).                                                 and income inclusion amounts for cars leased in 2005 are
                                                                             set forth (Rev. Proc. 2005-13, IRB 2005-12,759).
              Substantiation requirements are simplified for travel and
              meal reimbursement arrangements where a government             For automobiles placed in service for business purposes
              rate is used. For the period of October 1, 2004, through       in and for which the standard mileage allowance was
              September 30, 2005, one rate ($204 per day, of which           used, depreciation is considered to have been allowed at
              $46 is for meals and incidentals) applies to travel in         the rate of 17 cents per mile. The rate does not apply to
              high-cost areas; the other rate ($129 per day, of which        any year in which the actual cost method was used. This
              $36 is for meals and incidentals) applies for all other        depreciation reduces the auto’s basis (Rev. Proc. 2004-64,
              areas within the continental United States. Where an           IRB 2004-49,898).


              ¶1812          CHAPTER 18 STUDY QUESTIONS — Travel and Entertainment Expenses

                  1.    A taxpayer regularly works in one city. His family
                        lives in another city in the home he owns. For tax     For further information on travel and entertainment
                        purposes, which city is his “home?”                    expenses, see: IRS Publication 463: Travel, Enter-
                        a. The city in which he works                          tainment, Gift, and Car Expenses; and IRS Publica-
                        b. The city in which his family lives                  tion 1542: Per Diem Rates (For Travel Within the
                        c. The taxpayer may elect which city to call his       Continental United States).
                             tax home
                                                                               Answers to Study Questions, with feedback to both
                  2.    The standard mileage rate for business use of a        the correct and incorrect resposese, are provided in
                        car in the first eight months of 2005 is:              Chapter 35, beginning with ¶3518.
                        a. 14¢ per mile
                        b. 37.5¢ per mile
                        c. 40.5¢ per mile

                  3.    A gift to a customer may not exceed:
                        a. $25 per year
                        b. $400 per year
                        c. Any reasonable amount




    ¶1812



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                 PART 3 — DEDUCTIONS FOR BUSINESS AND OTHER SPECIAL DEDUCTION RULES


                 Other Business, Job-Related,
                 and Investment Expenses                                                                                19
                 LEARNING OBJECTIVES                                         Jury duty pay. If employees must give jury duty pay to
                                                                             their employer because their employer continues to pay
                 This chapter was prepared to enable participants to         their salary while they serve on a jury, they can deduct
                 learn about various business, job-related and investment    the amount turned over to the employer as an adjust-
                 expenses. More specifically, upon completion, you will      ment to gross income.
                 be able to:
                                                                             ¶1902 “Statutory Employee” Business
                    Figure the home office deduction.
                                                                                   Expenses (Sec. 62)
                    Determine deductible expenses in connection with
                    investments and income-producing activities.             Certain individuals may be treated as statutory em-
                    Claim a deduction for work-related education expenses.   ployees whose business expenses are deductible without
                                                                             regard to the 2% floor. Statutory employees are those
                 ¶1901 Deducting Other Business, Job-Related,                who are treated as employees for FICA tax purposes
                       and Investment Expenses                               but who are not traditional common-law employees.
                 Business, job-related, and investment expenses generally    They include:
                 are deductible. However, the way in which the deduction       Full-time life insurance salespersons whose entire or
                 is handled varies greatly.                                    principal activity is devoted to the solicitation of life
                 Self-employed persons.        Self-employed individuals       insurance, annuity contracts, or both, primarily for
                 deduct business expenses from gross income. More spe-         one life insurance company
                 cifically, such expenses are entered directly on Schedule     Agent-driver or commission driver
                 C and offset self-employment income.                          Home workers
                                                                               Traveling or city salespersons
                 Statutory employees. Outside salespersons, certain
                 insurance agents, and others defined under the Internal     Individuals need not make the determination of whether
                 Revenue Code as “statutory employees” may deduct busi-      they are statutory employees. Statutory employee status
                 ness expenses in the same way in which self-employed        is reflected on Form W-2 on which their wages for the
                 individuals handle these expenses. Such expenses are        year are reported.
                 entered directly on Schedule C and are not limited by       Statutory employees list their business expenses on
                 adjusted gross income.                                      Schedule C or Schedule C-EZ.
                 Employees. Job-related expenses which are not reim-
                                                                             ¶1903 Employee Business Expenses (Sec. 62)
                 bursed by employers under an accountable plan (see
                 ¶1801) are deductible only as miscellaneous expenses        Form 2106 is used to detail the amount of the employee
                 on Schedule A. These are deductible only to the extent      business expenses that must be entered on Schedule A of
                 that they exceed 2% of adjusted gross income. However,      Form 1040 and claimed as a miscellaneous itemized de-
                 special rules apply to qualified performing artists, who    duction (assuming the employee itemizes deductions).
                 can deduct expenses directly from gross income.
                                                                             ¶1904 Employees’ Expenses in Connection
                 Investment expenses. Expenses incurred for the man-               with Their Employment
                 agement, conservation, or maintenance of property held
                                                                             Unreimbursed employees’ business expenses are miscel-
                 for the production of income are deductible only as
                                                                             laneous itemized deductions and are thus deductible
                 miscellaneous itemized expenses, subject to the 2%-of-
                                                                             from adjusted gross income, together with other itemized
                 adjusted-gross-income floor.

                                                                                                                                        ¶1904



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              deductions. Here, again, the expenses must be “ordinary          Additionally, if the taxpayer is an employee, the busi-
              and necessary” and in a “reasonable amount.” This would          ness use of the home must be for the convenience of
              include the following:                                           the employer.
                 Union and trade-organization dues and convention
                 expenses                                                        PITFALL: The home office deduction of an employee
                 Work clothes, including cleaning and laundry                    is a miscellaneous itemized deduction subject to the
                 Small tools (if useful life is less than one year; other-       2% of AGI limitation.
                 wise, a depreciation deduction is in order)
                 Subscription to trade and technical journals and              If the space is in a separate building, not attached to the
                 newspapers                                                    taxpayer’s residence, it will qualify so long as it is used ex-
                 Hiring of assistants and substitutes (if not paid for         clusively and on a regular basis for business purposes.
                 by employer)
                                                                               Business expenses related to space in a home used
              The cost of work clothes and uniforms, including laun-           regularly (even if not exclusively) as a storage unit for
              dry or cleaning, is deductible if the taxpayer’s occupation      inventory or sample items (or both) are deductible if the
              is one that specifically requires special clothing that is not   home is the sole fixed location of the business.
              adaptable to general usage. The IRS lists the following
              as specifically deductible:                                      One exception to the exclusive use test is if the residence
                                                                               is the only fixed location of a trade or business engaged
                 Special uniforms and/or equipment required by                 in selling products at retail or wholesale, provided a
                 ballplayers, fire fighters, police officers, letter           separate, identifiable portion of the residence is regularly
                 carriers, nurses, and civilian faculty members of             used for inventory storage. Thus, where a part of a base-
                 military schools.                                             ment is used for this purpose the proportionate part of
                 Theatrical clothes and accessories used by professional       the expenses will qualify, even though the basement is
                 musicians and entertainers, if used solely in the course      used for other purposes as well.
                 of their trade or employment.
                 Uniforms of air, rail, bus, and other transportation em-      Another exception is where a residence is used to provide
                 ployees, if used solely in the course of employment.          day care services to children, handicapped individuals,
                 The cost of protective clothing, including safety             and the elderly on a regular basis.
                 shoes and helmets, work gloves, oilskins, rubber
                                                                               Home office deductions by self-employed individuals
                 boots, etc.
                                                                               are first figured on Form 8829, “Expenses for Business
              Fees paid to employment agencies for seeking or securing         Use of Your Home,” and then entered on Schedule C.
              a job in the same line of business are deductible, as are        (Employees claiming home office expenses figure deduc-
              expenses for drafting and printing of job resumes and            tions on Form 2106.) Form 8829 is comprised of four
              traveling to job interviews.                                     parts. Part I is used for figuring the portion of the home
                                                                               used for business. Generally, this is figured by dividing
              ¶1905 Home Office Expenses (Sec. 280A)                           the area used for business by the total area in the home
              A deduction for the business use of a personal residence         to arrive at a “business percentage.”
              is allowed only if the space is used exclusively and on a
              regular basis as any of the following:                             EXAMPLE: Sue uses 500 sq. ft. of her 2,000 sq. ft.
                                                                                 house as a home office. Her business percentage is
                 The principal place of any business. A home is treated          25% (500 sq. ft. ÷ 2,000 sq. ft).
                 as a principal place of business if it is used for sub-
                 stantial administrative or managerial activities and          The allocation, however, can be based on the number of
                 there is no other fixed location for the performance          rooms if the rooms are all of approximately equal size.
                 of these activities.
                 A place of business used for meeting clients, custom-         Part II of Form 8829, “Expenses for Business Use of
                 ers, or patients.                                             Your Home,” is used for figuring allowable deductions.
                 Separate structure.                                           The form distinguishes between direct and indirect ex-
                                                                               penses. Direct expenses are those solely connected with
                                                                               a home office. Indirect expenses are those applicable to


    ¶1905



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                 the entire residence, such as mortgage interest on a loan
                 for the entire residence and real property taxes. Indirect                     PITFALL: Any depreciation taken on a home office
                                                                                                after May 6, 1997, is “recaptured” at the rate of 25%.
                 expenses are first listed and then the percentage of busi-                     However, the home sale exclusion can be claimed for
                 ness use is applied to arrive at the deductible portion.                       the home office portion as long as the office is part
                 No deduction, direct or indirect, is allowed for the cost                      of the dwelling unit (no allocation of gain is required
                 of landscaping the home. Depreciation is figured in Part                       for the business portion of the home).
                 III of Form 8829. Again, it is figured on the business
                 portion of the home.




                                                                                                                                                                                    ¶1905



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                                                                                                                                         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
                                                                                                                                            2005
                                                                  home you used for business during the year.
              Department of the Treasury                                                                                                   Attachment
              Internal Revenue Service (99)                                 See separate instructions.                                     Sequence No. 66
              Name(s) of proprietor(s)                                                                                             Your social security number


               Part I          Part of Your Home Used for Business
                1    Area used regularly and exclusively for business, regularly for daycare, or for storage of inventory
                     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                          %
                     ● For daycare facilities not used exclusively for business, also complete lines 4–6.
                     ● All others, skip lines 4–6 and enter the amount from line 3 on line 7.
                4    Multiply days used for daycare during year by hours used per day                     4            hr.
                5    Total hours available for use during the year (365 days 24 hours) (see instructions) 5     8,760 h r .
                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                          %
               Part II         Figure Your Allowable Deduction
                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 9–20.
               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     Repairs and maintenance                                      18
              19     Utilities                                                    19
              20     Other expenses (see instructions)                            20
              21     Add lines 16 through 20                                      21
              22     Multiply line 21, column (b) by line 7                                            22
              23     Carryover of operating expenses from 2004 Form 8829, line 41                      23
              24     Add line 21 in column (a), line 22, and line 23                                                               24
              25     Allowable operating expenses. Enter the smaller of line 15 or line 24                                         25
              26     Limit on excess casualty losses and depreciation. Subtract line 25 from line 15                               26
              27     Excess casualty losses (see instructions)                                         27
              28     Depreciation of your home from Part III below                                     28
              29     Carryover of excess casualty losses and depreciation from 2004 Form 8829, line 42 29
              30     Add lines 27 through 29                                                                                       30
              31     Allowable excess casualty losses and depreciation. Enter the smaller of line 26 or line 30                    31
              32     Add lines 14, 25, and 31                                                                                      32
              33     Casualty loss portion, if any, from lines 14 and 31. Carry amount to Form 4684, Section B                     33
              34     Allowable expenses for business use of your home. Subtract line 33 from line 32. Enter here
                     and on Schedule C, line 30. If your home was used for more than one business, see instructions                34
               Part III        Depreciation of Your Home
              35     Enter the smaller of your home’s adjusted basis or its fair market value (see instructions)                   35
              36     Value of land included on line 35                                                                             36
              37     Basis of building. Subtract line 36 from line 35                                                              37
              38     Business basis of building. Multiply line 37 by line 7                                                        38
              39     Depreciation percentage (see instructions)                                                                    39                         %
              40     Depreciation allowable (see instructions). Multiply line 38 by line 39. Enter here and on line 28 above       40
               Part IV         Carryover of Unallowed Expenses to 2006
              41     Operating expenses. Subtract line 25 from line 24. If less than zero, enter -0-                               41
              42     Excess casualty losses and depreciation. Subtract line 31 from line 30. If less than zero, enter -0-          42
              For Paperwork Reduction Act Notice, see page 4 of separate instructions.                      Cat. No. 13232M                  Form   8829   (2005)




    ¶1905



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                 Gross income limit.      The deduction for home office                                                  ¶1906 Expenses in Connection with Investment
                 expenses is limited to the gross income from the business                                                     and Other Income-Producing Activities
                 use of the home less the sum of: (1) business percentage                                                      (Sec. 212)
                 of the mortgage interest, real estate taxes, and casualty
                                                                                                                         Section 212 of the Code allows taxpayers to deduct
                 losses and (2) business expenses other than those related
                                                                                                                         expenses “incurred for the management, conservation,
                 to the business use of a home. Therefore, the deduction
                                                                                                                         or maintenance of property held for the production
                 is limited to a modified net income from the business
                                                                                                                         of income.”
                 use of a home, that is, the net income of the business
                 without including the home expenses (other than the                                                     This section is the basis for permitting the deduction
                 business percentage of mortgage interest, real estate taxes,                                            from adjusted gross income (itemized deduction) of
                 and casualty losses). Thus, a deduction for the business                                                business expenses incurred in connection with invest-
                 use of a home will not create a business loss or increase                                               ments or other income-producing activities not in
                 a net loss from a business. The gross income limitation                                                 the taxpayer’s trade or business (so-called nontrade or
                 is built into Part III of Form 8829.                                                                    nonbusiness expenses). An exception is expenses that
                                                                                                                         are attributable to property held for production of rents
                 Disallowed home office deductions can be carried for-
                                                                                                                         or royalties that are deductible from gross income as
                 ward to later years, subject to the income limitations
                                                                                                                         “above-the-line” deductions.
                 in those years from the business activity. The carryover
                 of unallowed expenses to 2006 is figured in Part IV of                                                  Typical examples of these “nonbusiness” expenses are
                 Form 8829.                                                                                              investment counsel fees, cost of financial periodicals
                                                                                                                         and advisory services, safe deposit box rentals (if the box
                    EXAMPLE: Bob Brown operates a retail sales busi-                                                     is used for safe-keeping of securities or property held
                    ness from his home. He uses 20% of his home for                                                      for production of income), state and local transfer tax,
                    this business. In 2005, his gross income, expenses                                                   collection charges and commissions, cost of secretarial
                    for the business, and computation of the deduction                                                   services, telephone, postage, etc., and office (including
                    for the business use of his home are as follows:
                                                                                                                         a pro rata share of home office) expense.
                     Gross income . . . . . . . . . . . . . . . . . . . . .     $12,000
                     Less: Inventory, supplies, etc. . . . . . . . . . $9,000                                            The expenses in connection with investment and other
                        Business percentage of                                                                           income-producing activities are deductible as miscella-
                         mortgage interest and                                                                           neous itemized deductions only to the extent they exceed
                         real estate taxes . . . . . . . . . . . . . . . . 2,000 11,000
                     Modified net income—deduction limit . . .
                                                                                                                         2% of adjusted gross income.
                                                                                 $ 1,000
                     Business use of home expenses—                                                                      No deduction is allowed for the cost of travel to invest-
                      indirect expenses . . . . . . . . . . . . . . . . . .
                                                                                                                         ment seminars.
                         Maintenance, insurance,
                          utilities (20%) . . . . . . . . . . . . . . . . . .                      $ 800                 ¶1907 Educational Expenses (Sec. 162)
                         Depreciation (20%). . . . . . . . . . . . . . .                           1,600
                     Total . . . . . . . . . . . . . . . . . . . . . . . . . . . .               $ 2,400                 Taxpayers may deduct educational expenses, such as the
                     Deduction limited to modified                                                                       cost of special training programs or courses (including
                      net income . . . . . . . . . . . . . . . . . . . . . .                       1,000                 correspondence courses and research activities) under-
                     Carryover expenses to 2006 (subject                                                                 taken for the purpose of:
                      to income limitation in 2006). . . . . . . . .                             $ 1,400
                                                                                                                             Maintaining or improving skills required in the tax-
                 No deduction (other than deductible expenses like real                                                      payer’s present trade, business, or employment or
                 estate taxes and mortgage interest) is allowed for a home                                                   Meeting the requirements of the taxpayer’s present
                 office leased to an employer.                                                                               employer as a condition to retention of present em-
                                                                                                                             ployment or salary.
                 Telephone.   The cost of basic charges of a first phone
                 line in a home is not deductible. Other charges, such as                                                Deductible expenses include tuition, books, and other
                 long distance calls, call waiting, and equipment rentals,                                               supplies as well as the cost of travel, board, and lodging,
                 continue to be deductible.                                                                              if the training is away from home.




                                                                                                                                                                                                                ¶1907



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                 PRACTICE POINTER: Instead of deducting education             EXAMPLE: A self-employed psychiatrist undertakes
                 expenses, a taxpayer may qualify for education tax           a program of study and training as a psychoanalyst
                 credits. The credit may produce a greater tax benefit        at a psychoanalytic institute. The course will enable
                 than the deduction (see ¶1105).                              him to qualify as a practicing psychoanalyst. His
                                                                              expenditures are deductible because his study and
                                                                              training maintain or improve skills required for his
              Whether or not the education is of the type that meets          profession and do not qualify him for a new trade
              the above requirements depends on the facts of each             or business.
              case. Thus, if it is customary for other individuals in
              the taxpayer’s trade, business, or profession to under-
                                                                            In the case of an employee, a change of duties does not
              take such education, the expenses would ordinarily be
                                                                            constitute a “new trade or business,” if the new duties
              deductible.
                                                                            involve the same general type of work the individual is
              In the case of expenditures for education required by the     presently doing.
              taxpayer’s employer, the expenses would be deductible
                                                                            An employee is eligible to exclude certain educational
              only if the requirement was imposed primarily for the
                                                                            assistance provided by an employer if it qualifies as a
              employer’s bona fide business purposes and the expenses
                                                                            working condition fringe benefit or if it is received under
              were not intended primarily for the taxpayer’s benefit.
                                                                            an educational assistance plan (see ¶611). An employee
                                                                            can exclude up to $5,250 of employer-provided educa-
                 EXAMPLE: Jones is required by his employer (or by          tional assistance.
                 state law) either to read a list of books, or to take
                 certain courses giving six hours of academic credit        The regulations give special tax consideration to teachers
                 every two years, in order to retain his position as a      by providing that all teaching and related duties should
                 teacher. Jones fulfills his requirements by taking the
                                                                            be considered as involving the same general type of work.
                 courses. Since his purpose in taking the courses is
                 to fulfill his employer’s educational requirements,
                                                                            Thus, the cost of training undertaken by an elementary
                 his expenses for such education and transporta-            school teacher to become a high school teacher, by a math
                 tion and meals and lodging while away from home            teacher to become a science teacher, or by a teacher to
                 are deductible.                                            qualify as a principal is deductible.
                                                                            Likewise, if the purpose of the education is to meet the
                                                                            minimum requirements of the taxpayer’s present em-
                 EXAMPLE: A tax practitioner annually takes a
                 brushup course to review new tax developments and
                                                                            ployer, such expenses are not deductible, even though
                 refresh his tax knowledge. His expenses are deduct-        the taxpayer is already employed in the field.
                 ible because the training is undertaken to maintain or
                 improve skills required in his trade or business. (The       EXAMPLE: To become a permanent teacher, a tax-
                 expenses are deductible, regardless of whether the           payer is required to have a bachelor’s degree. In the
                 individual is self-employed or employed, and even if         meantime, he obtains a provisional teacher’s certifi-
                 the training is not required by his employer.)               cate, renewable on condition that he go to college
                                                                              and show progress towards obtaining the degree.
              However, under no circumstances will a deduction for            Since his educational expenses are incurred primarily
              educational expenses be permitted if the education or           to meet the minimum requirements or qualifications
                                                                              as a permanent teacher, they are not deductible.
              training qualifies (or helps qualify) the taxpayer for a
              new trade or business.
                                                                            If the taxpayer has met the minimum requirements for
                                                                            obtaining a position but the employer subsequently
                 EXAMPLE: An individual employed as a patent attor-
                 ney is required by his employer to go to engineering
                                                                            increases the requirements and, thus, necessitates fur-
                 school and obtain a degree in engineering to improve       ther study on the part of the employee, the expenses
                 his skills as a patent attorney. The educational ex-       are deductible.
                 penses are not deductible because they qualify him
                 for a new trade or business (as an engineer), even
                 though he does not intend to go into this field.




    ¶1907



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                                                                                                       retention of his or her present employment, status,
                    EXAMPLE: Miss Jones is a seventh grade teacher.
                                                                                                       or compensation.
                    She has four years of college education, which is
                    the minimum required by the state in which she is                            For employees, new duties involving the same general
                    employed for her continuing certification to teach                           type of work they are now performing do not consti-
                    this grade. The state recently changed its require-                          tute a new occupation.
                    ments, and now seventh grade teachers must have
                    five years of college education. Miss Jones is entitled                      C.   Illustrations
                    to expenses incurred in obtaining the additional year
                    of college required by her employer.                                         1.   Teachers
                                                                                                      a. An elementary school teacher can deduct the cost
                 No deduction is allowed for costs of travel that would                               of advanced courses to qualify as a high school in-
                 be deductible only on the ground that the travel itself                              structor.
                 is a form of education. For example, when a teacher of
                 French travels to France to maintain a general familiar-                             b. A teacher of one subject, such as mathematics,
                 ity with the French language and culture, the travel is                              can deduct the cost of courses to qualify in another
                 not deductible.                                                                      subject, such as science.

                 For persons engaged in a trade or business, the allowable                            c. A teacher of classroom subjects can deduct the cost
                 education expenses are deducted from gross income,                                   of courses to qualify as a guidance counselor.
                 along with all other business expenses as adjustments                                d. A classroom teacher can deduct the cost of courses
                 to gross income. Education expenses of an employee                                   and training to become a principal.
                 are considered miscellaneous deductions subject to the
                 2%-of-adjusted-gross-income rule (see ¶910). However,                           2.   Accountants
                 if the taxpayer’s AGI is below a set limit, higher educa-                            a. A self-employed accountant who takes law classes
                 tion tuition and fees up to $4,000 are deductible as an                              at night and receives a law degree is considered to
                 above-the-line deduction whether or not job-related (see                             have qualified for a new trade or business. Therefore,
                 ¶912). Excess tuition and fees, plus transportation and                              the cost is not deductible.
                 other work-related education costs can then be claimed
                 as a miscellaneous itemized deduction if job-related.                                b. A licensed public accountant was recently denied a
                                                                                                      deduction for the cost of a CPA review course. Even
                                                                                                      though the added education helped improve his ac-
                    PRACTICE POINTER: A taxpayer may be eligible for
                                                                                                      counting skills, it also qualified him for a new business,
                    an education credit for higher education courses if
                    modified adjusted gross income is below set limits,
                                                                                                      that of a certified public accountant whose sphere of
                    which are more modest than the limits for the above-                              work allowed him to handle more matters than he was
                    the-line deduction for tuition and fees (see ¶1105).                              permitted to do before (Glenn, 62 TC 270).
                                                                                                 3.   Engineers
                 Summary.      Education expenses can be summed up as
                 follows:                                                                             An engineer who takes law classes at night and re-
                                                                                                      ceives a law degree may not deduct the cost.
                 A. No deduction is allowed for educational expenses
                 that:                                                                           4.   Doctors
                                                                                                      a. A general practitioner who takes courses in recent
                 1.   Are necessary to meet the minimum requirements
                      for qualification in the taxpayer’s occupation or                               developments in specialized fields of medicine may
                                                                                                      deduct the cost.
                 2.   Will enable the taxpayer to qualify for a new occupation.
                                                                                                      b. A psychiatrist is permitted to deduct the expenses
                 B. Expenses not disallowed by the foregoing tests are                                of study and training in psychoanalysis.
                 allowable if the education:
                                                                                                 D. Travel expenses away from home incurred primarily
                 1.   Maintains or improves skills required by the indi-                         to obtain education, the expenses of which are deduct-
                      vidual in his or her occupation or                                         ible, are deductible to the extent they are not related
                 2.   Is needed to meet the express requirements of the                          to personal activities.
                      individual’s employer, or of applicable law or regu-
                      lations imposed as a condition to the individual’s
                                                                                                                                                                                        ¶1907



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    246       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




              ¶1908 Recent Developments Affecting                            A reimbursement arrangement for employees’ tools
                    Other Business, Job-Related,                             based on national statistics rather than on actual costs
                    and Investments Expenses                                 is not an accountable plan; reimbursements under the
                                                                             arrangement are taxable to employees. (Rev. Rul. 2005-
              A salesperson can deduct the costs of obtaining an MBA
                                                                             52, IRB 2005-35, 423)
              where the degree was not a condition of employment
              and did not qualify him for a new trade or business.
              (Allemeir, TC Memo 2005-207)


              ¶1909 CHAPTER 19 STUDY QUESTIONS —
                    Other Business, Job-Related, and Investment Expenses


                  1.    Which expense may be deductible from gross
                        income?                                                For further information on a number of business
                        a. Unreimbursed employee business expenses             expenses, see: IRS Publication 508: Tax Benefits
                        b. Investment expenses                                 for Work-Related Education; IRS Publication 529:
                        c. Jury duty pay that must be given to an em-          Miscellaneous Deductions; IRS Publication 535:
                             ployer who continues an employee’s salary         Business Expenses; and IRS Publication 587: Busi-
                             while serving on a jury                           ness Use of Your Home.

                  2.    Which indirect expense related to a home office is     Answers to Study Questions, with feedback to both
                        not part of a home office deduction?                   the correct and incorrect resposese, are provided in
                        a. Mortgage interest                                   Chapter 35, beginning with ¶3519.
                        b. Landscaping
                        c. Real estate taxes

                  3.    Which taxpayer cannot deduct educational
                        costs?
                        a. A teacher who takes courses to become a
                             principal
                        b. An accountant who takes classes at night to
                             obtain a law degree
                        c. An engineer who takes classes toward a
                             master’s degree in engineering




    ¶1909



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                                                                                              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 increased to 15¢ per mile for the                        Moving expenses are reported on Form 3903, “Moving
                       first eight months of 2005 and 22¢ per mile for the                       Expenses,” which is attached to the return. The deduct-
                       remainder of the year. See ¶2002.                                         ible 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:



                 Adjusted
                 Gross
                              1 0  23
                                   24
                                         Educator expenses (see page 29)
                                         Certain business expenses of reservists, performing artists, and
                                                                                                            23


                                         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 30)             29
                                   30    Penalty on early withdrawal of savings                             30
                                   31a   Alimony paid   b Recipient’s SSN                                   31a
                                   32    IRA deduction (see page 31)                                        32
                                   33    Student loan interest deduction (see page 33)                      33
                                   34    Tuition and fees deduction (see page 34)                           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 78.                      Cat. No. 11320B        Form   1040   (2005)




                                                                                                                                                              ¶2001



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    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




                                                                                                                                 OMB No. 1545-0062
               Form    3903                                                 Moving Expenses
                                                                              Attach to Form 1040.                                 2005
               Department of the Treasury                                                                                         Attachment
               Internal Revenue Service                                                                                           Sequence No.   62
               Name(s) shown on Form 1040                                                                                 Your social security number




                                f
               Before you begin:                 See the Distance Test and Time Test in the instructions to find out if you can deduct your moving
                                                 expenses.



                              o                  See Members of the Armed Forces on the back of the form, if applicable.




                            as 05
                 1    Transportation and storage of household goods and personal effects (see instructions)               1
                 2    Travel (including lodging) from your old home to your new home (see instructions). Do not include
                                                                                                                          2




                          ft 20
                      the cost of meals

                 3    Add lines 1 and 2                                                                                   3


                 4




                 5
                       ra 3/
                      Enter the total amount your employer paid you for the expenses listed on lines 1 and 2 that is




                      D /0
                      n o t 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?
                                                                                                                          4




                       0 5   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.

                             Yes. Moving expense deduction. Subtract line 4 from line 3. Enter the result here and on
                                  Form 1040, line 26                                                                      5




    ¶2001



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                                                                                                                      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                  249




                    Form     8822
                    (Rev. December 2005)
                                                                                        Change of Address
                                                                                                  Please type or print.                                                            OMB No. 1545-1163

                    Department of the Treasury
                    Internal Revenue Service                    See instructions on back.                    Do not attach this form to your return.
                     Part I            Complete This Part To Change Your Home Mailing Address
                    Check all boxes this change affects:
                     1


                                    f
                          Individual income tax returns (Forms 1040, 1040A, 1040EZ, 1040NR, etc.)




                                  o
                              If your last return was a joint return and you are now establishing a residence separate
                             from the spouse with whom you filed that return, check here

                     2

                                 s 5
                               Gift, estate, or generation-skipping transfer tax returns (Forms 706, 709, etc.)



                                a 0
                                  For Forms 706 and 706-NA, enter the decedent’s name and social security number below.




                              ft 20
                                   Decedent’s name                                                                         Social security number
                      3a     Your name (first name, initial, and last name)                                                                     3b                 Your social security number




                      4a



                      5
                            ra 0/
                             Spouse’s name (first name, initial, and last name)




                           D /3
                             Prior name(s). See instructions.
                                                                                                                                                             4b    Spouse’s social security number




                      6a



                      6b
                            09
                             Old address (no., street, city or town, state, and ZIP code). If a P.O. box or foreign address, see instructions.




                             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.




                                                                                                                                                                                               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. 12-2005)


                                                                                                                                                                                                              ¶2001



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              ¶2002 Eligible Expenses                                       the moving expense deduction will generally be denied,
                                                                            even if the 50-mile distance requirement is met. There
              Only certain types of expenses qualify for deduction.
                                                                            are two exceptions. The moving expense deduction will
              These include the reasonable cost of moving household
                                                                            not be denied if the taxpayer must reside at the new
              goods and personal effects from the former residence to
                                                                            residence as a condition of employment. Nor will it be
              the new residence. This includes the costs of packing,
                                                                            denied if the taxpayer’s residency results in an actual
              crating, and in-transit storage.
                                                                            decrease in commuting time or expense.
              Also deductible is the cost of traveling from the former
                                                                            Special rules apply to moves abroad that are covered in
              residence to the new residence. This means the cost of
                                                                            IRS Publication 521, “Moving Expenses.”
              transportation and lodging en route. However, the cost
              of meals in transit is not deductible.                        ¶2004 Time Requirements
              If taxpayers use their cars for moving their families and     To be eligible for the moving expense deduction, the
              household effects, they may use a flat mileage rate of        taxpayer (if an employee) must work in the new location
              15/22¢ per mile instead of computing actual car ex-           (but not necessarily for the same employer) on a full-
              penses. Parking fees and tolls are deductible in addition     time basis for at least 39 weeks in the 12-month period
              to the flat mileage rate.                                     following the moving date.
              Expenses related to someone other than the taxpayer           This provision is obviously designed to prevent the deduc-
              are deductible only if that other person has both the         tion of moving expenses by an individual who continu-
              same old residence and same new residence as the              ously moves from one location to another or who wants to
              taxpayer. Thus, the cost of moving the toys and cloth-        move to another city and temporarily goes to work there
              ing of the taxpayer’s child who lives with the taxpayer       in order to deduct his or her moving expenses.
              would be deductible.
                                                                            The “full-time” work requirement bars a moving
              ¶2003 What Move Qualifies for Deduction-                      expense deduction for semiretired persons, part-time
                    Mileage Limitations: Mileage Test                       students, or those who work only a few hours each week.
                                                                            In the case of self-employed individuals, the definition
              To qualify for the moving expense deduction, the new
                                                                            of “full-time” depends upon the customary practice of
              place of work or business must be at least 50 miles farther
                                                                            the taxpayer’s occupation.
              from the old residence than was the taxpayer’s previous
              job or business location. If the taxpayer had no previous     ¶2005 Self-Employed Persons
              job or business, the taxpayer will be permitted a deduc-
              tion if the new job or business is at least 50 miles from     If self-employed, taxpayers must perform full-time
              his or her previous residence.                                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: The distance from a taxpayer’s old
                 residence to his old job is 10 miles and from his old      ¶2006 Waiver Rules
                 residence to his new job is 65 miles. He qualifies for
                 the deduction because the new job is at least 50           Obviously there will be occasions when a taxpayer cannot,
                 miles farther from his old home than the old job.          for reasons beyond his or her control, fulfill the 39-week
                                                                            or 78-week work requirement. To provide for these even-
                                                                            tualities, the 39-week or 78-week test will be automatically
                 EXAMPLE: Assume that the distance from the old             waived if the taxpayer cannot fulfill it because of death or
                 residence to the old job is 10 miles and from the old      disability, loss of his or her job (if not for willful miscon-
                 residence to the new job is 55 miles. Here he does         duct), or retransfer by the employer for the employer’s ben-
                 not qualify for the deduction because the new job
                                                                            efit (provided that the employee had reasonably expected
                 is only 45 miles farther from his old residence than
                 the old job.
                                                                            to remain at his or her job for the required period).
                                                                            ¶2007 When to Claim the Deduction
              The law does not contain any specific requirements as
              to the location of the new residence. The IRS, however,       The moving expense deduction must be claimed for the
              takes the position that, if the new residence is farther      year in which it was paid or incurred. If the 39-week or
              from the new place of work than the old residence was,        78-week requirement has not been met by the time the


    ¶2002



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                                                                                  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   251




                 return is due but a sufficient portion of the 12-month or    Similarly, if the taxpayer claims a moving expense
                 24-month period remains so that it is possible to satisfy    deduction for one year, and discovers in a later year
                 the applicable requirement, the taxpayer may nevertheless    that he or she cannot meet the 39- or 78-week require-
                 take the moving expense deduction on his or her return. If   ment, the taxpayer can file an amended return for
                 it turns out later that the taxpayer does not meet the ap-   the year in which the deduction was claimed in order
                 plicable requirement (and the automatic waiver provisions    to eliminate that deduction. If the taxpayer files an
                 do not apply), he or she will have to report the amount      amended return, he or she is not required to include
                 deducted on the return for the taxable year in which he      the amount originally deducted in his or her return
                 or she is no longer able to satisfy the requirement.         for the later year.
                                                                              ¶2008 Employer Reimbursements
                    EXAMPLE: Mr. Smith moves to his new place of em-
                    ployment on November 5, 2005, and begins working          Moving expenses which are paid for or reimbursed by an
                    November 8. His allowable moving expenses come to         employer can be treated as a nontaxable fringe benefit if
                    $500. Although he cannot meet the 39-week require-        the expenses would have been deductible had they been
                    ment until August 2006, he may deduct his moving
                                                                              paid by the employee. Moving expenses that are treated
                    expenses on his 2005 return.
                                                                              as a fringe benefit are not includible in the employee’s
                                                                              gross income. They are not reported on the employee’s
                                                                              Form W-2.
                    EXAMPLE: Assume that Mr. Smith quits his job in
                    July 2006 and has no other employment during the          Moving expenses that do not qualify as a fringe benefit
                    rest of the year. He must report the $500 he deducted     are includible in gross income. This would include an
                    in 2005 as income on his 2006 income tax return.
                                                                              employer’s payment or reimbursement of expenses de-
                                                                              ducted by an employee in a prior year.
                 If the taxpayer prefers, he or she may instead file a re-
                 turn without the moving expense deduction and then           A move paid for by the armed services is tax free.
                 file an amended return on which these expenses are
                                                                              ¶2009 Recent Developments
                 deducted after the taxpayer has satisfied the 39-week
                                                                                    Affecting Moving Expenses
                 or 78-week requirement.
                                                                              Refuges from the former Yugoslavia to the U.S. could not
                    EXAMPLE: Assume that Mr. Smith chose to file his          deduct moving expenses because they were unsubstanti-
                    2005 return without claiming the moving expense           ated. (Bajramovic, TC Memo 2004-96)
                    deduction. During or after August 2006, when he has
                    met the 39-week requirement, he can file an amended
                    return for 2005, taking the deduction for his moving
                    expenses. He will then receive a refund for the dif-
                    ference between the tax as originally computed and
                    as computed on the amended return.




                                                                                                                                                           ¶2009



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              ¶2010          CHAPTER 20 STUDY QUESTIONS — Moving Expense Deduction

                  1.    All of the following are deductible expenses for pur-   3.   In order to satisfy the mileage test for the mov-
                        poses of the moving expense deduction except:                ing expense deduction, the new place of work or
                        a. The cost of lodging for the family during the             business must be at least how many miles farther
                             move                                                    from the old residence than was the previous job
                        b. Meals that the family eats during the move                or business?
                        c. The cost of packing and crating household                 a. 10 miles
                             goods                                                   b. 35 miles
                                                                                     c. 50 miles
                  2.    The standard mileage rate for use of a car during
                        a deductible move in 2005 is:
                        a. 14¢ per mile                                         For further information on moving expenses, see:
                        b. 15/22¢ per mile                                      IRS Publication 521: Moving Expenses.
                        c. 40.5¢ per mile
                                                                                Answers to Study Questions, with feedback to both
                                                                                the correct and incorrect resposese, are provided in
                                                                                Chapter 35, beginning with ¶3520.




    ¶2010



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                                                                                                                         21
                 PART 3 — DEDUCTIONS FOR BUSINESS AND OTHER SPECIAL DEDUCTION RULES


                 Depreciation

                 LEARNING OBJECTIVES
                                                                                 EXAMPLE: A taxpayer owns a two-family house; he
                 This chapter was prepared to enable participants to gain        resides in one apartment and rents the other. Depre-
                 an understanding of the rules on depreciation. More             ciation is allowed on the portion rented, usually on
                                                                                 the basis of the number of rooms.
                 specifically, upon completion, you will be able to:
                   Understand what property is depreciable.
                   Figure first-year expensing.
                   Report depreciation recapture.                                NOTE: Certain property used only partly for busi-
                                                                                 ness will be affected by the “mixed-use” rule. This
                                                                                 involves passenger cars and other so-called listed
                 NEW THIS YEAR
                                                                                 property (see ¶2106).

                       First-year expensing. The dollar limit increased to
                                                                               There are various methods to use in claiming deprecia-
                       $105,000 and the phaseout starting point doubled
                       to $420,000. See ¶2107.
                                                                               tion. The appropriate method depends on the type of
                                                                               asset involved (e.g., machinery or real estate) and the
                       Luxury cars and trucks. New dollar limits apply
                       to depreciation claimed on luxury cars and trucks
                                                                               time the asset is first used in the business or income-
                       placed in service in 2005. See ¶2106.                   producing activity. This time is referred to as the date
                                                                               the asset is “placed in service.” It is not the date on
                                                                               which the asset was purchased, but rather the date it
                 ¶2101 Introduction (Secs. 167 and 168)                        was put to use.
                 Taxpayers who acquire machinery, equipment, trucks,
                 office furniture, buildings, or other property used in a        PITFALL: Bonus depreciation, which was an addi-
                 trade, business, or other income-producing activity can         tional 50% first-year allowance, cannot be claimed
                                                                                 in 2005; the opportunity to claim bonus depreciation
                 recover the cost over a period of time by means of tax          expired at the end of 2004.
                 deductions (depreciation).
                 Depreciation is viewed as a deduction for the wear            MACRS.    Assets placed in service in 2005 generally
                 and tear on property. Thus, antiques generally are not        are depreciated under the Modified Accelerated Cost
                 depreciable (although two musicians convinced courts          Recovery System (MACRS). This method applies to
                 that their antique instruments were depreciable because       property placed in service after December 31, 1986,
                 they were subject to wear and tear—Simon, CA-2, 95-2          and to property placed in service after July 31, 1986,
                 USTC ¶50,552; Liddle, CA-3, 95-2 USTC ¶50,488). Land,         for which an election was made to have MACRS apply
                 which is not used up, is generally not depreciable.           (see ¶2104).
                 To be eligible for a depreciation deduction, the property     ACRS. The Accelerated Cost Recovery System (ACRS)
                 must be used in the taxpayer’s trade or business or be held   generally applies to property placed in service after 1980
                 for the production of income. No depreciation may be tak-     and before 1987.
                 en on a taxpayer’s private residence, pleasure automobile,
                 home furnishings, etc. Also, no depreciation allowance may    Old methods.    Property placed in service before 1981
                 be taken on property held primarily for sale to customers,    that has not yet been fully depreciated continues to be
                 such as stock in trade and merchandise inventory.             depreciated under the old rules in effect before ACRS.
                                                                               This usually means under the “Asset Depreciation
                 If property is used for both business and personal pur-       Range” (ADR) system or as determined by the facts and
                 poses, only that part of the depreciation allocable to        circumstances pertaining to each asset.
                 business use may be deducted.

                                                                                                                                         ¶2101



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              Reporting. Depreciation is claimed on Form 4562, “De-           can use Part IV of Schedule C to figure depreciation on
              preciation and Amortization.” However, the form need            a business car or truck if they are not otherwise required
              not be filed if no new property is placed in service in 2005;   to file Form 4562. Employees claiming depreciation on
              simply figure the depreciation and enter the amount in          cars must complete Form 2106, “Employee Business
              the appropriate form or schedule. Self-employed persons         Expenses,” which appears at ¶1810.




    ¶2101



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                                                                                                                                        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       255



                                                                                                                                                                 OMB No. 1545-0172
                                                                        Depreciation and Amortization
                  Form   4562                                     (Including Information on Listed Property)                                                         2005
                  Department of the Treasury
                  Internal Revenue Service
                  Name(s) shown on return


                                                                                      o f
                                                                See separate instructions.                 Attach to your tax return.
                                                                                          Business or activity to which this form relates
                                                                                                                                                                  Attachment
                                                                                                                                                                  Sequence No.
                                                                                                                                                               Identifying number
                                                                                                                                                                                 67


                   Part I

                                                                                     s 5
                                   Election To Expense Certain Property Under Section 179



                                                                                    a 0
                                   Note: If you have any listed property, complete Part V before you complete Part I.
                                                                                                                                                                     $105,000



                                                                                  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                                                            3          $420,000




                                                                               ra 3/
                   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 /0
                                                                                                                                                          5
                                                (a) Description of property                        (b) Cost (business use only)        (c) Elected cost

                   6




                                                                                 1
                   7 Listed property. Enter the amount from line 29                                          7
                                                                                                                                         8



                                                                               1
                   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 2004 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 2006. 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 allowance for certain aircraft, certain property with a long production period, and qualified
                         New York Liberty Zone property (other than listed property) placed in service during the tax year                                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 2005               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 2005 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 2005 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   (2005)



                                                                                                                                                                                                 ¶2101



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    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




              Form 4562 (2005)                                                                                                      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 5
              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 allowance for certain aircraft, certain property with a long production period, and qualified New York Liberty Zone




                                                                          ra 3/
                    property placed in service during the tax 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 /0
                                                                        %
                                                                        %
                                                                        %
              27    Property used 50% or less in a qualified business use:



                                                                            1
                                                                        %                                                               S/L –
                                                                        %                                                               S/L –

              28
              29
                                                                        %

                                                                          1
                    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
              Complete this section for vehicles used by a sole proprietor, partner, or other “more than 5% owner,” or related person.
                                                                                                                                        S/L –
                                                                                                                                                28
                                                                                                                                                           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 2005 tax year (see instructions):



              43    Amortization of costs that began before your 2005 tax year                                                                       43
              44    Total. Add amounts in column (f). See the instructions for where to report                                                       44
                                                                                                                                                                 Form   4562      (2005)



    ¶2101



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                                                                                                       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   257




                 ¶2102 Failure to Take Depreciation (Sec. 1016)
                                                                                      EXAMPLE: Assume that Mr. Grey, in the above
                 Taxpayers should claim the proper amount of the de-                  example, had invested only $8,500 in his property,
                 preciation deduction for each year. This includes the                the balance being secured by a mortgage. He is
                 bonus depreciation allowance unless the taxpayer elects              still entitled to a depreciation deduction on the
                 not to deduct it.                                                    entire $262,500.


                    PITFALL: If the taxpayers fail to deduct a reasonable           DEPRECIATION UNDER MODIFIED
                    amount in one year, generally they may not deduct the           ACCELERATED COST RECOVERY
                    unclaimed depreciation in a later year (except through
                                                                                    SYSTEM (MACRS)
                    an amended return). Still, the unclaimed depreciation
                    reduces the basis of the property for purposes of               ¶2104 In General
                    determining gain or loss on a disposition.
                                                                                    Under MACRS, the new classes of property are three-,
                                                                                    five-, seven-, 10-, 15-, and 20-year property. Different
                    PRACTICE POINTER: The IRS has a simplified pro-                 classes apply to Indian reservation property (see next
                    cedure for obtaining automatic consent to change                page). In addition, most real property is classified as
                    accounting method to claim underdepreciation when               residential rental or nonresidential real property (see
                    the taxpayer still owns the property. No user fee is            ¶2109 for depreciating real property).
                    required (see Rev. Proc. 2002-9).

                                                                                      PRACTICE POINTER: MACRS is not used for certain
                 ¶2103 Basis for Determining Depreciation                             property. For example, the income forecast method
                       (Secs. 167 and 168)                                            is used for film, video tape, sound recordings, copy-
                                                                                      rights, books, patents, and other similar property.
                 Generally, the basis for depreciation is the same as that used       However, the income forecast method cannot be
                 for determining gain if the property is sold. For this pur-          used for consumer durables subject to rent-to-own
                 pose, the basis is usually its cost increased by improvements        contracts placed in service after August 5, 1997.
                 and decreased by any depreciation previously deducted (see           Rent-to-own property placed in service after this
                 chapter 15). Under MACRS, the property’s unrecovered ba-             date is three-year property.
                 sis is used (that is, generally the cost or other basis adjusted
                 for depreciation previously allowed or allowable and for all       The class to which property is assigned is determined
                 other applicable adjustments). Under the Accelerated Cost          by its class life. The class life of an item of property
                 Recovery System, the unadjusted basis is used.                     determines its recovery period, the method of deprecia-
                                                                                    tion used, and the applicable convention. (Declining
                 If a nonbusiness asset is converted to business use, de-           balance, straight-line, and other depreciation methods
                 preciation is allowable from the date of its conversion,           are defined at ¶2111.)
                 and its basis is the lower of the fair market value or the
                 adjusted basis.                                                    The class life of an item of property is the asset guideline
                                                                                    period which would apply to the property on January
                    EXAMPLE: In 1996, John Grey purchased as his                    1, 1986, if an election had been made to use the asset
                    residence a one-family home for $271,000, of which              depreciation range (ADR) system prior to 1986.
                    $10,000 represented the cost of the land. In 1997,
                    he finished his basement at a cost of $1,500. On July           Under MACRS, property other than residential rental
                    1, 2005, he vacated the house and rented it. The fair           or nonresidential real property that the taxpayer places
                    market value of the house in July 2005 was $265,000             in service after 1986 (or after July 31, 1986, if elected),
                    (excluding the land). Mr. Grey’s basis for computing            will fall into one of the following classes:
                    depreciation is $262,500, the adjusted basis at the
                    time of the conversion, since it is less than fair market         Three-year property.     This class includes property
                    value. Land does not depreciate for tax purposes.                 with a class life of four years or less, such as tractor
                                                                                      units for use over the road, breeding hogs, and, as
                 Remember that depreciation is computed on the full                   designated, any race horse that is over two years old
                 cost or other basis of the property (other than land),               when placed in service and any other horse that is
                 even if the property is mortgaged or subject to other                over 12 years old when placed in service. This class
                 indebtedness.                                                        also includes rent-to-own property placed in service


                                                                                                                                                            ¶2104



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                 after August 5, 1997. Computer software generally                      For property in the three-, five-, seven-, or 10-year
                 is three-year property unless it has a shorter life (e.g.,             class, the 200% declining balance method over three,
                 it is the type that is replaced each year).                            five, seven, or 10 years and a half-year convention
                 Five-year property. This class includes property with                  is used. For property in the 15- or 20-year class, the
                 a class life of more than four years but less than 10                  150% declining balance method over 15 or 20 years
                 years, such as breeding sheep and goats; breeding and                  and a half-year convention is used. The applicable
                 dairy cattle; heavy, general-purpose trucks, computers                 depreciation rate (in percentage terms) is determined
                 and peripheral equipment; office machinery; and, as                    by dividing the specified declining balance percentage
                 designated, any auto or light, general-purpose truck.                  (150% or 200%) by the applicable recovery period.
                 Leasehold improvements to property used by a busi-                     This applicable depreciation rate is constant for each
                 ness in the New York Liberty Zone are also treated                     tax year in which the declining balance method is used
                 as five-year property.                                                 and is applied to the property’s unrecovered basis (that
                                                                                        is, generally, the cost or other basis adjusted for depre-
                 NOTE: There is a dollar limit on the depreciation                      ciation previously allowed or allowable and for all other
                 deduction for an auto (see ¶2106).                                     applicable adjustments).

                 Seven-year property.      This class includes property                   NOTE: The 200% declining balance method applied
                 with a class life of 10 years or more but less than 16                   to property with a five-year recovery period results
                 years, such as farm machinery and equipment, office                      in an applicable depreciation rate of 40% (200 ÷ 5)
                                                                                          in each full tax year. The 150% declining balance
                 furniture and fixtures, breeding and work horses 12                      method applied to property with a seven-year recov-
                 years old or less when placed in service and, as desig-                  ery period results in a depreciation rate of 21.43%
                 nated, any single-purpose agricultural or horticultural                  (150 ÷ 7) in each full tax year.
                 structure. This class also includes any property which
                 does not have a class life and which has not been                      The tables automatically change to the straight-line
                 designated by law as being in any other class.                         method for the first tax year in which use of this method
                 Ten-year property. This class includes property with a
                                                                                        yields an allowance equal to or greater than the allowance
                 class life of 16 years or more but less than 20 years.                 yielded by using the declining balance method. Also, the
                 Fifteen-year property. This class includes property
                                                                                        taxpayer must use the straight-line method for nonresi-
                 with a class life of 20 years or more but less than 25                 dential real property, residential rental property, and any
                 years.                                                                 other class of property for which the taxpayer elects to
                 Twenty-year property. This class includes property
                                                                                        use it. For all classes, salvage value is treated as zero.
                 with a class life of 16 years or more, such as farm
                 buildings.                                                             Half-year convention. Under MACRS, the half-year
                 Indian reservation property. Property placed in                        convention treats all property placed in service, or
                 service after 1993 used predominantly in the active                    disposed of, during a tax year as placed in service, or
                 conduct of a trade or business on an Indian reserva-                   disposed of, on the midpoint of that tax year. Thus, as
                 tion (for other than gaming purposes) has special                      a practical matter, five-year property will be depreci-
                 recovery periods:                                                      ated over a period of six years. The following example
                                                                                        is based on depreciation rates found in Table 1 on the
                Property Class                                        Recovery Period
                                                                                        following page.
                3-year property                                              2 years
                5-year property                                              3 years
                                                                                          EXAMPLE: On February 1, 2005, Green placed in
                7-year property                                              4 years
                                                                                          service five-year property costing $10,000. His al-
                10-year property                                             6 years      lowances are as follows:
                15-year property                                             9 years        2005   ..............   $2,000 (20% of $10,000)
                20-year property                                            12 years        2006   ..............   $3,200 (32% of $10,000)
                                                                                            2007   ..............   $1,920 (19.2% of $10,000)
                                                                                            2008   ..............   $1,152 (11.52% of $10,000)
                 NOTE: Motion picture films and videotapes cannot be                        2009   ..............   $1,152 (11.52% of $10,000)
                 depreciated using MACRS. Their costs must be recov-                        2010   ..............   $576 (5.76% of $10,000)
                 ered on the straight-line or income forecast method.




    ¶2104



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                                                                                                                                               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             259




                 Optional tables. Optional tables can be used by certain                                        is used instead of a half-year convention. In determining
                 taxpayers in computing annual depreciation allowances.                                         the aggregate bases of MACRS property, the following
                 These tables specify schedules of annual depreciation                                          property is not taken into account:
                 rates to be applied to the property’s unadjusted basis in
                 each tax year. If a taxpayer uses a table to compute the                                           Residential rental or nonresidential property
                 annual allowance for any item of property, the taxpayer                                            Property depreciated under another method pursuant
                 must use the table to compute the annual deprecia-                                                 to an election (e.g., unit of production method or
                 tion allowances for the entire recovery period of such                                             other method not expressed in a term of years other
                 property. However, a taxpayer may not continue to use                                              than the retirement-replacement-betterment method
                 the table if there are any adjustments to the property’s                                           or similar method)
                 basis for reasons other than (1) depreciation allowed or                                           Public utility property
                 allowable or (2) an addition or an improvement to such                                             Films and videotapes
                 property that is subject to depreciation as a separate                                             Sound recordings
                 item of property. Taxpayers use the appropriate table                                              Property placed in service for the purpose of secur-
                 for any property based on the depreciation system, the                                             ing accelerated depreciation (i.e., property placed in
                 applicable depreciation method, the applicable recovery                                            service in churning transactions)
                 period, and the applicable convention. The tables list                                             Short-term property (property placed in service and
                 the percentage depreciation rates to be applied to the                                             disposed of within the same year)
                 property’s unadjusted basis in each tax year (Rev. Proc.                                       In a mid-quarter convention, all property placed in
                 87-57, 1987-2 CB 117).                                                                         service, or disposed of, during any quarter of a tax year
                 Table 1: General Depreciation System
                                                                                                                is treated as placed in service, or disposed of, at the
                                                                                                                quarter’s midpoint.
                 Applicable Depreciation Method: 200 or 150 Percent
                 Declining Balance Switching to Straight-Line                                                   Property placed in service and disposed of within the same
                 Applicable Recovery Periods: 3, 5, 7, 10, 15, 20 years
                                                                                                                tax year is disregarded in making the 40% determination.
                 Applicable Convention: Half-year
                                                                                                                Table 2: General Depreciation System
                 If the
                 Recovery                                                                                       Applicable Depreciation Method: 200 or 150 Percent
                 Year is:          and the Recovery Period is:
                                                                                                                Declining Balance Switching to Straight-Line
                                   3-year 5-year 7-year 10-year 15-year 20-year
                                                                                                                Applicable Recovery Periods: 3, 5, 7, 10, 15, 20 years
                                   the Depreciation Rate is:
                                                                                                                Applicable Convention: Mid-quarter
                 1 . . . . . . . 33.33             20.00 14.29 10.00                            5.00    3.750   (property placed in service in first quarter)
                 2 . . . . . . . 44.45             32.00 24.49 18.00                            9.50    7.219
                 3 . . . . . . . 14.81             19.20 17.49 14.40                            8.55    6.677
                                                                                                                If the
                 4.......             7.41         11.52 12.49 11.52                            7.70    6.177   Recovery
                 5..............                   11.52           8.93          9.22           6.93    5.713   Year is:          and the Recovery Period is:
                 6..............                     5.76          8.92          7.37           6.23    5.285                     3-year 5-year    7-year 10-year 15-year 20-year
                 7.....................                            8.93          6.55           5.90    4.888                     the Depreciation Rate is:
                 8.....................                            4.46          6.55           5.90    4.522
                 9............................                                   6.56           5.91    4.462   1.......           58.33 35.00                  25.00          17.50             8.75   6.563
                 10 . . . . . . . . . . . . . . . . . . . . . . . . . . .        6.55           5.90    4.461   2.......           27.78 26.00                  21.43          16.50             9.13   7.000
                 11 . . . . . . . . . . . . . . . . . . . . . . . . . . .        3.28           5.91    4.462   3.......           12.35 15.60                  15.31          13.20             8.21   6.482
                 12 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .         5.90    4.461   4.......             1.54 11.01                 10.93          10.56             7.39   5.996
                 13 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .         5.91    4.462   5..............                  11.01            8.75           8.45            6.65   5.546
                 14 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .         5.90    4.461   6..............                    1.38           8.74           6.76            5.99   5.130
                 15 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .         5.91    4.462   7.....................                            8.75           6.55            5.90   4.746
                 16 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .         2.95    4.461   8.....................                            1.09           6.55            5.91   4.459
                 17 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   4.462   9............................                                    6.56            5.90   4.459
                 18 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   4.461   10 . . . . . . . . . . . . . . . . . . . . . . . . . . .         6.55            5.91   4.459
                 19 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   4.462   11 . . . . . . . . . . . . . . . . . . . . . . . . . . .         0.82            5.90   4.459
                 20 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   4.461   12 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .           5.91   4.460
                 21 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   2.231   13 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .           5.90   4.459
                                                                                                                14 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .           5.91   4.460
                                                                                                                15 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .           5.90   4.459
                 Mid-quarter convention. If, during any tax year, the                                           16 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .           0.74   4.460
                 aggregate bases of MACRS property which is placed                                              17 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .    4.459
                                                                                                                18 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .    4.460
                 in service during the last three months of that tax year                                       19 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .    4.459
                 exceed 40% of the aggregate bases of all property placed                                       20 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .    4.460
                 in service during that tax year, a mid-quarter convention                                      21 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .    0.557



                                                                                                                                                                                                                ¶2104



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              Table 3: General Depreciation System                                                             Table 5: General Depreciation System
              Applicable Depreciation Method: 200 or 150 Percent                                               Applicable Depreciation Method: 200 or 150 Percent
              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 second quarter)                                                   (property placed in service in fourth quarter)

              If the                                                                                           If the
              Recovery                                                                                         Recovery
              Year is:           and the Recovery Period is:                                                   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.......            41.67 25.00 17.85                         12.50            6.25     4.688    1.......              8.33          5.00          3.57           2.50           1.25   0.938
              2.......            38.89 30.00 23.47                         17.50            9.38     7.148    2.......            61.11 38.00 27.55                          19.50            9.88   7.430
              3.......            14.14 18.00 16.76                         14.00            8.44     6.612    3.......            20.37 22.80 19.68                          15.60            8.89   6.872
              4.......              5.30 11.37 11.97                        11.20            7.59     6.116    4.......            10.19 13.68 14.06                          12.48            8.00   6.357
              5..............                   11.37           8.87          8.96           6.83     5.658    5..............                   10.94 10.04                    9.98           7.20   5.880
              6..............                     4.26          8.87          7.17           6.15     5.233    6..............                     9.58          8.73           7.99           6.48   5.439
              7.....................                            8.87          6.55           5.91     4.841    7.....................                            8.73           6.55           5.90   5.031
              8.....................                            3.33          6.55           5.90     4.478    8.....................                            7.64           6.55           5.90   4.654
              9............................                                   6.56           5.91     4.463    9............................                                    6.56           5.90   4.458
              10 . . . . . . . . . . . . . . . . . . . . . . . . . . .        6.55           5.90     4.463    10 . . . . . . . . . . . . . . . . . . . . . . . . . . .         6.55           5.91   4.458
              11 . . . . . . . . . . . . . . . . . . . . . . . . . . .        2.46           5.91     4.463    11 . . . . . . . . . . . . . . . . . . . . . . . . . . .         5.74           5.90   4.458
              12 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .         5.90     4.463    12 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .          5.91   4.458
              13 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .         5.91     4.463    13 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .          5.90   4.458
              14 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .         5.90     4.463    14 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .          5.91   4.458
              15 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .         5.91     4.462    15 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .          5.90   4.458
              16 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .         2.21     4.463    16 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .          5.17   4.458
              17 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .    4.462    17 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   4.458
              18 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .    4.463    18 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   4.459
              19 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .    4.462    19 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   4.458
              20 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .    4.463    20 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   4.459
              21 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .    1.673    21 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   3.901

                                                                                                               Real property. Nonresidential real property includes
              Table 4: General Depreciation System
                                                                                                               any real property which is not residential rental prop-
              Applicable Depreciation Method: 200 or 150 Percent
              Declining Balance Switching to Straight-Line                                                     erty and property with a class life of 27.5 years or more.
              Applicable Recovery Periods: 3, 5, 7, 10, 15, 20 years                                           This includes factories, storefronts, office buildings and
              Applicable Convention: Mid-quarter                                                               a home office in a taxpayer’s residence. This property is
              (property placed in service in third quarter)
                                                                                                               depreciated over 39 years using the straight-line method
              If the                                                                                           and a mid-month convention (31.5 years for property
              Recovery
              Year is:          and the Recovery Period is:                                                    placed in service before May 13, 1993). Nonresidential
                                3-year 5-year 7-year 10-year 15-year                                 20-year   real property placed in service after 1993 and used
                                the Depreciation Rate is:                                                      predominantly in the active conduct of a trade or busi-
              1 . . . . . . . 25.00 15.00 10.71                               7.50           3.75     2.813    ness on an Indian reservation (for other than gaming
              2 . . . . . . . 50.00 34.00 25.51                             18.50            9.63     7.289
              3 . . . . . . . 16.67 20.40 18.22                             14.80            8.66     6.742
                                                                                                               purposes) has a 22-year recovery period.
              4.......              8.33 12.24 13.02                        11.84            7.80     6.237
              5 . . . . . . . . . . . . . . 11.30               9.30          9.47           7.02     5.769    For improvements to leaseholds and restaurant property
              6..............                    7.06           8.85          7.58           6.31     5.336    before 2006, costs can be deducted ratably over 15 years
              7.....................                            8.86          6.55           5.90     4.936    (rather than depreciated over 39 years) (see ¶2202).
              8.....................                            5.53          6.55           5.90     4.566
              9............................                                   6.56           5.91     4.460
              10 . . . . . . . . . . . . . . . . . . . . . . . . . . .        6.55           5.90     4.460
                                                                                                                   LOOKING AHEAD: Starting in 2006, certain energy
              11 . . . . . . . . . . . . . . . . . . . . . . . . . . .        4.10           5.91     4.460
              12 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .         5.90     4.460        improvements to commercial realty can be deducted
              13 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .         5.91     4.461        at the rate of $1.80 per square foot, rather than de-
              14 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .         5.90     4.460        preciated as a capital improvement to the building.
              15 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .         5.91     4.461
              16 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .         3.69     4.460
              17 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .    4.461    Residential rental property is a rental building or struc-
              18 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .    4.460    ture for which 80% or more of the gross rental income
              19 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .    4.461
              20 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .    4.460    for the tax year is rental income from dwelling units.
              21 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .    2.788


    ¶2104



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                                                                                                                   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    261




                 This property is depreciated over 27.5 years using the
                                                                                                  PRACTICE POINTER: Property acquired in a like-kind
                 straight-line method and mid-month convention.
                                                                                                  exchange can be depreciated over the remaining
                                                                                                  recovery period of the old property. For example, if
                    PRACTICE POINTER: Building components-spe-                                    there were 12 years remaining on the recovery period
                    cial wiring-can be depreciated separately from the                            of the old building, the newly acquired building can
                    building itself over their shorter recovery period. For                       be depreciated over those 12 years.
                    example, the IRS had allowed separate depreciation
                    of special flooring installed over wiring. However, the
                    IRS has revised its opinion and may require compo-
                                                                                               Mid-month convention.       Under a mid-month conven-
                    nents to be depreciated as part of the building (i.e.,                     tion, all property placed in service, or disposed of, during
                    over the building’s recovery period).                                      any month is treated as placed in service, or disposed of,
                                                                                               on the midpoint of that month.


                 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



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    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




               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

              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




    ¶2104



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                                                                                                     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




                 ¶2105 Alternative Depreciation System                          business use of a car is 80% and the deduction other-
                                                                                wise allowable for such car is $1,000, the deduction is
                 Instead of claiming accelerated depreciation over the
                                                                                limited to $800.
                 applicable recovery period for personal property and the
                 applicable recovery period for real property as described      All taxpayers claiming either a depreciation or lease
                 in ¶2104, different recovery periods (and methods)             payment deduction for autos or other listed property,
                 can be used under the alternative depreciation system          regardless of the tax year in which this property was
                 (ADS). For example, an election can be made to de-             placed in service, must provide certain information to
                 preciate equipment over its applicable recovery period         the IRS. Form 4562 is used for this purpose. The form
                 using the straight line method instead of accelerated          is only required for property placed in service in 2005.
                 depreciation.
                                                                                  PRACTICE POINTER: For mixed-use property, keep
                    EXAMPLE: Office furniture, which has a seven-year re-         a log or diary in which business and personal use is
                    covery period, normally is depreciated using the 200%         noted. This documentary evidence will help support
                    declining balance method. Under ADS, such furniture           a claim that business use exceeded 50%.
                    can be depreciated using the straight line method.
                                                                                Special dollar limits restrict write-offs for so-called luxury
                 For real property (both residential and nonresidential), an    cars used for business. Many of these limits no longer
                 election can be made to use a 40-year recovery period.         apply because the years have long since passed. The dollar
                                                                                limits for cars placed in service after 1999 are:
                    PRACTICE POINTER: Electing to use ADS may
                                                                                 Car Placed                                                   Later
                    be desirable to avoid adjustments for alternative            in Service       1st year     2nd year       3rd year        Years
                    minimum tax (AMT) purposes. For example, under a
                                                                                 2000-2001        $3,060*        $4,900         $2,950       $1,775
                    depreciation adjustment is required if real property is
                                                                                 2002              7,660          4,900          2,950         1,775
                    depreciated over any period other than 40 years.
                                                                                 2003             10,710**        4,900          2,950         1,775
                                                                                 2004             10,610***       4,800          2,850         1,675
                 ¶2106 Limits on Depreciation for
                                                                                 2005              2,960          4,700          2,850         1,675
                       Mixed-Use Property (Sec. 280F)
                                                                                * $7,660 for cars placed in service after 9/10/01.
                 Limits are placed on the depreciation deductions allowed       ** $7,760 for cars placed in service before 5/6/03.
                                                                                *** $2,960 for cars not eligible for bonus depreciation.
                 for cars, cellular phones, computers, and other “listed
                 property.”                                                     These limits are reduced when the percentage of business
                                                                                use is less than 100%.
                    PRACTICE POINTER: A computer used in a home
                    office, the expenses of which are deductible, is pre-         EXAMPLE: Smith places in service in April 2005 a
                    sumed to be used entirely for business. No records            car used 75% for business. His first-year dollar limit
                    proving business use are required.                            on depreciation is $2,220 (75% of $2,960).

                 Property not predominantly used in business. “Listed
                 property” not used more than 50% in a qualified business         PITFALL: The IRS has noted that claiming deprecia-
                 use is limited to depreciation on a straight-line basis. The     tion for a car in excess of the dollar limit is one of
                 property’s life is based on one used for computing earnings      the most common errors made on individual income
                 and profits. The earnings and profits life is as follows:        tax returns.

                   MACRS Life                       Earnings and Profits Life
                   3-year property                  5-year life                 Heavy SUVs. Vehicles weighing over 6,000 pounds but
                   5-year property                  12-year life                not over 14,000 pounds have a first-year expensing limit
                   10-year property                 25-year life                of $25,000 (if the SUV cost more than this amount).
                 Where business use exceeds 50%, then investment-re-            Light trucks and vans. The limit for such vehicles placed
                 lated use can be added to arrive at a final percentage. This   in service in 2005 is $3,260. The second year limit is
                 is the percentage of the otherwise allowable deduction         $5,200; the third year limit is $3,150; and the limit for
                 that can be claimed for listed property. For example, if       each succeeding year is $1,875.


                                                                                                                                                           ¶2106



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              Nonpersonal use trucks and vans. Vehicles       modified       as an expense deduction cannot exceed taxable income
              to permit only de minimis personal use are not subject to      derived from the active conduct of a trade or business.
              dollar limits. Modifications qualifying vehicles as non-       However, any deduction disallowed as a result of this
              personal use vehicles include special seating, permanent       limitation can be carried forward and deducted in a
              shelving, and signs painted on the exterior.                   subsequent year (assuming there is sufficient taxable
                                                                             income in that year).
              ¶2107 Expensing in Lieu of
                    Depreciation (Sec. 179)                                  For a partnership and an S corporation, both the
                                                                             entity and each owner are subject to the annual
              Taxpayers can elect to treat a qualifying property’s cost,     dollar limitation, as well as the taxable income
              up to a limited amount, as a current expense. The dol-         limitation.
              lar limit for 2005 generally is $105,000. The costs for
              which the election is made are allowed as a deduction          Expensing is not allowed for: (1) property ac-
              for the tax year in which the qualifying property is           quired from a related party, (2) property acquired
              placed in service and are deducted currently instead           by a component member of a controlled group
              of employing an MACRS deduction regarding the                  from another member of the same group, (3)
              costs expensed.                                                property held for the production of income, (4)
                                                                             autos on which the standard mileage rate is used,
                 LOOKING AHEAD: In 2006, the expensing limit will            or (5) property the basis of which is determined in
                 be $108,000. In 2008, the dollar limit will decline to      whole or in part (a) by reference to the transferor’s
                 $25,000 unless Congress extends the law.                    adjusted basis or (b) under the stepped-up basis
                                                                             rules for property acquired from a decedent. It
              Qualifying property.  Personal property that is recovery       is also not allowed for heating and air condition-
              property and qualified for the investment credit is eligible   ing units.
              for the expensing election. It must be property acquired       Limits on mixed-use property.     For passenger cars and
              for use in a trade or business. Off-the-shelf computer         other “listed property,” limits are placed on the depre-
              software now qualifies for expensing.                          ciation deductions allowed for this property placed in
                                                                             service (¶2106).
                 PRACTICE POINTER: Expensing can be used for
                 both new and used property.
                                                                               PITFALL: The expensing deduction is recaptured
                                                                               when property is not predominantly used in a trade
              A $105,000 ceiling for expensing is provided where               or business at any time before the end of the re-
              the total investment in tangible personal property is            covery period. This means that, in the tax year it is
              $420,000 or less. The $105,000 ceiling is reduced by $1          found that the property is not used predominantly
              for every dollar of investment in excess of $420,000.            in a trade or business, the taxpayer must include in
                                                                               income the “tax benefit” derived from the expens-
                                                                               ing deduction.
                 EXAMPLE: In 2005, a taxpayer places in service
                 equipment costing $433,000. The taxpayer’s first-year
                 expense deduction is limited to $92,000 ($105,000           Election.   An election to expense property is made on
                 less $13,000 [the amount over $420,000]).                   Form 4562 and must specify the items of property to
                                                                             which the election applies and the part of the cost of
              For equipment placed in service by a trade or business in      each of these items to be deducted currently. The elec-
              an enterprise zone (designated by HUD), in addition to         tion must be made on an original return (including a
              the $105,000 expense limitation, there is an additional        late-filed original return) for the year that the property is
              $35,000 dollar limit for a maximum first-year expense          placed in service. Through 2007, an election can be made
              deduction of $140,000. For equipment used in the New           if it was not done so on an original return or revoked
              York liberty zone, there is also an additional $35,000         if the election was made on an original return without
              dollar limit (total $140,000).                                 IRS consent. The change is made by filing an amended
                                                                             return, but once this is done, it cannot be changed again
              Taxable income limitation. An additional limitation is         without IRS consent.
              imposed on first-year expensing. The amount allowed



    ¶2107



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                 DEPRECIATION UNDER ACCELERATED                                                                 The optional recovery periods under the straight-line
                 COST RECOVERY SYSTEM (ACRS)                                                                    ACRS election for 15-year real property are 15, 35, or 45
                                                                                                                years. For 18-year real property and low-income housing,
                 ¶2108 Accelerated Cost Recovery System                                                         the optional recovery periods are 18, 35, or 45 years. For
                       (ACRS) for Personal Property                                                             19-year recovery property and low-income housing, the
                 The annual deduction for property placed in service                                            optional recovery periods are 19, 35, or 45 years.
                 after 1980 and before 1987 was found by applying the                                           Under ACRS, equal depreciation is required for the
                 appropriate percentage to the property’s unadjusted                                            entire structure other than those components that a
                 basis. This applicable percentage depended on the class                                        taxpayer properly elects to amortize (such as low-income
                 of property. The only property (other than real estate)                                        rehabilitation expenditures). Thus, the same recovery
                 still being depreciated under ACRS is 15-year public                                           period and method, in general, must be used for each
                 utility property.                                                                              component, such as plumbing, wiring, etc.
                 ¶2109 Real Property                                                                            When a taxpayer makes a substantial improvement to
                 Buildings placed in service after May 8, 1985, and before                                      a building, it is treated as a separate building rather
                 1987 have a 19-year recovery period (buildings placed in                                       than as one or more components. Thus, the taxpayer
                 service after March 15, 1984 and before May 9, 1985,                                           may use the regular ACRS deduction for the substan-
                 had an 18-year recovery period). Different recovery pe-                                        tial improvement, or he may elect the straight-line
                 riods apply to low-income housing and to other realty                                          ACRS deduction over the regular or a longer recovery
                 placed in service before January 1, 1987. Note that low-                                       period, regardless of the ACRS method or recovery
                 income housing placed in service before May 9, 1985,                                           period that is used for the rest of the building. An
                 which had been subject to a 15-year recovery period, has                                       improvement is substantial if: (1) the amounts added
                 now been fully depreciated.                                                                    to the building’s capital account over a two-year pe-
                                                                                                                riod are at least 25% of the building’s adjusted basis
                    NOTE: The first-year percentages are based on the
                                                                                                                (disregarding depreciation and amortization adjust-
                    number of months the realty is in service in the year                                       ments) as of the first day of that period and (2) the
                    it is placed in service. Real property placed in ser-                                       improvement is made at least three years after the
                    vice after March 15, 1984, and before May 9, 1985,                                          building was placed in service.
                    had an 18-year recovery period. Recovery property
                    placed in service after May 8, 1985, had a 19-year                                          Real property (other than low-income housing) placed
                    recovery period. Low-income housing retains the                                             in service after March 15, 1984, and before May 9,
                    15-year recovery period. Transitional rules applied                                         1985. An 18-year recovery period applied.
                    to property placed in service after May 8, 1985, and
                    before January 1, 1987, when there is a binding                                             The following table is used for 19-year real property
                    contract to acquire or construct the property.                                              (placed in service after May 8, 1985, and before Janu-
                                                                                                                ary 1, 1987):

                                                                                Month Placed in Service

                 Year                                                             1        2       3      4         5      6       7        8        9       10        11        12
                 1st. . . . . . . . . . . . . . . . . . . . . . . . . . . . .    8.8      8.1     7.3     6.5      5.8    5.0     4.2      3.5     2.7       1.9       1.1      0.4
                 2nd . . . . . . . . . . . . . . . . . . . . . . . . . . . .     8.4      8.5     8.5     8.6      8.7    8.8     8.8      8.9     9.0       9.0       9.1      9.2
                 3rd . . . . . . . . . . . . . . . . . . . . . . . . . . . .     7.6      7.7     7.7     7.8      7.9    7.9     8.0      8.1     8.1       8.2       8.3      8.3
                 4th . . . . . . . . . . . . . . . . . . . . . . . . . . . .     6.9      7.0     7.0     7.1      7.1    7.2     7.3      7.3     7.4       7.4       7.5      7.6
                 5th . . . . . . . . . . . . . . . . . . . . . . . . . . . .     6.3      6.3     6.4     6.4      6.5    6.5     6.6      6.6     6.7       6.8       6.8      6.9
                 6th . . . . . . . . . . . . . . . . . . . . . . . . . . . .     5.7      5.7     5.8     5.9      5.9    5.9     6.0      6.0     6.1       6.1       6.2      6.2
                 7th . . . . . . . . . . . . . . . . . . . . . . . . . . . .     5.2      5.2     5.3     5.3      5.3    5.4     5.4      5.5     5.5       5.6       5.6      5.6
                 8th . . . . . . . . . . . . . . . . . . . . . . . . . . . .     4.7      4.7     4.8     4.8      4.8    4.9     4.9      5.0     5.0       5.1       5.1      5.1
                 9th . . . . . . . . . . . . . . . . . . . . . . . . . . . .     4.2      4.3     4.3     4.4      4.4    4.5     4.5      4.5     4.5       4.6       4.6      4.7
                 10-19th . . . . . . . . . . . . . . . . . . . . . . . . .       4.2      4.2     4.2     4.2      4.2    4.2     4.2      4.2     4.2       4.2       4.2      4.2
                 20th . . . . . . . . . . . . . . . . . . . . . . . . . . .      0.2      0.5     0.9     1.2      1.6    1.9     2.3      2.6     3.0       3.3       3.7      4.0




                                                                                                                                                                                       ¶2109



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              DEPRECIATION NOT UNDER MACRS
                                                                                EXAMPLE: An individual builds an apartment building
              ¶2110 In General                                                  in 1980, but rents the first floor to commercial ten-
                                                                                ants. Rents from dwelling units total $75,000, while
              The cost or other basis of property not eligible for              rents from commercial tenants total $25,000. Since
              MACRS is depreciated over the asset’s estimated useful            rents from dwelling units are only 75% of the gross
              life. The estimated useful life refers to the period of years     rents, the taxpayer cannot use a method faster than
              during which the asset may be expected to be useful to            that applicable to new nonresidential property (that
                                                                                is, the 150% declining balance).
              taxpayers in their trade or business.
              So-called non-MACRS property means (1) property
              placed in service before 1981; (2) property not depreci-          EXAMPLE: Assume that in 2005 rents from dwelling
              ated in terms of years; (e.g., motion pictures and video          units rise to $125,000 while rents from commercial
              cassettes) (3) certain intangible property (for example,          tenants are still $25,000. The 80% test is met (83.3%)
              patents or copyrights) (see ¶2104); or (4) certain property       for 2005, so the 200% declining balance or sum-of-
              acquired in a “churning” transaction.                             the-years-digits method may now be used. IRS con-
                                                                                sent is not necessary for a shift to either method.

                 PRACTICE POINTER: As a practical matter, most
                 property placed in service before 1981, other than           On used residential rental property with a remaining use-
                 real estate, has already been fully depreciated.             ful life of at least 20 years, the taxpayer may use either the
                                                                              straight-line method or the declining balance method,
                                                                              but the latter is limited to a maximum of 125% of the
              ¶2111 Special Limitations on
                                                                              straight-line rate. All other used real estate is restricted to
                    Depreciation of Real Estate
                                                                              the straight-line method only; no accelerated deprecia-
              There are some special restrictions that apply only to          tion method can be used.
              accelerated depreciation on real estate. The restrictions
              do not apply to real estate owned before July 25, 1969.         ¶2112 Change of Depreciation Methods
              Likewise, the restrictions do not apply if a taxpayer had       Taxpayers may use different depreciation methods for
              either begun construction or entered into a binding             different assets; thus, they may use the straight-line
              contract to acquire or construct such property before           method for one asset or group of assets, and the declining
              July 25, 1969.                                                  balance method for other assets. However, once they have
                                                                              begun to use a particular depreciation method for any
              Also, the special restrictions do not apply to new “resi-
                                                                              asset or assets, they cannot change to another method
              dential” property, such as apartment buildings and rental
                                                                              without obtaining prior IRS approval. An exception
              housing developments, regardless of when acquired. Thus,
                                                                              to this rule is that, if taxpayers are using the declining
              on new residential rental property the 200% declining
                                                                              balance method, they may change to the straight-line
              balance method, as well as the sum-of-the-years-digits
                                                                              method at any time without obtaining prior approval.
              method, is permitted. Property held for mixed residen-
              tial and commercial use (such as apartment buildings            The IRS has developed procedures under which a
              containing stores) will be considered “residential” if 80%      number of changes in depreciation method can be
              or more of the gross rental income stems from dwelling          made—with approval considered to have been given—if
              units. A hotel, motel, or other establishment in which          specified rules are followed. File Form 3115, “Application
              more than half of the units are used on a transient basis       for Change in Accounting Method,” with the Service
              is not considered residential property for this purpose.        Center where the taxpayer filed his return during the year
                                                                              of change. Approval is automatic if the taxpayer files on
              On all other new real estate property, the taxpayer may
                                                                              time and furnishes all of the information required (See
              use either the straight-line method or the declining bal-
                                                                              IRS Publication 538 for details).
              ance method, but at a rate not to exceed 150% of the
              straight-line rate.                                             ¶2113 Deduction for Obsolescence
              For any year in which the 80% test is not met, the 150%         It frequently happens that an item of machinery or
              declining balance rate for new nonresidential property          equipment becomes outdated (or “obsolete”) because of
              can be used. A shift to or from the 150% rate by reason         technological advances or sudden economic changes long
              of the 80% test does not require IRS consent.                   before the physical usefulness of the item is exhausted.

    ¶2110



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                 Thus, if it becomes clear that an asset that has a useful      half of the year and no depreciation for those assets put
                 life of 10 years has to be discarded after two years, the      in service during the last half of the year.
                 taxpayer may take an additional depreciation deduction
                 as a result of obsolescence.                                   Asset Depreciation Range System guidelines.           A
                                                                                complete table with guideline lives can be found in Rev.
                 ¶2114 The ADR Depreciation System                              Proc. 83-35, 1983-1 CB 745.
                 The Asset Depreciation Range (ADR) System was
                 terminated for property placed in service after 1980. It         NOTE: The above revenue procedure sets out the
                                                                                  asset guideline classes, asset guideline periods and
                 is generally replaced by the Accelerated Cost Recovery
                                                                                  ranges, and annual asset guideline repair allowance
                 System (ACRS) and the Modified Accelerated Cost                  percentages for the Class Life Asset Depreciation
                 Recovery System (MACRS). However, post-1980 ADR                  Range System. The asset guideline periods (midpoint
                 depreciation may continue to be claimed on pre-1981              class lives) set out in Rev. Proc. 83-35 are also used
                 assets for which the ADR election was made.                      in defining the classes of recovery property under
                                                                                  ACRS. This revenue procedure remains effective for
                 Most types of assets are encompassed in the list of eligible     property subject to depreciation under those systems.
                 assets under ADR. Further, subsidiary assets (dies, tools,       Rev. Proc. 83-35 is obsoleted for property subject to
                 returnable containers, glassware, and silverware) can be         MACRS. (Rev. Proc. 87-56, 1987-2 CB 27)
                 depreciated as a separate class as set up by the IRS using
                 their own useful lives.
                                                                                DEPRECIATION RECAPTURE
                 ADR permits taxpayers to decrease the estimated useful
                                                                                ¶2115 In General (Secs. 1245 and 1250)
                 life of eligible assets by as much as 20% less than the use-
                 ful life specified in the Treasury Depreciation Guidelines     Until 1962, some taxpayers who had disposed of depre-
                 (see below) and, thus, increase their annual depreciation      ciable property at a gain had a unique tax advantage. In
                 deduction by as much as 25%.                                   many cases, as a result of accelerated depreciation deduc-
                                                                                tions, the basis of the property was less than the actual
                 Salvage value. The annual depreciation deduction un-
                                                                                decline in its value. Thus, when the property was sold,
                 der ADR is computed without taking salvage value into          there was a taxable gain. Under previous law, this gain
                 consideration. No matter what method of depreciation is        was taxed at capital gain rates (no more than half of the
                 used—straight-line, sum-of-the-years-digits, or declining      regular tax rates), even though the depreciation deduc-
                 balance— the total depreciation taken cannot reduce the        tion was a deduction against ordinary income. Hence, a
                 basis of the asset below estimated salvage value. However,     taxpayer who utilized accelerated depreciation deduc-
                 the amount of salvage value not in excess of 10% of the        tions on an asset and then sold the asset had, in effect,
                 cost of the property can be disregarded. Additionally,         converted ordinary income into a capital gain.
                 under ADR, if there is a dispute between the taxpayer
                 and the Treasury, the taxpayer’s estimate will not be          In 1962, Congress plugged part of this loophole by
                 disturbed if the difference is not more than 10% of the        enacting Code Sec. 1245, which provided for the
                 item’s cost. This, in effect, would allow depreciation of      “recapture” of certain depreciation deducted on most
                 the entire cost even though salvage value is as much as        depreciable property with the exception of real estate. In
                 20%. However, this extra leeway will not be allowed if         1964, Congress enacted Code Sec. 1250, which partially
                 the taxpayer makes a regular practice of underestimating       extended the same rules to depreciable real estate. Code
                 salvage value.                                                 Sec. 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
                 service during the year. They therefore can treat all assets   gain (or that part of it) that resulted from the depre-
                 as placed in service in the middle of the year (i.e., July     ciation deduction as ordinary income, rather than as
                 1 for a calendar-year taxpayer).                               a capital gain.
                 In the alternative, a taxpayer may elect a full year’s         Depreciation recapture is reported in Part III of Form
                 depreciation for assets placed in service during the first     4797, “Sales of Business Property.”




                                                                                                                                                       ¶2115



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                       4797
                                                                                                                                                          OMB No. 1545-0184
                                                                       Sales of Business Property
               Form
                                                        (Also Involuntary Conversions and Recapture Amounts
                                                                                                                                                              2005
                                                                                 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 5
                       Enter the gross proceeds from sales or exchanges reported to you for 2005 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 /1
                2




                                                                         10
                3      Gain, if any, from Form 4684, line 42                                                                                         3
                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 34 and 41a                                                                           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 38, 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 27, and the part of the
                      loss from property used as an employee on Schedule A (Form 1040), line 22. 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     (2005)




    ¶2115



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                       Form 4797 (2005)                                                                                                                                          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 5
                                                                                          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 /1
                       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




                                                                                       0
                       25      If section 1245 property:




                                                                                     1
                             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 36. 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
                                                                                                      Printed on recycled paper                                       Form   4797   (2005)


                                                                                                                                                                                          ¶2115



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              ¶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 Section1245, any gain on the sale or exchange
              of depreciable personal property is treated as ordinary                             Section 1245 recovery property.     Gain recognized on
              income (instead of as a Section 1231 gain) to the extent                            a post-1980 disposition of Sec. 1245 recovery property
              of depreciation deducted (called Section 1245 gain). The                            is ordinary income to the extent of prior ACRS deduc-
              remainder of the gain, if any, is treated as Section 1231                           tions.
              gain and, thus, may qualify for capital gain treatment.
                                                                                                  A first-year expense deduction (¶2107) is treated as a
                                                                                                  depreciated deduction for purposes of Sec. 1245 depre-
                 EXAMPLE: Collins installed equipment on January
                 5, 1995, for $5,600. On January 5, 2005, when the                                ciation recapture. Thus, if property that was expensed
                 adjusted basis of the equipment was $3,528 ($5,600                               ceases to be predominantly used in a trade or business
                 less $2,072 depreciation), he sold it for $6,400,                                (more than 50% business use), then recapture results.
                 resulting in a recognized gain of $2,872. Post-1961                              If property that was expensed is sold through the in-
                 depreciation is $2,072. A portion of this gain is Sec-                           stallment method, the expense deduction is subject to
                 tion 1245 income, computed as follows:
                                                                                                  immediate recapture.
                 Amount realized from sale . . . . . . . . . . . . . . . . . .          $6,400
                 Adjusted basis . . . . . . . . . . . . . . . . . . . . . . . . . . .    3,528    Installment sales.   Section 1245 recapture is reported
                     Realized gain. . . . . . . . . . . . . . . . . . . . . . . . .     $2,872    in the year of disposition, even if no payments are re-
                                                                                                  ceived in that year. The taxpayer’s adjusted basis in the
                 Ordinary income (Sec. 1245 gain) . . . . . . . . . . . .               $2,072
                                                                                                  property disposed of is treated as including the amount
                      (Depreciation of $1,680)
                 Eligible for capital gain (Sec. 1231) . . . . . . . . . . .            $   800
                                                                                                  of depreciation recapture income. Different rules applied
                                                                                                  to sales made before June 7, 1984.

              You will see from the above example that the Section                                Any “listed property” that was used more than 50% in
              1245 income is equal to the total depreciation deducted.                            a trade or business in the year it was placed in service,
              Obviously, if the selling price produced a gain less than                           but in the current tax year is used 50% or less, is subject
              the depreciation, the Section 1245 income will be limited                           to depreciation recapture (see also ¶2106).
              to the actual gain.
                                                                                                  Under MACRS, depreciation recapture on personal
                                                                                                  property has not changed.
                 EXAMPLE: Assume that, in the above example, the
                 taxpayer had sold the machine for $5,600 (instead                                ¶2117 Charitable Contributions
                 of $6,400), resulting in a recognized gain of $2,072.                                  of Section 1245 Property
                 The entire gain is Section 1245 income.
                                                                                                  If taxpayers contribute property to a qualifying charitable
              If a taxpayer transfers Section 1245 property to another                            organization, they are generally entitled to a deduction
              person by gift and the recipient later sells the property                           (from adjusted gross income) equal to the fair market
              at a gain, the taxpayer must take into account any de-                              value of the contributed property. However, if the con-
              preciation deducted by the donor in computing his or                                tributed property consists of Section 1245 property, the
              her Section 1245 income.                                                            contribution deduction must be reduced by the amount
                                                                                                  that would have been treated as Section 1245 gain if the
                                                                                                  property had been sold at its fair market value instead
                 EXAMPLE: Aaron purchased Section 1245 property on
                                                                                                  of contributed to the charity.
                 January 1, 2003, for $10,000. He takes depreciation de-
                 ductions of $2,000 before making a gift of the property
                 to his son, Ben. Under the rules previously discussed,                             EXAMPLE: A taxpayer donates to a charity depre-
                 the adjusted basis of the property to the son is $8,000,                           ciable property with an adjusted basis of $10,000.
                 the same as in the father’s hands. Assume further that                             Depreciation was $4,000. The property had a fair
                 the son later takes another $1,000 depreciation on the                             market value of $17,000. If he had sold the prop-
                 property (reducing his adjusted basis to $7,000) and                               erty for $17,000, he would have had a Section
                 then sells it for $10,500, realizing a recognized gain of                          1245 gain of $4,000. Hence, the amount of the
                 $3,500. Of the gain, $3,000 would be treated as Sec-                               contribution deduction would be only $13,000
                 tion 1245 ordinary income. The remainder of the gain,                              ($17,000 - $4,000).
                 $500, is treated as a Section 1231 gain.


    ¶2116



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                 ¶2118 Depreciation Recapture
                       on Real Estate (Sec. 1250)                               EXAMPLE: Property purchased for $100,000 is sold
                                                                                on the installment basis for $130,000 in five equal an-
                 There are now two different sets of rules for figuring         nual installments. The property had been depreciated
                 depreciation recapture on real estate.                         to $80,000, resulting in a gain on the sale of $50,000
                                                                                ($130,000 amount realized less $80,000 basis). The
                 Residential real property. For residential real property,      gain represents $20,000 unrecaptured depreciation,
                 there is the complete recapture of all post-1975 excess        plus $30,000 long-term capital gain. Of each pay-
                 depreciation. This rule already applies to post-1969           ment of $26,000, $10,000 represents gain. So gain
                                                                                in the first two payments is taxed at 25%, while gain
                 excess depreciation on commercial property.                    the final three payments is taxed at 15%.
                 All of the depreciation taken, including straight-line,
                 is recaptured if the property is disposed of within 12       ¶2119 Recent Developments
                 months. This has been the rule and remains unchanged.              Affecting Depreciation
                 Here is how the amount of recapture on a sale of resi-
                 dential rental housing is now computed:                      Final regulations on Section 179 first-year expensing
                                                                              have been issued (T.D. 9209, 7/12/05).
                 Post-1975. All excess depreciation (depreciation in
                 excess of straight-line) attributable to periods after De-   Final regulations issued on depreciation of non-personal-use
                 cember 31, 1975, is recaptured, regardless of when the       light trucks and vans, which are exempt from the dollar lim-
                 property was placed in service.                              its applicable to other vehicles weighing of 6,000 pounds or
                                                                              less (applicable to qualified vehicles placed in service before
                 Unrecaptured depreciation.        Under MACRS, there         and after June 6, 2003). (T.D. 9133, 6/24/04)
                 is no recapture for all residential rental or nonresi-
                 dential real property since they are subject to straight     Final regulations explain depreciation on the conversion
                 line depreciation. However, on sales of such property        of property to business use or vice versa (T.D. 9132,
                 on or after May 7, 1997, there may be “unrecaptured          6/16/04)
                 depreciation.” This is the total of all depreciation taken   Cell phone use must be substantiated (with a phone log
                 on such property not otherwise recaptured as ordinary        itemizing business calls) to support a deduction because
                 income and it is taxed at a maximum rate of 25% if           a cell phone is “listed property.” The cell phone bill did
                 the balance of the gain is subject to the 15% capital        not itemize charges so there was no documentary evi-
                 gains tax rate.                                              dence as required for listed property. (Moss, TC Summary
                 Installment sales.  The amount of gain representing          Opinion 2004-56)
                 unrecaptured depreciation is treated as reported first and   Luxury car ceilings for 2005 are $2,960 for first year;
                 subject to the 25% tax rate. Once all such unrecaptured      $4,700 for second year; $2,850 for third year; and
                 depreciation has been reported, further gain is taxed at     $1,675 for each year thereafter (Rev. Proc. 2005-13, IRB
                 the 15% rate.                                                2005-12, 759).




                                                                                                                                                       ¶2119



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              ¶2120          CHAPTER 21 STUDY QUESTIONS — Depreciation


                  1.    The maximum first-year expensing deduction for      3.   Unrecaptured depreciation means that all deprecia-
                        2005 is:                                                 tion claimed after May 6, 1997, is taxed at a 25%
                        a. $25,000                                               rate when property is disposed of (assuming the
                        b. $102,000                                              taxpayer is in a tax bracket at or above this rate).
                        c. $105,000                                              True or False?

                  2.    In 2005, a taxpayer begins to use a room in his
                        home as a deductible home office. He can depreci-
                                                                            For the IRS explanation of depreciation, see: IRS
                        ate the basis of the room over what period?
                                                                            Publication 534: Depreciating Property Placed in
                        a. 27.5 years                                       Service Before 1987 and IRS Publication 946: How
                        b. 31.5 years                                       to Depreciate Property.
                        c. 39 years

                                                                            Answers to Study Questions, with feedback to both
                                                                            the correct and incorrect resposese, are provided in
                                                                            Chapter 35, beginning with ¶3521.




    ¶2120



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                                                                                                                          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 op-
                    Identify expenses subject to amortization.                tions to renew the lease, the renewal period or periods
                    Figure depletion.                                         must be taken into account in determining the period
                                                                              in which amortization is allowed, but only if the re-
                 ¶2201 Amortization
                                                                              maining unexpired term of the lease (not counting the
                 The deduction for amortization is similar to depre-          renewal period) is less than 60% of the useful life of the
                 ciation in that the taxpayer is permitted to write off or    improvements.
                 “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
                 is deductible from gross income in computing adjusted          lease will not be renewed, the renewal period does
                 gross income. Form 4562, “Depreciation and Amorti-             not have to be taken into account.
                 zation,” is used to report amortization deductions (see
                 form at ¶2101).                                              No amortization deduction is permitted if the lessee
                                                                              and lessor are related persons at any time during the tax
                 ¶2202 Amortization of Improvements                           year. In such a case, the cost of the improvements must
                       Made by Lessee or Lessor                               be depreciated over the estimated useful life. “Related
                 Lessees. Lessees or tenants of business or income-pro-       persons” are husband and wife, parents and children,
                 ducing property frequently make alterations or other         grandparents and grandchildren, etc., or an individual
                 improvements to make the leased premises or property         and a corporation in which the former owns (directly or
                 suitable for their needs. The question then often arises     indirectly) 80% or more of the outstanding stock.
                 on how lessees deduct the amounts spent on the im-           Under MACRS, the lessee is treated the same as any
                 provements. Lessees must use MACRS real estate rates         owner-taxpayer for determining MACRS allowances
                 for leasehold improvements after 1986.                       as to improvements by the lessee placed in service after
                 For pre-1987 improvements, if the useful life of the         1986. This means that the allowances are found without
                 improvements is equal to or less than the remaining          regard to the lease term, but rather with regard to the
                 period of the lease, taxpayers can simply recover their      underlying property.
                 expenditures by way of the regular depreciation deduc-       Lessors. Lessors who make leasehold improvements to
                 tion. On the other hand, if the life of the improvements     rental property recover the cost of those improvements
                 is expected to last longer than the remaining period         over the term applicable to the underlying building.
                 of the lease (and assuming the improved property will        Thus, the same term is used for both the building and the
                 revert to the owner at the end of the lease without          improvements. However, the improvements are treated
                 compensation to the lessee), a depreciation deduction        as separate items whose depreciation begins on the date
                 would not permit taxpayers to recover their entire           they are placed in service.
                 cost. For this reason, the law permits taxpayers to
                 “amortize” or write off their costs over the remaining       A lessor who disposes of leasehold improvements made
                 period of the lease.                                         for a lessee upon the lessee’s termination of the lease



                                                                                                                                            ¶2202



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              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 improvement after October
              22, 2004. Nonresidential real property-related improve-
              ments placed qualify for a 15-year recovery period, using
                                                                              NOTE: For property placed in service after 1986, the
              straight-line depreciation instead of being required to         term of a lease is determined by including all renewal
              be depreciated over 39 years or amortized over the term         options as well as any other period for which the par-
              of the lease.                                                   ties reasonably expect the lease to be renewed.

              The 15-year recovery period applies to qualified restau-
              rant property. This is property placed in service more        ¶2204 Rehabilitation Outlays for Low-Income
              than three years after the building is placed in service.           Rental Housing (Sec. 167)
              The restaurant must use more than half of the building’s
              square footage for the preparation of meals and on-prem-      Rehabilitation expenditures generally are depreciated
              ises consumption of meals.                                    over the life of the building. In the past, a special rule
                                                                            allowed for amortization of certain expenditures over a
                                                                            60-month period. The rule applied to property placed
                 LOOKING AHEAD: The break for leasehold and res-
                                                                            in service before January 1, 1987. For low-income
                 taurant improvements applies only through 2005
                 unless Congress extends it.
                                                                            housing property placed in service after December 31,
                                                                            1986 (other than grandfathered property), a low-income
                                                                            housing credit replaces the amortization of rehabilitation
              ¶2203 Cost of Acquiring a Lease (Sec. 178)                    expenditures.
              When a taxpayer incurs expenses in acquiring a lease on
                                                                            ¶2205 Amortization of Intangibles
              business or income-producing property, that cost may
                                                                                  (Secs. 177 and 197)
              be amortized over the period or remaining period of the
              lease. If the lease contains a renewal option, the renewal    Acquired intangibles.     Goodwill and other intangibles
              period must be taken into account if less than 75% of         acquired after August 10, 1993 (or after July 25, 1991,
              the cost is attributable to the portion of the term of the    for which a special election was made), and used in a
              lease (not counting the renewal period) remaining on          trade or business or an activity engaged in for the pro-
              the date of its acquisition.                                  duction of income may be amortized over a period of
                                                                            15 years, beginning in the month of acquisition. These
                 EXAMPLE: A taxpayer paid a previous tenant                 assets are called “Section 197 intangibles.” The amortiz-
                 $10,000 for transferring to the taxpayer the lease in      able basis is generally the asset’s cost basis. If intangibles
                 a desirable office building. The remaining unexpired       are acquired as part of the sale of a business, the residual
                 period of the lease was five years, and the lease          method must be used to figure the allocated basis of
                 contained a five-year renewal clause.                      intangibles.

              Obviously, part of the amount paid for the lease was          Section 197 intangibles include goodwill; going-concern
              for its unexpired portion and part was for the option         value; workforce in place; information base; know-how;
              to renew the lease. If the amount attributable to the         any customer-based intangible; any supplier-based
              unexpired term is less than $7,500 (75% of $10,000),          intangible; any governmental unit or agency license,
              the renewal period must be taken into consideration.          permit, or other right; covenant not to compete; and
              The cost can, therefore, be amortized only over 10 years      any franchise (other than a sports franchise), trademark,
              (five years remaining plus the five-year renewal period).     or trade name.
              If $7,500 or more is attributable to the remaining term       Section 197 intangibles do not include self-created in-
              of the current lease, the renewal period need not be taken    tangibles; interests in a corporation, partnership, trust,
              into consideration, and the $10,000 may be amortized          or estate; interests under certain financial contracts;
              over five years.                                              interests in land; certain computer software; certain


    ¶2203



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                 separately acquired rights and interests; interests under        Organizational costs. The same rules for start-up costs
                 existing leases of tangible property; interests under exist-     apply to organizational costs.
                 ing indebtedness; certain residential mortgage servicing
                 rights; and certain corporate transaction costs.                 Start-up costs before October 23, 2004.          Taxpayers
                                                                                  can elect to amortize start-up expenditures over a period
                 Amortization of trademark expenditures. Expenses                 of not less than 60 months. Start-up expenditures are
                 incurred in the registration, protection, or defense of a        amounts (1) paid or incurred in connection with inves-
                 trademark or trade name would normally be treated as             tigating the creation or acquisition of an active trade
                 capital expenses. Thus, in the absence of a definite use-        or business or with creating an active trade or business
                 ful life, the expenses would not be recoverable (unless          and (2) which, if paid or incurred in connection with
                 the trademark or trade name is a Section 197 intangible          the expansion of an existing trade or business, would be
                 acquired with the purchase of a business).                       deductible for the tax year. In other words, start-up costs
                                                                                  are those incurred to determine whether to buy or start
                 ¶2206 Special Amortization for Pollution                         a business and which business to buy or start.
                       Control Facilities (Sec. 169)
                                                                                  If the trade or business is disposed of completely by the
                 To encourage owners and operators of plants causing air or       taxpayer before the end of the 60-month (or longer) pe-
                 water pollution to invest in pollution control devices, the      riod, the deferred expenses may be deducted to the extent
                 Code permits a special fast write-off for expenditures made      allowed by Code Section 165. The definition of “start-up
                 or incurred for that purpose. To qualify, the pollution con-     expenditures” is expanded to include amounts incurred or
                 trol device or facility must be certified by the state air or    paid before, and in anticipation of, the start of the business
                 water pollution control agency as suitable for the specific      in an activity for profit or production of income, but does
                 control task. The device must have been placed into service      not include any amount with respect to which a deduction
                 after 1975 and must have been added to, or been installed        is allowable under Code Section 163(a), 164, or 174.
                 at, a plant that was in operation before 1976.
                                                                                  ¶2207A Optional 10-Year Amortization of
                 If the facility has a useful life of 15 years or less, the en-
                                                                                         Certain Preferences (Sec. 59(e))
                 tire cost can be amortized over a five-year period. If the
                 useful life is more than 15 years, only that portion of the      Individuals can elect to amortize certain tax preferences
                 cost attributable to the first 15 years can be amortized         over a 10-year period. These preferences include mining
                 over the five-year period. The balance may be recovered          exploration and development costs, research and experi-
                 through the regular depreciation allowance.                      mental expenditures, and intangible drilling costs. A three-
                                                                                  year period applies to circulation expenditures. When the
                 ¶2207 Amortization of Business Start-Up                          amortization is elected, individuals do not have preferences
                       Expenditures (Sec. 195)                                    for the alternative minimum tax (see also ¶2503).
                 The tax treatment of start-up costs in 2005 depends on
                 when the costs are incurred. One rule applies to post-             PRACTICE POINTER: The election is made on a
                 October 22, 2004, costs, while another rule applies to             statement attached to the original (or amended)
                 pre-October 23, 2004 costs.                                        return for the year in which amortization begins. A
                                                                                    separate election is required for each project or activ-
                 Start-up costs after October 22, 2004.      A deduction            ity. The statement must contain various information
                 of up to $5,000 can be claimed for start-up costs in the           (see proposed amendments to Reg. §1.59-1).
                 year in which the business begins. Any start-up costs not
                 deductible under this rule can be amortized ratably over         ¶2208 Depletion (Secs. 611–613)
                 a period of 180 months (15 years). This amortization
                 period mirrors the write-off for acquired intangibles            Taxpayers who own mineral deposits, oil and gas wells,
                 under Code Sec. 197 (see ¶2205).                                 standing timber, or other so-called wasting assets are
                                                                                  permitted to take a “depletion” deduction to make allow-
                 The $5,000 limit is reduced by one dollar for each               ances for reduction in the remaining assets as resources
                 dollar of costs exceeding $50,000, so that no first-year         are diminished. In other words, depletion is a form of
                 deduction is allowed if start-up or organizational costs         “depreciation” of natural resources.
                 exceed $55,000.




                                                                                                                                                                   ¶2208



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              There are two methods of computing depletion: cost                                    Oil and gas. There is no oil and gas percentage depletion
              depletion and percentage depletion. Cost depletion                                    allowance for larger companies.
              may be used for all assets subject to depletion; percent-
              age depletion may be used for most, but not all, assets                               It is important to note that taxpayers may continue to
              (except by the larger oil and gas producers).                                         take allowances for percentage depletion even after they
                                                                                                    have recovered their cost or other basis. This provision
              ¶2209 Cost Depletion (Secs. 611 and 612)                                              was designed to encourage the exploration of natural
                                                                                                    resources through granting producers a singular tax
              Cost depletion, in general, is calculated by dividing the
                                                                                                    advantage not enjoyed by other taxpayers. For the same
              total of estimated recoverable units (tons, barrels, etc. as
                                                                                                    reason, the depletion deduction may generally be taken
              determined in accordance with prevailing methods in the
                                                                                                    only during the period the natural resources are actually
              respective industry) in the mine, well, or deposit, into
                                                                                                    being extracted from the property.
              the adjusted basis of the property (cost minus prior-year
              depletion allowances, cost, or percentage). The resulting                             Taxpayers engaged in the development and exploration
              figure is “depletion per unit” and is multiplied by the                               of geothermal resources are eligible for a depletion al-
              number of units for which payment is received during                                  lowance of 15%. A 10% depletion allowance will be
              the tax year (if on the cash basis) or by the number of                               permitted for natural gas from geo-pressured brine
              units sold (if on the accrual basis).                                                 from wells drilled in the United States or its possessions
                               Adjusted basis
                                                                                                    if drilling began after September 30, 1978, and before
                                                                      Depletion
                          ———————————                           =
                                                                       per unit
                                                                                                    January 1, 1984.
                          No. of units remaining as
                           of the beginning of the                                                  Where taxpayers, as is frequently the case, lease wells
                                 taxable year
                                                                                                    or mines in return for royalties to be received for each
                                                                                                    unit removed, their gross income from the property is
                 EXAMPLE: A taxpayer owns an oil well with an es-                                   ordinarily the sum of the royalties received from the lease
                 timated recoverable reserve of 50,000 barrels. The                                 (including any bonus, but excluding rentals).
                 adjusted basis is $10,000. During the year, he sold
                 and received payment for 8,000 barrels. Using the                                  If owners (or lessors) of resource property receive from
                 cost depletion method, he will claim a depletion                                   lessees minimum royalties, which are payable even if the
                 allowance of $1,600 ($10,000 ÷ 50,000 = 20¢ per                                    oil, gas, or minerals are not extracted, they are still en-
                 barrel. 8,000 barrels × 20 cents = $1,600).
                                                                                                    titled to the depletion allowance. However, no further
                                                                                                    deduction is allowed if and when the extraction actually
              ¶2210 Percentage Depletion (Sec. 613)                                                 takes place. If the lease is ended before all the minerals
                                                                                                    paid for by the minimum royalties have been extracted,
              Under this method, the taxpayer may deduct a certain                                  the depletion allowance taken for those minerals paid
              percentage of gross income from the resource during                                   for but not removed must be included in income. Of
              each year, but the deduction in any year may generally                                course, the basis of the property would be increased by
              not exceed 50% of the taxable income from the prop-                                   the same amount since that portion of the depletion is,
              erty, computed without the deduction for depletion. In                                in effect, nullified.
              no event, however, may the deduction be less than the
              amount available if computed on the cost basis. The                                   Just as in the case of depreciation, the amount of deple-
              major depletion percentages are as follows:                                           tion allowed (or allowable, even though not actually
                                                                                                    taken) reduces the basis of the property. The depletion
              Sulphur and uranium . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   22%   “allowable” is the greater of cost or percentage depletion,
              Gold, silver, copper, iron ore, and oil shale
                   (with some exceptions) if from mines
                                                                                                    regardless of which method was actually used.
                   or deposits in the United States. . . . . . . . . . . . . . . . .          15%
              Coal and sodium chloride . . . . . . . . . . . . . . . . . . . . . . . . .      10%
                                                                                                    ¶2211 Percentage Depletion as a Tax
              Gravel, peat, and pumice sand . . . . . . . . . . . . . . . . . . . . .          5%         Preference
              Asbestos, bauxite, graphite, lead, mica, nickel,
                   platinum, zinc, and most other minerals
                                                                                                    The amount by which percentage depletion deductions
                   and metals if from mines or deposits                                             taken exceed the basis of the resource property (not
                   in the United States.. . . . . . . . . . . . . . . . . . . . . . . . . .   22%   counting any depletion in the tax year) is a tax preference.
              Gold, silver, copper, iron ore, and most other                                        (Tax preferences are discussed in chapter 25.) No tax
                   minerals and metals extracted from
                   non-U.S. mines or deposits . . . . . . . . . . . . . . . . . . . .         14%   preference arises until total percentage depletion on the


    ¶2209



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                 property over the years equals the basis of the property.           for permitting use of the land, was held entitled to the
                 After the year that total percentage depletion equals the           depletion allowance, even though the actual oil deposit
                 property’s basis, every dollar of percentage depletion is           was not located on the property.
                 a dollar of tax preference.
                                                                                     ¶2213 Recent Developments Affecting
                                                                                           Amortization and Depletion
                    NOTE: The tax preference is not necessarily the
                    difference between percentage depletion and cost                 Proposed regulations describe how to make the op-
                    depletion.                                                       tional 10-year amortization election. (REG-124405,
                                                                                     7/20/04)
                 ¶2212 Who Is Entitled to
                       the Depletion Deduction?
                                                                                     A sole proprietor’s expenses related to activities in the
                                                                                     field of automobile production were start-up expenses
                 Anyone who owns or has an “economic interest” in an oil             rather than current deductions because the activities
                 or gas well, mine, timber, or other resource property sub-          had not advanced beyond exploration and preliminary
                 ject to depletion is entitled to the depletion allowance.           solicitation. (Gudrun, TC Memo 2004-108)
                 The Supreme Court has ruled that any person entitled
                 to a share of oil and gas in place, or who has a right to           The IRS has provided a new elective safe harbor for
                 a share of production, has an “economic interest” and               determining oil and gas property’s recoverable reserves
                 is therefore entitled to the allowance. Thus, the owner             for purposes of figuring depletion. The election is made
                 of ocean shore property that provided the only available            by attaching a statement to the return for the first year
                 site from which to drill oil from adjacent submerged                in which the safe harbor is used. (Rev. Proc. 2004-19,
                 coastal lands, and who received a share of the profits              IRB 2004-10, 563)


                 ¶2214         CHAPTER 22 STUDY QUESTIONS — Amortization and Depletion

                     1.      In January 2005, a boutique owner enters into a          3.      With respect to percentage depletion, which state-
                             10-year lease for her store, with a five-year renewal            ment is not correct?
                             option. To make the store more suitable for her pur-             a. It may not be used after the taxpayer has
                             poses, she makes extensive improvements (assume                       recovered his or her basis in the property.
                             the improvements have a 39-year recovery period).                b. It cannot exceed 50% of taxable income from
                             She can amortize the improvements over:                               the property.
                             a. 10 years                                                      c. It may give rise to a tax preference item.
                             b. 15 years
                             c. 39 years
                                                                                       For further information on amortization and depletion,
                     2.      In 2005, a taxpayer buys a local stationery store. A      see: IRS Publication 534: Depreciating Property
                             portion of the purchase price is allocated to good        Placed in Service Before 1987 and IRS Publication
                             will. He can amortize the goodwill over:                  946: How to Depreciate Property.
                             a. A period of at least 60 months
                             b. 15 years
                                                                                       Answers to Study Questions, with feedback to both
                             c. 27.5 years
                                                                                       the correct and incorrect resposese, are provided in
                                                                                       Chapter 35, beginning with ¶3522.




                                                                                                                                                                        ¶2214



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                                                                                                                           23
                 PART 3 — DEDUCTIONS FOR BUSINESS AND OTHER SPECIAL DEDUCTION RULES


                 Business and Casualty Losses

                 LEARNING OBJECTIVES                                            ¶2302 Trade or Business Losses (Sec. 165)

                 This chapter was prepared to enable participants to gain       A loss incurred in the taxpayer’s trade or business is
                 an understanding of the rules on business and casualty         deductible from gross income in computing adjusted
                 losses. More specifically, upon completion, you will be        gross income. Thus, a person selling his or her delivery
                 able to:                                                       truck at a loss can deduct the amount of this loss from
                                                                                gross income.
                    Apply the limits on trade or business losses.
                    Figure the amount of casualty and theft losses that         Further, if the operation of a trade or business results in
                    can be deducted.                                            a loss for the year, the loss is deductible.
                    Determine net operating losses.
                                                                                As previously explained, “trade or business” generally re-
                 NEW THIS YEAR
                                                                                fers to an occupation or profession to which the taxpayer
                                                                                devotes a substantial part of his or her time. A taxpayer
                                                                                may have several trades or businesses; therefore, if one
                       Personal casualty losses from Hurricane Ka-
                                                                                business operates at a loss, he or she may deduct this loss
                       trina. Personal casualty losses from Hurricane
                       Katrina can be claimed without regard to the $100
                                                                                from the profit realized on the others.
                       and 10%-of-AGI floors. See ¶2308.                        A loss by sale or otherwise (except through casualty or
                                                                                theft) of tangible personal property not connected with
                                                                                either the taxpayer’s trade or business or arising from
                 ¶2301 Introduction (Sec. 165)
                                                                                any other transaction entered into for profit is never
                 Section 165 of the Code permits taxpayers to deduct            deductible. Thus, a tailor who buys a used sewing ma-
                 certain losses, either from gross income or from adjusted      chine for $100 and shortly thereafter finds out that it is
                 gross income, depending upon the nature of the loss.           worthless and sells it for scrap can deduct the amount of
                 Only the following types of losses are deductible:             the loss. If the same thing happens to a housewife who
                                                                                uses the machine for her own purposes only, the loss is
                    Losses incurred in a trade or business,                     not deductible.
                    Losses incurred in any transaction entered into for
                    profit, not in the taxpayer’s regular course of busi-       Trade and business losses, as explained in chapter
                    ness, and                                                   16, generally qualify either as ordinary or as Section
                    Losses incurred as the result of casualty or theft.         1231 losses.
                 The first two types of losses, as can be seen, must be         ¶2303 Loss on Transactions
                 associated with a business or other income-producing                 Entered into for Profit (Sec. 165)
                 activity. Casualty losses, on the other hand, are deduct-
                                                                                In addition to losses from a trade or business, taxpay-
                 ible even in the case of purely personal property.
                                                                                ers may deduct from gross income any loss incurred
                 Losses on the sale or exchange of business or income-          in a transaction entered into with the expectation of
                 producing property were already covered in chapter 12.         a profit, even though the transaction is not connected
                 Also, as explained in chapter 16, a recognized loss may        with their trade or business. Thus, losses on the sale of
                 be treated as an ordinary loss, a capital loss, or a Section   stocks, bonds, or other securities are deductible, since
                 1231 loss, depending on the type of property involved.         the taxpayer presumably invested in them out of a desire
                                                                                for profit.




                                                                                                                                           ¶2303



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              A majority of these losses are treated as capital losses       time for claiming the loss deduction. Generally, there is
              and are subject to the capital loss limitations that were      a three-year period for amending returns to claim de-
              previously discussed in ¶1603.                                 ductions omitted from the original return. In the case of
                                                                             worthless securities, there is a seven-year period.
              Abandonment of assets. If, due to some unforeseen
              change in business conditions, taxpayers must suddenly
                                                                               EXAMPLE: A taxpayer discovers that securities he still
              and prematurely abandon their assets permanently, they
                                                                               owns became worthless in 1997. He has until April 15,
              can claim a deduction for their loss. The amount of the          2005 (seven years from the due date of the 1997 return)
              deductible loss is the adjusted basis of the asset.              to file an amended return to make a refund claim.

                 EXAMPLE: Five years ago, a taxpayer bought a spe-           ¶2304 Hobby Losses (Activities Not Engaged in
                 cial machine for $11,000, which he depreciated at the
                                                                                   for Profit) (Sec. 183)
                 rate of $1,000 a year. Because of changed business
                 conditions, it is no longer profitable to manufacture       There is a “hobby loss” rule that limits deductions at-
                 the product for which the machine was designed,             tributable to an activity not engaged in for profit. If the
                 and the taxpayer is forced to abandon it. He may
                                                                             activity is not engaged in for profit, the taxpayer may
                 deduct a loss of $6,000.
                                                                             deduct, in the following order:
              It should be noted that there must be a definite and per-        Those items whose deductibility does not depend on
              manent abandonment before a loss can be claimed. Mere            a profit motive, such as interest, property taxes, and
              nonuse is not sufficient. Also, it is important to point out     casualty losses.
              that this loss deduction does not apply to merchandise           Items deductible only if the activity is engaged in for
              or other items included in a taxpayer’s inventory, because       profit (other than depreciation), but only to the extent
              any such loss will automatically be taken into account           that the gross income from the activity exceeds the
              through a reduction in inventory values. As Schedule             deductions allowed in 1, above.
              C (the business schedule) shows, opening and closing             Depreciation.
              inventories are taken into account in computing profit or
              loss; thus, any decrease in inventory value will decrease      In other words, if the activity is not engaged in for profit,
              profit (or increase loss) by the same amount.                  a deduction is allowed to the extent of (1) the income
                                                                             from the activity or (2) the amount of deductions allow-
              Demolition of buildings.    When a building is bought          able, regardless of profit motive, whichever is larger.
              with the intention of demolishing it to use the land,
              the costs of demolition are generally not deductible but         EXAMPLE: Clarence collects paintings as a hobby,
              must be added to the basis of the land.                          and not for profit. His expenses connected with this
                                                                               activity, which would be deductible, regardless of
                                                                               profit motive (interest and personal property taxes,
                 EXCEPTION: Demolition costs are currently deduct-
                                                                               etc.), total $1,200. He may deduct this amount. As-
                 ible if both 75% or more of the existing external walls
                                                                               sume that he derived income of $2,000 from this ac-
                 and 75% or more of the existing internal framework
                                                                               tivity and assume further that he incurs maintenance
                 are retained.
                                                                               expenses, insurance, and shipping costs connected
                                                                               with his paintings totaling $1,500 in addition to his
              Worthless stocks. If stocks or bonds become worth-               $1,200 in deductions. These expenses would be
              less during the year, they are treated as if they had been       deductible in full if the activity was engaged in for
              sold on the last day of the year, with the owner entitled        profit. But, since it is a hobby, he may deduct only
                                                                               $2,000, consisting of the amount allowable, regard-
              to a capital loss deduction (as explained in chapter 16).
                                                                               less of profit motive ($1,200), plus $800 out of the
              However, the securities must be entirely worthless before        $1,500 of other costs.
              a loss can be claimed. If they retain any value at all, the
              only way to establish a loss is through a sale. The sale
              must be bona fide, not a sham. However, the fact that
                                                                               PITFALL: The IRS has noted that claiming losses
              the sole purpose of the sale was to establish a tax loss         from hobby activities in excess of income from those
              does not disqualify the deduction.                               activities is one of the most common errors made
                                                                               on individual income tax returns.
              In view of the difficulty in ascertaining precisely if and
              when securities become worthless, there is an extended


    ¶2304



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                 If the activity is a “hobby,” then income is reported on         Progressive deteriorations of property through a steadily
                 page 1 of Form 1040 as “other income” while expenses             operating cause or damage from a normal process are
                 are reported as miscellaneous itemized deductions on             not casualty losses. The steady weakening of a building
                 Schedule A (subject to the 2%-of-AGI limit).                     brought on by normal or ordinary wind or weather con-
                                                                                  ditions is not a casualty loss. Moth and termite damage
                    PITFALL: Hobby activity expenses are not deductible           is not normally a casualty loss. However, where it can be
                    for AMT purposes (since they are treated as miscel-           proven that property was suddenly infested and damaged
                    laneous itemized deductions).                                 by termites, the loss may be held deductible.
                                                                                  The cost of repairing damage to a taxpayer’s automobile
                 Presumption of profit motive.      A taxpayer will be pre-       from collision (even if resulting from his or her own faulty
                 sumed to engage in a profitable activity if, in any three        driving) is deductible, provided that it was not caused by
                 out of five consecutive years ending with the current year,      a willful act or negligence (e.g., drunk driving).
                 the activity produces a profit, or, in the case of breeding,
                 training, showing, or racing horses, in two out of seven         Theft losses are deductible if the taking constitutes a
                 consecutive taxable years. The IRS can overcome this             theft under state law. Losses from embezzlement are
                 presumption, however.                                            classed as thefts and are hence deductible. For example,
                                                                                  when a contractor disappeared after collecting a down
                 A taxpayer who suffers losses in the first couple of years and   payment for construction of a residence, the taxpayer
                 who wants to rely on the presumption can file an election        was permitted a deduction.
                 to do so on Form 5213, “Election to Postpone Determina-
                 tion.” In effect, this keeps the IRS from challenging a profit   Loss incurred through misplacement or disappearance of
                 motive until the end of the five-year testing period.            an item is not deductible. Consequently, a theft deduction
                                                                                  will be allowed only if the taxpayer can submit some reason-
                    EXAMPLE: Johnson starts a dog-breeding business               able evidence that the loss was due to theft. In questionable
                    in 2005 and incurs losses with very little income. He         cases, the police record will frequently be decisive.
                    can file Form 5213 to prevent the IRS from question-
                    ing losses from this activity until after 2009.
                                                                                    PRACTICE POINTER: It is important that the tax-
                                                                                    payer notify the police immediately when theft or
                 The election must be made within three years of the                suspected theft occurs, if only to substantiate a tax
                 due date of the return for the first year of the activity. In      deduction.
                 the example above, the election must be made by April
                 17, 2009 (within three years from April 17, 2006, the            ¶2306 Amount of Loss
                 due date for 2005, the year in which the dog-breeding
                 activity started). If the IRS questions any deductions           The amount deductible depends on whether the loss
                 before the end of this three-year period and an election         incurred is a business casualty loss or a personal casu-
                 has not yet been made, an election can still be put into         alty loss. But regardless of the nature of the loss, the
                 effect. The election must be made within 60 days of              deduction must be reduced by any insurance, or other
                 receiving a deficiency notice from the IRS.                      compensation, recovered or recoverable.
                                                                                  A “business” casualty loss is a loss sustained on property
                    PITFALL: The election to postpone determination of            used in the taxpayer’s trade or business, or held for invest-
                    profit motive also extends the statute of limitations         ment or the production of income, even though not in
                    for all items on the return related to the activity.
                                                                                  the taxpayer’s trade or business.
                                                                                  ¶2307 Personal Casualty Losses
                 ¶2305 Casualty and Theft Losses (Sec. 165)
                                                                                  Where nonbusiness or personal property has been dam-
                 Taxpayers are permitted a deduction for casualty losses,
                                                                                  aged or destroyed, the loss is the difference between the
                 whether on business or personal property. A casualty loss
                                                                                  fair market value of the property immediately before
                 is the complete or partial loss or destruction of property as
                                                                                  and the fair market value immediately after the casualty.
                 the result of a sudden, unexpected, or unusual destructive
                                                                                  However, the recognized loss cannot be greater than the
                 force, such as an automobile collision, a fire, flood, storm,
                                                                                  adjusted basis of the property. The deduction must be re-
                 drought, shipwreck, explosion, hurricane, or other simi-
                                                                                  duced by any salvage or insurance proceeds obtained.
                 lar event, or through theft, robbery, vandalism, or riot.

                                                                                                                                                                  ¶2307



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                                                                                                        the casualty losses are closely related in origin, the
                 EXAMPLE: J.B. Adams’s residence, which cost
                                                                                                        resulting losses are considered as a single casualty and,
                 him $112,000 in 1995, was partially destroyed by
                 fire during the taxable year. The value of the home
                                                                                                        thus, subject to only one $100 reduction. For example,
                 immediately before the fire was $188,000 and the                                       if a storm damages a taxpayer’s residence and also dam-
                 value immediately after was $175,000. He collected                                     ages his or her automobile parked in the driveway, it is
                 $10,000 from his insurance company. The amount of                                      considered as a single casualty. Similarly, if a hurricane
                 the casualty loss is computed as follows:                                              causes both wind and flood damage to a taxpayer’s
                 Value before fire . . . . . . . . . . . . . . . . . . . . . . . . . . $188,000         summer residence, a single casualty is involved. In
                 Value after fire. . . . . . . . . . . . . . . . . . . . . . . . . . . . 175,000        addition to the $100 floor for each separate casualty,
                     Decrease in value . . . . . . . . . . . . . . . . . . . . . $13,000                losses are deductible only when they exceed 10% of
                 Adjusted basis (cost in this case) . . . . . . . . . . . . . $112,000                  adjusted gross income.
                     Loss (lesser of decrease in value
                        or adjusted basis) . . . . . . . . . . . . . . . . . . .              $13,000   For purposes of applying the limitations, a husband and
                           Less insurance recovery . . . . . . . . . . . .                     10,000   wife filing a joint return are treated as one individual.
                 Loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   $ 3,000   If a husband and wife file a joint return, only one $100
                                                                                                        floor applies to each casualty, regardless of whether
              To determine accurately the difference in the fair market                                 the property on which the loss was sustained is owned
              value of the property immediately before and after the                                    jointly or separately. Also, the overall 10%-of-adjusted-
              loss, a competent appraiser should be employed.                                           gross-income limitation applies. By the same token, if
                                                                                                        a husband and wife file separate returns, each is subject
              The cost of repairs to damaged property is also accept-                                   to the $100 floor for each casualty, and the 10% of AGI
              able as proof of the amount of the loss, provided that                                    limit applies on each of their returns.
              the repairs do no more than restore the property to its
              condition immediately before the casualty and that the                                    Individual taxpayers, other than husband and wife, are
              amount spent for such repairs is not excessive. The cost                                  subject to a separate $100 floor for each casualty or theft,
              of clearing the property of debris is also deductible.                                    even though the property of other persons is damaged
                                                                                                        or destroyed by the same disaster. For example, if a fire
              For rules on when to deduct losses, see ¶2313.                                            damages the house and household goods of one indi-
                                                                                                        vidual, as well as the property of a visiting nephew, the
              ¶2308 Limitations on Personal Casualty Losses                                             homeowner is subject to one $100 reduction and the
              Personal casualty losses generally are deductible only to                                 nephew to a separate $100 reduction.
              the extent that the loss exceeds 10% of adjusted gross
                                                                                                        Special rules for Hurricane Katrina losses. The
              income. In addition, each separate casualty loss must be
                                                                                                        $100/10%-of-AGI floors do not apply for losses attribut-
              reduced by $100.
                                                                                                        able to this storm. Thus, personal casualty and theft losses
                                                                                                        arising in the Hurricane Katrina disaster area are treated
                 EXAMPLE: Referring to the previous example, as-                                        as a deduction separate from other casualty losses.
                 suming that Mr. Adams’s adjusted gross income is
                 $15,000, his casualty loss deduction is $1400 ($2900                                   ¶2309 Reporting of Personal Casualty
                 [$3,000 - $100] - $1,500 [10% of AGI]).                                                      Gains and Losses

                                                                                                        Form 4684, “Casualties and Thefts,” is used to figure
                 EXAMPLE: Assume that on the same day that Mr.                                          the gain or loss from casualties and thefts (see next two
                 Adams’s home burned down, a pickpocket stole                                           pages). Section A of Form 4684 is used to make this
                 his wallet containing $300. Since two separate acts                                    determination for personal use property. The $100 floor
                 of casualty are involved, he must reduce each loss                                     is applied to each casualty or theft event.
                 deduction by $100 before applying the 10%-of-
                 adjusted-gross-income limit. Accordingly, his total                                    If the net result of these events is a gain because of
                 casualty loss deduction would be $1600 ($300 - $100                                    insurance or other reimbursements, it is entered on
                 + $3,000 - $100 = $3,100 - $1,500 [10% of AGI]).                                       Schedule D. If the net result of these events is a loss,
                                                                                                        then the loss must be reduced by the 10%-of-adjusted-
              When the taxpayer suffers two or more losses as the                                       gross-income floor. The reduced loss is then entered
              result of one casualty act, or when the events causing                                    on Schedule A.



    ¶2308



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                                                                                                                                                               OMB No. 1545-0177
                      Form   4684                                                Casualties and Thefts
                                                                                     See separate instructions.
                                                                                                                                                                 2005
                                                                                      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 5
                      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 4/
                              Property A
                              Property B
                              Property C




                                                                            D /2
                              Property D

                                                                                                                                Properties
                                                                                                    A                      B                      C                      D


                        2
                        3



                        4
                             Cost or other basis of each property
                             Insurance or other reimbursement (whether or not
                             you filed a claim) (see instructions)
                                                                             1
                             Note: If line 2 is more than line 3, skip line 4.
                                                                               0        2


                                                                                        3


                             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. But if the loss arose in the Hurricane Katrina disaster area after August
                             24, 2005, and was caused by Hurricane Katrina, enter -0-                                                                     11
                      12     Subtract line 11 from line 10                                                                                                12
                             Caution: Use only one Form 4684 for lines 13 through 21.
                      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     Add the amounts on line 12 of all Forms 4684 on which you entered -0- on line 11                                             17
                      18     Is line 17 less than line 16?
                                  No. Stop. Enter the amount from line 16 on Schedule A (Form 1040), line 19. Estates and trusts; enter the               18
                                  amount from line 16 on the “Other deductions” line of your tax return.
                                  Yes. Subtract line 17 from line 16.
                      19     Enter 10% of your adjusted gross income from Form 1040, line 38. Estates and trusts, see instructions                       19
                      20     Subtract line 19 from line 18. If zero or less, enter -0-                                                                   20
                      21     Add lines 17 and 20. Also enter the result on Schedule A (Form 1040), line 19. Estates and trusts, enter the result
                             on the “Other deductions” line of your tax return                                                                           21
                      For Paperwork Reduction Act Notice, see page 4 of the instructions.                               Cat. No. 12997O                          Form   4684   (2005)


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               Form 4684 (2005)                                                   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 5
               22       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 A
                        Property B
                        Property C
                                                                                 a 0
                                                                               ft 20
                                                                            ra 4/
                        Property D
                                                                                                                                    Properties
                                                                                                     A                         B                          C                         D




                                                                           D /2
               23       Cost or adjusted basis of each property                     23
               24       Insurance or other reimbursement (whether or not
                        you filed a claim). See the instructions for line 3         24
                        Note: If line 23 is more than line 24, skip line 25




                                                                              0
               25       Gain from casualty or theft. If line 24 is more than line
                        23, enter the difference here and on line 32 or line 37,




                                                                            1
                        column (c), except as provided in the instructions for
                        line 36. Also, skip lines 26 through 30 for that column.
                        See the instructions for line 4 if line 24 includes
                        insurance or other reimbursement you did not claim, or
                        you received payment for your loss in a later tax year       25
               26       Fair market value before casualty or theft                   26
               27       Fair market value after casualty or theft                    27
               28       Subtract line 27 from line 26                                28
               29       Enter the smaller of line 23 or line 28                   29
                        Note: If the property was totally destroyed by
                         casualty or lost from theft, enter on line 29 the
                         amount from line 23.
               30       Subtract line 24 from line 29. If zero or less, enter -0- 30
               31       Casualty or theft loss. Add the amounts on line 30. Enter the total here and on line 32 or line 37 (see instructions)                    31
                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
               32                                                                                               (                            ) (                       )
                                                                                                                (                            ) (                       )
               33       Totals. Add the amounts on line 32                                                   33 (                            ) (                       )
               34       Combine line 33, 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                                                                                              34
               35       Enter the amount from line 33, column (b)(ii) here. Individuals, enter the amount from income-producing property
                        on Schedule A (Form 1040), line 27, and enter the amount from property used as an employee on Schedule A
                        (Form 1040), line 22. Estates and trusts, partnerships, and S corporations, see instructions                                             35
                                                          Casualty or Theft of Property Held More Than One Year
               36       Casualty or theft gains from Form 4797, line 32                                                                                          36
               37                                                                                               (                            ) (                       )
                                                                                                                (                            ) (                       )
               38       Total losses. Add amounts on line 37, columns (b)(i) and (b)(ii)                     38 (                            ) (                       )
               39       Total gains. Add lines 36 and 37, column (c)                                                                                             39
               40       Add amounts on line 38, columns (b)(i) and (b)(ii)                                                                                       40
               41       If the loss on line 40 is more than the gain on line 39:
                    a   Combine line 38, column (b)(i) and line 39, 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                                                                                 41a
                 b      Enter the amount from line 38, column (b)(ii) here. Individuals, enter the amount from income-producing property on
                        Schedule A (Form 1040), line 27, and enter the amount from property used as an employee on Schedule A (Form 1040),
                        line 22. 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                41b

               42       If the loss on line 40 is less than or equal to the gain on line 39, combine lines 39 and 40 and enter here. Partnerships
                        (except electing large partnerships), see the note below. All others, enter this amount on Form 4797, line 3                             42
                        Note: Partnerships, enter the amount from line 41a, 41b, or line 42 on Form 1065, Schedule K, line 11.
                                S corporations, enter the amount from line 41a or 41b on Form 1120S, Schedule K, line 10.


                                                                                          Printed on recycled paper                                                        Form   4684     (2005)

    ¶2309



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                 ¶2310 Business Casualty Losses
                                                                                                            EXAMPLE: A collision caused $1,000 in damage to
                 If business property or property held for the production                                   a taxpayer’s automobile. It has an adjusted basis of
                 of income is completely destroyed, the deductible loss is                                  $2,000 and is used on a 50-50 basis for business
                 the adjusted basis of the property, less any salvage value                                 and personal reasons. The taxpayer collected $900
                 and any insurance or other compensation received or                                        from his insurance company, with a net loss to the
                                                                                                            taxpayer of $100. Half the loss ($50) is considered
                 recoverable. The loss is deductible in full; the $100 floor
                                                                                                            a business loss and is fully deductible. The remain-
                 and the 10%-of-adjusted-gross-income limit apply only                                      ing $50 is personal and is nondeductible because
                 to nonbusiness casualty losses.                                                            it does not exceed $100. Assuming the loss was
                                                                                                            larger, the 10% AGI limit would apply only to the
                    EXAMPLE: Mr. Harding owns a building, which cost                                        personal-use portion.
                    him $130,000. He uses it for rental purposes. It was
                    completely destroyed by a tornado. The total de-
                                                                                                          ¶2311 Insurance or Other Compensation
                    preciation 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 be re-
                    was $100,000. He would compute his casualty loss                                      duced by any insurance or other compensation received.
                    as follows:
                                                                                                          This includes amounts received from disaster relief agen-
                    Cost . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $130,000   cies (such as the Red Cross) or other sources to restore
                         Less: Depreciation . . . . . . . . . . . . . . . . . . . .              26,000
                                                                                                          or rehabilitate lost or damaged property. Food, medical
                         Adjusted basis. . . . . . . . . . . . . . . . . . . . . . . . $104,000
                                                                                                          supplies, and other forms of subsistence received are not
                    Less: Salvage and insurance recovery. . . . . . . . . 100,000
                    Total loss deductible. . . . . . . . . . . . . . . . . . . . . . .           $4,000
                                                                                                          replacements of lost or destroyed property and do not
                                                                                                          reduce the deduction.

                 If business property is partially destroyed, the deduct-                                 A taxpayer is not allowed to deduct a personal casualty
                 ible loss is (1) the decrease in value due to the casualty                               loss unless the taxpayer files a timely insurance claim
                 or (2) the adjusted basis of the property damaged,                                       as to damage to that property. This rule applies to the
                 whichever is smaller, reduced by insurance or other                                      extent any insurance policy would provide reimburse-
                 compensation received.                                                                   ment for a loss.
                                                                                                          ¶2312 How Casualty Losses Are Deducted
                    EXAMPLE: Assume that Mr. Harding’s building was
                    only partially destroyed by the storm, and that the ac-                               As explained in chapter 16, all business casualty losses
                    tual value of the building was $120,000 immediately                                   must be grouped together to determine if there is a net
                    before the storm and $85,000 immediately after. The                                   gain or net loss. If a net gain results, all such casualty
                    loss is the decrease in value, $35,000, since this is                                 gains and losses are combined or “netted” with any
                    less than the adjusted basis of $104,000.                                             regular noncasualty, Section 1231 gains and losses to
                                                                                                          determine if there is a net gain on Section 1231 assets;
                 Casualty losses of business property are deductible from                                 such gain would be taxed as long-term capital gain. If a
                 gross income in computing adjusted gross income. The                                     net loss results from casualties, it does not come under
                 same applies to casualty losses of property held for the                                 Section 1231, and the loss is therefore fully deductible
                 production of rents and royalties.                                                       as an ordinary loss. The netting is done on Form 4684,
                                                                                                          “Casualties and Thefts.”
                 If the property is held partly for business purposes and
                 partly for personal purposes, the casualty or theft loss
                 deduction must be computed as though two separate                                          EXAMPLE: Mr. Jones had an uninsured loss of $5,000
                                                                                                            resulting from the destruction by fire of property he
                 pieces of property had been stolen, damaged, or de-
                                                                                                            used in his business. He also had a recognized gain
                 stroyed—one business and the other nonbusiness.                                            of $3,000 resulting from an insurance recovery on
                                                                                                            business property used in his business, which was
                 For a casualty loss of property used partially for busi-
                                                                                                            destroyed by a tornado. Since his losses exceed his
                 ness and partially for personal purposes, the $100 floor                                   gains, neither is subject to Section 1231. The net ef-
                 and the 10%-of-adjusted-gross-income limit apply                                           fect is an ordinary loss deduction of $2,000.
                 only to the net loss attributable to the part used for
                 personal purposes.



                                                                                                                                                                                          ¶2312



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              Business casualty loss rules can be summarized as follows:     ¶2314 Special Rule for Disaster Losses
                                                                                   (Sec. 165(h))
                 Step 1. Casualty and theft gains and losses are netted.
                 Step 2. If a net loss results, take it as an ordinary       A special rule permits quick tax relief for casualty losses
                 deduction.                                                  suffered by individuals residing in disaster areas. Under
                 Step 3. If a net gain results, take it into account under   this rule, any such losses sustained during the current
                 Section 1231 gains and losses. If the total is a gain,      tax year may be deducted on the tax return filed for the
                 Section 1231 is applicable. If the total is a loss, all     previous tax year. The disaster area must be so designated
                 gains and losses are ordinary.                              by the President. The taxpayer has the choice of elect-
                                                                             ing to take advantage of this provision or deferring the
              ¶2313 When to Deduct a Casualty Loss                           deduction until the return for the tax year.
              In general, casualty losses are deductible only in the
              tax year in which the casualty occurs. This is true even         EXAMPLE: A taxpayer’s home was severely damaged
              though the property may not be repaired or replaced              by a flood in May 2005. The area was subsequently
              until a later year. However, theft and embezzlement              declared a disaster area; the taxpayer may therefore
                                                                               elect to claim the loss on his income tax return for
              losses are deductible only in the year the loss is dis-
                                                                               either 2004 or 2005.
              covered, not in the year the theft or embezzlement
              occurred unless that is also the year in which the loss
              is discovered.                                                 Disaster loss treatment is extended when a disaster has
                                                                             rendered a personal residence unsafe (though still habit-
              If the amount of the loss sustained cannot be determined       able) and the taxpayer has been ordered by state or local
              before the due date for filing the return, the taxpayer        officials, within 120 days of the designation of the locality
              can file Form 4868 to obtain the automatic six-month           as a disaster area, to demolish or move the residence.
              extension of time to file. See ¶3203.
                                                                             If the casualty occurs after the return for the preceding
              If the taxpayer, with reasonable certainty, expects to         year has been filed, the taxpayer may file an amended
              receive insurance or other compensation, but has not           return in order to claim the loss.
              received it by the end of the year in which the casualty
              occurred, the loss deduction must be reduced by the              PITFALL: In the event that individuals elect to take
              estimated amount of insurance or other compensation              into account a personal disaster loss for the tax
              to be received. If the taxpayer subsequently receives            year immediately preceding the tax year in which
              less than the amount originally estimated, he or she is          the disaster occurred, they must use their adjusted
              entitled to an additional loss deduction in the year the         gross income for such prior year in determining the
              claim is settled.                                                extent to which the loss is deductible.


                 EXAMPLE: Business property with an adjusted basis
                 of $10,000 is completely destroyed by fire in 2005.           PRACTICE POINTER: Taxpayers who are in Presi-
                 The taxpayer’s only claim for reimbursement consists          dentially-declared disaster areas gain automatic
                 of an insurance claim for $8,000, which is settled            postponement for certain tax acts, such as filing
                 in 2005. The taxpayer sustained a loss of $2,000 in           returns. For details, see Rev. Proc. 2004-13, IRB
                 2005 and should claim it in that year.                        2004-7, 489.


                                                                             ¶2315 Gambling Losses (Sec. 165(d))
                 PITFALL: If a loss is claimed and an unexpected in-
                                                                             Taxpayers who are engaged (legally or illegally) in the
                 surance recovery is later received, the amount of the
                 loss must be reported as income in the year of the
                                                                             business of wagering or gambling may deduct such losses
                 insurance recovery. The return for the loss year is not     from gross income to the extent that they report their
                 amended, even if that year is still otherwise available     gambling gains as income. A net loss from gambling is not
                 for making amendments.                                      deductible. A person who is not engaged in gambling as a
                                                                             business may deduct such losses, along with other item-
                                                                             ized deductions, from adjusted gross income, but only to
                                                                             the extent that the gambling income was reported.



    ¶2313



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                                                                                 Capital losses may not exceed capital gains. Fur-
                    EXAMPLE: J. Redfield, an unmarried store clerk,
                                                                                 thermore, nonbusiness capital losses may not exceed
                    earned a $7,000 annual salary in 2005. He is an ar-
                    dent racing fan and had total winnings of $1,800 and
                                                                                 nonbusiness capital gains, even though the taxpayer’s
                    total losses of $3,000 resulting from betting on the         business-derived capital gains exceed his or her busi-
                    horses. Although Redfield’s wagering losses totaled          ness capital losses.
                    $3,000, he can only deduct $1,800, his losses to the         The deduction for personal and dependency exemp-
                    extent of his winnings. The $1,200 excess of losses          tions is disregarded.
                    over gains is not deductible and cannot be carried           Nonbusiness deductions may not exceed nonbusi-
                    over to another year.                                        ness income.
                                                                                 No net operating loss carryovers or carrybacks from
                 Where a husband and wife file a joint return, their             other years are considered.
                 combined gambling losses are allowable as itemized
                 deductions to the extent that their combined winnings          PRACTICE POINTER: No special form is used to
                                                                                figure the net operating loss. Instead, attach a state-
                 from such transactions were included in income.
                                                                                ment to the rturn that shows how the net operating
                                                                                loss deduction was figured.
                    NOTE: While certain miscellaneous itemized deduc-
                    tions are subject to a 2%-of-adjusted-gross-income
                                                                              ¶2318 Business or Nonbusiness
                    floor (¶910), this floor does not apply to gambling
                    losses, which are deductible in full to the extent of           Income and Expenses
                    gambling winnings.
                                                                              Since nonbusiness deductions may be claimed only to
                                                                              the extent of nonbusiness income in computing a net
                 ¶2316 Net Operating Losses (Sec. 172)                        operating loss, it is necessary to distinguish between
                                                                              business and nonbusiness income and expenses. For
                 If taxpayers sustain a net loss in the operation of their    purposes of the net operating loss computation, salaries
                 trade, business, or profession, or from casualty or theft,   and wages are considered as trade or business income.
                 and such loss or losses exceed their income from other       Also, loss sustained in the operation of rental property is
                 sources, they have a net operating loss that may be used     considered a business loss. Losses on Section 1244 stock
                 to reduce their income subject to tax (as adjusted) for      and the taxpayer’s pro rata share of losses from an S cor-
                 other years or entitle them to a refund of income tax        poration or partnership are allowable as business losses in
                 previously paid.                                             computing the net operating loss. Any gain or loss on the
                 Defined simply, a net operating loss is the excess of        sale or other disposition of real or depreciable property
                 allowable deductions over gross income after certain         used in a trade or business is included at 100%.
                 adjustments described below are applied to that excess.      Casualty and theft losses, including those losses incurred
                 ¶2317 How the Net Operating Loss                             on property used for personal purposes, are treated as
                       Is Computed                                            attributable to a trade or business in computing the
                                                                              net operating loss. However, a personal casualty loss is
                 A net operating loss is computed in the same way as          subject to the 10%-of-adjusted-gross-income limit and
                 taxable gross income less deductions, with the follow-       the $100 floor.
                 ing exceptions:




                                                                                                                                                              ¶2318



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                                                                                                     However, a small business net operating loss from a
                 EXAMPLE: A single taxpayer began operation of a
                                                                                                     Presidentially-declared disaster and an individual net
                 retail business in 2004 and had a net operating loss
                 of $185 for the year. He had no income subject to tax
                                                                                                     operating loss from a casualty or theft have a three-year
                 in 2003. During 2005, he had the following income                                   carryback in lieu of an applicable two-year period. Farm-
                 and deductions:                                                                     ers and ranchers can claim a five-year carryback for all
                                                                                                     their net operating losses, regardless of year, (unless they
                  INCOME
                  Salary earned as part-time helper in
                                                                                                     elect to forego the five-year period).
                  gas station (salary is business income) . . . . . . . .                    $875
                  Interest on savings. . . . . . . . . . . . . . . . . . . . . . . .        1,425      PRACTICE POINTER: Taxpayers must keep track of
                  Net long-term capital gain on sale of
                                                                                                       net operating losses from each year separately so
                  real estate used in business . . . . . . . . . . . . . . . .              1,000
                                                                                                       that the appropriate carryback and carryover period
                       Total income. . . . . . . . . . . . . . . . . . . . . . . . . .     $3,300
                                                                                                       can be used.
                  DEDUCTIONS
                  Net operating loss carryover from 2004 . . . . . . .                       $185
                  Net loss from business (gross receipts of
                                                                                                     Foregoing the carryback. A taxpayer can elect to forego
                     $67,000 minus expenses of $72,000) . . . . . . .                       5,000    the carryback and simply carry the loss forward for the
                  Net short-term capital loss on sale of stock . . . .                        500    applicable number of years. For purposes of the five-year
                  Net loss from rental property . . . . . . . . . . . . . . . .               900    carryback period, a taxpayer can forego this period in
                  Casualty loss short-term on
                     business property. . . . . . . . . . . . . . . . . . . . . . .           200    favor of a two-year period or forego the carryback en-
                  Itemized deductions . . . . . . . . . . . . . . . . . . . . . .           8,410    tirely. The election is made on a statement attached to
                       Total deductions . . . . . . . . . . . . . . . . . . . . . .       $15,195    the return for the year of the loss. The election cannot be
                  Deductions exceed income (loss) . . . . . . . . . . . . .              ($11,895)   made after the due date for filing the return (including
                                                                                                     extensions). The election is irrevocable.
                  To determine net operating loss,
                  the following adjustments must be made:
                                                                                                       PRACTICE POINTER: The election to forego the
                  Deductions in excess of income (loss) . . . . . . . .                  ($11,895)
                                                                                                       carryback should be considered where there is fear
                   1. Eliminate net operating                                                          of an audit for the earlier years.
                      loss carryover from 2004 . . . . . . . $185
                   2. Eliminate net nonbusiness
                      short-term capital loss . . . . . . . . .        500                           Before computing the net operating loss deduction for the
                   3. Eliminate the excess of
                      nonbusiness deductions                                                         year, it must be determined what part of any operating
                      (itemized deductions, $8,410)                                                  losses for any preceding or succeeding tax years represents
                      over nonbusiness income                                                        carryovers or carrybacks to the tax year under consideration.
                      (interest, $1,425) . . . . . . . . . . . . . . 6,985
                                                                                                     The sum of the net operating loss carrybacks and carryovers,
                  Total adjustments to net loss . . . . . . . . . . . . . . . .             7,670    then, is the net operating loss deduction for the tax year.
                  Net operating loss for 2005 . . . . . . . . . . . . . . . . .           ($4,225)
                                                                                                     The net operating loss is carried back to the second tax year
                                                                                                     preceding the year in which it is sustained. Any amount of
              ¶2319 Loss Carrybacks and Carryovers                                                   the loss not used to offset income subject to tax (adjusted,
                                                                                                     as explained below) for the third preceding year is carried
              The carryback and carryover periods for net operating                                  to the second preceding year. Any amount of the loss not
              losses depend on the year in which the net operating                                   used to offset income subject to tax (adjusted) for the
              loss arose.                                                                            third and second preceding years must be carried to the
                                                                                                     first preceding year. If the loss is not entirely used to offset
                 For losses arising in 2001 and 2002, the carryback
                                                                                                     income subject to tax (adjusted) in the three preceding
                 period is five years and the carryforward period is
                                                                                                     years, the balance may be carried forward to the twentieth
                 20 years.
                                                                                                     succeeding years in the order of their occurrence.
                 For losses arising in tax years beginning after August
                 5, 1997 (other than in 2001 and 2002), the carryback
                 period is two years and the carryforward period is                                    EXAMPLE: Jones started business in January 2001
                 20 years.                                                                             and had a $42,000 net operating loss for the year.
                                                                                                       Before 2001, his income consisted of wages. His
                 For losses arising tax years beginning before August                                  income subject to tax (after necessary adjustments)
                 6, 1997, the carryback period is three years and the                                  in the other years to which the loss may be carried
                 carryforward period is 15 years.                                                      back or forward is as follows:


    ¶2319



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                                                                                                                                                                  Adjusted             Unused
                                                                                                                                             Carryback or          Income         Carryback or
                    Year                                                                                                                        Carryover    Subject to Tax          Carryover

                    1998—3d preceding year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .       $42,000              $2,000           $40,000
                    1999—2d preceding year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .        40,000               3,000            37,000
                    2000—1st preceding year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .         37,000               5,500            31,500
                    2001—net operating loss year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
                    2002—1st succeeding year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .          31,500               7,000             24,500
                    2003—2d succeeding year. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .          24,500               3,800             20,700
                    2004—3d succeeding year. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .          20,700              10,700             10,000
                    2005—4th succeeding year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .          10,000               6,000              4,000


                    The $4,000 carryover remaining at the end of 2005 may be used, if needed, up to the year 2021.


                  If the taxpayer has more than one net operating loss to                                           or income subject to tax, as the case may be, determined
                 be carried to the same tax year, the loss from the earliest                                        after applying the carryback. Also, any credits based on
                 year is applied first.                                                                             or limited by the tax must be recomputed on the basis of
                                                                                                                    the tax liability after application of the carryback.
                    EXAMPLE: A taxpayer had net operating losses of
                                                                                                                    ¶2321 Effect on Self-Employment Tax
                    $10,000 and $15,000, respectively, in the years 2004
                    and 2005. His income subject to tax (adjusted) was                                              In computing net earnings from self-employment, the
                    $2,500 in 2002 and $14,000 in 2003. He carried a                                                net operating loss deduction is not to be considered.
                    $10,000 loss from 2004 to 2002, leaving an unused
                    portion of $7,500 to be used in 2003. The $15,000                                               ¶2322 Carrying the Loss to More Than One Year
                    loss from 2005 is used to offset $6,500 in 2003. The
                    remainder of the loss ($8,500) may be carried forward                                           The net operating loss is carried back to the oldest ap-
                    to future years up to 2025.                                                                     plicable preceding year. But if the loss exceeds the income
                                                                                                                    subject to tax in the year to which it is carried, certain
                 In making a claim for a net operating loss deduction,                                              adjustments must be made to the income subject to tax of
                 the taxpayer must file with his or her return for the                                              that year to determine the unused portion of the loss that
                 year of the deduction a concise statement setting forth                                            may be carried to another year. The amount of the loss
                 all related facts, including a detailed schedule showing                                           that may be carried to another year, after applying it to
                 how the deduction was computed. The net operating                                                  an earlier year or years, is the excess of the net operating
                 loss deduction is claimed on page 1 of Form 1040 as a                                              loss over the income subject to tax of the earlier year or
                 negative entry under “other income.”                                                               years, computed with the following modifications:
                 An election to relinquish the net operating loss car-                                                  The deduction for capital losses may not exceed the
                 ryback for regular tax purposes applies for alternative                                                capital gains included in gross income.
                 minimum tax purposes as well. Inconsistent elections                                                   Income subject to tax is determined without regard
                 are not permitted. Thus, in order to relinquish the car-                                               to the particular net operating loss being carried back
                 ryback for alternative minimum tax purposes, it must                                                   or forward, or to any later net operating loss. But any
                 be relinquished for regular tax purposes.                                                              earlier net operating losses being carried back or over
                                                                                                                        from other years may be taken into account.
                 ¶2320 Recomputing Tax Liability for                                                                    The taxpayer may not claim any personal exemptions
                       Year to Which a Loss Is Carried                                                                  or exemptions for dependents.
                 In recomputing the tax liability to determine the amount                                               Any deductions claimed, except charitable contribu-
                 of refund for the year to which the loss is carried back, the                                          tions, which are based on or limited to a percentage of
                 deduction for charitable contributions is determined with-                                             adjusted gross income or income subject to tax (such
                 out regard to any carryback. Any other deduction (such                                                 as medical expenses), must be recomputed on the basis
                 as medical expenses) based on, or limited to, a percentage                                             of the adjusted gross or income subject to tax after ap-
                 of adjusted gross income or income subject to tax must                                                 plying adjustments 1, 2, and 3, above. The deduction
                 be recomputed on the basis of the adjusted gross income                                                for charitable contributions is determined by using the


                                                                                                                                                                                                     ¶2322



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                 same adjustments, except that any net operating losses        from Carryback of Net Operating Loss or Unused Invest-
                 being carried back are not considered.                        ment Credit.” This form, which is the one used by the
                                                                               great majority of taxpayers entitled to a refund, furnishes
              The income subject to tax so computed is not to be               detailed instructions and schedules for computing the
              reduced to less than zero.                                       carryback and will normally be acted upon by the IRS
                                                                               within 90 days from the date it is filed.
              ¶2323 How to Claim a Carryback Refund

              Where the taxpayer is entitled to a refund of income tax         Form 1045 must be filed on or after the date of filing the
              previously paid as a result of a net operating loss car-         return for the tax year in which the loss was sustained
              ryback, the taxpayer can obtain the refund by filing an          and may not be filed later than 12 months from the
              amended return on Form 1040X. The Form 1040X may                 end of that tax year. Thus, a taxpayer entitled to a 2003
              also be used to correct a return filed in an earlier year. In    carryback refund as a result of a 2005 net operating loss
              either case, the form must be filed on or before the 15th        must file Form 1045 at any time between January 1 and
              day of the 40th month following the close of the year in         December 31, 2006. After that date, the taxpayer can
              which the net operating loss was sustained.                      still file a refund claim, but he or she must use Form
                                                                               1040X (see ¶3203).
                 EXAMPLE: A taxpayer sustained a net operating loss            ¶2324 Recent Developments Affecting
                 in 2005, which he carried back to 2003. It entitles him             Business and Casualty Losses
                 to a refund for that year. He must file Form 1040X on
                 or before April 15, 2009.                                     Taxpayers may not claim theft loss deductions for de-
                                                                               creases in the market value of their stock due to corporate
              The amended return should show a detailed computa-               misconduct, even where corporate officers are indicted
              tion of the net operating loss deduction and the recom-          for securities fraud and other criminal violations. (Notice
              putation of the carryback year’s tax.                            2004-276, IRB 2004-16, 782)

              Quick refunds. To simplify and accelerate the filing and         Gambling losses could not be offset by sweepstakes win-
              processing of carryback refunds, the IRS has provided            nings where the sweepstake did not require any purchase
              special Form 1045, “Application for Tentative Refund             to enter. (TAM 200417004)


              ¶2325          CHAPTER 23 STUDY QUESTIONS — Business and Casualty Losses


                  1.    To rely on a presumption that an activity (other
                        than a horse-related activity) has a profit motive
                                                                                 For further information on business and casualty loss-
                        in order to avoid the hobby loss rules, a taxpayer
                                                                                 es, see: IRS Publication 536: Net Operating Losses
                        must show a profit in how many years?
                                                                                 for Individuals, Estates and Trusts; IRS Publication
                        a. Two out of five years                                 544: Sales and Other Dispositions of Assets; IRS
                        b. Three out of five years                               Publication 547: Casualties, Disasters, and Thefts;
                        c. Two out of seven years                                IRS Publication 584: Nonbusiness Disaster, Casualty,
                                                                                 and Theft Loss Workbook; IRS Publication 2194, Di-
                  2.    A personal casualty loss from a house fire in Denver     saster Losses Kit for Individuals; and IRS Publication
                        is deductible only to the extent it exceeds what         2194B, Disaster Losses Kit for Businesses.
                        percentage of adjusted gross income?
                        a. 2.5%
                                                                                 Answers to Study Questions, with feedback to both
                        b. 7.5%
                                                                                 the correct and incorrect resposese, are provided in
                        c. 10%
                                                                                 Chapter 35, beginning with ¶3523.
                  3.    The ordinary net operating loss carryback for losses
                        arising in 2005 is:
                        a. Two years
                        b. Three years
                        c. Five years




    ¶2323



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                                                                                                                            24
                 PART 3 — DEDUCTIONS FOR BUSINESS AND OTHER SPECIAL DEDUCTION RULES


                 Bad Debts

                 LEARNING OBJECTIVES                                            Advances by a shareholder to a corporation may be
                                                                                capital contributions, not loans. This is so where the
                 This chapter was prepared to enable participants to learn      corporation has thin capitalization (little equity as com-
                 the rules on deducting bad debts. More specifically, upon      pared with debt) and where the corporation does not
                 completion, you will be able to:                               treat the advance as a loan (it agrees to make repayment
                    Determine whether a debt is a business or nonbusi-          only if there are profits, it does not enter the advance as
                    ness bad debt.                                              a loan on its books, and it does not make payments of
                    Determine whether a nonbusiness bad debt is                 interest and principal).
                    deductible.                                                 ¶2402 The Debt Must Be Worthless
                    Understand the statute of limitations running on
                    bad debts.                                                  A debt must be uncollectible, both now and in the future,
                                                                                before it can be charged off as a bad debt. Taxpayers must
                 ¶2401 Introduction (Sec. 166)                                  also show that they have taken reasonable steps to collect
                 If money is owed to a taxpayer and the debt becomes un-        the debt, unless circumstances clearly indicate that no
                 collectible, he or she may claim a “bad debt” deduction.       likelihood of recovery exists. Thus, the debtor’s bank-
                                                                                ruptcy or disappearance generally is sufficient evidence
                 The 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. A gambling debt, for instance,        the creditor is not necessary if it can otherwise be shown
                 in most states cannot be enforced and, therefore, will not     that a judgment would be worthless.
                 qualify for a bad debt deduction.
                                                                                If the taxpayer endorsed or guaranteed someone else’s
                 Where debts are owed to the taxpayer by his or her             noncorporate obligation and is later required to pay the
                 relatives, the question arises as to whether it is a           obligation, the taxpayer may take a bad debt deduction
                 bona fide loan or merely a gift. If the circumstances          if unable to collect from the borrower. Debts owed by
                 indicate that the loan was made with a definite                political parties are generally considered campaign con-
                 expectation of repayment, the deduction will be                tributions and are not deductible.
                 permitted. Otherwise, the deduction will be denied
                 on the grounds that the taxpayer was really making               PITFALL: Cash basis taxpayers may not claim a
                 a gift, not a loan.                                              bad debt deduction for uncollectible interest, salary,
                                                                                  rents, or fees, since they did not report these items
                    EXAMPLE: A taxpayer loaned money to his son-                  as income.
                    in-law to go into a new business venture. He did
                    not investigate whether the venture was sound
                    or practical, and the son-in-law had no means to            If taxpayers are on the accrual basis and have reported the
                    secure the debt. The venture subsequently failed,           rents, fees, interest, or other accounts receivable as income
                    and the son-in-law was unable to repay the debt.            when the amounts became due, they may claim them as bad
                    No bad debt deduction is permitted because the              debts when the debts later turn out to be uncollectible.
                    taxpayer, by all indications, did not seriously ex-
                    pect repayment.                                             ¶2403 Amount of Deduction

                                                                                The amount of the bad debt deduction is determined
                 In particular, when loans are made to a taxpayer’s children,   by the basis the debt would have had if it had been sold
                 the IRS will assume they are gifts unless the taxpayer is      at a loss. Thus, it is not necessarily the face amount of
                 able to show convincing evidence to the contrary.              the debt.



                                                                                                                                             ¶2402



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                                                                            16, and should be reported on a separate Schedule D,
                 EXAMPLE: Arthur sold $5,000 worth of merchandise
                                                                            together with any other capital gains and losses. Thus,
                 to Bob and received Bob’s note in return. Arthur then
                 sells the note to Carl for $4,500. Subsequently, Bob
                                                                            such losses are deductible, regardless of whether the
                 goes bankrupt, and the note becomes totally worth-         taxpayer itemizes or not.
                 less. Carl’s bad debt deduction is $4,500, the amount
                 he paid for the note.                                        PITFALL: The IRS has noted that claiming nonbusi-
                                                                              ness bad debt deductions on Schedule C, rather than
              The method of deducting a bad debt depends on whether           reporting nonbusiness bad debts on Schedule D, is
              the debt is a business bad debt or a nonbusiness bad debt.      one of the most common errors made on individual
                                                                              income tax returns.
              ¶2404 Business Bad Debts (Sec. 166)

              A business bad debt is one that arises out of a debt that     No deduction may be taken for a nonbusiness bad
              was originally created or acquired in the taxpayer’s trade    debt that becomes partially worthless. However, if part
              or business. Such debts may be deducted in determin-          of a debt has been paid and the remainder is entirely
              ing adjusted gross income if they become completely           uncollectible, this balance is wholly worthless and,
              worthless, or if they are partially worthless, provided       thus, is deductible.
              that the uncollectible portion can be determined with         The question of whether a debt is a business or a non-
              reasonable certainty.                                         business debt depends on the facts of the particular
                                                                            case. If the debt is created or acquired in the course of a
                 EXAMPLE: Mr. Hamilton, a jeweler reporting on the          taxpayer’s trade or business (including the trade or busi-
                 accrual basis, sold a $2,000 diamond bracelet to a         ness of being an employee), it is a business bad debt, even
                 customer on credit. The customer goes into bank-           though it has no relationship to the trade or business at
                 ruptcy, and it is reasonably certain that Mr. Hamilton     the time it becomes worthless.
                 will receive no more than 50% of the amount due
                 him. He may charge off $1,000 (50% of $2,000) as
                 a bad debt.                                                  EXAMPLE: Jones, a wholesale grocer using the
                                                                              accrual basis, in 1998 extended credit to Smith on
                                                                              an open account. In 2003, Jones sells the business
              A deduction on account of a partially worthless debt            to Brown but retains the claim against Smith. In
              is allowable only to the extent that the specific debt is       2005, the claim becomes worthless. It is a business
              charged off on the books during the taxable year. If no         bad debt because it was acquired in the course of
              charge-off is made, the entire debt is deductible when          Jones’s business.
              it becomes totally worthless.
              The deduction for business bad debts is reported on
                                                                              EXAMPLE: Assume the same facts as above, except
              Schedule C (or Schedule F, for bad debts connected              that Jones in 1998 sold the claim against Smith to
              with farming).                                                  Adams (not the individual who bought the business).
                                                                              Adams is entitled to a nonbusiness bad debt deduc-
              A taxpayer is not required to claim a partial bad debt but      tion in 2005.
              may wait until the total debt has become worthless.
              ¶2405 Nonbusiness Bad Debts (Sec. 166)                        If the relationship between the taxpayer’s trade or busi-
                                                                            ness and the bad debt is only incidental, the taxpayer will
              Debts that are not originally created or acquired in a        be entitled only to a nonbusiness bad debt deduction.
              taxpayer’s trade or business and that become worthless
              are called “nonbusiness” bad debts and are treated as         Taxpayers who are forced to make good on a loan guar-
              short-term capital losses, regardless of the length of time   antee and are unable to collect are treated as if they had
              the debt was in existence.                                    made a direct loan. Thus, if the loan guarantee arose
                                                                            in connection with taxpayer’s trade or business, he or
              Since nonbusiness bad debts are treated as short-term         she is entitled to a business bad debt; otherwise it’s a
              capital losses, they are subject to the limitations on        nonbusiness bad debt.
              deductions for capital losses, as explained in chapter




    ¶2404



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                 ¶2406 Loans by Shareholder-Employees                           the time the debt actually becomes worthless and the
                                                                                time the fact is established.
                 Individuals who make a loan to a corporation for which
                 they work and in which they own stock may have dif-
                 ficulty in deciding whether a bad debt is a business bad         EXAMPLE: In 2001, a taxpayer loaned money to a
                 debt or a nonbusiness bad debt. A loan by a shareholder          friend overseas. He received sporadic payments on
                                                                                  the loan until 2003. After the payments stopped, he
                 is treated as a non-business bad debt made to protect an         wrote a number of times to the debtor but received
                 investment. A loan by an employee is treated as a busi-          no reply. In 2005, after engaging an attorney, he was
                 ness bad debt made to protect a salary. Whether a loan           advised that the friend had been mentally ill since
                 by a shareholder-employee is a business or non-business          2004 and had no prospect of recovering. Under these
                 bad debt depends on the dominant motive for making               circumstances, the taxpayer should file an amended
                 the loan.                                                        return for 2004 and claim a refund for that year. The
                                                                                  return may be filed any time up to April 15, 2012,
                                                                                  seven years from April 15, 2005, the due date of the
                    EXAMPLE: An elderly businessman formed his                    2004 return.
                    own corporation when his employer decreased his
                    responsibilities. He did so to obtain sufficient salary
                    income, as well as investment opportunities. He             Completely worthless business bad debts must also
                    loaned money to his new corporation and guaranteed          be deducted in the year they become worthless. If a
                    a line of credit on which he suffered a loss. He was        business bad debt becomes partially worthless, the
                    actively involved in the day-to-day management of           deduction may be taken in that year or deferred to
                    the company and continued to be involved even after         the year when the debt (or part of it) becomes com-
                    the sale of his controlling interest and after his chance
                                                                                pletely worthless.
                    for significant capital return was lost. Therefore, the
                    dominant motive in making the loan was to protect           ¶2408 Recovery of Bad Debts (Sec. 111)
                    his compensation as an officer and employee of the
                    corporation rather than to protect his investment as        If a taxpayer deducted a bad debt from gross income and
                    a shareholder in the company. This was a business           later recovered all or part of it, any amount attributable
                    bad debt.                                                   to the recovery is excluded from gross income by the
                                                                                amount the deduction did not reduce the amount of
                                                                                tax in the earlier year.
                    EXAMPLE: An independently wealthy individual
                    started a corporation and loaned money to it. He            ¶2409 Explanation of Bad Debt Deduction
                    was not repaid. His salary from the corporation was               on Tax Return
                    $30,000, while his outside income was $1 million.
                    His dominant motive was protection of his invest-           A taxpayer claiming either a nonbusiness or business bad
                    ment and not job security. This was a nonbusiness           debt deduction must attach a statement to the return
                    bad debt.                                                   showing:
                                                                                  The nature of the debt
                 ¶2407 When Deductible
                                                                                  The name of the debtor and the business or family
                 Nonbusiness bad debts must be deducted in the year               relationship (if any) to the taxpayer
                 they become worthless. If taxpayers first find out in a          When the debt became due
                 later year that a debt had become worthless in a previous        What efforts were made to collect the debt
                 year, they should file an amended return for that year           How the debt was determined to be worthless
                 and claim a refund.
                                                                                ¶2410 The Nonaccrual-Experience Method
                 Although refund claims normally must be filed within
                 three years from the date the original return was due,         Taxpayers who use an accrual method and qualify under
                 refund claims based on bad debts or worthless securities       the rules need not accrue (include in income) any part
                 may be filed up to seven years after the due date of the       of amounts that they receive from performing services
                 original return. This gives taxpayers an opportunity to        which, on the basis of experience, will be uncollectible.
                 realize the benefit of a bad debt deduction, even though,      This is treated as a method of accounting called the
                 as frequently happens, a number of years elapse between        “nonaccrual-experience method.”




                                                                                                                                                 ¶2410



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              The nonaccrual-experience method may not be used for             deduction until there is no reasonable prospect of recov-
              amounts owed to taxpayers because they are engaged in            ery. (CCA 2004-06046)
              activities like: (1) lending money, (2) selling goods, or (3)
              acquiring receivables or other rights to receive payment           CPE NOTE: When you have completed your study
              from other persons (including related persons), regardless         and review of chapters 12 through 24, which com-
              of whether those persons earned these amounts through              prise Quizzer Module 3, you may wish to take the
              the providing of services.                                         Quizzer for this Module. CPE Quizzer instructions
                                                                                 can be found on page 459.
              Generally, the nonaccrual-experience method may not                The Module 3 Quizzer Questions begin on page 469.
              be used for amounts due for which interest or a penalty            The Module 3 Answer Sheet can be found on pages
              for late payment is required to be paid.                           487 and 489.

              ¶2411 Recent Developments Affecting Bad Debts                      For your convenience, you can also take this Quizzer
                                                                                 online at www.cchtestingcenter.com.
              Investors who agreed to take stock under a corporation’s
              bankruptcy reorganization could not claim a bad debt


              ¶2412          CHAPTER 24 STUDY QUESTIONS — Bad Debts


                  1.    In 2003, a taxpayer loans $1,000 to his friend who      3.   A nonbusiness bad debt from a loan made five
                        moved overseas. In 2005 he learns that learns                years ago is deducted as:
                        that his friend died in 2004 and left no assets. The         a. A short-term capital loss.
                        taxpayer should:                                             b. A long-term capital loss.
                        a. Claim the loss on the 2005 return.                        c. An ordinary loss.
                        b. File an amended return for 2004 to claim the
                             bad debt.
                        c. File an amended return for 2003 to claim the          For further information about bad debts, see IRS
                             bad debt.                                           Publication 334: Tax Guide for Small Business.

                  2.    The period during which an amended return can
                        be filed to claim a bad debt is:                         Answers to Study Questions, with feedback to both
                                                                                 the correct and incorrect resposese, are provided in
                        a. Three years
                                                                                 Chapter 35, beginning with ¶3524.
                        b. Five years
                        c. Seven years




    ¶2411



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                                                                                   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   411




                 3. a. Correct.    The amount of eligible expenses             8. c. Correct. The credit may be claimed in addition to
                 ($3,000) must be reduced by employer reimburse-               the IRA deduction.
                 ment ($2,000), leaving $1,000 of expenses on which            a. Incorrect.   While certain personal credits may not
                 the credit is figured.                                        offset the alternative minimum tax, this credit can.
                 b. Incorrect. Since the employer reimbursed $2,000,           b. Incorrect. Form 8880 is the correct form for figuring
                 the parent cannot figure the credit on the $3,000 regular     the credit.
                 expense limit.
                 c. Incorrect. $5,000 is the maximum child care exclusion      9. b. Correct. The    foreign tax credit is not part of the
                 if the employer pays for this amount.                         general business credit.
                                                                               a. Incorrect. The small employers pension plan startup
                 4. False. Correct. Since the credit may not be claimed        cost credit is part of the general business credit.
                 by someone receiving even modest Social Security ben-         c. Incorrect. The low-income housing credit is part of
                 efits, it is intended to help those who do not receive this   the general business credit even though an investor may
                 type of income.                                               not necessarily be in business.
                 True. Incorrect. The credit is designed to assist low-
                 income taxpayers who receive little or no tax-exempt          10. a. Correct. $399 is the earned income credit limit
                 Social Security benefits.                                     for a taxpayer with no qualifying child.
                                                                               b. Incorrect. $2,662 is the credit limit for a taxpayer
                 5. c. Correct. Taxpayers with modified AGI below              with one qualifying child.
                 set levels can claim a top credit of $1,000 per eligible      c. Incorrect. $4,400 is the credit limit for a taxpayer
                 child.                                                        with two or more qualifying children.
                 a. Incorrect. $600 was the child tax credit amount before
                 it was changed in 2003.                                       ¶3512 Answers to Questions from Chapter 12 —
                 b. Incorrect. $700 is the child tax credit amount that              Gain or Loss on the Sale or Exchange
                 had been set to apply in 2005 before Congress changed               of Property
                 the law.
                                                                               1. c. Correct. While her loss is $8,300, she cannot rec-
                                                                               ognize it because the car is personal property.
                 6. b. Correct.   The top credit of $2,000 must be re-
                                                                               a. Incorrect. Her loss is not $8,200 because this fails to
                 duced because the single taxpayer’s modified AGI is
                                                                               take the selling expense into account.
                 over $43,000; the reduction is [$45,000 - $43,000]
                                                                               b. Incorrect. While her loss is $8,300 ($3,800 - [$12,000
                 ($10,000, or .2, which multiplied by the maximum
                                                                               + $100]), it is not recognized.
                 credit of $2,000, for a reduction of $400. The credit is
                 $2,000 - $400 = $1,600.
                                                                               2. a. Correct.  U.S. realty cannot be exchanged tax free
                 a. Incorrect. $1,500 is the maximum Hope credit, but
                                                                               for foreign realty.
                 this taxpayer is not limited to the Hope credit and can
                                                                               b. Incorrect. Both an apartment building and a factory
                 opt for the lifetime learning credit.
                                                                               are considered like kind.
                 c. Incorrect. The $2,000 credit limit would apply
                                                                               c. Incorrect. Both unimproved land and a shopping
                 if the taxpayer’s modified AGI in 2005 was not over
                                                                               center are considered like kind.
                 $43,000.
                                                                               3. b. Correct. 180 days is the period in which property
                 7. a. Correct. Surrogate parenting costs do not qualify
                                                                               must be received to complete the like-kind exchange.
                 for the adoption credit.
                                                                               a. Incorrect. 45 days is the period in which property to
                 b. Incorrect. Adoption fees qualify for the adoption
                                                                               be received must be identified.
                 credit.
                                                                               c. Incorrect. If the 180 days exceeds the end of the year,
                 c. Incorrect. Court costs qualify for the adoption
                                                                               there is no requirement to conclude the exchange before
                 credit.
                                                                               the end of the tax year.




                                                                                                                                                              ¶3512



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              4. c. Correct. An annuity contract can be exchanged tax       ¶3514 Answers to Questions from Chapter 14 —
              free for another annuity contract.                                  Involuntary Conversions
              a. Incorrect. While a life insurance policy can be ex-
                                                                            1. a. Correct.  The ordinary replacement period is no
              changed tax free for an annuity contract, an annuity
                                                                            later than two years after the close of the first year in
              contract cannot be exchanged tax free for a life insur-
                                                                            which any part of the gain is realized.
              ance policy.
                                                                            b. Incorrect. A three-year replacement period only ap-
              b. Incorrect. An annuity contract cannot be exchanged
                                                                            plies to condemnations of real property held for business
              tax free for an endowment policy.
                                                                            or investment purposes.
                                                                            c. Incorrect. A five-year period only applies to New York
              ¶3513 Answers to Questions from Chapter 13 —
                                                                            Liberty Zone property.
                    Exclusion for Gain on the Sale of a
                    Principal Residence
                                                                            2. b. Correct.  Only property that is similar or related
              1. b. Correct. There is no age requirement for the home       in service or use qualifies as replacement property for
              sale exclusion.                                               involuntary conversion purposes.
              a. Incorrect. To qualify for the exclusion, the taxpayer      a. Incorrect. Like-kind property is qualified replace-
              must have owned the home for two out of five years            ment property only for like-kind exchanges and not for
              preceding the date of sale.                                   involuntary conversions.
              c. Incorrect. To qualify for the exclusion, the taxpayer      c. Incorrect. Code Sec. 1033 limits replacement prop-
              must have used the home as a principal residence for two      erty to “similar or related” property so that not just any
              out of five years preceding the date of sale.                 property qualifies.

              2. b. Correct.  They can exclude their entire gain of         3. False. Correct. While deferral of gain on a like-kind
              $300,000 because this is less than the exclusion amount       exchange is automatic, the same rule does not apply to
              of $500,000.                                                  an involuntary conversion.
              a. Incorrect. $250,000 is the exclusion limit for single      True. Incorrect. Taxpayers must make an affirmative
              taxpayers.                                                    election to defer gain on an involuntary conversion;
              c. Incorrect. While the maximum exclusion on a joint          the election can be made only if certain conditions
              return is $500,000, the actual exclusion is limited to        are met.
              gain recognized.
                                                                            4. c. Correct. The involuntary conversion rules apply
              3. a. Correct. While painting the exterior of the home        to both homeowners and renters.
              may be a costly expense, it is not a capital improvement      a. Incorrect. A disaster is indeed an involuntary conver-
              that increased to basis.                                      sion in an area declared by the President to qualify for
              b. Incorrect. Adding vinyl siding is a capital improve-       federal disaster assistance relief.
              ment that is added to basis.                                  b. Incorrect. Instead of the usual two-year replacement
              c. Incorrect. A retaining wall is a capital improvement       period, the replacement period for a personal residence
              that is added to basis.                                       and its contents in a disaster area is four years.

              4. c. Correct. She does not have to apportion her gain;       ¶3515 Answers to Questions from Chapter 15 —
              it is all excludable, but must recapture $2,800 deprecia-           Basis
              tion at a 25% rate.
                                                                            1. b. Correct. Basis is the basis of the old tractor plus
              a. Incorrect. While she can exclude all of her gain, she
                                                                            cash paid or $20,000 + $20,000 = $40,000.
              must recapture all depreciation claimed after May 6,
                                                                            a. Incorrect. Basis is not limited to cash paid, or
              1997.
                                                                            $20,000.
              b. Incorrect. She does not have to apportion her gain and
                                                                            c. Incorrect. Basis is not the fair market value of the
              so is not limited to excluding only 90% of her gain.
                                                                            new tractor, or $50,000.




    ¶3513



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                                                                                     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   413




                 2. b. Correct.    Since the sale results in a gain, the         3. a. Correct. Since the bond was held only for one year
                 donor’s original basis of $10,000 is the basis for figur-       (holding period starts on May 5, 2004, and ends on May
                 ing the gain.                                                   4, 2005, the holding period is short term.
                 a. Incorrect. Since the sale results in a gain, the fair mar-   b. Incorrect. To be long term, the bond must have been
                 ket value of the stock at the time of the gift, or $9,000,      held for at least one year and a day.
                 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.   Since the sale results in a loss, the          tion on losses that cannot be deducted currently.
                 property’s fair market value at the time of the gift must       b. Incorrect.  Losses that cannot be deducted currently
                 be used, which is $9,000, because it is less than the           can indeed be carried forward indefinitely.
                 donor’s basis.                                                  c. Incorrect. Capital losses can offset ordinary income to
                 b. Incorrect. Since 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            ¶3517 Answers to Questions from Chapter 17 —
                 as 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 estate tax purposes, the basis of inher-
                                                                                 b. Incorrect. Schedule C-EZ cannot be used if the pro-
                 ited property is usually its fair market value as reported
                                                                                 prietor has any employees.
                 on the estate tax return. $10,000.
                                                                                 c. Incorrect. Schedule C-EZ cannot be used if the busi-
                 a. Incorrect. For inherited property, the donor’s basis,
                                                                                 ness has expenses over $5,000.
                 or $3,000, does not control.
                 b. Incorrect. The amount received for the sale generally
                                                                                 2. c. Correct.      Business gifts are deductible within set
                 does not determine the basis of inherited property.
                                                                                 limits.
                                                                                 a. Incorrect.  No deduction may be claimed for the
                 ¶3516 Answers to Questions from Chapter 16 —
                                                                                 basic service charge for the first telephone line to a
                       Capital Gains and Losses
                                                                                 taxpayer’s home even if the phone is used in a deduct-
                 1. b. Correct. A self-created asset, such as a painting held    ible home office.
                 by an artist, is specifically excluded from the definition      b. Incorrect. No deduction can be claimed for interest
                 of a capital asset.                                             on a tax deficiency related to Schedule C.
                 a. Incorrect. A personal car is a capital asset because it is
                 not excluded from the definition of a capital asset.            3. c. Correct. No current deduction is allowed for capital
                 c. Incorrect. Stock in IBM is a capital asset because it is     improvements, although some may be depreciable.
                 not excluded from the definition of a capital asset.            a. Incorrect. Repairs are ordinary expenses that can be
                                                                                 currently deducted and do not have to be capitalized.
                 2. c. Correct. The 28% rate applies to sales of collectibles    b. Incorrect. Advertising expenses are ordinary and
                 (for taxpayers in tax brackets at or above this rate).          necessary expenses that are currently deductible.
                 a. Incorrect. The 15% rate is the general capital gains
                 rate for taxpayers in brackets above 15%.                       4. a. Correct. A homeowner who rents out the home for
                 b. Incorrect. The 25% rate applies to unrecaptured              less than 15 days does not have to report the income.
                 depreciation (for taxpayers in tax brackets at or above         b. Incorrect. A homeowner who rents out the home for
                 this rate).                                                     less than 15 days is not allowed to deduct any mainte-
                 d. Incorrect. The 35% rate for ordinary income does not         nance or depreciation on the home.
                 apply to the capital gain from the sale of collectables.        c. Incorrect. A homeowner who rents out a home for 15
                                                                                 days or more and uses the home for more than 14 days



                                                                                                                                                                ¶3517



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    414       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




              or 10% of the rental period is allowed to deduct expenses     3. b. Correct. An accountant who takes classes at night
              (other than mortgage interest, real estate taxes and casu-    to obtain a law degree cannot deduct the cost because
              alty losses) only to the extent of rental income.             the degree leads to a new trade or business (i.e., being
                                                                            an attorney).
              ¶3518 Answers to Questions from Chapter 18 —                  a. Incorrect. A teacher who takes courses to become a
                    Travel and Entertainment Expenses                       principal can deduct the cost because this is not treated
                                                                            as a new trade or business.
              1. a. Correct. Since he regularly works in a particular
                                                                            c. Incorrect. An engineer who takes classes toward
              city, the city of his employment is his tax home.
                                                                            a master’s degree in engineering can deduct the cost
              b. Incorrect. The city in which his family lives is not his
                                                                            because he is already in the trade or business of being
              tax home because of his work location.
                                                                            an engineer.
              c. Incorrect. The taxpayer cannot elect which city to
              call his tax home.
                                                                            ¶3520 Answers to Questions from Chapter 20 —
                                                                                  Moving Expense Deduction
              2. c. Correct. The standard business mileage rate for
              2005 has increased to 40.5¢ per mile.                         1. b. Correct. Meals that the family eats during the move
              a. Incorrect. The 2005 mileage rate for charitable pur-       are specifically nondeductible.
              poses is 14¢ per mile.                                        a. Incorrect. The cost of lodging for the family during
              b. Incorrect. For 2004, the standard business mileage         the move is a deductible moving expense.
              rate was 37.5¢ per mile.                                      c. Incorrect. The cost of packing and crating household
                                                                            goods is a deductible moving expense.
              3. a. Correct.  The limit on business gifts is $25 per
              person per year.                                              2. b. Correct. The mileage rate for 2005 has been in-
              b. Incorrect. $400 is the limit on nonqualified plan          creased to 15¢ per mile.
              awards to an employee per year.                               a. Incorrect. The mileage rate for 2004 was 14¢ per mile.
              c. Incorrect. While most expenses are fully deductible if     c. Incorrect. 40.5¢ per mile is the 2005 mileage rate for
              the amount is reasonable, the tax law limits the deduct-      business use of a car and a move is not treated as a busi-
              ible amount of business gifts.                                ness use even though the move must be business-related
                                                                            in order to be deductible.
              ¶3519 Answers to Questions from Chapter 19 —
                    Other Business, Job-Related, and                        3. c. Correct. The tax law fixes the minimum distance
                    Investment Expenses                                     test at 50 miles.
                                                                            a. Incorrect. If a taxpayer only moves 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 only moves 35 miles, the
              ing on a jury is an adjustment to gross income.
                                                                            moving costs will be nondeductible.
              a. Incorrect. Unreimbursed employee business expenses
              are deductible only as miscellaneous itemized deductions
                                                                            ¶3521 Answers to Questions from Chapter 21 —
              subject to the 2%-of-AGI floor.
                                                                                  Depreciation
              b. Incorrect. Investment expenses are deductible only
              as miscellaneous itemized deductions subject to the           1. c. Correct.  Due to a cost-of-living adjustment,
              2%-of-AGI floor.                                              the maximum dollar limit on expensing in 2005 is
                                                                            $105,000.
              2. b. Correct. No home office deduction can be claimed        a. Incorrect. $25,000 is the limit that will apply after
              for landscaping.                                              2007 if Congress does not extend the law.
              a. Incorrect. The portion of mortgage interest related to     b. Incorrect. $102,000 was the dollar limit in 2004.
              the home office is part of the home office deduction.
              c. Incorrect. The portion of real estate taxes related to     2. c. Correct. Since the home office is nonresidential
              the home office is part of the home office deduction.         rental property, its recovery period is 39 years.




    ¶3518



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                 a. Incorrect.  27.5 years is the recovery period for resi-   2. c. Correct. Only personal casualty losses in excess of
                 dential rental property, which a home office is not.         10% of AGI are deductible as an itemized deduction.
                 b. Incorrect. 31.5 years was the recovery period for         a. Incorrect. 2.5% is the AGI threshold for miscella-
                 nonresidential property placed in service before May         neous itemized deductions.
                 13, 1993.                                                    b. Incorrect. 7.5% is the AGI threshold for medical
                                                                              expenses.
                 3. True. Correct.  Unrecaptured depreciation is the total
                 amount of depreciation claimed after May 6, 1997, on prop-   3. a. Correct. Two years is the standard carryback period
                 erty on which straight line depreciation has been claimed.   for NOLs arising in 2005.
                 False. Incorrect. Straight line depreciation, which is not   b. Incorrect. A three-year carryback period applies
                 subject to Sec. 1250 recapture, is treated as unrecaptured   only to NOLs resulting from a presidentially-declared
                 depreciation if claimed after May 6, 1997.                   disaster.
                                                                              c. Incorrect. A five-year carryback period applied only
                 ¶3522 Answers to Questions from Chapter 22 —                 for NOLs arising in 2001 and 2002.
                       Amortization and Depletion
                                                                              ¶3524 Answers to Questions from Chapter 24 —
                 1. c. Correct.  Improvements must use a 27.5-year re-
                                                                                    Bad Debts
                 covery period after 1986.
                 a. Incorrect. She cannot amortize the improvements over      1. b. Correct. Since the debt became worthless in 2004,
                 the term of the lease, or 10 years, because this option      the taxpayer must claim the deduction on an amended
                 only applies to pre-1987 improvements.                       return for 2004.
                 b. Incorrect. She cannot amortize the improvements           a. Incorrect. Even though the taxpayer learned of the
                 over the term of the lease plus renewal periods, or 15       bad debt in 2005, the deduction can only be claimed in
                 years, because this option only applies to pre-1987          the year in which it became worthless (2004).
                 improvements.                                                c. Incorrect. The bad debt was not worthless in the year
                                                                              in which it was made (2003) so no deduction can be
                 2. b. Correct.  15 years is the amortization period for      claim on the return for that year.
                 Sec. 197 intangibles, which includes good will.
                 a. Incorrect. A period of at least 60 months applies to      2. c. Correct.   The statute of limitations for filing an
                 business start-up costs.                                     amended return to claim a bad debt is extended to
                 c. Incorrect. 39 years is the amortization period for        seven years.
                 leasehold improvements.                                      a. Incorrect. The normal statute of limitations, which is
                                                                              three years, does not apply in the case of a bad debt.
                 3. a. Correct. A taxpayer may continue to use percentage     b. Incorrect. Five years is not the limitations period for fil-
                 depletion, even after he or she has recovered his or her     ing an amended return to claim a bad debt deduction.
                 basis in the property.
                 b. Incorrect. It cannot exceed 50% of taxable income         3. a. Correct. The law allows a nonbusiness bad debt to
                 from the property, so this is not an incorrect state-        be deducted only as a short-term capital loss, regardless
                 ment.                                                        of when the loan was made.
                 c. Incorrect. It may give rise to a tax preference item,     b. Incorrect. Even though the loan was made more
                 so this is not an incorrect statement.                       a year ago, the debt is not deductible as a long-term
                                                                              capital loss.
                 ¶3523 Answers to Questions from Chapter 23 —                 c. Incorrect. Only a business bad debt is deductible as
                       Business and Casualty Losses                           an ordinary loss.
                 1. b. Correct. Three out of five years is the period for
                                                                              ¶3525 Answers to Questions from Chapter 25 —
                 determining a profit presumption under Sec. 183.
                                                                                    Alternative Minimum Tax
                 a. Incorrect. Two out of five years is the testing period
                 for the home sale exclusion.                                 1. c. Correct.  Taxable income (without regard to the
                 c. Incorrect. Two out of seven years is the testing period   standard deduction or personal exemptions) is the start-
                 for breeding, training, showing, or racing horses.           ing point for figuring AMT liability.

                                                                                                                                                             ¶3525



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                 1040 PREPARATION AND PLANNING GUIDE


                 Quizzer Questions: Module 3

                 71.     Humbert, who is in the 28% tax bracket, sold 10       75.   Daniel purchased a building for $150,000, has
                         shares of X stock for a gain on June 30, 2005. He           a basis of $40,000 after several years of straight-
                         had purchased the stock on April 12, 2004. The              line depreciation, and sells the building in August
                         gain is taxed at:                                           2005 for $175,000. Gain is taxed in the following
                                                                                     manner:
                         a.   15%
                         b.   18%                                                    a.   $135,000 at 15%
                         c.   20%                                                    b.   $110,000 at 25% and $25,000 at 15%
                         d.   28%                                                    c.   $135,000 at 20%
                                                                                     d.   $135,000 at 25%
                 72.     Assume the same facts as in Question 71, except
                         that the asset was a collectible. The rate is:        76.   Which of the following is incorrect as to Sec.
                                                                                     1202 stock?
                         a.   15%
                         b.   18%                                                    a. There is a 50% gain exclusion for stock held
                         c.   20%                                                       more than 5 years.
                         d.   28%                                                    b. The gain is excluded if reinvested in other
                                                                                        qualified small business stock within 60 days
                 73.     Which of the following is not true as to long-term             of sale.
                         capital gain in 2005?                                       c. The AMT preference on the small business
                                                                                        stock is 50% of the excluded gain.
                         a. For taxpayers in the 10% or 15% bracket, the             d. S corporation stock is not eligible for Sec. 1202
                            rate on long-term capital gains is 5% for sales.            treatment.
                         b. For taxpayers in the 10% or 15% bracket, there
                            is no tax on long-term capital gains for sales.
                                                                               77.   All of the following statements are correct except:
                         c. Corporations are ineligible for the special
                            rates.                                                   a. The totals for short-term capital gains and losses
                                                                                        and the totals for long-term capital gains and
                 74.     Which of the following is true as to long-term                 losses must be figured separately.
                         capital gain?                                               b. When you carry over any capital loss, its char-
                                                                                        acter will be long-term.
                         a. The 15% rate applies to installment payments             c. If the total of your capital gains is more than
                            received in 2005, on installment sales made                 the total of your capital losses, the excess is
                            before May 7, 2003.                                         taxable.
                         b. The 15% rate has been made permanent for
                                                                                     d. The yearly limit on the amount of the capital loss
                            long-term capital gains.                                    you can deduct in excess of capital gains is $3,000
                         c. The 15% rate applies to all sales or exchanges
                                                                                        ($1,500 if you are married filing separately).
                            made in 2005, even sales of collectibles and
                            unrecaptured depreciation.




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              78.      Which of the following is a requirement for the         83.   Which of the following will decrease the basis of
                       $250,000/$500,000 exclusion on sale of residence?             property?
                      a. Taxpayer must be age 55 or older.                           a.   Depreciation
                      b. Taxpayer must have owned and occupied the                   b.   Return of capital
                         residence as a principal residence for at least two         c.   Recognized losses on involuntary conversions
                         of the five years before the sale.                          d.   All of the above
                      c. Taxpayer must have owned and occupied the
                         residence as a principal residence for at least       84.   A gain on the disposition of Sec. 1245 property
                         three of the five years before the sale.                    is treated as ordinary income to the extent of:
                      d. Taxpayer must not have previously claimed any
                         home sale exclusion.                                        a. Depreciation allowed or allowable.
                                                                                     b. Excess of the accelerated depreciation allowed or
                                                                                        allowable over the depreciation figured for the
              79.      John, who is single, bought his home on May 1,
                                                                                        same period using the straight-line method.
                       2004. On May 1, 2005, he sold his home because
                                                                                     c. Excess of the appreciated value over deprecia-
                       his employer relocated him across the country.
                                                                                        tion allowed or allowable using the straight-line
                       Assume his gain is $20,000. He may exclude:
                                                                                        method.
                      a.     $0                                                      d. The difference between the amount realized
                      b.     $10,000                                                    over the cost of the property.
                      c.     $20,000
                                                                               85.   In 2005, the regular Section 179 deduction limit
              80.      Henry, who started his home office in 2000, has               is:
                       claimed $2,000 depreciation for the portion of
                                                                                     a.   $100,000
                       his residence used as a home office. If he sells his
                                                                                     b.   $102,000
                       home in 2005 at a gain of $80,000, which amount
                                                                                     c.   $105,000
                       is taxed at 25%?
                                                                                     d.   $420,000
                      a.     $78,000
                      b.     $2,000                                            86.   If the fair market value of Sec. 1245 property is
                      c.     $0                                                      greater than its basis, which of the following trans-
                                                                                     actions will give rise to Sec. 1245 income?
              81.      The basis of property received for services per-
                                                                                     a.   Disposition at death
                       formed is equal to the:
                                                                                     b.   Disposition by gift
                      a.     Lower-of-cost-or-market price of the property           c.   A like-kind exchange in which boot is received
                      b.     Cost of the property
                      c.     Cost of the services provided                     87.   Which of the following may be deducted as a
                      d.     Fair market value of the property                       business bad debt by Mr. G, an accrual basis
                                                                                     taxpayer?
              82.      Which of the following transactions do not qualify
                                                                                     a. Worthless trade receivable.
                       as a Sec. 1035 exchange?
                                                                                     b. Worthless loan to his partner which was used
                      a. Life insurance contract for an endowment                       to buy a house.
                         contract.                                                   c. Worthless loan to his sister who used the pro-
                      b. Life insurance contract for another life insurance             ceeds in her business.
                         contract.                                                   d. Worthless corporate security.
                      c. Life insurance contract for an annuity contract.
                      d. Annuity contract for a life insurance contract.




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                                                                                                        QUIZZER QUESTIONS — MODULE 3            471




                 88.     In determining which place of business constitutes      93.   Deductible nonbusiness casualty losses result from
                         an individual’s tax home, all of the following fac-           each of the following except:
                         tors are taken into account except:
                                                                                       a.   Earthquake damage
                         a. Total time spent at each place of business.                b.   Damage from sonic booms
                         b. The degree of business activity at each place of           c.   Termite damage
                            business.                                                  d.   Hurricane damage
                         c. The relative income earned at each place of
                            business.                                            94.   Which of the following is not deductible as an
                         d. The amount of expenses incurred at each place              “actual car expense” by a taxpayer who uses that
                            of business.                                               method to figure the deductible cost of operating
                                                                                       his/her car for business purposes?
                 89.     In 2005, a self-employed building contractor has
                                                                                       a.   Gas
                         gross receipts from home construction in the U.S.
                                                                                       b.   Depreciation
                         of $1 million and expenses of $500,000. Assume
                                                                                       c.   Parking fines
                         that his W-2 wages are $200,000 and his AGI
                                                                                       d.   Lease fees
                         is $300,000. His domestic production activities
                         deduction is:
                                                                                 95.   Which of the following is not a deductible trans-
                         a.   $9,000                                                   portation expense?
                         b.   $15,000
                         c.   $100,000                                                 a. Cost of round-trip transportation between
                         d.   $500,000                                                    an individual’s office and his client’s place
                                                                                          of business.
                                                                                       b. Cost of round-trip transportation between an
                 90.     Capital losses in excess of capital gains (after off-
                                                                                          individual’s home and a temporary training site
                         setting up to $3,000 of ordinary income) can be
                                                                                          in the same city.
                         carried forward:
                                                                                       c. Cost of round-trip transportation between an
                         a.   Two years                                                   individual’s home and office while conducting
                         b.   Five years                                                  business on his car phone.
                         c.   Indefinitely                                             d. Cost of round-trip transportation between an
                                                                                          individual’s office in the home and his client’s
                 91.     Susan met all the requirements to deduct mov-                    place of business.
                         ing expenses when she moved from Arizona to
                         Nevada. Which of the following are deductible           96.   Five elements must be proven with respect to
                         as moving expenses?                                           entertainment expenses. Two of the elements
                                                                                       are the amount and the business purpose of the
                         a.   Pre-move house hunting trips
                                                                                       expense. Which of the following is not one of the
                         b.   Meal expenses
                                                                                       other three elements?
                         c.   Expenses of buying or selling a home
                         d.   Traveling to her new home                                a.   The nature of the entertainment.
                                                                                       b.   The time/date of the entertainment.
                 92.     Mark is being permanently transferred from his                c.   The place of the entertainment.
                         office in Virginia to another office in Washing-              d.   The business relationship of the person(s) being
                         ton, D.C. His office in Virginia is 10 miles from                  entertained.
                         his home. For Mark to meet the distance test to
                         qualify for moving expense deductions, how many
                         miles must the office in Washington, D.C., be
                         from his current home?
                         a.   50
                         b.   40
                         c.   60
                         d.   10




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              97.      With regard to meal and entertainment expenses, all      101.   In regard to education expenses, which of the fol-
                       of the following statements are correct except:                 lowing statements is correct?
                      a. Club dues are not allowed as a deduction.                     a. Education expenses are deductible, even though
                      b. An entertainment expense must meet one of the                    they may be qualifying an individual for a new
                         two tests: directly related test or associated test.             trade or business, so long as they improve skills
                      c. The deductible limit on business meals and                       in a present trade or business.
                         entertainment expenses is 50%.                                b. Education expenses are deductible, even though
                      d. The allowable deduction for the cost of a Super                  they lead to meeting the minimum educational
                         Bowl ticket is limited to twice the face value of                requirements for employment.
                         the ticket.                                                   c. If the minimum educational requirements have
                                                                                          been met, than all additional education expenses
              98.     Julio pays club dues of $5,000 a year for which he                  are deductible in all cases.
                      is not reimbursed. He uses the club 75% for his                  d. Education expenses are deductible as long as
                      business, 50% for directly related entertainment,                   the minimum educational requirements have
                      and 25% for associated entertainment. How much                      been met, the education is not qualifying an
                      of the club dues may Julio deduct?                                  individual for a new trade or business, and the
                                                                                          education is necessary to maintain or improve
                      a.     $0                                                           skills in the established trade or business.
                      b.     $2,000
                      c.     $3,000                                             102.   Which of the following is not deductible as an
                      d.     $3,750
                                                                                       itemized educational expense?
              99.     What characteristic is not required for an account-              a. Mr. Bard was employed as a patent chemist on
                      able plan?                                                          the condition that he obtain a law degree at his
                                                                                          own expense. He enrolled in evening law school.
                      a. The purpose of the expense must be defined at                    When he graduated from law school, he was
                         the time of payment.                                             promoted to patent attorney with a substantial
                      b. The employee must provide adequate substan-                      increase in salary.
                         tiation of all expenses on a timely basis.                    b. Ms. Roland owns an accounting practice and
                      c. The plan must require remittance of any ad-                      took several courses in taxation and account-
                         vances or payments in excess of substantiated                    ing.
                         expenses.                                                     c. Mrs. Paine, a salesperson, was required by her
                      d. Substantiation and remittance of excess amounts                  employer to take a public speaking course at
                         must be made on a timely basis.                                  her own expense as a condition to retain her
                                                                                          position.
              100.    Accountable plans require that:                                  d. Ms. Lane, an elementary school teacher, took
                      a. Advances be made within 30 days of expense.                      additional courses to qualify her to teach math-
                      b. Substantiation be provided to the employer                       ematics in high school.
                         within 60 days of expense.
                      c. Excess amounts be returned within 120 days of
                         expense.
                      d. All of the above.




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                                                                                                         QUIZZER QUESTIONS — MODULE 3            473




                 103.    Which of the following is incorrect with regard         108.   In general, square footage is used to figure the
                         to vacation homes?                                             percentage of business use of a home for purposes
                                                                                        of the home office deduction. True or False?
                         a. Where annual rental is less than 15 days, rental
                            income is not reported and no deductions are
                            allowed (other than mortgage interest and            109.   Edwards explores a business in January and Febru-
                            taxes).                                                     ary 2005. In May 2005, the business begins. It has
                         b. Where annual rental is 15 days or more and                  start-up expenses of $15,000, costs for acquiring
                            personal use exceeds the greater of 14 days                 Sec. 197 assets of $25,000 and cost for acquiring a
                            or 10% of the rental period, deductions and                 lease of $10,000. Which of the following expenses
                            expenses are limited to rental income.                      can be amortized?
                         c. Where annual rental is 15 days or more and                  a.   Business start-up costs
                            personal use does not exceed 14 days or10% of               b.   Acquisition of Sec. 197 assets
                            rental period, property is treated as rental prop-          c.   Cost of acquiring a lease
                            erty subject to the passive loss limitations.               d.   All of the above
                         d. Interest and property taxes are not deductible
                            if expenses exceed rental income.                    110.   Business casualty losses are deductible only to the
                                                                                        extent they exceed 10% of adjusted gross income.
                 104.    The carryback period for an ordinary net operating             True or False?
                         loss arising in 2005 is:
                         a.   One year                                           111.   On deducting the cost of business gifts, which of
                         b.   Two years                                                 the following limitations applies?
                         c.   Three years
                         d.   Five years                                                a.   $25 per individual each year
                                                                                        b.   50% of the cost of the gift
                 105.    All of the following are requirements for filing               c.   Ordinary and necessary business expense
                         Schedule C-EZ except:
                                                                                 112.   An employer pays to relocate an employee across
                         a.   Gross receipts under $100,000                             the country. Which of the following statements
                         b.   Business expenses not exceeding $5,000                    is correct?
                         c.   No home office deduction
                         d.   No employees                                              a. The employee must report the employer’s pay-
                                                                                           ment of moving costs as income but can claim
                 106.    A factory building placed in service on May 1,                    an itemized deduction to offset the income.
                                                                                        b. The employee must report the employer’s pay-
                         2005, is depreciated using the straight line method
                         over:                                                             ment of moving costs as income but can deduct
                                                                                           the amount as an adjustment to gross income.
                         a.   27.5 years                                                c. The employee does not have any income from
                         b.   39 years                                                     the employer’s payment and does not claim any
                         c.   40 years                                                     deduction.

                 107.    In March 2005, a taxpayer bought a new car used         113.   Which of the following nonbusiness investment
                         100% for business. The car cost $26,000 and                    expense is not deductible?
                         weighs less than 6,000 pounds. (Assume that the
                         taxpayer made no other equipment purchases in                  a.   The cost of a safe deposit box rental.
                         2005). In 2005, the taxpayer may deduct:                       b.   A subscription to an investment advisory letter.
                                                                                        c.   The cost of travel to attend an investment
                         a.   $2,950                                                         seminar.
                         b.   $5,200
                         c.   $25,000
                         d.   $26,000




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    474       1 0 4 0 P R E PA R AT I O N A N D P L A N N I N G G U I D E




              114.     Which of the following is not listed property?       115.   Form 4562 is required to be filed in 2005 by an
                                                                                   individual in business only if property is placed
                      a.     Cell phones
                                                                                   in service in 2005. True or False?
                      b.     Cars
                      c.     Computers
                      d.     Office furniture




1040 Prep_book_06.indb 474                                                                                                         11/11/2005 8:40:05 AM