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414 Cards in this Set

  • Front
  • Back
power to tax
The source of Congressional Power to tax comes from THE CONSTITUTION, not the 16th Amendment
gross income
all income from any source (“whatever source derived”), including but not limited to (if not listed, doesn’t mean its not gross income):

a. compensation for services, including fees, commissions, fringe benefits, and similar items

b. gross income derived from business

c. gains derived from dealings in property

d. interest

e. rents

f. royalties

g. dividends

h. alimony and separate maintenance payments

i. annuities

j. income from life insurance and endowment contracts

k. pensions

l. income from discharge of indebtedness

m. distributive share of
partnership gross income

n. income in respect of a decedent, and

o. income from an interest in an estate or trust
glenshaw glass
gi is the money you report to the IRS. How much money you make during the year

glenshaw glass defines GI as a realized accession to wealth over which a taxpayer has control.

You have to realize the gain (sell, trade, dispose).
treasure trove
receipt of economic benefit
guy found 4500 in piano which didn’t have an identifiable owner, so he gets to keep it!

GI right away.

Realized the money right when he finds it.
buy pen at garage sale for 1 dollar. Gets appraised and finds out its worth 200k

Not until disposition

even though paid for it, its not GI until realized.


If you find something, GI immediately
buy house and its contents- find jewels inside.
You have GI once you dispose of it.

Since paid for house and everything in it, not GI
buy house and NOT contents find jewels worth 30k.
GI right away
old colony
substance over form
company paid income taxes for its employee.

GI? Yes!

Substance over form: doesnt matter what we call it, it matters what the IRS says it really is.

Ex: dad sells car for 1.00. looks more like a gift. Why structured as sale? To avoid gift taxes. IRS would call it a gift.
whats not gi?
getting house appraised is not GI

buy something and find out its worth more- not GI until disposition. (piano for 100, worth 100k)

unrealized gains (appreciation during your ownership) are not gross income

if there is a bargain purchase, it is not gross income
once the definition of gross income is met
it is the burden of the taxpayer to find an exclusion that the amount should not be included as gross income
civil rights discrimination lawsuits are not GI (race gender ethnicity alienage illegitimacy.. protected by fed gov)

if damage is designed just to make him whole, then it will not be GI

physical injury damages are not gi, even if it includes backpay

emotional distress is GI if no physical manifestation

punitive damages and treasure trove are considered gross income

discrimination based on other categories are GI (age weight sexual preferences)
services v. cash as GI
paying a legal obligation in exchange for services is gross income

where an employer pays expenses on a trip that is a reward for services by the employee, the value of the reward is gross income
Marcella, a recent law school graduate, is an associate with a large law firm. Her salary of $75,000 per year. Marcella’s take-home pay was only $50,000, however, as the firm withheld $15,000 for federal income taxes, $5,500 in Social Security taxes (employee’s share of Social Security and Medicare) and $4,5000 for state income taxes.

is this gi?
$75,000 is considered gross income because it is compensation for her services.
year-end bonus of $5,000 received from the law firm in recognition of the quality of her work.

Yes, the whole $5,000 is gross income because it is compensation for her services.
An antique oak desk and chair she purchased from the firm for $50 when the firm, as part of a renovation of its building, purchased all new office furniture. The oak desk and chair, which were approximately 90 years old, had a fair market value of $500

It seems as if it’s a bargain purchase, in which case, it would not be included as gross income. It could be disguised as compensation for services, in which case, it would be gross income. We would need more facts to evaluate which it is.
loans are not an accession of wealth to the borrower because it’s not an increase in their net worth

principal is not gross income to the lender because they’re getting the return of their investment back

but interest would be gross income because it’s earnings on that principal amount
illegal income
illegal income must be reported as gross income

illegal income is also subjected to getting deductions
claim of right
arises when a person is receiving earnings but there’s a condition where the person might have to repay (e.g. finding property)

if a taxpayer receives money under a claim of right, they report it when it’s a receipt of earnings held under a claim of right without restrictions imposed by the court
Must distinguish between deposits and advanced payments

if one has complete dominion over the money (the legal right to keep the money), then it is considered gross income

have to look to see who is in control of the funds, just because they can spend the money doesn’t mean they have “control” over it, they can get it back and then it is not an advanced payment and is not gross income

should a deposit at an apartment be reported as gross income? – if the tenant controls that they can get their money back, then it’s not gross income
On December 1, Steve received an annual royalty check or $25,000 from Little Publishing Co. On February 1 of the following year, prior to Steve’s filing of a tax return reporting the royalty check, Steve was informed by Little Publishing Co. that a mistake had been made in the calculation of his royalties for the prior year. Rather than $25,000, the royalties should have been $20,000. Steve returned $5,000 to the publisher.

For tax purposes, how should Steve report the receipt of the $25,000 and the repayment of $5,000?
The first year, $25,000 should be reported.

The second year, he can deduct $5,000. Commonly, people will just report $20,000
Assume that on December 1, the day he received the $25,000 royalty check, Steve also received a message on his telephone answering machine from Little Publishing Co. to the effect that the $25,000 payment was in error, that the payment should have been $20,000, and that Steve should return the check uncashed. Steve instead claimed that he had not received the message before cashing the check. Steve repaid the $5,000 overpayment to Little Publishing in January.

What tax consequences from these events?
This situation is a claim of right situation because he knows that the money is not his. Although it is illegal income, it still has to be reported as gross income.

The second year, he could take a $25,000 deduction (can still take deductions for illegal income).
A has stock Y
fmv 100
ab 40

B has stock X
FMV $90
A.B. $30

What is A’s basis in stock X if they exchange their stocks?
$90 (because A’s basis will be the fair market value of the property A receives).

A’s gain in stock Y would be AR-AB
$90 - $40 = $50.

But then, if A went to sell stock X, his adjusted basis in stock X would be $90
amount realized
amount of cash received +

fmv of property and/or services +

any obligations satisfied meaning someone whos paid your debt.

Everything you have received for what you’ve given up.
decreased basis
built a greenhouse on your property (increase in basis) but it got swept away by a flood,

the insurance gives you the money back for it but you don’t rebuild the greenhouse,

then the basis is decreased by that amount because it doesn’t have that improvement anymore

(it is only gross income in insurance situations when the amount realized exceeds the adjusted basis)
increased basis
improvements to a house
in a property for property exchange
the fair market value of the property received at the time of the receipt is the recipient’s adjusted basis
when you buy a house, the basis...
includes the money you borrow

you don’t get additional credit when you pay the principal because you already got credit for it
cost of property purchased by the taxpayer

Basis will go up when improvements are made to the property or down when depreciation is taken and then its called adjusted basis
philadelphia park
There is a presumption of equal value when people trade/sell items that do not have ascertainable fmv
John sells rare card of pope john paul on ebay. Card is so rare the value is not in any of the price guidelines.

Winning bidder bids 100k
card must be worth 100k!
John charges 150/hr for individual tutoring. Student agrees to give john a 200 tv for one hour of tutoring.

How much are johns services/tv worth?
whats your basis if your receiving a gift?
They take the carry over basis (their basis in the gift received will be the same that the donor had in the gift).

Just from receiving the gift you will not have GI.

But if you sell the gift at a gain, you will not have GI.
gift exception
i. If there is a gift and

ii. The basis in the gift is greater than the fmv at the time of gift and

iii. The gift is sold at a loss

If all the elements are met, instead of using ar-ab, we use ar-fmv at time of gift.

This gives less of a loss, which helps the irs.

***If donee sells the gift at a loss for a price somewhere between fmv and ab, there will be no gain or loss.
Wife gives john phone as gift. Sells for 200

How much gain?
Ar=200. Ab=c/o basis.

Wife paid 200. So johns basis is too.

200-200=0 gain/loss
donor pays 50 for painting. Painting goes down in price to 30 and donor gives it to donee. Donee sells it for 40.

How much gain/loss?
Donee reciving gift before sale has GI 0. The fact that he resold it- figure out gain or loss.

Normally use ar-ab (40-50=-10). But since exception applies, use exception formula. Ar-fmv.

But include adjusted basis.

Basis in gift is greater than fmv.

Ab=50. Fmv at time of gift=30.


Need to plug in AR which is 40. 40 falls in the middle of 30 and 50.


If sold for 60, lets say, since 60 (ar) is close at ab, use number closest to it (ab). Use AR-AB.

Lets say we sell it for 20. Which formula? Ar-closest number to 20. Fmv. 20-30=-10.

What if sold for 33? 33 falls in box. No gain or loss.
Dad paid 20k for a car. When worth 4k gave to john. John sells car

basis greater fmv at time of gift?
Dads basis is 20, johns basis is 20. Fmv at time of gift=4.

Gift sold at a loss? Do number line.

20 on top 4 on bottom. Draw box. Plug in amount realized.

20k is ab 4 is fmv at time of gift.

John sells the car for 8k. plug in 8k. falls in middle. 0 gain/loss.

What if he sold it for 15k. still falls in.

sells for 3k. 3 goes below. Ar is below box. Use ar-fmv since closer than ab. 3-4=loss of 1.
Wife pays 500 for car. Sells to husband for 800.

wifes gain?
whats husbands basis?
Ar what she got for it (800) basis (500).
Looks like 300.

Husbands basis (what he paid) 800. Basis is 800. WRONG.

Transfers between spouses or incident to divorce are not recognized by the IRS.

This means that the seller will have no gain or loss and the buyer will have a carryover basis, JUST LIKE A GIFT.
What if Deb performs services for her employer and receives a desk worth $4,000 for the services and a year later, she sells it for $6,000.
$6,000 - $4,000 = $2,000 in gain and should be reported as gross income

The $4,000 is compensation for services because form doesn’t matter.

Also, she already had to report the $4,000 in gross income when she got it and we don’t want to tax her twice for the same money.
*****Deb performs services for her employer and as a result, the employer sells Deb a desk worth $4,000 for $100.

A year later, Deb sells the desk for $6,000.
In form it’s a bargain purchase, but in substance, it’s compensation for services.

$6,000 – ($3,900+- $100) = $2,000,

The $3,900 is the compensation for services and she paid $100 for it and we don’t want to tax her investment so it gets added back in.
Spectacular purchased a 100-acre tract of desert land ten years ago for $250,000.

He sold the entire tract of land this year for $1,000,000.

How much income must Spectacular report?

What result is he subdivides the 100-acre parcel into 5 20-acre parcels and sells each one for $400,000?
$1,000,000 - $250,000 would give him a gain of $750,000 in the entire tract of land.

When dividing the land up, you must allocate the basis in a reasonable way.

$400,000 (each tract)
divided by $2,000,000 (total sale amount)
= 1/5 would be reasonable since they’re all equal.
Maggie purchased a summer home for $500,000. In purchasing the home, she used $100,000 of her own funds and borrowed the other $400,000 of the purchase price from the local bank.

What basis will Maggie have in the summer home?

Would your answer change if Maggie had purchased the summer home under a contract where she paid the seller $100,000 down and agreed to pay the balance of $400,000 (plus interest on the unpaid balance) over the next 10 years?
Maggie’s basis is $500,000.

Her basis wouldn’t change because of the interest because interest doesn’t affect your basis.
Assume during the 5 years following the purchase of the home, Maggie paid $100,000 on the principal balance owing the bank under the original mortgage to $300,000.

How, if at all, will the $100,000 in principal payments affect Maggie’s basis in the summer home?
The basis wouldn’t change because she was already given credit for the money borrowed up front so you can’t get more credit for basis again.
Katie transferred to Patrick an undeveloped 5-acre tract of land in Arizona in exchange for an acre of undeveloped lakefront property in Nevada. Katie intends to build a summer home for her family on the Nevada lake property while Patrick plans to move to Arizona and build a new home for himself on the Arizona land acquired from Katie.

Katie had a $150,000 adjusted basis in the tract of Arizona land that was worth $450,000 at the time of the exchange.

Patrick had a $50,000 adjusted basis in his Nevada lake property which (amazingly) also had a fair market value of exactly $450,000.

What tax consequences to Katie and Patrick on the exchange, i.e. what gain, if any, will each recognize and what basis will each take in the property received in the exchange?
Katie’s amount realized in the land is $450,000 and her adjusted basis is $150,000 making her gain $300,000 which must be reported in gross income.

. Patrick’s amount realized is also $450,000 but his adjusted basis is $50,000 making his gain $400,000 which must be reported as gross income.
How would your answers change if, instead of a fair market value of $450,000, Katie’s Arizona property had a fair market value of $500,000 and Patrick transferred to Katie his Nevada lake property plus $50,000 in cash in exchange for her land?
Katie’s amount realized is $500,000 (the property and the cash) and her adjusted basis is $150,000 so her gain is $350,000 that needs to be reported.

Patrick’s amount realized is $500,000
life insurance
Irs has decided that if someone is the beneficiary of a life insurance policy, they will not have GI until someone dies and they receive the money in a lump sum (too easy to see on an exam)

But if the beneficiary invests the money with the life insurance company instead of taking a lump sum, (and receives a certain amount for the rest of his life based on his life expectancy) they will also be collecting interest now.

The interest is GI. The original amount of the policy is not.

So how do you decide how much of each payment is gi and how much isn’t?
100k life insurance policy
Left insurance policy with insurance company for investment

Insurance agrees to pay 12k per year for life. Has a life expectancy of 10 years (120k) hes collecting 20k in interest.
When does interest become gross income?
A little part each year is GI.

Use formula to determine how much is not GI/excluded from GI.

Face value of insurance policy aka lump sum (100k). denominator: total amount you would receive under the deal if you live to your life expectancy.

Supposed to get 12k for 10 years. Total number would be 120k. 100/120. This is how much of each payment is NOT gross income.

5/6 of each payment received will not be GI.

12k as a fraction is 12/1.

5/6 x 12/1=60/6=10k.

answer: 2k is GI
What happens if he dies in year 11?
Gets 12k

only 2k is GI

Same if dies 30 years later
But if its just an annuity (no one died) and outlive life expectancy, the full payment becomes gross income.

Take above example but make it an annuity. 2k is gi.

Year 11, receives 12k, but gi is 12k.
what is an annuity
a type of investment that pays you every year

when you get a payment for an investment, it is includable as gross income

any amount over your investment is earnings and so is includable as gross income
joint life annuities
there is also a joint life table for annuities based on 2 people so you can determine the expected return, it is where their ages intersect on the table (will be provided on the exam)

for a joint life annuity, both people have to die before you start worrying about deductions, etc., everything is “normal” if one dies and the other is still alive
term life insurance
a policy holder pays for it for a certain period of time but the policy does not carry over

ex: if you have a term life policy for a year and the year is up and you have not died, then the policy is over and you have lost your insurance

only has an insurance component
whole/universal life insurance
the investment in the contract builds up and eventually pays for the insurance itself

once it reaches a certain threshold, you can cash it in

has an insurance and investment component

if a policy holder “cashes out” an insurance policy for the cash surrender value (the amount the insurance policy is worth), it is considered gross income for anything over the premiums the policy holder already paid for it
term life v. whole/universal life insurance
it does not matter if it was a term life or whole life policy, that money is still not considered gross income if it was received upon death of the insured
public policy consideration for not counting life insurance proceeds as gross income
the IRS wants to encourage people to insure their loved ones
if someone buys the policy from the policy holder and does not get the “intended benefit” of the policy..
(i.e. they did not receive the money because the insured died), the transferee must report gross income

the gross income the transferee must report is the amount they got minus what they paid
a terminally or chronically ill person who gets the benefit of a life insurance policy
does not have to pay gross income on the amount they receive (any amount that type of person receives, the amount will be treated as received as “death of the insured”)
If life insurance is provided by an employer
the first 5000 will not be GI, the rest will be
***suppose a seller of property on the installment basis takes out a life insurance on the life of the purchaser in an mount equal to the unpaid balance of the purchase price
SUBSTANCE OVER FORM - the insurance proceeds qualify as gross income because they are not paid by reasons of the death of the insured, rather they are a collection on the unpaid purchase price of the property
when he was 30 years old, Rick purchased an ordinary life insurance policy in the face amount of $40,000, naming his wife Mary as beneficiary. Rick paid an annual premium of $12,000 on the policy. At the time of Rick’s death, the policy had a cash surrender value of $14,000. The insurance company paid Mary the $40,000 face amount. Rick had paid a total of $18,000 in premiums prior to his death. Had Rick purchased $40,000 of term insurance rather than whole life insurance, his premium payments over the same period would have amounted to $6,000

What are the tax consequences to Mary upon receipt of the insurance proceeds?

Explain the difference, if any, between the tax treatment of ordinary life insurance in this case an term insurance.
Mary has no gross income because any insurance proceeds she receives as a result of the death of Rick (the insured) are excludable as gross income according to I.R.C. §101(a)(1).

It does not matter if it is a whole life or term insurance policy.
if the investor does not get all the payments
(i.e. he dies before the life expectancy in the table), he gets a deduction on that investment in his last tax return (filed by his estate)
if the investor gets more payments
(i.e. he lives after the life expectancy in the table), he has to report all of the payments as gross income
George Smith pays Friendly Life Insurance $5,000 on January 1 of this year, George’s 55th birthday. Friendly agrees to pay George (or his estate) $1,000 a year for 10 years.

How will the first $1,000 payment be taxed?
$5,000/$10,000 x $1,000 = $500

thus, $500 is excludable as gross income and the other $500 of the payment is gross income because it is earnings
Suppose, alternatively, George pays Friendly $10,000, and Friendly agrees to pay George $1,000 a year for the rest of George’s life

How will the first $1,000 be taxed?
$10,000/($1,000 x 28.6) x $1,000 = $349

thus, $349 is excludable as gross income and the other $651 of the payment is gross income because it is earnings

(the 28.6 was found in Treasury Regulation 1.72-9 based on George’s age of 55, it means he is expected to live 28.6 more years
What tax consequences in Problem 2 if George dies after 3 payments have been made to Friendly?
$10,000 (investment) – ($349 x 3) = $1,047,

$10,000 - $1,047 = $8,953,

thus, George will get a deduction for an uncaptured investment of $8,953
Assume the facts of Problem 2 and that George is still living 30 years from now.

How will the next $1,000 payment he receives be taxed?
Each $1,000 payment is fully taxable as gain and all of it is gross income.
Supposed George on his 60th birthday pays Friendly $15,000, and Friendly agrees to pay $1,000 a year to George and his wife Susan, or the survivor, for as long as either of them is living.

Susan, whose birthday was the day before George’s, is 52 years old.

How will the first $1,000 payment be taxed?
$15,000/($1,000 x 33.6)
x $1,000 = $446

thus, $446 is excludable as gross income and the other $500 of the payment is gross income because it is earnings
overview gifts
gifts and inheritances are excluded as gross income

a gift is from detached and disinterested generosity out of affection, respect, charity, or like impulses

have to look at the intent of the donor to see if it is detached and disinterested rather than an intent to be compensated or whether it was done for some legal or moral obligation
when a person goes to dispose of a gift
the earnings are gross income,

i.e. the income on a gift is not excludable
the adjusted basis for a gift is
basis carried over from the donor to the donee

there is an exception to the carry-over basis rule (and an exception to that exception!)
family member gift exception
if the donor and donee are family members and it can be shown that it was a gift
(basis rules)
a. donee gets the fair market value at the time of donor’s death as their adjusted basis

b. this is beneficial when property has increased in value because it wipes out a loss

c. if property has an unrecognized loss, sell it and recognize the loss and give the proceeds away to the donee
want to gift house to your son. Should talk her out of giving it to son and leave in will instead. Why?
If son sells property, he would sell fmv 800k.

whats his ab? Carry over basis so he takes her basis. 40k.

whats his gain? 760k. hes paying taxes on 760k.

if put it in the will, what would ab be?

It would be fmv at time of death. 800k if within same year.

That way, theres 0 gain

same will apply for inheritances
part sale/part gift v. bargain purchase
look at the donor’s intent

if it’s detached and disinterested generosity out of affection, respect, charity, or like impulses then it’s a part-sale, part gift

no loss can be recognized on a part-sale, part-gift (Congress should not subsidize if you sell at a loss)

gain should be reported as gross income
part sale/ part gift basis rules
part-sale, part-gift recipient’s basis is the greater of either:

i. donor’s adjusted basis, OR

ii. amount donee paid for the property
wolder v. commissioner
inheritance of stock
true test of a gift is looking at the intent of the parties and the reason for the transfer

substance over form! - while this was a bequest in a will and inheritances are excluded from gross income, the intent was not for Wolder to inherit the stock as a gift, but it was to pay him for his legal services to Boyce during her lifetime

thus, it is not a gift, but gross income and should be taxed
olk v. us
look at the donor’s intent, but look at the recipient’s intent, too

the dealers knew they were tips and not gifts, they had a routine for putting them together and dividing them between each other

if there is an industry standard where to get money for services other than your wage/salary, then it is gross income
Carol is 1 of 2 legal assistants employed by Lucille, a lawyer. The legal assistants work directly with Lucille and with the 2 lawyers Lucille employs as associate lawyers in her office. This year at the annual holiday office party, Carol received substantial cash presents from Lucille, from the 2 associate lawyers, and from one of Lucille’s clients. The other legal assistant, who has not worked there as long as Carol, received cash presents of lesser amounts from Lucille and the 2 associate lawyers.

Are the cash presents includable in Carol’s gross income?
there can be no gifts between employers and employees, so what Carol got from Lucille should be reported as gross income. The associate lawyers are not her employers so you have to evaluate whether they were gifts or compensation for services. It could go either way since the other secretary didn’t get as much for working there for a shorter amount of time (alternatively, the associates didn’t know her as well and didn’t give her as big of a gift). You would need more facts to know about the client’s “gift” as well as more about the associates to know if they were gifts or not.
***Caroline was named as personal representative in the will of her grandfather. The will contained the following provision: “I direct that my granddaughter, Caroline, be paid $25,000 for acting as the personal representative of my estate. That amount shall be in full satisfaction of any amount otherwise allowable to her under the statute of this state.” As personal representative, Caroline was entitled under state law to a commission not to exceed 4% of the gross estate of her grandfather. Given the size of her grandfather’s gross estate, Caroline was entitled to approximately $10,000 for serving as personal representative. Caroline paid herself $25,000 as authorized by the will.

Is the $25,000 excludable?
You have to look at what is actually compensation for services. Even if the $25,000 is payment for her services and it’s illegal, it’s ok, because illegal income is still gross income. You could look at other circumstances, like what other grandchildren got in the will to see if he meant for it to all be compensation for services or some to be a gift. You would need more facts.
Bernadette purchased a vacant lot for $60,000. Three years later, the lot increased in value to $150,000. Bernadette was offered $150,000 for the lot but refused. The following year when it was worth approximately the same amount, Bernadette deeded the lot to her son, Rob, as a gift.

Does either Bernadette or Rob recognize income on the transfer?

What basis will Rob have in the lot?
Bernadette’s adjusted basis is $60,000 and the fair market value is $150,000. Rob’s adjusted basis then is $60,000.

But, Rob doesn’t have gain unless he disposes of the property so there are no tax consequences until then.
Do your answers to Problem 3 change if Bernadette is a realtor and her son Rob is one of the sales agents she employs?
It is more likely looking now like an employer/employee relationship and under 102(c), gifts under this kind of relationship are not allowed.

But, in $1015, you can have a gift between an employer and employee if you can show that it is a gift and they are family members.
****Assume the facts of Problem 3, except the lot decreased in value and was worth only $45,000 at the time Rob received it. A year later, Rob sold the lot for $30,000. What are the tax consequences to Rob? What result if he sold the lot for $55,000?
Bernadette has an adjusted basis of $60,000 and a fair market value of $45,000.

Rob has an amount realized of $30,000 and an adjusted basis of $60,000.

That would put him at a loss of $30,000. Also, the donor’s adjusted basis was more than the fair market value at the time of the gift so we do not use the carry-over basis rule.

Instead, it would be $30,000 is Rob’s amount realized and $45,000 is his adjusted basis, giving him a $15,000 loss.

But since this produced a gain, he would not report the gain. If Rob’s amount realized was $55,000 and his adjusted basis was $60,000, the carry-over exception would not apply.

Instead, his amount realized would be $55,000 and his adjusted basis would be $45,000, giving him a $45,000 gain, but he would not report the gain.
Assume the facts of Problem 3, except instead of giving the lot to Rob, Bernadette sold it to him for $75,000.

What are the income tax consequences to Bernadette and Rob?
Bernadette’s adjusted basis is $60,000 and the fair market value is $150,000.

The amount Rob paid for it is $75,000. The amount Rob paid is more than Bernadette’s adjusted basis, so Rob’s adjusted basis in the property is $75,000.
Not GI if its meets qualified scholarship, which means the primary purpose is to further the education and training of the recipient and there are no conditions on the receipt of money.

Scholarship can cover tuition, fees, books, supplies, and equiptment required for the courses, but not living expenses like room and board

Educational assistance plan is not GI is it doesn’t discriminate among employees, no choice between educational assistance and other benefits, maximum excludable amount will be low @ 5250 and only applies to undergraduate degrees

amounts representing past, present, and future employment is not excludable as gross income under scholarships
prizes are GI unless:
Prizes made primarily in recognition of religious, charitable, scientific, educational, artistic, literary or civil achievement.

Prize is transferred directly by recipient to a charity or government without possession or use by recipient.

Recipient was selected without any action on his part.

And not required to render any substantial future services as a condition for winning prize (acceptance speech is not a substantial future service)
how do you tax prize?
fmv of prize is taxable
employee safety achievement and length of service awards may be excluded if
i. tangible property with a value of 400 or less, and

ii. given as part of a meaningful presentation
***Joan won a computer programming competition for high school students. The competition was sponsored by the Computer Store, which awarded computers to Joan and her teacher, Ted. The Computer Store, which purchased computers for $900 each, lists such computers for sale at $2,000, although it occasionally sells them at a reduced price as low as $1,600. Ted had a comparable computer already, so he promptly sold the computer he received to a fellow teacher for $1,200

What tax consequences to Ted and to Joan?
A prize is includable in gross income as the fair market value.

We’ll say (arbitrarily…on the exam, he will always tell us what the fair market value of property is) the fair market value is $1,500 so that is Joan and Ted’s gross income.

Ted’s amount realized is $1,200 and his basis (his tax-cost basis, because we don’t want him to get taxed twice) is $1,500

so Ted has a $300 loss.
Al Athlete is an outstanding high school basketball player. Private University awards a basketball scholarship to him covering tuition and fees ($30,000) and room and board ($10,000). Private U. obviously expects Al to be a star on its team.

Any income?
$10,000 is technically includable as gross income and $30,000 would be excludable as gross income.

It would also technically be compensation for past, present, and future services, but he is not required to provide the services really, he is just expected to so we won’t tax it.

But, from a public policy standpoint, it would be unpopular to tax it so the IRS doesn’t.
Discharge of Indebtedness (forgiveness of a debt you have)
If a debt that you owe is forgiven, the amount forgiven may still be GI to you!

If the debt is forgiven because you filed for bankruptcy, none of it will be GI, even if you are solvent after the bankruptcy

If theres not a bankruptcy filed, you will have GI to the extent that you are solvent after the discharge
john has 50 in assets and debts of 70. Hes involvent by 20.

what happens If sallie mae forgives 30?
Only gi to the extent that hes solvent. Since hes worth -20 and 30 is forgiven, then hes solvent by 10.

GI is 10
john worth -1000. someone forgives him 800. Worth -200.

Still no solvent.

whats johns GI?
0 gross income
mcneal trick!!!

john works and makes a dollar. Since still insolvent after, does he have gi?

Finding 100 on ground while insolvent is Still GI
what If john buys car for 5 dollars 2 yrs ago

I owe him 25.

Give him car and 4 bucks. Car worth 17.

Any debt discharge?
4 dollars debt discharge.

Accepting 21 for 25..

Tax consequences? John has gain of 12.

John paid 5, he got 17 worth of debt knocked off.

GI even though still insolvent
John worth -80 forgiven 60.

0. -20. Still insolvent
John -80 goes bankrupt 100 dollars forgiven. Positive 20.


REMMEBER no GI for bankruptcy!

Same scenario, not bankrupt. GI 20
general rule for debt discharge
if debt forgiven but no bankruptcy, that debt is GI to the extent that you are solvent.

If forgiven because of bankruptcy, your GI in 0. Debt is forgiven
when your liabilities exceed your assets

income is only excludable to the extent of your insolvency

liabilities = $100, $100
assets = $120

Right now, this taxpayer is insolvent because his liabilities ($200) exceed his assets ($120) by $80.

If he is given $100 in debt relief, $80 is excludable from gross income and $20 is includable in gross income.

His gross income is only excludable as far as he was insolvent ($80) so he only gets $80 excluded from gross income.
Rebates are not GI

They are just a reduction in the purchase price of the item
contested liabilities
debt relief from a contested liability is not debt relief and so is not gross income

an argument over a debt amount thus a reduction is made thus it is not debt relief and not gross income
purchase money debt relief
if there is a debt between purchaser and seller of property and the debt arose out of the purchase of property, a reduction of the debt is actually a reduction in the purchase price and is not debt relief

applies whether there is a dispute or not

insolvency and bankruptcy take precedence over purchase money debt relief
there are 2 contracts to purchase a quantity of goods, they were supposed to be shipped in 6 lots, seller shipped 2 lots but not the rest because he owed $1,000, settled for $500 instead
substance over form! - if cancellation of indebtedness is simply the medium for payment of some other form of income, it is taxable

it is gross income not because it is debt relief but because it was payment for lost profits (damages for lost profits because those would have been gross income)

it is not really debt relief but to compensate for lost profits
Donald borrowed $5,000 three years ago to assist his daughter who had incurred significant legal fees in a divorce battle.

After repaying $3,000 of the loan, Donald was forced to resign from his job for health reasons and, although he was not technically insolvent, Donald was unable to continue to make payments on the loan.

Under the circumstances, the lender forgave the balance of the loan.

What tax consequences to Donald if the lender were: (a) a local bank, (b) Donald’s employer; or (c) Donald’s brother?
Generally, $2,000 would be includable in gross income (the amount that the lender discharged).

(a) it would be debt relief in this situation,

(b) it could be compensation for services instead of debt relief, we would need more facts,

(c) it could be a gift instead of debt relief, we would need more facts.
Kevin received a bill for $10,000 for landscaping work done at his personal residence. Kevin protested the bill, claiming it was excessive. The landscaper reduced the bill to $5,000.

Alternatively, assume the landscaper succeeded in getting a judgment entered against Kevin in the amount of $10,000. Kevin threatened to appeal and the landscaper agreed to settle for $5,000

discharge of indebtedness?
This is contested liability so it is not relay debt relief.

Therefore, it is not gross income and doesn’t have to be reported.

If there is a judgment and appeals are still open, it is still contested liability so it is still not debt relief and, thus, not gross income.
To cover expenses associated with the start-up of his new business, Kevin borrowed $20,000 from Lender, giving the lender his unsecured note in the amount of $20,000.

One year after Kevin commences his business, the economy slowed and Kevin had problems paying his creditors.

Lender agreed to accept $10,000 in full satisfaction of the $19,000 balance remaining on the note.

discharge of indebtedness?
This would be debt relief and Kevin is not insolvent so Kevin must report $9,000 in gross income.
business/proeprty damages
to determine if something is gross income, you must look to see what the damages are in lieu of (what were they awarded for?)
*****A gets into a car accident, A paid $20,000 for his car and there is $10,000 in damages to it
if he gets the $10,000 to fix the car, if he doesn’t put the money into fixing the car, his basis decreases to $10,000 ($20,000 - $10,000) but it is not gross income

if he does put the money back into the car, then he is just restoring his basis to what it was and again, it is not gross income
A is a lawyer and files a slander suit, he gets awarded money for lost profits
that money is gross income because normal profits would be gross income

because he received the money “in lieu” of those profits, it is taxable
personal injury/ sickness
generally, the underlying cause of the action must be a tort or tort-like claim

and the damages must be awarded for personal injury or sickness to be excludable from gross income
health insurance
if an employer pays only some portion of the premium
the percentage of premiums that the employer pays is the same percentage of the amount received that is includable as gross income (and the percentage of premiums that the individual pays is the same percentage of the amount received that is excludable as gross income)

cannot exclude lost wages

premiums paid by the employer on your behalf are not gross income
what is excludable as gross income although employer pays the premiums
i. amounts received for medical expenses

ii. amounts received for loss of member

iii. amounts received for permanent dysfunction

iv. amounts received for permanent disfigurement
The building in which Emily conducted her travel agency was destroyed in a fire resulting from a Fourth of July fireworks display sponsored by a nearby shopping mall. In the negligence action she brought against both the shopping mall owners and the company they hired to produce the fireworks display, Emily recovered $350,000 for the destruction of her building and $150,000 in lost profits. Emily’s had an adjusted basis of $200,000 in the building which had a fair market value of $350,000.

What are the tax consequences to Emily?
$350,000 - $200,000 = $150,000

the $150,000 for lost income is also includable as GI

Thus she must report $300,000 in gross income.
***Tom, a self-employed landscape architect, was injured last year in an accident in which a car driven by a drunk driver struck his pickup truck. Tom filed a negligence suit against the driver and the driver’s insurance company seeking over $2M in compensatory and punitive damages. This year, the parties to the action settled the suit out of court for $900,000 which the parties to agreed to allocate as follows: payment for pain and suffering $500,000, reimbursed medical expenses $100,000, future medical expenses $50,000, lost income $80,000, punitive damages $150,000, damages to the pickup truck $20,000. Tom paid $10,000 of the reimbursed medical expenses last year from his own funds and was allowed a medical expense deduction of $6,000 under §213. The remaining $90,000 in reimbursed medical expenses was paid by Tom’s health insurance company.

What are the tax consequences to Tom as a result of this settlement?
$500,000 for pain and suffering are not gross income

for the reimbursement of medical expenses, $100,000 - $6,000 (already deducted) = $94,000 is excluded from gross income (he can exclude the $90,000 under $104(a)(3) and under §104(a)(2) but the insurance company will likely ask for remittance of that money)

$50,000 for future medical expenses are excludable,

$80,000 for lost income is INcludable

$150,000 for punitive damages is INcludable

$20,000 received for damages to the truck would affect his basis in the truck, not his gross income, if he gets gain from it, then he would have to report it as gross income
exclusion v. deduction
exclusion – not reported as gross income

deduction - expense/loss reduces gross income but is subtracted from gross income (it reduces gross income so less tax is paid)
intro to deductions
generally, personal expenses are not deductible

if a person buys something that lasts for a multi-year period, they cannot deduct it all in on year (it is spread out over time)

a person cannot take a deduction unless there is a specific I.R.C. section authorizing it (“deductions are a matter of legislative grace”)
a business expense is deductible if it meets the following elements:



incurred while carrying on trade on business

if you meet all of these, its completely deductible in year expense is incurred. But another element that is kind of implied in ordinary and necessary is that the expense has to be reasonable also
common within the business.

customary or expected in the line of business, even if it’s only one payment, it still might be customary

e.g. a broken window
appropriate and helpful to taxpayers business (taxpayers are best to judge so most of the time the court will refer to them unless it is person in nature then the taxpayer will have to justify that it brings in revenue)
benefit that won’t last longer than the taxable year


paid/incurred during the taxable year.

expense examples

does not materially add to the value of the property

does not prolong life to property beyond expected life at acquisition

maintains property in ordinary and efficient operating condition

and useful life of a year or less
expenditure examples

prolongs life of property

materially adds to value of property

adapts property for new or different use

useful life of more than 1 year
incurred while carrying a trade or business
business is operational, the doors are open for business.

trade/business –

(1) expectation of profit

(2) with continuity and regularity

(3) actively engaged in pursuing it (managing one’s own wealth is not a trade or business but under §212 a deduction can be taken for investment activity)
clothing for work deductible?
deductible if it is distinctive, not suitable for ordinary wear, and it is not worn outside of working
would an employer get a deduction for paying an employees salary?
To answer, remember that all expenses, including salaries, have to be reasonable level of difficulty of work and what similar employees are making.

a business expense that is incurred for start-up or investigation of starting a business are deductible if it meets the same elements of §162 EXCEPT for the “carrying on” element
a taxpayer will be allowed to take a deduction for the taxable year when the business begins of the lesser of either the amount of start-up expenditures OR $5,000, reduced (but not below 0) by the amount which the start-up are more than $50,000, the remainder of the expenditures will be taken as a deduction over the next 180 months starting with the month the business began
ex. $53,000 in start-up costs
since it’s start-up costs, there’s no §162 deduction

opens the doors August 1
§195 deduction?
$5,000 is less than $53,000, so we’re looking at the second provision, $5,000 - $3,000 (because the start-up costs exceed $50,000 by $3,000) = $2,000 that can be taken in the taxable year.

Then, the other $51,000 ($53,000 - $2,000) is to be spaced out over 180 months.

$51,000/180 = $283.33 deduction/month. The business started August 1, so a deduction can also be taken for August – December of that year, which is about $1,416.65 in the monthly deduction.

So, the $2,000 plus the $1,416.65 can be taken as a deduction in the first year.
if the start-up costs exceed $5,000 but not $50,000,
then you get the $5,000 deduction and the rest is spread out over the 180 months
if the start-up costs exceed $55,000
then no deduction is taken for the taxable year, but you still get the monthly deduction for that year
Can you deduct a loss that you have?
Yes if its related to a trade or business or an activity for the production of income or a casualty loss.

The loss must be realized before its allowed.

Ex: if a house that I own and have for sale depreciates in value by 10k. I don’t get a deduction until that loss is realized…like the house being sold for that much
personal items
personal items in general are not allowed to be deducted

But even if you don’t have a trade or business, you can deduct expenses that are related to:

1. an activity that is intended to produce/collect income

2. management of property held for production of income

3. dealing with tax matters

4. alimony

5. and casualty theft/ losses
payback of bankrupt bosses loans?
No deduction allowed for former employee who wanted to pay his bankrupt bosses loans back so he could keep good relationship with customers for a new business he was going to start.


Taxpayer wants it to be an expense so he can deduct this year.

If its an expenditure, he has to depreciate (cant deduct all the money you spent in one year, you have to take a little bit back at a time)
Casey owns an executive placement agency that he operates as a sole proprietorship. Earlier this year, Casey hired his daughter, Brennan as a placement advisor. Brennan, who recently earned her MBA, is one of three placement advisors working for Casey; the other two placement advisors have college degrees but neither has an MBA. Casey hired Brennan at a salary equal to that he paid the other placement advisors even though they had far more experience. Given the profitability of his agency, Casey gave each of the three placement advisors a substantial bonus at year end.

Brennan received a bonus of $15,000; the other placement advisors received a bonus of $5,000.

May Casey deduct the salary and bonus he paid to Brennan?
Under §162, reasonable salaries are deductible (would have to look at whether a third party would pay Brennan the same amount of money).

She has less experience but she has more education so it could go either way.

As for the bonus, she would have to show that her performance was somehow better to earn more of a bonus since she had been there a shorter time.
reasonable salaries
reasonable salaries are deductible

look at what an individual third party would pay the person

if the salary is unreasonable, the unreasonable portion is what is taxed (this generally only comes up when the parties are related)
Finn is a self-employed certified financial planner in Palm Desert, California.

Finn advised a client to invest $5,000 in a company that was manufacturing a low-cost but high-tech mousetrap. Finn’s enthusiasm for the company’s product was not shared by the public generally and the stock became worthless. Wishing to avoid hard feelings, Finn paid $25,000 to the client.

whats deductible?
Finn would have to show that it was to protect or promote his current business. This though sounds more like he was doing it to avoid hard feelings and not to protect and promote but may need more facts.
Finn paid $20,000 per year to an agency that provides chauffeur service. Under his contract with the agency, Finn is entitled to up to 20 hours of chauffeur service per week. Finn usually takes advantage of this service a couple times each business day when he makes house calls to some of his wealthy clients. Finn tells you: “The chauffeur service enables me to forget the problems of the world while I ride in luxury. My clients are impressed when they see me arrive in a chauffeured limousine. They assume that I must know what I’m doing.

whats deductible?
This is a necessary issue.

If he can show that it is helpful and appropriate to his business (that he gets/keeps clients with it) may be able to deduct.

The court refers to the taxpayers as to what is necessary but may need to show it.
Mark is a 35 year-old local television newscaster. His television work requires appropriate dress, and, accordingly, he maintains, as his employer expects, an extensive wardrobe of expensive suits, shirts, and ties which he uses for his twice-nightly newscasts. His laundry bill is quite high because each suit and shirt is used for only one show before being dry cleaned or laundered. In off-duty hours, Mark, who is single and “hangs out” with a young crowd, never wears the clothes worn at work but, like his friends, prefers to wear very casual attire.

Are the acquisition and maintenance costs of Mark’s television garb deductible?
The clothing and expenses for them are not deductible because the clothing is suitable for outside of work and it’s not distinctive clothing like a nurse or police officer. Just because he doesn’t wear it outside of work doesn’t mean he can’t, so he cannot deduct the clothing.
interest deductions
interest for investment activity or business activities is deductible but interest is generally not deductible when interest is incurred in personal life (e.g. car loans, credit cards, etc.)


i. interest on student loans

ii. interest for qualified residences
acquisition debt
deductible interest in acquiring, construing, or substantially improving a house

debt must be secured by the house

limited to the interest on a debt of $1M
home equity debt
deductible interest of any other debt secured by the house other than acquisition indebtedness

limited to the interest on a debt of $100,000

the debt cannot exceed the equity in the house
if a loan is for more than the $1M or the $100,000
you can deduct the interest on the first $1M or the first $100,000, the rest of the interest is not deductible
Kevin paid $3,000 interest on a bank loan used to pay operating expenses in Kevin’s retail shoe business.

Yes, it is deductible because the loan was incurred and thus interest was incurred for a trade or business.
Kevin paid $500 interest on a loan he obtained to purchase a car for his personal use and $1,000 interest on credit cards used to make personal purchases
No because it is interest from personal loans, etc. so it is not deductible
charitable contributions can be deductible if they meet the following requirements:

qualified recipient

actual payment

subject to certain limitations
it is a gift, i.e. it comes from detached and disinterested generosity

if you get something in return for your contribution, it is generally not a contribution because it’s not detached or disinterested

if you pay too much for the value of something, you get the excess as a deduction as long as the intent was for the excess to be a gift
qualified recipient
i. U.S.

ii. states or political subdivision (not campaigns)

iii. religious, charitable, scientific, literary, educational organizations

iv. CANNOT be an individual

v. it must be TO the organization or put in a trust for the organization
subject to certain limitation
cannot deduct the costs of services but you can deduct the costs incurred to provide those services

a charitable deduction cannot exceed more than 50% of adjusted gross income (on an exam, he would have to give us the adjusted gross income since we won’t know how to calculate that)
mormon church case
Davis brothers went on their missions for the Mormon church and their parents funded the trip

they lived frugally like they were supposed to but they were the ones who were in control of the money

the court found that the contribution had to be made to the church, and not just used by the sons for the purpose the church would use it for in order to be considered a charitable deduction
capital expenditures
expense v. capital expenditure

the benefit of a capital expenditure presumably lasts beyond the taxable year

if it’s a capital expenditure, it’s not an expense and so there can be no deduction under §162

Congress only wants to tax on net income and wants to reduce income distortion which is why there are expense and capital expenditures

capitalize – cost becomes the basis, you don’t get the deduction right away, it’s space out over time

INDOPCO general rule – if the material benefit extends beyond the tax year, it is a capital expenditure
cost of acquiring a capital expenditure
all costs incurred in acquiring or constructing a capital expenditure have to be capitalized (meaning it adds to the basis of the property)

defending title to a capital expenditure should also be capitalized

if legal fees don’t relate to the title but to income of the property, they can be deducted

the cost of selling a capital asset should be capitalized (adding it to basis is just as good as a deduction because it reduces gain instead of just deducting it off your gross income)

disposing of a capital expenditure is an expense and so is immediately deductible
capital expenditures
adds to the value of the property

substantially prolongs the useful life of the property

adapts property to a new or different use, or

is part of a project to rehabilitate or modernize the property
looks at when something is broken and needs to be fixed

a repair likens with expenses and an improvement likens with capitalization

look at the purpose of what the repair or improvement was done for

if you’re putting something back to its normal operation, that looks like a repair

“certainly the expense incurred un the replacement of a broken windowpane, a damaged lock, or a door, or even a periodic repainting of the entire structure, may well be treated as a deductible repair expenditure even though the benefits endure quite beyond the current year”
employee training
not capitalized but it is deductible if it meets the requirements of §162
not capitalized but it is deductible if it meets the requirements of §162

if the advertising is related to a physical asset (e.g. buying a sign), it must be capitalized (the sign, not the actual advertising)
expansion costs
must distinguish between start-up costs and expansion costs

expansion costs can be deducted and not capitalized if it meets the requirements of §162
generally, the costs incurred in acquiring or construction intangibles are capitalized except:

12 month rule
***12 month rule
capitalization is not required for amounts paid for a right or benefit that doesn’t extend beyond 12 months from first realizing the right or benefit AND the end of the tax year following the year of payment
i. Meat packing plant purchased. Found out hole in the lining. Lining needed to be repaired to keep cold.
Its an expense.

What if it cost 2k? still an expense

this was a repair so it was deductible, this did not really add value to the property or substantially prolong its life, it simply put it back to its normal operation
janet owns a restaurant.

cost $10,000 to repaint the exterior of the restaurant

are the expenditures deductible as expense or capital expenditure?
Painting is considered a repair and so can be deducted.
janet owns a restaurant

$12,000 to fix extensive damage to the new roof of the restaurant caused when a large tree fell on it during a storm

are the expenditures deductible as expense or capital expenditure?
It is already a new roof so fixing it and putting on a roof in the same condition doesn’t add value so it’s a repair and can be deducted.
janet owns a restaurant

$30,000 for completely rewiring and replumbing the restaurant and remodeling the interior. Assume for purposes of this paragraph, that the work in the previous 2 were done immediately after Janet’s purchase of the restaurant.

are the expenditures deductible as expense or capital expenditure?
Rewiring and replumbing is probably a repair. But, if all this is done at the same time, it may be a modernization project, in which case, it should be capitalized.

On its own, it may be a repair, but if modernizing, it is capitalized.
jane owns a restaurant

$3,000 for an advertising consultant to plan a 2-year advertising campaign for the restaurant; $7,000 for newspaper, radio and television advertising this year; $4,000 for a new sign outside the restaurant; and $1,000 to remove and discard the old sign that the new one replaced.

are the expenditures deductible as expense or capital expenditure?
The $3,000 for consulting, the $7,000 advertising for the year, and the $1,000 to remove the old sign are all deductible.

The new sign wouldn’t be because it’s a physical asset and would get capitalized.
jane owns a restaurant

$5,000 for a new oven for the restaurant. The price includes installation of the oven and one-year’s maintenance.

are the expenditures deductible as expense or capital expenditure?
The $5,000 is a capital expenditure because its benefit will extend beyond a year.

The maintenance plan could be argued as deductible because it doesn’t last more than a year (even if it goes into the next tax year, you can apply the 12 month rule and it will be fine).
jane owns a restaurant

3,000 for the annual insurance premium for fire, theft, and liability insurance paid at the end of the year and covering the 12-month period from February 1 of next year to January 31 of the year after

are the expenditures deductible as expense or capital expenditure?
The policy doesn’t last longer than 12 months but it has to expire by the end of the year following payment, therefore, in this situation, it has to end by year 2 and doesn’t so she must capitalize it
jane owns a restaurant

$2,000 for 2 years’ worth of cleaning supplies for the restaurant.

are the expenditures deductible as expense or capital expenditure?
The benefit is for more than a year, it’s for 2 so it’s a capital expenditure.
jane owns a restaurant

$6,000 in legal fees in successfully defending a lawsuit brought by a former chef of the restaurant who had worked there 4 years, and who claimed he had an agreement with Janet giving him one-quarter ownership interest in the restaurant, plus one quarter of restaurant profits in the past 4 years.

are the expenditures deductible as expense or capital expenditure?
The cost of defending title is a capital expenditure.
Janet would like to open a second restaurant (modeled on the first restaurant), elsewhere in the metropolitan area, provided there is enough demand for a second restaurant and provided she can find the right location. Janet hires a business consulting firm to assist her. The consultants conduct market surveys and other research to determine demand and to investigate potential locations for the restaurant. Janet pays the consulting firm a fee of $25,000.

To what extent is the fee deductible, if at all?

Would the answer be different if Janet, instead of opening a second restaurant, had been interested in the possibility of owning a health and fitness center and had hired the consultants to carry out the same research and activities with respect to a health and fitness center
$25,000 is an expansion cost for the restaurant because she was already in the business. If she were to open the health cub, she would have to look at §195 because she is not carrying on. Then she is looking to deduct start-up costs.
depletion in value of an asset by using it in your trade or business

it’s how you deduct a capital expenditure over time if it has a useful life

can’t depreciate personal assets (e.g. your car that you use for personal use)
depreciation deduction requirements
property must be held in trade or business or for the production of income

and property has a useful life of more than a year
useful life
amount allowed for depreciation deduction for one year.

X# years property will be used plus salvage value=original cost of property.

Now, we follow ACRS

some things don’t wear out (e.g. land, inventory, interest in a corporation), you could deduct when you sell it
what happens to your basis when you depreciate?
depreciation reduces your basis by that amount (matters because our basis goes down and increases your gain by that same amount)
tangible assets
i. tangible property

ii. subject to exhaustion

iii. placed in service after
1980, and

iv. used in trade/business or held for the production of income
with tangible assets, you must know basis (starting point) and
have to know the length of our recovery period or useful life of the asset

there is a predetermined useful class life

will be told on the exam what class life an asset it, don’t have to memorize
rate of depreciation
2 kinds
straight line

double declining balance
straight line
it’s spread out equally over each year, in most cases, it’s used for real estate.
double declining balance
for depreciable tangible property other than real estate

getting twice what we would get under straight line but use a half-year convention

given the tables on the exam and this methods are built into the tables
accelerated cost recovery system
allows depreciation deduction to be taken at a faster rate than useful life.

Useful life is irrelevant because property is assigned to a class

Salvage value is not considered so 100% of value of property is deducted

Taxpayer can either use ACRS (to speed up depreciation) or straightline
why not always use acrs?
If didn’t make a lot of money, it would be silly to depreciate using acres. You would want to spread it out over time
ACRS aka double declining balance
1. Allows greater deduction in early years and lower later

2. Personal property may be depreciated in 3,5, or 7 years using double declining business

3. 15 and 20 year classes use 150% declining balance
acrs example
John buys computer for business for 1000. Computer is 3 year property within the provision of the code (means if we use ACRS to speed up depreciation, professor will give chart with 4 years.

Why? Even though three year property, you don’t get full 3 years. Its spread out over 4. Fully depreciated over 4 years). Basis should be down to 0 by year 4.
Chart says 30% yr 1 25% yr 2 23% yr 3 22% yr 4. cost basis 1k

How much depreciation do you take each year?
30% of cost basis (1000). 30% of 1000=$300 depreciation). AB after year 1? After you depreciate asset, basis goes down. Since depreciated by 300, AB is 700. (1000-300).

Year 2? 25% of 1000 (not of 700). Depreciates by 250 in year 2. AB after year 2? (700-250). 450.

Year 3? 23% of 1000. Depreciates by 230. 450-230=AB 220

Year 4? 22% of 1000. Depreciates by 220. Whats AB?220-220=0.
what if given a chart that doesnt include mid year convention?
(give chart for 3 year property for 3 year property)

cost basis 1000.
Yr 1- 60%
yr 2 25%
yr 3 15%
Remember you don’t get all of first year.

** if you see a 3 year chart, you have to take the first year # and cut it in half.

So year 1= 300 instead of 600.
straight line expanded
Same amount taken over a number of years

(1000 computer over 5 years=200 a year)

Applicable recovery period is the number of years in which tax payer will deduct

1. for residential real property= 27.5 years

2. non residential real estate 39 years
recovery period for tangible personal property depends on class life

5 (machinery and equiptment, cars light trucks)

7 (longer lived equiptment)


15 (intangible: patents, licenses.
-Good will if purchased as a part of business
-and must use straight line for it

when you start depreciating property
b. personal property deemed acquired or sold half way through the year regardless of when it was purchased or disposed of
for real property, use the mid-month convention

start the depreciation at the mid-point of the month you obtain the property (table p. 349)
mid point of month depreciation example
building depreciable of 39 years.

12 months in year

39x12=468. 468 months.

Since must be under straightline, you depreciate 1/468 each month.

But what about that first month you buy building?

Take 1/468 and cut in half. Why?

You only get half a month, no matter if you bought it the 1st of the month, or the 30th.
building cost 374,400. Took building june 8 2010.

How much depreciation for june 2010?
Divide 374,400/39 (39 year property)=468 months.

374400/468= 800/month .

400 for june (only get half). 800 july. etc
2 types of real property tables
non-residential real property and real property

(if mixed use - won’t be asked - have to bifurcate the building and use 2 tables and use reasonable allocation, probably based on square footage)

convention for tangible property is half-year convention (p. 344)
the year you dispose of property
you get half of your depreciation

(divide the depreciation rate in half or calculate the full year depreciation and divide it in half)
****when greater than 40% of the assets are purchased in the fourth quarter, use the mid-quarter convention for each asset

example – all 5 year property –

1st - $20,

2nd quarter - $0

3rd quarter - $20

4th quarter - $60
In general you would use a half-year convention, but there the exception applies because 60% was bought in the 4th quarter, which is more than 40%, meaning the mid-quarter tables should be used, once you start with a table, you stick it with that asset for the life of the asset so it will add up to 100%

so if you start with the mid-quarter convention table, have to use it for the life of the asset

so, the first year, the 1st quarter asset would get a 35% deduction

the 3rd quarter asset would get a 15% deduction

and the 4th quarter would get a 5% deduction.
bonus depreciation
Property requirements:

i. tangible property (not real property - §179 does not apply to real property)

ii. subject to depreciation

iii. acquired for use in trade or business

allows you to deduct your cost to a certain threshold.

can only take it in the year the property is placed in service.

Year 1. If you don’t take it, you lose out.
bonus depreciation limitations
any cost in excess of $125,000 cannot be deducted under §179 but still can depreciate the remainder of the cost under §168
bonus depreciation limitations
once you spend over $500,000, you have to reduce your deduction for every dollar over
dollar for dollar example

property worth 525
Property you purchased is 525.

How much bonus can you usually take?
Up to 125. But once you exceed 500k, your over by 25k.

so you lose 25k of your bonus.

So your max was 125, since you went over 25k, you lose 25k of the bonus.

So you would only be able to take 100 bonus depreciation
buy an asset that is personal property and is depreciatible for 575. Computer system.

How much/ when will it be depreciated?

start with 500k.

lost 75 of bonus.

Can only take 50k of bonus.

Now go to ACRs.
***Lets say its 3 year property aka 4 years

spend 325k

Year 1 40%
Year 2 30%
year 3 20%
year 4 10%.
First take bonus 125k.

Brings Ab down to 200k.
Take 40% of 200.

Depreciated by 80.

But How much depreciation year 1? (125 bonus + 80 from chart) 205k.

year 2 30% of 200k=60k

year 3 20% of 200k. 20k

year 4 10%200k=10k.
****bonus depreciation example

Buying computer for trader business. Computer costs 600k.

step 1- since its tangible property and wants to depreciate asap, use sec 179 bonus.

Max is 125, and we exceeded 500k. exceeded by 100, so we lose 100 of bonus. Left with only a 25k bonus.

AB Basis of 600k drops to 575 (600-25).

575 is now ran through chart.

Year 1 40% 575 plus 25k bonus. Total depreciation is year 1 MUST include bonus!!!! Then continue on..

Year 2 30% 575k.

year 3 20% 575.

Year 4 10% 757.
when depreciating....
Tin year one you MUST include bonus for TOTAL depreciation amount
once you have spent $625,000
you have been phased out and cant take ANY bonus
taxpayer pays $600,000 for a piece of equipment
we can deduct $125,000 but have to reduce it by the amount it exceeds $500,000 so $600,000 - $500,000 = $100,000

$125,000 - $100,000 = $25,000 so we that is what we can deduct in year 1

then the rest of the $575,000 ($600,000 - $25,000 = $575,000) is used as the basis for §168
taxpayer spends $525,000 for a piece of equipment,
$525,000 - $500,000 = $25,000 → $125,000 - $25,000 = $100,000

thus $425,000 is left for §168
amortization of intangibles
straight line method over 180 months

amortization starts in the month you acquire the asset
****Rory decides to start a business publishing a monthly financial newsletter entitled “Taxes: Your Pain, the Government’s Gain”. She wanted to expand her customer base.

On February 1 of the second year, for $15,120 she purchased a list of customers (197 property) from BankCo, the local bank. She will send a flyer to each person on the list.

Can she amortize the cost of the list?

If so, how much can she claim in the year she purchased the list?

How much can she claim in the next year?
Meets the requirements of §197, cost of list is $15,120

15120/180 = $84/mo.

deduction, in year 1 she gets 11 months of deductions because she bought it in February

84 x 11 = $924 in year 1 deduction

in year 2 – 15 = $1,008

in year 16, she will get $84 for the 1 month she didn’t get in year 1, basis is going down the same way as in tangible property.
for asset associated with luxury hotel, depreciable or non depreciable asset?

The tract of land on which the hotel is constructed
- No real property is not depreciable
depreciable or not?

Fences and concrete sidewalks on the grounds of the hotel.
Yes depreciable

it can wear out.

Landscaping of the property around the hotel, including trees and shrubbery.
- Yes, it can wear out.


Elegantly framed but nondescript landscape paintings for each of the guest rooms. These paintings were produced by a business that provides hotels with paintings for decoration purposes. The business hires “starving artists” to paint the landscapes using colors that will match the décor of particular hotel rooms.
IRS says art not being used as trade or business, cannot deduct collectible art pieces, if they change their décor, it would be worthless, but you could argue that they get worn out as a part of the trade or business, might be able to deduct them through depreciation.
at risk limitations
Tp can deduct losses only to extent that he is at risk for the activity at close of taxable year

Basically, no deduction for personal.

If your trying to deduct for loss, mustr be for business.

And you can only deduct the amount you actually risked
at risk amount=
amount of money you’ve thrown into the business
adjusted basis of property TP has contributed to activity
amounts borrowed with respect to activity if TP is personally liable for repayment (recourse loans/nonrecourse exception)
recourse loans
ALWAYS personally liable
Liable for nonrecourse if:
loan secured with property NOT used in activity(collateral)

and financing came from government, was guaranteed byu government, or came from a qualified person who was NOT related to TP

cant be seller of property,

and cant be a person who receives a fee for TPs investment in property (like a broker)
Put 5k into les account+ computer from home into the office which has fmv 300 ab 1000. Any recourse loans.
5k+1000+any recourse loans
At risk amount will be reduced by amount of loss allowed as deduction.
Ex: if my amount at risk was 5k and I had a 2k deductible loss, my amount at risk next year will be down to 3k.
John loses 30k in his business. Had 20k at risk.

How much can he deduct?
just 20. The amount at risk limits deductible loss tyou can take
***Year 1 John loses 30 in business but had 50 at risk. How much can he deduct?
The whole 30. This reduces his at risk amount by 30, so if original was 50, its down to 20.

year 2? Can only deduct 20.
Ex when you want to deduct a loss for your business at risk
john puts 10k in (@ risk).

Has a recourse loan 5k (@ risk responsible).

Brings property fmv 2k. AB 5k.

whats the total amount @ risk?
@ risk formula- 10k+5k+5k=20k.
25 own money
25 from dad nonrecourse secured by apt building. Commercially reasonable.
Arms length transaction with her dad.

How much money @ risk?
Her 25 for sure.

What about her dads 25? Shes not personally liable for that loan.. meets the nonrecourse exception? Commercially reasonable.

Answer is 50k at risk
There are different ways of making money..actively working (non-passive) investing in stocks (portfolio) and making money by not actively working (passive).
If you have a loss in passive activity, you can only deduct that loss from other passive gains.

You ****cann not deduct a passive loss from a non passive gain (cant deduct apartment money from plastic surgery money.general rule)
johns a construction worker and owns his own business.

He makes 40k this year in his business that he materially participates in.

hes also a silent partner in a movie and his partnership share loses 10k.

so if john makes 40k and loses 10k how much is his adjustable/taxable gross income for the year?

why? The movie loss was a passive loss and cannot be subtracted from his non-passive income
business in which the taxpayer does not materially participate in

sat on ur ass and made money

Limited silent partnerships- per se passive

Rental real estate: per se passive, but 2 exceptions (will still be passive, but can deduct some loss from other non passive activites)
rental real estate exception #1
4 elements
i. Taxpayer spends more than half of his time in real estate

ii. Actively participates (finds tennats makes repairs etc)

iii. Owns 10% or more of the real estate activity

iv. Adjusted GI is less than 100k a year

v. If you meet all of these, TP can deduct up to 25k of passive losses per year off his nonpassive income.

Any passive losses that cant be clamed in a year carry over to the next year
plastic surgeon. Non passive. makes 100k/year.

Also meets rental real estate exception and loses 40k rental real estate he actively participates on.

How much can he deduct off his plastic surgery?
Can only deduct 25 out of the 40.

The extra 15 carries over to the next year.
***If you adjusted GI is over 100k, then the tp starts losing the deduction at a 50% rate
Ex: tp makes 140 nonpassive but meets rental real estate exception and has 25k in losses.

Since hes 40 over, take half which is 20.

You lose 20k of rental real estate exception.

He can only deduct 5k of his losses this year and 20k carry over to next year
Exception #2 rental real estate exception:

if TP is a real estate professional who spends more than 750 hours a year and materially participates in one or more real property trade or business which is
i. Development of real estate

ii. Construction

iii. Acquisition

iv. Conversion

v. Rental management or brokerahe

vi. Then if tp spends more than ½ his time in real estate he can deduct up to 25k/year

business in which tp materially participates
how to determine material participation
i. Involvement on a regular, continual basis

ii. Safe harbor tests (more than 500 hours per yar OR at least 100 hours per year and participation isnot elss than any other individuals involved in the activity
tp makes 80k in dental practice.

Loses 40k in his limited partnership as a widget investor.

He also has a 20% interest in real estate business which rents out apartments. He sets rental rates, drafts leases, sets up repairs, etc. he loses 30k in this.

Whats his taxable income for the year?

30 meets rental real estate exception.

Made 80 non passive, how much can we take off of the 30? 25. 80-25=55.
john makes 80k working for gm. He loses 40k, but meets the real estate exception.
Take 25 off of the 80 . And 15 carries over to the next year
***john makes 120k at GM. Loses 25k in apartment. meet real estate exception.

How much can he deduct?

10 carries over to the next year
"It’s a deduction allocable to activity exceed income derived from that activity”

basically, you spent more money than you gained

Only applies to activity in trade or business or production of income

losses are deductible
rebuttable presumption
Rebuttable presumption that activity is engaged in for profit if 3 or more of the past 5 years, gross income is derived from activity exceeds deductions (3/5 years you made money off of that activity.

And theres a rebuttable presumption that it’s a for profit activity)
determine losses the same way we calculate gains
(amount realized – adjusted basis)

loss is when you buy for more than you sell it for
when can you get losses for losses?
- an individual only get losses for losses

(1) arising from our trade or business

(2) from a transaction entered into for profit (an investment loss), or

(3) if not from either of the other two but it is from a casualty loss (from fire, storm, shipwreck, or other casualty or from theft)
lesser of rule
only for losses or depreciation, not when it is sold at a gain, when you sell property at a loss that was once personal use property and is now for trade or business or for investment, have to use the lesser of the cost basis or the fair market value at the time of the conversion, applies to depreciation too
lesser of rule example

buy house/property for $100,000, fair market value at the time of conversion into a rental property is $75,000, sold as rental property for $45,000-
dropped $25,000 during personal use, but $75,000 is less than $100,000 so that is the basis, $45,000 - $75,000 = $30,000 loss
if you use the lesser of rule and it produces a gain,
do not report a gain or loss (like with gifts)
mom’s adjusted basis is $10 and sells to son for $2 her amount realized is $2 - $10 = $8 loss and she can’t deduct it as a loss

when the son sells it, he sells it for $14, it gives the son a gain of $12, he only has to report the gain as mom’s disallowed loss,
so he only has to report $4 of gain ($12 - $8 = $4)

take his gain, subtract her loss, and this is all that must be reported
if son sold it for $9, his adjusted basis is $2 so it’s $7 of gain
what does he have to report?
and he only has to report 0 because it doesn’t exceed the $8 that mom lost

if son sold at a loss, no one would ever get the benefit of the disallowed loss, only works if it’s a gain
Mary purchased her residence for $250,000. After living there for four years, she moved to a different city. The residence was worth $225,000 at the time Mary moved and Mary’s adjusted basis in the residence was $250,000. Mary attempted to sell the property for over two years before she finally found a buyer. During that period, the residence remained vacant and Mary made no effort to rent it. Mary sold the residence for $200,000.

May Mary claim depreciation deductions and maintenance expenses with respect to the residence for the period during which she attempted to sell it?

May she claim a loss on the sale of the residence?
Mary made no attempt to rent so there were no steps to convert the property to rental property so there can be no claim for depreciation deductions or maintenance expenses. She could argue that she is holding it as an investment property but instantly put it up for sale. She wasn’t really holding it for profit rather she just couldn’t sell it for those years and had it.
***Assume Mary rented the residence during the period she offered it for sale and had been allowed to claim depreciation on the residence in the amount of $15,000. What are the tax consequences to Mary if she subsequently sold the residence for $200,000? For $225,000? For $240,000?
The house was $250,000 when she bough *** and used it for personal use. It was worth $225,000 when she moved out and made it rental property. §165(a)(2) is the lesser of rule which only applies to the depreciation and the calculation of losses. By renting the property, it is then an investment activity. She already claimed a $15,000 deduction which will come off of the $250,000 she paid for the house (her basis). But, because of the lesser of rule, it went from personal use property to investment property and is being sold at a loss, we will use the lesser of her basis or what the fair market value is at the time it was converted to investment. In this case, that is $225,000. So, we subtract the $15,000 we have already taken from $225,000 to get $210,000. $210,000 - $200,000 (Mary’s amount realized) = $10,000 loss that can be reported. Again using the lesser of rule, it would give us a $15,000 gain ($225,000 - $210,000 = $15,000 in gain). If you use the lesser of rule and it produces a gain, do n
bad debts
someone owes you money and it’s uncollectible

can take a deduction of a loss for a bad debt
bad debt requirements
a. bona fide debt (really only isn’t when it’s a related party)

b. worthless (can’t just be a forgiving a debt, it has to be a debt that is uncollectible, but don’t have to show it’s a judgment from a court, can show it other ways)

c. totally uncollectible (can’t get any outstanding remaining balance, treated as a short-term capital loss = our deduction may be limited to $3,000 per year, can carry it forward until it’s completely expired)
***worthless business bad debt
debt incurred in trade or business activities

can take a deduction when it’s partially worthless (can only collect part of it)

treated as an ordinary loss and there is no limitations on the deductibility and can deduct the entire amount in the year it became worthless

if it’s services (e.g. an attorney has $10,000 owed to him and client goes bankrupt), how much can you deduct?, what is the basis in the receivable? – 0 because you haven’t paid any tax on it, no basis unless included in gross income, whether you report it when you receive the funds (cash basis, would have not included it as gross income yet so don’t get a deduction) or when you complete your end of the bargain (accrual basis, meaning they can take a deduction because they reported it), neither is really in a better position because both are 0 ($10,000 - $10,000 = 0 or $0 - $0 = $0) but accrual basis could be in a worse position because they have to pay the money and then get the deduction later

loan has to be proximately related
***worthless nonbusiness bad debt
investment activity or personal debt

if you loan someone money, your basis is the amount you loan minus whatever they have given back to you
casualty/ theft losses
Loss caused by either someone stealing or a catastrophic event which causes damage (fire, storm, shipwreck)

165 says personal losses are not deductible unless they are the result of a casualty or theft
must be a realized loss (decline in property value is NOT a realized loss)

must have an identifiable one time unexpected event (termite damage is not covered!)

and must measure casualty loss (amount of loss will be deductible in year the loss was actually ascertainable unless there is a reasonable prospect of recovery..we then wait to see how much can be recovered before deducting loss).

If theres insurance, wait to see what they will cover before you start making your deductions!
amount deductible
as a general rule
difference between FMV before and after casualty.

fmv 225 before, 190 after. 225-190=35. Court gave him 35.

Hes asking for ab-fmv after but he doesn’t get it..
example of amount deductible
you cant deduct
If doesn’t exceed 10% of income,
broadly defined as the taking of property, it doesn’t have to be statutory defined as theft but just as a loss or taking of property (e.g. you give a fortuneteller money and they rip you off)
you must prove theft or circumstances where reasonable inference of a theft could be made.
Ex: owner lost broach in museum. Taxpayer had no proof of theft but claimed casualty loss. Court disallowed it- could have been lost, etc.
measure theft loss
generally, its when theft is discovered.

But in subsequent years tp recalls additional stolen items, their loss must be deducted in the year of theft by way of an amended return
exception to measuring theft loss
if statute of limitations to amend has run, and if there is a reasonable prospect of recovery, then no deduction is allowed until it becomes clear that there will be no recovery
theft amount deductible
fmv at time of theft
casualty calculation
it’s the same calculation as that for casualty, except in step 1 you compare fmv at time of theft with basis of property, and take the lower of the 2
other casualty
sudden, unexpected, and unusual event (these characteristics of what is already listed)

“other casualty” is there to put something that is like what’s listed but that is not listed

White – car door slammed on wife’s hand and the diamond popped out of her ring and the taxpayer took a loss for the diamond (losing property = damage to property), the court allowed it
timing of casualty loss deduction
a casualty loss deduction is taken in the year it occurs except in the case of a theft where it is taken the year you find out that the item is missing
calculation of amount to be taken as a casualty loss (this calculation minimizes losses making it a rule that is negative for the taxpayer, it limits the amount one is able to claim for a loss)
4 steps
Step 1 – determine whether the basis or the decrease in value is less*

Step 2 – subtract any recover (insurance or otherwise)

Step 3 – allowed only to the extent it exceeds $100 per casualty or theft (i.e. subtract $100)

Step 4 – aggregate amounts from all casualties from step 3 allowed only to the extent it exceeds 10% of adjusted gross income (i.e. determine 10% of adjusted gross income and subtract that amount)
step 1
determine whether the basis or the decrease in value is less
decrease in value - the fair market value before the loss and the fair market value after the loss, as a result of the casualty)

*if the asset is used for investment, trade, or business, and is totally destroyed, then the loss = adjusted basis

*** Formula: Compare damage diminution in value with basis in property, and take the LOWER of the 2.
step 2
subtracting any recover
if you decided not to file a claim with the insurance company, you still must reduce by the amount that you would have gotten had you filed a claim
Step 3
allowed only to the extent it exceeds $100 per casualty or theft (i.e. subtract $100)
i. First 100 are not deductible

ii. this is here so people don’t take de minimus losses
step 4
aggregate amounts from all casualties from step 3 allowed only to the extent it exceeds 10% of adjusted gross income (i.e. determine 10% of adjusted gross income and subtract that amount)
Basically, the remainder is deductible only if it exceeds 10% of taxpeyers adjusted Gi (GI after deductions)
***johns property hit by tornado. His house. Its an exception (casualty) Fmv before is 350k. fmv after is 320k. property value decreased by 30. Insurance covers 10k. adjusted GI for the year (GI after deduciotns) is 50k. ab is 335k.

how much of a casualty loss deduction can john take, if any?
i. Diminution in value (fmv before v. after, 30k damage) (property basis is 335). Start with 30k.

ii. Deduct insurance proceeds. Insurance will cover 10k. 30-10=20k max deductible

iii. First 100 is not deductible. 20k-100=$19,900

iv. Taxpayers adjusted GI is 50k. 10% 50k=5k. the first 5k is NOT deductible. Subtract 5k from 1990. 14900. If you get a negative number, it’s a 0 deduction.
business v. personal deductions
business allows partial deductions.

Ordinary loss- entire amount is deductible.

Personal- must be completely worthless before deduction allowed.
a. Carlos paid $1,500,000 for a five acre tract of land located on the northern coast of California. After purchasing the land, Carlos spent $1,000,000 for his home that he had built on the land. Two years later, Carlos built a guest house on the property for $250,000. The guest house was located near the western edge of Carlos’ property quite near the bluffs overlooking the Pacific Ocean. In building the guest house in the location, Carlos ignored warnings from other landowners in the area that the guest house in that location would be vulnerable to high winds and ocean waves during big storms that periodically buffet the coast. Last month, a terrible storm struck and the resulting high waves destroyed the guest house. While the storm also caused severe erosion to the bluffs, there was no erosion damage to Carlos’ land nor was there any damage to Carlos’ land nor was there any damage to Carlos’ home. Because of the storm, however, the natural erosion processes are now expected to accelerate a
The adjusted basis in the land is $1,500,000. The adjusted basis in the house is $1,000,000. The adjusted basis in the guest house is $250,000. The guest house can be considered a casualty loss from the storm. Even if Carlos was negligent for building it there, he can still get the deduction. The IRS would have to prove gross negligence in order to bar the deduction. The guest house could then be deducted for a casualty loss. The house has just declined in value because of the erosion and there is no physical damage so there is no casualty loss. Plus, the erosion is gradual and not sudden so it is not considered a casualty.
Paula had a diamond brooch worth $5,000. Before going into a crowded restaurant one evening, she removed the brooch from her dress and placed it in the glove compartment of her car. She though she had locked the car. When she returned to the car following the dinner, the car doors were unlocked and the brooch was missing. There was, however, no evidence of any forced entry into the car.

identify the loss
The taxpayer has the burden of proof to show the loss and that the event was really a theft and that the property is gone. It is an evidentiary issue and this case seems wishy washy. She can’t really show that the event of leaving it in the glove compartment was what caused the loss. For purposes of calculating the loss, assuming that it was stolen and she got the deduction, all of these numbers are made up. The decline in value is $5,000 (worth $5,000 before the theft when she had it now she doesn’t have it anymore and it is worth $0, so $5,000 - $0 = $5,000). Her basis in the ring is $7,000. $5,000 is less than $7,000, so that is our starting number. She didn’t file an insurance claim because it was not insured so there is no recovery to subtract. So, $5,000 - $0 = $5,000. Then, $5,000 - $100 = $4,900. Assuming her adjusted gross income is $40,000, 10% of that would be $4,000. So $4,900 - $4,000 = $900. She would get to claim a $900 deduction loss for theft.
sale of a principal resident
generally, you cannot deduct for the loss of a sale on a principal residence
requirements for sale of principal residence
i. must be the principal

ii. must own the residence 2 out of the 5 years before it is sold (it does not have to be consecutive)

iii. must live in the residence for 2 out of the 5 years before it is sold (it does not have to be consecutive and use and ownership do not have to be consecutive either)

iv. must not have used this exclusion in the prior 2 years
exclusion for the sale
allows for a $250,000 exclusion (i.e. excludable from gross income)
if a joint tax return is filed for a married couple, a $500,000 exclusion is allowed
i. both husband and wife must meet the use requirement but only one has to meet the ownership requirement

ii. even if you are not married, you can still get the $500,000 exclusion collectively, but it means you have to jointly own the house with someone else (because you can’t file a joint return unless you’re married)
principal residence
there are several factors to consider, the key factor is where the resident spends the majority of their time during the year, other factors:

a. where their family is located

b. where their car is registered

c. where they have a driver’s license

d. where they are registered to vote
Brian and Jennifer, husband and wife, purchased a home in Seattle in 2001 for $350,000 and held title to the home as joint tenants with right of survivorship. The home was their principal residence until May 2006 when they moved to a town in northern Idaho, where they purchased a home for $250,000. In January of 2007, Brian and Jennifer finally sold their Seattle home. The purchaser paid Brian and Jennifer $600,000 in cash and assumed a $250,000 mortgage encumbering the property. Brian and Jennifer, who had added an additional room to the Seattle home, had an adjusted basis in that home of $400,000.

Explain the tax consequences to Brian and Jennifer on the sale of their Seattle home. Assume Brian and Jennifer file a joint tax return for the year and they had never previously taken advantage of §121
The adjusted basis in the house is $350,000 in 2001 when they bought it. In 2006, they moved to Idaho but sold the house in 2007 for $850,000 which is their amount realized. Because they put an addition on the home, it adds $50,000 to their basis, making their basis $400,000. Their realized gain from the sale of the Washington home is $450,000. They can take up to a $500,000 deduction as an exclusion from gross income because they meet all the other requirements of §121.
Would your answer change if the title to the Seattle home was held by Jennifer in her name alone?
No. They can still get the exclusion if only one owns and both meet the use requirements.
like kind exchanges
when a taxpayer trades his property for other like kind property instead of selling it
LKE elements
1. applies to gains (which there is an exception to) and losses (which there is no exception to)

2. it is mandatory, not elective

3. it only applies to investment, trade or business property, NOT personal use property

a. trade or business and investment property don’t have to match, i.e. you can exchange a business property for an investment property

b. ex. exchange vacation rental for another but the property received was personal for them and property gave up would be personal, look at how each recipient will use it, one can qualify while the other doesn’t
what is like kind?
a. real estate for real estate almost always like-kind (but that doesn’t mean §1031 applies, you still have to meet the holding requirements)

b. have to show character and nature are similar

c. if it’s the same asset class as another (as in the depreciation tables) then it is like-kind property
holding periods
holding periods of old property is tacked on o the holding period of the new property.

If john owned the original real property for 8 months and then held onto the property he traded it for for another 5 months, it is like he had the property for 13 months
johns house has fmv 400k ab is 140k. it he sells he will have a gain of 260, but if he trades it to xs like kind property with fmv of 400, he still has a gain of 260. But he wont haveo report (recognize) any of that gain . is realized gain is 260, his recognized gain is 0. What if he trades his 400k house for house 390k?
you would make that person give you 10k cash (boot). He would have to report the 10k.
LKE requirements
a. property must be like-kind (refers to nature and character of the property not grade or quality. New building for old building is fine). Property within same general asset class are deemed like kind (mineral rihts for improved city ot is ok.. its real estate for real estate)

b. property gave up must have been held in trade or business or investment activity (holding requirement). This doe NOT include inventory, stocks, bonds, or promissory ntoes. STOCK FOR SALE IS NOT LIKE KIND

c. property received must be used in trade or business activity (holding requirement)

d. the transaction must be an exchange (giving of one thing for another. Generally no money involved, but on the exam there will be. And a small amount of money for purposes of adjusting differences in value will not disqualify the transaction from being a LKE
you only recognize gain...
to the extent of boot
like kind exchange questions you MUST ask
what is the realized gain?

what is the recognized gain?

How much boot was received?

Don’t forget recognize gain can never be more than realized gain.

What is the unrecognized gain?

What is his basis in the property? Is the property like kind or non like kind?
first, calculate the gain/loss realized
cFormula: AR –AB = realized gain or loss

Might also be FMV-AB if not told AR
make sure that the property qualify for like-kind treatment
was property held for productive use in trade or business or investment exchanged for property held for productive use in trade or business or investment?

examine for each asset exchanged
to calculate recognized gain, look at boot received.
Any cash received?
+ if dealing with non like kind property use FMV.

Most important-!!!

+ NET POSITIVE DEBT RELIEF- did you get more of your debt taken over than you took over? MORTGAGES.

Also check to see if gave boot. Subtract boot.

And subtract cash paid to other side
formula for unrecognized gain
total gain realized - recognized gain
determine basis in property received in transaction
i. non-like kind property - general rule applies, basis = cost = fair market value

ii. like-kind property (fmv of property received- unrecognized gain
basis shortcut
look at what invested in property (AB).

And If theres boot, include that.
LKE Example #1 :

John property Fmv 300k AB 100k.

Joe has property Fmv 250k AB 200k. Joe will throw in 50k to boot.

calculate for john
i. Whats the amount realized for johns property? 300k. FMV-AB=300k-100k=200k. realized gain is 200k.

ii. Whats recognized gain? Ask- how much boot is received? 50k. also recognize the MOST that can be recognized is 200k (the amount realized gain).

iii. ***Recognize gain CAN NEVER be more than realized gain!! Recognized gain is 50k.

iv. Next Ask- what is the unrecognized gain? unrecognized is 150.

v. #3. What is the basis in the property? Ask- was the property like kind or non like kind?

vi. If like kind, then FMV of new property (250) – unrecognized gain (150).250-150=100k BASIS in new property.
LKE Example #1 :

John property Fmv 300k AB 100k.

Joe has property Fmv 250k AB 200k. Joe will throw in 50k to boot.

calculate for joe
i. What is joes realized gain? AR is 250. AR = (FMV) AB 200. FMV- AB. 250-200=50 realized gain on his property

ii. What is joes recognized gain/ how much boot did joe receive? NONE. +FMV nonlike kind property. NONE. boot paid 50k. Since -50k, his recognized is 0. his unrecognized gain is 50.

iii. Basis- FMV of new property (300)-unrecognized gain (50). Basis in new property is 250.
Example #2: john is giving up property with FMV 100. AB 20. Joe will trade for property FMV 80 20 Cash to boot AB 60

calculate for john
i. Realized gain FMV-AB. 100-20=80k

ii. Recognized gain. The maximum could be 80. How much boot received? 20k recognized. Unrecognized gain 60k.

iii. Basis fmv of new property-unrecognized gain. 80-60=20k.
Example #2: john is giving up property with FMV 100. AB 20. Joe will trade for property FMV 80 20 Cash to boot AB 60

calculate for joe
i. AR for property 80k. FMV. Joe realized gain? FMV-AB. 80-60. Joe has a realized gain of 20.

ii. Joe recognized gain? Received 0 boot. Recognized 0. (-20 from boot)Unrecognized 20

iii. Basis- FMV property received- unrecognized. 100-20=80
Example #3- X has property FMV 200 and AB 80. Y will trade his property with FMV 150 and AB 90. He will also throw in a car with FMV 50 and AB 40

calculate for x
i. Realized gain- FMV-AB. 200-80=120.120k realized

ii. Recognized gain- received 0 cash but did receive car. Since car is non like kind property, we use FMV. FMV car is 50k, so recognize 50k. Unrecognized gain 70k.

iii. Basis in property- FMV-unrecognized. 150-70=80k basis in property

iv. BASIS SHORTCUT: money spent. AB. 80

v. Basis in car- FMV of car is 50k.
Example #3- X has property FMV 200 and AB 80. Y will trade his property with FMV 150 and AB 90. He will also throw in a car with FMV 50 and AB 40

calculate for y
i. Realized gain on car- FMV-AB. 50-40=10k.

ii. Recognized gain on car- SAME AS REALIZED GAIN. 10k.

iii. Realized gain on property- FMV-AB. 150-90=60k realized

iv. Recognized gain on property- no boot received. 0 recognized. 60 unrecognized

v. Basis in property- fmv- unrecognized. 200-60= basis 140k.
vi. BASIS SHORTCUT: 90+50=140.
property held for investment/trader business. Real estate for real estate.

kristens property: ab 200k fmv 500k mortgage 100k.

Kelly property: ab 100k fmv 470k mortgage 70k. (The boot being exchanged is the mortgage)

calculate for kristen
i. Realized gain- AR-AB. FMV is AR. 500k-200k=300k gain

ii. Recognized- most can be is 300k. 0 cash received. Fmv non like kind property? 0. NET POSITIVE DEBT RELIEF- did you get more of your debt taken over than you took over? 100k of kristens debt taken over is 100. 70k is being taken over. +30. Pay boot to other side? NO. Kristen received 30k boot. 30k recognized.

iii. Unrecognized gain- 300k-30k=270k.

iv. Basis in new property- like kind or non like kind? Like kind. FMV-unrecognized gain. 470k-270k=200k.

v. BASIS SHORTCUT- Kristen invested 200k into her own property. AB 200k.
property held for investment/trader business. Real estate for real estate.

kristens property: ab 200k fmv 500k mortgage 100k.

Kelly property: ab 100k fmv 470k mortgage 70k. (The boot being exchanged is the mortgage)

calculate for kelly
i. Realized gain- AR-AB. FMV-AB. 470k-100k=370k.

ii. Recognized gain-most it can be is 370k. cash received?0. + FMV nonlike porptery (cash stock boat)0. +net positive debt relief(more mrot taken over than she took over? No. 0. Recognized gain=0

iii. Unrecognized gain 370

iv. Basis in new property 500k-370=130k.

v. SHORTCUT invested 100k. threw in 30k extra in mortgage
Kristen property fmv 600k ab 200k mortgage 100k.

Kelly property fmv 470k ab 100k mortgage 70k 50k cash and boat (BOOT BOAT). Fmv boat 50k ab boat 30k

calculate for kristen
i. Realized gain- fmv-ab. 600k-200k=400k.

ii. Recognized- most it can be is 400k. cash received 50k. fmv non like kind property 50k. net positive debt relief- more mort. taken over than Kristen originally took over? Yes, 30k more. – cash paid to other side?0. –fmv boot paid to other side? 0. 130k recognized

iii. Unrecognized- 270k

iv. Basis in new like kind property- FMV- unrecog. 470-270=200k.

v. Basis in new boat? Since non like kind, use formula basis=cost=FMV. Fmv boat is 50k. kirstens basis in boat 50k.
Kristen property fmv 600k ab 200k mortgage 100k.

Kelly property fmv 470k ab 100k mortgage 70k 50k cash and boat (BOOT BOAT). Fmv boat 50k ab boat 30k

calculate for kelly
i. Realized gain- fmv-ab. 470-100=370k.

ii. Recognized- cash received? 0. Fmv non like kind property? 0. Net positive debt relief? 0. – cash and fmv boot paid. 130. Since its negative, its 0. 0 recognized

iii. Unrecognized gain 370k

iv. Basis in new property fmv new property 600k-370 unrecognized=230k.

v. BASIS SHORTCUT- Kelly invested 100k in own property, threw in 50k cash 50k boat 30k mortgage relief

vi. Realized gain in boat. Fmv – ab. 50-30=20k

vii. Recognized gain in boat: 20k. boat is boot. Realized gain will always be recognized gain for boot!! If gain or loss on boot, it must be recognized!
involuntary conversion
1. Non recognition provision- you don’t have to report your whole gain to the IRS. Very similar to LKE.

2. This is when property is Partially or completely destroyed property (conversion). STOLEN SEIZED CONDEMED
involuntary conversions in john language


basically, If ur forced to sell property and put money into new property within 2 years, this means you wont need to recognize gain, as long as you put new money into the new property. Treat as like kind exchange. Money not recognized get defers.
Ex: tp buys 2 adjacent pieces of land to use in his trucking
involuntary conversion examples
Tp sold 6 story office building to city under threat of condemnation and bought controlling stock in hotel. court said it was not similar use.

In another case tp had a bowling alley destroyed by a fire. Used insurance money to buy a billiard hall with a lounge. Court held it was a different use and not like kind because different equiptment was used to operate the second building. Since not like kind, doesn’t qualify and will have to report it (recognize it).
John has ab 20k in bowling alley 20 years ago. Today it burns to the ground. How much will insurance gave if insured for fmv? Fmv today. Worth 300k.
if puts 300k into another bowling alley, john wont have to recognize any of it. Is puts 290 into bowling alley, he has to recognize 10k.
nonrecognition provision
Basis on old alley is 20k. insurance gives 300k. realized gain is 280. Buy bowling alley tomorrow for 310k. Basis in new property=same basis as old property, unless threw in own money. So its 20+10=30k in new bowling alley
Another situation where gain is NOT recognized:

If you sell your principle residence.
a gain of 250k or 500k if your married and filing jointly will never be recognized if:

its your principal residence

tp occupies it for 2 of the proceeding 5 years

no limit on number of sales

and no age requirements
11. Old couple splits time between Michigan and florida. Where live longest is your principle resident. Occupied 2/5 years and meet the requirements above
up to 250k is completely forgiven from your gain.
how are involuntary conversions tested?

Tp has lived here 13 years. Bought house for 100k. he and his wife who own together just sold for 500k. what is their recognized gain?
completely forgiven.
difference between casualty losses and involuntary conversions
involuntary conversions deal with GAINS, not losses
2. The home Aaron had owned and used as his principal residence for ten years was destroyed by fire. Aaron had a $200,000 adjusted basis in the residence, which had a fair market value of $600,000 in insurance proceeds and immediately purchased another residence for $500,000. Aaron had never previously taken advantage of §121.

How much gain, if any, must Aaron report if he takes advantage of both §§121 and 1033?

What basis will Aaron have in the new residence? –
When use you use §121 and §1033, use §121 first then use §1033. Step 1: This is an involuntary conversion. Step 2: The amount realized is $600,000 and the adjusted basis is $200,000. But, Aaron can use §121 first so the amount realized would be $350,000 instead ($600,000 - $250,000 (total amount excluded under §121) = $350,000). This means the realized gain is $150,000 ($350,000 - $200,000 = $150,000). Step 3: The taxpayer invested in a qualified replacement property within 2 years. Step 4: The amount realized is $350,000 and the cost is $500,000 making the recognized gain 0 (since it is a negative number, there is no gain). Step 5: The realized gain is $150,000 and the recognized gain is 0 making the unrecognized gain $150,000 ($150,000 - $0 = $150,000). That amount is deferred. Step 6: The cost of the replacement property is $500,000 and the unrecognized gain is $150,000 so the adjusted basis in the property is $350,000 ($500,000 - $150,000 = $350,000). This provision only applies if it is a


Sale or exchange of capital asset required for a capital gain or loss
3 steps

“what gets irs attention? DISPOSITION”.
- capital asset is all property used whether or not used in trade or business or transaction entered into for profit EXCEPT:
c. Inventory ( ALWAYS ORDINARY)

d. real property (land) held primarily for sale to customer in the ordinary course of business. Look to see how often this guy sells his land (ORDINARY)

e. accounts receivable (i.e. a debt) generated from services or the sale of inventory. Money you make from your job. (ORDINARY)
1231 hotchpot
real or depreciable property used in as trade or business and held for more than one year.

NOTE- exam usually will not mention held for more than a year
ordinary v. capital
think landlord v tenant. Income to landlord is just kike account receivable.


But lets say landlord pays tenant to move out. Does this usually happen? No but landlord might change use of property. This is considered CAPITAL
reputation of the business.

john opens restaurant tomorrow.

If you create the goodwill (LES) and you sell business/name/customers/etc, this si considered capital to him.

If you BUY goodwill, its considered hotchpot to them.

Because they can take the money they paid for goodwill and depreciate it.

Copyrights in the hands of the person who created them

ACCOUNTS receivable created from personal services or from sale of inventory
are both ordinary
deduction off of ordinary income when theres a capital loss
you can deduct up to $3,000 from ordinary income when there is a capital loss

start with short term loss and when that is exhausted then go to long term loss (you can do it until you die)

(you can only take 3k capital loss off of your ordinary income )
short term v. long term
if a year or less it’s short-term, more than a year and a day it’s long-term.

Why does this matter?

For gains, long term gets preferential treatment.
Make 50k for job.
Also have 2 stocks that you sell and you lose 3k on each of them. 1 had for 8 months and the other for 15 months .
income from job= ordinary

Can only take 3k off...use short term first
the rate you get depends on the asset you sell
a. collectibles 28% - things you collect and sell

b. unrecaptured §1250 gain 25% - gain created as a result of depreciation deductions (you sell it and your basis has been reduced because of the deduction)

c. everything else 15% - stock and real property held more than a year
short/long term deductions
short term losses first deducted against short term gains, if any remaining and then deduct it against any net long term gain (starting with the highest rate)

first deduct long term losses against long term gains (15% losses deducted against 15% gains), then deduct against highest % categories
johns calculations of gains and losses
a. Net together all long term capital gains/ losses

b. Net together all short term capital gains or losses in a different column

c. If they are both gains, LT gets better tax treatment than ST

d. If they are both losses, up to 3k of capital loss can come off ordinary income per year

e. The rest carries over to the following year. Use up ST before LT

f. If theres on gain and one loss, net these together!
make 50k ordinary income at work.

Selling 4 stocks this year. 1st stock sell, lose 500 on. Has it for 5 months. SHORT TERM COLUMN. Other stock made 300 on. Only had for a month. SHORT TERM COLUMN. Sold other 2 stock that he had for a few years because needed money. Made 1800 on one, and lost 100 on the other. LONG TERM COLUMN FOR BOTH. Think: opposites attract. Want to combine into one column.
Think absolute value: ignore the sign. Ask which is bigger? 1700. Move the smaller number to the bigger number column. Gain 1700 loss 200, come out with a gain of 1500.

What kind of gain is it? Whichever column its been moved to. Here: long term capital gain.

Johns GI? 51,500. 50k ordinary 1500 long term capital.

Once we net everything (short term and positive) and lets say they are both positive…keep them separate. Do not combine. Same with 2 losses.

how much total income? 51k. characterize. 50k ordinary 1700 long 200 short.
john makes 50k work. Short term net= loss 4k. long term net=gain 200. Opposite! Move the smaller number into bigger column. 200 moves into short term column. -4k+200=-3800.

What is johns adjusted GI for the year?
47k. we can only take off 3k..the other 800 carries over to the next year
net short term have loss of 4k. net long term have loss 4k. 50k ordinary.

What is johns adjusted GI?
50k ordinary total of 8k loss..keep separated..can only take of 3k. answer=47k.

What is johns carry over into the next year? Use short term loss first. The 3k subtracted comes from short term column. This means johns carry over will be 1k short term loss, and 4k long term loss.

Next tax year john makes 50k at work and has the carry overs.

Whats johns adjusted GI? 47k. whats his carry over? 2k long term.

The next year john makes 50k and no more capital assets. GI? 48k. take the 2k left over. All capital losses have been used up now.
10,000 long-term capital gain (15%), 10,000 long-term capital gain (28%), 10,000 long term capital gain (28%), 10,000 long term capital gain (25%), 10,000 short-term capital loss, 20,000 short-term capital loss → $40,000 long term gain and $30,000 short term loss, can deduct $30,000 leaving us with $10,000 gain and its rate is 15% ($20,000 is from 28% and $10,000 is from 25% leaving us with $10,000 for 15%)
no clue about the %ages
10,000 long-term capital gain (15%), 10,000 long-term capital gain (28%), 10,000 long term capital gain (28%), 10,000 long term capital gain (25%), 20,000 long-term capital loss (25%), 10,000 short-term capital loss → $20,000 long term gain and $10,000 short term loss, ($10,000 is from 25% and $10,000 is from 28% leaving us with $10,000 from 28% and $10,000 from 15%), then deduct the short term loss from the highest % category ($10,000 from 28% leaving us with $10,000 long term gain taxed at 15%)
no clue about %ages 2
capital asset?

ii. The van Friendly uses to transport customers to and from its service department.
- No because it’s depreciable property used in the trade or business but the gain might end up in §1231 as long as it’s held for more than a year.
capital asset?

new station wagon Terry and Margaret have just purchased as their family car.
Capital asset because it is an asset held by the taxpayer and an exception doesn’t apply
capital asset?

land and building Friendly owns and uses in the car dealership
Not a capital asset because it’s real property used in a trade or business but could end up in §1231 if held more than a year.
capital asset?

v. The promissory note Terry received on the sale of the adjacent vacant land he purchased as an investment several years ago
Receivable should be categorized as the underlying income stream and it’s notes as vacant land held as an investment so it’s investment property which is capital so it is a capital asset.
capital asset?

promissory note Friendly received on the sale of a new truck. –
capital asset because the new truck is inventory so the receivable treated in the same way as the truck.
capital asset?

The computer which Friendly formerly owned and used in the dealership, but which Terry and Margaret now own and use to manage their investments
It is depreciable property used in investment activity and so it is a capital asset (look at character at the time of the sale), wouldn’t get §1231 treatment.
capital asset?

Terry and Margaret’s stock in Friendly Car Dealership. -
Capital asset because it’s an investment which is what should get capital treatment, and it’s not on our list unless you’re in the business of selling stock.
capital asset?

Terry and Margaret’s home.
Capital because there is no exception from the list but don’t care because if sell at a loss, §165 doesn’t allow it and a gain is covered by §121 to exclude and you would prefer reporting no income rather than getting a preferred tax rate.
2. Four years ago, Dennis became aware of the rapid appreciation in the value of certain recreational properties located near a major national park. He purchased the properties anticipating they would make a satisfactory profit. Over a three-year period, Dennis purchased 15 tracts of recreational property. He subdivided some of the tracts, made surveys, obtained some rights of way, installed some drainage facilities and extinguished easements on the land. He did not otherwise add any structures or facilities to the land purchased. The demand for large tracts of unimproved property like that owned by Dennis became so great that he did not have to advertise – prospective buyers using public records identified him as the owned and contacted him. Dennis sold 10 parcels of land this year. In each instance, the sale was initiated by the purchaser. Dennis never listed any properties with a real estate broker and realized a gain of $150,000 on the 10 parcels.

What is the character of his gain?
One of the exceptions to capital gains is property held for the sale of customers. Courts will look at improvements made to the land, advertising, extent you use real estate agents, and volume and frequency of sale. He sold a lot of lots, made improvements by putting in drainage system, etc. to make it sellable to customers but he didn’t advertise or use real estate agents. Most likely would be held as inventory and an exception to capital gains

(on exam, argue both sides and all four factors and why they apply).
Two years ago, State University hired Steve as its head basketball coach. Under the fiver year contract Steve entered into with the University, the University agreed to pay Steve $250,000 per year and to transfer to Steve title to a home worth $400,000. After 2 losing seasons, the University proposes to pay Steve $1,000,000 for the home (which at the time of the buyout is worth $500,000) and remaining 3 years on his contract if Steve will resign. Steve asks you to advise him on the tax consequences to him of this proposal.

what do you advise him?
The home when he gets it is for compensation for services and is ordinary income. His adjusted basis in the house would be $400,000 (because at the time he got it, he paid taxes on $400,000, his tax-cost basis) and we wouldn’t want to tax him twice on that $400,000. You would have to determine each asset individually. The amount realized on the house is $500,000 and the adjusted basis is $400,000 making his gain on the house $100,000. He should be able to exclude the amount on the house under §121 if he met all the requirements. The amount from his contract is ordinary income because it is a replacement of ordinary income (compensation for services). $500,000 would be a replacement for ordinary income and so the replacement for that income is ordinary income so $500,000 would be reported as ordinary income.
1231 hotchpot
at the end of the year, add everything up and if it’s positive, it’s moved to long-term (because one requirement is that it has to be held for more than year) capital and if it’s negative, move to ordinary

definition: real or depreciable property held in trade or business held for more than a year
how to figure out HP

depreciation recapture
1. determine if property is 1231 or not. This is important because if a whole businesss is sold, we have to determine the character of the gain or loss asset by asset. Then, do recapture on gains but not on buildings

2. Then put all 1231 property in HP column and net gains and losses
i. If gains are greater than or equal to losses, each gain is treated as long term capital gain. Each loss is treated as long term capital loss
ii. If losses are greater than gains, each gai is ordinary income. Each loss is ordinary loss

3. If you have a net loss your done (wont happen). If you have a net gain, then we have to do 1231 recapture and depreciation recapture

i. 1231c HOTCHPOT recapture: if theres a net hp loss in the past 5 years we have to make it up by making that much of this years HP gain ordinary
ii. Depreciation recapture next: any hp gain will be ordinary to the extent of depreciation taken on the asset. Not for buildings!
John has computer than it 5 year property that he uses in his trade or business (depreciation). He bought it for 5k(cost basis) and has depreciated it by 3k. AB on asset is 2k. (5-3). Suckers someone into paying 6k (AR).

Whats the extent of johns gain/loss
Its capital unless its inventory, accounts receivable, real property sold, unless real depreciable property sold in trade or business for over a year. We know he had it for more than a year because its been depreciated by 60%. It’s a HP gain. 4k goes in HP. If it was aloss, it would just be ordinary. But since its again, we need to do depreciation recapture. Was depreciated by 3k. make 3k of the 4k HP ordinary, and the extra 1k of the gain is long term capital. Answer: gain 4k. 3k ordinary. 1k long term capital
Tina a Hair dresser in shop has Hair dryers for her beauty shop. Spent 6000, sold them for 7500k. depreciated by $4740. What is the amount and character of tinas gain?
Amount of gain/loss: AR-AB. But remember 6k is cost basis.. must subtract 4740 from the 6k.when we depreciate, basis goes down. new adjusted basis becomes 1260. 7500-1260=6240 gain. Character of hair dryers? Throw in HP. Why not inventory? Not selling hair dryers, using them. We know its real/depreciable asset. Held for more than ayear? Gain 6240. Thjrow in HP. We need to do depreciation recapture. Depreciated already. 4740 of the gain is ordinary. 1500 long term capital gain
I.R.C. §1245 applies to depreciable property other than real property, including tangible and intangible depreciable property
i. figure out if you have §1245 property
ii. is there a gain? (because it doesn’t apply to losses)
iii. move gain over to ordinary to the extent of gain taken on the property
iv. if §1245 is less than depreciation deduction, can only recapture to the extent you have gain
adjusted basis $10,000 and took $3,000 of depreciation deduction making the basis $7,000, taxpayer sells the property in year 3 for $10,000 (amount realized is $10,000) making $3,000 of gain ($10,000 - $7,000 = $3,000),
normally the $3,000 gain would land in §1231 because depreciable property held in trade or business held for more than a year but §1245 takes precedent over §1231, our depreciation deduction was $3,000 and so the entire $3,000 gain is moved to ordinary, all of the gain resulted from taking the depreciation deductions
same facts (adjusted basis $10,000 and took $3,000 of depreciation deduction making the basis $7,000) but now the taxpayer sells for $11,000 (amount realized is $11,000) making $4,000 of gain ($11,000 - $7,000 = $4,000),
normally $4,000 would land in §1231 because depreciable property held in trade or business held for more than a year but §1245 takes precedent over §1231, our depreciation deduction was $3,000 and so $3,000 gain is moved to ordinary and $1,000 remains in §1231 and the gain is from appreciation in gain of the asset, the other $3,000 resulted from basis being reduced from depreciation deductions
ex. same facts (adjusted basis $10,000 and took $3,000 of depreciation deduction making the basis $7,000) but now the taxpayer sells it for $9,000 creating $2,000 of gain ($9,000 - $7,000 = $2,000)
normally $2,000 would land in §1231 because depreciable property held in trade or business held for more than a year but §1245 takes precedent over §1231, all $2,000 would move to ordinary because all of the gain resulted from the depreciation deduction, §1245 doesn’t create gain, it recharacterizes it so all of the gain, would move to ordinary
On January 1, Year 1, John purchased a boat for $150,000 for use in his charter fishing business. One June 1, Year 3, he sold the boat for $165,000. Assuming that he claimed all proper depreciation deductions in Years 1, 2, and 3, how much is John’s gain and how is it characterized? In answering this question, assume: (a) John claims $100,000 §179 deduction; (b) he does not make the straight line election under §168(b)(3); (c) the boat is 5-year property; (d) the boat is used solely in John’s business; and (e) §168(d)(3) does not apply.
His original basis $150,000 and his amount realized is $165,000. The §179 deduction reduces his basis by $100,000 over the 3 years, bringing his basis to $50,000. The depreciation deduction in Year 1 is 20% (because it’s 5-year property and the table says 20%), so at the start of Year 2 he has a $40,000 basis ($50,000 - $10,000). In Year 2, he gets a $16,000 ($50,000 x .32) deduction bringing his basis down to $24,000 ($40,000 - $16,000) . In Year 3, he sold it making his depreciation rate 19.2% so his deduction is $9,600 (but he only gets half because it’s the year of sale so he only gets $4,800) making his basis $19,200. His gain is $165,000 - $19,200 = $145,800. That gain would go in §1231 because it’s depreciable property in the trade or business and held for more than a year. It’s §1245 property and he took deductions of $130,800 ($100,000 + $10,000 + $16,000 + $4,800). $15,000 ($145,800 - $130,800) left in §1231 and $130,800 moved to ordinary.
installment sales
At least 1 payment is made of total purchase price is received after the close of the taxable year in which the sale occurred. (biught something for 5, sold for 12. 7 gain. Guy pays 3 amonth for 4 months all in 2010. Not an installment sale).

Someone doesn’t fully pay you at time of sale.. but spreads payment over 2 taxable years
rules for installment method
i. Allows gains to be spread over the payment period, not losses. If something is sold at a loss, even if receives payment in year 2 must be reported year 1 (year of sale).

Ex: bought for 12, sold for 10. Loss of 2. Buyer pays 5 this year 5 next yr. when does john have to report loss? All in year of sale.

Now lets say cost 12, sold 10. Loss 2. No payment made this year. Next year pays full 10. How much gain/loss in year 1? Loss of 2.

ii. Requires a % of each payment received to be included in GI in year of receipt (FORMULA)

iii. TP can opt out of installment method on or before due date of income tax return in the year of the sale. If tp opts out, his gain is reported under cash/accrual basis rules

iv. Does not change characterization of sale. If you sold capital asset on installment method, its still long term capital gain.

v. If installment notes are sold tp must recognize gain or loss according to AR-Ab in note

vi. Cant use installment method for ordinary income (inventory)***
basically, doesn’t apply (mean apply it all in the year of sale, don’t spread it over the payment period) to
a. losses (§453(a))

b. inventory (§453(b)(2)) and

c. recapture of depreciation (§453(i))

d. but DOES apply to capital and HP can
fraction from formula
gross profit ratio.

This tells you what percentage of payment receiving for that year will be GI. And you keep the same fraction for each year of payment.
bought house for 5 dollars and sold for 12 dollars. 7 dollar gain. That’s assuming person paid 12 dollars that year. But what if he pays 6 this year and 6 next year? Still have a gain of 7..but now it becomes an installment sale question.
TP doesn’t pay on 7 gain that year since he doesn’t have the money yet
seller sells property AB 200. 50cash and 950 promissory note payable100 per year. Last payment 150. AR: cash 50 +950 promisory note=1000. AB 200. AR (1000)-AB (200) Gain=800.. characterize the gain.
Land is a capital asset and none of the exceptions apply. Held more than 1 year, so it’s a long term capital gain.*****maximimum tax on LTGC=15%. 15%/800=120. Problem with this is tax payer might not have enough money to pay this from the transaction!
carry over basis of house is 10k. sold house for 500k. 490k gain. If given 500k that day, pay taxes on 490k gain. Gives 10k this year, 50k next year, etc, its an installment sale.
Automatically, when you have an installment sale, you don’t have to recognize all of your gain in the year of sale. Realized gain is 490k…but installment knows taxes on 490 is ridiculous when your only getting 10k. irs will recognize the gain as you receive payments. Its another way of DEFERRING gain until you receive payment
john formula
AR-AB-Recapture divided by AR-Mortgage assumed.

You will get a fraction. Every year someone makes the payment, you take the payment (lets say 10), multiply by the fraction you get (lets say ½). This is how much is reported as Gi (recognized). 5k GI.

Next year gives 50k. hwo much is GI? Take fraction used before. 50k times ½=25k.
how to approach an installment k problem
whats the gain/loss
characterize it
depreciation recapture
when is it reported
installment formula
i. Year 1 sells computer business for 20k. one of the assets (the machine) cost 200. (cost basis) depreciated by 120. Since depreciated, basis will go down. 200-120=80 AB. Buyer agreed to pay 240 (AR). Mortgage of 40.00 RED FLAG ISNTALLMENT SALE QUESTION. 50 will be paid in year 1. 150 will be paid in year 2 (changed question). Assume Charlie makes no elections (ON INSTALLMENT METHOD)…
ii. What is the gain/loss: AR-AB. 240-80=160 gain

iii. whats the character: what was sold? Equipment for business that he had for over a year. Depreciated it by 120 under straightline (same amount each year..more than halfway depreciated it.. so more than 1 year). Its HP gain..but remember, not final answer. HP is a temporary category. We need to do the depreciation recapture. Out of HP gain of 160, we are going to take the amount the asset was depreciated by (120) and stick it in ORDINARY. So 120 is ordinary, 40 is long term capital gain.

iv. When does the gain/loss have to be reported. Use formula. AR (240)-AB(80)-recapture(120)=40 over AR (240)-mortgage assumed (40)=200. 40/200 is our fraction. Reduce it. 1/5. This is how much of the payment will be GI. Payment in year 1 was 50. 1/5 of 50=10 GI. Year 2 payment was 150. 150 times 1/5=30 GI.

v. question: how much GI in year 2? 30. Trick question: How much GI in year 1? 130. Ordinary gain of 120 which was not eligible for installment method + 10. =130.
***Sale involving mortgage assumption: cash 50 mort assumed 200 promissory ntoe 750. Payable 100/year. Last payment 150. AR=1000 AB 200 elegible gain 800 (ar-ab). eligible gain/k price-mortgage. 800/1000-200. 800/800=1 100%. 100%x50 (payment received)= $50.00 gain reported. Taxed at 15% 7.5
Sue is a cash method tax payer who owned a parcel of investment land that she has owned for 3 years. She paid 4k for the land. In the current year sue sold the land to bill for 20k. terms of the sale call for 4k down payment and 4k interest bearing promissory notes. One note is payable on each of the first four anniversary dates of sale. Each note has a fmv 4k. determine tax consequences in each of the five years. Disregard interest payments.
i. AR: cash 4k. prom notes 16 (4@4k)=20k. AB 4k. 20-4= gain of 16

j. Characterized as long term capital gain. Investment property held for over a year

k. How do we record it?could report all gain in year of sale if they wanted, but they wont.
ar-ab-dep / ar-mort
4/5 x payment (4k)=3200.
3200 each year is reported as GI

ltcg year 1 tax @15%
What result if property was subject to a 4k mortgage that bill assumed so he have sue cash of 4k and 3 prom notes at 4k each?
AR cash 4 pn 12 mtg 4=20. AB 4.
AR-AB=Gain 16. LTCG.


100%x4k next year
another 4k note paid then another 4k note
then another 4k note.

Tied reporting of the gain to cash of the seller.
What result if property subject to 6k mortgage that bill assumed so he gave cash 4k to sue and only 2 promissory notes for 4k each and a pn note 2k?
ar cash 4 pn 10 mtg 6=20k. AB 4k. gain 16k LTCG. Installment method: 16/20-6. 16/14..8/7..converted to a percentage is 114%. If mrotgage exceeds AB, excess amount is NOT mtg, it is cash paid year of sale. 100%x6=6 gain in eyar 1. 4=4 year 2 4-4 year 3 2-2 year 4. Maximum tax on each 15%.
John sells computer used in business for 4 years. Cost him (Cost basis) was 500. Depreciated by 300. Sold for 600. Out of 600, theres a mortgage of 100 (gives john 500 and pays 100 mortgage). Will pay over course of 3 years. Year 1 will pay 200. Year 2 will pay 100. Year 3 will pay 200.
vii. How much gain/loss? AB is 200 (500-300). AR (600)-AB (200)= gain 400.

viii. Character of gain/loss?computer used in business for more than 1 year, depreciated, its HP. 400 gain goes in HP. Before HP becomes LTCG we need to do depreciation recaptire. 300 of the 400 gain is ordinary. 100 goes to long term capital. 100 is our eligible gain.

ix. When reported? AR (600)-AB(200)-recapture(300)=100. SAME AS ELIGIBLE GAIN. Over AR (600)-mortgage(100)=100. 100/500=1/5. Year 1 200 times 1/5=40. Don’t forget to report ordinary 300!! So 340 total year 1. Year 2 100 times 1/5=20. Year 3 200 times 1/5 =40. How much did she receive over 3 years? 40+20+40=100!
if you add up all payments, should add up to the numerator
figure out gain/loss of each asset
x. Inventory. Gain/loss: ar-ab. Fmv-ab. 10-20=loss 10. Character? Ordinary since inventory. When must it be reported? On year of sale. Why? Is ordinary, and it’s a loss.

xi. Equipment. Gain/loss: ar-ab. Cot 400 depreciated by 240 sold for 500. AB is 160 (400-240). AR-AB. 500-160=340. Character? HP gain 340. Need to do depreciation recapture. Depreciated by 240 which si ordinary. 100 becomes long term capital. What’s you eligible gain? 100. Ordinary goes in year os sale, rest spread over years.

xii. Furniture. Cost 100 depreciated by 60. Ab 40. Fmv 20. Ar 20-ab40=loss 20. Since we have a loss of 20, don’t worry about recapture. Character is ordinary since Hp and loss. Must be reported in year of sale

xiii. Goodwill. Ab 0 since created. Fmv 100. Gain 100. Goodwill that you create is capital. Long term capital gain. Eligible for installment methods? Yes.
cash method accounting
in general
a. Measures tax liability by including an item in GI at time cash or cash equivalent is received, or constructively received or deduction when expense is actually paid

1. Generally used by individuals

2. Must include items in year received regardless of whether you are paid in cash check property services etc tax liability until cash or its equivalent is received. A disadvantage is lack of matching of income and expense

3. CHECK IS CASH. becomes GI upon receipt

4. Write check put in mail its
deductibe expense, tis deductible the year the char is put in the mail
john, cash method payer, receives check from les student end of year 1 december 31. Banks closed, john cashes check January 2 year 2. Which year does john have GI.
Since hes cash method, year 1.
when do you have gi
When you actually receive the money, or constructively receive money.

constructive receipt – requires gross income inclusion when they set money aside for you, credited to your account, or is otherwise made available to you without substantial limitations or restrictions.

And subject to TPs unfettered control (nothing will get in your way of getting to that).

If these elements are met, it will then be considered GI even though it has not been actually received yet
guy wins car from magazine on December 31 yer 1. Doesn’t have keys or title until January year 2.

when does he have gi?
year 2. Not constructive receipt. Money deposited in an account is different or money placed in someones mailbox
when do you get deductions/
when you pay the bill
1. 2009. Students owe john 5k.

2. December 2009 tutoring bill due. Janaury 2010 still haven’t paid john.when does john have GI?
1. if cash method- report on taxes NOTHING. Why? Haven’t gotten money yet.

if Accrual method? Already reported it.

Prolly wont get paid all the money.. if doesn’t get paid the money goes for bad debt deduction.

2. 2009 if accrual
john who runs Les spends 4k on office supplies at ABc office store. He gets a bill from them on December 22, 2005.he sends a business check for the 4k December 28th. Because of the holiday mail, abc doesn’t receive his check until January 4, 2006. When does john get deduction on his office supplies? When does abc have GI from the check they received from john?
are john and abc calendar year tp of fiscal eyar? Do they use accrual method or cash accounting method?
taxable year methods
calendar year=12 month period starting January 1 ending December 31. Fiscal year= 12 month period ending on last day of any other month. Ex: john opens business september 1997. September 97-august 98. On exam, it will be calendar year.
choice of the taxpayer
Taxpayer can chose if he wants to be accrual or cash, but if he wants to change he has to get tax commissioner approval and have a good business purpose for the change, NOT to distort income
what is cash or equivalent?
a. Check is equivalent to cash if no legal condition on cashing check, check has FMV for face value of check, and must be reported in year received, not when cashed

b. Promissory notes: unsecured note does not have fmv and doesnt have to ne reported in year received. Negotiable note has fmv and must reported in year received

c. Property other than money- fmv of property received must be included in GI on date received

d. Credit card payments. Look to see if it’s a 2 or 3 party card. 2 party: john uses office max card at office max. deduction for john when he pays the bill. 3 party: john uses visa card at office max. deduction when he signs the slip
other deductions
prepaid insurance premiums must be amortized over the taxable eyars in which the asset will be used if asset has a life longer than1 yrar. Prepaid interest nmust be amortized too unless it is points (deductible when paud)
ames v. commissioner
agreement with russia
constructive receipt
taxpayer said he constructively received the money in 1985, the year he reached the agreement with Russia for the $2M (want the constructive receipt in this case because he’s trying to get around the auditing statute of limitations which would be a closed year), the IRS said it was gross income as he received it, but usually the arguments are reversed, the court said there was no constructive receipt because he did not have unfettered control over the money, doesn’t have access to the money until he gives the information to Russia, taxpayer had to include it as gross income when he actually received it
factors for substantial limitations or restriction
a. distance (Horning case – won a car for being MVP in the Superbowl, won it on December 31 in Wisconsin and the dealership was closed and was in New York, the car was far away and the dealership was closed so it was not receipt; look at context of the distance and the time of the year and how much notice there was to get there, not just looking at it alone)

b. mailing (if an item is put in the mail, until it reaches you, you have not received it)

c. knowledge (if you don’t know funds are made available to you, you don’t have constructive receipt, if you don’t know about it, you don’t know you have access to it and didn’t know it was available to you)

d. contract itself (payment is due at a certain time but the one who is making payments tries to pay earlier, you do not have to forgo contractual rights therefore there is no gross income inclusion just because the funds are made available to you and you reject it, you don’t have to include it as constructive receipt, if you took actual paymen
economic benefit doctrine
i. you’re free to enter into contracts and defer payments as long as you enter into the contract before you provide the services but there is a risk that you may not be able to collect unless you have them put it into a trust or escrow account so your rights are secured
economic benefit doctrine
if you have an economic benefit that is subject to valuation you have to include the value in gross income (subject to valuation when

1) fully vested, no other services to provide.

2) non-forfeitable, no condition of tax to it,

and 3) secured from the creditors of the employer),

basically applies when an employer and the account is subject to valuation meaning you have to include that in gross income, doesn’t have to be employer-employee relationship though)
i. Mike, a cash method, calendar year taxpayer, provides legal services to a wide range of clients. On December 20 of Year 1, Mike sent Developer a bill for $50,000 for services Mike rendered in October, November, and December of that year on a complex suit filed against Developer. Developer mailed a check for $50,000 to Mike on December 30, Year 1. Mike, however, did not receive the check until January 2 of Year 2. When must Mike recognize the income? Would it make any difference if Developer’s officer were less than a block from Mike’s office?
Cash Method
Year 2 because that is when the check was received in the mail.
Year 1 because the all-events test would be satisfied.

Year 1 because that is when he sent the check.

Year 1 because that is when the economic performance was had. It would only make a difference if Mike’s office were a block away if Developer called and told Mike to come get the check. Then it would be constructive receipt because 1 block away is probably not a substantial limitation or restriction.
Assume the facts of Problem 1 except the Postal Service delivered Developer’s check to Mike’s office on December 31, Year 1. Mike’s secretary received the mail, including Developer’s check. Assume Mike was on a ski vacation at the time of the delivery and did not return to his office until January 15, Year 2. Mike deposited the check immediately. When must Mike recognize the income? Would your answer change if the Postal Service placed the mail in Mike’s post office box on December 31?
Year 1 because that is when the check came in the mail. It doesn’t matter if he was on vacation.
Year 1 because that is when the check was sent.

Year 1 because the all-events test would be satisfied.
Year 1 because that is when the economic performance was had.
iii. Suppose instead that, on December 15, Developer called Mike and requested that Mike immediately send him a statement for all legal services rendered to date. Mike, who had not intended to send a statement to Developer until December 31, Year 1 agreed to send the statement but requested that Developer wait until January of Year 2 to pay Mike. Developer sent Mike the check on January 5, Year 2. When must Mike recognize the income?
If the money was made available to him in Year 1 then it’s reported in Year 1 if Mike takes it.
It would be deductible in Year 2 because there is no constructive payment doctrine. Actual payment was made in Year 2 which is when it should be reported.

Year 1 because the all-events test would be satisfied.
Year 1 because that is when the economic performance was had.
iv. Assume the facts in Problem 1 except that, upon receive the bill, Developer called Mike and explained that he was experiencing some cash flow problems. Developer indicated he could pay the bill on March 1 of Year 2. Mike agreed to the deferral of the payment and requested that Developer send Mike a signed promissory note on December 20 of Year 1. Assume that Developer, consistent with the terms of the promissory note, paid Mike $50,000 on March 1, Year 2. When must Mike recognize the income?
cash method
Year 2 (would report in the year of receipt since this promissory note is not a cash equivalent).
It would be deductible in Year 2 because it can be paid in cash, check, or property and he paid it in Year 2.

Year 1 because the all-events test would be satisfied.
Year 1 because that is when the economic performance was had
accrual method accounting
a. Measure tax liability by including an item in GI at time tp becomes entitled to it (or receives it, whichever comes first) and allows a deduction when th expense becomes fixed or certain

1. Generally used by corporations

2. All events test will be used to find out when tp has right to payment or duty to make payment. All events- it means that all events we need to determine actual expense or income have been set
john is an accrual method tp who has to get 500 outlines copied. He drops them off at copy store on December 20 year 1. December 28 copy place calls and says outlines are done and ready for purchase 1500. John pays it January 2 of year 2. When does john get deduction ?
if he is using accrual? year 1 when debt is fixed and certain.

Cash? Eyar 2 when I actually pay bill
What about if you are accrual and are owed money?
You have to claim it as GI when you are entitled to it. If you never receive ti, the bad debt may be deducted, but only when ti becomes worthless.
student owes john accrual method tp 1k for tutoring. Student files for bankruptcy and john wants to deduct he full 1000 debt, thinking that the all events test has been met and we have seen all the events and we need to see to figure out how much john will get paid.
Court will not allow it until after bankruptcy proceedings show how much he will recover from student
when do you have GI and when can you make deductions for accrual method?
you have GI when you have earned or are entitled to the money or receive it, whichever comes first.

Ex: Someone prepays you in 2010. Haven’t earned it but you received it, s its GI in 2010.

When get deductions? When you know what the amount of the bill is. when it becomes fixed and certain
what about the right to receive money from litigation?>
? I win 50k today, and other side appeals. Do I have the right to the money yet? No. when do know for sure I have the right to the money? When its been decided by the highest court it will go to or if the time period to appeal has expired.
Sell business bulindg at a gain of 100k. person will pay 100k for the next 15 years. Thinking isntlalment method. OPT OFF installment method, and is an accrual method taxpayer. When does he have GI?
When hes entitled to it. When he signed paperwork. Closing time. Now he has to pay GI on it. Why opt out? If you have the money to pay taxes, might at well! Remember, automatically installment method is paying over 2 years
landlord receiving rent
if he gets paid ahead of time, it is gi when he received it. Security deposit is not considered gi.
all events test and its exception
all events test – all events have occurred that fix the right to the income and the amount can be determined with legal accuracy

narrow exception to all events test - if a party is insolvent once you have completed the services, if reasonable doubt exists as to whether all events test will be satisfied, if it’s based on legal contingency or insolvency of the payor, you don’t have to report it, won’t take a bad debt deduction unless there is a basis in the amount owed to you
deductions and all events test
get a deduction when you satisfy the all events test (with an extra element) – when all events have occurred which determine the fact of liability, the amount of the liability can be determined with reasonable accuracy, and there’s economic performance (when services are provided, when you get use of property, when taxpayer provides the cash for getting services or getting use of property)

prepayment effect on economic performance – take the deduction when you do the economic performance (e.g. when you get use of the property)

contested liabilities – it wouldn’t meet the test because it hasn’t been established, but Congress under §461 allows accrual method taxpayers to take a deduction by making payment while they are still trying to determine the liability
annual accounting
i. report tax on a calendar year basis

ii. not all transactions are wrapped up in that period

iii. when there is a claim of right inclusion but then later you don’t have that money, you get whatever is better for you, the tax credit based on the amount of additional tax you paid because of the inclusion or get a deduction for the amount paid

a. a deduction is dollar for dollar a reduction of gross income

b. a tax credit is a dollar for dollar reduction of tax liability
no clue***
$100,000 gross income (claim of right) - $0 deductions = $100,000 taxable income x 35% tax rate = $35,000 tax liability
2003 with deduction
$200,000 gross income - $100,000 deduction (claim of right deduction) = $100,000 taxable income x 40% tax rate = $40,000 tax liability
2003 with tax credit
$200,000 - $0 deduction = $200,000 taxable income x 40% tax rate = $80,000 tax liability - $35,000 tax credit (what tax amount was paid before because of the inclusion in 2001) = $45,000 tax liability
Since using the deduction would only make $40,000 taxable as opposed to $45,000 taxable using the tax credit, the taxpayer would use the deduction.
tax benefit rule and its exception
a. the taxpayer takes a deduction and the taxpayer is subsequently repaid so the deduction is no longer appropriate (e.g. bad debt deduction)

b. include the payment in gross income in the year you receive it

c. you wouldn’t amend the return because a deduction was appropriate at the time it was taken

d. exception – a deduction that doesn’t provide a tax benefit (i.e. the year where a taxpayer took a deduction and had no gross income so it doesn’t do anything, you don’t have to report is as gross income because there is nothing to offset)
I.R.C §1341 – requirements
a. amount of deduction must exceed $3,000

b. appearance that there is an unrestricted to the income when included (i.e. doesn’t apply to illegal money or the repayment of stolen money, it is deductible only)

c. established in a subsequent year (didn’t have the right to the income)
in 1996, Tom Powers earned a salary of $60,000 plus a special commission of $10,000 from his employer. In 1998, the employer obtained a court-ordered repayment, which Powers contested, of the special commissions. Powers eventually repaid the $10,000 in 1998. Powers’ federal income tax for 1996 was $30,200 and his tax would have been $23,900 without the inclusion of the commission; Powers’ federal income tax for 1998, without a deduction for repayment, would be $20,800 and with such deduction would be $15,300. As to Powers’ 1998 tax liability, computed in accordance with the provisions of §1341 (restoration of amount held under claim of right), which of the following is correct?-
The amount of the tax credit is $6,300 ($30,200 - $23,900 = $6,300). The amount in 1998 with the deduction is $15,300 and the amount with the tax credit is $14,500 ($20,800 - $6,300 = $14,500). Since $14,500 is a lower amount to be taxed, Tom should use the tax credit instead of the deduction under §1341.
assignnent of income
1. care because otherwise it could be transferred to someone with a lower tax bracket

2. if you are receiving money on behalf of someone else, you don’t have to include it in gross income

3. ex: you make 200k. tax rate 30%. 60k. 100k. 25%. 25k. good news: made lots of money. Bad news- high tax bracket

4. whoever controls paycheck gets taxed-lucas
who gets taxed?
(Lucas v. Earl) earned income is taxed to the person who earned it. He assigned half of his paycheck to wife and it was paid directly to her. He gets taxed! assignment of income from services – the provider of services is taxed on the income
Giannini revisited: (will never see in real life)
a person half way through the year tells him employer he has made enough money and tells him not to pay him and the employer on their own gives the salary to a certain organization, the court said you have the right to forfeit the funds before you earn them, if he had chosen the donee himself, it would be different, but otherwise, you don’t have to include it in gross income
assignment of income from property
the owner of the property is the one who is taxed on the income from the property

ex: john gives son an apartment complex which has 40 tenants paying rent january 1. Whose income is the rent? Treat property given (apt complex) as tree and income produced from property (rents) as fruits of that tree. John still has gi in january. Son will have it feb on.

if the recipient of the property never has control of the income, whoever receives the income reports it as gross income
valid partnerships
Another way of shifting income from one person to another is by setting up sham partnership

partnership is 2 or more people joined together in a business for profit. Its not a taxable entity. It will file an informational return letting the irs know who the partners were and how much the ps made. Its then up to the partners to claim their income according to whatever the ps agreement is
have a valid PS, we need
i. Intent to be partners (for business purposes, not just tax purposes)

ii. Contributions of property or services to the PS
culbertson case
father andson owned cattle ranch partnership. Father donated all property and performed alls ervices but divided income up among all of them. Irs fond this was not a PS. However, IRC 704e was passed after this, and in effect makes it a ps if a partner owns a capital interest (share of ps) regardless of how he received it (even by gift) if the ps is one where capital is a material income producing factor
5. In summary, to see if you it is a PS, if a service tyoe PS (doctor lawyer accountant) test is intent for a business purpose. If a “It takes money to make money partnership test is “is capital a material income producing factor?”
1. How dot axes work if we have a corp?

2. C corp: taxable as separate entities. SH taxed indicuvlaly on income received from corporation AFTER corporation gets taxed! Double tax!

3. S corp:: not subject to tax. SH pay their pro rata share of corp. income
kiddie tax
2. 18 kids unearned income after a certain allowance (exemption) will be taxed at the parents rate!

3. Watch out for the kid having a paper route, etc and earning the money.. then tis all taxed at his rate

4. Latesdt exemption on this is 950 per parent or 1900 if the kid ives with both parents

5. the tax imposed on a child when net unearned income (passive income, i.e. royalties and rents, income from annuities) is transferred to them (not earned income, not subject to the kiddie tax)

6. must be under the age of 18
a. at the close of the taxable year
b. if the kid is in college, it increases the age to 23

7. taxed at the greater of the parental rate or the child’s rate
a. if the parents are divorced, then use the custodial parent’s tax rate

9. it prevents a shift of income to kids because they would have a lower tax rate

10. doesn’t apply if both parents are dead

11. in 2008, the child standard deduction is $900
kiddie formula
net unearned income:

child’s unearned income – 2(child standard deduction) = the amount subject to the kiddie tax
ii. cash

iii. to or for the benefit of the spouse (e.g. mortgage, car payment)

iv. must be received directly by spouse/ former spouse or third party on behalf of them

v. pursuant to a divorce or separation agreement

vi. parties did not elect non-alimony treatment

vii. not members of the same household if legally separated or divorced

viii. no liability to continue payments after the death of the payee/recipient (if the person is dead, there is no reason to pay because there is no lifestyle to maintain)

ix. if just separated, cannot file joint tax return

x. not child support
alimony in general
a. alimony (if it meets the definition of alimony) is gross income to the recipient

b. alimony (if it meets the definition of alimony) is deductible to the payor

c. paid to support the person in the kind of lifestyle they’re accustomed to when not married anymore
child support
a. child support is not includable as gross income

b. child support is not deductible

c. payor might try to disguise child support as alimony. (spouse has to pay ex wife 2000 a month until kid turns 18 then just 1500 a month. 500 is disguised as alimony when its really child support)

d. if something is labeled as child support, then it is

e. if the payment is called alimony but it is contingent to something having to do with the child, it’s disguised as child support and is really related to the child and does not qualify for alimony treatment

f. even if it is just at a time where a contingency relating to the child would occur, the IRS won’t let alimony be disguised that way either
property transfers incident to divorce
a. transfers of property during marriage or incident to divorce are not includable in gross income and the recipient gets the carry-over basis (i.e. what they paid for it)

b. no exceptions

c. same rule applies even if one spouse pays the other for the property

d. requirements: transfers during marriage
asset fair market value basis
cash (wife) $100,000 $100,000
building (hus.) $150,000 $80,000
stocks (wife) $50,000 $40,000
Wife’s deal is better. If she sells the stock, the gain would be $10,000 ($50,000 - $40,000 = $10,000). At a 15% tax rate (since it is a long term capital gain), the tax liability would be $1,500 making the wife gets $148,000 ($100,000 + $48,500 = $148,500).
If the husband sold the building, the gain would be $70,000 ($150,000 - $80,000 = $70,000). If the tax rate is 15%, the tax liability is $10,500. The husband gets $139,500 ($150,000 - $10,500 = $139,500).
frank and Maureen were married for fifteen years. On September 30, Year 1 they separated. Maureen remained in the family home, and Frank moved into an apartment. They entered into a written separation agreement on January 1, Year 2, and a divorce decree, incorporating the terms of that agreement, was entered on July 1, Year 2.

a. Assume in October, Year 1, immediately after the separation, Frank wrote a letter to Maureen in which he agreed to pay Maureen $2,000 per month starting in October 1, Year 1. Maureen did not respond to the letter. Frank nonetheless made the promised payments.

Do the Year 1 payments constitute alimony?
No because there is no divorce agreement between the 2 parties.
b. Which of the following payments, made pursuant to their January 1, Year 2 agreement constitute alimony?
i. As of January 1, Year 2, Frank has been paying Maureen $2,000 per month. -
$2,000 is includable as gross income because it’s alimony (as long as there is no obligation to pay after Maureen’s death).
ii. On January 1, Year 2, Frank transferred to Maureen a parcel of land Frank purchased years before as an investment (value $100,000; basis $75,000). – No because alimony must be cash.
d. What are the tax consequences to Frank and Maureen of the following property transactions?

i. Frank and Maureen jointly owned some ABC stock (value of $30,000, purchased for $45,000) and a parcel of land (value of $60,000, purchased for $20,000 and subject to a $30,000 mortgage they incurred in order to pay medical bills). During Year 2, Frank transferred to Maureen his interest in the land, subject to the mortgage, and Maureen transferred to Frank her interest in the ABC stock. In Year 4, Frank sold the ABC stock for $40,000, and Maureen sold the land for $10,000 in cash, and the purchaser took the land subject to the $30,000 mortgage. –
There are no tax consequences because child support is not includable as gross income and is not a deduction to the payor). In Year 4, it may be a contingency related to the child because it is Donna’s 16th birthday but probably not because there is no real reason for the deduction. In Year 7, the same idea as Year 4 but it is within 6 months of Donna’s 18th birthday. There is a presumption of contingency but it could be rebutted using the fact that he is already paying child support or he could maybe find something else that is based on besides maybe the 18th birthday.
Instead of transferring to Maureen his interest in the land, Frank paid Maureen $15,000 for her interest in the ABC stock and $15,000 for her interest in the land. Frank later sold the stock for $40,000 and the land for $10,000 subject to the $30,000 mortgage. –
The amount realized for the stock is $40,000 and the adjusted basis is $45,000 making it a $5,000 loss, a deduction for investment property. The amount realized for the land is $40,000 and the adjusted basis is $20,000 making the gain $20,000. Since it is a transfer of property between husband and wife, there is no inclusion in gross income and no deduction.