Deductions

Question 1

What is depreciation?

Answer 1

Loss in value of a business asset.

Question 2

How is depreciation deducted for tax purposes?

Answer 2

Deduct a portion of the asset over the assessed life. E.g. purchase a laptop for $5,000 with a 5 year lifespan. Can deduct $1,000 of depreciation each year for the 5 years.

Question 3

What is a non-recourse loan?

Answer 3

Lender can only look to the asset purchased with the loan to recover money not paid (limited to the secured collateral).

Question 4

What is a tax shelter?

Answer 4

investments entered into largely for the sake of tax benefits, such as accelerated depreciation of real estate and other assets.

Question 5

What is the basis when property is gained through inheritance?

Answer 5

Step-up basis. The receiver’s basis is the FMV (or appraised value) of the property at the time of the transfer.

Question 6

How is depreciation related to basis?

Answer 6

Depreciation taken is subtracted from the basis to form the new basis.

If you take a $5,000 laptop and deducted $1,000 each year for 5 years, your new basis is zero dollars.

Question 7

How are qualified dividends taxed?

Answer 7

As long-term capital gains.

Question 8

What is the tax status of a non-recourse loan?

Answer 8

Non-recourse loan in excess of basis is not a taxable event.

Question 9

What is the legal test for recognition of a loss?

Answer 9

A change in legal entitlements. generally an exchange of title.

Question 10

What are non-recognition rules?

Answer 10

statutory exemptions that allow a realized gain to be non-recognized, usually for a period of time, to avoid paying taxes on the gain until a later date.

Question 11

What is a § 1031 exchange?

Answer 11

allows a person who sells a business or investment property to purchase a similar business or property within the statutory time, without the loss or gain being recognized.
• Does not permit the receipt of cash. Money is held in escrow and used to purchase the second property.
• Must be “like items.”
• Usually used for real property, but must be an investment property.
• Can also be used for other assets

Question 12

What is a private letter ruling?

Answer 12

letter from the IRS in response to a taxpayers request for an opinion on the tax implications of a certain transaction.
• Only applies to the specific taxpayer. Cannot be used as precedent for another situation.
• Could be used as guidance in similar situations.

Question 13

What is a “boot” and how is gain recognized?

Answer 13

money, and property other than money, that, under a provision like § 1031, is transferred as part of the like-kind exchange but is not like-kind property.
• Gain recognized is the lessor of the amount of gain realized or the amount of the boot.
• New basis in the replacement property - take the original basis and add the recognized gain.

Question 14

What is the difference in thinking between realization and recognition?

Answer 14

Realization - think of it economically, what is your economic gain.

Recognition - only for tax purposes. Something that is recognized for tax purposes must be reported and tax paid for the gain.

Question 15

What is the adjusted tax basis?

Answer 15

Cost plus capital improvements

Question 16

What is gain realized?

Answer 16

amount realized minus basis.

Question 17

What is taxed when you have a like-kind exchange with boot?

Answer 17

Lessor of gain realized or the boot.

Question 18

What is an open transaction?

Answer 18

a transaction that has not closed for tax purposes.

Burnet v. Logan (1931)
• Taxpayer sold stock in a mining company for $120,000 cash and future payments based on the amount of ore shipped each year for 25 years. Basis was $180,000.
• Taxpayer claimed the transaction was open, and all proceeds should go to the basis until it was covered. Once the basis is covered, then the remainder of the annual payments would be taxed as profits.
Court agreed.

Question 19

What are the three approaches to open transactions for tax purposes?

Answer 19

Open Transaction
Present Value
Installment method

Question 20

What is the Open Transaction approach?

Answer 20

all payments received are treated as recovery of basis until the full amount of the basis is recovered, then all subsequent payments are treated as gains.

Question 21

What is the present value (closed transaction) approach?

Answer 21

calculate the present value of the expected payments and treat the sum as if it were cash received at the time of the sale.

Question 22

What is the installment method approach?

Answer 22

allocate some portion of basis to each expected payment received so that some portion of the gain or loss is recognized as each payment is received.

E.g., Basis of $100,000, sale for $300,000. For each payment, 1/3 of the payment will be treated as basis, and 2/3’s will be treated as gain.

Question 23

What is an installment sale?

Answer 23

disposition of property where at least one payment us to be received after the close of the taxable year in which the disposition occurs. § 453(b)(1).

Question 24

Is the taxpayer required to report under the installment method?

Answer 24

No, it is optional.

Question 25

What is a constructive receipt?

Answer 25

Taxpayer must realize a gain or income when the money is placed under his control.

Amend v. Commissioner (1949)
• Farmer sold and delivered crop of wheat in the fall, but did not receive payment until January of the following year. Reported income for the year he received the payment.
• Contract stated the money was due in January and the farmer had no right to demand early payment.
• IRS claimed he had a deficit and should have reported income when he delivered the wheat because he was guaranteed payment.
• Court disagreed. The contract was valid and provided for payment in January.
• Court looked at the legal rights and entitlements of the taxpayer, which was to get paid in January

Question 26

What is the economic benefit doctrine?

Answer 26

standard income, economic benefit granted to a person is income in the year the benefit is granted.

Question 27

What is the status is a benefit is placed directly in trust?

Answer 27

If the benefit is placed in trust, and cannot be withdrawn until a certain time, then the benefit is realized when the money can be withdrawn.

If the money could be obtained at any time, or by filing an application, then the benefits are realized immediately (Pulsifer v. Commissioner)

Question 28

What is Nonqualified Deferred Compensation?

Answer 28

Employees make money in a certain year, but the company holds the money (at the employee’s request) until a later year. Usually done by high-income executives.

Question 29

What is the benefit of a qualified employer plan?

Answer 29

get more tax benefits (deferral) than non-qualified plans.

Question 30

What are the three main approaches to taxation of employee stock options under § 422, and describe them?

Answer 30

1. Income upon receipt of the option.
   - Income received in year 1 of the option’s FMV same as if he received cash. Income realized when the option is exercised is the gain (price at the time) minus the basis (the FMV that was already taxed.
2. Income upon exercise of the option.
   - No income until the stock option is exercised. Income is the FMV minus the exercise price (how much the employee had to pay per share). This forms the basis for later realized gains upon sale.
3. Gain recognized upon sale of the stock.
   - No income until employee sales the stock. Taxable income (capital gain) will be the sale price minus the exercise price (basis). Taxed as capital gains.

Note: Company receives a deduction for the option when the income is recognized by the taxpayer.

Question 31

What are incentive stock options and how are they taxed?

Answer 31

Incentive Stock Options (ISOs) apply the third approach, but require the employee to retain the stock for at least two years after the option grant and one year after receiving the stock under the option. There is also a limit of $100,000 in value of unexercised options under this statute (§ 422).

Question 32

What are non statutory stock options?

Answer 32

Stock options that do not fall under § 422.

requires mandatory inclusion in an employee’s income if the option has a “readily ascertainable FMV” (very rare). If it does not meet this, the employee can elect the option to be includable by determining the FMV without regard to time-limited restrictions. § 83(b).

If there is no “readily ascertainable FMV,” then the option is not taxed until exercised, and is considered regular income.

Question 33

What is the tax rule for transfer to a spouse incident to divorce?

Answer 33

§ 1041- No gain or loss shall be recognized on a transfer of property from an individual to a spouse or incident to divorce.

Tax code generally looks at husband and wife as a single economic unit.

Question 34

How is alimony taxed?

Answer 34

Alimony - Deduction for the payor and income for the payee
• Must be pursuant to a written divorce or settlement agreement to qualify.
• Alimony must be cash to be deductible. E.g. - insurance policy on the former spouse is not deductible.

Question 35

How is child support taxed?

Answer 35

no deduction for the payor and no income for the payee. Child support payments are not recognized for tax purposes.

Payments that are stated as alimony, but structured as child support (e.g., dependant upon age or death of the child), then they will be considered child support and not deductible for the payor.

Question 36

What are personal deductions?

Answer 36

those that are not used to generate income. These are also called “below the line”

Question 37

What are “above the line” deductions?

Answer 37

Deductions from moneys that are used to generate income.

Gross income minus above the line deductions equals adjusted gross income.

Question 38

How do personal deductions affect tax?

Answer 38

Subtracted from Adjusted Gross income to calculate Taxable Income.
• Home mortgage interest, State taxes paid, medical expenses, etc.

Question 39

What is a charitable deduction?

Answer 39

a contribution or gift to or for the use of certain enumerated eligible donees. § 170(c).
• Donations to these organizations are deductible to the taxpayer, and generally not included as income for the charity.

Question 40

How are charitable deductions affected by benefits received by the taxpayer?

Answer 40

Charitable deductions are reduced by the amount of benefit received from the taxpayer.
• E.g. - if you donate $100 and receive a backpack worth $20, the charitable deduction is $80.
• Deduction is the amount spent over the FMV of the item/benefit received.

Question 41

How is interest paid treated for tax purposes?

Answer 41

§ 163(a) - There shall be allowed as a deduction all interest paid or accrued within the taxable year on indebtedness.
• Personal interest is generally not allowed (under section (h)) unless:
○ Qualified residence interest (loan to acquire the property ($1 million limitation) and/or home equity loan ($100k limitation).