IV. Federal Taxation of Individuals-Deduction

Question 1

IV. Federal Taxation of Individuals-Deduction

2. Deductions
3. Deductions—Basic Principles

Answer 1

I. General Rule: 2 Categories of deduction: deductions for AGI and deductions from AGI

II. Disallowed Deduction

1. scost of goods sold can be deducted for an illegal drug business. The ordinary, necessary, and reasonable expenses of operating other illegal businesses are permitted (as long as the expense itself is not against public policy).
2. Lobbying expenses at the state and federal level; beginning in 2018 deductions are not permitted at the city and county government level.
3. Beginning in 2018, no deduction is allowed for a settlement or attorney fees paid related to sexual harassment or sexual abuse claim if the payments are subject to a nondisclosure agreement.
4. Beginning in 2018, entertainment expenses are no longer deductible.

III. Business Interest

1. Businesses cannot deduct net interest expense in excess of its business interest income plus 30% of the business’s adjusted taxable income.
2. Determination is made at the partnership level and S corporation level for pass-through entities.
3. Adjusted taxable income does not include depreciation, amortization, or depletion.
4. Does not apply to taxpayers with average annual gross receipts (three years) that do not exceed $25 million.
5. Disallowed interest may be carried forward indefinitely.
6. Real property trade/businesses can elect out if they use ADS to depreciate real property.
7. Farming businesses can elect out if they use ADS to depreciate property with a recovery period of 10 years or more.

Question 2

IV. Federal Taxation of Individuals-Deduction

2. Deductions
3. Deductions—Basic Principles

Saints Inc. has had more than $25 million in average gross receipts for the last three years. In 2019, Saints, Inc. reported the following information:

Gross receipts |$30,000,000

COGS |$18,000,000

Advertising | $25,000

Business interest expense | $150,000

Depreciation expense | $1,250,000

Other operating expenses |$11,500,000

How much can Saints Inc. deduct for business interest expense?

1. $0
2. $118,750
3. $142,500
4. $150,000

Answer 2

C.

Correct! Business interest expense is limited to 30% of the business’s adjusted taxable income. The allowable business interest expense deduction is calculated as follows:

Gross receipts $30,000,000

COGS (18,000,000)

Advertising (25,000)

Other operating expenses (11,500,000)

Adjusted taxable income $ 475,000

x 30%

Business interest expense limit $ 142,500

The remaining $7,500 is business interest is carried forward to 2020. Depreciation expense is not included in computing adjusted taxable income.

Question 3

IV. Federal Taxation of Individuals-Deduction

2. Deductions
3. Deductions—Basic Principles

On December 1, 2018, Michaels, a self-employed cash-basis taxpayer, borrowed $100,000 to use in her business. The loan was to be repaid on November 30, 2019. Michaels paid the entire interest of $12,000 on December 31, 2018.

What amount of interest was deductible on Michaels’s 2019 income tax return?

1. $12,000
2. $11,000
3. $1,000
4. $0

Answer 3

B.

Cash-basis taxpayers report income when cash or property is actually or constructively received. There is no constructive receipt for deductions. Deductions for cash-basis taxpayers generally are taken when actually paid. However, for expenses covering 12 months or more, the deduction must be spread over the period for which the expenses apply. Thus, since the loan was to be repaid in 12 months, the deduction for the interest must be spread over the 12-month period.

Thus, to account for the period of December 1, 2018, to December 31, 2018, Michaels would have deducted $1,000 of the interest on her 2018 income tax return and $11,000 on her 2019 income tax return to account for the period January 1, 2019, to November 30, 2019.

Question 4

IV. Federal Taxation of Individuals-Deduction

2. Deductions
3. Deductions for AGI

Cole earned $3,000 in wages, incurred $1,000 in unreimbursed employee business expenses, paid $400 as interest on a student loan, and contributed $100 to a charity. What is Cole’s adjusted gross income?

1. $3,000
2. $2,600
3. $2,500
4. $1,600

Answer 4

B.

The itemized deduction for unreimbursed employee business expenses has been suspended for years 2018–2025. The charitable contribution is an itemized deduction and does not affect the computation of adjusted gross income. AGI equals the $3,000 of wages less student loan interest of $400, or $2,600.

Question 5

IV. Federal Taxation of Individuals-Deduction

2. Deductions
3. Itemized Deductions—Medical, Taxes, Interest

Answer 5

III. Medical Expenses

D. Nondeductible items include funeral, burial, and cremation expenses; nonprescription drugs (except insulin); bottled water; toiletries; cosmetics; health spas; unnecessary cosmetic surgery.

Question 6

IV. Federal Taxation of Individuals-Deduction

2. Deductions
3. Itemized Deductions—Medical, Taxes, Interest

Answer 6

V. Interest

A. Home Mortgage Interest

Example

Allan purchased a home for $380,000, borrowing $250,000 of the purchase price that was secured by a fifteen-year mortgage. In 2019, when the home was worth $400,000 and the balance of the first mortgage was $230,000, Allan obtained a second mortgage on the home in the amount of $120,000, using the proceeds to purchase a car and to pay off personal loans. Allan may deduct the interest on the balance of the first mortgage acquisition indebtedness of $230,000. However, he cannot deduct interest on the second mortgage as qualified residence interest because it is considered home equity indebtedness (i.e., the loan proceeds were not used to acquire, construct, or substantially improve a home).

Question 7

IV. Federal Taxation of Individuals-Deduction

2. Deductions
3. Itemized Deductions—Medical, Taxes, Interest

An individual taxpayer earned $10,000 in investment income, $8,000 in noninterest investment expenses, and $5,000 in investment interest expense. How much is the taxpayer allowed to deduct on the current-year’s tax return for investment interest expenses?

1. $0
2. $2,000
3. $3,000
4. $5,000

Answer 7

D.

Correct! Net investment income is defined as investment income ($10,000) less deductible noninterest investment expenses ($0), or $10,000. Noninterest investment expenses are not deductible beginning in 2018. So, the entire $5,000 of interest expense is deductible since it does not exceed the net investment income of $10,000.

Question 8

IV. Federal Taxation of Individuals-Deduction

2. Deductions
3. Itemized Deductions—Medical, Taxes, Interest

Which of the following statements is correct regarding the deductibility of an individual’s medical expenses?

1. A medical expense paid by credit card is deductible in the year the credit card bill is paid.
2. A medical expense deduction is allowed for payments made in the current year for medical services received in earlier years.
3. Medical expenses, net of insurance reimbursements, are disregarded in the alternative minimum tax calculation.
4. A medical expense deduction is NOT allowed for Medicare insurance premiums.

Answer 8

1. Expenses paid by credit card by an individual are deductible in the year the charge is made.
2. Medical expenses paid by an individual are deductible in the year paid.
3. This statement is incorrect because medical expenses are deductible for AMT to the extent they exceed 10% of AGI.
4. Medicare insurance premiums are a deductible expense.

Question 9

IV. Federal Taxation of Individuals-Deduction

2. Deductions
3. Itemized Deductions—Other

Answer 9

I. Charitable Contributions

1. LTCG property is limited to 30% of AGI.
2. The deduction is the fair market value of the property reduced by ordinary income or short-term capital gain that would be recognized if the property was sold.
3. Ordinary income property includes ordinary income due to depreciation recapture.
4. If the fair market value of the property is less than its adjusted basis, the deduction is limited to the fair market value.

Example

Taxpayer owns machinery with a fair market value of $25,000 and adjusted basis of $15,000. Depreciation claimed is $7,000. If the machine was sold, the total gain would be $10,000 ($25,000 – $15,000), of which $7,000 would be recaptured as ordinary income. If this property was contributed to a qualified charitable organization, the deduction would be $18,000 ($25,000 − $7,000).

5. Up to $100,000 of distributions from an IRA will be tax-free if contributed to a charitable organization by an individual age 70 or over. This contribution will also not be subject to the 50% or 30% limitations.

Question 10

IV. Federal Taxation of Individuals-Deduction

2. Deductions
3. Itemized Deductions—Other
   I. Charitable Contributions

Jimet, an unmarried taxpayer, qualified to itemize deductions. Jimet’s adjusted gross income was $30,000 and he made a $2,000 cash donation directly to a needy family. Jimet also donated stock, valued at $3,000, to his church. Jimet had purchased the stock four months earlier for $1,500.

What was the maximum amount of the charitable contribution allowable as an itemized deduction on Jimet’s income tax return?

1. $0
2. $1,500
3. $2,000
4. $5,000

Answer 10

B.

$1,500 is correct. The $2,000 cash donated to a needy family is not deductible because the needy family is not a qualified charitable organization. The stock was purchased for $1,500 and not held for one year to be capital gain property, therefore the deduction for the stock is the fair market value of the stock ($3,000) less the short-term capital gain ($1,500) if the stock had been sold ($3,000 − basis of $1,500) = $1,500.

Question 11

IV. Federal Taxation of Individuals-Deduction

2. Deductions
3. Itemized Deductions—Other
   I. Charitable Contributions

Deet, an unmarried taxpayer, qualified to itemize deductions.

Deet’s adjusted gross income was $40,000 and he made a $1,500 substantiated cash donation directly to a needy family. Deet also donated art, valued at $11,000, to a local art museum. Deet had purchased the artwork two years earlier for $2,000.

What was the maximum amount of the charitable contribution allowable as an itemized deduction on Deet’s income tax return in 2019?

1. $12,500
2. $11,000
3. $ 3,500
4. $ 2,000

Answer 11

B.

The $1,500 donation to the needy family is incorrect. The family is not a qualified charitable organization. Because the artwork was held over two years, it is capital gain property and Deet can use FMV of $11,000 for the value of his charitable contribution to the art museum.

Question 12

IV. Federal Taxation of Individuals-Deduction

2. Deductions
3. Itemized Deductions—Other
   I. Charitable Contributions

Stein, an unmarried taxpayer, had adjusted gross income of $80,000 for the year, and qualified to itemize deductions. Stein had no charitable contribution carryovers and only made one contribution during the year.

Stein donated stock, purchased seven years earlier for $17,000, to a tax-exempt educational organization. The stock was valued at $25,000 when it was contributed.

What is the amount of charitable contributions deductible on Stein’s current year income tax return?

1. $17,000
2. $21,000
3. $24,000
4. $25,000

Answer 12

C.

$24,000 is correct. Although Stein can deduct the fair market value (FMV) of $25,000 for the stock contributed, the deduction is limited to 30% of his AGI, $80,000.

Question 13

IV. Federal Taxation of Individuals-Deduction

2. Deductions
3. Itemized Deductions—Other
   II. Casualty Losses

Robinson’s personal residence was partially destroyed by a wildfire that was part of a federally declared disaster area. The fair market value (FMV) of the residence before the fire was $500,000, and the FMV after the fire was $300,000. Robinson’s adjusted basis in the home was $350,000. Robinson settled the insurance claim on the fire for $175,000. If Robinson’s adjusted gross income (AGI) for the year is $120,000, what amount of the casualty loss may Robinson claim after consideration of threshold limitations?

1. $12,900
2. $13,000
3. $24,900
4. $25,000

Answer 13

A.

Lower of decline in FMV ($200,000) or AB of property ($350,000)$200,000

Insurance Reimbursements (175,000)

− $100 per casualty ( 100)

− 10% × AGI ( 12,000)

Casualty loss deduction $ 12,900

Question 14

IV. Federal Taxation of Individuals-Deduction

2. Deductions
3. Itemized Deductions—Other
   III. Miscellaneous Itemized Deductions

Dr. Merry, a self-employed dentist, incurred the following expenses:

Investment expenses $ 700

Custodial fees related to Dr. Merry’s Keogh plan 40

Work uniforms for Dr. Merry and Dr. Merry’s employees 320

Subscriptions for periodicals used in the waiting room 110

Dental education seminar 1,300

What is the amount of expenses the doctor can deduct as business expenses on Schedule C, Profit or Loss from Business?

1. $1,620
2. $1,730
3. $1,770
4. $2,430

Answer 14

B.

The deductible business expenses are the uniforms ($320), subscriptions ($110), and seminar ($1,300). The investment expenses and custodial fees are 2% miscellaneous itemized deductions and are no longer deductible beginning in 2018.

Question 15

IV. Federal Taxation of Individuals-Deduction

2. Deductions
3. Itemized Deductions—Other
   I. Charitable Contributions

Moore, a single taxpayer, had $50,000 in adjusted gross income for 2019. During 2019, she contributed $18,000 to her church. She had a $10,000 charitable contribution carryover from her 2018 church contribution.

What was the maximum amount of properly substantiated charitable contributions that Moore could claim as an itemized deduction for 2019?

1. $10,000
2. $18,000
3. $25,000
4. $28,000

Answer 15

D.

An individual’s cash charitable contribution to public charities may not exceed 50%/60% of the individual’s adjusted gross income. The 50%/60% deduction ceiling applies to contributions made to:

churches;

educational institutions that maintain a regular faculty and curriculum;

hospitals and medical schools;

organizations supported by the government that hold property and/or investments for the benefit of a college or university;

federal, state or local governmental units; and

organizations normally receiving most of its support from the public or a governmental unit. The amount that exceeds the 50%/60% deduction ceiling may be carried forward for 5 years.

Since Moore’s cash charitable contributions were made to an organization (a church) qualifying for a 50%/60% deduction ceiling, she may deduct up to $30,000, 50%/60% of her adjusted gross income of $50,000. Moore may meet this ceiling by deducting the $18,000 that she contributed to her church in 2019 and carrying forward $10,000 charitable contribution carryover from her 2018 church contribution. Her deduction is $28,000.

Question 16

IV. Federal Taxation of Individuals-Deduction

2. Deductions
3. Business Expenses

I. Accountable Plans

Answer 16

For a plan to be accountable:

1. Must substantiate all expenses to be reimbursed, and
2. Excess reimbursements must be returned to the employer.
3. Per diem reimbursements at a rate not in excess of the federal per diem rate and mileage rate per mile are deemed to satisfy the substantiation requirement if the employee provides the time, place, and business purpose of expenses.

Question 17

IV. Federal Taxation of Individuals-Deduction

2. Deductions
3. Business Expenses

IV. Education Expenses

Answer 17

1. Education expenses are not deductible if:
   
   1. To meet minimum standards of a current job or
   2. To qualify the taxpayer for a new trade or business
2. Education expenses are deductible if:
   
   1. To maintain or improve existing skills required in a current job or
   2. To meet the requirements of an employer or imposed by law to retain employment status

Question 18

IV. Federal Taxation of Individuals-Deduction

2. Deductions
3. Business Expenses

IV. Education Expenses

Baker, a sole proprietor CPA, has several clients that do business in Spain. While on a four-week vacation in Spain, Baker took a five-day seminar on Spanish business practices that cost $700. Baker’s round-trip airfare to Spain was $600. While in Spain, Baker spent an average of $100 per day on accommodations, local travel, and other incidental expenses, for total expenses of $2,800.

What amount of educational expense can Baker deduct on Form 1040 Schedule C, Profit or Loss From Business?

1. $ 700
2. $1,200
3. $1,800
4. $4,100

Answer 18

B.

When traveling outside the U.S. primarily for vacation (4 weeks total versus 1 week seminar), the cost of the trip is a nondeductible personal expense. Baker can deduct the registration fees for the business seminar and deduct the out of pocket expenses for the time that was directly related to the business seminar (1 week). 5 days × $100 per day plus $700 registration = $1200 of deductible education expense.

Question 19

IV. Federal Taxation of Individuals-Deduction

2. Deductions
3. Deductions—Losses and Bad Debts

IV. Net Operating Losses

Answer 19

1. NOLs incurred before 2018 must be carried back to the two preceding tax years (beginning with the second prior year) unless an election is made in the year of the NOL to forgo the carryback. The carryover period is 20 years.
2. NOLs incurred in 2018 and beyond, except for certain farming losses, may only be carried forward indefinitely and only to the extent of 80% of taxable income (as determined without regard to the deduction).
3. NOLs are only allowed for business losses and casualty losses. Any nonbusiness losses or expenses must be added back to the taxable loss to determine the NOL. Losses from rental activity are business losses for purposes of computing the NOL.

Question 20

IV. Federal Taxation of Individuals-Deduction

2. Deductions
3. Deductions—Losses and Bad Debts

V. Excess Business Losses

Answer 20

1. No deduction is allowed for aggregate losses that:
   
   1. Were incurred by a noncorporate taxpayer (including sole proprietors and owners of partnerships, S corporations, and limited liability companies), and
   2. That exceed $500,000/$250,000 (married filing joint/other).
2. The disallowed amount is added to the taxpayer’s NOL carryforward.

Question 21

IV. Federal Taxation of Individuals-Deduction

2. Deductions
3. Deductions—Losses and Bad Debts

Ross is single and operates two businesses. In 2019, his Schedule C consulting business generated a ($300,000) business loss, and his partnership distributive share is $30,000. What is Ross’s excess business loss for 2019?

1. $20,000
2. $30,000
3. $250,000
4. $270,000

Answer 21

A.

The Tax Cuts and Jobs Act provides a new limitation on excess business losses. This limitation applies to noncorporate taxpayers. The limitation applies only to aggregate excess business losses exceeding a threshold amount of $500,000 (married filing jointly taxpayers) or $250,000 (all other taxpayers). Ross’s aggregate loss is ($270,000). The aggregate loss in excess of $250,000 ($270,000 – $250,000 = $20,000) is disallowed and carried forward as an NOL.

Question 22

IV. Federal Taxation of Individuals-Deduction

2. Deductions
3. Deductions—Losses and Bad Debts

Jason Budd, CPA, reports on the cash basis. In April 2018, Budd billed a client $3,500 for the following professional services:

Personal estate planning $2,000

Personal tax return preparation 1,000

Compilation of business financial statements 500

No part of the $3,500 was ever paid. In April 2019, the client declared bankruptcy, and the $3,500 obligation became totally uncollectible. What loss can Budd deduct on his tax return for this bad debt?

1. $0
2. $ 500
3. $ 1,500
4. $3,500

Answer 22

A.

Since Budd reports on the cash basis he did not recognize income when the client was billed. Therefore, he has no basis in the receivable to deduct when it becomes uncollectible.

Question 23

IV. Federal Taxation of Individuals-Deduction

2. Deductions
3. Deductions—Losses and Bad Debts

For the year ended December 31, 2019, Sanchez had a net operating loss of $100,000. Taxable income for the earlier years, computed without reference to the net operating loss, was as follows:

Taxable income

2015 $90,000

2016 $80,000

2017 $50,000

2018 $40,000

What amount of net operating loss will be available to Sanchez for 2020?

1. $ 0
2. $ 10,000
3. $ 60,000
4. $ 100,000

Answer 23

D.

Beginning in 2018, an NOL may not be carried back and may be carried forward indefinitely. $100,000 is available to carry forward to 2020.

Question 24

IV. Federal Taxation of Individuals-Deduction

2. Deductions
3. Deductions—Losses and Bad Debts

Destry, a single taxpayer, reported the following on his 2019 U.S. Individual Income Tax Return Form 1040:

Income:

Wages $ 5,000

Interest on savings account 1,000

Net rental income 4,000

Deductions:

Standard deduction 12,200

Net business loss 16,000

Net short-term capital loss 2,000

What is Destry’s net operating loss that is available for carryforward?

1. $ 7,000
2. $ 9,000
3. $15,100
4. $16,000

Answer 24

A.

Wages $ 5,000

Interest on savings account 1,000

Net rental income 4,000

Net business loss (16,000)

Net short-term capital loss (2,000)

AGI (8,000)

Deductions:

Standard deduction 12,200

Taxable loss (20,200)

Adjustments to arrive at NOL carry forward (use Form 1045, Schedule A for calculation purposes):

$20,200 TAXABLE LOSS

Plus $11,200 Adjustment for deductions that are not connected to a trade or business or employment, such as the standard deduction of $12,200 reduced by the non-business income of $1,000 interest from savings.

Plus $ 2,000 Short-term capital loss as adjusted by business capital gains and losses (-0-).

($ 7,000) Correct carryforward

Question 25

IV. Federal Taxation of Individuals-Deduction

2. Deductions
3. Deductions—Losses and Bad Debts

In the case of a corporation that is not a financial institution, which of the following statements is correct with regard to the deduction for bad debts?

1. Either the reserve method or the direct charge-off method may be used, if the election is made in the corporation’s first taxable year.
2. On approval from the IRS, a corporation may change its method from direct charge-off to reserve.
3. If the reserve method was consistently used in prior years, the corporation may take a deduction for a reasonable addition to the reserve for bad debts.
4. A corporation is required to use the direct charge-off method rather than the reserve method.

Answer 25

D.

Corporations other than certain financial institutions are required to use the direct charge-off method in accounting for bad debts. Certain financial institutions are allowed to use the reserve method.

Under the direct charge-off method, corporations may claim a deduction once a specific business debt becomes partially or wholly worthless and a specific nonbusiness debt becomes wholly worthless.

Question 26

IV. Federal Taxation of Individuals-Deduction

2. Deductions
3. Limitations on Business Deductions

I. Hobby Losses

Answer 26

A. Hobby expenses are not deductible.

Definition

Hobby: An activity that is not primarily profit-oriented because it is primarily undertaken for personal enjoyment.

• The expenses from this activity are deductible, but only to the extent the activity generates revenues. In other words, no hobby loss (expenses in excess of revenue) is deductible. However, beginning in 2018, the expenses are not deductible at all, so all of the revenue from the hobby is included in taxable income.
• The limitation is imposed by deducting expenses in the following order:

1. Interest and taxes (fully deductible as itemized deductions to the extent deductible for other reasons)
2. Cash expenses
3. Depreciation

Question 27

IV. Federal Taxation of Individuals-Deduction

2. Deductions
3. Limitations on Business Deductions

II. Business Use of the Home

A. Home Office Expenses

Answer 27

1. allowable square footage by $5. The maximum square footage under this method is 300, limiting the deduction to $1,500.
2. Office deductions are limited to income after non-office expenses. For self-employed taxpayers, office deductions are applied toward income in the same order as the hobby loss limit (mortgage interest and real estate taxes, cash expenses, depreciation), but excess deductions carry forward and can be used in future years when business income is sufficient.
3. Office expenses for employees are classified as 2% miscellaneous itemized deductions, which are no longer deductible.

Question 28

IV. Federal Taxation of Individuals-Deduction

2. Deductions
3. Limitations on Business Deductions

II. Business Use of the Home

B. Vacation Home Expense—These occur when a personal residence is rented.

Answer 28

1. If rented for less than 15 days a year, it is treated as a personal residence. Rent income is excluded and mortgage interest and property taxes are deductible on Schedule A.
2. If rented for 15 days or more, and if it is not used for personal purposes for more than the greater of 1) 14 days or 2) 10% of the total days rented, it is treated as rental property. All rent is taxable, net of all regular rental expenses, pro-rated for the percentage of rental days only. A rental loss is allowable. Since the property is treated as rental property, the mortgage interest allocated to the personal use is not deductible since the property is not used as a residence. The property taxes allocated to the personal use are deductible as an itemized deduction.
3. If rented for 15 days or more, and if it is used for personal purposes for more than the greater of 1) 14 days or 2) 10% of the total days rented, it is treated as personal/rental property. All regular expenses are pro-rated as above for rental days, but a rental loss is not allowed. Expenses must be deducted in the same order as for a hobby.

Question 29

IV. Federal Taxation of Individuals-Deduction

2. Deductions
3. Limitations on Business Deductions

III. At Risk—Loss deductions incurred in a trade or business, or in the production of income, are limited to the amount a taxpayer has “at risk.”

Answer 29

1. Applies to all activities except the leasing of personal property by a closely held corporation (5 or fewer individuals own more than 50% of stock).
2. Applies to individuals and closely held regular corporations.
3. Amount “at risk” includes
   
   1. The cash and adjusted basis of property contributed by the taxpayer, and
   2. Liabilities for which the taxpayer is personally liable; excludes nonrecourse debt.
4. For real estate activities, a taxpayer’s amount at risk includes “qualified” nonrecourse financing secured by the real property used in the activity.
   
   1. Nonrecourse financing is qualified if it is borrowed from a lender engaged in the business of making loans (e.g., bank, savings and loan) provided that the lender is not the promoter or seller of the property or a party related to either; or is borrowed from or guaranteed by any federal, state, or local government or instrumentality thereof
   2. Nonrecourse financing obtained from a qualified lender who has an equity interest in the venture is treated as an amount at risk, as long as the terms of the financing are commercially reasonable
   3. The nonrecourse financing must not be convertible, and no person can be personally liable for repayment.
5. Excess losses can be carried over to subsequent years (no time limit) and deducted when the “at risk” amount has been increased.

Question 30

IV. Federal Taxation of Individuals-Deduction

2. Deductions
3. Limitations on Business Deductions

IV. Passive Activity Losses—Losses from passive activities can offset only passive income. Passive losses cannot offset portfolio income or income from active businesses.

Definitions

• Portfolio Income: Investment income such as interest, dividends, capital gains, and royalties.
• Passive Activity: A profit-seeking activity in which the taxpayer does not materially participate in its management.

Answer 30

1. There are seven tests that can be met to materially participate in an activity.
2. Participate in the activity for more than 500 hours.*
3. Participation was substantially all the participation in the activity of all individuals for the tax year.
4. Participate in the activity for more than 100 hours during the tax year, and the participation is at least as much as any other individual for the year.
5. The activity is a significant participation activity, and participation in all significant participation activities for the year exceeds 500 hours. A significant participation activity is any trade or business activity in which the taxpayer participated for more than 100 hours during the year.
6. The taxpayer materially participated in the activity for any 5 of the 10 immediately preceding tax years.*
7. The activity is a personal service activity in which the taxpayer materially participated for any 3 preceding tax years.*
8. Based on all the facts and circumstances, participation in the activity was on a regular, continuous, and substantial basis during the year.

(The three tests with an “*” at the end are the only tests that can be used by limited partners.)

2. All limited partners and most rental activities are considered passive without regard to the taxpayer’s participation. Exceptions to this rule are allowed for car rentals, hotels, golf courses, and other activities where the average rental time is seven days or less, or 30 days or less if significant personal services are provided by the owner in connection with the rental.
3. Real estate professionals are excepted from the limit. A real estate professional must perform more than 50% of his or her personal services in trades or businesses involving real property, and must perform more than 750 hours of services in real property trades or businesses in which he or she materially participates.

Note

The passive loss rules apply to individuals, estates, trusts, personal service corporations, and closely held C corporations.

Question 31

IV. Federal Taxation of Individuals-Deduction

2. Deductions
3. Limitations on Business Deductions

IV. Passive Activity Losses—Losses from passive activities can offset only passive income. Passive losses cannot offset portfolio income or income from active businesses.

B. Rental Real Estate—An exception to the limitation of passive losses exists for taxpayers who actively manage rental reality.

Definition

Active Participation: Occurs for taxpayers who own at least 10% of the property and significantly participate in decision-making. This is a much easier benchmark to meet than material participation.

Answer 31

1. An active manager can deduct a maximum loss of $25,000 per year.
2. The exception is phased out for taxpayers with an AGI exceeding $100,000 at the rate of 50% ($1 of deduction for each $2 of AGI exceeding $100,000).

Example

TP has an AGI of $130,000 and is an active manager in rental realty. If the rental activity generates a loss of $20,000, TP is limited to a deduction of $10,000 ($25,000 − [($130,000 − 100,000) × 50%]).

Question 32

IV. Federal Taxation of Individuals-Deduction

2. Deductions
3. Limitations on Business Deductions

Lane, a single taxpayer, received $160,000 in salary, $15,000 in income from an S Corporation in which Lane does not materially participate, and a $35,000 passive loss from a real estate rental activity in which Lane materially participated. Lane’s modified adjusted gross income was $165,000. What amount of the real estate rental activity loss was deductible?

1. $0
2. $15,000
3. $25,000
4. $35,000

Answer 32

B.

Lane has $160,000 in active income, $15,000 of passive income, and $35,000 of passive losses. Note that the exception that allows deduction for up to $25,000 of rental real estate losses does not apply since Lane’s modified AGI exceeds $150,000. The passive losses can only be deducted to the extent of passive income, so $15,000 is correct.

Question 33

IV. Federal Taxation of Individuals-Deduction

2. Deductions
3. Limitations on Business Deductions

A review of Bearing’s year 2 records disclosed the following tax information:

Wages$ 18,000

Taxable interest and qualifying dividends4,000

Schedule C trucking business net income32,000

Rental (loss) from residential property(35,000)

Limited partnership (loss)(5,000)

Bearing actively participated in the rental property and was a limited partner in the partnership. Bearing had sufficient amounts at risk for the rental property and the partnership. What is Bearing’s year 2 adjusted gross income?

1. $14,000
2. $19,000
3. $29,000
4. $54,000

Answer 33

C.

Wages, interest, dividends, and Schedule C income are all taxable for a total of $54,000. $25,000 of the rental loss is allowed since Bearing actively participates in the rental real estate activity and his modified AGI does not exceed $100,000. However, the $5,000 passive loss from the partnership cannot reduce other income. Therefore, AGI is $29,000.

Question 34

IV. Federal Taxation of Individuals-Deduction

2. Deductions
3. Limitations on Business Deductions

The term active participation for a passive activity loss is relevant in relation to

1. Rental real estate activities.
2. Working interests in oil and gas properties.
3. Passive activities in which the taxpayer materially participates.
4. Passive activities in which the taxpayer does not materially participate.

Answer 34

A.

An owner of rental real estate can deduct up to $25,000 of rental real estate losses against other income if he actively participates in managing the real estate.

Question 35

IV. Federal Taxation of Individuals-Deduction

2. Deductions
3. Limitations on Business Deductions

Smith has an adjusted gross income (AGI) of $120,000 without taking into consideration $40,000 of losses from rental real estate activities. Smith actively participates in the rental real estate activities. What amount of the rental losses may Smith deduct in determining taxable income?

1. $0
2. $15,000
3. $20,000
4. $40,000

Answer 35

B.

Since Smith actively participates in the rental real estate activity he can deduct up to $25,000 of rental losses. However, this deduction is reduced once modified AGI exceeds $100,000. Smith has $20,000 of excess AGI ($120,000 − $100,000) so he loses $10,000 ($20,000 × 50%) of the deduction. Of the $40,000 of losses, he can deduct $15,000 ($25,000 − $10,000). The remaining $25,000 of losses is suspended.