Part 1 - Individuals - All Units Flashcards

Question

Innocent Spouse

Answer 1

- Innocent Spouse Relief: This is when a joint return has understated tax liability due to “erroneous items” attributable to a taxpayer’s spouse or former spouse. Erroneous items include income received by a spouse that is omitted from the return

Answer 2

- An “injured spouse” claim and “innocent spouse” relief have similar-sounding names, but they are entirely different. To be considered an injured spouse, a taxpayer must meet all of the following criteria: - Have filed a joint return - Have paid federal income tax or claimed a refundable tax credit - All or part of the taxpayer's refund was, or is expected to be, applied to his or her spouse's past financial obligations, and - Not be responsible for the debt - A spouse who believes that he is entitled to a portion of the refund on a joint return can file Form 8379, Injured Spouse Allocation

Answer 3

- To claim a refund, a taxpayer must generally file an amended tax return (Form 1040X) within three years from the date the return was filed, or two years from the date the tax was paid, whichever is later - If a claim is not filed within the statute period, a taxpayer generally, will not be entitled to a refund. However, if the taxpayer files an extension and files his or her original return prior to the October 15 extension deadline, the three-year period begins on the date that the taxpayer originally filed his or her return

Answer 4

- In some cases, a late-filed tax return and claiming a tax refund beyond the deadline will be honored. The IRS will consider many sound reasons with reasonable cause for failing to file a tax return, make a deposit, or pay tax when due. Sound reasons, if established, include: - Fire, casualty, natural disaster or other disturbances - Inability to obtain records - Death, serious illness, incapacitation or unavoidable absence of the taxpayer or a member of the taxpayer's immediate family. - Several unique scenarios allow a taxpayer to request a refund beyond the "normal" deadline. These unique scenarios involve: - A bad debt from worthless securities (up to seven years prior) - A payment or accrual of foreign tax (up to ten years prior) - A net operating loss carryback - Exceptions for military personnel - Taxpayers in federally declared disaster areas - Taxpayers who have been affected by a terroristic or military action

Answer 5

- The IRS is generally required to assess tax within three years after the return is filed or, if filed early, the due date of the return. If a taxpayer files pursuant to an extension, or files his tax return late, then IRS has three years from the actual filing date. - If a taxpayer never files a return, or a return is fraudulent, then there is no statute of limitations for an assessment of tax. The IRS has six years to assess tax on a return if a “substantial understatement” is identified, meaning that gross income was understated by more than 25%. - The statute of limitations for IRS collection is ten years from the date tax is assessed. This is also called the Collection Statute Expiration Date (CSED). This ten-year period begins to run on the date of the tax assessment, not on the date of filing. So, for example, if the taxpayer owes when they file their tax return, the IRS will send a bill. The bill date is the assessment date. The IRS can attempt to collect unpaid taxes for up to ten years from the date the taxes are assessed

Answer 6

If a taxpayer fails to file a return, the statute of limitation on assessment remains open indefinitely

Answer 7

- There are five filing statuses: - Single - MFJ - MFS - HOH - QSS - A taxpayer may be able to claim more than one filing status. Usually, the taxpayer will choose the filing status that results in the lowest tax

Answer 8

- A taxpayer is considered single for the entire tax year if, on the last day of the tax year, he or she was: - Unmarried, - Legally separated under a decree of divorce or separate maintenance, - Legally divorced - STATE LAW governs whether a taxpayer is married or legally separated under a divorce or separate maintenance decree. Single filing status generally applies if the taxpayer is not married, divorced, or legally separated according to state law

Answer 9

- The “married filing jointly” status typically provides more tax benefits than filing a separate return. On a joint return, spouses report all of their combined income, allowable expenses, exemptions, and deductions. Spouses can file a joint return even if only one spouse had income. - If one spouse does not wish to file jointly, then both spouses must default to MFS, (unless one qualifies for a different filing status). - Live together as married spouses, or - Live together in a common-law marriage recognized in the state where they now reside or in the state where the common law marriage began, or - Live apart but are not legally separated or divorced, or - Are separated under an interlocutory (not final) divorce decree. - In addition, a widowed taxpayer may use the married filing jointly status and file jointly with their deceased spouse, if the taxpayer’s spouse died during the year and the taxpayer has not remarried as of the end of the year.

Answer 10

- The MFS status is for taxpayers who are married and either: - Choose to file separate returns, or - Do not agree to file a joint return. - If one spouse chooses to file MFS, the other is forced to do the same, since a joint return must be signed by both spouses. The MFS filing status means the two spouses report their own income, exemptions, credits, and deductions on separate returns, even if one spouse had no income. This filing status may benefit a taxpayer who wants to be responsible only for their own tax, or if it results in less tax than filing a joint return. - TYPICALLY, but not always, a married couple will pay more tax on a combined basis when filing separately, than they would by filing jointly.

Answer 11

- Specific features of the MFS filing status include the following: - The tax rates are generally higher at the same levels of taxable income than those applicable to MFJ. - The exemption amount for the alternative minimum tax is half that which is allowed on a joint return. - Various credits are either not allowed or are more limited than on a joint return. - The capital loss deduction is limited to $1,500; half of what is allowable on a joint or single return. - The standard deduction is half the amount allowed on a joint return and cannot be claimed if the taxpayer's spouse itemizes deductions. - Neither spouse can deduct student loan interest on an MFS return. - Married taxpayers sometimes choose to file separate returns when one spouse does not want to be responsible for the other spouse’s tax obligations, or because filing separately may result in a lower total tax. - For example, if one spouse has high medical expenses or a large casualty loss, separate returns may result in a lower total tax liability because a lower adjusted gross income allows more expenses or losses to be deducted.

Answer 12

- There are rules for when married taxpayers are allowed to change their filing status. Although it is possible to amend a person’s filing status, there are strict rules for doing so. - Taxpayers generally cannot change from a joint return to a separate return after the due date of the return. For example, if a married couple files a joint return, and subsequently decide they wanted to file separately instead, they would have only until April 15, (the due date of the original return) to file amended returns using the MFS filing status.

Answer 13

- A notable exception to this rule allows a personal representative for a deceased taxpayer to change from a joint return, elected by the surviving spouse, to a separate return for the decedent for up to a year after the filing deadline.

Answer 14

- To change from separate returns to a joint return (MFS to MFJ), taxpayers must file an amended return using Form 1040X and may do so at any time within three years from the due date of the separate returns (not including extensions).

Answer 15

- A taxpayer who qualifies to file as head of household will usually have a lower tax rate than a single or MFS taxpayer and will receive a higher standard deduction. The head of household status is available to taxpayers who meet all of the following requirements: - The taxpayer must be single, divorced, legally separated, or “considered unmarried” on the last day of the year. - The taxpayer must have paid more than half the cost of keeping up a home for the year. - The taxpayer must have had a qualifying person living in their home for more than half the year. There are exceptions for temporary absences, as well as for a qualifying parent, who does not have to live with the taxpayer. This would include hospitalization and stays in a nursing home.

Answer 16

- For the purpose of determining head of household filing status, valid household expenses used to calculate whether a taxpayer is paying more than half the cost of maintaining a home include: - Rent, mortgage interest, property taxes - Home insurance, repairs, and utilities - Food eaten in the home - Valid expenses do not include clothing, education, medical treatment, vacations, life insurance, or transportation. Welfare payments are not considered amounts that the taxpayer provides to maintain a home.

Answer 17

- The qualifying person for HOH filing status must generally be related to the taxpayer either by blood, adoption, or marriage. However, a foster child also qualifies if the child was legally placed in the home by a government agency. For purposes of the head of household status, a “qualifying person” is defined as: - A qualifying child, - A married child who can be claimed as a dependent, or - A dependent parent, - A qualifying relative that meets certain relationship tests - A taxpayer’s qualifying person may include: a child or stepchild, sibling or stepsibling, or a descendant of any of these. For example, a niece or nephew, stepbrother or stepsister, or grandchild may all be eligible as qualifying persons for the HOH filing status.

Answer 18

- An unrelated individual, and even certain family members, may still be considered a “qualifying relative” for dependency purposes but will not be a qualifying person for the HOH filing status. - An example of someone who could be a qualifying relative, but not a qualifying person for the head of household filing status, are cousins. - A cousin is not a close enough relative to be a qualifying child (unless the cousin is placed in the taxpayer’s home as a qualifying foster child). A cousin can be a qualifying relative, but only if the cousin lives with the taxpayer the entire year.

Answer 19

- There are some instances where a taxpayer can be “considered unmarried” for tax purposes only. To be “considered unmarried” on the last day of the tax year, a taxpayer must meet all of the following conditions: - File a separate return from the other spouse. - Pay more than half the cost of keeping up a home for the tax year and maintain the home as the main residence of a qualifying child, stepchild, or foster child for more than half the year. - Not live with a spouse in the home during the last six months of the tax year. - Be able to claim an exemption for the child (although there is an exception for divorced parents).

Answer 20

- Dependent Parents: If a taxpayer’s qualifying person is a dependent parent, the taxpayer can file as HOH even if the parent does not live with the taxpayer. The taxpayer must pay more than half the cost of keeping up a home that was the parent’s main home for the entire year. This rule also applies to a parent in a rest home. - A qualifying “parent” may be a stepparent, in-law, or grandparent who is related to the taxpayer by blood, marriage, or adoption.

Answer 21

- A taxpayer who is married to a nonresident alien spouse may elect to file as HOH by “disregarding” the nonresident alien spouse. This is a unique rule that only applies to taxpayers who are married to nonresident aliens. - This is true even if both spouses lived together throughout the year. The U.S. taxpayer must not elect to treat the nonresident alien spouse as a U.S. resident, and the taxpayer must have a qualifying child (or another qualifying dependent, such as a parent) to qualify for the HOH status. - The taxpayer’s nonresident alien spouse cannot be a qualifying person for head of household purposes. The taxpayer must have another qualifying person and meet the other tests to be eligible to file as a head of household.

Answer 22

- Qualifying Surviving Spouse (QSS) is the least common filing status. A qualifying surviving spouse receives the same standard deduction and uses the same tax brackets as married taxpayers who file jointly. In the year of the spouse’s death, a taxpayer can generally file a joint return. - For each of the two years following the year of the spouse’s death, the surviving spouse can use the QSS filing status if he has a qualifying dependent and does not remarry. After two years, the taxpayer’s filing status converts to single or HOH, depending upon which status applies. - However, if the surviving spouse remarries before the end of the year, the deceased spouse’s return must be filed MFS (married filing separately).

Answer 23

- To be eligible for the QSS filing status, the taxpayer normally must: - Not have remarried before the end of the year. - Have been eligible to file a joint return for the year the spouse died; (it does not matter if a joint return was actually filed). - Have a qualifying child for the year. A qualifying child can be a child, adopted child, or a stepchild, but does not include a foster child for the purposes of this filing status. - Have furnished over half the cost of keeping up the qualifying child’s home for the entire year.

Answer 24

- Annulment is a legal procedure for declaring a marriage null and void. If a taxpayer obtains a court decree of annulment that holds no valid marriage ever existed, the couple is considered unmarried even if they filed joint returns for earlier years. - Unlike divorce, an annulment is retroactive. Taxpayers who have annulled their marriage must file amended returns (Form 1040X), claiming single (or head of household status, if applicable) for all the tax years affected by the annulment that are not closed by the statute of limitations. - Fraud is the most common basis for annulment petitions, but depending on the jurisdiction, other legal reasons for an annulment include bigamy, forced marriage, impotence, undisclosed infertility or sterility, and mental incompetence.

Answer 25

- To file an accurate tax return, a taxpayer is considered a resident or a nonresident. For IRS purposes, an “alien” is an individual who is not a U.S. citizen. Aliens are further classified as “nonresident” aliens and “resident” aliens. - Residency status is important because these taxpayers are taxed in different ways: - Resident aliens are generally taxed on their worldwide income, the same as U.S. citizens. - Nonresident aliens are taxed only on their income from sources within the United States and on certain income connected with the conduct of a trade or business in the U.S. - Dual-status aliens are those that are both nonresident and resident aliens during the same tax year. Different rules apply for the part of the year a taxpayer is a U.S. resident and the part of the year the taxpayer is a nonresident. The most common dual-status tax years are the years of arrival and departure.

Answer 26

A dual-status return is cannot be e-filed. Dual status aliens file a combined tax return including a Form 1040 (resident income tax return) and a Form 1040NR (nonresident alien income tax return)

Answer 27

- Residency for IRS purposes is not the same as legal immigration status. Do not confuse residency for federal tax purposes with: - Immigration residency - Residency requirements for earning a degree, etc. - Residency requirements for state income taxes - An individual may be considered a U.S. resident for tax purposes, based upon the time spent in the United States, regardless of immigration status. - A nonresident alien could be someone who lives outside the U.S., and simply invests in U.S. property or stocks, and is therefore required to file a tax return to correctly report their U.S. income.

Answer 28

- A taxpayer is considered a nonresident alien for tax purposes unless they meet at least one of two tests: the green card test or the substantial presence test. - Green Card Test - An alien who has been present in the U.S. any time during a calendar year as a lawful permanent resident may opt to be treated as a resident alien for the entire calendar year.

Answer 29

- Substantial Presence Test: An alien without a green card is considered a U.S. resident for tax purposes only if they meet the substantial presence test for the calendar year. To meet this test, they must be physically present in the United States for at least: - 31 days during the current tax year (2023), and - 183 days during the three-year period, which includes the current year (2023) and the two years immediately preceding the current year (2021 and 2022). - For purposes of the 183-day requirement, all the days present in the current year are counted, along with: - 1/3 of the days present in the previous year (i.e., 2022), and - 1/6 of the days present in the second year before the current year (i.e., 2021). - A taxpayer that does not meet either the green card test or the substantial presence test is considered a nonresident alien for tax purposes and is subject to U.S. income tax only on their U.S.-source income

Answer 30

- Numerous exceptions are considered when counting days for the substantial presence test. Is an exempt individual. Exempt individuals include aliens who are: - Foreign government officials in the U.S. temporarily under an “A” or “G” visa (such as foreign ambassadors and other important diplomats); - Teachers on temporary visas; visiting scholars or researchers (scholars are exempt from the substantial presence test for two years); and au pairs on a J-1 visa; - Foreign students on temporary visas who do not intend to reside permanently in the U.S. (foreign students are exempt from the substantial presence test for five years). - In addition, noncitizens who pass the substantial presence test can still be deemed a nonresident alien if they claim a “closer connection” to their home country (for example this is commonplace for Canadian snowbirds).

Answer 31

- International students holding specific visas are exempt from the substantial presence test for the first five calendar years they are in the U.S. - The five calendar years need not be consecutive. Any part of a calendar year in which the student is present in the U.S. counts as a full year. - Nonresident Aliens in F-1 or J-1 visas do not have to pay Social Security tax or Medicare Tax. For example, if an international student’s very first F-1 or J-1 entry date to the U.S. was in 2018, their five exempt years will be 2018-2022. The student will become a Resident Alien for tax purposes for tax year 2023. Once a person becomes a U.S. resident alien for tax purposes, they will be required to pay Social Security tax and Medicare tax on their earnings.

Answer 32

- A nonresident alien who does not meet the substantial presence test and does not have a green card, may still elect to be treated as a resident for tax purposes if he or she is married to a U.S. citizen or resident. This election can be made only if: - At the end of the year, one spouse is a nonresident alien, and the other is a U.S. citizen or resident, and - Both spouses agree to file a joint return and treat the nonresident alien as a resident alien for the entire tax year.

Answer 33

- Personal and dependency exemptions are suspended (reduced to $0) until tax year 2025. However, the ability to claim a dependent can make taxpayers eligible for other tax benefits. - Dependents are either a “qualifying child” or a “qualifying relative” of the taxpayer. Examples of dependents include a child, stepchild, brother, sister, or parent.

Answer 34

- In order to determine if a taxpayer can claim a dependent, there are three primary tests: - Dependent taxpayer test: A person who may be claimed as a dependent by another taxpayer, may not claim anyone as a dependent on his or her own tax return. - Joint return test: If a married person files a joint return, that individual normally cannot be claimed as a dependent by another taxpayer. - Citizenship or residency test: A dependent must be a citizen or resident of the United States or a citizen or resident of Canada or Mexico (with an exception for foreign-born adopted children). - NOTE: Both “qualifying children” and “qualifying relatives” must first meet all of the primary dependency requirements already specified: the dependent taxpayer, joint return, and citizenship or residency tests. If these three tests are met, the person is a dependent.

Answer 35

- A taxpayer is generally not allowed to claim a dependent if that person files a joint return with his or her spouse. There is only one narrow exception to this test. The joint return test does not apply if the joint return is filed by the dependent only to claim a refund, and neither spouse would have a tax liability, even if they filed separate returns.

Answer 36

- The tests for a “qualifying child” are more stringent than the tests for a “qualifying relative.” There are five tests for a qualifying child: - Relationship Test - Age Test - Residency Test - Support Test - Tiebreaker Test (for a qualifying child of more than one person)

Answer 37

- The qualifying child must be related to the taxpayer by blood, marriage, or legal adoption. Qualifying children include: - A child, stepchild, or adopted child. - A sibling, half-sibling, or stepsibling (includes; half-brother, half-sister, stepbrother, etc.) - A descendant of one of the above (such as a grandchild, niece, or nephew) - A foster child

Answer 38

- In order to be a qualifying child, the dependent must be: - Under the age of 19 at the end of the tax year, or - Under the age of 24 at the end of the tax year and a full-time student, or - Permanently and totally disabled at any time during the year, regardless of age. - A child who is claimed as a dependent must be younger than the taxpayer who is claiming them, except in the case of dependents who are disabled.

Answer 39

- A qualifying child must live with the taxpayer for more than half the tax year (over six months). The taxpayer’s home is any location where they regularly live; it does not need to be a traditional home. For example, a child who lived with the taxpayer for over half the year in a homeless shelter meets the residency test. - In most cases, because of the residency test, a child is automatically the qualifying child of the custodial parent. However, exceptions to the residency test apply for children of divorced parents, kidnapped children, children who were born or died during the year, and temporary absences (such as for college, hospitalization, or a summer camp). - A “temporary absence” includes illness, college, vacation, military service, institutionalized care for a child who is permanently and totally disabled and incarceration in a juvenile facility. It must be reasonable to assume that the child will return to the home after the temporary absence.

Answer 40

- A qualifying child cannot provide more than one-half of his or her own support. State benefits provided to a person in need, such as welfare, food stamps, or subsidized housing, are generally considered support provided by the state. - Foster parents may claim a foster child, if the child is legally placed in their home by the courts or a government agency. Payments received from a child placement agency for the support of a foster child are considered “support” provided by the agency, rather than support provided by the child. - However, if a child receives Social Security benefits (like survivor benefits), and uses them for his or her own support, the benefits are considered to be provided by the child. - A full-time student does not take scholarships (whether taxable or nontaxable) into account when calculating the support test.

Answer 41

- NOTE: The definition of “support” includes only income that is actually used for living expenses. A person’s own funds are not “support” unless they are actually spent for support. For example, if a child earns income that is saved in a bank account rather than spent on the child’s living expenses, the amounts saved are not included in the support test.

Answer 42

- Only one person can claim a qualifying child, even if the child qualifies for more than one person. If more than one taxpayer attempts to claim the same child under the normal dependency rules, the tiebreaker rules apply, meaning the child is treated as a qualifying child in the following sequence: - By the child’s parents if they file a joint return. - By the parent, if only one of the taxpayers is the child’s parent. - By the parent with whom the child lived the longest during the year. - By the parent with the highest AGI, if the child lived with each parent for the same length of time during the tax year. - By the taxpayer with the highest AGI, if neither of the child’s parents can claim the child as a qualifying child. - By a taxpayer with a higher AGI than either of the child’s parents who can also claim the child as a qualifying child but does not.

Answer 43

- The tie-breaker test applies when two taxpayers attempt to claim the same child, but all of the primary tests for dependency still apply. Many times, these cases will go into audit, or even to litigation in the U.S. Tax Court. - Based on U.S. Tax Court case Griffin v. Comm’r. The Tax Court held that a child’s aunt was entitled to dependency exemption and all the tax credits that go with claiming the children based on the time they spent living with her, which was determined by the court to be more than half the year.

Answer 44

- A person who is not a qualifying child may still qualify as a dependent under the rules for qualifying relatives. Even an individual who is not a family member can be a qualifying relative. Unlike a qualifying child, a qualifying relative can be any age. - The tests for a qualifying relative are applied only when the tests for qualifying child are not met. To be claimed as a qualifying relative, the dependent must meet the following four tests: - Not a qualifying child test - Member of household or relationship test - Gross income test - Support test

Answer 45

- If a child is already a qualifying child for any other taxpayer, he or she cannot also be a qualifying relative of another taxpayer. A taxpayer cannot claim an individual who can be claimed as a dependent on another tax return.

Answer 46

- A dependent that is not related to the taxpayer must have lived with the taxpayer the entire tax year in order to meet the member of household or relationship test. - However, a family member who is related to the taxpayer in any of the following ways does not have to live with the taxpayer to meet this test: - A child, stepchild, foster child, or descendant of any of them (for example, a grandchild) - A sibling, stepsibling, or half-sibling - A parent, grandparent, stepparent, or another direct ancestor (but not a foster parent) - A niece or nephew, son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law - A taxpayer may not claim a housekeeper or other household employee as a dependent, even if the employee lives with the taxpayer all year.

Answer 47

- Any relationship that is established by marriage does not end as a result of death or divorce. For example, if a taxpayer supports his mother-in-law, he can continue to claim her as a dependent even if he and his ex-spouse are divorced or if he becomes widowed. - Treasury Regulation Section 1.152-2(d) currently provides that "the relationship of affinity once existing will not terminate by divorce or death of spouse."

Answer 48

- To meet the gross income test, a qualifying relative cannot earn more than the “deemed exemption” amount, which is $4,700 in 2023. For the purposes of this test, “gross income” includes all income in the form of money, property, and services that are not exempt from tax.

Answer 49

- To claim an individual as a qualifying relative, the taxpayer must provide more than one-half of the dependent’s total support during the year. - Support includes: food, clothing, shelter, education, medical and dental care. It also includes amounts from Social Security and welfare payments, even if that support is nontaxable. Support can include the fair market value of housing. Note that this “support test” is very different from the one for a qualifying child.

Answer 50

- Special rules apply to divorced or separated parents. In most cases, the child is the qualifying child of the custodial parent. However, a custodial parent may permit the noncustodial parent to claim the child. The noncustodial parent must attach Form 8332, Release/Revocation of Release of Claim to Exemption for Child by Custodial Parent, to his or her tax return. - This rule is an exception to the normal residency test for a qualifying child. It does not apply to the determination of head of household filing status or to eligibility for the Earned Income Tax Credit. - The EITC and HOH filing status can be claimed only by the custodial parent, even if the noncustodial parent claims the child.

Answer 51

- Under a multiple support agreement, family members together must pay more than half of the person’s total support, but no one member individually may pay more than half. - Taxpayers use Form 2120, Multiple Support Declaration, to report a multiple support arrangement. - The taxpayer who claims the dependent must provide more than 10% of the person’s support. Only one family member can claim a dependent in a single year, but different qualifying family members can agree to claim the dependent in other years.

Answer 52

Income and Assets

Answer 53

- The Internal Revenue Code (IRC) describes types of income that are taxable and nontaxable. - Federal tax law sets forth that all income is taxable unless it is specifically excluded. An exclusion is not the same as a deduction, and it is important to understand the distinction because some deductions and credits are phased out as a taxpayer’s gross income increases. - Excluded income, on the other hand, retains its nontaxable character without regard to the amount of the taxpayer’s gross income. Most types of excluded income do not have to be reported on a tax return, although there are some notable exceptions, like municipal bond interest.

Answer 54

- Gross income is all income a taxpayer receives in the form of money, goods, property, and services that are not exempt from tax. In addition to wages, salaries, commissions, tips, and self-employment income, gross income includes other forms of compensation, such as interest, dividends, capital gains, taxable fringe benefits, and stock options. - Next, the taxpayer calculates their adjusted gross income (AGI) by subtracting from gross income certain specific deductions or adjustments. Examples of some of these “for AGI” (commonly referred to as “above the line”) deductions include certain IRA contributions, certain expenses for self-employed individuals, deductible alimony payments, and moving expenses. The amount of a taxpayer’s AGI is important because it helps determine eligibility for certain deductions and credits.

Answer 55

- Earned income such as wages, salaries, tips, professional fees, or self-employment income is received for services performed. Earned income is generally subject to Social Security and Medicare taxes (also called FICA taxes). - Unearned income includes interest, dividends, retirement income, taxable alimony, and disability benefits. Investment income and other unearned income are generally not subject to FICA/payroll/SE taxes. The amount of taxable income is used to determine the taxpayer’s gross income tax liability before applicable credits.

Answer 56

- The doctrine of constructive receipt requires that cash-basis taxpayers be taxed on income when it becomes available and is not subject to substantial limitations or restrictions, regardless of whether it is actually in their physical possession. Income received by an agent for a taxpayer is constructively received in the year the agent receives it. - If there are SIGNIFICANT RESTRICTIONS on the income, or if the income is not accessible to the taxpayer, it is not considered to have been constructively received. According to the IRS constructive receipt requires that an amount credited to an individual's account be subject to “unqualified demand.”

Answer 57

- A Claim of Right occurs when a taxpayer reported income as being taxable in one year, but then has to repay more than $3000 of that income back in a future year. - The tax treatment of the repayment differs based on the type of income. If the taxpayer is self-employed, and if in the prior year it had been included as self-employment income, the repayment is deducted on Schedule C by reducing income in the year the amounts were repaid. - However, if the income was previously reported as wages, taxable unemployment compensation, Social Security, or other nonbusiness income, the tax treatment is different. If there is a dispute and income is later repaid, the repayment is not deductible in the year repaid unless the repayment is over $3,000. - If the amount repaid was $3,000 or less, the Claim of Right under IRC Section 1341 does not apply. See IRS Publication 525, under “Repayments Under Claim of Right.”

Answer 58

- Self-employment income is earned by taxpayers who work for themselves. A taxpayer who has self-employment income of $400 or more in a year must file a tax return and report the earnings to the IRS. - Taxpayers who are independent contractors usually receive Form 1099-NEC from their business customers showing the income they were paid for the year (if $600 or more). - The amounts reported on Forms 1099-NEC, along with any other business income, are reported by most self-employed individuals on Schedule C, Profit or Loss from Business, of Form 1040. - Self-employed farmers report their earnings on Schedule F.

Answer 59

- Self-employment income also includes: - Income of ministers, priests, and rabbis for the performance of services such as baptisms and marriages. - The distributive share of trade or business income allocated by a partnership to its general partners. The income is reported to the individual partners on Schedule K-1 (Form 1065). - A taxpayer does not have to conduct regular full-time business activities to be considered self-employed. A taxpayer may have a side business in addition to a regular job, and this is also considered self-employment.

Answer 60

- Self-employment tax (SE tax) is imposed on self-employed individuals in a manner similar to the Social Security and Medicare taxes that apply to wage earners. Self-employment tax is calculated on IRS Schedule SE, Self-Employment Tax. - More Than One Business: If a taxpayer owns more than one business, he must net the profit or loss from each business to determine the total earnings subject to SE tax. - However, married taxpayers cannot combine their income or loss from self-employment to determine their individual earnings subject to SE tax.

Answer 61

- Wages, salaries, bonuses, tips, and commissions are compensation received by employees for services performed. Employee compensation is taxable income to the employee and a deductible expense for the employer. - For federal tax purposes, the IRS classifies “workers” in two broad categories: employees or independent contractors. These workers are taxed in different ways, and businesses must identify the correct classification for each individual to whom it makes payments for services.

Answer 62

- The general rule is that an individual is an independent contractor if the payer has the right to control or direct only the result of the work, not what will be done and how it will be done. - If a worker receives a Form 1099-NEC, but believes that they are an employee and should have received a Form W-2 instead, they can file Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding with the IRS, and if a determination is made that they are an employee, they will file Form 8919, Uncollected Social Security and Medicare Tax on Wages, with their tax return.

Answer 63

- Tips received by food servers, baggage handlers, hairdressers, and others for performing services are taxable income. An individual who receives $20 or more per month in tips must report the tip income to their employer. An employee who receives less than $20 per month in tips while working one job does not have to report the tip income to their employer. - Tips of less than $20 per month are exempt from Social Security and Medicare taxes, but are still subject to federal income tax. - An employee who does not report all of their tips to their employer generally must report the tips and related Social Security and Medicare taxes on his Form 1040. Form 4137, Social Security and Medicare Tax on Unreported Tip Income, is used to compute the additional tax. - Noncash tips (for example, concert tickets, or other items) do not have to be reported to the employer, but they must be reported and included in the taxpayer’s income at their fair market value.

Answer 64

- Employers often offer fringe benefits to employees; common fringe benefits include health insurance, retirement plans, and parking passes. Although most employee fringe benefits are nontaxable, some benefits must be reported on the employee’s Form W-2 and included in their taxable income.

Answer 65

- Combat Pay and Veterans’ Benefits: Wages earned by military personnel are generally taxable. However, there are several special rules for military personnel regarding taxable income. Combat zone wages (combat pay) are not taxable income. - Hazardous duty pay is also excludable for certain military personnel. Enlisted personnel who serve in a combat zone for any part of a month may exclude their pay from tax. For officers, the pay is excluded up to a certain amount, depending on the branch of service. - Similarly, veterans’ benefits paid by the Department of Veterans Affairs to a veteran or his or her family are not taxable if they are for education (the GI Bill), training, disability compensation, work therapy, dependent care assistance, or other benefits or pension payments given to the veteran because of disability.

Answer 66

- Medicare waiver payments are also called “difficulty-of-care” payments. Payments to a taxpayer for home-care services provided to a disabled individual living in the same residence may be excluded from gross income. The exemption applies to individuals who provide care in their home, regardless of who owns the home. The taxpayer does not have to be related to the disabled individual, although generally this is the case. - Qualified waiver payments may be excluded from income only when the care provider and the care recipient reside in the same home. When the care provider and the care recipient do not live together in the same home, the Medicare waiver payments may not be excluded from gross income. - Taxpayers who receive these payments may choose to include them in their income for refundable credit purposes due to Feigh v. Commissioner. - In addition, under the SECURE Act, taxpayers can use them to fund an IRA, but since the contributions come from amounts excluded from tax, they are treated as nondeductible contributions.

Answer 67

- There are several types of disability payments, and the taxability of the income depends on several factors. Some types of disability-related payments are given to workers that are not taxable at all. - Worker’s compensation is one such example. Worker’s compensation should not be confused with disability insurance, sick pay, or unemployment compensation; it is a type of benefit that only pays workers who are injured on the job. Worker’s compensation is paid to a taxpayer under a worker’s compensation act or another state statute. The amounts are always exempt from tax. - Workers’ compensation is a type of mandatory business insurance, meaning most large and mid-sized employers are required to have coverage for their employees.

Answer 68

- A taxpayer may also receive long-term disability payments as a result of an insurance policy. As a general rule, long-term disability payments from an insurance policy are excluded from income if the taxpayer pays the premiums for the policy. - If an employer pays the insurance premiums, the employee must report the payments as taxable income. If both an employee and the employer have paid premiums for a disability policy, only the employer’s portion of the disability payments would be reported as taxable income.

Answer 69

- Disability retirement benefits are TAXABLE AS WAGES if a taxpayer retired on disability before reaching the minimum retirement age. The benefit is usually based on the employee’s final average earnings and their years of actual service. Once the taxpayer reaches retirement age, the payments are no longer taxable as wages. They are taxable as pension income. - This type of disability retirement benefit is offered to most Federal government workers and U.S. Postal Service employees. To apply for this benefit, the employee’s disability generally must have caused them to discontinue working.

Answer 70

- Veterans disability benefits (also called VA Disability Compensation) are a type of disability benefit paid specifically to a veteran for disabilities that are service-connected, which means the injury or disease linked to their military service. Veterans disability benefits are exempt from taxation if the veteran was terminated through separation or discharged under honorable conditions. The VA typically does not issue Form W-2, Form 1099-R, or any other tax-related document for veterans’ disability benefits.

Answer 71

- Life insurance payouts generally are not taxable to a beneficiary if the payment was the result of the death of the insured. This is true even if the proceeds were paid under an accident or health insurance policy. However, interest income received as a result of life insurance proceeds (for example, in the form of an annuity) is usually taxable. - A terminally ill person may receive a viatical settlement. In this case, the funds are tax-free. A “viatical settlement” when the policyholder is deemed to be terminally or chronically ill and executes a “deemed sale” of their life insurance policy. As long as the taxpayer has proof from a physician that they have a life expectancy of 24 months or less, the sale of their life insurance policy is treated as a viatical settlement and is tax-free.

Answer 72

- Investment income can come from many different sources. - Taxpayers who deposit cash or invest in securities such as stocks, bonds, and mutual funds may earn income from interest, dividends, and capital appreciation. - Other types of income from investments, such as capital gains resulting from sales, are covered later.

Answer 73

- Interest is a form of income that may be earned from deposits, such as in bank and money market accounts, notes receivable, and investments in instruments such as bonds. Some interest income is taxable, and some is not. - Certain distributions, commonly referred to as dividends, are actually reported as taxable interest. These include “dividends” on deposits or share accounts in cooperative banks, credit unions, domestic savings and loan associations, and mutual savings banks. - Interest income is generally reported to the taxpayer on Form 1099-INT by the financial institution or another payor if the amount of interest is $10 or more for the year. - If taxable interest income exceeds $1,500, the taxpayer must report the interest on Schedule B, Interest and Ordinary Dividends.

Answer 74

- Gift for Opening a Bank Account: If a taxpayer receives noncash gifts or services for making deposits or for opening an account in a savings institution, the value of the gift may have to be reported as interest. The value of the gift is determined by the cost of the gift or service to the financial institution. - A cash bonus for opening a new checking or credit card account is also taxable interest. However, rewards earned on credit and debit card purchases are generally not taxable income. Most major airlines also offer frequent flyer programs under which passengers accumulate miles for each flight. - The IRS generally views rewards as “rebates” and not taxable income. The same is true for customer loyalty programs like grocery store discount cards, punch cards that provide a price reduction after a number of purchases, and discounts for opening a store credit card.

Answer 75

- Interest earned on debt obligations of state and local governments (also commonly called muni bonds or municipal bonds) is generally exempt from federal income tax but may be subject to income taxes by state and local governments. However, interest on federally guaranteed state and local obligations is generally taxable. - Also, even if interest on an obligation is nontaxable, the taxpayer may need to report a capital gain or loss when the investment is sold. The taxpayer’s Form(s) 1099-INT may include both taxable and tax-exempt interest. Tax-exempt interest must be reported on Form 1040, even though it is not taxable. - If a taxpayer borrows money to buy investments that generate tax-free income, the interest is not deductible as investment interest.

Answer 76

- A dividend is a distribution of cash, stock, or other property from a corporation or a mutual fund. Most corporations pay dividends in cash. The payor will generally use Form 1099-DIV to report dividend income to taxpayers. If a taxpayer does not receive Form 1099-DIV from a payor, the taxpayer must still report all taxable dividend income. - Generally, if a taxpayer’s total dividend income is more than $1,500, it must be reported on Schedule B, Interest and Ordinary Dividends. Otherwise, it can be reported directly on Form 1040. - Dividends are not subject to employment taxes. The maximum rate on long-term capital gains and qualified dividends is 20%, regardless of the taxpayer’s individual tax bracket. - However, higher-income taxpayers may also be subject to the Net Investment Income Tax (NIIT) on long-term capital gains and qualified dividends (the NIIT is covered in detail later).

Answer 77

- Distributions that are not paid out of earnings and profits are nondividend distributions. They are considered a recovery or return of capital and therefore are generally not taxable. However, these distributions reduce the taxpayer’s basis in the stock of the corporation. - Once the basis is reduced to zero, any additional distributions are capital gains and are taxed as such. Nondividend distributions are reported in Box 3 of Form 1099-DIV.

Answer 78

- A stock dividend is a distribution of stock, rather than money, by a corporation to its own shareholders. A stock dividend is generally not a taxable event and does not affect the shareholder’s income in the year of distribution because the stockholder is not actually receiving any money, and all shareholders increase their total number of shares pro-rata. - When a stock dividend is granted, the total basis of the shareholder’s stock is not affected, but the basis of individual shares is adjusted by the inclusion of the newly-issued shares. - If a shareholder has the option to receive cash instead of stock, the stock dividend is taxable in the year it is distributed.

Answer 79

- A mutual fund is an investment strategy that allows investors to pool their money to invest in stocks, bonds, and other securities. The combined holdings of stocks, bonds, or other assets the fund owns are known as its “portfolio.” Mutual funds are professionally managed by a portfolio manager. Mutual funds generally distribute all of their ordinary income to shareholders by the end of the year to obtain favorable tax treatment. - A taxpayer who receives mutual fund distributions during the year will also receive Form 1099-DIV, identifying the types of distributions received. - Ordinary dividends are the most common type of distribution from a mutual fund; these dividends are taxable as ordinary income. - Capital gain distributions from a mutual fund are always treated as long-term, regardless of the actual period the mutual fund investment is held. Distributions from a mutual fund investing in tax-exempt securities are tax-exempt interest and retain their tax-exempt character for the payee.

Answer 80

- If a mutual fund or Real Estate Investment Trust (REIT) declares a dividend payable to shareholders in October, November, or December, but actually pays the dividend during January of the following year, the shareholder is considered to have received the dividend on December 31 of the prior tax year and must report the dividend in the year it was declared.

Answer 81

- Certain transactions between a corporation and its shareholders may be regarded as constructive dividends or constructive distributions. In general, constructive distributions (also called “constructive dividends”) are assessed under audit, and they can have very negative consequences for the corporation as well as to the shareholder. - They may be considered dividends and therefore taxable to the shareholders and non-deductible to the corporation.

Answer 82

- Payment of personal expenses: If a corporation pays personal expenses on behalf of an employee-shareholder, the amounts should be classified as a distribution, rather than expenses of the corporation. - Unreasonable compensation: If a corporation pays an employee-shareholder an unreasonably high salary considering the services actually performed, the excessive part of the salary may be treated as a distribution. - Unreasonable rents: If a corporation rents property from a shareholder and the rent is unreasonably higher than the shareholder would charge an unrelated party for the use of the property, the excessive part of the rent may be treated as a distribution. Conversely, if a corporation rents property to a shareholder and the rent is unreasonably low, the discounted portion of the rent could be treated as a distribution as well. - Cancellation of a shareholder’s debt: If a corporation cancels a shareholder’s debt without repayment by the shareholder, the amount canceled may be treated as a distribution. - Property transfers for less than FMV: If a corporation transfers or sells property to a shareholder for less than its FMV, the excess may be treated as a distribution. - Below-market or interest-free loans: If a corporation gives a loan to a shareholder on an interest-free basis or at a rate below the applicable federal rate, the uncharged interest may be treated as a distribution.

Answer 83

- Much of tax law deals with the taxation of assets. In order to calculate gains and losses from the sale or other disposition of an asset, you need to be able to properly classify the asset first. There are two main types of assets: real property and personal property. - “Real property” is real estate. Real property includes land and anything permanently attached to it. Examples include: buildings, farmland, personal homes, commercial buildings, residential rentals, and subsurface mineral rights. - “Personal property” is anything other than real estate. Personal property includes: furniture, equipment, vehicles, household goods, collectibles, and even livestock. It also includes intangible assets, such as corporate stock, trademarks, cryptocurrency, and copyrights. The tax treatment of an asset also varies based on whether the asset is personal-use, business property, or investment property. - Note: Do not get the term “personal property” confused with “personal-use property.” The term “personal property” is an accounting and legal term which describes all movable assets, whether they are used in a business or not. “Personal-use” property refers to any property that is used personally by the taxpayer and not used in a trade, business, or for investment.

Answer 84

- To correctly calculate gains and losses, you must also understand the concept of “basis.” The initial basis of an asset is usually its cost. However, there are instances in which basis is determined based upon the fair market value of the asset when acquired by the taxpayer, rather than its cost, typically when property is acquired by inheritance and sometimes by gift. The basis of an asset may include: - Sales taxes charged during the purchase - Freight-in charges and shipping fees - Installation costs and testing fees - Delinquent real estate taxes that are paid by the buyer of a property - The cost of any major improvements to the property - Legal and accounting fees for transferring an asset - Legal fees for obtaining title to a property - All of these costs will increase an asset’s basis. The result of these adjustments to the basis is the “adjusted” basis.

Answer 85

- Depreciation is an income tax deduction that allows a business to recover the cost or basis of property used in the business over time. Depreciation decreases the basis of an asset, usually over several years - Some types of property, such as land, cannot be depreciated. Most other types of tangible property, such as buildings, machinery, vehicles, furniture, and equipment, are depreciable. - Study Note: Depreciation is an important accounting concept, so it is tested most often on Part 2: Businesses of the EA exam. For Part 1 of the EA exam, test-takers must understand depreciation primarily in the context of residential rental property. Most residential rental property is depreciated over 27.5 years. Only the value of the building can be depreciated, never the land.

Answer 86

- In order to correctly report a taxable gain or loss related to the disposition of an asset, a taxpayer needs to identify: - Whether the asset is personal-use or used for business or investment; - The asset’s basis or adjusted basis; - The asset’s holding period: - Short-term property is held for one year or less. - Long-term property is held for more than one year (at least a year, plus one day). - The proceeds from the sale.

Answer 87

- The basis of real estate usually includes a number of costs in addition to the purchase price. If a taxpayer purchases real property (such as land or a building), certain fees and other expenses are automatically included in the cost basis. The transaction might include real estate taxes the seller owed at the time of the purchase. If delinquent real estate taxes are paid by the buyer, those amounts must be added to the property’s basis.

Answer 88

- If a property is CONSTRUCTED rather than PURCHASED, the basis of the property includes all the expenses of construction. This includes the cost of payments to contractors, building materials, and inspection fees. Demolition costs and other costs related to the preparation of land prior to construction must be added to the basis of the land, rather than to any buildings constructed on it later.

Answer 89

- Property in Exchange for Services: If a taxpayer receives property in payment for services, he must include the property’s FMV in income, and this becomes his basis in the property. If two people agree on a cost for services beforehand, the agreed-upon cost may be used to establish the amount included as income and as the asset’s basis.

Answer 90

- A taxpayer’s basis in securities (such as stocks or bonds) is usually the purchase price plus any additional costs (e.g., brokers’ commissions, settlement fees). - When taxpayers sells securities, their investment brokers should provide them with Form 1099-B, Proceeds from Broker and Barter Exchange Transactions, showing the proceeds of the sale. The IRS also receives a copy of Form 1099-B. - If Form 1099-B does not identify a taxpayer’s basis in the sold securities, the taxpayer must provide this information from their own records. If a taxpayer cannot provide evidence of their basis in an asset sold, the IRS may deem the basis to be zero.

Answer 91

- The basis of property transferred by a spouse (or ex-spouse, if the transfer is due to divorce) is the same as the spouse’s adjusted basis. Generally, there is no gain or loss recognized on the transfer of property between spouses (or between former spouses if the transfer is because of divorce). - For property transfers related to a divorce, the transfer generally must occur within one year after the date the marriage ends. This nonrecognition rule applies even if the transfer was in exchange for cash, the release of marital rights, the assumption of liabilities, or other financial considerations.

Answer 92

- The basis of property received as a gift is determined differently than property that is purchased or inherited. The taxpayer must know the donor’s adjusted basis in the property when it was gifted, its fair market value on the date of the gift, and the amount of gift tax the donor paid on it, (if any). - The concept of “fair market value” is important when calculating any capital gains tax liability on a gift, so it’s important to know how the basis and FMV is determined. - Generally, the basis of gifted property for the donee is equal to the donor’s adjusted basis. This is called a “transferred basis.” For example, if a father gives his son a car and the father’s basis in the car is $2,000, the basis of the vehicle remains $2,000 for the son. - The holding period of the gift would also transfer to the donee.

Answer 93

- In situations where the fair market value of the property on the date of the gift is less than the transferred basis, the donee’s basis for gain is the transferred basis. - However, if the donee reports a loss on the sale of gifted property where the fair market value of the property on the date of the gift is less than the transferred basis, his basis is the FMV of gifted property on the date of the gift. - The sale of gifted property can also result in no gain or loss. This happens when the sale proceeds are greater than the gift’s FMV but less than the transferred basis in situations where the fair market value of the property on the date of the gift is less than the transferred basis.

Answer 94

- The basis of inherited property is treated very differently for tax purposes. In most cases, the basis is the FMV of the property on the date of the decedent’s death, regardless of what the deceased person paid for the property or the adjusted basis of the property right before death. - In addition, when inherited property is sold by the beneficiary, it is deemed to have a long-term holding period, regardless of how long the beneficiary held it. - When inherited property is sold by a beneficiary, the gain will be calculated based on the change in value from the date of death. This usually results in a beneficial tax situation for anyone who inherits property because the taxpayer generally gets an increased or “stepped-up” basis.

Answer 95

- However, there are cases in which this rule can work against taxpayers. Although the value of most property such as stocks, collectibles, and bonds generally increases over time, there are also instances in which a property’s value drops. This creates a “stepped-down” basis.

Answer 96

- Although the basis of an estate for estate tax purposes is usually determined on the date of death, a special rule allows the personal representative of the estate to elect a different valuation date of six months after the date of death. This is known as the alternate valuation date. - To elect the alternate valuation date, the estate’s value and related estate tax must be less than they would have been on the date of the taxpayer’s death. If the alternate valuation date has been elected for the estate, the basis for inherited assets is normally the fair market value of the assets six months after the date of death. - However, if any assets are received from the estate less than six months after the date of death, the basis in these inherited assets is the fair market value as of the date the asset was distributed to the heir. If a federal estate tax return (Form 706) is not filed for the deceased taxpayer, the basis in the beneficiary’s inherited property is the FMV value at the date of death, and the alternate valuation date does not apply.

Answer 97

- In the previous chapter, we discussed assets in general. In this chapter, we will discuss capital gains and losses, which occur when a taxpayer sells or disposes of an asset. - Many of the items a taxpayer owns and uses for personal or investment purposes are classified as “capital assets” This means that the net gains that result from their sale or disposition may be subject to tax at favorable capital gains tax rates. Examples of capital assets include: - A main home or vacation home - Furniture, a car, or a boat - Antiques and collectibles - Stocks, bonds, and mutual funds (except when held for sale by a professional securities dealer) - Cryptocurrency or virtual currency - Note: Losses from the sale of personal-use property, such as a main home, furniture, or jewelry, are not deductible. However, gains from the sale of personal-use assets usually are taxable, subject to certain exclusions. - The applicable capital gains tax rate depends on the holding period, the type of asset, and the taxpayer’s ordinary income tax bracket.

Answer 98

- An individual usually owns many assets, including investments, like stocks and bonds. The gain or loss on each asset is figured separately and the tax treatment depends on the type of asset that is sold. In the case of capital assets, the gains and losses are typically reported on these two forms: - Schedule D, Capital Gains and Losses, and - Form 8949, Sales and Other Dispositions of Capital Assets. - Schedule D is used to report gain or loss on the sale of investment property and most capital gain (or loss) transactions. However, before the taxpayer can calculate their net gain or loss on Schedule D, the taxpayer may also have to complete Form 8949, Sales and Other Dispositions of Capital Assets.

Answer 99

- Form 8949 reports the details about each stock trade or capital asset sale the taxpayer makes during the year. There are two parts to Form 8949. The first is for short-term assets, and the second part is for long-term assets. Form 8949 is used to report the following: - The sale or exchange of capital assets - Gains from involuntary conversions - Nonbusiness bad debts - Worthless securities - The election to defer capital gain invested in a qualified opportunity fund (QOF) - The totals are transferred and netted on the Schedule D, which contains a summary of all capital gains and losses. - Note: Some sales and dispositions can be reported on Schedule D without also reporting them on Form 8949 if the taxpayer received Form 1099-B with basis information and no wash sale losses.

Answer 100

- Assets held for business-use or created by a taxpayer for purposes of earning revenue (copyrights, inventory, etc.) are considered noncapital assets. Gains and losses from the sale of business assets are reported on Form 4797, Sales of Business Property, and in the case of individual taxpayers, the amounts flow through to Form 1040, Schedule D, Capital Gains and Losses. The following assets are noncapital assets: - Inventory or any similar property held for sale to customers - Depreciable property used in a business, even if it is fully depreciated - Real property used in a trade or business, such as a commercial building or a residential rental - Self-produced copyrights, transcripts, manuscripts, drawings, photographs, or artistic compositions - Accounts receivable or notes receivable acquired by a business - Stocks and bonds held by professional securities dealers - Business supplies - Commodities and derivative financial instruments - Unlike capital assets, the costs of many noncapital assets may be deducted as business expenses when they are sold, and losses are generally fully deductible. Depending on the circumstances, a gain or loss on a sale or trade of property used in a trade or business may be treated as either capital or ordinary (this topic is covered in more detail in Book 2, Businesses).

Answer 101

- A disposition of stock and the related income or loss must be reported in the year of sale, regardless of when the taxpayer receives the proceeds. Capital losses are “netted” against capital gains. - A taxpayer can deduct up to $3,000 ($1,500 for MFS) of net capital losses against ordinary income in a tax year. Unused losses in excess of this limit are carried over to later years. The carryover losses are combined with gains and losses that occur in the next year. - Amounts carried over retain their character as either long-term or short-term and are reported on Schedule D. Thus, a long-term capital loss carried over to the next tax year will reduce that year’s long-term capital gains before it reduces that year’s short-term capital gains. - Note: Married taxpayers are actually at a disadvantage when deducting capital losses. On a joint return, the capital loss limit is $3,000, which is the same limit for single taxpayers. MFS filers only get half of that (a $1,500 capital loss limit).

Answer 102

- A capital loss can be carried over indefinitely during the taxpayer’s life. However, once a taxpayer dies, the capital losses not used on the final return cannot be carried over to a beneficiary or an heir. - Capital losses always belong to the decedent. Any capital loss carryovers that are not used on the taxpayer’s final return are essentially lost.

Answer 103

- A wash sale occurs when an investor sells a security to claim a capital loss, only to repurchase it again very soon thereafter. A taxpayer cannot deduct a loss on the sale of an investment if an identical investment was purchased within 30 days before or after the sale. - A wash sale is considered to have occurred when a taxpayer sells a security and, within 30 days: - Buys the identical security, - Acquires a substantially identical security in a taxable trade, or - Acquires a contract or option to buy the identical security. - If a taxpayer’s loss is disallowed because of the wash sale rules, they must add the disallowed loss to the basis of the new stock or securities. The result is an increase in the taxpayer’s basis in the new stock or securities. This adjustment postpones the loss deduction until the disposition of the new stock or securities. - It is considered a wash sale if a taxpayer sells stock and his/her spouse then repurchases identical stock within 30 days, even if the spouses file separate tax returns. The “wash sale” period is technically 61 days long, from 30 days before the date of the sale to 30 days after.

Answer 104

- For purposes of the wash sale rules, securities of one corporation are not considered identical to securities of another corporation. This means that a person can sell shares in one corporation and then purchase shares in a different corporation, and this will not trigger a wash sale. - Similarly, preferred stock of a corporation is not considered identical to the common stock of the same corporation.

Answer 105

- The wash sale rules do not apply to professional securities dealers of stocks or securities.

Answer 106

- Special rules apply to related party transactions, which are between two parties who are joined by a special relationship. If a taxpayer sells an asset to a close family member or to a business entity that the family member controls, they may not receive all the benefits of the capital gains tax rates, and they may not be able to deduct their losses. The rules were made to prevent related persons and entities from shuffling assets back and forth and taking improper losses. - “50% Control” Rule: If a taxpayer controls more than 50% of a corporation or partnership, any property transactions between the taxpayer and the business are subject to related party transaction rules. - In general, a loss on the sale of property between related parties is not deductible. When the property is later sold to an unrelated party, gain is recognized only to the extent it is more than the disallowed loss. If the property is later sold at a loss, the loss that was disallowed to the related party cannot be recognized.

Answer 107

- If a taxpayer sells or trades property at a loss (other than in the complete liquidation of a corporation), the loss is not deductible if the transaction is between the taxpayer and the following related parties: - Members of immediate family, including a spouse, siblings, half-siblings, direct ancestors (e.g., parents, grandparents) and lineal descendants of those persons (i.e., children, grandchildren.) - A partnership or corporation that the taxpayer controls. A taxpayer “controls” an entity when he or she has more than 50% ownership in it. This also includes partial ownership by other family members. - A tax-exempt or charitable organization controlled by the taxpayer or a member of his or her family - Losses on sales between certain closely related trusts or business entities controlled by the same owners - For purposes of this rule, the following ARE NOT CONSIDERED RELATED PARTIES: uncles, aunts, nephews, nieces, cousins, stepchildren, stepparents, in-laws, and ex-spouses.

Answer 108

- A taxpayer may choose to “abandon” a security that has lost its entire value in order to take advantage of the loss for tax purposes rather than retaining ownership. Stocks, stock rights, and bonds (other than those held for sale by a securities dealer) that became worthless during the tax year are treated as though they were sold for zero dollars on the last day of the tax year. - A loss from worthless securities receives special tax treatment. Unlike other losses, a taxpayer is allowed to amend a tax return for up to seven years in order to claim a loss from worthless securities. This is more than double the usual three-year statute of limitations for amending returns. - To abandon a worthless security, a taxpayer must permanently surrender all rights to it and receive no consideration in exchange. Taxpayers should report worthless securities on Form 8949 and indicate as a worthless security deduction by writing “WORTHLESS” in the applicable column of Form 8949.

Answer 109

- A worthless security deduction applies to securities that no longer have any value. “Cryptocurrencies” do not qualify according to the current definition in the IRC, which defines a “security” as: - A share of stock in a corporation; - A right to subscribe for, or to receive, a share of stock in a corporation; or - A bond, debenture, note, or certificate, or other evidence of indebtedness, issued by a corporation or by a government or political subdivision, with interest coupons or in registered form.

Answer 110

- Note: Once a corporation has been delisted from a stock exchange as a result of bankruptcy, the stockholder will often have to fill out a worthless securities processing request. Some brokerage firms will purchase worthless stock for a nominal amount (such as a penny), or permanently remove worthless securities from a taxpayer’s account to provide closure and an official sale date to the customer on their brokerage statement.

Answer 111

- The three most common examples of nonrecognition transactions are: - Section 121: Sale of a main home (Part 1, Individuals Only) - Section 1031 (Part 1 & Part 2-Also in Textbook 2, Unit 9): Like-kind exchanges - Section 1033 (Part 1 & Part 2-Also in Textbook 2, Unit 9): Involuntary conversions

Answer 112

- The precursor law to Sec. 121 was Sec. 112, enacted in 1951. Sec. 112 addressed the issue that taxes on the gain from the sale of a home would reduce the capital available for purchasing a replacement home. - Current law, Section 121, allows a taxpayer to exclude the gain from the sale of a main home. Up to $250,000 of gain may be excluded by single filers and up to $500,000 by joint filers. Generally, if the taxpayer can exclude all of the gain, it is not necessary to report the sale. - However, if part of the gain is taxable, the sale must be reported on Form 8949. Gain from the sale of a residence that is not the taxpayer’s main home must be reported as taxable income.

Answer 113

- The section 121 exclusion only pertains to a taxpayer's primary residence and does not apply to rental properties, vacation homes, or secondary residences. A taxpayer's main home is considered to be the place where they reside for the majority of the year, and it does not have to be a typical house. - This could include a houseboat, mobile home, cooperative apartment, or condominium. To qualify as a home, it must have sleeping, kitchen, and bathroom facilities.

Answer 114

- To be eligible for the section 121 exclusion, a taxpayer must: - Have sold their main home - Meet “ownership and use” tests - Not have excluded gain in the two years prior to the current sale of a home (although there are exceptions when the primary reason for selling the home residence was a change of employment, health, or unforeseen circumstances, covered later).

Answer 115

- To The IRS figures the ownership and use tests separately, and the time periods do not have to be continuous. During the five-year period ending on the date of the sale, the taxpayer must have: - Owned the home for at least 2 years (the ownership test), and - Lived in the home as their main home for at least 2 years (the use test). - A taxpayer meets both tests if the taxpayer owned and lived in the property as their main home for either 24 full months or 730 days (365 × 2) during the five-year period. The required two years of ownership and use do not have to be continuous. Further, ownership and use tests can be met during different two-year periods.

Answer 116

- The ownership and use tests are applied differently to married homeowners. Married homeowners can exclude gain of up to $500,000 if they meet all of the following conditions: - They file a joint return. - Either spouse meets the ownership test (only one is required to own the home). - Both spouses meet the use test. - Neither spouse has excluded gain in the two years before the current sale of the home. - If the requirements are not met, the couple will not be able to claim the full $500,000 exclusion for married couples. However, if only one spouse qualifies, that spouse may still be eligible for a separate exclusion of up to $250,000.

Answer 117

- An unmarried couple or other taxpayers who own a home and live together may take the $250,000 exclusion individually on their separate returns if they meet the use and ownership tests.

Answer 118

- A special rule for the holding period applies to a home that is transferred by a spouse in a divorce. The receiving spouse is considered to have owned the home during any period of time that the transferor owned it. - However, the receiving spouse must still satisfy the two out of five-year use test on their own to qualify for the entire exclusion. This is a tax-free transfer of property “incident to a divorce” (a Section 1041 transfer).

Answer 119

- In the case of a deceased spouse, the surviving spouse is treated as if they owned and lived in the home during any period that the deceased spouse did. This means that the surviving spouse may exclude up to $500,000 of gain from the sale of the home, even if it occurs within two years after the death of the deceased spouse (as long as the surviving spouse did not remarry before the sale). - Essentially, the holding period for the deceased spouse is transferred to the surviving spouse, allowing them to benefit from the full exclusion for married couples.

Answer 120

- Members of the armed forces are often required to move and might have difficulty meeting the tests for ownership and use within the five-year period prior to the sale of a home. The five-year period can be suspended for up to ten years for U.S. military and Foreign Service personnel, Peace Corps workers, and intelligence officers that are on official extended duty. - This offers taxpayers a greater chance to fulfill the two-year residency requirement, even if they or their spouse did not physically reside in the home for the standard five-year timeframe that applies to other taxpayers.

Answer 121

- There is an exception to the use test if, during the five-year period before the sale of the home, a taxpayer becomes physically or mentally disabled. They must have owned and lived in the home for at least one year. - However, a taxpayer is considered to have “lived in the home” during any time that they are forced to live in a licensed facility, including a nursing home. The taxpayer must still meet the two-year ownership test.

Answer 122

- The partial exclusion is based on a fraction, which is multiplied by the maximum allowable exclusion (250K/500K MFJ). - The numerator of the fraction is the shorter of: - (1) the period of time the taxpayer owned the property during the five-year period ending on the date of the sale; - (2) the period of time that the taxpayer used the property as the taxpayer’s principal residence during the five-year period ending on the date of the sale; or - (3) or the period of time between the date of a prior sale or exchange of property for which the taxpayer excluded gain under section 121 and the date of the current sale or exchange. - The numerator of the fraction can be expressed in days or months. - The denominator of the fraction is 730 days or 24 months (i.e., two years), depending on the measure of time used in the numerator.

Answer 123

- A taxpayer who owned and used a home for less than two years (and therefore does not meet the ownership and use tests) or who has used the home sale exclusion within the prior two-year period, they may still be eligible for a “reduced” exclusion if they meet one of three exceptions: - Work-Related Move: The job change safe harbor applies if a new job is at least 50 miles farther from the old home than was the former place of employment. If there was no former place of employment, the distance between the new place of employment and the old home must be at least 50 miles. - Health-Related Move: The health safe harbor applies if a doctor recommends a change of residence for reasons of health of the taxpayer, a spouse, a child, or certain other related persons. The related person does not have to be a dependent for the reduced exclusion to apply. - Unforeseeable Events: The home was destroyed or condemned, the taxpayer or a co-owner of the home: died; became divorced or legally separated; or - Gave birth to two or more children from the same pregnancy; - Became eligible for unemployment compensation; - Became unable, because of a change in employment status, to pay the mortgage. - Any other event that is determined to be an “unforeseeable circumstance” in IRS published guidance.

Answer 124

- If a taxpayer sells the land on which his main home is located but not the house itself, the gain is not excludible. Similarly, the sale of a vacant plot of land with no house on it does not qualify for the section 121 exclusion. - In some cases, a taxpayer may be able to exclude the gain from selling a vacant lot that is connected to their primary residence. This exclusion can only be applied if the vacant land was used in connection with the main home and the sale occurs within two years before or after selling the home. The land must have been directly adjacent to the home and must have been owned and used as part of the home, not for any business purposes. - In terms of tax treatment, both the sale of the land and the sale of the home are considered one transaction for the purpose of applying this exclusion.

Answer 125

- A section 1031 “like-kind” exchange occurs when a business or individual exchanges business or investment property for similar property. These are also called “tax deferred” exchanges. - If an exchange qualifies under section 1031, the taxpayer does not pay tax currently on a resulting gain and cannot deduct a loss until the acquired property is later sold or otherwise disposed of. - To qualify under section 1031, an exchange must involve like-kind property. The Tax Cuts and Jobs Act only allows section 1031 exchanges of real property. Personal property exchanges will no longer qualify.

Answer 126

- The most straightforward type of Section 1031 exchange involves a simultaneous swap of two properties. The other type of exchange is called a “deferred exchange.” They allow a taxpayer to sell their property and then acquire one or more replacement properties at a later date. Deferred exchanges offer more flexibility but are more complex, and they also require a qualified intermediary, or “QI.” - Currently, the following types of real property may qualify for like-kind treatment: - Land, and improvements to land (such as buildings, concrete parking lots, foundations), - Unsevered natural products of land, (such as natural mineral deposits, mines, and wells) - Water and air space superjacent to land, - Certain intangible interests in real property (such as leaseholds), and - Property that is real property under state or local law.

Answer 127

- To qualify for nonrecognition treatment, the exchange must meet all the following conditions: - The property must be held for investment or business-use. Property held for personal use, such as a personal residence, does not qualify. - The property must NOT be “held primarily for sale” (such as real estate held as inventory by a real estate dealer). - There must be an actual exchange of two or more assets or properties (the exchange of property for cash is always treated as a sale, not an exchange). - For most exchanges, a “qualified intermediary” must be procured to facilitate the exchange using escrow accounts. This type of qualified intermediary (sometimes also known as an exchange accommodator or facilitator) promises to return the proceeds of the exchange to the transferor of the property.

Answer 128

- In a section 1031 exchange, the property to be received must be identified in writing (or actually received) within 45 days after the date of transfer of the property given up. Further, the replacement property in a deferred exchange must be received by the earlier of: - The 180th day after the date on which the property given up was transferred, or - The due date, including extensions, of the tax return for the year in which the transfer of that property occurs. - These deadlines are based on calendar days; there are no exceptions for weekends or holidays. - These deadlines are unwavering, except in the event of a natural disaster when the IRS may grant an extension. - Taxpayers report like-kind exchanges on Form 8824, Like-Kind Exchanges. The taxpayer must calculate and keep track of their basis in the new property they acquired in an exchange.

Answer 129

- “Boot,” is frequently used to describe cash or other property added to an exchange to compensate for a difference in the values of properties traded. - A taxpayer must generally not receive “boot” in an exchange, in order for the exchange to be completely tax-free. - This does not mean that the exchange is not valid, but the taxpayer who receives boot may have to recognize taxable gain to the extent of the cash and the FMV of unlike property received, but the recognized gain when boot is received is still limited to the realized gain on the exchange. The amount considered boot would also be reduced by any qualified costs paid in connection with the transaction.

Answer 130

- The basis of property received in a section 1031 exchange is the basis of the property given up with some adjustments. Gain is only deferred, not forgiven, in a like-kind exchange. - If a taxpayer trades property and also pays money as part of the exchange, the basis of the property received is the basis of the property given up, increased by any additional money paid.

Answer 131

- Like-kind exchanges are permitted between related parties. However, if either party disposes of the property within two years after a 1031 exchange, the exchange is disqualified from nonrecognition treatment; any gain or loss that was deferred in the original transaction must be recognized in the year the disposition occurs. - For purposes of this rule, a “related person” includes a close family member (i.e., spouse, sibling, parent, or child). It also includes a corporation or partnership in which a taxpayer holds ownership or interests of more than 50%. This mandatory two-year holding period rule does not apply: - If one of the parties involved in the exchange subsequently dies; - If the property is subsequently converted in an involuntary exchange (such as a fire); - If it can be established to the satisfaction of the IRS that the exchange and subsequent disposition were not done mainly for tax avoidance purposes. - The IRS closely scrutinizes exchanges between related parties because they can be used by taxpayers to evade taxes on gains. Taxpayers must file Form 8824 for the 2 years following the year of a related party exchange.

Answer 132

- Involuntary conversions are also called “involuntary exchanges.” - An involuntary conversion refers to a situation where a taxpayer's property is lost, damaged, or destroyed, and the taxpayer receives a payment as a result. This can occur due to a casualty, disaster, theft, or condemnation. Sometimes, a taxpayer can have a taxable gain from an involuntary conversion. This usually happens when a taxpayer’s insurance reimbursement exceeds their basis in the property. - Involuntary conversions can occur with business property, investment property, as well as personal-use property. - A taxpayer reports the gain or deducts the loss in the year the gain or loss is realized. Nevertheless, an involuntary conversion does not automatically result in a taxable event, even if the insurance reimbursement exceeds the taxpayer’s basis. Under section 1033, a taxpayer can elect to defer reporting the gain from an involuntary conversion if they reinvest the proceeds in similar property.

Answer 133

- While a section 1031 exchange only has a 180-day exchange period, a section 1033 exchange has a much longer time for completion. The replacement period for an involuntary conversion generally ends two years after the end of the first tax year in which any part of the gain is realized. - Unlike a Section 1031 exchange, there is no requirement under Section 1033 that a qualified intermediary be employed to hold the escrow funds or conversion proceeds. - Real property that is held for investment or used in a trade or business (such as a rental) is allowed a three-year replacement period. The replacement period is four years for livestock that is involuntarily converted because of weather-related conditions. - If a taxpayer’s main home is damaged or destroyed and is in a federally declared disaster area, the replacement period is four years, but sometimes can even be extended to five years, depending on the severity of the disaster.

Answer 134

- If a taxpayer reinvests in replacement property similar to the converted property, the replacement property’s basis is the same as the converted property’s basis on the date of the conversion, subject to the certain adjustments. - The basis is decreased by any loss a taxpayer recognizes on the involuntary conversion, or any money a taxpayer receives that they do not spend on similar property. The basis is increased by any gain a taxpayer recognizes on the involuntary conversion and any additional costs of acquiring the replacement property.

Answer 135

- A "condemnation" is a specific type of involuntary conversion that involves the legal process of taking private property for public use. If a building poses a threat to public safety or health, it may also be condemned by the government. This process is sometimes referred to as "eminent domain." - It is considered a forced sale, where the owner is essentially selling their property to the government or another party. Eminent domain gives the government the power to take private property in exchange for compensation. - A condemnation can be initiated by a state or local government or by a private organization with the authority to seize property. In most cases, the owner will receive some form of payment or compensation for their property that is being taken.

Answer 136

- If a taxpayer’s main home is condemned or destroyed, the taxpayer can generally exclude the gain as if they had sold the home under the section 121 exclusion. This includes homes that are seized or disposed of under the “threat of condemnation.” In the case of a condemnation, the property owner must be aware of the threat and must reasonably believe that a condemnation is likely to occur. - If the taxpayer’s main home is eligible for a section 121 exclusion, single filers can exclude up to $250,000 of the gain and joint filers up to $500,000. Any excess gains above these amounts may be potentially deferred under section 1033 if the taxpayer reinvests all the proceeds in another, similar property.

Answer 137

- Rental income refers to any payment received for the use or occupancy of physical property. Examples of rental activities include residential rentals, transient lodging at hotels and motels, commercial rentals, and personal property rentals such as car rentals or machinery rentals. - Taxpayers must report all rental income as part of their gross income, and the way in which rental activities are reported may differ depending on the specific type of rental activity involved.

Answer 138

- Generally, rental activities are reported on Schedule E (Form 1040), though there are some exceptions to this rule. - As a general rule of thumb, all rental income is classified as passive and is reported Schedule E - Hotel and Motel owners report rental income on Schedule C. These are considered “transient rentals” and will be covered in Part 2. - The rental of personal property (such as vehicles, equipment, or formal wear) is not reported on Schedule E. Instead, it is reported on Schedule C, if the activity is a trade or business.

Answer 139

- Advance Rent: Taxpayers must report rental income when it is constructively received (i.e., available without restrictions). This includes advance rent, which is any amount received before the period that it covers. - Thus, a taxpayer must include advance rent in income in the year he or she receives it, regardless of the period covered or the accounting method used, unless the amounts are subject to restrictions. - Lease Cancellation: If a tenant pays to cancel a lease, the amount received for the lease cancellation is classified rental income. The payment is included in the year received regardless of the taxpayer’s accounting method.

Answer 140

- Refundable Security Deposits: When a tenant pays a refundable security deposit upon renting a property, the money is not considered income for the landlord at that time. However, if the property owner keeps some or all of the security deposit because the tenant did not live up to the terms of the lease or because they damaged the property, then the deposit amount retained is recognized as income in the year it is forfeited by the tenant.

Answer 141

- Property or Services in Lieu of Rent: If a landlord receives property or services as payment for rent instead of cash, the fair market value must be recognized as rental income. - If the tenant and landlord agree in advance to a price, the agreed-upon price is deemed the fair market value unless there is evidence to the contrary. If a tenant pays expenses on behalf of the landlord, the landlord must recognize the payments as rental income. However, the property owner can also deduct the expenses as rental expenses.

Answer 142

- A property owner cannot claim a "loss" of rental income for any period of time that the property remains unoccupied. However, if the owner is putting in effort to attract tenants and make the property available for rent, they can still deduct necessary expenses as soon as the property is deemed "available" for renting, regardless of whether or not a tenant is found immediately. - In other words, if the property is available for rent, the owner can deduct expenses, including depreciation, even if the property is unoccupied. - Sometimes a rental property will stand vacant for other reasons. For example, if a landlord must make repairs after a tenant moves out, the owner may still depreciate the rental property during the time it is not available for rent. This is assuming the rental property had already been placed in service as a rental. This is called “idle property.”

Answer 143

- The rules are different, however, if the owner makes rental property repairs before actually placing the property into service. In this case, the repairs must be capitalized and included in the property’s basis. The owner can only deduct expenses once the property is placed into service for the production of rental income. - “In order to deduct costs as expenses rather than having to capitalize them, the rental unit must be placed into service, i.e., it must be ready and available for rent” (IRS Reg. § 1.263(a)-2(d)(1)).

Answer 144

- A landlord can start claiming deductions for the depreciation of a rental property once it is put into use for generating income. - Most residential rentals are depreciated over 27.5 years. - Nonresidential buildings are generally depreciated over 39 years. An example of a nonresidential rental would be a medical office complex, where the offices are rented to business tenants, but nobody lives or sleeps in the building. - The cost of land is never depreciated because land does not wear out, become obsolete, or get used up. - Note: Depreciation and the safe harbor rule of the tangible property regulations are covered in more detail in Part 2, Businesses.

Answer 145

- The tax treatment of rental income depends on several factors: whether a property owner is a real estate professional or actively participates in managing a property; whether there is any personal use of the rental property, and if so, whether the dwelling is considered a home; and whether the rental activity is for “carried on” for profit. - Rental activities are generally considered passive unless the taxpayer qualifies as a real estate professional (covered in Part 2). - Generally, losses from passive activities that exceed income from passive activities in the same year are disallowed. The disallowed losses are carried forward to the next taxable year and can be used to offset future income from passive activities. - There is a special “$25,000 exception” to this rule, however, for rental real estate activities for taxpayers who actively participate in their rental activities.

Answer 146

- It's important to distinguish that active participation does not require the same level of involvement as material participation. - “Active participation” is not the same standard as “material participation.” Material participation is a much higher standard. For example, the owner of a rental property will generally be treated as “actively” participating if they make management decisions such as deciding rental contracts, approving repairs, and other similar management decisions. - To be considered “actively participating” in a rental activity, a property owner must own at least 10% of the rental property and must make management decisions in a significant and bona fide way, such as approving new tenants and establishing the rental terms. - Active participation can also include participation by the property owner’s spouse.

Answer 147

- If a landlord is actively involved in managing their rental properties, they may be eligible to deduct up to $25,000 of losses from their nonpassive income. This special loss allowance is subject to an income phaseout. The full $25,000 loss allowance is available for taxpayers, whether single or MFJ, whose modified adjusted gross income (MAGI) is $100,000 or less. - If the IRS determines a taxpayer has not “actively” participated, rental losses are not currently deductible, and the taxpayer would not be eligible for the special $25,000 loss allowance. - If a taxpayer is married and files a separate return (MFS), but lived apart from their spouse for the entire tax year, the taxpayer’s special allowance for rental losses cannot exceed $12,500; and this $12,500 allowance would only be available if the taxpayer’s MAGI is $50,000 or less. - However, if the taxpayer lives with their spouse at any time during the year and is filing MFS, the taxpayer cannot use any passive rental losses to offset nonpassive income.

Answer 148

- In the case of a taxpayer who only rents a portion of a property, they must allocate specific expenses between the part used for rental purposes and the part used for personal use. Essentially treating the property as two separate units. Any costs related to the rental portion can be claimed as rental expenses on Schedule E. - If an expense applies to both rental use and personal use, such as a heating bill for the entire house, the landlord must divide the expense between the two. The two most common methods for dividing such expenses are based on either (1) the number of rooms in the house, or (2) the square footage of the house.

Answer 149

- If a taxpayer uses a property for both personal and rental purposes, the way expenses are handled depends on if their personal use qualifies as usage of a "residence." - The home is considered a “residence” if the owner uses the property for personal purposes during the year for more than the greater of (1) fourteen days, or (2) 10% of the total days it is rented at a fair rental price. - If the property is (1) deemed to be a personal residence, (2) the rental activity is a “partial rental activity” and (3) the owner’s rental expenses exceed rental income, then the owner cannot use the excess expenses to offset income from other sources. However, excess deductions may be carried forward to the next year and treated as rental expenses for the same property, subject to the same limits.

Answer 150

- If a taxpayer does not rent their property with the intention of making a profit, they cannot claim any rental expenses that exceed their rental income. - In the case of a “not-for-profit” or “below market” rental, the rental income is not reported on Schedule E, and the taxpayer cannot deduct a loss. Any unused expenses on a “not-for-profit” rental cannot be carried forward to the following year. - Below-market rentals to a family member or another related party is the most common type of “not-for-profit” rental. - If the taxpayer itemizes deductions, they can deduct the mortgage interest and real estate taxes (subject to the limitations on the deductibility of state and local taxes) on the appropriate lines of Schedule A (Form 1040).

Answer 151

- If a taxpayer rents a main home or vacation home that is considered a “residence” for fewer than 15 days, the taxpayer does not have to recognize any of the income as taxable. - This is called the “15-day rule,” or “minimal rental use.” The taxpayer also cannot deduct any rental expenses.

Answer 152

- The rental of personal property (such as vehicles, equipment, or formal wear) is not reported on Schedule E. Instead, it is reported on Schedule C, if the activity is a trade or business. - Taxpayers who are “not in the business” of renting personal property but still have a profit motive, should report their income on line 8l and expenses on line 24b of Schedule 1 (Form 1040). For example, if a taxpayer only rents out their boat occasionally to friends and family, this would be a personal property rental that may not rise to the level of a “trade or business.” - Note that the IRS publications do not specifically address the treatment of personal property rentals, nor do they define at which point a personal property rental activity becomes a “trade or business.”

Answer 153

- Personal property is not the same as “personal-use” property that a taxpayer uses for personal purposes. - “Personal property” is an accounting term that is used to describe any tangible asset other than real estate. In civil law, personal property is sometimes called “movable property.” - Examples of personal property include appliances, furniture, vehicles, and collectibles. The distinguishing factor between personal property and real property is that personal property is movable, while real property, such as land or buildings, remains in one location.

Answer 154

- Like rental income, most royalty income is reported on Schedule E. Royalties from patents, oil, gas, and mineral properties are taxable as ordinary income, but the amounts are generally not subject to self-employment tax. - Royalties from copyrights on literary, musical, or artistic works, or from patents on inventions, are usually paid to a taxpayer for the right to use a creator’s work over a specified period of time. Royalties can also be based on the number of units sold, such as the number of books, tickets to a performance, or machines sold. - Royalty payments are always reported to the taxpayer on Form 1099-MISC. A business is required to issue Form 1099-MISC, Miscellaneous Income, to each person that has been paid at least $10 of royalties for the year.

Answer 155

- Special rules apply to self-employed writers, musicians, and inventors. These taxpayers must report their royalty income on Schedule C, Profit or Loss from Business, and the income is also subject to self-employment tax. - This is because their personal efforts created the property. As stated in earlier chapters, a copyright or trademark in the hands of its creator is not a capital asset. - However, in the event that the creator of an intellectual property asset passes away, and the asset is passed down to a beneficiary through inheritance, it is classified as a capital asset for the beneficiary. Any income earned by the beneficiary on this asset will no longer be subject to self-employment tax.

Answer 156

- A “recovery” is a return of an amount a taxpayer deducted or took a credit for in an earlier year. The most common recoveries are refunds, reimbursements, and rebates of deductions itemized on Schedule A. A taxpayer must include a recovery in income in the year he receives it, to the extent the deduction or credit reduced his tax in the earlier year. - State and local income tax refunds are reported as taxable income in the year received only if (1) the taxpayer itemized deductions in the prior year in which those taxes were overpaid and (2) the amounts paid in the prior year reduced his or her tax liability in that year (i.e., provided a tax benefit). - The payor of the tax refunds should send Form 1099-G, Certain Government Payments, to the taxpayer by January 31, and also send a copy to the IRS.

Answer 157

- The Tax Cuts and Jobs Act changed the treatment of alimony, making it nondeductible to the payor and nontaxable to the recipient. Divorce and separation agreements entered into before 2019 are “grandfathered,” so there will continue to be alimony deductions and taxable alimony income for individuals with divorce agreements that were finalized prior to 2019.

Answer 158

- If alimony payments continue after the receiving spouse dies, they will not be considered alimony. For a payment to qualify as alimony: - The divorce agreement may not include a clause indicating that the payment is something else (such as child support or repayment of a loan). - The payor must have no liability to make any payment after the death of the former spouse. - Not all payments that are made to an ex-spouse qualify as taxable alimony. Alimony does not include: - Payments that are a former spouse’s share of income from community property - Payments to keep up the payer’s property, or “free use” of the payer’s property - Noncash property settlements - Any payment made other than in cash - Any payments made to an ex-spouse when the divorce was finalized in 2019 or later years.

Answer 159

- In contrast, child support is never taxable income to the receiver and not deductible by the payer because it is viewed as a payment a parent makes simply to support his or her own child. - If a divorce agreement specifies payments of both alimony and child support and only partial payments are made by the payer, the partial payments are considered child support until that obligation is fully paid. Any additional amounts paid are then treated as alimony. - If an alimony payment is subject to reduction based on a contingency relating to a child (e.g., attaining a certain age, marrying, or going to college), the amount subject to reduction is treated as child support for tax purposes. This is regardless of whether or not the contingency is likely to occur.

Answer 160

- Note: Property settlements are simply a division of property and are not treated as alimony. In general, property transferred to an ex-spouse as part of a divorce proceeding is not a taxable event.

Answer 161

- Social Security income is reported to the taxpayer on Form SSA-1099, Social Security Benefit Statement. Do not confuse this with Supplemental Security Income (SSI), which is not taxable. - To determine if any percentage of Social Security benefits is taxable, a taxpayer must compare the base threshold amount for his or her filing status with the total of: - One-half of his or her benefits, plus - All of the taxpayer’s other income, including tax-exempt interest. - If the sum is less than the base amount for his or her filing status, none of the Social Security is taxable. If the sum is more than the base amount for his or her filing status, a percentage of the Social Security is taxable. - Base Amounts for Calculating Taxability of Social Security - MFJ: $32,000 - Single, HOH, QSS, or MFS (and lived apart from spouse all year): $25,000 - MFS (if lived with spouse at any time during the year): $0 - The taxable portion of Social Security benefits is never more than 85% and, in most cases, is less than 50%.

Answer 162

- Gambling income may include winnings from lotteries, raffles, horse races, and casinos. Gambling winnings will be reported to a taxpayer on Form W-2G. - A taxpayer must report and pay tax on all gambling winnings, regardless of whether he or she receives a Form W-2G. Gambling losses are deductible on Schedule A as a miscellaneous itemized deduction, but the deduction is limited to the amount of gambling winnings. - Note: The TCJA expanded the definition of “gambling losses.” In prior years, professional gamblers who filed on Schedule C were able to generate an NOL from their wagering activities. The TCJA modified the limit on gambling losses so that all the deductions for expenses incurred in carrying out gambling activities, not just direct gambling losses, are limited to the extent of gambling winnings. For example, an individual who is a professional gambler can include expenses traveling to and from a casino as gambling losses as an offset against any gambling winnings, but cannot use the expenses to generate a loss on Schedule C.

Answer 163

- Generally, if a taxpayer’s debt is canceled or forgiven, the taxpayer must include the debt forgiveness in his or her gross income. If a lender cancels a debt and issues Form 1099-C, the lender will indicate on the form if the borrower was personally liable for repayment of the debt. The tax impact depends on the type of debt and whether the loan is recourse or nonrecourse. - A recourse debt holds the borrower personally liable. All other debt is considered nonrecourse. Cancellation of debt may include any indebtedness for which a taxpayer is personally liable, or which attaches to the taxpayer’s property, such as an auto loan, credit card debt, mortgage, or home equity loan. - Note: A “nonrecourse” loan does not allow the lender to pursue anything other than the collateral to collect the debt. For example, if a borrower defaults on a nonrecourse home loan, the bank can only foreclose on the home. The bank cannot take further legal action to collect the money owed on the debt.

Answer 164

- If the original debt is a nonbusiness debt, the canceled debt amount is reported as “other income” on Schedule 1, Form 1040. The taxpayer must generally report two transactions: - The cancellation of debt income - Gain or loss on the sale or repossession, generally equal to the difference between the FMV of the property at the time of the foreclosure and the taxpayer’s adjusted basis in the property - A repossession or foreclosure is treated as a “sale” for tax purposes, and a gain or loss must be computed. Any loss related to a personal-use asset would be nondeductible.

Answer 165

- There are several circumstances in which canceled debt is not taxable. The law provides several exceptions in which the canceled debt is excludable from income or nontaxable due to the nature of the debt. - Insolvency: A taxpayer is insolvent when his or her total debts are more than the FMV of his total assets immediately prior to the discharge of the debt. If a taxpayer is insolvent when the debt is canceled, the canceled debt is not taxable, but only to the extent of the insolvency (i.e., by how much his or her debts exceed their assets). For this purpose, a taxpayer’s assets include the value of everything they own, including pensions and retirement accounts. - Bankruptcy: Debts discharged through a legal bankruptcy are not considered taxable income. The taxpayer must attach Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, to his federal income tax return to report debt canceled in bankruptcy.

Answer 166

- A taxpayer is insolvent when total debts exceed the value of the taxpayer’s total assets immediately prior to the discharge of the debt. Insolvency is a condition in which the fair market value (FMV) of all assets is less than one’s liabilities. - If a taxpayer is insolvent when the debt is canceled, the canceled debt is not taxable, but only to the extent of the insolvency. For this purpose, the taxpayer’s assets include the value of everything he or she owns, including pensions and retirement accounts.

Answer 167

- Normally, when a bank forecloses on a home and sells it for less than the borrower’s outstanding mortgage, the bank forgives the unpaid mortgage debt, and the canceled debt is taxable income to the homeowner. However, a taxpayer may exclude income realized as a result of loan modification or foreclosure of a taxpayer’s principal residence. - Under the Mortgage Forgiveness Debt Relief Act, mortgage debt on a primary residence that was forgiven was excluded from taxable income. This provision had expired but was extended until 2025 by the Consolidated Appropriations Act of 2021. - In 2021 and later years, the CAA-2021 lowered the amount of qualified principal residence debt that can be discharged tax-free to $750,000 ($375,000 for married individuals filing separately).

Answer 168

- “Qualified principal residence indebtedness” or QPRI, is a mortgage secured by a taxpayer’s principal residence that was taken out to buy, build, or substantially improve that residence and may also include debt from refinancing. - Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure may qualify for the exclusion. This exclusion only applies to a main home: it does not apply to second homes, rental properties, or vacation homes.

Answer 169

- Special rules apply to canceled student loans. The American Rescue Plan Act (ARPA) allows exclusion from taxation on most student loans forgiven through tax year 2025. This includes all federal student loans and certain private loans and institutional loans. - Loans can be discharged for any reason without an income tax consequence. - IRS Notice 2021-01 provides notice to lenders that they are not to issue Forms 1099-C, Cancellation of Debt, for discharges that qualify for this relief.

Answer 170

- Canceled Debt that is Otherwise Deductible: If a taxpayer uses the cash method of accounting, he or she should not recognize canceled debt income if payment of the debt would have otherwise been a deductible expense.

Answer 171

- A “hobby” is an activity typically undertaken primarily for pleasure. Even though it may produce income, a hobby is not considered a business because it is not carried on to make a profit. Gross income from a hobby is taxable and reported on Form 1040, Schedule 1. Hobby income is not subject to self-employment tax. - Note: The use of hobby expenses to offset hobby-related income is no longer permitted. The Tax Cuts and Jobs Act repealed most miscellaneous itemized deductions, including the deduction for hobby-related expenses on Schedule A. A taxpayer with hobby income is still allowed to deduct cost of goods sold (COGS), if it applies, in order to arrive at taxable income.

Answer 172

- Treasury Regulation Section 1.183-1(e) states that a taxpayer may determine gross income from any activity by subtracting the cost of goods sold (COGS) from the gross receipts so long as he or she consistently does so and follows generally accepted methods of accounting in determining such gross income.

Answer 173

- Court awards for compensation for lost wages or profits are generally taxable as ordinary income, as well as punitive damages. Interest payments on any settlement award are also taxable. Compensatory damages for personal physical injury or physical sickness are not taxable income, whether they are from a settlement or an actual court award. - Damages received for emotional distress due to “physical injury or sickness” are treated the same way as damages for physical injury or sickness, so they are not included in income. However, if the plaintiff’s emotional distress is not due to a physical injury (for example, an employment lawsuit in which a taxpayer suffers emotional distress for injury to reputation), the proceeds are taxable, except for any damages received for medical care that are directly related to that emotional distress. - “Emotional distress” can include physical symptoms such as headaches, depression, insomnia, and stomach disorders.

Answer 174

- Punitive damages are always taxable, even if the punitive damages were received as part of a court award for personal physical injuries or physical sickness. Punitive damages are legal damages assessed in order to “punish” the defendant for outrageous or malicious conduct. Punitive damages should be reported as “Other Income” on Schedule 1 (Form 1040).

Answer 175

- Civil damages, restitution, or other monetary awards that the taxpayer received as compensation for wrongful incarceration are not taxable.

Answer 176

- No tax deduction is allowed for any settlement, payout, or attorney fees related to sexual harassment or sexual abuse if the payments are subject to a nondisclosure agreement.

Answer 177

- Prizes and awards are taxable and are reported as “other income” on Schedule 1 of Form 1040. If the prize or award is in the form of property rather than cash, the fair market value of the property is treated as the taxable amount. The winner may avoid taxation of the award by rejecting the prize. The taxpayer may also avoid taxation by having the payor directly transfer the prize to a charity or other nonprofit organization.

Answer 178

- A scholarship is an amount paid to an undergraduate or graduate student to pursue a college degree. A fellowship is an amount paid to an individual to pursue research. A scholarship or fellowship may be excluded from income only if: - The taxpayer is a degree candidate at an eligible educational institution - The amounts do not exceed qualified educational expenses. - It is not designated for other purposes, such as room and board. - It does not represent payment for teaching, research, or other personal services. - Qualified educational expenses include: tuition, required fees, and course-related expenses such as books and required equipment. An athletic scholarship is tax-free only if it meets the requirements described above.

Answer 179

- Qualified Tuition Programs (QTPs), also known as Section 529 plans, are established and maintained by states or educational institutions. These plans allow a taxpayer to either prepay a student’s qualified educational expenses at an eligible educational institution or contribute to an account that will be used to pay future expenses. A Section 529 functions somewhat like a Roth IRA account: the amounts contributed to a Section 529 plan are not deductible for federal tax purposes, but the earnings grow tax-free. - Contributions to a Section 529 are treated as gifts for tax purposes, which means that a donor can contribute up to the annual gift limit, without incurring any gift tax. The amounts contributed to a 529 are removed from the calculation of a donor’s gross estate (this is why 529 plans are commonly used for estate planning purposes). - Unlike a Coverdell ESA, a 529 plan does not impose age limits or income limits to contribute. Distributions from a 529 plan are reported to the taxpayer on Form 1099-Q.

Answer 180

- The beneficiary does not have to include in taxable income any earnings distributed from a 529 plan if the total distribution is less than or equal to a student’s qualified education expenses (after reduction of the latter by other tax-free education assistance received during the year). - “Qualified expenses” include tuition, fees, books, computer equipment, and software, and room and board for any time the beneficiary is enrolled in school. A beneficiary may be anyone the taxpayer designates: the taxpayer, a spouse, a child, a grandchild, or an unrelated person. - If the total distribution is greater than a student’s adjusted qualified expenses, an allocable portion of the earnings is taxable. In this type of taxable distribution, an additional excise tax of 10% generally applies to the amount included in income. - Any amount distributed from a 529 plan is not taxable if it is rolled over to another 529 plan for the use of the same beneficiary or for a member of the beneficiary’s family. The amount must be rolled over to another educational account within 60 days after the date of distribution.

Answer 181

- Also called “Education IRAs,” the Coverdell Education Savings Account (ESA) is a tax-advantaged investment account for higher education. A Coverdell is generally structured as a trust or custodial account set up to pay qualified elementary, secondary, or higher education expenses for a designated beneficiary. The funds in a Coverdell can be withdrawn tax-free when used for educational purposes. - Coverdell ESAs have income and age limits, but under certain conditions, they can offer more flexibility in investing. Coverdell accounts are self-directed, which means that there are a variety of investment options available, whereas 529 plans are limited to the state’s selected investment options. - Contributions to a Coverdell must be made before the beneficiary reaches age 18, and the use of the account must be made by age 30, unless the beneficiary is special-needs. If there is a balance in the ESA when the beneficiary reaches age 30, it must be distributed within 30 days of turning 30 (or within 30 days after the death, if before age 30 of the beneficiary). The beneficiary can also choose to transfer the ESA to another beneficiary (such as a younger sibling or another family member) to avoid the tax.

Answer 182

- Contributions to a Coverdell ESA are not tax-deductible, but amounts deposited in the account grow tax-free until they are later distributed. - There is no limit to the number of Coverdell accounts that can be established for a beneficiary; however, the total contribution to all accounts on behalf of a beneficiary cannot exceed $2,000 per year, no matter how many accounts are established. - All contributions that exceed $2,000 for a single beneficiary in a taxable year will be treated as excess contributions. There will be a 6% excise tax if the excess contributions and earnings on amounts that are not withdrawn. - The penalty for excess contributions is imposed on the beneficiary of the account (usually a minor child), and not on the person who over-contributed to the account. The excise tax must be reported on the child’s income tax return, using IRS Form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts. - This rule seems contrary to common sense, but the penalty is imposed on the child, not the child’s parents, or the contributor of the excess funds. - An additional penalty tax of 10% applies to distributions that are not used for qualifying educational expenses.

Answer 183

- If the beneficiary is special-needs, the Coverdell account can continue in existence (without transfer to another beneficiary) after the beneficiary turns 30.

Answer 184

- Other types of income that are taxable to the recipient and reported on Schedule 1 include the following (this list is not exhaustive): - Strike benefits, - Jury duty pay (when it is not turned over to the employee’s employer and deducted as an adjustment to income), - Alaska Permanent Fund dividends - Fees paid by an estate to a personal representative/executor, - Gifts or gratuities received by a host or hostess of a party or event where sales are made.

Answer 185

- An “adjustment to income” reduces taxable income and thus the amount of tax owed. Because adjustments are taken before AGI is calculated, they are designated as “above-the-line” deductions. - Adjustments to income are reported on Form 1040, Schedule 1, Additional Income and Adjustments to Income. - Adjustments are beneficial because they not only reduce taxable income, but a lower AGI may increase a taxpayer’s eligibility for certain credits and deductions and the amounts that he can claim. Unlike “below-the-line” deductions, adjustments are not added back when calculating the alternative minimum tax.

Answer 186

- This is sometimes called the “Teacher Credit” or the “Educator Expense Deduction.” An eligible educator is allowed to deduct up to $300 of unreimbursed expenses for books, supplies, computer equipment (including related software and services), other equipment, and supplementary materials used in the classroom. Professional development expenses are also allowed. - On a joint tax return, if both taxpayers are eligible, they each may take the deduction, up to a maximum of $600 ($300 each). Any educator expenses that exceed the $300 adjustment to income deduction cannot be deducted as unreimbursed employee business expenses on Schedule A. - Since this is an adjustment to income, teachers can deduct these expenses even if they do not itemize deductions. For courses in health and physical education, expenses are deductible only if they are related to athletics. - Nonathletic supplies for physical education and expenses related to health courses do not qualify. Materials used for homeschooling cannot be deducted. - An “eligible educator” must work at least 900 hours a school year in a school that provides elementary or secondary education (K-12). College instructors do not qualify. For the purposes of this credit, an “educator” includes a: - Teacher - Counselor - Principal - Teacher's aide - School coach

Answer 187

- Certain employees are allowed to claim specified work-related expenses as an adjustment to income. Although most employee-related business expenses are no longer deductible, business expenses for reservists, performing artists, and fee-basis government officials are still allowed. - Form 2106, Employee Business Expenses, is used to calculate the deduction. This adjustment applies only to reservists (members of the reserve component of the Armed Forces of the United States, National Guard, or the Reserve Corps of the Public Health Service), qualified performing artists; and state or local government officials who are compensated on a fee basis.

Answer 188

- HSA contributions are deductible as an adjustment to income on Form 1040. An HSA is always paired with a high-deductible health plan. Self-employed individuals can set up and contribute to an HSA, (but not to an FSA). And unlike an FSA, funds in an HSA do not expire from year-to-year. - Before a taxpayer can contribute to an HSA, the taxpayer must first be enrolled in a high-deductible health plan (HDHP). Once the HSA is set up, the taxpayer can take tax-free withdrawals from the HSA to pay for their qualifying medical expenses. To qualify for an HSA, the taxpayer: - Must not be enrolled in Medicare, - Cannot be claimed as a dependent on anyone else’s tax return, - Must be covered under a high deductible health plan and have no other health coverage, other than for a specific disease or illness; a fixed amount for a certain time period of hospitalization; or liabilities incurred under worker’s compensation laws or tort liabilities.

Answer 189

- An employee and the employer are both allowed to contribute to the employee’s HSA in the same year. If an employer makes an HSA contribution on behalf of an employee, it is excluded from the employee’s income and is not subject to income or payroll taxes. - HSA holders who are age 55 and older get to contribute an extra $1,000, beyond the regular limits (as detailed in the chart), as a catch-up contribution. - Any excess contributions over these limits are subject to a 6% penalty. Any amount the employer puts into the employee’s HSA counts toward the employee’s contribution maximum for the year. - The deduction for an HSA is reported on Form 8889, Health Savings Accounts. To claim the HSA deduction for a particular year, the HSA contributions must be made on or before that year’s tax filing date (without extensions).

Answer 190

- Allowable medical expenses are those that would generally qualify for purposes of the deduction for medical expense deduction. - Qualifying expenses also include over-the-counter medications without a prescription, as well as menstrual products. - Although an account holder can withdraw funds from an HSA at any time, withdrawals that are not used for qualifying medical expenses are generally subject to income tax. They may also be subject to a 20% penalty, except in the following instances: - When a taxpayer turns age 65 or older - When a taxpayer becomes disabled - When a taxpayer dies

Answer 191

- The Tax Cuts and Jobs Act eliminated the moving expense deduction for most taxpayers, with the exception of Armed Forces personnel moving pursuant to military orders or a permanent change of station. An employee of the armed forces is also allowed to deduct the costs of moving a spouse, dependents, and household goods or pets. - A “permanent change of station” includes: - A move from home to their first post of active duty, - A move from one permanent post of duty to another, and - A move from their last post of duty to a home or to a nearer point in the United States. - A service member cannot deduct any amounts that were already reimbursed by the government. Form 3903, Moving Expenses, is used to calculate the qualifying moving expenses of Armed Forces personnel.

Answer 192

- A self-employed taxpayer can subtract from income 50% of their self-employment tax, equal to the amount of Social Security and Medicare taxes that an employer normally pays for an employee, which is excluded from an employee’s income. The deduction is figured on Schedule SE. - A self-employed taxpayer cannot deduct one-half of the Additional Medicare Tax on earned income.

Answer 193

- When a taxpayer is self-employed, they have access to some of the same kinds of retirement plans that are utilized by larger employers. Self-employed individuals can deduct contributions to the following types of retirement plans: - Simplified Employee Pension (SEP) plans - Savings Incentive Match Plan for Employees (SIMPLE) plans - Qualified plans - A taxpayer must have self-employment income to contribute to his or her own plan. However, a self-employed taxpayer does not need to show a profit on Schedule C to contribute to an employee’s retirement plan.

Answer 194

- A self-employed taxpayer may be able to deduct 100% of their health insurance premiums as an adjustment to income (as long as the business has profits for the year). Premiums paid by the taxpayer for a spouse and dependents under age 27 are also deductible. The deduction is limited to the net profits from the business. The taxpayer must either: - Be self-employed and have a net profit for the year, - Be a partner in a partnership with net earnings from self-employment, or - Have received wages from an S corporation in which the taxpayer was a more-than-2% shareholder. - Long-term care insurance and Medicare premiums are also considered health insurance for purposes of this deduction. - A self-employed taxpayer may not take the deduction if either the taxpayer or their spouse (if MFJ) is eligible to participate in an employer-sponsored and subsidized health insurance plan, even if they decline coverage.

Answer 195

- If a taxpayer withdraws money from a certificate of deposit (CD) or other time-deposit savings account prior to maturity, the taxpayer usually incurs a penalty for early withdrawal. This penalty is charged by the bank or other financial institution and withheld from a taxpayer’s proceeds. - Taxpayers can take an adjustment to income for early withdrawal penalties. The penalties are reported on a taxpayer’s Form 1099-INT, which lists interest income as well as the penalty amount. - Note: Don’t be confused by this concept! It is frequently tested. Only the penalty for early withdrawal from a timed deposit (a certificate of deposit) is tax-deductible. The penalty for early withdrawal from an IRA or a retirement plan is never deductible.

Answer 196

- By definition, alimony is a payment to a former spouse under a divorce or separation instrument. - In order to deduct alimony paid, the payor’s Form 1040 requires the amount paid, recipient’s SSN, and the date of the original divorce or separation agreement. If the divorce decree was finalized before 2019, alimony paid is normally an adjustment to income for the payor. - Alimony received on a grandfathered divorce decree is generally treated as the mirror image, and is taxable income to the payee. - Voluntary payments that are not required by a divorce decree or separation instrument do not qualify as alimony.

Answer 197

- An individual retirement arrangement (IRA) offers tax advantages for setting aside money for retirement. Some taxpayers can claim a deduction for the amounts contributed to a traditional IRA as an adjustment to gross income. Only amounts contributed to a traditional IRA are deductible. Amounts that do not qualify for deduction include: - Contributions to a Roth IRA, - Contributions to a traditional IRA that are nondeductible because the taxpayer and/or spouse is covered by an employer-sponsored retirement plan and modified adjusted gross income (MAGI) exceeds certain limits, (covered later) - Contributions that apply to the previous tax year, - Rollover contributions. - Deductions are allowed in full for contributions to a traditional IRA by a taxpayer (and spouse, if married) who is not covered by a retirement plan at work. If the taxpayer (and/or spouse) is covered by a retirement plan at work, deductions are phased out at certain income levels. - Traditional and Roth IRAs are covered in much greater detail in Unit 16: Individual Retirement Accounts

Answer 198

- Generally, personal interest (other than mortgage interest) is not deductible. However, interest on a qualified student loan is deductible. A qualified student loan is a loan used solely to pay qualified higher-education expenses for the taxpayer, the spouse, or their dependents. A taxpayer can claim the deduction if: - The taxpayer paid interest on a qualified student loan on which they were legally obligated, - The filing status is not MFS, - Neither the taxpayer (nor their spouse, if filing jointly) can be claimed as a dependent on someone else’s return. - In order for student loan interest to qualify, the student must have been enrolled in a higher education program leading to a degree, certificate, or other recognized educational credential. The maximum deduction for student loan interest is $2,500. The student loan interest deduction limit is PER RETURN, NOT PER STUDENT.

Answer 199

- Qualifying higher-education expenses include the costs of attending an eligible educational institution, including graduate schools, such as: - Tuition and fees, - Room and board, - Books, supplies, and required equipment, and other necessary school-related expenses. - The amounts for qualified expenses must be reduced by the amounts of tax-free items used to pay them, such as tax-free scholarships and fellowships, and veterans’ educational assistance benefits. - A student loan is not eligible if it is from certain related persons (such as family members or certain corporations, partnerships, or trusts). Loans from an employer plan also do not qualify. - Lenders are required to send the taxpayer Form 1098-E, Student Loan Interest, when the amount of interest paid is at least $600 or more.

Answer 200

- Line 22 is reserved for future use (there is no deduction listed on that line). - Line 23 is the deduction for contributions to Archer MSA accounts. Archer MSA accounts are an older type of tax-advantaged medical savings account available to self-employed taxpayers and employees of small businesses with 50 or fewer employees. New Archer MSAs are no longer available. Archer MSA accounts are not listed on the EA exam content outlines.

Answer 201

- This is used as both the total for all adjustments to income as well as for writing-in more obscure deductions. Although these deductions are not frequently seen, they are still available. A taxpayer does not need to itemize in order to deduct these amounts. These “other adjustments” are listed in the instructions for Form 1040. - Jury duty pay remitted to an employer, - Deductible expenses related to the rental of personal property engaged in for-profit (this would be income from the rental of personal property (such as equipment or vehicles), when the taxpayer was not “in the business” of renting personal property), - Nontaxable amount of the value of Olympic and Paralympic medals and USOC prize money, - Reforestation amortization and expenses, - Repayment of supplemental unemployment benefits, - Contributions to section 501(c)(18)(D) pension plans, - Contributions by certain chaplains to section 403(b) plans, - Attorney fees and court costs for actions involving certain unlawful discrimination claims, but only to the extent of gross income from such actions. - Attorney fees and court costs paid in connection with an award from the IRS for information provided that helped the IRS detect tax law violations, up to the amount of the award includible in the taxpayer’s gross income. These awards are called “whistleblower awards” - Housing deduction from Form 2555 - Excess deductions of section 67(e) expenses from Schedule K-1 (Form 1041). These are deductions that are passed through to the beneficiary on the final return of an estate or trust. - Other adjustments for more obscure adjustments

Answer 202

- Publication 537, page 7, states that in some cases, the sales agreement or a later agreement may call for the buyer to establish an irrevocable escrow account from which the remaining installment payments (including interest) are to be made. These sales cannot be reported on the installment method. The buyer's obligation is paid in full when the balance of the purchase price is deposited into the escrow account. When an escrow account is established, the taxpayer no longer relies on the buyer for the rest of the payments, but on the escrow arrangement.

Answer 203

- An expense is for an improvement if it results in a betterment to the taxpayer’s property, restores the taxpayer’s property, or adapts the property to a new or different use. Table 1-1 of Publication 527, page 5, shows examples of many improvements. - In general, improvements add to the value of the property, prolong its useful life, or adapt it to new uses. (See also pages 4–5 of Publication 551 for examples of increases to basis.) Improvements include but are not limited to: - Putting a recreation room in an unfinished basement, - Adding a bathroom or bedroom, - Putting up a new fence, - Putting in new plumbing or wiring, - Putting on a new roof, and - Paving an unpaved driveway. - Furthermore, if a taxpayer makes improvements to the property, the cost of the improvement must be capitalized and depreciated as if the improvement were separate property. Replacement of old assets with new assets are generally considered improvements and as such, must be capitalized. However, if the taxpayer qualifies and makes a de minimis safe harbor election, the taxpayer may immediately deduct repairs and maintenance costs up to $2,500 per invoice per item.

Answer 204

- In this problem, Frank sells his property for $200,000 (item 1) and an adjusted basis for installment sale purposes of $120,000, which is the sum of $110,000 (item 2) and selling expenses of $10,000 (item 3). Hence, the gross profit percentage is 40%, which is the gross profit of $80,000 ($200,000 - $120,000) divided by the selling price of $200,000. Thus, Frank would report a gain of $20,000 in 2023, which is 40% of the $50,000 down payment. - Publication 537, pages 2 and 3, provides that an installment sale is a sale of property where a taxpayer receives at least one payment after the tax year of the sale. If the taxpayer realizes a gain on an installment sale, the taxpayer may be able to report part of the gain when it is received with each payment. This method of reporting gain is called the installment sale method. If the taxpayer prefers, they can elect out of the installment sale method and choose to report all of their gain in the year of sale. On the other hand, a taxpayer cannot use the installment method to report a loss (although it is unknown why a taxpayer would want to defer the write-off). (Publication 537, pages 4 and 5). - In the case of an installment sale, a certain percentage of each payment (after subtracting interest) is reported as installment sale income. This percentage is called the gross profit percentage and is figured by dividing the taxpayer's gross profit from the sale by the contract price. The gross profit percentage generally remains the same for each payment the taxpayer receives. (Publication 537, page 4). - To figure the adjusted basis and gross profit percentage for an installment sale, the following worksheet (see Worksheet A, Publication 537, page 3) is used.

Answer 205

C. 2, 4, and 5 - When a taxpayer rents property and incurs expenses, those expenses may either be expensed or capitalized and depreciated over a period of time. In determining which items to expense or depreciate, each expense must be categorized as a repair (expense) or improvement (depreciation). Expenses deemed to be repairs are those expenses that keep up the maintenance on the taxpayer's property and do not materially add to the value or useful life of his or her property. Repairs include but are not limited to repainting, fixing gutters or floors, fixing leaks, plastering, and replacing broken windows. (Publication 527, page 5) - On the other hand, expenses that add value and prolong the life of the property or adapt it to new uses are categorized as improvements and are treated as capital expense. These expenses must be deducted through depreciation, amortization, or depletion. Examples of improvements or capital expenses include additions, lawn and grounds, heating and air conditioning, plumbing, and interior improvements as given in Table 1-1 on page 5 of Publication 527. - Therefore, the costs of replacing a screen in the storm door, sowing grass seed in some bare spots on the lawn and buying a welcome mat for the front stoop are costs that should be expensed as repairs. The costs associated with replacing the heating system, building a detached 2-car garage, and installing a new dishwasher should be treated as capital expenses, and depreciated.

Answer 206

- Publication 590-A, pages 34 and 35, states, in part, that if any part of a taxpayer's contributions is an excess contribution for 2023, it is subject to a 6% excise tax. The taxpayer will not have to pay the 6% tax if any 2023 excess contributions including earnings on those contributions were withdrawn by April 15, 2024 (plus extensions).

Answer 207

C. $3,000 - Publication 544, pages 21 and 22, states, in part, that when a taxpayer receives property from a related party in a purchase or exchange, a loss is not allowable. Furthermore, if the taxpayer later sells or exchanges the property at a gain, the taxpayer recognizes the gain only to the extent that it is more than the loss previously disallowed to the related party. This rule applies only to the original transferee. - A loss on the sale or exchange of property between related persons is not deductible. This applies to both direct and indirect transactions, but not to distributions of property from a corporation in a complete liquidation. Publication 544, page 21, provides 13 situations that are classified as related parties. The second illustration states that a related party is one where the individual directly or indirectly owns more than 50% in value of the outstanding stock of the corporation. - The question's transaction is treated as a related party transaction. As a result, the $2,000 loss (sale price of $10,000 less an adjusted basis of $12,000) from the transfer of the car to Mark by the corporation is disallowed. Mark, as a result, has a basis of $10,000 (his purchase price). If Mark had sold the car for $7,000, he would have only been able to deduct his $3,000 loss. The $2,000 corporate loss would have benefited no taxpayer. Because Mark sold the car for $15,000, he realizes a gain of $5,000. However, he is allowed to reduce his gain by the loss disallowed of $2,000, so his recognized gain is equal to $3,000.

Answer 208

A. None of the expenses are deductible in 2023. - The Taxpayer Certainty and Disaster Tax Act of 2020 repealed the tuition and fees deduction for tax years beginning after 2020. - Note: The taxpayer may be entitled to claim the American Opportunity Credit or the Lifetime Learning Credit however those are not an option for this question. - Therefore, Anki cannot deduct any of the educational expenses in 2023.

Answer 209

D. Pension Income - Publication 590-A, page 6, provides that compensation includes wages, salaries, tips, professional fees, bonuses, and self-employment income. - Publication 590-A, page 7, provides that compensation does not include items such as pensions and annuity income and earnings and profits from property, such as rental income, interest income, and dividend income.

Answer 210

D. Ms. Miller should include $50,000 in income and use $50,000 as the basis for the storage facility. - In general, when property is received for services, the taxpayer includes the property's FMV in income, and the amount included in income becomes the basis of the property received. - If the services were performed for a price agreed on beforehand, it will be accepted as the FMV of the property if there is no evidence to the contrary. - In this case, Ms. Miller should include $50,000 in income and use the same amount as the basis for the storage facility.

Answer 211

- Fringe benefits received in connection with the performance of a taxpayer's services are included in income as compensation unless the taxpayer pays fair market value (FMV) for them or they are specifically excluded by law. In this case, there is no information to suggest that the fringe benefit is excluded by law; so the $2,000 must be included. (Publication 17, pages 47–48) - Pursuant to Publication 17, page 53, a taxpayer must report as income any amounts received for personal injury or sickness through an accident or health plan that is paid for by their employer. If both the taxpayer and employer pay for the plan, only the amount received that is due to the employer's payments is reported as income. - There are, however, some other sickness and injury benefits that are not taxable. These include the following amounts (Publication 17, page 53): 1. Compensatory damages received by the taxpayer for physical injury or physical sickness, whether paid in a lump sum or in periodic payments. 2. Benefits received by the taxpayer under an accident or health insurance policy on which either the taxpayer or the taxpayer's employer paid the premiums, but the taxpayer had to include them in his or her income. 3. Disability benefits received by the taxpayer for loss of income or earning capacity as a result of injuries under a no-fault car insurance policy. - As a result of the above information, Mr. and Mrs. Black would include $32,000 in income on their 2023 tax return, which is Mrs. Black's W-2 income and her $2,000 in fringe benefits that are not included in the W-2 income. Mr. Black's $5,000 in disability income, on the other hand, is not included because the cost of the policy was included in his pay.

Answer 212

- Pursuant to Publication 590-A, page 6, compensation in determining the amount of an allowable contribution to a traditional IRA includes wages, salaries, commissions, self-employment income, and alimony and separate maintenance payments. - If a taxpayer is self-employed, compensation for this purpose is the net earnings from the trade or business reduced by the total of: 1. The deduction for contributions made on the taxpayer's behalf to retirement plans and 2. The deduction allowed for the deductible part of a person's self-employment taxes. - Moreover, compensation includes earnings from self-employment even if they are not subject to self-employment tax due to religious beliefs. - Additionally, if there is a net loss from self-employment, this amount is not subtracted from salaries or wages when calculating total compensation. - Therefore, all of the responses given are true except a net loss from self-employment is not subtracted from any salary or wages received when figuring total compensation.

Answer 213

C. $1,800 - Pursuant to Publication 590-A, page 9, a taxpayer can contribute to his or her traditional IRA the smaller of $6,500 ($7,500 if the taxpayer is 50 or older) or the taxpayer's taxable compensation for the year (Publication 590-A, page 6). 1. Compensation includes items such as wages, salaries, commissions, self-employment income, alimony and separate maintenance payments, and nontaxable combat pay. 2. Compensation does not include items such as earnings and profits from property, interest and dividend income, pension or annuity income, deferred compensation, income from certain partnerships, and any amounts the taxpayer excludes from income (other than combat pay). (Publication 590-A, page 6) - In addition, compensation does not include government-provided unemployment compensation (IRC Section 219(f)(1) and Revenue Procedure 91-18). - As a result, Minnie's earned income for purposes of determining how much she can contribute to an IRA is $1,800, which is the sum of her wages of $800 and alimony of $1,000.

Answer 214

B. $0. - Publication 590-A, page 9, states that the maximum annual contribution to a person's traditional IRA is the smaller of $6,500 ($7,500 if age 50 or older) or the person's taxable compensation for the year. - If, however, a taxpayer is covered by an employer retirement plan and the taxpayer did not receive any Social Security benefits, his or her IRA deduction may be reduced or eliminated entirely depending on the taxpayer's filing status and modified AGI. That is, a single taxpayer is able to claim: 1. A full deduction if the taxpayer's modified AGI is $73,000 or less, 2. A partial deduction if the taxpayer's modified AGI is between $73,000 and $83,000, or 3. No deduction if the taxpayer's modified AGI is $83,000 or more. (Publication 590-A, page 13, Table 1-2) - Because Rena has a filing status of single, she is covered by a plan, and her modified AGI is $89,000 (over the threshold of $83,000), she cannot make a deductible IRA contribution in 2023. Hence, the correct response is $0. - Note: This question can appear in a variety of ways and, as such, needs to be read carefully.

Answer 215

B. Net short-term gains/losses and long-term gains/losses separately, then combine. - The determination of a taxpayer's capital gains or losses in a particular year goes through a process that is better known as the netting rules. That is, a taxpayer figures the total net gain or loss by combining the net short-term capital gain or loss (line 7 of Schedule D, Form 1040) with the net long-term capital gain or loss (line 15 of Schedule D, Form 1040). All short-term items are netted separately, and all long-term items are netted separately before the two are combined. - For more information on this issue, you should read Chapter 4 of Publication 550.

Answer 216

D. $45,000 for Alex and $40,000 for Arthur - Publication 541, page 7, provides that guaranteed payments are included in income in the partner's tax year in which the partnership's tax year ends. - Furthermore, the partner's distributive share of ordinary income from a partnership and guaranteed payments are subject to self-employment (SE) tax by including that amount on Schedule SE (Form 1040). (Schedule SE Instructions, page SE-1). - The exception to the above rule pertains to limited partners, which is not the case in this problem. Nevertheless, a limited partner generally does not include his or her distributive share of income or loss in computing net earnings from self-employment; however, limited partners do include guaranteed payments. (Schedule SE (Form 1040) Instructions, page SE-4) - Therefore, Alex would include $45,000 as self-employment income, which is the sum of $5,000 from guaranteed payments and $40,000 from his one-half share of the partnership's distributive net income (i.e., $80,000). Arthur, on the other hand, would include only $40,000, which is his one-half share of the partnership's distributive net income (i.e., $80,000).

Answer 217

A. $1,600. - The general rule for 2023 as given in Publication 590-A, page 9, is that the maximum annual contribution to a person's traditional IRA is the smaller of $6,500 ($7,500 if you are 50 or older) or the person's taxable compensation for the year if neither the taxpayer nor their spouse (if applicable) were covered by an employer retirement plan. - For IRA purposes, compensation includes any taxable alimony and separate maintenance payments the taxpayer receives under a decree of divorce or separate maintenance. (See Publication 590-A, page 6.) - Remember, for divorce or separation agreements executed after December 31, 2018, you may no longer deduct an amount equal to the alimony or separate maintenance payments paid during the tax year, nor will the alimony or separate maintenance payments be included in the gross income of the recipient spouse. - Compensation does not include items such as earnings and profits from property, such as rental income, interest income, dividend income, pension or annuity income, deferred compensation received (compensation payments postponed from a past year), income from a partnership for which the taxpayer did not provide services that are a material income-producing factor, or any amounts excluded from income (other than combat pay), such as foreign earned income and housing costs. (See Publication 590-A, page 7.) - The maximum contribution that Celeste can make into her traditional IRA is $1,600, which is the sum of her earned income of $1,200 and alimony of $400. The $1,500 of foreign income that has been excluded does not count toward compensation.

Answer 218

C. $3,250. - The general rule as given in Publication 590-A, page 9, is that the maximum annual contribution to a person's traditional IRA is the smaller of $6,500 ($7,500 if you are 50 or older) or the person's taxable compensation for the year. - If, however, a taxpayer is not covered by an employer retirement plan, but the taxpayer's spouse is, and the taxpayer did not receive any Social Security benefits, his or her IRA deduction may be reduced or eliminated entirely depending on the taxpayer's filing status and modified AGI (Publication 590-A, pages 13 through 15). Thus, a taxpayer that has a filing status of married joint is able to claim: 1. A full deduction if the couple's modified AGI is $218,000 or less, 2. A partial deduction if the couple's modified AGI is between $218,000 and $228,000, or 3. No deduction if the couple's modified AGI is $228,000 or more. (Publication 590-A, page 13) - Because Peter and Jill file as married joint, Jill is covered by a qualified plan, and their modified AGI is $223,000 (middle of the partial area), Peter (not covered by a plan) is able to contribute up to one-half of the annual contribution for 2023. That is, he may contribute up to $3,250 (50% of $6,500). - Note: As an aside, if Peter was 50 or older, he could contribute $3,750 (50% of $7,500). However, since no age is given, you must assume that he is under 50.

Answer 219

D. All of the answer choices are correct. - Publication 969, page 3, provides that a health savings account (HSA) may receive contributions from an eligible individual or any other person, including an employer or a family member, on behalf of an eligible individual. - Contributions, other than employer contributions, are deductible on the eligible individual's return whether or not the individual itemizes deductions. Employer contributions are not included in income. - Distributions from an HSA that are used to pay qualified medical expenses are not taxed.

Answer 220

B. Maude must pay self-employment tax on $15,000. - Publication 334, pages 40-41, provides the following information concerning self-employment tax and filing a joint return. If a taxpayer files a joint return, the taxpayer cannot file a joint Schedule SE. This is true whether one spouse or both spouses have earnings subject to SE tax. - In addition, a taxpayer's spouse is not considered self-employed just because the taxpayer is self-employed. If both of the spouses have earnings subject to SE tax, then each spouse must complete a separate Schedule SE. - In this case, Maude must pay self-employment tax on the $15,000 of profit that she made in her business.

Answer 221

C. He does not qualify for the optional self-employment tax computation. - Publication 334, page 40, provides that a self-employed taxpayer must pay self-employment (SE) tax and file Schedule SE (Form 1040) if the taxpayer's net earnings from self-employment were $400 or more. - In addition to the regular method for computing a person's SE tax, a person may want to use the optional method (see Publication 334, page 42, and Schedule SE (Form 1040) Instructions) when he or she has a loss or a small net profit and the taxpayer: 1. Wants to receive credit for Social Security benefit coverage, 2. Incurred child or dependent care expenses and could claim a credit, 3. Is entitled to the earned income credit, or 4. Is entitled to the additional child tax credit. - To qualify for use of the nonfarm optional method as given in Publication 334, page 42, the taxpayer must satisfy all of the following tests: 1. The taxpayer is self-employed on a regular basis. This means that actual net earnings from self-employment were $400 or more in at least 2 of the 3 tax years before the current taxable year for which this method is being elected. The net earnings can be from either farm or nonfarm earnings or both, and 2. The taxpayer has used this method less than 5 years. (There is a 5-year lifetime limit.) The years do not have to be one after another, and 3. The taxpayer's net nonfarm profits were less than $7,103, and less than 72.189% of the taxpayer's gross nonfarm income. - The facts given in this problem do not satisfy the first test of $400 in at least 2 of the 3 years. Therefore, the taxpayer does not qualify for the optional self-employment tax computation.

Answer 222

D. $275,000. - A taxpayer's basis is the amount of a taxpayer's investment in property for tax purposes. The basis of property that is received as a gift is the same as the donor's adjusted basis at the time of gift if the fair market value of the property is equal to or greater than the donor's adjusted basis. Therefore, Jane's basis in the property received from Charles is $275,000, which is calculated as the sum of the adjusted basis to Charles on the date of the gift of $250,000 and the additional cost for the roof of $25,000. (Publication 551, page 9) - Publication 551, page 10 provides that if the property is converted from personal to business, the basis is the lesser of the following two amounts: 1. The FMV of the property on the date of the conversion 2. The adjusted basis on the date of the conversion - In this case, we must assume that the adjusted basis of the gifted property is less than the FMV on the date of conversion since information to the contrary is not provided. Therefore, Jane's basis in the property is $275,000.

Answer 223

B. The discount amount is reported as income. - Publication 17, page 68, states, in part, that if a taxpayer's financial institution offers a discount for the early payment of the taxpayer's mortgage loan, the amount of the discount is canceled debt, and as such, the amount is included in gross income of the taxpayer. - Be careful, however; there are several exceptions to the inclusion of canceled debt in income. (See Publication 17, page 68 and Publication 525, page 21, and Publication 4681, page 9 for more details on excluded debt.) Since the facts in this question do not indicate that there is an exception, you cannot assume that is the case.

Answer 224

Deductions and Credits

Answer 225

- The Tax Cuts and Jobs Act (TCJA) made sweeping changes to the standard deduction and itemized deductions. The standard deduction nearly doubled after the enactment of the TCJA. As a result, fewer taxpayers are forced to itemize. - Many itemized deductions have been eliminated or restricted through 2025. The TCJA also temporarily removed the so-called “Pease limitation” on itemized deductions, which means that itemized deductions will no longer be phased out at higher income levels. - A taxpayer generally may choose either to claim a standard deduction amount or to itemize deductions. Depending on the option selected, either the applicable standard deduction amount or the taxpayer’s total itemized deductions is subtracted from his or her adjusted gross income. The choice should be based on which option results in a lower tax liability.

Answer 226

- The standard deduction is a specific dollar amount that reduces the amount of income on which a taxpayer is taxed. Using the standard deduction eliminates the need for a taxpayer to itemize. - An additional standard deduction is available to taxpayers who, at the end of the year, are: - 65 or older, and/or - Blind or partially blind

Answer 227

- The 2023 additional standard deduction is $1,500 for joint filers who are over 65 and/or blind, and $1,850 higher for unmarried taxpayers (single and head of household).

Answer 228

- The standard deduction for a deceased taxpayer is the same as if the taxpayer had lived the entire year, with one exception: If the taxpayer died before his actual 65th birthday, the higher standard deduction for being 65 does not apply.

Answer 229

- The additional amount for blindness is allowed if the taxpayer is blind on the last day of the tax year, even if the taxpayer was not blind the rest of the year. A taxpayer must obtain a statement from an eye doctor indicating that: - The taxpayer cannot see better than 20/200, even when corrected with eyeglasses, or - The taxpayer’s field of vision is not more than 20 degrees (the taxpayer has disabled peripheral vision).

Answer 230

- A dependent’s standard deduction for 2023 is limited to the greater of: (1) $1,250, or (2) their earned income plus $400 (but the total can't be more than the basic standard deduction for their filing status). - The standard deduction amount can be higher if the dependent happens to be 65 or older and/or blind.

Answer 231

- Itemized deductions may be taken in lieu of the standard deduction; they allow taxpayers to reduce their taxable income based on specific personal expenses. In most cases, taxpayers may choose whether to claim itemized deductions or the standard deduction, depending on which is more beneficial. However, the following taxpayers are required to itemize, and cannot take the standard deduction: - MFS filers: If both spouses are filing MFS, and one spouse itemizes, the other spouse also must itemize (or else deduct $0 as a standard deduction). As such, in lieu of a $0 standard deduction, they both must itemize. - Nonresident Aliens: If the taxpayer is a nonresident alien or dual-status alien filing Form 1040-NR (who is not married to a U.S. citizen or U.S. resident). - Short tax year: If the taxpayer files a tax return for a period of less than twelve months due to a change in accounting methods (this scenario would be extremely rare for an individual taxpayer). - Itemized deductions are reported on Schedule A, Form 1040. Nonresident aliens can also claim a limited amount of itemized deductions on Schedule A, Form 1040-NR. We will review the specific requirements for various itemized deductions next.

Answer 232

- Medical and dental expenses (other than self-employed health insurance premiums) are deductible only if a taxpayer itemizes deductions. Qualifying medical expenses include the costs of diagnosis, cure, mitigation, treatment, or prevention of disease, and the costs of medical (but not cosmetic) treatments. - A taxpayer may only deduct medical expenses they paid during the year, regardless of when the services were provided (an exception exists for deceased taxpayers) - Medical expenses must be primarily to alleviate or prevent a physical or mental defect or illness. Medical expenses do not include expenses that are merely beneficial to general health, such as vitamins, spa treatments, gym memberships, or vacations. - A taxpayer can deduct medical expenses paid on behalf of an adopted child, even before the adoption is final. A taxpayer can also deduct medical expenses paid for a dependent parent. All the standard rules for a dependency exemption apply, so the dependent parent does not have to live with the taxpayer to qualify.

Answer 233

- Note: If a child of divorced or separated parents is claimed as a dependent on either parent’s return, each parent can deduct medical expenses they individually paid for the child. This is true even if the other parent claims the child’s dependency exemption. Basically, it doesn’t matter which parent claims the child—the medical expenses are deductible for the parent that pays them.

Answer 234

- Taxpayers can deduct only the amount of unreimbursed medical expenses that exceed 7.5% of adjusted gross income (AGI).

Answer 235

- The Tax Cuts and Jobs Act instituted a cap on State and Local taxes (also called the “SALT cap”). The deduction for state and local income, sales or property taxes (on a combined basis) is capped at $10,000 ($5,000 for MFS filers). - Taxpayers can deduct certain taxes if they itemize deductions. To be deductible, a tax must have been imposed on the taxpayer and paid by the taxpayer during the tax year. Deductible taxes include: - State, local, and foreign income taxes, - State and local sales taxes, - Real estate taxes (but not for foreign real estate), - Personal property taxes (such as DMV fees).

Answer 236

- Note: The Tax Cuts and Jobs Act eliminated the deduction for foreign real estate taxes. These taxes are no longer deductible on Schedule A as an itemized deduction. Foreign income taxes are still deductible, however. Foreign income taxes are not subject to the SALT cap. State and local taxes are reported on lines 5a, 5b, and 5c of Schedule A. Foreign Income tax is listed on line 6, “Other Taxes.”

Answer 237

- Taxpayers are allowed to deduct certain types of interest. Qualified interest payments are deductible as itemized deductions on Form 1040, Schedule A. Deductible interest includes: - Home mortgage interest, - Late fees on a mortgage loan, - Points on a mortgage loan, - Investment interest expense. - Home mortgage interest is paid on a loan secured by a taxpayer’s home. A taxpayer is allowed to deduct the interest related to a primary residence and a second home. The maximum amount of qualified acquisition Indebtedness secured by a qualified primary or secondary residence to allow a full deduction for home mortgage interest is $750,000 ($375,000 for MFS). - If the qualified acquisition indebtedness was incurred on or before December 15, 2017, then the grandfathered limit of $1 million ($500,000 MFS) applies.

Answer 238

- The TCJA suspended all the miscellaneous itemized deductions subject to the 2%-of-AGI floor, which includes the deduction for investment expenses, (for example, safe deposit fees, trustee fees, and investment advisor fees). However, the TCJA did not repeal the deduction for investment interest expense. Investment interest expense is any interest incurred on loans used to purchase taxable investments. - The amount of investment interest expense a taxpayer can deduct each year is limited to the amount of net investment income earned. However, the taxpayer can carry forward any disallowed investment interest expense to the next year. - A common type of investment interest expense is margin interest. One way investors borrow funds from brokerage houses is through margin accounts. The investor uses the loan to purchase stocks and bonds without having to invest the full amount in cash.

Answer 239

- The following expenses CANNOT be deducted as investment interest: - Interest on personal loans, such as car loans - Fees for credit cards and finance charges for nonbusiness credit card purchases - Loan fees for services needed to get a loan - Interest on debt the taxpayer is not legally obligated to pay - Service charges - Interest to purchase or carry tax-exempt securities - Late payment charges paid to a public utility - Expenses relating to stockholders’ meetings or investment-related seminars - Interest expenses from single-premium life insurance and annuity contracts - Interest incurred from borrowing against an insurance policy - Short-sale expenses - Fines and penalties paid to any government entity for violations of the law.

Answer 240

- Taxpayers can elect to deduct cash contributions up to 60% of adjusted gross income. The 60%-of-AGI limit applies to cash contributions only—not real estate, not stocks, not furniture, or any other types of noncash donations. Donations of property are treated differently. There are four major AGI limits: - The 60% limit: applies to cash contributions to a public charity, specifically, 501(c)(3) organizations. Noncash property contributions do not qualify for this limit. - The 50% limit: This limit applies to most noncash contributions to public charities. Examples of noncash contributions include furniture, clothing, and housewares. This limit also applies to most conservation easements. - The 30% limit: This limit applies to donations of most appreciated capital gain property (property that would have resulted in a long-term capital gain if sold instead of donated) where the donor can claim the FMV as a deduction. Common examples include stock, cryptocurrency, land, or other real estate that has appreciated in value. - The 20% limit: This limit applies specifically to gifts of appreciated capital gain property to most private nonoperating foundations and certain other non-public charities.

Answer 241

- Qualifying Public Charities include: nonprofits organized solely for charitable, religious, educational, scientific, or literary purposes or for the prevention of cruelty to children or animals such as: - Churches, mosques, synagogues, and similar religious organizations, - Nonprofit hospitals, - Most schools and colleges, - State or federal government entities, - Organizations that foster youth sports, or national or international amateur sports competition (examples include: Little League Baseball and Softball, the Olympics, Special Olympics, and the Paralympic Games).

Answer 242

- A taxpayer’s contributions to other types of nonprofit organizations are limited to either 30% or 20% of AGI. The 30% limit applies to organizations that include the following: - Certain private nonoperating foundations, - Veterans organizations and fraternal benefit societies (such as the Knights of Columbus, the Freemasons, and the Shriners), - Nonprofit cemeteries. - In addition, a separate 30% limit applies in the following cases: - Gifts for use by the charitable organization (such as the donation of a vehicle the organization uses for itself), - Gifts of appreciated property (also called capital gain property). - The 20% limit applies to contributions of capital gain property to organizations subject to the 30% limit.

Answer 243

- To the extent a taxpayer’s deductions for contributions are limited; they may be carried over to subsequent years. However, the carryover period is generally limited to five years. Any carryover amounts that cannot be deducted within five years due to AGI limits are lost. - Any contributions made by the taxpayer and carried over to future years retain their original character. For example, contributions made to a 30% organization continue to be subject to the 30%-of-AGI limit in future years.

Answer 244

- In order to claim deductions for noncash donations, the donated items must be in good condition. In most cases, the taxpayer will be able to claim a deduction for the fair market value of the contribution (generally, what someone would be willing to pay at a garage sale or thrift store). No deduction is allowed for items that are in poor or unusable condition. Deductible contributions may include: - Unreimbursed expenses that relate directly to the services the taxpayer provided for the organization. - The amount of a contribution in excess of the fair market value of items received, such as merchandise and tickets to a charity ball. - Transportation expenses, including bus fare, parking fees, tolls, and either the actual cost of gas and oil or a standard mileage deduction of 14 cents per mile. - Volunteer Expenses: A taxpayer cannot deduct a monetary value for hours spent volunteering. However, taxpayers are allowed to deduct out-of-pocket costs related to their volunteer work for qualifying organizations.

Answer 245

- Not all nonprofit organizations qualify as charitable organizations for purposes of donors being able to claim tax deductions. The following are examples of that do not qualify as deductible charitable contributions: - Gifts to civic leagues, social and sports clubs, and Chambers of Commerce, - Gifts to groups run for personal profit, - Gifts to political groups, candidates, or political organizations, - Gifts to homeowner’s associations, - Donations made directly to individuals, - The cost of raffle, bingo, or lottery tickets, even if the raffle is part of a qualified organization’s fundraiser, - Dues paid to country clubs or similar groups, - Gifts and dues to labor unions, - Blood donated to a blood bank or to the Red Cross (although the mileage incurred to donate blood may be deductible), - Any part of a contribution that benefits the taxpayer, such as the FMV of a meal eaten at a charity dinner, - Donors who purchase items at a charity auction may claim a charitable contribution deduction only for the excess of the purchase price paid for an item over its fair market value.

Answer 246

- Here are the basic rules for ALL charitable gifts: - At a minimum, the donor must have at least a bank record or a written receipt (or written acknowledgment) from a charity for any cash contribution before the donor can claim a charitable deduction. - The donor is responsible for obtaining a written receipt from a charity for any single contribution of $250 or more before he or she or she can claim a charitable deduction.

Answer 247

- Cash Donations of LESS than $250: Cash contributions include those paid by cash, check, debit card, credit card, or payroll deduction. If the value of an individual donation is less than $250, the taxpayer must keep a reliable written record. - Cash Donations of $250 or MORE: For cash donations of $250 or more, the taxpayer must have a receipt or a written acknowledgment from the organization that includes: - The amount of cash the taxpayer contributed, - The date of the contribution, - Whether the qualified organization gave any goods or services as a result of the contribution. And If applicable, a description and a good faith estimate of the value of goods or services provided by the organization as a result of the contribution (if applicable). - A single annual statement from the charitable organization may be used to substantiate multiple contributions of $250 or more. These are also commonly called “donor acknowledgment letters.” There is no specific IRS form for the acknowledgment.

Answer 248

- Noncash Contributions of Less than $250: For each contribution of less than $250, the taxpayer must obtain a receipt from the receiving organization and keep a list of the items donated. - Noncash Donations between $250 and $500: For each contribution of at least $250, but not exceeding $500, the taxpayer must have the same documentation as described above, for noncash contributions less than $250. In addition, the organization’s written acknowledgment must state whether the taxpayer received any goods or services in return and included a description and a good faith estimate of the fair market value of any such items. - Noncash Donations Over $500: If a taxpayer’s total deduction for all noncash contributions for the year is more than $500, he must also file Form 8283, Noncash Charitable Contributions. - Noncash Donations Over $5,000: If any single donation or a group of similar items is valued at more than $5,000, a qualified appraiser is required to make a written appraisal of the donated property. The taxpayer must also complete Form 8283, Section B, and attach the form to his or her tax return. The taxpayer generally does not have to attach the appraisal itself but must retain a copy for his or her records. - For donations of artwork valued at more than $20,000, or property valued at more than $500,000, the appraisal itself must be included with the tax return.

Answer 249

- Special rules apply to any donation of vehicles, including boats and airplanes. If the taxpayer claims a deduction of more than $500, he or she can only deduct the smaller of: - The gross proceeds from the sale of the item by the charity, or - The fair market value on the date of the contribution. - The charitable organization should provide Form 1098-C, Contributions of Motor Vehicles, Boats, and Airplanes, which shows the gross proceeds from the sale of the vehicle donated. If the taxpayer does not attach Form 1098-C, the maximum deduction that can be taken for the donation is $500. - Two exceptions apply to the rules regarding vehicle donations: - If the charity keeps the vehicle for its own use, the taxpayer can generally deduct the vehicle’s FMV. - If the charity gives the vehicle directly to a needy person, the taxpayer can generally deduct the vehicle’s FMV.

Answer 250

- The Tax Cuts and Jobs Act suspended the itemized deduction for most personal (i.e., non-business) casualty and theft losses through tax year 2025. Only personal losses derived from federally declared disaster areas are deductible. - Personal casualty and theft losses attributable to a federally declared disaster (FEMA disaster) are subject to a $100-per-casualty and 10%-of-adjusted gross income (AGI) limit. These limitations only apply to personal casualty losses (losses of nonbusiness property). - The casualty loss deduction on a personal-use asset is the lesser of (1) the decrease in the fair market value of the property (before and after the casualty event) or (2) the taxpayer’s adjusted basis in the property at the time of the casualty event. - Casualty losses of investment property are treated differently and covered in the next section. Business casualty losses are covered in more detail in Part 2, Businesses.

Answer 251

- The Tax Cuts and Jobs Act suspended miscellaneous itemized deductions subject to the 2%-of-AGI floor through 2025. There are still some miscellaneous itemized deductions that a taxpayer can deduct on Schedule A. These are less commonly seen, but some of them are still tested on the EA exam. Miscellaneous itemized deductions that are still allowable include: - The amortizable premium on taxable bonds, - Casualty and theft losses from “income-producing” property, - Federal estate tax on income “in respect of a decedent” (IRD), - Gambling losses to the extent of gambling winnings, - Impairment-related work expenses of persons with disabilities, - Losses from Ponzi-type investment schemes (fraudulent investment schemes), - Excess deductions of an estate or trust in the entity’s final tax year, - Repayments of more than $3,000 under a claim of right, - Unrecovered investment in an annuity.

Answer 252

- These are expenses that enable a disabled person to work, such as special equipment or attendant care services at the workplace. Impairment-related work expenses must be incurred in connection with the taxpayer’s place of work, or necessary for the taxpayer to be able to work.

Answer 253

- A tax credit directly reduces a taxpayer’s liability on a dollar-for-dollar basis. - Various types of tax credits are either refundable or nonrefundable.

Answer 254

- A nonrefundable tax credit reduces a taxpayer’s liability for the year to zero but not beyond that, so any remaining credit is not refunded to the taxpayer. The most common nonrefundable tax credits available are: - Foreign Tax Credit (covered later) - Adoption Credit - American Opportunity Tax Credit (although the AOTC has a refundable component) - Lifetime Learning Credit - Retirement Savings Contributions Credit or, the “Saver’s Credit” - The Credit for Other Dependents (ODC) - Child and Dependent Care Credit - Child Tax Credit (CTC) (the CTC also has a refundable component)

Answer 255

- A refundable tax credit can reduce a taxpayer’s liability to zero and also generate a refund to the taxpayer for the amount by which the credit exceeds the amount of tax he or she would otherwise owe. Refundable tax credits include the following: - Additional Child Tax Credit (ACTC) - The Earned Income Tax Credit (EITC) - Premium Tax Credit (related to the Affordable Care Act, covered later) - American Opportunity Tax Credit (partially refundable) - Credit for excess Social Security and RRTA tax withheld

Answer 256

- Stringent diligence requirements apply to Tax Preparers who prepare returns claiming the Earned Income Tax Credit (EITC), the Child Tax Credit (CTC/ACTC), and the American Opportunity Tax Credit (AOTC). Due diligence requirements also apply to the determination of Head of Household filing status. - Tax preparers must complete Form 8867, Paid Preparer’s Due Diligence Checklist, for each EITC, CTC/ACTC, or AOTC claim they prepare. - In the past, a taxpayer was allowed to amend their return to claim these credits retroactively after a valid taxpayer identification number was issued, but this is no longer permitted. This includes the filing of an original return past the due date (including extensions) if the taxpayer failed to timely file.

Answer 257

- The Child and Dependent Care Credit (CDCTC) is not refundable in the current year. - This credit allows a taxpayer a credit for a percentage of childcare expenses for children under age 13 and/or for disabled dependents of any age. - This is a credit for childcare expenses that allow taxpayers to work or to seek work. If a taxpayer receives a reimbursement under a flexible spending account, the amount is treated as being pretax, and the taxpayer must deduct the reimbursed amount from their qualified expenses to determine the credit. - The maximum amount of care expenses used to calculate the credit is $3,000 for one qualifying dependent, or $6,000 for two or more qualifying dependents. - The amount of the credit ranges between 20% to 35% of qualified expenses, with the maximum credit being 35% of a taxpayer’s qualifying daycare expenses.

Answer 258

- For purposes of the Child and Dependent Care Credit, a “qualifying person” is: - A dependent child under the age of 13 (at the time the care was provided) - A spouse who is physically or mentally disabled - Any other disabled dependent (such as a dependent parent). - A disabled person that the taxpayer could claim as a dependent except the disabled person had gross income that exceeds the deemed exemption amount (IRC Section 21(b)(1)(B)).

Answer 259

- The following kinds of expenses qualify for the credit. - Preschool education: Preschool or other programs below the level of kindergarten. Expenses to attend kindergarten or a higher-grade level are not qualifying expenses. - After-school care: Daycare that is after-school care (or before school) for a child in kindergarten or above. Childcare expenses incurred during the summer and throughout the rest of the year are also qualifying expenses if the expenses are incurred in order to allow parents to work. - Disabled care: Adult daycare or supportive care for a disabled dependent or spouse (of any age, there is no age limit when the person is disabled). - Transportation costs: Costs incurred for a care provider to take a qualifying person to or from a place where care is provided. - Fees and Deposits: Any fees and deposits paid to a daycare or preschool to acquire childcare. - Household services: If they are at least partly for the well-being and protection of a qualifying person (such as the services of a full-time nanny or in-home care aide)

Answer 260

- Nonqualifying expenses: Examples of childcare expenses that do not qualify for the credit include: - Tuition for children in kindergarten and above (i.e., private elementary school costs), - Summer school or tutoring programs, - The cost of sending a child to an overnight camp (but day camps generally do qualify), - The cost of transportation not provided by a daycare provider, - A forfeited deposit to a daycare center (since it is not for care and therefore not a work-related expense). - Qualifying care expenses also do not include amounts paid for food, clothing, education, or entertainment. Small amounts paid for these items, however, can be included if they are incidental and cannot be separated from the cost of care.

Answer 261

- If a taxpayer’s filing status is married filing separately, and all of the following apply, the taxpayer is still permitted to claim the credit on Form 2441. - The taxpayer lived apart from their spouse during the last 6 months of the year. - The taxpayer’s home was a qualifying person's home for more than half the year. - The taxpayer paid more than half of the cost of keeping up the home.

Answer 262

- The Child Tax Credit (CTC) is totally separate from the Child and Dependent Care Credit. Do not confuse these two credits! - The nonrefundable Child Tax Credit is $2,000 per qualifying child - The refundable Additional Child Tax Credit is a maximum of $1,600 per qualifying child in 2023 - The AGI phaseout for the Child Tax Credit is $200,000 ($400,000 for joint filers). If income exceeds the limit, the credit will decrease by $50 for every $1,000 that the AGI exceeds the limit. - The child must have a valid Social Security number to qualify for the Child Tax Credit. ITINs and ATINs are not sufficient. - Taxpayers with income below certain threshold amounts can claim the Child Tax Credit for each qualifying child under the age of 17. - Unlike the Earned Income Tax Credit, disability has no effect on the eligibility for this credit. The child’s age is the primary determining factor.

Answer 263

- A taxpayer whose tax liability is zero cannot take the Child Tax Credit because there is no tax to reduce. - The Child Tax Credit is limited to the amounts of regular income tax and any alternative minimum tax owed. - However, a taxpayer with zero tax liability may be able to take the Additional Child Tax Credit, which is a refundable credit. - In order to qualify for the Additional Child Tax Credit, the taxpayer must have “earned income,” such as wages or income from self-employment. - Schedule 8812 is used for figuring and reporting the Child Tax Credit as well as the Credit for Other Dependents.

Answer 264

- To be eligible to claim the Child Tax Credit, the taxpayer must have at least one qualifying child. To qualify, the child must meet the following tests: - Age Test: The child must have been younger than 17 at the end of the year. - Relationship Test: The child must be the taxpayer’s child, stepchild, foster child, sibling, stepsibling, half-sibling, or a descendant of any of them. Adopted children always qualify as the taxpayer’s own child. - Support Test: The child must not provide more than half of their own support. - Dependency Test: The child must be a dependent claimed on the tax return. A noncustodial parent may claim the child tax credit for their child if the parent is allowed to claim the child as a dependent and otherwise qualifies to claim the child tax credit. - Joint Return Test: The child cannot file a joint return for the year unless the only reason they are filing is to claim a refund, and otherwise the child would not have a tax liability. - Citizenship Test: The child must be a U.S. citizen or U.S. resident alien with a valid Social Security Number. An ITIN or ATIN is not acceptable. - Residency Test: In most cases, the child must have lived with the taxpayer for more than half of the year (over six months). Exceptions exist for temporary absences and children who are born or die within the year.

Answer 265

- The Additional Child Tax Credit is the refundable component of the Child Tax Credit. In order to claim the Additional Child Tax Credit, a taxpayer must be able to claim the Child Tax Credit, even if the taxpayer does not qualify for full refundability. - Unlike the nonrefundable Child Tax Credit, the Additional Child Tax Credit is refundable, and it can produce a refund even if the taxpayer does not owe any tax. The additional child tax credit allows eligible taxpayers to claim up to $1,600 for each qualifying child in 2023. The ACTC is based on the lesser of: - 15% of the taxpayer’s taxable earned income that is over $2,500 or, - The amount of unused Child Tax Credit (caused when the tax liability is less than the allowed Child Tax Credit)

Answer 266

- Taxpayers cannot claim the refundable ACTC if they also claim the foreign earned income exclusion (Form 2555). - Taxpayers filing Form 2555 can still claim the non-refundable portion of the Child Tax Credit.

Answer 267

- The $500 “Credit for Other Dependents” or “Other Dependent Credit” (ODC) applies to dependents who do not qualify for the Child Tax Credit, such as children who are over the age threshold or other dependents (such as elderly parents). - Taxpayers cannot claim the ODC credit for themselves or a spouse; in other words, the credit is only available for dependents who are listed on the return. - The dependent must be a U.S citizen, U.S. national, or U.S. resident. The AGI phaseout for the Credit for Other Dependents is $200,000 for unmarried taxpayers and $400,000 for joint filers. - To claim the Credit for Other Dependents, the dependent must have a valid identification number (ITIN or SSN) by the due date of the return (including extensions).

Answer 268

- In 2023, a nonrefundable credit of up to $15,950 per child can be taken for qualified expenses paid to adopt a child. An eligible child is: - Under 18 years of age, or - Physically or mentally disabled, regardless of age. - Unlike most other tax credits, the adoption credit has the same phaseout range for all filing statuses. The MAGI phaseout range in 2023 starts at $239,230 and ends at $279,230 for all filing statuses. - If a taxpayer’s MAGI is higher than $279,230 in 2023, they cannot claim the adoption credit.

Answer 269

- For a special-needs child, the maximum credit amount is allowed even if the taxpayer does not have any adoption expenses. - In making the determination about special needs, a state may take into account the following factors: a child’s ethnic background and age; whether the child is a member of a minority or sibling group; and whether they have a physical, mental, or emotional handicap. The child does not have to be disabled for the child to qualify as “special needs.” - For the purposes of this rule, a special needs child must be a U.S. citizen or U.S. resident when the adoption begins. - Although the adoption credit is nonrefundable, any unused credit may be carried forward for up to five years. - Taxpayers who file MFS cannot claim the Adoption Credit.

Answer 270

- Qualified adoption expenses must be directly related to the adoption of the child. Qualifying expenses may include: - Adoption fees and court costs, attorney fees, - Travel expenses related to the adoption, including meals and lodging, - Costs of an unsuccessful adoption (a FAILED adoption) of a U.S. citizen or U.S. national, - Re-adoption expenses to adopt a foreign child. - Qualified expenses do not include: any illegal adoption expenses, any surrogate parenting arrangement, or the adoption of a spouse’s child.

Answer 271

- Timing of the Payment: Adoption expenses are generally deductible in the year the adoption becomes final, with a few exceptions. - Domestic adoptions: with the adoption of a domestic child, qualified expenses paid before the year in which the adoption becomes final may be claimed in the year after the expenses were paid. This is true even if the adoption is unsuccessful. - Foreign adoptions: for a foreign adoption, expenses paid before or during the adoptive process are only deductible once the adoption actually becomes final. - Post-adoption expenses: Any additional expenses paid after an adoption becomes final (for example, additional legal fees related to the adoption), then those expenses would be allowed in the year paid, regardless of whether or not the adoption was foreign or domestic.

Answer 272

- Two education credits are available based on qualified expenses a taxpayer pays for post-secondary education: - American Opportunity Tax Credit (AOTC) - Lifetime Learning Credit - Certain general rules apply to both of these credits, and there are also specific rules for each. To claim the credit for a dependent’s education expenses, the taxpayer must claim the dependent on their return. A taxpayer cannot claim education credits if he or she: - Can be claimed as a dependent on someone else’s tax return, - Files MFS, - Has adjusted gross income above the phaseout limit.

Answer 273

- Form 8863, Education Credits, is used to figure and claim both education credits. Qualified education expenses are tuition and related expenses, such as books and other course materials required as a condition of enrollment. - Qualified education expenses must be reduced by the amount of any tax-free educational assistance received, such as Pell grants, tax-free portions of scholarships, and employer-provided educational assistance. - Education expenses that do not qualify include: - Room and board, (even if the housing is on-campus and a condition of enrollment) - Any medical expenses, including student health fees, even if charged by the college - Other insurance costs - Transportation costs - Personal, living, or family expenses

Answer 274

- The American Opportunity Tax Credit (also referred to as the AOTC or AOC) allows taxpayers to claim a maximum credit of up to $2,500 for each eligible student. The credit covers 100% of the first $2,000 and 25% of the second $2,000 of eligible expenses per student. - Qualified expenses include tuition and required fees, books, supplies, equipment, and other required course materials (but not room and board or student health fees). - Unlike other education credits and deductions, the American Opportunity Tax Credit is partially refundable. Up to 40% of the credit is refundable, which means the taxpayer can receive up to $1,000 even if no taxes are owed. Requirements for the AOTC are as follows: - Degree requirement: The student must be enrolled in a program that leads to a degree, certificate, or other recognized educational credential. Taking classes merely for fun or recreation does not qualify. - Workload: For at least one academic period of the year, the student must carry at least half of the normal full-time workload for his or her course of study. - No felony drug conviction: The student must not have any felony convictions for possessing or distributing a controlled substance. - Four years of postsecondary education: The credit can be claimed only for expenses related to a student’s post-secondary education and only for a maximum of four years.

Answer 275

- The Lifetime Learning Credit is a nonrefundable tax credit of 20% of qualified tuition, fees, and any amounts paid directly to the educational institution for required books, supplies and equipment, up to $10,000, paid during the tax year. - The maximum credit is $2,000 per tax return, not per student. A family’s maximum credit is the same regardless of the number of qualified students. The requirements for the Lifetime Learning Credit differ from those for the AOTC as follows: - No workload requirement: A student is eligible no matter how few courses he or she takes. - Non-Degree courses eligible: A student qualifies if the student is simply taking a course to acquire or improve job skills. There is no degree requirement. - All levels of postsecondary education: A student may be an undergraduate, graduate, or professional degree candidate. The courses can also be just for professional development. - An unlimited number of years: There is no limit on the number of years for which the credit can be claimed for each student. - Felony drug convictions permissible: A student can be convicted for a felony drug conviction and still qualify.

Answer 276

- A taxpayer cannot claim both the American Opportunity Credit and the Lifetime Learning Credit for the same student in one year. However, if a taxpayer incurs education expenses for multiple students, the taxpayer may be eligible to take the American Opportunity Credit for one student and the Lifetime Learning Credit for another student on the same tax return.

Answer 277

- The Earned Income Tax Credit (EITC or EIC), is a fully refundable federal income tax credit for lower-income people who work and have earned income and adjusted gross income under certain thresholds. This credit is claimed on Schedule EIC, Earned Income Credit. - There are strict rules and income guidelines for the EITC. To claim the EITC, a taxpayer must meet all of the following tests: - Have a Social Security number that is valid for employment. - Have “earned income” from wages, combat pay, or self-employment, etc. - Not be claimed as a dependent by another taxpayer, - Be a U.S. citizen or legal resident all year.

Answer 278

- Only “earned” income, such as: wages, tips, combat pay, union strike benefits, and net earnings from self-employment qualifies for the EITC. For EITC purposes, “earned income” does not include the following income: - Social Security benefits, SSI, or welfare payments, - Alimony (even if taxable to the recipient) or child support, - Pensions or annuities, - Unemployment benefits, - Inmate wages, including work release programs, - Income from investments, passive rental activities, or other passive sources. - Income that is excluded from tax is generally not considered earned income for the EITC. Nontaxable combat pay and qualified Medicare waiver payments are a notable exception. - You cannot exclude foreign income by filing Form 2555, Foreign Earned Income.

Answer 279

- Relationship test: The child must be related to the taxpayer in one of the following ways: - Son, daughter, stepchild, adopted child, or descendant of any of them (for example, a grandchild), or - Brother, sister, half-brother, half-sister, stepbrother, stepsister, or descendant of any of them (for example, a niece or nephew). - A foster child also qualifies - Age test: To qualify for the EITC, the child must be: - Age 18 or younger, - A full-time student, age 23 or younger, or - Any age, if permanently disabled. - In addition, the qualifying child must be younger than the taxpayer claiming him or her, unless the child (the dependent) is permanently disabled.

Answer 280

- Joint Return Test: The qualifying child (dependent) cannot file a joint return with a spouse, except to claim a refund. - Residency Test: The child must have lived with the taxpayer in the United States for more than half the year (although there are exceptions to this test for temporary absences). Only a custodial parent can claim the EITC (or, in the case of another family member that claims the child, the child must have lived with that family member for more than half the year). A child who was born or died during the year would meet the residency test for the entire year if the child lived with the taxpayer the time the child was alive.

Answer 281

- “Childless EITC”: A taxpayer with a qualifying child can claim the EITC without any age limitations, but a taxpayer without a child can only claim the EITC if all of the following tests are met: - Must be between the age of 25 and 65. On a joint return, only one spouse must meet the age requirement - Must not qualify as a dependent of another person - Must live in the United States for more than half the year

Answer 282

- The credit is 10%–50% of eligible contributions to IRAs and other qualifying retirement plans up to a maximum credit of $1,000 ($2,000 MFJ), depending on a taxpayer’s adjusted gross income. Eligible contributions must be made to an IRA or an employer-sponsored retirement plan. - To be eligible for this credit, the taxpayer must fulfill all the following requirements: - Be at least age 18 or older; - Not a full-time student; and - Not claimed as a dependent on another person’s return. - Most workers who contribute to traditional IRAs already deduct all or part of their contributions. The Saver’s Credit is in addition to these deductions. In essence, a taxpayer could potentially deduct their contribution to a traditional IRA, and then also receive the Saver’s Credit in the same year. - This credit is claimed on Form 8880, Credit for Qualified Retirement Savings Contributions.

Answer 283

- This credit is for workers who overpay their tax for Social Security, which usually happens when an employee is working two jobs, and both employers withhold Social Security tax. Each year, a limit is set as to how much Social Security tax an individual should have withheld from their earnings. - If the taxpayer’s withholding for Social Security tax exceeds the annual maximum, the taxpayer can request a refund of the excess amount. This also applies to overpaid Railroad Retirement taxes. - The maximum earnings subject to Social Security tax is $160,200 in 2023. - If a single employer over withheld Social Security, and refuses to refund the over-collection, the employee can file a claim for refund using Form 843, Claim for Refund and Request for Abatement.

Answer 284

- In this webinar, we will cover the ACA from the individual taxpayer’s perspective. - The ACA from the employer’s perspective is covered in detail in the webinars and textbook for part 2, Businesses. All of the employer-shared responsibility provisions remain in place, which means that large employers must still offer qualifying health coverage to their employees or face the prospect of severe excise penalties.

Answer 285

- The Affordable Care Act is a comprehensive health care reform law first enacted in March 2010. The Affordable Care Act (ACA) tax provisions are administered by the IRS. - Congress permanently eliminated the penalty under the Affordable Care Act’s individual mandate (i.e., the penalty for an individual for failing to maintain minimum essential coverage, or MEC). - However, even though the individual healthcare penalty has been reduced to $0, many Marketplace provisions are still active, and taxpayers can still purchase health insurance through the Marketplace and receive the Premium Tax Credit, which is designed to cover a percentage of their health insurance costs. - Also, the two taxes that were instituted to help fund the ACA (the Additional Medicare Tax and the Net Investment Income Tax), were not repealed.

Answer 286

- The IRS has created a group of forms to help handle some of the requirements of the ACA. Taxpayers who are covered by health insurance, will most likely receive one of the forms listed below. Taxpayers must use the information from these statements when preparing their taxes. - Form 1095-A, Health Insurance Marketplace Statement: This form is for individuals who enroll in Marketplace coverage. - Form 1095-B, Health Coverage: This is for employees or taxpayers whose insurance comes from a source other than the Marketplace. - Form 1095-C, Employer-Provided Health Insurance Offer and Coverage: Individuals who work for applicable large employers will typically get this form (employees will also get this form if they enroll in self-insured coverage provided by an applicable large employer). - Some taxpayers will receive multiple forms in the same year. For example, if a taxpayer purchased health insurance through the Healthcare Marketplace at the beginning of the year, and then started a new job in the middle of the year that offered health coverage, the taxpayer may receive both Forms 1095-B and 1095-C.

Answer 287

- There are two ways to get the Premium Tax Credit: - If the taxpayer qualifies for advance payments of the Premium Tax Credit, they can choose to have the amounts paid directly to the insurance provider to help cover their monthly insurance premiums. This is also called the “Advance Premium Tax Credit” (APTC) because the taxpayers receive the credit in advance in order to lower their monthly health insurance premiums. - The taxpayer can choose to pay full price for their insurance through the Marketplace, then receive the PTC as a refundable credit on their individual tax return. - The amount of the Premium Tax Credit is based on a sliding scale, so the higher the household income, the lower the amount of the credit. - Note: The Premium Tax Credit is only available to taxpayers who purchase their insurance from the federal exchange (i.e., the “Marketplace”); it is not available to taxpayers who obtain insurance through their employer or purchase their health insurance directly from an insurance provider.

Answer 288

- To be eligible for a Premium Tax Credit or the Advance Premium Tax Credit, a taxpayer must generally meet all of the following requirements: - Purchase health insurance through the Marketplace, - Be a U.S. citizen or legal U.S. resident, - Be unable to get coverage from an employer or the government (i.e., cannot be enrolled in Medicare, Tricare, Medical, or Medicaid), - Not be claimed as a dependent on anyone else’s tax return, - If married, the couple must generally file a joint tax return. In general, taxpayers who file separate returns will not qualify for the credit, although there are some exceptions for spousal abuse or spousal abandonment. - The taxpayer must meet certain household income requirements.

Answer 289

- If a worker voluntarily enrolls in an employer-sponsored plan, (including retiree coverage or COBRA coverage), the worker is not eligible for the premium tax credit, even if the employer plan is unaffordable or fails to provide minimum value. - However, the taxpayer may be eligible for a premium tax credit for coverage of another member of the family who enrolls in Marketplace coverage and is not enrolled in the employer plan.

Answer 290

- When a taxpayer first applies for a Marketplace plan, the amount of the credit is estimated using information the taxpayer provides about family size and projected household income. Since it can be difficult to know exactly how much income a taxpayer will earn in a given year and family circumstances can change during the year, the actual amount of the credit can vary from the estimated amount. - A taxpayer who chose Advance Premium Tax Credit (APTC) payments must file a tax return, in order to reconcile the advance credit payments with the actual Premium Tax Credit earned. - This is called “reconciling” the advance payments of the Premium Tax Credit and the actual Premium Tax Credit the taxpayer actually qualifies for based on their annual income. This reconciliation is calculated on Form 8962, Premium Tax Credit. The IRS will reject e-filed returns missing Form 8962 if advance payments were made.

Answer 291

- Remember, the Premium Tax Credit is a refundable credit. If the amount of the credit is more than the amount of the tax liability of the return, a taxpayer may receive the difference as a refund. If no tax is owed, a taxpayer can receive the full amount of the credit as a refund. - Although the IRS is restricted in its ability to collect the pre-2018 shared responsibility payment, the agency may use full collection actions, including levies and liens, against a taxpayer who does not repay excess advance premium tax credits.

Answer 292

- The Affordable Care Act imposes a Net Investment Income Tax (also called the “NIIT”) on higher-income taxpayers. The tax applies to individuals, estates, and trusts. For individuals, a 3.8% tax is imposed on the lesser of: - The individual’s net investment income for the year, or - Any excess of the individual’s modified adjusted gross income for the tax year over the following thresholds: - MFJ or QSS: $250,000 - MFS: $125,000 - Single or HOH: $200,000 - These threshold amounts are not indexed for inflation. The NIIT is imposed only on U.S. citizens and resident aliens; nonresident aliens are not subject to the NIIT. - Employers are not required to withhold the NIIT from an employee’s wages, but an employee can choose to increase their annual withholding to cover the NIIT. The tax is computed on Form 8960, Net Investment Tax.

Answer 293

- “Net investment income” includes: - Interest income, unless it is otherwise tax-exempt, (like municipal bonds), - Dividends and capital gains, - Rental and royalty income (if passive), - Nonqualified annuities, - Income from trading of financial instruments or commodities, - Income from businesses that are passive activities for the taxpayer (such as a limited partnership). - Net investment income does not include earned income or pension income. - The NIIT also does not apply to: wages, self-employment income, Social Security benefits, veterans’ benefits, unemployment compensation, taxable alimony, or distributions from IRAs or certain qualified retirement plans.

Answer 294

- The NIIT does not apply to any gains or investment income that is excluded from gross income for regular income tax purposes. For example, municipal bond interest is exempt from federal tax, so it is not included in the calculation for the NIIT.

Answer 295

- Net investment income does not include any gain on the sale of a personal residence that is excluded from gross income (such as the Section 121 exclusion on the sale of a main home). - A gain from the sale of a second home or a vacation home would not be eligible for section 121 exclusion and therefore, would be fully subject to the NIIT.

Answer 296

- The Additional Medicare Tax only applies to earned income. The Additional Medicare Tax is withheld at a rate of 0.9%. The tax is assessed on earned income in excess of the following thresholds: - MFJ: $250,000 - MFS: $125,000 - Single, HOH, or QSS: $200,000 - A taxpayer’s earned income (including wages, taxable fringe benefits, bonuses, tips, commissions, and self-employment income) that is subject to regular Medicare tax is also subject to the Additional Medicare Tax to the extent it exceeds the applicable threshold amount for his or her filing status. - Unlike regular Medicare taxes, there is no “employer share” of the Additional Medicare Tax. Self-employed taxpayers also cannot deduct one-half of the 0.9% Additional Medicare Tax. It is imposed entirely on the employee (or the self-employed taxpayer). The tax is reported on Form 8959, Additional Medicare Tax.

Answer 297

- An employer is required to withhold the Additional Medicare Tax if an employee is paid more than $200,000, regardless of an employee’s filing status or whether the employee has wages paid by another employer. - The Additional Medicare Tax applies, even if the amounts are not withheld from a taxpayer’s wages. - If an employer withholds amounts for an employee who earns more than $200,000, but the combined earnings of the employee (and their spouse) are less than the $250,000 MFJ threshold, the taxpayers can apply the overpayment against any other type of tax that may be owed on their income tax return. - Filing status determines the threshold amount. For those who are married and file a joint return, they must combine the wages, compensation, or self-employment income of their spouse with their own.

Answer 298

- Beginning in 2018, a taxpayer can no longer claim a deduction for unreimbursed employee expenses unless they fall into one of the following categories of employment or have certain qualified educator expenses (Publication 17, page 102). The eligible categories are: 1. Armed Forces reservists 2. Qualified performing artists 3. Fee-basis state or local government officials 4. Employees with impairment-related work expenses - Therefore, unless a taxpayer falls into one of the qualified categories of employment, miscellaneous itemized deductions that are subject to the 2% of adjusted gross income limitation can no longer be claimed. - In this case, Michael cannot claim any miscellaneous itemized deductions. (Publication 17, page 102)

Answer 299

C. $300 for maternity clothes - The lists for items that are and are not treated as deductible medical and dental expenses are provided on pages 15 through 17 of Publication 502. The following items are deductible medical and dental expenses: 1. Hospital services fees (lab work, therapy, nursing services, surgery, etc.) 2. Medical services fees (from doctors, dentists, surgeons, specialists, and other medical practitioners) 3. Prescription medicines (prescribed by a doctor) and insulin 4. Special items (artificial limbs, false teeth, eyeglasses, contact lenses, hearing aids, crutches, wheelchair, etc.) - Page 16 of the same Publication indicates maternity clothes are not deductible.

Answer 300

- Beginning in 2018, certain miscellaneous deductions have been suspended. Two categories of miscellaneous expenses that have been suspended are: miscellaneous itemized deductions subject to the 2% AGI floor and those expenses that are traditionally nondeductible under the Internal Revenue Code. - Suspended miscellaneous itemized deductions include: 1. Unreimbursed employee expenses (exceptions apply) 2. Appraisal fees 3. Investment fees and expenses 4. Casualty and theft losses 5. Depreciation on home computer 6. Fees to collect interest and dividends 7. Hobby expenses 8. Indirect Deductions of Pass-through Entities 9. Legal expenses. - Items that are not subject to the 2% of AGI limit are still deductible as miscellaneous itemized deductions. These items are reported on Schedule A (Form 1040 and 1040-SR) and include items such as: 1. Amortizable premium on taxable bonds 2. Federal estate tax on income in respect of a decedent 3. Unlawful discrimination claims 4. Gambling losses up to the amount of gambling winnings - Hence, the correct response is the amortizable premium on a taxable bond, which is an itemized deduction that appears on line 16 of Schedule A. Publication 529, pages 9 through 11, provides a list of other items that are deductible as a miscellaneous deduction.

Answer 301

C. 80% - A taxpayer can deduct 50% of the expenses incurred for business-related meals. - The business meal expenses are required to be incurred for food and beverages provided by a restaurant. However, a taxpayer can deduct a higher percentage of their meal expenses while traveling away from their tax home if the meals take place during or incident to any period subject to the Department of Transportation's “hours of service” limits. The percentage, in this situation, is 80%.

Answer 302

D. $340 - Publication 526, page 2, provides, in part, that a charitable contribution is a donation or gift to, or for the use of, a qualified organization. It is voluntary and is made without getting, or expecting to get, anything of equal value. - In the case of volunteer work, a person is not able to deduct the value of his or her time but can deduct any out-of-pocket costs. For example, a volunteer can deduct the cost and upkeep of uniforms that are not suitable for everyday use and that the taxpayer must wear while performing donated services for a charitable organization. A volunteer also can deduct 14 cents per mile for travel to and from the charitable activity (see material and Table 2 on page 5 in Publication 526).

Answer 303

D. Neither Martha nor Max can claim the EIC. - As found in Rule 3 on page 5 of Publication 596, a taxpayer that is married is required to file a joint return in order to claim the EIC. - There is an exception to this rule as given in the explanation for Rule 3: the taxpayer cannot file as married filing separately unless the taxpayer's spouse did not live in the taxpayer's home at any time during the last 6 months of the year. In this case, the taxpayer may be able to file as head of household, instead of married filing separately, and as such may be able to claim the EIC.

Answer 304

- Publication 17, page 98, states that a taxpayer can deduct state and local income taxes. However, the taxpayer cannot deduct state and local income taxes paid on income that is exempt from federal income tax, unless the exempt income is interest income. - Beginning in 2005, a taxpayer can elect to deduct state and local general sales taxes instead of state and local income taxes as an itemized deduction on Schedule A of Form 1040 (Publication 17, page 98). - Deductible real estate taxes, on the other hand, are any state or local taxes on real property levied for the general public welfare. A taxpayer can deduct these taxes only if they are based on the assessed value of the real property and charged uniformly against all property under the jurisdiction of the taxing authority. (See Publication 17, page 98.) Real estate taxes, however, paid on property that produces rent or royalty income are deductible on Schedule E (Publication 17, page 100). - Publication 17, page 102, goes on to stipulate that Social Security and other employment taxes for household workers that a taxpayer pays cannot be deducted. However, the taxpayer may be able to include them in medical expenses that are deductible or child care expenses that allow the taxpayer to claim the child and dependent care credit. - For tax years 2018 through 2026, the deduction for state and local taxes is limited to $10,000 ($5,000 if filing married separately). State and local taxes are the taxes that you include on Schedule A (Form 1040 or 1040-SR), lines 5a, 5b, and 5c. - Ms. Gonzales' itemized deductions for 2023 are $4,675, which is the sum of $3,425 (real estate tax on her residence) and $1,250 (New Jersey state income taxes). Of course, Ms. Gonzales would be wiser to claim the standard deduction of $13,850, which is greater than the itemized amount of $4,675 unless her total itemized deductions exceed $13,850.

Answer 305

D. $600. - Publication 526, page 2, provides that a taxpayer can deduct contributions of money or property that are made to, or for the use of, a qualified organization. A contribution is “for the use of” a qualified organization when it is held in a legally enforceable trust for the qualified organization or in a similar legal arrangement. - With respect to contributed property to a qualified organization, a taxpayer generally can deduct the fair market value of the property at the time of the contribution. In the case of clothing and household items, a person cannot take a deduction for these items unless the item is in good used condition or better. An exception to this rule is if the taxpayer deducts more than $500 for an item and a qualified appraisal of the item is included in the return, a deduction for an item that is not in good used condition or better is deductible. (Publication 526, page 8) - Another restriction on the deductibility of charitable contributions pertains to the amount contributed. In particular, a taxpayer can claim a deduction for a contribution of $250 or more only if the taxpayer has a contemporaneously written acknowledgment of the contribution from the qualified organization or if the taxpayer has certain payroll deduction records (Publication 526, page 20). In figuring whether a taxpayer's contribution is $250 or more, the taxpayer does not combine multiple contributions. For example, if a person gave $25 per week, the weekly contributions do not need to be combined. Each payment is a separate contribution. - A taxpayer cannot deduct a cash contribution, regardless of the amount, unless the taxpayer keeps records to prove the amount of the contribution made during the year. The kind of record required includes a bank record (e.g., a canceled check, a bank or credit union statement, or a credit card statement), a receipt, or a payroll deduction record. (Publication 526, page 20) - Given the above restrictions, Joe's charitable contributions for the year are limited to $600, which is the sum of his payroll deduction plan. The $200 cash contribution is not deductible since he has no documentation; the $300 contribution to his church is not permitted because he lacks an acknowledgment; and the clothes donation is not in good condition.

Answer 306

A. $182,100. - The Tax Cuts and Jobs Act of 2017 (TCJA) created IRC Section 199A, which allows owners of pass-through entities to deduct 20% of their qualified business income, with certain limitations being phased in for taxpayers with taxable income exceeding $364,200 (joint filers) or $182,100 (other filers) in 2023.

Answer 307

- The Form 1040-NR Instructions, page 38, provide that a person filing Form 1040NR includes only those deductions and losses properly allocated and apportioned to income effectively connected with a U.S. trade or business. A person, however, does not include deductions and/or losses that relate to exempt income or to income that is not effectively connected with a U.S. trade or business. - State and local income taxes withheld from the taxpayer's salary during 2023 on income connected with a U.S. trade or business are deductible. Likewise, contributions given to U.S. organizations that are religious, charitable, educational, scientific, or literary in purpose are deductible. - As a result, Thomas cannot include as an itemized deduction loss related to exempt income connected with a non-U.S. business in 2023.

Answer 308

B. The taxpayer can claim the American Opportunity credit on the taxpayer's return for tuition expenses of $3,000 when the student reports the additional $2,500 scholarship as income. - Publication 970, page 16, states that scholarships and fellowship grants included in the student's income do not reduce the student’s qualified education expenses available for calculating the American Opportunity Credit. If the student reports the $2,500 scholarship as income on their return, the taxpayer claiming the student as a dependent can use the remaining tuition expenses of $3,000 to claim the American Opportunity Credit.

Answer 309

D. The taxpayer can elect either method 2 or method 3. - The instructions for line 5 of Schedule A (Form 1040), pages A-3 and A-4, state that the deduction for state and local taxes is limited to $10,000 ($5,000 if married filing separately). In addition, line 5a states that a taxpayer can deduct from adjusted gross income either state and local income taxes or state and local sales tax. The taxpayer cannot deduct both in the same year. - In addition, a taxpayer can deduct either his or her actual expenses (which would include the sales tax paid on specific items such as a motor vehicle, boat, etc.) or an amount figured using the Optional State and Certain Local Sales Tax Tables in the instructions for Schedule A, Form 1040. - If the taxpayer uses the Optional State and Certain Local Sales Tax Tables, they may be able to add to the table any state and local general sales tax paid on motor vehicles, motorcycles, motor homes, RVs, SUVs, trucks, vans, and off-road vehicles. (For more information, see the instructions for line 7 of the State and Local General Sales Tax Deduction Worksheet on page A-7 of the Schedule A (Form 1040) Instructions.)

Answer 310

C. The couple cannot claim the EIC because Hilda is not able to get an SSN. - Publication 596, page 5, states, in part, that under Rule 2 for claiming the EIC, the taxpayer (and the taxpayer's spouse if filing a joint return) must have a valid SSN issued by the Social Security Administration (SSA). Also, Rule 3 states that a taxpayer's filing status cannot be married filing separately. - Since Franz and Hilda file a joint return and Hilda cannot obtain a valid SSN, the couple is not eligible to claim the earned income credit for their qualifying child.

Answer 311

A. $375. - Publication 526, page 5, provides that a taxpayer may be able to deduct some amounts the taxpayer pays in giving services to a qualified organization. The amounts must be: 1. Unreimbursed, 2. Directly connected with the services, 3. Expenses the taxpayer had only because of the services he or she gave, and 4. Not personal, living, or family expenses. - Table 2 on page 5 contains questions and answers that apply to some individuals who volunteer their services. - In addition, a taxpayer cannot deduct the value of his or her time or services (see Publication 526, page 7), including but not limited to: 1. Value of blood given to a blood bank and 2. Dues, fees, or bills paid to country clubs, lodges, fraternal orders, or similar groups. - As a result, the Meads can deduct $375 as charitable contributions for the year, which is the sum of their out-of-pocket expenses ($25 for parking fees and $350 for gas and oil). None of the other expenses are deductible.

Answer 312

D. $21,600. - There are a number of rules associated with calculating the amount of itemized deductions. To begin with, deductible real estate taxes are any state, local, or foreign taxes on real property levied for the general public welfare. A taxpayer can deduct these taxes only if they are assessed uniformly against all property under the jurisdiction of the taxing authority. The proceeds must be for general community or governmental purposes and not be a payment for a special privilege granted or service rendered to the taxpayer. Similarly, state and local income taxes are deductible. In this case, Jack is limited to $3,600 ($2,000 + $1,600). (Publication 17, pages 97–100, and Table 11-1 on page 100). Also be aware that the deduction for state and local taxes is limited to $10,000 ($5,000 if married filing separately) beginning in 2018. - Publication 502, page 3, provides that a taxpayer can deduct on Schedule A (Form 1040 or 1040-SR) only the amount of the taxpayer's medical and dental expenses that is more than 7.5% of the taxpayer's adjusted gross income. In this case, Jack cannot deduct any medical expenses because his medical expenses of $2,500 are less than the limit amount of $5,625 ($75,000 × 0.075). (The 7.5% floor was extended for all taxpayers by the Further Consolidated Appropriations Act of 2020.) - Publication 936, page 2 and the Instructions to Schedule A, Form 1040, page A-8, state, in general, that home mortgage interest is an itemized deduction and includes any interest that is paid on a loan secured by the taxpayer's home (main home or a second home), not to exceed the cost of the home. The loan may be a mortgage to buy the taxpayer's home or a second mortgage. Jack's mortgage amount is $8,000. - Publication 17, page 76, provides that a taxpayer must report the full amount of his or her gambling winnings for the year on Schedule 1 (Form 1040 or 1040-SR) line 8. In addition, the taxpayer is able to deduct any gambling losses for the year on line 16, Schedule A (Form 1040 or 1040-SR), as a miscellaneous deduction that is not subject to the 2% limitation. A taxpayer cannot deduct gambling losses that are more than the winnings. If the taxpayer cannot or does not itemize, then the taxpayer must still claim the gambling winning but cannot deduct losses. Thus, Jack can claim $10,000 as his gambling losses for the year. - Finally, a taxpayer may no longer claim a deduction for unreimbursed employee expenses unless they fall into one of the following categories of employment or have certain qualified educator expenses (Publication 17, page 102). The eligible categories are: 1. Armed Forces reservists 2. Qualified performing artists 3. Fee-basis state or local government officials 4. Employees with impairment-related work expenses -Therefore, unless a taxpayer falls into one of the qualified categories of employment, miscellaneous itemized deductions that are subject to the 2% of adjusted gross income limitation can no longer be claimed. Jack cannot claim any miscellaneous itemized deductions. (Publication 17, page 102) - The total itemized deductions that Jack can take on his 2023 tax return is $21,600, which is the sum of $3,600, $0, $8,000, and $10,000.

Answer 313

- In this unit, we cover a variety of other taxes and credits, including the taxation and reporting of foreign income, the “nanny tax,” and the “kiddie tax.” - We start with a look at the Alternative Minimum Tax (AMT).

Answer 314

- The Alternative Minimum Tax (AMT) gives an alternative set of rules to calculate an individual’s taxable income. For this reason, the AMT is sometimes called a “parallel tax” system. Congress adopted the AMT in 1969 in an attempt to ensure that individuals and corporations paid at least a minimum amount of tax. - The TCJA made a number of significant changes to the individual AMT. First, the AMT exemption was increased substantially and is now indexed for inflation every year. - This means that taxpayers who have Alternative Minimum Taxable Income (AMTI) below these thresholds will not be subject to AMT, regardless of how many tax deductions or credits they may have.

Answer 315

- Certain situations may “trigger” the AMT tax. Some scenarios when a taxpayer may have to pay the AMT tax include: - Having a high income coupled with high itemized deductions, - The exercise of incentive stock options, (ISOs) - A large sale of capital assets that results in long-term capital gains, - Tax-exempt interest from private activity bonds. - Individual taxpayers compute AMT on Form 6251, Alternative Minimum Tax, Individuals.

Answer 316

- Years ago, wealthy families could transfer investments to their minor children and save tax dollars because the investment income would be taxed at the children’s lower rates. Congress closed this tax loophole, and now investment income earned by dependent children may be taxed at the parent’s rate. This law became known as the “Kiddie Tax.” - The kiddie tax does not apply to earned income (such as wages); it applies only to certain unearned income, including investment income, such as interest, dividends, and capital gains distributions (and unemployment).

Answer 317

- Part of a child’s investment income may be subject to the Kiddie tax if: - The child’s investment income is more than $2,500 (in 2023). The first $1,250 in investment income is tax-free; the second $1,250 is taxed at the child’s marginal rate. - The child is (1) a dependent under age 18, (2) under the age of 19 and does not provide more than half of his or her own support with their own earned income, or (3) a full-time college student under age 24. - The child is required to file a tax return for the tax year. - At least one of the child’s parents was alive at the end of the year. If both of the child’s parents are deceased, then the kiddie tax does not apply, regardless of how much unearned income the child has. - If this unearned income threshold ($2,500 in 2023) is not exceeded, then the kiddie tax does not apply. - The kiddie tax does not apply to a child who is married and files a joint return with their spouse. This rule applies whether the child is a minor, under age 18, or a full-time college student under age 24.

Answer 318

- If the kiddie tax threshold is exceeded, only the child’s unearned income in excess of the threshold is subject to the kiddie tax. All of the child’s investment income in excess of the kiddie tax threshold is then taxed at the parent’s tax rate. - There are two ways to report the kiddie tax. - Child’s return: The child can file their own return, and report the tax by attaching Form 8615, Tax for Certain Children Who Have Unearned Income, to their Form 1040. This is the most common method. - Parent’s return: Or, the parents can report their child’s unearned income on Form 8814, Parent's Election to Report Child's Interest and Dividends, on their Form 1040, rather than having the child file a separate return. In order to use this method, the child can only have income from interest, dividends, or capital gain distributions. If the child has earned income as well as investment income, the child must file his or her own return to report the income that way. - A child’s investment income may also be subject to the net investment income tax, which is calculated using only the child’s income. However, the NIIT applies only if the child’s net investment income exceeds the $200,000 threshold for single filers (this scenario would be very rare, and would only apply if a dependent child had more than $200,000 in taxable income).

Answer 319

- A taxpayer who hires household employees may need to pay employment taxes. This obligation is commonly referred to as the “nanny tax” or the tax on household employees. - A worker is the taxpayer’s employee if the taxpayer can control not only what work is done, but how it is done, regardless of whether the work is full-time or part-time; the employee is paid on an hourly, daily, weekly, or per-job basis; or the employee is hired through an agency. - Examples of household employees include nannies, housekeepers, private nurses, yard workers, and private chauffeurs. - A self-employed worker, such as a daycare provider who cares for several children from different families in their own home, is not considered a household employee.

Answer 320

- If a taxpayer pays a household employee cash wages (including amounts paid by check, money order, etc.) of $2,600 or more in 2023, the employer must normally withhold the employee’s share of Social Security and Medicare taxes and remit them along with the employer’s matching share, for a total of 15.3%.

Answer 321

- Schedule H, Household Employment Taxes, is used to report the nanny tax, along with their Form 1040. A household employer needs to request an EIN to file Schedule H. - An employer is not required to withhold income tax from a household employee’s wages. However, income tax may be withheld at the employee’s request. Even if the employer is not required to pay FICA (Social Security and Medicare) taxes, the employee’s wages may be subject to income tax. - The employer must also file Form W-2, Wage and Tax Statement, and furnish a copy of the W-2 form to the employee.

Answer 322

- Wages paid to a taxpayer’s spouse, parent, or child under the age of 21 are exempt from the nanny tax rules. In that case, the taxpayer would not have to withhold FICA tax.

Answer 323

- This provision, also known as the QBI deduction, allows a deduction of up to 20% of qualified business income for owners of most pass-through businesses. - The section 199A deduction does not reduce self-employment taxes, excise taxes, or penalties. The section 199A deduction is only an income tax deduction. - The QBI deduction is available regardless of whether an individual itemizes their deductions on Schedule A or takes the standard deduction. - The QBI deduction expires after 2025, unless Congress decides to extend it.

Answer 324

- The deduction allows owners of eligible businesses to deduct up to 20% of their qualified business income (QBI), along with a special 20% deduction for certain investment income. Only taxable income is counted. The 199A deduction has two components: - 1. QBI Component: This component of the deduction equals 20% of qualifying business income from a domestic business operated as a sole proprietorship, or through a partnership, S corporation, trust, or estate. - 2. REIT / PTP Component: This component of the deduction equals 20% of the combined qualified REIT dividends and qualified PTP income. - A real estate investment trust (REIT) is a company that owns, operates, or finances income-producing properties. - A publicly traded partnership (PTP) is any partnership with interests in the partnership that are traded on an established securities market.

Answer 325

- For taxpayers with taxable income that exceeds the threshold amounts, the deduction is subject to two limitations: (1) the type of trade or business and (2) the amount of W-2 wages paid by the qualified trade or business and the unadjusted basis immediately after acquisition (UBIA) of qualified property held by the trade or business. The modified taxable income thresholds are indexed for inflation. - 2023 QBI deduction Limits are as follows: - Married Filing Joint: $364,200-$464,200 - All other filing statuses: $182,100-$232,100

Answer 326

- “Qualified Business Income” (QBI) includes items of income, gain, deduction, and loss from any domestic trade or business activity, including rental activities that rise to the level of a trade or business. Qualified items of income, gain, deduction, and loss include: - Only items effectively connected with the conduct of a trade or business within the United States (including Puerto Rico) - Only items included or allowed in determining taxable income for the year. - Note: “Material participation” under section 469 is not required for the QBI deduction. Eligible taxpayers with income from a trade or business may be entitled to the QBI deduction regardless of their involvement in the trade or business.

Answer 327

- The determination of whether a business qualifies for the 199A QBI deduction occurs at the entity level. The deduction then “flows through” to the individual owners. - The deduction only applies to income from pass-through entities. Sole proprietors, partners in partnerships, LLC members, beneficial owners of trusts, estates and shareholders in S corporations may be eligible for this deduction. - Income earned through a C corporation is not eligible for the 199A deduction. - The 199A deduction only applies to domestic income, so the deduction is generally available only to U.S. businesses. For businesses with both U.S. and foreign operations, the income must be allocated properly between foreign activity and domestic activity in order to calculate the QBI deduction.

Answer 328

- In order to claim the QBI deduction, taxpayers will need to fill out either Form 8995, Qualified Business Income Deduction Simplified Computation, or Form 8995-A, Qualified Business Income Deduction. - The deduction is then transferred to the Form 1040 or the Form 1040-NR

Answer 329

- The deduction is claimed by individuals, so businesses cannot take the deduction at the entity level. However, all S corporations and partnerships report each shareholder’s or partner’s share of QBI on Schedule K-1, so the shareholders or partners may determine their deduction. - With regards to partnerships and S corporations, the Schedule K-1s for these entities have codes for the QBI deduction items. The entity is responsible for providing each partner or shareholder with their share of QBI items, W-2 wages, UBIA of qualified property, and other information necessary for partners and shareholders to compute their deduction. - If the entity fails to provide this information, final regulations provide that QBI will be presumed to be zero.

Answer 330

- A qualified business loss results in no QBI deduction for the taxable year. The loss carries over to subsequent years and reduces the section 199A deduction for QBI for those years. The section 199A loss carryover is solely for purposes of section 199A computations.

Answer 331

- Qualified Business Income, or QBI, does not include: - Employee wages, (except wages earned by statutory employees) - Capital gains, - Interest and dividend income, - Hobby income, - Non-taxable income, (such as muni bond interest) - Rental income where the owner is not engaged in a bona-fide real estate “trade or business.” This does not mean that the taxpayer has to be a “real estate professional” in order to get the QBI deduction. The rental of real property may constitute a trade or business, even if the rental activity is reported on Schedule E. - Guaranteed payments received from a partnership.

Answer 332

- IRS Notice 2019-07 provides a “250 hour” safe harbor under which rental real estate activity will be treated as a trade or business for purposes of the QBI deduction. This safe harbor is optional, not required. - For the taxpayer to qualify for the safe harbor, 250 or more hours of service must be provided per year to each rental real estate enterprise, in any three of the five consecutive taxable years. The safe harbor applies if the following three tests are met: - The taxpayer maintained separate books and records for each enterprise; - At least 250 hours of rental services are performed per year by owners, employees, contractors, or agents for the enterprise; and - The taxpayer maintains sufficient, contemporaneous records, including time reports, logs, or similar documents, regarding the following: hours of all services performed; description of all services performed; dates on which such services were performed; and who performed the services. - If the taxpayer uses the 250-hour safe harbor, a statement must be attached to their return, stating that the taxpayer is relying on the safe harbor provision. - Note: This safe harbor does not apply to triple-net leases (also called NNN leases), where the tenant pays for property taxes, insurance, and maintenance. In addition, the safe harbor does not apply to rental activities in which the owner also uses a portion of the property as their personal residence.

Answer 333

- In general, the 199A deduction is available to eligible taxpayers whose pre-QBI deduction taxable income falls below the Qualified Business Income (QBI) threshold. - The 199A deduction for taxpayers above the taxable income threshold the QBI deduction is subject to limitations based on: - SSTB Limitation: This limitation is based on the type of trade or business activity, (also called the “Specified Service Trade or Business” or “SSTB” limitation) - Wage and Property Limitation: For a non-SSTB business whose income exceeds the phaseout ranges, the 20% deduction against QBI is further potentially limited to the greater of: - 50% of allocable W-2 wages paid by the business, or - 25% of W-2 wages, plus 2.5% of the unadjusted basis immediately after acquisition (UBIA) of all qualified property.

Answer 334

- The SSTB limitation is a limitation that applies to certain business types only. - If the taxpayer’s taxable income is above the phase-in range (listed previously) and the business income is from a “specified service business,” then the deduction is completely disallowed. - In some scenarios, a married couple may benefit from filing separate tax returns in order to avoid the SSTB limit, if both spouses have taxable income and one spouse would qualify separately.

Answer 335

- If the taxpayer’s income is above the phase-in range, and the business is not a specified service business, the deduction is subject to the wage and “property limitation.” - This limits the QBI deduction to 50% of qualified wages paid by the business, or, (if greater) 25% of qualified wages plus 2.5% of the unadjusted tax basis of certain depreciable business property. - Note: The taxpayer does not have to calculate any wage limitation if the taxpayer’s taxable income is less than the income thresholds or “phase-in-range” figures. This is true even if the taxpayer has income from a specified service trade or business (SSTB).

Answer 336

- For the purposes of this limitation, “qualifying wages” refers to taxable wages (NOT CONTRACTOR PAYMENTS) the business has paid to its employees, plus any amounts paid into a tax-deferred retirement plan. - “Qualified property” includes the original unadjusted basis of depreciable, tangible property that: - Is held by the business and available for use at the close of the taxable year (i.e., the asset is not sold or disposed of during the year), - Has a remaining depreciable period. The term “depreciable period” means that (1) its regular depreciable life has not ended prior to the end of the tax year of the business or (2) if it has not been more than 10 years since it was first placed in service. - Note that land and intangible assets are not included in the definition of qualified property. - This is commonly called “UBIA” which stands for “unadjusted basis immediately after acquisition” of qualified property. The unadjusted basis calculation is based on the original capitalized cost immediately after the asset’s acquisition (UBIA), not the adjusted depreciated basis of the qualified property. - In simplified terms, this means that taxpayers with QBI who have taxable income above the phaseout threshold must be owners of a business that either (1) pays wages to employees or (2) own qualifying depreciable property, otherwise the QBI deduction will not be permitted.

Answer 337

- There are some instances where a business may have SSTB income, but still not be subject to the SSTB limitation. These are called “de minimis” exceptions. - These exceptions apply even if the business itself is operated by a taxpayer that would normally be classified as an “SSTB” (such as a doctor, lawyer, or professional athlete).

Answer 338

- If a business’ gross receipts are $25 million or less, and less than 10% of the gross receipts are from the performance of services in a specified service trade or business, then the trade or business is not considered specified service trade or business, and thus the owner(s) of the business may be eligible for the QBI deduction.

Answer 339

- If a business’ gross receipts exceeds $25 million, and less than 5% of the gross receipts are from the performance of services in a specified service trade or business, then the trade or business is not considered an SSTB, and owner(s) of the business are not subject to the SSTB limitation.

Answer 340

- All income of U.S. citizens and U.S. resident aliens is subject to tax by the United States, regardless of where the individual lives and even if the income is earned outside the United States. - “Foreign earned income” is income received for services performed in a foreign country while the taxpayer’s tax home is also in a foreign country. The exclusion does not apply to investment income, such as dividends, interest, or passive income from rental activities. It also does not apply to pension or retirement income. - It does not matter whether the income is paid by a U.S. employer or a foreign employer. The tax home of the taxpayer (where the taxpayer resides) is the main determining factor.

Answer 341

- For 2023, the maximum foreign earned income exclusion is $120,000 per person. - For married couples, the exclusion is applied on a per spouse basis, whether filing MFS or MFJ. In other words, if married taxpayers file jointly (or separately) and both individuals live and work abroad, each can claim the foreign earned income exclusion, for a total exclusion amount of $240,000 in 2023.

Answer 342

- The foreign earned income exclusion is NOT AUTOMATIC. - Eligible taxpayers must file a U.S. income tax return each year with a Form 2555 attached if they wish to claim the exclusion. All of the normal filing thresholds for U.S. taxpayers apply, regardless of where the taxpayer works or resides. - If the election is made to exclude foreign earned income, the election remains in effect for subsequent years, unless it is formally revoked. - However, it is not necessary to affirmatively revoke the election if the taxpayer does not have any foreign earned income for the year. For example, if the taxpayer lived overseas and had foreign earned income in the prior year but returned to the United States and no longer had any foreign earned income, then the taxpayer does not need to revoke the election.

Answer 343

- A taxpayer must be either a U.S. citizen or a legal resident alien of the United States who has foreign earned income, a foreign tax home, and passes one of two tests to claim the exclusion: - Bona Fide Residence Test: A U.S. citizen or U.S. Resident who is a bona fide resident of a foreign country for an uninterrupted period that includes an entire tax year. - The Physical Presence Test: A U.S. citizen or U.S. resident alien who is physically present in a foreign country (or multiple countries, if applicable) for at least 330 full days during twelve consecutive months. A taxpayer may qualify under the physical presence test, and the income may span a period of multiple tax years. If so, the taxpayer must prorate the foreign earned income exclusion based on the number of days spent in a foreign country.

Answer 344

- In addition to the foreign earned income exclusion, a taxpayer can claim an exclusion (or a deduction) for foreign housing costs. - The foreign housing exclusion applies only to amounts paid by an employer, while the foreign housing deduction applies only to amounts paid with self-employment earnings. Qualified housing expenses include reasonable expenses paid for housing in a foreign country. - Only housing expenses for the part of the year that the taxpayer actually qualified for the foreign earned income exclusion are considered. - The foreign housing exclusion and/or deduction will reduce regular income tax but will not reduce self-employment tax (for taxpayers who are self-employed). - Housing expenses do not include the cost of meals, or expenses that are lavish or extravagant.

Answer 345

- Foreign Income Taxes: Generally, income taxes paid to a foreign country can be deducted as an itemized deduction on Schedule A or as a credit against U.S. income tax. A taxpayer can choose between a deduction or a credit and use whichever one results in the lowest tax. - Individuals claim the Foreign Tax deduction on Schedule A (Form 1040) as an itemized deduction. The Foreign Tax Credit is claimed on Form 1116, Foreign Tax Credit. - A taxpayer cannot claim both—the deduction and the tax credit—on the same return, but may alternate years, taking a credit in one year and a deduction in the next year, choosing whichever one gives them a better tax result. - A taxpayer is allowed to switch between claiming the Foreign Tax Credit or an itemized deduction for foreign tax paid. If a taxpayer claimed an itemized deduction for a prior year for qualified foreign taxes, the taxpayer can also switch to claiming a credit by filing an amended return within ten years from the original due date of the return. This type of amended return has a much longer statute period than normal amended returns.

Answer 346

- U.S. citizens and resident aliens are eligible for the Foreign Tax Credit. Nonresident aliens are not eligible for this credit. - Four tests must be met to qualify for the credit: - The tax must be imposed on the taxpayer. - The taxpayer must have paid the tax. - The tax must be a legal and actual foreign tax liability. - The tax must be an income tax (not an excise tax, sales tax, etc.). - Taxpayers cannot claim the Foreign Tax Credit for taxes paid on any income that has already been excluded using the foreign earned income exclusion or the foreign housing exclusion. - Unlike the foreign earned income exclusion, which applies only to income that is earned while a taxpayer is living and working abroad, the Foreign Tax Credit applies to any type of foreign income, including investment income. - Foreign tax paid may be reported to the taxpayer by a financial institution on Form 1099-INT or Form 1099-DIV. - If the amount of foreign tax that the taxpayers incur is small, then taxpayers can claim the credit directly on Form 1040 if, among other conditions, all foreign income is specified passive income, reported on an information return (such as a 1099-DIV or 1099-INT) and total taxes paid do not exceed $300 ($600 MFJ). - If the foreign tax paid exceeds $300 ($600 MFJ), the taxpayer must file Form 1116, Foreign Tax Credit, in order to claim the credit. - Certain taxes do not qualify for the Foreign Tax Credit, including interest or penalties paid to a foreign country, taxes imposed by countries involved with international terrorism, and taxes on foreign oil or gas extraction income.

Answer 347

A. He may be eligible to take a credit for the prior-year minimum tax. - Publication 17, page 108, states, in part, that the tax law gives special treatment to some kinds of income and allows special deductions and credits for some kinds of expenses. Taxpayers who benefit from the law in these ways may have to pay at least a minimum amount of tax through an additional tax (not a tax credit). This additional tax is called the alternative minimum tax (AMT). - The special treatment of some items of income and expenses only allows taxpayers to postpone paying tax until a later year. If in prior years the taxpayer paid alternative minimum tax because of these tax postponement items, they may be able to take a credit for prior-year minimum tax against their current year's regular tax. The taxpayer may be able to take a credit against their regular tax if for 2023 they had: 1. An alternative minimum tax liability and adjustments or preferences other than exclusion items, 2. A minimum tax credit that they are carrying forward to 2023, or 3. An unallowed qualified electric vehicle credit. - In this case, Jamie may be eligible to claim a nonrefundable credit.

Answer 348

C. They may be carried forward and used against other deferral-type preferences. - The tax laws give special treatment to some kinds of income and allow special deductions and credits for some kinds of expenses. If a taxpayer benefits from these laws, they may have to pay at least a minimum amount of tax in addition to any other tax on their tax return. This is called the alternative minimum tax. - The special treatment of some items of income and expenses only allows a taxpayer to postpone paying tax until a later year. If in prior years a taxpayer paid alternative minimum tax (AMT) because of these tax postponement items, the taxpayer may be able to take a credit for prior-year minimum tax against his or her current-year regular tax. - The AMT is attributable to two types of adjustments and preferences—deferral items and exclusion items. Deferral items (for example, depreciation) generally do not cause a permanent difference in taxable income over time. Exclusion items (for example, the standard deduction), on the other hand, do cause a permanent difference. The minimum tax credit is allowed only for the AMT attributable to deferral items (Form 8801 Instructions, page 1). - More specifically, a taxpayer may be able to take a credit against his or her regular tax if for 2023 the taxpayer had: 1. An alternative minimum tax liability and adjustments or preferences other than exclusion items, 2. A minimum tax credit that is being carried forward to 2023, or 3. An unallowed qualified electric vehicle credit.

Answer 349

Advising the Individual Taxpayer

Answer 350

- Traditional IRAs and Roth IRAs may be tested heavily on Part 1 of the EA exam. - Traditional IRA: Amounts in a traditional IRA, including contributions and earnings, are generally not taxed until they are distributed. Typically, a taxpayer can deduct his traditional IRA contributions as an adjustment to gross income. However, the deduction is phased out at higher income levels, when the taxpayer (or the taxpayer’s spouse) is also covered by a workplace retirement plan. - Roth IRA: Contributions to a Roth IRA are paid with after-tax income and are not deductible. In contrast to a traditional IRA, withdrawals from a Roth IRA are generally not taxed. Income limits apply in determining who is eligible to participate in a Roth IRA. However, there is no income limit for taxpayers who wish to convert their traditional IRA to a Roth.

Answer 351

- The deductibility of a traditional IRA contribution is based on income, filing status, and whether the taxpayer (or spouse) is covered by an employer retirement plan at work. - Any taxpayer with qualifying compensation is permitted to contribute to a traditional IRA, regardless of whether they are covered by an employer retirement plan; however, the deductibility of the contribution may be limited. - If a taxpayer makes nondeductible contributions to a traditional IRA, the taxpayer must file Form 8606, Nondeductible IRAs. Form 8606 reflects a taxpayer’s cumulative nondeductible contributions, which is the taxpayer’s “basis in the IRA.” - If a taxpayer does not report nondeductible contributions properly, all future withdrawals from the IRA may be taxable unless the taxpayer can prove, with satisfactory evidence, that nondeductible contributions were made. - If neither the taxpayer (or their spouse) is not covered by an employer plan, there is no limitation on the deductibility of either of their traditional IRA contributions, as long as the taxpayer has qualifying compensation.

Answer 352

- The limits for contributions to an IRA in 2023 are the lesser of qualifying taxable compensation or the following amounts: - $6,500 per taxpayer ($7,500 if age 50 or older) - Each spouse must have their own IRA account, but in the case of married spouses that file jointly, only one spouse must have qualified compensation. - This yearly IRA contribution limit does not apply to: - Rollover contributions (rolling over from one IRA account to another) - Qualified reservist repayments - Repayments of qualified disaster distributions (QDDs) and Coronavirus-Related Distributions (CRDs) (last year for repayments is 2023)

Answer 353

- Taxpayers who took a qualified disaster distribution (QDD) or a coronavirus-related distribution (CRD) from their IRA may repay the distribution. Taxpayers have up to three years from the date of the distribution to make a partial or full repayment. Retirement plan account owners may make a CRD repayment through 2023. - Note: Do not confuse a “qualified disaster distribution” or a “coronavirus-related distribution” with other types of emergency retirement distributions. These were generally allowable distributions of up to $100,000 from certain retirement plans for specific disasters. Unlike most distributions, taxpayers can choose to recognize the income ratably over three years, and taxpayers can also choose to repay a qualified disaster distribution over a three-year period. The repayments are treated as a trustee-to-trustee transfer. - Note: The Secure Act 2.0 includes a retroactive provision which includes permanent relief for those impacted by federal disasters. This provision allows penalty-free disaster distributions of up to $22,000 from a retirement plan per participant. This change is retroactive and applies to FEMA disasters occurring on or after January 26, 2021, and moving forward. Taxpayers can choose to recontribute those amounts back into their retirement accounts within three years.

Answer 354

- To make contributions to an IRA, the taxpayer must have qualifying taxable compensation, such as wages, salaries, commissions, tips, bonuses, or self-employment income. For purposes of making an IRA contribution, taxable alimony (but not child support) counts as qualifying compensation. Nontaxable combat pay also qualifies as compensation for this purpose. - Difficulty-of-care payments (also called “qualified Medicare waiver payments) to home healthcare workers, are considered “qualifying compensation” for IRA contribution purposes. This is true even if the amounts are not subject to income tax; however, the amounts contributed are non-deductible and create basis in the IRA. - In prior years, there were age limits to contribute to a traditional IRA, but the age limits were abolished by the SECURE Act 1.0. Anyone with qualifying compensation, regardless of age, may contribute to an IRA.

Answer 355

- “Compensation” for purposes of contributing to an IRA does not include: - Child support or nontaxable alimony, - Passive rental income, - Dividend and interest income, - Pension or annuity income, - Deferred compensation, - Prize winnings or gambling income, - Items that are excluded from income, such as certain foreign earned income and excludable foreign housing costs (except for nontaxable combat pay and qualified Medicare waiver payments).

Answer 356

- IRAs cannot be owned jointly. Therefore, each spouse must have their own IRA account. However, a married couple filing jointly may contribute to each of their IRA accounts, even if only one taxpayer has qualifying compensation. This is called a “spousal IRA contribution.” - If married taxpayers choose to file separately, they must consider only their own qualifying compensation for IRA contribution purposes.

Answer 357

- If a person’s only qualifying compensation for the year is from self-employment and the self-employment activity generates a loss for that year, the taxpayer would not be able to contribute to an IRA. - However, if the taxpayer has wages in addition to self-employment income, a loss from self-employment would not be subtracted from the wages when figuring total “qualifying” compensation income for purposes of determining an IRA contribution. - For married taxpayers filing a joint return, the combined IRA contributions cannot exceed their combined qualifying compensation.

Answer 358

- Roth IRAs and traditional IRAs have many differences, but they are both used for retirement planning. Unlike a traditional IRA, none of the contributions to a Roth IRA are deductible, but qualified distributions are generally tax-free at the time of withdrawal. The major differences between a Roth IRA and a traditional IRA are as follows: - Contributions to a Roth IRA are not deductible by the taxpayer, and participation in an employer plan has no effect on the taxpayer’s contribution limits. - There are no required minimum distributions from a Roth IRA. No distributions are required until a Roth IRA owner dies. - Roth IRA contributions can be made at any age. - Income limits apply, which means high-income earners may be prohibited from contributing to a Roth IRA.

Answer 359

- Distributions from a traditional IRA are generally taxable in the year they are received, subject to the following exceptions: - Rollovers to another retirement plan - Qualified charitable distributions directly to a qualified charity (must be a trustee-to-trustee transfer), - Distributions of nondeductible contributions. - ROTH Distributions: The rules are different for Roth IRA distributions. A taxpayer can withdraw their regular Roth IRA contributions (their basis, but not the earnings) at any time and at any age with no penalty or tax. However, withdrawing earnings before age 59½ may result in a 10% early withdrawal penalty. - In order to qualify for completely tax-free and penalty-free withdrawal, Roth IRA distributions generally must meet a five-year holding requirement and occur after age 59½, although there are exceptions for disability or death of the IRA owner.

Answer 360

- Form 1099-R, Distributions from Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., is used to report distributions of $10 or more from a retirement plan or an IRA.

Answer 361

- IRAs are owned and controlled by their owners. This means that a taxpayer may withdraw funds at any time from their traditional IRA account, regardless of age and for any reason; however, there may be serious tax consequences if distributions are made early. - Distributions before age 59½ may be subject to an extra 10% excise tax, in addition to income tax. There are several exceptions to the general rule for early distributions.

Answer 362

- An individual may not have to pay the additional 10% tax in the following situations: - To the extent the taxpayer has unreimbursed medical expenses that exceed 7.5% of AGI, - To cover the cost of medical insurance while the taxpayer is unemployed, - The taxpayer becomes permanently disabled or dies, - The distributions are not more than qualified higher education expenses, - The distributions are used to buy, build, or rebuild a first home (up to $10,000), - The distributions are used to pay the IRS due to a levy, - Made as part of a series of substantially equal periodic payments, - The distributions are made to a qualified reservist (an individual called up to active duty), - Qualified disaster distributions, or QDDs. - Qualified birth and adoption distributions (maximum $5,000 per child, per parent, made within one year of the date of birth or adoption). - Terminal illness distributions (added by SECURE 2.0 Act of 2022 and effective for distributions made after December 29, 2022). - Even though distributions in these situations will not be subject to the additional 10% tax, they will be subject to income tax at the taxpayer’s normal rates. - Distributions that are properly rolled over into another retirement plan or account (other than conversions to a Roth IRA) are generally not subject to either income tax or the 10% additional penalty. - Taxpayers should use Form 5329 to report penalty exceptions.

Answer 363

- Roth IRA accounts do not require minimum distributions, but traditional IRA accounts do. A person cannot keep funds in a traditional IRA account indefinitely. - The Secure Act 2.0 pushed RMDs back from age 72 to age 73 in 2023 (and to age 75 in 2033). - These are permanent changes and became effective in 2023. The Secure Act 2.0 also reduces the penalty tax for failure to take RMDs from 50% to 25%. If the failure is corrected in a timely manner, the penalty is reduced to 10%. This penalty reduction also applies starting in 2023.

Answer 364

- The first RMD distribution can be delayed until April 1 of the year following the year the taxpayer turns 73. The distribution for each subsequent year must be made by December 31.

Answer 365

- A taxpayer who is 70½ or older may choose to make a qualified charitable distribution (QCD) of up to $100,000 from a traditional IRA to qualified charitable organizations and exclude that amount from income. - QCD amounts count toward a taxpayer’s RMD, if required, but cannot be claimed as a charitable deduction. In order to qualify, the funds must come out of the taxpayer’s IRA by the deadline for minimum distributions (generally December 31). If a taxpayer is filing jointly, the other spouse can also take a QCD up to $100,000. - The IRA trustee must make the distribution directly to the qualified charity; the taxpayer cannot request a distribution and then donate the money later. - A taxpayer could potentially make a QCD from a Roth IRA, but there would be no tax advantage to doing so, since the amounts in Roth IRAs have already been taxed, and qualified distributions are tax-free anyway.

Answer 366

- A rollover is a transfer from one retirement plan to another retirement plan or account. If executed properly, most rollovers are nontaxable events. - With an indirect rollover, it is up to the employee to redeposit the funds into the new IRA or another qualifying retirement account within the mandatory 60-day period to avoid penalty. A taxpayer can make only one indirect rollover from an IRA to another IRA in any twelve-month period. - However, trustee-to-trustee transfers between IRAs are not limited, and rollovers (conversions) from a traditional IRA to a Roth IRA are not limited. With a direct rollover, the funds from the taxpayer’s current retirement account are transferred directly to a new retirement plan.

Answer 367

- It is not uncommon for employees to roll funds from one retirement plan to another, especially after a job change. An “indirect” rollover of a retirement account may be requested when an employee changes jobs or leaves a job to start an independent business but does not want to share information with his or her former employer. With an indirect rollover, the employer generally withholds 20% of the amount that is pending transfer in order to pay the taxes due. - This withholding is mandatory, even if the taxpayer intends to roll it over. If the taxpayer does roll it over and wants to defer tax on the entire taxable portion, he or she will be forced to add funds from other sources equal to the amount of tax withheld. This money is returned as a tax credit for the year when the rollover process is completed. - Note: In order to avoid this mandatory 20% withholding, a taxpayer may request a “direct rollover.” The distribution is then made directly from the custodian or trustee for the employer-sponsored plan to the custodian for the employee’s IRA or his or her new employer’s retirement plan. Under this option, the 20% mandatory withholding does not apply.

Answer 368

- If a taxpayer accidentally contributes more to an IRA than is allowed for the year, the excess contribution is subject to a 6% excise tax. However, the IRS will allow a taxpayer to correct an excess contribution if certain rules are followed. - If a taxpayer makes an IRA contribution that exceeds the annual maximum (or qualifying compensation), the excess contribution and all related earnings must be withdrawn from the IRA before the due date (including extensions) of the tax return for that year. - If a taxpayer corrects the excess contribution by this deadline, the 6% penalty will apply only to the amounts earned on the excess contribution. - Taxpayers who owe this excise tax must complete Form 5329 Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts and submit it with their Form 1040.

Answer 369

- Anyone can inherit an IRA, but inherited IRAs are subject to special rules. Following the death of an IRA owner, the IRA usually passes to a beneficiary. Required minimum distributions generally apply once an IRA account owner dies. This applies to Roth and traditional IRAs. - Before the SECURE Act 1.0, beneficiaries of inherited IRAs could choose a “lump sum” withdrawal or stretch the withdrawal of required minimum distributions over their life expectancy. - The SECURE Act 1.0 abolished “stretch IRAs” for most non-spousal beneficiaries. In most cases, the inherited IRA must now be fully distributed to the beneficiary within 10 years after the original owner passes away. When the SECURE Act 1.0 was passed, it was believed that the 10-year rule did not require annual RMDs, as long as the entire account was distributed before the end of the 10-year term. - On February 23, 2022, the IRS issued proposed regulations that beneficiaries subject to the 10-year rule also will be subject to RMDs for years 1–9 if the beneficiary inherited the account from someone who had already begun taking their RMDs. Due to confusion created by these proposed regulations, the Internal Revenue Service issued transition relief in Notice 2022-53 and Notice 2023-54, waiving the penalty for 2021, 2022, and 2023 for RMD failures committed by designated beneficiaries.

Answer 370

- With regards to inherited IRAs, all of the amounts must be distributed from the inherited account by the end of the tenth year following the year of the original owner’s death (for MOST beneficiaries). - If a beneficiary does not distribute the balance of the account by the end of the tenth year following the year of death, an excise tax will apply to any amount left in the account that is not distributed. - Under the SECURE Act 1.0, there are two classifications of designated beneficiaries for an IRA. The Act distinguishes between a “Eligible Designated Beneficiaries” (EDBs) and other beneficiaries who inherit an account or IRA. An “Eligible Designated Beneficiary” includes: - A surviving spouse, - A disabled or chronically ill individual, - A minor child of the IRA owner (but not a grandchild), or - An individual who is not more than 10 years younger than the account owner.

Answer 371

- Spousal Beneficiary: Surviving spouses have the most choices and flexibility. Surviving spouses have the same options they had before the SECURE Act 1.0. A surviving spouse can elect to treat the IRA as their own by (1) changing the ownership designation or (2) rolling over the IRA balance to their own IRA account. A surviving spouse can also choose to take distributions over their own life expectancy if desired.

Answer 372

- Other “eligible designated beneficiaries” may take their distributions over their own life expectancy. However, minor children must still take remaining distributions within 10 years of reaching the age of majority.

Answer 373

- Any other beneficiary: For any other beneficiaries, the account balance must generally be fully distributed by the 10-year period after the death of the IRA owner.

Answer 374

- Generally, a prohibited transaction is the “improper use” of an IRA by the owner, a beneficiary, or a disqualified person. Prohibited transactions related to an IRA include: - Using an IRA as security or collateral for a loan, - Buying property for personal use with IRA funds (for example, using IRA funds to buy a vacation home the IRA owner will use), - Personally borrowing money from the IRA (i.e., there is no such thing as an “IRA loan,” although some types of retirement plans do allow borrowing, traditional IRAs do not) - Selling, leasing, or exchanging property to the IRA account, - Accepting unreasonable compensation for managing IRA assets, - Allowing account fiduciaries to obtain, use, or borrow against account assets for their own gain, - Transferring plan assets, lending money, or providing goods and services to “disqualified persons,” usually a close family member, or a business that a close family member owns and controls. - For the purposes of the prohibited transaction rules, “family members” includes the taxpayer’s spouse, parents, grandparents, children; and grandchildren and spouses of the taxpayer’s children and grandchildren. - Family members do not include in-laws, cousins, friends, aunts, uncles, siblings, and stepsiblings. - Although occurrences of prohibited transactions are rare, the consequences can be catastrophic. If a prohibited transaction occurs at any time during the year, normally, the account ceases to be treated as an IRA, and its assets are treated as if having been wholly distributed on the first day of the year. - Prohibited transactions are rare occurrences, and they generally only occur when a taxpayer has a “self-directed” IRA. A self-directed IRA is a type of account that offers a taxpayer the ability to use his retirement funds to make almost any type of investment without requiring a financial institution or another custodian.

Answer 375

- Prohibited IRA Investments: Almost any type of investment is permissible inside an IRA, including stocks, bonds, mutual funds and even real estate. However, there are some investments that are prohibited. For example, the law does not permit IRA funds to be invested in life insurance contracts or collectibles. If the taxpayer invests in any of these prohibited investments using IRA funds, it is treated as a prohibited transaction. The following investments are prohibited: - Collectibles and jewelry, such as: artwork, antiques, porcelain, baseball cards, uncut gemstones, or comic books, - Precious metals, coins, and gemstones - S corporation stock, - Life insurance contracts, - Real estate held for personal use (real property can be held in an IRA as long as the investments are not in the taxpayer’s personal name, and not used for personal use, such as a vacation home used by the taxpayer). - There is a narrow exception for investments in gold and silver coins minted by the U.S. Treasury Department. Investments in certain gold, silver, palladium, and platinum bullion are also allowable.

Answer 376

B. The 10% additional tax on early distributions will not apply. - According to Publication 590-A, page 29, if a taxpayer has started taking substantially equal periodic payments from a traditional IRA, the taxpayer may convert the amounts in the traditional IRA to a Roth IRA and then continue the periodic payments. The 10% additional tax on early distributions will not apply even if the distributions are not qualified distributions (as long as they are part of a series of substantially equal periodic payments). - Furthermore, starting in 2010 the $100,000 modified AGI limit and filing status requirements were eliminated. Therefore, the taxpayer does not have a failed conversion.

Answer 377

A. No gain on sale. - Pages 14 through 15 of Publication 523 provide that the gain or loss on a sale or trade of property is found by comparing the amount realized with the adjusted basis of the property. In the case of a personal residence that is the primary residence, a special rule applies whereby the taxpayer can exclude up to $250,000 per spouse of the gain on the sale of the main home if all of the following are true: 1. The taxpayer meets the ownership test (i.e., owned the home for at least 2 of the last 5 years). 2. The taxpayer meets the use test (i.e., lived in the main home for at least 2 of the last 5 years). 3. During the 2-year period ending on the date of the sale, the taxpayer did not exclude gain from the sale of another home. (Publication 523, page 15) - A condominium (as well as houseboat, mobile home, or cooperative apartment) qualifies as a main home as provided in Publication 523, page 3. Therefore, John satisfied the special rule for excluding up to $250,000. In this case, the gain from the sale is $150,000, which is the amount received of $400,000 less the property's basis of $250,000. Since $150,000 is less than the excludable amount, the correct answer is no gain on sale.

Answer 378

B. The reimbursement of meal expenditures is limited to 50% of the amount incurred. - Publication 463, page 29, states, in part, that an accountable plan is one whereby the reimbursement or allowance arrangement by the employer must include all three of the following rules: 1. Your expenses must have a business connection—that is, you must have paid or incurred deductible expenses while performing services as an employee of your employer, 2. You must adequately account to your employer for these expenses within a reasonable period of time, and 3. You must return any excess reimbursement or allowance within a reasonable period of time. - A “reasonable period of time” for accounting to your employer is 60 days from the date of the expenditure. A “reasonable period of time” for returning an excess reimbursement is 120 days after the expense is paid or incurred. If an employee meets the rules for accountable plans, the employer excludes the payments from the employee's W-2 income. - In addition, an exception to the 50% cutback rule is where an employee is reimbursed under an accountable plan and the employer is only able to deduct up to 50% for meals. In this case, the 50% rule doesn't apply to the employee but rather shifts from the employee to the employer (refer to Table 6-1, page 31, Publication 463). - Thus, in this question, it is incorrect to say that the reimbursement of meal and entertainment expenditures is limited to 50% of the amount incurred.

Answer 379

C. $1,000 on Form 8949 and transfer to Schedule D. - In the case where property is condemned or disposed of under the threat of condemnation, the gain or loss is determined by comparing the adjusted basis of the condemned property with the net condemnation award. (Publication 544, pages 6 and 7) - Because this question deals with a gain situation, there are two parts to the question: amount of gain and reporting of gain. The first part is addressed in Publication 544, page 9, which provides that a taxpayer can postpone reporting all the gain if the taxpayer buys replacement property costing at least as much as the amount realized for the condemned property. If the cost of the replacement property is less than the amount realized, the taxpayer must report the gain up to the unspent part of the amount realized. - The second part is addressed in Publication 544, page 11, which provides that a taxpayer reports a gain from a condemnation of property held for personal use (other than excluded gain from a condemnation of the taxpayer's main home or postponed gain) on Form 8949 and transfers to Schedule D (Form 1040 or 1040-SR). - In this case, Joe has a reportable gain of $1,000, which is the amount of the condemnation award not used on the replacement property ($36,000 less $35,000). The gain would be reported on Form 8949 or Schedule D (Form 1040 or 1040-SR), as applicable.

Answer 380

C. The employer must pay a per diem for meals. - In order for an employer's reimbursement or allowance arrangements to qualify as an accountable plan the arrangements must include all three of the following rules: 1. Your expenses must have a business connection—that is, you must have paid or incurred deductible expenses while performing services as an employee of your employer. 2. You must adequately account to your employer for these expenses within a reasonable period of time. 3. You must return any excess reimbursement or allowance within a reasonable period of time.

Answer 381

D. All of the answer choices are correct. - The rules for the automatic waiver to apply are found in Publication 590-A, pages 22 and 23. In general, the 60-day rollover requirement is waived automatically only if all of the following apply: 1. The financial institution receives the funds on the taxpayer's behalf before the end of the 60-day rollover period. 2. The taxpayer followed all the procedures set by the financial institution for depositing the funds into an eligible retirement plan within the 60-day period (including giving instructions to deposit the funds into an eligible retirement plan). 3. The funds are not deposited into an eligible retirement plan within the 60-day rollover period solely because of an error on the part of the financial institution. 4. The funds are deposited into an eligible retirement plan within 1 year from the beginning of the 60-day rollover period. 5. It would have been a valid rollover if the financial institution had deposited the funds as instructed. - Beginning in 2016, if a taxpayer does not qualify for an automatic waiver, they can use the self-certification procedure to make a late rollover contribution or they can apply to the IRS for a waiver of the 60-day rollover requirement. Revenue Procedure 2016-47 provides the rules associated with the procedures for a taxpayer to self-certify. However, it should be realized that this is not a waiver; it is only a written certification to a plan administrator or an IRA trustee that the taxpayer missed the 60-day rollover contribution deadline because of one or more of the 11 reasons listed in Revenue Procedure 2016-47. - In this problem, all of the responses are needed to satisfy the automatic waiver rules for the 60-day rollover rules.

Answer 382

A. Yolanda does not have to pay a recapture tax on any amount received due to a change in distribution method. - Publication 590-B, page 26, provides the general rules for an annuity type distribution from an IRA. In general, a taxpayer can receive distributions from his or her traditional IRA that are part of a series of substantially equal payments over the taxpayer's life (or the taxpayer's life expectancy), or over the lives (or the joint life expectancies) of the taxpayer and the taxpayer's beneficiary, without having to pay the 10% additional tax, even if the taxpayer received such distributions before the taxpayer is age 59-1/2. - The payments under the above exception must generally continue until at least 5 years after the date of the first payment, or until the taxpayer reaches age 59-1/2, whichever is later. If a change from an approved distribution method is made before the end of the appropriate period, any payments the taxpayer receives before the taxpayer reaches age 59-1/2 will be subject to the 10% additional tax. This is true even if the change is made after the taxpayer reaches age 59-1/2. The payments will not be subject to the 10% additional tax if another exception applies or if the change is made because of the taxpayer's death or disability. - Since Yolanda has been receiving the annuity distribution for over 10 years, the additional distribution that she takes at age 62 is not subject to the 10% early distribution.

Answer 383

A. The taxpayer has a failed conversion. - According to Publication 590-A, page 29, if a taxpayer has started taking substantially equal periodic payments from a traditional IRA, the taxpayer may convert the amounts in the traditional IRA to a Roth IRA and then continue the periodic payments. The 10% additional tax on early distributions will not apply even if the distributions are not qualified distributions (as long as they are part of a series of substantially equal periodic payments). - Furthermore, starting in 2010 the $100,000 modified AGI limit and filing status requirements were eliminated. Therefore, the taxpayer does not have a failed conversion.

Answer 384

Specialized Returns for Individuals

Answer 385

- In this chapter, we will discuss foreign financial reporting requirements for U.S. taxpayers. The Bank Secrecy Act (BSA) is the law that imposes reporting requirements on foreign financial accounts. Congress passed the Bank Secrecy Act in 1970 as the first laws to fight money laundering in the United States. - The Foreign Account Tax Compliance Act (FATCA) is the law that mandates the reporting of foreign financial assets. - The subject of foreign financial reporting is extremely complex, and the IRS continues to issue guidance on how taxpayers and tax professionals should approach this difficult topic.

Answer 386

- A person who holds a foreign financial account may have a reporting obligation even when the account produces no taxable income, and even if the person does not have an individual income tax filing requirement. - For the purposes of foreign financial reporting requirements, a “United States person” includes: U.S. citizens, U.S. nationals, U.S. residents, and U.S. entities. It also includes nonresident aliens electing to be treated as U.S. residents in order to file a joint tax return. - There are several different forms used for reporting foreign bank accounts, foreign assets, and foreign gifts. These are: - The FBAR (Form 114, Report of Foreign Bank and Financial Accounts) - Form 8938, Statement of Specified Foreign Financial Assets - Schedule B, Interest and Ordinary Dividends (Part III) - Form 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts - Form 5471, Information Return of U.S. Persons With Respect To Certain Foreign Corporations.

Answer 387

- The term “FBAR” refers to Form 114, Report of Foreign Bank and Financial Accounts. The FBAR is a reporting requirement and does not directly impact tax liability. In 2003, the Department of the U.S. Treasury delegated FBAR enforcement authority to the Internal Revenue Service (IRS). This means that the IRS does not process the FBAR filings, but the IRS is responsible for FBAR enforcement. With regard to FBAR filings, the IRS is responsible for: - Investigating possible civil violations, - Assessing and collecting civil penalties, and - Issuing administrative rulings. - A U.S. taxpayer is required to file an FBAR if: - The person had a financial interest in, or signature authority over, at least one financial account located outside of the United States, and - The aggregate value of all foreign financial accounts exceeded $10,000 (U.S. dollars) at any time during the calendar year reported. This threshold is the same for every filing status. - The FBAR filing requirement, is a separate filing requirement than filing a regular tax return. FBARs are not filed with the IRS. These forms are filed directly with the Financial Crimes Enforcement Network (FinCEN), which is a division of the U.S. Treasury Department. - Records of accounts required to be reported on the FBAR should be kept for five years from the due date of the report, which is the year following the calendar year being reported.

Answer 388

- There is no minimum age requirement for filing an FBAR. The requirement includes minor children, as well. If a child holds $10,000 in a foreign financial account, even if the account is not earning revenues, the child will be required to file their own FBAR. - This is true even if the child would otherwise not have a U.S. filing requirement. If a child cannot file his or her own FBAR for any reason, such as age, the child's parent, guardian, or another legally responsible person must file and sign it for the child.

Answer 389

- The FBAR is due by April 15th of the year following the year in which the account holder meets the $10,000 threshold. However, FinCEN grants filers an automatic extension to October 15 to file the FBAR. There is no requirement or form to request this extra time. - Whether or not an account produces income does not affect the requirement to file an FBAR. - Also, if the IRS issues a release for extensions of filing due to a disaster situation, do not assume that the FBAR filing deadlines are extended, as well. FBAR filing extensions are rare, even for disaster situations.

Answer 390

- Spouses and Jointly-Owned Accounts: Spouses do not need to file separate FBARs if they complete and sign Form 114a, Record of Authorization to Electronically File FBARs, and: - All reportable financial accounts of the nonfiling spouse are jointly owned with the filing spouse, and, - The filing spouse reports all accounts jointly-owned with the nonfiling spouse on a timely-filed FBAR. - Otherwise, both spouses must file separate FBARs, and each spouse must report the entire value of the jointly-owned accounts. - The e-filing system will not allow both spouses’ signatures on the same electronic form – only the filing spouse signs in the system. Taxpayers don’t submit Form 114a with the FBAR, but they must keep it for their records.

Answer 391

- The Treasury Department reports that FBAR filings have surged in recent years, with current filings exceeding one million per year. The consequences of failure to timely file an FBAR can be extremely severe. - Both civil penalties and criminal sanctions can be imposed. By law, civil penalties could exceed $10,000 per year (adjusted for inflation) for a “non-willful” failure to file. - A “willful” failure could result in the greater of $100,000 or 50% of the balance in an unreported foreign account per year for up to six years. This is in addition to criminal penalties. Criminal penalties may include a fine of up to $250,000 and five years in prison. - The potential penalties for willful failure to file an FBAR are huge. These penalties can include criminal prosecution as well as severe monetary civil penalties. - The most common FBAR reporting mistake is simply failing to file. The IRS has issued guidance on penalties for failing to file an FBAR that caps the maximum percentage of the penalty.

Answer 392

- Important Update: For the purposes of the “non-willful” civil penalty mentioned directly above, on February 28, 2023, in a 5-4 decision, the United States Supreme Court ruled that this penalty applies per FBAR report - not for each reportable foreign account. Therefore, even if an individual has multiple reportable foreign bank accounts with a “non-willful” FBAR violation, only one civil penalty can be imposed on the taxpayer for the year. Prior to this decision, there was a split in the lower courts about whether the non-willful civil penalty could be imposed per FBAR report or for each reportable foreign account. - Case: Alexandru Bittner, Petitioner v. United States--Decided February 28, 2023.

Answer 393

- For FBAR purposes, a “foreign financial account” is a financial account located outside of the United States. - The following accounts are not considered “foreign financial accounts”: - Foreign financial accounts owned by a governmental entity, - Foreign financial accounts owned by an international financial institution, - Foreign financial accounts maintained on a United States military banking facility (for example, a banking institution on a U.S. military base).

Answer 394

- Note: A safe deposit box at a foreign financial institution is not considered a “financial account” for tax reporting purposes. However, under the FBAR rules, if gold, bullion, or foreign currency is held inside a foreign financial institution, it is subject to FBAR reporting. Specified foreign financial assets do not include gold, bullion, or currency held directly by the taxpayer.

Answer 395

- U.S. individuals who received large gifts or bequests from certain foreign persons may be required to file Form 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts. Form 3520 is due at the same time as the U.S. person’s income tax return (including extensions) but is filed separately from the income tax return. - A U.S. person must file Form 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts, if the taxpayer receives gifts or bequests valued at more than $100,000 from a nonresident alien individual or foreign estate. A taxpayer must aggregate gifts received from related parties. - Form 3520 is considered an “information return,” not a tax return, and no taxes are assessed on this form, because foreign gifts or bequests are not subject to income tax.

Answer 396

- A “foreign gift” to a U.S. person does not include amounts paid for qualified tuition or medical payments made on behalf of the U.S. person.

Answer 397

- Taxpayers who hold “specified foreign financial assets” must also file Form 8938, Statement of Specified Foreign Financial Assets, with their tax returns if the amount of their assets exceeds certain thresholds. - This is a separate filing requirement in addition to the FBAR filing requirements. Form 8938 requires the taxpayer to provide detailed financial information about their foreign accounts. Specified foreign assets include (this is not an exhaustive list): - Foreign stock or foreign securities (not held in a U.S. brokerage account), - Financial accounts maintained by a foreign financial institution, - Foreign pensions or deferred compensation plans, - Interests in a foreign estate, - A partnership interest in a foreign partnership; - Any interest in a foreign-issued insurance contract or annuity with a cash-surrender value.

Answer 398

- A filing requirement is triggered if the aggregate value of specified foreign financial assets is more than the following reporting thresholds: - Taxpayers living inside the US: - Unmarried and MFS taxpayers: The total value of specified foreign financial assets is more than $50,000 on the last day of the tax year or more than $75,000 at any time during the tax year. - Married taxpayers filing MFJ: The total value of specified foreign financial assets is more than $100,000 on the last day of the tax year or more than $150,000 at any time during the tax year. - Taxpayers living abroad: - Unmarried and MFS taxpayers: living abroad must file Form 8938 if the total value of their specified foreign assets is more than $200,000 on the last day of the tax year or more than $300,000 at any time during the year. - Married taxpayers filing MFJ: for joint filers, the value of their specified foreign assets is more than $400,000 on the last day of the tax year or more than $600,000 at any time during the year. - Note: If a taxpayer is not required to file an income tax return for the year, he or she does not need to file Form 8938, even if the value of their specified foreign assets is greater than one of the reporting thresholds.

Answer 399

- Foreign real estate is not a “specified foreign financial asset.” Therefore, a personal residence or a rental property in a foreign country does not have to be reported as a “foreign financial asset,” unless the property is held by a foreign entity. - Directly-held tangible assets, such as art, gold, antiques, jewelry, cars and other collectibles, are also not specified foreign financial assets. - Foreign currency is not a specified “foreign financial asset” if it is directly-held by the taxpayer and not held in a financial institution.

Answer 400

- Schedule B is used to report interest and dividend income received during the tax year. However, the last part of Schedule B (Part III) is used by taxpayers who have financial accounts in foreign countries. This section of the form is where the taxpayer must disclose any foreign bank or investment accounts and whether or not the taxpayer received any distributions from a foreign trust. - On Part III, Schedule B, a taxpayer must check “yes” or “no” to the question of whether he or she had at any time during the year a financial interest in or signature authority over a financial account. - Note: If a taxpayer does not have a filing requirement, they are not required to file a tax return merely to report their foreign financial accounts on Schedule B. - A taxpayer who had a financial interest in a foreign account during the year should check the “yes” box even if he or she is not required to file FinCEN Form 114, Report of Foreign Bank and Financial Accounts (FBAR). There is no dollar threshold to report foreign accounts on Schedule B. - Even if the taxpayer does not have an FBAR reporting requirement, the “yes” box must be checked if the taxpayer has any financial interest in, or signature authority over, a foreign account.

Answer 401

- When a U.S. taxpayer is an officer, director, or shareholders in a foreign corporation, they may have an IRS reporting requirement. Form 5471 is typically used to report ownership of a foreign corporation that exceeds a 10% threshold. - The Form 5471 is generally filed with a taxpayer’s individual return. Even if a person is not required to file a tax return, (for example, their income is below the filing threshold), the Form 5471 may still be required. - The requirement to file Form 5471 is not based on whether the business generated any income. Form 5471 is an informational return, not a tax return. The penalties for nonfiling are severe. Each failure to file a required Form 5471 can result in a $10,000 penalty.

Answer 402

- Sometimes, the estate tax is called a “death tax” or an “inheritance tax.” The estate tax is not an income tax. It is a tax that is imposed on the transfer of property after a person’s death. - Estate and gift taxes are often considered together because they share the same lifetime exemption amount. However, the estate tax applies to transfers of the decedent's property after death, while the gift tax applies to transfers made while a person is alive.

Answer 403

- Estates and trusts are separate legal entities that are defined by the assets they hold. A decedent’s estate is created when a taxpayer dies. - A bankruptcy estate is created when a taxpayer files for bankruptcy. Most of what we will be covering is the estates of deceased taxpayers. - A trust can be created while the taxpayer is alive, or by the taxpayer’s last will and testament. A trust can hold title to property for the benefit of one or more persons or entities. Trusts are most commonly used for estate planning. We will talk more about trusts in a separate webinar on trusts. - An estate (whether a bankruptcy estate or a decedent’s estate) is required to obtain an employer identification number (EIN), just like any other legal entity.

Answer 404

- After a person dies, a personal representative, will typically manage the estate and settle the decedent’s final financial affairs. - Probate is the court-supervised process of administering an estate. Not all estates have to go through probate, but this is governed by state law and varies from state to state. - Executors are appointed when the decedent has a will, and administrators are appointed when the decedent dies without a will. If a person dies with a will, these are sometimes called testamentary probate proceedings. If a person dies without a will, the person is said to have died intestate. The executor or administrator has the legal authority to act on behalf of the estate. - The IRS will sometimes use the term “executor” and “personal representative” interchangeably. The IRS often uses the term “personal representative” to refer to anyone filing a return on behalf of a decedent, regardless if that person has been appointed by the courts or formally named in the taxpayer’s will. - When performing required duties for an estate before the IRS, executors must provide documentation proving their status. Documentation will vary but may include documents such as a certified copy of the will or a court order designating the executor. Merely a statement by the executor attesting to their status is insufficient.

Answer 405

- Duties of the executor/personal representative: - Obtain an estate EIN - File Form 56, Notice Concerning Fiduciary Relationship. - Distribute Estate assets according to the decedent’s wishes - Sign the appropriate line of each of the following tax returns that may need to be filed: - The final income tax return (Form 1040) for the decedent (for income received before death); - Fiduciary income tax returns (Form 1041) for the estate for the period of its administration; and - The estate tax return (Form 706). - The personal representative is responsible for determining any estate tax liability before the estate’s assets are distributed to beneficiaries.

Answer 406

- The executor or “personal representative” must include fees paid to them from an estate in their gross income. If the executor is not in the trade or business of being an executor (for instance, the executor is a friend or family member of the deceased), these fees are reported on the executor’s individual Form 1040, as “other income.” - If the executor is in the “trade or business” of being an executor, (such as a self-employed estate attorney), the executor would report the fees received from the estate as self-employment income on Schedule C.

Answer 407

- The executor is responsible for determining any estate tax liability before the estate’s assets are distributed to beneficiaries. The tax liability for an estate attaches to the assets of the estate itself. - If the assets are distributed to the beneficiaries before the taxes are paid, the beneficiaries or the executor may be held liable for the tax debt, up to the value of the assets distributed. - A personal representative or executor of an estate cannot be held liable if an insolvent estate does not have enough assets to cover any of the income taxes due or debts. - However, the executor must be sure that any income taxes are paid before any assets are distributed to the beneficiaries of the estate; otherwise, the executor might be held personally liable for the tax debt.

Answer 408

- After a taxpayer dies, the following tax returns may need to be filed by the personal representative of the estate: - Form 1040, Final income tax return for the decedent (for income received before death). - Form 1041, U.S. Income Tax Return for Estates and Trusts: Fiduciary income tax returns for the estate for the period of its administration - Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return: If the gross estate, based on the fair market value of its assets, exceeds the applicable threshold. This return is used to report tax on the taxable estate (the gross estate minus certain deductions). - The personal representative or executor must sign each required return. A personal representative should sign the decedent’s final income tax return as “Personal Representative” or “executor”. - If the taxpayer’s final income tax return is a joint return, then the surviving spouse may sign as a “Surviving Spouse.”

Answer 409

- An estate is a taxable legal entity that exists from the time of an individual’s death until all assets have been distributed to the decedent’s beneficiaries. Most estates are administered and distributed within 12-18 months, but sometimes, when the decedent was a very wealthy person, or if the estate is in litigation, the estate may not terminate for years, sometimes, even decades. - The Form 1041 is an annual income tax return, similar to the return an individual or business would file. Form 706 is different: it is not an income tax return. Instead, it is a tax form used to calculate estate taxes only. Depending on the value of an estate, and income that it generates, both forms may have to be filed (or, in the case of a small estate, neither form may have to be filed). - A decedent’s assets will often continue to earn revenue after a taxpayer has died, this income, such as rents, dividends and interest, must be reported on Form 1041. The Schedule K-1 is used to report any income that is distributed or distributable to each beneficiary and is filed with Form 1041, with a copy also given to the beneficiary.

Answer 410

- Estates and trusts generally terminate when all of their assets and income have been distributed, and all of their liabilities have been paid. - If an estate or trust has a loss in its final year, the loss can be passed through to the beneficiaries, allowing them deductions on their individual returns. Losses cannot be passed through to beneficiaries in a non-termination year.

Answer 411

- The due date for Form 1041 is the 15th day of the fourth month following the end of the entity’s tax year (usually April 15 for a calendar year entity), but an extension of five-and-a-half months (to Sept 30) can be requested by filing Form 7004. - The tax year of an estate may be either a calendar or a fiscal year, subject to the election made at the time the first return is filed. An election will also be made on the first return as to method (cash, accrual, or other) to report an estate’s income. - Form 1041 must be filed for any domestic estate that has gross income for the tax year of $600 or more, or a beneficiary who is a nonresident alien (with any amount of income).

Answer 412

- All the property the decedent owned at the time of death is included in the gross estate for estate tax purposes. - In 2023, an estate is allowed an income tax exemption amount of $600 for income tax purposes and an exclusion amount of $12.92 million for estate tax purposes. - If a taxpayer died in 2023, and the value of their assets at the time of death was less than $12.92 million, an estate tax return (Form 706) does not have to be filed.

Answer 413

- The taxpayer’s final income tax return is filed on the same form that would have been used if the taxpayer were still alive, but “deceased” is written after the taxpayer’s name. The filing deadline is the same deadline that applies for individual income tax returns. - The personal representative must file the final individual income tax return of the decedent for the year of death and any returns not filed for preceding years. - On a decedent’s final tax return, the rules for deductions are the same as those that apply for any individual taxpayer. The decedent's year of death is not treated as a short tax year.

Answer 414

- An estate tax return is filed using Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return. This return is due nine months after the death of the decedent. A six-month extension is allowed by filing Form 4768. - The maximum estate tax rate is 40%. - The applicable estate tax rate is applied to derive a tentative tax, from which any gift taxes paid or payable are subtracted to determine the gross estate tax. - Basic Exclusion Amount: This amount is adjusted for inflation each year and may be used to reduce or eliminate gift and/or estate taxes. ($12.92 million in 2023) - Deceased Spousal Unused Exclusion (DSUE): This is the unused portion of the decedent’s predeceased spouse’s basic exclusion (the amount that was not used to offset gift or estate tax liabilities). A portability election must be made to claim the DSUE on behalf of the surviving spouse’s estate. This election can be made automatically by timely completion and filing of Form 706 for the estate of the predeceased spouse. A Form 706 must be timely filed by the executor of any estate who intends to transfer the DSUE a decedent’s surviving spouse, regardless of the amount of the gross estate.

Answer 415

- The gross estate is based upon the fair market value of the decedent’s property, which is not necessarily equal to its cost. The gross estate includes: - The FMV of all tangible and intangible property owned partially or outright by the decedent at the time of death, - Life insurance proceeds payable to the estate or, for policies owned by the decedent, payable to the heirs, - The value of certain annuities or survivor benefits payable to the heirs, and - The value of certain property that was transferred within three years before the decedent’s death. - The gross estate does not include property owned solely by the decedent’s spouse or other individuals. Lifetime gifts that are complete (so that no control over the gifts was retained) are not included in the decedent’s gross estate. In order to qualify as a “lifetime gift,” the transfer must be complete and irrevocable.

Answer 416

- Once the gross estate has been calculated, certain deductions are allowed to determine the taxable estate. Deductions from the gross estate may include: - Funeral expenses paid out of the estate. - Administration expenses for the estate (if not deducted on Form 1041). - Debts owed at the time of death. - The marital deduction (generally, the value of the property that passes from the estate to a surviving spouse who is a U.S. citizen) (covered next). - The charitable deduction (generally, the value of the property that passes from the estate to qualifying charities). - The state death tax deduction (generally, any inheritance or estate taxes paid to any state. Some states impose a death tax, and some do not). - The following items are not deductible from the gross estate: - Federal estate taxes paid. - Alimony paid after the taxpayer’s death. These payments would be treated as distributions to a beneficiary. - Property taxes are deductible only if they accrue under state law prior to the decedent’s death.

Answer 417

- Income in respect of a decedent (IRD) is any taxable income that was earned but not received by the decedent by the time of death. IRD is not taxed on the final return of the deceased taxpayer. IRD is reported on the tax return of the person (or entity) that receives the income. - This could be the estate, in which case it would be reported on Form 1041. Otherwise, it could be the surviving spouse or another beneficiary, such as a child. If there is no designated beneficiary for the income, then the IRD items are reported on the estate’s Form 1041. - IRD retains the same tax nature that would have applied if the deceased taxpayer were still alive. For example, if the income would have been short-term capital gain, it is taxed the same way to the beneficiary. - However, wages paid as income in respect of a decedent after the year of death generally are not subject to withholding for any federal taxes. - For self-employment tax purposes only, the decedent's self-employment income will include the decedent's distributive share of a partnership's income or loss through the end of the month in which death occurred.

Answer 418

- IRD can come from various sources, including: - Unpaid salary, wages, or bonuses - Amounts distributed from retirement plans distributed by payor before the taxpayer’s death, but not yet received by the decedent at the time of death. - Deferred compensation benefits - Accrued but unpaid interest, dividends, and rent - Dividends declared before the decedent’s death, but payable after death - Outstanding income owed to a self-employed decedent (accounts receivable) is considered IRD but is not subject to self-employment tax. - IRD is included in the decedent’s estate and may be subject to estate tax. This may happen with a very wealthy person. If a beneficiary receives IRD and the income is subject to estate tax, the beneficiary can deduct the tax on Schedule A of their individual income tax return as a miscellaneous itemized deduction. The beneficiary must claim the IRD deduction in the same tax year in which they actually receive the income. The IRD deduction was not suspended by the Tax Cuts and Jobs Act.

Answer 419

- Estates and certain trusts are subject to the additional tax of 3.8% on net investment income. The provisions for this tax are generally similar to those for individuals, and it must be reported on Form 8960, Net Investment Tax: Individuals, Estates, and Trusts. - For trusts and estates, the tax applies to the lesser of undistributed net investment income or the excess of adjusted gross income over the threshold amount at which the highest tax bracket begins. The NIIT does not apply to tax-exempt trusts or to grantor trusts.

Answer 420

- Estates and Trusts are hybrid “pass-through” entities, income can be taxed at the estate or trust level. Taxable income earned by an estate or trust is taxable to either the entity or the beneficiaries, but NOT to both. Distributable net income (DNI) is income that is currently available for distribution. The income distribution deduction (IDD) is allowed to trusts and estates for amounts that are paid, credited, or required to be distributed to beneficiaries.

Answer 421

- The Marital Deduction: Transfers from one spouse to the other are typically tax-free. The marital deduction allows spouses to transfer an unlimited amount of property to one another during their lifetimes or at death without being subject to estate or gift taxes if the spouse is a U.S. citizen. - To receive an unlimited marital deduction, the spouse receiving the assets must be a U.S. citizen and a legal spouse and must have outright ownership of the assets. The unlimited marital deduction is generally not allowed if the transferee spouse is not a U.S. citizen (even if the spouse is a legal resident of the United States). - Note: The marital deduction is NOT the same thing as the Deceased Spousal Unused Exclusion, or DSUE. The DSUE is an election that is only available to U.S. citizen spouses.

Answer 422

- The DSUE is the unused portion of the decedent’s predeceased spouse’s basic exclusion (the amount that was not used to offset gift or estate tax liabilities). A “portability” election must be made to claim the DSUE on behalf of the surviving spouse’s estate. This election can be made automatically by timely completion and filing of Form 706 for the estate of the predeceased spouse. - Portability is not automatic: Form 706 must be filed in order to make the election. - This means that the executor, (usually, this is the surviving spouse, but not always), will need to transfer the unused exclusion to the surviving spouse. This is done by filing an estate tax return. - In order to make the election, an estate tax return is required when the first spouse dies, even if no tax is owed. This return is due nine months after the death of the first spouse. A six-month extension is allowed. The DSUE is not available to nonresident alien spouses.

Answer 423

- For federal income tax purposes, cash inheritances are generally not taxable to the beneficiary, although the beneficiary may be responsible if there is a related estate tax liability that has not been satisfied. - Beneficiaries of cash inheritances generally do not have any reporting requirements, UNLESS the inheritance is coming from a foreign estate.

Answer 424

- Inherited retirement accounts are treated a bit differently. Distributions of retirement plan benefits or distributions from taxable IRA accounts to the decedent’s beneficiaries are generally subject to income tax when received, although inherited IRAs are not subject to an early-withdrawal penalty, regardless of the beneficiary’s age. - Qualified distributions from a Roth IRA or of previously nondeductible contributions to a traditional IRA are generally not taxable. - The decedent’s surviving spouse may be able to defer taxation by rolling over the assets of a taxable IRA to another IRA or to a qualified plan.

Answer 425

- The basis of property inherited from a decedent is generally one of the following: - The FMV of the property on the date of death (“stepped-up” or “stepped-down” basis). - The FMV on the alternate valuation date, if ELECTED, the alternate valuation date is six months after the date of death. The estate value and related estate tax must be less than they would have been on the date of the taxpayer’s death. However, for any assets distributed to a beneficiary after death, but prior to six months after death, the basis for these assets is the fair market value as of the date of distribution. - The value under a special-use valuation method for real property used in farming or another closely-held business, if elected by the personal representative.

Answer 426

- The gift tax is not an income tax. The gift tax may apply to the transfer of property by one individual to another, whether the donor intends the transfer to be a gift or not. - The gift tax and the estate tax are “tied together”. Estate and gift taxes are often considered together because they share the same lifetime exemption amount. However, the estate tax applies to transfers of the decedent's property after death, while the gift tax applies to transfers made while a person is alive. - Gift tax is always imposed on the donor, not the receiver, of the gift. The recipient of a gift typically owes no taxes and does have to report the gift unless it comes from a foreign donor.

Answer 427

- An individual taxpayer’s liability for estate tax and gift tax is subject to a combined basic exclusion amount, and the use of any portion of this exclusion amount to reduce payment of gift taxes during the taxpayer’s lifetime will reduce the amount available upon death to reduce applicable estate taxes. - In 2023, the estate and gift tax exemption is $12.92 million per decedent. This limit is indexed for inflation through 2025. - Gift taxes are reported on Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return. Form 709 must be filed if a taxpayer gives more than the annual exclusion amount to at least one individual (except to a U.S. citizen spouse). The gift exclusion amount is $17,000 for 2023. - The top estate and gift tax rate remains at 40%.

Answer 428

- If a gift tax return is required to be filed, Form 709 is generally due by April 15 of the following year. However, if the donor dies during the year, the filing deadline may be the due date (with extensions) for his estate tax return, if earlier than April 15 of the following year. - Taxpayers who extend the filing of Form 1040 for six months by using Form 4868 are “deemed to have extended” their gift tax returns, if no gift tax is due with the extension. - If the taxpayer does not extend their individual return, the gift tax return can be extended separately by using Form 8892, Application for Automatic Extension of Time to File Form 709 and/or Payment of Gift/Generation-Skipping Transfer Tax.

Answer 429

- A gift tax return (Form 709) filing requirement may be triggered if: - You give a single person a gift above the annual gift limit (except a U.S. spouse) - A taxpayer “splits gifts” with a spouse, - A taxpayer gives a “future interest” to anyone other than a U.S. citizen spouse.

Answer 430

- A gift is considered a present interest if the donee has all immediate rights to the use, possession, and enjoyment of the property or income from the property, with no strings attached. - A gift is considered a future interest if the donee’s rights to the use, possession, and enjoyment of the property or income from the property will not begin until some future date. A gift of a future interest cannot be excluded under the annual exclusion. With a “future interest” the beneficiary typically does not become the owner of the property until the donor’s death.

Answer 431

- Both the basic exclusion amount and the annual exclusion amount apply separately to each spouse, and each spouse must separately file a gift tax return if he or she made reportable gifts during the year. - However, if either spouse makes a gift to another person, the gift can be considered as being one-half from one spouse and one-half from the other spouse. This concept is known as gift splitting. - Both spouses must consent to split a gift. - If gifts are made by spouses from community property funds, the gift is deemed to have been made 50% by each spouse.

Answer 432

- The following gifts are not taxable and DO NOT need to be reported: - Gifts to an individual that do not exceed the annual exclusion amount ($17,000 in 2023). - Tuition or medical expenses paid directly to the educational or medical institution for someone else. - Unlimited gifts to a spouse, as long as the spouse is a U.S. citizen. - Gifts to a political organization for its use. - Gifts to a qualifying charity. - A parent’s support for a minor child. This may include support required as part of a legal obligation, such as by a divorce decree.

Answer 433

- For taxable gifts, each taxpayer has an aggregate lifetime exemption before any out-of-pocket gift tax is due. (in 2023, this is $12.92 million) - A taxpayer’s gross estate tax is reduced by the applicable credit, also referred to as the unified credit. The unified credit is the combination of the lifetime gift tax exclusion and estate tax exclusion. - Just as with the basic exclusion amount, any portion of the applicable credit amount used to avoid payment of gift taxes reduces the amount of credit available in later years that can be used to offset gift or estate taxes. - For example, if a taxpayer exceeds the annual gift tax exclusion amount in any year, the taxpayer can choose to either pay the gift tax on the excess or take advantage of the unified credit to avoid paying the tax in the current year.

Answer 434

A. $0 - The gift tax presently payable is determined by applying the applicable tax rate to the sum of all prior years' taxable gifts and then subtracting that from the tentative tax. The tentative tax is then reduced by the amount of applicable credit. The basic credit (formerly the unified credit) amount in 2023 is $5,113,800. (Form 709 Instructions, page 1) - Thus, the balance of tax due on Margaret's Form 709 gift tax return this year is $544,000, which is the tax on current-year gifts of $3,036,000 less the applicable credit of $2,492,000. (The applicable credit is calculated as $5,113,800 − $2,621,800.)

Answer 435

B. Value of property interest not included in the decedent's gross estate. - Generally, a taxpayer may list on Schedule M all property interests that pass from the decedent to the surviving spouse and are included in the gross estate. However, the instructions for Form 706, page 38, provide that certain property interests are listed on Schedule M and that other property interests that are not listed on Schedule M and therefore are not eligible for the marital deduction, such as: 1. The value of any property that does not pass from the decedent to the surviving spouse; 2. Property interests that are not included in the decedent's gross estate; 3. The full value of a property interest for which a deduction is claimed on Schedules J through L (The value of the property interest should be reduced by the deductions claimed with respect to it.); 4. The full value of a property interest that passes to the surviving spouse subject to a mortgage or other encumbrance or an obligation of the surviving spouse (Include on Schedule M only the net value of the interest after reducing it by the amount of the mortgage or other debt.); 5. Nondeductible terminable interests (as further described on pages 35 and 36 of the Form 706 Instructions); or 6. Any property interest disclaimed by the surviving spouse. - Based on the list provided above, the correct response is the value of property interest not included in the decedent's gross estate is not eligible for the marital deduction.

Answer 436

A. A surviving spouse that is a U.S. citizen. - Pursuant to the instructions for Form 706, page 38, the marital deduction is authorized by IRC Section 2056 for certain property interests that pass from the decedent to the surviving spouse (not children). The estate may claim the deduction only for property interests that are included in the decedent's gross estate (Schedules A through I). - In addition, the marital deduction is generally not allowed if the surviving spouse is not a U.S. citizen. The marital deduction is allowed for property passing to such a surviving spouse in a qualified domestic trust (QDOT) or if such property is transferred or irrevocably assigned to such a trust before the estate tax return is filed. The executor must elect QDOT status on this return.

Answer 437

D. 1, 2, and 3. - For 2023, an estate will arrive at the taxable estate by subtracting related deductions against their gross estate. A taxpayer must file the first four pages of Form 706 and all required schedules (such as A through PC—see page 1 of the Form 706 Instructions for a complete listing). As applicable in this question, the following items are provided on a separate schedule of Form 706 (see, for example, Form 706 Instructions, page 1): 1. Funeral expenses (Schedule J, Form 706) 2. Generation-skipping transfer tax (Schedule R and R-1, Form 706) 3. Charitable, public, and similar gifts and bequests (Schedule O, Form 706)

Answer 438

- In general, an estate will arrive at the taxable estate by subtracting related deductions from the gross estate. As applicable in this question, the following expenses are permitted as deductions for an estate: 1. Funeral expenses (net any reimbursements) 2. Executor's commissions (have been paid or are expected to be paid) - Executors’ commissions may be deducted that have actually been paid or that will be paid. Commissions are not deducted if none will be collected. - Interest incurred as the result of a federal estate tax deficiency is a deductible administrative expense. Penalties, on the other hand, are not deductible even if they are allowable under local law. - Likewise, attorney fees incidental to litigation incurred by the beneficiaries are not deductible. These expenses are charged against the beneficiaries personally and are not administrative expenses. - Therefore, the only statement that is true regarding allowable deductions on Form 706 is that executor's commissions may be deducted if they have actually been paid or if it is expected that they will be paid.

Answer 439

B. Authorization of more than one person to represent the estate. - For decedents who died in 2023, Form 706 must be filed by the executor of the estate whose gross estate, plus adjusted taxable gifts and specific exemptions, is more than $12,920,000. An estate, therefore, will arrive at the taxable estate by subtracting related deductions against their gross estate. (Form 706 Instructions, page 2) - As applicable in this question, a taxpayer must file the first four pages of Form 706 and all required schedules (Form 706 Instructions, page 5). The separate schedules of Form 706 are given on page 1 of the instructions for Form 706 and include but are not limited to the following: 1. Funeral expenses (Schedule J, Form 706) 2. Generation-skipping transfer tax (Schedules R and R-1, Form 706) 3. Stocks and bonds (Schedule B, Form 706) - As provided in Part 4 on pages 15–16 of the instructions for Form 706, completing the authorization (on page 2 of Form 706) will authorize one attorney, accountant, or enrolled agent to represent the estate and receive confidential tax information. However, if a taxpayer wishes more than one person to be authorized, then Form 2848 must be completed and attached to Form 706.

Answer 440

D. No estate tax return is filed. - For decedents dying in 2023, Form 706 must be filed by the executor for the estate of every U.S. citizen or resident: 1. Whose gross estate, plus adjusted taxable gifts and specific exemption, is more than $12,920,000 or 2. Whose executor elects to transfer the decedent’s unused exclusion (DSUE) amount to the surviving spouse, regardless of the size of the decedent's gross estate. - If the executor must file Form 706 to report estate and/or generation-skipping transfer tax, it is due within 9 months after the date of the decedent's death unless an extension of time to file has been granted. An automatic 6-month extension of time to file is requested by filing Form 4768. - In this case, January 30 of the following year is the 9-month limit. - Form 706, however, is not filed in this case because the value of the estate is below $12,920,000, which is the threshold amount for requiring the filing of an estate form.

Answer 441

D. All of the answer choices are correct. - Specific to this question, a citizen or resident of the United States generally must file a gift tax return (whether or not any tax is ultimately due) in the following situations: 1. If gifts were given to someone in 2023 totaling more than $17,000 (other than to your spouse), 2. A gift of community property, because it is considered made one-half by each spouse, 3. Certain gifts, called future interests, are not subject to the $17,000 annual exclusion and Form 709 must be filed even if the gift was under $17,000, and 4. A gift tax return must be filed to split gifts with a spouse (regardless of the amount). - Therefore, in the above question, all of the situations would require the filing of Form 709. - For a detailed list of "who must file" situations requiring Form 709 to be filed, refer to page 2 of the IRS instructions for Form 709.

Answer 442

C. $53,000. - Generally, the federal gift tax applies to any transfer by gift of real or personal property, whether tangible or intangible, that is made directly or indirectly, in trust, or by any other means to a donee. Additionally, there are four types of transfers that are not subject to the gift tax. These are transfers to political organizations, transfers to certain exempt organizations, and payments that qualify for the educational and medical exclusions. More specific to this question, transfers to a political organization as defined in IRC Section 527(e)(1) for the use of the organization is not subject to the gift tax and are not reported on Form 709. (Form 709 Instructions, page 2) - Furthermore, the value of a gift is the fair market value (FMV) of the property on the date the gift was made (valuation date). That is, the FMV is the price at which the property would change hands between a willing buyer and a willing seller, when neither is forced to buy or to sell, and when both have reasonable knowledge of all relevant facts. (Form 709 Instructions, page 10) - If the taxpayer is required to file a return to report noncharitable gifts and the taxpayer made gifts to charities, the taxpayer must include all of his or her gifts to charities on the return. (Form 709 Instructions, page 2) -Thus, John will report a gross amount of $53,000 of gifts on his 2023 Form 709, which is the sum of $29,000 to his son Bradley ($12,000 plus $17,000 (FMV of car)), $18,000 to his daughter Alexandria, and $6,000 to charities. -Be aware: This question is somewhat tricky in that it gave two gifts to Bradley, where one is below the $17,000 threshold. When some gifts are below the $17,000 threshold and others are more than the threshold, all gifts have to be disclosed on the tax return. The $17,000 will be applied to each gift to determine the taxable portion of the gift. For instance, if the taxpayer gifts three gifts: $18,000, $6,000, $22,000, he/she will have taxable gifts of $6,000 calculated as follows: $18,000 - $17,000 = $1,000, $6,000 - $17,000 = no taxable gift, $22,000 - $17,000 = $5,000. Total taxable gifts = $6,000. Beware that the unused exclusion from one gift is lost and cannot be used against other gifts that are over the threshold. In our example, the unused $11,000 from the $6,000 gift cannot be used against the other gifts. - Also, in determining the taxability of gifts for gift tax purposes, various gifts will not be aggregated. In our example earlier, the taxpayer is not allowed to sum up the gifts of $46,000 ($18,000 + $6,000 + $22,000) and exclude $17,000 × 3 = $51,000 to conclude there are no taxable gifts. The exclusion must be applied on a gift-by-gift basis.

Answer 443

A. The deduction for estate tax can be claimed only for the same tax year in which the income in respect of a decedent must be included in the recipient's income. - Income that a decedent had a right to receive is included in the decedent's gross estate and is subject to estate tax. This income in respect of a decedent is also taxed when received by the recipient (estate or beneficiary). However, an income tax deduction is allowed to the recipient for the estate taxes paid on this income. - The deduction for estate tax can be claimed only for the same tax year in which the income in respect of a decedent must be included in the recipient's income. (This is also true for income in respect of a prior decedent.) - Individuals can claim this deduction only as an itemized deduction on line 16 of Schedule A (Form 1040 or 1040-SR), which is a miscellaneous deduction that is not subject to the 2% limitation. - Hence, the only correct response is the deduction for estate tax can be claimed only for the same tax year in which the income in respect of a decedent must be included in the recipient's income.

Answer 444

D. Your spouse does not have the unlimited power, while he or she is alive or by will, to appoint the entire interest in all circumstances. - A taxpayer's ability to deduct a gift of a terminable interest, without an election, is permitted if it meets all four of the following requirements: 1. Your spouse is entitled for life to all of the income from the entire interest. 2. The income is paid yearly or more often. 3. Your spouse has the unlimited power, while he or she is alive or by will, to appoint the entire interest in all circumstances. 4. No part of the entire interest is subject to another person's power of appointment (except to appoint it to your spouse). - If either the right to income or the power of appointment given to the spouse pertains only to a specific portion of a property interest, the marital deduction is allowed only to the extent that the rights of the spouse meet all four of the above conditions. For example, if the spouse is to receive all of the income from the entire interest, but only has a power to appoint one-half of the entire interest, then only one-half qualifies for the marital deduction. - The election is made by listing the qualified terminable interest property on Schedule A and deducting its value on line 4, Part 4 of Schedule A. - Thus, a necessary requirement does not include the case where the spouse does not have the unlimited power, while he or she is alive or by will, to appoint the entire interest in all circumstances.

Answer 445

D. $4,750,000. - The gross estate includes all property in which the decedent had an interest (including real property outside the United States). It also includes: 1. Certain transfers made during the decedent's life without an adequate and full consideration in money or money's worth; 2. Annuities; 3. The includible portion of joint estates with right of survivorship; 4. The includible portion of tenancies by the entirety; 5. Certain life insurance proceeds (even though payable to beneficiaries other than the estate); 6. Digital assets; 7. Property over which the decedent possessed a general power of appointment; 8. Dower or curtesy (or statutory estate) of the surviving spouse; and 9. Community property to the extent of the decedent's interest as defined by applicable law. - Additionally, any “QTIP” property received from a pre-deceased spouse must be included in the gross estate. - Accordingly, Lisa's gross estate is $4,750,000, computed as follows: Gross estate Revocable grantor trust $3,750,000 QTIP trust 1,000,000 Lisa's gross estate $4,750,000 - The estate of Lisa would not file an estate tax return because the gross estate is $12,920,000 or less.

Answer 446

B. Within 9 months of the date of death. - Unless an extension of time to file Form 706 has been received, the estate tax return must be filed within 9 months after the date of the decedent's death.

Answer 447

D. No estimated payments are required. - Generally, estimated tax must be paid if the estate is expected to owe, after subtracting any withholding and credits, at least $1,000 in tax for 2024. You will not, however, have to pay estimated tax if you expect the withholding and credits to be at least: 1. 90% of the tax to be shown on the 2024 return or 2. 100% of the tax shown on the 2023 return. (The percentage is 110% if the estate's 2023 adjusted gross income (AGI) was more than $150,000.) This exception does not apply if there was no return filed for 2023 or if the 2023 return did not cover a full 12 months. - If the estate has adopted a calendar year as its tax year, it must file under the rules set forth for trusts (Form 1041-ES, page 2). That is, the estate can either pay all of the estimated tax on April 15 or pay it in four equal installment amounts (i.e., April 15, June 15, September 15, and January 15). - There are three exceptions to this general rule. One of the exceptions pertains to the first 2 years following the death of the taxpayer. During this period, no estimated payments are necessary. Estates, therefore, with tax years ending 2 or more years after the date of the decedent's death must pay estimated tax in the same manner as individuals. - Since the return being filed in 2024 is within the 2-year period, no estimated payments are required.

Answer 448

D. All of the answer choices are correct. - As applicable to the above question and according to the IRS instructions for line 15 of Form 706, page 10, the following credits are allowed on an estate tax return: credit for foreign death taxes (Schedule P), and credit for tax on prior transfers as discussed on pages 40–42. In addition, line 10 provides an exemption for decedent made gifts. - As a result, all of the answer choices are correct.

Answer 449

A. Specific bequest to son. - In figuring taxable income, an estate is generally allowed the same deductions as an individual. - A bequest is the act of giving or leaving property to another through the last will and testament. Generally, any distribution of income (or property in kind) to a beneficiary is an allowable deduction to the estate and is includible in the beneficiary's gross income to the extent of the estate's distributable net income. However, a distribution will not be an allowable deduction to the estate and will not be includible in the beneficiary's gross income if the distribution meets the following requirements: 1. It is required by the terms of the will, 2. It is a gift or bequest of a specific sum of money or property, and 3. It is paid out in three or fewer installments under the terms of the will. - Therefore, a “specific” bequest to a son would not be an allowable deduction because it meets the above requirements.

Answer 450

B. Qualified charitable contributions. - Form 706, Part 2, line 3a, provides that an estate will arrive at the tentative taxable estate by subtracting total allowable deductions (not credits) from Part 5 (Form 706, line 2) against their gross estate. As applicable in this question, the following expense (Form 706, Part 5) is permitted as a deduction: - Charitable bequest (Schedule O, Form 706) - Additionally, estates are allowed to take certain credits (Part 2, lines 9a to 9e and line 15 of Form 706) against the gross estate which include but are not limited to foreign death taxes, the credit for tax on prior transfers (Form 706 Instructions, page 10), and the unified credit (applicable credit amount) on line 11. - As such, the charitable contribution is a deduction and not a credit.

Answer 451

D. No estate tax return is filed. - For decedents dying in 2023, Form 706 must be filed by the executor for the estate of every U.S. citizen or resident: 1. Whose gross estate, plus adjusted taxable gifts and specific exemption, is more than $12,920,000 or 2. Whose executor elects to transfer the decedent’s unused exclusion (DSUE) amount to the surviving spouse, regardless of the size of the decedent's gross estate. - If the executor must file Form 706 to report estate and/or generation-skipping transfer tax, it is due within 9 months after the date of the decedent's death unless an extension of time to file has been granted. An automatic 6-month extension of time to file is requested by filing Form 4768. - In this case, January 30 of the following year is the 9-month limit. - Form 706, however, is not filed in this case because the value of the estate is below $12,920,000, which is the threshold amount for requiring the filing of an estate form.