Unit 2 - Income and Assets Flashcards
Gross Income
Includes all forms of taxable compensation such as wages, salaries, commissions, tips, and self-employment income.
Non-monetary forms of compensation include goods, property, services, and taxable fringe benefits (interest, dividends, capital gains, and stock options)
Adjusted Gross Income (AGI)
Calculated by subtracting from gross income certain specific deductions or adjustments.
I.e. IRA contributions, certain expenses for self-employed individuals, deductible student loan interest and penalties paid to banks on early withdrawals of savings
** Helps determine eligibility for certain deductions and credits
Taxable Income
Calculated by subtracting additional deductions (standardized or itemized) from the AGI
How to Calculate Taxable Income and Tax Liability for Most Individuals
Earned Income
Received for services performed, such as wages, salaries, tips, professional fees, or self-employment income
Subject to Social Security and Medicare taxes (also called FICA taxes)
Unearned Income
Interest, dividends, retirement income, taxable alimony, and disability benefits
Investment income and other unearned income are generally not subject to FICA taxes
Constructive Receipt of Income
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 in their physical possession
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.
Income is also not considered to have been “constructively received” if a taxpayer declines to accept an item, such as a prize or award, or if the prize is not received by the taxpayer
The “Claim of Right” Doctrine
If a taxpayer is required to pay back an amount over $3,000, which they included in income in a previous year, the taxpayer may claim a tax credit on schedule 3 (Form 1040) in the repayment year equal to the tax change caused by the income inclusion in the prior year if it results in less tax
If the repayment is $3,000 or less, repayment is generally deducted on the same form or schedule on which it was previously included. However, if the income was previously reported as wages, taxable unemployment compensation, or other nonbusiness ordinary income, and the repayment is less than $3,000, the repayment cannot be deducted.
**A taxpayer should not amend their reported gross income for the earlier year
Self-Employed Taxpayers
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.
Independent contractors usually receive Form 1099-NEC from their business customers showing the income they were paid for the year (if $600+)
Self-employed farmers report their earnings on schedule F
Self- Employment Income 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 or by an LLC to its members. The income is reported to the individual partners on schedule K-1
FICA Tax (Payroll Taxes)
The Federal Insurance Contributions Act (FICA) tax includes 2 separate taxes:
- Social Security Tax (currently 6.2% each for employee and employer)
- Medicare Tax (currently 1.45% each for employee and employer)
Applies up to $160,200 of a taxpayer’s combined earned income, including wages, tips, and 92.35% of net earnings from self-employment
If the taxpayer’s combined earned income exceeds $160,200 in 2023, a rate of 2.9%, representing only the
Medicare portion, applies to any excess earnings over the earned income threshold.
For certain high-income individuals, an additional Medicare surtax of 0.9% is applied to wages and self-employment income above certain thresholds.
Self-Employment Tax
Self-employed individuals are
responsible for paying the entire amount of Social Security and Medicare taxes applicable to their net
earnings from self-employment.
Tax.
If a taxpayer has wages in addition to self-employment earnings, the Social Security tax on the wages is paid first.
Self-Employment Tax Adjustments
There are two adjustments related to the self-employment tax that reduce overall taxes for a taxpayer with self-employment income
- The taxpayer’s net earnings from self-employment are reduced by 7.65%. Just as the employer’s share of Social Security tax is not considered wages to the employee, this reduction
removes a corresponding amount from the net earnings before the SE tax is calculated. - The taxpayer can deduct the employer-equivalent portion of his self-employment tax in determining his adjusted gross income
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.
Employee Compensation
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.
Worker Classification
For federal tax purposes, the IRS classifies “workers” in two broad
categories: employees and 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.
Worker Classification - Employees
In general, a business must withhold and remit income taxes, Social Security and Medicare taxes (payroll taxes), and pay unemployment tax on salaries and wages paid to an employee. Employers are required by January 31 to issue Forms W-2, which shows the amounts of wages paid to employees for
the previous year.
Worker Classification - Independent Contractors
A business generally does not have to withhold or pay taxes on payments to
independent contractors, because the earnings of a person working as an independent contractor are subject to self-employment tax. The general rule is that an individual is an independent contractor if the payor 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.
Wages from Form 8919 also are reported on the Form 1040 on line 1g.
Advance Wages
If an employee receives advance wages, commissions, or other earnings, the employee must recognize the income in the year it is actually or constructively received. If the employee is later required to pay back a portion of the earnings, the amount would be deducted from
their taxable wages at that time.
Supplemental Wages
Supplemental wages are compensation paid to an employee in addition to his regular pay.
May include:
- Vacation pay
- Sick pay
- Bonuses, commissions, prizes
- Severance pay, back pay, and holiday pay
- Payment for nondeductible moving expenses
Garnished Wages
An employee may have their wages garnished for various reasons, such as when the employee owes child support, back taxes, or other debts.
State and federal law require employers to comply with various income-withholding orders for child support and other court-mandated obligations.
Regardless of the amounts garnished from the employee’s paycheck, the full amount of gross wages must be included in his taxable wages at year-end.
Property or Services “in Lieu” of Wages
Wages paid in any form other than cash are measured by their fair market value.
Wages paid in any form other than cash are measured by their fair market value. An employee who receives property for services performed must generally recognize the fair market value of the property when it is received as taxable income. However, if an employee receives stock or other
property that is restricted, the property is not included in income until it is available to the employee
without restriction.
Another common arrangement is when colleges offer tuition reduction and/or free on-campus housing in lieu of wages to student teachers. Any portion of a grant or scholarship that is compensation for services is taxable as wages.
Tip 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 his employer. Tips of less than $20 per month are exempt from Social Security and Medicare taxes, but are still subject to federal income tax.
In situations where an employee works more than one job, the $20 tip reporting threshold applies on a per job basis, and not on an overall basis for the employee. An employee who does not report all their tips to their employer generally must report the tips and related Social Security and Medicare taxes on Form 1040. Form 4137, Social Security and Medicare Tax on Unreported Tip Income, is used to
compute the additional tax.
Taxpayers who are self-employed and receive tips must include their tip income in gross receipts on Schedule C.
Non-cash 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 gross income at their fair market value.
Taxable Fringe Benefits for Employees
The IRS considers fringe benefits to be
any additional cash, property, or service given to employees on top of their regular taxable wages. Employers often offer fringe benefits as part of a compensation package, with common examples being health insurance, retirement plans, and parking passes.
While most fringe benefits are not subject to taxes, there are some exceptions. Some taxable fringe benefits include:
* Off-site athletic facilities and health club memberships,
* Concert and athletic event tickets,
* The value of employer-provided life insurance over $50,000,
* Any cash benefit in the form of a credit card or gift card (an exception applies for occasional
meal money or transportation fare to allow an employee to work beyond normal hours),
* Transportation benefits exceeding the monthly maximum ($300 per month in 2023),
* Employer-provided vehicles, if they are used for personal purposes. There is an exception for
qualified nonpersonal use vehicles (i.e., police cars, school buses, transit buses, etc.).
Nontaxable Fringe Benefits for Employees - Retirement Plans
Employer contributions on behalf of their employees’ qualified retirement plans are not taxable to the employees when they are made. However, when an employee receives distributions from a retirement plan, the amounts received are taxable income.
Retirement plans may also allow employees to contribute part of their pre-tax compensation to the plan. This type of contribution is called an elective deferral and is excluded from taxable compensation for income tax purposes but is subject to Social Security and Medicare taxes.
Nontaxable Fringe Benefits for Employees - Cafeteria Plans
A cafeteria plan allows employees to receive certain benefits before taxes are taken out. Employees must be given the option to choose at least one taxable benefit (like cash) and one qualified benefit (nontaxable). Some examples of qualified benefits that can be offered in a cafeteria plan include
accident, dental, vision, and medical insurance (excluding Archer medical savings accounts and long-term care insurance), flexible spending accounts for health and dependent care, as well as adoption assistance and dependent care assistance.
Employee contributions are typically deducted through salary reduction agreements, meaning the money is taken directly from their paychecks and deposited into an account. These contributions do not count as taxable income and are not subject to employment taxes. Employers may also extend these benefits to employees’ spouses and dependents.
Nontaxable Fringe Benefits for Employees - FSA
An FSA is a form of cafeteria plan benefit that reimburses employees for expenses incurred for certain qualified benefits, such as health care and daycare expenses.
In 2023, employee salary reduction contributions to a Healthcare FSA are capped at $3,050. Both employer and employee may contribute to an employee’s Healthcare FSA, but contributions from all sources combined must not exceed the annual maximum
FSA benefits are subject to annual maximums and are typically subject
to an annual “use-it-or-lose-it” rule, with a short (two-and-a-half-months) grace period after year-end to claim subsequent year qualifying expenses against the prior plan year remaining balance.
Typically, Healthcare FSA funds that are not spent by the employee within the plan year are forfeited back to the employer. Cafeteria plans may offer employees a two-and-a-half-month grace period after the end of the year to spend down any remaining FSA funds. Employee plans can also offer
a carryover option, with the maximum amount that can be carried forward into the following year (if allowed by the employer) being 20% of the maximum available salary reduction for the year
Dependent Care FSA
Also known as a Dependent Care
Assistance Plan
Used to pay for dependent care
For unmarried taxpayers and married
couples filing jointly, the annual limit is $5,000. For married couples filing separately, the limit is $2,500.
The funds in a DCFSA can be used to pay for eligible daycare services, before or after school programs, and adult daycare for disabled dependents.
Adoption Assistance in a Cafeteria Plan
Although uncommon, adoption assistance benefits may be offered under a cafeteria plan and paid for entirely with pre-tax salary reductions. An employee can exclude amounts paid or reimbursed by an employer under a qualified adoption assistance program (up to a maximum of $15,930 for 2023).
Highly Compensated Employees (HCEs)
A cafeteria plan cannot have rules that favor eligibility for highly compensated employees to participate, contribute, or benefit from a cafeteria plan. If a benefit plan favors HCEs, the value of their benefits may become taxable. This is to discourage companies from offering excellent tax-free benefits to their top executives while ignoring the needs of lower-paid employees.
A “highly compensated
employee” is for 2023 is defined as:
* A company officer (i.e., company president, vice-president, treasurer).
* A 5% (or greater) shareholder in the current or prior year;
* An employee paid $150,000 or more for 2023,
* A spouse or close family member of one of the persons described above, regardless of salary level.
The IRS uses a process called “family attribution” in order to make the determination of who qualifies as an HCE, which means that an employee can be determined to be an HCE merely by familial relationship. An individual is attributed to interests owned by their spouse, siblings, and ancestors.
Employees that are hired in the middle of the year will not receive HCE status until the start of the following year, when they are eligible to collect the entirety of their salary.
A plan is considered to have improperly “favored” HCEs and key employees if more than 25% of all
the benefits are given to those employees. If a cafeteria plan or a retirement plan fails to pass IRS non-
discrimination testing, highly compensated employees and key employees may lose the tax benefits of
participating in the plan.
Key Employees
Employer-provided benefits also cannot favor “key employees.
“Key employees” are any of the following:
* A company officer having annual pay of more than $215,000 in 2023 (in this case, the officer
does not have to be an owner of the company).
* An employee who is either of the following:
o A 5% owner of the business, or;
o A 1% owner of the business whose annual pay is more than $150,000 in 2023.
Although the compensation threshold is lower for HCEs than Key Employees, an employee can be classified as a key employee without having any ownership in the company.
A plan is considered to have improperly “favored” HCEs and key employees if more than 25% of all
the benefits are given to those employees. If a cafeteria plan or a retirement plan fails to pass IRS non-
discrimination testing, highly compensated employees and key employees may lose the tax benefits of
participating in the plan. If this happens, then the plans can lose their tax-favored status, and the HCEs
or key employees must include the value of these benefits as taxable compensation. These types of
“corrections” often take the form of taxable distributions to plan participants.
Employee Fringe Benefits - Educational Assistance
An employer can offer employees educational assistance for the cost of
tuition, fees, books, supplies, and equipment. The payments may be for either undergraduate or graduate-level courses, and do not have to be work-related.
An employer may contribute up to $5,250 annually toward educational expenses, student loans, or a
combination of both. If an employer pays more than $5,250, the excess is generally taxed as wages to the employee.
The cost of courses involving sports, games, or hobbies is not covered unless they are related to the business or are required as part of a degree program. The cost of lodging, meals,
and transportation is also not included.
Employee Fringe Benefits - Tuition Reduction Benefits
A college or other educational institution can exclude the value of a
qualified undergraduate tuition reduction to an employee, his spouse, or a dependent child. A tuition reduction is “qualified” only if the taxpayer receives it from, and uses it at, an eligible educational institution. Graduate education only qualifies if it is for the education of a graduate student who performs teaching or research activities for the educational organization.
Employee Fringe Benefits - Employee-Provided Meals and Lodging
An employer may exclude the value of meals and lodging provided to employees if they are provided:
* On the employer’s business premises, and
* For the employer’s convenience.
Employee Fringe Benefits - Employee-Provided Lodging
For lodging, there is an additional rule: it must be required as a condition of employment. Lodging can be provided for the taxpayer, the taxpayer’s spouse, and the taxpayer’s dependents and still not be taxable to the employee. However, the exclusion from taxation does not apply if the employee can choose to receive additional pay instead of lodging.
Employee Fringe Benefits - Employee-Provided Meals
Meals may be provided to employees for the convenience of the employer on the employer’s business premises for several reasons, such as when:
* Police officers and firefighters need to be on call for emergencies during the meal period.
* The nature of the business requires short meal periods.
* Eating facilities are not available in areas near the workplace, such as in the case of remote or dangerous locations.
* Meals are furnished immediately after working hours because the employee’s duties prevented him from obtaining a meal during working hours.
Meals furnished to restaurant employees before, during, or after work hours are also considered
furnished for the employer’s convenience and are not taxable to the employee.
Transportation Fringe Benefits
Employers have the option to provide transportation benefits to their employees, such as transit passes, paid parking, or commuter passes (bus passes). These benefits are non-taxable for employees up to a certain amount.
Under the Tax Cuts and Jobs Act (TCJA), employers can no longer deduct these expenses. This does not affect the tax-exempt status of transportation benefits for employees.
Any expenses exceeding $300 per month in 2023 for transit and parking benefits will be added to the
employee’s taxable income as wages.
The use of a company car for commuting purposes or other personal use is generally a taxable
benefit. Thus, the value of using the vehicle for these reasons will be included in their taxable wages.
Transportation Fringe Benefits - EXCEPTION
There is an exception in IRS regulations that exempts the personal use of certain types of vehicles.
Qualified “nonpersonal use” vehicles, such as police or fire vehicles, school buses, and ambulances, are exempt from fringe benefit reporting, even if the vehicles are used for commuting purposes, as long as the employer requires their use for the employees to do their jobs.
Transportation Fringe Benefits - Cell Phones
Employer-provided cell phones can be excluded from an employee’s income.
The employer must have valid business-related reasons for providing the phone, such as the need to
contact the employee during work emergencies or to communicate with clients while away from the office.
Transportation Fringe Benefits - Group-Term Life Insurance Coverage
Up to $50,000 of life insurance coverage may be provided
as a nontaxable benefit to an employee.
The cost of insurance coverage on policies that exceed $50,000 is a taxable benefit. If an employer provides more than $50,000 of coverage, the amount included in
the taxpayer’s income is reported as part of their taxable wages on their Form W-2.
Transportation Fringe Benefits - Work-Related Moving Expense Reimbursements
Moving expenses are no longer deductible for most taxpayers, except for certain members of the armed forces. Therefore, moving expenses that are reimbursed or paid by an employer must be included in the employee’s taxable income as wages.
Transportation Fringe Benefits - No-Additional-Cost Services
Nontaxable fringe benefits also include services provided to employees that do not impose any substantial additional cost to the employer because the employer already offers those services in the ordinary course of doing business. Employees do not need to include these no-additional-cost services in their income. Typically, no-additional-cost services are excess capacity services, such as unused airline seat tickets for airline employees or open hotel rooms for hotel employees.
If an employee is provided with free or low-cost use of a health club on the employer’s premises, the value is not included in the employee’s compensation. The gym must be used primarily by employees, their spouses, and their dependent children. However, if the employer pays for a fitness program or use of a facility at an off-site location, the value of the program is included in the employee’s
compensation.
Transportation Fringe Benefits - Employee Achievement Awards
Employers may generally exclude from an employee’s taxable wages the value of awards given for length-of-service or safety achievement. The tax-free amount is limited to the following:
- $400 for awards that are not qualified plan awards.
- $1,600 for qualified plan awards. A qualified plan award is one that does not discriminate in favor of highly compensated employees, and that is established under a written plan.
- The exclusion for employee awards does not apply to awards of cash, gift cards, lodging, stocks, bonds, or tickets to sporting events.
Transportation Fringe Benefits - De Minimis (Minimal) Benefits
This is a property or service an employer provides that has so
little value that accounting for it would be impractical. Examples of de minimis benefits include the following:
- Occasional personal use of a company copying machine.
- Holiday gifts with a low fair market value (such as a holiday turkey or a gift basket)
- Flowers, fruit, books or similar property provided to employees under special circumstances, such as an employee’s birthday
- Beverages and snacks, such as coffee or doughnuts for employees
- Cash is not excludable as de minimis benefits unless they are for occasional meal money or transportation fare, and they are not given out on the basis of hours worked (for example, $1.50
per hour for each hour over 8 hours). In order to be non-taxable, the benefit must also be provided so that an employee can work an unusual, extended schedule.
Transportation Fringe Benefits - Employee Discounts
Employers may exclude the value of employee discounts from wages up to
the following limits:
- For services, a 20% discount of the price charged to nonemployee customers.
- For merchandise, the company’s gross profit percentage multiplied by the price nonemployee customers pay.
Accountable Plan Reimbursement of Employee-Business Expenses
When a company reimburses its workers for specific business-related costs, such as work travel and meals, the reimbursements are not considered taxable income if the employees meet all of the following requirements under an accountable plan:
- Have incurred the expenses while performing their duties as employees.
- Provide proper documentation for travel, meals, and lodging expenses.
- Supply evidence of their employee business expenditures, such as receipts or records.
- Return any surplus reimbursements within a reasonable timeframe.
Under an accountable plan, a company may give cash advances to employees. These advances must reasonably align with anticipated expenses and must be given within a reasonable timeframe. If any expenses reimbursed through this arrangement cannot be substantiated, they will be considered taxable income for the employee.
Accountable Plan Reimbursement of Employee-Business Expenses - Travel
Qualifying expenses for travel are excludable from an employee’s income if they are incurred for temporary travel on business away from the area of the employee’s tax home. Travel expenses paid in connection with an indefinite work assignment cannot be excluded from income. Any work assignment more than one year is considered “indefinite.”
Reimbursement for travel expenses may cover: expenses incurred while traveling to and from the designated business location (such as airfare and
mileage reimbursements), transportation costs during the trip (such as taxi fares), hotels, meals, and
other related costs, and dry cleaning, laundry, and any other miscellaneous expenses during the period spent away from home on assignment.
Taxation of Clergy Members
A clergy member’s salary is reported on Form W-2 and is taxable. For services in the exercise of the ministry, members of the clergy receive a Form W-2 but do not have social security or Medicare taxes withheld.
Offerings and fees received for performing marriages, baptisms, and funerals must be reported as self-
employment income on Schedule C.
Taxation of Clergy Members - Exemption from SE tax
A clergy member may apply for an exemption from self-employment tax if he is conscientiously opposed to public insurance because of religious principles. For a clergy member or a minister to claim an exemption from SE tax, the minister must file IRS Form 4029, Application for Exemption from Social Security and Medicare Taxes and Waiver of Benefits. Generally, this exemption is irrevocable.
The sect or religious order must also complete part of the form. The exemption does not apply to
federal income tax, only to self-employment tax. If the exemption is granted, the clergy member will
not pay Social Security or Medicare taxes on his earnings, and he will not receive credit toward those benefits in retirement. If a clergy member is a member of a religious order that has taken a vow of poverty, he is exempt from paying SE tax on his earnings for qualified services. The earnings are tax-free because they are considered the income of the religious order, rather than of the individual clergy
member
Taxation of Clergy Members - Housing Allowance for Clergy
A clergy member who receives a housing allowance may exclude
the allowance from gross income to the extent it is used to pay the expenses of providing a home. Only
taxpayers who are serving as clergy (ministers, priests, etc.) are eligible for a housing allowance. The exclusion is limited to the lesser of the following amounts:
- The amount officially designated as a housing allowance.
- The amount actually used to provide or rent a home.
- The fair market rental value of the home (including utilities, property taxes, insurance, etc.)
The housing allowance cannot exceed reasonable pay and must be used for housing in the year it
is received. Salary, other fees, and housing allowances must be included in income for purposes of
determining self-employment tax.
Combat Pay
Typically, military personnel’s regular wages are subject to taxes. However, there are specific exceptions and rules for military personnel regarding income that is taxable. For instance, combat zone wages or “combat pay” is not considered taxable income. Hazardous duty pay is also excludable for 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.
Veterans Benefits
Similarly, veterans’ benefits paid by the Department of Veterans Affairs to a veteran or his 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.
Medicare Waiver Payments
“Difficulty-of-care” payments, also known as Medicare waiver payments, can be excluded from a taxpayer’s gross income. These payments are nontaxable to the caregiver if they are for in-home-care services provided to a disabled individual who resides in the same home. The exemption applies
to anyone providing care in their own home, regardless of who owns the home. It is also not necessary
for the caregiver to be related to the disabled individual, although this is often the case.
Qualified Medicare 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 purposes of the earned income credit (EITC) or the additional child tax credit (ACTC). In addition, under the SECURE Act, taxpayers can use this income to fund an IRA, but since the contributions come from
amounts excluded from tax, they are treated as nondeductible contributions.
Disability Payments
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
Worker’s compensation is a type of mandatory business insurance, meaning most large and mid-
sized employers are required to have coverage for their employees. Worker’s compensation coverage can include wage replacement as well as rehabilitation services that help injured employees return to work when they are medically able to do so. Worker’s compensation is always exempt from tax.
Disability Retirement Benefits
Disability retirement benefits are unique. These 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 (usually, this is age 62), 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 and is often called “FERS disability” because the disability retirement benefits are offered under the Federal Employees Retirement System (FERS).74 To apply for this benefit, the employee’s disability generally must have caused them to discontinue working.
Disability Insurance Benefits
A taxpayer may receive long-term disability insurance payments because of an insurance policy.
Generally, 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.
Veterans Disability Benefits
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 is 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.
Life Insurance Payments
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 on life insurance proceeds is usually taxable.
Further, if a taxpayer surrenders a life insurance policy for cash, they must generally include in income
any proceeds that are more than the cost of the policy. However, an exception exists for when a terminally ill person receives a viatical settlement. In this case, the funds are tax-free. Sometimes, a taxpayer will choose to receive life insurance proceeds in installments rather than as a lump sum. In this case, part of the installment generally includes interest income.
If a taxpayer receives life insurance proceeds in installments (also called a life insurance annuity), they can exclude part of each installment from his income. To determine the excluded part, the amount held by the insurance company (generally the total lump sum payable at the death of the insured
person) is divided by the number of installments to be paid. The taxpayer would include any amount over this excluded portion as taxable interest income.
Real Property
Real estate, which includes land and anything permanently attached to it.
i.e. Buildings, farmland, residential homes, commercial properties,
rental properties, and subsurface mineral rights.
Gift for Opening a Bank Account
If the deposit is less than $5,000, any gifts or services valued at more than $10 must be reported. For deposits of $5,000 or more, gifts or services valued over $20 must be reported as interest. The financial institution determines the value of the gift based on its cost.
Rewards earned from credit and debit card purchases are typically not deemed as taxable income
Interest Earned on a Certificate of Deposit
Generally taxable when the taxpayer receives it or is entitled to receive it without incurring a penalty
The interest a taxpayer pays on funds borrowed from a financial institution to meet the minimum deposit required for a CD, and the interest a taxpayer earns on the CD are two separate items.
The taxpayer must include the total interest earned on the CD
in income. If the taxpayer chooses to itemize deductions, they can deduct the interest paid as investment interest, as long as it does not exceed their net investment income, by using “Form 4952,
Investment Interest Expense Deduction”
Tax-Exempt Interest
Interest earned on debt obligations of state and local governments (aka muni bonds or municipal bonds) is generally exempt from federal income tax but may be subject to income taxes by state and local governments.
Even if the 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.
Interest on U.S. Treasury Bills, Notes, and Bonds
Interest on U.S. obligations, such as U.S. Treasury bills, notes, or bonds issued by any agency of the United States, is normally taxable for federal income tax purposes and exempt from state and local
income taxes
Individual taxpayers can generally report interest income
from a Series EE or Series I savings bond either:
* When the bond matures or is redeemed (whichever occurs first), or
* Each year as the bond’s redemption value increases (if the taxpayer makes an election).
However, taxpayers must use the same reporting method for all the Series EE and Series I bonds they own. When taxpayers redeem savings bonds, they should receive a Form 1099-INT from a bank
or another payor.
Series EE bond
Issued at a discount, and the difference between the purchase
price and the amount received when the bonds are later redeemed (or “cashed in”) is interest income.
Series I bonds
Issued at face value with a maturity period of thirty years. The face value and accrued interest are payable at maturity.
The Education Savings Bond Program
The program permits qualified taxpayers to exempt the interest earned upon redemption of eligible savings bonds, if they
are used to pay higher education expenses in the same year.
Series EE and I savings bonds are also called “educational savings bonds.”
The educational expenses must be for the taxpayer, a spouse, or dependents.
Interest earned on these bonds is usually exempt from state taxes as well.
The taxpayer must use both the principal and interest to pay for qualified education expenses. If the amount of savings bonds cashed during the year exceeds the amount of qualified educational expenses paid during the year, the amount of excludable interest is reduced.
In general, only tuition and fees are considered qualified expenses for the purposes of the savings bond exclusion. The costs of room and board, as well as required textbooks, are not eligible expenses.
However, the cost of required textbooks is a qualified educational expense for the purposes of the Lifetime Learning Credit and the American Opportunity Credit.
The amount of qualified expenses must be further reduced by the amount of any scholarships, fellowships, employer-provided educational assistance, and other forms of tuition reduction.
The Education Savings Bond Program Requirements
To exclude interest earnings on Series EE and Series I bonds:
- A taxpayer must be at least twenty-four years old before the bond’s issue date.
- The bonds must be purchased by the owner. They cannot be a gift, although the bond proceeds can be used to pay the tuition expenses of a dependent child.
- Qualified higher-education expenses must be reduced by scholarships and other tax-free benefits received and by expenses used to claim the American Opportunity and Lifetime Learning credits.
- The total interest received may be excluded only if the combined amounts of the principal and the interest received do not exceed the taxpayer’s qualified higher education expenses.
** Married taxpayers who file separately (MFS) do not qualify for the education savings bond interest exclusion. If a taxpayer cashes an education savings bond during the year and then files MFS, all the
interest would be taxable, regardless of whether the taxpayer had qualifying education expenses.
Dividend Income
if a taxpayer’s total dividend income is more than $1,500, it must
be reported on Schedule B, Interest and Ordinary Dividends.
Otherwise, the dividend income can be reported directly on Form 1040.
In 2023, the top rate on long-term capital gains and qualified
dividends is 20%. However, many higher-income taxpayers may also be subject to the Net Investment Income Tax (NIIT) on long-term capital gains and qualified dividends
Dividend
A dividend is a distribution of cash, stock, or other property from a corporation or a mutual fund.
Most large corporations pay dividends in cash. The payor will generally use Form 1099-DIV to report dividend income to its shareholders.
Ordinary Dividends
Ordinary dividends are corporate distributions in cash (as opposed to
property or stock shares) that are paid to shareholders out of earnings and profits.
They are taxed at ordinary income tax rates rather than at lower long-term capital gain rates.
Ordinary dividends are reported in Box 1a of Form 1099-DIV.
Qualified Dividends
Qualified dividends that meet certain requirements are taxed at lower capital gain rates if specific criteria are met. Short-term capital gains and ordinary dividends are taxed at ordinary income rates.
Qualified dividends are reported to the taxpayer in Box 1b of Form 1099-DIV.
Qualified Dividends Requirements
- The dividends must be paid by a U.S. corporation or qualified foreign corporation
- The taxpayer generally must have held the stock for more than sixty days during the 121-day period that begins sixty days before the ex-dividend date.
When figuring the holding period for qualified dividends, the taxpayer may count the number of days the stock was held, with the first day being the day after the stock was acquired (not including the holding period) and include the day the stock was sold.
A longer holding period may apply for dividends paid on preferred stock
Ex-dividend Date
The date a shareholder will no longer be entitled to receive the most recently declared dividend (typically the day following the record date).
Nondividend Distributions
Distributions that are not paid out of a corporation’s earnings and
profits are called nondividend distributions. They are considered a recovery or return of capital and therefore are generally not taxable.
Nondividend distributions are reported in Box 3 of Form 1099-DIV.
Money market funds
Money market funds pay dividends and are offered by nonbank financial institutions
Generally, amounts received from money market funds should be reported as dividends, not as interest.
Stock Dividends and Stock Distributions
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 shareholder 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. The recipient of the stock must include the FMV of the newly issued stock in his
gross income, and that same amount is the basis of the shares received.
Dividend Reinvestment Plans (DRIP)
A dividend reinvestment plan allows a taxpayer to use their dividends to purchase more shares of stock in a corporation instead of receiving dividends in cash. If the taxpayer uses their dividends to
buy more stock at a price equal to its fair market value, the taxpayer must still report the dividends as income
Some plans also allow taxpayers to invest cash to buy shares of stock at a price less than fair market value. In this case, taxpayers must report as dividend income the difference between the cash they
invest and the FMV of the stock they purchase.
Mutual Fund Distributions
A taxpayer who receives mutual fund distributions during the year will also receive Form 1099-DIV, identifying the types of distributions received.
Mutual fund distributions are reported based on
the character of the income source and may include ordinary dividends, qualified dividends, capital gain distributions, exempt-interest dividends, and nondividend distributions.
Ordinary dividends are the most common type of distribution from a mutual fund
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.
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.
Mutual Fund
A mutual fund is an investment vehicle 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.
Constructive Distributions (aka Constructive Dividends)
Certain transactions between a corporation and its shareholders may be considered constructive distributions. In general, constructive distributions are assessed under audit, and they can have very negative consequences for the company as well as to the
shareholder. They may be considered dividends and, therefore taxable to the shareholders and non-deductible to the corporation.
Examples of Constructive Distributions
- 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.
Personal Property
All assets that are not classified as real estate.
This includes items such as furniture, equipment, vehicles, household goods, collectibles, and livestock. It also covers intangible assets like stocks, trademarks, cryptocurrency, and copyrights.
The tax treatment of an asset may differ depending on whether it is intended for personal use, business purposes, or investment.
Basis in General
The original basis of an asset is typically its purchase price.
However, there may be cases where the basis is calculated based on the fair market value at the time of acquisition, rather than the cost, such as when property is inherited or gifted.
The cost 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
Certain post-acquisition costs can also increase the basis of an asset, including:
* The cost of extending utility service lines to the property and impact fees
* Legal fees or court costs perfecting title to a property
* Legal fees for obtaining a decrease in an assessment levied against property to pay for local improvements; and/or zoning costs and the capitalized value of a redeemable ground rent.
Depreciation Deduction
Depreciation is a tax deduction that allows businesses to gradually recoup the cost of assets they use over time. This process decreases the basis of an asset over the course of several years.
The annual amount allowed for depreciation is meant to account for natural wear and tear, deterioration, or obsolescence of assets. Eventually, the asset will no longer be depreciable once its basis has been fully recovered or if it is sold or retired from service. Some types of property, such as land, cannot be depreciated, but most tangible assets like buildings, machinery, vehicles, furniture, and
equipment can be depreciated.
Most residential rental property is depreciated over 27.5 years. Only the value of the building can be depreciated, never the land.
Dispositions and Holding Period
The length of time an asset is held determines whether any gain or loss from its sale will be considered long-term or short-term. The holding period for an asset begins the day after it is acquired and ends on the day it is sold. If an asset is sold, the difference between its initial cost and selling price may result in a taxable gain or loss.
To accurately report any taxable gain or loss from the sale or disposal of an asset, a taxpayer must identify:
* Whether the asset is personal-use or used for business or investment;
* The asset’s basis or adjusted basis:
o As described above, the initial basis of an asset is usually its purchase cost, including certain ancillary charges.
o “Adjusted basis” includes the original basis plus any increases or decreases (such as subsequent improvements, depreciation deductions, casualty losses, rebates, and insurance reimbursements).
* The asset’s holding period:
o Short-term property is held for one year or less.
o Long-term property is held for more than one year (at least a year, plus a day).
* The proceeds from the sale.
Basis of Real Property (Real Estate)
The basis of real estate usually includes a number of costs in addition to the purchase price.
If a property is constructed rather than purchased, the basis of the property includes all the expenses of construction.
If raw land is purchased on its own, the basis includes the purchase price plus any legal and recording fees, abstract fees, and land survey costs.
Settlement Costs
Generally, a taxpayer must include settlement costs for the purchase of property in his basis. The following fees are some of the closing costs that can be included in a property’s basis:
* Abstract fees
* Charges for installing utilities
* Legal fees (including title search and preparation of the deed)
* Recording fees and land surveys
* Transfer taxes
* Owner’s title insurance
Property in Exchange for Services
When a taxpayer receives property in exchange for services,
they are required to report the property’s fair market value as income. This value then becomes their basis for the property.
In situations where two individuals have agreed on a price for services beforehand, this agreed-upon cost can be used to determine both the amount of income and the asset’s basis.
Basis After Casualty Loss
If a taxpayer has a deductible casualty loss, the taxpayer should
increase the basis in the property by the amount spent on repairs that restore the property to its pre-casualty condition. However, a taxpayer must decrease the basis of the property by any related
insurance proceeds.
Basis After Mortgage Assumption
If a taxpayer buys a property and assumes an existing mortgage on it, the taxpayer’s basis includes the amount paid for the property plus the amount owed on the mortgage.84 The basis also includes the settlement fees and closing costs paid to buy the property. However, fees and costs for obtaining a loan on the property (points) are not included in a property’s basis.
Basis of Securities
Their basis is typically the cost of purchase plus any additional fees, such as brokers’ commissions. When these securities are sold, the investment broker should provide the taxpayer with Form 1099-B, which shows the proceeds from the transaction. The IRS also receives a copy of this form.
Specific Identification
When instructing a broker to sell shares, the taxpayer can specify which set, or portion of a set, they wish to sell.
A taxpayer may own more than one block of shares in a particular company’s stock. Each block may differ from the others in its holding period (long-term or short-term), its basis, or both.
Keeping accurate records is essential for using this method.
The IRS requires stockbrokers and mutual fund companies to report the basis for most stock sold on Form 1099-B, Proceeds From Broker and Barter Exchange Transactions. The form also includes any federal income tax that has been withheld (if any). The reporting is made to investors and to the IRS.
First In, First Out (FIFO)
If the taxpayer cannot identify a specific set at the time of sale, the shares sold are considered to be from the earliest set purchased.
Stock Split
Occurs when a company issues additional shares of stock for every existing share an investor holds. Stock splits are a way for a company to lower the market price of its stock. The stock’s market capitalization, however, remains the same.
Stock Options
A taxpayer may purchase options to buy or sell securities (such as stocks or commodities) through an exchange or in the open market. With a stock option, an investor can choose to buy or sell a stock
at a predetermined price.
Companies may also offer stock options to their employees as a form of equity-based compensation.
Statutory stock options
Options granted under an employee stock purchase plan (ESPP) or an incentive stock option (ISO) plan
When exercising ISOs, no taxes are due until the eventual sale of the shares. Although incentive stock options come with favorable tax
treatment, they may be subject to alternative minimum tax (AMT) in the year of exercise.
Nonstatutory stock options
Stock options that are not granted under an employee stock purchase plan or an ISO plan
Generally, a taxpayer recognizes taxable wage income upon the exercise of a nonstatutory stock option. The taxable wage income is the difference between the fair market value of the stock on the exercise date and the option price and will be reflected on the employee’s Form W-2.
Property Transfers Incident to Divorce
When property is transferred from one spouse to another, the recipient’s adjusted basis remains the same as the original owner’s. Typically, there will be no tax implications for this transfer, regardless
of whether it was due to divorce or not.
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.
The Basis of Gifted Property
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).
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 $4,000, the basis of the vehicle remains $4,000 for the son. The holding period of the gift would also transfer to the donee
However, 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, the 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.
The Basis of Inherited Property
The basis of inherited property is treated very differently for tax purposes as compared to gifts.
In most cases, the basis of inherited property is the fair market value 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.
Although the value of most property such as stock, collectibles, and bonds, generally increases over time, there are also instances
in which a property’s value drops. This creates a “stepped-down” basis.
Alternate Valuation Date
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.
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.
Capital Assets
Personal or investment items
Any net gains from their sale may be subject to more favorable tax rates for capital gains.
The specific rate depends on factors such as how long the asset was held, what type of asset it is, and the taxpayer’s income bracket.
Losses from the sale of personal-use property, such as a main home, a vacation home, personal-use furniture, or jewelry, are not deductible. However, gains from the sale of personal-use assets usually are taxable, subject to certain exclusions.
How to Report the Sale of Capital Assets
For capital assets, gains and losses are typically reported using two forms: Schedule D, Capital Gains and Losses, and Form 8949, Sales and Other Dispositions of Capital Assets.
Schedule D
Used to report gain or loss on the sale of investment property and most capital gain (or loss) transactions.
Form 8949
Sales and Other Dispositions of Capital Assets
Form 8949 is used to report the following:
* The sale or exchange of capital assets
* Gains from involuntary conversions (other than from casualty or theft)
* Nonbusiness bad debts and
* Worthless securities
* The election to defer capital gain invested in a qualified opportunity fund (QOF) and the disposition of interests in QOFs.
There are two parts to Form 8949. The first part is for short-term assets, and the second part is for long-term assets. This form must be filed along with Schedule D, which contains the summary of all capital gains and losses on Form 8949.
Noncapital Assets
Assets held for business-use or created by a taxpayer for purposes of earning revenue (copyrights, inventory, etc.) are considered noncapital assets.
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 rental
* Self-produced copyrights, transcripts, manuscripts, photographs, or artistic compositions
* Accounts receivable or notes receivable acquired by a business
* Stocks and bonds held by stockbrokers and professional securities dealers
* Business supplies
* Commodities and derivative financial instruments
Gains and losses from the sale of business assets are typically 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. However, the sale of the inventory is reported as ordinary income on the Schedule C (or Schedule F) and not as a sale of an asset on the Form 4797.
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
Holding Period (Short-Term or Long-Term)
To calculate the holding period of investment property, one must start counting on the day after they acquire the property and end on the day they sell it. The date of the sale is included in the holding
period.
Stock shares acquired because of a nontaxable stock dividend or stock-split have the same holding period as the original shares owned.
The holding period for a gift is treated differently than the holding period for purchased property. If a taxpayer receives a gift of property, his holding period normally includes the donor’s holding
period. This concept is known as “tacking on” the holding period.
Determining Capital Gain or Loss
A taxpayer determines gain or loss on a sale or trade of stock or property by comparing the amount realized with the adjusted basis of the property. A disposition of stock and the related income or loss
must always be reported in the year of the sale, regardless of when the taxpayer actually receives the proceeds.
Capital losses are netted against any capital gains that may be generated in the same year. 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 above this limit are carried over to subsequent years.
Special rules apply to married couples. Married taxpayers are at a disadvantage when deducting capital losses. On a joint return, the net capital loss deduction limit is still $3,000, which is the same
limit for unmarried taxpayers. And MFS filers only get half of that limit (a $1,500 capital loss limit can be offset against other income).
Carryover Losses
Carryover losses are combined with gains and losses that occur in the next year. A taxpayer first nets short-term capital gains and losses (including carryover losses) against each other, and then long-
term capital gains and losses (including carryover losses) against each other. The results are then netted against each other, if applicable.
Any net capital losses 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.
A net 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 lost forever.
Capital Gains from Mutual Funds
Two different types of transactions may result in taxable capital gains reporting by a taxpayer who invests in mutual funds.
First, profits resulting from investments made by the fund itself are reported to its own shareholders as capital gain distributions on Form 1099-DIV. The capital gain distributions are always taxed at long-term capital gains tax rates, without regard to how long a taxpayer has owned shares in the mutual fund.
If a taxpayer disposes of shares that represent all or a portion of his investment in the mutual fund itself, a Form 1099-B will be issued. The taxable gain or loss that results from the sale or exchange of
the taxpayer’s shares in the mutual fund is reported on Form 1040, Schedule D.
Brokers are now required to include the basis of mutual funds on Form 1099-B.
Wash Sales
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 a
substantially identical investment is purchased within 30 days before or after the sale
A wash sale is considered to have occurred when a taxpayer sells a security at a loss 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, he 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.
The wash sale rules do not apply to professional securities dealers or stockbrokers.
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.
Home Sale Gain or Loss
The rules for selling a primary residence are beneficial for taxpayers. Typically, selling a home does not result in a taxable gain.
The following are used to determine the basis and the gain (or loss) on a home sale:
* Selling price
* Amount realized
* Basis
* Adjusted basis
If the amount realized on the sale of a home is less than the adjusted basis, the difference is a nondeductible loss. If the amount realized is more than the adjusted basis of the property, the difference is a gain (but not always a taxable gain).
Selling Price
The total selling price for a main home includes all forms of payment received by the taxpayer, such as cash, notes, mortgages, or other debts assumed by the buyer.
The fair market value of any additional property or services given to the seller also contributes to the selling price.
Typically, Form 1099-S, Proceeds from Real Estate Transactions, is used to report real estate sales proceeds.
Amount Realized
The “amount realized” is calculated by subtracting selling expenses from the sales price.
Expenses can include: realtor’s commissions, advertising fees, legal fees, and loan charges paid by the seller, such as points.
Basis in a Home
The basis of a residence is determined by how the owner of the home acquired the property.
If an individual purchases a home, their basis would be the cost of the home.
If an individual constructs a home, their basis would be the building expenses plus the cost of the land.
In cases where an individual inherits a property, their basis would typically be its fair market value on the date of the previous owner’s death or on the later alternate valuation date selected by the
representative for the estate.
If an individual receives a home as a gift, their basis would typically
be the donor’s adjusted basis at the time of the gift.
Adjusted Basis
The adjusted basis is the taxpayer’s basis in the home increased or decreased by certain amounts.
Increases include additions or improvements to the home that have a useful life of more than one year.
Repairs that simply maintain a home in good condition are not considered improvements and should not be added to the basis of the property.
Decreases to basis include deductible casualty losses, credits, and product rebates.
Related Party Transaction Rules
If a taxpayer sells an asset to a family member or a business they own, they may not qualify for the full benefits of capital gains
tax rates and may be limited in deducting their losses. These rules were established to prevent the transfer of assets between related persons or entities for the purpose of claiming improper losses.
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 by the original party buyer, a gain is recognized by the related party buyer only to the extent it is more than the disallowed loss to the original party seller.
However, if the property is later sold at a loss by the original party buyer, the loss that was disallowed to the related party cannot be recognized.
In the case of a related party transaction, if a taxpayer sells multiple pieces of property and some are at a gain while others are at a loss, the gains will generally be taxable while the losses cannot be used to offset the gains.
More Than “50% Control” Rule
If a taxpayer has majority control (more than 50%) of a
corporation, partnership, or other business entity, any property transactions between the taxpayer and the business are subject to related party transaction rules.
- Immediate family members, such as a spouse, siblings, and direct ancestors (e.g., parents, grandparents), and lineal descendants (i.e., grandchildren). For purposes of this rule, the following are not considered related parties: uncles, aunts, nephews, nieces, cousins, step-children, step-parents, in-laws, and ex-spouses.
- Partnership, corporation, or other business entity that is controlled by the taxpayer. “Control” is defined as having “more than 50%” ownership in the entity. This also includes ownership by other family members.
- A tax-exempt organization that is controlled by the taxpayer or a member of their family.
- A closely-related trust, or business entities controlled by the same owners.
Installment Sales
An installment sale is a type of financing arrangement. It is essentially a seller-financed purchase of a capital asset in which at least one payment is expected to be received after the tax year in which
the sale occurs.
The most common type of installment sale is the sale of business real estate (i.e., farmland, rental properties, office buildings). Other common installment sales include the sale of a small business, and the sale of intangibles (such as a patent, client list, trademark, or a website).
Installment sales are reported on Form 6252, Installment Sale Income, which is attached to the taxpayer’s Form 1040. A taxpayer may also be required to complete Schedule D or Form 4797,
depending on the type of asset that is being sold.
The installment sale rules also do not apply to property that is sold at a loss, or to the sale of inventory.
Installment Method
If a taxpayer sells property and receives payments over multiple years, the seller may use the installment method to defer tax by only reporting a portion of the gain as each installment is received.
The installment sale method is the default method in this situation, unless the taxpayer elects to report all gain in the year of sale. If a seller “elects out” of the installment method, the seller must report all
the gain in the year of the sale. If applicable, any depreciation recapture must also be recognized in full in the year of the sale.
Each payment received on an installment sale typically consists of the following three parts:
* Interest income
* Return of the adjusted basis in the property
* Gain on the sale (determined by applying the gross profit percentage to the amount of the payment received minus the interest portion)
Each year the seller receives a payment, they must report the interest income and the portion of the payments that relate to their gain on the sale. A taxpayer’s gain, or gross profit, is the amount by which the selling price exceeds the adjusted basis in the property sold. A gross profit percentage is calculated by dividing the gross profit from the sale by the selling price. The seller does not get taxed on the portion that is the return of their basis in the property.
Installment Method - Securities
The installment method cannot be used for publicly-traded securities, such as stocks and bonds that are traded on an established securities market (i.e., NASDAQ or the New York Stock Exchange).
A taxpayer must report the gain on the sale of securities in the year of the sale regardless of whether the proceeds are received in the following year. However, stock in a private company, such as a small
corporation that is being sold to a private buyer, can qualify for the installment method.
Installment Sale to Related Persons
Installment sales to related persons are permitted. However, if a taxpayer sells a property to a related person who then sells or disposes of the property within two years of the original sale, the
seller will lose the benefit of installment sale reporting (although there are exceptions to this rule for involuntary conversions or death of the original seller or buyer).
Special Rules for Worthless Securities
A loss from worthless securities receives special tax treatment. 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.
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.
Special Rules for Sec. 1244 Small Business Stock
Section 1244 stock is a special type of investment that is subject to beneficial tax treatment. If a taxpayer’s stock qualifies as Section 1244 stock, and sells that stock for a loss, up to $50,000 of the loss
($100,000 if MFJ) may be treated as an ordinary loss instead of a capital loss. The benefit of this provision is that the loss is not subject to the $3,000 “loss limitation” that normally applies to capital
losses.
Sale of Main Home
When selling their primary residence, taxpayers can often exclude the gain from selling their primary residence.
For those who are unmarried or Married Filing Separately, up to $250,000 of gain can be excluded. Joint filers have a higher exclusion amount of $500,000. Additionally, special rules apply for taxpayers whose spouses have passed away.
If the entire profit is excluded, it is not necessary to report the sale unless a Form 1099-S is received for the proceeds. If a portion of the gain is taxable, the sale must be reported on Schedule D and Form
8949. Any profit earned from selling a home that is not considered the taxpayer’s primary residence must be reported as taxable income.
Section 121 Exclusion
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.
The key criteria for a property to be classified as a home includes having sleeping quarters, a kitchen, and bathroom facilities.
Eligibility Requirements for Section 121
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).
Ownership Test and Use Test
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 two years (the ownership test), and
* Lived in the home as their main home for at least two 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.
To satisfy the “use” requirement, the taxpayer must physically occupy the home. However, brief, temporary absences, are still considered periods of use, even if the property is rented during that time.
Examples of short absences include short vacations and seasonal trips. However, longer breaks, such as a one-year sabbatical, do not count towards the period of use.
Different Rules for Married Homeowners
Married homeowners can exclude gain of up to $500,000 if they meet all 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.
Legally married spouses are eligible for the maximum $500,000 exclusion from gain on their jointly filed returns. If an unmarried couple owns and lives in a house together, and later gets married, the $500,000 exclusion applies if they file a joint return. If the couple files separate returns, each spouse would figure their exclusion separately on their own return.
Section 1041 Transfer
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”
Section 121 Exclusion - Unrelated Individuals
An unmarried couple 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.
This would also be the case if it was any type of cohabitating partners. Whether or not they are related to each other is irrelevant, although many times siblings will cohabitate and own a home together.
Section 121 Exclusion - Deceased Spouses
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.
Section 121 Exclusion - Military Personnel Exception
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 as well as
for Foreign Service personnel, U.S. 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.
Section 121 Exclusion - Disability Exception
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.
Rules for Reduced Exclusions
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, may still be eligible for a “reduced” exclusion if they meet one of the following three exceptions:
*Work-related Move
*Health-related Move
*Unforeseeable Events
The reduced exclusion amount equals the full $250,000 (or $500,000) multiplied by a fraction. The numerator is the shorter of:
- The period the taxpayer owned and used the home as a principal residence during the five-year period ending on the sale date
- The period between the last sale for which the taxpayer claimed the exclusion and the sale date for the home currently being sold.
The denominator is two years or the equivalent in months or days. Thus, the amount of the reduced exclusion is figured by multiplying the full exclusion amount by the number of days or months the
taxpayer owned and used the property and dividing by either 730 days or 24 months.
Rules for Reduced Exclusions - Work-Related Move
This 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. Other circumstances may qualify as related to a job change even if the safe
harbor is not met based on the facts and circumstances.
Rules for Reduced Exclusions - 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.
Other circumstances may qualify as related to health even if the safe harbor is not met based on the facts and circumstances.
Rules for Reduced Exclusions - Unforeseeable Events
The “unforeseen circumstances” safe harbors include the following:
o Death, divorce, or legal separation,
o Unemployment,
o Multiple births resulting from the same pregnancy,
o Damage to the residence resulting from a disaster, an act of war, or terrorism; and
o Involuntary conversion of the property or condemnation.
o Other situations may qualify as unforeseen circumstances.
Rules for Reduced Exclusions - Land Sales
If a taxpayer sells the land on which their 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 certain 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.
Homes Used Partially for Business
If a taxpayer’s home was used partially for business purposes or as a rental property, the gain is reported on Form 4797, Sales of Business Property. If a taxpayer claimed depreciation deductions for using their home as a rental property or for other business purposes, they cannot exclude the portion of the gain equivalent to the amount of depreciation deducted.
Section 121 only applies to the personal portion of a home.
In addition, under IRC section 121(b)(5), an additional rule applies for properties that are converted from a non-qualifying use (for example, as a rental) to a qualifying use (i.e., as a personal residence). In these situations, generally time of the non-qualifying use of the property is compared to the total time the property was owned by the taxpayer prior to sale. This ratio is then applied to the realized gain on the sale of the property to determine (exclusive of any depreciation deductions that may have been taken on the property prior to the date of sale) the amount of the gain that can potentially be excluded under IRC section 121.
Another common scenario is when a taxpayer has a home office for their business activities, and they depreciate the home office and then later sell the home at a gain. The amount of straight-line
depreciation claimed in prior years is considered as “unrecaptured §1250 gain” up to the amount of recognized gain.
Unrecaptured §1250 Gain
Technically long-term capital gain, with a special maximum rate of
25%. This only applies to the sale of depreciable real estate, and not other types of business assets, like machinery or equipment.
Like-Kind Exchanges (Section 1031 Exchange)
A Section 1031 like-kind exchange takes place when a taxpayer trades one qualifying real property for another. In this type of exchange, any gain is considered postponed.
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.”
The most common type of section 1031 exchange is a swap of one rental property for another.
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.
In general, any exchange of any real property generally qualifies as like-kind, regardless of how each property is used or whether each property is improved or unimproved. For instance, the exchange of an office building for farmland would qualify, as would the exchange of an apartment complex for an office building.
Deferred Exchange
A deferred exchange allows 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. It’s important to note that like-kind exchanges only apply to real estate exchanges;
any exchange of personal property will be treated as a non-cash sale and will not qualify for nonrecognition treatment.
Like-Kind Exchanges Qualified Types of Real Property
- 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 options)
- Property that is real property under state or local law.
Like-Kind Exchanges Requirements
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).
- In instances when a property is transferred in exchange for like-kind property to be received later (known as a “deferred 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.
- 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.
Like-Kind Exchanges Deadlines
The replacement property in a section 1031 exchange must be received by the earlier of
- The 180th day after the date on which the property was 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. The IRS is very strict about these deadlines.
Like-Kind Exchanges Nonqualifying Exchanges
Personal-use realty is not eligible for a like-kind exchange. So, the
exchange of a personal residence for another personal residence does not qualify, nor would an exchange of a personal residence for an apartment building. This prohibition would also apply to a
vacation home.
The exchange of property within the United States for similar property outside the United States also would not be a qualifying exchange.
Foreign real estate is not eligible for nonrecognition
treatment.
Inventory is never eligible for like-kind treatment.
Like-Kind Exchanges Taxable Exchanges
If a taxpayer receives property in exchange for other property that does not meet the like-kind exchange rules, he may need to recognize gain if the fair market value of the property received is greater than the adjusted basis of the property given up. His basis in the property received is generally its FMV at the time of the exchange.
Boot
Although the Internal Revenue Code itself does not use the term “boot,” it 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.
Boot can be given, as well as received, in a like-kind exchange. If cash is given to the other party in a like-kind exchange, none of the realized gain (or loss) will be recognized.
However, if noncash boot is given to the other party, then gain (or loss) will be recognized based on the difference between the
non-cash boot’s fair market value and adjusted basis at the time of the exchange.
When there is mortgage boot and cash boot in the same transaction, the mortgage boot paid does not offset any “cash boot” received. Net cash boot received is always taxable if there is a realized gain on the exchange.
Boot - Loss
In situations when there is a realized loss on a section 1031 exchange, and the taxpayer receives boot, none of the loss is recognized. However, the deferred loss is added to the basis of the contributed like-kind property given to the other party to determine the basis of the like-kind property received.
Cash Boot and Mortgage Boot
When an exchange involves property that is subject to a liability (such as an existing mortgage), the assumption of the liability is treated as if it was a transfer of cash and thus considered boot by the party who is relieved of the liability. Sometimes this is called “mortgage boot” or “debt reduction boot.”
If a party assumes a mortgage from the other party, it is treated as cash boot given to the other party. If each property in an exchange is transferred subject to a liability, a taxpayer is treated as having received boot only if he or she is relieved of a greater liability than the liability he assumes.
Basis of Property Received in a Like-Kind Exchange
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.
If a taxpayer receives boot in connection with an exchange and recognizes gain, the basis of the like-kind property received is equal to the basis of the like-kind property given up plus the amount of
gain recognized, plus the basis of any boot given, minus the fair market value of any boot received, minus any loss recognized. The basis of any non-cash boot received is its fair market value. The
taxpayer may reduce the amount of recognized gain by any exchange expenses (closing costs) paid.
Like-Kind Exchanges Between Related Parties
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%.
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 two years following the year
of a related party exchange.
Like-Kind Exchanges Between Related Parties - 2 Year Holding Period Exception
- 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.
Involuntary Conversions (Section 1033 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, but the rules
differ for each. Gain or loss from an involuntary conversion is usually recognized for tax purposes unless the property is a main home. A taxpayer reports the gain or deducts the loss in the year the gain or loss is realized. However, 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. In other words, the gain on an involuntary conversion can be deferred until a later, taxable sale occurs. Unlike a 1031 exchange, replacing the converted property with property purchased from a related party does not qualify for nonrecognition treatment.
Involuntary Conversions (Section 1033 Exchanges) - Longer Replacement Period
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. There is no requirement under Section 1033 that a qualified intermediary be employed to hold the escrow funds or conversion proceeds.
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.
Condemnation
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.
Amounts taken out of a condemnation award to pay debts on the property are considered paid to the taxpayer and are included in the amount of the award.
The deadlines for replacing condemned property are the same as other qualified section 1033 exchanges.
Eminent domain
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.
Condemnation or Destruction of a Main Home
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. In order to qualify for deferral, the taxpayer’s use of the replacement property must be substantially the same as the replaced property. In other words, a home must be replaced with another home .
Royalty Income
A form of income received for the use of another person’s property. This type
of income can come from patents, copyrights, or the use of natural resources like timberland, oil and
gas wells, or a copper mine. Generally, rental and royalty activities are declared on Schedule E (Form
1040), though there are some exceptions to this rule.
Rental Income
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.
Rental Property Eligible Deductions
Rental property owners are eligible to deduct various expenses related to the management, preservation, and upkeep of their properties. These expenses may include:
- Interest on mortgage payments and property taxes
- Maintenance, lawn care, repairs, and cleaning services
- Expenses for advertising vacancies
- Utilities that are covered by the homeowner (such as sewer or trash)
- Insurance premiums for home, liability, and natural disaster coverage
- Depreciation
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 they receive 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 as rental income. The payment is included in the year received regardless of the taxpayer’s accounting method.
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.
Insurance Premiums Paid in Advance
If a taxpayer operates on a cash-basis and they pay an
insurance premium that covers multiple years, they can only deduct the portion of the payment that applies to the current year. It is not possible to deduct the entire premium in the year it was paid, if the
policy is paid multiple years in advance.
Local Benefit Taxes
In most cases, a property owner cannot deduct charges for local taxes that increase the value of a rental property, such as assessments for streets, sidewalks, or water and sewer systems. These charges are capital expenditures that must be added to the basis of the property. Only taxes to maintain or repair such infrastructure, or interest charges related to financing its construction, can be deducted.
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.
Vacant Rental Property
A property owner cannot claim a “loss” of rental income for any period of time when the property remains unoccupied. However, if the owner is putting in effort to attract tenants and make the property 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.
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.
Depreciation of Rental Property
A landlord can start claiming deductions for the depreciation of a rental property once it is put into use for generating income. A rental property is considered to be “put into use” when it is prepared and
available for rent. Depreciation stops when the landlord has either fully recuperated their cost or basis, or when the property is no longer in use, whichever comes first.
Nonresidential buildings Depreciation
Nonresidential buildings are generally depreciated over 39 years, with a half-month’s worth of depreciation allowed for the first and last month of the depreciable life of the property
Residential Rentals Depreciation
Most residential rentals are depreciated over 27.5 years.
Main Factors to Determine How Much Depreciation a Landlord Can Deduct
- the property’s basis
- the recovery period for the property
- the depreciation method used.
Converting a Home to Rental Use
Sometimes, taxpayers will convert their personal residence to
a rental property. If a taxpayer converts a personal home to rental use at any time other than the beginning of a tax year, the owner must divide the expenses between rental use and personal use. Only
the portion of expenses for the period when the property was used or held as a rental can be deducted as rental expenses.
When converting a property to rental use, it will be considered “placed in service” on the date of conversion. Additionally, if a taxpayer converts a personal home into a rental property, the basis for depreciation will be the lesser of the fair market value or their adjusted basis on the date of conversion.
Section 179 Rules for Certain Types of Rental Property
In 2023, the maximum Section 179 deduction is $1,160,000.
The Tax Cuts and Jobs Act expanded the Section 179 deduction to certain types of tangible personal property that is used predominantly to furnish lodging. This new provision includes lodging facilities, such as dormitories, hostels, drug treatment centers, or similar facilities where sleeping accommodations are provided.
Section 179 is elective and can be taken on new or used
property. The TCJA also expanded the definition of “eligible property” to include certain expenditures for nonresidential buildings: including roofs, heating, ventilating, and air conditioning (HVAC) equipment, fire protection and alarm systems, and security systems. Nonresidential commercial property includes office buildings, medical centers, hotels, and malls.
Section 179 Rules for Mixed-Use Buildings
Special rules apply to “mixed-use” buildings. Under current IRS rules, if 80% or more of the annual gross rental income from a mixed-use building is generated from the residential rental apartments, the entire building and its structural components will be classified as a residential rental property. This also means that if 80% of the income generated is from residential rentals, then the entire building and improvements are depreciated over 27.5 years. If the building does not meet the 80% test, the entire building and improvements are depreciated over 39 years.
Repairs vs. Improvements to Rental Property
A taxpayer can expense the cost of repairs to rental property but cannot currently expense the cost of substantial improvements. The IRS defines repairs and improvements in the IRS’ tangible property
regulations.
Unless the improvement qualifies for accelerated depreciation, a property owner must typically recover the cost of an improvement by taking depreciation deductions over the asset’s applicable recovery period.
Repair
Keeps an asset or property in good working condition but does not add to the value of the asset or substantially prolong its life.
Repainting a rental, fixing leaks, and replacing broken windows are examples of repairs that are fully deductible in the year they are paid or incurred.
Improvement
Major expenditures that go beyond normal repairs.
This can include adding a bedroom or completely replacing the plumbing system, and in most cases, these improvements must be depreciated over time. An “improvement” is defined as anything that results in the betterment of a property, restoration of a property, or adaptation of a property to a new or different use.
The capitalized cost of an improvement is depreciated separately from the original cost of the asset or property that is being improved.
De Minimis Safe Harbor Rule - Tangible Property
The taxpayer can elect to expense tangible property costing no more than $2,500 per invoice or item in the year they are used or consumed.
The de minimis safe harbor election does not apply to inventory or to the purchase of land, but can apply to land improvements, such as: livestock fencing, driveways, walkways, retaining walls, and outdoor lighting.
Safe Harbor Election for Small Taxpayers (SHST) - Landlords
Landlords can use the SHST only if the total amount paid during
the year for repairs, improvements, and similar expenses for a building does not exceed the lesser of
(1) $10,000 or
(2) 2% of the unadjusted basis of the building. The SHST applies only to buildings with
an unadjusted basis of $1 million or less (not including the cost of the land).
Deductible Rental Losses
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;
- Whether the rental activity is for “carried on” for profit.
In general, a trade or business activity is considered a passive activity if the taxpayer does not materially participate in it, and rental activities are generally considered passive activities regardless of the participation of the owners. The deductibility of losses from passive activities is limited, and a taxpayer usually cannot deduct losses from passive activities to offset other nonpassive income (such as wages, or self-employment).
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.
Special $25,000 “Loss Allowance” for Real Estate Rental Activities
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. It is important to distinguish that active
participation does not require the same level of involvement as material participation.
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.
Only passive rental activities qualify for this “special loss allowance,” and not other types of passive activities. Furthermore, certain taxpayers do not qualify for the special loss allowance. The following
taxpayers are not allowed to claim the special loss allowance:
* A limited partner in a business activity,
* A property owner who has less than 10% ownership in a rental activity,
* A trust or corporation (The $25,000 special allowance is available only to natural persons,
although disregarded grantor trusts are permitted.)
Modified Adjusted Gross Income (MAGI)
A taxpayer’s adjusted gross income with certain deductions added back in. These may include IRA contributions, rental losses, student loan interest, and qualified tuition expenses, among others. A taxpayer’s MAGI is used as a basis for determining whether he qualifies for certain tax deductions.
“Actively Participating”
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.
Special $25,000 “Loss Allowance” for Real Estate Rental Activities - Married Filing Single
