Chapter 6

Individual Deductions

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Learning objectives
1.

2.

3.

Identify the common deductions necessary for calculating adjusted gross income (AGI) Describe the different types of itemized deductions available to individuals and compute itemized deductions Explain the operation of the standard deduction, determine the deduction for personal and dependency exemptions, and compute taxable income
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Deductions for AGI

Three categories of deductions for AGI

Directly related to business activities Indirectly related to business activities Deductions subsidizing specific activities

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Deductions for AGI

Directly Related to Business Activities

Taxpayers are allowed to deduct expenses incurred to generate business income For tax purposes activities are either profit-motivated or motivated by personal objectives Profit-motivated activities are classified as
1. 2.

business activities (called trade or business) or investment activities

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Deductions for AGI

Although both are motivated primarily by profit, business activities are distinguished from investment activities:

Trade or Business activities require a relatively high involvement or effort from the taxpayer where as investment activities dont require Investment activities involve investing in property for appreciation or for income payments

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Deductions for AGI

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Deductions for AGI

Trade or Business Expenses must be:

directly connected to the business activity ordinary and necessary for the activity (e.g., appropriate and helpful for generating a profit) reasonable in amount (not extravagant) Revenues from the same activity are also reported on the same Schedule C The net income or loss from Schedule C is transferred to Form 1040 (page 1) on line 12
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Expenses are claimed on Schedule C

Deductions for AGI

Rental & Royalty Expenses

Claimed above the line (for AGI) Could either be an investment activity or a trade activity depending on facts Taxpayers report expenses and revenue on Schedule E and transfer the net income or loss from Schedule E to Form 1040 (page 1), line 17 Expenses and losses incurred by a flow-through entity pass through to the entity owners who typically report these amounts on Schedule E and Line 17
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Flow-through Entities

Deductions for AGI

Losses

Taxpayers disposing of trade or business assets at a loss are allowed to deduct the loss for AGI Losses from investment assets (called capital assets) are offset against capital gains If capital losses exceed capital gains, this is called a net capital loss A net capital loss is deducted for AGI but limited to $3,000. Losses in excess of the $3,000 limit are carried forward indefinitely to subsequent years

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Deductions for AGI

Deductions indirectly Related to Business Activities

The cost of moving personal possessions is not a direct cost of doing business or being employed Moving Expenses are deductible for AGI if the move meets two tests
1. 2.

A distance test A business test associated with a move

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Deductions for AGI

Distance test the new job site must extend existing commute by 50 miles

A new job site is required, but a new employer is not essential

Business test - Taxpayer must be employed at least 39 of 52 weeks or be self-employed for 78 of the 104 weeks following the move Taxpayers are allowed to deduct a mileage rate in lieu of the actual costs of driving their personal automobiles during the move (24 cents per mile in 2013)

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Deductions for AGI

Health Insurance deduction by Self-Employed Taxpayers

Deduction provides equity with employees who receive health insurance as a qualified fringe benefit Insurance must be provided for taxpayer or dependents who are not eligible for employerprovided health insurance
Reduces the taxpayers net interest income to the amount actually received

Penalty for early withdrawals of savings

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Deductions for AGI

SE Tax Deduction

Employer and employees each pay the employees Social Security tax Employers deduct the portion of Social Security taxes they pay for employees Self-employed individuals are required to pay SE tax in lieu of Social Security tax Self-employed tax payers are allowed to deduct the employer portion of the SE tax they pay to compensate for employers deducting their portion of Social Security
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Deductions for AGI

Alimony payments are deductible for AGI to maintain equity Contributions to a qualified retirement account are deductible for AGI to encourage savings Interest expense on qualified educational loans Qualified educational expenses
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Deductions for AGI

Deduction for Interest expense on loans used to fund qualified educational expenses

Up to $2,500 of interest on education loans is deductible for AGI The interest deduction is phased-out for taxpayers with AGI exceeding $60,000 ($125,000 filing joint) The deduction is eliminated for taxpayers with AGI exceeding $75,000 ($155,000 filing joint)

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Deductions for AGI

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Deductions from AGI: Itemized Deductions

Medical Expenses
Taxpayers may deduct medical expenses incurred to treat themselves, their spouse, and their dependents Qualifying medical expenses include unreimbursed payments for care, prevention, diagnosis or cure of injury, disease, or bodily function Taxpayers using personal automobiles for medical transportation purposes may deduct a standard mileage allowance (24 cents per mile in 2013) in lieu of actual costs

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Deductions from AGI: Itemized Deductions

Hospitals and Long-term Care Facilities

Taxpayers may deduct the costs of actual medical care whether the care is provided at hospitals or other long-term care facilities It is limited to the amount of unreimbursed qualifying medical expenses paid during the year which is reduced by 10% (7.5% for a taxpayer or spouse age 65 or older) of the taxpayers AGI

Medical Expenses Deduction Limitation

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Deductions from AGI: Itemized Deductions

Taxes
Individuals may deduct itemized deductions payments for following taxes

State, local, and foreign income taxes Real estate taxes on property held for personal or investment purposes Personal property taxes that are assessed on the value of the specific property

Sales Tax deduction

State and local sales taxes can be deducted in lieu of state and local income taxes
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Deductions from AGI: Itemized Deductions

Interest

Two itemized deductions for interest expense:

Deduction of investment interest is limited to a taxpayers net investment income Any investment interest in excess of the net investment income limitation carries forward to the subsequent year

Home mortgage interest

Interest on acquisition indebtedness of $1million Interest on home equity debt of $100K

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Deductions from AGI: Itemized Deductions

Charitable Contributions
Contribution of money or property must be made to a qualified charity
Special rules apply to charitable contributions of property depending on the type of property: Capital gain property Ordinary income property

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Deductions from AGI: Itemized Deductions

Charitable Contribution Deduction Limitations for property donations

Apply the AGI limitations in the following sequence

Step 1: Determine limitation for the 50% contributions Step 2: Apply limitation to 30% contributions, which is the lesser of (a) AGI 30% or (b) AGI 50% minus the contributions subject to 50% limit Step 3: Apply limitation to 20% contributions, which is the lesser of (a) AGI 20% , (b) AGI 30% minus the contributions subject to 30% limit, or (c) AGI x 50% minus the contributions subject to the 50% limit and the contributions subject to the 30% limit
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Deductions from AGI: Itemized Deductions

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Deductions from AGI: Itemized Deductions

Casualty and theft losses on personal-use assets

The amount of the tax loss from any specific casualty event (including theft) is the lesser of

decline in value of the property caused by the casualty or taxpayers tax basis in the damaged or stolen asset

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Deductions from AGI: Itemized Deductions

Casualty Loss Deduction Floor Limitations

It must exceed two separate floor limitations to qualify as itemized deductions $100 for each casualty during the year 10 percent of AGI floor limit applied to the sum of all casualty losses for the year (after applying the $100 floor) In other words, the itemized deduction is the aggregate amount of casualty losses that exceeds 10 percent of AGI

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Deductions from AGI: Itemized Deductions

Miscellaneous Itemized Deductions Subject to AGI Floor

Employee Business Expenses

Travel and transportation Employee expense reimbursements

Investment Expenses Tax Preparation Fees Hobby losses Total miscellaneous itemized deductions are subject to a 2 percent of AGI floor limit
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Itemized Deductions and the Standard Deduction

Miscellaneous Itemized Deductions Not Subject to AGI Floor

Individuals include all gambling winnings for the year in gross income and deduct gambling losses to the extent of gambling winnings for the year Taxpayers generally deduct the greater of their standard deduction or their itemized deductions High income taxpayers are subject to a phase out of certain itemized deductions
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Standard Deductions

The Standard Deduction

Standard deduction amounts for 2013 Standard deduction Additional standard deduction (age and blindness)

Filing status

Married filing
jointly Head of household Single Married filing separately

$12,200

$1,200

8,950 6,100 6,100

1,500 1,500 1,500

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Standard Deductions & Exemptions

Bunching Itemized Deductions

Tax benefit can be gained by implementing simple timing tax-planning strategy

Taxpayers with itemized deductions that fall just short of the standard deduction amount These itemized deductions do not produce any tax benefit

Rather than deduct the standard deduction every year time deductions (when possible) to bunch together in one year
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Standard Deductions & Exemptions

Deduction for Personal and Dependency Exemptions

$3,900 for the taxpayer $3,900 for the taxpayers spouse $3,900 for each dependent Subject to phase-out for high income taxpayers

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