Whittenburg Gerald E., Altus-Buller Martha. Income Tax Fundamentals
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Student Name
Class/Section
Date
KEY NUMBER TAX RETURN SUMMARY
Chapter 2
Comprehensive Problem 1
Adjusted Gross Income (Line 21) ________________
Taxable Income (Line 27) ________________
Tax Liability (Line 37) ________________
Tax Overpaid (Line 45) ________________
Comprehensive Problem 2A
Adjusted Gross Income (Line 37) ________________
Taxable Income (Line 43) ________________
Tax Liability (Line 60) ________________
Tax Overpaid (Line 73) ________________
Comprehensive Problem 2B
Adjusted Gross Income (Line 37) ________________
Taxable Income (Line 43) ________________
Tax Liability (Line 60) ________________
Tax Overpaid (Line 73) ________________
Questions and Problems 2-51
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Chapter 3
Business Income
and Expenses, Part I
LEARNING OBJECTIVES
.............................................. .........................
After completing this chapter, you should be able to:
LO 3.1 Apply the tax rules for rental property and vacation homes.
LO 3.2 Explain the treatment of passive income and losses.
LO 3.3 Identify the tax treatment of various deductions for
adjusted gross income, including bad debts, cost of goods
sold, and net operating losses.
LO 3.4 Understand the treatment of Individual Retirement
Accounts (IRAs), including Roth IRAs.
LO 3.5 Explain the general contribution rules for Keogh
and Simplified Employee Pension (SEP) plans.
LO 3.6 Describe the general rules for qualified retirement plans
and 401(k) plans.
LO 3.7 Explain the pension plan rollover rules.
Overview
This chapter covers the taxation of business income and expenses (Part I). The first half of
this chapter includes material on rental income and expenses, passive income and losses,
bad debts, inventories, and net operati ng losse s (NOLs) . The second half of the chapter
covers retirement plans and retirement plan deductions associated with business and
wage income. The retirement plans covered include IRAs, Section 401(k) plans, Keogh
plans, and Simplified Employee Pension (SEP) plans.
The business income and expenses included in this chapter are all part of the calculation
of a taxpayer’s adjusted gross income (AGI). Chapter 4 continues the discussion started
here, with additional important elements of income and expense which ent er into the
calculation of AGI.
3-1
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SECTION 3.1
RENTAL INCOME AND EXPENSES
The net income from rental property is taxable income to the taxpayer. In most cases,
rental income is reported with the related expenses on Part I of Schedule E. If services
are provided to the tenant b eyond those customarily provided, such as cleaning and
maid services, the income is reported on Schedule C and is subject to the self-employment
tax. Expenditures deductible as rental expenses include real estate taxes, mortgage interest,
insurance, commissions, repairs, and depreciation.
EXAMPLE June Sanchez owns a house that she rents for $600 per month. The
following are her expenses for the year:
Real estate taxes $ 800
Mortgage interest 2,000
Insurance 200
Rent collection commissions 432
General repairs 350
June bought the property on July 1, 1990, and her basis for depre-
ciation of the house is $55,000. She uses straight-line depreciation
with a 27.5 year life.
In 2010, June bought a new stove for the rental house that
cost $500. The stove has a 5-year life, and 20 percent of the stove’s
cost is depreciated this year. June’s net rental income for the year is
calculated as follow s:
Rental income ($600 12) $ 7,200
Less expenses:
Real estate taxes $ 800
Mortgage interest 2,000
Insurance 200
Commissions 432
General repairs 350
Depreciation:
House ($55,000/27.5) $2,000
Stove ($500 20%)
100
Total expenses
(5,882)
Net rental income
$ 1,318
Please note that depreciation is an advanced topic which will be cov-
ered in detail in Chapter 7. N
Vacation Homes
Many taxpayers own residences which they use personally as part-year residences and rent
during the remainder of the year. Such part-year rental properties are often referred to as
‘‘vacation homes.’’ The tax law limits the deduction of expenses associated with the rental
of vacation homes.
3-2 Chapter 3
Business Income and Expenses, Part I
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EXAMPLE Jean owns a condo in Vail, Colorado. The condo is rented for 3 months
during the year and is used by Jean for 1 month. If there were no
vacation home limitations, Jean could deduct 11 months’ worth of
depreciation, maintenance, and other costs associated with the prop-
erty. The resulting loss could then be deducted against Jean’s other
taxable income. N
To prevent taxpayers from claiming a deduction for expenses effectively personal in
nature (associated with a personal residence), the tax law limits the deductions a taxpayer
can claim for expenses associated with a vacation home. Deductions attributable to vaca-
tion homes used primarily as personal residence s are limited to the income generated
from the rental of the property. In general, only profit or break-even (no loss) tax situations
are allowed on the rental of vacation homes.
The expenses associated with the rental of a residence used for both personal and rental
purposes are subject to three possible tax treatments. The tax treatment depends on the
period of time the residence is used for personal versus rental purposes.
1. Primarily Personal Use
If a residence is rented for fewer than 15 days during the year, the rental period is
disregarded and it is treated as a personal residence for tax purposes. The rental
income is not taxable and the mortgage interest and real estate taxes may be allowed
as itemized deductions. Other expenses, such as utilities and maintenance, are consid-
ered nondeductible personal expenses.
EXAMPLE Glenn owns a lake home. During the year he rented the home for
$1,800 for 2 weeks, lived in the home for 3 months, and left the
home vacant during the remainder of the year. The expenses for the
lake home included $5,000 in mortgage interest, $700 in property
taxes, $2,100 in utilities and maintenance, and $3,000 in depreciation.
Since the lake home was rented for fewer than 15 days, Glenn would
not report the $1,800 of income and would deduct only the interest
and taxes as itemized deductions on Schedule A. The other expenses
are nondeductible personal expenses. N
2. Primarily Rental Use
If the residence is rented for 15 days or more and is used for personal purposes for
not more than 14 days or 10 percent of the days rented, whichever is greater, the residence
is treated as rental property. The expenses must then be allocated between the per-
sonal and rental days. If this is the case, the rental expenses may exceed the rental
income, and the resulting loss would be deducted against other income, subject to the
passive loss rules.
EXAMPLE Assume the same facts as in the preceding example except that the
$1,800 rental fee is for 20 days and Glenn uses the lake home for
only 10 days during the year. Since the lake home is now rented for
15 days or more and Glenn’s use of the home is not more than
14 days (or 10 percent of the days rented, if greater), the property is
treated partially as rental property and partially as personal residence.
Section 3.1
Rental Income and Expenses 3-3
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Allocation of expenses associated with the home is based on the num-
ber of days of ren tal or personal use compared to the total number
of days of use. Glenn’s personal use percentage is 33.33 percent
(10 days/30 days) and the rental portion is 66.67 percent (20 days/
30 days). For tax purposes, the rental income (loss) is calculated as
follows:
Rental
(66.67%)
Personal
(33.33%)
Income $ 1,800 $ 0
Interest and taxes (3,800) (1,900)
Utilities and maintenance (1,400) (700)
Depreciation
(2,000) (1,000)
Rental Loss
($ 5,400) $0
N
3. Rental/Personal Use
If the residence is r ented for 15 days or more and is used for personal p urposes for
more than 14 days or 10 percent of the days rented, w hichever is greater, allocable rental
expenses are allowed only to the extent of rental in come. Alloca ble rental expenses
are deducted in three separate steps: first, the interest and taxes are deducted; sec-
ond, utilities and maintenance expenses are deducted; and third, depreciation expense
is deducted. For utilit ies, maintenance, and depreciation expenses to be deductible,
there m ust be positive income foll owing the deduction of items in the preceding
step(s). In addition, the expenses, other than int erest and taxes, are only deductible
to the extent of that positive income. Expenses are allocated be tween th e rental an d
personal days before the limits ar e applied. The IRS req uires that the allocation be
on the basis of the total days of rental use or personal use compared to the total
days of use.
EXAMPLE Assume Glenn rents the lake home for $2,500 for 20 days and uses it
for personal purposes for 60 days. Assume Glenn has the same oper-
ating expenses as in the previous examples. Since the lake home is
rented for 15 days or more and Glenn uses the home for personal
purposes for more than 14 days (or 10 percent of the days rented, if
greater), the property is subject to the vacation home limitations.
Glenn’s personal use percentage is 75 percent (60 days/80 days) and
the rental portion is 25 percent (20 days/80 days). The IRS requires
that the rental income or loss be calculated as follows:
Gross rental income $ 2,500
Less: interest and taxes (25%)
(1,425)
Balance 1,075
Less: utilities and maintenance (25%)
(525)
Balance 550
Less: depre ciation (25%, limited to $550)
(550)
Net income
$0
3-4 Chapter 3
Business Income and Expenses, Part I
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
The interest and taxes allocable to Glenn’s personal use of the
property in both examples are deductible as itemized deductions
on Sched ule A.
The personal portion of the utilities, maintenan ce, and deprecia-
tion is a nondeductible personal expense. N
It should be noted that the U.S. Tax Court has allowed taxpayers to use 365 days for the
allocation of interest and taxes. Under the Tax Court rules, the interest and taxes allocable
to the rental use of the property in the abov e example wo uld be 5.5 percent (20/365)
instead of 25 percent (20/80). The allocation of utilities and maintenance would remain
unchanged, while a full $750 of de preciation (25% of $3,000) would be allowed and the
remaining interest and taxes (345/365) would be included in itemized deductions. This
controversy between the Tax Court decisions and the IRS has not been resolved.
Taxpayers may pay for their vacation with tax-free income by renting out their
homes while they are away. If a home is rented fewer than 15 days a year, the
rental income is tax-exempt. For example, a taxpayer with a home near the
beach in San Diego could advertise a two-week winter rental, or a taxpayer with
a home near a Super Bowl could advertise a short rental.
SECTION 3.2
PASSIVE LOSS LIMITATIONS
Because of past abuses primarily involving tax shelters and loss deductions from rental real
estate, Congress enacted legislation limiting the deduction of certain ‘‘passive’’ losses from
other taxable income. Because the most common passive loss seen on tax returns is from
ordinary real estate rental activities, many taxpayers with an investment in a real estate
rental property are affected by these rules. In establishing the limitations, the tax law clas-
sifies individual income into three categories. These categories are (1) active income (e.g.,
wages, self-employment income, and salaries), (2) portfolio income (e.g., dividends and
interest), and (3) passive income and losses (e.g., rental real estate income and loss and
income and loss passed through from limited partnerships and other ventures in which
the taxpayer has minimal or no involvement).
Generally, passive losses cannot be used to offset either active or portfolio income. Also,
any tax credits derived from passive activities can only offset income taxes attributable to
passive income. Any unused passive losses and credits are carried over and may be used
to offset future passive income or taxes attributable to such incom e, respectively. Gener-
ally, losses remaining when the taxpayer disposes of his or her entire interest in the passive
activity may be used in full; however, the taxpayer can only use remaining credits to offset
the income tax arising from any gain recognized on the disposition of the activity.
Self-Study Problem 3.1
Janet Randolf rents one-half of her duplex and lives in the other half. Her
rental income for the year is $6,000. Janet’s basis for depreciation in the rental
portion is $15,000, and she uses straight-line depreciation with a 27.5 year
useful life. On the whole duplex, real estate taxes are $1,200, interest on the
mortgage is $3,400, utilities are $1,800, and insurance is $450. Use Part I of
Schedule E on page 3-7 to report Janet’s income from rental of part of the
duplex.
Section 3.2
Passive Loss Limitation s 3-5
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
EXAMPLE Mike’s income items for 2010 are:
Salary $40,000
Sales commissions 15,0 00
Dividends on Exxon stock 2,000
Rental income from real estate 6,000
Loss from limited partnership (9,000)
Interest on savings account 4,000
Mike’s active income for the year is $55,000 ($40,000 þ $15,000),
his portfolio income is $6,000 ($2,000 þ $4,000), and his passive loss is
$3,000 ($6,000 $9,000). Mike must report gross income of $61,000
($55,000 þ $6,000), since the passive loss cannot be used to offset his
active or portfolio income. The net passive loss of $3,000 will be car-
ried over to 2011. N
Under the passive loss rules, real estate rental activities are specifically defined as pas-
sive, even if the taxpayer actively manages the property and even if the activity is not con-
ducted as a partnership. Individual taxpayers, however, may deduct up to $25,000 of rental
property losses against other income, if they are actively involved in the management of the
property and their income does not exce ed certain limits. The $25,000 loss deduction is
phased out when the taxpayer’s modified adjusted gross income (adjusted gross income
before passive losses and Individual Retirement Account deductions) exceeds $100,000.
The $25,000 is reduced by 50 cents for each $1.00 the taxpayer’s modified adjusted
gross income exceeds that amount. Therefore, no deduction is allowed when the taxpayer’s
modified adjusted gross income reaches $150,000. Special limitations apply to taxpayers fil-
ing as Married, Filing Separately and claiming a deduction for real estate rental losses
under this special rule.
EXAMPLE Mary has modified AGI before passive losses of $120,000. In addition,
she has a rental house which shows a loss of $18,000 for the year. She
may deduct only $15,000 ($25,000 50% of $20,000) of the loss
because of the phase-out of the $25,000 allowance for passive rental
losses where modified AGI is over $100,000. N
Real Estate Rental as Trade or Business
Taxpayers heavily involved in real estat e rental activities may qualify as having an active
busi ness rather than a passive activity. If so, the income and losses f rom qualified rental
activities will no longer be sub ject to passive loss limitations. For a real estate rental to
be considered active, the taxpayer must materially participate in the activity. An individual
will satisfy this requirement if:
1. More than 50 percent of the individual’s personal service during the tax year is
performed in real property trades or businesses.
2. The individual performs more than 750 hours of service in the real property trade or
business in which he or she claims material participation.
EXAMPLE In 2010, Allan owns eighteen rental houses and spends 100 percent of
his personal service time (1,800 hours in 2010) managing them. Allan
spends his 1,800 hours of management time doing repairs, gardening,
collecting rents, cleaning and painting vacant houses, advertising for
3-6 Chapter 3
Business Income and Expenses, Part I
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
Section 3.2
Passive Loss Limitation s 3-7
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
3-8 Chapter 3
Business Income and Expenses, Part I
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.