REG - Notes Chapter 2

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Adjustments and Itemized Deductions
Adjustments – deductions to arrive at AGI, above the line deductions

Educator expenses
 An eligible instructor is a K-12 teacher, instructor, counselor principal or aide in a school for at least 900
hours during a school year
 An eligible educator can deduct up to $250 of qualified expenses

Traditional IRA’s
 Contributions are deductible
 Exceptions: If both conditions are met, deductions are disallowed
- Excessive AGI (S $60,000/ MFJ 100,000)
- Active participation in another qualified plan (an individual is not considered to be an active
participant in an employer sponsored plan merely because the individuals spouse is an active
participant)
 Individuals over 50 can additionally contribute and extra $1,000

Roth IRA’s – non deductible, tax free accumulation, tax free distributions. No tax impact now or later
Non-deductible IRA’s – Tax free accumulation, withdrawal of principal tax free, accumulated earnings
taxable
Coverdell Education Savings Account (Education IRA) – non deductible, $2000 contribution max, tax free
accumulation, tax free distributions for qualified educational expenses, child beneficiary must be under 19,
there is a phaseout

Student loan interest expense – adjustment for education loan interest is limited to $2,500

Tuition and fees deduction – qualified higher education expenses are an above the line deduction (adjustment)
 4,000 max deduction
 Phaseout

Health Savings accounts – workers with high deductible health insurance to make pre-tax contributions (S
$2,700/ MFJ $5,450) to cover health care costs

Moving Expenses – work related only

 New workplace is 50 miles farther away from old house and old workplace
 Must work full-time at new location at least 39 weeks of 52 (75%)
 Only direct moving costs are allowable – travel and lodging, moving household goods
- Non deductible – meals, pre-move house hunting, breaking of a lease, temporary living expenses

Tax on self-employment (social security 50%) – 50% of the self employed SS/Medicare tax is deducted
(Bosses half)

Self employed health insurance (100% deductible for taxpayer, spouse and dependents)

Keogh (profit sharing) plans – self employed taxpayer is allowed to set up one of these plans
 Maximum annual deductible amount is limited to the lesser of
- $44,000 indexed for inflation, or
- 20% * Gross self employment income

Penalty on early withdrawal of savings is an adjustment to AGI – when you withdraw early the fund is a CD

Alimony – is income to payee, and an adjustment to Payor as long as it’s a qualifying alimony
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 Child support – non taxable to payee/ non-deductible to payor
 Property settlements - non taxable to payee/ non-deductible to payor

Deductions from AGI – below the line deductions

Standard deduction – if somebody used a 1040 EZ then they took a standard deduction
 Additional deduction for the elderly (over 65) and the blind
- its not an additional exemption

Itemized deductions limitation

 The limitation reduces, but not more than 80%, applicable itemized deductions by 3% of the amount of AGI
exceeding (75, 250/150,500)
 Itemized deductions that are not subject to limitation include:
- Gambling losses
- Investment interest expense
- Medical expenses
- Casualty and theft losses (non-business)

Medical expenses – for yourself, spouse and dependents are deductible

 Must be paid or charged during the year
 Only medical expenses that exceed 7.5% of AGI are deductible
 Types of deductible medical expenses
- Medicine and prescription drugs
- Doctors
- Medical and accident insurance
- Required surgery (even cosmetic surgery to correct a deformity caused by a crash)
- Transportation to medical facility
- Physically handicapped costs – expenses to remove structural barriers
 Non-deductible medical expenses
- Elective surgery, elective cosmetic surgery
- Life insurance
- Capital expenditures to accommodate handicapped

State, local and Foreign taxes (not federal taxes) – are generally deductible

Real estate taxes (state, local and foreign)

 Taxpayer must be legally obligated to pay in order to deduct (name must be on the deed)
 Prorate taxes in year of sale/purchase (only deduct for the length of time you lived in the house)
 Taxes paid under protest (goes to court) are deductible. Subsequent recovery (win the case) is included in
gross income
 Real estate taxes do not include street, sewer and sidewalk assessment taxes

Income taxes (state, local and foreign)

 Estimated taxes paid during the year are deductible
 Withheld taxes from paychecks during the year are deductible
 Assessments paid during the year for prior years are deductible

Personal property taxes (state and local)

Sales tax (state and local general sales taxes)

 Taxpayer may elect to deduct either state and local income taxes or state and local sales tax. If the sales tax
is chosen to be deductible the amount is either
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- The total of actual general sales taxes paid
- IRS table plus any amount of sales tax paid for a motor vehicle, boat or other IRS approved items
Non-deductible taxes
 Federal taxes (including social security)
 Inheritance taxes for states (also called “federal estate pick up tax”)
 Business (on schedule C) and rental property taxes (on schedule E)

Cash basis taxpayers are entitled to a deduction in the year the item is paid or charged. There is no matching to
the year the tax is applicable

Interest Expense – HIPPE

Home Mortgage Interest
 Interest on up to 1 million is acquisition indebtedness is deductible
- incurred for buying, constructing or improving taxpayers 1st or 2nd home
 Home equity indebtedness up to $100,000 is deductible (money can be used for anything). The maximum
amount that can be deductible is the lesser of:
- $100,000 or
- FMV of the property reduced by the amount of outstanding acquisition indebtedness

Investment Interest Expense

 Investment interest deduction for individuals is limited to the net taxable investment income
- Dividend income from stock purchased with borrowed funds which is treated as investment income to
limit investment expense can not be a qualifying dividend available for the 15% tax rate
- Interest expense used to purchase tax free bonds are not deductible because the interest warned on the
bonds is not taxable

Personal (consumer) interest – is not deductible

Prepaid interest – allocate to proper period

 Deduct when incurred and paid

Educational loan interest – is an adjustment (above the line), not an itemized deduction

Charitable contributions
 Charity – items given to organizations (tax deductible)
 Gifts – items given individuals (non-deductible)
 Political contributions – items given to candidates (non-deductible)
 Maximum allowable deduction is 50% of AGI:
- Cash = may be all 50%
- General property = lesser of basis or FMV
- Long term appreciated property is limited to the lesser of
30% of AGI
The remaining amount to reach 50% after cash contributions
 Can only deduct the excess amount over the FMV consideration received
- example: buy ticket to charity ball, value of ticket was $50, so can take a $150 charitable deduction
 Taxpayer cannot deduct the value of time or services donated
 Carryforward excess charitable contributions 5 years

Casualty and theft losses

 A casualty loss must be sudden or unexpected
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 Deductible loss formula
Smaller of: (1) lost cost/adjusted basis, (2) decreased FMV
(insurance recovery)
($100)
(10% of AGI)
= deductible loss (if any)

Usually nobody gets a deductible here because of the high hurdles. So in a question usually the lowest # or 0 is
the correct answer

Miscellaneous itemized deductions – allowed only to the extent they exceed 2% of AGI
Unreimbursed business expenses (employee)
 Travel, meals and lodging – 100% deductible, only for overnight business travel
 Transportation expenses (not regular/ordinary commute expenses) are 100% deductible
 Meals and entertainment expenses – 50% deductible

Educational expenses (those not deducted above AGI for 2004-2006)

 Qualified expenses are deductible
- Maintain or improve the skills needed by the individual in his or her trade or business
- Meet the express requirements of the individuals employer for retention of this job
 Disqualified expenses can not be deducted
- education needed to meet minimum job requirements
- qualified him for a new trade or business

Uniform purchases, cleaning and repair are deductible as long as its not worn as street wear off the job
Business gifts - $25 per year is deductible
Investor expenses – safe deposit box, investment advice are deductible
Subscriptions to professional journals are deductible
Legal and accounting fees incurred for tax preparation is deductible

Other Misc items that may be fully deducted (not subject to 2% AGI test)
 Gambling losses to the extent of gambling winnings

Tax Calculations and Credits

Child and dependent care credit
 Tax credit of 20% to 35% of eligible expenditures
- 1 dependent - $3,000 max expenditure limit
- 2 or more dependents - $6,000 max expenditure limit
 Must be qualified child under 13 or any aged disabled dependent
 Eligible expenses must be for the purpose of enabling the taxpayer to be gainfully employed (allowing that
person to work or look for work)
- Babysitter
- Nursery school
- Day Care
- Not grammar school

Credit for the elderly and/or permanently disabled

 For people 65 years or older or under 65 but retired due to permanent disability
 Max potential credit S $5,000/ MFJ $7,500; formula
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Max potential credit
- Social security payments received
- ½ excess AGI (S $7,500/ MFJ $10,000)
* 15%
= Credit allowed

Education tax incentives

 Hope scholarship credit - ($1,650 max) Qualified tuition and related expenses paid for a students first two
years of college (multiple kids ok)
 Lifetime learning credit – ($2,000 max) credit is equal to 20% of qualified expenses up to $10,000 (only
one per year)
 Using both in the same year is OK

Adoption credit
 Credit for qualifying expenses of adopting a child is available
- per child $10,960
 All reasonable and necessary expenses, cost and fees are available for the credit
 The credit is not available for adopting the child of a spouse or a surrogate parenting arrangement
 There is a phase out

Retirement savings credit – only for the poor

 Non-refundable credit that may offset both regular and alternative minimum tax is available for traditional
or roth IRA contributions
 Must be 18 years old
 Not a full time student
 Not a dependent

Foreign tax credit – limited to the lesser of:

 Foreign taxes paid, or
 Foreign tax credit limit = [(taxable income from all foreign operations) / (taxable income + exemptions)] *
U.S. tax rate

Work opportunity credit – available to employers who hire employees from a targeted group. Part of the
general business credit
 40% of first $6,000 of first years wages

Welfare to work credit

 35% of the first $10,000 of qualified first year wages, and
 50% of the first $10,000 of qualifies second year wages

Child tax credit – taxpayers may claim a $1,000 tax credit for each qualifying child
 CARES rules apply except child must be under 17 (not 19 or 24)

Earned income credit – for very poor people – it’s a refundable credit

Withholding taxes (paycheck credit) – all income taxes withheld from your paycheck are treated as a credit

Excess FICA (social security tax withheld)

 If you switch employers in the middle of the year, you may pay additional FICA than required, the excess
paid is a credit against income tax

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Individual Taxation – Other taxes
Alternative minimum tax – designed to ensure that taxpayers who take a large number of deductions pay a
minimum amount of tax on their income

The exemption formula?

Adjustments – timing differences that may increase or decrease the AMTI – PANIC TIMME
 Passive activity losses
 Accelerated depreciation
 Net operating losses of the individual tax payer
 Installment income of a dealer
 Contracts - % completion vs, completed contract
Itemized deductions – always adds back to regular taxable income
 Tax “deductions” – taxes reduced by taxable funds
 Interest deductions – Mortgage interest not used for the home, and investment interest exp is recalculated
 Medical deductions (limited to excess over 10% AGI rather than 7.5%)
 Misc deductions subject to the 2% floor are not allowed
 Exemptions (personal) and standard deduction

Tax preference items - always add backs – PPP

 Private activity bond interest income
 Percentage depletion the excess over adjusted basis of property
 Pre-1987 accelerated depreciation

AMT Credit – certain allowable AMT paid in a taxable year may be carried forward (forever) as a credit. It
may only reduce regular tax, not future AMT

The following tax credits are permitted to reduce the AMT

 Foreign tax credit
 Adoption credit
 Child tax credit
 Contributions to retirement plans credit
 Earned income credit

Individual Taxation – Other Items (R2-51)

Statue of limitations – period during which the gov’t can assess additional tax.
 In general, its 3 years from the later of:
- Due date of return, or
- Date return is filed (including amended returns)
 If there is a 25% understatement of gross income, its 6 years from the later of:
- Due date of return, or
- Date return is filed
 If there is fraud or false return, there is no statue of limitations

The statue of limitations on refunds – period during which the tax payer can claim and receive a refund
 Later of:
- 3 years from due date of return, or
- 2 years from time tax was paid
 For bad debts, worthless securities, its 7 years from the later of:
- Due date of return, or
- Date return is filed
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Taxpayer is required to make estimated quarterly payments if both of the following conditions are met
 $1,000 or more of tax liability owed
 Inadequate estimates payments – taxpayers withholdings is less then the lesser of:
- 90% of current years tax, or
- 100% of last years tax
 Failure to pay estimated taxes (withholding) a penalty will be assessed