Chap 3: Special Rules for Inclusion and Exclusion

Below Market Loans

Purpose: block a sophisticated method of shifting the income from property. High bracket Tp's (parents or corporations) might loan $$ at zero interest to low bracket related parties (family members, corp. executives, shareholders) who use the $$ to buy income-producing assets.

The rule: If stated interest on a loan to a related party is below the "Applicable Federal Rates" (rates the government pays on its borrowings), the borrower is treated as though paying the difference to the lender, and the lender is treated as though returning the difference to the borrower as a gift, as compensation, or as a dividend. Two fictitious transactions are booked in order to create a result similar to parties acting at arms length.

Exceptions for loans under $10K, and limited exception for family loans under $100K not used to acquire property that produces income.

Tax Benefit Rule

This is a timing rule that applies when an expense deducted in one year is refunded in a later year. Instead of correcting the earlier year (which may be a statute of limitations problem), the refund is treated as income in the year it is received --

But: (Sec. 111) the refund is income only if (-- and only to the extent--) the earlier year expense reduced taxable income and tax. For example, a standard allowance or a threshhold might mean that the expense had no effect on income, or perhaps the expense just made negative income more negative (so tax was already zero) . In these cases a refund of the expense is not taxable.

Tax-Exempt Income

No Federal tax on interest received on state/local government bonds. No state tax on Federal interest. Policy (traditionally) was to prevent each level of government from interfering with the other

Note that there is an "implicit tax" -- lenders bid down the stated yield on exempt bonds. Low bracket lenders may be better off buying taxable bonds!

Lease Improvement forfeitures

Gifts, Inheritances and Life Insurance

A transfer motivated by "love and generosity" is not taxable income, and inheritances and life insurance payoffs (usually) aren't taxable income

Exception for purchased or "viatical" life insurance policies

What about "Gifts" as part of a business relationship? If they really are payments for past or future services, they are income: xx Duberstein v. CIR

What if income recipient gives away the money? xxSchuster v. CIR

Cancellation of Debt

Borrowed money isn't income, but relief from indebtedness is. xx Old Colony Trust; xx Kirby Lumber

Exceptions: debt relief isn't income if Tp is bankrupt, or insolvent, or elects to reduce the tax cost of real estate securing the debt

Gains and Losses from Property Sales: Overview

Gross receipts aren't income. Must subtract the tax cost ("basis") of any property Tp gave up in exchange to determine gain or loss.

Generally, gains are recognized and taxable unless certain "nonrecognition" rules apply. (For example, asset transfers to controlled corporations or partnerships, real estate exchanges, and corporate mergers.)

For individuals, net gains from the sale of "capital assets" held over one year receive favorable treatment in the form of special, lower tax rates, "capped" at 20% to 28%. A lot of individual tax planning involves trying to maximize this favorable treatment.

There are many limits on the deductibility of losses. Such losses must result from business transactions, or profit-seeking activity or casualties. "Capital" losses are limited to offsetting capital gains, and "Passive" losses can only be used against passive-type income. If not usable in the current year, some losses just vanish, while others are "carried" into a different year and treated as arising in that year.

Chapter 15: Income Exclusions

Specific inclusions/exclusions for individuals

Receipts that aren't income = "exclusions", usually not reported on any form.

Reason may be that a type of receipt is on the borderline of the concept of income, or administrative convenience, or a policy decision to encourage certain forms of receipt

Family transfers: gifts, inheritance, alimony (already covered)

Prizes and Awards

In income at the FMV of the prize.

Scholarships for degree candidates are not income to extent used for tuition, fees, required books and materials

Exclusion for certain employee awards

Lawsuit awards and settlements

Compensation for personal physical injury is not taxable income (theory is that Tp isn't better off)

What about attorneys fees? Deductible?

Transfers From government

Not considered income if need based, such as food stamps, public housing, etc.

Unemployment comp is taxable income

Social Security benefits

A complicated formula makes benefits nontaxable at low income levels. Then a first phase-in makes up to 50% of SSB's taxable as AGI increases. At higher income levels, a second phase-in makes up to 85% of the SSB's taxable

Employer-Provided fringe benefits (covered later)

Chapter 15: Itemized Deductions

These deductions are not as valuable as costs of business or the other adjustments "for" AGI, because the standard deduction is an alternative, because of a high-income phaseout, and because a threshhold percentage of AGI is subtracted in calculating some of them. Some itemized deductions are allowed as a matter of income measurement, some due to social policy, and some due to politics and tradition. The three largest itemized deductions are those for state taxes, interest and charitable contributions.

State & Local Income and Property taxes

Was a counterpart to the nontaxability of state bond interest. Sales taxes dropped because recordkeeping was impossible.

State and Local Income taxes

• note: includes CA SDI
• note frequent timing problems with refunds: tax benefit rule

Deduction also for foreign income taxes -- but usually a credit helps Tp more

Real property

• Includes personal residence, and any other RE
• Tp has some control (payment timing)
• But, if a sale, prorate to reflect actual ownership. like accrual.

Personal property

For CA note treatment of auto registration fee: all over $38

Home Mortage and Investment Interest

Interest paid on certain loans secured by Tp's primary -- and 1 secondary -- residence (i.e if have several vacation homes, select the one to which the rule will apply)

Acquisition debt

• Is secured by residence, and was used to acquire or improve it
• Maximum $ 1mm. If loan is larger, exceeds is "home equity debt" or just nondeductible personal interest
• "Grandfather" rules for pre-10/87 debt
• If refinance: outstanding balance of acquisition loan remains acquisition debt

Home equity debt

• Secured by the residence, used for anything
• Limited to $100,000: interest on excess is nondeductible personal

Timing of the Interest Deduction

General rule: prepayment does not speed up interest deduction

Special treatment of mortgage "points"

Normally, accrue points expense over life of loan (IRS allows straight line, not compounding, for simplicity).

Exception is current deduction of points paid on loan to buy or improve principal residence. Not vacation homes, not refinancing.

Investment Interest

Deduct ii up to, not to exceed, current year's net investment income. Indefinite carryover of excess

Note: Net Capital Gains not treated as "investment Y" unless waive 20% rate. Reason is to prevent arbitrage, as explained here

Problem: interest tracing

Money is fungible. Deduction for interest other than home mortgage depends on the use of the funds. Complicated regulations provide tracing rules for multiple debts, in multiple accounts used for multiple purposes.

Itemized Deductions - Medical Expense Disasters

Mechanics of Deduction:

Deduct unreimbursed medical and medical insurance costs for taxpayer and dependents, after subtracting 7.5% of AGI. This "threshhold" means that the fringe benefit insurance exclusion is worth a lot more

Decrease deduction by any reimbursments. A reimbursement in a later year may activate the tax benefit rule

Definition of "medical"

"Alleviates a recognized disorder of the body or mind" is medical, "improve general health" isn't.

Includes doctors, dentists, hospitals, prescription-required drugs and insulin. Psychological counseling. Further examples: eyeglasses, acupuncture. Anti- smoking therapy added @ 1998 by IRS policy change

Query treatment of health clubs or weightwatchers?

Medical travel & transportation

If not primarily vacation, then deductio a limited amount of travel & lodging. and medical transportation

Personal Casualty losses: Acts of God or thieves

Measuring the loss

limited to lesser of cost (basis) or market

Mechanics

• Calculate unreimbursed loss
• Then Subtract $100 per casualty event;
• Then Subtract 10% of AGI from total of all events
• What's left is the itemized casualty deduction

Note: different rules apply to investment property

Itemized Deductions - the "small stuff"

Many are greatly limited by a 2% of AGI threshhold (and not deductible at all for AMT calculations)

The unreimbursed, out of pocket costs of being an employee. Note that equivalent proprietorship costs are deducted for, not from, AGI

The cost of being an investor (other than rent/royalty income)

The cost of tax assistance ("Tax" is broader than preparation)

Specialized deductions not subject to 2% limit, like estate tax paid on Y items, and gambling losses to extent of winnings