Ind.chapter 6

Prentice Hall's Federal Taxation 2013 Individuals, 26e (Pope)

Chapter I6 Deductions and Losses

1) Expenses are deductible only if connected to trade or business or property held for the production of income.Answer: FALSEExplanation: Other expenses are allowed by the Code such as interest expense, taxes, bad debts, medical expenses, alimony, and moving, etc.Page Ref.: I:6-2Objective: 1

2) A deduction will be allowed for an expenditure unless the Internal Revenue Code specifically disallows it.Answer: FALSEExplanation: Deductions are not allowed unless the statute allows for them.Page Ref.: I:16-2Objective: 1

3) Itemized deductions are deductions for AGI.Answer: FALSEExplanation: Itemized deductions are deductions from AGI.Page Ref.: I:6-3Objective: 1

4) According to the tax formula, individuals can deduct the greater of for AGI deductions or from AGI deductions.Answer: FALSEExplanation: Individuals can always deduct "for" AGI deductions, but they will choose the greater of itemized deductions or the standard deduction for their "from" AGI deductions.Page Ref.: I:6-3Objective: 1

5) Expenses incurred in a trade or business generally are deductions for AGI.Answer: TRUEPage Ref.: I:6-3Objective: 1

6) Individuals are allowed to deduct the greater of the standard deduction or itemized deductions.Answer: TRUEPage Ref.: I:6-3Objective: 1

7) Adjusted gross income (AGI) is the basis for a number of phase-outs of deductions.Answer: TRUEPage Ref.: I:6-4Objective: 1

1Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

8) Generally, expenses incurred in an investment activity other than those incurred to produce rent and royalties are deductions from AGI.Answer: TRUEPage Ref.: I:6-6Objective: 2

9) Fees paid to prepare a taxpayer's Schedule C (Profit or Loss from Business) are for AGI deductions.Answer: TRUEPage Ref.: I:6-7Objective: 2

10) Taxpayers may deduct legal fees incurred in the acquisition of property.Answer: FALSEExplanation: All costs related to acquiring the asset and placing it in service must be capitalized into the basis of the asset.Page Ref.: I:6-7Objective: 2

11) In order for an expense to be ordinary, it must be reasonable in amount and it must bear a reasonable and proximate relationship to the income-producing activity or property.Answer: TRUEPage Ref.: I:6-7Objective: 2

12) An expense is considered necessary if it is "appropriate and helpful" in the taxpayer's business.Answer: TRUEPage Ref.: I:6-8Objective: 2

13) Capital expenditures add to the value, substantially prolong the useful life, or restore the life property.Answer: TRUEPage Ref.: I:6-10Objective: 3

14) Interest expense on debt incurred to purchase or carry tax-exempt securities is not tax deductible.Answer: TRUEPage Ref.: I:6-12Objective: 3

15) Kickbacks and bribes paid to federal officials are deductible only if related to the taxpayer's trade or business.Answer: FALSEExplanation: Illegal payments to governmental officials are contrary to public policy.Page Ref.: I:6-12Objective: 3


16) Fines and penalties are tax deductible if related to the taxpayer's trade or business.Answer: FALSEExplanation: Fines and penalties are contrary to public policy.Page Ref.: I:6-12Objective: 3

17) Contributions to political candidates are not deductible even if made through the taxpayer's trade or business.Answer: TRUEPage Ref.: I:6-14Objective: 3

18) Taxpayers may deduct lobbying expenses incurred to influence legislation at any governmental level if the legislation is of direct interest to the taxpayer's trade or business.Answer: FALSEExplanation: Only lobbying expenses to influence local legislation are deductible.Page Ref.: I:6-15Objective: 3

19) Sue Swank owns a local accounting firm in New Orleans, Louisiana. The city of New Orleans has proposed legislation to increase the hotel room tax. Swank incurs $1,000 lobbying expenses. Because the legislation is local, Swank may deduct the $1,000.Answer: FALSEExplanation: While the expenses are used to influence legislation on the local level, they are not of direct interest to Swank's business.Page Ref.: I:6-15; Example I:6-19Objective: 3

20) At the election of the taxpayer, a current deduction is allowed for the lesser of actual business start-up expenditures incurred or $5,000 with the remainder capitalized and amortized over 180 months.Answer: TRUEPage Ref.: I:6-15Objective: 3

21) Business investigation expenses incurred by a taxpayer who is already involved in a similar business and who enters the new business are deductible currently.Answer: TRUEPage Ref.: I:6-16Objective: 3

22) Rachel has significant travel and entertainment expenses for her work, but she has not kept receipts. She will be able to deduct a reasonable amount of these ordinary and necessary expenses under the Cohan rule.Answer: FALSEExplanation: The Cohan rule does not apply to travel and entertainment. The Code does not allow any travel and entertainment deductions unless strict documentation requirements are met.Page Ref.: I:6-18Objective: 4


23) Expenses paid with a credit card are deductible at the time a cash-basis taxpayer pays for the charge.Answer: FALSEExplanation: The expenses are deductible at the time of the charge.Page Ref.: I:6-19Objective: 5

24) Points paid in connection with the purchase of a principal residence may be deducted in the year paid.Answer: TRUEPage Ref.: I:6-19 and I:6-20Objective: 5

25) Points paid to refinance a mortgage on a principal residence are fully deductible in the year paid.Answer: FALSEExplanation: They are treated as prepaid interest and amortized over the term of the loan.Page Ref.: I:6-20Objective: 5

26) Accrual-basis taxpayers are allowed to deduct expenses when they meet either the economic performance test or the all-events test.Answer: FALSEExplanation: Both criteria must be satisfied.Page Ref.: I:6-21Objective: 5

27) An accrual-basis taxpayer may elect to accrue real property taxes ratably over the period to which the taxes relate.Answer: TRUEPage Ref.: I:6-22Objective: 5

28) Losses incurred on wash sales of stock or securities are generally disallowed in the year of sale.Answer: TRUEPage Ref.: I:6-23Objective: 6

29) A wash sale occurs when a taxpayer realizes a loss on the sale of stock or securities and the taxpayer acquires substantially identical stock or securities within a 61 day period after the date of sale.Answer: FALSEExplanation: The 61-day period of time extends from 30 days before the date of the sale to 30 days after the date of the sale.Page Ref.: I:6-23 and I:6-24Objective: 6

30) Under the wash sale rule, if all of the sold shares are not re-purchased within the relevant time period than were disposed of, a portion of the loss on the sale is allowed.Answer: TRUEPage Ref.: I:6-25; Example I:6-32Objective: 6

31) Losses on sales of property between a taxpayer and his/her siblings are disallowed.Answer: TRUEPage Ref.: I:6-26Objective: 6


32) Losses on the sale of property between a taxpayer and his/her more than 50-percent-owned corporation are disallowed.Answer: TRUEPage Ref.: I:6-26Objective: 6

33) If a loss is disallowed under Section 267, a gain on a subsequent sale of the property by the related purchaser may be offset by the previously unrecognized loss.Answer: TRUEPage Ref.: I:6-28Objective: 6

34) Generally, Section 267 requires that unpaid expenses may not be deducted by a taxpayer in a different year than when the related payee recognizes the amount as income.Answer: TRUEPage Ref.: I:6-28Objective: 6

35) If an activity produces a profit for at least two years during a consecutive five-year period, the burden of proof shifts to the IRS to show that the activity is not profit-motivated.Answer: FALSEExplanation: The time period is three out of five years.Page Ref.: I:6-29Objective: 6

36) Hobby expenses are deductible as for AGI deductions.Answer: FALSEExplanation: Hobby-related expenses, to the extent allowed, are itemized deductions.Page Ref.: I:6-30Objective: 6

37) Expenses related to a hobby are deductible only to the extent of the gross income from the hobby.Answer: TRUEPage Ref.: I:6-30Objective: 6

38) The vacation home limitations of Section 280A may also apply to boats and mobile homes.Answer: TRUEPage Ref.: I:6-31Objective: 6


39) Expenses attributable to the rental use of a taxpayer's personal residence are limited to the gross income generated by the property.Answer: TRUEPage Ref.: I:6-32Objective: 6

40) If property that qualifies as a taxpayer's residence is rented for less than 15 days per year, the taxpayer includes no rental income in gross income and similarly may claim no expenses related to the property other than interest and taxes.Answer: TRUEPage Ref.: I:6-34Objective: 6

41) The term "principal place of business" includes a home office used by a taxpayer for administrative or management activities of the business if no fixed location exists where the taxpayer conducts these activities.Answer: TRUEPage Ref.: I:6-35 and I:6-36Objective: 6

42) Generally, deductions for adjusted gross income on an individual's tax return include all the following types of expenses except thoseA) incurred in gambling activities.B) incurred in a trade or business.C) incurred in the production of rent income.D) incurred in the production of royalty income.Answer: AExplanation: A) All except expenses related to gambling activities are specifically listed as "For AGI" deductions in the Code.Page Ref.: I:6-3Objective: 1

43) On Form 1040, deductions for adjusted gross income include the amounts paid for all of the following exceptA) alimony.B) home mortgage interest.C) student loan interest.D) moving expenses.Answer: BExplanation: B) Home mortgage interest is an itemized deduction or deduction from AGI.Page Ref.: I:6-3Objective: 1


44) Deductions for adjusted gross income include all of the following exceptA) contributions to certain retirement plan arrangements.B) alimony.C) expenses attributable to production of rental income.D) unreimbursed employee business expenses.Answer: DExplanation: D) All except unreimbursed employee business expenses, deductible only as an itemized deduction, are specifically included as "For AGI" deductions.Page Ref.: I:6-3Objective: 1

45) Self-employed individuals may claim, as a deduction for adjusted gross income, 50 percent of theirA) traditional IRA contributions.B) disability insurance premiums.C) health insurance premiums.D) self-employment tax.Answer: DExplanation: D) The Code specifically allows for the deduction of 1/2 of self-employment tax as a "For AGI deduction."Page Ref.: I:6-3Objective: 1

46) Charles is a single person, age 35, with no dependents. In 2012, Charles has gross income of $75,000 from his sole proprietorship. Charles also incurs $80,000 of deductible business expenses in connection with his proprietorship. He has interest and dividend income of $22,000. Charles has no itemized deductions. Charles's taxable income isA) $7,250.B) $11,050.C) $13,200.D) $17,000.Answer: AExplanation: A) Interest and dividend income $22,000 Gross income from business $75,000Minus: Business deductions 80,000 ( 5,000)Adjusted gross income $17,000 Minus: Standard deduction ( 5,950)Minus: Exemption ( 3,800)Taxable income $ 7,250

Page Ref.: I:6-3 and I:6-4; Example I:6-1Objective: 1


47) In 2012, Sean, who is single and age 44, received $55,000 of gross income and had $5,000 of deductions for AGI and $4,600 of itemized deductions. Sean's taxable income isA) $40,250.B) $44,050.C) $45,250.D) $46,200.Answer: AExplanation: A) Gross income $55,000 Deductions for AGI ( 5,000)Adjusted gross income $50,000 Standard deduction ( 5,950)Exemption ( 3,800)Taxable income $40,250


48) In 2012, Venkat, who is single and age 37, received $60,000 of gross income and had $6,200 of itemized deductions. Venkat's taxable income isA) $50,000.B) $50,250.C) $56,200.D) $50,500.Answer: AExplanation: A) Gross income $60,000Minus > standard deduction or itemized deductions ( 6,200)Personal exemption ( 3,800)Taxable income $50,000

Page Ref.: I:6-4; Example I:6-1Objective: 1


49) Liz, who is single, lives in a single family home and owns a second single family home that she rented for the entire year at a fair rental rate. Liz had the following items of income and expense during the current year.Income:Gross salary and commissions from Ace Corporation $50,000Rent received from tenant in Liz's rental house 13,000Dividends received on her portfolio of stocks 5,000

Expenses:Unreimbursed professional dues 200Subscriptions to newsletters recommending stocks 900Taxes, interest and repair expenses on rental house 3,500Depreciation expense on rental house 2,300

What is her adjusted gross income for the year?A) $52,700B) $61,100C) $62,200D) $68,000Answer: CExplanation: C) Gross salary and commissions from Ace Corporation $50,000Rent received from tenant in Liz's rental house 13,000 Dividends received on her portfolio of stocks 5,000 Gross income $68,000

For AGI Deductions:Taxes, interest and repair expenses on rental house ( 3,500)Depreciation expense on rental house ( 2,300) Adjusted Gross Income $62,200

Page Ref.: I:6-4Objective: 1

50) Deductions for AGI may be locatedA) on the front page of Form 1040.B) on Schedule C as a deduction.C) on Schedule E as a deduction.D) All of the above are true.Answer: DExplanation: D) "For AGI" deductions include trade or business expenses located on Schedule C, rent expenses included on Schedule E, and those items specifically included on the face of the Form 1040.Page Ref.: I:6-4Objective: 1


51) To be tax deductible, an expense must be all of the following exceptA) ordinary and necessary.B) paid in cash.C) reasonable in amount.D) an expense of the taxpayer.Answer: BExplanation: B) With certain exceptions, accrual basis taxpayers may deduct accrued expenses.Page Ref.: I:6-5Objective: 2

52) Which of the following is not required for an expenditure to be deductible as a business or investment expense?A) recurring in natureB) ordinary and necessaryC) reasonable in amountD) incurred by the taxpayerAnswer: AExplanation: A) There is no requirement that an expense must be recurring in nature to be deductible.Page Ref.: I:6-5Objective: 2

53) Which of the following expenditures is tax deductible?A) capital expendituresB) expenses related to tax-exempt incomeC) expenses related to a trade or businessD) expenses that are illegal or in violation of public policyAnswer: CExplanation: C) The Code specifically disallows the current deduction of capital expenditures, expenses related to tax-exempt income, and expenses that are illegal or in violation of public policy.Page Ref.: I:6-5Objective: 2


54) Maria pays the following legal and accounting fees during the year:

Legal fees in connection with trade or business $4,000Legal fees related to purchase of personal residence 2,600Legal fees related to tax deficiency related to Schedule A itemized deductions 500Tax return preparation fees: Allocable to preparation of Schedule C 2,000Tax return preparation fees: Allocable to preparation of remainder of return 2,100

What is the total amount of her for AGI deduction for these fees?A) $4,000B) $6,000C) $8,100D) $11,200Answer: BExplanation: B) $4,000 + 2,000 = $6,000Page Ref.: I:6-7; Example I:6-4Objective: 2

55) Leigh pays the following legal and accounting fees during the year:

Legal fees in connection with a contract dispute in her trade or business $8,800Legal fees related to resolving a tax deficiency related to business 4,000Tax return preparation fees: Allocable to Schedules A and B 1,000Tax return preparation fees: Allocable to Schedule C 1,200Legal fees incident to a divorce 5,000

What is the total amount of her for AGI deduction for these fees?A) $10,800B) $14,000C) $15,000D) $20,000Answer: BExplanation: B) $8,800 + $4,000 + $1,200 = $14,000Page Ref.: I:6-7; Example I:6-4Objective: 2


56) During the current year, Martin purchases undeveloped land as an investment. Martin intends to rent the land as pastureland and hopefully sell it later for a profit. In the current year, Martin receives no rent but he does pay taxes of $2,800, mortgage interest of $900 and liability insurance of $500. How much of these expenses can Martin deduct (before any limitations) on his current tax return?A) $0B) $1,400C) $3,700D) $4,200Answer: DExplanation: D) $2,800 + $900 + $500 = $4,200Page Ref.: I:6-7; Example I:6-5Objective: 2

57) Pamela was an officer in Green Restaurant which subsequently went bankrupt. Pamela started a new restaurant and, to establish goodwill, paid off the debts of $100,000 of Green Restaurant. She was under no obligation to do so. The $100,000 isA) deductible currently as an itemized deduction.B) capitalized because the expenses are not ordinary. C) deductible currently as a trade or business expense since the expenses are considered ordinary and necessary business expenses.D) None of the above.Answer: BExplanation: B) The payments are not ordinary so they are not currently deductible but must be capitalized. Page Ref.: I:6-8; Example I:6-6Objective: 2

58) Laura, the controlling shareholder and an employee of Southwest Corporation, receives an annual salary of $750,000. Based on several factors including the size of the corporation's operations and a comparison of salary received by officers of comparably-sized corporations, the IRS contends that Laura's salary should be no higher than $600,000. The Court upheld the IRS's position. As a result, which of the following is true?A) $600,000 is deductible by the corporation; $600,000 is taxable to Laura.B) $600,000 is deductible by the corporation; $750,000 is taxable to Laura.C) $750,000 is deductible by the corporation; $750,000 is taxable to Laura.D) $750,000 is deductible by the corporation; $600,000 is taxable to Laura.Answer: BExplanation: B) The corporation is entitled a deduction for $600,000 which is considered "reasonable." However, the entire amount is taxable to Laura—$600,000 as salary and $150,000 as a dividend.Page Ref.: I:6-8; Example I:6-9Objective: 2


59) Carole owns 75% of Pet Foods, Inc. As CEO, Carole must travel extensively and does so on the company jet. In addition, she also uses the jet to take several personal vacations. Carole reports the value of the personal use of the jet, $140,000, as additional compensation. Which of the following is true in terms of the corporation?A) The corporation includes $140,000 as miscellaneous income.B) The $140,000 has no impact on the corporation's income tax.C) The corporation takes a deduction of $140,000 for compensation expense.D) The corporation takes a deduction of $140,000 for dividend expense.Answer: CExplanation: C) Because the $140,000 is considered taxable compensation to Carole, the corporation gets a related compensation expense deduction.Page Ref.: I:6-9; Example I:6-10Objective: 2

60) Mark and his brother, Rick, each own farms. Rick is experiencing severe financial difficulties and cannot afford to buy feed for his cattle. Mark purchases $2,000 of feed and gives Rick one-half of the feed. Mark tells Rick that there is no need to repay him and to consider the feed a gift. Which of the following statements is true?A) Mark can deduct $2,000 for the feed.B) Mark can deduct $1,000 for the feed.C) Rick must report $1,000 as income.D) None of the above is true.Answer: BExplanation: B) Taxpayers cannot take a deduction for the expense of another person.Page Ref.: I:6-9Objective: 2

61) Which of the following factors is important in distinguishing between capital and revenue expenditures?A) The expenditure improves the property, adding to the value of the property.B) The expenditure provides a betterment, adding to the value of the property.C) The expenditure restores the property.D) All of the above.Answer: DPage Ref.: I:6-10Objective: 3


62) During 2011 and 2012, Danny pays property taxes of $3,500 each year on a piece of land. During 2011, the land is vacant and unproductive. In 2012 Danny uses the land as a parking lot and generates $16,000 in income. Which of the following is true regarding the property taxes?A) Capitalize $3,500 each year.B) Deduct $3,500 each year.C) Capitalize $3,500 in 2011 and deduct $3,500 in 2012.D) Either B or C is acceptable.Answer: DExplanation: D) A taxpayer may elect to capitalize the expenses on unimproved and unproductive real estate each year. Therefore, Danny may either capitalize or deduct the $3,500 in 2011 but he must deduct the $3,500 in 2012.Page Ref.: I:6-11; Example I:6-12Objective: 3

63) During the current year, Ivan begins construction of an office building and a hotel. He incurs $10,000 in property taxes during the construction of the office building and $15,000 for the hotel. Which of the following statements is true of the property taxes during the construction period?A) Ivan must capitalize the property taxes on both properties each year if an election is made.B) Ivan must deduct the property taxes on both properties each year.C) Ivan may elect to capitalize the property taxes on one of the properties while deducting the property taxes on the other for each year.D) Ivan may elect to capitalize the property taxes for the properties in one year and then deduct the property taxes on the properties the next year.Answer: CExplanation: C) Separate elections to capitalize the property taxes are allowed on the different properties.Page Ref.: I:6-11; Example I:6-13Objective: 3

64) Emeril borrows $340,000 to finance taxable and tax-exempt investments. He incurs $18,000 investment interest expense, allocated equally between the taxable and tax-exempt investments. Ignore any possible investment interest expense limitation. How much of the interest expense is deductible, and where is it deductible?A) $18,000 for AGIB) $18,000 from AGIC) $9,000 for AGID) $9,000 from AGIAnswer: DExplanation: D) Interest incurred to acquire tax-exempt investments is not deductible. Deductible investment interest expense is not enumerated in Sec. 62 as a "for" deduction so it is a "from" deduction.Page Ref.: I:6-12; Example I:6-14Objective: 3


65) Jimmy owns a trucking business. During the current year he incurred the following:

Gasoline and Oil $ 100,000Maintenance $ 15,000Fines for Speeding and Illegal parking $ 8,000Bribes to Government Inspection Officials $ 21,000

What is the total amount of deductible expenses?A) $115,000B) $123,000C) $108,000D) $144,000Answer: AExplanation: A) Bribes and fines are not deductible. $100,000 + $15,000 = $115,000.Page Ref.: I:6-14Objective: 3

66) During the current year, the United States files criminal and civil actions against Joe, the CEO of Box Corporation, and Jane, the president of Cable Corporation, for price fixing. Both enter pleas of no contest and appropriate judgments are entered. Subsequent to this action, Square Corporation sues both Box and Cable for treble damages of $6,000,000. In settlement, Box and Cable each pay Square $1,200,000. What is the maximum amount that Box and Cable may each deduct?A) $400,000B) $1,200,000C) $2,000,000D) $6,000,000Answer: AExplanation: A) $1,200,000/3 = $400,000Page Ref.: I:6-14; Example I:6-16Objective: 3

67) Troy incurs the following expenses in his business (illegal gambling establishment): Salaries to employees, $200,000; insurance expense, $60,000; utilities expense, $70,000; and bribes to police, $60,000. His deductible expenses areA) $-0-.B) $200,000.C) $330,000.D) $390,000.Answer: CExplanation: C) $200,000 + $60,000 + $70,000 = $330,000Page Ref.: I:6-14; Example I:6-17Objective: 3


68) Pat, an insurance executive, contributed $1,000,000 to the re-election campaign of Governor Stephens, in hopes that Stephens will appoint her to a coveted position on the State Board of Insurance. How much of the contribution can Pat deduct?A) $0B) $100,000C) $500,000D) $1,000,000Answer: AExplanation: A) No deduction is allowed for a political contribution.Page Ref.: I:6-14Objective: 3

69) American Healthcare (AH), an insurance company, is trying to persuade Congress to enact nationwide anti-smoking legislation. As part of this effort, AH paid $500,000 to hire a lobbying firm to discuss its concerns with members of Congress. AH also contributed $100,000 to candidates for political office who support limiting public smoking. What amount of these expenditures can AH deduct?A) $0B) $100,000C) $500,000D) $600,000Answer: AExplanation: A) Lobbying expenses are only deductible if incurred for local issues; political contributions are not deductible.Page Ref.: I:6-14 and I:6-15Objective: 3

70) In March of the current year, Marcus began investigating the possibility of opening a specialty clothing store. From March through June, he spent $2,300 on a market survey, $2,700 in consulting fees to find the best location and $3,600 in professional fees setting up an accounting and inventory system. Although he had never run his own business before, on August 1 he opened his doors for business. What is the maximum amount of deduction for the current year attributable to these expenditures?A) $0B) $5,000C) $5,100D) $8,600Answer: CExplanation: C) Marcus may elect to deduct lesser of the $8,600 expenses incurred or $5,000 currently. He can amortize the remaining $3,600 over 180 months, resulting in $20 per month. His current year amortization is $20 × 5 = $100, for a total deduction of $5,100.Page Ref.: I:6-15Objective: 3


71) Toby, owner of a cupcake shop in New York, is considering opening a similar business (i.e., a cupcake shop) in Phoenix. After spending $4,200 investigating such possibilities in Phoenix, Toby decides against opening the store. What is the maximum amount of deduction for the current year attributable to these expenditures?A) $-0-B) $420C) $840D) $4,200Answer: DExplanation: D) Business investigation expenses of a taxpayer who is already engaged in a similar trade or business are fully deductible in the year incurred regardless of whether or not the taxpayer goes into the new business.Page Ref.: I:6-16Objective: 2

72) Jones, Inc., a calendar-year taxpayer, is in the air conditioner repair business. The business uses the cash method. In December of the current year, Jones charged $100 of supplies at Refrigeration, Inc., (he will pay the credit card bill in January) and also purchased $600 of supplies at XYZ on open account (he will make a payment on the open account in January). What is the amount that is deductible by Jones, Inc., in the current year?A) $100B) $600C) $700D) The amounts must be capitalized and charged to expense as used.Answer: AExplanation: A) Credit card charges are deductible in the year the charge is made regardless of the year in which the payment is made.Page Ref.: I:6-19; Example I:6-21Objective: 5

73) On August 1 of this year, Sharon, a cash method taxpayer, signs a lease for office space and begins business. The lease is for 3 years. At the time the lease is signed, Sharon pays the $12,600 rent for the entire 36-month lease term. How much can Sharon deduct this year?A) $350B) $1,750C) $5,950D) $12,600Answer: BExplanation: B) ($12,600/36) × 5 = $1,750Page Ref.: I:6-19; Example I:6-22Objective: 5


74) On December 1, Robert, a cash method taxpayer, borrows $10,000 from the bank for use in his business. Under the terms of the loan, the bank discounts the loan by $300, paying Robert the $9,700 cash proceeds. If Robert repays the loan next year, he may deductA) $300 next year.B) $300 this year.C) $25 this year and $275 next year.D) nothing since the note is "noninterest-bearing."Answer: AExplanation: A) A cash basis taxpayer gets the deduction in the year in which interest is paid.Page Ref.: I:6-19; Example I:6-23Objective: 5

75) In which of the following situations are points paid on a home mortgage loan not deductible in the year of payment?A) purchaseB) refinanceC) constructionD) improvementAnswer: BExplanation: B) The Code specifies that points paid to refinance a home must be capitalized and amortized over the life of the loan.Page Ref.: I:6-19 and I:6-20Objective: 5

76) On August 1 of the current year, Terry refinances her home and borrows $240,000. Terry is required to pay two points on the loan. The loan is secured by the residence and the charging of points is an established business practice in the area. The term of the loan is 20 years, beginning on August 1 of the current year. How much, if any, of the points may Terry deduct in the current year?A) $0B) $100C) $240D) $4,800Answer: BExplanation: B) $240,000 × 2% = $4,800 points paid. 20 years × 12 months per year = 240 months in the loan. $4,800 ÷ 240 = $20.00 per month amortization. Five months this year: $20 × 5 = $100.Page Ref.: I:6-20; Example I:6-24Objective: 5


77) On July 1 of the current year, Marcia purchases a new home and borrows $320,000. Marcia is required to pay two points on the loan. The loan is secured by the residence and the charging of points is an established business practice in the area. The term of the loan is 20 years, beginning on July 1 of the current year. How much, if any, of the points may Marcia deduct in the current year?A) $0B) $160C) $3,200D) $6,400Answer: DExplanation: D) Because these points are paid in connection with the purchase of a principal residence, Marcia may deduct $6,400 ($320,000 × 2%) as interest expense during the current year.Page Ref.: I:6-20; Example I:6-24Objective: 5

78) Which of the following is not required for an accrual method taxpayer to currently deduct the cost of services received?A) The liability must be paid.B) The existence of a liability must be established.C) The amount of the liability is determined with reasonable accuracy.D) The services must actually be provided.Answer: AExplanation: A) There is no requirement for an accrual basis taxpayer to pay an expense in order to get a deduction.Page Ref.: I:6-21Objective: 5

79) All of the following statements are true exceptA) A tax deduction is allowed to a taxpayer for estimated warranty expense.B) A tax deduction is allowed in association with a warranty only in the year in which warranty work is performed.C) A tax deduction is allowed for a contested amount if the amount is paid prior to final settlement.D) No tax deduction is allowed to an accrual basis taxpayer for the amount of a down payment for a non-recurring expense when the work is to be performed in a subsequent period.Answer: AExplanation: A) No tax deduction is allowed until warranty work is actually done.Page Ref.: I:6-21; Example I:6-25, I:6-26, and I:6-27Objective: 5

80) Under the accrual method, recurring liabilities may be deducted currently and paid in the next period if all of the following are present except forA) the all-events test is met.B) the expense is recurring.C) the expense is material.D) economic performance occurs within the shorter of 8 1/2 months after the close of the year or a reasonable period after the close of the year.Answer: CExplanation: C) There is no requirement that the expense be material.Page Ref.: I:6-21Objective: 5

81) Victor, a calendar year taxpayer, owns 100 shares of AB Corporation stock, which was purchased three years ago for $5,000. Victor sells all 100 shares on December 27, of the


current year, for $4,000 and on January 5, of the following year, purchases 60 shares of AB Corporation stock. Victor's recognized loss will beA) $0.B) $400.C) $600.D) $1,000.Answer: BExplanation: B) (40/100) × ($5,000 - $4,000) = $400 allowedPage Ref.: I:6-25; Example I:6-32Objective: 6

82) Ashley, a calendar year taxpayer, owns 400 shares of Yale Corporation stock that she purchased two years ago for $4,000. In the current year Ashley sells all 400 shares of the Yale Corporation stock for $2,400 on December 27. On January 4 of the following year, Ashley purchases 300 shares of Yale Corporation stock for $800. Ashley's recognized loss and her basis in the newly purchased 300 shares of Yale Corporation stock areA) Recognized Loss Basis$0 $3,200.

B) Recognized Loss Basis$400 $2,000.

C) Recognized Loss Basis$1,200 $2,000.

D) Recognized Loss Basis$1,600 $ 800.

Answer: BExplanation: B) Realized loss is ($2,400 - $4,000 = $1,600). $1,600 × 3/4 = $1,200 disallowed loss. $1,600 - $1,200 = $400 allowed loss. The cost of the new shares is $800 plus $1,200 unrecognized loss = $2,000 basis in new stock.Page Ref.: I:6-24 and I:6-25; Example I:6-31 and I:6-32Objective: 6


83) Samuel, a calendar year taxpayer, owns 100 shares of R Corporation common stock which was purchased two years ago for $3,600. Samuel sells all 100 shares on December 27 of the current year for $1,000. On January 4 of the following year, Samuel purchases 40 shares of R Corporation preferred stock. Samuel's recognized loss will beA) $0.B) $960.C) $1,040.D) $2,600.Answer: DExplanation: D) Preferred stock is not considered substantially identical to common stock of the same corporation and wash sale rules will not apply. Therefore, the loss of $2,600 ($1,000 - $3,600) is allowed.Page Ref.: I:6-25Objective: 6

84) Which of the following individuals is not considered a relative for purposes of the loss disallowance rules under Sec. 267?A) brotherB) husbandC) sister-in-lawD) grandfatherAnswer: CExplanation: C) Emma's husband, brother, and grandfather are all considered related parties under Section 267 and any loss on a sale to them would be disallowed. Page Ref.: I:6-26Objective: 6

85) Erin, Sarah, and Timmy are equal partners in EST Partnership. Sarah also owns 40% of Elton Corporation. The remaining shareholders of Elton Corporation are: Erin (24%) and Sarah's uncle (36%). What percent ownership does Sarah directly or constructively own in Elton Corporation?A) 40%B) 64%C) 76%D) 100%Answer: BExplanation: B) Sarah directly owns 40% and constructively owns Erin's (her partner) 24% of the stock , but not her uncle's stock.Page Ref.: I:6-26 and I:6-27; Example I:6-34Objective: 6


86) Jason sells stock with an adjusted basis of $66,000 to JJ Inc., his 60% owned corporation, for its fair market value of $60,000. JJ Inc. sells the stock three years later for $67,000. JJ Inc.'s recognized gain or loss on the sale will beA) $-0-.B) ($3,000).C) $1,000.D) $4,000.Answer: CExplanation: C) Selling Price $67,000 Minus: Cost (60,000)Gain $7,000Minus: Previously disallowed loss ($60,000 - $66,000) ( 6, 000)Taxable gain $ 1,000


87) Donald sells stock with an adjusted basis of $38,000 to his son, Kiefer, for its fair market value of $30,000. Kiefer sells the stock three years later for $32,000. Kiefer will recognize a gain on the subsequent sale ofA) $-0-.B) $2,000.C) ($6,000).D) ($8,000).Answer: AExplanation: A) Selling Price $32,000 Minus: Cost (30,000)Gain $2,000 Minus: Previously disallowed loss ($30,000 - $38,000) ( 2,000)Taxable gain $ -0-

The previously disallowed loss cannot reduce the gain below zero.Page Ref.: I:6-28; Example I:6-35Objective: 6


88) Dana purchased an asset from her brother for $15,000. Her brother's basis was $20,000. If Dana sells the asset to an unrelated party for $12,000, she will recognizeA) $-0-.B) ($1,000) loss.C) ($3,000) loss.D) ($4,000) loss.Answer: CExplanation: C) Selling Price $ 12,000 Minus: Cost (15,000)Loss ($3,000)


89) Sheila sells stock, which has a basis of $12,000, to her daughter for $7,000, the stock's fair market value. Subsequently, the daughter sells the stock to an unrelated party for $5,000. Which of the following is true for the Sheila and the Daughter?A) Sheila Daughterrecognizes no loss recognizes loss of $2,000

B) Sheila Daughterrecognizes no loss recognizes loss of $5,000

C) Sheila Daughterrecognizes loss of $3,000 recognizes loss of $5,000

D) Sheila Daughterrecognizes loss of $3,000 recognizes loss of $2,000

Answer: AExplanation: A) The $5,000 ($7,000 - $12,000) loss on Sheila's sale to Daughter is disallowed under the related party transaction rules. Her daughter's subsequent sale at a $2,000 loss, however, is recognized.Page Ref.: I:6-28; Example I:6-35Objective: 6


90) Rob sells stock with a cost of $3,000 to his daughter for $2,200, which is its fair market value. Later the daughter sells the stock for $3,200 to an unrelated party. Which of the following describes the tax treatment to Rob and Daughter?

A) Rob Daughter

Recognizes no lossRecognizes gain of $1,000

B) Rob DaughterRecognizes no loss Recognizes gain of $200

C) Rob Daughter

Recognizes $800 lossRecognizes gain of $1,000

D) Rob DaughterRecognizes $800 loss Recognizes gain of $200

Answer: BExplanation: B) The $800 ($2,200 - $3,000) loss on Rob's sale to Daughter is disallowed under the related party transaction rules. His daughter's subsequent sale at a $1,000 gain ($3,200 - $2,200) may be reduced by Rob's $800 disallowed loss resulting in a gain to Daughter of $200 ($1,000 gain - $800 loss).Page Ref.: I:6-28; Example I:6-35Objective: 6

91) Bart operates a sole proprietorship for which he uses the accrual method of accounting. Bart's sister Samantha, a cash method taxpayer, did some advertising work for Bart's business in November 2011. In December, Bart received a billing statement from Samantha for $5,000. Bart paid Samantha the $5,000 in January 2012. Both Bart and Samantha are calendar year taxpayers. When may Bart deduct the $5,000?A) 2011B) 2012C) Either 2011 or 2012D) The expense is not deductible since Samantha is Bart's sister.Answer: BExplanation: B) Since Bart and Samantha are related parties under Section 267, Bart may not take a deduction until Samantha recognizes the $5,000 in income.Page Ref.: I:6-28; Example I:6-36Objective: 6


92) Which of the following factors is not used to determine whether an activity is a hobby or a business?A) the taxpayer's expertise in the activityB) the taxpayer's financial statusC) the personal pleasure derived from the activityD) the success of the taxpayer in other dissimilar activitiesAnswer: DPage Ref.: I:6-29Objective: 6

93) For the years 2008 through 2012 (inclusive) Max, a surgeon, has been involved in raising poodles. Only in 2011 and 2012 did his income exceed the expenses from the activity. Which statement is correct?A) The activity is a business. The IRS cannot prove it is a hobby.B) The activity is a hobby. Max cannot prove it is a business.C) The activity is presumed to be a business. However, the IRS may prove it is a hobby.D) The activity is presumed to be a hobby. However, Max may prove it is a business.Answer: DExplanation: D) Under the presumption rule, if an activity results in a loss for 3 of 5 years, the burden of proof falls to the taxpayer to prove that the activity is a business rather than a hobby.Page Ref.: I:6-29Objective: 6

94) For the years 2008 through 2012 (inclusive) Mary, a a best-selling author, has been involved in operating an antique store. In 2008, 2009 and 2010 her income exceeded the expenses from the activity. In 2011 and 2012, the antique store generated a loss. Which statement is correct?A) The activity is a business. The IRS cannot prove it is a hobby.B) The activity is a hobby. Mary cannot prove it is a business.C) The activity is presumed to be a business. However, the IRS may prove it is a hobby.D) The activity is presumed to be a hobby. However, Mary may prove it is a business.Answer: CExplanation: C) Under the presumption rule, if an activity results in income in 3 of 5 years, the burden of proof falls to the IRS to prove that the activity is a hobby rather than a trade or business. Page Ref.: I:6-29Objective: 6

95) Abigail's hobby is sculpting. During the current year, Abigail sold three of her sculptures for a total of $3,200. Her related expenses include $1,500 in utilities, $1,200 in supplies and $900 in depreciation. Of the total expenses incurred, Abigail may deductA) $0.B) $1,500 in utilities and $1,200 in supplies.C) $1,500 in utilities, $1,200 in supplies, and $500 in depreciation.D) $1,500 in utilities, $1,200 in supplies and $900 in depreciation.Answer: CExplanation: C) Since the activity is classified as a hobby, hobby expenses are deductible to the extent of hobby income of $3,200. Further, they are deducted in a specific order—those that are otherwise allowable such as property taxes and interest; those related to the activity other than those that decrease basis; and those that reduce basis (depreciation).Page Ref.: I:6-30 and I:6-31; Example I:6-39Objective: 6

96) Kyle drives a race car in his spare time and on weekends. His records regarding this activity reflect the following information for the year.


Income $7,800Entry fees 2,100Depreciation on car 1,700Gasoline 1,000Interest on home equity loan for race car 800Insurance premiums 2,500

What is the allowable deduction (before any AGI limitation) for depreciation assuming that this activity is not engaged in for profit and Kyle can itemize his deductions?A) $0B) $300C) $1,400D) $1,700Answer: CExplanation: C) Income $7,800 Minus: Interest on loan for race car ( 800)Income before tier 2 expenses $7,000 Tier 2 expense: Entry fees $2,100 Tier 2 expense: Gasoline 1,000 Tier 2 expense: Insurance premiums 2,500 Total tier 2 expenses 5,600 Net income before tier 3 expenses $ 1,400 Depreciation on car $ 1,700Deductible depreciation (limit = 1,400) ( 1,400)

$ -0-


97) Juanita knits blankets as a hobby and sells them. In the current year, she earns $5,000 from her blanket sales and incurs expenses of $600. Juanita does not itemize deductions. On her tax return, she shouldA) report $5,000 of hobby income and deduct $500 of hobby expenses from AGI.B) report $5,000 of hobby income and deduct $400 of hobby expenses for AGI.C) report $5,000 of hobby income and deduct nothing from AGI since Juanita does not itemize deductions.D) report no hobby income and no hobby deductions.Answer: CExplanation: C) A deduction for hobby expenses is only available to taxpayers itemizing deductions.Page Ref.: I:6-30Objective: 6


98) Vanessa owns a houseboat on Lake Las Vegas that she personally uses for 25 days out of the year and rents for 280 days. For tax purposes, the houseboat is classified as:A) neither a residence nor rental property. Because it is rented a nominal number of personal use days, both revenue and expenses (other than those otherwise allowable) are ignored.B) rental property. Expenses in excess of income may be deducted although net income or loss is subject to the passive activity rules.C) property that is treated as a hobby which gives rise to from AGI deductions only.D) a combination of the taxpayer's residence and rental property. The deduction for expenses is limited to the amount of income generated by the property.Answer: BExplanation: B) Since Vanessa's personal use of 25 days does not exceed 10% of the rental days (280 × .10 = 28 days), then the houseboat is not considered a residence under Section 280A. Neither is the use considered nominal since rental days exceed 14. Therefore, the houseboat is classified as rental property.Page Ref.: I:6-31; Example I:6-40Objective: 6

99) Mackensie owns a condominium in the Rocky Mountains. During the year, Mackensie uses the condo a total of 23 days. The condo is also rented to tourists for a total of 77 days and generates rental income of $10,900. Mackensie incurs the following expenses in the condo:

Expense AmountMortgage interest $ 5,000Property taxes 3,500Utilities 2,500Insurance 1,800Depreciation 11,000

Using the court's method of allocating expenses, the amount of depreciation that Mackensie may take with respect to the rental property will beA) $0.B) $1,044.C) $5,796.D) $11,000Answer: CExplanation: C) Rental income $10,900 Minus: Mortgage interest (77/365 × $5,000) ( 1,055)Minus: Property taxes (77/365 × $3,500) ( 738)Minus: Utilities (77/100 × $2,500) (1,925)Minus: Insurance (77/100 × $1,800) ( 1,386)Minus: Depreciation (Remaining income) ( 5,796)Taxable rental income $ -0-

Note that the potential depreciation deduction is 77/100 × $11,000 = $$8,470, but it is limited to the remaining income after taking all other deductions into account.Page Ref.: I:6-32 and I:6-33; Example I:6-42Objective: 6

100) Abby owns a condominium in the Great Smokey Mountains. During the year, Abby uses the condo a total of 21 days. The condo is also rented to tourists for a total of 79 days and generates rental income of $12,500. Abby incurs the following expenses:


Expense AmountMortgage interest $ 4,100Property taxes 1,900Utilities 2,200Insurance 1,200Depreciation 10,000

Using the IRS method of allocating expenses, the amount of depreciation that Abby may take with respect to the rental property will beA) $ 5,074.B) $ 8,515.C) $ 7,900.D) $10,000.Answer: AExplanation: A) Income $12,500Mortgage interest ($4,100 × 79/100) $3,239Property taxes ($1,900 × 79/100 1,501 4 ,740Income after tier 1 expenses 7,760Utilities ($2,200 × 79/100) 1,738Insurance ($1,200 × 79/100) 948 2,686Income after tier 2 expenses 5,074Depreciation ($10,000 × 79/100, limited to $5,074) 5,074


101) Nikki is a single taxpayer who owns a vacation cottage on the lake. During the year, she rented it for $2,000 for 14 days, lived in it for 56 days, and left it vacant the remainder of the year. The year's expenses amounted to $5,000 interest expense, $800 property taxes, $1,500 utilities and maintenance, and $2,400 depreciation. Using the IRS method of allocating expenses, how much of the property-related expenses will be deductible for AGI?A) 0B) $2,000C) $1,940D) $9,700Answer: AExplanation: A) When property is rented for 14 days or less, the property is treated as 100% personal. None of the expenses are deductible for AGI, but none of the rental income has to be reported.Page Ref.: I:6-34; Example I:6-44Objective: 6


102) Brent must substantiate his travel and entertainment expenses. Which of the following is not required for documentation?A) company expense reportB) business relationship to the taxpayer of individuals entertainedC) purpose of the expenditureD) time and place of the travel or entertainmentAnswer: AExplanation: A) All but the company expense report are specifically required under the substantiation rules.Page Ref.: I:6-37Objective: 8


103) During the current year, Donna, a single taxpayer, reports the following items income of income and expenses:

Income:Salary $86,000Municipal bond interest 1,300Bank account interest 2,300Alimony received 24,000Capital gain on an asset held less than one year 3,000Rental income from residential rental house 12,500

Expenses/losses:Interest on principal residence 8,000Real estate taxes on principal residence 1,000Capital loss on an asset held less than one year 7,000Expenses related to rental property

Mortgage interest 6,000Repairs 2,400Taxes 700Depreciation 1,200

Compute Donna's taxable income. (Show all calculations in good form.)Answer: Salary $86,000 Bank account interest (municipal bond is excluded) 2,300 Net short-term capital loss (3,000 - 7,000 = 4,000 but limited)(3,000)Alimony 24,000 Rental income $12,500

Less rental expensesMortgage interest (6,000)Repairs (2,400)Taxes ( 700)Depreciation (1,200)

Net rental income 2,200 AGI 111,500 Itemized deductions:Interest on personal residence 8,000Real estate taxes on residence 1,000

Total itemized deductions ( 9,000)Personal exemption (3,800)

Taxable income $98,700

Page Ref.: I:6-2 through I:6-4Objective: 1


104) During the current year, Lucy, who has a sole proprietorship, pays legal and accounting fees for the following:

Services performed to resolve a business contract $ 5,000Services rendered in resolving a federal tax deficiency

relating to her business 2,000Tax return preparation fees:

Allocable to Schedule C (her sole proprietorship) 1,800Allocable to Schedule E (a rental property she owns) 800Allocable to remainder of Form 1040 900

Legal fees incident to her divorce (no tax advice) 2,000

What amount is deductible for AGI?Answer: Lucy may deduct $9,600 ($5,000 + $2,000 + $1,800 + $800) for AGI. The $900 for preparation of Lucy's 1040 excluding Schedules C and E is deductible from AGI as a miscellaneous itemized deduction subject to the 2% of AGI limit. The legal fees incident to divorce are personal expenses that are nondeductible.Page Ref.: I:6-7; Example I:6-4Objective: 2

105) Desi Corporation incurs $5,000 in travel, market surveys, and legal expenses to investigate the feasibility of opening a new coffee house in one of the new suburban malls in town. Desi already owns a similar coffee house across town.a. What is the proper tax treatment of these expenses if Desi decides not to open the new coffee house?b. What is the proper tax treatment of these expenses if Desi decides to open the new coffee house?c. Assume that Desi Corp is currently in the cleaning services business and incurs the noted expenses because it is considering opening a coffee house. Reconsider your responses to parts a and b.

Answer: a. Since Desi is already in a similar business, the entire $5,000 is deductible in the year the expenses are incurred.b. Same as a.c. Since Desi is incurring the expenditures with respect to a possible new line of business, it cannot deduct the expenditures at all if it decides not to pursue the coffee house business. If it does go forward with the coffee house, the $5,000 is considered a start-up expenditure. Because the expenditure does not exceed $5,000, full amount can be deducted. Larger amounts would require capitalization and amortization over 180 months.Page Ref.: I:6-16Objective: 2


106) Lloyd purchased 100 shares of Gold Corporation common stock for $20 per share for a total basis of $2,000. Several years later, on May 1 of the current year, Lloyd sells all 100 shares for $500. On May 29 of the current year, Lloyd purchases 30 shares of Gold Corporation common stock for $180. a. How much loss is Lloyd allowed to recognize?b. What is Lloyd's basis in the 30 new shares?Answer: a. 70/100 × ($500-$2,000) = $1,050 loss allowed.b. $180 + $1,500 disallowed loss = $1,680.Page Ref.: I:6-25; Example I:6-32Objective: 6

107) During the current year, Paul, a single taxpayer, reported the following items:

Salary $75,000Interest on original loan incurred to purchase home 14,000Taxes on home 3,500Revenue from hobby 5,000Interest on home equity loan incurred to purchase hobby assets 800Expenses of hobby 8,500

Compute Paul's taxable income for the year.Answer: Salary $75,000 Revenue from hobby 5,000 AGI $80,000 Minus:Interest on home acquisition $14,000

Interest on home equity loan 800Taxes on home 3,500 ( 18,300)

Miscellaneous itemized deductions:Expenses of hobby limitedto remaining income ($5,000-$800) $ 4,200Minus: 2% of AGI (80,000 × .02) ( 1,600) ( 2,600)Total itemized deductions (20,900)Minus: Personal exemption( 3,800)Taxable income $55,300 Page Ref.: I:6-30 and I:6-31; Example I:6-39Objective: 6


108) Lindsey Forbes, a detective who is single, operates a small pottery activity in her spare time. This year she reported the following income and expenses from this activity:

Revenue from sale of pottery $ 9,000Depreciation on potter's wheel ( 3,000)Property taxes on shed where she does pottery ( 1,200)Supplies used such as clay, etc. ( 6,500)

In addition, she had salary of $70,000 and itemized deductions, not including expenses listed above, of $6,100.

a. What is the amount of Lindsey's taxable income assuming the activity is classified as a hobby?b. What is the amount of Lindsey's taxable income assuming the activity is classified as a trade or business?

Answer: a. Hobby:Gross income:

Salary $70,000 Hobby income 9,000 Gross income/AGI $79,000

Itemized deductions:Other than from hobby $6,100

Tier One—Property taxes from hobby 1,200

Miscellaneous itemized deductions/hobby:Hobby income $ 9,000

Less: prop taxes ( 1,200)Ceiling on Tiers 2 & 3 $ 7,800 Supplies ( 6,500)Ceiling on Tier 3 $ 1,300 Depreciation ( 1,300)Deductible depreciation and supplies $ 7,800 Less: 2% AGI -1,580 Misc. itemized deductions 6,220 Total itemized deductions (13,520)

Personal exemption ( 3,800)Taxable income $61,680


b. Trade or business:Gross income:

Salary $70,000 Net loss from trade/business: Revenue from sale of pottery $ 9,000 Depreciation on potter's wheel ( 3,000) Property taxes on shed where she does work( 1,200) Supplies used such as clay, etc. ( 6,500) (1,700)

Gross income/AGI $68,300 Itemized deductions ( 6,100)Personal exemption ( 3,800)Taxable income $58,400



109) Margaret, a single taxpayer, operates a small pottery activity in her spare time. During the current year, she reported the following income and expenses from this activity which is classified as a hobby:

Revenue from sale of pottery $ 4,000 Depreciation on potter's wheel ( 3,000)Property taxes on shed where she does work ( 1,100)Supplies used such as clay, etc. ( 6,500)

In addition, she had salary of $75,000 and itemized deductions, not including those listed above, of $2,200.

What is the amount of her taxable income?Answer: Gross income:

Salary $75,000Hobby income 4,000Gross income/AGI $79,000 Greater of itemized deductions or SD* ( 5,950)

Personal exemption ( 3,800)Taxable income $69,250

Itemized deductions:Other than from hobby $2,200

Tier One—Property taxes from hobby 1,100Miscellaneous itemized deductions/hobby:

Hobby income $ 4,000Less: prop taxes 1,100

Limit Tiers 2 & 3 $ 2,900Supplies 2,900Limit for Tier 3 $ -0-Depreciation ( -0-)Total Tiers 2&3 $ 2,900Less: 2% AGI 1,580 1,320

Total itemized deductions $4,620 *Standard deduction of $5,950 exceeds the itemized deduction total.Page Ref.: I:6-30 and I:6-31; Example I:6-39Objective: 6


110) Discuss why the distinction between deductions for AGI and from AGI is important to individuals.Answer: The individual is permitted to deduct the greater of the standard deduction or the total "from" AGI deductions in arriving at taxable income. Where the sum of the "from" AGI deductions does not exceed the standard deduction, the benefit of the "from" AGI deductions is lost. "For" AGI deductions, however, reduce AGI and taxable income even though the standard deduction is used to compute taxable income.

AGI is also used to establish limits on certain deductions from AGI—such as charitable contributions, medical expenses, casualty losses, and miscellaneous itemized deductions—and the phase-outs for certain credits and deductions. Because AGI is used as a benchmark to establish these limits, it is important to properly classify deductions as deductions for AGI or deductions from AGI.Page Ref.: I:6-3 and I:6-4; Example I:6-1Objective: 1

111) List those criteria necessary for an expenditure to be deductible as business or investment expenses.Answer: To be deductible as business or investment expenses, an expenditure must be:

Related to a profit-motivated activity of the taxpayerOrdinaryNecessaryReasonable in amountProperly documentedAn expense of the taxpayer.

In addition, the expense must not be:A capital expenditureRelated to tax-exempt incomeIllegal or in violation of public policySpecifically disallowed by tax law.

Page Ref.: I:6-5Objective: 2

112) Ben is a well-known professional football quarterback. His team's owners expect him to be a role model for young people. Any endorsement contracts that he receives are based on his reputation. In the current year, Ben is charged with assault. Ben hires an attorney to represent him in this matter. Ultimately, the charges are dismissed. What tax issues should Ben consider? Answer: Is the fee paid to the attorney a personal (nondeductible) expense, or a business (deductible) expense?Page Ref.: I:6-5 through I:6-7Objective: 2

113) Mickey has a rare blood type and sells his blood for payment on a regular basis. In order to maintain the quality of his blood, Mickey takes expensive vitamins and nutritional supplements. What tax issues should Mickey consider?Answer: Does the sale of blood constitute a trade or business to Mickey? Are the vitamins and supplements deductible as business expenses?Page Ref.: I:6-7 through I:6-9Objective: 2


114) Ronna is a professional golfer. In order to correct her vision, Ronna has eye surgery. The costs of the surgery and subsequent medical care are not covered by insurance. What tax issues should Ronna consider?Answer: Can Ronna deduct the costs as a business expense, rather than a medical expense subject to the 7.5% floor?Page Ref.: I:6-7 through I:6-9Objective: 2

115) Super Development Company purchased land in the current year from Riverside Chemicals, Inc. The land was contaminated with harmful pollutants, so Super Development paid $1,000,000 to remove the contaminants. What tax issue(s) should be considered before Super files its current year tax return?Answer: Is the environmental cleanup cost a capital expenditure or deductible as a current operating expenditure? If capitalized, are the cleanup costs added to the basis of the land? Is there any tax incentive available since the expenditure has an environmental benefit?Page Ref.: I:6-10Objective: 3

116) During the current year, Charlene borrows $10,000 to purchase Kansas City bonds. Charlene incurs $800 of interest on her outstanding loan. Explain how much interest expense Charlene may deduct in the current year.Answer: $0. Charlene may not deduct any interest expense because her loan was used to purchase tax-exempt securities. Section 265 specifically disallows any deduction.Page Ref.: I:6-12Objective: 3

117) Eugene, a hardware store owner in Detroit, incurs $7,000 in an attempt to influence the Detroit City Council on the matter of a new tax assessment on hardware stores in Detroit. Explain what amount Eugene can deduct.Answer: Eugene may deduct the full $7,000, because the lobbying expense is incurred on a local legislative item that directly affects his business.Page Ref.: I:6-15Objective: 3

118) Why can business investigation expenditures be deducted currently by a taxpayer who is engaged in a line of business similar to the one being investigated, while the same costs must be capitalized and amortized to be deductible by a taxpayer who is not engaged in a similar business?Answer: In order to be currently deductible, the expenses must be ordinary and necessary business expenses. Business expenses must be incurred in an existing business. Since no business or similar business exists when the taxpayer not engaged in a similar business incurs these costs, no current deduction is allowed.Page Ref.: I:6-15Objective: 3


119) What must a taxpayer do to properly document a deductible travel or entertainment expense?Answer: A taxpayer must substantiate the following items:1. The amount of the expense2. The time and place of the travel or entertainment activity3. The business purpose of the travel or entertainment activity4. The business relationship of the persons entertained.Page Ref.: I:6-18Objective: 4

120) Discuss when expenses are deductible under the accrual method of accounting.Answer: To be deductible under the accrual method of accounting, expenses must meet both the all-events test and the economic performance test.

The all-events test is met when the existence of a liability is established and the amount of the liability is determined with reasonable accuracy.

The occurrence of economic performance depends upon the type of transaction. For example, if another person is to provide the taxpayer with property or services, economic performance is deemed to have occurred when the property or services are actually provided.

To determine when economic performance is deemed to have occurred in other types of transactions, see Table I6-1.Page Ref.: I:6-21 and I:6-22Objective: 5

121) Anita has decided to sell her stock in TOM, Inc. She purchased the stock 5 years ago for $1,000. The current fair market value is $600. Anita's sister, Kathy, is interested in buying the stock as is Anita's friend, Marcia. What tax issues should Anita consider when deciding to whom the stock should be sold?Answer: A taxpayer must consider the Section 267 loss rules when selling property which has declined in value to a "related party." Since a sister is a related party under Section 267, Anita's loss on the sale of the securities would be disallowed. The same would not be true if the stock were sold to a friend, who is not a related party under Section 267.Page Ref.: I:6-26Objective: 6


122) Diane, a successful accountant with an annual income of $150,000, also enjoys raising and training race horses, an activity in which she spends about 10 hours per week. Over the past five years her winnings from races have amounted to $20,000. She employs neighborhood children to feed the horses but has a professional trainer who works with the horses about 5 hours per week. Discuss some of the factors that might enter into the determination of whether or not this activity is a hobby or a trade/business.Answer: There is no direct way to prove a profit motivation. Factors taken into account include: whether the taxpayer conducts the activity in a businesslike manner; the expertise of the taxpayer or the taxpayer's advisors; the time and effort expended by the taxpayer in carrying on the activity; whether the assets used in the activity are expected to appreciate in value; the taxpayer's success in carrying on other similar activities; the taxpayer's history of income or losses with respect to the activity; the amount of occasional profits earned, if any; the taxpayer's financial status; and any elements of personal pleasure or recreation the activity might involve.Page Ref.: I:6-29; Example I:6-37Objective: 6

123) During the current year, Jack personally uses his summer home for 25 days. He also rented his summer home to a group of vacationers for 12 days for $600 per day. How much income does Jack report from the rental of his summer home?Answer: $0. Jack may exclude all of the $7,200 income from renting his summer home, because he only rented it for a nominal number of days (less than 15 days). No expenses attributable to the summer home may be deducted other than interest and taxes as itemized deductions.Page Ref.: I:6-34Objective: 6

124) Explain the rules for determining whether a home is considered a rental property or a vacation home and the tax consequences of this classification.Answer: If a property is used for personal purposes for the greater of (1) more than 14 days, or (2) 10% of the number of days rented, then the property is a vacation home. Deductible expenses must be allocated based on the ratio of the number of rental use over the total number of days used. The IRS allocates interest and taxes based on the ratio of the number of days of rental use over 365.The deductible expenses are limited to the property's rental income and are subtracted in the following order: interest and taxes allocable to the property, other expenses, and depreciation. Vacation home expenses cannot create a loss for tax purposes.

If the property is rented for less than 14 days or less, no rental income is reported. However, the taxpayer cannot deduct any expenses related to the rental activity other than interest and taxes.

If the property is rented for more than 14 days, and used for personal purposes for the greater of (1) less than 14 days, or (2) less than 10% of the number of days rented, expenses in excess of rental income can be deducted. There is no limitation on the amount of the deductible loss.Page Ref.: I:6-32 through I:6-34Objective: 6


125) Discuss tax planning considerations which a taxpayer may use to possibly avoid classification of an activity as a hobby.Answer: 1. Accelerate income so that profitable operations are realized in at least three out of five years.2. Maintain detailed financial records.3. Maintain a separate checking account for the activity.4. Advertise as a business activity when appropriate.5. Utilize business consultants where appropriate.Page Ref.: I:6-36Objective: 7


Documents

Ind.chapter 6