Income Tax Exam 2

Ch. 6,7,8,9

What form do sole proprietors use to report business income and deductions?

Schedule C of Form 1040 — net income flows directly into AGI as a for-AGI deduction

What accounting method is the default for sole proprietors?

Cash method — recognize income when received, deduct expenses when paid

When is the accrual method required for a sole proprietor?

When average gross receipts exceed $26 million over the prior 3 years AND inventory is a material income-producing factor

What are the three court-established requirements for a trade or business?

(1) Profit motivation, (2) Continuity and regularity, (3) Oriented toward livelihood — not sporadic or a hobby

What does "holding oneself out to sell goods or services" refer to?

The court-established phrase defining trade or business activity

What are the three requirements for a business expense to be deductible on Schedule C?

(1) Ordinary — customary or usual in that business, (2) Necessary — appropriate and helpful, (3) Reasonable in amount

What types of expenses are expressly forbidden as deductions even if ordinary, necessary, and reasonable?

Illegal bribes/kickbacks, lobbying/political payments, and fines/penalties paid to a government

What is the standard mileage rate for 2021?

56 cents per mile for business use

What additional items can a self-employed taxpayer deduct even when using the standard mileage rate?

Business portion of loan interest on the vehicle, property taxes, parking fees, and tolls

Once a taxpayer uses MACRS/Section 179/bonus depreciation on a vehicle, can they switch to the standard mileage rate?

No — they are permanently locked into the actual cost method for that vehicle

What is the 2021 rule for business meal deductibility?

100% deductible if provided by a restaurant (Consolidated Appropriations Act 2021 — temporary COVID relief); normally 50%

Are entertainment expenses deductible after 2017?

No — entertainment expenses are 100% disallowed since the Tax Cuts and Jobs Act of 2017

What is the business gift deduction limit?

$25 per recipient per year, regardless of the number of gifts given

Are club dues and membership fees deductible?

No — expressly nondeductible

When are education expenses deductible on Schedule C?

When the education (1) maintains or improves skills in the taxpayer's CURRENT trade or business, or (2) is expressly required by the employer or applicable law

When are education expenses NOT deductible?

When the education meets minimum qualifications for a position not yet held, or qualifies the taxpayer for an entirely NEW trade or business

What is the "capital recovery concept" in depreciation?

The idea that the cost of a long-lived business asset is recovered (deducted) over its useful life rather than all at once in the year of purchase

What is depreciable basis for a purchased asset?

Generally the cost — cash paid plus liabilities assumed plus acquisition costs

What is the depreciable basis for a personal asset converted to business use?

The LOWER of the original adjusted cost basis OR the fair market value at the date of conversion

What is the depreciable basis for inherited property?

Fair market value at the decedent's date of death (stepped-up basis)

What is adjusted basis?

Original cost basis MINUS accumulated depreciation — used to calculate gain or loss on sale

What recovery period applies to autos and light trucks under MACRS?

5-year property

What recovery period applies to furniture, fixtures, and most equipment under MACRS?

7-year property

What recovery period applies to residential rental property?

27.5 years, straight-line method

What recovery period applies to nonresidential real property (offices, warehouses) placed in service after May 13, 1993?

39 years, straight-line method

What is the half-year convention?

All personal property placed in service during the year is treated as placed in service at the midpoint of the year — you get exactly one-half year of depreciation in year one regardless of actual purchase date

When is the mid-quarter convention required?

When more than 40% of the total depreciable basis of all personal property placed in service during the year is placed in service in the fourth quarter (Q4)

What does the mid-quarter convention do?

Treats all personal property placed in service that year as placed in service at the midpoint of the quarter in which it was actually placed in service — requires separate depreciation tables

What property uses the mid-month convention?

Real property only — 27.5-year and 39-year assets

How does the mid-month convention work?

Property is treated as placed in service at the midpoint of the month acquired, determining how many months of depreciation are taken in year one

How much depreciation is taken in the year of disposal for a half-year convention asset?

One-half of the normal table percentage (same convention applies in disposal year)

What depreciation method is used for 3, 5, 7, and 10-year MACRS property?

200% declining balance switching to straight-line in the year SL produces a larger deduction

What depreciation method is used for 15-year and 20-year MACRS property?

150% declining balance switching to straight-line

What depreciation method is required for real property under MACRS?

Straight-line only

Is salvage value considered under MACRS?

No — salvage value is ignored; assets are depreciated all the way to zero

What is the Section 179 expense election limit for 2021?

$1,050,000 maximum deduction

At what dollar amount of total asset acquisitions does the Section 179 deduction begin to phase out in 2021?

$2,620,000 — phases out dollar-for-dollar; eliminated completely at $3,670,000

Can Section 179 create a net operating loss?

Not from the business activity alone — though wage income from other employment counts toward the income limit

Can Section 179 be used for rental property?

Not for the rental activity itself — but qualified improvements to nonresidential real property (roofs, HVAC, etc.) do qualify

What is bonus (first-year) depreciation for 2021?

100% of the cost of eligible property (MACRS recovery period of 20 years or less, new OR used) can be deducted in the year placed in service

How does bonus depreciation differ from Section 179?

Bonus: no dollar cap, no income limitation, applies to used property, mandatory by class (must elect out); Section 179: has income and dollar caps, applies to specific chosen assets

What types of assets are considered "listed property"?

Vehicles (under 6,000 lbs), entertainment/recreation equipment, boats — items prone to personal use (computers removed in 2017)

What happens if a listed property asset's business use is 50% or less?

Must use straight-line depreciation only; Section 179 deduction is not allowed

What is the Year 1 luxury automobile depreciation cap for 2021 (with 100% bonus)?

$18,200 (100% business use)

What is the Year 1 luxury automobile depreciation cap for 2021 WITHOUT bonus depreciation?

$10,200

What is the Section 179 limit for heavy SUVs (over 6,000 lbs) in 2021?

$26,200 — regular MACRS has no luxury cap; 100% bonus has no cap

What is the Section 199A (QBI) deduction?

Up to 20% of qualified business income from Schedule C and pass-through entities, deducted below the line (reduces taxable income but not AGI)

What caps the QBI deduction?

The LESSER of: (1) 20% of QBI, or (2) 20% of taxable income less net capital gains

At what taxable income level does the QBI deduction begin to phase out for specified service businesses (MFJ)?

$329,800 — fully eliminated at $429,800

What are "specified service businesses" for QBI purposes?

Health, law, accounting, consulting, financial services, athletics, and businesses where reputation/skill of one person drives income

What is the self-employment (SE) tax rate?

15.3% total: 12.4% Social Security + 2.9% Medicare

What is the Social Security wage base for SE tax in 2021?

$142,800 — only the first $142,800 of net SE income is subject to the 12.4% Social Security portion

What percentage of net SE income is used as the SE tax base?

92.35% (this accounts for the deductibility of the employer's share)

What three items can self-employed individuals deduct FOR AGI?

(1) One-half of SE taxes paid, (2) health insurance premiums paid for self and family, (3) contributions to qualified retirement plans (SEP-IRA, SIMPLE, Keogh)

What is required for a home office deduction?

The space must be used EXCLUSIVELY and REGULARLY as the taxpayer's principal place of business or a place to meet clients/customers

What is a "direct expense" in the home office calculation?

An expense incurred exclusively for the business portion of the home (e.g., painting only the office) — 100% deductible

What is an "indirect expense" in the home office calculation?

An expense for the entire home (utilities, insurance, depreciation) — deductible only in proportion to the business-use percentage

What limits the home office deduction?

Total deduction cannot exceed gross income from the business after subtracting other business expenses and the allocated mortgage interest/taxes

What happens to disallowed home office expenses?

They carry forward indefinitely to future years

What is the simplified home office option?

$5 per square foot of business space, maximum 300 sq ft ($1,500 max); no depreciation allowed; full mortgage interest and taxes go on Schedule A

What happens to hobby income under current law (post-2017)?

Fully taxable as income — and expenses are completely disallowed (zero deduction)

What is the hobby loss "safe harbor"?

If the activity shows a profit for 3 of the last 5 consecutive years (2 of 7 for horse breeding), the burden of proof shifts to the IRS

What are the three categories of assets for tax purposes?

(1) Ordinary income property, (2) Section 1221 capital assets, (3) Section 1231 trade or business property

What are examples of ordinary income property?

Inventory, accounts/notes receivable, and business assets held one year or less — gains taxed at ordinary rates, losses fully deductible

What is a Section 1221 capital asset?

Any personal-use or investment asset — stocks, bonds, home, collectibles, jewelry — that is NOT in the excluded categories (inventory, depreciable business property, accounts receivable, etc.)

What is a Section 1231 asset?

Depreciable or nondepreciable property used in a trade or business and held for MORE than one year — buildings, machinery, equipment, business land

What is the hybrid tax benefit of Section 1231?

Net §1231 GAINS are treated as long-term capital gains (preferential rates); net §1231 LOSSES are ordinary (fully deductible, no $3,000 cap)

What is "amount realized"?

Everything received in a sale transaction — cash + FMV of property received + liabilities assumed by the buyer

What is the holding period required for long-term capital gain treatment?

More than one year

What capital gains tax rate applies to single filers with taxable income up to $40,400 in 2021?

0%

What capital gains tax rate applies to most taxpayers in 2021 (between the 0% and 20% thresholds)?

15%

What capital gains tax rate applies to collectibles gains?

28%

What capital gains tax rate applies to unrecaptured Section 1250 gain?

25%

What is the 3.8% Medicare surtax, and when does it apply?

A surtax on net investment income (NII) when MAGI exceeds $250,000 (MFJ), $200,000 (single), or $125,000 (MFS)

What is included in Net Investment Income for the 3.8% surtax?

Interest, dividends, rents, royalties, and capital gains from the sale of investment property

What is the annual capital loss deduction limit for individuals?

$3,000 per year against ordinary income — excess carries forward indefinitely, retaining short-term or long-term character

How is the capital loss netting process performed?

Step 1: Net all short-term gains and losses → Step 2: Net all long-term gains and losses → Step 3: Combine the two net figures

What is the basis rule for gifted property when FMV ≥ donor's adjusted basis?

Donee uses donor's adjusted basis for both gain and loss; holding period includes donor's holding period

What is the "dual basis rule" for gifted property when FMV < donor's adjusted basis?

Use donor's basis to compute GAIN; use FMV at date of gift to compute LOSS; if sale price is between the two — no gain or loss

What is the basis of inherited property?

FMV at the decedent's date of death (stepped-up basis); always treated as LONG-TERM regardless of actual holding period

When are worthless securities deemed sold for tax purposes?

On the LAST DAY of the tax year in which they become worthless — determines short-term vs. long-term character

What is Section 1245 recapture?

On the sale of depreciable PERSONAL business property (equipment, autos), gain is ORDINARY INCOME to the extent of total depreciation taken — any remaining gain is §1231 gain

What is Section 1250 recapture?

On the sale of depreciable REAL property, gain is ordinary income only to the extent depreciation EXCEEDS straight-line — since 1987 all real property uses SL, so typically zero ordinary recapture

What is "unrecaptured Section 1250 gain"?

The portion of gain on business real property equal to total straight-line depreciation taken — taxed at a special 25% rate (not 0/15/20%)

What is the tax treatment of a net Section 1231 LOSS?

Treated as ordinary loss — fully deductible against any income with no dollar limitation

What are the three methods for determining basis of mutual fund shares sold?

(1) First-in, first-out (FIFO), (2) Specific identification, (3) Average cost single-category method

What schedule is used to report rental income and expenses?

Schedule E, Part I (Page 1 of Form 1040)

What three items constitute gross rental income?

Regular rent received, advance rent (taxable when received), and services/expenses provided by tenant in lieu of rent (included at FMV)

Are security deposits included in rental income?

No — not income as long as the taxpayer is obligated to return them

What depreciation method and life applies to residential rental property?

Straight-line over 27.5 years

What depreciation life applies to furniture and appliances in a rental (not home office)?

5-year MACRS — shorter than the normal 7-year life for office furniture

Can Section 179 be used for rental property (traditional election)?

No — Section 179 is not available for rental property; 100% bonus depreciation IS available for qualifying personal property within rentals

What are the three categories of vacation/second home use?

(1) Primarily personal — rented fewer than 15 days, (2) Primarily rental — rented 15+ days and personal use ≤ 14 days or 10% of rental days, (3) Personal/rental — both thresholds exceeded

What is the tax treatment of a "primarily personal" vacation property rented fewer than 15 days?

Zero rental income reported; zero rental expenses deducted; mortgage interest and taxes still deductible as itemized deductions

What is the key restriction on a "personal/rental" vacation property?

No net rental loss allowed — expenses can only offset rental income to zero; excess (including depreciation) carries forward

What days count as "personal use" days for vacation home purposes?

Days used by the taxpayer, family members, anyone with an ownership interest, or anyone under a reciprocal arrangement — days spent on maintenance/repairs do NOT count

What is the IRS method for allocating vacation home expenses?

All expenses (including mortgage interest and taxes) allocated by: Rental Days ÷ Total Days Used (rental + personal)

What is the Tax Court method for allocating vacation home expenses?

Mortgage interest and taxes allocated by Rental Days ÷ 365; all other expenses allocated by Rental Days ÷ Total Days Used — nearly always better for the taxpayer

Why is the Tax Court method generally better for the taxpayer?

It allocates a smaller portion of interest and taxes to the rental, leaving more rental income available to absorb depreciation and other deductions

What is the general passive activity loss rule for rental property?

Rental activity is PASSIVE by definition; passive losses can only offset passive income — excess losses are suspended and carried forward