Income Tax
Chapter 5
Who recognizes the income?
assignment of income doctrine: taxpayer who earns the money pays the taxes on it
community property: half of income earned from the services of one spouse is included in the gross income of the other spouse
Types of income
Annuities
property dispositions: real estate, bonds, etc
taxpayers recognize a gain/loss when disposing of an asset
allowed to recover their investment in property (tax basis) before they realize any gain
sales proceeds
Less: Selling expenses
= amount realized
Less: tax basis (investment) in property
= Gain (loss) on sale → short term investments = ordinary income
Income from flow through entities:
ind’s may invest in various business enities
if entity is a flow through entity (partnership/S corp) the income and deductions of the entity “flow through” to the owners of the entity
LLC: members (owners)
S-corporations: less of now — LLCs are more common —limited to # of stockholders you can have — does not pay taxes, shareholders do — usually family owned
LLP: typically accountants, lawyers, doctors
Alimony
transfer of cash made under a written separation agreement/divorce degree
after 2018 → alimony is not taxable to the recipient or deductible by payor
before 2019 → alimony is taxable and deductible
property divisions and child support DO NOT qualify as alimony
Prizes, winnings, and awards
excluded only if made: 1. for scientific/charitable achievement, 2. for employee length of service/safety ($400 limit per employee), 3. USA athletes on account of competition
Social security benefits
taxable up to 85% of SS benefits in gross income depending on status, benefits, and AGI
different for each filing status
Imputed income/Interest
certain employee discounts or low interest loans generate income via indirect benefits
low interest loans: amt of imputed income is the difference between the amt of interest using the applicable federal interest rate and the amt the taxpayer actually pays
Ex → loan a friend $5,000 and get paid back in 2 years NO INTEREST. IRS thinks you should have collected interest, so you need to report that for taxation
IRS says: we’re still gonna tax you on what you should have charged for interest, whether you did charge for it or not
familial loans → just don’t tell anybody
does not apply if less than $10,000
Discharge of indebtedness
someone forgives a loan
taxpayer must include the amt of relief in gross income
some exceptions for certain types of loans
Exclusion provisions
municipal bond interest
gain on sale of personal residence (single → $250,000; married → $500,000)
fringe benefits
value of benefits included in employee’s gross income as compensation of services
some are excluded from gross income (common: medical and dental health insurance, life insurance—within limits, de minimis benefits)
scholarships (cover tuition, books, fees)
other educational subsidies (529 plans, EE savings bonds, Coverdell education savings accounts)
Exclusions that mitigate double taxation
gifts and inheritances (excluded from GI because these transfers are subject to a federal gift and estate tax)
life insurance if you are the beneficiary
foreign income can be excluded
workers’ compensation
payments associated with personal injury
health care reimbursement
disability insurance (covers wages lost when work missed due to injury/disability)
paid for by employee → excluded
employer purchased and premiums taxable compensation → excluded
employer purchased is a FRINGE benefit → taxable
deferral provisions (allow taxpayers to defer the recognition of certain types of realized income)
installment sales
like kind exchanges
Terms
accelerated death benefits → some insurances will pay benefits before that person dies; terminally ill, no tax; not terminally ill, tax
accrual method → revenue recorded when it is earned, expenses recorded when incurred; corps can use for the most part, but individuals use the cash method
alimony → before dec 31, 2018, tax deductible to payer and taxable to receiver; after 2019, neither of those things (child support does not count as alimony)
annuity →
assignment of income doctrine → person who earns the income is liable for the taxes on it
barter club/system → noncash setup; technically still taxable in eyes of the gov’t; reality is that it really isn’t. The IRS doesn’t care
community property doctrine → issue in a divorce; each spouse owns 50% of the property
constructive receipt → when you have access to the income, you must pay taxes on it in the year received
disability insurance →
discharge of indebtedness → generally taxable; forgiven debt
earned income → comes from employer
unearned income →
flow through entities → S-corps; LLC; LLP
fringe benefits → usually not taxable (now); exception is life insurance; not taxed as ordinary income (taxed on different rate)
inheritance → never taxable
gifts → taxable only over a certain amount; gifter pays the tax (reportable if over 19,000 BUT still not taxed until 5M)
imputed interest → calculated interest that would have been applicable in a normal interaction, but was not made reality (Ex. paying $200 on loan when the real interest is $2,400 = $2,200 is the imputed interest)
municipal bonds → state, county, city (non taxable)
return of capital → applicable in an annuity
tax basis → Ex. house, stock, tangible items; how much it cost
Social Security
tax laws change often
there was a time it wasn’t taxed at all
today, up to 85% of the paid benefits are taxable depending on filing status, amount of SS benefit, and modified AGI (AGI plus tax exempt interest like municipal bonds)
It’s complicated
Single
modified AGI + 50% of SS benefits < $25,000 → no tax
modified AGI + 50% > $25,000 but < $34,000 → taxable SS is the lesser of 1. 50% of SS or 2. 50% of modified AGI + 50% of SS - $25,000)
Example:
-George and Wanda received $30,200 of social security benefits. They
also received $5,000 from a municipal bond and $8,000 in dividends
from stocks they own. What amount of Social Security is taxable?
8000 + 5000 + (50% of 30,200) = $28,100
28,100 < 32,000 → none of their SS is taxable
Chapter 6
Deductions for AGI
three categories
deductions directly related to business activities
deductions indirectly related to business activities
deductions to subsidize certain activities
directly related to business activities
allowed to deduct expenses incurred to generate business income
if income is taxable, expenses to earn that income should be deductible
profit motivated activities are classified as:
business activities
investment activities
business activities require high involvement/effort from the taxpayer, while investment activities do not
business expenses must be:
directly connected to the business activity
ordinary and necessary for the activity (appropriate and helpful)
reasonable in amount; not extravagant
expenses claimed on schedule C and revenues from that activity are also reported on schedule C
net income from schedule C is transferred to schedule 1 (line 3) and then combined with other items and included on 1040 (line 8)
rental and royalty expenses
claimed above the line
could be investment or trade activity
flow through entities
Losses
losses from investment assets (capital) are offset against capital gains
capital losses exceed capital gains, called a net capital loss
net capital loss is deducted for AGI but limited to $3,000
excess business loss limitation
business loss → when starting out, may have higher expenses than revenues
other deductions
limited charitable contribution for non itemizing deductions
health insurance deduction for self employed
self employment tax deduction
deductions for individual retirement accounts (IRAs)
deductions for health savings accounts
alimony (only before 2019)
home mortgage
interest
taxes
hospitals and long term care facilities
medical expense
SALT → state and local taxes
Exam Review
-AGI is just an arbitrary number — but it is used to determine who gets a particular deduction or credit and how much
-Main idea: deductions and credits should go to the people who need them, not the wealthy who don’t
-AGI is your total income - “above the line” deductions
-401K comes from employer, so employer should provide a match
-IRA, no employer involvement
“For AGI” deductions
business expenses (ordinary and necessary) flow thru schedule C, Schedule 1, then 1040 form → includes rental expenses
retirement account contributions like a trad IRA (up to $7,000 in 2026) or SEP (self-employed plan)
health savings accounts
student loan interest (limit is $2,500)
self-employment taxes
self-employed premiums for medical insurance, dental insurance, and some long-term care insurance
a very few narrow deductions that no one uses
“From AGI” deductions
-once you have AGI, there are deductions from AGI to get to taxable income
-taxpayer choice: standard deduction or itemized deductions - 90% use standard
-standard in 2026: single → $16,100 ; married → $32,200
itemized deductions:
SALT up to $40,000
interest on mortgages up to $750,000
charitable deductions (up to 60% of AGI or lower)
un-reimbursed medical and dental expenses that exceed 7.5% of AGI
un-reimbursed educator expenses can be claimed as an itemized deduction w/o dollar limits
gambling losses capped at the lesser of 90% total losses or your total gambling winnings
casualty and theft losses from both federally declared and state declared disasters
for high income earners in the 37% tax bracket, additional limits on above list apply
-AGI minus either the standard deduction or the itemized deductions equals taxable income
-itemized deductions used to be a long list, much shorter now
-moving expenses used to be deductible; not anymore
-most interest payments were deductible; not anymore
-for SALT, you can deduct property taxes plus either state and local income taxes OR sales tax, but not both
-remember about pass thru entities: (not subject to income tax, but it flows down thru)
sole proprietorships
partnerships
limited liability companies (LLCs) → members
S corporations (S-Corps) → limited shareholders, mostly a family business, taxed as a partnership
Lawsuits
Nontaxable settlement:
if you got compensation for injuries, medical bills, pain and suffering, and emotional distress that stems from injury
Taxable settlement:
lost wages, back pay, wrongful discrimination → taxed as ordinary income
emotional distress not caused by physical injury (defamation, harassment)
punitive damages (always taxable income, even in physical injury cases)
-barter transactions → technically taxable
-capital loss max amount deductible → $3,000
-selling private home → exclusions (single: $250,000) OR (married: $500,000)
Charitable Donations
-people who take the standard deduction can also deduct up to $1,000 (single) or $2,000 (married filing jointly) for donations to a qualified operating charity
-60% rule → cash gifts to public charities up to 60% of your AGI are deductible
-public charity: purpose is to do charitable work (american cancer society)
-private foundations: support the work of public charities
-30% rule → cash donations made to private nonoperating foundations are capped at 30% of your AGI
*cash donations are 100% deductible based on AGI limits (60%) and stocks are deductible at their FMV (30% AGI)
-Social security: taxable amt depends on total income
-prize money from a hobby is taxable and expenses from that hobby are not deductible
Chapter 5 terms
accelerated death benefits - life insurance before you die if you are terminally ill (fully tax deductible)
annuity - plan that people use to invest in
barter clubs - babysitting example
return of capital doctrine - not taxed on getting OG amount back, just the interest
accrual method - recognize revenue when earned and expenses when accrued
assignment of income doctrine - if you earned it, you pay the taxes
community property laws - rights under marriage/divorce for land
tax basis - cost of an asset
alimony - before 2019: deductible and taxable
constructive receipt - if you had access to they money, it is taxable
imputed interest - the interest you should have charged on a loan but didn’t
earned vs. unearned - earned → from your employer; unearned → from everyone else
Chapter 6 terms
business activities -
investment activities -
ordinary and necessary
capital gain property - stock/house
excess business loss
private nonoperating foundations
traditional IRA
private operating foundations
standard vs itemized deductions
Exam
-multiple choice
-true/false
-capital gain problem
-annuity problem
-charity problem
-SALT tax itemization
Chapter 7
-bond → functions as a loan
buy a walmart bond, you are loaning walmart money
need to pay you back PLUS interest
-stock → owning part of the corporation
dividends (not required by law)
most companies actually don’t pay dividends
they DO have to look out for your best interests (in theory)
hoping for a capital gain (buy low, sell high)
3 primary ways of making money
interest
dividends
capital gain
Interest
income you receive when you let other people use your money
putting money in a bank
buying a bond
buying a government bond (popular bc you’re likely to get your money back)
treasury bonds
US savings bonds
often are zero-coupon bonds (do not send you regular interest payments; discounted at the beginning → buy a $1,000 bond for $500, then receive the full $1,000 at maturity)
the “coupon” is the interest rate
corporate bonds may be bought at
face value
bond discount (bond is sold at LESS than face value)
bond premium (bond is sold at MORE than face value)
Bonds
unless you are told different, assume bonds pay interest twice a year (biannually)
assume bonds are in $1,000 denominations
the rate of interest to be paid every 6 months is the “coupon rate” and given as an APR (annual percentage rate)
8% coupon rate means 4% of the face value twice a year
interest payments received are taxed as ordinary income
bonds issued at a discount/premium must include amortization of the discount/premium as a taxable interest (amortization table)
step 1: 700,000 * 6% = 42,000
step 2: 700,000 × 7% (the FMV rate) = 46,664
step 3: find the difference → 4,664
step 4: add step 3 to the outstanding balance
step 5: repeat in next row by multiplying 7% to the new balance
Investments Overview
before-tax rate of return on investment
after-tax rate of return on investment
depends on when investment income is taxed
relates to timing tax planning strat
depends on the rate at which the income is taxed
relates to the conversion tax planning strat
portfolio vs. passive investments
portfolio losses deferred until investment is sold
passive investment losses may be deducted annually
Portfolio income
usually taxed when received
interest from bonds, CDs, and savings accounts
ordinary income taxed at ordinary rate unless municipal bond interest
interest from US treasury bonds not taxable by states
dividends on stock
typically taxed at preferential capital gains rate
qualified dividends
dividends must be paid by domestic or certain foreign corps that are held for a certain length of time
subject to preferential tax rate
nonqualified dividends
taxed as ordinary income
Portfolio income: capital gains and losses
investments held for appreciation potential
growth stock (stock you expect to increase in value → expect CG)
income stock → anticipate dividends
land (anticipate it will be worth more in the future than what you paid)
mutual funds (401K plans and variations will give you options of mutual funds → gov’t bonds, growth bonds, foreign corp bonds → investor money is pooled and that money is used to invest)
other assets (expensive jewelry, metals, etc)
investments held for appreciation potential (generally investments in capital assets)
gains deferred for tax purposes
generally taxed at preferential rates
special loss rules apply
capital asset
any asset other than:
asset used in trade/business
AR or NR acquired in sale from business
inventory
sale of capital assets generates capital gains and losses
specific identification vs. FIFO (i wanna sell these specific stocks OR whichever ones i owned first)
long-term if held for more than 1 year
short-term if held for less than 1 year
Capital gains
net short term gains are taxed at ordinary rates
generally net capital gains are taxed at max preferential rate of 0, 15, or 20 %
stock broker commissions are part of your basis
bought 200 shares at $50 a share ($10,000)
paid a commission of $600
basis is $10,600
long term capital gains from collectibles and qualified small business stock are taxed at max of 28%
Capital losses
indv. can deduct up to $3,000 of net capital losses against ordinary income
remainder carries over
Netting process:
Combining short-term gains and losses and separately combining 0/15/20
percent gains and losses (including any losses carried over from prior years).If, after this step, both short-term and long-term categories yield gains—or if
they both yield losses—the netting process is complete.Otherwise, the taxpayer will combine the short- and long-term outcomes
against each other to produce a final net gain or net loss. The result may be
classified as either short-term or long-term depending on which outcome is
greater
Limitations for capital loss deductions
special rules apply to the sale of personal-use assets
gains are taxable as capital gains
losses not deductible
capital losses from sales to “related parties” are not deducted
gov’t questions the arms-length-transaction aspect → were they acting in own best interest?
the “wash sale” rule disallows the loss on stocks sold if the taxpayer purchases the same or “substantially identical”' stock within 61-day period (centered on sale)
30 days before the sale, the day of sale, 30 days after the sale
i own 500 shares of stock; bought at $20; now worth $15 (down $2,500) → i have a capital gain on other stocks worth $5,000 → ill sell the stock and reduce taxes, then buy them back
intended to ensure taxpayers cannot deduct losses from stock sales while continuing their investment (buying it back quickly)
Tax planning strats for capital assets
hold capital assets for more than a year
taxed at pref rate
tax deferred
loss harvesting
$3,000 offset against ordinary income
offset other short term CG
must balance tax with nontax factors (world events)
2008 recession
2020 pandemic
Ex. Boeing stock plummeting after plane crashes
Investment interest expense
investment expenses
expenses incurred to generate investment income
not deductible
investment interest expense
interest expense on loans used to acquire investments
deductible as an itemized deduction
limited to taxpayer’s investment income
carry over indefinitely
Passive activity income and losses
typically, an investment in a partnership, S corp, or direct ownership in rental real estate
taxpayer does not materially participate in business functions
ordinary income and is taxable annually
ordinary losses may be deducted currently if able to overcome:
tax basis limitation
at risk limitation
passive loss limitation