Chapter 4 Individual Income Tax Overview, Dependents, and Filing Status

Individual Income Tax Formula

• Individuals report taxable income to the IRS using Form 1040.
• U.S. tax laws use the all-inclusive income concept.
  • Realized income: Measurable change in property rights.
  • All realized income is included in gross income unless expressly excluded or deferred.
  • Recognized income: Reported on tax return.
• Formula:
  • Gross income
  • Minus: For AGI (above the line) deductions
  • Equals: Adjusted gross income (AGI)
  • Minus: From AGI (below the line) deductions:
    • Greater of (a) Standard deduction or (b) Itemized deductions and
    • Deduction for qualified business income
  • Equals: Taxable income
  • Taxable income
  • Times: Tax rates
  • Equals: Income tax liability
  • Plus: Other taxes
  • Equals: Total tax
  • Minus: Credits
  • Minus: Prepayments
  • Equals: Taxes due or (refund)

Excluded and Deferred Income

• Excluded and deferred income are not included in gross income.
• Excluded income
  • Income never included in taxable income.
    • Examples: Municipal bond interest and Gain on sale of personal residence.
• Deferred income
  • Income included in a subsequent tax year.
    • Examples: Installment sales and Like-kind exchanges.

Character of Income or Loss

• Determines rates applicable to income or loss in current year.
• Tax-exempt: No tax.
• Tax-deferred: No tax in current year (current-year tax rate is zero).
• Ordinary: Ordinary rates from tax rate schedule.
• Qualified dividends: Taxed at 0 percent, 15 percent, or 20 percent depending on taxpayer’s income level.

Capital Gains and Losses

• Capital gain or loss depends on whether it is short-term or long-term.
• Results from selling a capital asset.
• If a capital asset is held for more than a year, the gain or loss is long-term; otherwise, it is short-term.
• Net long-term gains in excess of short-term capital losses, if any, are called “net capital gains” and are taxed at rates lower than rates on ordinary income.
• Capital assets
  • Generally, all assets except:
    • Accounts receivable
    • Inventory
    • Assets used in trade or business, including supplies
• Capital gains and losses
  • Net long-term capital gains in excess of net short-term capital losses are generally taxed at 0 percent, 15 percent, or 20 percent depending on the taxpayer’s taxable income.
  • Short-term capital gains are taxed at ordinary rates.
• Net capital losses (losses in excess of gains for year)
  • $3,000$ deductible against ordinary income for the year (reduce AGI).
  • Losses over $3,000$ are carried forward indefinitely.

Netting Capital Gains/Losses

• Net short-term gains/losses.
• Net long-term gains/losses.
• If net short-term and net long-term have the same sign (both negative or both positive), stop.
• If net short-term and net long-term have different signs (one positive and one negative), net them together.
• Capital loss can reduce ordinary income by $3,000$.

Example of Netting Capital Gains/Losses

• Short term-gain $4,000$ or $2,000$
• Short term-loss $(2,000)$
• Long term-gain $3,000$
• Long term-loss $(10,000)$ or $(7,000)$
• Long term-loss $(5,000)$
• Deduct against ordinary income $(3,000)$
• Carryover $(2,000)$

Deductions for AGI

• “Deductions above the line.”
• Deducted in determining adjusted gross income.
• Always reduce taxable income dollar for dollar.
• Common for AGI deductions:
  • Alimony paid (pre-2019 divorce decree)
  • Rental and royalty expenses
  • Contributions to qualified retirement accounts

Deductions from AGI

• Deducted from adjusted gross income to determine taxable income.
• “Deductions below the line.”
• Greater of the standard deduction or itemized deductions.
• Common itemized deductions (Schedule A):
  • Mortgage interest
  • State income taxes
  • Charitable contributions
• Deduction for qualified business income (not an itemized deduction).
  • Deduction = Qualified business income × 20%

2024 Standard Deduction Amounts

• Married filing jointly: $29,200$
• Qualifying surviving spouse: $29,200$
• Married filing separately: $14,600$
• Head of household: $21,900$
• Single: $14,600$

Tax Calculation

• The United States uses a progressive tax rate schedule.
• Rates range from 10 percent to 37 percent.
• Some items are taxed at preferential rates, such as net capital gains and qualified dividends.
• Tax on these items is calculated separately from income taxed at ordinary rates.

Tax Prepayments

• Pay-as-you-go system.
• Payments already made toward tax liability, including:
  • Income taxes withheld from wages by the employer.
  • Estimated tax payments made during the year.
  • Taxes overpaid in the prior year and applied toward the current year’s liability.
• If prepayments exceed tax liability after credits, the taxpayer receives a refund.

Filing Status

• Married filing jointly
  • Must be married on the last day of the year.
  • If one spouse dies, the surviving spouse is considered to be married to the decedent spouse at year-end, unless the surviving spouse remarries before year’s end.
  • Joint and several liability for tax.
• Married filing separately
  • Taxpayers are married but file separate returns.
  • Typically not beneficial from a tax perspective due to tax rates and other tax benefits.
  • May be beneficial for non-tax reasons.
  • No joint and several liability.
• Married individuals treated as unmarried (abandoned spouse) if the individual:
  • Is married at the end of the year (or is not legally separated from the other spouse).
  • Does not file a joint tax return with the other spouse.
  • Pays > 1/2 the cost of maintaining a household that serves as the principal abode for a qualifying child for more than half the year.
  • Lived apart from the other spouse for the last six months of the year (other than temporary absences).
• Qualifying surviving spouse
  • Available for the two years following the year of the spouse’s death.
  • The surviving spouse does not qualify if he or she remarries during the two-year period.
  • The surviving spouse must maintain a household for a dependent child.
• Single
  • Unmarried unless qualifying for head of household.
• Head of household
  • Unmarried or considered unmarried at the end of the year.
  • Not a qualifying surviving spouse.
  • Pays more than half the costs of keeping up a home during the year.
  • Lived in the taxpayer’s home with a “qualifying person” for more than half of the year (exception for parents).