Fluent Essays

Please see problems at the end of the attachment. Chapter 7 Deductions: Business/Investment Losses and Passive Activity Losses OBJECTIVES After completing  , you should be able to: 1. Determine the amount and classification of losses originating from business operations. 2. Ascertain the amount and classification of losses from investment-related activities. 3. Understand tax shelters and the rationale for at-risk rules. 4. Achieve a thorough understanding of the intricacies of the passive activity rules. 5. Identify and determine the amount of allowable business and theft losses. 6. Calculate the amount of a net operating loss and determine the amounts to be carried forward. 7. Understand the allowable home office expenses and determine the limitation on the deduction for such losses. 8. Achieve an understanding of the vacation home rental rules and the limitation on such losses. OVERVIEW Deductions are provided in the Code for losses resulting from unprofitable investment-related activities, dispositions of certain assets, and unprofitable business operations. In each of these cases certain limitations or adjustments may apply, thus limiting the amount of deductible loss. Generally, deductible losses from a business, property held for production of income, or investment property are deductible for adjusted gross income. This chapter deals with losses originating from business operations and certain investment-related activities. Tax shelters, at-risk rules, passive activity rules, business casualty and theft losses, net operating losses, hobby losses, home office expenses, and vacation homes are among the topics addressed. Losses resulting from the sale of capital assets (e.g., stocks and bonds) and business-use assets (Code Sec. 1231) are discussed in  . Tax Shelters and At-Risk Rules ¶7001 TAX SHELTERS A tax shelter is an activity providing deductions and/or credits to an investor which will reduce tax liability with respect to income from other sources. Prior to the Tax Reform Act of 1986, tax shelters played an unreasonably influential role in the financial planning of many individuals. A Treasury study revealed that in 1983, 21 percent of tax returns reporting total positive income greater than $250,000 paid taxes equaling 10 percent or less of total positive income (which is composed of salary, interest, dividends, and income from profitable businesses and investments). S. Rept. No. 313, 99th Cong., 2d Sess. (1986), p. 714. Congress recognized the undesirable consequences that tax shelters created, which included declining federal tax revenues, diverting investment capital from productive activities to tax avoidance schemes, and perhaps most importantly, the loss of faith in the federal tax system. The Senate Finance Committee went so far as to say: “Extensive shelter activity contributes to public concerns that the tax system is unfair and to the belief that tax is paid only by the naive and unsophisticated.” The reason Congress had allowed tax shelters to exist in the first place was to encourage investment in certain areas in order to promote economic growth. EXAMPLE 7.1 Arthur Johnson, a corporate executive, had income of $275,000 during 1983 (before passive loss rules). He took advantage of the tax laws (legally) by purchasing a shopping center in January 1983. The price was $500,000. He paid $25,000 down and financed the balance over 20 years. Rental income averaged $3,500 a month, while payment on the $475,000 note was $6,000 a month. Maintenance, taxes, and repairs averaged $1,500 a month. Initially, it appears that Mr. Johnson was losing $4,000 a month ($3,500 – $6,000 – $1,500) during his first year of ownership ($48,000 a year). But after considering his tax bracket (50 percent) and depreciation (12 percent for 1983), his net cash flow actually increased by $5,000 for the year because of preferential tax rules: Net Cash Flow Before Tax Benefit $(48,000) Depreciation (12% × $500,000) (60,000) Principal Payment Adjustment 2,000 Net Deductible Loss $(106,000) Times Tax Bracket × .50 Tax Benefit $53,000 Net Cash Flow Before Tax Benefit (48,000) Net Cash Flow $5,000  $2,000 of the note payments were applied to principal (i.e., not deductible), all other monthly expenses were deductible.   Notice that the tax benefit in the preceding example was treated as an immediate cash inflow. It simply reduced the taxpayer’s tax liability by the tax benefit amount, which, essentially, represented taxes that would have been paid on income from other sources, such as salary, dividends, interest, etc. When coupled with the possibility that the property could increase in value, this was a popular form of investment and an easy concept for tax shelter salesmen to sell. However, most such investments never provided a net cash flow as illustrated in the example. Practically all tax shelters were formed as limited partnerships. Limited partnerships were used because they allowed losses and credits to be passed through to the partners’ individual tax returns. A limited partner is a partner who is not personally liable for the debts of the partnership. More importantly, a limited partner can utilize deductions and/or credits that “flow through” from the partnership. Some examples of the activities tax shelter limited partnerships engaged in included equipment leasing, real estate, oil and gas, movie productions, cattle breeding, cattle feeding, and farming. Even though most tax shelters never made a profit, thousands of taxpayers bought into them for the sole purpose of avoiding income taxes. Thus, genuine economic value was rarely considered in making an investment decision to acquire an interest in a tax shelter activity. The Tax Reform Act of 1986 significantly impacted such investment decisions with the passage of the passive activity rules. Code Sec. 469. Essentially all limited partnership investments, rental properties, and businesses in which an owner does not materially participate have been affected. The general rule is that losses arising from a passive activity are not deductible, except against income from a passive activity. The unused portion of the loss, however, is not lost but is suspended (i.e., carried over) until offset by passive income in a future tax year or until the entire activity is disposed of in a fully taxable transaction. EXAMPLE 7.2 Assume the same facts as in the preceding example, except that if Arthur Johnson purchased the shopping center in 2020, his investment would fall under the passive activity rules, which would allow no deduction (i.e., no tax benefit) for the loss in 2020. The entire disallowed loss would become a suspended loss until passive income is later received or he appropriately disposes of the rental property. For instance, if in 2021 the shopping center yields $25,000 in income, then the loss from 2020 would be used to offset the income and any unused balance of suspended loss would be carried over to 2022. ¶7125 AT-RISK RULES Prior to the 1986 Act, Congress made a rather weak attempt to curb tax shelter abuse by enacting the at-risk provisions (Code Sec. 465) in 1976. The at-risk rules disallow losses that are in excess of an investor’s amount at risk. In a general sense, at risk is the amount of investment that an investor could possibly lose. The rules apply to individuals as well as closely held corporations. An investor’s amount at risk is computed as follows: Cash invested + Adjusted basis of other property invested + Borrowings for which investor is personally liable + Borrowings for which investor has pledged collateral + Allocated portion of income – Allocated portion of losses – Withdrawals = Amount at risk The formula does not indicate to what extent the allocated losses are deductible for tax purposes, because the amount at risk is reduced (but not below zero) regardless of the extent to which the losses are deductible. The deductible portion of any possible losses is calculated after applying the at-risk rules. An investor is not at risk for nonrecourse borrowings, stop-loss arrangements, no-loss guarantees, or borrowings in which the lender has an interest (as in seller financing). Code Sec. 465. A nonrecourse loan is a loan that is secured by the property purchased, rather than the personal assets of the borrower (i.e., the borrower is not personally liable). A recourse loan, on the other hand, is one where the borrower is personally liable for repayment. EXAMPLE 7.3 Betty Smith gave $10,000 cash, pledged $10,000 for security of a partnership loan, and gave a computer with an adjusted basis of $5,000 for her interest in a limited partnership. Her amount at risk is $25,000. The activity allocated a $40,000 loss (passive loss) to her. Only $25,000 (the amount at risk) of the $40,000 loss can be used to offset income from other passive activities during the year. Since she is not at risk for the remaining $15,000, it is carried over into a future tax year until she becomes at risk, which would then free up this amount to be offset against passive income. EXAMPLE 7.4 Assume Betty Smith gave $10,000 cash and signed a nonrecourse note for property that the limited partnership was acquiring. Ms. Smith would only be at risk for her $10,000 cash investment, and, consequently, only $10,000 of the $40,000 could be used to offset income from other passive activities. The remaining $30,000 is carried over until she becomes at risk. Generally, taxpayers are not considered at risk with regard to nonrecourse loans. However, a partner is considered to be at risk for certain qualified nonrecourse loans on real property. A qualified nonrecourse loan is one acquired from: 1. a person who is actively and regularly engaged in the business of lending money, or 2. any federal, state, or local government (including loans guaranteed by such governments) (Code Sec. 465(b)(6)(B)) An exception to this rule applies for loans acquired from: 1. Related parties, 2. The seller of the property, or 3. A person who receives a fee due to the taxpayer’s investment in the property. A partner would not be at risk for such loans. Code Sec. 49(a)(1)(D)(iv). Because losses reduce the amount at risk, such losses usually may be recaptured if the investor’s amount at risk is less than zero at the close of a taxable year. Code Sec. 465(e). Thus, when an individual’s amount at risk drops below zero, the taxpayer will include in gross income the amount of the excess. A drop in at risk, for example, can occur when a debt arrangement is changed from recourse to nonrecourse. TAX BLUNDER Lynn R. and Wade L. Moser et al., the taxpayers, entered into a leveraged computer leasing transaction with Finalco Inc. Finalco entered into leases with end-users, purchased the equipment, financed the purchase with a lending institution, and then resold the equipment in a sale and leaseback transaction to Lease Pro Inc., a company engaged in the purchase, sale, and leasing of computer equipment. The taxpayers then purchased the equipment from Lease Pro and leased it back to Finalco. The fixed monthly rental payment that Finalco owed to the taxpayers was the same amount as the monthly installments that the taxpayers owed to Lease Pro that, in term, was identical to the monthly installments Lease Pro owed to Finalco. As a result, in making payments, no cash was exchanged because the amount owed by each group equaled the amount each group was due. From 1981 to 1983, the taxpayers reported net losses totaling $300,937. However, these losses were disallowed because the court held that the taxpayers were not at risk under Code Sec. 465(b)(4). That is, this section suspends at-risk treatment where a transaction is structured, by whatever technique, to remove any realistic possibility that the taxpayer will suffer an economic loss if the transaction turns out to be unprofitable. W.L. Moser, 90-2 USTC ¶50,498, 914 F.2d 1040 (CA-8 1990). Whenever the circular nature of the taxpayers’ obligations effectively shields the taxpayers from economic loss, Code Sec. 465(b)(4) will hold that the taxpayers are not at risk for any portion of the notes underlying the transaction. Passive Activity Loss Rules ¶7201 APPLICATION OF RULES The at-risk rules are still in effect and are applied before passive loss restrictions. Once the at-risk rules are satisfied, a passive loss can then be used in the following ways: offset passive income, offset other income (under certain conditions), and/or become suspended. Passive income and losses are “before AGI” items. EXAMPLE 7.5 Bob McKeown contributed $35,000 cash and signed a $15,000 nonrecourse note to invest in Limited Partnership A (LPA). He is at risk for $35,000 in the partnership. Bob is also at risk for $50,000 in Limited Partnership B (LPB). Both activities are considered to be passive activities. During the year, LPA experienced a loss and allocated to him his portion of the loss, $65,000. LPB had a better year and allocated $25,000 of income to Bob. Because Bob is at risk for only $35,000 for LPA, only $35,000 of the $65,000 loss is considered as a passive loss. As a result, $25,000 of the $35,000 passive loss from LPA can be used to offset the $25,000 of passive income (before AGI) from LPB. Ten thousand dollars ($35,000 – $25,000) of the passive loss from LPA is suspended under the passive loss rules. At the end of the year, Bob’s amount at risk for LPA will be zero ($35,000 – $35,000). The remaining $30,000 ($65,000 – $35,000) loss from LPA is carried over under the at-risk rules until Bob increases his amount at risk in LPA. Once Bob satisfies the at-risk rules, this amount will become a passive loss and may be used to offset future passive gains. Bob will be at risk for $75,000 ($50,000 + $25,000) for LPB at the end of the year. Partnership Initial Amount At Risk Allocated Gain (Loss) Loss Passive Income (Loss) Carryover Under At-Risk Rules Suspended Passive Loss Ending Amount At Risk A $35,000 ($65,000) ($35,000) ($30,000) ($10,000) $0 B $50,000 $25,000 $25,000 — — $75,000 If Bob had received $45,000 of passive income from LPB (instead of $25,000), his results would be different. He could offset the passive income with $35,000 of passive losses from LPA, resulting in $10,000 of net passive income, and have no suspended passive loss. His amount at risk for LPA is still zero and he still has a loss carryover under the at-risk rules of $30,000. His ending amount at risk for LPB would be $95,000 ($50,000 + $45,000). Partnership Initial Amount At Risk Allocated Gain (Loss) Passive Income (Loss) Loss Carryover Under At-Risk Rules Suspended Passive Loss Ending Amount At Risk A $35,000 ($65,000) ($35,000) ($30,000) $0 $0 B $50,000 $45,000 $45,000 — — $95,000 ¶7205 CLASSIFICATION OF INCOME Because of the passive activity rules, income is required to be classified as active, passive, or portfolio. Ordinarily, active income is attributable to the direct efforts of the taxpayer, such as salary, commissions, wages, etc. Passive income is income derived from a passive activity. Portfolio income is interest, dividends, annuities, and royalties not derived in the ordinary course of a trade or business. The gain from the sale of property that produces portfolio income (e.g., stocks and bonds) is also classified as portfolio income. Code Sec. 469(e). The reason for the classification is to keep separate the types of income that passive losses can offset. As previously mentioned, passive losses can only offset passive income and cannot be used as a deduction against active or portfolio income (except in certain instances). Similarly, tax credits from passive activities can only offset taxes incurred from passive income. Portfolio income received by a limited partnership and allocated to the partners is not passive income, and the partners cannot offset the portfolio income by passive losses from this partnership or any other passive activity. Thus, limited partnerships that receive portfolio income and experience net income (or loss) from operations must separately allocate income (loss) generated from operations and portfolio income to its partners. ¶7211 DISALLOWANCE OF PASSIVE LOSSES AND CREDITS For tax years after 1990, no passive activity losses or credits may be deducted against active and portfolio income. Interests in passive activities acquired by the taxpayer on or before October 22, 1986 (the date on which the Tax Reform Act of 1986 was enacted), were eligible for a special deduction and credit phaseout of losses for a five-year period. Code Sec. 469(m)(2). Thus, after 1990, passive losses in excess of passive gains are not deductible and must be carried forward. ¶7215 SUSPENDED LOSSES Generally, any loss or credit from a passive activity which is disallowed by the passive loss rules is treated as a deduction or credit allocable to such activity in the next taxable year. Code Sec. 469(b). Suspended losses can become deductible against future income from passive activities or against nonpassive income upon the fully taxable disposition of an entire interest. Keeping suspended losses for each passive activity separate is necessary in order to determine the amount of an activity’s deductible portion of suspended loss whenever an event qualifying for the deduction occurs (e.g., a fully taxable disposition). EXAMPLE 7.6 Linda Helmsly owned the following passive activities during 2020 (all were acquired after 1986, and she was at risk for all losses): Activity Income/(Loss) Suspended (Loss) ABC $35,000 $0 XYZ (45,000) (20,000) BBD (60,000) (80,000) $(70,000)  Suspended losses from previous years. The amount of net loss experienced in 2020, $70,000, is not deductible but is suspended. It must be allocated, however, between all activities showing a loss for the year (XYZ and BBD): Activity Allocation Suspended (Loss) Total Suspended (Loss) ABC N/A $ 0 $ 0 XYZ $45,000/$105,000 × $70,000 (30,000) (50,000) BBD $60,000/$105,000 × $70,000 (40,000) (120,000) APPLICATION OF THE AT-RISK AND PASSIVE LOSS RULES Step 1. Determine the amount at risk for each passive activity (before considering gain or loss for that year). Step 2. Determine whether each passive activity results in a gain or loss for the tax year. Step 3. If an activity results in a gain: (a) Increase the amount at risk for that activity. (b) Treat gain as passive gain. Step 4. If an activity results in a loss: (a) Reduce the amount at risk for that activity (but not below zero) by the amount of the loss. (b) Any excess losses are carried over under the at-risk rules. (c) Treat losses (except for amounts carried over) as passive losses. Step 5. Add up all passive gains. Step 6. Add up all passive losses. Step 7. Reduce passive gains (but not below zero) by passive losses and any passive loss credits. Include any net passive gain in gross income. Step 8. Carry over excess passive losses as suspended passive losses. (a) If more than one activity results in a passive loss, allocate suspended passive losses between the activities in proportion to the amount of their passive losses. (b) In future tax years, use suspended passive losses to offset passive income. ¶7225 DISPOSITION OF A PASSIVE ACTIVITY If a passive activity is disposed of in a fully taxable transaction, any losses (including suspended losses from prior years) may be recognized by the taxpayer in the year of disposition to the extent of $259,000 for 2020 (or $518,000 in the case of a joint return). The losses that exceed these amounts will be added to the taxpayer’s net operating loss. Such losses can offset active and portfolio income (nonpassive income). However, losses from the sale of passive activities to related parties generally are not deductible. See  . The excess of the sum of Items 1 + 2 over 3 will be treated as a loss which is not from a passive activity (i.e., deductible against nonpassive income): 1. Any loss from the activity for the tax year, including suspended losses from prior years, plus 2. Any loss realized from the disposition of the activity, over 3. Net income or gain from all passive activities (determined without regard to losses from the disposition or losses from the activity). Code Sec. 469(g)(1). Passive activity interests that are capital assets and are appropriately disposed of are subject to the capital asset rules for losses (Code Sec. 1211) after applying the passive loss rules. See  . A limited partnership interest held as an investment is a capital asset. EXAMPLE 7.7 Rob Williams had gross income of $125,000 in 2020 and owned the following passive activities during the year: Activity Gain/(Loss) Suspended (Loss) ZZZ $15,000 $(50,000) XXX (10,000)  (28,000) YYY (22,500)  (45,000) All activities were acquired after 1986, and Rob was at risk for all losses. He sold his entire interest in ZZZ in a fully taxable transaction. ZZZ was a limited partnership in which Rob was a limited partner. He acquired the limited partnership interest in 1987. The selling price was $22,000, while his basis in the interest was $55,000. The result is computed as follows: Selling price $22,000 Adjusted basis (55,000) Realized loss $(33,000) The $50,000 of suspended losses will first offset the $15,000 gain from ZZZ, and the balance ($35,000) will be deductible against active and portfolio income. The $33,000 realized loss resulting from the sale of the limited partnership interest will become a long-term capital loss. Death, Gift, and Other Transfers If an interest in a passive activity is transferred by reason of death, suspended losses are deductible on a decedent’s income tax return to the extent that the excess of the stepped-up basis in the hands of the transferee over the decedent’s adjusted basis is less than the amount of suspended loss. EXAMPLE 7.8 Zeb McFarland died and left a passive activity to his nephew. Zeb’s basis in the activity was $25,000, while the nephew’s basis was “stepped up” to $40,000. Suspended losses amounted to $21,000. The amount of passive loss deduction that can offset nonpassive income is $6,000, the $21,000 suspended loss minus the $15,000 step-up in basis. If an interest in a passive activity is transferred by gift, the suspended losses are not deductible but are added to the recipient’s basis. EXAMPLE 7.9 Jennie Franklin gave her daughter a limited partnership interest in a real estate activity. Suspended losses amounted to $20,000. The mother’s adjusted basis at the time of the gift was $30,000. The daughter’s basis would be the mother’s adjusted basis plus the amount of suspended losses, or $50,000 (assuming fair market value was greater than $30,000). ¶7231 TAXPAYERS AFFECTED BY PASSIVE LOSSES The passive loss limitations apply to individuals, estates, trusts, closely held corporations, and personal service corporations. Code Sec. 469(a)(2). This list describes taxpayers that would otherwise be entitled to the tax benefits of losses or credits from a passive activity. Partnerships and S corporations are not included. Limitations on losses or credits from activities operated by these entities are passed through and applied at the level of the partners and shareholders, respectively. Personal Service Corporations The application of the passive activity loss rules to personal service corporations is intended to prevent taxpayers from sheltering personal service income simply by incorporating as a personal service corporation and acquiring passive activity investments at the corporate level. In general, a corporation is a personal service corporation if (1) it is a C corporation, (2) its principal activity is the performance of personal services, (3) the services are substantially performed by employee-owners, and (4) such employee-owners own more than 10 percent of the fair market value of the corporation’s outstanding stock. Whether these qualifications are satisfied is determined during a testing period for the tax year, which is generally the corporation’s prior tax year. Temp. Reg. §1.469-1T(g)(2). Closely Held Corporations A closely held corporation’s losses and credits from a passive activity may be limited if (1) it is a C corporation that is not a personal service corporation, and (2) more than 50 percent of its stock is owned directly or indirectly by (or for) not more than five individuals. Noting the distinction between taxpayers is worthwhile because closely held corporations are able to offset passive losses with net active income, but not portfolio income. Code Sec. 469(e)(2). Consequently, a closely held corporation is the only entity affected by the passive loss rules that can deduct losses from a passive activity that it owns. EXAMPLE 7.10 Jasper Corporation, a closely held corporation, generated $150,000 of income from operations during the year. It also received passive losses of $200,000 and interest of $30,000. (Jasper Corporation was fully at risk for the amount of loss.) The corporation’s taxable income is $30,000 because it can offset passive losses with active income, but not with portfolio income. The remaining $50,000 of passive losses will become suspended. Oil and Gas Working Interests A working interest which a taxpayer holds in oil and gas properties is not subject to the passive activity rules. Code Sec. 469(c)(3). The working interest cannot be held through any entity that limits the taxpayer’s liability (e.g., limited partnership interest or stock in a corporation). A working interest is a working or operating mineral interest in any tract or parcel of land. Temp. Reg. §1.469-1T(e)(4)(iv). ¶7235 MATERIAL PARTICIPATION A passive activity is defined as “any activity which involves the conduct of a trade or business, and in which the taxpayer does not materially participate.” Code Sec. 469(c)(1). Also included in the definition are rental activities, without regard to the extent of taxpayer participation. Temp. Reg. §1.469-1T(e)(1)(ii). As a consequence, trade or business activities in which a taxpayer does materially participate are not passive activities. Nevertheless, rental of real estate properties is generally classified as a passive activity regardless of the level of participation. “Material participation” requires a taxpayer to be involved in the operations of the activity on a regular, continuous, and substantial basis. Code Sec. 469(h)(1). When making this rule, Congress was aware that many taxpayers would accumulate suspended losses from tax shelter investments as a result of the passive loss rules. Moreover, some of these taxpayers might own profitable businesses that could be turned into passive activities (which would then be used to offset passive losses). The change from an active business to a passive activity could possibly be achieved by lowering a taxpayer’s level of participation in the active business. The result of such maneuvering would impede the overall effectiveness of the passive loss provisions. Material participation, then, was devised to include virtually all “passive” business owners but at the same time exclude certain “active” business owners from being brought into the passive loss arena. On the other hand, a business in which an individual materially participates is not a passive activity. Therefore, if the business experiences a loss, the loss will be deductible against all other types of income (passive, active, and/or portfolio) without regard to the passive loss restrictions. Additional guidance in making the determination as to who qualifies as a material participant is provided under the regulations by furnishing seven tests. Temp. Reg. §1.469-5T(a). Thus, an individual will be treated as materially participating in an activity for the tax year if any of the following tests apply: Test 1. The individual participates in the activity for more than 500 hours during the tax year. Test 2. The individual’s participation in the activity constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners) for the tax year. Test 3. The individual participates in the activity for more than 100 hours during the tax year, and such individual’s participation for the tax year is not less than the participation in the activity of any other individual (including nonowners) for the tax year. Test 4. The activity is a “significant participation” activity for the tax year, and the individual’s aggregate participation in all significant participation activities during such year exceeds 500 hours (see below). Test 5. The individual materially participated in the activity for any five tax years, whether or not consecutive, during the 10 tax years that immediately preceded the tax year. Test 6. The activity is a … Chapter 8 Deductions: Itemized Deductions OBJECTIVES After completing  , you should be able to: 1. List items making up the medical expense deduction. 2. Determine the deduction for state and local taxes. 3. Apply rules for the interest expense deduction. 4. Explain the requirements for the charitable contribution deduction. 5. Calculate the limitations on the charitable contribution deduction. 6. Compute the ordinary business income deduction. OVERVIEW In computing taxable income, personal, living, or family expenses are generally disallowed. However, tax rules do allow some deductions for expenses which are essentially personal in nature. These types of expenses are deductible from adjusted gross income, referred to as itemized deductions, and deducted on Schedule A of the individual tax return. This chapter discusses those expenses that are specifically allowed as itemized deductions. These deductions include: medical expenses, taxes, interest, charitable contributions, and limited personal casualty losses. Medical Expenses ¶8001 REQUIREMENTS FOR THE DEDUCTION Individuals can deduct many types of medical expenses as itemized deductions. The deduction is allowable only to individuals and only for medical expenses actually paid during the year, regardless of when the expenses were incurred or the method of accounting used by the taxpayer. Any medical expense deduction will be reduced by the amount of any insurance reimbursement or other similar compensation. Only medical expenses in excess of 7.5% percent of adjusted gross income (10% after 2020) are deductible. Code Sec. 213. EXAMPLE 8.1 Jerome Jenkins, 35, has an adjusted gross income of $20,000 and pays for the following medical expenses during 2020: Medical insurance $1,820 Medicines and drugs 175 Other medical expenses 500 The medical deduction is computed as follows: Medicines and drugs $175 Medical insurance 1,820 Other medical expenses 500 Total Medical Expenses $2,495 Less 7.5% of $20,000 (adjusted gross income) 1,500 Total Medical Expense Deduction $995 For medical expenses to be deductible, they must be for the medical care of the taxpayer, the taxpayer’s spouse, or someone who would have qualified as a dependent of the taxpayer under pre-2018 rules – that is, a qualifying child (meets relationship, residency, age and support tests) or a qualifying relative (meets relationship, gross income and support tests). A child of divorced parents is treated as the dependent of both parents for purposes of the medical expense deduction. The gross income requirement is waived for purposes of determining who is a “dependent” with respect to the medical care deduction. EXAMPLE 8.2 Joan Farley pays medical expenses for the care of her father. Joan also pays over half of the support of her father but would have been unable to claim her father as a dependent under pre-2018 law because his gross income for the year was too high. Joan may include the medical expenses for the care of her father in her medical expense computation even though she can not claim her father as a dependent. ¶8015 MEDICAL CARE EXPENSES The medical expense deduction is specifically limited to amounts spent for medical care. The term “medical care” is broadly defined to include amounts paid for the diagnosis, cure, mitigation, treatment, or prevention of disease. Accordingly, payments for the following are payments for medical care: hospital services, nursing services, medical, laboratory, surgical, dental and other diagnostic and healing services, X-rays, medicines, and drugs. Amounts paid for accident or health insurance are generally deductible as medical expenses. Further, expenses paid for “medical care” include those paid for transportation primarily for and essential to medical care, such as the expense of using an ambulance. Amounts expended for illegal operations or treatments are not deductible. An expenditure which is merely beneficial to the general health of an individual, such as an expenditure for a vacation or for health club fees, is also not deductible. Payments for unnecessary cosmetic surgery (such as facelifts or cheek implants) whose purpose is solely to improve the patient’s appearance do not qualify as a medical expense deduction for tax purposes. This rule does not apply to cosmetic surgery necessary to help correct a deformity arising from a congenital abnormality, or heal an injury arising from an accident or a disfiguring disease. Any employer reimbursements for unnecessary cosmetic surgery under a medical expense reimbursement plan must be included in the gross income of the employee in the year received. EXAMPLE 8.3 In June 2020, Jane Martin undergoes a liposuction operation solely to improve her physical appearance. None of the expenses related to this operation would be deductible for tax purposes on her 2020 income tax return. EXAMPLE 8.4 Should the costs of changing one’s sex qualify as a medical deduction? After all, the change is just cosmetic and isn’t necessary, is it? Interestingly, gender identity disorder is a condition recognized by the medical community, so a strong case can be made that a sex reassignment surgery is just a means of treating that condition. A 2010 Tax Court case (O’Donnabhain, 134 TC No. 34, Dec. 58,122 (2010)) ruled that a sexual reassignment surgery was deductible as a medical expense. Although it initially disagreed, the IRS later decided to follow this decision. Action on Decision 2011-003, Nov. 4, 2011. ¶8025 CAPITAL EXPENDITURES Capital expenditures for home improvements and additions which are constructed primarily for the medical care of an individual generally qualify for a medical expense deduction only to the extent that the cost of the improvement or addition exceeds any increase in the value of the affected property that is due to the improvement. The entire cost of additions or improvements that do not increase the value of the home is deductible as a medical expense. Medical expense deductions have been allowed for the costs of installing elevators in the homes of persons suffering from heart disease, air conditioning devices for persons suffering from allergies, and specially built swimming pools for persons suffering from polio. EXAMPLE 8.5 Gary Greene is advised by a physician to install an elevator in his residence so that his wife, who is afflicted with heart disease, will not be required to climb stairs. If the cost of installing the elevator is $1,500 and the increase in the value of the residence is only $1,100, the difference of $400 is deductible as a medical expense. However, if the value of the residence is not increased by the addition, the entire cost of installing the elevator qualifies as a medical expense. Specific types of capital expenditures incurred to accommodate a personal residence to the needs of a physically handicapped individual are fully deductible medical expenses since these types of expenditures do not increase the fair market value of the residence. Examples are construction of entrance ramps, widening of doorways, or installation of railings to allow use of wheelchairs, Capital expenditures which are related only to the sick person and not related to permanent improvement or betterment of property are deductible if such expenditures otherwise qualify as expenditures for medical care. For example, expenditures for eye glasses, handicapped service animals, dentures, artificial limbs, wheel chairs, crutches, inclinators, or air conditioners (if detachable from the property and purchased only for the use of a sick person) are deductible. ¶8035 TRANSPORTATION AND LODGING EXPENSES Transportation expenses incurred in order to obtain medical care are deductible. However, the transportation deduction does not include the cost of any meals while away from home receiving medical treatment unless the meals are provided as part of the in-patient care at a hospital or similar facility. If a doctor prescribes an operation or other medical care, and the taxpayer chooses for purely personal considerations to travel to another locality for the medical care, neither the cost of transportation nor the cost of meals and lodging is deductible. Instead of a deduction for actual expenses incurred, a standard mileage rate of $.17 per mile for 2020 is allowed in computing the cost of driving an automobile for medical purposes. Parking fees and tolls may be deducted in addition to the mileage rate deduction. Lodging while away from home on trips that are primarily for and essential to medical care is deductible. This deduction is not allowed for amounts paid for lodging that is lavish or extravagant. No medical deduction is allowed for any amount of lodging expenses if there is any significant element of personal pleasure, recreation, or vacation in the travel away from home. The amount of the deduction for lodging is subject to a limitation of $50 per night for each eligible person. The deduction is allowed not only for the patient but also for a person who must travel with the patient. This means that if a parent accompanies a dependent child on a trip away from home for medical treatment, the parent could deduct up to $100 per day for lodging expenses. EXAMPLE 8.6 Corola Combs travels out of state for special surgery for her daughter. She travels 400 miles round trip and incurs $12 in parking fees and tolls. Corola spends three nights in a hotel while her daughter is in the hospital. Her lodging expense totals $165, and she spends $90 eating out. Her meal expenses are not deductible. Her other qualifying medical expenses are: Lodging limited to $150 ($50 per night × 3 nights) $150 Mileage 400 miles × $.17 per mile 68 Parking fees and tolls 12 Qualifying medical expenses from trip $230 ¶8045 HOSPITAL AND OTHER INSTITUTIONAL CARE The cost of in-patient hospital care (requiring an overnight stay), including the cost of meals and lodging, is deductible. The extent to which expenses for care in an institution other than a hospital (e.g., a nursing home, home for the aged, or therapeutic center for alcohol or drug addiction) qualify as a deduction for medical care is primarily a question of fact, and depends on the condition of the individual and the nature of the services received. If the availability of medical care in an institution is the principal reason for the patient’s presence there, the entire cost of the care, including meals and lodging furnished incident to such care, is deductible. However, if an individual is placed in the institution primarily for personal or family reasons, then only that portion of the cost attributable to medical or nursing care (excluding meals and lodging) is deductible. EXAMPLE 8.7 Alexis Amberson is 80, totally disabled, and suffers from a chronic ailment. Her family places her in a nursing home equipped to provide medical and nursing care services. The nursing home expenses are $25,000 a year. Of this amount, $8,500 is directly attributable to medical and nursing care. Since Alexis is in need of intensive medical and nursing care and has been placed in the nursing home facility for this purpose, all $25,000 is deductible (subject to the 7.5 percent of AGI limitation). Had Alexis been placed in the nursing home primarily for personal or family considerations, only $8,500 would be deductible. Although education ordinarily does not qualify as medical care, special schooling for a mentally or physically handicapped individual is deductible, if the resources of the institution for alleviating the individual’s mental or physical handicap are the principal reason for the individual’s presence there. In such a case the cost of attending the school includes the cost of meals and lodging, if supplied, and the cost of ordinary education that is incidental to the special services furnished by the school. ¶8055 MEDICINES AND DRUGS Only amounts paid for insulin and prescription medicines or drugs are deductible as a medical expense. Pharmaceutical items acquired without a prescription (such as over-the-counter ibuprophen or allergy medicines) do not qualify even though they are used for a particular illness, disease, or medical condition. Cosmetics and toiletries are not considered medicines and drugs. EXAMPLE 8.8 Larry James, 28, had adjusted gross income of $22,000 in 2020. He paid a doctor $800 for medical expenses, a hospital $2,000, $200 for prescription drugs, and $150 for over-the-counter cold remedies and vitamins during 2020. His 2020 medical expense deduction is computed as follows: Doctor $800 Hospital 2,000 Medicine and drugs 200 Over-the-counter cold remedies and vitamins 0 Medical expenses $3,000 Less: 7.5% of $22,000 (adjusted gross income) 1,650 Allowable medical expense deduction $1,350 ¶8065 MEDICAL INSURANCE PREMIUMS A medical expense deduction is allowed for premiums paid for medical care insurance (including contact lens insurance), subject to the 7.5 percent limitation. If amounts are payable under an insurance contract for other than medical care (such as indemnity for loss of income or, life, limb, or sight), no amount paid for the insurance is deductible unless the medical care charge is stated separately in the contract or furnished in a separate statement. Long-term health care insurance premiums are deductible, but in 2020, the maximum deduction for prepaid long-term care insurance premiums is $430 for a taxpayer age 40 or less to $5,430 for a taxpayer more than age 70. The basic cost of Medicare insurance (Medicare Part A) is not deductible unless voluntarily paid by the taxpayer for coverage. However, the cost of extra Medicare (Medicare Part B) is deductible. Self-employed persons are allowed to deduct 100 percent of amounts paid for health insurance for herself, her spouse, her dependents, and her under-27-year-old children as a business expense (deductible for adjusted gross income). Code Sec. 162(l). See   for a discussion of deductions for Medical Savings Accounts. In general, this deduction is reduced by any premium tax credits the taxpayer takes. Medical expenses are deductible only in the year paid. If medical expenses are reimbursed under a medical care insurance plan in the same year as paid, then the reimbursement merely reduces the amount that would otherwise be deductible. However, where reimbursement, from insurance or otherwise, for medical expenses is received in a year subsequent to a year in which a deduction was claimed, the reimbursement must be included in gross income in the year received to the extent attributable to deductions allowed in the prior year. EXAMPLE 8.9 Morris Masters, 45, had adjusted gross income of $60,000 in 2020. He had a medical operation and, as a result, paid $5,000 in 2020 for hospitalization and $700 in doctors’ bills. His transportation mileage for medical reasons totaled 200 miles. He also paid $640 for prescription medicines and drugs, $275 for contact lenses, and a $900 medical insurance premium in 2020. Under the medical insurance policy carried by the taxpayer, there is an allowance for the operation of only the first $1,000, which amount Morris received in 2020. His deduction for medical expenses is computed as follows: Hospitalization (medical operation) $5,000 Less: Reimbursement from insurance company 1,000 $4,000 Premium on medical insurance policy 900 Doctors’ bills 700 Prescription medicines and drugs 640 Contact lenses 275 Transportation for medical purposes (200 miles × $.17) 34 Total $6,549 Less: 7.5% of $60,000 (adjusted gross income) 4,500 Total medical expenses deduction $2,049 If Morris received the $1,000 reimbursement in 2021 rather than 2020, he would have a deduction of $3,049 ($2,049 + $1,000) in 2020 and income of $1,000 in 2021 (assuming he itemizes in 2020). Taxes ¶8101 SUMMARY OF DEDUCTIBLE TAXES The following taxes are deductible as itemized deductions (Code Sec. 164(a)): 1. State, local, or foreign real property taxes 2. State or local personal property taxes 3. State, local, or foreign income taxes 4. State and local general sales taxes The aggregate itemized deduction for the above taxes is limited to $10,000 ($5,000 for married, filing separately). The $10,000 limit does not apply to taxes in categories (1) and (2) above (or to foreign income taxes) if they are trade or business expenses or are incurred in the production of income. The following discussion of taxes relates only to the deductibility of nonbusiness taxes by individuals. ¶8105 PROPERTY TAXES Local and state real property taxes are generally deductible only by the person upon whom they are imposed, and in the year in which they were paid or accrued. If they relate to nonbusiness real property, they are deductible as an itemized deduction. A tax paid for local benefits such as street, sidewalk, and other similar improvements (also known as special assessments) is not deductible if imposed because of some direct benefit to the property against which the assessment is levied. Special assessments are not deductible, even though some incidental benefit may flow to the public welfare. Special assessments can, however, be added to the basis of the related property. If real property is sold during the year, the real property tax deduction must be allocated between the buyer and the seller based on the number of days during the year that each party held the property. The seller is treated as paying the taxes up to, but not including, the date of sale. This allocation is required regardless of which party actually writes the check for the property tax or the method of accounting used by the taxpayers. EXAMPLE 8.10 William Wasserman sold land to David Deere on April 1. Property taxes of $14,600 were paid by David on November 27 to cover the real property taxes for the entire calendar year. Assuming it is not a leap year, William is entitled to a $3,600 real property tax deduction ($14,600/365 = $40 per day × 90 days). David is entitled to an $11,000 real property tax deduction ($40 per day × 275 days), but his itemized deduction for all state and local taxes would be limited to $10,000. A tenant-stockholder in a cooperative housing corporation may deduct amounts paid or accrued to the corporation to the extent that they represent the tenant-stockholder’s proportional share of the real property taxes on the apartment building or houses and land on which situated. Similarly, a taxpayer who owns an apartment in a condominium apartment complex may deduct the taxes assessed on the taxpayer’s interest in the property and paid by the taxpayer each year, provided the taxpayer itemizes deductions in filing a federal income tax return. To be deductible, personal property taxes must be ad valorem (i.e., a tax that is based on the value of the personal property.) A tax which is based on criteria other than value does not qualify as ad valorem. For example, a motor vehicle tax based on weight, model year, and horsepower, or any of these characteristics, is not an ad valorem tax. However, a tax which is partly based on value and partly based on other criteria may qualify in part. EXAMPLE 8.11 Gayla Gopher paid $135 for motor vehicle license plates. The license plate fee is based on a combination of value and weight of the automobile. If $75 of the $135 fee is based on the value of the automobile, then $75 is deductible as a tax. Taxes imposed by some states on intangible personal property or the income therefrom are deductible. ¶8115 INCOME AND SALES TAXES State or city income taxes, including franchise taxes measured by net income, are deductible as itemized deductions by individuals. Either state and local sales taxes or state and local income taxes can be deducted, but not both. State and local income taxes on interest income that is exempt from federal income tax are also deductible. However, state and local income taxes on other exempt income are not deductible. Taxpayers may deduct state and local income taxes withheld from their salary. They may also deduct tax payments made on prior year income in the year they were actually withheld or paid. EXAMPLE 8.12 During 2020, Carl Castor had $1,200 in state income taxes withheld from his salary. In addition, he paid an additional $325 in 2020 when he filed his 2019 state income tax return. Carl’s state income tax deduction for 2020 is $1,525, the amount he actually paid during 2020. Any estimated state tax payments made that are in fact not required to be made are not deductible. For example, if a taxpayer made an estimated state income tax payment but the estimate of the state tax liability for the year shows that the taxpayer will receive a refund of the full amount of the estimated payment, then the taxpayer was not required to make the payment and may not deduct it as an itemized deduction. If a taxpayer receives a refund of state, local, or foreign income taxes, all or part of the refund may need to be included in income in the year received. The tax benefit rule requires the taxpayer to include a tax refund in gross income of the year received to the extent that a tax benefit resulted from the deduction of the item in the earlier year. This includes refunds resulting from taxes that were overwithheld, not determined correctly, or redetermined as a result of an amended return. The tax benefit from a refund of taxes that were paid in a year that the $10,000 limit on the deduction of state and local taxes applied is reduced by the reduction in the deduction in the prior year due to the limitation. A refund of state, local, or foreign taxes may not be used to reduce the amount of taxes paid during the year to lower the deduction. The taxes paid and the refund received must be reported separately. EXAMPLE 8.13 Paul Plymouth, a single taxpayer, received a refund of $1,000 in 2021 from his 2020 state income tax return. Paul had total itemized deductions in 2020 of $12,600, including $2,500 for state income taxes. The amount to be included in gross income for 2021 is $200. The amount included is the lesser of the refund received ($1,000) or the excess itemized deductions taken in 2020 ($200). The $1,000 refund received in 2021 will not affect the itemized deduction for state income taxes in either 2021 or 2020. Itemized deductions for 2020 $12,600 Less: Standard deduction for 2020 12,400 Excess itemized deductions for 2020 $200 Individual taxpayers are able to deduct the greater of state and local income taxes or state and local general sales taxes as an itemized deduction on their federal income tax returns. Code Sec. 164(b)(5). The amount to be deducted for state and local general sales taxes is either (1) the total of actual general sales taxes paid as substantiated by accumulated receipts, or (2) an amount from IRS-generated tables, plus the amount of general sales taxes from the purchase of a motor vehicle, boat, or motor home. Interest ¶8201 REQUIREMENTS FOR DEDUCTION Interest is the amount which one has contracted to pay for the use of borrowed money. For tax purposes the term has the usual ordinary, everyday meaning given to it in the business world. Old Colony R.R. Co., 3 USTC ¶880, 284 U.S. 552, 52 S.Ct. 211 (1932). Interest incurred in a trade or business is deductible. However, as discussed in  , interest incurred to purchase assets on which the income is tax exempt (such as state and municipal bonds) is not deductible. It is not necessary that the parties to a transaction label a payment made for the use of money as interest for it to be treated as interest. The method of computation also does not control its deductibility, so long as the amount in question is an ascertainable sum paid for the use of borrowed money. The timing of a deduction for interest expense depends on whether the taxpayer is on the cash basis or the accrual basis. Taxpayers on the cash basis will deduct interest expense when the payment of the interest is actually made. Deducting the amount of the interest from the original loan amount is not considered “payment” for this purpose. Accrual basis taxpayers, on the other hand, will deduct interest as it accrues. Prepaid interest (“points”) is generally amortized over the life of the loan, but is currently deductible if paid in connection with a loan made to purchase the taxpayer’s principal residence. (See   for further information.) EXAMPLE 8.14 On November 1 Ben borrows $10,000 to be used in his business. He actually receives $9,400, but will have to pay the full $10,000 back on April 30 of the next year. If he is a cash basis taxpayer, he will deduct the entire $600 of interest in the next year, when it is paid. If he is on the accrual basis, he would deduct $200 (2/6) this year and $400 (4/6) next year. Interest deductions for tax purposes can be separated into six types: personal (consumer) interest, qualified residence interest, investment interest, trade or business interest, passive investment interest, and qualified education loan interest. Each of these six types of interest deductions is explained in the following sections. ¶8205 PERSONAL (CONSUMER) INTEREST Generally, interest on personal loans is not deductible by individuals. The vast majority of nondeductible personal interest consists of interest on credit card debt, automobile loans, or student loans. Of course, if the credit card or automobile are used for business purposes then the related interest is business, not personal, interest, and is deductible. Similarly, under certain circumstances student loan interest is deductible (see below). Interest on tax deficiencies (even those arising from individual business income) is also personal interest, and it is therefore not deductible. EXAMPLE 8.15 Sara Short incurs personal interest of $1,000 on an auto loan. Sara is not allowed an itemized deduction for the auto loan interest. ¶8210 QUALIFIED EDUCATION LOAN INTEREST Taxpayers are allowed an interest deduction for AGI of up to $2,500 for interest paid on qualified education loans. Qualified education loans are loans incurred to pay expenses for undergraduate and graduate tuition, room and board, and related expenses. The deduction is phased out for single taxpayers with AGI between $70,000 and $85,000 and married taxpayers filing joint returns with AGI between $140,000 and $170,000. The deduction will be allowed in figuring adjusted gross income. ¶8215 QUALIFIED RESIDENCE INTEREST Taxpayers may deduct interest on loans secured by first or second homes, but the homes must be “qualified residences.” A home is a qualified residence if it is the taxpayer’s principal residence or if it is a second residence designated for this purpose that is used for personal purposes for more than the greater of 14 days or 10 percent of the number of days it is rented (such as a vacation home). Taxpayers having more than two residences can designate each year which residence is to be considered the second residence. If the second residence is not used by the taxpayer or rented at any time during the year, the taxpayer need not meet the requirements that the residence be used for personal (nonrental) purposes for more than 14 days. Code Sec. 163(h). Qualified residence interest on acquisition indebtedness is deductible. Acquisition indebtedness is up to $750,000 of debt ($1,000,000 for debt incurred before December 15, 2017) incurred to acquire, construct, or substantially improve any qualified residence and which is secured by the residence. If a residence is refinanced, the amount qualifying as acquisition indebtedness is limited to the amount of acquisition debt existing at the time of refinancing plus any of the amount of the new loan which is used to substantially improve the residence. EXAMPLE 8.16 In 2020 Alexis Carson bought a house for $1,500,000 and paid $300,000 down on it. Her interest on the $1,200,000 initial mortgage was $72,000. The interest on $750,000 of her mortgage will be deductible. Her residence interest deduction will be limited to $750,000/$1,200,000 of $72,000, or $45,000. Mortgage insurance premiums paid by a taxpayer in connection with acquisition indebtedness on a qualified residence are treated as qualified residence interest and are deductible as an itemized deduction through 2020. The allowable deduction is phased out ratably if the taxpayer's adjusted gross income exceeds $100,000 ($50,000 for a married taxpayer filing a separate return) . ¶8225 INVESTMENT INTEREST The deduction for investment interest is limited to the amount of net investment income. Investment interest in excess of this limitation is carried forward and treated as investment interest in the succeeding tax year. However, an investment interest carryover is allowed in a subsequent year only to the extent the taxpayer has net investment income in the later year. Definition of Investment Interest Interest that is subject to the investment interest limitation is defined as interest on debt incurred or continued to purchase or carry property held for investment. Property held for investment includes any property that produces income of the following types: interest, dividends, annuities, or royalties not derived in the ordinary course of a trade or business. The most common types of property held for …