Solutions to Text Appendix E, “Comprehensive Tax Return Problems”

Marvine and Molly Hall

Brent and Paige Taylor

Problem 1:

MARVIN & MOLLY

HALL

2009 TAX RETURN

SOLUTION

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NOTES ON HALL PROBLEM

[References are to the number used in the fact situation.]

1. Marvin needs to use a Schedule C since he is self-employed. Also, a Schedule SE needs to be completed. Some observations regarding Schedule C follow—

Part I should include the $72,000 amount received from the insurance companies and the cash payments of $10,500 from various repair shops and building contractors. Under the Duberstein rationale (see the discussion of Gifts and Inheritances in Chapter 5), these payment are not nontaxable gifts but are payments for services rendered in the past or to be rendered in the future. The legality of the payments is of no concern, although Marvin was careful to protect his own position with the advice of an attorney. On this basis, the $300 Marvin paid the attorney relates to the business and should be included on line 17 of Part II (along with the $1,200 for accounting services).

Other entries in Part II include: office rent of $8,100 listed on line 20b; renters’ insurance of $1,500 (line 15); state and local license fees of $900 (line 23); the expensing of the reception room furnishings of $2,200 (line 13) and requires the completion on the § 179 portion of Form 4562 (Part I); business lunches of $1,400 are subject to the cutback adjustment (line 24b); professional dues and subscriptions to trade publications of $400 are listed in Part V (page 2) and carried forward to “Other expenses” (line 27 of page 1). Automobile expenses (line 9) necessitates the filling out of Part V of Form 4562 because that form is used for another reason (expensing of furnishings). Otherwise, the appropriate information would be reported in Part IV (on page 2) of Schedule C.

Contributions to H.R. 10 (Keogh) and medical insurance plans are not part of Schedule C but are deducted on line 28 and line 29, page 1, of Form 1040.

2. Molly’s work related expenses are reported on Form 2106, transferred to Schedule A, and subject to the 2%- of-AGI limitation. All of the expenses listed qualify as deductible—it is assumed the shoes purchased are of the type used by nurses and not the street-wear variety. An issue could be raised as to whether the mileage involved constitutes commuting and is, therefore, nondeductible. Molly’s principal place of business appears to be her home—she keeps her records there, lists it as her business address, and receives her work assignments there. Thus, she is not commuting when she goes to a job assignment from her home. The fact that she does not claim a deduction for an office in the home could be attributable to nonbusiness factors (e.g., failure to meet the exclusive use requirement, poor records, or the effort is not worth the benefit of the deduction) and not be determinative of where her tax home is located.

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3. The rental property acquired by the Halls requires the filing of Schedule E and a Form 4562. Regarding Schedule E, the income to be reported (line 3) is $12,000 (prepaid rent is taxed in the year of receipt). The $2,000 deposit is not income until it is forfeited. The street paving assessment of $1,200 is not deductible as to tax but should be capitalized as part of the cost of the land. All other expenses should be reported on Schedule E as follows: property taxes of $1,800 (line 16); interest of $1,500 on mortgage (line 12); repairs of $400 (line 14); insurance of $2,500 (line 9); and depreciation of $5,122 (line 20). In determining the depreciation, complete Form 4562 (Part III, line 19h).

[Computation is (see Table 8.6 of the text) $260,000 X 1.970% = $5,122. But the H&R BLOCK At Home tax program will compute it as $5,121.]

4. Molly has made an installment sale and needs to complete Form 6252. Molly’s basis in the property of $20,000 (i.e., her father’s basis—see § 1015) and since the sale price is $100,000, her gross profit percentage is 80% ($80,000/$100,000). Thus, she has a long-term capital gain of $8,000 [$10,000 (down payment) X 80% (gross profit percentage)] for 2009. The $8,000 is transferred to line 11 of Schedule D.

5. Life insurance proceeds of $100,000 are nontaxable. When this amount is paid in installments, the nontaxable portion is prorated over the payout period. Thus, $20,000 of each payment Molly receives is nontaxable. Of the $23,000 she receives in 2009, therefore, $20,000 is not reported anywhere on the return and the $3,000 balance is listed as interest income on Schedule B, Part I.

6. The Halls have a $14,000 capital loss as to the Eagle Corporation common stock. Although the holding period appears to be less than a year, Code § 165(g)(1) specifies that such securities are deemed worthless as of the last day of the taxable year. Consequently, since the securities are treated as becoming worthless on December 31, 2009, the capital loss is long-term. Enter on Schedule D, Part II, line 8.

7. The $1,000 payment from Peregrine represents the recovery of an outlay from a prior year. Since it provided no tax benefit, it has no present tax consequences. Do not, therefore, include it in the tax return.

8. The $300 should be added to the state income tax deduction (Schedule A) for 2009. Even though a 2007 tax liability is involved, the year of payment (2009) controls the year of deductibility.

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9. The state income tax refund is taxable under the tax benefit rule since the Halls itemized their deductions in the past (include $350 on line 10, page 1 of Form 1040). The Federal income tax refund is nontaxable.

The interest on the South Bend bonds ($900) is nontaxable, while the interest on the CD ($800) is taxable. Include the $900 on line 8b of Form 1040 (page 1) while the $800 goes on Schedule B (Part I) and is ultimately transferred to line 8a of Form 1040 (page 1).

The garage sale probably produced a nondeductible personal loss since this type of sale rarely yields the true fair market value of property. A gain, however, is not likely since her father died the prior year (2008), Molly’s income tax basis in the property’s fair market value is equal to (or probably less) than the selling price. With a nondeductible loss probable and a taxable gain unlikely, none of the garage sale proceeds need be reported on Form 1040.

Marcie’s repayment of the $20,000 loan is a nontaxable return of capital to Marvin. As long as no interest is involved (as in this case), no tax consequences result.

The concert tickets won in the church raffle generate income of $240 (their fair market value). Income could have been avoided if the tickets had not been accepted. Report on line 21 of Form 1040 (page 1).

10. The $5,000 paid for Zoe’s operation qualifies as a deductible medical expense even though she cannot be claimed as a dependent of the Halls [§ 213(a) and Chapter 3 in the text]. The interest on the home equity loan ($1,200) is deductible since it does not matter what the borrowed funds were used for. All of the expenses listed under item 10 are reported on Schedule A except for $240 ($400 X 60%) of the tax return preparation fee which in claimed on Schedule C.

11. All of the children are dependents of the Halls under the qualifying child category. Consequently, Dale is not subject to the gross income test. Because he is not self-supporting, the amount of Dale’s earnings is not relevant.

12. The state income tax withheld and paid in installments for both Marvin and Molly is reported on Schedule A (line 5a). To these amounts should be added the $300 additional assessment for year 2007 (see item 8).

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Problem 2:

BRENT & PAIGE

TAYLOR

2009 TAX RETURN

SOLUTION

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NOTES ON TAYLOR PROBLEM

[References are to the number used in the fact situation.]

1. Because Brent’s early retirement settlement involved a noncontributory pension plan (i.e., entirely funded by the employer), the full $36,000 is included in gross income. Include on line 16a and 16b of Form 1040 (page 1). The life insurance policy transfer and conversion from term to whole life carries no tax consequences. As will be noted later, the premiums paid on life insurance are nondeductible (see item 15 below).

2. A Schedule C must be used to report the transactions concerning Taylor Road Construction. Income to be reported for 2009 is $82,000—the year of payment controls recognition and prepaid income is taxed in the year received. The Marcus Parker project has no effect for tax purposes—it is not income since no payment was received—it is not deductible as a bad debt because Brent has no basis in the account. Report the $82,000 income on lines 1 and 7 of Schedule C (page 1).

3. Expenses reported on Schedule C are: office supplies, $810 (line 18); travel expenses of $7,150 [$6,800 (lodging) + $350 (incidentals)] on line 24a and meals ($7,000 X 50%) on line 24b. Under supplies (line 22) include drafting supplies, $1,600. The Jeep expenses (see item 4. below) are entered on line 9 and the office in the home (see item 5. below) on line 30. The depreciation portion of the Jeep expense, however, is reported on line 13 of Schedule C.

4. Expenses for the Jeep under the actual cost method are $3,900 ($1,800 + $90 + $1,400 + $310 + $210 + $90). To this must be added depreciation of $4,800 for a total of $8,700. Regarding the depreciation, the second year restriction limit for a car purchased in 2008 is $4,800. Under regular MACRS, accelerated depreciation for 5-year property in the second year (see Table 8.1 in the text) is $11,520 ($36,000 X 32%). Then the restricted limit of $4,800 must be used since it is less than $11,520. Reporting the depreciation on the Jeep requires completion of Sections A and B, Part V, page 2 of Form 4562. Under the automatic mileage method the car deduction would be $7,700 (14,000 X $0.55).

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5. In claiming the office in the home deduction, Form 8829 must be completed. Part I of this form determines the percentage of the home that qualifies for business use. In this case, 25% (500 square feet/2,000 square feet) is the result (lines 1, 2, 3, and 7). For obvious reasons, Form 8829 divides the expenses between direct expenses (fully deductible) and indirect expenses (only 25% deductible in this case). The indirect expenses (and line number of the Form 8829) are listed below.

Indirect expenses—

Deductible mortgage interest (line 10) $ 3,200

Real estate taxes (line 11) 4,200

Insurance (line 17) 2,600

Repairs and maintenance (line 19) 1,100

Utilities (line 20) 5,000

Other expenses—cleaning and trash pickup (line 21) 1,800

Total indirect expenses $17,900

Business portion (lines 13 and 23) X 25%

$ 4,475

To the business portion of indirect expenses, add the direct expenses of $2,000 for carpeting (line 25) for a total of $6,475. The depreciation factor is determined by completing Part III. For depreciation purposes, the basis of the residence is its adjusted basis of $320,000 [$360,000 – $40,000 (nondepreciable land)] which is less than fair market value (line 36, 37, and 38) times the business-use portion of 25%, or $80,000. Referring to Table 8.6 (MACRS Straight-Line Depreciation for Real Property Assuming Mid-Month Convention) in the text, the applicable percentage for 39-year nonresidential real property for the recovery period of 2–39 years is 2.564%. The depreciation for 2009 is $2,051 ($80,000 X 2.564%) and is entered on lines 29 and 31 (Form 8829). Thus, the total of $8,526 ($4,475 + $2,000 + $2,051) is transferred to Schedule C (line 30).

Based on Brent’s prior practices, it seems apparent that he would prefer not to capitalize and depreciate the cost of the drafting table ($900) and the desk ($2,400). Consequently, Part I of Form 4562 should be completed to claim the § 179 election to expense. The $3,300 is entered on line 13 of Schedule C. Line 13, therefore, totals $9,600 [$4,800 (depreciation on Jeep) + $3,300 (expensing of office furniture) + $1,500 (expensing of survey equipment)].

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6. Except for the $250 educator expenses (line 23, Form 1040, page 1)—taken from the classroom supplies category—Paige’s expenses are reported on Form 2106. From there, they are transferred to Schedule A (line 21) and will be subject to the 2%-of-AGI limitation. Expenses include—

Classroom supplies (less $250 already claimed) $ 400

Education expenses 420

Lodging 950

Job hunting expenses 4,300

License fee 110

Professional dues 80

Professional journals 90

$6,350

In view of the new assignment Paige has received from Robin (i.e., coaching duties), the education expenses seem justified. The deduction for lodging is appropriate as Robin expects the teachers and parents to absorb these expenses, and it has no reimbursement policy.

7. Paige’s job hunting expenses are deductible even though she did not accept a new position. The expenses are listed on Form 2106 (see item 6 above) but could have been separately listed on line 23 of Schedule A. Either way, they are subject to the 2%-of-AGI limitation.

The $10,000 bonus is not taxed to Paige until the year of its receipt (i.e., 2010). This is the case even though it relates to services she performed in 2009.

8. Sec. 403(b)(1) is a qualified pension plan applicable to teachers and other employees of nonprofit organizations. Like other qualified plans that are noncontributory, it has no tax effect on the participant until a distribution occurs (usually at retirement). However, the $3,150 Paige contributed to Robin’s medical insurance plan can be claimed as a medical expense on Schedule A.

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9 The $28,000 long-term capital loss carryover is listed in Part II, line 14 of Schedule D.

10. The Taylors lost their fishing camp due to a casualty but the event resulted in a gain. The gain of $10,000 [$80,000 (insurance recovery) – $70,000 (cost basis)] is a capital gain. Although the facts do not state that the camp (not the land) had a holding period of more than a year, the solution presumes long-term classification. Enter the $10,000 gain in Part II, line 11, of Schedule D.

11. Paige has avoided a large recognized gain by entering into a like kind exchange. Paige’s basis in the land is $25,000 (see § 1015 and Chapter 14 in the text) and an outright sale for $125,000 yields a realized and recognized gain of $100,000. By limiting the boot, therefore, her recognized gain is only $15,000 [lesser of $100,000 (realized gain) or $15,000 (boot received)]. Complete Form 8824 and enter the $15,000 gain (line 23) on Part II, line 11 of Schedule D.

12. Fees for jury duty are taxable income, while any expenses involved in serving (e.g., parking) are not deductible. The $500 Paige received is listed under other income—line 21 of Form 1040 (page 1). The repayment is included on line 36. For each entry, identify the item on the dotted line as “Jury Pay.” In effect, therefore, the receipt and repayment wash out. See the Instructions to Form 1040.

13. In spite of being nontaxable, the $1,400 interest from the City of Idaho Falls bonds must be reported on line 8b of Form 1040 (page 1). The $1,100 in interest on the IBM bonds is reported on Part I of Schedule B then carried over to Line 8a of Form 1040 (page 1). The $800 interest on the CD is treated similarly to that on the IBM bonds. Thus, line 8a of Form 1040 now becomes $1,900 ($1,100 + $800). Gambling gains and losses cannot be netted but must be accounted for separately. Gambling income of $900 is shown on line 21 of Form 1040, while the loss of $700 is shown on line 28 of Schedule A (Miscellaneous deductions) but are not subject to the 2%-of-AGI limitation.

14. Wesley can be claimed as a dependent by either Brent or Mark because together they contributed more than 50% of the support. Whoever is the one to claim the dependency exemption should also pay for Wesley’s medical bills. In this regard, therefore, the parties have acted correctly.

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15. As adjusted, the itemized deductions appearing on Schedule A appear below.

Medical—

Insurance premiums (see item 8) $ 3,150

Wesley Taylor (see item 14) 11,000

Dental 8,000

Medical mileage (270 miles X $0.24) 65 $22,215

Less: 7.5% X $121,148 (AGI) 9,086 $13,129

Taxes—

State income tax

Amount paid with 2008 return $ 210

The Taylors’ quarterly payments 4,000

Amounts withheld ($1,200 + $1,500) 2,700 $6,910

Real estate taxes [$4,200 – $1,050 (amount allocatedto office in the home)] 3,150 10,060

Interest [$3,200 – $800 (amount allocated to office inthe home)] 2,400

Charitable contributions—

Church pledge $3,600

Charitable mileage (1,050 miles X $0.14) 147 3,747

Paige’s occupational license fees ($110), professional dues ($80), and professional journals ($90) should be included on line 4 of Form 2106—see item 6 above. Brent’s license fee of $240 is reported on line 23 of Schedule C, while his professional dues of $180 and professional journals of $120 are separately listed in Part V (page 2 of Schedule C) and the $300 total is carried over to line 27 of page 1 of Schedule C.

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16. Unless the Kirk’s are co-owners of Kirk’s residence or co-signors on his mortgage, they cannot deduct any of the house payments they made on his behalf. See Example 32 in Chapter 6 of the text.

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