Chapter 5

Gross Income and Exclusions

Howard Godfrey, Ph.D., CPAProfessor of Accounting ©Howard Godfrey-2015

Concepts: Benefit, Realize, Recognize [2]Form of receipt, Return of capital [4]Tax benefit rule: [5: 51] [refund of amount deducted earlier] Recognize income: Accounting methods, [6] Constructive Receipt [7] Claim of right [7]Who Recognizes? Assignment of income [8]Income: Compensation for services [10]STOCK OPTIONS: Nonqualified and ISO [10: 56]

Chapter 5. Gross Income & Exclusions

Income from Property, Annuity, Dividend [12: 59], & 14-3Property dispositions: Gain or Loss [15]CAP. GAINS: Netting, Loss carryover, etc. [16: 64]Sales to Related Parties, Wash sales [19]Other income, Flow-through Entities [20]Alimony, Prizes, Gambling Income, etc. [21: 61]Social Security Benefits [24]Bargain purchase or loan, Mun. Interest [26]Gain-Sale of Residence, Fringe Benefits [29,30: 82, 69]Scholarship, 529 Plan, Coverdale, EE Bond [32]Gifts/Inheritance. Life Insurance proceeds. [33: 74, 81]Foreign earned income [35]Sickness and Injury Exclusions. Employer [36] Retirement Plan. Early Withdraw Penalty [38, 40: 84]Unemployment compensation is taxable

Chapter 5. Part 1Concepts: Benefit, Realize, Recognize [2]Form of receipt Return of capital [4]Tax benefit rule: [5: 51] [refund of amt deducted earlier] Recognize income: [6]Accounting methods, Constructive Receipt [7] Claim of right [7]Who Recognizes? [8]Assignment of incomeIncome: Compensation for services [10]

Gross income- Less Excl.

Less: Deductions for adjusted gross income

Equals: Adjusted Gross Income (AGI)

Less: Deductions from AGI (greater of

itemized or standard deduction)

Less: Exemptions (personal & dependency)

Equals: Taxable income (loss)

Individual Tax Model-1.

Taxable income

Times: Tax rates

Equals: Gross income tax liability

Plus: Additions to tax

Less: Tax credits or prepayments

Equals: Tax owed or refund due

Individual Tax Model-2

General Tax Formula ($000)Gross Income - Form 1040-Pg 1 $110

Deductions For A.G.I. (10) Adjusted Gross Income (AGI) 100 Exemptions (8) Regular Itemized Deduct. (13) Misc. Itemized Ded. (5)

Less 2% of AGI 2 Deductible Amount (3)

Total Deductions From AGI (24) Taxable Income $76

Gross Income - Sec. 61Less: Deductible expenses Equals: Taxable income Times: Corporate tax rate Equals: Corporate income tax Plus: Additions to tax Less: Tax credits Equals: Net corporate tax

Corp-Big Picture

The next seven slides contain some basic code sections that form the overall structure of the tax system. The code sections illustrate parts of the formula shown on the preceding slideIncluded are two examples of items in the overall formula.1. Sale of a residence may generate a gain that is

excluded from Gross Income.2. The employee claims a credit on the tax return

for amounts of federal income tax withheld from salary.

Sec. 1. Tax Imposed(a) Married Individuals Filing Joint Returns and Surviving Spouses. There is hereby imposed on the taxable income of—(1) every married individual (as defined in section

7703) who makes a single return jointly with his spouse under section 6013, and

(2) every surviving spouse (as defined in section 2(a)), a tax determined in accordance with the following table:…. [omitted]

Sec. 61. Gross Income Defined. General Definition. Except as otherwise provided in this subtitle, gross income means all income from whatever source derived, including (but not limited to):(1) Compensation for services, including fees, commissions, fringe benefits, and similar items;(2) Gross income derived from business;(3) Gains derived from dealings in property;(4) Interest;(5) Rents;(6) Royalties;(7) Dividends;(8) Alimony and separate maintenance payments;(9) Annuities;(10) Income from life insurance and endowment contracts;(11) Pensions;(12) Income from discharge of indebtedness;(13) Distributive share of partnership gross income;(14) Income in respect of a decedent; and(15) Income from an interest in an estate or trust.

Sec. 62. Adjusted Gross Income Defined.(a) General Rule. For purposes of this subtitle, the term “adjusted gross income” means, in the case of an individual, gross income minus the following deductions:(1) Trade and business deductions. The deductions allowed by this chapter (other than by part VII of this subchapter) which are attributable to a trade or business carried on by the taxpayer, if such trade or business does not consist of the performance of services by the taxpayer as an employee.------material omitted(3) Losses from sale or exchange of property. [omitted](7) Retirement savings. The deduction allowed by section 219 (relating to deduction for certain retirement savings). ---material omitted

Sec. 63.Taxable Income Defined.

(a) In General. Except as provided in subsection (b), for purposes of this subtitle, the term “taxable income”means gross income minus the deductions allowed by this chapter (other than the standard deduction).

Sec. 121. Exclusion of Gain from Sale of Principal Residence.

(a) Exclusion. Gross income shall not include gain from the sale or exchange of property if, during the 5-year period ending on the date of the sale or exchange, such property has been owned and used by the taxpayer as the taxpayer's principal residence for periods aggregating 2 years or more.(b) Limitations.(1) In general. The amount of gain excluded from gross income under subsection (a) with respect to any sale or exchange shall not exceed $250,000.

Sec. 121. Exclusion of Gain from Sale of Principal Residence.(b) Limitations.(1) In general. The amount of gain excluded from gross income under subsection (a) with respect to any sale or exchange shall not exceed $250,000.(2) Special rules for joint returns. In the case of a husband and wife who make a joint return for the taxable year of the sale or exchange of the property—(A) $500,000 limitation for certain joint returns. Paragraph (1) shall be applied by substituting “$500,000”for“$250,000” if—(i) either spouse meets the ownership requirements of subsection (a) with respect to such property;(ii) both spouses meet the use requirements of subsection (a) with respect to such property; and(iii) neither spouse is ineligible for the benefits of subsection (a) with respect to such property by reason of paragraph (3).

Sec. 31. Tax Withheld On Wages.(a) Wage Withholding for Income Tax Purposes.(1) In general. The amount withheld as tax under chapter 24 shall be allowed to the recipient of the income as a credit against the tax imposed by this subtitle. [omitted]

Tax benefit ruleIn 2015, Ms. Jones (single) reported the following information on their 2015 income tax return: Salary Earned $60,000 State income taxes $5,000 Mortgage interest $6,000 Real estate taxes $1,000 She supports her three small children. (next slide) She receives a state income tax refund of $3,000 in 2016, for 2015. How much income does she report from this refund? a. $1,000 b. $250 c. Other

Gross income $60,000 Deduct. for AGIAdj. Gross Income 60,000Less:1a. Standard Ded. 9,2501b. Itemized Ded. 12,000

(12,000)2. Exemptions 4,000 16,000 (16,000)Taxable Income $32,000Tax Before Credits

Ms. Jones (H-of-H) 2015

Continue preceding case.Ms. Jones had itemized deductions of $12,000. If she had not deducted the state income taxes of $5,000, her itemized deductions would have been $7,000, and she would have deducted the $9,250 standard deduction. She did not benefit from all of the $5,000 in deduction for the state income tax. Her tax benefit was $2,750.She received a refund of $3,000.She will include $2,750 in income.

Accounting Methods.Taxpayers can use different methods for financial accounting and tax– Cash method:

receipt of cash or cash equivalents determine income/expense recognition (subject to constructive receipt doctrine)

– Accrual method: the all-events test determines income/expense recognition

Cash Method. Income is recognized when cash or cash equivalents received

– Cash equivalents broadly defined to include property and services

– Cash equivalents included at fair market value

Cash MethodA cash-basis taxpayer recognizes income when an amount is

–Credited to the taxpayer’s account–Set apart for the taxpayer, or–Made available in some other way

to the taxpayer

Constructive Receipt Doctrine.• Constructive receipt

is a rule that prevents cash basis taxpayers from “turning their backs” on income

• Income is not constructively received if– The taxpayer is not entitled to the income– The payor has insufficient funds from which to

make payment– There are substantial limitations or restrictions

placed on actual receipt

Hall started business on Jan. 1, 2015.

Rentals receivable at 12-31-2015 $6,000

Cash received from tenants $50,000

Depreciation Expense ($15,000)Other Expenses ($5,000)Net Income $30,000 Hall should report 2015 taxable income of:a. $24,000 b. $30,000 c. $36,000 d. Other CPA

Hall [accrual basis taxpayer] leases offices.

Rent is due in advance on the first day ofeach month. Not all tenants pay promptly.Hall's records at the end of 2015 show:

Accounting MethodsHall Co., -ContinuedThe rent receivable of $6,000 must be included in revenue – using the accrual method. Corrected computations: Revenue $56,000 Expenses $20,000 Taxable Income $36,000

Stock OptionsSee See SeparatePowerPointFile

Chapter 5. Part 2

Income from Property [12: 59]Annuities [13]Dividend (Also page 14-3)Property dispositions: [15] Gain or Loss, FIFO, etc.CAP. GAINS: [16: 64]

Netting, Carryover, etc. [18]Sales to Related Parties [19]Wash sales [19]Other income [20]Flow-through Entities [21]

Chapter 5. Part 3

Annuities An annuity is a series of payments. Typically an individual invests a sum of money and receives periodic payments (often monthly) over a period of years, maybe for as long at the individual lives.Example: invest $120,000 and receive $1,000 per month for life, and life expectancy is 20 years. Half of each payment is return of investment.

Life expectancy- in years 30Annuity income per month $1,000Annuity income per yearIncome over life expectancy

Cost $270,000Profit expectedProfit percentageProfit per year

Annuity Example - age 55

Life expectancy- in years 30Annuity income per month $1,000Annuity income per year $12,000Income over life expectancy $360,000Cost $270,000Profit expected $90,000Profit percentage 25%Profit per year $3,000What happens when he gets to age 86?

Annuity Example - age 55

Annuity Income. Usually includes taxable & nontaxable amounts

– Nontaxable amount is a return of capital – Nontaxable amount of a payment is equal to: the Investment in annuity

________________________

expected return from annuity

multiplied by

annuity payment received If the amounts invested in the annuity were all made by the employer (or by the employee using pre-tax dollars), then the employee’s investment is treated as zero

Annuity Example- Susan-Slide 1

Susan, age 70, purchased an annuity for $30,000. She begins receiving $10,000 per month in January. What amount of each monthly payment is included in her gross income?

From Table 5-1, the return multiple is: _____.

Annuity Cost $99,000

Age of Taxpayer 70

Expected return multiple 16

Monthly annuity payment $1,000

Expected return $192,000

Return of capital % 51.56%

Return of capital per payment $515.63

Gross income per payment $484.38

Suppose Susan dies after receiving annuity payments for exactly 4 years.What is the amount of the deduction on the final return for the unrecovered cost of the annuity?

Annuity Cost $99,000Cost recovered-%Cost recoveredUnrecovered cost

Assume Susan dies after receiving payments for 4 years.How much is deducted on her final return?

Annuity Cost $99,000Cost recovered-% 25%Cost recovered 24,750Unrecovered cost $74,250

Assume Susan dies after receiving payments for 4 years.How much is deducted on her final return?

+ Cash Received

+ FMV of property received

+ Seller’s liabilities assumed by the buyer

- Buyer’s liabilities assumed by the seller

- Selling expenses

= Amount Realized

Amount Realized on Sale

Realized Gain or Loss

Amount realized

- Adjusted basis of property given up

Realized gain or loss

Recognized Gain or Loss • Almost all realized gains are recognized

(taxable)• Losses are usually only recognized

(deductible) if they are– Incurred in a business– Incurred in an investment activity– Casualty or theft losses

Gains and LossesAllan sold a lot that was encumbered by a $13,000 liability that the buyer assumed. Allan received $5,000 cash and an auto worth $15,000 in exchange.

a. What is the amount realized on this sale?

b. If Allan had a basis of $34,000 in the land, what is his gain or loss on the sale?

Cash received $5,000Other Prop. Received- Auto 15,000 Mortgage assumed by buyer 13,000 Total Consideration Received 33,000 Expenses of sale

Sales commission - Other selling expenses -

Total expenses of sale - Amount Realized 33,000 Cost of property (34,000)Gain (Loss) ($1,000)

Allan's Transactions

Capital Gains & LossesCapital Gain-&-Loss Netting

Treatment of Capital Gains

Treatment of Dividends

Treatment of Capital Losses

Rules for Conduits

Capital Assets• Capital assets include stock, bonds,

land held for appreciation, collectibles (coins, art), and personal-use assets

• Long-term holding period is more than one year

• Short-term holding period is one year or less

Capital Gain & Loss Netting • Subtract long-term capital losses from long-

term capital gains (including net Section 1231 gains)

• Subtract short-term losses from short-term gains

• Continue netting (subtracting losses from gains) until only gains or only losses remain– A (net) short-term capital gain resulting from this

process is taxed at ordinary income rates– Taxation of (net) long-term capital gains and all

capital losses differs for corporations and individuals

Capital Losses for Individuals • $3,000 per year deduction against other

income for capital losses; (net) short-term capital losses deducted before (net) long-term capital losses

• Remaining (net) capital losses are carried forward indefinitely (no carry back permitted)

• Losses on personal-use assets are not recognized (deductible) even though gains are recognized (taxable)

Cap. Gains & Losses of C Corporations • No current deduction for capital losses

from regular income; losses are carried back 3 years and forward 5 years to use only against capital gains

• Both long-term and short-term capital gains taxed as ordinary income

• Benefit of capital gains is limited to ability to offset capital losses

$100,000

Cost S. Price

IBM $2,000 $3,000

Big Co. $8,000 $1,000

Adjusted gross income?

Joe had salary of

Joe sold stock- bought in 2015:

Capital Gains and Losses-1

Loss Limit

Overall gain or loss

$100,000

Cost S. Price

IBM $2,000 $3,000 $1,000

Big Co. $8,000 $1,000 ($7,000)

($6,000)

($3,000)

$97,000Adjusted gross income?

Joe had salary of

Joe sold stock- bought in 2015:

Capital Gains and Losses-2

Loss Limit

Overall gain or loss

$100,000

IBM $4,000Big Co. $2,000Sale of land used in Bus. $5,000

Adjusted gross income?

Jo had salary ofShe losses on sales of:

Capital Losses-1

Loss Deduction

$100,000

IBM $4,000Big Co. $2,000Sale of land used in Bus. $5,000

($8,000)$92,000Adjusted gross income?

Jo had salary ofShe losses on sales of:

Capital Losses-2

Loss Deduction

Net Net Net TaxShort-T. Long-T. Gain (Loss) Return

Yr 1 STCG $0

Yr 1 STCL ($2,400)

Yr 1 LTCG $400

Yr 1 LTCL ($3,500)

Individual

Deduct STCL

Deduct LTCL

Carry over to next year

Deduction limit this year

Net Net Net TaxShort-T. Long-T. Gain (Loss) Return

Yr 1 STCG $0

Yr 1 STCL ($2,400) ($2,400)

Yr 1 LTCG $400

Yr 1 LTCL ($3,500) ($3,100)

($5,500)

($2,400)

($600)

($3,000)

($2,500)

Individual

Deduct STCL

Deduct LTCL

Carry over to next year

Deduction limit this year

Cap. Asset Sale-1 Details Capital Ordinary Return

Other Income (Other AGI) $68,000 $68,000

Net L.T. capital gain or loss $15,000

Net S.T. capital loss or loss (24,000)

Gain (loss) non-cap. asset:

Gain (Loss)-bus. use asset

Sec. 1231 gain (Cap. Gain.)

Net capital gain or loss

Cap. Loss limited to $3,000

Net capital gain or loss in AGI

Adjusted Gross Income

Carryforward

Cap. Asset Sale - 2 Details Capital Ordinary Return

Other Income (Other AGI) $68,000 $68,000

Net L.T. capital gain or loss $15,000

Net S.T. capital loss or loss (24,000) (9,000)

Gain (loss) non-cap. asset:

Gain (Loss)-bus. use asset

Sec. 1231 gain (Cap. Gain.)

Net capital gain or loss (9,000)

Cap. Loss limited to $3,000 (3,000)

Net capital gain or loss in AGI (3,000)

Adjusted Gross Income $65,000

Carryforward to next year ($6,000)

General Capital Gains Rates for Individuals• 15% rate applies to most long-term

capital gains – those with marginal brackets above 15%. Rate is now 20% for those in 39.6% regular tax bracket.

• 0% rate applies to taxpayers whose ordinary income is taxed at the 10% and 15% marginal tax brackets to the extent their long-term gains fall within these marginal tax brackets.

Special Capital Gains Rates for Individuals

• 25% rate applies to Sec. 1250 unrecaptured gain on realty; gain in excess of the recapture amount is taxed at 15% rate– If taxpayer’s ordinary income tax rate is lower than

25%, then the lower ordinary income rate applies to gain that falls within that tax bracket

• Collectibles such as antiques, art objects, and rare coins are taxed at a 28% rate due to potential personal enjoyment of asset– If taxpayer’s ordinary tax rate is lower than 28%, then

the lower ordinary rate applies to gain that falls within that tax bracket

Single taxpayers Mike Mary

Salary from IBM $40,000 $120,000

Exemption (4,000) (4,000)

Itemized deduct. (16,000) (16,000)

Net $20,000 $100,000

S.T. capital gain $10,000 $10,000

Tax rate on gain? 15% 28%

Single taxpayers Mike Mary

Salary from IBM $40,000 $120,000

Exemption (4,000) (4,000)

Itemized deduct. (16,000) (16,000)

Net $20,000 $100,000

L.T. capital gain $10,000 $10,000

Tax rate on gain?

Single taxpayers Mike Mary

Salary from IBM $40,000 $120,000

Exemption (4,000) (4,000)

Itemized deduct. (16,000) (16,000)

Net $20,000 $100,000

L.T. capital gain $10,000 $10,000

Tax rate on gain? 0% 15%

• The next few slides have information about a single taxpayer with salary of $50,000 and deductions of $20,000.

• She also had several sales of stock, some held less than a year, and some longer.

Netting of Capital Gains and LossesSalary 50,000$ Deductions (20,000)$ Taxable income beforecapital gains, losses 30,000$

Com-pany Date Cost Date Cost S-Term L-TermATT 05/08/12 $12,000 05/08/15 $15,000

BMW 09/02/15 $18,000 11/02/15 $16,000BAT 04/29/15 $4,000 09/29/15 $9,000IBM 12/02/14 $5,000 12/22/15 $6,000

TotalsNet Gain or Loss

Short-term Gain reported this year ST GainLong-term Gain reported this year LT GainShort-term Loss reported this year ST LossLong-term Loss reported this year LT LossLoss Carryover to next year: S-Term C/O STLoss Carryover to next year: L-Term C/O LT

Sum

mary

Bought Sold Gain / (Loss)

Com-pany Date Cost Date Cost S-Term L-TermATT 05/08/12 $12,000 05/08/15 $15,000 $3,000

BMW 09/02/15 $18,000 11/02/15 $16,000 ($2,000)BAT 04/29/15 $4,000 09/29/15 $9,000 $5,000IBM 12/02/14 $5,000 12/22/15 $6,000 $1,000

Totals $3,000 $4,000Net Gain or Loss

Short-term Gain reported this year ST Gain $3,000Long-term Gain reported this year LT Gain $4,000Short-term Loss reported this year ST Loss $0Long-term Loss reported this year LT Loss $0Loss Carryover to next year: S-Term C/O ST $0Loss Carryover to next year: L-Term C/O LT $0

Sum

mary

Bought Sold Gain / (Loss)

$7,000

Com-pany Date Cost Date Cost S-Term L-TermATT 05/08/12 $12,000 05/08/15 $15,000 $3,000

BMW 09/02/15 $18,000 11/02/15 $16,000 ($2,000)BAT 04/29/15 $4,000 09/29/15 $9,000 $5,000IBM 12/02/14 $5,000 12/22/15 $6,000 $1,000

Totals $3,000 $4,000Net Gain or Loss

Short-term Gain reported this year ST Gain $3,000Long-term Gain reported this year LT Gain $4,000Short-term Loss reported this year ST Loss $0Long-term Loss reported this year LT Loss $0Loss Carryover to next year: S-Term C/O ST $0Loss Carryover to next year: L-Term C/O LT $0

Sum

mary

Bought Sold Gain / (Loss)

$7,000

Com-pany Date Cost Date Cost S-Term L-TermATT 05/08/12 $12,000 05/08/15 $15,000 $3,000

BMW 09/02/15 $18,000 11/02/15 $12,000 ($6,000)BAT 04/29/15 $4,000 09/29/15 $9,000 $5,000IBM 12/02/14 $5,000 12/22/15 $6,000 $1,000

Totals ($1,000) $4,000Net Gain or Loss

Short-term Gain reported this year ST GainLong-term Gain reported this year LT Gain $3,000Short-term Loss reported this year ST LossLong-term Loss reported this year LT Loss $0Loss Carryover to next year: S-Term C/O ST $0Loss Carryover to next year: L-Term C/O LT $0

Sum

mary

Bought Sold Gain / (Loss)

$3,000

Ben’s Flow-Through Income – Slide-1These activities were in 2015Ben paid $60,000 for 5% of the stock of Big Corp., which is a C corp.Ben earned a salary of $200,000 from Big Corp. Big Corp. had net income of $100,000. Ben received dividends of $1,000 from Big. Corp.

Ben’s Flow-Through Income – Slide-2Ben paid $30,000 for a 25% interest in BCD partnership, which owns rental property. BCD’s revenue was $90,000. BCD’s expenses was $50,000. No salary or guaranteed payment was made to any partner. Ben withdrew $4,000 from BCD. He has no deduction “for AGI?” What is Ben’s AGI a. $204,000 b. $211,000 d. Other

Big Corporation is a C Corporation Ben'sBen paid $60,000 for Big Corp. stock ReturnBig Corp. paid salary to Ben $200,000

Ben's ownership of Big Corp. 5%

Big Corporation's net income $100,000

Ben's dividend from Big Corp. $1,000

Ben paid $30,000 for 25% interest in BCD Partnership

BCD Partnership Rent Revenue $90,000

BCD Partnership expenses $50,000

BCD Partnership net income $40,000

Ben's ownership of BCD 25%

Ben's Flow-through incomeBen's withdrawal from BCD $4,000

Ben's Adjusted Gross Income(Ignore deduction for self-employment tax.)Ben's basis in corporation at Year-endBen's basis in partnership at Year-end

Big Corporation is a C Corporation Ben'sBen paid $60,000 for Big Corp. stock ReturnBig Corp. paid salary to Ben $200,000 $200,000Ben's ownership of Big Corp. 5%

Big Corporation's net income $100,000

Ben's dividend from Big Corp. $1,000 $1,000Ben paid $30,000 for 25% interest in BCD Partnership

BCD Partnership Rent Revenue $90,000

BCD Partnership expenses $50,000

BCD Partnership net income $40,000

Ben's ownership of BCD 25%

Ben's Flow-through income $10,000Ben's withdrawal from BCD $4,000

Ben's Adjusted Gross Income $211,000(Ignore deduction for self-employment tax.)Ben's basis in corporation at Year-end $60,000

Ben's basis in partnership at Year-end $36,000

Chapter 5. Part 4Alimony, Divorce related issues [21: 61]Prizes, Gambling Income, etc. [23.]Social Security Benefits [24]Bargain purchase or loan, [26]Municipal Interest [29]Gain-Sale of Residence, Fringe Benefits [29,30: 82, 69]Scholarship, 529 Plan, Coverdale, EE Bond [32]Gifts/Inheritance. Life Insurance proceeds. [33: 74, 81]Foreign earned income [35]Sickness and Injury Exclusions. Employer [36] Retirement Plan. Early Withdraw Penalty [38, 40: 84]Unemployment compensation is taxable

Divorce-Related Payments-1. • A property settlement is simply a division of

assets (no income, no deduction)• Alimony is a legal shifting of income so it is

taxable income to the person receiving it and deductible by the person who pays it.

• Child support fulfills a legal obligation to support a child (no income to parent receiving, no deduction for parent paying it)

• Both parties may benefit by negotiating an increase in payment if it qualifies as alimony.

Tax Consequences of Divorce. Stu & Beth divorce after 8 years of marriage. Beth receives a vacation home that had been held jointly with Stu. It was acquired 7 years ago at a cost of $90,000 but is worth $170,000 today. Stu must pay Beth $2,000 per month; $1,300 is for alimony and $700 is for child support for their 6-year-old son who lives with Beth. a. What is Beth’s gross income? b. Will Stu get a tax deduction?c. Beth’s basis in the vacation home?

Tax Consequences of Divorce. a. Beth must recognize the $1,300 monthly alimony payment as income. She has no income on the transfer of the home as part of the divorce settlement or for the child support payments.

b. Stu is permitted to deduct the monthly alimony payments of $1,300 in determining his adjusted gross income.

Prizes and Awards.

• Prizes, awards, gambling winnings, and treasure finds are taxable.

• The fair market value of goods or services received is included in gross income.

Income from Lottery WinningsJulie wins a $15 million lottery payable over 30 years. In years 1 through 4, she receives annual installments of $500,000. At the beginning of year 5, Julie sells her right to receive the remaining 26 payments to a third-party for a lump-sum payment of $8,900,000. How much does Julie include in income each year?

Income from Lottery WinningsSolution: Julie must include all $500,000 of each payment received in years 1 through 4 in income when received. When she sells her rights to the remaining 26 payments for $8,900,000, the $8,900,000 must be included in income when received.

Social Security Benefits.

Social Security Benefits. • Government devised a complex formula

that can result in the taxation of up to 85% of social security benefits for taxpayers who have significant other income while leaving benefits completely tax free for those who have little other income

• MAGI = AGI before any social security benefits + exempt interest income + ½ of social security benefits

Social Security Benefits • If MAGI is less than $25,000 for single

individuals or $32,000 for married couples, then none of the social security benefits received are taxable

• Single taxpayers with MAGI above $34,000 and married taxpayers with income above $44,000 can be taxed on up to 85% of their benefits

• Taxpayers between the above thresholds can be taxed on up to 50% of their social security benefits

Social Security Benefits.

Although the tax-exempt bond interest must be included in determining modified AGI, it is not included in determining gross income for tax purposes.

Below-Market-Rate Loans. • Certain loans between related parties

(family members, corporation and stockholder, etc.) may be made at low interest rates (or even interest-free)

• Interest income that is not actually received or accrued may be imputed (treated as received or accrued and taxed) at the applicable federal rate of interest

Gift Loan Exceptions. • Any gift loan of $10,000 or less is

exempt from the imputed interest rules

• For gift loans of $100,000 or less– Imputed interest cannot exceed the

borrower’s net investment income for the year

– If borrower’s net investment income is no more than $1,000, imputed interest is zero

Loan to employee• Imputed exchange of cash is treated as

taxable compensation (income to employee and salary deduction for employer) Employee also has imputed interest expense, which may not be deductible.

Loan to shareholder • Imputed exchange of cash is treated as a

dividend (taxable income to shareholder, no deduction for corporation)

Employee/Shareholder Loans.

Sheldon Corporation loans $80,000 interest-free for one year to Lynn, an employee. Assume that the applicable federal rate of interest is 5 percent.

Lynn uses the loan to pay for personal debts. What are the tax consequences of this loan to Sheldon and to Lynn?

How would your answer change if Lynn was a shareholder of Sheldon Corp?

Employee/Shareholder Loans. Solution: Lynn is assumed to pay Sheldon Corp. $4,000 in interest (5% x $80,000) on the loan.

Sheldon has $4,000 in interest income. If Lynn is an employee, Sheldon is assumed to then return the $4,000 to Lynn as taxable compensation, deductible by the corporation. If Lynn is a shareholder, the return of the $4,000 is assumed to be taxable dividend income to Lynn that is not deductible by the corporation.

Sale of Principal Residence• An individual who has owned and

occupied a home as a principal residence for at least 2 of the 5 years before the sale can exclude up to $250,000 of gain ($500,000 for qualified married taxpayers filing a joint return)

• The full exclusion can only be used once every 2 years

Sale of Principal Residence• Married taxpayers filing jointly can exclude up

to $500,000 of gain if– Either spouse owned the home for at least 2

of previous 5 years, and– Both spouses used the home as a principal

residence for at least 2 of previous 5 years, and

– Neither spouse is ineligible for the exclusion because of the once-every-2-year limit

– Amount realized on sale is reduced by selling expenses such as advertising, broker’s commissions, and legal fees

Sale of Principal ResidencePartial exclusion available if failure to meet two-year time period requirement is due to

–A change in place of employment–Health (moving into nursing home)–Other unforeseen circumstances

including divorce, death of spouse or co-owner, unemployment, disasters, and involuntary conversion of residence

Sale of Principal ResidencePartial exclusion is calculated by taking dividing the number of qualifying months by 24 and then multiplying this fraction by $250,000 ($500,000 if qualifying jointly)The number of qualifying months is the shorter of

– The use and ownership during the 5 preceding years or

– The period of time that has passed since the taxpayer last claimed the exclusion

Sale of Principal Residence• A principal residence does not lose

that status if temporarily rented during the period of time it is for sale

• The exclusion does not apply to any gain attributable to depreciation claimed for rental or business use of the residence– The 25% rate for unrecaptured Section

1250 gain applies to gain up to the previous depreciation deductions

Sale of Principal Residence

Taxpayers filing MFJ may exclude up to $500,000 provided

• Either spouse meets the ownership test

• Both meet the use test, and• Neither used the exclusion in the

last two years.

Sale of Residence Clyde, a single person, purchased his home in 1995 for $225,000 and lived there until he sold it for $700,000. He paid commissions of $40,000 on the sale. What is Clyde’s taxable gain?

Selling price of house $700,000

Selling expenses

Amount realized

Basis of old house

Gain Realized

Gain Recognized

Sale of Residence - Clyde

Selling price of house $700,000

Selling expenses (40,000)

Amount realized 660,000

Basis of old house (225,000)

Gain Realized 435,000

Gain Recognized $185,000

Sale of Residence - Clyde

Sale of Residence Clyde, a single person, bought his home on 1-1-15 for $225,000 and lived there until he sold it on 12-1-15 for $700,000. He paid commissions of $40,000 on the sale. (Clyde sold the home because he was required to enter an assisted living center.) What is Clyde’s taxable gain?(He qualifies for partial exclusion because the sale was not voluntary.)

Selling price of house $700,000Selling expenses (40,000)Amount realized 660,000Basis of old house (225,000) Gain Realized 435,000 Gain - General rule $435,000

Sale of Residence - Clyde

Gain - General Rule $435,000NumeratorDenominator% of exclusionMaximum ExclusionExclusion allowedGain recognzed

Sale of Residence - ClydeRelief Provision

Gain - General Rule $435,000Numerator 11Denominator 24% of exclusion 46%Maximum Exclusion 250,000Exclusion allowed 114,583Gain recognized $320,417

Sale of Residence - ClydeRelief Provision

End