Comprehensive Volume C6-1 Chapter 6 Deductions and Losses: In General Copyright ©2010 Cengage...

C6-C6-11Comprehensive VolumeComprehensive Volume

Chapter 6Chapter 6

Deductions and Losses: In General

Deductions and Losses: In General

Copyright ©2010 Cengage Learning

Comprehensive Volume


DeductionsDeductions

• Exclusive definition of deductions– Deductions are allowed based on legislative

grace and defined narrowly– Substantiation requirements

• Taxpayer has burden of proof for substantiating all expenses deducted on return

• Thus, adequate records of expenses must be maintained

• Exclusive definition of deductions– Deductions are allowed based on legislative

grace and defined narrowly– Substantiation requirements

• Taxpayer has burden of proof for substantiating all expenses deducted on return

• Thus, adequate records of expenses must be maintained


Deductions for and from AGI (slide 1 of 3)


• Deductions for AGI– Can be claimed even if taxpayer does not

itemize– Important in determining the amount of certain

itemized deductions • Certain itemized deductions are limited to amounts

in excess of specified percentages of AGI– e.g., Medial expenses (7.5% of AGI), misc. itemized

deductions ( 2% of AGI)

• Deductions for AGI– Can be claimed even if taxpayer does not

itemize– Important in determining the amount of certain

itemized deductions • Certain itemized deductions are limited to amounts

in excess of specified percentages of AGI– e.g., Medial expenses (7.5% of AGI), misc. itemized

deductions ( 2% of AGI)




• Deductions from AGI:– In total, must exceed the standard deduction to

provide any tax benefit– Called “below the line” or itemized deductions

• Deductions from AGI:– In total, must exceed the standard deduction to

provide any tax benefit– Called “below the line” or itemized deductions




• Comparison of deductions for and from AGI (2009 tax year)– Single taxpayer has gross income of $45,000 and

a $6,000 deduction For AGIFrom AGI

Gross income $45,000 $45,000Less: for AGI ded. 6,000 0 AGI $39,000 $45,000Less: from AGI ded. 5,700 6,000Less: personal exempt. 3,650 3,650Taxable income $29,650 $35,350

• Comparison of deductions for and from AGI (2009 tax year)– Single taxpayer has gross income of $45,000 and

a $6,000 deduction For AGIFrom AGI

Gross income $45,000 $45,000Less: for AGI ded. 6,000 0 AGI $39,000 $45,000Less: from AGI ded. 5,700 6,000Less: personal exempt. 3,650 3,650Taxable income $29,650 $35,350


Deductions for AGI (slide 1 of 3)


• Partial list includes:– Trade or business expenses– Reimbursed employee business expenses– Deductions from losses on sale or exchange of

property – Deductions from rental and royalty property – Alimony– One-half of self-employment tax paid

• Partial list includes:– Trade or business expenses– Reimbursed employee business expenses– Deductions from losses on sale or exchange of

property – Deductions from rental and royalty property – Alimony– One-half of self-employment tax paid




• Partial list includes:– 100% of health insurance premiums paid by a

self-employed individual– Contributions to pension, profit sharing,

annuity plans, IRAs, etc.– Penalty on premature withdrawals from time

savings accounts or deposits– Moving expenses

• Partial list includes:– 100% of health insurance premiums paid by a

self-employed individual– Contributions to pension, profit sharing,

annuity plans, IRAs, etc.– Penalty on premature withdrawals from time

savings accounts or deposits– Moving expenses




• Partial list includes:– Interest on student loans– Qualified tuition and related expenses under

§ 222– Up to $250 for teacher supplies for elementary

and secondary school teachers

• Partial list includes:– Interest on student loans– Qualified tuition and related expenses under

§ 222– Up to $250 for teacher supplies for elementary

and secondary school teachers


Deductions from AGIDeductions from AGI

• Itemized deductions include:– Medical expenses (in excess of 7.5% of AGI) – Certain state and local taxes – Contributions to qualified charitable organizations – Personal casualty losses (in excess of 10 % of AGI and

a $100 floor per casualty)– Certain personal interest expense (e.g., mortgage

interest on a personal residence)– Miscellaneous itemized deductions (in excess of 2% of

AGI)

• Itemized deductions include:– Medical expenses (in excess of 7.5% of AGI) – Certain state and local taxes – Contributions to qualified charitable organizations – Personal casualty losses (in excess of 10 % of AGI and

a $100 floor per casualty)– Certain personal interest expense (e.g., mortgage

interest on a personal residence)– Miscellaneous itemized deductions (in excess of 2% of

AGI)


Trade or Business Deductions (slide 1 of 2)


• Section 162(a) permits a deduction for all ordinary and necessary expenses paid or incurred in carrying on a trade or business including:– Reasonable salaries paid for services– Expenses for the use of business property– One-half of self-employment taxes paid

• Such expenses are deducted for AGI

• Section 162(a) permits a deduction for all ordinary and necessary expenses paid or incurred in carrying on a trade or business including:– Reasonable salaries paid for services– Expenses for the use of business property– One-half of self-employment taxes paid

• Such expenses are deducted for AGI




• In order for expenses to be deductible, they must be:– Ordinary: normal, usual, or customary for

others in similar business, and not capital in nature

– Necessary: prudent businessperson would incur same expense

– Reasonable: question of fact– Incurred in conduct of business

• In order for expenses to be deductible, they must be:– Ordinary: normal, usual, or customary for

others in similar business, and not capital in nature

– Necessary: prudent businessperson would incur same expense

– Reasonable: question of fact– Incurred in conduct of business


Section 212 Expenses (slide 1 of 2)Section 212 Expenses (slide 1 of 2)

• Section 212 allows deductions for ordinary and necessary expenses paid or incurred for the following:– The production or collection of income– The management, conservation, or maintenance

of property held for the production of income– Expenses paid in connection with the

determination, collection, or refund of any tax

• Section 212 allows deductions for ordinary and necessary expenses paid or incurred for the following:– The production or collection of income– The management, conservation, or maintenance

of property held for the production of income– Expenses paid in connection with the

determination, collection, or refund of any tax


Section 212 Expenses (slide 2 of 2)Section 212 Expenses (slide 2 of 2)

• § 212 expenses that are deductions for AGI include:– Expenses related to rent and royalty income– Expenses paid in connection with the determination,

collection, or refund of taxes related to the income of sole proprietorships, rents and royalties, or farming operations

• All other § 212 expenses are itemized deductions (deductions from AGI)– For example, investment-related expenses (e.g., safe

deposit box rentals) are deductible as itemized deductions attributable to the production of investment income

• § 212 expenses that are deductions for AGI include:– Expenses related to rent and royalty income– Expenses paid in connection with the determination,

collection, or refund of taxes related to the income of sole proprietorships, rents and royalties, or farming operations

• All other § 212 expenses are itemized deductions (deductions from AGI)– For example, investment-related expenses (e.g., safe

deposit box rentals) are deductible as itemized deductions attributable to the production of investment income


Business And Nonbusiness Losses

Business And Nonbusiness Losses

• Deductible losses of individual taxpayers are limited to those:– Incurred in a trade or business,– Incurred in a transaction entered into for profit

• Individuals may also deduct casualty losses from fire, storm, shipwreck, and theft

• Deductible losses of individual taxpayers are limited to those:– Incurred in a trade or business,– Incurred in a transaction entered into for profit

• Individuals may also deduct casualty losses from fire, storm, shipwreck, and theft


Methods of AccountingMethods of Accounting

• The method of accounting affects when deductions are taken– Cash: expenses are deductible only when paid– Accrual: expenses are deductible when incurred

• Apply the all events test and the economic performance test

– Exception to the economic performance test for recurring items

• The method of accounting affects when deductions are taken– Cash: expenses are deductible only when paid– Accrual: expenses are deductible when incurred

• Apply the all events test and the economic performance test

– Exception to the economic performance test for recurring items


Disallowance PossibilitiesDisallowance Possibilities

• The tax law disallows the deduction of certain types of expenses for a variety of reasons– e.g., May restrict taxpayer attempts to deduct certain

items that, in reality, are personal expenditures

• Certain disallowance provisions are a codification or extension of prior court decisions– e.g., After courts denied deductions for payments in

violation of public policy, tax law was changed to provide specific authority for the disallowance

• The tax law disallows the deduction of certain types of expenses for a variety of reasons– e.g., May restrict taxpayer attempts to deduct certain

items that, in reality, are personal expenditures

• Certain disallowance provisions are a codification or extension of prior court decisions– e.g., After courts denied deductions for payments in

violation of public policy, tax law was changed to provide specific authority for the disallowance


Expenditures Contrary To Public Policy

Expenditures Contrary To Public Policy

• Deductions are disallowed for certain specific types of expenditures that are considered contrary to public policy– Examples: penalties, fines, illegal bribes or

kickbacks, two-thirds of treble damage payments for violation of anti-trust law

• Deductions are disallowed for certain specific types of expenditures that are considered contrary to public policy– Examples: penalties, fines, illegal bribes or

kickbacks, two-thirds of treble damage payments for violation of anti-trust law


Legal Expenses Incurred In Defense Of Civil Or Criminal Penalties

Legal Expenses Incurred In Defense Of Civil Or Criminal Penalties

• To deduct legal expenses– Must be directly related to a trade or business,

an income producing activity, or the determination, collection, or refund of a tax

• e.g., Corporate officer’s legal fees in defending against price-fixing charges

• e.g., Landlord’s legal fees associated with eviction of tenant

• To deduct legal expenses– Must be directly related to a trade or business,

an income producing activity, or the determination, collection, or refund of a tax

• e.g., Corporate officer’s legal fees in defending against price-fixing charges

• e.g., Landlord’s legal fees associated with eviction of tenant


Expenses Relating To An Illegal Business

Expenses Relating To An Illegal Business

• Usual expenses of operating an illegal business are deductible– However, deduction for fines, bribes to public

officials, illegal kickbacks, and other illegal payments are disallowed

• Trafficking in controlled substances: only cost of goods sold can reduce gross income

• Usual expenses of operating an illegal business are deductible– However, deduction for fines, bribes to public

officials, illegal kickbacks, and other illegal payments are disallowed

• Trafficking in controlled substances: only cost of goods sold can reduce gross income


Political Contributions And Lobbying Activities

Political Contributions And Lobbying Activities

• Generally, no business deduction is allowed for payments made for political purposes or for lobbying– Exceptions are allowed for lobbying:

• To influence local legislation,

• To monitor legislation, and

• De minimis in-house expenses (limited to $2,000)– If greater than $2,000, none can be deducted

• Generally, no business deduction is allowed for payments made for political purposes or for lobbying– Exceptions are allowed for lobbying:

• To influence local legislation,

• To monitor legislation, and

• De minimis in-house expenses (limited to $2,000)– If greater than $2,000, none can be deducted


Excessive Executive CompensationExcessive Executive Compensation

• For publicly held corporations: – Deduction for compensation of CEO and four

other highest compensated officers is limited to $1 million each

– Does not include:• Certain performance-based compensation

• Payments to qualified retirement plans

• Payments excludible from gross income

• For publicly held corporations: – Deduction for compensation of CEO and four

other highest compensated officers is limited to $1 million each

– Does not include:• Certain performance-based compensation

• Payments to qualified retirement plans

• Payments excludible from gross income


Investigation Of A Business(slide 1 of 3)


• Investigation expenses - incurred to determine the feasibility of entering a new business or expanding an existing business– Include costs such as travel, engineering, architectural

surveys, marketing reports, various legal and accounting services

• Tax treatment of these expenses depends on: – The current business, if any, of the taxpayer– The nature of the business being investigated– The extent to which the investigation has proceeded– Whether or not the acquisition actually takes place

• Investigation expenses - incurred to determine the feasibility of entering a new business or expanding an existing business– Include costs such as travel, engineering, architectural

surveys, marketing reports, various legal and accounting services

• Tax treatment of these expenses depends on: – The current business, if any, of the taxpayer– The nature of the business being investigated– The extent to which the investigation has proceeded– Whether or not the acquisition actually takes place




• If the taxpayer is in a business the same as or similar to that being investigated– Investigation expenses are deductible in the

year paid or incurred• The tax result is the same whether or not the

taxpayer acquires the business being investigated

• If the taxpayer is in a business the same as or similar to that being investigated– Investigation expenses are deductible in the

year paid or incurred• The tax result is the same whether or not the

taxpayer acquires the business being investigated




• When the taxpayer is not in a business the same as or similar to that being investigated – Tax result depends on whether new business is acquired

• If not acquired– All investigation expenses generally are nondeductible

• If acquired– Investigation expenses must be capitalized– May elect to deduct the first $5,000 of expenses currently – Any excess expenses can be amortized over a period of

not less than 180 months (15 years)– In arriving at the $5,000 immediate deduction allowed, a

dollar-for-dollar reduction must be made for those expenses in excess of $50,000

• When the taxpayer is not in a business the same as or similar to that being investigated – Tax result depends on whether new business is acquired

• If not acquired– All investigation expenses generally are nondeductible

• If acquired– Investigation expenses must be capitalized– May elect to deduct the first $5,000 of expenses currently – Any excess expenses can be amortized over a period of

not less than 180 months (15 years)– In arriving at the $5,000 immediate deduction allowed, a

dollar-for-dollar reduction must be made for those expenses in excess of $50,000


Hobby Losses (slide 1 of 8)Hobby Losses (slide 1 of 8)

• Hobby defined– Activity not entered into for profit

• Personal pleasure associated with activity• Examples: raising horses, fishing boat charter

• If an activity is not engaged in for profit, the hobby loss rules apply– Hobby expenses are deductible only to the

extent of hobby income

• Hobby defined– Activity not entered into for profit

• Personal pleasure associated with activity• Examples: raising horses, fishing boat charter

• If an activity is not engaged in for profit, the hobby loss rules apply– Hobby expenses are deductible only to the

extent of hobby income



• Profit activity– If activity is entered into for profit, taxpayer

can deduct expenses for AGI even in excess of income from the activity

• At-risk and passive loss rules may apply

• Often it is difficult to determine if an activity is profit motivated or a hobby

• Regulations provide nine factors to consider in making this determination

• Profit activity– If activity is entered into for profit, taxpayer

can deduct expenses for AGI even in excess of income from the activity

• At-risk and passive loss rules may apply

• Often it is difficult to determine if an activity is profit motivated or a hobby

• Regulations provide nine factors to consider in making this determination



• Presumptive rule of § 183– If activity shows profit 3 out of 5 years (2 out

of 7 years for horses), the activity is presumed to be a trade or business rather than a personal hobby

– Rebuttable presumption, shifts burden of proof to IRS

– Otherwise, taxpayer has burden to prove profit motive

• Presumptive rule of § 183– If activity shows profit 3 out of 5 years (2 out

of 7 years for horses), the activity is presumed to be a trade or business rather than a personal hobby

– Rebuttable presumption, shifts burden of proof to IRS

– Otherwise, taxpayer has burden to prove profit motive



Year Income (loss) Hobby?

2003 $500 Yes

2004 (1,500) Yes

2005 700 Yes

2006 (1,000) Yes

2007 900 No, profit 3 of 5 years

2008 (500) Yes, profit only 2 of 5 years

2009 1,200 No, profit 3 of 5 years



• If an activity is deemed to be a hobby– Can only deduct expenses to extent of income

from activity (i.e., cannot deduct hobby losses)

• If an activity is deemed to be a hobby– Can only deduct expenses to extent of income

from activity (i.e., cannot deduct hobby losses)



• If an activity is a hobby:– Expenses are deductible from AGI

• Treated as miscellaneous itemized deductions subject to the 2% of AGI limitation

• Exception: expenses that are deductible without regard to profit motive are deductible in full, such as

– Home mortgage interest

– Property taxes

• If an activity is a hobby:– Expenses are deductible from AGI

• Treated as miscellaneous itemized deductions subject to the 2% of AGI limitation

• Exception: expenses that are deductible without regard to profit motive are deductible in full, such as

– Home mortgage interest

– Property taxes



• Order in which hobby expenses are deductible:– First: Those otherwise deductible: e.g.,

home mortgage interest and property taxes – Then: Expenses that do not affect adjusted

basis: e.g., maintenance, utilities– Then: Expenses that affect adjusted basis:

e.g., Depreciation (or cost recovery)

• Order in which hobby expenses are deductible:– First: Those otherwise deductible: e.g.,

home mortgage interest and property taxes – Then: Expenses that do not affect adjusted

basis: e.g., maintenance, utilities– Then: Expenses that affect adjusted basis:

e.g., Depreciation (or cost recovery)



• Example of hobby expenses: Taxpayer sells horses raised as a hobby for $15,500

• Example of hobby expenses: Taxpayer sells horses raised as a hobby for $15,500

Amount Order Amount

Income $15,500

Interest 6,000 1 $ 6,000

Taxes 3,000 1 3,000

Vet Bills 2,000 2 2,000

Feed 4,000 2 4,000

Depreciation 1,000 3 Ltd. to 500

Total 15,500


Rental Vacation Homes(slide 1 of 9)


• May have both personal and rental use of a vacation home

• Rental expenses may be limited to rental income if primarily used for personal purposes

• Determination of vacation home treatment is dependent on personal use vs. rental use

• May have both personal and rental use of a vacation home

• Rental expenses may be limited to rental income if primarily used for personal purposes

• Determination of vacation home treatment is dependent on personal use vs. rental use




• Rental days– Less than 15 days: No gross income recognized

from rentals and no deductible rental expenses• Mortgage interest and property taxes treated as if on

personal residence (generally deductible in full)

– More than 14 days: Treatment depends on amount of personal use

• Rental days– Less than 15 days: No gross income recognized

from rentals and no deductible rental expenses• Mortgage interest and property taxes treated as if on

personal residence (generally deductible in full)

– More than 14 days: Treatment depends on amount of personal use




• Primarily rental use– If rented for 15 days or more and personal use

days NOT more than the greater of 14 days or 10 percent of fair rental days

– Can deduct all expenses allocated to rental use even if loss results

• Rental loss subject to passive loss rules

• Primarily rental use– If rented for 15 days or more and personal use

days NOT more than the greater of 14 days or 10 percent of fair rental days

– Can deduct all expenses allocated to rental use even if loss results

• Rental loss subject to passive loss rules




• Personal/rental use– If rented for 15 days or more and personal use

days exceed the greater of 14 days or 10 percent of fair rental days

– Treated similar to hobby• Rental expenses deducted in three step process

• No rental loss allowed

• Carryforward of disallowed rental expenses

• Personal/rental use– If rented for 15 days or more and personal use

days exceed the greater of 14 days or 10 percent of fair rental days

– Treated similar to hobby• Rental expenses deducted in three step process

• No rental loss allowed

• Carryforward of disallowed rental expenses




• Example of personal use

Rental days: 200 (10% = 20)

Personal use Not Significant Significant 7 days X 18 days X 25 days X


Rental days: 200 (10% = 20)

Personal use Not Significant Significant 7 days X 18 days X 25 days X





Rental days: 100 (10% = 10)

Personal Use Not Significant Significant 7 days X14 days X18 days X


Rental days: 100 (10% = 10)

Personal Use Not Significant Significant 7 days X14 days X18 days X




• Allocation of expenses between personal and rental– Mortgage interest and real estate taxes

• IRS requires allocation based on total days used

• Courts have allowed allocation based on days in year

– Other expenses are allocated based on total days used

• Allocation of expenses between personal and rental– Mortgage interest and real estate taxes

• IRS requires allocation based on total days used

• Courts have allowed allocation based on days in year

– Other expenses are allocated based on total days used




• Tax treatment of income and expenses of a primarily rental vacation home– Rental income included in gross income– Rental expenses deductible for AGI– Rental income and expenses reported on Sch. E

• Tax treatment of income and expenses of a primarily rental vacation home– Rental income included in gross income– Rental expenses deductible for AGI– Rental income and expenses reported on Sch. E




• Treatment of allocated personal portion of vacation home expenses– Primarily rental use: taxes deductible from

AGI, mortgage interest nondeductible (personal interest)

– Personal/rental use: mortgage interest and taxes deductible from AGI

– Personal portion of other expenses (e.g., insurance, maintenance) nondeductible

• Treatment of allocated personal portion of vacation home expenses– Primarily rental use: taxes deductible from

AGI, mortgage interest nondeductible (personal interest)

– Personal/rental use: mortgage interest and taxes deductible from AGI

– Personal portion of other expenses (e.g., insurance, maintenance) nondeductible


Expenditures Incurred for Taxpayer’s Benefit or Obligation

Expenditures Incurred for Taxpayer’s Benefit or Obligation

• No deduction is allowed for payment of another taxpayer’s expenses– Must be incurred for taxpayer’s benefit or arise

from taxpayer’s obligation– Exception: Payment of medical expenses for a

dependent

• No deduction is allowed for payment of another taxpayer’s expenses– Must be incurred for taxpayer’s benefit or arise

from taxpayer’s obligation– Exception: Payment of medical expenses for a

dependent


Personal ExpendituresPersonal Expenditures

• Unless otherwise provided in the Code, personal expenses are not deductible

• Unless otherwise provided in the Code, personal expenses are not deductible


Capital ExpendituresCapital Expenditures

• Amounts are capitalized

• Asset may be subject to depreciation (or cost recovery), amortization, or depletion

• Amounts are capitalized

• Asset may be subject to depreciation (or cost recovery), amortization, or depletion


Transactions Between Related Parties (slide 1 of 2) Transactions Between Related Parties (slide 1 of 2)

• Section 267 disallows losses from direct or indirect sales or exchanges of property between related parties– Family and entity relationships apply– Constructive ownership rules apply– Loss disallowed may reduce gain on

subsequent disposition to unrelated third party

• Section 267 disallows losses from direct or indirect sales or exchanges of property between related parties– Family and entity relationships apply– Constructive ownership rules apply– Loss disallowed may reduce gain on

subsequent disposition to unrelated third party


Transactions Between Related Parties (slide 2 of 2) Transactions Between Related Parties (slide 2 of 2)

• Section 267 also requires the matching principle be applied for unpaid expenses and interest when different accounting methods used– Example: An accrual basis, closely held

corporation, cannot deduct accrued, but unpaid, salary to cash basis related party employee/shareholder until it is actually paid

• Section 267 also requires the matching principle be applied for unpaid expenses and interest when different accounting methods used– Example: An accrual basis, closely held

corporation, cannot deduct accrued, but unpaid, salary to cash basis related party employee/shareholder until it is actually paid


Expenses and Interest Relating to Tax-Exempt Income

Expenses and Interest Relating to Tax-Exempt Income

• Expenses relating to production of tax-exempt income are nondeductible– Example: interest expense on loan where funds

used to acquire municipal bonds

• Expenses relating to production of tax-exempt income are nondeductible– Example: interest expense on loan where funds

used to acquire municipal bonds


If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact:

Dr. Donald R. Trippeer, CPA [email protected]

SUNY Oneonta

If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact:

Dr. Donald R. Trippeer, CPA [email protected]

SUNY Oneonta

Comprehensive Volume C6-1 Chapter 6 Deductions and Losses: In General Copyright ©2010 Cengage...

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