Income Tax I
Bogdanski
Fall 2003
Sample Answers to Question 2
Exam No. 3096
Getting married and buying house
Getting married would subject Heather and Bob to a marriage penalty later in life as their incomes increase. Right now, Bob is in the 15% bracket single because his taxable income is $24,200 ($32,000 profit less $3,050 personal exemption less $4,750 standard deduction). Heather is in the 25% bracket because her taxable income is $32,200 (40,000 - 4,750 - 3,050). When they marry, their combined income will be $72,000 -- the taxable income will be $56,400 ($7,200 - 6,100 (personal exemptions) – $9,500 (standard deduction)). $56,400 puts them in the 15% bracket. Therefore, there is a short-term tax break. However, a minimal increase in income and the tax reduction will be gone. But in the short term, a marriage transaction would reduce their overall tax liability.
Purchasing a house would also reduce their tax liability. They would have imputed income from buying, rather than renting, but imputed income is not taxable. The home mortgage interest from buying the home would be deductible under §163(h), if they itemize deductions. So they’d probably start.
Even if they use money they already have rather than take out a loan, they are better-off tax-wise because if they have money in savings they use to pay the rent, they pay tax on the interest prior to paying the rent. They don’t pay rent on any appreciation in their home until they sell it. At that point, their basis is the price they bought the home for. The gain on the sale of the home would be tax-exempt up to $500,000 (if they continue to use it as primary residence and otherwise satisfy §121). Therefore, they can accrue tax-free gain in their house but would not be able to get tax free gain on money paid in rent. Excess gain on sale of house would be capital.
Coat
When Bob gives Heather the coat, it is a gift and not income to Heather or realizing event to Bob. Bob’s basis in the coat is $100, a stepped-up basis of the FMV of coat when Granny died, per § 1014. Per § 1015, Heather’s basis in the coat is a carryover basis of $100. This is true whether or not Heather and Bob are married or unmarried. When Heather sells the coat she has a gain of $125 -- the $225 amount realized less her basis of $100. Personal use assets are capital, so the $100 gain is taxed at § 1(h) capital gains rates. Except it would be a short-term capital gain -- because she didn’t hold it for one year, so not get as preferential treatment -- §1 (h) applies to net capital gain, which requires long-term gain. So the gain would be taxed ordinary. Bob gets no deduction for the gift. Only business gifts deductible.
Bob’s Student Loans
Bob’s student loan interest is deductible only in the amount of $2,500 under § 221. This amount is allowed whether married or single because the phaseout starts at $50,000 single or $100,000 married – neither of which they would exceed. The deduction is an above-the-line deduction, so it is taken regardless of whether they itemize.
Bob’s Business Expenses
Bob’s purchase of $2,000 of supplies for his business would be a current expense (assuming UniCap doesn’t apply -- I don’t know if software is tangible personal property). This would be deductible above the line under § 62(a)(1) because he is self-employed. This treatment is accorded because the supplies are not likely to have a benefit that extends beyond the present tax year. The $8,000 for equipment is a capital expenditure because it has long-term benefit and is a non-recurring purchase (unlike supplies). Therefore, the expense of the equipment will be depreciated over its useful life – unless he elects under §179 – then he can treat the entire expenditure for equipment as current expense and it would be deductible above the line. If he takes the $8,000 as a current expense, his basis is zero. If he depreciates, the basis is $8,000.
Even if Bob depreciates, he’ll likely get bonus depreciation and be able to take $4,000 deduction in year of purchase. The other $4,000 would be given ACRS double declining depreciation (unless he elected straight-line depreciation – his option). His basis would decline each year in an amount equal to the depreciation deduction.
The $700 in sales tax on his business items is an above-the-line deduction for Bob under § 62(a)(1), expenses of his own business as a self-employed individual.
Heather and Bob are looking for advice about getting married and buying a home. Regarding marriage, Heather and Bob should be aware of the marriage penalty and marriage bonus. Because they are each wage earners, they might be disfavored by the tax code. Individually, now, their marginal tax rate is each 25%. If they get married, together they will file a tax return on which their marginal tax rate will be 25%. Thus, they experience neither a marriage penalty nor a married bonus. If their income increases, as they hope it does, they might experience a marriage penalty. If combined they increase their income to $120,000 they’d jump to the 28% marginal rate assuming they both contributed 60,000 each, individually they’d be in the 25% bracket, so they might consider that in marriage considerations. Also, now, their standard deductions will each remain at 4750 or 9500 for both.
However, they should buy a house. The tax code definitely favors homeowners and offers many bonuses and imputed income. Heather and Bob experience horizontal equity disparities in relation to homeowners. Now, Heather and Bob pay rent with already taxed dollars and they are not allowed a deduction. They are throwing money down the tubes. If they bought a home they could secure a loan, which is not income, as a mortgage on the house and pay for the house over an extended period of time. You’d rather pay later and have your dollars now! Additionally, they’d have the house as collateral to secure other loans including home equity loans on which interest would be deductible to them. They could pay other debt with that loan and still deduct the interest. Furthermore, if they lived in house for 2 years they could take advantage of the nonrecognition provision of 121 and have non-taxable gain, although presumably, it would take a lot longer to have gain on the house -- but the imputed income of having their own home would make them all warm and fuzzy! Also, they could deduct state and local property taxes and possibly itemize, as the itemized deductions would likely exceed the standard deduction amount. If they itemized their deductions, they’d be able to deduct interest on a qualified residence loan -- like a home equity loan or a home acquisition loan. If they were itemizers they might be able to deduct the tax advice under § 212(3) but it would be subject to miscellaneous limitations, § 67.
On his birthday, Bob gifted Heather a fur coat. Bob’s basis in the coat per 1014 is a “stepped up” basis. A great deal for people and inheritors who bequest appreciated property as the appreciation is never taxed. Upon the gift, as nonrealizing event, neither Bob nor Heather realized any income and Heather’s basis is a carryover basis of $100. When she sells the coat for 225 dollars, she has a gain of $125 of which would be a capital gain taxed at lower rates because it’s a personal use asset.
Bob should be deducting the interest on his student loans § 221. He can deduct up to $2,500 per year if his income is < 65,000, which it is. This deduction is above the line per § 221. So, he can deduct 2,500 unless Heather and Bob get married immediately upon my advice and against my advice, file separately.
Bob has additional deductions in 2003. Because he is self-employed, he is allowed to deduct expenses incurred in his business above the line. This would include the current expense of supplies, which would not be capital asset but are currently deductible, as keeping track of and depreciating them would be administratively difficult. When a deduction is taken of cost, the items have a basis of zero. He’s glad to take the deduction immediately because he’d rather pay less today in taxes. The 8,000 of equipment is likely a capital expenditure which would be subject to the ACRS as it has a useful life of greater than 1 year. The sales tax is also deductible as a current business expense above the line. Although because Bob is a software developer, he might be subject to UNICAP rules which state that the cost of producing self-created assets must be capitalized. This includes all direct and indirect costs, which must be allocated to tangible personal property produced by the taxpayer. Indirect expenses would include salaries, warehouse, overhead and insurance but not marketing or advertising. However, the UNICAP rules exclude retailers and wholesalers with gross receipts < 10,000,000 and writers, artists and photographers. Because Bob doesn’t likely have an inventory, I doubt he’d be subject to Unicap rules.