Income Tax I
Bogdanski
Fall 2004

Sample Answers to Question 2

Exam No. 6154

The award to Joe under the new law is designed to replace “damage” done to his property by the State’s land use regulations. As such, the award amount is to be treated as a return of basis. Since Joe’s basis is $100,000, he gets to reduce his basis on the property to $0 and then must report the excess, $150,000, as capital gain - since the land was held for investment for more than one year. (§ 1221). Also, because the land is a capital asset, Joe can deduct the $25,000 legal fees from his capital income, under § 212, as an expense for the production of income, resulting in a capital gain of $125,000.

Since the city condemned Joe’s property and paid him $500,000 in compensation, the transaction qualifies as an involuntary conversion subject to § 1033. Under this section, Joe may elect to only recognize $350,000 of capital gain on blackacre (amount realized – cost of greenacre) since he used $150,000 of the proceeds of the conversion to buy similar property, greenacre (land held for investment). In that case, his basis would rollover from the converted property and thus would be $0 in the new property. Or, Joe may recognize the entire $500,000 as capital gain and receive a basis in greenacre of $150,000, the cost of the property.

Joe’s $160 worth of internet costs are not deductible by Joe as a business expense. Joe is a dentist. Joe does not use the internet or his blog site as part of his business. He uses the site in his spare time as a means of entertainment. Joe’s $150 of donations is gross income for Joe. Joe is not a non-profit or charitable organization which can accept donations tax free. He is essentially receiving tips (or payments) for his services rendered (entertainment to readers). Joe may try to argue that since he must report his “donations” as gross income that he should be able to deduct his internet expenses as business expenses. But Joe only spends 20% of his total internet time on his blog. This means he is using the majority of his internet time doing other things. Joe’s blog is a hobby and not a business. As a hobby, Joe may deduct his hobby expenses from his hobby income under § 183. This means that $148 dollars is deductible from his $150 dollars of income ($140 blog cost + 20% ($40) internet cost). Joe has $150 of gross income from which he may deduct $148 in hobby expenses.

Exam No. 6147

Compensation Issues

This sale would most likely be similar to an easement per the Inaja Land case, rather than as something similar to water rights per the Gladden case because it would be exceedingly difficult to apportion this judgment to the property in question. The difference between the two approaches would be in regard to the amount of basis that could be used up in this Sec. 1001(a) transaction. The attorney fees would also go into basis, because any gain in this transaction will be gross income. If Inaja land rules, as expected, then this Sec. 1001(a) judgment transaction would be as follows:

$250,000 =Amount Realized

-100,000 + 25,000 attorney fees = Adjusted Basis

$150,000

Joe must record the $150,000 as a capital gain in the year that the judgment is made available to him. Joe’s basis in the property is now, “0”. Joe could try to retain some basis by claiming an apportionment of basis per the Gladden case, but it would be extremely hard to value. Additionally, he would probably not elect to do so, because saving more basis would only increase his capital gains for this transaction.

Condemnation Issues

Joe could elect to claim a special exemption under Sec. 1033 for involuntary conversions to reduce his capital gains as a result of the condemnation. If so then the transaction would be recorded as follows:

1. Realized gain

$500,000 – Amount Realized

$0 Basis, from the earlier transaction above

$500, 000 realized gain

2. Use the lesser of realized gain or the amount not reinvested in the like-kind property as recognized gain. Here the realized gain is $500,000 and the amount not reinvested is $500,000 - $150,000 = $350,000. Joe would recognize $350,000

3. The basis of the new property would be the cost of the new property minus the gain not recognized by the transaction =

150,000 – 150,000 = 0

If Joe elects to use this the special exemption for involuntary conversions under Sec. 1033, then his recognized gain would be only $350,000. If he elects not to use it, then his recognized gain would be the full $500,000 and the basis in the new property would be its cost, $150,000. In either case, he would need to recognize this gain, as a capital gain in the year of transaction. Most likely, he would choose to use the Sec. 1033 approach because the capital gains rate is not dependent on the level of income. Given a capital gains rate of 15%, using Sec. 1033 would save him $22,500 in taxes. Furthermore, any capital gains on the Greenacre would be deferred until Joe sells it.

Web Blog issues

At first glance, since Joe is a dentist and that is a busy full-time occupation, it appears that Joe’s web blog is properly designated a hobby. For one thing, there is no presumption that it is a business under Sec. 183(d)(3) because Joe cannot show a profit for 3 out of the last 5 years. Additionally, by looking at the venture through the nine factors in Reg. 1.183-2 that the IRS uses to distinguish hobbies from business ventures, the case is even stronger that it is a hobby:

Ø Manner in which the taxpayer carries on the venture – Appears to be a hobby as Joe works as a dentist.

Ø The expertise of the taxpayer – Joe is a dentist, does not seem to have professional writing background.

Ø Time and effort spent by the taxpayer. Here Joes spends only 20 percent of his time on the internet with the blog.

Ø Appreciation of assets expectation. Joe only hopes that it will generate more income, but per the Nickerson case, his expectation does not need to be reasonable, only that he was motivated.

Ø History of losses – from the facts, very limited history and it would appear to be all losses as the costs are much greater than the profits.

Ø Profit if any that are earned. No profits so far even with only 20% of the internet cost allocated to the business.

Ø Personal satisfaction. The blog is basically a recollection of Joe’s personal thoughts, more personal than business related.

Joe might try to claim his computer as a depreciable asset, or write it off as an expense using Sec. 179, in his business of blogging. However, this would not be allowed because for listed assets, depreciation is only allowed if it is used 50% for business and here Joe only uses the computer for his blog for 20% of his time on the internet, not to mention whatever else he uses the computer for.

The donation that he receives is ordinary income in the year of receipt since Joe is a cash method taxpayer. It is doubtful that Joe could claim that the amounts were gifts, rather than compensation. The money appears to be analogous to tip income, which has been held to be income. However, per Sec. 183(b), Joe can still zero out his hobby income, with hobby deductions. Joe’s hobby deductions could include both the amount of money to host the blog, $120, and possibly 20% of his high speed internet costs which, in a year, would be $96/year. Since Joe is a cash method taxpayer, he could only deduct 20% of the amount he paid. However, since his income is only $150, only a small portion of this would more than wipe out his hobby income. Per Sec. 183, he could not report a loss, only zero out his income.

Exam No. 6262

This question brings up a number of issues, Whether he can exclude compensation of the value of his property as a return of his basis or whether it is gain, whether he can deduct his attorney’s fees, whether he has to report any of the gain after Blackacre was condemned, and whether his blogging activity is a profit-oriented activity or whether they are hobby losses.

The issue with the award of $250,000 for local land use regulations diminishing the value of his property is whether this is a return of his basis, in part, or whether it is all gain. In Inaja Land the court held that Inaja could use their entire basis to get the amount received to zero. However, Inaja land applies to permanent easements on the property when it is involuntarily sold through government action. Since local land use regulations diminished the value of Joe’s property, this situation is more similar to Gladden v. Commissioner, where their water rights in perpetuity were involuntarily sold and they were allowed to use the basis that was allocable to water rights. Regulations 1.61-6(a) second the results of the Gladden case. Joe would need to allocate the amount of basis that is the source of his diminished property value to the amount he received to know how much was gain and then his basis would be diminished. For instance, if it was worth half of his basis (if it were a land use regulation which kept his water rights and it were farming land, for instance), then $50,000 would be allocated as basis to diminish his received amount of $250,000. This would leave Joe with a gain of $200,000, which would have to be reported in gross income under IRC 1001, as this is a sale or other disposition of property. There is now a question of whether this is capital gain or ordinary income. Since this is not in the list of IRC 1221(a)’s assets that do not generate capital gain and since it was land held for investment for several years under IRC 1221 and since there was a sale or other disposition of property under IRC 1001(a) it is capital gain and is subject to a highest tax rate of 15%, which is more advantageous to the taxpayer. In this transaction, Joe would want to know whether he could deduct his attorney’s fees as well. Since Joe is a plaintiff, under Regulation 1.262-1(b)(7), the test isn’t the origin of the claim but whether the recovery would be gross income. Since the recovery is gross income, Joe gets to deduct his attorney’s fees. He will have to report a capital gain of $175,000 (the $25,000 attorney’s fees subtracted from the $200,000 gain, assuming he was allowed to use 50% of his basis). If Joe’s case fell under Inaja land’s doctrine, then he would be allowed to use his entire basis and would report a gain lessened by the rest of the $50,000 in basis. That would be a capital gain of $150,000.

When Joe’s land is condemned, he will want to know whether he will have to report all of this as gain or whether some of it can be left out of his gross income. The general rule under IRC 1033 is that if the property as a result of its condemnation is compulsorily or involuntarily converted and converted into money then the gain will not be recognized if the taxpayer purchases similar property within two years after the close of the first taxable year in which the gain is realized. There will be little to no basis left on Joe’s property, if it falls under the regulations, and assuming that the basis allocable to the diminished value is 50%, then Joe will be left with a $50,000 basis. If the circumstances were deemed under the Inaja Land doctrine then Joe will have no basis left. The $150,000 that Joe uses to purchase Greenacre, a parcel of land he also plans to hold for investment, will not be recognized and will have a basis of its purchase price of $150,000, IRC 1033(1). The $500,000 (purchase price) minus the $50,000 (of basis) minus the $150,000 (reinvestment in a new property per IRC 1033(1) equals a gain of $300,000. If he fell under the Inaja Land doctrine it would be a gain of $350,000. This will have to be reported on his income tax as a capital gain. This is a capital gain because it is a sale or other disposition under IRC 1001(a) and it is a land held for investment under IRC 1221, it is also a long-term capital gain since it was held for years. This is a good thing for Joe because capital gain has a lower tax rate, the highest being 15%.

Joe also has a blog and would want to know whether he can deduct the $160 he spends on the ISP payment and the ($40 per month multiplied by 12) $480 he spends on his Internet costs. He would also want to know whether he has to report the donations of $150. The issue is whether this is a hobby or a profit-oriented activity. IRC 183(c) defines an activity not engaged in for profit as any activity other than one with respect to which deductions are allowable under IRC 162 (the “ordinary and necessary” business expenses) or under IRC 212 (expenses related to the production of income. There is also a rebuttable presumption in IRC 183(d) that an activity is engaged in for profit if, in three or more of five consecutive years, the activity earns a profit. IRC 212 allows for a deduction of expenses for the production of income. Since 20% of the time Joe spends on the Internet is related to his blogging activity, he will be allowed to deduct 20% of the $480, which is a deduction of $96. The $96 for his Internet service the $120 he pays his ISP total to costs of $216. Since the $216 exceed the donations of $150 (which will be includable in gross income since they are online tips and thus includable in gross income, Reg. 1.61-2(a)(1) and the point in Olk v. US that if it isn’t given with detached and disinterested generosity but is, instead, for some service, which is what these donations are) then Joe will have a loss of $66.

Joe could overcome the rebuttable presumption in IRC 183(d) by trying to establish that it is a profit-engaging activity. This turns on subjective intent, as illustrated in Nickerson v. Commissioner (7^th Cir. 1983), the taxpayer need only prove their sincerity rather than their realism. However, Regulation 1.18302(b) makes a determination of whether an activity is engaged in an activity for profit in light of all facts and circumstances and lists nine factors to evaluate the activity. These are whether the taxpayer carries on business in a businesslike manner and keeps complete and accurate books and records, the degree to which the taxpayer has prepared for the activity, either by study or consultation with experts, the time and effort expended by the taxpayer in carrying on the activity, the likelihood that assets used in the activity will appreciate in value, the success or failure of the taxpayer in carrying on similar activities, the history of income and losses with respect to the activity, the amount of occasional profits as compared with the taxpayer’s investment in the activity, the financial status of the taxpayer, and the degree to which the activity is recreational or for personal pleasure. Though, under the sixth factor, the losses in a start-up phase of an activity do not necessarily indicate that the activity is not engaged in for profit, due to the low likelihood of earning in this activity, and unless Joe can show he keeps accurate books of amount of time and money spent on blogging and the donations he accrues, or perhaps a trade magazine related to blogging, it is unlikely this will be deemed a profit-oriented activity. As a result, Joe can deduct hobby losses against hobby income only, IRC 183(b). So, Joe will still be able to deduct $150, the ordinary hobby losses to the extent of his gains in donations. However, though Joe can in theory deduct the $150, IRC 67 provides a two percent floor on miscellaneous itemized deductions. So, unless Joe’s income is under $7,500, in which case he wouldn’t have any income to report anyway because the personal exemption and standard deduction would exceed his income, then he get this deduction reflected against his hobby income.