Income Tax I
Bogdanski
Fall 2005

Sample Answers to Question 2

Exam No. 9041

 

A.  Muriel’s Truck

 

            Because Muriel is self-employed, any “ordinary and necessary” business expenses related to her house painting work would normally be deductible above-the-line against her income under § 162.  However, the purchase of a truck is generally considered a capital expenditure and not a current expense because the truck is an asset that can be expected to be useful for more than one year.  Therefore, normally Muriel would not be allowed to deduct the $40,000 that she spent on the truck in 2005.  Instead, the $40,000 would be attributed as basis in the truck, and she would be permitted to take depreciation on the truck each year. 

 

            The ACRS provisions of § 168 would apply because the truck is tangible property.  Under the ACRS scheme, a “light general purpose truck” will be depreciated over 5 years.  See § 168(e)(3)(B).  The half-year convention will apply, and the applicable depreciation method will be the double declining method (unless Muriel elects the straight line method, which would likely be less advantageous).  Under the double-declining method, Muriel’s deduction of her basis each year will be the Adjusted Basis / # Years In Period times 2.  Each year, for purposes of the calculation, the basis will go down by the amount deducted, unlike the straight method where the amount of depreciation remains constant throughout.  For the first year, Muriel’s deduction would be $16,000.  For the second year, the deduction would be $9,600, and so forth.  In the last year, the straight method would apply and the depreciation would be the basis remaining divided by the number of years remaining (or 1). 

 

            One minor modification to this approach should be noted.  Because the half-year convention applies, Muriel may only claim ½ year of depreciation when she deducts in 2005.  This means that she would deduct $8,000.  The remaining $8,000 plus half of $9,600 ($4,800 or $12,800 total) would be deducted in 2006, etc.  The half-year convention takes notice of the fact that a full year’s worth of depreciation should not be permitted to taxpayers that purchase property on December 31 of the year, but it also recognizes that some taxpayers purchase property early on.  Rather than complicating the accounting problems by using a proportional per diem calculation, the Code opts for a black-and-white rule that applies to all. 

 

            However, because Muriel qualifies as a small business under § 179, she may elect to deduct the entire basis of the truck right away, thereby treating the truck exactly the same as if it were a current expense and not a capital asset.  The small business election applies to purchases under $100,000 (except for real estate) by businesses that do not buy more than $400,000 in the year.  Because Muriel is only buying the truck at $40,000, she clearly qualifies. 

 

B.  Muriel and Donna

 

            When Muriel prepares her taxes, she is normally permitted to take one personal exemption for herself and one for each dependent.  Every taxpayer qualifies for the personal exemption just by showing up, although it is phased out for high income taxpayers (2% taken away for each $2,500 that the AGI exceeds the threshold amount indexed for inflation – currently $218,950 for surviving spouses). 

 

            Muriel will be able to take a personal exemption for herself, but she will not be able to take one for her daughter, Donna, because Donna does not qualify as a dependent under § 152.  A dependent is either a qualifying child or a qualifying relative.  Even though Donna still lives with her mother, a qualifying child must not earn more than one-half of his or her own support.  Because Donna earns more than one-half of her own support, she is not a qualifying child.  Nor is she a qualifying relative because Muriel does not pay for more than half of her support, and Donna (presumably) makes more than the personal exemption amount of $3200.

 

            Muriel will be taxed at the rate assigned to her taxable income for unmarried individuals, § 1(c).  She is not a surviving spouse because her husband died three years ago (presumably in 2002), and the surviving spouse qualification only applies when the spouse died during either of the two preceding taxable years (2003 or 2004).  Muriel is also not a head of household for purposes of determining her tax rate.  A head of household must maintain a home including at least one dependent.  For the reasons discussed above, Donna is not a dependent, and therefore Muriel will not qualify as a head of household.  The tax rates for head of household individuals are generally more advantageous than the unmarried individual rates.  Therefore, depending on Donna’s current income, the tax code may provide an incentive for Donna to work less and become a dependent of Muriel – a perverse incentive that demonstrates how the tax code may function as a tool of social policy. 

 

C.  Muriel’s Apartment Building

 

            Muriel must determine her capital gain or loss on the sale of the building according to § 1001.  Under the Crane case, Muriel’s amount received equals the amount of the mortgage that she no longer has to pay -- $540,000.  Under the Tufts v. Commissioner rule, Muriel may not claim that she only received the FMV of the property, $490,000, even though the mortgage on the property was non-recourse meaning that the bank was not legally entitled to seek Muriel’s personal assets to satisfy the mortgage.  For the same reason, the bank’s foreclosure on the apartment building is not treated as discharge of indebtedness income because the bank received full satisfaction of the loan in the amount to which it was entitled – the fair market value of the building. 

 

            Muriel’s basis in the property is the total cost to her, minus her depreciation deductions.   She purchased the property for $550,000, and she has spent $50,000 in improvements.  She has taken $75,000 in deductions.  Therefore her basis is $525,000 and under § 1001 she has a gain of $15,000 on the foreclosure.  The gain is a capital gain because it occurred during the exchange of a capital asset – the building.  Capital gain is treated more favorably than ordinary income the tax rates are lower.

 

            If the mortgage had been recourse rather than nonrecourse, the analysis would be slightly different.  On the sale, Muriel’s amount realized would be $490,000, giving her a capital loss $35,000.  Capital losses are less favorable than ordinary losses because they may only be taken against capital gains (Except losses resulting from the sale of real estate used in business.  Such losses will be treated as ordinary losses under the complicated combinations of §§ 1231, 1245, and 1250 – I believe the apartment building here would be a business property since it appears to be held for rental income).  In addition, the bank would have a possible cause of action against Muriel for $50,000 – the difference between the amount of her loan and the FMV of the property.  If the bank were unable to collect on the $50,000, then that amount would be discharge of indebtedness income to Muriel, taxable at ordinary income rates, not capital gain rates.  This would be an application of the Wayne Barnett theory that would work out poorly for Muriel.    

 

           

Exam No. 9284

 

            Muriel’s “new” 2-year old light general purpose truck satisfies the requirements of section 167 in that it is property, held for the use of trade or business and is subject to wear and tear, and thus would create a depreciation deduction for Muriel in 2005.  This deduction is figured under section 168, the accelerated cost recovery system.  The truck is considered “5 year property.”  Because the truck is depreciable property, Muriel could elect to use either the straight line depreciation method or the “double-declining balance” method.

 

            If Muriel decides to use the “straight-line” method, she would divide her original basis by the total number of years in payment to determine her annual deduction.  Her basis is $40,000 and the total number of years in the period is 5, giving her an annual deduction of $8,000.  Now, because her property was purchased in August, and tangible property requires a 1/2 year convention, she would be entitled to a deduction of $4000 in her first year of ownership. 

 

            If Muriel decides to use the “double-declining balance” method, the analysis changes.  She must again divide her basis of $40,000 by 5, the total number of years in the period, but then she must multiply the result ($8000) by 2.   Thus, in the first year before applying the convention, she would receive $16,000 depreciation deduction.  Again though, because she purchased her truck in the later half of 2005, the 1/2 year convention would kick in for the first year and provide her with a deduction of $8000. 

 

            Muriel also may be able to elect, under section 179, to treat the entire cost of her new truck as an expense, and thus deduct the entire cost of $40,000 in that first year. 

 

            These would all be ordinary losses or deductions because there hasn’t been a sale or exchange of property. 

 

            Muriel’s daughter is young enough that she could be claimed as a dependent, allowing Muriel to claim a personal exemption deduction for herself and Donna.  Unfortunately, Donna provides more than 1/2 of her own support, so Muriel cannot claim her as a dependent under section 152.  I think the fact that Donna provides more than 1/2 of her own support also precludes her from being a dependent for the standard deduction, which Muriel could otherwise take. Nonetheless, Muriel would have a personal exemption of $3200 for herself,  If she chooses not to itemize, she would also receive the standard deduction for herself of $5000.  These would both be ordinary deductions. 

 

            Muriel’s original cost basis of $550,000 for her apartment building was increased when she spent $50,000 to improve it.  This $50,000, I believe, was a capital expenditure, and thus, those improvement costs get rolled into her basis. Her adjusted basis after that was $600,000, which is also reduced by $75,000 to reflect the depreciation deductions she has also taken.  Therefore, in 2005, she has an adjusted basis of $525,000 in the apartment building.  When she walks away from the building and allows the bank to foreclose on it, she will realize a gain IF the outstanding balance of the mortgage exceeds her basis.  In this case, the outstanding mortgage is $540,000.  Her basis, as calculated prior is $525,000.  Therefore, the mortgage exceeds her basis by $15,000.  This is a gain for Muriel, and she will be taxed accordingly.

 

            Although this appears to be discharge of indebtedness income, which may be excepted, given the fact that Muriel is insolvent at the time, we know that it is not DOI income because the mortgage the bank held was a non-recourse mortgage.  Discharge of indebtedness income, which may be excepted under section 108, only occurs when the debt is forgiven for less than what is expected.  In a non-recourse mortgage situation, the bank gets exactly what they bargain for – the property that is secured by the mortgage and nothing else.  Therefore, the gain that Muriel sees of $15,000 is income to her.  As we saw in Crane and Tufts, this is about the benefit the taxpayer got when they bought the property, not the benefit when they walk away.  Muriel was able to deduct $75,000 in depreciation during her ownership, and that needs to be accounted for.

 

            Finally, the gain that Muriel realizes are capital gains.  They are gains realized on the disposition of property that was held as an investment.  Therefore, the $15,000 of gain that Muriel will be taxed on will be taxed at a more favorable rate than ordinary income. 

 

 

Exam No.  9137

 

Truck

 

            Muriel will not be able to deduct the whole expense of the truck ($40,000) immediately. Instead she will have to depreciate it under § 167. In determining how to depreciate a particular piece of property, the taxpayer needs to look at the applicable method, recovery period, and the convention.

 

As for Muriel’s recovery period, trucks and autos are depreciated over a period of 5 years under § 168(c).

 

As for Muriel’s method, she will have a choice of using either the straight line method or the double-declining balance method.

 

            Under the straight line method, the depreciation will be the original basis of $40,000 / total number of years in the period of 5 = $8,000. Thus, under this method, Muriel would be able to deduct $8,000 per year, subject to the ½ year convention under § 168(d)(1). This would mean that in 2005, Muriel would only be able to deduct $4,000.

 

            Muriel may find it more advantageous to depreciate under the double-declining balance method. The calculation is as follows: the adjusted basis of $40,000 / total number of years in period of 5 = $8,000 multiplied by two = $16,000. Thus, her deduction in 2005 would be $16,000 subject to the ½ year convention of § 168(d)(1), brining Muriel’s total deduction down to $8,000.

 

            Muriel may also have the option of deducting the entire basis right away at her election under §179. This section applies to small businesses and the cots of property are treated as an expense but it does not apply to real estate. Depreciable equipment may be deducted up to $100,000 per year. However, if Muriel were purchasing more than $400,000 of depreciable property, then this election cannot be used.

 

Personal exemption - Donna

 

            Muriel will not be able to take as an exemption her daughter, Donna, because she is not a qualifying child. § 152 defines a dependent qualifying child as (1) the taxpayer’s child or grandchild, linear descendant, sibling, niece or nephew (2) that lives with the taxpayer more than ½ the year and (3) is under the age of 19 or under 24 if a fulltime student and (4) doesn’t provide more than one half of her own support. Donna meets the first three elements but fails on the fourth.

 

            Donna is Muriel’s child; she lives with Muriel more than ½ the year; she is under 24 and a full-time student; however Donna provides more than one half her support. This means that Muriel will not be able to take a personal exemption as a below the line deduction of $3200 for Donna.

 

Personal exemption - Muriel

 

            Muriel will be able to take a personal exemption for herself because she is not someone else’s dependent (which would prohibit taking oneself as a dependent under § 151(d)(2)) as she provides more than one half of her support failing the qualifying relative test under § 152. Thus, Muriel will be able to deduct $3200 for herself as a personal exemption as a below the line deduction. If Muriel were married she would be entitled to deduct as a personal exemption $3200 for a spouse if he had no income. However, since Muriel is single, this is inapplicable.

 

Education expenses

 

            If Muriel is paying for Donna’s education it may be possible for her to take credits. § 25A provides credits for education expenses regardless of relation to the taxpayer’s job. There are two types of credits (1) the hope credit available during the first two years of college ($1500 per student) and (2) the lifetime learning credit which may be $2,000 per taxpayer for as long as the taxpayer is in school. These credits are subject to phaseouts at a certain income level. And under § 222, Muriel may elect to take a deduction instead of a credit for some of the tuition.

 

Apartment Building

 

            When Muriel originally purchased the apartment building she spent $550,000 making that figure her basis. However, since then, her basis has been adjusted. First, making improvements at a cost of $50,000 means that this figure will be added into her basis. She will get no deductions for the improvements but her basis will grow to $600,000. However, Muriel’s depreciation deductions of $75,000 bring her adjusted basis down to $525,000.

 

            When Muriel defaults on the loan and the bank forecloses on the property, Muriel may have income under a discharge of indebtedness theory. Kirby Lumber; § 61(a)(12). Muriel owes the bank $540,000 on a loan secured by a nonrecourse mortgage (NOTE: the loan is not income to Muriel. Muriel may also be able to deduct interest on the loan under § 62(a)(4)). When the bank forecloses it appears as though the FMV of the property is only $490,000. Thus, the difference between the debt ($540,000) and what the bank received in satisfaction of the debt ($490,000) is $50,000. It would appear that Muriel has $50,000 of income. This rule applies even when the nonrecourse mortgage exceeds the value of the property (as is the case here). Tufts. There is no opportunity for exclusion under § 108 even when the debtor is bankrupt or insolvent. Thus, Muriel would have $50,000 of capital gain. (NOTE: if Muriel had deductions from the apartment complex they would be passive, unless she is a real estate professional or qualified under the mom & pop exception, and could be deducted against her income as § 469 limits the taxpayer’s ability to take losses – may only be taken to the extent of passive gains).

 

            However, if I am incorrect, and § 108 does apply, then discharge of indebtedness if forgiven under § 108(a) when the debtor is in bankruptcy or insolvent. Muriel is insolvent under the bankruptcy sense of the word (which is what matters for § 108) as her liabilities exceed the FMV of her assets. Thus, Muriel has no income because of this foreclosure.  However, if she takes advantage of the exception form discharge she will lose some favorable tax attributes in the future. Muriel will not be able to carry over NOLs (they are all set to zero) and her basis would get reduced to zero (however that probably doesn’t apply here because she no longer has the property).

 

 

Exam No.  9200 – See pdf file here.

 

 

Created by: bojack@lclark.edu
Update:  23 Jan 06
Expires:  31 Aug 06