Income
Tax I
Bogdanski
Fall 2007
Sample Answers to Question 2
Exam No. 6822
Dear Mr. Charles:
I am writing you in regards to our meeting in which you inquired as to the tax consequences of several recent or potential transactions. In particular, the life insurance proceeds from Mom, the cabin that you inherited from mom, including the $250K outstanding home equity mortgage, the planned rental and personal use of the cabin, and the recent contribution of your automobile to charity. I have addressed each of your questions in detail below. Please review them carefully and do not hesitate to contact me with any questions that you may have. My bill will arrive shortly (which incidentally, is tax deductible per § 213(3), but below the line, subject to the 2% floor, and subject to AMT … c’est la vie).
First, congratulations on your recent windfall (oh yeah, sorry about Mom too … ).
Regarding the $100,000 that you received as a lump sum payment pursuant to Mom’s death had a basis of $65K. Under § 101(a), you are entitled the benefit without owing any tax on it. The policy of congress is that this is a bad time to tax folks, and thus the exemption has a “strong odor of condolence.”
Regarding the mountain cabin that you inherited, it was transferred to you by bequest, devise or inheritance, which under § 1014 qualifies for a “stepped up basis.” This means that although Mom had a basis of just $100K in the property, the $900K of potential capital gains is forgiven and your new basis will be stepped up to the full FMV of $1mil at the time of Mom’s death.
Unfortunately the cabin is encumbered by a hefty $250,000 home equity mortgage. You will have to make the payments on that mortgage using after tax dollars for the principle. A portion of the interest however is deductible. I’ll discuss the rental aspects below, but until such time that you engage in pursuit of a trade/business (e.g. rental income) using the cabin, under § 163(h)(3) you can deduct the interest on the home equity loan. You can deduct home equity interest on both your primary and secondary (the cabin) residences, however, the interest is limited to $100,000 of home equity indebtedness. Your $250,000 loan is already over this amount, not including any home equity loan on your primary residence. Any such deduction would be “below the line” meaning you must itemize to receive it.
Regarding your use of the cabin as a vacation rental. Renting out a property and using it for personal use brings up a tension between § 162 rental activity for a profit motive and § 262 use of personal property for personal reasons. Under § 280A(a) you will need to compute a fraction which includes the number of days rented to strangers at FMV divided by the TOTAL number of days the cabin wsa used at all (this includes by you or strangers who rented). So, if you used the cabin say 100 days (90 days for 3x summer months plus 5 weekends) and you rented the cabin at FMV to strangers for a total of 50 days, you would end up with a ratio of 50 / 150, or 1/3 (a third). You then apply this ratio to depreciation, dues, maintenance fees, insurance, utility bills, management rental fees, etc. Therefore, in such an example, which is based on your stated intentions and some guesses, you could “deduct” a third of all expenses and depreciation. These deductions may turn out to be sizable and will help to offset any PASSIVE ACTIVITY INCOME or losses that you have as a result of the vacation home. That is because the vacation home is real property and can be depreciated over 27.5 years per § 167, thus giving you a normal deduction of $1mil over 27.5yrs which equals $36,363/year. If you take 1/3 of this, you get $12,121 meaning that you can offset any passive rental income received from the property by $12,121 per year, plus a third of all other associated rental costs. If this amount turns out to be more than your total income, you can carry the amounts forward into future years. The depreciation deduction of course will be deducted from your $1mil basis per § 1016. Your depreciation will be calculated via the mid-month convention as used for all real estate, so the first month you place the rental into service, you will get ½ of 1 months deduction, then the full month going forward. These business related deductions for your rental would be above the line as they are in pursuit of profit/trade/business, but as stated, they are confined in a bucket to PAL income and losses only. Any income that you receive above and beyond your deductions will be ordinary income and thus, taxed massively at your highest marginal rate (the tax bracket in which your last dollar of income falls). All of the particular expenses that I mentioned would be considered ordinary and necessary expenses, and thus deductible current year as ordinary vs. capital expenditure.
Regarding the donation of your personal automobile. Your basis in this automobile was $30,000, however, as the auto was not used in the pursuit of a trade or business, you are not entitled to a business deduction. You are however, entitled to a personal deduction under § 170. This deduction will occur “below the line” meaning that you must itemize to receive it, and it cannot represent greater than 30% of your income. In order to qualify for the deduction, it must go to a qualified entity, which the school for trouble youth appears to be and the deduction must be verifiable by the secretary, typically via receipt. Although the car had a current FMV of $12,000 at a used car lot, a charity is not a used car lot and you are only entitled to deduct the amount of money that the school actually sold the automobile for under § 170(f)(12). This means you’re you will have an ordinary deduction, meaning deduct against ordinary income, in the amount of $9500.00, the actual sales price. You may take the deduction as a full current year deduction.
I wish you the very best. Please contact me with any questions that you may have.
Exam No. 6719
Dear Charles,
Below please find the tax advice you requested from me. For your convenience I have broken it down into sections.
A. Life Insurance
You do not have taxable income from the $1,000,000 life insurance benefit you received upon your mother’s death. The only person who has income from life insurance is someone who bought it for valuable consideration. That is not you, because you did not buy the life insurance.
B. Inheritance of the Cabin
You do not have income from the receipt of the cabin and land. However, it will be subject to estate tax. Your basis in the cabin will be $1,000,000, because when you receive a gift from an estate the basis is the fair market value at the time of the decedent’s death, under § 1014. However, if the estate uses a smaller basis for figuring the estate tax, you will be stuck with that as your basis. The equity loan will not effect your basis in the cabin, because basis is based on the fair market value, not the equity in the property.
Not to sound callous, but it is lucky for you, in terms of calculating your basis in this valuable property, because had she died in 2010 there would be no estate tax, but your basis would be the lesser of your mother’s basis ($100,000) or the fair market value of the property when she died.
C. Use of cabin as vacation home
IRC §280A covers vacation homes. Since you are planning on using the house for the entire summer it will probably be treated as a residence, because you will use it for more than 14 days or 10% of the days it is rented. This means the most of your expenses will not be fully deductible. The property taxes and mortgage interest will always be deductible. If you rent the house for less than 15 days, you can exclude all rental income, but cannot take any deductions other than interest and taxes. If you rent the unit for more than 15 days, you will have to create a ratio of days rented and days used for personal use (including friends staying there and not paying you). You can deduct other expenses, like insurance, maintenance and the fee to the rental company, according to the portion of the time the rental unit was rented. Remember that the total of your deductions cannot exceed the amount you make in rent, because this is passive activity.
D. Donation of car
For
the donation of the car to charity to be deductible, the charity must be
“permissible recipient” under §170. If it is a public school, then it is a
political subdivision of the state, and is a permissible recipient as long as
the contribution is for exclusively public purposes. It doesn’t seem like you
would get any gain out of donating the car, so you should be ok. If it is a
private school, to be a permissible recipient the school must meet the
following criteria: (1) be organized in the
There are special rules for donating cars under §170(f)(12). First, you need to have gotten a written acknowledgement of the contribution from the school within 30 days of them selling it, which includes: (1) the VIN number on the car, (2) your name and taxpayer identification number (your social security number), (3) certification that it was sold in an arm’s length transaction, (4) the amount of gross proceeds from the sale and (5) a statement that the deductible amount will not exceed the proceeds. Then, you can deduct $9,500, the amount of gross proceeds from the sale. This is a deduction below the line deduction from ordinary income.
There is a ceiling for deduction from charitable contributions, which could potentially be a problem if you have a lot of other charitable contributions this year or an exceptionally low adjusted gross income. If your deductions total 30% or 50% of your adjusted gross income (depending on the type of charity), then your deductions will be cut off there. But you would be able to roll the rest over to next year. This is an unlikely occurrence though.
Exam No. 6586
Memo to Charles (“C”):
Charlie you lucky dog! Your mother was kind enough to leave you quite a bit of excellent benefits from her death! Normally, accessions to wealth, clearly realized, as this, are gross income to you. Glenshaw Glass. However, Sec101(a) excludes “amounts received…under a life insurance contract, if such amounts are paid by reason of death of the insured.” Both the term component and the investment component are “amounts received” for purposes of this section. Because she died, her basis in the property is irrelevant and you do not need to include any gross income for purposes of income tax. See the gift and estate lawyer in the offices next to me for questions concerning those taxes.
The real estate is also a great deal but real estate lobbyists apparently have not made as good enough of an effort compared to insurance lobbyists. 102(a) excludes gifts and bequests from the gross income of the donee heir. However, Sec1014 steps up the basis in the property to the FMV at the date of Mom’s death. Therefore, you have received a $1M piece of property and your basis in that property is $1M.
The mortgage, on the other hand, will have to be repaid. Although no particular section explains this, loans are not income to the debtor at the time of receipt. Because of this, the IRS will want to the tax returned to them, which occurs when you pay the loan back out of after-tax income, despite the fact that no depreciation could be taken on the property since it was not held in a trade or business or for the production of income. The loan is an equity loan so oddly enough, although you are not allowed a deduction under 163(h) for personal interest, there are two exceptions including home equity indebtedness under 163(h)(3)(c). Your deduction for interest is limited by a $100k debt limit. Assumedly there was no refinancing or other acquisition related debt in this amount to avail of the other exception.
Sorry, Charlie, now for the really sad part. Now you want to use the home for part personal uses and part rental income. Sec 469 disallows deductions for “passive activity losses,” a loss on an investment that constitutes a trade or business and which the taxpayer does not “materially participate.” Because you intend to hire a management company, there won’t be much ability to argue that you are materially participating. 469(d)(1). That, and this specifically includes “any rental activity.” So, what this means is not that you can’t deduct, but that you can only offset passive activity income, such as your rental income. You cannot use it for your active business (salary) or against your portfolio (stock market). Passive losses may be carried forward.
The various provisions of the code intersect here. Under 280A(a), there is a general rule denying deductions for any uses of a “dwelling unit” for business purposes. This includes vacation homes. You intend to use the rental property for personal purposes in excess of 14 days or 10% of the fair rental days. Because of this, you will get limited deductions. Expenses other than interest and taxes must be prorated comparing rental to personal use. But the deduction cannot exceed the rent received, reduced by an allocable share of the interest and taxes. Thank the supreme one you don’t have actual figure for me because this calculation is a doozy. 280A(c)(5). You can carry any losses forward.
Good for you, donations to charity are a wonderful thing to do, especially for someone who has come into so much cash recently. Deductions for any charitable contribution, in the same taxable year, are allowed when donations go to an eligible donee. Likely the donee, a school for troubled children, is an eligible organization as a domestic organization organized and operated for an exclusively charitable, or perhaps, educational purpose. You may deduct this car at the FMV even if there is untaxed appreciation. However, under Sec170(f)(12) lest you thought to pump up this ragged vehicle into a big mack truck, you can only deduct for what the charity sells it for. Since the charity sold it for $9,500, we start there. This is a below the line deduction, although not a miscellaneous one, subject to 68 3% phaseout and AGI, but not subject to the Sec67 floor. You must keep records of the donation. You are limited to 30% or 50% of AGI depending on where this charity lands in the hierarchy.
The car was a capital asset. A capital asset must have been involved in a sale or exchange, which presumably you did, and under Sec1221(a) personal use assets are capital for purposes of gains (but not losses). Thus, your deduction is limited to capital gains.
Although it probably goes without saying, you cannot deduct the commuting you did in the vehicle. 162(a)(2) and Flowers.
Created by: bojack@lclark.edu
Update: 14 Jan 08
Expires: 31 Aug 08