Income
Tax I
Bogdanski
Fall 2014
Sample Answers to Question 2
Exam No. 9535
DANA
Self-employed
Dana might be able to deduct
trade/business expenses on the (more-preferential) above the line basis b/c she
is self-employed. This might help reduce her tax burden.
Rent
Our tax system is automatically set to
disadvantage Dana, she will not be able to deduct any expenses for her personal
rent (compare to a homeowner that would be able to deduct loan interest from a
qualified residence and also deduct property taxes.) Hopefully the economic
argument is true and Dana will receive a lower rent b/c the true owner got to
deduct these costs. But call me a skeptic.
Home Office
Taxpayers can deduct costs under 280A for
the use of a home office if certain requirements are met. This section applies
to a "dwelling unit" used as a residence, and is not limited to one
that is rented. Therefore Dana might be able to use a deduction if she
otherwise qualifies. Under (c) the location must be "exclusively
used" on a "regular basis" as (A) a principal place of business
for any trade or business of the taxpayer - this is met b/c Dana does all of
her design and administrative work in the converted space. There are two tests
to meet - "relative importance" for a clothing designer is designing
the clothing, and this is done in the home office space. The second test is the
"amount of time". Unknown in the facts whether Dana meets this test.
However, it may not matter b/c she would
not meet the "exclusive use" rule if the shed space she uses for yoga
is the same as the garage space she uses for her business. If so, her yoga use
would preclude Dana from deducting any of the costs of the home office because
her use is no longer "exclusive" for business.
If she doesn't do yoga in the space (or
ceased doing yoga in a future tax year) she could deduct a prorated amount of
the expense for her home office, based on the sq footage 10% of $1500 rent =
$150 per month. This would be deductible as a 162 above the line expense and
not subject to any AGI floor b/c she is self-employed.
Blackacre - Loans
Generally, a loan is not income, rather
it is money received with a commensurate obligation to pay back in the future.
When Dana receives $270k she has no income.
When the amount of a loan received is
greater than the amount paid back, the difference is income and is taxable as
ordinary income as a discharge of indebtedness. However, this concept does not
apply to non-recourse loans b/c the bank is getting what it bargained for -
either repayment, or the property. When Dana gives the property back to the
bank, and walks away from the $250k in debt, she does not realize any income as
a result of the $250 debt being wiped away. The fact that she is solvent plays
no role and 108 does not apply.
Blackacre - Property
Land cannot be depreciated, so it does
not appear that Dana took any deductions for the land, meaning she does not
have to pay anything back under the tax benefit rule. However, she may have a
165 loss from her dealing in property.
Under 1001(a) the gain or loss from a
property is the difference between:
1. the amount realized from a sale or
disposition of property - Dana has '"disposed" of the property when
she surrendered it to the bank, so this transaction qualifies for treatment
under 1001, it does not matter that she didn't "sell" the property.
This includes any amount of liability assumed. In Dana's case, the amount of liability
assumed is $250 (the value of the mortgage.)
2. and the taxpayers adjusted basis for
the property sold.
Under 1012 basis is defined as cost, but
subject to adjustment under 1016. Dana has made no improvements so she does not
have an adjustment to her original basis of $300k (cost). Her loss is $250 -
$300 = $50k. This matches the amount of investment she has put into the
property ($30k original + $20k principal on mortgage payments.) Her interest
was likely already deducted as a business expense b/c she held the property for
investment purposes, although it was probably subject to the 469 passive
activity interest which is restricted to offset passive activity only.
Land is a capital expense (defined under
1222 to include land held as investment) so this means her loss is a capital
expense and can only be deducted from capital gains under 1211(b) (except $3000
of the amount per year that is allowed to be deducted against ordinary income.)
Thankfully, Dana will be able to carry the loss forward indefinitely until she
is able to deduct against capital gains (but she cannot carry it backwards.)
Divorce
Under 215 alimony payments made are
deductible by the payor (and they are taxable to the payee under 71(a).) To
determine if this is alimony, there is a multi-part test -
1. under 71(b)(1) the payment must be in
cash - this appears to be met b/c the facts do not say anything other than
$1200 is paid so I assume this is cash
2. under 71(b)(1)(A) the payment must be
made under an instrument to divorce - met b/c facts say "under a divorce
settlement agreement"
3. (B) the parties must not have agreed
that the payment will be nontaxable to the payee and nondeductible to the payor
- no evidence they made this agreement b/c the agreement "says nothing
about the tax treatment"
4. (C) the members cannot be in the same
household - facts do not say, but presumed to be met since it is normally the
case with a divorce and the facts do not suggest this is a sham divorce.
5. (D) payments cannot continue after
death of payee spouse - this is not met b/c facts say payments must continue
after Harley's death and paid according to his will.
6. also cannot be child support and must
be substantially equal for the first three years (under periodicity rules) -
these are both presumed to be met b/c of absence of contrary facts.
Because this arrangement does not meet
item 5 above, this is not alimony under 215 & 71 and could instead be
treated as a property settlement under 1041. This is not as favorable to Dana
b/c she will not get a deduction for her payments to Harvey under 1041.
Death
Following her death, Dana's estate will
need to file her final tax return. The I.R.D. amount discussed below will not
be included because the money hasn't been received and Dana is presumed to be a
cash basis taxpayer per the test instructions. It will however, be included and
subject to estate tax b/c it is still property.
SETH
I.R.D.
Normally, gifts from a bequest are not
taxed to the recipient. Income in respect of a decedent refers to deferral of
money for services that were performed prior to the decedent's death and
discussed in 1014(c). Dana performed services for the manufacturing company,
but had not yet recovered the payment owed. Once the payment is made, Dana's
estate must report as income and tax normally (ordinary income - just like
income paid for services.) If any estate tax was paid, it can be deducted from
the IRD income reported.
Giftcard
Rather than accept money, Seth has opted
to take a giftcard. This is a barter (Dana's services exchanged for
manufacturer's giftcard) and subject to Rev Rul 79-24. The reportable income is
the fair market value of what the taxpayer receives from the other party. Seth
has received a $5k giftcard, so he must report $5k as income and pay tax on
that amount. This is ordinary income. The only exception is if estate tax was
paid on the $5k, if so, the value of tax can be deducted from income before it
is reported.
The remainder of Seth's inheritance, if
any, qualifies for gift treatment under 102 and is not taxed.
Exam
No. 9352
Tax Consequences to Dana & Seth
Home Office
Dana could argue that 10% of her rent of
$1500/month ($150/month) is deductible as a home office deduction under IRC
280A. This would be considered a business expense, and therefore be a above the
line deduction that Dana would get. In order to get this deduction Dana would
have to prove (see Popov) that her garage is used exclusively for
her business. There are also three requirements: (1) it must be your principal
place of business(PPB); (2) as place of business which is used by patients,
clients, or customers in normal course of business, or (3) separate structure
of dwelling. For PPB you must prove that it is the place where you do your most
important work. For Dana she could prove that it is her PPB because she does
all of her design work as a clothing designer and her administrative work in
her garage. It has been found that if you do all of you administrative work
somewhere it can be considered PPB. She could also argue that it is in her
garage so it is in fact a separate structure of the dwelling. Unfortunately for
Dana, she would fail this test anyways because Congress is very strict about
this and they do not want you to deduct unless you use it exclusively for home
office. Because Dana occasionally does yoga in the garage (i assume that is
what was meant by "shed"), it cannot be considered exclusively used
for her work. She would not be able to deduct under 280A.
Tufts - nonrecourse
loan, sell back to bank
Dana's situation is almost identical to
the case of Tufts involving debts and property transactions. The vacant
land that she owns in Blackacre (which is non-depreciable because it is just
land), is now at a lower FMV than she owes. Dana's adjusted basis in the land
is $300K (she bought it for that much, and is not able to take depreciations
because it is just land). This is however a capital investment (one that has
benefits over 1 year), this means she will get taxed at capital rates if she
gets a gain. Her nonrecourse loan means that she is not personally liable for
the loan, and she has her land as collateral for it. In order to figure out how
much gain or loss she has on her land we must first see that she borrowed $270K
after paying $30K to acquire the land. This resulted in a $300K basis (she can
do this! You get basis even if you use loan money!). She has repaid $20K of the
loan, so now she owes $250K. Thought the FMV of the land is $225K, we look at
what Dana will not have to pay back when we see her gain or loss from this
transaction. We will treat it like a 1001 sale or exchange of debt per se. The
amount of money she owes is $250K, she has a basis of $300K... Amount realized
= $250K; Adjusted Basis = $300K. ($250K - $300K) = $50K loss. This is
technically just Crane applied as well.
Because
this is a capital asset, we will then need to look at this as a capital loss or
income loss. All capital losses require a sale or exchange (1001). This is
satisfied as you look at it like she is selling her debt and house to the
bank. Under 1221, Dana will need to argue
that it is in fact an investment (which by the facts it is), and then she will
be able to get her capital loss from her land. This only applies as long as she
is not a real estate developer, which Dana is not. She could try to argue that
it is not used for a business, or she could try to argue that is used for
business and try to get 1231 which would allow her an ordinary loss, but it is
not likely to work for her. She will likely be able to get a capital loss
(which can only be deducted from capital gain +$3000) because it is an
investment property, not for business. If she does not have $47K (because
automatically gets $3K) of capital gain this year, she can carry it forward.
Once she dies, it will not be able to be carried forward (it dies with her).
Divorce Settlement - spousal support
When making the divorce settlement with
her former husband, Harley for $1200/month it look like they are trying for
alimony. Alimony under IRC 71 (income) and IRC 215 (deductions) for Dana would
result in an above the line deduction. There are many requirements of alimony,
and congress makes sure that people don't cheat the system by trying to include
child support or property settlements. It does not look like child support
would be a problem in this case. The four year agreement fits under alimony's
rule of 71(f) in deducting alimony over 3 years. The IRS may look at the first
years of alimony, and if there is any fluctuation will treat it as a property
settlement, and not allow the payor to deduct. There is however, a $15K de minimis
rule. Because their agreement involves four years of payment, and the
$1200/month for each payment, it will pass under IRC 71(f). Where there is a
problem is in the other alimony requirements. The requirements include: has to
be money, has to be received by or on behalf of a spouse under a divorce
written instrument, pursuant to the written instrument, the payor and payee
must live apart, and there is no obligation to pay after the payee dies. The
problem arise in the condition that Dana must continue making the monthly
payments to whomever Harley specifies in his will if he dies during the 4 year
period. This would not work under 71(b), and so the "spousal support"
payments would not fall under alimony. Unless they change this Dana cannot deduct
the payments!
IRD
This situation between Dana and her son Seth
would be an issue under IRC 1014. When Dana leaves the debt that is owed to her
by the manufacturing company XYZ, for $5000 she is leaving him with a problem
of Income in Respect of a Decedent (IRD). Seth will not get basis step up down
the road. This will be subject to income tax for Dana's estate, or in this case
directly to Seth. With the FMV of the IOU at $4800 when she dies, and XYZ
reaching out to Seth to make a deal to make a settlement for $5000 gift card in
exchange for the debt of $4800 this is permissible, however in an arm's length
exchange the FMV is assumed to be the same for both, so it would come out that
the FMV for the gift car could be argued to be $4800 for Seth. Because he will
be taxed in the place of Dana for IRD, he will want to argue getting the lesser
amount, which he will likely get. The manufacturer will be governed by the
UNICAP rules under IRC §263A however. For the company it is a similar situation
as well to Zarin. Because they get to settlement of their indebtedness,
they may deduct the $4800 which is agreed on (should be treated as the amount
of debt for tax purposes).
Exam
No. 9819
Dana's Home Office
The test of whether the expenses
associated w/ a home office are deductible is "exclusively used" on a
regular basis .... (for) a separate structure used in connection w/a trade of
business (biz). A deduction for expenses of maintenance and utilities are at
stake. If the shed and garage are the same thing, then the yoga that Dana does
would conflict with exclusive use in connection w/a trade or biz, but perhaps
an argument could be made the distress from the job that yoga provides is in
connection w/ her trade or biz. The yoga probably does conflict w/ the exclusive
use in connection w/ trade or biz b/c exclusive use is a high bar. However,
Dana does much if not all of her work in the office and the design and admin
work is certainly in connection w/ her trade or biz. She has a chance for this
deduction. This deduction would be a biz expense and deducted from her ordinary
biz income above-the line.
Blackacre
Dana's basis in black acre is $300k. The
30k of her own money and the $270k that was borrowed. The principal amt
outstanding on the loan is 250k. Upon surrendering the property to the bank she
was discharged from her debt in the amt of 250k, b/c her basis was 300k, she
has a capital loss of 50k.
Land is not depreciable, so there it doesn’t
get the special 1221 treatment. The capital loss would only apply against any
capital gains, and up to 3k in the year of ordinary income. She can carry the
loss forward until she dies under 1211(b).
The Divorce
In order to deduct alimony there must be
a written agreement. The payments must be in cash. To or for the benefit of the
ex. No election to have payment not be alimony. The payor and payee must live apart,
and there must be no obligation to pay after payee dies under 215. There are
problems with the divorce settlement, which will make it hard for Dana to
deduct the alimony, which is unfortunate b/c alimony is an above-the-line
deduction. A problem is that the payments are allowed to continue after Harley
dies. Also, if this happens the payments would no longer be to the benefit of
the ex (Harley).
Gift from decedent
Because this is an account receivable the
bequethment is ordinary and not capital if it turns out to be income 1221(a).
Usually a gift form a decedent get a basis of FMV of the gift at the time of
death, which is 4800. However, Seth does not get the stepped up basis under
1014(c). Income that a decedent earns while alive, but does not receive until
after death gets no stepped up (i.e. FMV) basis. B/c the gift is A/R the gift
represent amts earned while his mother was alive. Seth will have to pay the
same income tax as his mother would have. This will be ordinary income to Seth.
Seth will also recognize a gain of 200 in the additional value of the gift card
above the $4800, which will be ordinary.