Homework

Chapter 8

Deductions: Itemized Deductions

OBJECTIVES

After completing  Chapter 8 , you should be able to:

1. List items making up the medical expense deduction.

2. Determine the deduction for state and local taxes.

3. Apply rules for the interest expense deduction.

4. Explain the requirements for the charitable contribution deduction.

5. Calculate the limitations on the charitable contribution deduction.

6. Compute the ordinary business income deduction.

OVERVIEW

In computing taxable income, personal, living, or family expenses are generally disallowed. However, tax rules do allow some deductions for expenses which are essentially personal in nature. These types of expenses are deductible from adjusted gross income, referred to as itemized deductions, and deducted on Schedule A of the individual tax return.

This chapter discusses those expenses that are specifically allowed as itemized deductions. These deductions include: medical expenses, taxes, interest, charitable contributions, and limited personal casualty losses.

Medical Expenses

¶8001

REQUIREMENTS FOR THE DEDUCTION

Individuals can deduct many types of medical expenses as itemized deductions. The deduction is allowable only to individuals and only for medical expenses actually paid during the year, regardless of when the expenses were incurred or the method of accounting used by the taxpayer. Any medical expense deduction will be reduced by the amount of any insurance reimbursement or other similar compensation. Only medical expenses in excess of 7.5% percent of adjusted gross income (10% after 2020) are deductible. Code Sec. 213.

EXAMPLE 8.1

Jerome Jenkins, 35, has an adjusted gross income of $20,000 and pays for the following medical expenses during 2020:

Medical insurance	$1,820
Medicines and drugs	175
Other medical expenses	500

The medical deduction is computed as follows:

Medicines and drugs	$175
Medical insurance	1,820
Other medical expenses	500
Total Medical Expenses	$2,495
Less 7.5% of $20,000 (adjusted gross income)	1,500
Total Medical Expense Deduction	$995

For medical expenses to be deductible, they must be for the medical care of the taxpayer, the taxpayer’s spouse, or someone who would have qualified as a dependent of the taxpayer under pre-2018 rules – that is, a qualifying child (meets relationship, residency, age and support tests) or a qualifying relative (meets relationship, gross income and support tests). A child of divorced parents is treated as the dependent of both parents for purposes of the medical expense deduction. The gross income requirement is waived for purposes of determining who is a “dependent” with respect to the medical care deduction.

EXAMPLE 8.2

Joan Farley pays medical expenses for the care of her father. Joan also pays over half of the support of her father but would have been unable to claim her father as a dependent under pre-2018 law because his gross income for the year was too high. Joan may include the medical expenses for the care of her father in her medical expense computation even though she can not claim her father as a dependent.

¶8015

MEDICAL CARE EXPENSES

The medical expense deduction is specifically limited to amounts spent for medical care. The term “medical care” is broadly defined to include amounts paid for the diagnosis, cure, mitigation, treatment, or prevention of disease. Accordingly, payments for the following are payments for medical care: hospital services, nursing services, medical, laboratory, surgical, dental and other diagnostic and healing services, X-rays, medicines, and drugs. Amounts paid for accident or health insurance are generally deductible as medical expenses. Further, expenses paid for “medical care” include those paid for transportation primarily for and essential to medical care, such as the expense of using an ambulance. Amounts expended for illegal operations or treatments are not deductible. An expenditure which is merely beneficial to the general health of an individual, such as an expenditure for a vacation or for health club fees, is also not deductible.

Payments for unnecessary cosmetic surgery (such as facelifts or cheek implants) whose purpose is solely to improve the patient’s appearance do not qualify as a medical expense deduction for tax purposes. This rule does not apply to cosmetic surgery necessary to help correct a deformity arising from a congenital abnormality, or heal an injury arising from an accident or a disfiguring disease. Any employer reimbursements for unnecessary cosmetic surgery under a medical expense reimbursement plan must be included in the gross income of the employee in the year received.

EXAMPLE 8.3

In June 2020, Jane Martin undergoes a liposuction operation solely to improve her physical appearance. None of the expenses related to this operation would be deductible for tax purposes on her 2020 income tax return.

EXAMPLE 8.4

Should the costs of changing one’s sex qualify as a medical deduction? After all, the change is just cosmetic and isn’t necessary, is it? Interestingly, gender identity disorder is a condition recognized by the medical community, so a strong case can be made that a sex reassignment surgery is just a means of treating that condition. A 2010 Tax Court case (O’Donnabhain, 134 TC No. 34, Dec. 58,122 (2010)) ruled that a sexual reassignment surgery was deductible as a medical expense. Although it initially disagreed, the IRS later decided to follow this decision. Action on Decision 2011-003, Nov. 4, 2011.

¶8025

CAPITAL EXPENDITURES

Capital expenditures for home improvements and additions which are constructed primarily for the medical care of an individual generally qualify for a medical expense deduction only to the extent that the cost of the improvement or addition exceeds any increase in the value of the affected property that is due to the improvement. The entire cost of additions or improvements that do not increase the value of the home is deductible as a medical expense. Medical expense deductions have been allowed for the costs of installing elevators in the homes of persons suffering from heart disease, air conditioning devices for persons suffering from allergies, and specially built swimming pools for persons suffering from polio.

EXAMPLE 8.5

Gary Greene is advised by a physician to install an elevator in his residence so that his wife, who is afflicted with heart disease, will not be required to climb stairs. If the cost of installing the elevator is $1,500 and the increase in the value of the residence is only $1,100, the difference of $400 is deductible as a medical expense. However, if the value of the residence is not increased by the addition, the entire cost of installing the elevator qualifies as a medical expense.

Specific types of capital expenditures incurred to accommodate a personal residence to the needs of a physically handicapped individual are fully deductible medical expenses since these types of expenditures do not increase the fair market value of the residence. Examples are construction of entrance ramps, widening of doorways, or installation of railings to allow use of wheelchairs,

Capital expenditures which are related only to the sick person and not related to permanent improvement or betterment of property are deductible if such expenditures otherwise qualify as expenditures for medical care. For example, expenditures for eye glasses, handicapped service animals, dentures, artificial limbs, wheel chairs, crutches, inclinators, or air conditioners (if detachable from the property and purchased only for the use of a sick person) are deductible.

¶8035

TRANSPORTATION AND LODGING EXPENSES

Transportation expenses incurred in order to obtain medical care are deductible. However, the transportation deduction does not include the cost of any meals while away from home receiving medical treatment unless the meals are provided as part of the in-patient care at a hospital or similar facility. If a doctor prescribes an operation or other medical care, and the taxpayer chooses for purely personal considerations to travel to another locality for the medical care, neither the cost of transportation nor the cost of meals and lodging is deductible. Instead of a deduction for actual expenses incurred, a standard mileage rate of $.17 per mile for 2020 is allowed in computing the cost of driving an automobile for medical purposes. Parking fees and tolls may be deducted in addition to the mileage rate deduction.

Lodging while away from home on trips that are primarily for and essential to medical care is deductible. This deduction is not allowed for amounts paid for lodging that is lavish or extravagant. No medical deduction is allowed for any amount of lodging expenses if there is any significant element of personal pleasure, recreation, or vacation in the travel away from home.

The amount of the deduction for lodging is subject to a limitation of $50 per night for each eligible person. The deduction is allowed not only for the patient but also for a person who must travel with the patient. This means that if a parent accompanies a dependent child on a trip away from home for medical treatment, the parent could deduct up to $100 per day for lodging expenses.

EXAMPLE 8.6

Corola Combs travels out of state for special surgery for her daughter. She travels 400 miles round trip and incurs $12 in parking fees and tolls. Corola spends three nights in a hotel while her daughter is in the hospital. Her lodging expense totals $165, and she spends $90 eating out. Her meal expenses are not deductible. Her other qualifying medical expenses are:

Lodging limited to $150 ($50 per night × 3 nights)	$150
Mileage 400 miles × $.17 per mile	68
Parking fees and tolls	12
Qualifying medical expenses from trip	$230

¶8045

HOSPITAL AND OTHER INSTITUTIONAL CARE

The cost of in-patient hospital care (requiring an overnight stay), including the cost of meals and lodging, is deductible. The extent to which expenses for care in an institution other than a hospital (e.g., a nursing home, home for the aged, or therapeutic center for alcohol or drug addiction) qualify as a deduction for medical care is primarily a question of fact, and depends on the condition of the individual and the nature of the services received. If the availability of medical care in an institution is the principal reason for the patient’s presence there, the entire cost of the care, including meals and lodging furnished incident to such care, is deductible. However, if an individual is placed in the institution primarily for personal or family reasons, then only that portion of the cost attributable to medical or nursing care (excluding meals and lodging) is deductible.

EXAMPLE 8.7

Alexis Amberson is 80, totally disabled, and suffers from a chronic ailment. Her family places her in a nursing home equipped to provide medical and nursing care services. The nursing home expenses are $25,000 a year. Of this amount, $8,500 is directly attributable to medical and nursing care. Since Alexis is in need of intensive medical and nursing care and has been placed in the nursing home facility for this purpose, all $25,000 is deductible (subject to the 7.5 percent of AGI limitation). Had Alexis been placed in the nursing home primarily for personal or family considerations, only $8,500 would be deductible.

Although education ordinarily does not qualify as medical care, special schooling for a mentally or physically handicapped individual is deductible, if the resources of the institution for alleviating the individual’s mental or physical handicap are the principal reason for the individual’s presence there. In such a case the cost of attending the school includes the cost of meals and lodging, if supplied, and the cost of ordinary education that is incidental to the special services furnished by the school.

¶8055

MEDICINES AND DRUGS

Only amounts paid for insulin and prescription medicines or drugs are deductible as a medical expense. Pharmaceutical items acquired without a prescription (such as over-the-counter ibuprophen or allergy medicines) do not qualify even though they are used for a particular illness, disease, or medical condition. Cosmetics and toiletries are not considered medicines and drugs.

EXAMPLE 8.8

Larry James, 28, had adjusted gross income of $22,000 in 2020. He paid a doctor $800 for medical expenses, a hospital $2,000, $200 for prescription drugs, and $150 for over-the-counter cold remedies and vitamins during 2020. His 2020 medical expense deduction is computed as follows:

Doctor	$800
Hospital	2,000
Medicine and drugs	200
Over-the-counter cold remedies and vitamins	0
Medical expenses	$3,000
Less: 7.5% of $22,000 (adjusted gross income)	1,650
Allowable medical expense deduction	$1,350

¶8065

MEDICAL INSURANCE PREMIUMS

A medical expense deduction is allowed for premiums paid for medical care insurance (including contact lens insurance), subject to the 7.5 percent limitation. If amounts are payable under an insurance contract for other than medical care (such as indemnity for loss of income or, life, limb, or sight), no amount paid for the insurance is deductible unless the medical care charge is stated separately in the contract or furnished in a separate statement. Long-term health care insurance premiums are deductible, but in 2020, the maximum deduction for prepaid long-term care insurance premiums is $430 for a taxpayer age 40 or less to $5,430 for a taxpayer more than age 70.

The basic cost of Medicare insurance (Medicare Part A) is not deductible unless voluntarily paid by the taxpayer for coverage. However, the cost of extra Medicare (Medicare Part B) is deductible. Self-employed persons are allowed to deduct 100 percent of amounts paid for health insurance for herself, her spouse, her dependents, and her under-27-year-old children as a business expense (deductible for adjusted gross income). Code Sec. 162(l). See  ¶6575  for a discussion of deductions for Medical Savings Accounts. In general, this deduction is reduced by any premium tax credits the taxpayer takes.

Medical expenses are deductible only in the year paid. If medical expenses are reimbursed under a medical care insurance plan in the same year as paid, then the reimbursement merely reduces the amount that would otherwise be deductible. However, where reimbursement, from insurance or otherwise, for medical expenses is received in a year subsequent to a year in which a deduction was claimed, the reimbursement must be included in gross income in the year received to the extent attributable to deductions allowed in the prior year.

EXAMPLE 8.9

Morris Masters, 45, had adjusted gross income of $60,000 in 2020. He had a medical operation and, as a result, paid $5,000 in 2020 for hospitalization and $700 in doctors’ bills. His transportation mileage for medical reasons totaled 200 miles. He also paid $640 for prescription medicines and drugs, $275 for contact lenses, and a $900 medical insurance premium in 2020. Under the medical insurance policy carried by the taxpayer, there is an allowance for the operation of only the first $1,000, which amount Morris received in 2020. His deduction for medical expenses is computed as follows:

Hospitalization (medical operation)	$5,000
Less: Reimbursement from insurance company	1,000	$4,000
Premium on medical insurance policy		900
Doctors’ bills		700
Prescription medicines and drugs		640
Contact lenses		275
Transportation for medical purposes (200 miles × $.17)		34
Total		$6,549
Less: 7.5% of $60,000 (adjusted gross income)		4,500
Total medical expenses deduction		$2,049

If Morris received the $1,000 reimbursement in 2021 rather than 2020, he would have a deduction of $3,049 ($2,049 + $1,000) in 2020 and income of $1,000 in 2021 (assuming he itemizes in 2020).

Taxes

¶8101

SUMMARY OF DEDUCTIBLE TAXES

The following taxes are deductible as itemized deductions (Code Sec. 164(a)):

1. State, local, or foreign real property taxes

2. State or local personal property taxes

3. State, local, or foreign income taxes

4. State and local general sales taxes

The aggregate itemized deduction for the above taxes is limited to $10,000 ($5,000 for married, filing separately). The $10,000 limit does not apply to taxes in categories (1) and (2) above (or to foreign income taxes) if they are trade or business expenses or are incurred in the production of income. The following discussion of taxes relates only to the deductibility of nonbusiness taxes by individuals.

¶8105

PROPERTY TAXES

Local and state real property taxes are generally deductible only by the person upon whom they are imposed, and in the year in which they were paid or accrued. If they relate to nonbusiness real property, they are deductible as an itemized deduction.

A tax paid for local benefits such as street, sidewalk, and other similar improvements (also known as special assessments) is not deductible if imposed because of some direct benefit to the property against which the assessment is levied. Special assessments are not deductible, even though some incidental benefit may flow to the public welfare. Special assessments can, however, be added to the basis of the related property.

If real property is sold during the year, the real property tax deduction must be allocated between the buyer and the seller based on the number of days during the year that each party held the property. The seller is treated as paying the taxes up to, but not including, the date of sale. This allocation is required regardless of which party actually writes the check for the property tax or the method of accounting used by the taxpayers.

EXAMPLE 8.10

William Wasserman sold land to David Deere on April 1. Property taxes of $14,600 were paid by David on November 27 to cover the real property taxes for the entire calendar year. Assuming it is not a leap year, William is entitled to a $3,600 real property tax deduction ($14,600/365 = $40 per day × 90 days). David is entitled to an $11,000 real property tax deduction ($40 per day × 275 days), but his itemized deduction for all state and local taxes would be limited to $10,000.

A tenant-stockholder in a cooperative housing corporation may deduct amounts paid or accrued to the corporation to the extent that they represent the tenant-stockholder’s proportional share of the real property taxes on the apartment building or houses and land on which situated. Similarly, a taxpayer who owns an apartment in a condominium apartment complex may deduct the taxes assessed on the taxpayer’s interest in the property and paid by the taxpayer each year, provided the taxpayer itemizes deductions in filing a federal income tax return.

To be deductible, personal property taxes must be ad valorem (i.e., a tax that is based on the value of the personal property.) A tax which is based on criteria other than value does not qualify as ad valorem. For example, a motor vehicle tax based on weight, model year, and horsepower, or any of these characteristics, is not an ad valorem tax. However, a tax which is partly based on value and partly based on other criteria may qualify in part.

EXAMPLE 8.11

Gayla Gopher paid $135 for motor vehicle license plates. The license plate fee is based on a combination of value and weight of the automobile. If $75 of the $135 fee is based on the value of the automobile, then $75 is deductible as a tax.

Taxes imposed by some states on intangible personal property or the income therefrom are deductible.

¶8115

INCOME AND SALES TAXES

State or city income taxes, including franchise taxes measured by net income, are deductible as itemized deductions by individuals. Either state and local sales taxes or state and local income taxes can be deducted, but not both. State and local income taxes on interest income that is exempt from federal income tax are also deductible. However, state and local income taxes on other exempt income are not deductible.

Taxpayers may deduct state and local income taxes withheld from their salary. They may also deduct tax payments made on prior year income in the year they were actually withheld or paid.

EXAMPLE 8.12

During 2020, Carl Castor had $1,200 in state income taxes withheld from his salary. In addition, he paid an additional $325 in 2020 when he filed his 2019 state income tax return. Carl’s state income tax deduction for 2020 is $1,525, the amount he actually paid during 2020.

Any estimated state tax payments made that are in fact not required to be made are not deductible. For example, if a taxpayer made an estimated state income tax payment but the estimate of the state tax liability for the year shows that the taxpayer will receive a refund of the full amount of the estimated payment, then the taxpayer was not required to make the payment and may not deduct it as an itemized deduction.

If a taxpayer receives a refund of state, local, or foreign income taxes, all or part of the refund may need to be included in income in the year received. The tax benefit rule requires the taxpayer to include a tax refund in gross income of the year received to the extent that a tax benefit resulted from the deduction of the item in the earlier year. This includes refunds resulting from taxes that were overwithheld, not determined correctly, or redetermined as a result of an amended return. The tax benefit from a refund of taxes that were paid in a year that the $10,000 limit on the deduction of state and local taxes applied is reduced by the reduction in the deduction in the prior year due to the limitation. A refund of state, local, or foreign taxes may not be used to reduce the amount of taxes paid during the year to lower the deduction. The taxes paid and the refund received must be reported separately.

EXAMPLE 8.13

Paul Plymouth, a single taxpayer, received a refund of $1,000 in 2021 from his 2020 state income tax return. Paul had total itemized deductions in 2020 of $12,600, including $2,500 for state income taxes. The amount to be included in gross income for 2021 is $200. The amount included is the lesser of the refund received ($1,000) or the excess itemized deductions taken in 2020 ($200). The $1,000 refund received in 2021 will not affect the itemized deduction for state income taxes in either 2021 or 2020.

Itemized deductions for 2020	$12,600
Less: Standard deduction for 2020	12,400
Excess itemized deductions for 2020	$200

Individual taxpayers are able to deduct the greater of state and local income taxes or state and local general sales taxes as an itemized deduction on their federal income tax returns. Code Sec. 164(b)(5). The amount to be deducted for state and local general sales taxes is either (1) the total of actual general sales taxes paid as substantiated by accumulated receipts, or (2) an amount from IRS-generated tables, plus the amount of general sales taxes from the purchase of a motor vehicle, boat, or motor home.

Interest

¶8201

REQUIREMENTS FOR DEDUCTION

Interest is the amount which one has contracted to pay for the use of borrowed money. For tax purposes the term has the usual ordinary, everyday meaning given to it in the business world. Old Colony R.R. Co., 3 USTC ¶880, 284 U.S. 552, 52 S.Ct. 211 (1932). Interest incurred in a trade or business is deductible. However, as discussed in  Chapter 6 , interest incurred to purchase assets on which the income is tax exempt (such as state and municipal bonds) is not deductible.

It is not necessary that the parties to a transaction label a payment made for the use of money as interest for it to be treated as interest. The method of computation also does not control its deductibility, so long as the amount in question is an ascertainable sum paid for the use of borrowed money.

The timing of a deduction for interest expense depends on whether the taxpayer is on the cash basis or the accrual basis. Taxpayers on the cash basis will deduct interest expense when the payment of the interest is actually made. Deducting the amount of the interest from the original loan amount is not considered “payment” for this purpose. Accrual basis taxpayers, on the other hand, will deduct interest as it accrues. Prepaid interest (“points”) is generally amortized over the life of the loan, but is currently deductible if paid in connection with a loan made to purchase the taxpayer’s principal residence. (See  ¶8265  for further information.)

EXAMPLE 8.14

On November 1 Ben borrows $10,000 to be used in his business. He actually receives $9,400, but will have to pay the full $10,000 back on April 30 of the next year. If he is a cash basis taxpayer, he will deduct the entire $600 of interest in the next year, when it is paid. If he is on the accrual basis, he would deduct $200 (2/6) this year and $400 (4/6) next year.

Interest deductions for tax purposes can be separated into six types: personal (consumer) interest, qualified residence interest, investment interest, trade or business interest, passive investment interest, and qualified education loan interest. Each of these six types of interest deductions is explained in the following sections.

¶8205

PERSONAL (CONSUMER) INTEREST

Generally, interest on personal loans is not deductible by individuals. The vast majority of nondeductible personal interest consists of interest on credit card debt, automobile loans, or student loans. Of course, if the credit card or automobile are used for business purposes then the related interest is business, not personal, interest, and is deductible. Similarly, under certain circumstances student loan interest is deductible (see below). Interest on tax deficiencies (even those arising from individual business income) is also personal interest, and it is therefore not deductible.

EXAMPLE 8.15

Sara Short incurs personal interest of $1,000 on an auto loan. Sara is not allowed an itemized deduction for the auto loan interest.

¶8210

QUALIFIED EDUCATION LOAN INTEREST

Taxpayers are allowed an interest deduction for AGI of up to $2,500 for interest paid on qualified education loans. Qualified education loans are loans incurred to pay expenses for undergraduate and graduate tuition, room and board, and related expenses. The deduction is phased out for single taxpayers with AGI between $70,000 and $85,000 and married taxpayers filing joint returns with AGI between $140,000 and $170,000. The deduction will be allowed in figuring adjusted gross income.

¶8215

QUALIFIED RESIDENCE INTEREST

Taxpayers may deduct interest on loans secured by first or second homes, but the homes must be “qualified residences.” A home is a qualified residence if it is the taxpayer’s principal residence or if it is a second residence designated for this purpose that is used for personal purposes for more than the greater of 14 days or 10 percent of the number of days it is rented (such as a vacation home). Taxpayers having more than two residences can designate each year which residence is to be considered the second residence. If the second residence is not used by the taxpayer or rented at any time during the year, the taxpayer need not meet the requirements that the residence be used for personal (nonrental) purposes for more than 14 days. Code Sec. 163(h).

Qualified residence interest on acquisition indebtedness is deductible. Acquisition indebtedness is up to $750,000 of debt ($1,000,000 for debt incurred before December 15, 2017) incurred to acquire, construct, or substantially improve any qualified residence and which is secured by the residence. If a residence is refinanced, the amount qualifying as acquisition indebtedness is limited to the amount of acquisition debt existing at the time of refinancing plus any of the amount of the new loan which is used to substantially improve the residence.

EXAMPLE 8.16

In 2020 Alexis Carson bought a house for $1,500,000 and paid $300,000 down on it. Her interest on the $1,200,000 initial mortgage was $72,000. The interest on $750,000 of her mortgage will be deductible. Her residence interest deduction will be limited to $750,000/$1,200,000 of $72,000, or $45,000.

Mortgage insurance premiums paid by a taxpayer in connection with acquisition indebtedness on a qualified residence are treated as qualified residence interest and are deductible as an itemized deduction through 2020. The allowable deduction is phased out ratably if the taxpayer's adjusted gross income exceeds $100,000 ($50,000 for a married taxpayer filing a separate return) .

¶8225

INVESTMENT INTEREST

The deduction for investment interest is limited to the amount of net investment income. Investment interest in excess of this limitation is carried forward and treated as investment interest in the succeeding tax year. However, an investment interest carryover is allowed in a subsequent year only to the extent the taxpayer has net investment income in the later year.

Definition of Investment Interest

Interest that is subject to the investment interest limitation is defined as interest on debt incurred or continued to purchase or carry property held for investment. Property held for investment includes any property that produces income of the following types: interest, dividends, annuities, or royalties not derived in the ordinary course of a trade or business. The most common types of property held for investment are stocks, bonds, and raw land.

Investment income includes gross income from property held for investment such as dividends, interest, and royalties. Net short term gains are normally included in the definition of investment income, and net long term gains are not. However, a taxpayer has the option of giving up the long-term capital gain rate (0/15/20%) on the sale of long term capital assets in order to have all or a portion of the long-term capital gains included as net investment income, thereby increasing the allowable deductible investment interest expense. The taxpayers also have the option of giving up the preferential tax rate treatment for dividends in order to have the dividend income included as net investment income.

Net investment income is investment income net of investment expenses. Investment expenses are deductible expenses (other than interest) directly connected with the production of investment income, such as investment advisor fees.

EXAMPLE 8.17

Roberta Ramsey has $17,000 of investment interest expense and $4,000 of net investment income in 2020. Her investment interest deduction for 2020 is $4,000. The other $13,000 of investment interest she paid may be carried over to 2021 and deducted in that year to the extent that it, together with 2021 investment interest and other investment interest carryovers, does not exceed the investment interest limitation.

¶8235

TRADE OR BUSINESS INTEREST

Most interest payments incurred in a trade or business are fully deductible for tax purposes. Trade or business interest payments are deductible in computing adjusted gross income and are discussed in  Chapter 6 .

¶8245

PASSIVE INVESTMENT INTEREST

Passive investment interest is the interest incurred on money borrowed to invest in a passive activity. The amount of passive investment interest is subtracted from any gain or added to any loss from the passive activity. Losses from passive activities are subject to the passive loss limitation rules explained beginning at  ¶7201 .

¶8255

PAYMENTS FOR SERVICES

Payments for specific services which the lender performs in connection with the borrower’s account are not deductible as interest. For example, interest does not include the separate charges made for investigation of the prospective borrower and the borrower’s collateral, closing costs of the loan and the papers drawn in connection with the closing, or fees paid to a third party for servicing and collecting the particular loan. Rev. Rul. 69-188, 1969-1 CB 54.

¶8265

PREPAID INTEREST

Taxpayers on either the accrual or cash method of accounting are generally required to deduct prepaid interest over the time period during which the prepaid interest represents the cost of using the borrowed funds. Interest subtracted in advance from the proceeds of a loan is not considered paid until the loan payments are made.

EXAMPLE 8.18

On October 1, 2020, Horace Holmes borrows $50,000 from the bank on a one-year, 10 percent loan. The bank subtracts the interest in advance and remits $45,000 to Horace. He pays the due amount of $50,000 on September 30, 2021. Horace has an interest expense deduction of $5,000 for 2021. He is not considered to have prepaid the interest in 2020. If he had received the full $50,000 from the bank and prepaid the $5,000 interest in 2020, $1,250 (3/12) would have been deductible in 2020 and $3,750 (9/12) would have been deductible in 2021.

“Points” are additional interest charges which are usually paid when a loan is closed and which are generally imposed by the lender in lieu of a higher interest rate. Where points are paid as compensation for the use of borrowed money, rather than as payment for the lender’s services, the points substitute for a higher stated annual interest rate. These types of points are similar to a prepayment of interest, and are to be treated as paid over the term of the loan. An exception allows the current deduction of points paid in connection with a mortgage incurred in the purchase, building, or improvement of the taxpayer’s principal residence. This exception applies only if points are generally charged in the geographical area where the loan is made and to the extent of the number of points generally charged in that area for a home loan. Points paid on refinancing must be deducted ratably over the life of the loan. Any unamortized points are deductible when the loan is paid off.

Charitable Contributions

Contributions made to “qualified domestic organizations” by individuals and corporations are deductible as charitable contributions. Code Sec. 170. Any charitable contribution actually paid during the year is allowable as a deduction regardless of the method of accounting used by the taxpayer.

Ordinarily, a contribution is deemed made at the time delivery is made. The unconditional delivery or mailing of a check which subsequently clears in due course will constitute a contribution on the date of delivery or mailing. A “pledge” by a taxpayer to make a contribution is not deductible until it is actually paid.

EXAMPLE 8.19

On December 1, 2020, Sherri Jones made a pledge to donate $1,200 to the City Museum. She mailed a check for $800 to the museum on December 30, 2020, and mailed another check for $400 on January 31, 2021. The museum did not receive the $800 check until January 5, 2021, and deposited it on January 6. The museum received and deposited the $400 check on February 3, 2021. Her pledge does not affect the timing or the deductibility of her contributions. She can deduct $800 in 2020, the year the $800 check was mailed (the time of “delivery”), and the other $400 is deductible in 2021.

¶8301

QUALIFIED ORGANIZATIONS

To qualify for the deduction, a contribution must be made to one of the following organizations:

1. The United States, a state, a possession of the United States, or any political subdivision of the foregoing

2. Corporation, trust, community chest, fund, or foundation that is created or organized in the United States and operated exclusively for religious, charitable, scientific, literary, or educational purposes

3. Veterans’ organization

4. Domestic fraternal society

5. Nonprofit cemetery company

Generally, contributions made to foreign organizations are not deductible. No deduction is allowed for amounts paid to an organization which participates in any political campaign activities on behalf of or in opposition to any candidate for public office.

Gifts made to individuals generally are not deductible. For a contribution to be deductible, a donor cannot earmark it for the benefit of a specific individual.

EXAMPLE 8.20

Fred Fromm made donations to needy individuals. The payments were made by Fred from personal funds directly to the individuals after an investigation of their needs. There was no specific fund established or maintained by Fred or any other person for the purpose of distributing the money to the needy individuals. Fred is not allowed a charitable contribution deduction for his donations to the individuals.

EXAMPLE 8.21

Charlotte sets up an account with GoFundMe to raise money for her personal medical expenses. George contributes $50 to Charlotte’s account. George has not made a deductible charitable contribution.

TAX BLUNDER

Referring to the facts in  Example 8.20 , Fred should have made donations to qualified charitable organizations who help needy individuals instead of making the contribution directly to needy individuals. In this way, Fred would have preserved a charitable contribution deduction on his federal income tax return.

An organization must meet specific requirements in order to be exempt from taxation. Code Sec. 501. However, this does not necessarily mean that a contribution to that organization is deductible by the donor. The IRS publishes a list of organizations which have applied for and received rulings or determination letters holding contributions to them to be deductible. If an organization has not received a determination letter, it is not recognized as an organization to which contributions are deductible unless it is an organization described in (1), above.

Qualified charitable organizations are divided into two categories: public charities and private charities. Public charities include:

1. Churches or a convention or association of churches

2. Educational organizations which normally maintain a regular faculty, curriculum, and a regularly enrolled body of students

3. Hospitals and medical research organizations

4. Organizations supported by the government which are organized to administer property to or for the benefit of a college or university described in (2), above

5. Governmental units

6. A corporation, trust, or community chest, fund, or foundation that is created or organized in the United States and is organized and operated exclusively for religious, charitable, scientific, literary, or educational purposes

7. Certain types of private foundations

Private foundations are organizations which do not normally receive donations from the general public. There are two types of private foundations: operating and nonoperating. A private operating foundation is generally an organization with respect to which more than 50% of its assets are devoted directly to activities for which it is organized and operated and that distributes substantially all of its income for the conduct of its charitable purposes. Private operating foundations are treated as public charities.

Most private foundations fall into the nonoperating foundation classification. Private nonoperating foundations that distribute all of their contributions to public charities are also treated as public charities. Thus, a public charity is any qualified charity except for private nonoperating foundations that do not distribute all of their income to public charities. These private nonoperating foundations not contributing all of their income are classified as private charities.

¶8315

VALUATION OF CHARITABLE DONATIONS

If a charitable contribution is made in property, the amount of the contribution is normally the fair market value of the property at the time of the contribution. The fair market value is generally the price at which the property would change hands between a willing buyer and a willing seller, with both having a reasonable knowledge of relevant facts. No charitable deduction is allowed for the contribution of services.

Where the taxpayer receives some benefit in return for payment to a charitable organization, the deduction is reduced by the value of the benefit received. Where a charitable organization sponsors charity balls, bazaars, banquets, shows, or athletic events, there is a presumption that the price of admission is not a gift, and that the payment is for an item of value. The burden is on the taxpayer to show that the amount paid exceeds the fair market value of admission. The fact that the full payment or a portion of the payment made by the taxpayer is used by the organization exclusively for charitable purposes has no bearing upon the determination to be made as to the value of the admission or the amount qualifying as a contribution. The IRS says that a benefit is “insubstantial” and won’t reduce the deduction if it is not more than the lesser of 2% of the payment or $112 (for 2020).

EXAMPLE 8.22

Members of a charitable organization sell candy to raise funds for the charity. The candy is purchased at $5 per box, normally sells for $8 a box, but is sold at $10 per box. The organization promotes the sale as a “tax-deductible donation.” Only $2 per box qualifies as a charitable contribution. Other instances in which a deductible contribution could be claimed for the excess paid above fair market value would be (1) purchase of a ticket (from a charitable organization) to an artist’s benefit performance and (2) purchase of an item at a benefit auction for more than its fair market value.

Taxpayers who make a payment to a college or university for the right to purchase tickets to an athletic event are not entitled to deduct any part of the payment as a charitable deduction.If a taxpayer makes a payment or transfers property to an entity that can receive tax deductible contributions, the amount of the taxpayer’s charitable contribution deduction is reduced by the amount of any state or local tax credit the taxpayer receives or expects to receive in consideration for the payment or transfer.

Unreimbursed expenditures made incident to the rendering of services to an organization may constitute a deductible contribution. These expenses include reasonable expenditures for meals and lodging while away from home in the course of performing donated services.

Automobile expenses incurred in travel or transportation to perform charitable services are deductible. A standard mileage rate of $.14 per mile (not indexed for inflation) or the actual expenses of operating the automobile may be used. Rev. Proc. 2004-64. Parking fees and tolls are added to either method of computation. General repairs or maintenance expenses, depreciation, insurance, or registration fees are not deductible. The costs of meals for the volunteers or the costs of child care for the volunteer’s own children while the individual is performing services are not deductible.

TAX BLUNDER

John Adams does volunteer work for a number of charitable organizations. He uses his car in connection with his volunteer work but does not keep track of the miles driven while performing his charitable duties. Because he didn’t keep track of his mileage, John has foregone a $.14 per mile charitable contribution deduction for all of the miles driven while performing his volunteer work.

¶8325

LIMITATIONS ON CHARITABLE CONTRIBUTIONS

An individual’s charitable contribution deduction is subject to 20 percent, 30 percent, 50 percent, and 60 percent of AGI limitations. If a husband and wife file a joint return, the deduction for contributions is the aggregate of the contributions made by the spouses.

The limitation that applies generally depends on the type of property contributed and the type of charity (public or private) to which the contribution is made. The deduction an individual can take for cash contributions to public charities (such as churches, Goodwill, etc.—see  ¶8301 ) is limited to 60% of adjusted gross income. The deduction an individual can take for contributions of “ordinary income property” to public charities is limited to 50% of adjusted gross income. Contributions of appreciated capital gain property to public charities and contributions of cash and “ordinary income property” to private charities are limited to 30 percent of adjusted gross income. An individual may only deduct charitable contributions made to certain private charities to the extent the contributions do not exceed 20 percent of adjusted gross income. In addition, the total charitable contribution deduction is limited to 50 percent of adjusted gross income. For purposes of the charitable contribution deduction limitations, adjusted gross income is computed before any deduction for net operating loss carrybacks.

Ordinary Income Property

“Ordinary income property” means property that if sold at the time of contribution would trigger income other than long-term capital gains. For example, ordinary income property includes property held by the donor as inventory, depreciation recapture property, a work of art created by the donor, a manuscript prepared by the donor, letters and memorandums prepared by or for the donor, and capital assets held one year or less by the donor (short term capital gain property).

When ordinary income property is contributed, the amount of the deduction must be reduced by the amount that would have been recognized as ordinary income if the property had been sold by the donor at its fair market value at the time of the contribution. Essentially, the deduction for ordinary income property is limited to the basis of the property.

EXAMPLE 8.23

Donna Fairfield contributes equipment held as inventory to the Salvation Army. The equipment has a basis of $10,000 and a fair market value of $12,000. Her charitable deduction is limited to $10,000 ($12,000 fair market value – $2,000 ordinary income).

Capital Gain Property

Capital gain property is appreciated property where the sale would result in a long-term capital gain if the property were sold at fair market value at the time of the contribution. Section 1231 property (which is discussed in  Chapter 12 ) is considered capital gain property for charitable contributions purposes. If the contributed property would have produced both ordinary income and long-term capital gain if sold, the fair market value (as used for computing the deduction) must be reduced by the amount which would have been ordinary income, typically the potential depreciation recapture on the property.

EXAMPLE 8.24

Brent Bates contributed an asset to a qualified charity. The asset has a fair market value of $1,000 and a basis to him of $400. If the sale would result in a $600 gain of which $250 would be classified as ordinary income and $350 as long-term capital gain, the asset is considered to be capital gain property. However, the charitable contribution deduction is limited to $750 ($1,000 FMV – $250 ordinary income element).

The charitable contribution deduction for capital gain property that is either (1) contributed to a private charity or (2) tangible personal property which has an “unrelated use” to the organization receiving it must be reduced by the property’s unrecognized long-term capital gain. This reduced contribution amount is the basis of the property.

“Unrelated use” means a use which is unrelated to the purpose or function of the charitable organization. For example, if a painting contributed to an educational institution is used by the organization for educational purposes by being placed in its library for display and study by art students, its use is “related” to the educational purpose of the institution. However, if the painting is sold and the proceeds are used by the organization for educational purposes, the use of the property is unrelated.

EXAMPLE 8.25

Lois Lacey contributes an antique lamp to a qualified charity. The lamp has a fair market value of $5,000 and a basis to her of $3,000. The charity intends to sell the lamp and use the proceeds for charitable purposes. Lois’s charitable deduction is limited to $3,000.

Contributions of “qualified appreciated stock” to private charities are deductible at the full fair market value of the stock. “Qualified appreciated stock” is any stock of a corporation (1) for which market quotations are readily available on an established securities market, and (2) which is a long-term capital asset.

PLANNING POINTER

If the property to be contributed has not appreciated over the taxpayer’s basis, the contribution is valued at fair market value. It is not wise to contribute property that would otherwise create a deductible loss if sold. The taxpayer should sell the property and donate the proceeds to the charitable organization.

Charitable Contribution Percentage Limits

As indicated previously, charitable contributions are subject to several limitations that are based on adjusted gross income. There are 60 percent, 50 percent, 30 percent, and 20 percent category limits that are determined by the type of property contributed and the type of charity receiving the donated property. In addition, there is an overall limit on total charitable contributions that is 50 percent of adjusted gross income.

A carryover of any unused charitable contributions is allowed for up to five years, even if the taxpayer does not itemize for the current year. Current charitable contributions are considered first and then carryforwards are considered on a first-in, first-out basis. Any carryovers will be subject to the same percentage limitations as when they were first originated.

50 Percent Limitation Category

The deduction for contributions of cash and ordinary income property made to public charities may not exceed 50 percent of an individual’s adjusted gross income for the year. The deduction for the 50 percent category is the smaller of (1) the 50 percent category contribution amount or (2) 50 percent of adjusted gross income.

EXAMPLE 8.26

Beatrice Bold donates inventory with a basis of $10,000 to State University, a public charity. Her adjusted gross income for the year is $17,000. She would be limited to a charitable deduction of $8,500 ($17,000 × 50%). She would have a five-year carryover of $1,500, which would be subject to the 50% of AGI limitation in all future years.

30 Percent Limitation Category

The 30 percent limit category is comprised of two distinct 30 percent limits that must be kept separate. The 30 percent public category consists of contributions of capital gain property or appreciated Section 1231 (depreciable) property made to any public charitable organization. The 30 percent private category consists of contributions of cash or ordinary income property to private charities.

An individual may elect to reduce 30 percent capital gain property (contributed to a public charity) by the long-term capital gain and have the reduced contribution qualify for the 50 percent limitation category. This “reduced contribution election” applies to all contributions of 30 percent capital gain property made during the year or carried over to such year. The “reduced contribution election” is normally only tax advantageous to the taxpayer if the contributed property has appreciated only a small amount.

Neither capital assets reduced because of the “reduced contribution election” nor capital assets reduced because of “unrelated use” are considered 30 percent capital gain property, but instead are placed in the 50 percent limitation category.

EXAMPLE 8.27

Teri Rogers contributes $5,000 of common stock to the local homeless shelter, which is a public charitable organization. The stock has a basis to her of $4,800. Teri could now elect to reduce the 30 percent capital gain property by the $200 long-term capital gain on the property and classify the contribution as 50 percent limitation category property. If Teri has AGI of $10,000, a “reduced contribution election” would allow her to deduct a $4,800 charitable contribution deduction (with zero carryover) instead of a $3,000 charitable contribution deduction (with $2,000 carryover) with no election. If the basis of the stock to her was $3,400, a “reduced contribution election” would result in a deduction of $3,400 (with zero carryover) instead of a $3,000 deduction (with $2,000 carryover) with no election. Clearly, the tax advantage of the “reduced contribution election” is greater if the property has appreciated only a small amount.

20 Percent Limitation Category

An individual may deduct charitable contributions made during the year to any qualified charitable organization not considered to be a public charity (generally any “private charity”). Such contributions are limited to 20 percent of adjusted gross income. The 20 percent limitation generally applies to private charities and to certain other organizations, such as war veterans’ organizations, domestic fraternal societies, and nonprofit cemeteries.

The deduction for capital gain property donated to a private charity must be reduced by the long-term capital gain inherent in the property. Donations of “qualified appreciated stock,” however, are deductible at full fair market value.

EXAMPLE 8.28

Brandon Fryar has adjusted gross income for the year of $100,000. On February 1, 2020, he donates stock to a private charity. The stock has a fair market value of $25,000 and a basis to him of $10,000. He must reduce the fair market value by the long-term capital gain, leaving a charitable contribution deduction of $10,000. If the stock were qualified appreciated stock, his deduction in the current year would be $20,000. He would be allowed a deduction equal to the full fair market value but would only be able to deduct up to 20 percent of adjusted gross income this year. The other $5,000 would be carried over to the five subsequent years (subject to the 20% limitation in each year).

50 Percent Overall Limitation

There is an overall limitation placed on total deductions for all charitable contributions equal to 50 percent of adjusted gross income. This limitation is applied after the other limitations are computed. The overall 50 percent limit does not apply to 60 percent contributions, but 60 percent contributions do reduce the overall 50 percent limit. In applying the overall limitation, the 60 percent deduction, the 50 percent deduction, 30 percent public deduction, 30 percent private deduction, and 20 percent deduction must be taken, in that order.

Since the overall 50 percent limitation amount is the same as the specific 50 percent limitation amount, if the 60 percent and/or 50 percent contributions exceed the 50 percent limitation there will be no further deductions allowed from the other categories.

The 30 percent public deduction limit is determined by taking the smaller of (1) 30 percent of AGI or (2) 50 percent of AGI minus the 60 percent and 50 percent contributions.

The 30 percent private deduction limit is determined by taking the smaller of (1) 30 percent of AGI or (2) 50 percent of AGI minus all 60 percent and 50 percent contributions and minus the 30 percent public contributions. The 60 percent, 50 percent and 30 percent public contribution amounts are used in computing the limitations rather than the related deduction amounts.

The 20 percent deduction limit is determined by taking the smaller of (1) 20 percent of AGI or (2) 50 percent of AGI minus the 60 percent contributions, the 50 percent contributions, the 30 percent public contributions, and the 30 percent private contributions. (Further limitations on 20 percent contributions exist but are beyond the scope of this book. They can be found in Publication 526.)

EXAMPLE 8.29

Darin Drum has adjusted gross income for the year of $100,000. On March 1, 2020, he makes two charitable contributions. He makes 30 percent public charity contributions in the amount of $42,000. He also contributes $23,000 in qualified appreciated stock to a private charity. His charitable contribution deduction for the year is limited to $38,000, computed as follows. His $42,000 30 percent public charity contribution is limited to $30,000 ($100,000 × 30%). His $23,000 contribution of qualified appreciated stock to a private charity is first limited to $20,000 ($100,000 × 20%) and further limited to $8,000 ($50,000 maximum charitable deduction under the 50 percent overall limitation minus the $42,000 30 percent contribution amount). His total deduction will therefore be $30,000 + $8,000 = $38,000. Next year Darin will have a $12,000 ($42,000 - $30,000) carryover subject to the 30 percent public limit and a $15,000 ($23,000 - $8,000) carryover subject to the 20 percent limit.

Steps In Determining Individual Charitable Contributions

Step 1.	Determine the contribution amounts. The contribution amount is the fair market value reduced by any ordinary income and by the long-term capital gain deduction required because of unrelated use, reduced contribution election, or contribution to a private charity.
Step 2.	Place all contributions into 60 percent, 50 percent, 30 percent public, 30 percent private, and 20 percent limitation categories.
Property Given	Contribution Amount	Limitation Category
Cash
Public Charity	Cash	60%
Private Charity	Cash	30% Private
Ordinary Income Property
Public Charity	Basis	50%
Private Charity	Basis	30% Private
Capital Gain Property
Public Charity	FMV-OI	30% Public
Public Reduced Contribution Election	Basis	50%
Private Charity	Basis	20%
Appreciated Tangible Personal Property with Unrelated Use
Public Charity	Basis	50%
Private Charity	Basis	20%
Qualified Appreciated Stock
Public Charity	FMV	30% Public
Private Charity	FMV	20%

Step 3.	Determine each percent limit amount based on the 60 percent, 50 percent, 30 percent public, 30 percent private, and 20 percent limits.
Step 4.	Determine each percent deduction limit. Any difference between the contribution amount and the deduction allowed in each category is carried over for five years.
Step 5.	Add the respective percent deduction amounts, as limited, to arrive at the total charitable contribution deduction for the year.

EXAMPLE 8.30

Grace Goodheart has $100,000 of adjusted gross income and made charitable contributions as follows: $13,000 cash to the Red Cross, $24,000 (fair market value) in stock to the Boy Scouts, $9,000 in cash to a private charity, and $23,000 in qualified appreciated stock to a private charity. The charitable contribution deduction is computed as follows:

Limitation Category	Contribution Amounts	AGI Limit Amounts	Remaining Overall Limit (50%)	Deductible Amounts	Carryover
60%	$13,000	$60,000	$50,000	$13,000	$0
30% Public	24,000	30,000	37,000	24,000	0
30% Private	9,000	30,000	13,000	9,000	0
20%	23,000	20,000	4,000	4,000	19,000
Total Charitable Deduction			$50,000

There are no reductions to arrive at the contribution amounts above. The AGI limit amounts are AGI times the percent (60%, 50%, 30%, or 20%) that relates to the limitation category.

The deductible amounts are determined as follows:

1. The 60 percent deduction is the smaller of the $13,000 contribution or $60,000 ($100,000 × 60 percent).

2. The 30 percent public deduction is $24,000, the smaller of (1) the $24,000 contribution amount, (2) $30,000 ($100,000 AGI × 30 percent) or (3) $37,000 [$50,000 minus $13,000 (60% contributions)].

3. The 30 percent private deduction is $9,000 because it is the lesser of (1) the $9,000 contribution, (2) $30,000 (30% of $100,000 AGI) or (3) the $50,000 limit minus the 60 percent and 30 percent public contributions ($50,000 - $13,000 - $24,000 = $13,000).

4. The 20 percent limit deduction is $4,000, the lesser of (1) the $23,000 contribution amount, (2) $20,000 ($100,000 AGI × 20 percent), or (3) $4,000, the $50,000 (50% overall) limit minus the $13,000 50 percent contribution amount, the $24,000 30 percent public contribution amount, and the $9,000 30 percent private contribution amount.

After reducing the overall 50% limit for prior 60% and 30% contributions, there is only $4,000 of overall 50% limit left in which to deduct the 20% contributions.

¶8355

FILING AND SUBSTANTIATION REQUIREMENTS

The deduction for contributions is an itemized deduction and is therefore made on Schedule A of Form 1040. Cash contributions of less than $250 must be substantiated by a bank record (cancelled check, bank statement, credit card statement) or a written acknowledgment from the donee organization. Any charitable contribution of $250 or more must be substantiated by a contemporaneous written acknowledgment of the contribution from the donee organization. The written acknowledgment should include the amount of cash contributed and/or a description of the property contributed. The written acknowledgment must state whether the donee provides any goods or services in consideration for the contribution.

If the contribution is made in property other than money and is over $500, the taxpayer is required to state the kind of property contributed, the method used in determining the fair market value of the property at the time the contribution was made, and whether or not the amount of the contribution was reduced.

For contributed property for which the claimed value of one item or group of similar items exceeds $5,000, the taxpayer claiming the deduction must attach an appraisal of the donated property’s fair market value to the income tax return. The appraisal must be obtained from a qualified appraiser. If the donee sells the property within two years (three years for related-use tangible personal property), the donee must furnish the IRS and the donor with a statement regarding the sale.

In regard to donations of automobiles to charities, if the claimed value of the donated motor vehicle, boat or plane exceeds $500 and the item is sold by the charity, the taxpayer is limited to a charitable donation equal to the gross proceeds from the sale.

Personal Casualty Losses

¶8501

CASUALTY LOSSES

This section discusses personal casualty losses. Business casualty losses are discussed in  Chapter 7 . Personal casualty losses are deductible as itemized deductions while business casualty and theft losses are deductible from gross income. Personal casualty loss deductions are not allowable unless they are attributable to a federally declared disaster. However, net “nonfederal” (not attributable to a federally declared disaster) casualty gains will reduce the amount of the deduction from a federal disaster casualty loss. The net nonfederal casualty gain is all nonfederal casualty gains minus all nonfederal casualty losses.

Criteria for Deduction

Any uninsured loss arising from fire, storm, shipwreck, or other casualty is allowable as a deduction in the year in which the loss is sustained. Code Sec. 165(c)(3). The IRS position is that the loss must be the result of sudden, unexpected, identifiable, and provable events of an unusual nature, such as an accident, mishap, or sudden invasion by a hostile agency, the cause of which was unknown, or was an unusual effect of a known cause, which occurred by chance and unexpectedly.

Determination of Amount of Loss

To determine the amount of deductible loss, the fair market value of the property immediately before and immediately after the casualty generally must be ascertained by competent appraisal. This appraisal must recognize the effects of any general market decline affecting undamaged as well as damaged property, which may have occurred simultaneously with the casualty, so that any deduction will be limited to the actual loss resulting from damage to the property.

Cleanup expenses are deductible as a part of the casualty loss. Costs incurred to protect damaged property from future losses are not deductible as part of the casualty loss. Personal living expenses, such as temporary housing, rentals, medical care, lights, fuel, food and drink, or moving expenses are also not deductible as casualty losses.

The cost of repairs of the property damaged is acceptable as evidence of the loss of value. The taxpayer must show that (1) the repairs were necessary to restore the property to its condition immediately before the casualty, (2) the amount spent for such repairs was not excessive, (3) the repairs don’t repair more than the damage suffered, and (4) the value of the property after the repairs doesn’t, as a result of the repairs, exceed the value of the property immediately before the casualty.

The amount of loss to be taken into account is the lesser of either (1) the excess of the fair market value of the property immediately before the casualty minus the fair market value of the property immediately after the casualty, or (2) the amount of the adjusted basis of the property.

Limitations on Losses

Each personal casualty loss, even federal casualty losses, must be reduced by $100. The $100 reduction is applied per event, not per item damaged in an event. Where the recognized casualty losses exceed the recognized casualty gains, the annual casualty deduction is limited to the net casualty loss in excess of 10 percent of adjusted gross income. If the recognized casualty losses exceed the recognized casualty gains after reductions, all gains and losses are ordinary. Where the recognized gains exceed the recognized losses, each gain or loss is treated as a capital gain or loss. The $100 and 10 percent of adjusted gross income reductions apply separately to each individual taxpayer who sustains a loss, even though the property damaged or destroyed is owned by two or more individuals. However, a husband and wife filing a joint return are treated as one individual taxpayer. Business casualty losses are not subject to either the $100 or the 10 percent of AGI reductions. As indicated above, net casualty gains from "nonfederal" casualties will reduce the federal casualty loss deduction. Otherwise nonfederal casualty losses are not deductible.

EXAMPLE 8.31

Roberta Reynolds has $60,000 of adjusted gross income, a federal casualty loss of $8,500, and a casualty gain of $12,000. The casualty loss of $8,500 is reduced by $100 to $8,400 and netted against the $12,000 gain. The 10 percent of AGI reduction does not apply since a gain results from the netting. The $12,000 casualty gain is treated as a capital gain and the $8,400 casualty loss is treated as capital loss.

EXAMPLE 8.32

Ken Garrett has $40,000 of adjusted gross income, a $9,000 federal casualty loss after the $100 reduction, and a $3,000 nonfederal casualty gain. The casualty loss deduction is limited to $2,000. The federal casualty loss must be reduced by the nonfederal casualty gain and then reduced by 10 percent of adjusted gross income ($9,000 – $3,000 – $4,000).

If a loss is sustained in respect of property used partially for business and partially for nonbusiness purposes, the 10 percent and $100 reductions apply only to that portion of the loss properly attributable to the nonbusiness use.

Casualty losses are deductible in the year incurred. However, no portion of the casualty loss can be taken until it can be determined with reasonable certainty whether or not a reimbursement for the loss will be received. If a portion of the loss is not covered by a claim for reimbursement, then that portion of the loss is deductible in the year in which the casualty occurs.

EXAMPLE 8.33

Robert Rayer’s personal use property having a basis of $20,000 and a fair market value of $23,000 is completely destroyed by fire in 2020. The fire was associated with a federally declared disaster. In 2020 Robert filed an insurance claim for $8,000, and in that year Robert determined with reasonable certainty that the full amount of the claim would eventually be paid. The $8,000 payment was actually received in 2021. He had adjusted gross income of $17,000 in 2020. Robert’s 2020 loss equals $10,200 ($20,000 – $8,000 – $100 – $1,700 (10 percent of adjusted gross income)). The loss is deductible in 2020, the year incurred, because the loss can be ascertained with reasonable accuracy.

A taxpayer is not permitted to deduct a casualty loss for damage to insured property unless a timely insurance claim is filed. This rule applies to the extent that any insurance policy provides for full or partial reimbursement of the loss. The portion of the loss not covered by insurance (for example, a deductible) is not subject to this rule.

In order to accelerate tax refunds to taxpayers that have sustained a disaster loss, a taxpayer who has sustained a federal casualty loss may elect to deduct the loss for the tax year immediately preceding the year in which the loss actually occurred. This special provision applies only to disasters occurring in an area determined by the President of the United States to warrant assistance by the federal government. In addition, in federally declared disaster areas, taxpayers will never have to recognize gain on the receipt of insurance proceeds for personal property contained in personal residences.

If an election is made, the disaster is deemed to have occurred in the tax year immediately preceding the year in which the disaster actually occurred, and the loss deemed to have been sustained in the preceding tax year. The election is made by deducting the disaster loss on either an original federal tax return or an amended federal tax return for the preceding year. The original federal tax return or amended federal tax return must include an election statement indicating the taxpayer is making a §165(i) election. The original federal tax return or amended federal tax return must be filed on or before the date that is six months after the original due date for the taxpayer's federal tax return for the disaster year (determined without regard to any extension of time to file).

¶8701

RENT AND ROYALTY EXPENSES

Rents and royalties are closely related for tax purposes. Rents generally involve payments for the use of land, buildings, and other tangible property whereas royalties usually involve payments for copyrights, patents, and oil, gas, or mineral property reported on Schedule E. Rental income and expenses are normally treated as related to investment property if only minimal services are provided to the tenants. “Minimal service” usually means that service is limited, for instance, to providing heat, light, and trash pickup. If additional services (such as maid services) are provided to tenants, rental income and expenses may have to be considered as business income and expenses. If royalty income and expenses are derived from royalty property where the taxpayer has an operating interest or if the taxpayer is self-employed and created the royalty property, such as a writer with a copyright on a book, royalty income and expenses are trade or business income and expenses reported on Schedule C instead of investment income and expenses.

All rent and royalty expenses are deductible for AGI. Code Sec. 62(a)(4). Normal rent and royalty expenses include depreciation, depletion, repairs and maintenance expenditures, insurance, interest, taxes, and other items. If one piece of property is part rental property and part personal property, expenses must be allocated between the investment portion of the property and the personal portion with only the investment portion of the expenses being deductible for tax purposes.

¶8775

WAGERING LOSSES

Losses sustained during the year on wagering transactions are allowed as an itemized deduction but only to the extent of the gains during the year from wagering. In the case of a husband and wife filing a joint return, the combined wagering losses of the spouses are allowed to the extent of the combined wagering gains. Code Sec. 165(d).The Supreme Court has ruled that a professional gambler is entitled to deduct gambling losses as a trade or business expense reported on Schedule C. The fact that the taxpayer did not offer goods or services to others did not preclude characterization of the activities as a trade or business, rather, the appropriate “business” test was that the taxpayer must be involved in the activity with continuity and regularity and the taxpayer’s primary purpose for engaging in the activity must be for income or profit. R.P. Groetzinger, 87-1 USTC ¶9191 480 U.S. 23, 107 S.Ct. 980 (1987), aff’g 85-2 USTC ¶9622, 771 F.2d 269 (CA-7 1985).

Thus, if gambling is conducted as a business, any wagering losses are deductible as business losses, but only to the extent of wagering gains. The deduction of a professional gambler’s non-wagering business expenses, such as transportation, meals and lodging are considered wagering losses, and are also limited by wagering gains. Losses of nonprofessional gamblers are nonbusiness losses and are deductible (to the extent of gains) only if itemized on Schedule A of Form 1040.

¶8785

UNRECOVERED INVESTMENT IN ANNUITY

A taxpayer who contributes after-tax amounts to the cost of an annuity can exclude from income a part of each annuity payment received as a tax-free return of the cost of the annuity. If the taxpayer dies before the entire cost of the annuity is recovered tax-free, any unrecovered cost of the annuity can be deducted as an “Other Itemized Deduction” on the taxpayer’s final tax return.

¶8790

QUALIFIED BUSINESS INCOME DEDUCTION

Individuals are allowed a deduction of 20% of the qualified business income (QBI) from pass-through entities. The qualified pass-through entities include sole proprietorships, S corporations, partnerships, trusts, and estates.

Qualified business income does not include the following items of investment income: short-term capital gain or loss, long-term capital gain or loss, dividend income; or interest income. Qualified business income does not include any wages or guaranteed payments earned as an employee or for the use of capital.

EXAMPLE 8.34

Norma owns 40% of an S corporation that pays her $50,000 of wages and allocates to her $90,000 of income. Her QBI from the S corporation is only the $90,000 of income; the $50,000 of wages does not count.

The QBI deduction is equal to the sum of:

1. The lesser of:

a. 20% of the “combined qualified business income” of the taxpayer, or

b. 20% of the excess of taxable income over the sum of any capital gain. Taxable income is computed without the 20% deduction.

2. Plus the lesser of:

a. 20% of qualified cooperative dividends, or

b. 20% of taxable income less net capital gain.

The deduction is limited to the lesser of:

1. 20% of the taxpayer’s “qualified business income” or

2. The greater of:

a. 50% of the W-2 wages with respect to the business, or

b. 25% of the W-2 wages with respect to the business plus 2.5% of the unadjusted basis of all qualified property. (If taxable income is lower than certain threshold amounts (see below), (2) does not apply.)

W-2 wages are exactly that: wages paid to an employee, including any elective deferrals into a Section 401(k)-type vehicle or other deferred compensation. W-2 wages do not include, however, amounts like payments to an independent contractor or management fees, because new Section 1119A(b)(4)(C) clearly states that an amount is not a W-2 wage for these purposes unless it shows up on a payroll tax return.

Qualified property is defined as tangible property of a character subject to depreciation that is held by, and available for use in, the qualified trade or business at the close of the tax year, and which is used in the production of qualified business income, and for which the depreciable pe-riod has not ended before the close of the tax year. Land and intangibles do not qualify.

The use of the unadjusted basis of property begins on the date the property is placed in service and ends on the later of:

1. 10 years, or

2. The last day of the last full year in the asset’s “regular” (not ADS) depreciation period.

The W-2 wages/qualified property limit does not apply if the taxpayer’s taxable income for the tax year is equal to or less than a $163,300 threshold amount ($163,300 for married filing separate returns, and $326,600 for taxpayers filing a joint return in 2020). The limit is fully phased in at $213,300/$426,600 of taxable income.

EXAMPLE 8.35

Michael has QBI of $180,000 from an S corporation that paid him a total of $30,000 of W-2 wages. The S corporation paid a total of $50,000 in W-2 wages and that has no qualified property. Michael’s spouse has $86,000 of W-2 income, and Michael and his spouse have interest income of $10,000. They have itemized deductions of $26,000. Thus, total taxable income is $280,000.

Normally, Michael’s deduction would be limited to $25,000, the lesser of:

1. 20% of QBI of $180,000, or $36,000, or

2. The greater of:

a. 50% of W-2 wages of $50,000, or $25,000, or

b. 25% of $50,000 plus 2.5% of $0, or $12,500

While normally Michael’s deduction would be limited to $25,000, because Michael’s taxable income is $280,000 – which is less than $326,600 – the W-2 limitation is disregarded, and Michael simply takes a deduction equal to 20% of QBI, or $36,000.

EXAMPLE 8.36

Jerry and Judy are married. Judy has a qualified business that is not a specified service business. For the 2020 tax year, they file a joint return reporting taxable income of $335,000. In that tax year, 20% of the qualified business income from Judy’s business is $25,000. Judy’s share of wages paid by the business in the tax year is $40,000, so 50% of the W-2 wages from the business is $20,000. (For purposes of this example, assume that no qualified property factors into the calculation.) The $5,000 benefit from being able to use the 20% QBI deduction ($25,000) over the 50% of W-2 wages paid ($20,000) is reduced by 8.4% (($335,000 taxable income - $326,600 threshold amount)/$100,000) or $420. Jerry and Judy take a Code Sec. 199A deduction of $24,580 ($25,000 - $420).

A qualified trade or business means any trade or business other than a specified service trade or business and other than the trade or business of being an employee.

A “Specified Service Activity” normally includes:

· Health,

· Law,

· Accounting,

· Actuarial Science,

· Performing Arts,

· Consulting,

· Athletics,

· Financial Services,

· Brokerage Services, or

· Any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees.

The definition of “Specified Service Activity” is modified to exclude engineering and architec-ture services.

A disallowance of the deduction with respect to specified service trades or businesses is also phased in above the threshold amount ($163,300/$326,600) of taxable income.

EXAMPLE 8.37

Carol, an attorney, files married filing jointly, her taxable income is $300,000, her share of the income of the law firm LLC is $200,000, her share of the W-2 wages is $100,000, and her share of the assets of the LLC is $40,000. Even though Carol is a lawyer, she may take the deduction because her taxable income is below $326,600, the start of the phase-in threshold. As a result, Carol can take a deduction of 20% of $200,000, or $40,000. Remember, when taxable income is less than $326,600, the service trade or business limitation does not apply. As a result, Carol is entitled to the full $40,000 deduction.

EXAMPLE 8.38

Mark, single, has taxable income of $177,500, of which $144,000 is attributable to an accounting sole proprietorship (i.e., a specified service business) after paying wages of $68,000 to employees. Because his taxable income is less than the $213,300 full phase-in amount ($163,300 + $50,000) for specified service businesses, Mark can claim the Code Sec. 199A deduction, but only for an applicable percentage of his qualified items of income, gain, deduction, or loss, and the W-2 wages, from the accounting business. (For purposes of this example, assume that no qualified property factors into the calculation.) Mark has a 66.4% applicable percentage (1 - ($177,500 - $163,300)/$50,000 = 1 - $14,200/$50,000 = 1 - 0.284 = 0.716). In determining includible qualified business income, Mark takes into account 71.6% of $144,000, or $103,104. In determining the includible W-2 wages, Mark takes into account 71.6% of $68,000, or $48,688. Mark calculates the deduction by taking the lesser of: 20% of $103,104 ($20,620.80), or 50% of $48,688 ($24,344). Mark can take a Code Sec. 199A deduction of $20,620.80.

The deduction is allowed only for Federal income tax purposes. The deduction does not re-duce self-employment income or net investment income for purposes of the tax on net invest-ment income of individuals. The 20% deduction is not allowed in computing adjusted gross income, and instead is allowed as a deduction reducing taxable income. Thus, for example, the 20% deduction does not affect limitations based on adjusted gross in-come. The deduction is available to both non-itemizers and itemizers. The deduction is taken on line 10 of Form 1040.

If the net amount of qualified income, gain, deduction, and loss is less than zero, the loss is carried over to the next tax year. Any deduction allowed in the next tax year is reduced (but not below zero) by 20% of any carryover qualified business loss.

EXAMPLE 8.39

Larry owns 50% of an S corporation. In 2020, the S corporation allocates a $100,000 loss to Larry. Because Larry materially participates in the S corporation, he is able to use the $100,000 loss in full to offset his wife’s $150,000 of wages. In 2021, the S corporation allocates $250,000 of income to Larry. While Larry would generally start the process of determining his Section 199A deduction by taking 20% of $250,000, Section 199A(b)(6) provides that in determining Larry’s QBI deduction for 2021, the $250,000 of income must be reduced by the $100,000 of loss from 2020. Thus, while Larry will still include the full $250,000 of S corporation income in his taxable income in 2021, his deduction will be limited to $30,000 (20% × $150,000) rather than $50,000 (20% × $250,000).

EXAMPLE 8.40

Judy carries on two qualified business, Alpha LLC and Beta, LLC. Judy has qualified business income of $30,000 from Alpha and a qualified business loss of $70,000 for Beta. Judy cannot claim the Sec. 199A deduction for 2020, but has a carryover qualified business loss of $40,000 to 2021. In 2021, Judy has qualified business income of $30,000 from Alpha and $60,000 from Beta. To determine the Sec. 199A deduction for 2021, Judy reduces the $60,0000 of Beta income by the $40,000 qualified carryover loss from 2020.

Items are treated as qualified items of income, gain, deduction, and loss only to the extent they are effectively connected with the conduct of a trade or business within the United States. The 20% deduction will be required to be computed with respect to each “trade or business”, but different businesses can be aggregated together if it can be shown that they have at least 50% common ownership, and at least two of the following: (1) similar or complementary products, (2) shared facilities or business elements, and (3) interdependence (Reg. §1.199A-4(b)(1)).

Section 199A(f)(2) provides than when computing alternative minimum taxable income, you determine “qualified business income” without taking into consideration any AMT adjustments or preferences as provided in Section 55-59. QBI is the same for AMT as it is for regular tax, and thus, the 20% deduction is computed the same way. The determination of alternative minimum taxable income starts with taxable income, and the amended Code provides no specific add-back to AMTI for the 20% deduction.

Section 172(d) has been amended to provide that a net operating loss does not include the Section 199A deduction.

Section 199A(c) requires that QBI be earned in a qualified trade or business. The term “trade or business” is not well defined by the tax law (although certain Specified Service Activities are specifically excluded under Section 199A). In fact, there are a number of different interpretations of what constitutes a trade or business for different purposes of the Code The highest standard, however, is that of a "Section 162 trade or business," and in order for an activity to achieve this standard, the business must be regular, continuous, and substantial. Over 100 years of judicial precedent has not provided much insight into whether a rental activity rises to the level of a “Section 162 trade or business.” The determination depends on many factors: how long is the lease? Is the lease gross or triple net? What type of property is being leased?

Fortunately, under Section 199A there is a safe harbor that allows rental real estate to be treated as a trade or business for the purposes of Section 199A. Two of the requirements that must be met are that (1) separate books and records of the rental activity must be kept, and (2) the taxpayer must perform, in general, 250 hours of rental services for the rental activity each year.

EXAMPLE 8.41

Alice owns a 50% interest in a commercial rental properties through an LLC. Alice’s share of the rental income of the LLC is $1,500,000. The LLC pays no W-2 wages, rather, it pays a management fee to an S corporation Alice controls. The management company pays W-2 wages, but also breaks even, passing out no net income to Alice. Alice’s share of the total unadjusted basis of the commercial rental property is $9,000,000.

Alice is entitled to a deduction -- assuming the rental activities rise to the level of a Section 162 business – equal to the lesser of:

1. 20% of QBI or $1,500,000 ($300,000) or

2. 2.5% of the unadjusted asset basis of $9,000,000 ($225,000).

As a result, Alice is allowed a $225,000 deduction that was very nearly zero before the property addition.

EXAMPLE 8.42

Capital Gains Example. Tony has $90,000 of QBI. In addition, Tony has $200,000 of long-term capital gains, $30,000 of wages, and $50,000 of itemized deduction, for a taxable income of $270,000.

Tony’s deduction is limited to the lesser of:

1. 20% of QBI of $90,000, or $18,000, or

2. 20% of ($270,000 - $200,000), or $14,000

Thus, Tony’s deduction is limited to $14,000. Because while Tony has taxable income of $270,000 – including $90,000 of QBI – $200,000 of that taxable income will be taxed at favorable long-term capital gains rates. Thus, there is only $70,000 to be taxed at ordinary rates, meaning the 20% deduction should be limited to $70,000 of income; after all, you do not want to give a 20% deduction against income that is already taxed at a top rate of 23.8%.

The 20% deduction has no effect on an S shareholder’s or partner’s basis.

A taxpayer who claims the Code Sec. 199A deduction may be subject to the 20-percent accuracy-related penalty for a substantial understatement of income tax if the understatement is more than the greater of five percent (not 10 percent) of the tax required to be shown on the return for the tax year, or $5,000. [Code Sec. 6662(d)(1)(C)]

KEYSTONE PROBLEM

Bill and Clara are married and file a joint individual income tax return. Bill earned $500,000 in wages as an employee of an unrelated company in 2021. Clara owns 100% of the shares of Zenith Corporation, an S corporation that provides landscaping services. Zenith generated $100,000 in net income from operations in 2021. Zenith paid Clara $150,000 in wages in 2021. Bill and Clara have no capital gains or losses. After allowable deductions not related to Zenith, Bill and Clara's total taxable income for 2021 is $270,000. What is Bill and Clara’s ordinary business income deduction?

SUMMARY

· Personal expenditures are generally disallowed as deductions on the tax return. However, certain personal expenses, as listed in the Internal Revenue Code, are specifically allowed as itemized deductions. These deductions are taken on Schedule A of Form 1040. Itemized deductions are beneficial to a taxpayer only if the total of the itemized deductions exceeds the standard deduction.

· Only medical expenses actually paid during the year are allowed as an itemized deduction. The total of the allowable medical expenses must be reduced by 7.5% percent of adjusted gross income. Medical expenses must be for the medical care of the taxpayer, spouse, or a dependent of the taxpayer.

· The taxes category of itemized deductions is made up of (1) state and local property and sales taxes and (2) state, local, and foreign income taxes. Federal income, estate, gift, and Social Security taxes imposed on the taxpayer are not deductible. The aggregate itemized deductions from state and local taxes are limited to $10,000.

· Certain interest paid or accrued on indebtedness qualifies as a deduction in computing taxable income. Prepaid interest is not deductible when paid but must be allocated to the periods for which it represents the cost of borrowing funds. Interest expense incurred to purchase tax-exempt income-producing assets is not deductible.

· Charitable contributions must be made to qualified organizations in order to qualify for the deduction. Only contributions made during the year are deductible. There are limits imposed on charitable contributions equal to 60 percent, 50 percent, 30 percent, and 20 percent of adjusted gross income, depending on the type of property given and the charity to which it is given.

· Certain personal casualty losses may qualify as itemized deductions, but only if associated with a federally declared disaster. Generally, the loss is equal to the smaller of the reduction in fair market value or the basis of the asset, reduced by (1) insurance proceeds, (2) $100 for each casualty, and (3) 10 percent of adjusted gross income.

· The qualified business income deduction is equal to 20% of the qualified business income passed through to an individual from a sole proprietorship, partnership, or S corporation. The deduction is limited to the lesser of (1) 50% of the W-2 wages associated with the business, or (2) 25% of the W-2 wages associated with the business plus 2.5% of the unadjusted basis of all qualified property associated with the business.

32. Mike and Sally Card file a joint return for the 2020 tax year. Their adjusted gross income is $65,000 and they incur the following interest expenses:

Qualified education loans	$3,500
Personal loan	1,000
Home mortgage loan	4,000
Loan used to purchase a variety of stocks, bonds, and securities	15,000

Investment income and related expenses amount to $7,000 and $500, respectively. What is Mike and Sally’s interest deduction for the 2020 tax year?

33. Greg Grove pays $50,000 interest in 2020 on his mortgage on his principal residence. It has an interest rate of 4 percent and balance of $1,250,000 during the year. He took out the mortgage in 2019. How much of this interest is deductible on Greg’s tax return for 2020?

39. Elmore Eisner made the following contributions during the current tax year:

Cash to United Way	$5,000
Land to Boy Scouts to be used as a summer camp:
Cost	20,000
Fair market value	30,000
Painting to a 20 percent charity for permanent display in foundation’s public gallery:
Cost	5,000
Fair market value	7,000
Cash to individual needy families around town	3,000

34. Assuming Elmore’s adjusted gross income is $80,000, what is his charitable contribution deduction for the year and carryover?

35. What is the charitable contribution and carryover if the cost and fair market value of the painting are $25,000 and $27,000, respectively?