Chap 014

Chapter 14 - Tax Consequences of Home Ownership
Chapter 14
Tax Consequences of Home Ownership
SOLUTIONS MANUAL
Discussion Questions
1. [LO 1] How does a taxpayer determine whether a dwelling unit is treated as a residence or
nonresidence for tax purposes?
Whether a dwelling unit is treated as a residence or not depends on the number of days the
dwelling unit is used for personal purposes compared to the number of days it is used for
rental purposes. A dwelling unit is considered to be a residence if the number of personal
use days of the home exceeds the greater of (1) 14 days or (2) 10% of the number of rental
days during the year.
2. [LO 1] Does a residence need to be situated at a fixed location? Explain.
No. A residence is a dwelling unit that provides a place suitable for people to occupy
(live and sleep). For tax purposes, a dwelling unit includes a house, condominium,
mobile home, and boat. As long as the taxpayer lives in the property (uses it for
personal purposes) for the requisite number of days, the property qualifies as a
residence even if it is mobile.
3. [LO 1] When determining whether a dwelling unit is treated as a residence or a nonresidence

for tax purposes, what constitutes a day of personal use and what constitutes a day of rental
use?
Personal use by a taxpayer includes days when (1) the taxpayer or other owner stays in the
home, (2) a relative of an owner stays in the home, even if the relative pays full fair market
value rent, except if the relative is renting the home as his or her principal residence, (3) a
nonowner stays in the home under a vacation home exchange or swap arrangement, and (4)
the taxpayer rents out the property for less than fair market value. Rental use includes days
when the property is rented out at fair market value. Days spent repairing or maintaining
the vacation home for rental use count as rental days, and days when the home is available
for rent, but not actually rented out, do not count as personal days or as rental days.
4. [LO 1] A taxpayer owns a home in Salt Lake City, Utah and a second home in St. George,
Utah. How does the taxpayer determine which home her principal residence is for tax
purposes?
When a taxpayer lives in more than one residence during the year, the determination of
which residence is the principal residence depends on the facts and circumstances. Factors
to consider in making this determination include the amount of time the taxpayer spends at
each residence during the year, the proximity of each residence to the taxpayers
employment, the principal place of abode of the taxpayers family, and the taxpayers mailing
address for bills and correspondence among other things.
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5. [LO 2] What are the ownership and use requirements a taxpayer must meet to qualify for the
exclusion of gain on the sale of a residence?
Ownership test: The taxpayer must have owned the property for a total of two or more years
during the five-year period ending on the date of the sale.
Use test: The taxpayer must have used the property as the taxpayers principal residence for
a total of two or more years during the five-year period ending on the date of the sale.
Married couples are eligible for the married filing jointly exclusion amount if either spouse
meets the ownership test and both spouses meet the principal use test.
6. [LO 2] Under what circumstances, if any, can a taxpayer fail to meet the ownership and use
requirements but still be able to exclude all of the gain on the sale of a principal residence?
The taxpayer may be able to exclude the gain on the sale of a principal residence when she
sells the home due to unusual circumstances such as a change in employment, significant
health issues, or other unforeseen financial difficulties. To qualify for the exclusion due to a
change in employment, the taxpayers new place of employment must be at least 50 miles
farther from the residence that is sold than was the previous place of employment. That is,
the taxpayer will not qualify unless the taxpayers commute from the old home to the new job
is at least 50 miles longer than the taxpayers commute from the old home to the old job. The
maximum exclusion available to a taxpayer selling under these circumstances is the product
of (1) the maximum exclusion had the taxpayer fully qualified for the exclusion (i.e.,
$250,000 for a single taxpayer or $500,000 for a taxpayer filing a joint return) and (2) the
ratio of (a) the number of days or number of months the taxpayer met the ownership and use
requirements to (b) 730 days or 24 months, respectively. The taxpayer may use either days or
months in the computation. Note that under this hardship provision, the maximum
limitation is reduced, not necessarily the excludable gain. Consequently, if the taxpayer has
a gain on the sale of the residence that is less than the reduced maximum exclusion, the full
amount of the gain may be excluded.
7. [LO 2] Under what circumstances can a taxpayer meet the ownership and use requirements
for a residence but still not be allowed to exclude all realized gain on the sale of the
residence?
A taxpayer is limited to one exclusion on a sale of a principal residence every two years.
That is, once the taxpayer sells a residence and uses the exclusion on the sale, she will not be
allowed a second exclusion until at least two years passes from the time of the first sale.
Consequently, although a taxpayer may meet the use and ownership tests on two residences,
she cant exclude gain from the sale of her second residence if she has sold the first residence
within the two preceding years.
Also, if a taxpayer sells a home after December 31, 2008, and the taxpayer had nonqualified
use of the property after December 31, 2008 (that is, the taxpayer used the property for a
purpose other than as a principal residence such as vacation home or rental property) the
taxpayer is not allowed to deduct a certain percentage of the otherwise excludable gain.
Note, however, that nonqualified use does not include use during any portion of the five-year
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period that is after the last date the property was used as the principal residence of the
taxpayer or the taxpayers spouse. That is this exception allows the taxpayer a five year
period to sell the principal residence after moving out of it without having to count the time
the house is available for sale as noncqualified use. The percentage of the gain that is not
excludable is the period of nonqualified use after December 31, 2008, divided by the period
of time the taxpayer owned the home before selling.
8. [LO 2] A taxpayer purchases and lives in a home for a year. The home appreciates in value
by $50,000. The taxpayer sells the home after her employer transfers her to an office in a
nearby city. The taxpayer buys a new home. What information do you need to obtain to
determine whether the taxpayer is allowed to exclude the gain on the sale of the first home?
To qualify for the exclusion due to a change in employment, the taxpayers new place of
employment must be at least 50 miles farther from the residence that is sold than was the
previous place of employment. So, you would need to find out how far the new place of
employment is from the old residence. If the distance between the old residence and the new
place of employment is less than 50 miles farther from the old residence to the old place of
employment, the taxpayer doesnt meet the hardship provision, and hence the gain cant be
excluded. Another aspect to consider is whether or not the taxpayer has used the exclusion
on a different home sale within the past two years.
9. [LO 3] Juanita owns a principal residence in New Jersey, a cabin in Montana, and a
houseboat in Hawaii. All of these properties have mortgages on which Juanita pays interest.
What limits, if any, apply to Juanitas mortgage interest deductions? Explain whether
deductible interest is deductible for AGI or from AGI?
Taxpayers are allowed to deduct qualified residence interest as an itemized deduction.
Qualified residence interest includes interest paid on loans secured by the taxpayers
principal residence and one other residence. The second qualified residence is an annual
election for a taxpayer with more than two residences. If the taxpayer rents the second
residence for part of the year, it still qualifies as a residence for interest deduction purposes
as long as the taxpayers personal use of the property exceeds the greater of (1) 14 days or
(2) 10% of the number of rental days during the year. This use limitation is designed to
ensure that taxpayers are using the property as a residence for a significant part of the year
relative to the rental use of the property. A taxpayers residence need not be a typical home
attached to the ground; rather, it could include a houseboat or mobile home. Hence,
Juanitas principal residence in New Jersey as well as either the cabin in Montana or the
houseboat in Hawaii will qualify as qualified residences. The deduction for mortgage
interest on these two properties is subject to additional limits: acquisition indebtedness and
home equity indebtedness. Interest expense on up to $1,000,000 of acquisition indebtedness
is deductible as qualified residence interest. Once acquisition indebtedness is established for
a qualifying residence (or qualifying residences), it is reduced by principal payments on the
loan(s) and can only be increased by additional indebtedness, secured by the residence,
incurred to substantially improve the residence. Interest on home-equity indebtedness is
deductible as qualified residence interest. However, the amount of home-equity indebtedness
is limited to the lesser of (1) the fair market value of the qualified residence in excess of the
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acquisition debt related to that residence and (2) $100,000 ($50,000 for married filing
separately). This means that a taxpayer is able to deduct interest on up to $100,000 of debt
above and beyond acquisition debt as long as the debt is secured by the equity in the home.
This is true no matter what the taxpayer does with the proceeds from the home-equity debt.
10. [ LO 3] Barbi really wants to acquire an expensive automobile (perhaps more expensive than
she can really afford). She has two options. Option 1: finance the purchase with an
automobile loan from her local bank at a 7 percent interest rate or Option 2: finance the
purchase with a home-equity loan at a rate of 7 percent. Compare and contrast the tax and
nontax factors Barbi should consider before deciding which loan to use to pay for the
automobile. Barbi typically has more itemized deductions than the standard deduction
amount.
For tax purposes, Barbi would be better off using the home-equity loan to acquire the
automobile because she would be allowed to deduct the interest payments on the loan. Thus,
her after-tax interest rate for the home-equity loan would be 7% (1 marginal tax rate).
In contrast, her after-tax interest rate on the automobile loan from the bank would be 7%.
However, nontax considerations are also important. If Barbi is unable to make her payments
on the automobile loan, she may lose the automobile. However, if she is unable to make the
payments on the home-equity loan, she could lose her home because the home-equity loan is
secured by the home. This is an important consideration for Barbi because she apparently
would like to borrow more than she can afford to pay back.
11. [LO 3] Lars and Leigha saved up for years before they purchased their dream home. They
were considering (1) using all of their savings to make a large down payment on the home
(90 percent of the value of the home) and barely scraping by without the backup savings or
(2) making a more modest down payment (50 percent of the value of the loan) and holding
some of the savings in reserve as needed if funds get tight. They decided to go with the
large down payment because they figured they could always refinance the home to pull some
equity out of the home if things got tight. What advice would you give them about the tax
consequences of their decision?
If the couple is forced to refinance their loan sometime in the future, the refinanced loan is
treated as acquisition debt only to the extent that the principal amount of the refinancing
does not exceed the amount of the acquisition debt immediately before the refinancing. That
is, the refinancing cannot increase their acquisition indebtedness. Consequently, any amount
borrowed in excess of the remaining principal on the original loan does not qualify as
acquisition indebtedness (unless it is used to substantially improve the home). However,
interest on the excess part of this loan can be deducted to the extent that it qualifies as homeequity indebtedness. Home equity indebtedness is limited to the lesser of (1) the fair market
value of the qualified residence(s) in excess of the acquisition debt related to the residence(s)
and (2) $100,000. Thus, the couple will be able to increase their mortgage interest
deduction only to the extent that the refinanced loan qualifies as home-equity indebtedness.
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12. [LO 3] How are acquisition indebtedness and home-equity indebtedness similar? How are
they dissimilar?
Both acquisition and home-equity indebtedness are loans that are secured by the residence.
That is, if the owner does not make the payments on the loan, the bank or lender may take
possession of the home to satisfy the owners responsibility for the loan. However,
acquisition indebtedness is debt that is incurred in acquiring, constructing, or substantially
improving the residence and the interest on this type of debt is deductible on up to
$1,000,000 of principal. On the other hand, home-equity indebtedness may be used for any
purpose, and the interest is deductible on the lesser of (1) the fair market value of the home
over the acquisition indebtedness or (2) $100,000.
13. [LO 3] Why might it be good advice from a tax perspective to think hard before deciding to
quickly pay down mortgage debt?
If the taxpayer has a cash crunch in the future due to quickly paying down the mortgage
debt, he may be forced to refinance the loan to get the necessary cash. However, when a
taxpayer refinances his home, and the amount of the refinancing exceeds the amount of the
acquisition indebtedness immediately before the refinancing (and the taxpayer doesnt use
the proceeds to substantially improve the home), the excess cannot be classified as
acquisition indebtedness, it can be treated only as home-equity indebtedness (to the lesser of
the fair market value of the home in excess of the acquisition indebtedness or $100,000).
Thus, the taxpayer may be in a situation where he will not be able to deduct as much interest
due to the refinance as he would have been able to had he not quickly paid down mortgage
debt. That is, by decreasing the acquisition indebtedness by paying down the debt, the
taxpayer may be unable to deduct a portion of his interest payments due to refinancing.
14. [LO 3] Can portions of one loan secured by a residence consist of both acquisition
indebtedness and home-equity indebtedness? Explain.
Yes; even though there are separate limits on acquisition indebtedness and home-equity
indebtedness, both limits can apply to the same loan. When a taxpayer refinances his home
and the amount of the refinancing exceeds the amount of the acquisition indebtedness
immediately before the refinancing, the excess cannot be classified as acquisition
indebtedness. However, the excess can be treated as home-equity indebtedness. Thus, the
refinancing includes both acquisition indebtedness and home-equity indebtedness. Likewise,
a taxpayer with a home valued at $1.1 million or greater can borrow and deduct interest on
$1.1 million dollars. In this situation, the first $1 million is considered to be acquisition
indebtedness and the remaining $100K would be considered home-equity indebtedness, even
though the taxpayer holds only one loan. Also, if a taxpayer takes out a loan and uses part
of the proceeds to substantially improve the home and part for other purposes, the part to
improve the home would be acquisition indebtedness and the remainder would be home
equity debt.
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15. [LO 3] When a taxpayer has multiple loans secured by her residence that in total exceed the
limits for deductibility, how does the taxpayer determine the amount of the deductible
interest expense?
When a taxpayers home-related debt exceeds the limitations, the amount of deductible
interest can be determined in one of two ways. First, the deductible interest can be computed
by the product of the ratio of qualified debt to total debt outstanding on the home and total
interest expense on debt secured by the home as follows:
Qualified debt/Total debt total interest expense = deductible interest
The second method is based on the order in which the loan was taken out. Interest on the
first loan taken out (up to the limit) is deductible first and then interest on the next loan is
deductible, etc. Interest on loans in excess of the limits does not generate deductible interest.
A taxpayer may opt for this second method when the loans taken out first have a higher
interest rate than loans taken out later.
16. [LO 3] Compare and contrast the characteristics of a deductible point from a nondeductible
point on a first home mortgage.
Deductible points include points paid to lenders in exchange for a reduced interest rate on
the loan or for loan origination fees. These points are immediately deductible as qualified
residence interest if certain requirements are met. In contrast, nondeductible points are
points paid to compensate lenders for specific services such as appraisal fees, document fees,
or notary fees.
Points paid for a reduced interest rate or for a loan origination fee in refinancing a home
loan are not immediately deductible by the homeowner. These points must be amortized and
deducted on a straight-line basis over the life of the loan.
17. [LO 3] Is the break-even period generally longer or shorter for points paid to reduce the
interest rate on initial home loans or points paid for the same purpose on a refinance?
Explain.
The break-even period is generally shorter for points paid to reduce the interest rate on
initial home loans than for points paid for a refinance. The reason for the extended breakeven period in a refinance situation is that the refinance points are not immediately
deductible, and hence, they effectively cost more (on a present value basis) than points on
initial home loans. Thus, it takes longer to recoup these greater costs. Note, however, that
this is true only if the taxpayer itemizes deductions. If the taxpayer does not itemize, neither
points paid on an initial home loan nor points paid on a refinance generate any tax savings.
18. [LO 3] {Planning} Under what circumstances is it likely economically beneficial to pay
points to reduce the interest rate on a home loan?
Generally speaking, the longer the taxpayer plans on staying in the home and maintaining
the loan (i.e., not refinancing the loan), the more likely it is financially beneficial to pay
points to obtain a lower interest rate. However, paying points can be costly if after a short
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time the taxpayer sells the home or refinances the home loan. In these situations, the
taxpayer may not reach the break-even point.
19. [LO 3] Harry decides to finance his new home with a 30-year fixed mortgage. Because he
figures he will be in this home for a long time, he decides to pay a fully deductible discount
point on his mortgage to reduce the interest rate. Assuming Harry itemizes deductions and
has a constant marginal tax rate over time, will the time required to recover the cost of the
discount point be shorter or longer if Harry makes extra principal payments starting in the
first year than it would be if he does not make any extra principal payments? Explain.
The time required to recoup the cost of the discount point will be longer if Harry makes extra
principal payments. If Harry makes extra principal payments on his mortgage during the
first year, the balance of the loan is reduced and, as a result, Harry will pay less interest than
he would have paid had he not made the extra loan payments (a smaller loan principal times
the same interest rate equals a smaller amount of interest). Consequently, his after-tax
savings from having the lower interest rate is reduced relative to what it would have been
had he not made the extra payments. Because the interest expense is deductible for tax
purposes, the after tax savings from having the lower interest rate is calculated as follows:
Interest saved = principal amount of loan (original interest rate lower interest rate)
After-tax interest savings = interest saved (interest saved MTR)
Because, the after-tax cost of paying points remains constant, the reduction in after-tax
savings from the lower interest rate increases the break-even point. Recall that the breakeven point is calculated as follows:
Break-even point = after-tax cost of paying points/after-tax savings of lower interest rate.
20. [LO 4] A taxpayer sold a piece of real property in year 1. The amount of year 1 real property
taxes was estimated at the closing of the sale and the amounts were allocated between the
buyer and the taxpayer. At the end of year 1, the buyer receives a property tax bill that turns
out to be higher than the estimate. After paying the tax bill, the buyer contacts the taxpayer
at the beginning of year 2 and asks the taxpayer to pay the taxpayers share of the shortfall.
The taxpayer sends a check to the buyer. Should the taxpayer be concerned that she wont
get to deduct the extra tax payment because it was paid to the buyer and not to the taxing
jurisdiction? Explain.
The taxpayer will be allowed to deduct her share of the real property taxes even though she
didnt pay the taxing jurisdiction. In most situations, the buyer and seller will agree to divide
the responsibility for the tax payments based on the portion of the property tax year that each
party held the property. This allocation of taxes between buyer and seller is generally
spelled out on the settlement statement when the sale becomes final. However, the amount
specified at settlement is generally just an estimate, so the actual taxes may differ from
amounts for taxes on the settlement statement. For tax purposes, however, it doesnt matter
who actually pays the tax to the taxing jurisdiction. Assuming the taxes are actually paid by
someone, the tax deduction is based on the relative amount of time each party held the
property during the year. Thus, the taxpayer will get to deduct the total share of the tax bill
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allocated to her which is dependent on how long she held the property during the year. The
buyer will get to deduct the remaining portion. This is true even if the taxpayer does not
send the extra payment to the seller.
21. [LO 4] Is a homeowner allowed a property tax deduction for amounts included in the
monthly mortgage payment that are earmarked for property taxes? Explain.
Frequently homeowners pay their real estate taxes through an escrow (holding) account with
their mortgage lender. Each monthly payment to the lender includes an amount that
represents roughly 1/12th of the anticipated real property taxes for the year. The actual
annual tax payment is made by the mortgage company with funds accumulated in the escrow
account. The homeowner gets a deduction when the actual taxes are paid to the taxing
jurisdiction and not when the homeowner makes payments for taxes to the escrow account.
22. [LO 4] How do the 2012 tax consequences of the first-time home buyer credit differ
depending on whether the taxpayer claimed the credit for a home purchase in 2008 or a
purchase in 2009 or 2010?
Taxpayers claiming the credit for home purchases on or after April 9, 2008 through
December 31, 2008 are required to pay back the credit over a 15-year period
beginning in 2010 (with their 2010 tax returns). Consequently, these taxpayers are
required to pay back on their 2012 tax returns 6.67% (one-fifteenth) of the credit
they originally claimed. Further, if the taxpayer sells or ceases to use the home as
her principal residence before repaying the entire credit, the balance of the credit is
due in the year in which the residence is sold or is otherwise no longer used as a
principal residence. The amount of the credit required to be repaid in these
circumstances may not exceed the amount of gain from the sale of the residence to
an unrelated person.
Taxpayers claiming the credit for home purchases on or after January 1, 2009
through April 30, 2010, are not required to pay back the credit unless they sell the
home or otherwise stop using it as their principal residence within 36 months after
purchasing the home. If they sell or otherwise stop using the home as their principal
residence, they are required to pay back the credit in the year they sell or stop using
the home as their principal residence.
23. [LO 5] {Planning} Is it possible for a taxpayer to receive rental income that is not subject to
taxation? Explain.
Yes. A taxpayer (owner) who lives in a home for at least 15 days and rents it out for 14 days
or less (residence with minimal rental use) is not required to include the gross receipts in
rental income but is not allowed to deduct any expenses related to the rental.
24. [LO 5] Halle just acquired a vacation home. She plans on spending several months each year
vacationing in the home, and she plans on renting the property for the rest of the year. She is
projecting tax losses on the rental portion of the property for the year. She is not too
concerned about the losses because she is confident she will be able to use the losses to offset
her income from other sources. Is her confidence misplaced? Explain.
Because Halle will be living in the home for several months, the home will be considered a
residence with significant rental use. Consequently, she may deduct expenses to obtain
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tenants (direct rental expenses such as advertising and realtor commissions) and mortgage
interest and real property taxes allocated to the rental use of the home. To the extent that
these expenses exceed gross rental income she may deduct the loss (the passive loss rules do
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not apply). However, the remaining expenses allocated to the rental use of the home may
only be deducted to the extent of the net rental income after deducting the direct rental
expenses and rental mortgage interest and real property taxes allocated to the property. This
limitation reduces her ability to deduct a rental loss from the home.
25. [LO 5] {Planning} A taxpayer stays in a second home for the entire month of September. He
would like the home to fall into the residence with significant rental use category for tax
purposes. What is the maximum number of days he can rent out the home and have it
qualify?
To qualify for the residence with significant rental use category, the taxpayer must have used
the home for personal purposes more than the greater of (1) 14 days or (2) 10% of the total
days it is rented out during the tax year and rented the house for more than 14 days. In this
situation, the taxpayer used the second home for personal purposes for 30 days (the entire
month of September). To qualify, the 30 days of personal use must be greater than 10% of
the number of days the property is rented out. If the taxpayer rents the property out for 300
days, the number of personal use days will be exactly 10% of the number of rental days, and
the property would not qualify as residence. However, if the taxpayer rents out the property
for 299 days, the 30 days of personal use will be greater than 10% of the number of rental
days, so the property would qualify as a residence with significant rental use. So, the
maximum number of days the taxpayer can rent out the home and have it qualify as a
residence with significant rental use is 299 days. Anything more than that and the property
would be considered a nonresidence with rental use.
26. [LO 5] Compare and contrast the IRS method and the Tax Court method for allocating
expenses between personal use and rental use for vacation homes. Include the Tax Courts
justification for departing from the IRS method in your answer.
The IRS method of allocating deductions between personal and rental use allocates the
deductions based on a fraction with the number of days the property was used for rental
property in the numerator and the number of days the property was used for any reason
during the year in the denominator. Each expense relating to the home is multiplied by this
fraction to determine the amount allocable to rental use. Subject to the gross rental income
limitation, tier 1 expenses are deducted first, followed by tier 2 expenses, and then tier 3
expenses.
The Tax Court and the IRS method of allocating deductions are identical except for the
allocation of the tier 1 expenses of interest and real property taxes. Under the Tax Court
approach, interest and taxes are allocated to rental use based on the fraction of days that the
property was rented over the number of days in the year (not the number of days the property
was used for any purpose during the year). The Tax Court justifies this approach by pointing
out that interest expense and property taxes accrue over the entire year regardless of the
level of personal or rental use. The Tax Court method is generally taxpayer favorable
because it tends to allocate less interest and real property taxes to the rental use which
allows more tier 2 and tier 3 expenses to be deducted when the gross income limitation
applies. The taxpayer does not lose deductions for the interest and property taxes allocated
to personal use and not to the rental activity because these expenses are deductible anyway
as itemized deductions.
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27. [LO 5] In what circumstances is the IRS method for allocating expenses between personal
use and rental use for vacation homes more beneficial to a taxpayer than the Tax Court
method?
The IRS method is generally more beneficial than the Tax Court method when the property is
considered to be a nonresidence with rental use. When the property is not a residence, the
interest allocated to personal use is not deductible. Thus, under these circumstances, the
taxpayer is better off by allocating as little interest as possible to personal use. The IRS
method accomplishes this by allocating interest (a tier 1 expense) to rental use by dividing
the total rental days by the total days used and allocating the remainder to personal use.
The Tax Court method would allocate less interest to rental use because the denominator is
365 (366 in a leap year), rather than total days used.
28. [LO 5] Under what circumstances would a taxpayer who generates a loss from renting a
home that is not a residence be able to fully deduct the loss? What potential limitations
apply?
By definition, a rental activity is considered to be a passive activity. Because they are
passive losses, losses from rental property are generally not allowed to offset other ordinary
or investment type income.
However, the loss from a rental activity may be deductible under two circumstances. First, a
taxpayer who is an active participant in the rental activity may be allowed to deduct up to
$25,000 of the rental loss against other types of income (subject to phase-out beginning at
$100,000 AGI). Second, the taxpayer may offset the passive loss from the rental activity
against other sources of passive income.
29. [LO 5] Describe the circumstances in which a taxpayer acquires a home and rents it out and
is not allowed to deduct a portion of the interest expense on the loan the taxpayer used to
acquire the home.
When a rental home is not a residence, the interest allocable to any personal-use days is
nondeductible.
30. [LO 5] Is it possible for a rental property to generate a positive annual cash flow and at the
same time produce a loss for tax purposes? Explain.
Yes. A taxpayer is able to have a positive cash flow and at the same time produce a loss for
tax purposes. This outcome is possible due to depreciation expense that is deductible for tax
purposes but does not require an annual cash outflow. A rental property could provide a
positive cash flow (gross receipts greater than cash expense for the year) but generate a tax
loss when depreciation expense is deducted.
31. [LO 5, LO 6] How are the tax issues associated with home offices and vacation homes used
as rentals similar? How are the tax issues or requirements dissimilar?
The tax issues facing renters of second homes are similar in a lot of ways with tax issues
facing taxpayers qualifying for home office deductions. Both taxpayers with home offices
and taxpayers with vacation homes are allowed to deduct business or rental expenses not
associated with the use of the home as for AGI deductions without income limitations.
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Taxpayers with home offices allocate expenses of the entire home between personal use of
the home and business use of the home. In a similar way, renters of second homes generally
allocate expenses of the second home between personal use of the home and rental use of the
home. Taxpayers with home offices and vacation homes may deduct mortgage interest and
real property taxes allocated to the business or rental use of the home as for AGI deductions
without income limitations. Further, the non mortgage interest and non real property tax
expenses allocated to business use of the home and rental use of a residence with significant
rental use may be limited by the income generated by the property (after deducting business
and rental expenses unrelated to the home and after deducting mortgage interest and real
property taxes allocated to the business or rental use of the home). Disallowed expenses are
carried over and treated as incurred in the next year.
The treatment of home offices and vacation homes are also dissimilar. By definition, a home
office is located in the taxpayers home and the home office must be used exclusively for
business purposes. In contrast, the tax consequences of owning a second home depend on
the extent to which the property is used for personal and for rental purposes. Personal use
of a rental property is allowed. This is not the case for home offices.
32. [LO 6] Are employees or self-employed taxpayers more likely to qualify for the home office
deduction? Explain.
Self-employed taxpayers are more likely to qualify for the home office deduction. Both must
meet the requirement of using the home office as either (1) the principal place of business for
any of the taxpayers trade or businesses or (2) as a place to meet with patients, clients, or
customers in the normal course of business. However, an employee must meet the additional
requirement of using the home office for the convenience of the employer. Thus, selfemployed taxpayers are more likely to qualify for the home office deduction.
33. [LO 6] Compare and contrast the manner in which employees and employers report home
office deductions on their tax returns.
Both employees and employers will determine the amount of their eligible home office
expenses in the same manner. However, each is subject to different limitations and reports
the deduction in different places on the tax return. An employer reports his home office
deduction on Schedule C of his 1040 and is limited to his Schedule C net income before
deducting the home office expense. Thus, an employers home office deduction is a for AGI
deduction.
An employee will report his home office expenses as unreimbursed employee business
expenses that are itemized deductions subject to the 2% of AGI floor. Thus, an employees
home office deduction is a from AGI deduction.
34. [LO 6] For taxpayers qualifying for home office deductions, what are considered to be
indirect expenses of maintaining the home? How are these expenses allocated to personal
and home office use?
Indirect expenses are expenses incurred in maintaining and using the home. Indirect
expenses include insurance, utilities, interest, real property taxes, general repairs, and
depreciation on the home as if it were used entirely for business purposes. Only indirect
expenses allocated to the home office space, however, are deductible. If the rooms in the
14-12
home are roughly of equal size, the taxpayer may allocate the indirect expenses to the
business portion of the home based on the number of rooms. Alternatively, the taxpayer may
allocate indirect expenses based on the amount of the space or square footage of the
business-use room relative to the total square footage in the home.
35. [LO 6] What limitations exist for self-employed taxpayers in deducting home office
expenses, and how does the taxpayer determine which expenses are deductible and which are
not in situations when the overall amount of the home office deduction is limited?
The total home office deductions other than mortgage interest and real property taxes
allocated to business use of the home allowable for the taxpayer in any given year is limited
to a taxpayers Schedule C net income (without any home office expense deductions) minus
mortgage interest and real property taxes allocated to business use of the home. Thus, home
office deductions other than mortgage interest and real property taxes cannot either create
or increase a loss on the taxpayers Schedule C. Amounts that are not deducted in the
current year are carried over and deducted in the next year subject to the same Schedule C
limitation.
The sequence of deductions for the home office follows the exact same sequence of
deductions for homes with significant personal use and significant rental use. Tier 1-type
expenses that would be deductible as itemized deductions (interest and taxes) are deducted
first (and deducted in full regardless of income). Tier 2-type expenses are deducted second,
and Tier 3-type expense (depreciation) is deducted last.
36. [LO 2, 6] A self-employed taxpayer deducts home office expenses, including depreciation
expense. The taxpayer then sells the home at a $100,000 gain. Assuming the taxpayer meets
the ownership and use tests, does the full gain qualify for exclusion? Explain.
No. When a taxpayer deducts depreciation as a home office expense, the depreciation
expense reduces the taxpayers basis in the home. Consequently, when the taxpayer sells the
home, the gain on the sale will be greater than it would have been had depreciation not been
deducted. Further, the gain on the sale of the home attributable to depreciation is not
eligible to be excluded under the home sale exclusion provisions. This gain is treated as
unrecaptured 1250 gain and is subject to a maximum 25% tax rate.
Problems
37. [LO 1] Several years ago, Junior acquired a home that he vacationed in part of the time and
rented out part of the time. During the current year Junior:
Personally stayed in the home for 22 days.
Rented it to his favorite brother at a discount for 10 days.
Rented it to his least favorite brother for eight days at the full market rate.
Rented it to his friend at a discounted rate for four days.
Rented the home to third parties for 58 days at the market rate.
Did repair and maintenance work on the home for two days.
Marketed the property and made it available for rent for 150 days during the year (in
addition to the days mentioned above).
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How many days of personal use and how many days of rental use did Junior experience on
the property during the year?
Junior has 44 days of personal use and 60 days of rental use. Personal use days include the
22 days used personally, the combined 18 days rented to relatives, and the 4 days rented out
at a discount. The rental days include the 58 days rented out to third parties at the market
rate and the 2 days for repairs and maintenance.
38. [LO 1] Lauren owns a condomium. In each of the following alternative situations, determine
whether the condominium should be treated as a residence or nonresidence for tax purposes?
a. Lauren lives in the condo for 19 days and rents it out for 22 days.
Residence: personal use (19 days) exceeds 14 days and 10% of rental days (2.2)
b. Lauren lives in the condo for 8 days and rents it out for 9 days
Nonresidence: Personal use does not exceed 14 days.
c. Lauren lives in the condo for 80 days and rents it out for 120 days
Residence: personal use (80 days) exceeds 14 days and 10% of rental days (12)
d. Lauren lives in the condo for 30 days and rents it out for 320 days.
Nonresidence: Personal use (30 days) exceeds 14 days but not 10% of rental days (32).
39. [LO 2] Steve and Stephanie Pratt purchased a home in Spokane, Washington for $400,000.
They moved into the home on February 1 of year 1. They lived in the home as their primary
residence until June 30 of year 5, when they sold the home for $700,000.
a. What amount of gain on the sale of the home are the Pratts required to include in
taxable income?
b. Assume the original facts, except that Steve and Stephanie lived in the home until
January 1 of year 3 when they purchased a new home and rented out the original
home. They finally sell the original home on June 30 of year 5 for $700,000.
Ignoring any issues relating to depreciation taken on the home while it was being
rented, what amount of realized gain on the sale of the home are the Pratts required to
include in taxable income?
c. Assume the same facts as in (b), except that the Pratts lived in the home until January
of year 4 when they purchased a new home and rented out the first home. What
amount of realized gain on the sale of the home will the Pratts include in taxable
income if they sell the first home on June 30 of year 5 for $700,000?
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d. Assume the original facts, except that Stephanie moved in with Steve on March 1 of
year 3 and the couple was married on March 1 of year 4. Under state law, the couple
jointly owned Steves home beginning on the date they were married. On December 1
of year 3, Stephanie sold her home that she lived in before she moved in with Steve.
She excluded the entire $50,000 gain on the sale on her individual year 3 tax return.
What amount of gain must the couple recognize on the sale in June of year 5?
a. $0. They are allowed to excluded the entire realized gain..
Amount realized from the sale$700,000
Adjusted basis
400,000
Gain realized
$300,000
Since the Pratts owned and used the Spokane home for at least 2 years during the 5-year
period ending on the date of the sale, they qualify for the gain exclusion. The maximum
exclusion for married taxpayers filing jointly is $500,000. Because the exclusion is more
than the gain realized on the sale, the entire gain is excluded from taxation. The Pratts
will not be required to pay any taxes on the gain on the sale of their home.
b. $300,000.
Because the Pratts used the home as their principal residence for less than 2 years
(February 1 of year 1 to January 1 of year 3) and their reason for leaving wasnt due to
unusual circumstances they dont qualify for the home sale exclusion. Consequently, they
must recognize all $300,000 of gain realized on the sale.
c. $0.
The Pratts owned and used the home for at least two years (February 1 of year 1 to
January of year 4) during the five-year period ending on the date of sale, so they qualify
for the exclusion. Consequently, the Pratts can exclude the entire $300,000 realized gain
from taxable income.
d. $50,000.
Steve meets the ownership and use test but Stephanie does not (even though she meets the
use test) because she sold her own home on December 1, year 3 and excluded the entire gain
on the sale of her home. She is not eligible to claim another exclusion for two years after
December 1, year 3. Consequently, Steve qualifies for the $250,000 exclusion (not the
$500,000 exclusion because Stephanie does not qualify). Steve (and Stephanie) must
recognize $50,000 of the $300,000 gain.
40. [LO 2] Steve and Stephanie Pratt purchased a home in Spokane, Washington for $400,000.
They moved into the home on February 1, of year 1. They lived in the home as their primary
residence until November 1 of year 1 when they sold the home for $500,000. The Pratts
marginal ordinary tax rate is 35 percent
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a. Assume that the Pratts sold their home and moved because they dont like their
neighbors. How much gain will the Pratts recognize on their home sale? At what rate, if
any, will the gain be taxed?
b. Assume the Pratts sell the home because Stephanies employer transfers her to an
office in Utah. How much gain will the Pratts recognize on their home sale?
c. Assume the same facts as in (b), except that the Pratts sell their home for $700,000.
How much gain will the Pratts recognize on the home sale?
d. Assume the same facts as (b), except that on December 1 of year 0 the Pratts sold their
home in Seattle and excluded the $300,000 gain from income on their year 0 tax return.
How much gain will the Pratts recognize on the sale of their Spokane home?
a. $100,000.
Adjusted basis
400,000
Gain realized
$100,000
The Pratts owned and used the Spokane home for only 9 months (February 1 to
November 1 of year 1), and so they fail the ownership and use tests required to qualify
for the exclusion. They also dont qualify for the hardship exception because disliking
ones neighbors does not meet the unusual circumstances test. Thus the entire
$100,000 gain is recognized. The gain is taxed at the Pratts ordinary income rate of
35% because they did not hold the home (a capital asset) for more than one year, so the
gain is a short-term capital gain, subject to ordinary income rates (note that this assumes
that they did not have any capital losses).
b. $0.
A change in employment qualifies as a hardship circumstance, so the Pratts wont be
disqualified for the exclusion. However, the maximum available exclusion must be
reduced to reflect the amount of time the Pratts owned and used the Spokane home
relative to the two year ownership and use requirements as follows:
Maximum exclusion number of months taxpayers met the use and ownership tests
24 months
$500,000 9 months = $187,500
24 months
The Pratts can exclude up to $187,500 of gain on the sale. Because they realized a gain
of only $100,000 ($500,000 400,000) they are able to exclude the entire gain from
taxable income. Consequently, the Pratts are not required to pay any taxes on the gain
on the sale of the home.
c. $112,500.
A change in employment qualifies as a hardship circumstance, so the Pratts wont be
disqualified from the exclusion. However, the maximum available exclusion must be
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reduced to reflect the amount of time the Pratts owned and used the Spokane home
relative to the two year ownership and use requirements as follows:
Maximum exclusion number of months taxpayers met the use and ownership tests
24 months
$500,000 9 months = $187,500
24 months
The Pratts can exclude up to $187,500 of gain on the sale. Because they realized a gain
of only $300,000 ($700,000 400,000) they are able to exclude $187,500 of the gain
from income but they must include $112,500 in their income. The gain is taxed at the
Pratts ordinary tax rate because they did not own the home (a capital asset) for more
than a year before they sold it.
d. $0.
Same answer as b. The rule that prohibits taxpayers from claiming an exclusion more
than once every two years does not apply to taxpayers who are selling homes under
hardship circumstances.
41. [LO 2] Steve Pratt, who is single, purchased a home in Spokane, Washington for $400,000.
He moved into the home on February 1 of year 1. He lived in the home as his primary
residence until June 30 of year 5, when he sold the home for $700,000.
a. What amount of gain will Steve be required to recognize on the sale of the home?
b. Assume the original facts, except that the home is Steves vacation home and he
vacations there four months each year. Steve does not ever rent the home to others.
What gain must Steve recognize on the home sale?
c. Assume the original facts except that Steve married Stephanie on February 1 of year 3
and the couple lived in the home until they sold it in June of year 5. Under state law,
Steve owned the home by himself. How much gain must Steve and Stephanie recognize
on the sale (assume they file a joint return in year 5).
a.
$50,000.
Adjusted basis
400,000
Gain realized
$300,000
Since Steve owned and used the Spokane home for at least 2 years during the 5-year
period ending on the date of the sale, he qualifies for the gain exclusion. The maximum
exclusion for single taxpayers is $250,000. This exclusion will reduce Steves recognized
gain to $50,000 ($300,000 gain realized less the $250,000 exclusion).
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b.
$300,000 gain recognized.

Adjusted basis
400,000
Gain realized
$300,000
Exclusion
0
Gain recognized
$300,000
Steve must recognize all of the realized gain because he does not meet the use test. That
is, the home was not his principal residence for two years during the five-year period
ending on the date of the sale.
c. $0 gain recognized.
They realized a $300,000 gain on the sale. However, the couple qualifies for the married
filing joint exclusion of $500,000 because Steve meets the ownership test and Steve and
Stephanie meet the principal use test. Consequently, they can exclude the entire gain.
42. [LO 2] Celia has been married to Daryl for 52 years. The couple has lived in their current
home for the last 20 years. On October of year 0, Daryl passed away. Celia sold their home
and moved into a condominium. What is the maximum exclusion Celia is entitled to if she
sells the home on December 15 of year 1?
Celia may exclude up to $500,000 of gain on the sale of her home because she sold the
within two years of the date of the death of her spouse, she meets the ownership and use
tests, and her husband met the ownership and use tests prior to his death.
43. [LO 2] Sarah purchased a home on January 1, 2007 for $600,000. She eventually sold the
home for $800,000. What amount of the $200,000 gain on the sale may Sarah exclude from
gross income in each of the following alternative situations?
a. Sarah used the home as her principal residence until July 1, 2012. She used the home
as a vacation home from July 1, 2012 until she sold it on July 1, 2014.
b. Sarah used the property as a vacation home until July 1, 2012. She then used the
home as her principal residence from July 1, 2012 until she sold it on July 1, 2014.
c. Sarah used the home as a vacation home from January 1, 2007 until January 1, 2013.
She used the home as her principal residence from January 1, 2013 until she sold it on
July 1, 2014.
d. Sarah used the home as a vacation home from January 1, 2008 until July 1, 2009. She
used the home as her principal residence from July 1, 2009 until she sold it on July 1,
2012.
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a. $200,000 of gain is excluded and $0 gain is recognized.

Sarah meets the ownership and use tests because she has owned the property for two
or more years and used it as her principal residence for at least two out of the last
five years, so she can exclude her gain up to $250,000. She does not have any
nonqualified use because the nonqualified use period does not include the five tax
years immediately after she stopped using the home as a principal residence.
b. $106,667 of gain is excluded and $93,333 of gain recognized. If not for the limitation
for nonqualified use after December 31, 2008, Sarah could have excluded the entire
$200,000 gain. However, because Sarah sold the home after December 31, 2008 and
she had nonqualified use after December 31, 2008, she is not allowed to exclude a
percentage of the gain that would otherwise be excluded. The percentage of the gain
that is not excluded is a fraction, the numerator of which is the nonqualified use after
December 31, 2008, and the denominator is the amount of time she owned the
property. In this case, $93,333 of the $200,000 gain (46.67%) is not excludable. The
numerator of the disallowance fraction is 3.5 years of post 2008 nonqualified use
(January 1, 2009 through July 1, 2012) and the denominator is 7.5 years of
ownership (January 1, 2007 through July 1, 2014) (3.5/7.5 = 46.67%).
c. $0 of gain is excluded and $200,000 of gain is recognized.
While Sarah meets the ownership test, she does not meet the use test because she
used the property as her principal residence for less than two of the five years
preceding the sale.
d. $181,818 of gain is excluded and $18,182 of gain is recognized. If not for the
limitation for nonqualified use after December 31, 2008, Sarah could have excluded
the entire $200,000 gain. However, because Sarah sold the home after December 31,
2008 and she had nonqualified use after December 31, 2008, she is not allowed to
exclude a percentage of the gain that would otherwise be excluded. The percentage
of the gain that is not excluded is a fraction, the numerator of which is the
nonqualified use after December 31, 2008, and the denominator is the amount of time
she owned the property. In this case, the numerator of the disallowance fraction is .5
years of post-2008 nonqualified use (January 1, 2009 through July 1, 2009) and the
denominator is 5.5 years of ownership (January 1, 2007 through July 1, 2014) (.5/5.5
= 9.091%). So the gain not eligible for exclusion is $18,182 ($200,000 9.091%).
44. [LO 2] Troy (single) purchased a home in Hopkinton, MA on April 6, 2005 for $300,000. He
sold the home on October 6, 2012 for $320,000. How much gain must Troy recognize on his
home sale in each of the following alternative situations?
a. Troy rented the home out from April 6, 2005 through July 5, 2009. He lived in the
home as his principal residence from July 6, 2009 through the date of sale.
Accumulated depreciation on the home at the time of sale was $7,000.
b. Troy lived in the home as his principal residence from April 6, 2005 through July 5,
2009. He rented the home from July 6, 2009 through the date of the sale.
Accumulated depreciation on the home at the time of sale was $2,000.
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c. Troy lived in the home as his principal residence from April 6, 2005 through April 5,
2010. He rented out the home from April 6, 2010 through the date of the sale.
Accumulated depreciation on the home at the time of sale was $0.
d. Troy rented the home from April 6, 2005 through March 31, 2009. He lived in the
home as his principal residence from April 1, 2009 through October 31, 2010. He
rented out the home from November 1, 2010 through March 31, 2012 and he lived in
the home as his principal residence from April 1, 2012, through the date of the sale.
Accumulated depreciation on the home at the time of sale was $0.
a. $7,000 of gain recognized. Troy meets the ownership and use tests but gain
created by the accumulated depreciation is not eligible for exclusion. Troy
realized a gain of $27,000 ($320,000 amount realized minus $293,000 adjusted
basis (basis reduced by $7,000 of accumulated depreciation).
b. $22,000 gain recognized. Troy meets the ownership test but he fails the use test
because he did not use the home as his principal residence for two years between
October 7, 2007, and October 6, 2012 (five year period ending on the date of
sale). During this five year period, he lived in the home as his principal residence
from October 7, 2007 through July5, 2009 which is less than two years. Troys
gain is $22,000 ($320,000 - $298,000). Note that the basis of the home was
reduced by the $2,000 of accumulated depreciation.
c. $0 gain recognized. Troy meets the ownership and use tests. Further, the period
from April 6, 2010 through the date of the sale is not nonqualified use because
nonqualified use does not include the five year period after the last date the
taxpayer used the home as a principal residence.
d. $1,905 of gain recognized. Troy meets the ownership and use requirements.
However, his use from January 1, 2009 through March 31, 2009 (three months)
and his use from November 1, 2010 through March 31, 2012 (five months) is
nonqualified use (post 2008 use as other than principal residence and does not
extend beyond his last use of the home as a principal residence). Troy had 8
months of nonqualified use (3 + 5) of the home that he owned for 84 months
(2005 - 2012). Consequently, of the $20,000 gain realized, Troy must recognize
8/84ths or $1,905 ($20,000 8/84).
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45. [LO 3] Javier and Anita Sanchez purchased a home on January 1, 2012 for, $500,000 by
paying $200,000 down and borrowing the remaining $300,000 with a 7 percent loan secured
by the home. The loan requires interest-only payments for the first five years. The
Sanchezes would itemize deductions even if they did not have any deductible interest. The
Sanchezes marginal tax rate is 30 percent.
a. What is the after-tax cost of the interest expense to the Sanchezes in 2012?
b. Assume the original facts, except that the Sanchezes rent a home and pay $21,000 in
rent during the year. What is the after-tax cost of their rental payments in 2012?
c. Assuming the interest expense is their only itemized deduction for the year and that
Javier and Anita file a joint return, have great eyesight, and are under 60 years of age,
what is the after-tax cost of their 2012 interest expense?
a.
$14,700.
The $300,000 loan is treated as acquisition indebtedness, since it was to initially acquire
the home. Interest on up to $1,000,000 of acquisition indebtedness is deductible as an
itemized deduction. Since the $300,000 loan principal is less than the limit, all of the
interest associated with the loan is deductible. The after-tax cost of the interest expense
is calculated as follows:
b.
Description
(1) Before-tax interest expense
Amount
$21,000
(2) Marginal tax rate

(3) Tax savings from interest expense
After-tax cost of interest expense
30%
$6,300
$14,700
Explanation
$300,000 7%. All
deductible.
(1) (2)
(1) (3)
$21,000.
Because rental payments are not deductible, they do not generate any tax savings, so the
before- and after-tax cost of the rental payments is the same.
14-21
c.
$18,270.
Because the Sanchezes had no other itemized deductions, their interest expense only
produces a benefit to them to the extent that it exceeds the standard deduction, calculated
as follows:
Description
(1) Before-tax interest expense
Amount
$21,000
(2) Standard deduction

(3) Interest in excess of standard
deduction
(5) Tax savings from interest expense
After-tax cost of interest expense
11,900
$9,100
30%
$2,730
$18,270
Explanation
$300,000 7%. All
deductible.
MFJ
(1) (2)
(3) (4)
(1) (5)
46. [LO 3] Javier and Anita Sanchez purchased a home on January 1 of year 1 for $500,000 by
Sanchezes would itemize deductions even if they did not have any deductible interest.
a. Assume the Sanchezes also took out a second loan (on the same day as the first loan)
secured by the home for $80,000 to fund expenses unrelated to the home. The interest
rate on the second loan is 8 percent. The Sanchezes make interest-only payments on the
loan in year 1. What is the maximum amount of their deductible interest expense (on
both loans combined) in year 1?
b. Assume the original facts and that the Sanchezes take out a second loan (on the same
day as the first loan) secured by the home in the amount of $50,000 to fund expenses
unrelated to the home. The interest rate on the second loan is 8 percent. The Sanchezes
make interest-only payments during the year. What is the maximum amount of their
deductible interest expense (on both loans combined) in year 1?
a.
$35,755, using the average interest expense method.
The first loan of $450,000 is classified as acquisition indebtedness. The second loan of
$80,000 is classified as home-equity indebtedness. The amount of home-equity
indebtedness is limited to the lesser of (1) the fair market value of the qualified residence
in excess of the acquisition debt related to that residence and (2) $100,000 ($50,000 for
married filing separately). The Sanchezes home is worth $500,000 ($50,000 down
payment plus the $450,000 acquisition indebtedness). Hence the home-equity
indebtedness is limited to $50,000 which is the lesser of
(1) FMV of residence less acquisition debt ($500,000 - $450,000) = $50,000 or
(2) the amount of home-equity indebtedness or $100,000
Because the total debt secured by the home exceeds the total qualifying debt, the
Sanchezes can use the chronological order method or the average interest method to
determine the total deductible interest.
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Under the chronological method, the Sanchezes could deduct $4,000 on the second loan
($50,000 8%) and $31,500 on the first loan for a total of $35,500 interest expense.
14-23
Under the average interest method the Sanchezes may deduct $35,755 of interest in total,
computed as follows:
$37,900 total interest $500,000/$530,000 = $35,755. Consequently the average
interest method allows them to deduct more interest in total.
b.
$35,500 consisting of $4,000 on the second loan and $31,500 on the acquisition
loan.
In this case, the Sanchezes are able to deduct all of the interest on both loans because the
actual home-equity loan ($50,000) does not exceed the home-equity indebtedness limit
calculated above ($50,000).
47. [LO 3] Javier and Anita Sanchez purchased a home on January 1, year 1 for $500,000 by
Sanchezes would itemize deductions even if they did not have any deductible interest. On
January 1, the Sanchezes also borrowed money on a second loan secured by the home for
$75,000. The interest rate on the loan is 8 percent and the Sanchezes make interest-only
payments in year 1 on the second loan.
a. Assuming the Sanchezes use the second loan to landscape the yard to their home, what
is the maximum amount of interest expense (on both loans combined) they are allowed
to deduct year 1?
b. Assume the original facts and that the Sanchezes use the $75,000 loan proceeds for an
extended family vacation. What is the maximum amount of interest expense (on both
loans combined) they are allowed to deduct in year 1?
c. Assume the original facts, except that the Sanchezes borrow $120,000 on the second
loan and they use the proceeds for an extended family vacation and other personal
expenses. What is the maximum amount of interest expense (on both loans combined)
they are allowed to deduct in year 1?
a.
$27,000 ($21,000 + $6,000), determined as follows:

The first loan of $300,000 is classified as acquisition indebtedness. The second loan of
$75,000 would likely also be classified as acquisition indebtedness because it was used
to substantially improve the home. Because the Sanchezes acquisition indebtedness of
$375,000 ($300,000 + $75,000) does not exceed the $1,000,000 acquisition debt limit,
they may deduct all of the $21,000 interest on the first loan ($300,000 7%) and the
entire $6,000 of interest on the second loan ($75,000 8%).
b.
$27,000 ($21,000 + $6,000), determined as follows:

The Sanchezes can deduct the $21,000 interest on the first loan which is acquisition debt
($300,000 7%). The second loan qualifies as a home-equity loan because it was not
used to substantially improve the home. The amount of home-equity indebtedness is
limited to the lesser of (1) the fair market value of the qualified residence in excess of the
14-24
acquisition debt related to that residence and (2) $100,000 ($50,000 for married filing
separately). The Sanchezes home is worth $500,000 ($200,000 down payment plus the
14-25
$300,000 acquisition indebtedness). Hence the home-equity indebtedness is limited to

$75,000 which is the lesser of
(1) FMV of residence less acquisition debt ($500,000 - $300,000) = $200,000, or
(2) the amount of home-equity indebtedness or $100,000,
Thus the Sanchezes can deduct interest on up to $100,000 of home-equity indebtedness.
Because their second loan of $75,000 is below this limit, they can deduct the full $6,000
of interest paid on the second loan ($75,000 8%).
c.
$29,143 under the average interest expense method, determined as follows:

In this case, the Sanchezes have $420,000 of debt but only $400,000 of qualifying debt
($300,000 acquisition debt + $100,000 qualifying home equity debt). The second loan
qualifies as a home-equity loan because it was not used to substantially improve the
home. The amount of home-equity indebtedness is limited to the lesser of (1) the fair
market value of the qualified residence in excess of the acquisition debt related to that
residence and (2) $100,000 ($50,000 for married filing separately). The Sanchezes
home is worth $500,000 ($200,000 down payment plus the $300,000 acquisition
indebtedness). Hence the home-equity indebtedness is limited to $100,000 which is the
lesser of
(1) FMV of residence less acquisition debt ($500,000 - $300,000) = $200,000 or
(2) the amount of qualifying home-equity indebtedness of $100,000
In total, the Sanchezes paid $30,600 of interest ($21,000 on the acquisition debt
$300,000 7% + $9,600 on the second loan $120,000 8%). Because the total debt
secured by the home exceeds the total qualifying debt, the Sanchezes can use the average
interest method or the chronological order method to determine the total deductible
interest.
Under the chronological method, they would deduct the $21,000 interest on the first
mortgage and $8,000 on the second mortgage ($100,000 qualifying home equity debt
8%) for a total of $29,000.
Under the average interest method the Sanchezes may deduct $29,143 of interest,
computed as follows:
$30,600 total interest $400,000/$420,000 = $29,143. Assuming the $21,000 interest on
the acquisition debt is deductible in full, $8,143 of the interest on the second loan is
deductible.
In total, the Sanchezes would deduct more interest under the average interest method
than under the chronological method.
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48. [LO 3] Lewis and Laurie who are married and jointly own a home valued at $240,000. They
recently paid off the mortgage on their home. In need of cash for personal purposes
unrelated to the home, the couple borrowed money from the local credit union. How much
interest may the couple deduct in each of the following alternative situations (assume they
itemize deductions no matter the amount of interest)?
a. The couple borrows $40,000 and the loan is secured by their home. They use the loan
proceeds for purposes unrelated to the home. The couple pays $1,600 interest on the
loan during the year and the couple files a joint return.
b. The couple borrows $10,000 unsecured from the credit union. The couple pays $900
interest on the loan during the year and the couple files a joint return.
c. The couple borrows $110,000 and the loan is secured by their home. The couple pays
$5,200 interest on the loan during the year and the couple files a joint return.
d. The couple borrows $110,000 and the loan is secured by their home. The couple pays
$5,200 interest on the loan during the year and the couple files separate tax returns.
Determine the interest deductible by Lewis only.
a. $1,600. The couple would be able to do deduct all of the interest as home equity
indebtedness (limited to $100,000 of principal).
b. $0. Because the loan is for personal purposes and is not secured by the home, the
interest is nondeductible personal interest.
c. $4,727. While the loan is secured by the home, interest is deductible on only
$100,000 of principal. Consequently, the deductible interest is computed as follows:
$5,200 $100,000/$110,000.
d. $2,364 (rounded). This is exactly half of the full amount of deductible interest if the
couple had filed jointly. The limit on qualifying home equity indebtedness for
married persons filing separately is $50,000. Because Lewis and Laurie jointly own
the home (presumably 50-50), each spouse is treated as having paid $2,600 of
interest. Consequently, Lewiss deductible interest is $2,600 $50,000/55,000.
49. [LO 3] On January 1 of year 1, Arthur and Aretha Franklin purchased a home for $1.5
million by paying $200,000 down and borrowing the remaining $1.3 million with a 7 percent
loan secured by the home.
a. What is the amount of the interest expense the Franklins may deduct in year 1?
b. Assume that in year 2, the Franklins pay off the entire loan but at the beginning of year
3, they borrow $300,000 secured by the home at a 7 percent rate. They make interestonly payments on the loan during the year. What amount of interest expense may the
Franklins deduct in year 3 on this loan (the Franklins do not use the loan proceeds to
improve the home)?
c. Assume the same facts as in (b), except that the Franklins borrow $80,000 secured by
their home. What amount of interest expense may the Franklins deduct in year 3 on this
loan (the Franklins do not use the loan proceeds to improve the home)?
a.
$77,000.
Because the acquisition indebtedness limit ($1,000,000) and the home-equity
indebtedness limit ($100,000) are two separate limits, the maximum amount of debt on
which a taxpayer may deduct qualified residence interest is $1,100,000 as long as the
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value of the taxpayers residence (or residences) is at least $1,100,000. Since the
Franklins home is worth $1.5 million, they can deduct interest on up to $1.1 million.
Thus, the amount of deductible interest on the loan is calculated as follows:
Total interest expense = total loan principal x interest rate
= $1.3 million 7%
= $91,000
Deductible interest expense = Qualified debt/Total debt x total interest expense
= [$1.1 million/1.3 million] $91,000
= $77,000
b.
$7,000.
Once acquisition indebtedness is established, only payments on principal can reduce the
indebtedness and only additional indebtedness secured by the residence and incurred to
substantially improve the residence can increase it. In this case, the Franklins reduced
their original acquisition indebtedness to zero. Because the Franklins do not use the
additional loan in year 3 to substantially improve their home, the loan cannot be
classified as acquisition indebtedness. Thus, the interest on the loan can only be
deducted to the extent that it qualifies as home-equity indebtedness. $100,000 of the loan
qualifies as home-equity indebtedness and the Franklins may deduct $7,000 of interest
paid on the loan ($100,000 7%).
c.
$5,600
Similar to part b above, the new loan can only be classified as acquisition indebtedness
to the extent that the loan proceeds are used to substantially improve the residence.
However, in this scenario, the Franklins will be able to deduct the full $5,600 ($80,000
7%) paid in interest because even though the loan proceeds are not used to substantially
improve the residence, the full amount of interest is deductible because it qualifies as
home-equity indebtedness and the amount of the loan is less than $100,000. Thus, it does
not matter how the Franklins use the loan proceeds as long as the loan is less than
$100,000.
50. [LO 3] In year 0, Eva took out a $50,000 home-equity loan from her local credit union. At
the time she took out the loan, her home was valued at $350,000. At the time of the loan,
Evas original mortgage on the home was $265,000. At the end of year 1, her original
mortgage is $260,000. Unfortunately for Eva, during year 1, the value of her home dropped
to $280,000. Consequently, as of the end of year 1, Evas home secured $310,000 of homerelated debt but her home is only valued at $280,000. Assuming Eva paid $15,000 of interest
on the original mortgage and $3,500 of interest on the home-equity loan during the year, how
much qualified residence interest can Eva deduct in year 1?
Eva may deduct the full $15,000 of interest on the original loan and the full $3,500 of
interest on the home-equity loan. The determination of the fair market value of the home (in
order to determine the amount of home equity) is made on the date that the last debt is
secured by the home. In this case, the determination would be the date that Eva took out the
$50,000 loan. Because the home was valued at $350,000 at that time, the entire $50,000 is
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considered to be home-equity indebtedness even though the value of the home subsequently
dropped to the point that she does not have $50,000 of available equity in the home. Thus, in
year 1, Eva would be able to deduct the full $15,000 interest on the original mortgage and
the full $3,500 from the home-equity loan.
51. [LO 3] On January 1 of year 1, Jason and Jill Marsh acquired a home for $500,000 by paying
$400,000 down and borrowing $100,000 with a 7 percent loan secured by the home. On
January 1, of year 2, the Marshes needed cash so they refinanced the original loan by taking
out a new $250,000 7 percent loan. With the $250,000 proceeds from the new loan, the
Marshes paid off the original $100,000 loan and used the remaining $150,000 to fund their
sons college education.
a. What amount of interest expense on the refinanced loan may the Marshes deduct in
year 2?
b. Assume the original facts except that the Marshes use the $150,000 cash from the
refinancing to add two rooms and a garage to their home. What amount of interest
expense on the refinanced loan may the Marshes deduct in year 2?
a.
$14,000, determined as follows:
Because the Marshes paid off all of their original acquisition indebtedness and did not
increase it by making substantial improvements on their home, their acquisition
indebtedness remains at $100,000. Therefore, the Marshes may deduct interest on
$100,000 of the acquisition indebtedness portion of the loan for the year. This amounts
to $7,000 ($100,000 7%). They may also deduct interest on $100,000 of home equity
indebtedness. Home-equity indebtedness is limited to the lesser of (1) $100,000 or (2)
the fair market value of the qualified residence in excess of the acquisition debt related to
the residence. Assuming the home is worth at least $250,000, the Marshes may also
deduct interest on $100,000 of home equity loan for the year. This amounts to $7,000
($100,000 7% ). In total, the Marshes may deduct $14,000 of interest on the
refinanced loan.
b.
$17,500.
In this case, because the Marshes used the loan proceeds to add on to their house, the
entire refinanced loan qualifies as acquisition indebtedness. Because the total
acquisition indebtedness is under $1,000,000, the Marshes may deduct all of the interest
on the refinanced loan. The interest on the loan and the Marshes deduction is $17,500
($250,000 7%).
52. [LO 3] {Planning} On January 1, year 1 Brandon and Alisa Roy purchased a home for $1.5
million by paying $500,000 down and borrowing the remaining $1 million with a 7 percent
loan secured by the home. Later the same day, the Roys took out a second loan, secured by
the home, in the amount of $300,000.
a. Assuming the interest rate on the second loan is 8 percent. What is the maximum
amount of the interest expense the Roys may deduct on these two loans (combined) in
year 1?
b. Assuming the interest rate on the second loan is 6 percent, what is the maximum
amount of interest expense the Roys may deduct on these two loans (combined) in year
1?
14-29
a.
$79,538.
value of the taxpayers residence (or residences) is at least $1,100,000. Since the Roys
home is worth $1.5 million, they can deduct interest on up to $1.1 million. The Roys
have two options for determining the amount of deductible interest. First, they could
deduct a pro-rata portion of the interest expense from each loan. Under this option, their
deductible interest expense would be calculated as follows:
Option 1: Total interest expense = [acquisition debt interest rate] + [home equity debt
interest rate]
=[$1 million 7%] + [$300,000 8%]
= $94,000
Deductible interest expense= Qualified debt/Total debt x total interest expense
= [$1.1 million/1.3 million] x $94,000
= $79,538
Alternatively, the Roys could deduct the interest based on the order in which the loans
were taken out. Under this option, the Roys deductible interest expense would be as
follows:
Option 2: Deductible interest expense
$1 million 7% = $70,000
$100,000 8% = $8,000
Deductible interest expense = $78,000
The Roys would maximize their interest expense deductions by using option 1 (the
average interest expense method). This option generates $1,538 more in interest
deductions than option 2.
b.
$76,000.
value of the taxpayers residence (or residences) is at least $1,100,000. Since the Roys
home is worth $1.5 million, they can deduct interest on up to $1.1 million. The Roys
have two options for determining the amount of deductible interest. First, they could
deduct a pro-rata portion of the interest expense from each loan. Under this option, their
deductible interest expense would be calculated as follows:
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Option 1: Total interest expense = [acquisition debt x interest rate] + [home equity debt
interest rate]
=[$1 million 7%] + [$300,000 6%]
= $88,000
Deductible interest expense= Qualified debt/Total debt total interest expense
= [$1.1 million/1.3 million] $88,000
= $74,462
Alternatively, the Roys could deduct the interest based on the order in which the loans
were taken out. Under this option, the Roys deductible interest expense would be as
follows:
Option 2: Deductible interest expense
$1 million 7% = $70,000
$100,000 6% = $6,000
Deductible interest expense = $76,000
The Roys would maximize their interest expense deductions by using option 2 (the
chronological order method). This option generates $1,538 more in interest deductions
than option 1.
53. [LO 3] {Research} Jennifer has been living in her current principal residence for three years.
Six months ago Jennifer decided that she would like to purchase a second home near a beach
so she can vacation there for part of the year. Despite her best efforts, Jennifer has been
unable to find what she is looking for. Consequently, Jennifer recently decided to change
plans. She purchased a parcel of land for $200,000 with the intention of building her second
home on the property. To acquire the land, she borrowed $200,000 secured by the land.
Jennifer would like to know whether the interest she pays on the loan before construction on
the house is completed is deductible as mortgage interest.
a. How should Jennifer treat the interest if she has begun construction on the home and
plans to live in the home in 12 months from the time construction began?
b. How should Jennifer treat the interest if she hasnt begun construction on the home, but
plans to live in the home in 15 months?
c. How should Jennifer treat the interest if she has begun construction on the home but
doesnt plan to live in the home for 37 months from the time construction began?
See Reg 1.163-10T(p)(5).
a.
Unless the taxpayer has begun construction of a home on the land that the taxpayer
can occupy within 24 months, the land would be considered an investment and the
interest paid on the second mortgage would not qualify as deductible mortgage interest.
Because Jennifer will be in the home within 12 months, the interest qualifies as mortgage
interest.
b.
Because Jennifer has not begun construction on the home, the interest on the loan is
not eligible for mortgage interest even though Jennifer will live in the home in 15 months.
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She would be able to deduct the interest as investment interest expense (subject to
limitations on the expense) if she itemizes her deductions.
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c.
Even though she has begun construction, because Jennifer will not occupy the home
within 24 months the interest expense does not qualify as mortgage interest. However,
she would be able to deduct it as an itemized deduction for investment interest expense
(subject to limitations on investment interest expenses deductibility).
54. [LO 3] {Planning} Rajiv and Laurie Amin are recent college graduates looking to purchase a
new home. They are purchasing a $200,000 home by paying $20,000 down and borrowing
the other $180,000 with a 30-year loan secured by the home. The Amins have the option of
(1) paying no discount points on the loan and paying interest at 8 percent or (2) paying one
discount point on the loan and paying interest of 7.5 percent. Both loans require the Amins
to make interest-only payments for the first five years. Unless otherwise stated, the Amins
itemize deductions irrespective of the amount of interest expense. The Amins are in the 25
percent marginal ordinary income tax bracket.
a. Assuming the Amins do not itemize deductions, what is the break-even point for
paying the point to get a lower interest rate?
b. Assuming the Amins do itemize deductions, what is the break-even point for paying
the point to get a lower interest rate?
c. Assume the original facts except that the amount of the loan is $300,000. What is the
break-even point for the Amins for paying the point to get a lower interest rate?
d. Assume the original facts except that the $180,000 loan is a refinance instead of an
original loan. What is the break-even point for paying the point to get a lower interest
rate?
e. Assume the original facts except that the amount of the loan is $300,000 and the loan is
a refinance and not an original loan. What is the break-even point for paying the point to
get a lower interest rate?
a. 2 years.
Cost of paying 1 point= loan principal 1%
=$180,000 1%
=$1,800
Because the Amins do not itemize deductions, they will receive no tax benefit from the
deduction for the points paid. Consequently, the after-tax cost of the point is the same as
the before-tax cost of the point$1,800. The Amins need to determine how long it will
take them to recoup this cost due to a lower interest rate. To do this, they should divide
the after-tax cost of paying the point by the yearly after-tax interest savings from the
point. The after-tax cost of paying the point is $1,800. The after-tax savings due to a
lower interest rate is $900 calculated as follows:
Before-tax savings due to a lower interest rate= $180,000 loan (8%-7.5%)
= $900
Because the Amins are not itemizing deductions, additional interest payments do not
generate any tax savings, therefore the after-tax savings from the lower interest rate is
the same as the before-tax savings of $900.
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The break-even period, then, is 2 years ($1,800 after-tax cost of the point/$900 after-tax
annual savings from the lower interest rate).
b.
2 years.
Loan summary: $180,000; 8% rate with no
points. 7.5% rate with 1 point. The Amins pay
only interest for the first five years.
Description
(1)Initial cash outflow from paying 1 point
(2) Tax benefit from deducting points
(3) After-tax cost of points
(4) Before-tax savings per year from 7.5% vs.
8% interest rate
(5) Forgone tax benefit per year of higher
interest rate
(6) After-tax savings per year of 7.5% vs. 8%
interest rate
Break-even point in years
Amounts
($1,800)
+ $450
($1,350)
$900
($225)
$675
2 years
Calculation
$180,000 1%
(1) 25%
(1) + (2)
[$180,000 (8%
7.5%)]
(4) 25%
(4) + (5)
(3) / (6)
The break even period is 2 years. This is the same break-even point for the Amins even if
they dont itemize deductions.
c.
2 years.
only interest for the first five years.
Description
(1)Initial cash outflow from paying 1 point
8% interest rate
(5) Forgone tax benefit per year of higher
interest rate
interest rate
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Amounts
($3,000)
+ $750
($2,250)
$1,500
($375)
Calculation
$300,000 x 1%
(1) 25%
(1) + (2)
[$300,000 x (8%
-7.5%)]
(4) 25%
$1,125
(4) + (5)
2 years
(3) / (6)
d.
2.6 years.
interest only for the first 5 years. 30-year loan.
Description
(1) Initial cash outflow from paying points
8% interest rate
(5) Foregone tax benefit per year of higher
interest payments
interest rate
(7) Annual tax savings from amortizing points
(8) Annual after-tax cash flow benefit of paying
points
Points
($1,800)
0
($1,800)
$900
($225)
$675
$15
$690
2.6 years
Calculation
$180,000 1%
(1) + (2)
[$180,000 (8%
-7.5%)]
(4) 25%
(4) + (5)
(1) / 30 years 25%
(6) + (7)
(3) / (8)
Because this is a refinance, the $1,800 paid for the point is not immediately deductible.
Consequently, the after-tax cost of the point is $1,800. The $1,800 is amortized over 30
years, generating a $60 deduction each year. The $60 deduction will save the Amins $15
in taxes each year ($60 25%).
14-35
e.
2.6 years.
interest only for the first 5 years. 30-year loan.
Description
8% interest rate
(5) Foregone tax benefit per year of higher
interest payments
interest rate
(7) Annual tax savings from amortizing points
(8) Annual after-tax cash flow benefit of paying
points
Points
($3,000)
0
($3,000)
$1,500
Notes
$300,000 1%
(1) + (2)
[$300,000 (8%
-7.5%)]
(4) 25%
($375)
$1,125
(4) + (5)
$25
$1,150
(1) / 30 years 25%

(6) + (7)
2.6 years
(3) /(8)
Because this is a refinance, the $3,000 paid for the point is not immediately deductible.
Consequently, the after-tax cost of the point is $3,000. The $3,000 is amortized over 30
years, generating a $100 deduction each year. The $100 deduction will save the Amins
$25 in taxes each year ($100 25%).
55. [LO 4] In year 1, Peter and Shaline Johnsen moved into a home in a new subdivision. Theirs
was one of the first homes in the subdivision. In year 1, they paid $1,500 in real property
taxes to the state government, $500 to the developer of the subdivision for an assessment to
pay for the sidewalks, and $900 for real property taxes on land they hold as an investment.
What amount of property taxes are the Johnsens allowed to deduct assuming their itemized
deductions exceed the standard deduction amount before considering any property tax
deductions?
The Johnsens may deduct $2,400 of property taxes as itemized deductions. This includes the
$1,500 paid in property taxes on their home and $900 in property taxes paid on land they are
holding as an investment. However, taxpayers are not allowed to deduct fees paid for water
and sewer services, and assessments for local benefits such as streets and sidewalks. Thus,
the Johnsens may not deduct the $500 assessment fee to pay for sidewalks.
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56. [LO 4] Jesse Brimhall is single. In 2012, his itemized deductions were $4,000 before
considering any real property taxes he paid during the year. Jesses adjusted gross income
was $70,000 (also before considering any property tax deductions). In 2012, he paid real
property taxes of $3,000 on property 1 and $1,200 of real property taxes on property 2.
a. If property 1 is Jesses primary residence and property 2 is his vacation home (he
does not rent it out at all), what is his taxable income after taking property taxes into
account?
b. If property 1 is Jesses business building (he owns the property) and property 2 is his
primary residence, what is his taxable income after taking property taxes into
account?
c. If property 1 is Jesses primary residence and property 2 is a parcel of land he holds
for investment, what is his taxable income after taking property taxes into account?
a.
$58,000.
The property tax on both properties are deductible as itemized deductions because
neither property is used for business or rental activities and the sum of Jesses itemized
deductions, including property taxes, exceeds his standard deduction.
Description
(1) AGI
(2) Standard deduction
(3) Itemized deductions
(4) Personal exemption
Taxable income after property taxes
b.
Amount
$70,000
(5,950)
(8,200)
(3,800)
$58,000
Calculation
$4,000+ $3,000 + $1,200
(1) + (3) + (4)
$57,300.
The property tax on the business building is deductible for AGI, and the tax on the
personal residence is deductible as an itemized deduction
Description
(1) AGI before property taxes
(2) Business property taxes
(3) AGI
(4) Basic standard deduction
(5) Itemized deductions (including property
taxes)
(6) Greater of standard deduction or
itemized deductions
(7) Personal exemption
Taxable income after property taxes
Amount
$70,000
(3,000)
67,000
(5,950)
(5,200)
(5,950)
(3,800)
$57,250
Calculation
For AGI deduction
(1) + (2)
$4,000 + $1,200
(5) > (4)
(1) + (6) + (7)
c.
$58,000.
The answer is the same as part (a). The property taxes on both properties (residence and
investment property) are deductible as itemized deductions because neither property is used
for business or rental activities.
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57. [LO 4] Craig and Karen Conder purchased a new home on May 1 of year 1 for $200,000. At
the time of the purchase, it was estimated that the real property tax rate for the year would be
one percent of the propertys value. How much in property taxes on the new home are the
Conders allowed to deduct under each of the following circumstances (the Conders itemized
deductions exceed the standard deduction before considering property taxes)?
a. The property tax estimate proves to be accurate. The seller and the Conders paid their
share of the tax. The full property tax bill is paid to the taxing jurisdiction by the end of
the year.
b. The actual property tax bill turns out to be 1.05 percent of the propertys value. The
Conders paid their share of the estimated tax bill and the entire difference between the
one percent estimate and the 1.05 percent actual tax bill and the seller paid the rest. The
full property tax bill is paid to the taxing jurisdiction by the end of the year.
c. The actual property tax bill turns out to be .95 percent of the propertys value. The
seller paid taxes based on their share of the one percent estimate and the Conders paid the
difference between what the seller paid and the amount of the final tax bill. The full
property tax bill is paid to the taxing jurisdiction by the end of the year.
a. $1,333 ($200,000 .01 8/12). Because the Conders owned the property for 8 of 12
months in year 1, they are allowed to deduct two-thirds (8/12) of the actual property taxes
paid to the taxing jurisdiction for the year.
b. $1,400 ($200,000 .0105 8/12). Because the Conders owned the property for 8 of 12
paid to the taxing jurisdiction for the year. This is true even though the Conders ended up
paying more than $1,400 to the taxing jurisdiction for the year.
c. $1,267 ($200,000 .0095 8/12). Because the Conders owned the property for 8 of 12
paid to the taxing jurisdiction for the year. This is true even though the Conders ended up
paying less than $1,267 to the taxing jurisdiction for the year.
58. [LO 4] Kirk and Lorna Newbold purchased a new home on August 1 of year 1 for $300,000.
At the time of the purchase, it was estimated that the real property tax rate for the year would
be .5 percent of the propertys value. Because the taxing jurisdiction collects taxes on a July
1 year-end, it was estimated that the Newbolds would be required to pay $1,375 in property
taxes for the property tax year relating to August through June of year 2 ($300,000 .005
11/12). The seller would be required to pay the $125 for July of year 1. Along with their
monthly payment of principal and interest, the Newbolds paid $125 to the mortgage company
to cover the property taxes. The mortgage company placed the money in escrow and used
the funds in the escrow account to pay the property tax bill in July of year 2. The Newbolds
itemized deductions exceed the standard deduction before considering property taxes.
a. How much in property taxes can the Newbolds deduct for year 1?
b. How much in property taxes can the Newbolds deduct for year 2?
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c. Assume the original facts except that the Newbolds were not able to collect $125 from
the Seller for the property taxes for July of year 1. How much in property taxes can the
Newbolds deduct for year 1 and year 2?
d. Assume the original facts except that the tax bill for July 1 of year 1 through June 30 of
year 2 turned out to be $1,200 instead of $1,500. How much in property taxes can the
Newbolds deduct in year 1 and year 2?
a.
$0. Homeowners are allowed to deduct property taxes when the actual taxes are
paid to the taxing jurisdiction and not when they make payments for taxes to the escrow
account. Consequently, the Newbolds will deduct their share of the property taxes when
the taxes are actually paid in year 2. They are not allowed to deduct any property taxes
in year 1 because they did not pay any taxes to the taxing jurisdiction during year 1.
b.
For tax purposes, it doesnt matter who actually pays the tax. Assuming the taxes are
paid, the tax deduction is based on the relative amount of time each party held the
property during the year. Thus, the Newbolds tax deduction is $1,375, calculated as
follows:
Tax deduction = $300,000 0.005 11/12 (since they held the property for 11 months
of the property tax year)
= $1,375
c.
For tax purposes, it doesnt matter who actually pays the tax. Thus, it doesnt matter
that the Newbolds were unable to collect $125 from the seller for property taxes.
Assuming the taxes are paid, the tax deduction is based on the relative amount of time
each party held the property during the year. Since no taxes were paid during year 1, no
deduction is allowed for year one. The Newbolds tax deduction for year 2 is still $1,375,
calculated as follows:
Tax deduction = $300,000 0.005 11/12 (since they held the property for 11 months
of the property tax year)
= $1,375
d.
Since no taxes were paid during year 1, the Newbolds dont deduct any property taxes
for year one. However, the Newbolds tax deduction for year 2 is $1,100 calculated as
follows:
Tax deduction = $1,200 (total tax liability) 11/12 (number of months property was
held by the Newbolds)
= $1,100
59. [LO 4] {Research} Jenae and Terry Hutchings own a parcel of land as tenants by entirety.
That is, they both own the property but when one of them dies the other becomes the sole
owner of the property. For nontax reasons, Jenae and Terry decide to file separate tax returns
for the current year. Jenae paid the entire $3,000 property tax bill for the land. How much of
the $3,000 property tax payment is each spouse entitled to deduct in the current year?
14-39
According to Rev. Rul. 72-79, 1972-1 CB 51, if a husband and wife are co-owners of property
and they are jointly and severally liable for the property tax and they file separate tax returns for
the year, each spouse is allowed to deduct on his or her separate return the amount of the
property taxes he or she paid for the year. In this case, because Jenae paid the entire $3,000
property tax bill, she is allowed to deduct the entire $3,000 on her separate tax return.
60. [LO 4] After renting an apartment for five years, Todd and Diane purchased a new home on
July 1, 2008. On their 2008 joint tax return, they claimed a $7,500 first-time home buyer
credit. Answer the following questions relating to the credit.
a. Assuming they still live in the home, what amount of credit must Todd and Diane
repay with their 2012 tax return?
b. Assuming they sell the home in August 2012 for a $20,000 gain, what amount of
credit must they pay back with their 2012 tax return?
c. Assuming they sell the home in August 2012 for a $3,000 gain, what amount of credit
must they pay back with their 2012 tax return?
a. Because they purchased the home and claimed the credit in 2008, they must pay back
the credit in 15 equal installments beginning with 2010. With their 2012 tax return,
Todd and Diane must repay $500 ($7,500/15).
b. $6,500. Because Todd and Diane sold the home before repaying the entire credit,
they must repay the balance of the unpaid credit with their 2012 tax return.
Assuming they made the proper payments of $500 in 2010 and $500 in 2011, they
would then be required to pay the remaining $6,500 ($7,500 - $1,000) with their 2012
tax return
c. $3,000. This is the same answer as (b) except the payback is limited to the gain on
the sale of the home.
61. [LO 4] In March of 2010, Harold purchased a new condominium for $70,000 to use as his
principal residence. Harold files as a single taxpayer. On his 2010 tax return, Harold
claimed $7,000 of first-time home buyer tax credit. What are Harolds 2012 tax
consequences associated with the credit in the following alternative situations?
a. Harold lived in the condominium for all of 2012.
b. Harold lived in the condominium until November 1, 2012 when he moved out of the
condo and into an apartment. He began renting out the condominium to tenants.
c. Harold lived in the condominium until July 1, 2012 when he sold it at a $2,000 loss.
d. Harold lived in the condominium until December 1, 2012 when he sold it at a
$10,000 gain.
a. Harold is not required to pay any of the credit back because he continued to use the
condo as his principal residence through 2012.
b. Must repay $7,000 of credit. Harold must pay back the entire $7,000 credit with his
2012 tax return because he stopped using the condo as his principal residence in
2012 (less than 36 months after the date of purchase).
c. $0 credit repayment required. Harold is not required to pay back the credit even
though he sold it in 2012 (less than 36 months after purchasing it) because he sold
the property at a loss. The required pay back amount is the lesser of the amount of
gain on the sale or the amount of the credit claimed.
14-40
d. $7,000 credit repayment required. Because Harold sold the home within 36 months
of purchasing it, he is required to pay the entire credit back with his 2012 tax return
(the year of sale). The gain limitation does not apply because the amount of credit is
less than the gain on the sale.
62. [LO 4] {Research} For her 90th birthday, Jamie (a widow) purchased a new home on
September 1, 2008 and appropriately claimed a first-time home buyer credit of $7,500 on her
2008 tax return. Jamie followed the appropriate schedule for paying back the credit.
However, in December 2014, Jamie passed away of old age. Is Jamie (her estate) responsible
for paying the unpaid balance of the credit? Explain.
In this case Jamie (or her estate) would not be required to pay the remaining installments (see
36(f)(4)(A).
63. [LO 5] Dillon rented his personal residence at Lake Tahoe for 14 days while he was
vacationing in Ireland. He resided in the home for the remainder of the year. Rental income
from the property was $6,500. Expenses associated with use of the home for the entire year
were as follows:
Real property taxes
$3,100
Mortgage interest
12,000
Repairs
1,500
Insurance
1,500
Utilities
3,900
Depreciation
13,000
a. What effect does the rental have on Dillons AGI?
b. What effect does the rental have on Dillons itemized deductions?
a.
Since Dillon resided in his home for at least 15 days during the year and rented the
home for fewer than 15 days, he excludes the rental income from taxable income and
does not deduct the associated rental expenses. So, the rental has no effect on Dillons
AGI.
b.
He will be allowed to deduct the real property taxes of $3,100 and mortgage interest
of $12,000 as itemized deductions.
Use the following facts to answer problems 64 and 65.

Natalie owns a condominium near Cocoa Beach in Florida. This year, she incurs the
following expenses in connection with her condo:
Insurance
$1,000
Advertising expense
500
Mortgage interest
3,500
Property taxes
900
Repairs & maintenance
650
Utilities
950
Depreciation
8,500
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During the year, Natalie rented out the condo for 75 days, receiving $10,000 of gross income.
She personally used the condo for 35 days during her vacation.
64. [LO 5] Assume Natalie uses the IRS method of allocating expenses to rental use of the
property.
a. What is the total amount of for AGI (rental) deductions Natalie may deduct in the
current year related to the condo?
b. What is the total amount of itemized deductions Natalie may deduct in the current year
related to the condo?
c. If Natalies basis in the condo at the beginning of the year was $150,000, what is her
basis in the condo at the end of the year?
d. Assume that gross rental revenue was $2,000 (rather than $10,000), what amount of
for AGI deductions may Natalie deduct in the current year related to the condo?
e. Complete Natalies Form 1040, Schedule E for this property using the original facts.
Note that the home falls into the residence with significant rental use category.
a. $10,000, calculated as follows:
Gross rental income
Tier 1 expenses:
Advertising expense = $500
Mortgage interest = (75/110) $3,500=$2,386
Property taxes= (75/110) $900=$614
Less: total Tier 1 expenses
Balance
Tier 2 expenses:
Insurance = (75/110) $1,000=$682
Repairs & Maintenance = (75/110) $650=$443
Utilities= (75/110) $950=$648
Balance
Tier 3 expenses:
Depreciation (75/110) $8,500= $5,795, but the
deduction is limited to the remaining income
Balance
Total For AGI deductions ($3,500 + $1,773 + $4,727)
14-42
$10,000
(3,500)
$6,500
(1,773)
$4,727
(4,727)
$0
$10,000
b. Natalie may deduct the personal-use portion of the mortgage interest and property taxes
since they are deductible without regard to rental income. Her deductions for these items
are computed as follows:
Mortgage interest [(35/110) $3,500]
Real property taxes [(35/110) $900]
Total from AGI deductions
$1,114
286
$1,400
c. $145,273, calculated as follows:

Beginning basis
Less: depreciation actually deducted
Adjusted basis
$150,000
(4,727)
$145,273
d. $3,500. Even though it creates a loss ($2,000 - $3,500), Natalie is allowed to deduct all
of the advertising expense and the portion of the mortgage interest expense and real
property taxes allocated to the rental use of the home as for AGI deductions (these
deductions are not limited to rental revenue). The loss is not subject to the passive loss
rule limitations.
14-43
e.
14-44
65. [LO 5] Assume Natalie uses the Tax Court method of allocating expenses to rental use of the
property.
a. What is the total amount of for AGI (rental) deductions Natalie may deduct in the
current year related to the condo?
b. What is the total amount of itemized deductions Natalie may deduct in the current year
related to the condo?
c. If Natalies basis in the condo at the beginning of the year was $150,000, what is her
basis in the condo at the end of the year?
d. Assume that gross rental revenue was $2,000 (rather than $10,000), what amount of
for AGI deductions may Natalie deduct in the current year related to the condo?
Note that the home falls into the residence with significant rental use category. Also note
that this solution assumes 2012 has 365 days in a year.
a.
$8,972, calculated as follows:

Gross rental income
$10,00
0
Tier 1 expenses:
Advertising expense = $500
Mortgage interest = (75/365) $3,500=$719
Property taxes= (75/365) $900=$185
Balance
Tier 2 expenses:
Insurance = (75/110) $1,000=$682
Repairs & Maintenance = (75/110) $650=$443
Utilities= (75/110) $950=$648
Balance
Tier 3 expenses:
Depreciation (75/110) $8,500= $5,795
Balancenet income from rental of condo
Total For AGI deductions ($1,404 + $1,773 + $5,795)
b.
(1,404)
$8,596
(1,773)
$6,823
(5,795)
$1,028
$8,972
Natalie may deduct the personal-use portion of the mortgage interest and property
taxes since they are deductible without regard to rental income. Her deductions for these
items are computed as follows:
Mortgage interest [(290/365) $3,500]
Real property taxes [(290/365) $900]
Total "from AGI" deductions
14-45
$2,781
$715
$3,496
c.
14-46
Beginning basis
Less: depreciation actually deducted
Adjusted basis
d.
$150,000
(5,795)
$144,205
$2,000. Natalie is allowed to deduct all $1,404 of the advertising expense and the
portion of the mortgage interest expense and real property taxes allocated to the rental
use of the home as for AGI deductions (these deductions would not be limited to rental
revenue even if it created a loss). Natalie is also able to deduct $576 of the tier two
expenses. In total, she will deduct $2,000 of rental related expensesleaving her with $0
net income from the property.
Use the following facts to answer problems 66 - 68.

Alexa owns a condominium near Cocoa Beach in Florida. This year, she incurs the
following expenses in connection with her condo:
Insurance
$2,000
Mortgage interest
6,500
Property taxes
2,000
1,400
Utilities
2,500
Depreciation
14,500
During the year, Alexa rented out the condo for 100 days. She did not use the condo at
all for personal purposes during the year. Alexas AGI from all sources other than the
rental property is $200,000. Unless otherwise specified, Alexa has no sources of passive
income.
66. [LO 5] Assume Alexa receives $30,000 in gross rental receipts.
a. What effect do the expenses associated with the property have on her AGI?
b. What effect do the expenses associated with the property have on her itemized
deductions?
14-47
a.
Expenses reduce AGI by $28,900. Alexas property is treated as a nonresidence with

rental use property because she rented it for 100 days and did not use it all for personal
purposes. The rental deductions are fully deductible for AGI. Thus, the expenses reduce
Alexas AGI by $28,900 and the gross rental income increases the AGI by $30,000.
Overall, Alexas AGI will be increased by the rental net income of $1,100, calculated as
follows:
Gross rental income
Expenses:
Insurance
Mortgage interest
Property taxes
Utilities
Depreciation
Less: total expenses
Balancenet rental income
b.
$30,000
(2,000)
(6,500)
(2,000)
(1,400)
(2,500)
(14,500)
(28,900)
$1,100
Because Alexa did not use the rental property for personal purposes, all expenses
associated with the property were allocated to rental use and were deducted for AGI.
Thus, the expenses associated with the property have no effect on her itemized
deductions.
67. [LO 5] Assuming Alexa receives $20,000 in gross rental receipts, answer the following
questions:
a. What effect does the rental activity have on her AGI for the year?
b. Assuming that Alexas AGI from other sources is $90,000, what effect does the rental
activity have on Alexas AGI? Alexa makes all decisions with respect to the property.
c. Assuming that Alexas AGI from other sources is $120,000 what effect does the rental
activity have on Alexas AGI? Alexa makes all decisions with respect to the property.
d. Assume that Alexas AGI from other sources is $200,000. This consists of $150,000
salary, $10,000 of dividends, and $25,000 of long-term capital gain, and net rental
income from another rental property in the amount of $15,000. What effect does the
Cocoa Beach Condo rental activity have on Alexas AGI?
Note that the property is a nonresidence with rental use property.
14-48
a.
Alexas AGI will be reduced by $0, calculated as follows:

Gross rental income
Expenses:
Insurance
Mortgage interest
Property taxes
Utilities
Depreciation
Balancenet rental loss
$20,000
(2,000)
(6,500)
(2,000)
(1,400)
(2,500)
(14,500)
(28,900)
($8,900)
By definition, a rental activity [unless it is a residence with significant rental use (a

vacation home rental)], is considered to be a passive activity. Consequently, losses from
rental property are not allowed to offset other ordinary or investment type income. As a
result, Alexa will include $20,000 of rental income in gross income. She will also get to
deduct $20,000 of expenses related to the rental property. The remaining $8,900 of
expenses (the rental loss) is not deductible this year because (1) the rental activity is a
passive activity, (2) Alexa has no passive income from other sources, and (3) Alexas AGI
is above the phase-out range ($100,000 - $150,000) so she is not allowed to deduct any
of the loss under the rental real estate exception to the passive loss rules. She may,
however, carry the loss forward to future years in which she has passive income to offset.
b.
Reduction of $8,900.
Under a rental real estate exception, a taxpayer who is an active participant in the
rental activity may be allowed to deduct up to $25,000 of the rental loss against other
types of income. To be considered an active participant, the taxpayer must (1) own at
least 10% of the rental property and (2) participate in the process of making management
decisions such as approving new tenants, deciding on rental terms, and approving
repairs and capital expenditures. Since Alexa owns 100% of the property, and she makes
all decisions with respect to the property, she is an active participant in the rental
activity. Thus, she meets the rental real estate exception, and, because her AGI is below
$100,000 she is eligible to deduct up to $25,000 of the loss against other types of income.
In this case, she may deduct the entire $8,900 loss as an ordinary deduction in the
current year.
c.
Reduction of $8,900.
Under a rental real estate exception, a taxpayer who is an active participant in the
rental activity may be allowed to deduct up to $25,000 of the rental loss against other
types of income. To be considered an active participant, the taxpayer must (1) own at
least 10% of the rental property and (2) participate in the process of making management
decisions such as approving new tenants, deciding on rental terms, and approving
repairs and capital expenditures. The $25,000 maximum exception amount is phased out
by 50 cents for every dollar the taxpayers adjusted gross income exceeds $100,000.
14-49
Consequently, the entire $25,000 is phased-out when the taxpayers adjusted gross
income reaches $150,000.
Since, Alexa owns 100% of the property, and she makes all decisions with respect to the
property, she is an active participant in the rental activity. Thus, she meets the rental real
estate exception, and she may potentially deduct the rental loss as an ordinary deduction
in the current year. However, because her AGI exceeds $100,000, part of the exception
amount is phased out as follows:
Phase-out = [AGI - $100,000] $.50
= [$120,000 - $100,000] $.50
= $10,000
Exception amount = $25,000 (maximum) - $10,000 (phase-out) = $15,000
Since Alexas rental loss of $8,900 is less than the exception amount of $15,000, she can
deduct the entire $8,900 as an ordinary deduction in the current year.
d.
The rental activity reduces her AGI by $8,900. (All transactions described in the
problem increase her AGI by $191,100.)
Since Alexa has passive income (the rental income from another property), she can
deduct the loss against this passive income. Thus, her net passive income is $6,100
($15,000 rental income - $8,900 rental loss). In summary, she will include $150,000
salary, $10,000 dividends, $25,000 LTCG, and $35,000 rental income ($15,000 +
$20,000) in gross income. She will also be able to deduct all of the expenses related to
the rental property ($28,900) from the income in arriving at AGI. The $8,900 loss from
the rental property reduces her AGI by $8,900.
68. [LO 5] {Planning} Assume that in addition to renting the condo for 100 days, Alexa uses the
condo for 8 days of personal use. Also assume that Alexa receives $30,000 of gross rental
receipts. Answer the following questions:
a. What is the total amount of for AGI deductions relating to the condo that Alexa may
deduct in the current year? Assume she uses the IRS method of allocating expenses
between rental and personal days.
b. What is the total amount of from AGI deductions relating to the condo that Alexa may
deduct in the current year? Assume she uses the IRS method of allocating expenses
between rental and personal days.
c. Would Alexa be better or worse off after taxes in the current year if she uses the Tax
Court method of allocating expenses?
Note that the home is considered to be a nonresidence with rental use
14-50
a.
$26,760.
Since Alexa used the condo personally for 8 days, she must allocate the expenses between
personal use and rental use days. As illustrated below, the portion attributable to the
rental days are deductible as for AGI deductions.
Gross rental income
Expenses:
Insurance [100/108] $2,000
Mortgage interest [100/108] $6,500
Property taxes [100/108] $2,000
Repairs & maintenance [100/108] $1,400
Utilities [100/108] $2,500
Depreciation [100/108] $14,500
Balancenet rental income
Total for AGI deductions
b.
$30,000
(1,852)
(6,019)
(1,852)
(1,296)
(2,315)
(13,426
)
(26,760)
$3,240
$26,760
Alexa may deduct the personal-use portion of property taxes since they are
deductible without regard to rental income. However, she is not allowed to deduct the
mortgage interest related to personal-use days because the property no longer qualifies
as a personal residence. Her deduction for the property taxes is calculated as follows:
Real property taxes = (8/108) $2,000 = $148. Note that Alexa would be able to
deduct the taxes whether she itemized or not (as an increase to her basic standard
deduction).
c.
The Tax Court method is less favorable in this circumstance because it allocates
less interest expense to the rental activity and more to personal use. The interest expense
allocated to personal use, however, does not qualify for an interest deduction because the
taxpayer does not meet the minimum amount of personal use required for the deduction.
By using the Tax Court method, any mortgage interest allocated to the personal-use days
generates no tax benefit. Also, since this is primarily rental property, the taxpayer may
deduct expenses in excess of income from the property. So, the taxpayer may not be as
concerned about allocating more taxes to the rental property because doing so does not
limit the taxpayers ability to deduct other expenses, as it might with mixed-use property.
Note however, that a loss may not be immediately deductible due to the passive activity
rules.
14-51
69. [LO 6] Brooke owns a sole proprietorship in which she works as a management consultant.
She maintains an office in her home where she meets with clients, prepares bills, and
performs other work-related tasks. The home office is 300 square feet and the entire house is
4,500 square feet. Brooke incurred the following home-related expenses during the year.
Real property taxes
Interest on home mortgage
Operating expenses of home
Depreciation
Repairs to home theater room
$ 3,600
14,000
5,000
12,000
1,000
a. What amount of each of these expenses is allocated to the home office?

The expenses are allocated to the home office as follows:
Expense
Amount
Type
Real property taxes

Depreciation
Repairs to home theater room
Total expenses
$3,600
14,000
5,000
12,000
1,000
$35,600
Indirect
Indirect
Indirect
Indirect
Unrelated
Allocated to home office

6.667% of indirect (300/4,500 sq.
ft)
$240
933
333
800
0
$2,306
b. What are the total amounts of tier 1, tier 2, and tier 3 expenses allocated to the home
office?
Tier 1 expenses: $1,173 ($240 real property + $933 interest on home mortgage).
Tier 2 expenses: $333 (operating expenses of the home)
Tier 3 expense: $800 depreciation.
c. If Brooke reported $2,000 of Schedule C income before the home office expense
deduction, what is the amount of her home office expense deduction and what home office
expenses, if any, would she carry over to next year?
$2,000 home office expense in total and $306 depreciation expense carryover to next year.
She would subtract all $1,173 of the tier 1 expenses and all $333 of the tier 2 expenses from
her $2,000 of Schedule C income. This leaves $494 ($2,000 - $1,173 333) of net income
before depreciation (tier 3 expense). Because the home office expense deduction can reduce
net income to $0 but not below, Brook may deduct $494 of depreciation expense and carry
the remaining $306 over to next year.
14-52
d. Assuming Brooke reported $2,000 of Schedule C income before the home office expense
deduction, complete Form 8829 for Brooks home office expense deduction. Also assume the
value of the home is $500,000 and the adjusted basis of the home (exclusive of land) is
$468,019.
14-53
14-54
Use the following facts to answer problems 70 71.

Rita owns a sole proprietorship in which she works as a management consultant. She
maintains an office in her home where she meets with clients, prepares bills, and performs
other work-related tasks. Her business expenses, other than home office expenses, total
$5,600. The following home-related expenses have been allocated to her home office.
Real property taxes
Depreciation
$1,600
5,100
800
1,600
Also, assume that not counting the sole proprietorship, Ritas AGI is $60,000.
70. [LO 6] Assume Ritas consulting business generated $15,000 in gross income.
a. What is Ritas home office deduction for the current year?
b. What would Ritas home office deduction for the current year be if her business
generated $10,000 of gross income instead of $15,000?
c. Given the original facts, what is Ritas AGI for the year?
d. Given the original facts, what types and amounts of expenses will she carry over to
next year?
a.
Gross Income
Less: business expenses
Balance
Less: Tier 1 expenses (interest $5,100 + $1,600
taxes)
Balance after tier 1 expenses
Less Tier 2 expenses (operating expenses)
Less Tier 3 expenses (depreciation)
Net income from business
$15,000
(5,600)
$9,400
(6,700)
$2,700
(800)
1,900
(1,600)
$300
Rita is allowed to deduct all expenses allocated to the home office ($6,700 interest and taxes
+ 800 home operating expenses + depreciation 1,600).
14-55
b.
Gross Income
$10,000
(5,600)
Balance
$4,400
taxes)
(6,700)
Loss after tier 1 expenses
($2,300)
Less Tier 2 expenses (operating expenses)
0
Loss after tier 2 expenses
($2,300)
Less Tier 3 expenses (depreciation)
0
Net loss from business
($2,300)
Rita is allowed to deduct only the mortgage interest and real property taxes allocated to the
business use of the home. The remaining expenses (tier 2 and tier 3) are suspended and
carried over to next year.
c.
Ritas AGI is $60,300 for the year. This is her AGI without the sole
proprietorship plus the net income from the business ($60,000 + $300).
d.
None. Because Rita is allowed to deduct all of the expenses this year, she does
not carry any over to next year.
71. [LO 6] Assume Ritas consulting business generated $13,000 in gross income for the current
year.
a. What is Ritas home office deduction for the current year?
b. What is Ritas AGI for the year?
c. Assume the original facts, except that Rita is an employee, and not self-employed (she
uses the home office for the convenience of the employer). Consequently, she does not
receive any gross income from the (sole proprietorship) business and she does not incur
any business expenses unrelated to the home office. Finally, her AGI is $60,000
consisting of salary from her work as an employee. What effect do her home office
expenses have on her itemized deductions?
d. Assuming the original facts, what types and amounts of expenses will she carry over to
next year?
14-56
e. $7,400, calculated as follows:

Gross Income
Balance
taxes)
Less: Tier 2 expenses (operating expenses $800
before limit)
Less Tier 3 expenses (depreciation $1,600 before
limit)
Net income from business
$13,000
(5,600)
$7,400
(6,700)
$700
(700)
0
(0)
$0
Rita is allowed to deduct a total of $7,400 in home office expenses ($6,700 in interest and
taxes and $700 of home operating expenses).
b. $60,000. This is the $60,000 of AGI without the sole proprietorship plus $0 net income
from the home business.
c. Because the home office deduction is deductible from AGI for employees, Ritas AGI is
unchanged by her home office expenses. Employees who may deduct home office expenses
do so as itemized deductions subject to the 2% AGI floor. Thus, Ritas $9,100 of home office
expenses are reduced by $1,200 ($60,000 2%) and she may deduct $7,900 as an itemized
deduction.
d. Rita will carry over $100 of tier 2 expenses (operating expenses) and $1,600 of tier 3
expenses (depreciation expense) to next year.
72. [LO 2, 6] Alisha, who is single, owns a sole proprietorship in which she works as a
management consultant. She maintains an office in her home where she meets with clients,
prepares bills, and performs other work-related tasks. She purchased the home at the
beginning of year 1 for $400,000. Since she purchased the home and moved into it she has
been able to deduct $10,000 of depreciation expenses to offset her consulting income. At the
end of year 3, Alisha sold the home for $500,000. What is the amount of taxes Alisha will be
required to pay on the gain from the sale of the home? Alishas ordinary marginal tax rate is
30 percent.
14-57
Amount realized
Beginning basis
Less depreciation
Adjusted basis
Gain realized
Gain eligible for exclusion (gain
realized minus depreciation
expense)
Less: exclusion amount
(lesser of gain eligible for
exclusion or $250,000)
Total gain recognized
(Gain realized minus exclusion)
$500,000
$400,000
(10,000)
$390,000
$110,000
$100,000
(100,000)
$10,000
When a taxpayer deducts depreciation as a home office expense, the depreciation expense
reduces the taxpayers basis in the home. Consequently, when the taxpayer sells the home,
the gain on the sale will be greater than it would have been had depreciation not been
deducted. Further, the gain on the sale of the home attributable to depreciation is not
eligible to be excluded under the home sale exclusion provisions. This gain is treated as
unrecaptured 1250 gain and is subject to a maximum 25% tax rate. Thus, Alisha will owe
$2,500 ($10,000 25%) in taxes on the sale.
Comprehensive Problems
73. {Planning} Derek and Meagan Jacoby recently graduated from State University and Derek
accepted a job in business consulting while Meagan accepted a job in computer
programming. Meagan inherited $75,000 from her grandfather who recently passed away.
The couple is debating whether they should buy or rent a home. They located a rental home
that meets their needs. The monthly rent is $2,250. They also found a three-bedroom home
that would cost $475,000 to purchase. The Jacobys could use Meagans inheritance for a
down-payment on the home. Thus they would need to borrow $400,000 to acquire the home.
They have the option of paying two discount points to receive a fixed interest rate of 4.5
percent on the loan or paying no points and receiving a fixed interest rate of 5.75 percent for
a 30-year fixed loan.
Though anything could happen, the couple expects to live in the home for no more than five
years before relocating to a different region of the country. Derek and Meagan dont have
any school-related debt, so they will save the $75,000 if they dont purchase a home.
Also, consider the following information:
The couples marginal tax rate is 25 percent.
Regardless of whether they buy or rent, the couple will itemize their deductions.
If they buy, the Jacobys would purchase and move into the home on January 1, 2012.
If they buy the home, the property taxes for the year are $3,600.
Disregard loan-related fees not mentioned above.
14-58
If the couple does not buy a home, they will put their money into their savings
account where they earn 5 percent annual interest.
14-59
Assume all unstated costs are equal between the buy and rent option.
Required: Help the Jacobys with their decisions by answering the following questions:
a. If the Jacobys decide to rent the home, what is their after-tax cost of the rental for the first
year (include income from the savings account in your analysis)?
b. What is the approximate break-even point in years (or months) for paying the points to
receive a reduced interest rate (to simplify this computation, assume the Jacobys will make
interest-only payments and ignore the time value of money)?
c. What is the after-tax cost of the interest expense and property taxes of living in the home
for 2012? Assume that the Jacobys interest rate is 5.75 percent, they do not pay discount
points, they make interest-only payments for the first year, and the value of the home does
not change during the year.
d. Assume that on March 1, 2012, the Jacobys sold their home for $525,000, so that Derek
and Meagan could accept job opportunities in a different state. The Jacobys used the sale
proceeds to (1) pay off the $400,000 principal of the mortgage, (2) pay a $10,000
commission to their real estate broker, and (3) make a down payment on a new home in the
different state. However, the new home cost only $300,000. What gain or loss do the
Jacobys realize and recognize on the sale of their home and what amount of taxes must they
pay on the gain, if any (assume they make interest only payments on the loan)?
e. Assume the same facts as in (d), except that the Jacobys sell their home for $450,000 and
they pay a $7,500 commission. What effect does the sale have on their 2012 income tax
liability? Recall that the Jacobys are subject to an ordinary marginal tax rate of 25 percent
and assume that they do not have any other transactions involving capital assets in 2012.
a.
$24,188, computed as follows:
Rent the Home

Amount
(1) Monthly rent
($2,250)
(2) Total rent payments for the year
(27,000)
(3) Interest earned on inheritance
3,750
(4) Taxes on earnings
(938)
(5) After-tax interest earnings
2,812
Total after-tax cost of renting for first year
($24,188)
Description
b.
1.6 years (19.2 months), computed as follows:
14-60
Calculation
(1) 12 months
$75,000 5%
(3) 25%
(3) + (4)
(2) (5)
Loan summary: $400,000; 5.75% rate with no

points. 4.5% rate with 2 points ($8,000). Assume
the Jacobys pay interest only for first three years.
Description
(4) Before-tax savings per year from 4.5% vs. 5.75%
interest rate
(5) Forgone tax benefit per year of higher interest
rate
(6) After-tax savings per year of 4.5% vs. 5.75%
interest rate
Break-even point in years (months)
c.
($1,250)
$3,750
1.6 years
(19.2
months)
Calculation
$400,000 2%
(1) 25%
(1) + (2)
[$400,000 (5.75%
- 4.5%)]
(4) 25%
(4) + (5)
(3) / (6)
$19,950, computed as follows:
Description
(2) Mortgage principal
(3) Mortgage interest rate
(4) First year interest payment
(5) Tax savings from interest payments
(6) After-tax cost of interest payments
(7) Deductible property taxes for year
(8) Tax savings from property tax deduction
(9) After-tax cost of real property taxes
After-tax cost of buying home for 2012
d.
Amounts
($8,000)
+ 2,000
($6,000)
$5,000
Amount
25%
$400,000
5.75%
(23,000)
5,750
(17,250)
(3,600)
900
(2,700)
($19,950)
Explanation
(2) (3)
(1) (4)
(4) + (5)
(1) (7)
(7) + (8)
(6) + (9)
$40,000 gain realized; $0 recognized gain; $0 taxes payable on gain, computed as

follows:
14-61
Description
(1) Sales proceeds
(2) Sales commission
(3) Amount realized
(4) Basis in home
Amount
$525,000
(10,000)
$515,000
(475,000)
(5) Gain realized

(6) Exclusion for sale of home
$40,000
(40,000)
(7) Gain recognized and taxes

payable on gain
$0
e.
Explanation
(1) + (2)
Initial purchase price. Assumes interest
only payments on mortgage
(3) + (4)
Because after 2 months the Jacobys moved
for work reasons, they qualify for a
maximum exclusion on their home of
$41,667 ($500,000 2/24)
(5) (6), no gain, no taxes on the gain.
$32,500 loss realized; $0 recognized loss; $0 tax benefit from loss, computed as
follows:
Description
(1) Sales proceeds
(2) Sales commission
(3) Amount realized
(4) Basis in home
(5) Loss realized
Effect of loss on Jacobys tax
liability
Amount
$450,000
(7,500)
$442,500
(475,000)
(32,500)
$0
Explanation
(1) + (2)
Initial purchase price. Assumes interest
only payments on mortgage
(3) + (4)
Loss not deductible because it is a personal
loss so no effect on tax liability.
74. James and Kate Sawyer were married on New Years Eve of 2011. Before their marriage,
Kate lived in New York and worked as a hair stylist for one of the citys top salons. James
lives in Atlanta where he works for a public accounting firm earning an annual salary of
$100,000. After their marriage, Kate left her job in New York and moved into the couples
newly purchased 3,200-square-foot home in Atlanta. Kate incurred $2,200 of qualified
moving expenses. The couple purchased the home on January 3, 2012 by paying $100,000
down and obtaining a $240,000 mortgage for the remainder. The interest rate on this loan
was 7 percent and the Sawyers made interest-only payments on the loan through June 30,
2012 (assume they paid exactly one-half of a years worth of interest expense on the loan by
June 30). On July 1, 2012, because the value of their home had increased to $400,000, the
Sawyers were in need of cash, and interest rates had dropped, the Sawyers refinanced their
home loan. On the refinancing, they borrowed $370,000 at 6 percent interest. They made
interest-only payments on the home loan through the end of the year and they spent $20,000
of the loan proceeds improving their home (assume they paid exactly one-half of a years
worth of interest on this loan by year end).
Kate wanted to try her hand at making it on her own in business, and with Jamess help, she
started Kates Beauty Cuts LLC. She set up shop in a 384-square-foot corner room of the
14-62
couples home and began to get it ready for business. The room conveniently had a door to
the outside providing customers direct access to the shop. Before she opened the doors to the
14-63
business, Kate paid $2,100 to have the carpet replaced with a tile floor. She also paid $1,200
to have the room painted with vibrant colors and $650 to have the room rewired for
appropriate lighting. Kate ran an ad in the local newspaper and officially opened her shop on
January 24, 2012. By the end of the year, Kates Beauty Cuts LLC generated $40,000 of net
income before considering the home office deduction. The Sawyers incurred the following
home-related expenditures during 2012:
$4,200 of real property taxes.
$2,000 for homeowners insurance.
$2,400 for electricity.
$1,500 for gas and other utilities.
They determined depreciation expense for their entire house for the year was $7,300.
Also, on March 2, Kate was able to finally sell her one-bedroom Manhattan
condominium for $478,000. She purchased the condo, which she had lived in for six years
prior to her marriage, for $205,000.
Kate owns a vacation home in Myrtle Beach, South Carolina. She purchased the home
several years ago, largely as an investment opportunity. To help cover the expenses of
maintaining the home, James and Kate decided to rent the home out. They rented the home
for a total of 106 days at fair market value (this included eight days that they rented the home
to Jamess brother Jack). In addition to the 106 days, Kate allowed a good friend and
customer, Clair, to stay in the home for half-price for two days. James and Kate stayed in the
home for six days for a romantic getaway and another three days in order to do some repair
and maintenance work on the home. The rental revenues from the home in 2012 were
$18,400. The Sawyers incurred the following expenses associated with the home.
$9,100 of interest expense.
$3,400 of real property taxes.
$1,900 for homeowners insurance.
$1,200 for electricity.
$1,600 for gas, other utilities, and landscaping.
$5,200 for depreciation.
Required: Determine the Sawyers taxable income for 2012. Disregard self-employment
taxes for Kate. Assume the couple paid $4,400 in state income taxes and files a joint return.
The Sawyers use the method of allocating expenses to the rental that minimizes their overall
taxable income for 2012.
NOTE: This solution assumes 2012 has 365 days.
14-64
James and Kate have taxable income of $117,220. See the analysis below.
Description
Amount
Explanation
Total income
Jamess Salary
$100,000
Kates Schedule C income before

home office deduction
40,000
Home-office deduction (for AGI)
(8,342)
Rent revenue
18,400
Rental expenses (for AGI)
Gain on sale of principal residence

after exclusion
(1) Total income
(2) Moving expenses
(3) AGI
(12,005)
23,000
See Note A below for computation. Not

limited by income limitation
Tax court method allows more total
deductions for year ($937 more in
deductions); See Note B below for
computation
$478,000 205,000 = $273,000 gain
minus 250,000 exclusion
$161,053
(2,200)
$158,853
(1)+ (2)
Itemized deductions:
State income taxes
(4,400)
Real property taxes on principal

residence
(3,696)
$4,200 504 (deducted as home office

expense) = $3,696
Real property taxes on

vacation/rental home
(2,459)
$3,400 941(deducted as rental

expense) =$2,459
Home mortgage interest expense on

principal residence
(16,896)
Home mortgage interest expense on

vacation/rental home
(6,58
2)
$19,200 2,304 (deducted as home

office expense) = $16,896
$9,100 2,518 (deducted as rental
expense) = $6,582
(4) Total itemized deductions
(34,033)
(5) Personal and dependency

exemptions
(7,600)
(6) Total from AGI deductions
(41,633)
(4) + (5)
Taxable income
$117,220
(3) + (6)
14-65
Standard deduction for MFJ is $11,900

so James and Kate deduct itemized
deductions.
$3,8 00 2 = $7,6 00
Note A: Home office deduction computation

Home Office Deduction
(A)
Type
Amount
(B)
Office %
(384/3,200
for indirect)
100%
100%
100%
12%
12%
12%
12%
12%
(A) (B)
Home office
Expense
New flooring
Direct
$2,100
$2,100
New paint for office
Direct
1,200
1,200
New office lighting
Direct
650
650
Real property taxes
Indirect
4,200
504
Home interest expense*
Indirect
19,200
2,304
Utilities
Indirect
3,900
468
Homeowners insurance
Indirect
2,000
240
Depreciation
Indirect
7,300
876
Total expenses
$40,550
$8,342
*Total interest expense for the year is computed as follows:
First loan: $240,000 7% of a year = $8,400.
Second loan: $240,000 of initial acquisition debt plus $20,000 of refinanced loan to improve
home (can be considered acquisition indebtedness) plus $100,000 of home equity debt equals
$360,000 of qualifying debt (interest on $10,000 of the $370,000 loan is not deductible).
$360,000 6% = $10,800.
Total interest expense = $19,200 ($8,400 from loan 1 + $10,800 from loan 2).
14-66
Note B: Rental expenses: The Sawyers used the rental home as follows: Rental days: 101
(98 rental to unrelated parties at fair market value + 3 maintenance); Personal days: 16
days (6 vacation days + 8 rented to brother + 2 rented at less than fair market value).
Because personal use of 16 is more than the greater of (1) 14 days or (2)10% of the number
of rental days (10.1), their residence qualifies as property with significant personal and
significant rental use (mixed use or vacation home)this means deductions are limited to
gross rental income. Because the Tax Court method allows them to deduct $937 more
deductions overall (rental + personal taxes and interest), they use the Tax Court method to
determine their deductions from the rental.
Allocation method to
Rental Home Expense Allocation
rental use
IRS method
Expense
Interest
Real estate taxes
Total tier 1 expenses
Electricity
Gas/other utilities and landscaping
Insurance
Total tier 2 expenses
Depreciation (tier 3)
Total Expenses on property
Amount
$9,100
3,400
$12,500
1,200
1,600
1,900
$4,700
5,200
$22,400
Net income from rental

Rental receipts
Less tier 1 expenses
Income after tier 1 expenses
Less tier 2 expenses
Income after tier 2 expenses
Less: tier 3 expenses
Taxable rental income
Deductible personal use expenses
(interest and property taxes)
Deductible rental expenses (sum of
tier 1 , 2, and 3 expenses) (for AGI)
Depreciation expense carried over to
next year
Total deductions associated with
property (for and from)
14-67
Tier
1
1
1
2
2
2
2
3
(101/117)
Tax Court
method
(101/365 tier 1
101/117 other)
$7,856
2,935
$10,791
1,036
1,381
1,640
$4,057
4,489
$2,518
941
$3,459
1,036
1,381
1,640
$4,057
4,489
IRS
method
$18,400
(10,791)
7,609
(4,057)
3,552
(3,552)
$0
Tax Court
method
$18,400
(3,459)
14,941
(4,057)
10,884
(4,489)
$6,395
$1,709
$9,041
18,400
12,005
937
$20,109
$21,046

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Chapter 14 - Tax Consequences of Home Ownership

3. [LO 1] When determining whether a dwelling unit is treated as a residence or a nonresidence

Chapter 14 - Tax Consequences of Home Ownership

Chapter 14 - Tax Consequences of Home Ownership

Chapter 14 - Tax Consequences of Home Ownership

Chapter 14 - Tax Consequences of Home Ownership

Chapter 14 - Tax Consequences of Home Ownership

Chapter 14 - Tax Consequences of Home Ownership

Chapter 14 - Tax Consequences of Home Ownership

Chapter 14 - Tax Consequences of Home Ownership

Chapter 14 - Tax Consequences of Home Ownership

Chapter 14 - Tax Consequences of Home Ownership

Chapter 14 - Tax Consequences of Home Ownership

Chapter 14 - Tax Consequences of Home Ownership

Chapter 14 - Tax Consequences of Home Ownership

Chapter 14 - Tax Consequences of Home Ownership

Chapter 14 - Tax Consequences of Home Ownership

Chapter 14 - Tax Consequences of Home Ownership

Chapter 14 - Tax Consequences of Home Ownership

$300,000 gain recognized.

Chapter 14 - Tax Consequences of Home Ownership

a. $200,000 of gain is excluded and $0 gain is recognized.

Chapter 14 - Tax Consequences of Home Ownership

Chapter 14 - Tax Consequences of Home Ownership

(2) Marginal tax rate

Chapter 14 - Tax Consequences of Home Ownership

(2) Standard deduction

Chapter 14 - Tax Consequences of Home Ownership

Chapter 14 - Tax Consequences of Home Ownership

$27,000 ($21,000 + $6,000), determined as follows:

$27,000 ($21,000 + $6,000), determined as follows:

Chapter 14 - Tax Consequences of Home Ownership

Chapter 14 - Tax Consequences of Home Ownership

$300,000 acquisition indebtedness). Hence the home-equity indebtedness is limited to

$29,143 under the average interest expense method, determined as follows:

Chapter 14 - Tax Consequences of Home Ownership

Chapter 14 - Tax Consequences of Home Ownership

Chapter 14 - Tax Consequences of Home Ownership

Chapter 14 - Tax Consequences of Home Ownership

Chapter 14 - Tax Consequences of Home Ownership

Chapter 14 - Tax Consequences of Home Ownership

Chapter 14 - Tax Consequences of Home Ownership

Chapter 14 - Tax Consequences of Home Ownership

Chapter 14 - Tax Consequences of Home Ownership

Chapter 14 - Tax Consequences of Home Ownership

(1) / 30 years 25%

Chapter 14 - Tax Consequences of Home Ownership

Chapter 14 - Tax Consequences of Home Ownership

Chapter 14 - Tax Consequences of Home Ownership

Chapter 14 - Tax Consequences of Home Ownership

Chapter 14 - Tax Consequences of Home Ownership

Use the following facts to answer problems 64 and 65.

Chapter 14 - Tax Consequences of Home Ownership

Chapter 14 - Tax Consequences of Home Ownership

c. $145,273, calculated as follows:

Chapter 14 - Tax Consequences of Home Ownership

Chapter 14 - Tax Consequences of Home Ownership

$8,972, calculated as follows:

Chapter 14 - Tax Consequences of Home Ownership

$144,205, calculated as follows:

Chapter 14 - Tax Consequences of Home Ownership

Use the following facts to answer problems 66 - 68.

Chapter 14 - Tax Consequences of Home Ownership

Expenses reduce AGI by $28,900. Alexas property is treated as a nonresidence with