CHAPTER 10 BASIS RULES, DEPRECIATION, AND ASSET CATEGORIZATION

1. Several years before his marriage to Marie, Patrick purchased a vacation home in a remote
shoreline community for $250,000. After their marriage, Patrick needed some cash to invest in a
new business opportunity, so he sold the house to his wife Marie for its current fair market
value, $750,000. Nine months after purchasing the house, Marie sold it for $1 million. What is
the amount and nature of Marie’s taxable gain on the sale of the home?

Answer: $750,000 long term capital gain

Explanation: Even though Patrick sold the home to Marie in an arm’s-length transaction, at the
time of the sale Patrick and Marie were married. IRC Section 1041 requires all transfers between
spouses to be treated as gifts for income tax purposes, and when a gift of appreciated property
is made, a carry-over basis result. Consequently, even though Marie paid $750,000 for the
home, her basis in the home is $250,000. When Marie sells the house for $1 million, her gain is
$750,000 ($1 million - $250,000), and the gain is characterized as a long-term capital gain. The
holding period of both the husband and wife are added together to determine whether the
holding period is long-term or short-term. If this were their personal residence, they may get
relief under IRC Section 121.

2. Tanya gave her nephew, Liam, 100 shares of Bridge Corporation stock that she purchased 6
months ago for $10,000. At the time of the gift, the fair market value of the stock was $12,000.
Which of the following statements concerning the stock is correct?

Answer: Liam’s basis in the stock is $10,000.

Explanation: Since Tanya transferred appreciated property to Liam by gift, her basis carries over
to Liam. Liam has a $10,000 basis in the stock.

3. Five years ago, Frederick purchased 1,000 shares of Ickenham Industries, Inc. for $10 per share.
He signed an agreement with the company which allowed the company to use his dividend
payments to purchase additional shares for him. Over the last 5 years, Frederick received a total
of $1,200 in dividend payments, which purchased an additional 100 shares of stock. If Frederick
sells all of his shares for $24,000, what is his taxable gain?

Answer: $12,800 (1000shares*10pershare+1200divpayment)

Explanation: Frederick’s adjusted basis in the shares equals the initial purchase price of the
shares, $10,000 plus the dividends that were reinvested of $1,200 since Frederick was required
to pay tax on the dividend payments the year they were made. When he sells the shares, he has
an amount realized of $24,000, less his adjusted basis of $11,200, which equals a taxable gain of
$12,800.
4. Two years ago, Vernon purchased 100 shares of Stairwell Refitters, Inc., a start-up company, for
$12,000. Unfortunately, Stairwell Refitter’s business model did not perform as expected, and
the value of the shares has dropped to $8,000. Vernon’s son, Dudley, recently realized a large
capital gain on an investment he held, so Vernon gave his shares of Stairwell Refitters, Inc. to
Dudley when they were worth $8,000. If Dudley sells the shares for $5,000 thirteen months
after the transfer, what is the amount and character of his gain or loss?

Answer: $3,000 long-term capital loss

Explanation: Vernon gave loss property to his son. When a taxpayer transfers property with a
loss to someone else, and the recipient sells the property for less than the fair market value as
of the date of the gift, the basis in the hands of the donee for purposes of calculating loss is the
fair market value of the property as of the date of the gift. This is referred to as the “loss basis”
in the property. When loss basis is used to calculate loss, the holding period is deemed to begin
at the date of the gift – the donor’s holding period does not tack on to the donee’s holding
period to determine the nature of the loss. Since the fair market value of the property was
$8,000 on the date of the gift, and Dudley sold the property for $5,000 thirteen months after
receiving it, Dudley’s loss is a $3,000 long-term capital loss.

5. Two years ago, Olive purchased 100 shares of Pennsylvania Railroad, Inc. for $15,000.
Unfortunately, the value of the shares has dropped to $10,000. Olive’s daughter, Angie, was
heading off to college, and Olive was tired of waiting for a return on the stock. Olive gave the
stock to Angie when it was worth $10,000 to help fund Angie’s education. If Angie sells the
shares for $12,000 three months after the transfer, what is the amount and character of her
gain or loss?

Answer: $0

Explanation: Olive gave loss property to her daughter. When a taxpayer transfers property with
a loss to someone else, and the recipient sells the property for an amount between the donor’s
adjusted basis and the fair market value of the stock on the date of the gift, no gain or loss is
recognized. In this example, the no-gain, no-loss corridor is from $10,000 (the fair market value
of the stock on the date of the gift) to $15,000 (the adjusted basis in the hands of the donor). If
Angie sold the stock for any amount between $10 and $15 thousand dollars, she is not required
to recognize any gain, and she is prohibited from recognizing any loss on the transaction. Since
there is no gain or loss, there is no need to categorize the tax result as either long-term or short-
term.

6. Which of the following items is not included in the cost basis of an investment?
Nonrecourse debt incurred in purchasing the investment; Non-recourse debt is generally not
included in basis because a taxpayer is not personally obligated to repay the loan. All of the
other items are included in the determination of a taxpayer’s basis in their investment.
7. Christopher recently purchased Quarry City Industrial Park, a commercial, industrial and office
community, as an investment. The complex is already rented out to tenants, and Christopher
will continue to lease the property to industrial and office space tenants while he owns the
property. Which of the following statements concerning the depreciation deductions that can
be taken on the property is correct?

Answer: Christopher can depreciate the cost allocable to the buildings (but not the land) over
a 39-year period;

Explanation: Commercial rental property is depreciated on a straight-line basis over a 39-year

period. Depreciation deductions are allowed for the structures, but not the land.

8. Wilson runs an oil and gas operations consulting practice, and has had a very good year. Oil
prices, as well as the demand for his services, have risen. Given the windfall profits his firm
received this year, in December of 2018 Wilson decided to redecorate his office and upgrade the
computer system used by himself and his employees. The cost of the office equipment is
$40,000 and the computer upgrade cost $20,000. Assuming Wilson has purchased no other
depreciable assets in 2018, the net income from his consulting practice was $500,000, and
Wilson would like to minimize his exposure to income taxes, how should he treat the new
purchases for income tax purposes?

Answer: Wilson should deduct the entire cost of the office equipment and computer upgrades
against this year’s business income.

Explanation: Wilson qualifies for the Section 179 election, allowing him to immediately expense
the cost of up to $1,000,000 for 2018 (as indexed) against his business income. Since Wilson had
business income to offset with the deduction, and he did not put more than $2,500,000 for 2018
of depreciable property in service this year, and he has expressed a desire to minimize his
exposure to income tax this year, he qualifies for the immediate expense election.

9. Two months after Tom purchased Greenacre for $30,000, he died. The fair market value of
Greenacre as of the date of Tom’s death was $32,000. He left Greenacre to his son, Kevin. Since
Kevin was the only beneficiary of the estate and there were no estate taxes due, the title to the
property was transferred to Kevin within one month of Tom’s death. Two weeks after receiving
title to the property, Kevin sold Greenacre for $35,000. What is the amount and type of income
that Kevin will report on the sale?

Answer: $3,000 long term capital gain

Explanation: When Tom died the basis of Greenacre qualified for a step-to fair market values
under IRC Section 1014. Kevin’s basis in the property is therefore $32,000. Since he sold the
property for $35,000 and his basis was $32,000, Kevin’s gain in $3,000. Even though Tom
purchased the property three and a half-months before it was sold, Kevin’s gain will be a long-
 term capital gain. Any property received through the estate of a decedent automatically
qualifies for long-term capital gains treatment.

10. Mike gave his granddaughter, Jordan, stock worth $500,000 this year. He purchased the stock
for $250,000 several years earlier, and felt that the value would increase substantially in the
near future. Since he had already used up his lifetime gift-tax exemption in prior tax years, Mike
paid $200,000 in gift taxes on the transfer. If Jordan sells the stock for $750,000 six months after
the transfer, which of the following statements is correct?

Answer: Jordan will realize a $400,000 long-term capital gain

Explanation: Jordan received the stock by gift, so she qualifies for a carry-over basis. Mike’s
original basis in the property was $250,000. Since Mike paid gift tax on the transfer, Jordan is
permitted to increase her basis by the portion of the gift tax paid that represents gain. The
portion of the gift that represents gain is 50% ($250,000 appreciation in the property divided by
$500,000 fair market value of the property as of the date of gift). 50% of the gift taxes paid
equals $100,000. Jordan’s basis, therefore, is $350,000. If she sells the stock six months after the
transfer for $750,000, she will realize a $400,000 gain. Because Mike transferred appreciated
property to Jordan, his holding period is added to Jordan’s holding period for the asset,
transforming the gain into a long-term capital gain.

11. All of the following statements concerning depreciation are correct EXCEPT:

Answer: Assets purchased for personal use are eligible for depreciation deductions.

Explanation: Assets purchased for personal use are not eligible for depreciation deductions –
only assets used in a trade or business or for the production of income qualify for depreciation
deductions. All of the other statements are correct.

12. Uncle Richard died in 2018, he left his estate to his ungrateful cousin, Henry. Richard’s cost basis
in his property was $2 million but, due to turbulent political and economic times, it was only
worth $1 million at his death. Richard had reinvested approximately $250,000 of dividends
during his holding period, and his estate paid $500,000 in transfer taxes at his death. What is
Henry’s basis in the property?

Answer: $1,000,000

Explanation: Section 1014 can result in a step-down in basis as well as a step-up in basis. Since
the property was worth $1 million as of the date of Uncle Richard’s death, that is the basis of the
property in Henry’s hands despite the fact that Uncle Richard had $2,250,000 in after-tax capital
invested in the property and his estate paid transfer taxes of $500,000.

13. Which of the following assets qualifies as a Section 1231 asset?

 Answer: An Apartment building held for rental to tenants

Explanation: The only asset that is listed that qualifies for depreciation deductions is the
apartment building held for rental to tenants. Many individuals automatically classify real estate
as a capital asset, but depreciable real estate held for productive use in a trade or business or
for the production of income is classified as a Section 1231 asset. The greeting cards in option a
are ordinary income assets (inventory), and the bicycle and artwork in options b and d are
capital assets.

14. Two years ago, Amanda purchased 100 shares of Quick Produce, Inc. for $15,000. Unfortunately,
the value of the shares has dropped to $10,000. Amanda gave the stock to her daughter,
Daphna, when it was worth $10,000. If Daphna sells the shares for $17,000 three months after
the transfer, what is the amount and character of his gain or loss?

Answer: $2,000 long term capital gain

Explanation: Amanda gave property subject to a loss to her daughter, Daphna, but Daphna sold
the property at a price greater than the donor’s adjusted basis in the property. Since the sale
price exceeded the donor’s adjusted basis, the donor’s basis transfers to the donee, and is
referred to as the gain basis. Daphna sold the stock for $17,000 and Amanda’s basis (that carried
over to Daphna) was $15,000, so Daphna’s gain is $2,000. Whenever gain basis is used to
determine the tax result, the donor’s holding period tacks on to the donee’s holding period.
Daphna’s gain will be a long-term capital gain, since Amanda held the shares for over one year
prior to the gift.

15. Milton, an independent consultant for Initech, Inc., purchased a new, red video camera to
match his red stapler. He plans to use the camera primarily for personal purposes, but will
occasionally use it (perhaps 25% of the time) to complete assignments that he has accepted
from Initech, a client. Which of the following statements concerning the red camera is correct?

Answer: Milton will not be eligible to claim depreciation deductions for the camera because
his wage is less than 50%.

Explanation: Video cameras are listed property. In order to qualify for depreciation deductions
on listed property, the property must be used for business purposes more than 50% of the time.
Provided that the property is used primarily for business purposes, the owner may take
depreciation deductions for that portion of the property that is used for business. Since Milton
used the property primarily for personal, not business purposes, he may not claim depreciation
deductions.
CHAPTER 9 TAX CREDITS
1. Which of the following statements concerning the Credit for the Elderly or Disabled is correct?

Answer: For purposes of this credit, the taxpayer is considered to be age 65 on the day before
his actual birthday.

Explanation: The credit for the elderly or disabled is available to a U.S. citizen or resident who is
a qualified individual and has income below specified limits. A qualified individual must be 65 or
older at the end of the tax year or under age 65 and (1) retired on total and permanent
disability, (2) the recipient of taxable disability benefits from an employer’s plan for the tax year,
and (3) younger than the mandatory retirement age of the employer at the beginning of the tax
year. The amount of the credit is a fixed base amount less three possible reductions, multiplied
by a rate of 15 percent. For purposes of this credit, the taxpayer is considered to be age 65 on
the day before his actual birthday.

2. Jim, a married filing jointly taxpayer, paid $10,000 of qualified tuition and related expenses for
each of his twin daughters, Stephanie and Amanda, during 2018. They started their freshman
year of college during 2018. Jim was very excited that both daughters excelled in the college
environment; especially since Stephanie had a drug addiction during her senior year of high
school (Jim had a friend on the college admissions board that thankfully overlooked Stephanie’s
felony drug conviction). Jim also paid $2,000 of qualified tuition and related expenses for his
daughter Linda’s sophomore year of college, and $3,000 for his own master’s degree program.
Jim claims all three of his daughters as dependents. His modified gross income for the year is
$50,000. What is the available American Opportunity Tax Credit for 2018?

Answer: $4500

Explanation: The credit is not available for Stephanie since she has a felony drug conviction. The
maximum American Opportunity Tax Credit of $2,500 is available to Amanda. The credit
available for Linda is $2,000 ($2,000 x 100%). Linda would have needed $4,000 of expenses to
get the maximum credit. The total of credits for Amanda and Linda is $4,500 for 2018.

3. Jim, a married filing jointly taxpayer, paid $5,000 of qualified tuition and related expenses for
each of his twin daughters, Stephanie and Amanda, during 2018. They started their freshman
year of college during 2018. Jim was very excited that both daughters excelled in the college
environment; especially since Stephanie had a drug addiction during her senior year of high
school (Jim had a friend on the college admissions board that thankfully overlooked Stephanie’s
felony drug conviction). Jim also paid $2,000 of qualified tuition and related expenses for his
daughter Linda’s sophomore year of college and $3,000 for his own master’s program. Jim
claims all three of his daughters as dependents. His modified gross income for the year is
$50,000. What is the available Lifetime Learning Credit assuming he elects to use the Lifetime
Learning Credit for those expenses that do not qualify for the American Opportunity Tax Credit?
 Answer: $1600

Explanation: Amanda and Linda both qualify for the American Opportunity Tax Credit. The
felony drug conviction does not hinder availability of the lifetime learning credit, thus the $5,000
in expenses for Stephanie qualify. His own expenses qualify as well. The taxpayer’s lifetime
learning credit for 2018 is $1,600 (($5,000 + $3,000) x 20%).

4. Steve and Kendra have been unable to have a baby. They decided last year that adoption would
the best choice for them. They believe that they can support a child that has special needs both
financially and emotionally. Therefore, they adopted, Janice, a four-year-old special needs child
this year. They paid $8,000 in qualifying adoption expense for the current year. Their MAGI for
the year is $160,000 and their tax due before the application of the qualified adoption credit is
$10,000. What amount can Steve and Kendra’s claim as an adoption credit for 2018?

Answer: $13,810

Explanation: Because they have adopted a special needs child, they can take a credit of the full
credit amount, $13,810, even though they did not spend that much in adoption expenses.
Because this is a nonrefundable credit, they can only use $10,000. The additional $3,840 can be
carried forward for up to five years.

5. Which of the following statements concerning refundable tax credits is correct?

Answer: Refundable tax credits can generate a tax refund.

Explanation: Refundable credits are far fewer in number than nonrefundable credits. In addition
to reducing or eliminating the current year’s tax, refundable tax credits can generate a tax
refund. Furthermore, nonrefundable credits are used before refundable credits for federal
income tax purpose.

6. Which of the following statements concerning business credits is correct?

Answer: The amount of the rehabilitation credit is 20 percent of the qualified rehabilitation
expenditures for certified historic structures

Explanation: The investment credit consists of the sum of four different credits, (1) the
rehabilitation credit, (2) the energy credit, (3) the qualifying advanced coal project credit, and
(4) the qualifying gasification project credit. The amount of the rehabilitation credit is 10 percent
of the qualified rehabilitation expenditures made for pre- 1936 buildings plus 20 percent of the
qualified rehabilitation expenditures for certified historic structures. The work opportunity
credit is intended to promote the hiring of targeted groups of people who have special needs or
high unemployment rates. The employer-provided child care credit is intended to encourage
employers to help provide and promote appropriate child care for their employees and is for
facilities owned by the employer.
7. Brandy is a single mom with 2 children, Zach and Wendy. Zach is 14 years old and Wendy is 3
years old. Brandy has AGI of $50,000. She paid the following expenses for child care this year:
• $300 to Zach to care for Wendy so Brandy could go out to dinner with friends.
• $1,000 for an after-school program for Zach.
• $3,500 to Brandy’s mother for the care of Wendy during the day.

Answer: $600

Explanation: The payment to Zach does not qualify because he is a dependent child of Brandy
under the age of 19 and because the expense was not employment related. The payment for
Zach’s after-school program does not qualify because Zach is not under the age of 13 (note that
means there is only one qualifying dependent). The payment to Brandy’s mother does count
towards eligible expenses. However, the eligible expenses are limited to $3,000 since there is
only one qualifying dependent. Since Brandy has AGI over $43,000 she is able to take a credit of
20% x $3,000 = $600.

8. In 2018, Ginger paid $5,000 for qualified solar electric property and $4,000 for qualified fuel cell
property with one kilowatt of capacity for her vacation home. She also paid $10,000 for
qualified solar water heating property for her personal residence. What is her maximum
residential energy efficient property credit for 2018?

Answer: $4,500

Explanation: Her maximum residential energy efficient property credit for 2018 is $4,500
[($5,000 x 30%) + ($10,000 x 30%)]. $5,000 spent for the qualified solar electric property
qualifies for the credit even though the expenditures were not for her principal residence.
However, the amount paid for the qualified fuel cell property does not qualify since it was not
for her personal residence. The amount paid for the qualified solar water heating property is
limited to $3,000 ($10,000 x 30%).

9. Andy’s second wife, Gina, died several years ago. Andy and Gina had two children together, Sara
and Ben (twins, age 6) and they had adopted a child Andrew (age 10). Andy also had a child,
Angela, age 18, with his first wife. Andy’s fiancé (who also lives with Andy) gave birth to Andy’s
biological child, Sue Ellen, in November of the current year. All five children live with Andy and
he claims all of them as dependents. Andy’s AGI for the current year is $60,000 and he files head
of household. What is Andy’s available child tax credit?

Answer: $8,000

Explanation: He is entitled to $2,000 credit for four of the five children. Angela does not count
because she is age 18. Sue Ellen counts, since she was born before the end of the year and lives
with him. Andrew is considered to be Andy’s own child even though he is adopted. Andy would
be able to claim a $500 family tax credit for Angela.
10. Kathryn earns a salary of $150,000 from Hospitals, Inc. as a hospital administrator during 2018.
Hospitals, Inc. withholds OASDI taxes in the amount of $7,961. She also earns $20,000 of wages
from CPR Experts where she teaches CPR. CPR Experts withholds OASDI taxes in the amount of
$1,240. What is Kathryn’s available credit for excess Social Security taxes withheld, assuming
Kathryn’s tax due before application of the credit is $800?

Answer: $1240

Explanation: Kathryn will be allowed to take a $1,240 refundable credit against income taxes for
the excess Social Security taxes withheld from her compensation during the year. She is only
required to pay Social Security tax on the first $128,400 (2018) which was withheld from
Hospitals, Inc. The amount withheld from CPR Experts is the excess amount.

11. Which of the following statements concerning the earned income credit is correct?

Answer: If the taxpayer has a qualifying child, the child must meet a relationship, age, and
residency test.

Explanation: The taxpayer must have earned income – investment income does not qualify.
Individual filing married filing separately cannot claim the credit. If the taxpayer does not have a
qualifying child then the taxpayer must be at least 25, but under age 65.

12. Amber pays foreign income taxes of $1,200 (at the same rate as U.S. income taxes) on foreign
earned income for the current year. Her U.S. income tax for the year is $22,000. Her total
itemized deductions other than the allowable deduction for foreign income taxes are $500 less
than her standard deduction. If she is in the 24% marginal tax bracket, which of the following
should she do?

Answer: She should take a credit for the foreign taxes paid

Explanation: She should take a credit for the tax paid. If she takes an itemized deduction for
foreign income taxes, only $700 of the $1,200 of foreign taxes paid will produce a tax benefit
(the excess over the standard deduction greater than her itemized deductions). The tax benefit
will be equal to $700 multiplied by her marginal tax rate of 24% = $168. Any tax benefit for the
remaining $500 of foreign taxes will be lost. Alternatively, if she takes a foreign tax credit, she
will reduce her U.S. income tax by the full $1,200 of foreign taxes paid. Finally, if she can’t use
the entire foreign tax credit in the current year, she may be able to carry it back to the preceding
year and forward to future tax years, as needed. The taxpayer must select one or the other.

13. Sara, who is single, contributed $5,500 to her Roth IRA for 2018. She had MAGI of $17,000 for
2018 and used the single filing status. She has never taken a distribution from a retirement plan.
What is her maximum retirement savings credit for 2018?

Answer: $1000
 Explanation: Her maximum credit for 2018 is $1,000 ($2,000 x 50%).

14. Which of the following statements concerning the general business credit is correct?

Answer: The general business credit is a combination of more than 30 different nonrefundable
tax credits

Explanation: Any unused credit can be carried back to the prior year or forward 20 years. The
credits are used in a FIFO Sequence – carryforwards, current year, then carryback credits. The
general business credit may not be allowed to offset all of the income tax remaining after the
application of the other nonrefundable credits.

CHAPTER 8 OTHER DEDUCTIONS, PENALTIES, AND LOSS DISALLOWANCE

1. John, a single individual, is an avid coin collector. To raise some money to support his hobby,
John began to occasionally buy and sell coins about 10 years ago, incurring business-related
expenses in those transactions. John does not consider himself to be in the business of dealing
in coins, and over the time he has been selling coins, he has never made a profit. This year, John
grossed $4,000 in sales, and had $4,500 in expenses associated with the activity. John’s AGI for
the year (including any inclusion due to the coin trading activity) is $50,000, and aside from the
coin trading loss, his only other permissible itemized deductions are mortgage interest of $8,000
and real estate taxes of $2,500. Which of the following statements concerning this situation is
correct?

Answer: The increase in John’s taxable income as a result of the coin trading activity is equal to
the income of $4,000.

Explanation: John is engaging in a hobby activity. He has never made a profit, and does not
appear to have a profit motive. Consequently, he must include all $4,000 in his gross income. He
cannot deduct his hobby expenses after 2017.

2. Christopher runs an extortion racket in his home neighborhood. He paid Bobby $100,000 to run
the street operations, and incurred $30,000 for secretarial support and $20,000 in
miscellaneous expenses, such as rent for his office and supplies. Christopher had gross income
from the extortion ring of $400,000. How much of the income is subject to income tax this year?

Answer: $250,000

Explanation: Even though Christopher is running an illegal business, the income from the activity
is subject to income tax. Christopher is entitled to deduct all reasonable and necessary expenses
associated with the production of the income, including salaries and costs incurred in business
operations.
3. Ten years ago, Fernando loaned his son, Salvatore, $20,000 to start a business. The note
required the payment of interest at a rate of nine percent for ten years, with a balloon payment
of the principal at the end of the note term. Salvatore has been making interest payments on
the note for the past six years, but this year his business took a turn for the worse and he was
not able to make the annual interest payment of $1,800. The business was closed down, and
Salvatore owed an amount greater than his net worth to secured creditors, so he informed his
father that he would not be able to make the interest or principal payments on the note. How
should Fernando treat the default for income tax purposes?

Answer: Fernando may deduct $20,000 as a short-term capital loss

Explanation: Since Fernando is not in the business of making loans, the debt is classified as a
non-business bad debt. As an individual, Fernando is a cash basis tax payer. While he did lose
both the principal of the loan and the current year interest payment from an economic
perspective, he never included the current year interest payment in his income (because he did
not receive it), and therefore cannot take a deduction for that amount. All nonbusiness bad
debts are treated as short-term capital losses regardless of the length of time the note has been
outstanding, so Fernando can deduct $20,000 as a short-term capital loss.

4. Which of the following statements concerning Net Operating Losses (NOL) is correct?

Answer: NOLs can be carried forward indefinitely

Explanation: NOLs can be carried forward indefinitely and cannot generally be carried back for
years after 2017.

5. Wally, a 45-year-old professor, was speaking with his good friend, Larry, who is 53 years old. The
topic of retirement savings came up, and Larry told Wally that individuals age 50 and over could
contribute $6,500 to an IRA. Wally did not review the laws for those younger than 50 which
indicates the deduction limit to be $5,500, but instead contributed $6,500 also. Assuming that
Wally does not correct his error, what is the amount of the tax penalty that Wally must pay for
making the $6,500 contribution for (the current tax year) to the IRA?

Answer: $60

Explanation: Wally has made an excess contribution to his IRA of $1,000. Larry was permitted to
make the contribution due to the catch-up provisions for taxpayers over the age of 50. The
excess contribution penalty is 6%, so Wally must pay a penalty tax of $60.

6. All of the following expenses incurred when an individual travel from his office to a client’s place
of business to discuss business matters will qualify as a business deduction, EXCEPT:

Answer: A $30 parking ticket for parking in a no-parking zone since no other parking spaces
were available
 Explanation: Penalties and fines are never deductible business expenses, even if they are
incurred in the conduct of a trade or business. The other expenses are deductible.

7. Michael owns a beach home, which is his second home, in a national resort area. Since this
home is only a vacation home, and he can generate substantial cash flow by renting the
property, Michael lists the property with a real estate agent who successfully rents the property
for 12 weeks a year. Michael and his family use the home for the entire month of September,
for two weeks in January, and for two weeks in May each year. If Michael’s gross rental income
from the property is $60,000, and he has $75,000 of expenses (mortgage interest, real estate
taxes, brokerage fees, and miscellaneous expenses) associated with the rental activity, which of
the following statements is correct?

Answer: Michael will be able to take a deduction for expenses limited to $60,000.

Explanation: This is a mixed-use property, since the property was rented out for more than 14
days (12 weeks), and Michael used the property for more than 14 days (8 weeks) (10 percent of
the rental days, in this example, would only be 8.4 days). Therefore, Michael must include the
rental income, but is permitted to deduct expenses to the extent of the income generated from
the activity as a production of income expense, which directly offsets gross income (is an above-
the-line deduction). Therefore, there will be no increase in Michael’s AGI or taxable income for
the year. The $15,000 of additional expenses that would otherwise have generated a loss are
not deductible, so there is no loss that can be suspended under the passive activity rules. Since
the expenses are deducted as above-the line deductions, the income will not reduce itemized
deductions since it will not increase AGI.

8. On December 1 of last year, Bertie purchased 100 shares of Wooster Enterprises, Inc. (a large,
publicly held company established 80 years ago that is traded on the New York Stock Exchange)
common stock for $5,000. On March 1 of this year, Wooster Enterprises declared that it was
bankrupt, that it will wind up operations and that all of its assets will be used to satisfy secured
creditor claims so there will be no residual equity left for the stockholders. Which of the
following statements describes the tax treatment of this transaction?

Answer: Bertie may deduct the $5,000 investment as a long-term capital loss.

Explanation: Bertie is not an original owner of Wooster Enterprises, so even if the company was
originally capitalized with less than $1 million, Bertie will not qualify for the ordinary loss
deduction allowed under IRC Section 1244. Since the company became worthless during the
year, a constructive sale of the stock occurs on December 31 of this year making Bertie’s
holding period for the stock long-term (he purchased the stock on December1 of the prior year).
Therefore, Bertie will be able to deduct the $5,000 investment as a long-term capital loss.

9. Happy Harry not only uses drugs, he also sells them to a circle of friends and associates. This
year, Harry grossed $650,000 from drug sales. He paid $125,000 to his street pushers to
compensate them for their services, $200,000 for the raw drugs, $30,000 for rent for the drug
 processing and packaging plant, and $30,000 in supplies and equipment leasing costs. How
much income will be subject to tax on Harry’s income tax return?

Answer: $450,000

Explanation: Since Happy Harry is conducting a drug related business, he is only permitted to
deduct from his gross income the cost of goods sold when determining the amount of income
subject to tax. The salary/commission payments to the drug pushers, rent, supplies and
equipment leasing costs will not qualify as a deduction.

10. Which of the following statements concerning the tax deductibility of executive compensation is
correct?

Answer: Performance based compensation and payments to qualified retirement plans are
not considered to be compensation subject to the $1 million deduction cap.

Explanation: The limitation on deductibility of executive compensation only applies to the CEO
and the four highest compensated executives. It does not apply to private (non-publicly traded)
companies. When applying the $1 million deduction cap, performance-based compensation and
contributions to qualified pension plans are not considered to be part of the executive’s
compensation.

11. Harry, a married individual who files jointly with his wife, is one of the founders and original
shareholders of Brittania Yacht Charters, Inc., a company that charters yachts for corporate
events. The company was initially capitalized with $200,000, and Harry was a 50 percent owner.
The company was structured as a C corporation, and all filing requirements and permissible tax
elections that could benefit the taxpayers were made at the time the company was created.
After several years of successful operations, Brittania Yacht Charters, Inc. lost market share to
large national firms, and eventually closed down operations. Since it had no assets other than
the goodwill of the business after all secured creditors were paid, there was nothing left to
distribute to the shareholders. Assuming that there were no changes to Harry’s ownership
interest in Brittania Yacht Charters, Inc. over his period of ownership, and that Harry had no
other capital transactions in the current tax year, what portion of Harry’s loss on his investment
in Brittania Yacht Charters can he deduct against ordinary income this year?

Answer: $100,000

Explanation: Harry’s initial investment in the company was $100,000 and the stock was Section
1244 stock in his hands. He is married and files a joint tax return with his wife, so the entire loss
of $100,000 is deducted against ordinary income this year. Since the entire loss is treated as an
ordinary loss for tax purposes, there is no additional capital loss on the transaction.

12. Keegan owns and operates an engineering consulting business as a sole proprietorship. For tax
reporting, Keegan uses the cash method. Last year, he provided services to a local builder, and
 upon completing the task he was asked to do, he sent an invoice to the builder for $5,000. The
builder never paid the bill, and recently filed for bankruptcy, so Keegan will not be able to collect
the amount due. How should this bad debt be treated for income tax purposes?

Answer: No bad debt deduction is permitted

Explanation: No bad debt deduction is allowed in this case because Keegan is a cash basis
taxpayer. Cash basis taxpayers report and pay tax on their income when it is received, so Keegan
was never taxed on the $5,000 of income that he billed the builder. If Keegan’s business was
accounting on an accrual basis, he would have reported and paid tax on the income last year
and would be entitled to a deduction against his business income this year to reverse out the
inclusion of the $5,000 of income. Since the deduction results from a specific client failing to
pay, this would have been an example of the specific charge-off method if Keegan was using the
accrual method of accounting.

13. Two years ago, Roger purchased his dream home, paying $800,000 for the house.
Unfortunately, the real estate market was at its height when he purchased the home, and has
since “corrected” as interest rates began to climb. Roger was transferred by his employer to an
office across the country, and he put his home on the market, eventually selling it for $720,000.
Assuming Roger had no other capital transactions this year, which of the following statements
correctly describes the income tax consequences of this transaction?

Answer: Roger’s AGI will not be affected in any way by the loss.

Explanation: The home is a personal use asset. It was not purchased for investment or
production of income. While Roger did suffer an economic loss on the home, he is not entitled
to take any part of the loss as a tax deduction since the home was a personal use asset.

14. One year ago, David, age 55, changed jobs and now works for a company that offers a SIMPLE
plan to its employees. Each year, the company makes a non-contributory contribution of two
percent of an employee’s salary to the account of each participant. David’s daughter is getting
married this year, and he needed some extra funds to help pay the expenses associated with the
wedding. David took a $4,000 distribution from the SIMPLE Plan. What is the amount of the tax
penalty that David must pay for taking the distribution from the SIMPLE plan?

Answer: $1,000

Explanation: Since David took an early distribution from a SIMPLE plan within 2 years of initially
participating in the plan, the penalty is 25% of the amount of the distribution. David must pay a
$1,000 tax penalty in addition to regular income tax on the $4,000 distribution.

15. Seth owns a mansion built on the cliff of a large island overlooking the Atlantic ocean. Each year,
an international sailing race takes place around the Island, and large corporations descend on
the town, inviting clients and business associates to entertain them. Carman Corporation, a
 custom designer of racing sailboats, is particularly interested in this event each year, and for the
week and a half of the race, they rent Seth’s mansion, paying him $200,000. At first, Seth was
hesitant to rent the home, but decided that since it would only be a week and a half, he could go
on vacation himself at that time. Seth incurs some costs associated with the rental, including
storage charges for his valuables of $10,000, cleaning expenses before and after the rental of
$8,000 and he estimates that the pro-rata portion of real estate taxes for the period of the
rental is $1,000. How much income from this rental activity will be included in Seth’s AGI?

Answer: $0

Explanation: Because the home is rented out for 14 days or less, Seth will not be required to
report any income for the rental, but he cannot deduct any expenses associated with the rental
activity.

CHAPTER 7 ITEMIZED DEDUCTION

1. In June of this year, Kelly purchased her first home. The price of the house was $260,000, and
she financed the purchase with a 30-year, $200,000 mortgage. Since she plans on staying in the
home for quite a while, and she expects interest rates to rise in the future, she paid $4,000 in
points to receive a lower interest rate on the loan. As of the end of the year, Kelly had paid
$7,614 in interest on the loan by making her monthly installment payments. How much should
she claim as mortgage interest on her itemized deductions this year?

Answer: $11,614

Explanation: In the year a home is acquired, the interest paid on a mortgage used to acquire the
home, as well as the points paid to qualify for a lower interest rate on the loan are deductible as
mortgage interest expense, subject to the overall limitations on acquisition indebtedness. Since
Kelly acquired her home this year, she can deduct the $4,000 she paid in points as well as the
$7,614 paid in mortgage interest, for a total of $11,614.

2. In which of the following situations would educational expenses be deductible for income tax
purposes?

Answer: A financial planner takes classes necessary to sit for the CFP® Certification
Examination

Explanation: Educational expenses are deductible if they are for the purpose of furthering and
expanding the taxpayer’s knowledge in his/her chosen trade or profession. Taking classes to
enter a new trade or profession, such as medicine or law, will not qualify as an income tax
deduction. Furthermore, classes taken for personal enrichment, such as those referred to in
option c, are not related to production of income or a trade or business, so they are not
deductible.
3. Which of the following miscellaneous itemized deductions is not subject to the 2 percent floor?

Answer: Gambling Losses

Explanation: Gambling losses are not subject to the 2 percent floor that generally applies to
miscellaneous itemized deductions. Investment expenses, hobby activity expenses, and other
unreimbursed employee business expenses are subject to the 2 percent floor and thus not
deductible.

4. Kasey has been an avid investor since his teenage years, when his uncle taught him the basics of
investing. This year, Kasey incurred investment interest expense of $800. Kasey had $200 of
dividend income and $100 of interest income this year since he has a growth focus in his
portfolio. Kasey also realized $600 of capital gains for the current year. Applying the default
rules for the deductibility of investment interest expenses, which of the following statements is
correct?

Answer: Kasey will be able to carryover $500 of investment interest expense to deduct against
future investment income in subsequent tax years.

Explanation: Investment expenses are deductible to the extent of net investment income.
Investment income includes interest and dividends received on a portfolio, but does not include
capital gains unless the taxpayer makes an affirmative election to include capital gains in the
definition of investment income (and, in the process, loses the special tax rate that applies to
long-term capital gains). Kasey’s investment interest expense was $800 and his investment
income was $300, so he is able to claim $300 of the investment income expense this year. He
can carry forward the remaining $500 of investment interest expense indefinitely, and claim it
when he generates interest or dividends in the future.

5. John is the 100 percent owner, president, and CEO of FadCo, Inc. His salary is approximately $1
million per year, and he has substantial income from investments and other business interests.
FadCo’s taxable income each year is $10 million. Due to his high level of income, his itemized
deductions are in the phaseout range. John would like to make a $1.8 million contribution to the
local opera company to renovate the concert hall and stage, but does not feel that he can get
significant tax benefits if he makes them himself. Instead, he has his company make the
contribution on December 31, and he reduces his salary to $100,000 per year for the next two
years so that the contribution does not deprive the company of cash flow needed for expansion.
Which of the following statements concerning this situation is correct?

Answer: FadCo will be able to take a charitable deduction of $1 million on its tax return this
year.

Explanation: Corporations may make tax deductible gifts to charity, but may not deduct more
than 10% of their taxable income. If FadCo donates the $1.8 million to the opera company, it will
 only be able to take a $1 million deduction. This works well for John, since he can reduce his
salary, thereby reducing his income subject to tax. In essence, by reducing his income to
$100,000 John has moved his charitable deduction above the line. He cannot take an itemized
charitable deduction, since he did not make the contribution (the company did).

6. Bertie is an avid fan of his alma-mater’s football team. The team has had such a good record in
the last 6 years that getting tickets to the games has proven difficult. Recently the school
announced that those wishing to purchase football tickets could have their name placed on a
waiting list once they made a $5,000 contribution to the University. Since Bertie did not want to
miss any of the games, he made the contribution, and also paid $1,000 for the season tickets.
How much can Bertie deduct as a charitable contribution on his income tax return?

Answer: 0

Explanation: When a contribution is made to a charity to obtain an option to purchase sporting

tickets, there is no charitable deduction (TCJA 2017).

7. Jennifer, a college student, had her car recently broken into. The perpetrators caused $800 in
damage to her car, and stole a camera with a fair market value of $700 that was originally
purchased for $1,500. Jennifer’s AGI for the year is $8,000. How much can Jennifer claim as a
casualty loss deduction on her income tax return this year?

Answer: 0

Explanation: Jennifer suffered a casualty loss. Casualty losses are only deductible, if declared a
national disaster by the President.

8. Ryan, age 66, has a severe asthmatic condition, and his physician recommended that he install a
lap pool in his home so that he can swim regularly, which should help control his condition. Ryan
has a friend who is a real estate agent, and strongly advised him not to install the pool, since
pools depress the market value of homes in the area. If Ryan’s AGI for the year is $100,000 how
much of the cost of the lap pool can Ryan actually deduct as a medical expense if it cost him
$9,500 to install the pool and all of his other health insurance costs were covered by his health
insurance policy? The value of the house did not change due to the pool.

Answer: $2,000 itemized deduction

Explanation: Capital improvements to a home can be deducted as medical expenses if they are
medically necessary. The only portion of the expense that can be deducted, however, is the
difference between the cost of the improvement and the increase in the value of the home. In
this case, installation of a pool did not result in a market value increase in Ryan’s home, so he is
permitted to deduct the full cost of $9,500. Out of the $9,500 cost, however, Ryan will only be
able to deduct that portion of the cost that exceeds 7.5% of his AGI. Since his AGI is $100,000,
 he can deduct $2,000 (calculated by subtracting 7.5% of his AGI, $7,500 from the installation
cost, $9,500).

9. Edward, a U.S. Citizen, has always felt drawn to the town in Ireland that his family came from.
The local church in that town is in dire need of repair, and Edward would like to make a
contribution to the restoration fund which is managed by the Archdiocese of Laois, Ireland. If
Edward makes a contribution, which of the following statements is correct?

Answer: If Edward donates the funds to his parish in the United States, and the parish sends
the fund to the church in Ireland, Edward will qualify for an income tax charitable deduction

Explanation: To be deductible for federal income tax purposes (unlike the rules that apply to the
federal estate tax charitable deduction), a contribution must be made to a U.S. charity. Gifts to
foreign charities are not deductible. One way to avoid this problem is to make a gift to a U.S.-
based charity that will transfer the funds to the foreign charity, making answer c the correct
answer.

10. Rennie purchased a new car this year, and paid $3,600 in total sales taxes for the year. Rennie’s
state income tax for the year was $2,000. The property taxes on Rennie’s home this year were
$6,000, and he made approximately $12,000 in charitable deductions. How much should Rennie
deduct for taxes as an itemized deduction?

Answer: $9600

Explanation: Taxpayers are permitted to claim the higher of state income taxes paid or sales
taxes paid as an itemized deduction. Since Rennie paid $3,600 in sales taxes, but only $2,000 for
income tax, he will claim sales taxes as an itemized deduction this year. This election does not
impose limits on the deductibility of other taxes, so Rennie can still claim his property taxes of
$6,000 as well as the $12,000 in charitable deductions. Consequently, Rennie’s total itemized
deductions for the year are $21,600 but his itemized deduction for taxes is $9,600, which is less
than the $10,000 limit.

11. Keegan is in a high tax bracket, and decided to add some public purpose municipal bonds to his
portfolio. He did not want to liquidate any of his current positions to acquire the bonds,
however, so he took out a margin loan to make the purchase. Keegan incurred $800 of margin
interest on the loan used to purchase the bonds, and received $600 of coupon payments from
the bonds this year. Assuming that Keegan had no other margin interest or other investment
income this year, which of the following statements is correct?

Answer: Keegan cannot deduct any of the margin interest incurred this year.

Explanation: Interest incurred to acquire tax-exempt investments may not be deducted as an

investment interest expense. Since Keegan used the margin proceeds to purchase public
purpose municipal bonds, which will never be subject to income tax (in the regular or AMT tax
 systems), he may not deduct any portion of the $800 in margin interest paid to acquire the
assets.

12. Ryan’s AGI this year was $100,000. He inherited a large amount of money from the estate of his
grandfather, and is very charitably inclined. A recent earthquake devastated several cities on the
West Coast, and Ryan wanted to assist in getting the people affected back on their feet. He gave
a $75,000 donation to the Red Cross, which is spearheading relief efforts in the region. How
much of the contribution can Ryan deduct on his income tax return this year?

Answer: $60,000

Discussion: Ryan made a contribution of cash to a public charity. Since he does not have any net
operating loss carrybacks this year, his contribution base is his AGI, or $100,000. The maximum
amount (the ceiling) that can be deducted in any one year for gifts of cash to a public charity
(the Red Cross) is 60% of the taxpayer’s contribution base. Ryan can deduct, therefore, $60,000
of the $75,000 gift. The remaining $15,000 may be carried forward for up to five years and
deducted against income from those years, subject to the ceiling limitations for charitable gifts.

13. Patrick, a small business owner who is worn out from years of work without a vacation, decides
he needs a break and wants to go on a 3-month cruise around the world. The cost of the cruise
is $45,000, and Patrick does not have the liquid funds to pay for the extravagant vacation.
Patrick does not want to liquidate investments to cover the expenses, and does not want to
incur high-interest credit card debt. His only debt outstanding is the remaining balance on his
mortgage of $60,000, so he decides to take out a home equity loan for $45,000 to pay for the
trip. Which of the following statements concerning this situation is correct?

Answer: The amount of interest paid on the loan is not deductible for income tax purposes.

Explanation: Taxpayers are permitted to deduct the interest on up to $750,000 of acquisition

indebtedness as an itemized deduction. To fund his trip, Patrick took out a home equity loan for
$45,000. The interest on this loan is not deductible since it is not acquisitioning indebtedness.

14. Brendan is a tax attorney who specializes in intergenerational wealth transfer planning. He is
also very charitably inclined, and sits on several charitable boards. A local animal shelter and
Friends of Animals group recently decided to work together on joint goals, and decided to form
a new charitable organization, which meets the definition of a public charity. Brendan created
the organization and received exempt determination status from the IRS. He usually charges
$5,000 to perform this service, plus the exempt determination letter fee charged by the IRS of
$500, but he volunteered for this activity since his wife will be on the board. Brendan was not
reimbursed for the expenses he incurred. Assuming that his AGI and contribution base is
$150,000, how much can Brendan deduct for income tax purposes?

Answer: $500
 Explanation: In order to be deductible for federal income tax purposes, a taxpayer must make a
gift of property, not services. While Brendan provided a valuable service to the charitable
organization, he cannot deduct the value of his services as a charitable deduction since he never
included the value of his services in income. The actual expenses he incurred, however, are
deductible. Since he paid $500 to obtain the exempt determination letter from the IRS, Brendan
is allowed to deduct $500 as a charitable deduction.

15. Last year, Randy incurred the following tax expenses and related items:

Federal income tax due with return $2,150

State income tax withheld this year $4,500

State income tax paid with return this year $600

Real estate taxes paid on residence $6,500

Sewer and water tax $600

Car tax (flat rate for all car owners) $300

State income tax refund from prior year $400

Answer: 10,000

Explanation: Federal income taxes are never deductible as an itemized deduction. Generally,
state and local income taxes are deductible as an itemized deduction. There are some
limitations to this rule, however. Use taxes, such as sewer and water tax, are not deductible.
Property taxes that are based on value (ad valorem taxes) are deductible, but flat rate property
taxes, such as the car tax in this problem, are not deductible. Consequently, Randy can deduct
the $4,500 of state income taxes withheld this year, the $600 of state income taxes paid with his
return this year, and the $6,500 of real estate taxes on his personal residence. He may not
deduct the car tax, sewer and water tax, or federal income tax. While his state income tax
refund from a prior tax year is important in preparing his return, it is not factored into his
itemized deductions – it is included in gross income pursuant to the tax benefit rule.

CHAPTER 6 INTRODUCTION TO DEDUCTION

1. All of the following individuals are considered to be self-employed individuals EXCEPT:

Answer: Greater than 5% owners of C corporations

 Explanation: For income tax purposes, sole proprietors, partners (including members in LLCs and
LLPs, and limited partners), and greater than 2 percent owners of S corporations are considered
self-employed individuals. When computing the AGI of a self-employed individual, special
adjustments must be made. Owners of C corporations, without regard to the extent of their
ownership interest, are not considered self-employed individuals, but are rather considered to
be employees of the corporation if they work for that corporation. (Recall that a corporation is
an entity separate and distinct from its owners that pays tax on its income, while pass-through
entities and sole proprietorships require the owners to pay the tax on the business income.)

2. Kasey is the three-year-old son of Randy. Since he was born, Kasey has received large gifts from
family members, which have been invested for his benefit, and are now beginning to generate
some investment income even though a majority of the funds are invested in growth-type
investments. This year, Kasey will earn $2,000 in investment income, but due to his age, he does
not have any earnings from employment. Randy recently attended a tax planning seminar
sponsored by Fly-By-Nite Financial Services, and based on advice he received at the seminar, has
decided to take Kasey’s income and contribute it to an IRA for Kasey’s benefit. Randy feels that
the additional deferral of tax on the income would be beneficial from an income tax standpoint.
How much can Kasey contribute to his IRA this year?

Answer: $0

Explanation: Since Kasey does not have any earned income, he may not make a contribution to
either a traditional or Roth IRA. Even though Kasey has investment income, he has no earned
income.

3. On January 1, 2018, Henry and Sandra were divorced. Under the terms of the divorce decree,
Sandra was given custody of their only child, Jennifer, who is 16 years old. The court decree also
requires Henry to pay Sandra $1,000 a month in alimony for two years, followed by $800 a
month for the next four years. Which of the following statements concerning the payments that
Henry makes to Sandra is correct?

Answer: Henry’s tax deduction will be limited to $9,600 per year during the six-year period.

Explanation: For income tax purposes, alimony payments that are reduced when a minor child
reaches the age of majority (18 in most states), are considered to be a form of child support.
Since Henry’s alimony payments will be reduced by $200 per month once Jennifer reaches age
18, $200 of the payment will be considered child support, leaving the remaining $800 as
alimony. As a result, Henry will only be able to deduct from his income, and Sandra will be
required to include in her income, $9,600 per year.

4. Brian is a single individual who works for Dutch Enterprises, Inc., and is a participant in their
qualified defined benefit plan and profit sharing plan. His adjusted gross income this year was
$90,000 and Brian is interested in generating some deductions to offset his income. While
watching the television show of a financial planner who claims to have all the answers for
 everyone, Brian follows the planner’s advice and makes a contribution to a traditional IRA of
$5,500. How will the contribution be reflected on his income tax return for the year?

Answer: Brian may not deduct any portion of the IRA contribution.

Explanation: Since Brian is an active participant in his company’s qualified plan, and his income
exceeds the deductibility limits for IRAs, Brian will not be able to deduct his IRA contribution for
the year. He will, however, benefit from tax deferral on the earnings generated from the $5,500
investment, and will pay tax on those earnings when he withdraws them from the IRA. A better
course of action for Brian would have been to contribute the $5,500 to a Roth IRA. He could not
get a tax deduction for the Roth IRA either, but the earnings on the contribution would escape
federal income taxation.

5. Marty Smith, a vocalist, has frequently undergone cosmetic surgery. Marty claims that the
reason for his surgery is to maintain the air passages from his nose through his throat so he can
have a consistent singing voice. Several other vocalists have claimed deductions for this type of
surgery. This year, Marty spent $25,000 on cosmetic surgery, and his AGI for the year was
$200,000. How much of the cosmetic surgery expenses will Marty be able to deduct as an
itemized deduction?

Answer: $0

Explanation: While elective cosmetic surgery is generally not a deductible medical expense (it is
specifically excluded from the type of medical expenses that can be claimed as an itemized
deduction), when the expense is considered to be an ordinary and necessary business expense,
it can be used to offset business income. Since Marty is undergoing surgery to ensure his
continued ability to generate income, he can deduct the expenses on his Schedule C or business
tax return, resulting in an above the line deduction that reduces his adjusted gross income. He
will not be permitted to deduct the expenses as a medical expense on his Schedule A (Itemized
deductions).

6. Richard is preparing his personal tax return for the year. He represents major pharmaceutical
firms, and operates his sales business as a sole proprietorship. This year was not the best for
Richard, and he has net earnings of $2,000. Since the pharmaceutical companies he works for do
not provide him with office space, Richard has a room in his home that he uses exclusively and
regularly for the conduct of his business. The expenses Richard incurred that could be properly
allocated to the home office were $5,000. How much can Richard take as a home office
deduction this year?

Answer: $2,000

Explanation: Provided that a business owner uses part of his home exclusively and regularly for
the conduct of a trade or business, he can claim a portion of the expenses associated with the
home as a business expense. The amount claimed, however, cannot exceed the income of the
 business. In this case, the business income was $2,000 and the home office expenses were
$5,000, so the maximum home office deduction allowed for the year is $2,000. Home office
expenses can reduce business income to, but not below, zero.

7. Which of the following expenses can a taxpayer deduct as an adjustment to gross income
(above-the line)?

Answer: Expenses incurred in conducting a sole proprietorship

Explanation: Business expenses incurred by business owners directly offset income from a
business activity. A sole proprietor reports gross income from business operations on Schedule C
and deducts expenses on Schedule C. It is only the net income from the business that is included
in the Gross Income section of the taxpayer’s income tax return. By reducing income subject to
tax, business expenses incurred by a business owner in the active conduct of a trade or business
are always deducted “above the line,” or for AGI. Real estate taxes paid on a principal residence,
charitable gifts, and employee business expenses are itemized deductions, and are not taken
into account when calculating AGI.

8. All of the following statements concerning Health Savings Accounts (HSAs) are correct EXCEPT:

Answer: Contributions to HSAs must be distributed to cover health care costs by the end of
the taxable year, or they are forfeited.

Explanation: Unlike Health Care Savings Accounts (which are accounts maintained by employers
that allow employees to allocate part of their income on a pre-tax basis to the account),
amounts contributed to HSAs that are not used by the end of the taxable year can be carried
forward and used in future years. Excess contributions to HSAs are subject to a 6% penalty tax,
and early distributions (before age 65) are subject to a 20% penalty tax. Furthermore,
contributions to HSAs are not taken into consideration when determining the amount of income
subject to Social Security taxes for self-employed individuals.

9. All of the following requirements must be met for a payment to be treated as alimony EXCEPT:

Answer: The payment must cease at the death of the payor.

Explanation: In order to be considered alimony for income tax purposes, the payment must be
made pursuant to a court decree, the payer and payee may not be members of the same
household, the payment must not be a form of disguised child support, and the payment must
cease at the death of the payee (not the payer) spouse.

10. Mark owns a security consulting firm. He gained experience in security issues through his tenure
in the Marine Corps. The security business was established 10 years ago, and now practically
runs itself. Aside from helping with occasional projects, Mark has found himself in the enviable
position of collecting a large residual cash flow from the business while expending minimal
 effort in running it. To fill up the empty hours in his day, Mark decides to investigate new lines of
business, and has been looking into purchasing a retail Army-Navy store chain. He has taken
several trips to inspect the properties, and has retained accountants and lawyers to review the
financial and business operations.

Answer: Mark may deduct the costs incurred up to $5,000 of startup expenses in the year the
startup begins operations.

Explanation: The Army-Navy retail store is a different trade or business than the security
consulting business. Taxpayers may deduct up to $5,000 of startup costs (reduced (but not
below zero) by the amount the startup expenditures exceed $50,000) can be deducted in the
year that the new active trade or business begins its operations. Startup organizational costs in
excess of $5,000 are amortized for 180 months beginning with the month the new business
begins its operations.

11. Brian, who is an oil and gas engineering consultant, recently moved due to a change in
employment. Before his move, Brian only had a 20-mile commute to work, but after his move,
he had to commute 25 miles to his new job. If he had stayed in his old home, however, he would
have had to commute 75 miles to his new job. If Brian incurred $5,000 of moving expenses of
which $4,000 was reimbursed by his employer. How much can Brian take as a tax deduction?

Answer: $0

Explanation: Brian meets the distance test, but he is not a member of the Armed Forces. Moving
expenses for non-active duty military are not deductible between 2018 and 2025 as a result of
the TCJA 2017. In addition to no tax deduction, Brian would have $4,000 in income due to the
employer reimbursement.

12. Which of the following statements concerning Medical Savings Accounts (MSAs) and Health
Savings Accounts (HSAs), is correct?

Answer: Taxpayers who use MSAs and HSAs convert below the line deductions into above the
line deductions

Explanation: A significant advantage of HSAs and MSAs is an ability to transform what would
otherwise be below-the-line medical expense deductions (taken as an itemized deduction) to
above the line deductions. Taxpayers receive a tax deduction when they make a contribution to
the HSA or MSA, and do not have to pay tax on distributions to the extent that the distributions
are used to pay medical expenses. To set up an MSA, a taxpayer must be a business owner,
making option A incorrect. Individuals enrolled in Medicare (which is not a high-deductible
health plan) are not eligible to make MSA or HSA contributions, making option C incorrect. Since
contributions to these accounts are claimed as adjustments to income (above-the-line), option D
incorrectly states that they are below-the-line deductions.
13. Orion works for Mad Hatter Chemical Company, Inc. as an engineer. He has been employed
there for the past 5 years, and earns a salary of $100,000. Earlier this year, acting on advice
given to him by his financial planner, Orion purchased a qualified long-term care insurance
policy, and paid a premium of $800. All of his other medical expenses are covered by his
employer sponsored health insurance plan. Which of the following statements concerning the
long-term care policy is correct?

Answer: Mad Hatter Chemical Company could have provided the long-term care policy to
Orion as an employee benefit even if they did not provide similar coverage for other
employees.

Explanation: Qualified long-term care insurance contracts are treated as health insurance
contracts for income tax purposes, and are deductible. Orion cannot deduct the cost as an
adjustment to income because he is an employee – only self-employed individuals can receive
above-the-line deductions for long-term care premiums that are personally paid by them.
Companies can, however, provide long-term care coverage for their employees on a
discriminatory basis (there is no need to cover all employees – the employer can pick and
choose those employees he or she wishes to cover), so option D is correct. Even though Orion
can claim the cost as a medical expense deduction on his Itemized Deduction schedule, he will
not get any tax benefit because medical expenses are only deductible to the extent that they
exceed 7.5% of AGI.

14. In 2018, Colin, a single individual who is not in the Armed Forces, received a salary of $85,000
after making a contribution to his 401(k) plan. Colin incurred the following deductions last year:

Moving Expenses (due to change in employment) $5,000

Individual Retirement Account Contribution $5,500

Mortgage Interest $6,500

Charitable Gifts $2,000

Answer: AGI = $85,000

Explanation: Colin’s gross income of $85,000 is not reduced by any of the above. Colin is not
entitled to take a deduction for the contribution to his individual retirement account, since his
AGI exceeds the deductibility threshold and he is an active participant in a qualified plan 401(k).
Mortgage interest and charitable deductions are itemized deductions, and will therefore not
affect Colin’s AGI. Moving expenses for non-Armed Forces are not deductible between 2018 and
2025 as a result of the 2017 TCJA

15. Ryan is a 20% owner in Beverly Farms, Inc., an S corporation. All of the following expenses
incurred by or on behalf of Ryan by the corporation are deductible on the corporation’s tax
return, EXCEPT
 Answer: contributions to Ryan’s account in the company profit sharing plan

Explanation: Since Ryan is a greater than 2 percent owner in the S corporation, the Corporation
may not deduct pension contributions made on Ryan’s behalf. Instead, the pension
contributions must be “passed through” to Ryan on his K-1, which allocates his share of
corporate profits and financial results, and Ryan will report the contribution as an adjustment to
income on his personal tax return. Note that if contributions were made to the profit-sharing
plan of Ryan’s assistant (and she was not a greater than 2% owner of the corporation), the
corporation would deduct that payment on its tax return.

CHAPTER 5 GROSS INCOME FROM EMPLOYMENT

1. Which of the following can make contributions to Heidi’s HSA?

Answer: All of the above

Explanation: Heidi’s employer, as well as any other person (including her aunt and her ex-
husband) can make contributions to Heidi’s HSA.

2. George is single and received $28,000 of dividend income during the year. He also received
$18,000 of Social Security benefits. What portion of his Social Security benefits are taxable?

Answer: $7050

3. Which of the following fringe benefits provided by Oceanside Company would be taxable to its
employee, Violet?

Answer: Monthly dues to the local health club paid by Oceanside for Violet and all other
employees

Explanation: In order for an athletic facility to be nontaxable, it must be on the premises of the
employer. The other choices are all nontaxable to employees, assuming they are not provided
on a discriminatory basis.

4. Ralph receives stock options (ISOs) with an exercise price of $16 when the stock is trading at
$16. Ralph exercises these options two years after the date of the grant when the stock price is
$37 per share. Which of the following statements is correct?

Answer: Upon exercise Ralph will have no income for regular tax purposes.

Explanation: Ralph does not have regular income at the date of exercise. Ralph’s adjusted basis
will be $16. The AMT adjustment will be the difference between the fair market value and the
exercise price ($37-$16=$21).
5. Suri recently entered an assisted living facility. She is unable to feed or dress herself, although
she can still walk and go to the bathroom unassisted. She had a life insurance policy with a
death payout of $100,000. She sold the policy to a viatical company for $60,000 and used the
money to pay for her long-term care at the assisted living facility. Which of the following
statements is true?

Answer: The policy proceeds will be excluded from Suri’s income.

Explanation: The policy is excluded from Suri’s income because she is chronically ill (she is
unable to do 2 of the 6 activities of daily living) and the money was used to pay for long-term
care.

6. Piper, age 68, had $50,000 in salary for the current year. She also received Social Security
benefits of $10,000 and workers’ compensation of $25,000. Which of the following is true?

Answer: The salary and 85% of the Social Security benefits will be taxable to Piper.

Explanation: The salary will be taxable at 100%. The workers’ compensation is excluded from
income. The Social Security benefits will be taxed at 85%.

7. Henrietta is unmarried, has a high-deductible medical plan, and recently set up an HSA. Under
what circumstances are contributions to Henrietta’s HSA deductible for 2018?

Answer: Contributions made by Henrietta up to $3,450 are deductible

Explanation: Option a is not correct because contributions made to Henrietta’s HSA by her
employer are deductible by the employer, not Henrietta. Option b is not correct because,
beginning in 2007, the contribution limit is not determined by the deductible of the high-
deductible plan. In addition, for years before 2007, the contribution would only be deductible
up to the amount of the deductible, not the amount that exceeds the deductible. Option d is not
correct. Although distributions are only tax-free if they are used to pay for qualified medical
expenses, contributions are not affected by qualified medical expenses. For 2018, Henrietta’s
contributions up to $3,450 are deductible.

8. Which of the following is not a qualifying person for the purpose of employer-provided
dependent care assistance?

Answer: child of the employee regardless of whether the child can be claimed as a dependent
on the employee’s tax return.

Explanation: Options b, c, and d list the three categories of qualifying persons for the purpose of
employer-provided dependent care assistance. Under the rules, a child of the employee must be
claimed as a dependent of the employee in order to exclude employer-provided dependent care
assistance from the employee’s income.
9. Which of the following requirements must be satisfied in order for a U.S. citizen to exclude
foreign earned income from U.S. taxation?

Answer: Either the bona fide resident test or the physical presence test must be satisfied

Explanation: A taxpayer who has foreign earned income is not required to satisfy both the bona
fide resident test and the physical presence test. If the foreign earned income is earned by an
employee of the U.S. government, it must be included in the taxpayer’s gross income. A
taxpayer must choose either to exclude the foreign earned income from gross income or take
the foreign tax credit; a taxpayer may not choose to do both.

10. Mike, a short order cook at the Bull’s Corner restaurant, works from 12 p.m. to 10 p.m. five days
a week. Each workday, he is furnished two meals without charge. The manager of the restaurant
encourages Mike to eat lunch in the employee break room each day before 12 p.m., but does
not expressly require him to do so. The manager does, however, require Mike to eat dinner in
the employee break room. The cost to the restaurant is $5 per lunch and $7 per dinner.
Assuming that Mike eats both lunch and dinner at the restaurant, what amount of this fringe
benefit should be included in Mike’s income?

Answer: Neither the cost of the lunches nor the cost of the dinners should be included in
Mike’s income.

Explanation: Because Mike is a food service employee and works during the normal lunch and
dinner periods, he can exclude the value of the lunches and dinners from his gross income. This
example does not appear to fall within the new 2018 rules regarding a 50% limitation on the
deduction for the employer for meals provided to employees for the convenience of the
employer.