Vol 01 chapter 10 2015

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Individual Income Taxes
1
Chapter 10
Deductions and Losses:
Certain Itemized Deductions

2
The Big Picture (slide 1 of 3)
• John and Susan Williamson have been
renting an apartment since they were
married.
– They now want to purchase their own home.
• Their current monthly rent is $2,000.
– They are willing to spend $2,500 per month
on an after-tax basis if necessary to purchase
their first home.

3
• After months of house hunting, they have found the perfect
home, but they fear it may be too expensive.
• Using a standard mortgage to finance the purchase, the total
cash outlay during the first year of ownership would be as
follows.
Principal payments $ 2,000
Interest payments 37,000
Real estate taxes 4,000
Total cash outlay $43,000
Monthly cost ($43,000 ÷ 12) = $ 3,583

4
• Alternatively, if they use investments to secure
financing, they could qualify for a lower interest rate.
– Reduces the interest charge from $37,000 to $35,000.
• Their Federal AGI will be $200,000 and their taxable
income will be between $160,000 and $185,000 for
the year.
– They do not itemize their deductions.
• Can John and Susan Williamson afford to pursue their
dream of home ownership?
– Read the chapter and formulate your response.

5
Itemized Deductions
(slide 1 of 2)
• Personal expenditures that are deductible from
AGI as itemized deductions include:
– Medical expenses
– Certain taxes
– Mortgage and investment interest
– Charitable Contributions
– Miscellaneous itemized deductions

6
Itemized Deductions
(slide 2 of 2)
• Itemized deductions provide a tax benefit only
to extent that, in total, they exceed the
standard deduction amount for the taxpayer

7
The Big Picture - Example 1
Allowable Itemized Deductions
• Return to the facts of The Big Picture on p. 10-1.
• With the purchase of a home, John and Susan will be able to
itemize their deductions for the first time instead of claiming
the standard deduction.
– Assuming the home mortgage interest expense and real estate taxes
meet the requirements discussed in this chapter, they will be deducted
from AGI.
– Their total itemized deductions will exceed the amount of their
allowable standard deduction.
• Further, other qualifying expenditures (e.g., state income taxes
and charitable contributions) likewise will be deductible as
itemized deductions, providing an explicit tax benefit to the
Williamsons.

8
Medical Expenses
(slide 1 of 6)
• Medical expenses are deductible to the extent
unreimbursed medical expenses, in total,
exceed 10% of AGI
– For taxpayers age 65 and older, the threshold is
7.5% of AGI until 2017, when it increases to 10%
– Prior to 2013, the percentage threshold for regular
income tax purposes was 7.5% of AGI for all
taxpayers

9
Medical Expenses
(slide 2 of 6)
• Example of medical expense deduction
limitation:
– Amy, age 24, has AGI of $10,000 and medical
expenses of $1,500
– Amy’s medical expense deduction = $500
[$1,500 – ($10,000 × 10%)]

10
Medical Expenses
(slide 3 of 6)
• Example of medical expense deduction
limitation:
– Bob, age 67, has AGI of $4,000 and medical
expenses of $1,000
– Bob’s medical expense deduction = $700
[$1,000 – ($4,000 × 7.5%)]

11
Medical Expenses
(slide 4 of 6)
• Expenditures for:
– The diagnosis, cure, mitigation, treatment,
prevention of disease, or
– The purpose of affecting any structure or function
of the body of the taxpayer, spouse, or dependents
– Includes prescription drugs and insulin

12
Medical Expenses
(slide 5 of 6)
• Does not include the cost of items such as :
– Unnecessary cosmetic surgery
– General health items
– Nonprescription drugs
• If cosmetic surgery is deemed necessary, it is
deductible as a medical expense
– Cosmetic surgery is necessary when it ameliorates
• A deformity arising from a congenital abnormality
• A personal injury, or
• A disfiguring disease

13
Medical Expenses
(slide 6 of 6)
• Medical expenditures are deductible in year
paid
– Includes payment by check or credit card

14
Medical Expenses
• The Williamsons had medical expenses of
$25,000.
– $3,000 of medical expenses were reimbursed by
their insurance company.
• With AGI of $200,000, the itemized deduction
for medical expenses is limited to $2,000.
– [($25,000 − $3,000) – (10% × $200,000)]
– Note: the Williamsons will not receive a tax
benefit from their medical expenses unless:
• Unreimbursed medical expenses exceed $20,000, and
• They itemize their deductions.

Examples of Deductible and
Nondeductible Medical Expenses
15Exhibit 10.1

16
Nursing Home Expenditures
• If primary reason for being in nursing home is
medical, costs (including meals and lodging)
qualify
• If primary purpose of placement in home is
personal, only specific medical costs qualify
(no meals or lodging)

17
Special School Expenditures
• Medical expense deduction may include the
expenses of a special school for a mentally or
physically handicapped individual
– Deduction is allowed if a principal reason for
sending the individual to the school is the school’s
special resources for alleviating the infirmities
– In this case, the cost of meals and lodging, in
addition to the tuition, is a proper medical expense
deduction

18
Capital Medical Expenditures
• May include a pool, air conditioners if they do not
become permanent improvements, dust elimination
systems, elevators, etc.
• Must be medical necessity, advised by a physician,
used primarily by patient, and expense is reasonable
• Full amount of cost is medical expense in year paid
• Maintenance on capital expenditures also medical
expense

19
Capital Improvement to Home
• Deductible medical expense only to extent cost
exceeds increase in value of home
– Appraisal costs related to capital improvements are
also deductible, but not as medical expenses
• Exception: removal of structural barriers to
home of handicapped are deemed to add no
value to home
– Thus, full amount is a medical expense

20
Medical Care for Spouse
and Dependents
• Taxpayer may deduct cost of medical care for
spouse and dependents
– Dependents need not meet gross income or joint
return tests
– Medical expenses of children of divorced parents
can be deducted by non-custodial parent even
though child is claimed as dependent of custodial
parent

21
Medical Transportation
and Lodging
• Transportation costs to and from medical care are
deductible
– Mileage allowance of 23.5 cents per mile (in 2014) may be
used instead of actual out-of-pocket automobile expenses
• Lodging while away from home for medical care
– Allowable amount is $50 per person per night
• If parent and/or aide needs to accompany patient,
their expenses are also deductible

22
Medical Expenses
• Because of her disabilities, John’s mother, Martha, moves in with them.
– She becomes their dependent.
• The family physician advises them that Martha needs specialized treatment
for her heart condition.
– John and Martha fly to Cleveland, Ohio, where Martha receives therapy
• Expenses in connection with the trip are as follows:
– Round-trip airfare ($250 each) $500
– Lodging in Cleveland for two nights ($120 each per night) $480
• Assuming that the Williamsons itemize their deductions, the medical
expense deduction is as follows:
– Transportation $500
– Lodging ($50 per night per person) $200
• Because Martha is disabled, it is assumed that John’s accompanying her is justified.

23
Medical Insurance Premiums
(slide 1 of 2)
• Premiums paid for medical care insurance are
deductible medical expenses
– If employer pays all or part of taxpayer’s medical
insurance premiums the amount paid by employer
is
• Not included in gross income by employee
• Not deductible by the employee as medical expense

24
(slide 2 of 2)
• For self-employed, 100% of insurance premiums are
deductible for AGI
– Includes amounts paid for taxpayer’s spouse and
dependents
– Not allowed if taxpayer is eligible to participate in a
subsidized health plan maintained by any employer of the
taxpayer or the taxpayer’s spouse
• Premiums paid for qualified long-term care insurance
are deductible medical expenses
– Subject to limitations based on age of the insured

25
• John Williamson is the sole practitioner in his
unincorporated accounting firm.
• During the year, he paid health insurance premiums
of $8,000 for his own coverage and $7,000 for
coverage for his wife, Susan.
– John can deduct $15,000 as a business deduction (for AGI)
in computing their taxable income

26
Reimbursement by
Medical Insurance
• If reimbursed in same year as expense paid:
– Reimbursement offsets medical expense
– Amount deductible is excess of expenses over
reimbursement
• If reimbursed in the year after medical expenses were
paid:
– Reimbursement is income only to extent medical deduction
decreased taxable income in the earlier year (tax benefit
rule)
– If standard deduction was taken in year expenses were
paid, none of the reimbursement is included in income

27
Example of Medical Reimbursements
(slide 1 of 2)
• In 2014, taxpayer, age 35, paid medical
expenses = $4,200; In 2014, reimbursed $800
by insurance company
– For 2014, deductible medical expense is
$3,400 – (10% × AGI)

28
Example of Medical Reimbursements
(slide 2 of 2)
• In 2014, taxpayer, age 35, paid medical
expenses of $4,200; In 2015, reimbursed $800
by insurance company
– For 2014, deductible medical expense is
$4,200 – (10% × AGI)
– For 2015, reimbursement is income to extent
taxpayer received a tax benefit from medical
expense deduction in 2014

29
Health Savings Accounts
• Used in conjunction with a high deductible medical
insurance policy
– Employee contributions to HSA are deductible for AGI and
earnings on funds in account are not taxable
– Deductible contributions are limited to the sum of the
monthly limitations. The monthly deductible amount is
limited to the lesser of one twelfth of:
• $3,300 for self-only ($6,550 for family coverage) in 2014
– Withdrawals from HSA are excludible to the extent used
for qualified medical expenses

30
Taxes
(slide 1 of 4)
• State, local, and foreign income and real
property taxes are deductible in the year paid
– Real property taxes do not include taxes assessed
for local benefits
• e.g., Special assessments for streets, sidewalks, curbing,
and other similar improvements
• State and local personal property taxes based
on value (ad valorem) are deductible in the
year paid

31
Taxes
(slide 2 of 4)
• Other taxes such as FICA, excise, etc., are not
deductible
– May be deductible if incurred in business or
production of income activity
• Fees are not deductible as tax

32
Taxes
(slide 3 of 4)
• Real estate taxes for year property is sold must
be apportioned between the buyer and the
seller
– Failure to correctly apportion requires offsetting
adjustments to seller’s amount realized and buyer’s
adjusted basis

33
Taxes
(slide 4 of 4)
• Can elect to deduct either state & local income taxes
or sales/use taxes
– For state and local income taxes, deduct amounts paid
during year:
• Amounts withheld
• Estimated tax payments
• Amounts paid in current year for prior year’s liability
– For sales/use taxes, deduct either:
• Actual sales/use tax payments or
• Amount from an IRS table
– Table amount may be increased by sales tax paid on certain specific
items (e.g., purchase of motor vehicles, boats, etc.)
– This deduction alternative was available through 2013
• Many tax professionals believe that Congress will extend this provision

34
Deductible Property Taxes
• If the Williamsons purchase their home, the real
estate taxes they pay will be deductible from AGI as
an itemized deduction.
• If they also pay personal property tax on their car, the
payment may be only partially deductible.
– In their state, the motor vehicle registration tax is 2% of the
value of the vehicle plus 40 cents per hundredweight.
– The Williamsons car is valued at $20,000 and weighs 3,000
lbs.
– Their annual registration fee is $412.
• $400 (2% of $20,000) is deductible as a personal property tax.
• The remaining $12, based on the weight of the car, is not
deductible.

35
Interest Expense
• Deduction of interest expense is limited to:
– Interest on qualified student loans
– Investment interest
– Qualified residence (home mortgage) interest
– Business interest
• Personal interest expense is not deductible

36
Interest on Qualified
Student Loans
• Deductible for AGI, subject to limits
– Maximum deduction is $2,500 per year
– Deduction is phased out for taxpayers with
modified AGI (MAGI) between $60,000 and
$75,000 ($125,000 and $155,000 on joint returns)
– Not allowed for those claimed as a dependent or
for married filing separate returns

37
Qualified Residence Interest
(slide 1 of 4)
• Interest on indebtedness secured by the
principal residence and one other residence
(qualified residences)
• Interest must be on acquisition indebtedness or
home equity loans

38
(slide 2 of 4)
• Acquisition indebtedness: amounts incurred to
acquire, construct, or substantially improve the
qualified residences
– Interest paid on aggregate acquisition indebtedness
of $1 million or less ($500,000 for married, filing
separately) is deductible as qualified residence
interest

39
(slide 3 of 4)
• Home equity indebtedness: loans secured by
qualified residences
• Interest is deductible only on portion of home
equity loan that does not exceed the lesser of:
– $100,000 ($50,000 for married, filing separate), or
– FMV of home – acquisition indebtedness

40
(slide 4 of 4)
• Thus, maximum loans on qualified residences
that will produce qualified residence interest is
$1.1 million
• Interest on mortgage debt exceeding $1.1
million or on mortgage debt relating to
nonqualified residence (e.g., second vacation
home) is nondeductible personal interest

41
Acquisition Indebtedness
• John and Susan will need to borrow at least a portion of the
purchase price of their new home
– A standard mortgage likely will qualify as acquisition indebtedness.
– However, the interest on the acquisition indebtedness will be fully
deductible only if
• The amount of the mortgage is $1 million or less (assuming they file a
joint return), and
• The mortgage is secured by the home.
• Recall that they are also considering what appears to be a less
expensive route of using their investments to secure the debt.
– If they choose this alternative, the interest will not be deductible as
qualified residence interest because the loan would not be acquisition
indebtedness.

42
Interest Paid For Services
(slide 1 of 2)
• “Points” paid for the use or forbearance of
money qualify as deductible interest
– Cannot be a service charge if they are to qualify as
deductible interest
• Points generally must be capitalized and
amortized over the life of loan

43
Interest Paid For Services
(slide 2 of 2)
• Exception: Points paid in the acquisition or
improvement of principal residence
– Entire amount of such points are deductible in the
year paid
– Points paid to refinance an existing home
mortgage must be capitalized and amortized over
the life of the new loan

44
Mortgage Insurance Payments
• Mortgage insurance premiums are deductible
as interest if they relate to a qualified residence
of the taxpayer
– The deduction begins to phase out for taxpayers
with AGI in excess of $100,000 ($50,000 for
married taxpayers filing separately)

45
Investment Interest
• Investment interest on loans whose proceeds
are used to purchase investment property may
be deductible
– e.g., Investment property may include stock,
bonds, and land held for investment
• Deduction of investment interest expense is
limited to net investment income

46
Classification of Interest Expense
• Whether interest is deductible for AGI or as an itemized
deduction (from AGI) depends on purpose of indebtedness
– If related to a business or the production of rent or royalty income
• Interest is deductible for AGI
– If incurred for personal use, such as qualified residence interest
• Deduction is reported on Schedule A, Form 1040 if taxpayer itemizes
• However, interest on a student loan is a deduction for AGI
– If the taxpayer incurs debt in relation to his or her employment
• Interest is considered to be personal, or consumer, interest

47
Charitable Contributions
(slide 1 of 2)
• Individuals and corporations may deduct
contributions made to qualified domestic
organizations
• Contributor must have donative intent and
expect nothing in return
– If contributor receives tangible benefit, the FMV
of such benefit reduces the amount of the
charitable contribution deduction

48
Charitable Contributions
(slide 2 of 2)
• Exception to tangible benefit rule
– Allows deduction of 80% of amount paid for the
right to purchase athletic tickets from colleges and
universities

49
Contribution of Services
• No deduction is allowed for the contribution of
services
– Unreimbursed expenses related to the services are
deductible
– Out-of-pocket transportation costs or a standard
mileage rate of 14 cents per mile are deductible
– Deductions are also permitted for transportation,
reasonable expenses for lodging, and the cost of
meals while away from home incurred in
performing the donated services

50
Nondeductible Items
• The following items may not be deducted as
charitable contributions:
– Dues, fees, or bills paid to country clubs, lodges, fraternal
orders, or similar groups
– Cost of raffle, bingo, or lottery tickets
– Cost of tuition
– Value of blood given to a blood bank
– Donations to homeowners associations
– Gifts to individuals
– Rental value of property used by a qualified charity

51
Qualified Organizations
• To be deductible, contributions must be to a
qualified domestic nonprofit organization or
state or possession of U.S. or any subdivisions
thereof
– Many (but not all) qualified domestic charities are
listed in IRS Publication #78

52
Record-Keeping Requirements
• No deduction is allowed for charitable
contributions unless the taxpayer has
appropriate documentation and substantiation
– The specific type of documentation required
depends on the amount of the contribution and
whether the contribution is made in cash or
noncash property
– Special rules may apply to gifts of certain types of
property (e.g., used automobiles) where Congress
has noted taxpayer abuse in the past

53
Ordinary Income Property
• Defined: assets that would produce ordinary
income or short-term capital gain if sold
• Contribution amount
– FMV of asset less ordinary income (or STCG)
potential; generally the lower of adjusted basis or
FMV

54
Capital Gain Property
• Defined: assets that would produce long-term
capital gain or Section 1231 gain if sold
• Contribution amount
– Generally FMV of asset

55
Exceptions to FMV Deduction
of Capital Gain Property (slide 1 of 3)
• Private nonoperating foundations
– Deduction for contributions to private
nonoperating foundations must be reduced by the
amount of long-term capital gain potential
– Thus, the contribution deduction is limited to the
adjusted basis

56
• For contributions of tangible personalty
– The charitable deduction may limited to the
adjusted basis if the asset contributed is not used in
charity’s exempt function
– This reduction generally does not apply if
• The property is, in fact, not put to an unrelated use, or
• At the time of the contribution, it was reasonable to
anticipate that the property would not be put to an
unrelated use by the donee

57
• For contributions of certain types of
intellectual property
– Contribution deduction is limited to the lesser of
the taxpayer’s basis in the property or the
property’s fair market value
– Includes patents, certain copyrights, trademarks,
trade names, trade secrets, know-how, and some
software

58
Example of Contributions
of Tangible Personalty
• Taxpayer contributes painting to local charity:
FMV $100,000 and adjusted basis $10,000
– If charitable organization is a local museum that
hangs the painting for patrons to view, taxpayer
has $100,000 contribution deduction
– If charitable organization is a local church that
sells the painting immediately to obtain funds for
its operation, taxpayer has $10,000 contribution

59
Charitable Contribution
Limitations (slide 1 of 4)
• 50% limit
– In no case can the charitable contribution deduction for a
year exceed 50% of the taxpayer’s AGI
– Contributions of cash, ordinary income property, and
certain capital gain property (where the contribution
amount is adjusted basis) are subject to the 50% limit (50%
assets)
– Generally, applies to contributions to public charities
• e.g., Churches, schools, hospitals, and Federal, state, or local
governmental units
• Also applies to private operating foundations and certain private
nonoperating foundations

60
• 30% limit
– Charitable contribution deduction for certain assets
cannot exceed 30% of the taxpayer’s AGI
• Applies to 30% assets which are:
– Capital gain property for which the contribution amount is
FMV
– Certain contributions to private nonoperating foundations

61
• 30% limit
– Taxpayer can elect to treat capital gain property as
50% assets by limiting the amount of such
contributions to their adjusted bases
– Referred to as the reduced deduction election
• Enables the taxpayer to move from the 30% limitation
to the 50% limitation

62
• 20% limit
– Certain contributions of capital gain property to
private nonoperating foundations

63
Charitable Contributions Carryover
• Contributions that cannot be taken in current
year due to limitations may be carried forward
for 5 years
– Contributions carried forward retain their
classification
• e.g., If the contribution originally involved 30%
property, the carryover will continue to be classified as
30% property in the carryover year
– When using carryovers, current contributions are
used first, then carryovers used on a FIFO basis

64
Example of Charitable Contribution
AGI Limits
• Taxpayer, AGI $100,000, contributed $40,000
cash and long-term stocks with a FMV of
$35,000 and a basis of $8,000 to a University
• 50% limit = $50,000 30% limit = $30,000
– Amount of deduction = $50,000 (40,000 cash +
10,000 stock)
– Contribution carryforward = $25,000 stock (as
30% asset)

65
Miscellaneous Itemized Deductions
• Some expenditures are deductible only to the extent
they exceed 2% of AGI
• Examples include:
– Professional dues
– Uniforms
– Tax return prep fees
– Job-hunting costs
– Certain investment expenses
– Hobby losses
– Unreimbursed employee expenses

66
Misc. Itemized Deductions Not Subject
to 2% of AGI Floor
• Examples include:
– Gambling losses to the extent of gambling
winnings
– Impairment-related work expenses of a
handicapped person
– Deduction for repayment of amounts under a claim
of right if more than $3,000
– Unrecovered investment in an annuity contract
when annuity ceases by reason of death

Itemized Deduction Phaseout
(slide 1 of 3)
• For higher income taxpayers, the otherwise
allowable itemized deductions are reduced by
3% of the amount AGI exceeds the applicable
threshold amount
– The reduction in itemized deductions is limited to
80% of affected itemized deductions
67

(slide 2 of 3)
• The limitation applies to the following frequently encountered
itemized deductions:
– Taxes
– Home mortgage interest, including points
– Charitable contributions
– Unreimbursed employee expenses and all other expenses subject to the
2%-of-AGI floor
• Certain itemized deductions are not subject to phaseout
including:
– Medical expenses
– Investment interest expense
– Wagering losses, and
– Casualty and theft losses
68

(slide 3 of 3)
• The applicable threshold amounts in 2014 for the itemized
deduction phaseout are as follows:
Filing status AGI Threshold
Single $254,200
Married, filing jointly 305,050
Head of household 279,650
Married, filing separately 152,525
• These threshold amounts are adjusted for inflation annually
69

70
Refocus On The Big Picture (slide 1 of 2)
• Because qualified residence interest and real estate taxes are deductible, the after-
tax cost of a home purchase is reduced by the tax savings associated with these
itemized tax deductions.
• Given the Williamsons’ projected taxable income, they are in the 28% Federal and
6% state tax brackets for an aggregate marginal tax bracket of 34%.
– As a result, the after-tax cost of financing the purchase of the home will be:
Nondeductible principal payments $ 2,000
Deductible qualified residence interest and
real estate taxes [($37,000 + $4,000) X (1- .34)] 27,060
Total $29,060
After-tax monthly cost ($29,060 ÷ 12) $ 2,422
• Because the Williamsons will be able to itemize their deductions if they purchase a
new home and will be able to deduct most of their monthly house payment, the
home purchase will be affordable.

71
Refocus On The Big Picture (slide 2 of 2)
• What if the Williamsons choose to finance the purchase of
their home using their investments as security for the loan?
– What may appear to be a cost-effective approach ends up being more
costly on an after-tax basis.
• With this approach, the interest expense is not deductible.
– It is not qualified residence interest or investment interest.
• Therefore, the after-tax cost of financing the home using this
approach makes the home unaffordable.
Nondeductible principal and interest payments $37,000
Deductible real estate taxes [$4,000 X (1 - .34)] 2,640
Total $39,640
After-tax monthly cost ($39,640 ÷ 12) $ 3,303

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
72
If you have any comments or suggestions concerning this
PowerPoint Presentation for South-Western Federal
Taxation, please contact:
Dr. Donald R. Trippeer, CPA
trippedr@oneonta.edu
SUNY Oneonta

Vol 01 chapter 10 2015

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