Solutions Manual: Tax Consequences of Home Ownership

Chapter 14 - Tax Consequences of Home Ownership
Chapter 14
Tax Consequences of Home Ownership
SOLUTIONS MANUAL
Discussion Questions:
1. [LO 1] A taxpayer owns a home in a!t La"e City# $tah an% a secon% home in t. &eor'e#
$tah. The taxpayer se!!s the home in t. &eor'e at a 'ain. How %oes the taxpayer %etermine
which home her principa! resi%ence is for purposes of qua!ifyin' for the exc!usion of 'ain on
the sa!e of a persona! resi%ence(
When a taxpayer lives in more than one residence during the year, the determination of
which residence is the principal residence depends on the facts and circumstances. Factors
to consider in making this determination include the amount of time the taxpayer spends at
each residence during the year, the proximity of each residence to the taxpayers
employment, the principal place of abode of the taxpayers family, and the taxpayers mailing
address for bills and correspondence among other things.
). [LO 1] *hat are the ownership an% use requirements a taxpayer must meet to qua!ify for the
exc!usion of the 'ain on the sa!e of a resi%ence(
Ownership test: he taxpayer must have owned the property for a total of two or more years
during the five!year period ending on the date of the sale.
"se test: he taxpayer must have used the property as the taxpayers principal residence for
a total of two or more years during the five!year period ending on the date of the sale.
#arried couples are eligible for the married filing $ointly exclusion amount if either spouse
meets the ownership test and both spouses meet the principal use test.
+. [LO 1] $n%er what circumstances# if any# can a taxpayer fai! to meet the ownership an% use
requirements ,ut sti!! ,e a,!e to exc!u%e a!! of the 'ain on the sa!e of a principa! resi%ence(
he taxpayer may be able to exclude the gain on the sale of a principal residence when she
sells the home due to unusual circumstances such as a change in employment, significant
health issues, or other unforeseen financial difficulties. o %ualify for the exclusion due to a
change in employment, the taxpayers new place of employment must be at least &' miles
farther from the residence that is sold than was the previous place of employment. hat is,
the taxpayer will not %ualify unless the taxpayers commute from the old home to the new $ob
is at least &' miles longer than the taxpayers commute from the old home to the old $ob. he
maximum exclusion available to a taxpayer selling under these circumstances is the product
of ()* the maximum exclusion had the taxpayer fully %ualified for the exclusion (i.e.,
+,&',''' for a single taxpayer or +&'',''' for a taxpayer filing a $oint return* and (,* the
ratio of (a* the number of days or number of months the taxpayer met the ownership and use
re%uirements to (b* -.' days or ,/ months, respectively. he taxpayer may use either days or
months in the computation. 0ote that under this 1hardship2 provision, the maximum
limitation is reduced, not necessarily the excludable gain. 3onse%uently, if the taxpayer has
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a gain on the sale of the residence that is less than the reduced maximum exclusion, the full
amount of the gain may be excluded.
4. [LO 1] $n%er what circumstances can a taxpayer meet the ownership an% use requirements
for a resi%ence ,ut sti!! not ,e a!!owe% to exc!u%e 'ain on the sa!e of the resi%ence(
4 taxpayer is limited to one exclusion on a sale of a principal residence every two years.
hat is, once the taxpayer sells a residence and uses the exclusion on the sale, she will not be
allowed a second exclusion until at least two years passes from the time of the first sale.
3onse%uently, although a taxpayer may meet the use and ownership tests on two residences,
she cant exclude gain from the sale of her second residence if she has sold the first residence
within the two preceding years.
4lso, if a taxpayer sells a home after 5ecember .), ,''6, and the taxpayer used the property
for a purpose other than as a principal residence (such as vacation home or rental property*
after 5ecember .), ,''6 (called 1non%ualified use2* and then the taxpayer moved back into
the home and used it as a principal residence before selling it, the taxpayer is not allowed to
deduct a certain percentage of the otherwise excludable gain. he percentage of the gain
that is not excludable is the ratio of the non%ualified use after 5ecember .), ,''6, divided
by the amount of time the taxpayer owned the home before selling.
-. [LO 1] A taxpayer purchases an% !i.es in a home for a year. The home appreciates in .a!ue
,y /-0#000. The taxpayer se!!s the home after her emp!oyer transfers her to an office in a
near,y city. The taxpayer ,uys a new home. *hat information %o you nee% to o,tain to
%etermine whether the taxpayer is a!!owe% to exc!u%e the 'ain on the sa!e of the first home(
o %ualify for the exclusion due to a change in employment, the taxpayers new place of
employment must be at least &' miles farther from the residence that is sold than was the
previous place of employment. 7o, you would need to find out how far the new place of
employment is from the old residence. 8f the distance between the old residence and the new
place of employment is less than &' miles farther from the old residence to the old place of
employment, the taxpayer doesnt meet the hardship provision, and hence the gain cant be
excluded. 4nother aspect to consider is whether or not the taxpayer has used the exclusion
on a different home sale within the past two years.
1. [LO )] 2uanita owns a principa! resi%ence in 3ew 2ersey# a ca,in in 4ontana# an% a
house,oat in Hawaii. A!! of these properties ha.e mort'a'es on which 2uanita pays interest.
*hat !imits# if any# app!y to 2uanita5s mort'a'e interest %e%uctions( 6xp!ain whether
%e%ucti,!e interest is %e%ucti,!e for A&7 or from A&7(
axpayers are allowed to deduct 1%ualified residence interest2 as an itemi9ed deduction.
:ualified residence interest includes interest paid on loans secured by the taxpayers
principal residence and one other residence. he second %ualified residence is an annual
election for a taxpayer with more than two residences. 8f the taxpayer rents the second
residence for part of the year, it still %ualifies as a residence for interest deduction purposes
as long as the taxpayers personal use of the property exceeds the greater of ()* )/ days or
(,* )'; of the number of rental days during the year. his use limitation is designed to
ensure that taxpayers are using the property as a residence for a significant part of the year
relative to the rental use of the property. 4 taxpayers residence need not be a typical home
attached to the ground< rather, it could include a houseboat or mobile home. =ence,
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>uanitas principal residence in 0ew >ersey as well as either the cabin in #ontana or the
houseboat in =awaii will %ualify as %ualified residences. he deduction for mortgage
interest on these two properties is sub$ect to additional limits: ac%uisition indebtedness and
home e%uity indebtedness. 8nterest expense on up to +),''',''' of ac%uisition indebtedness
is deductible as %ualified residence interest. Once ac%uisition indebtedness is established for
a %ualifying residence (or %ualifying residences*, it is reduced by principal payments on the
loan(s* and can only be increased by additional indebtedness, secured by the residence,
incurred to substantially improve the residence. 8nterest on home!e%uity indebtedness is
deductible as %ualified residence interest. =owever, the amount of home!e%uity indebtedness
is limited to the lesser of ()* the fair market value of the %ualified residence in excess of the
ac%uisition debt related to that residence and (,* +)'',''' (+&',''' for married filing
separately*. his means that a taxpayer is able to deduct interest on up to +)'',''' of debt
above and beyond ac%uisition debt as long as the debt is secured by the e%uity in the home.
his is true no matter what the taxpayer does with the proceeds from the home!e%uity debt.
8. [ LO )] 9ar,i rea!!y wants to acquire an expensi.e automo,i!e :perhaps more expensi.e than
she can rea!!y affor%;. he has two options. Option 1< finance the purchase with an
automo,i!e !oan from her !oca! ,an" at a 8 percent interest rate or Option )< finance the
purchase with a home-equity !oan at a rate of 8 percent. Compare an% contrast the tax an%
nontax factors 9ar,i shou!% consi%er ,efore %eci%in' which !oan to use to pay for the
automo,i!e. 9ar,i typica!!y has more itemi=e% %e%uctions than the stan%ar% %e%uction
amount.
For tax purposes, ?arbi would be better off using the home!e%uity loan to ac%uire the
automobile because she would be allowed to deduct the interest payments on the loan. hus,
her after!tax interest rate for the home!e%uity loan would be -; @ () A marginal tax rate*.
8n contrast, her after!tax interest rate on the automobile loan from the bank would be -;.
=owever, nontax considerations are also important. 8f ?arbi is unable to make her payments
on the automobile loan, she may lose the automobile. =owever, if she is unable to make the
payments on the home!e%uity loan, she could lose her home because the home!e%uity loan is
secured by the home. his is an important consideration for ?arbi because she apparently
would like to borrow more than she can afford to pay back.
>. [LO )] Lars an% Lei'ha sa.e% up for years ,efore they purchase% their %ream home. They
were consi%erin' :1; usin' a!! of their sa.in's to ma"e a !ar'e %own payment on the home
:?0 percent of the .a!ue of the home; an% ,are!y scrapin' ,y without the ,ac"up sa.in's or
:); ma"in' a more mo%est %own payment :-0 percent of the .a!ue of the !oan; an% ho!%in'
some of the sa.in's in reser.e as nee%e% if fun%s 'et ti'ht. They %eci%e% to 'o with the
!ar'e %own payment ,ecause they fi'ure% they cou!% a!ways refinance the home to pu!! some
equity out of the home if thin's 'ot ti'ht. *hat a%.ice wou!% you 'i.e them a,out the tax
consequences of their %ecision(
8f the couple is forced to refinance their loan sometime in the future, the refinanced loan is
treated as ac%uisition debt only to the extent that the principal amount of the refinancing
does not exceed the amount of the ac%uisition debt immediately before the refinancing. hat
is, the refinancing cannot increase their ac%uisition indebtedness. 3onse%uently, any amount
borrowed in excess of the remaining principal on the original loan does not %ualify as
ac%uisition indebtedness (unless it is used to substantially improve the home*. =owever,
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interest on the excess part of this loan can be deducted to the extent that it %ualifies as home!
e%uity indebtedness. =ome e%uity indebtedness is limited to the lesser of ()* the fair market
value of the %ualified residence(s* in excess of the ac%uisition debt related to the residence(s*
and (,* +)'','''. hus, the couple will be able to increase their mortgage interest
deduction only to the extent that the refinanced loan %ualifies as home!e%uity indebtedness.
?. [LO )] How are acquisition in%e,te%ness an% home-equity in%e,te%ness simi!ar( How are
they %issimi!ar(
?oth ac%uisition and home!e%uity indebtedness are loans that are secured by the residence.
hat is, if the owner does not make the payments on the loan, the bank or lender may take
possession of the home to satisfy the owners responsibility for the loan. =owever,
ac%uisition indebtedness is debt that is incurred in ac%uiring, constructing, or substantially
improving the residence and the interest on this type of debt is deductible on up to
+),''',''' of principal. On the other hand, home!e%uity indebtedness may be used for any
purpose and the interest is deductible on the lesser of ()* the fair market value of the home
over the ac%uisition indebtedness or (,* +)'','''.
10. [LO )] *hy mi'ht it ,e 'oo% a%.ice from a tax perspecti.e to thin" har% ,efore %eci%in' to
quic"!y pay %own mort'a'e %e,t(
8f the taxpayer has a cash crunch in the future due to %uickly paying down the mortgage
debt, he may be forced to refinance the loan to get the necessary cash. =owever, when a
taxpayer refinances his home and the amount of the refinancing exceeds the amount of the
ac%uisition indebtedness immediately before the refinancing (and the taxpayer doesnt use
the proceeds to substantially improve the home*, the excess cannot be classified as
ac%uisition indebtedness, it can be treated only as home!e%uity indebtedness (to the lesser of
the fair market value of the home in excess of the ac%uisition indebtedness or +)'','''*.
hus, the taxpayer may be in a situation where he will not be able to deduct as much interest
due to the refinance as he would have been able to had he not %uickly paid down mortgage
debt. hat is, by decreasing the ac%uisition indebtedness by paying down the debt, the
taxpayer may be unable to deduct a portion of his interest payments due to refinancing.
11. [LO )] Can portions of one !oan secure% ,y a resi%ence consist of ,oth acquisition
in%e,te%ness an% home-equity in%e,te%ness( 6xp!ain.
Bes< even though there are separate limits on ac%uisition indebtedness and home!e%uity
indebtedness, both limits can apply to the same loan. When a taxpayer refinances his home
and the amount of the refinancing exceeds the amount of the ac%uisition indebtedness
immediately before the refinancing, the excess cannot be classified as ac%uisition
indebtedness. =owever, the excess can be treated as home!e%uity indebtedness. hus, the
refinancing includes both ac%uisition indebtedness and home!e%uity indebtedness. Cikewise,
a taxpayer with a home valued at +).) million or greater can borrow and deduct interest on
+).) million dollars. 8n this situation, the first +) million is considered to be ac%uisition
indebtedness and the remaining +)''D would be considered home!e%uity indebtedness, even
though the taxpayer holds only one loan. 4lso, if a taxpayer takes out a loan and uses part
of the proceeds to substantially improve the home and part for other purposes, the part to
improve the home would be ac%uisition indebtedness and the remainder would be home
e%uity debt.
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1). [LO )] *hen a taxpayer has mu!tip!e !oans secure% ,y her resi%ence that in tota! excee% the
!imits for %e%ucti,i!ity# how %oes the taxpayer %etermine the amount of the %e%ucti,!e
interest expense(
When a taxpayers home!related debt exceeds the limitations, the amount of deductible
interest can be determined in one of two ways. First, the deductible interest can be computed
by the product of the ratio of %ualified debt to total debt outstanding on the home and total
interest expense on debt secured by the home as follows:
:ualified debtEotal debt x total interest expense F deductible interest
he second method is based on the order in which the loan was taken out. 8nterest on the
first loan taken out (up to the limit* is deductible first and then interest on the next loan is
deductible, etc. 8nterest on loans in excess of the limits does not generate deductible interest.
4 taxpayer may opt for this second method when the loans taken out first have a higher
interest rate than loans taken out later.
1+. [LO )] Compare an% contrast the characteristics of a %e%ucti,!e point from a non%e%ucti,!e
point on a first home mort'a'e.
5eductible points include points paid to lenders in exchange for a reduced interest rate on
the loan or for loan origination fees. hese points are immediately deductible as %ualified
residence interest if certain re%uirements are met. 8n contrast, nondeductible points are
points paid to compensate lenders for specific services such as appraisal fees, document fees,
or notary fees.
Goints paid for a reduced interest rate or for a loan origination fee in refinancing a home
loan are not immediately deductible by the homeowner. hese points must be amorti9ed and
deducted on a straight!line basis over the life of the loan.
14. [LO )] 7s the ,rea"-e.en perio% 'enera!!y !on'er or shorter for points pai% to re%uce the
interest rate on initia! home !oans or points pai% for the same purpose on a refinance(
6xp!ain.
he break!even period is generally shorter for points paid to reduce the interest rate on
initial home loans than for points paid for a refinance. he reason for the extended break!
even period in a refinance situation is that the refinance points are not immediately
deductible, and hence, they effectively cost more (on a present value basis* than points on
initial home loans. hus, it takes longer to recoup these greater costs. 0ote, however, that
this is true only if the taxpayer itemi9es deductions. 8f the taxpayer does not itemi9e, neither
points paid on an initial home loan nor points paid on a refinance generate any tax savings.
1-. [LO )] @A!annin'B $n%er what circumstances is it !i"e!y economica!!y ,eneficia! to pay
points to re%uce the interest rate on a home !oan(
Henerally speaking, the longer the taxpayer plans on staying in the home and maintaining
the loan (i.e., not refinancing the loan*, the more likely it is financially beneficial to pay
points to obtain a lower interest rate. =owever, paying points can be costly if after a short
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time the taxpayer sells the home or refinances the home loan. 8n these situations, the
taxpayer may not reach the break!even point.
11. [LO )] Harry %eci%es to finance his new home with a +0-year fixe% mort'a'e. 9ecause he
fi'ures he wi!! ,e in this home for a !on' time# he %eci%es to pay a fu!!y %e%ucti,!e %iscount
point on his mort'a'e to re%uce the interest rate. Assumin' Harry itemi=es %e%uctions an%
has a constant mar'ina! tax rate o.er time# wi!! the time require% to reco.er the cost of the
%iscount point ,e shorter or !on'er if Harry ma"es extra principa! payments startin' in the
first year than it wou!% ,e if he %oes not ma"e any extra principa! payments(
he time re%uired to recoup the cost of the discount point will be longer if =arry makes extra
principal payments. 8f =arry makes extra principal payments on his mortgage during the
first year, the balance of the loan is reduced and, as a result, =arry will pay less interest than
he would have paid had he not made the extra loan payments (a smaller loan principal times
the same interest rate e%uals a smaller amount of interest*. 3onse%uently, his after!tax
savings from having the lower interest rate is reduced relative to what it would have been
had he not made the extra payments. ?ecause the interest expense is deductible for tax
purposes, the after tax savings from having the lower interest rate is calculated as follows:
8nterest saved F principal amount of loan @ (original interest rate A lower interest rate*
4fter!tax interest savings F interest saved A (interest saved @ #I*
?ecause, the after!tax cost of paying points remains constant, the reduction in after!tax
savings from the lower interest rate increases the break!even point. Iecall that the break!
even point is calculated as follows:
?reak!even point F after!tax cost of paying pointsEafter!tax savings of lower interest rate.
18. [LO +] A taxpayer so!% a piece of rea! property in year 1. The amount of year 1 rea! property
taxes was estimate% at the c!osin' of the sa!e an% the amounts were a!!ocate% ,etween the
,uyer an% the taxpayer. At the en% of year 1# the ,uyer recei.es a property tax ,i!! that turns
out to ,e hi'her than the estimate. After payin' the tax ,i!!# the ,uyer contacts the taxpayer
at the ,e'innin' of year ) an% as"s the taxpayer to pay the taxpayer5s share of the shortfa!!.
The taxpayer sen%s a chec" to the ,uyer. hou!% the taxpayer ,e concerne% that she won5t
'et to %e%uct the extra tax payment ,ecause it was pai% to the ,uyer an% not to the taxin'
Curis%iction( 6xp!ain.
he taxpayer will be allowed to deduct her share of the real property taxes even though she
didnt pay the taxing $urisdiction. 8n most situations, the buyer and seller will agree to divide
the responsibility for the tax payments based on the portion of the property tax year that each
party held the property. his allocation of taxes between buyer and seller is generally
spelled out on the settlement statement when the sale becomes final. =owever, the amount
specified at settlement is generally $ust an estimate, so the actual taxes may differ from
amounts for taxes on the settlement statement. For tax purposes, however, it doesnt matter
who actually pays the tax to the taxing $urisdiction. 4ssuming the taxes are actually paid by
someone, the tax deduction is based on the relative amount of time each party held the
property during the year. hus, the taxpayer will get to deduct the total share of the tax bill
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allocated to her which is dependent on how long she held the property during the year. he
buyer will get to deduct the remaining portion. his is true even if the taxpayer does not
send the extra payment to the seller.
1>. [LO +] 7s a homeowner a!!owe% a property tax %e%uction for amounts inc!u%e% in the
month!y mort'a'e payment that are earmar"e% for property taxes( 6xp!ain.
Fre%uently homeowners pay their real estate taxes through an escrow (i.e., holding* account
with their mortgage lender. Jach monthly payment to the lender includes an amount that
represents roughly )E),
th
of the anticipated real property taxes for the year. he actual
annual tax payment is made by the mortgage company with funds accumulated in the escrow
account. he homeowner gets a deduction when the actual taxes are paid to the taxing
$urisdiction and not when the homeowner makes payments for taxes to the escrow account.
1?. [LO +] How is the first-time home ,uyer cre%it simi!ar to an interest-free !oan from the
'o.ernment( How is it %ifferent from an interest-free !oan( Answer for qua!ifyin' home
purchases in )00># )00?# an% )010.
For %ualifying home purchases in ,''6, the first!time home buyer credit is similar to an
interest!free loan from the government because the taxpayer receives the credit (payment*
when she files her tax return for the year in which the payment is made. he taxpayer
subse%uently pays the amount back to the government over a )& year period. he credit is
different from an interest!free loan in the sense that the amount of credit the taxpayer must
pay back may not exceed the amount of gain from the sale of the residence. hat is, in
certain circumstances, the taxpayer may not be re%uired to pay back the entire amount of the
credit.
For %ualifying home purchases in ,''K and ,')' the first!time homebuyer credit is similar
to an interest!free loan if the taxpayer claims the credit and then sells the home within .L
months after purchasing it. 8n this situation, the taxpayer could initially claim the credit but
would be re%uired to pay the entire credit back on the tax return filed for the year of the sale.
he credit is different from an interest!free loan because under the general rule (assuming
the taxpayer uses the property as a principal residence for more than .L months after
ac%uiring it, the taxpayer will not be re%uired to pay back the credit.
)0. [LO +] 7s it possi,!e for a taxpayer who current!y owns a principa! resi%ence to se!! the
resi%ence an% acquire a new principa! resi%ence with a purchase that qua!ifies for the first-
time home ,uyer cre%it( 6xp!ain.
Bes, taxpayers who own a principal residence, sell it, and ac%uire a new principal residence
may %ualify for the first!time home buyer credit under the following circumstances if the
taxpayer owned the principal residence for & consecutive years in the 6 year period
immediately before ac%uiring the new principal residence that %ualifies for the credit. 4lso,
the taxpayer must have ac%uired the new principal residence after 0ovember L, ,''K, but
before #ay ), ,')' (the taxpayer could have entered into a binding contract to ac%uire
before #ay ), ,')' as long as the taxpayer closes on the home loan before >uly ), ,')'*. 8f
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the taxpayer %ualifies for the credit under these circumstances, the maximum credit is +L,&''
(+.,,&' if married filing separately*.
)1. [LO 4] Dor taxpayers that own secon% homes# how %oes the taxpayer %istin'uish a %ay of
persona! use from a %ay of renta! use(
Gersonal use by a taxpayer includes days when ()* the taxpayer stays in the home, (,* a
relative of an owner stays in the home, even if the relative pays full fair market value rent, (.*
a nonowner stays in the home under a vacation home exchange or swap arrangement, and
(/* the taxpayer rents out the property for less than fair market value. Iental use includes
days when the property is rented out at fair market value. 5ays spent repairing or
maintaining the vacation home for rental use count as rental days, and days when the home
is available for rent but not actually rented out do not count as personal days or as rental
days.
)). [LO 4] @A!annin'B 7s it possi,!e for a taxpayer to recei.e renta! income that is not su,Cect to
taxation( 6xp!ain.
Bes. 4 taxpayer (owner* who lives in a home for at least )& days and rents it out for )/ days
or less (residence with minimal rental use* is not re%uired to include the gross receipts in
rental income but is not allowed to deduct any expenses related to the rental.
)+. [LO 4] Ha!!e Cust acquire% a .acation home. he p!ans on spen%in' se.era! months each year
.acationin' in the home# an% she p!ans on rentin' the property for the rest of the year. he is
proCectin' tax !osses on the renta! portion of the property for the year. he is not too
concerne% a,out the !osses ,ecause she is confi%ent she wi!! ,e a,!e to use the !osses to offset
her income from other sources. 7s her confi%ence misp!ace%( 6xp!ain.
?ecause =alle will be living in the home for several months, the home will be considered a
residence with significant rental use. 3onse%uently, she may deduct expenses to obtain
tenants (direct rental expenses such as advertising and realtor commissions* and mortgage
interest and real property taxes allocated to the rental use of the home. o the extent that
these expenses exceed gross rental income she may deduct the loss (the passive loss rules do
not apply*. =owever, the remaining expenses allocated to the rental use of the home may
only be deducted to the extent of the net rental income after deducting the direct rental
expenses and rental mortgage interest and real property taxes allocated to the property. his
limitation reduces her ability to deduct a rental loss from the home.
)4. [LO 4] @A!annin'B A taxpayer stays in a secon% home for the entire month of eptem,er. He
wou!% !i"e the home to fa!! into the resi%ence with si'nificant renta! use cate'ory for tax
purposes. *hat is the maximum num,er of %ays he can rent out the home an% ha.e it
qua!ify(
o %ualify for the residence with significant rental use category, the taxpayer must have used
the home for personal purposes for the greater of ()* )& days or (,* more than )'; of the
total days it is rented out during the tax year. 8n this situation, the taxpayer used the second
home for personal purposes for .' days (the entire month of 7eptember*. o %ualify, the .'
days of personal use must be greater than )'; of the number of days the property is rented
out. 8f the taxpayer rents the property out for .'' days, the number of personal use days will
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be exactly )'; of the number of rental days, and the property would not %ualify as
residence. =owever, if the taxpayer rents out the property for ,KK days, the .' days of
personal use will be greater than )'; of the number of rental days, so the property would
%ualify as a residence with significant rental use. 7o, the maximum number of days the
taxpayer can rent out the home and have it %ualify as a residence with significant rental use
is ,KK days. 4nything more than that and the property would be considered a nonresidence
with rental use.
)-. [LO 4] Compare an% contrast the 7E metho% an% the Tax Court metho% for a!!ocatin'
expenses ,etween persona! use an% renta! use for .acation homes. 7nc!u%e the Tax Court5s
Custification for %epartin' from the 7E metho% in your answer.
he 8I7 method of allocating deductions between personal and rental use allocates the
deductions based on a fraction with the number of days the property was used for rental
property in the numerator and the number of days the property was used for any reason
during the year in the denominator. Jach expense relating to the home is multiplied by this
fraction to determine the amount allocable to rental use. 7ub$ect to the gross rental income
limitation, tier ) expenses are deducted first, followed by tier , expenses, and then tier .
expenses.
he ax 3ourt and the 8I7 method of allocating deductions are identical except for the
allocation of the tier ) expenses of interest and real property taxes. "nder the ax 3ourt
approach, interest and taxes are allocated to rental use based on the fraction of days that the
property was rented over the number of days in the year (not the number of days the property
was used for any purpose during the year*. he ax 3ourt $ustifies this approach by pointing
out that interest expense and property taxes accrue over the entire year regardless of the
level of personal or rental use. he ax 3ourt method is generally taxpayer favorable
because it tends to allocate less interest and real property taxes to the rental use which
allows more tier , and tier . expenses to be deducted when the gross income limitation
applies. he taxpayer does not lose deductions for the interest and property taxes allocated
to personal use and not to the rental activity because these expenses are deductible anyway
as itemi9ed deductions. 8n the case of property taxes, the taxes would be deductible as an
additional standard deduction even if the taxpayer did not itemi9e (limited to +),''' for
married filing $ointly taxpayers and +&'' for other taxpayers*.
)1. [LO 4] 7n what circumstances is the 7E metho% for a!!ocatin' expenses ,etween persona!
use an% renta! use for .acation homes more ,eneficia! to a taxpayer than the Tax Court
metho%(
he 8I7 method is generally more beneficial than the ax 3ourt method when the property is
considered to be a nonresidence with rental use. When the property is not a residence , the
interest allocated to personal use is not deductible. hus, under these circumstances, the
taxpayer is better off by allocating as little interest as possible to personal use. he 8I7
method accomplishes this by allocating interest (a tier ) expense* to rental use by dividing
the total rental days by the total days used and allocating the remainder to personal use.
he ax 3ourt method would allocate less interest to rental use because the denominator is
.L&, rather than total days used.
14-?
)8. [LO 4] $n%er what circumstances wou!% a taxpayer who 'enerates a !oss from rentin' a
home that is not a resi%ence ,e a,!e to fu!!y %e%uct the !oss( *hat potentia! !imitations
app!y(
?y definition, a rental activity is considered to be a passive activity. ?ecause they are
passive losses, losses from rental property are generally not allowed to offset other ordinary
or investment type income.
=owever, the loss from a rental activity may be deductible under two circumstances. First, a
taxpayer who is an active participant in the rental activity may be allowed to deduct up to
+,&,''' of the rental loss against other types of income (sub$ect to phase!out beginning at
+)'',''' 4H8*. 7econd, the taxpayer may offset the passive loss from the rental active
against other sources of passive income.
)>. [LO 4] Fescri,e the circumstances in which a taxpayer acquires a home an% rents it out an%
is not a!!owe% to %e%uct a portion of the interest expense on the !oan the taxpayer use% to
acquire the home.
When a rental home is not a residence, the interest allocable to any personal!use days is
nondeductible.
)?. [LO 4] 7s it possi,!e for a renta! property to 'enerate a positi.e annua! cash f!ow an% at the
same time pro%uce a !oss for tax purposes( 6xp!ain.
Bes. 4 taxpayer is able to have a positive cash flow and at the same time produce a loss for
tax purposes. his outcome is possible due to depreciation expense that is deductible for tax
purposes but does not re%uire an annual cash outflow. 4 rental property could provide a
positive cash flow (gross receipts greater than cash expense for the year* but generate a tax
loss when depreciation expense is deducted.
+0. [LO 4# LO -] How are the tax issues associate% with home offices an% .acation homes use%
as renta!s simi!ar( How are the tax issues or requirements %issimi!ar(
he tax issues facing renters of second homes are similar in a lot of ways with tax issues
facing taxpayers %ualifying for home office deductions. ?oth taxpayers with home offices
and taxpayers with vacation homes are allowed to deduct business or rental expenses not
associated with the use of the home as for 4H8 deductions without income limitations.
axpayers with home offices allocate expenses of the entire home between personal use of
the home and business use of the home. 8n a similar way, renters of second homes generally
allocate expenses of the second home between personal use of the home and rental use of the
home. axpayers with home offices and vacation homes may deduct mortgage interest and
real property taxes allocated to the business or rental use of the home as for 4H8 deductions
without income limitations. Further, the non mortgage interest and non real property tax
expenses allocated to business use of the home and rental use of a residence with significant
rental use may be limited by the income generated by the property (after deducting business
and rental expenses unrelated to the home and after deducting mortgage interest and real
property taxes allocated to the business or rental use of the home*. 5isallowed expenses are
carried over and treated as incurred in the next year.
14-10
he treatment of home offices and vacation homes are also dissimilar. ?y definition, a home
office is located in the taxpayers 1home2 and the home office must be used exclusively for
business purposes. 8n contrast, the tax conse%uences of owning a second home depend on
the extent to which the property is used for personal and for rental purposes. Gersonal use
of a rental property is allowed. his is not the case for home offices.
+1. [LO -] Are emp!oyees or se!f-emp!oye% taxpayers more !i"e!y to qua!ify for the home office
%e%uction( 6xp!ain.
7elf!employed taxpayers are more likely to %ualify for the home office deduction. ?oth must
meet the re%uirement of using the home office as either ()* the principal place of business for
any of the taxpayers trade or businesses or (,* as a place to meet with patients, clients, or
customers in the normal course of business. =owever, an employee must meet the additional
re%uirement of using the home office for the convenience of the employer. hus, self!
employed taxpayers are more likely to %ualify for the home office deduction.
+). [LO -] Compare an% contrast the manner in which emp!oyees an% emp!oyers report home
office %e%uctions on their tax returns.
?oth employees and employers will determine the amount of their eligible home office
expenses in the same manner. =owever, each is sub$ect to different limitations and reports
the deduction in different places on the tax return. 4n employer reports his home office
deduction on 7chedule 3 of his )'/' and is limited to his 7chedule 3 net income before
deducting the home office expense. hus, an employers home office deduction is a for 4H8
deduction.
4n employee will report his home office expenses as unreimbursed employee business
expenses that are itemi9ed deductions sub$ect to the ,; of 4H8 floor. hus, an employees
home office deduction is a from 4H8 deduction.
++. [LO -] Dor taxpayers qua!ifyin' for home office %e%uctions# what are consi%ere% to ,e
in%irect expenses of maintainin' the home( How are these expenses a!!ocate% to persona!
an% home office use(
8ndirect expenses are expenses incurred in maintaining and using the home. 8ndirect
expenses include insurance, utilities, interest, real property taxes, general repairs, and
depreciation on the home as if it were used entirely for business purposes. Only indirect
expenses allocated to the home office space, however, are deductible. 8f the rooms in the
home are roughly of e%ual si9e, the taxpayer may allocate the indirect expenses to the
business portion of the home based on the number of rooms. 4lternatively, the taxpayer may
allocate indirect expenses based on the amount of the space or s%uare footage of the
business!use room relative to the total s%uare footage in the home.
+4. [LO -] *hat !imitations exist for se!f-emp!oye% taxpayers in %e%uctin' home office
expenses# an% how %oes the taxpayer %etermine which %e%uctions are %e%ucti,!e an% which
are not in situations when the o.era!! amount of the home office %e%uction is !imite%(
he total home office deductions other than mortgage interest and real property taxes
allocated to business use of the home allowable for the taxpayer in any given year is limited
to a taxpayers 7chedule 3 net income (without any home office expense deductions* minus
mortgage interest and real property taxes allocated to business use of the home. hus, home
14-11
office deductions other than mortgage interest and real property taxes cannot either create
or increase a loss on the taxpayers 7chedule 3. 4mounts that are not deducted in the
current year are carried over and deducted in the next year sub$ect to the same 7chedule 3
limitation.
he se%uence of deductions for the home office follows the exact same se%uence of
deductions for homes with significant personal use and significant rental use. ier )!type
expenses that would be deductible as itemi9ed deductions (interest and taxes* are deducted
first (and deducted in full regardless of income*. ier ,!type expenses are deducted second,
and ier .!type expense (depreciation* is deducted last.
+-. [LO 1# -] A se!f-emp!oye% taxpayer %e%ucts home office expenses. The taxpayer then se!!s
the home at a /100#000 'ain. Assumin' the taxpayer meets the ownership an% use tests# %oes
the fu!! 'ain qua!ify for exc!usion( 6xp!ain.
0o. When a taxpayer deducts depreciation as a home office expense, the depreciation
expense reduces the taxpayers basis in the home. 3onse%uently, when the taxpayer sells the
home, the gain on the sale will be greater than it would have been had depreciation not been
deducted. Further, the gain on the sale of the home attributable to depreciation is not
eligible to be excluded under the home sale exclusion provisions. his gain is treated as
unrecaptured M),&' gain and is sub$ect to a maximum ,&; tax rate.
Problems
+1. [LO 1] te.e an% tephanie Aratt purchase% a home in po"ane# *ashin'ton for /400#000.
They mo.e% into the home on De,ruary 1 of year 1. They !i.e% in the home as their primary
resi%ence unti! 2une +0 of year -# when they so!% the home for /800#000. The Aratts5
mar'ina! tax rate is +4 percent.
a. How much in taxes wi!! they ,e require% to pay on the 'ain on the sa!e of the home(
,. Assume the ori'ina! facts# except that te.e an% tephanie !i.e in the home unti!
2anuary 1 of year + when they purchase% a new home an% rente% the ori'ina! home.
They fina!!y se!! the ori'ina! home on 2une +0 of year - for /800#000. 7'norin' any
issues re!atin' to %epreciation ta"en on the home whi!e it was ,ein' rente%# what
amount of taxes wi!! the Aratts ,e require% to pay on the sa!e of the home(
c. Assume the same facts as in :,;# except that the Aratts !i.e% in the home unti! 2anuary
of year 4 when they purchase% a new home an% rente% the first home. *hat amount
of taxes wi!! the Aratts nee% to pay if they se!! the first home on 2une +0 of year - for
/800#000(
a. +' in taxes.
4mount reali9ed from the sale+-'','''
4d$usted basis /'','''
Hain reali9ed +.'','''
7ince the Gratts owned and used the 7pokane home for at least , years during the &!year
period ending on the date of the sale, they %ualify for the gain exclusion. he maximum
exclusion for married taxpayers filing $ointly is +&'','''. ?ecause the exclusion is more
14-1)
than the gain reali9ed on the sale, the entire gain is excluded from taxation. he Gratts
will not be re%uired to pay any taxes on the gain on the sale of their home.
b. +/&,'''.
?ecause the Gratts used the home as their principal residence for less than , years
(February ) of year ) to >anuary ) of year .* and their reason for leaving wasnt due to
unusual circumstances they dont %ualify for the exclusion. 3onse%uently, they must
recogni9e all +.'',''' of gain reali9ed on the sale. ?ecause the gain is long!term
capital gain (i.e., a capital asset held for more than year*, the Gratts must pay +/&,''' in
taxes on the gain on the sale of their home (+.'',''' @ )&;*.
c. /0.
he Gratts owned and used the home for at least two years (February ) of year ) to
>anuary of year /* during the five!year period ending on the date of sale, so they %ualify
for the exclusion. 3onse%uently, the Gratts can exclude the entire +.'',''' reali9ed gain
from taxable income, and they are not re%uired to pay taxes on the gain on the sale of the
home.
+8. [LO 1] te.e an% tephanie Aratt purchase% a home in po"ane# *ashin'ton for /400#000.
They mo.e% into the home on De,ruary 1# of year 1. They !i.e% in the home as their primary
resi%ence unti! 3o.em,er 1 of year 1 when they so!% the home for /-00#000. The Aratts5
a. Assume that the Aratts so!% their home an% mo.e% ,ecause they %on5t !i"e their
nei'h,ors. How much 'ain wi!! the Aratts reco'ni=e on their home sa!e( At what rate# if
any# wi!! the 'ain ,e taxe%(
,. Assume the Aratts se!! the home ,ecause tephanie5s emp!oyer transfers her to an
office in $tah. How much 'ain wi!! the Aratts reco'ni=e on their home sa!e(
c. Assume the same facts as in :,;# except that the Aratts se!! their home for /800#000.
How much 'ain wi!! the Aratts reco'ni=e on the home sa!e(
%. Assume the same facts as :,;# except that on Fecem,er 1 of year 0 the Aratts so!% their
home in eatt!e an% exc!u%e% the /+00#000 'ain from income on their year 0 tax return.
How much 'ain wi!! the Aratts reco'ni=e on the sa!e of their po"ane home(
a. +)'','''.
4mount reali9ed from the sale+&'','''
Hain reali9ed +)'','''
he Gratts owned and used the 7pokane home for only K months (February ) to
0ovember ) of year )*, and so they fail the ownership and use tests re%uired to %ualify
for the exclusion. hey also dont %ualify for the hardship exception because disliking
ones neighbors does not meet the 1unusual circumstances2 test. hus the entire
+)'',''' gain is recogni9ed. he gain is taxed at the Gratts ordinary income rate of
./; because they did not hold the home (a capital asset* for more than one year, so the
gain is a short!term capital gain, sub$ect to ordinary income rates (note that this assumes
that they did not have any capital losses*.
14-1+
b. +'.
4 change in employment %ualifies as 1unusual circumstances,2 so the Gratts wont be
dis%ualified for the exclusion. =owever, the maximum available exclusion must be
reduced to reflect the amount of time the Gratts owned and used the 7pokane home
relative to the two year ownership and use re%uirements as follows:
#aximum exclusion @ number of months taxpayers met the use and ownership tests
,/ months
+&'',''' @ K months F +)6-,&''
,/ months
he Gratts can exclude up to +)6-,&'' of gain on the sale. ?ecause they reali9ed a gain
of only +)'',''' (+&'',''' A /'','''* they are able to exclude the entire gain from
taxable income. 3onse%uently, the Gratts are not re%uired to pay any taxes on the gain
on the sale of the home.
c. +)),,&''.
4 change in employment %ualifies as 1unusual circumstances,2 so the Gratts wont be
dis%ualified for the exclusion. =owever, the maximum available exclusion must be
reduced to reflect the amount of time the Gratts owned and used the 7pokane home
relative to the two year ownership and use re%uirements as follows:
#aximum exclusion @ number of months taxpayers met the use and ownership tests
,/ months
+&'',''' @ K months F +)6-,&''
,/ months
he Gratts can exclude up to +)6-,&'' of gain on the sale. ?ecause they reali9ed a gain
of only +.'',''' (+-'',''' A /'','''* they are able to exclude +)6-,&'' of the gain
from income but they must include +)),,&'' in their income. he gain is taxed at the
Gratts ordinary tax rate because they did not own the home (a capital asset* for more
than a year before they sold it.
d. +'.
7ame answer as b. he rule that prohibits taxpayers from claiming an exclusion more
than once every two years does not apply to taxpayers who are selling homes under the
hardship circumstances.
+>. [LO 1] te.e Aratt# who is sin'!e# purchase% a home in po"ane# *ashin'ton for /400#000.
He mo.e% into the home on De,ruary 1 of year 1. He !i.e% in the home as his primary
resi%ence unti! 2une +0 of year -# when he so!% the home for /800#000. te.e5s or%inary
a. *hat amount of 'ain wi!! te.e ,e require% to reco'ni=e on the sa!e of the home(
14-14
,. Assume the ori'ina! facts# except that the home is te.e5s .acation home an% he
.acations there four months each year. te.e %oes not e.er rent the home to others.
*hat 'ain must te.e reco'ni=e on the home sa!e(
c. Assume the ori'ina! facts except that te.e marrie% tephanie on De,ruary 1 of year +
an% the coup!e !i.e% in the home unti! they so!% it in 2une of year -. $n%er state !aw#
te.e owne% the home ,y himse!f. How much 'ain must te.e an% tephanie reco'ni=e
on the sa!e :assume they fi!e a Coint return in year -;.
%. Assume the ori'ina! facts# except that tephanie mo.e% in with te.e on 4arch 1 of
year + an% the coup!e was marrie% on 4arch 1 of year 4. $n%er state !aw# the coup!e
Coint!y owne% te.e5s home ,e'innin' on the %ate they were marrie%. On Fecem,er 1 of
year +# tephanie so!% her home that she !i.e% in ,efore she mo.e% in with te.e. he
exc!u%e% the entire /-0#000 'ain on the sa!e on her in%i.i%ua! year + tax return. *hat
amount of 'ain must the coup!e reco'ni=e on the sa!e in 2une of year -(
a. +&','''.
7ince 7teve owned and used the 7pokane home for at least , years during the &!year
period ending on the date of the sale, he %ualifies for the gain exclusion. he maximum
exclusion for single taxpayers is +,&','''. his exclusion will reduce 7teves recogni9ed
gain to +&',''' (+.'',''' gain reali9ed less the +,&',''' exclusion*.
b. +.'',''' gain recogni9ed.
Jxclusion '
Hain recogni9ed +.'','''
7teve must recogni9e all of the reali9ed gain because he does not meet the use test. hat
is, the home was not his principal residence for two years during the five!year period
ending on the date of the sale.
c. +' gain recogni9ed.
hey reali9ed a +.'',''' gain on the sale. =owever, the couple %ualifies for the married
filing $oint exclusion of +&'',''' because 7teve meets the ownership test and 7teve and
7tephanie meet the principal use test. 3onse%uently, they can exclude the entire gain.
d. +&',''' gain recogni9ed.
he couple reali9es a gain of +.'','''. ?oth 7teve and 7tephanie meet the ownership
and use tests. =owever, because 7tephanie used the exclusion from her home sale during
the two years prior to the sale of the Gratts home in year &, they may exclude only
+,&',''' of the +.'',''' gain.
14-1-
+?. Ce!ia has ,een marrie% to Fary! for -) years. The coup!e has !i.e% in their current home for
the !ast )0 years. On Octo,er of year 0# Fary! passe% away. Ce!ia so!% their home an%
mo.e% into a con%ominium. *hat is the maximum exc!usion Ce!ia is entit!e% to if she se!!s
the home on Fecem,er 1- of year 1(
3elia may exclude up to +&'',''' of gain on the sale of her home because she sold the
within two years of the date of the death of her spouse, and she meets the ownership and
use tests.
40. [LO 1] arah purchase% a home on 2anuary 1# )008 for /100#000. he e.entua!!y so!% the
home for />00#000. *hat amount of the /)00#000 'ain on the sa!e may arah exc!u%e from
'ross income in each of the fo!!owin' a!ternati.e situations(
a. arah use% the home as her principa! resi%ence unti! 2u!y 1# )01). he use% the home
as a .acation home from 2u!y 1# )01) unti! she so!% it on 2u!y 1# )014.
,. arah use% the property as a .acation home unti! 2u!y 1# )01). he then use% the
home as her principa! resi%ence from 2u!y 1# )01) unti! she so!% it on 2u!y 1# )014.
c. arah use% the home as a .acation home from 2anuary 1# )008 unti! 2anuary 1# )01+.
he use% the home as her principa! resi%ence from 2anuary 1# )01+ unti! she so!% it on
2u!y 1# )014.
%. arah use% the home as a .acation home from 2anuary 1# )008 unti! 2u!y 1# )00>. he
use% the home as her principa! resi%ence from 2u!y 1# )00> unti! she so!% it on 2u!y 1#
)011.
a. +' gain recogni9ed
7arah meets the ownership and use tests because she has owned the property for two
or more years and used it as her principal residence for at least two out of the last
five years, so she can exclude her gain up to +,&','''. he limitation does not apply
to her because she did not live in the home at the time she sold it.
b. +K.,... gain recogni9ed. 8f not for the limitation for non%ualified use after
5ecember .), ,''6, 7arah could have excluded the entire +,'',''' gain. =owever,
because 7arah sold the home after 5ecember .), ,''6, she lived in it when she sold
it, and she used it for purposes other than as a principal residence after 5ecember
.), ,''6, she is not allowed to exclude a percentage of the gain that would otherwise
be excluded. he percentage of the gain that is not excluded is a fraction, the
numerator of which is the non%ualified use after 5ecember .), ,''6, and the
denominator is the amount of time she owned the property. 8n this case, +K.,... of
the +,'',''' gain (/L.L-;* not excludable. he numerator of the disallowance
fraction is ..& years of post ,''6 non%ualified use (>anuary ), ,''K through >uly ),
,'),* and the denominator is -.& years of ownership (>anuary ), ,''- through >uly
), ,')/* (..&E-.& F /L.L-;*.
c. +,'',''' gain recogni9ed.
While 7arah meets the ownership test, she does not meet the use test because she
used the property as her principal residence for less than two of the last five years.
d. +'
7arah meets the ownership and use tests because she has owned the property for two
or more years and used it as her principal residence for at least two out of the last
five years, so she can exclude her gain up to+,&','''.
14-11
41. [LO )] 2a.ier an% Anita anche= purchase% a home on 2anuary 1# )010 for# /-00#000 ,y
payin' /)00#000 %own an% ,orrowin' the remainin' /+00#000 with a 8 percent !oan secure%
,y the home. The !oan requires interest-on!y payments for the first fi.e years. The
anche=es wou!% itemi=e %e%uctions e.en if they %i% not ha.e any %e%ucti,!e interest. The
anche=es5 mar'ina! tax rate is +0 percent.
a. *hat is the after-tax cost of the interest expense to the anche=es in )010(
,. Assume the ori'ina! facts# except that the anche=es rent a home an% pay /)1#000 in
rent %urin' the year. *hat is the after-tax cost of their renta! payments in )010(
c. Assumin' the interest expense is their on!y itemi=e% %e%uction for the year an% that
2a.ier an% Anita fi!e a Coint return# ha.e 'reat eyesi'ht# an% are un%er 10 years of a'e#
what is the after-tax cost of their )010 interest expense(
a. +)/,-''.
he +.'',''' loan is treated as ac%uisition indebtedness, since it was to initially ac%uire
the home. 8nterest on up to +),''',''' of ac%uisition indebtedness is deductible as an
itemi9ed deduction. 7ince the +.'',''' loan principal is less than the limit, all of the
interest associated with the loan is deductible. he after!tax cost of the interest expense
is calculated as follows:
Description Amount Explanation
()* ?efore!tax interest expense +,),''' +.'',''' @ -;. 4ll
deductible.
(,* #arginal tax rate @ .';
(.* ax savings from interest expense +L,.'' ()* @ (,*
After-tax cost of interest expense $14,700 ()* A (.*
b. +,),'''.
?ecause rental payments are not deductible, they do not generate any tax savings, so the
before! and after!tax cost of the rental payments is the same.
c. +)6,),'.
?ecause the 7anche9es had no other itemi9ed deductions, their interest expense only
produces a benefit to them to the extent that it exceeds the standard deduction, calculated
as follows:
()* ?efore!tax interest expense +,),''' +.'',''' @ -;. 4ll
deductible.
(,* 7tandard deduction )),/'' #F>
(.* 8nterest in excess of standard
deduction
+K,L'' ()* A (,*
(/* #arginal tax rate @ .';
(&* ax savings from interest expense +,,66' (.* @ (/*
After-tax cost of interest expense $18,120 ()* A (&*
14-18
4). [LO )] 2a.ier an% Anita anche= purchase% a home on 2anuary 1 of year 1 for /-00#000 ,y
payin' /-0#000 %own an% ,orrowin' the remainin' /4-0#000 with a 8 percent !oan secure%
anche=es wou!% itemi=e %e%uctions e.en if they %i% not ha.e any %e%ucti,!e interest.
a. Assume the anche=es a!so too" out a secon% !oan secure% ,y the home for />0#000 to
fun% expenses unre!ate% to the home. The interest rate on the secon% !oan is > percent.
The anche=es ma"e interest-on!y payments on the !oan in year 1. *hat is the amount of
their %e%ucti,!e interest expense on the secon% !oan in year 1(
,. Assume the ori'ina! facts an% that the anche=es ta"e out a secon% !oan secure% ,y the
home in the amount of /-0#000 to fun% expenses unre!ate% to the home. The interest rate
on the secon% !oan is > percent. The anche=es ma"e interest-on!y payments %urin' the
year. *hat is the amount of their %e%ucti,!e interest expense on the secon% !oan in year
1(
a. +.&,-&&.
he first loan of +/&',''' is classified as ac%uisition indebtedness. he second loan of
+6',''' is classified as home!e%uity indebtedness. he amount of home!e%uity
indebtedness is limited to the lesser of ()* the fair market value of the %ualified residence
in excess of the ac%uisition debt related to that residence and (,* +)'',''' (+&',''' for
married filing separately*. he 7anche9es home is worth +&'',''' (+&',''' down
payment plus the +/&',''' ac%uisition indebtedness*. =ence the home!e%uity
indebtedness is limited to +&',''' which is the lesser of
()* F#N of residence less ac%uisition debt (+&'',''' ! +/&','''* F +&',''' or
(,* the amount of home!e%uity indebtedness or +)'','''
?ecause the total debt secured by the home exceeds the total %ualifying debt, the
7anche9es can use the chronological order method or the average interest method to
determine the total deductible interest.
"nder the chronological method, the 7anche9es could deduct +/,''' on the second loan
(+&',''' x 6;* and +.),&'' on the first loan for a total of +.&,&'' interest expense.
"nder the average interest method the 7anche9es may deduct +.&,-&& of interest in total,
computed as follows:
+.-,K'' total interest x +&'','''E+&.',''' F +.&,-&&. 3onse%uently the average
interest method allows them to deduct more interest in total.
4ssuming the home ac%uisition interest is deductible in full, the 7anche9es would deduct
+/,-&& of interest on the second loan (+.&,-&& total interest minus +.),''' ac%uisition
debt interest*. echnically, the interest under the average method relates to both the first
and second loan so it is difficult break out the interest for the first and second loans
separately. =owever, as mentioned above the 7anche9es would deduct more interest
under the average interest method.
14-1>
b. +/,''' on the second loan< +.),&'' on the ac%uisition loan.
8n this case, the 7anche9es are able to deduct all of the interest on both loans because the
actual home!e%uity loan (+&','''* does not exceed the home!e%uity indebtedness limit
calculated above (+&','''*. .
4+. [LO )] 2a.ier an% Anita anche= purchase% a home on 2anuary 1# year 1 for /-00#000 ,y
payin' /)00#000 %own an% ,orrowin' the remainin' /+00#000 with a 8 percent !oan secure%
anche=es wou!% itemi=e %e%uctions e.en if they %i% not ha.e any %e%ucti,!e interest. On
2anuary 1# the anche=es a!so ,orrowe% money on a secon% !oan secure% ,y the home for
/8-#000. The interest rate on the !oan is > percent an% the anche=es ma"e interest-on!y
payments in year 1 on the secon% !oan.
a. Assumin' the anche=es use the secon% !oan to !an%scape the yar% to their home# how
much of the interest expense on the secon% !oan are they a!!owe% to %e%uct in year 1(
,. Assume the ori'ina! facts an% that the anche=es use the /8-#000 !oan procee%s for an
exten%e% fami!y .acation. How much of the interest expense on the secon% !oan are they
a!!owe% to %e%uct in year 1(
c. Assume the ori'ina! facts# except that the anche=es ,orrow /1)0#000 on the secon%
!oan an% they use the procee%s for an exten%e% fami!y .acation an% other persona!
expenses. How much of the secon% !oan interest expense are the anche=es a!!owe% to
%e%uct in year 1(
a. +L,''' (+-&,''' @ 6;*.
he first loan of +.'',''' is classified as ac%uisition indebtedness. he second loan of
+-&,''' would likely also be classified as ac%uisition indebtedness because it was used
to substantially improve the home. ?ecause the 7anche9es ac%uisition indebtedness of
+.-&,''' (+.'',''' O +-&,'''* does not exceed the +),''',''' ac%uisition debt limit,
they may deduct all of the +,),''' interest on the first loan (+.'',''' @ -;* and the
entire +L,''' of interest on the second loan (+-&,''' @ 6;*.
b. +L,''' (+-&,''' @ 6;*.
he 7anche9es can deduct the +,),''' interest on the first loan which is ac%uisition debt
(+.'',''' @ -;*. he second loan %ualifies as a home!e%uity loan because it was not
used to substantially improve the home. he amount of home!e%uity indebtedness is
limited to the lesser of ()* the fair market value of the %ualified residence in excess of the
ac%uisition debt related to that residence and (,* +)'',''' (+&',''' for married filing
separately*. he 7anche9es home is worth +&'',''' (+,'',''' down payment plus the
+.'',''' ac%uisition indebtedness*. =ence the home!e%uity indebtedness is limited to
+-&,''' which is the lesser of
()* F#N of residence less ac%uisition debt (+&'',''' ! +.'','''* F +,'',''', or
(,* the amount of home!e%uity indebtedness or +)'',''',
14-1?
hus the 7anche9es can deduct interest on up to +)'',''' of home!e%uity indebtedness.
?ecause their second loan of +-&,''' is below this limit, they can deduct the full +L,'''
of interest paid on the second loan (+-&,''' @ 6;*.
c. +,K,)/..
8n this case, the 7anche9es have +/,',''' of debt but only +/'',''' of %ualifying debt
(+.'',''' ac%uisition debt O +)'',''' %ualifying home e%uity debt*. he second loan
%ualifies as a home!e%uity loan because it was not used to substantially improve the
home. he amount of home!e%uity indebtedness is limited to the lesser of ()* the fair
market value of the %ualified residence in excess of the ac%uisition debt related to that
residence and (,* +)'',''' (+&',''' for married filing separately*. he 7anche9es
home is worth +&'',''' (+,'',''' down payment plus the +.'',''' ac%uisition
indebtedness*. =ence the home!e%uity indebtedness is limited to +)'',''' which is the
lesser of
()* F#N of residence less ac%uisition debt (+&'',''' ! +.'','''* F +,'',''' or
(,* the amount of %ualifying home!e%uity indebtedness of +)'','''
8n total, the 7anche9es paid +.',L'' of interest (+,),''' on the ac%uisition debt
+.'',''' @ -; O +K,L'' on the second loan +),',''' @ 6;*. ?ecause the total debt
secured by the home exceeds the total %ualifying debt, the 7anche9es can use the average
interest method or the chronological order method to determine the total deductible
interest.
"nder the chronological method, they would deduct the +,),''' interest on the first
mortgage and +6,''' on the second mortgage (+)'',''' %ualifying home e%uity debt @
6;* for a total of +,K,'''.
"nder the average interest method the 7anche9es may deduct +,K,)/. of interest,
computed as follows:
+.',L'' total interest x +/'','''E+/,',''' F +,K,)/.. 4ssuming the +,),''' interest on
the ac%uisition debt is deductible in full, +6,)/. of the interest on the second loan is
deductible.
8n total, the 7anche9es would deduct more interest under the average interest method
than under the chronological method.
44. On 2anuary 1 of year 1# Arthur an% Aretha Dran"!in purchase% a home for /1.- mi!!ion ,y
payin' /)00#000 %own an% ,orrowin' the remainin' /1.+ mi!!ion with a 8 percent !oan
secure% ,y the home.
a. *hat is the amount of the interest expense the Dran"!ins may %e%uct in year 1(
,. Assume that in year )# the Dran"!ins pay off the entire !oan ,ut at the ,e'innin' of year
+# they ,orrow /+00#000 secure% ,y the home at a 8 percent rate. They ma"e interest-
on!y payments on the !oan %urin' the year. *hat amount of interest expense
14-)0
may the Dran"!ins %e%uct in year + on this !oan( Foes it matter what they %o with the
!oan procee%s( 6xp!ain.
c. Assume the same facts as in :,;# except that the Dran"!ins ,orrow />0#000 secure% ,y
their home. *hat amount of interest expense may the Dran"!ins %e%uct in year + on this
!oan( Foes it matter what they %o with the !oan procee%s( 6xp!ain.
a. +--,'''.
?ecause the ac%uisition indebtedness limit (+),''','''* and the home!e%uity
indebtedness limit (+)'','''* are two separate limits, the maximum amount of debt on
which a taxpayer may deduct %ualified residence interest is +),)'',''' as long as the
value of the taxpayers residence (or residences* is at least +),)'','''. 7ince the
Franklins home is worth +).& million, they can deduct interest on up to +).) million.
hus, the amount of deductible interest on the loan is calculated as follows:
otal interest expense F total loan principal x interest rate
F +).. million @ -;
F +K),'''
5eductible interest expense F :ualified debtEotal debt x total interest expense
F P+).) millionE).. millionQ @ +K),'''
F +--,'''
b. +-,''' or +,),''' depending on what they do with the proceeds.
Once ac%uisition indebtedness is established, only payments on principal can reduce the
indebtedness and only additional indebtedness secured by the residence and incurred to
substantially improve the residence can increase it. 8n this case, the Franklins reduced
their original ac%uisition indebtedness to 9ero. 4ssuming the Franklins do not use the
additional loan in year . to substantially improve their home, the loan cannot be
classified as ac%uisition indebtedness. hus, the interest on the loan can only be
deducted to the extent that it %ualifies as home!e%uity indebtedness. +)'',''' of the loan
%ualifies as home!e%uity indebtedness and the Franklins may deduct +-,''' of interest
paid on the loan (+)'',''' @ -;*. On the other hand, if the Franklins use the proceeds
of the loan to substantially improve the home, they may deduct the full +,),''' of interest
paid on the loan (+.'',''' @ -;*.
c. +&,L''
7imilar to part b above, the new loan can only be classified as ac%uisition indebtedness
to the extent that the loan proceeds are used to substantially improve the residence.
=owever, in this scenario, the Franklins will be able to deduct the full +&,L'' (+6',''' @
-;* paid in interest because even if the loan proceeds are not used to substantially
improve the residence, the full amount of interest is deductible because it %ualifies as
home!e%uity indebtedness and the amount of the loan is less than +)'','''. hus, it does
not matter how the Franklins use the loan proceeds as long as the loan is less than
+)'','''.
14-)1
4-. [LO )] 7n year 0# 6.a too" out a /-0#000 home-equity !oan from her !oca! cre%it union. At
the time she too" out the !oan# her home was .a!ue% at /+-0#000. At the time of the !oan#
6.a5s ori'ina! mort'a'e on the home was /)1-#000. At the en% of year 1# her ori'ina!
mort'a'e is /)10#000. $nfortunate!y for 6.a# %urin' year 1# the .a!ue of her home %roppe%
to /)>0#000. Consequent!y# as of the en% of year 1# 6.a5s home secure% /+10#000 of home-
re!ate% %e,t ,ut her home is on!y .a!ue% at /)>0#000. Assumin' 6.a pai% /1-#000 of interest
on the ori'ina! mort'a'e an% /+#-00 of interest on the home-equity !oan %urin' the year# how
much qua!ifie% resi%ence interest can 6.a %e%uct in year 1(
Jva may deduct the full +)&,''' of interest on the original loan and the full +.,&'' of
interest on the home!e%uity loan. he determination of the fair market value of the home (in
order to determine the amount of home e%uity* is made on the date that the last debt is
secured by the home. 8n this case, the determination would be the date that Jva took out the
+&',''' loan. ?ecause the home was valued at +.&',''' at that time, the entire +&',''' is
considered to be home!e%uity indebtedness even though the value of the home subse%uently
dropped to the point that she does not have +&',''' of available e%uity in the home. hus, in
year ), Jva would be able to deduct the full +)&,''' interest on the original mortgage and
the full +.,&'' from the home!e%uity loan.
41. [LO )] On 2anuary 1 of year 1# 2ason an% 2i!! 4arsh acquire% a home for /-00#000 ,y payin'
/400#000 %own an% ,orrowin' /100#000 with a 8 percent !oan secure% ,y the home. On
2une +0# of year 1# the 4arshes nee%e% cash so they refinance% the ori'ina! !oan ,y ta"in'
out a new /)-0#000 8 percent !oan. *ith the /)-0#000 procee%s from the new !oan# the
4arshes pai% off the ori'ina! /100#000 !oan an% use% the remainin' /1-0#000 to fun% their
son5s co!!e'e e%ucation.
a. *hat amount of interest expense on this !oan may the 4arshes %e%uct in year 1(
,. Assume the same facts as in :a;# except that the 4arshes use the /1-0#000 cash from
the refinancin' to a%% two rooms an% a 'ara'e to their home. *hat amount of interest
expense on the refinance% !oan may the 4arshes %e%uct in year 1(
a. +-,'''.
?ecause the #arshes paid off all of their original ac%uisition indebtedness and did not
increase it by making substantial improvements on their home, their ac%uisition
indebtedness remains at +)'','''. herefore, the #arshes may deduct interest on
+)'',''' of the ac%uisition indebtedness portion of the loan for the second half of the
year. his amounts to +.,&'' (+)'',''' x -; @ LE),*. hey may also deduct interest on
+)'',''' of home e%uity indebtedness. =ome!e%uity indebtedness is limited to the lesser
of ()* +)'',''' or (,* the fair market value of the %ualified residence in excess of the
ac%uisition debt related to the residence. 4ssuming the home is worth at least +,&',''',
the #arshes may deduct interest on +)'',''' of home e%uity loan for half the year. his
amounts to +.,&'' (+)'',''' x -; @ LE),*. 8n total, the #arshes may deduct +-,''' of
interest on the refinanced loan.
,. +6,-&'.
8n this case, because the #arshes used the loan proceeds to add on to their house, the
entire refinanced loan %ualifies as ac%uisition indebtedness. ?ecause the total
ac%uisition indebtedness is under +),''',''', the #arshes may deduct all of the interest
14-))
on the refinanced loan. ?ecause the loan was outstanding for half the year, the interest
on the loan and the #arshes deduction is +6,-&' (+,&',''' x -; @ LE),*.
48. [LO )] @A!annin'B On 2anuary 1# year 1 9ran%on an% A!isa Eoy purchase% a home for /1.-
mi!!ion ,y payin' /-00#000 %own an% ,orrowin' the remainin' /1 mi!!ion with a 8 percent
!oan secure% ,y the home. On the same %ay# the Eoys too" out a secon% !oan# secure% ,y the
home# in the amount of /+00#000.
a. Assumin' the interest rate on the secon% !oan is > percent. *hat is the maximum
amount of the interest expense the Eoys may %e%uct on these two !oans in year 1(
,. Assumin' the interest rate on the secon% !oan is 1 percent# what is the maximum
amount of interest expense the Eoys may %e%uct on these two !oans in year 1(
a. +-K,&.6.
value of the taxpayers residence (or residences* is at least +),)'','''. 7ince the Ioys
home is worth +).& million, they can deduct interest on up to +).) million. he Ioys
have two options for determining the amount of deductible interest. First, they could
deduct a pro!rata portion of the interest expense from each loan. "nder this option, their
deductible interest expense would be calculated as follows:
Option ): otal interest expense F Pac%uisition debt @ interest rateQ O Phome e%uity debt
@ interest rateQ
FP+) million @ -;Q O P+.'',''' @ 6;Q
F +K/,'''
5eductible interest expenseF :ualified debtEotal debt x total interest expense
F P+).) millionE).. millionQ x +K/,'''
F +-K,&.6
4lternatively, the Ioys could deduct the interest based on the order in which the loans
were taken out. "nder this option, the Ioys deductible interest expense would be as
follows:
Option ,: 5eductible interest expense
+) million @ -; F +-','''
+)'',''' @ 6; F +6,'''
5eductible interest expense F +-6,'''
he Ioys would maximi9e their interest expense deductions by using option ). his
option generates +),&.6 more in interest deductions than option ,.
,. +-L,'''.
value of the taxpayers residence (or residences* is at least +),)'','''. 7ince the Ioys
14-)+
home is worth +).& million, they can deduct interest on up to +).) million. he Ioys
have two options for determining the amount of deductible interest. First, they could
deduct a pro!rata portion of the interest expense from each loan. "nder this option, their
deductible interest expense would be calculated as follows:
Option ): otal interest expense F Pac%uisition debt x interest rateQ O Phome e%uity debt
x interest rateQ
FP+) million @ -;Q O P+.'',''' @ L;Q
F +66,'''
5eductible interest expenseF :ualified debtEotal debt x total interest expense
F P+).) millionE).. millionQ @ +66,'''
F +-/,/L,
4lternatively, the Ioys could deduct the interest based on the order in which the loans
were taken out. "nder this option, the Ioys deductible interest expense would be as
follows:
Option ,: 5eductible interest expense
+) million @ -; F +-','''
+)'',''' @ L; F +L,'''
5eductible interest expense F +-L,'''
he Ioys would maximi9e their interest expense deductions by using option ,. his
option generates +),&.6 more in interest deductions than option ).
4>. [LO )] @EesearchB 2ennifer has ,een !i.in' in her current principa! resi%ence for three years.
ix months a'o 2ennifer %eci%e% that she wou!% !i"e to purchase a secon% home near a ,each
so she can .acation there for part of the year. Fespite her ,est efforts# 2ennifer has ,een
una,!e to fin% what she is !oo"in' for. Consequent!y# 2ennifer recent!y %eci%e% to chan'e
p!ans. he purchase% a parce! of !an% for /)00#000 with the intention of ,ui!%in' her secon%
home on the property. To acquire the !an%# she ,orrowe% /)00#000 secure% ,y the !an%.
2ennifer wou!% !i"e to "now whether the interest she pays on the !oan ,efore construction on
the house is comp!ete% is %e%ucti,!e as mort'a'e interest.
a. How shou!% 2ennifer treat the interest if she has ,e'un construction on the home an%
p!ans to !i.e in the home in 1) months(
,. How shou!% 2ennifer treat the interest if she hasn5t ,e'un construction on the home# ,ut
p!ans to !i.e in the home in 1- months(
c. How shou!% 2ennifer treat the interest if she has ,e'un construction on the home ,ut
%oesn5t p!an to !i.e in the home for +8 months(
7ee Ieg M).)L.!)'(p*(&*.
a. "nless the taxpayer has begun construction of a home on the land that the taxpayer
can occupy within ,/ months, the land would be considered an investment and the
interest paid on the second mortgage would not %ualify as deductible mortgage interest.
?ecause >ennifer will be in the home within ), months, the interest %ualifies as mortgage
interest.
14-)4
,. ?ecause >ennifer has not begun construction on the home, the interest on the loan is
not eligible for mortgage interest even though >ennifer will live in the home in )& months.
7he would be able to deduct the interest as investment interest expense (sub$ect to
limitations on the expense* if she itemi9es her deductions.
c. Jven though she has begun construction, because >ennifer will not occupy the home
within ,/ months the interest expense does not %ualify as mortgage interest. =owever,
she would be able to deduct it as an itemi9ed deduction for investment interest expense
(sub$ect to limitations on investment interest expenses deductibility*.
4?. [LO )] @A!annin'B EaCi. an% Laurie Amin are recent co!!e'e 'ra%uates !oo"in' to purchase a
new home. They are purchasin' a /)00#000 home ,y payin' /)0#000 %own an% ,orrowin'
the other /1>0#000 with a +0-year !oan secure% ,y the home. The Amins ha.e the option of
:1; payin' no %iscount points on the !oan an% payin' interest at > percent or :); payin' one
%iscount point on the !oan an% payin' interest of 8.- percent. 9oth !oans require the Amins
to ma"e interest-on!y payments for the first fi.e years. $n!ess otherwise state%# the Amins
itemi=e %e%uctions irrespecti.e of the amount of interest expense. The Amins are in the )-
percent mar'ina! or%inary income tax ,rac"et.
a. Assumin' the Amins do not itemi9e deductions# what is the ,rea"-e.en point for
payin' the point to 'et a !ower interest rate(
,. Assumin' the Amins %o itemi=e %e%uctions# what is the ,rea"-e.en point for payin'
the point to 'et a !ower interest rate(
c. Assume the ori'ina! facts except that the amount of the !oan is /+00#000. *hat is the
,rea"-e.en point for the Amins for payin' the point to 'et a !ower interest rate(
%. Assume the ori'ina! facts except that the /1>0#000 !oan is a refinance instea% of an
ori'ina! !oan. *hat is the ,rea"-e.en point for payin' the point to 'et a !ower interest
rate(
e. Assume the ori'ina! facts except that the amount of the !oan is /+00#000 an% the !oan is
a refinance an% not an ori'ina! !oan. *hat is the ,rea"-e.en point for payin' the point to
'et a !ower interest rate(
a. , years.
3ost of paying ) pointF loan principal @ );
F+)6',''' @ );
F+),6''
?ecause the 4mins do not itemi9e deductions, they will receive no tax benefit from the
deduction for the points paid. 3onse%uently, the after!tax cost of the point is the same as
the before!tax cost of the pointR+),6''. he 4mins need to determine how long it will
take them to recoup this cost due to a lower interest rate. o do this, they should divide
the after!tax cost of paying the point by the yearly after!tax interest savings from the
point. he after!tax cost of paying the point is +),6''. he after!tax savings due to a
lower interest rate is +K'' calculated as follows:
?efore!tax savings due to a lower interest rateF +)6',''' loan @ (6;!-.&;*
F +K''
14-)-
?ecause the 4mins are not itemi9ing deductions, additional interest payments do not
generate any tax savings, therefore the after!tax savings from the lower interest rate is
the same as the before!tax savings of +K''.
he break!even period, then, is , years (+),6'' after!tax cost of the pointE+K'' after!tax
annual savings from the lower interest rate*.
b. , years.
Loan summary: +)6','''< 6; rate with no
points. -.&; rate with ) point. he 4mins pay
only interest for the first five years.
Description Amounts alculation
()*8nitial cash outflow from paying ) point (+),6''* +)6',''' @ );
(,* ax benefit from deducting points O +/&' ()* @ ,&;
(.* 4fter!tax cost of points (+),.&'* ()* O (,*
(/* ?efore!tax savings per year from -.&; vs.
6; interest rate
+K'' P+)6',''' @ (6; A
-.&;*Q
(&* Forgone tax benefit per year of higher
interest rate
(+,,&* (/* @ ,&;
(L* 4fter!tax savings per year of -.&; vs. 6;
interest rate
+L-& (/* O (&*
!rea"-e#en point in years 2 years $%& ' $(&
he break even period is , years. his is the same break even point for the 4mins even if
they dont itemi9e deductions.
c. , years.
Loan summary: +.'','''< 6; rate with no
only interest for the first five years.
()*8nitial cash outflow from paying ) point (+.,'''* +.'',''' x );
(,* ax benefit from deducting points O +-&' ()* @ ,&;
(.* 4fter!tax cost of points (+,,,&'* ()* O (,*
6; interest rate
+),&'' P+.'',''' x (6;
!-.&;*Q
(&* Forgone tax benefit per year of higher
interest rate
(+.-&* (/* @ ,&;
interest rate
+),),& (/* O (&*
!rea"-e#en point in years 2 years $%& ' $(&
d. ,.L years.
14-)1
Loan summary: +)6','''< 6; rate with no
interest only for the first & years. .'!year loan.
Description
)oints alculation
()* 8nitial cash outflow from paying points (+),6''* +)6',''' @ );
(,* ax benefit from deducting points '
(.* 4fter!tax cost of points (+),6''* ()* O (,*
6; interest rate +K''
P+)6',''' @ (6;
!-.&;*Q
(&* Foregone tax benefit per year of higher
interest payments (+,,&*
(/* @ ,&;
interest rate
+L-& (/* O (&*
(-* 4nnual tax savings from amorti9ing points +)& ()* E .' years @ ,&;
(6* 4nnual after!tax cash flow benefit of paying
points
+LK' (L* O (-*
!rea"-e#en point in years 2*( years $%& ' $8&
?ecause this is a refinance, the +),6'' paid for the point is not immediately deductible.
3onse%uently, the after!tax cost of the point is +),6''. he +),6'' is amorti9ed over .'
years, generating a +L' deduction each year. he +L' deduction will save the 4mins +)&
in taxes each year (+L' @ ,&;*.
e. ,.L years.
Loan summary: +.'','''< 6; rate with no
interest only for the first & years. .'!year loan.
Description
)oints +otes
()* 8nitial cash outflow from paying points (+.,'''* +.'',''' @ );
(,* ax benefit from deducting points '
(.* 4fter!tax cost of points (+.,'''* ()* O (,*
6; interest rate +),&''
P+.'',''' @ (6;
!-.&;*Q
(&* Foregone tax benefit per year of higher
interest payments (+.-&*
(/* @ ,&;
interest rate
+),),& (/* O (&*
(-* 4nnual tax savings from amorti9ing points +,& ()* E .' years @ ,&;
(6* 4nnual after!tax cash flow benefit of paying
points
+),)&' (L* O (-*
14-)8
!rea"-e#en point in years 2*( years $%& '$8&
?ecause this is a refinance, the +.,''' paid for the point is not immediately deductible.
3onse%uently, the after!tax cost of the point is +.,'''. he +.,''' is amorti9ed over .'
years, generating a +)'' deduction each year. he +)'' deduction will save the 4mins
+,& in taxes each year (+)'' @ ,&;*.
-0. [LO +] 7n year 1# Aeter an% ha!ine 2ohnsen mo.e% into a home in a new su,%i.ision. Theirs
was one of the first homes in the su,%i.ision. 7n year 1# they pai% /1#-00 in property taxes to
the state 'o.ernment# /-00 to the %e.e!oper of the su,%i.ision for an assessment to pay for
the si%ewa!"s# an% /?00 for property taxes on !an% they ho!% as an in.estment. *hat amount
of taxes are the 2ohnsens a!!owe% to %e%uct assumin' their itemi=e% %e%uctions excee% the
stan%ar% %e%uction amount ,efore consi%erin' any property tax %e%uctions(
he >ohnsens may deduct +,,/'' of property taxes as itemi9ed deductions. his includes the
+),&'' paid in property taxes on their home and +K'' in property taxes paid on land they are
holding as an investment. =owever, taxpayers are not allowed to deduct fees paid for water
and sewer services, and assessments for local benefits such as streets and sidewalks. hus,
the >ohnsens may not deduct the +&'' assessment fee to pay for sidewalks.
-1. [LO +] 2esse 9rimha!! is sin'!e. 7n )010# his itemi=e% %e%uctions were /-#000 ,efore
consi%erin' any rea! property taxes he pai% %urin' the year. 2esse5s a%Custe% 'ross income
was /80#000 :a!so ,efore consi%erin' any property tax %e%uctions;. 7n )010# he pai% rea!
property taxes of /+#000 on property 1 an% />00 of rea! property taxes on property ).
a. 7f property 1 is 2esse5s primary resi%ence an% property ) is his .acation home :he
%oes not rent it out at a!!;# what is his taxa,!e income after ta"in' property taxes into
account(
,. 7f property 1 is 2esse5s ,usiness ,ui!%in' :he owns the property; an% property ) is his
primary resi%ence# what is his taxa,!e income after ta"in' property taxes into
account(
c. 7f property 1 is 2esse5s primary resi%ence an% property ) is a parce! of !an% he ho!%s
for in.estment# what is his taxa,!e income after ta"in' property taxes into account(
a. +&-,&&'.
he property tax on both properties are deductible as itemi9ed deductions because
neither property is used for business or rental activities and the sum of >esses itemi9ed
deductions, including property taxes, exceeds his standard deduction.
Description Amount alculation
()* 4H8 +-','''
(,* 7tandard deduction (&,-''*
(.* 8temi9ed deductions (6,6''* +&,''' O +.,''' O +6''
(/* Gersonal exemption (.,L&'*
,axa-le income after property taxes $.7,..0 ()* O (.* O (/*
b. +&-,)&'.
14-)>
he property tax on the business building is deductible for 4H8, and the tax on the
personal residence is deductible as an itemi9ed deduction. 8n this situation, >esse
deducts the basic standard deduction plus an additional standard deduction for property
taxes paid because this amount exceeds his itemi9ed deductions if the law allowing the
additional standard deduction for property taxes is extended into ,')'.
()* 4H8 before property taxes +-','''
(,* ?usiness property taxes (.,'''* For 4H8 deduction
(.* 4H8 L-,''' ()* O (,*
(/* ?asic standard deduction O additional
standard deduction for property taxes paid
during year (limited to +&'' for single
taxpayers*
(L,,''* +&,-'' O +&''
(&* 8temi9ed deductions (including property
taxes*
(&,6''* +&,''' O +6''
(L* Hreater of standard deduction or
itemi9ed deductions
(L,,''* (/* S (&*
(-* Gersonal exemption (.,L&'*
,axa-le income after property taxes $.7,1.0 ()* O (L* O (-*
c. +&-,&&'.
he answer is the same as part (a*. he property taxes on both properties (residence and
investment property* are deductible as itemi9ed deductions because neither property is used
for business or rental activities.
-). [LO +] Gir" an% Lorna 3ew,o!% purchase% a new home on Au'ust 1 of year 1 for /+00#000.
At the time of the purchase# it was estimate% that the rea! property tax rate for the year wou!%
,e .- percent of the property5s .a!ue. 9ecause the taxin' Curis%iction co!!ects taxes on a 2u!y
1 year-en%# it was estimate% that the 3ew,o!%s wou!% ,e require% to pay /1#+8- in property
taxes for the property tax year re!atin' to Au'ust throu'h 2une of year ) :/+00#000 H .00- H
11I1);. The se!!er wou!% ,e require% to pay the /1)- for 2u!y of year 1. A!on' with their
month!y payment of principa! an% interest# the 3ew,o!%s pai% /1)- to the mort'a'e company
to co.er the property taxes. The mort'a'e company p!ace% the money in escrow an% use%
the fun%s in the escrow account to pay the property tax ,i!! in 2u!y of year ). The 3ew,o!%s5
itemi=e% %e%uctions excee% the stan%ar% %e%uction ,efore consi%erin' property taxes.
a. How much in property taxes can the 3ew,o!%s %e%uct for year 1(
,. How much in property taxes can the 3ew,o!%s %e%uct for year )(
c. Assume the ori'ina! facts except that the 3ew,o!%s were not a,!e to co!!ect /1)- from
the e!!er for the property taxes for 2u!y of year 1. How much in property taxes can the
3ew,o!%s %e%uct for year 1 an% year )(
%. Assume the ori'ina! facts except that the tax ,i!! for 2u!y 1 of year 1 throu'h 2une +0 of
year ) turne% out to ,e /1#)00 instea% of /1#-00. How much in property taxes can the
3ew,o!%s %e%uct in year 1 an% year )(
14-)?
a. +'. =omeowners are allowed to deduct property taxes when the actual taxes are
paid to the taxing $urisdiction and not when they make payments for taxes to the escrow
account. 3onse%uently, the 0ewbolds will deduct their share of the property taxes when
the taxes are actually paid in year ,. hey are not allowed to deduct any property taxes
in year ) because they did not pay any taxes to the taxing $urisdiction during year ).
,. For tax purposes, it doesnt matter who actually pays the tax. 4ssuming the taxes are
paid, the tax deduction is based on the relative amount of time each party held the
property during the year. hus, the 0ewbolds tax deduction is +),.-&, calculated as
follows:
ax deduction F +.'',''' @ '.''& @ ))E), (since they held the property for )) months
of the property tax year*
F +),.-&
c. For tax purposes, it doesnt matter who actually pays the tax. hus, it doesnt matter
that the 0ewbolds were unable to collect +),& from the seller for property taxes.
4ssuming the taxes are paid, the tax deduction is based on the relative amount of time
each party held the property during the year. 7ince no taxes were paid during year ), no
deduction is allowed for year one. he 0ewbolds tax deduction for year , is still +),.-&,
calculated as follows:
ax deduction F +.'',''' @ '.''& @ ))E), (since they held the property for )) months
of the property tax year*
F +),.-&
%. 7ince no taxes were paid during year ), the 0ewbolds dont deduct any property taxes
for year one. =owever, the 0ewbolds tax deduction for year , is +),)'' calculated as
follows:
ax deduction F +),,'' (total tax liability* @ ))E), (number of months property was
held by the 0ewbolds*
F +),)''
-+. [LO +] @EesearchB 2enae an% Terry Hutchin's own a parce! of !an% as tenants ,y entirety.
That is# they ,oth own the property ,ut when one of them %ies the other ,ecomes the so!e
owner of the property. Dor nontax reasons# 2enae an% Terry %eci%e to fi!e separate tax returns
for the current year. 2enae pai% the entire /+#000 property tax ,i!! for the !an%. How much of
the /+#000 property tax payment is each spouse entit!e% to %e%uct in the current year(
4ccording to Iev. Iul. -,!-K, )K-,!) 3? &), if a husband and wife are co!owners of property
and they are $ointly and severally liable for the property tax and they file separate tax returns for
the year, each spouse is allowed to deduct on his or her separate return the amount of the
property taxes he or she paid for the year. 8n this case, because >enae paid the entire +.,'''
property tax bill, she is allowed to deduct the entire +.,''' on her separate tax return.
14-+0
-4. [LO +] After rentin' an apartment for fi.e years# To%% an% Fiane purchase% a new home for
/1-0#000 on 2u!y 1# )00>. On their )00> Coint tax return# they c!aime% a /8#-00 first-time
home ,uyer cre%it. Answer the fo!!owin' questions re!atin' to the cre%it.
a. Assumin' they sti!! !i.e in the home# what amount of cre%it must To%% an% Fiane
repay with their )010 tax return(
,. Assumin' they se!! the home in Au'ust )014 for a /)0#000 'ain# what amount of
cre%it must they pay ,ac" with their )014 tax return(
c. Assumin' they se!! the home in Au'ust )014 for a /+#000 'ain# what amount of cre%it
must they pay ,ac" with their )014 tax return(
a. ?ecause they purchased the home and claimed the credit in ,''6, they must pay back
the credit in )& e%ual installments beginning with ,')'. With their ,')' tax return,
odd and 5iane must repay +&'' (+-,&''E)&*.
b. +&,&''. ?ecause odd and 5iane sold the home before repaying the entire credit,
they must repay the balance of the unpaid credit with their ,')/ tax return.
4ssuming they made the proper payment of +&'' a year of four years (,')' A ,').*,
they would have paid +,,''' by the time they sold the home. hey would then be
re%uired to pay the remaining +&,&'' (+-,&'' ! +,,'''* with their ,')/ tax return
c. +.,'''. his is the same answer as (b* except the payback is limited to the gain on
the sale of the home.
--. [LO +] 7n )010# Haro!% purchase% a new con%ominium for /80#000 to use as his principa!
resi%ence. Haro!% fi!es as a sin'!e taxpayer. *hat is Haro!%5s first-time home ,uyer cre%it in
the fo!!owin' a!ternati.e situations(
a. Haro!% purchase% the con%ominium on De,ruary 1# )010. Haro!% has !i.e% in an
apartment he rente% since )00). Haro!%5s )010 A&7 is /10#000.
,. Haro!% purchase% the con%ominium on De,ruary 1# )010. Haro!% has !i.e% in an
apartment he has rente% since )00). Haro!%5s )010 A&7 is /1+-#000.
c. Haro!% purchase% the con%ominium on De,ruary 1# )010. 7n the six years prece%in'
this purchase# Haro!% !i.e% in another home he owne%. Haro!% so!% that other home
on 4arch 1# )010. Haro!%5s )010 A&7 is /10#000.
%. Haro!% purchase% the con%ominium on De,ruary 1# )010. 7n the three years
prece%in' this purchase# Haro!% !i.e% in a home he owne%. This was the first home
Haro!% e.er owne%. Haro!% so!% this home on 4arch 1# )010. Haro!%5s )010 A&7 is
/10#000.
a. +-,''' (+-',''' @ )';*. ?ecause =arold purchased the home before #ay ), ,')'
and he did not own a home in the previous three years, =arold may claim a credit
e%ual to )'; of the purchase price (total credit may not exceed +6,'''*.
b. +.,&'' (+-',''' @ )'; @&';*. ?ecause =arold purchased the home before #ay ),
,')' and he did not own a home in the previous three years, =arold may claim a
credit e%ual to )'; of the purchase price (total credit may not exceed +6,'''*.
=owever, because =arolds 4H8 is half way through the phase!out range for the
credit (+),&,''' ! +)/&,'''*, he loses half of the credit he was otherwise eligible to
claim (+).&,''' is half way in between +),&,''' and +)/&,''' so he loses &'; of
the credit*.
14-+1
c. +L,&''. ?ecause =arold purchased the home before #ay ), ,')' and because he
owned a principal residence for a consecutive five year period during the eight year
period ending on the date he ac%uired the condominium (February ), ,')'*, he may
claim a credit e%ual to )'; of the purchase price of the home (but not to exceed
+L,&''*. ?ecause +L,&'' is less than +-,''' (+-',''' purchase price @ )';*
=arolds credit is limited to +L,&''.
d. +'. ?ecause =arold owned a principal residence prior to ac%uiring the condominium
but did not own the condominium for five consecutive years in the eight year period
preceding the purchase of the condominium, he is not eligible to claim the first time
home buyer credit.
-1. [LO +] @EesearchB Dor her ?0
th
,irth%ay# 2amie :a wi%ow; purchase% a new home on
eptem,er 1# )00> an% appropriate!y c!aime% a first-time home ,uyer cre%it of /8#-00 on her
)00> tax return. 2amie fo!!owe% the appropriate sche%u!e for payin' ,ac" the cre%it.
Howe.er# in Fecem,er )014# 2amie passe% away of o!% a'e. 7s 2amie :or her estate;
responsi,!e for payin' the unpai% ,a!ance of the cre%it( 6xp!ain.
8n this case >amie (or her estate* would not be re%uired to pay the remaining installments (see
M.L(f*(/*(4*.
-8. [LO 4] e.era! years a'o# 2unior acquire% a home that he .acatione% in part of the time an%
rente% out part of the time. Furin' the current year 2unior<
Aersona!!y staye% in the home for )) %ays.
Eente% it to his fa.orite ,rother at a %iscount for 10 %ays.
Eente% it to his !east fa.orite ,rother for ei'ht %ays at the fu!! mar"et rate.
Eente% it to his frien% at a %iscounte% rate for four %ays.
Eente% the home to thir% parties for -> %ays at the mar"et rate.
Fi% repair an% maintenance wor" for two %ays.
4ar"ete% the property an% ma%e it a.ai!a,!e for rent for 1-0 %ays %urin' the year.
How many %ays of persona! use an% how many %ays of renta! use %i% 2unior experience on
the property %urin' the year(
>unior has // days of personal use and L' days of rental use. Gersonal use days include the
,, days used personally, the combined )6 days rented to relatives, and the / days rented out
at a discount. he rental days include the &6 days rented out to third parties at the market
rate and the , days for repairs and maintenance.
->. [LO 4] Fi!!on rente% his persona! resi%ence at La"e Tahoe for 14 %ays whi!e he was
.acationin' in 7re!an%. He resi%e% in the home for the remain%er of the year. Eenta! income
from the property was /1#-00. 6xpenses associate% with use of the home for the entire year
were as fo!!ows<
Eea! property taxes /+#100
4ort'a'e interest 1)#000
Eepairs 1#-00
7nsurance 1#-00
$ti!ities +#?00
Fepreciation 1+#000
14-+)
a. *hat effect %oes the renta! ha.e on Fi!!on5s A&7(
,. *hat effect %oes the renta! ha.e on Fi!!on5s itemi=e% %e%uctions(
a. 7ince 5illon resided in his home for at least )& days during the year and rented the
home for fewer than )& days, he excludes the rental income from taxable income and
does not deduct the associated rental expenses. 7o, the rental has no effect on 5illons
4H8.
,. =e will be allowed to deduct the real property taxes of +.,)'' and mortgage interest
of +),,''' as itemi9ed deductions.
Use the following facts to answer problems 59 and 60.
3ata!ie owns a con%ominium near Cocoa 9each in D!ori%a. This year# she incurs the
fo!!owin' expenses in connection with her con%o<
7nsurance /1#000
A%.ertisin' expense -00
4ort'a'e interest +#-00
Aroperty taxes ?00
Eepairs J maintenance 1-0
$ti!ities ?-0
Fepreciation >#-00
Furin' the year# 3ata!ie rente% out the con%o for 8- %ays# recei.in' /10#000 of 'ross income.
he persona!!y use% the con%o for +- %ays %urin' her .acation.
-?. [LO 4] Assume 3ata!ie uses the 8I7 metho% of a!!ocatin' expenses to renta! use of the
property.
a. *hat is the tota! amount of for A&7 :renta!; %e%uctions 3ata!ie may %e%uct in the
current year re!ate% to the con%o(
,. *hat is the tota! amount of itemi=e% %e%uctions 3ata!ie may %e%uct in the current year
re!ate% to the con%o(
c. 7f 3ata!ie5s ,asis in the con%o at the ,e'innin' of the year was /1-0#000# what is her
,asis in the con%o at the en% of the year(
%. Assume that 'ross renta! re.enue was /1#000 :rather than /10#000;# what amount of
for A&7 %e%uctions may 3ata!ie %e%uct in the current year re!ate% to the con%o(
0ote that the home falls into the residence with significant rental use category.
a. +)',''', calculated as follows:
14-++
Hross rental income +)','''
ier ) expenses:
4dvertising expense F +&''
#ortgage interest F (-&E))'* @ +.,&''F+,,.6L
Groperty taxesF (-&E))'* @ +K''F+L)/
Cess: total ier ) expenses (.,&''*
?alance +L,&''
ier , expenses:
8nsurance F (-&E))'* @ +),'''F+L6,
Iepairs T #aintenance F (-&E))'* @ +L&'F+//.
"tilitiesF (-&E))'* @ +K&'F+L/6
Cess: total ier , expenses (),--.*
?alance +/,-,-
ier . expenses:
5epreciation (-&E))'* @ +6,&''F +&,-K&, but the
deduction is limited to the remaining income (/,-,-*
?alance +'
otal 1For 4H82 deductions (+.,&'' O +),--. O +/,-,-* +)','''
b. 0atalie may deduct the personal!use portion of the mortgage interest and property taxes
since they are deductible without regard to rental income. =er deductions for these items
are computed as follows:
#ortgage interest P(.&E))'* @ +.,&''Q +),))/
Ieal property taxes P(.&E))'* @ +K''Q ,6L
otal 1from 4H82 deductions +),/''
c. +)/&,,-., calculated as follows:
?eginning basis +)&','''
Cess: depreciation actually deducted (/,-,-*
4d$usted basis +)/&,,-.
d. +.,&''. Jven though it creates a loss (+),''' ! +.,&''*, 0atalie is allowed to deduct all
of the advertising expense and the portion of the mortgage interest expense and real
property taxes allocated to the rental use of the home as for 4H8 deductions (these
deductions are not limited to rental revenue*. he loss is not sub$ect to the passive loss
rule limitations.
10. [LO 4] Assume 3ata!ie uses the ax 3ourt metho% of a!!ocatin' expenses to renta! use of the
property.
a. *hat is the tota! amount of for A&7 :renta!; %e%uctions 3ata!ie may %e%uct in the
current year re!ate% to the con%o(
14-+4
,. *hat is the tota! amount of itemi=e% %e%uctions 3ata!ie may %e%uct in the current year
re!ate% to the con%o(
c. 7f 3ata!ie5s ,asis in the con%o at the ,e'innin' of the year was /1-0#000# what is her
,asis in the con%o at the en% of the year(
%. Assume that 'ross renta! re.enue was /)#000 :rather than /10#000;# what amount of
for A&7 %e%uctions may 3ata!ie %e%uct in the current year re!ate% to the con%o(
0ote that the home falls into the residence with significant rental use category.
a. +6,K-,, calculated as follows:
Hross rental income +)',''
'
ier ) expenses:
4dvertising expense F +&''
#ortgage interest F (-&E.L&* @ +.,&''F+-)K
Groperty taxesF (-&E.L&* @ +K''F+)6&
Cess: total ier ) expenses
(),/'/*
?alance +6,&KL
ier , expenses:
8nsurance F (-&E))'* @ +),'''F+L6,
Iepairs T #aintenance F (-&E))'* @ +L&'F+//.
"tilitiesF (-&E))'* @ +K&'F+L/6
Cess: total ier , expenses (),--.*
?alance +L,6,.
ier . expenses:
5epreciation (-&E))'* @ +6,&''F +&,-K& (&,-K&*
?alanceRnet income from rental of condo +),',6
otal 1For 4H82 deductions (+),/'/ O +),--. O +&,-K&* +6,K-,
,. 0atalie may deduct the personal!use portion of the mortgage interest and property
taxes since they are deductible without regard to rental income. =er deductions for these
items are computed as follows:
#ortgage interest P(,K'E.L&* @ +.,&''Q +,,-6)
Ieal property taxes P(,K'E.L&* @ +K''Q +-)&
otal Ufrom 4H8U deductions +.,/KL
c. +)//,,'&, calculated as follows:
?eginning basis +)&','''
Cess: depreciation actually deducted (&,-K&*
4d$usted basis +)//,,'&
14-+-
%. +),/'/. Jven though it creates a loss (+),''' ! +),/'/*, 0atalie is allowed to deduct
all of the advertising expense and the portion of the mortgage interest expense and real
14-+1
e. property taxes allocated to the rental use of the home as for 4H8 deductions (these
deductions are not limited to rental revenue*. he loss is not sub$ect to the passive loss
rule limitations.
Use the following facts to answer problems 61 - 63.
A!exa owns a con%ominium near Cocoa 9each in D!ori%a. This year# she incurs the
fo!!owin' expenses in connection with her con%o<
7nsurance /)#000
4ort'a'e interest 1#-00
Aroperty taxes )#000
Eepairs J maintenance 1#400
$ti!ities )#-00
Fepreciation 14#-00
Furin' the year# A!exa rente% out the con%o for 100 %ays. he %i% not use the con%o at
a!! for persona! purposes %urin' the year. A!exa5s A&7 from a!! sources other than the
renta! property is /)00#000. $n!ess otherwise specifie%# A!exa has no sources of passi.e
income.
11. [LO 4] Assume A!exa recei.es /+0#000 in 'ross renta! receipts.
a. *hat effect %o the expenses associate% with the property ha.e on her A&7(
,. *hat effect %o the expenses associate% with the property ha.e on her itemi=e%
%e%uctions(
a. 4lexas property is treated as a nonresidence with rental use property because she
rented it for )'' days and did not use it all for personal purposes. he rental deductions
are fully deductible for 4H8. hus, 4lexas 4H8 will be increased by the rental net
income of +),)'', calculated as follows:
Hross rental income +.','''
Jxpenses:
8nsurance
#ortgage interest
Groperty taxes
Iepairs T maintenance
"tilities
5epreciation
Cess: total expenses
(,,'''*
(L,&''*
(,,'''*
(),/''*
(,,&''*
()/,&''*
(,6,K''*
?alanceRnet rental income +),)''
,. ?ecause 4lexa did not use the rental property for personal purposes, all expenses
associated with the property were allocated to rental use and were deducted for 4H8.
hus, the expenses associated with the property have no effect on her itemi9ed
deductions.
14-+8
1). [LO 4] Assumin' A!exa recei.es /)0#000 in 'ross renta! receipts# answer the fo!!owin'
questions<
a. *hat effect %oes the renta! acti.ity ha.e on her A&7 for the year(
,. Assumin' that A!exa5s A&7 from other sources is /?0#000# what effect %oes the renta!
acti.ity ha.e on A!exa5s A&7( A!exa ma"es a!! %ecisions with respect to the property.
c. Assumin' that A!exa5s A&7 from other sources is /1)0#000 what effect %oes the renta!
acti.ity ha.e on A!exa5s A&7( A!exa ma"es a!! %ecisions with respect to the property.
%. Assume that A!exa5s A&7 from other sources is /)00#000. This consists of /1-0#000
sa!ary# /10#000 of %i.i%en%s# an% /)-#000 of !on'-term capita! 'ain# an% net renta!
income from another renta! property in the amount of /1-#000. *hat effect %oes the
Cocoa 9each Con%o renta! acti.ity ha.e on A!exa5s A&7(
0ote that the property is a nonresidence with rental use property.
a. 4lexas 4H8 will be reduced by +', calculated as follows:
Hross rental income +,','''
Jxpenses:
8nsurance
#ortgage interest
Groperty taxes
Iepairs T maintenance
"tilities
5epreciation
(,,'''*
(L,&''*
(,,'''*
(),/''*
(,,&''*
()/,&''*
(,6,K''*
?alanceRnet rental loss (+6,K''*
?y definition, a rental activity Punless it is a residence with significant rental use (a
vacation home rental*Q, is considered to be a passive activity. 3onse%uently, losses from
rental property are not allowed to offset other ordinary or investment type income. 4s a
result, 4lexa will include +,',''' of rental income in gross income. 7he will also get to
deduct +,',''' of expenses related to the rental property. he remaining +6,K'' of
expenses (the rental loss* is not deductible this year because ()* the rental activity is a
passive activity, (,* 4lexa has no passive income from other sources, and (.* 4lexas 4H8
is above the phase!out range (+)'',''' ! +)&','''* so she is not allowed to deduct any
of the loss under the rental real estate exception to the passive loss rules. 7he may,
however, carry the loss forward to future years in which she has passive income to offset.
b. Ieduction of +6,K''.
"nder a rental real estate exception, a taxpayer who is an 1active2 participant in the
rental activity may be allowed to deduct up to +,&,''' of the rental loss against other
types of income. o be considered an active participant, the taxpayer must ()* own at
least )'; of the rental property and (,* participate in the process of making management
decisions such as approving new tenants, deciding on rental terms, and approving
repairs and capital expenditures. 7ince 4lexa owns )''; of the property, and she makes
14-+>
all decisions with respect to the property, she is an active participant in the rental
activity. hus, she meets the rental real estate exception, and, because her 4H8 is below
+)'',''' she is eligible to deduct up to +,&,''' of the loss against other types of income.
8n this case, she may deduct the entire +6,K'' loss as an ordinary deduction in the
current year.
c. Ieduction of +6,K''.
"nder a rental real estate exception, a taxpayer who is an 1active2 participant in the
rental activity may be allowed to deduct up to +,&,''' of the rental loss against other
types of income. o be considered an active participant, the taxpayer must ()* own at
least )'; of the rental property and (,* participate in the process of making management
decisions such as approving new tenants, deciding on rental terms, and approving
repairs and capital expenditures. he +,&,''' maximum exception amount is phased out
by &' cents for every dollar the taxpayers ad$usted gross income exceeds +)'','''.
3onse%uently, the entire +,&,''' is phased!out when the taxpayers ad$usted gross
income reaches +)&','''.
7ince, 4lexa owns )''; of the property, and she makes all decisions with respect to the
property, she is an active participant in the rental activity. hus, she meets the rental real
estate exception, and she may potentially deduct the rental loss as an ordinary deduction
in the current year. =owever, because her 4H8 exceeds +)'',''', part of the exception
amount is phased out as follows:
Ghase!out F P4H8 ! +)'','''Q @ +.&'
F P+),',''' ! +)'','''Q @ +.&'
F +)','''
Jxception amount F +,&,''' (maximum* ! +)',''' (phase!out* F +)&,'''
7ince 4lexas rental loss of +6,K'' is less than the exception amount of +)&,''', she can
deduct the entire +6,K'' as an ordinary deduction in the current year.
d. he rental activity reduces her 4H8 by +6,K''. (4ll transactions described in the
problem increase her 4H8 by +)K),)''.*
7ince 4lexa has passive income (the rental income from another property*, she can
deduct the loss against this passive income. hus, her net passive income is +L,)''
(+)&,''' rental income ! +6,K'' rental loss*. 8n summary, she will include +)&','''
salary, +)',''' dividends, +,&,''' C3H, and +.&,''' rental income (+)&,''' O
+,','''* in gross income. 7he will also be able to deduct all of the expenses related to
the rental property (+,6,K''* from the income in arriving at 4H8. he +6,K'' loss from
the rental property reduces her 4H8 by +6,K''.
1+. [LO 4] @A!annin'B Assume that in a%%ition to rentin' the con%o for 100 %ays# A!exa uses the
con%o for > %ays of persona! use. A!so assume that A!exa recei.es /+0#000 of 'ross renta!
receipts. Answer the fo!!owin' questions<
14-+?
a. *hat is the tota! amount of for A&7 %e%uctions re!atin' to the con%o that A!exa may
%e%uct in the current year( Assume she uses the 7E metho% of a!!ocatin' expenses
,etween renta! an% persona! %ays.
,. *hat is the tota! amount of from A&7 %e%uctions that A!exa re!atin' to the con%o that
A!exa may %e%uct in the current year( Assume she uses the 7E metho% of a!!ocatin'
expenses ,etween renta! an% persona! %ays.
c. *ou!% A!exa ,e ,etter or worse off after taxes if she uses the Tax Court metho% of
a!!ocatin' expenses(
0ote that the home is considered to be a nonresidence with rental use
a. +,L,-L'.
7ince 4lexa used the condo personally for 6 days, she must allocate the expenses between
personal use and rental use days. 4s illustrated below, the portion attributable to the
rental days are deductible as 1for 4H82 deductions.
Hross rental income +.','''
Jxpenses:
8nsurance P)''E)'6Q @ +,,'''
#ortgage interest P)''E)'6Q @ +L,&''
Groperty taxes P)''E)'6Q @ +,,'''
Iepairs T maintenance P)''E)'6Q @ +),/''
"tilities P)''E)'6Q @ +,,&''
5epreciation P)''E)'6Q @ +)/,&''
(),6&,*
(L,')K*
(),6&,*
(),,KL*
(,,.)&*
().,/,L
* (,L,-L'*
?alanceRnet rental income +.,,/'
otal 1for 4H82 deductions +,L,-L'
b. 4lexa may deduct the personal!use portion of property taxes since they are
deductible without regard to rental income. =owever, she is not allowed to deduct the
mortgage interest related to personal!use days because the property no longer %ualifies
as a personal residence. =er deduction for the property taxes is calculated as follows:
Ieal property taxes F (6E)'6* @ +,,''' F +)/6. 0ote that 4lexa would be able to
deduct the taxes whether she itemi9ed or not (as an increase to her basic standard
deduction*.
c. he ax 3ourt method is less favorable in this circumstance because it allocates
less interest expense to the rental activity and more to personal use. he interest expense
allocated to personal use, however, does not %ualify for an interest deduction because the
taxpayer does not meet the minimum amount of personal use re%uired for the deduction.
?y using the ax 3ourt method, any mortgage interest allocated to the personal!use days
generates no tax benefit. 4lso, since this is primarily rental property, the taxpayer may
deduct expenses in excess of income from the property. 7o, the taxpayer may not be as
concerned about allocating more taxes to the rental property because doing so does not
limit the taxpayers ability to deduct other expenses, as it might with mixed!use property.
14-40
d. 0ote however, that a loss may not be immediately deductible due to the passive
activity rules.
14. [LO -] 9roo"e owns a so!e proprietorship in which she wor"s as a mana'ement consu!tant.
he maintains an office in her home where she meets with c!ients# prepares ,i!!s# an%
performs other wor"-re!ate% tas"s. The home office is +00 square feet an% the entire house is
4#-00 square feet. 9roo"e incurre% the fo!!owin' home-re!ate% expenses %urin' the year.
Eea! property taxes / +#100
7nterest on home mort'a'e 14#000
Operatin' expenses of home -#000
Fepreciation 1)#000
Eepairs to home theater room 1#000
*hat amount of each of these expenses is a!!ocate% to the home office(
he expenses are allocated to the home office as follows:
Jxpense 4mount ype 4llocated to home office
L.LL-; of indirect (.''E/,&'' s%.
ft*
Ieal property taxes +.,L'' 8ndirect +,/'
8nterest on home mortgage )/,''' 8ndirect K..
Operating expenses of home &,''' 8ndirect ...
5epreciation ),,''' 8ndirect 6''
Iepairs to home theater room ),''' "nrelated '
otal expenses +.&,L'' +,,.'L
Use the following facts to answer problems 65 66.
Eita owns a so!e proprietorship in which she wor"s as a mana'ement consu!tant. he
maintains an office in her home where she meets with c!ients# prepares ,i!!s# an% performs
other wor"-re!ate% tas"s. Her ,usiness expenses# other than home office expenses# tota!
/-#100. The fo!!owin' home-re!ate% expenses ha.e ,een a!!ocate% to her home office.
Eea! property taxes /1#100
7nterest on home mort'a'e -#100
Operatin' expenses of home >00
Fepreciation 1#100
A!so# assume that not countin' the so!e proprietorship# Eita5s A&7 is /10#000.
1-. [LO -] Assume Eita5s consu!tin' ,usiness 'enerate% /1-#000 in 'ross income.
a. *hat is Eita5s home office %e%uction for the current year(
,. *hat wou!% Eita5s home office %e%uction for the current year ,e if her ,usiness
'enerate% /10#000 of 'ross income instea% of /1-#000(
c. *hat is Eita5s A&7 for the year(
%. *hat types an% amounts of expenses wi!! she carry o.er to next year(
14-41
a. +K,)'', calculated as follows:
Hross 8ncome +)&,'''
Cess: business expenses (&,L''*
?alance +K,/''
Cess: ier ) expenses (interest +&,)'' O +),L''
taxes* (L,-''*
?alance after tier ) expenses +,,-''
Cess ier , expenses (operating expenses* (6''*
?alance after tier , expenses ),K''
Cess ier . expenses (depreciation* (),L''*
0et income from business +.''
Iita is allowed to deduct all expenses allocated to the home office (+L,-'' interest and taxes
O 6'' home operating expenses O depreciation ),L''*.
b.
Hross 8ncome +)','''
?alance +/,/''
taxes* (L,-''*
Coss after tier ) expenses (+,,.''*
Cess ier , expenses (operating expenses* '
Coss after tier , expenses (+,,.''*
Cess ier . expenses (depreciation* '
0et loss from business (+,,.''*
Iita is allowed to deduct only the mortgage interest and real property taxes allocated to the
business use of the home. he remaining expenses (tier , and tier .* are suspended and
carried over to next year.
c. Iitas 4H8 is +L',.'' for the year. his is her 4H8 without the sole
proprietorship plus the net income from the business (+L',''' O +.''*.
d. 0one. ?ecause Iita is allowed to deduct all of the expenses this year, she does
not carry any over to next year.

11. [LO -] Assume Eita5s consu!tin' ,usiness 'enerate% /1+#000 in 'ross income for the current
year.
a. *hat is Eita5s home office %e%uction for the current year(
,. *hat is Eita5s A&7 for the year(
c. Assume the ori'ina! facts# except that Eita is an emp!oyee# an% not se!f-emp!oye%.
Consequent!y# she %oes not recei.e any 'ross income from the :so!e proprietorship;
,usiness an% she %oes not incur any ,usiness expenses unre!ate% to the home office.
14-4)
Dina!!y# her A&7 is /10#000 consistin' of sa!ary from her wor" as an emp!oyee. *hat
effect %o her home office expenses ha.e on her itemi=e% %e%uctions(
%. Assumin' the ori'ina! facts# what types an% amounts of expenses wi!! she carry o.er to
next year(
a. +-,/'', calculated as follows:
Hross 8ncome +).,'''
?alance +-,/''
taxes* (L,-''*
?alance after tier ) expenses +-''
Cess: ier , expenses (operating expenses +6''
before limit* (-''*
?alance after tier , expenses '
Cess ier . expenses (depreciation +),L'' before
limit* ('*
0et income from business +'
Iita is allowed to deduct a total of +-,/'' in home office expenses (+L,-'' in interest and
taxes and +-'' of home operating expenses*.
b. +L','''. his is the +L',''' of 4H8 without the sole proprietorship plus +' net income
from the home business.
c. ?ecause the home office deduction is deductible from 4H8 for employees, Iitas 4H8 is
unchanged by her home office expenses. Jmployees who may deduct home office expenses
do so as itemi9ed deductions sub$ect to the ,; 4H8 floor. hus, Iitas +K,)'' of home office
expenses are reduced by +),,'' (+L',''' x ,;* and she may deduct +-,K'' as an itemi9ed
deduction.
d. Iita will carry over +)'' of tier , expenses (operating expenses* and +),L'' of tier .
expenses (depreciation expense* to next year.
18. [LO 1# -] A!isha# who is sin'!e# owns a so!e proprietorship in which she wor"s as a
mana'ement consu!tant. he maintains an office in her home where she meets with c!ients#
prepares ,i!!s# an% performs other wor"-re!ate% tas"s. he purchase% the home at the
,e'innin' of year 1 for /400#000. ince she purchase% the home an% mo.e% into it she has
,een a,!e to %e%uct /10#000 of %epreciation expenses to offset her consu!tin' income. At the
en% of year +# A!isha so!% the home for /-00#000. *hat is the amount of taxes A!isha wi!! ,e
require% to pay on the 'ain from the sa!e of the home( A!isha5s or%inary mar'ina! tax rate is
+0 percent.
+,,&'', calculated as follows:
14-4+
4mount reali9ed +&'','''
?eginning basis +/'','''
Cess depreciation ()','''*
4d$usted basis +.K','''
Hain reali9ed +))','''
Hain eligible for exclusion (gain
reali9ed minus depreciation
expense*
+)'','''
Cess: exclusion amount
(lesser of gain eligible for
exclusion or +,&','''* ()'','''*
otal gain recogni9ed
(Hain reali9ed minus exclusion* +)','''
When a taxpayer deducts depreciation as a home office expense, the depreciation expense
reduces the taxpayers basis in the home. 3onse%uently, when the taxpayer sells the home,
the gain on the sale will be greater than it would have been had depreciation not been
deducted. Further, the gain on the sale of the home attributable to depreciation is not
eligible to be excluded under the home sale exclusion provisions. his gain is treated as
unrecaptured M),&' gain and is sub$ect to a maximum ,&; tax rate. hus, ?rooke will owe
+,,&'' (+)',''' @ ,&;* in taxes due to the sale.
Comprehensie Problems
1>. @A!annin'B Fere" an% 4ea'an 2aco,y recent!y 'ra%uate% from tate $ni.ersity an% Fere"
accepte% a Co, in ,usiness consu!tin' whi!e 4ea'an accepte% a Co, in computer
pro'rammin'. 4ea'an inherite% /8-#000 from her 'ran%father who recent!y passe% away.
The coup!e is %e,atin' whether they shou!% ,uy or rent a home. They !ocate% a renta! home
that meets their nee%s. The month!y rent is /)#)-0. They a!so foun% a three-,e%room home
that wou!% cost /48-#000 to purchase. The 2aco,ys cou!% use 4ea'an5s inheritance for a
%own-payment on the home. Thus they wou!% nee% to ,orrow /400#000 to acquire the home.
They ha.e the option of payin' two %iscount points to recei.e a fixe% interest rate of 4.-
percent on the !oan or payin' no points an% recei.in' a fixe% interest rate of -.8- percent for
a +0-year fixe% !oan.
Thou'h anythin' cou!% happen# the coup!e expects to !i.e in the home for no more than fi.e
years ,efore re!ocatin' to a %ifferent re'ion of the country. Fere" an% 4ea'an %on5t ha.e
any schoo!-re!ate% %e,t# so they wi!! sa.e the /8-#000 if they %on5t purchase a home.
A!so# consi%er the fo!!owin' information<
The coup!e5s mar'ina! tax rate is )- percent.
Ee'ar%!ess of whether they ,uy or rent# the coup!e wi!! itemi=e their %e%uctions.
7f they ,uy# the 2aco,ys wou!% purchase an% mo.e into the home on 2anuary 1# )010.
7f they ,uy the home# the property tax year runs from 2u!y 1 throu'h 2une +0. The
taxes paya,!e on the home on 2une +0# )0010 are /+#100. The taxes paya,!e on the
home on 2une +0# )011 are /4#000.
14-44
Fisre'ar% !oan-re!ate% fees not mentione% a,o.e.
14-4-
7f the coup!e %oes not ,uy a home# they wi!! put their money into their sa.in's
account where they earn - percent annua! interest.
Assume a!! unstate% costs are equa! ,etween the ,uy an% rent option.
!e"#ired$ He!p the 2aco,ys with their %ecisions ,y answerin' the fo!!owin' questions<
a. 7f the 2aco,ys %eci%e to rent the home# what is their after-tax cost of the renta! for the first
year(
,. *hat is the approximate ,rea"-e.en point in years :or months; for payin' the points to
recei.e a re%uce% interest rate :to simp!ify this computation# assume the 2aco,ys wi!! ma"e
interest-on!y payments an% i'nore the time .a!ue of money;(
c. *hat is the after-tax cost of the interest expense an% property taxes of !i.in' in the home
for )010( Assume that the 2aco,y5s interest rate is -.8- percent# they %o not pay %iscount
points# they ma"e interest-on!y payments for the first year# an% the .a!ue of the home %oes
not chan'e %urin' the year. A!so consi%er the after-tax cost of the property tax :i'nore the
time .a!ue of money; they must pay ,ecause they !i.e% in the home %urin' )010 :not
necessari!y paya,!e in )010;. Dina!!y# assume the 2aco,ys se!! the home as %escri,e% in part
%.
%. Assume that on 4arch 1# )011# the 2aco,ys so!% their home for /-)-#000# so that Fere"
an% 4ea'an cou!% accept Co, opportunities in a %ifferent state. The 2aco,ys use% the sa!e
procee%s to :1; pay off the /400#000 principa! of the mort'a'e# :); pay a /10#000
commission to their rea! estate ,ro"er# an% :+; ma"e a %own payment on a new home in the
%ifferent state. Howe.er# the new home cost on!y /+00#000. *hat 'ain or !oss %o the
2aco,ys rea!i=e an% reco'ni=e on the sa!e of their home an% what amount of taxes must they
pay on the 'ain# if any :assume they ma"e interest on!y payments on the !oan;(
e. Assume the same facts as in :%;# except that the 2aco,ys se!! their home for /4-0#000 an%
they pay a /8#-00 commission. *hat effect %oes the sa!e ha.e on their )011 income tax
!ia,i!ity( Eeca!! that the 2aco,ys are su,Cect to an or%inary mar'ina! tax rate of )- percent
an% assume that they %o not ha.e any other transactions in.o!.in' capita! assets in )011.
a. +,/,)66, computed as follows:
/ent t0e 1ome
()* #onthly rent (+,,,&'*
(,* otal rent payments for the year (,-,'''* ()* @ ), months
(.* 8nterest earned on inheritance .,-&' +-&,''' @ &;
(/* axes on earnings (K.6* (.* @ ,&;
(&* 4fter!tax interest earnings ,,6), (.* O (/*
,otal after-tax cost of rentin2 for first year $$24,188& (,* A (&*
14-41
,. ).L years ()K., months*, computed as follows:
Loan summary: +/'','''< &.-&; rate with no
points. /.&; rate with , points (+6,'''*. 4ssume the
>acobys pay interest only for first three years.
()* 8nitial cash outflow from paying points (+6,'''* +/'',''' @ ,;
(,* ax benefit from deducting points O ,,''' ()* @ ,&;
(.* 4fter!tax cost of points (+L,'''* ()* O (,*
(/* ?efore!tax savings per year from /.&; vs. &.-&;
interest rate
+&,''' P+/'',''' @ (&.-&;
! /.&;*Q
(&* Forgone tax benefit per year of higher interest
rate
(+),,&'* (/* @ ,&;
(L* 4fter!tax savings per year of /.&; vs. &.-&;
interest rate
+.,-&' (/* O (&*
?reak!even point in years (months* ).L years
()K.,
months*
(.* E (L*
c. +,',)'', computed as follows:
()* #arginal tax rate ,&;
(,* #ortgage principal +/'','''
(.* #ortgage interest rate &.-&;
(/* First year interest payment (,.,'''* (,* @ (.*
(&* ax savings from interest payments &,-&' ()* @ (/*
(L* 4fter!tax cost of interest payments ()-,,&'* (/* O (&*
(-* 5eductible property taxes for year (.,6''* +),6'' (+.,L'' x LE), for
>an. year ) through >une
year )* O ,,''' (/,''' x
LE), for >uly year )
through 5ec. year )*
(6* ax savings from property tax deduction K&' ()* @ (-*
(K* 4fter!tax cost of real property taxes (,,6&'* (-* O (6*
After-tax cost of -uyin2 0ome for 2010 (+,',)''* (L* O (K*
0ote that the >acobys do not %ualify for the first!time home buyer credit because they sold the
home within .L months of purchasing it.
14-48
%. +/',''' gain reali9ed< +' recogni9ed gain< +' taxes payable on gain, computed as
follows:
()* 7ales proceeds +&,&,'''
(,* 7ales commission ()','''*
(.* 4mount reali9ed +&)&,''' ()* O (,*
(/* ?asis in home (/-&,'''* 8nitial purchase price. 4ssumes interest
only payments on mortgage
(&* Hain reali9ed +/',''' (.* O (/*
(L* Jxclusion for sale of home (/','''* ?ecause after )/ months the >acobys
moved for work reasons, they %ualify for a
maximum exclusion on their home of
+,K),LL- (+&'',''' @ )/E,/*
(-* Hain recogni9ed and taxes
payable on gain
+' (&* A (L*, no gain, no taxes on the gain.
e. +.,,&'' loss reali9ed< +' recogni9ed loss< +' tax benefit from loss, computed as
follows:
()* 7ales proceeds +/&','''
(,* 7ales commission (-,&''*
(.* 4mount reali9ed +//,,&'' ()* O (,*
(/* ?asis in home (/-&,'''* 8nitial purchase price. 4ssumes interest
only payments on mortgage
(&* Coss reali9ed (.,,&''* (.* O (/*
Jffect of loss on >acobys tax
liability
+' Coss not deductible because it is a personal
loss so no effect on tax liability.
1?. 2ames an% Gate awyer were marrie% on 3ew Kears 6.e of )00?. 9efore their marria'e#
Gate !i.e% in 3ew Kor" an% wor"e% as a hair sty!ist for one of the city5s top sa!ons. 2ames
!i.es in At!anta where he wor"s for a pu,!ic accountin' firm earnin' an annua! sa!ary of
/100#000. After their marria'e# Gate !eft her Co, in 3ew Kor" an% mo.e% into the coup!e5s
new!y purchase% +#)00-square-foot home in At!anta. Gate incurre% /)#)00 of qua!ifie%
mo.in' expenses. The coup!e purchase% the home on 2anuary +# )010 ,y payin' /100#000
%own an% o,tainin' a /)40#000 mort'a'e for the remain%er. The interest rate on this !oan
was 8 percent an% the awyers ma%e interest-on!y payments on the !oan throu'h 2une +0#
)010 :assume they pai% exact!y one-ha!f of a year5s worth of interest expense on the !oan ,y
2une +0;. On 2u!y 1# )010# ,ecause the .a!ue of their home ha% increase% to /400#000# the
awyers were in nee% of cash# an% interest rates ha% %roppe%# the awyers refinance% their
home !oan. On the refinancin'# they ,orrowe% /+80#000 at 1 percent interest. They ma%e
interest-on!y payments on the home !oan throu'h the en% of the year an% they spent /)0#000
of the !oan procee%s impro.in' their home :assume they pai% exact!y one-ha!f of a year5s
worth of interest on this !oan ,y year en%;.
14-4>
Gate wante% to try her han% at ma"in' it on her own in ,usiness# an% with 2ames5s he!p# she
starte% Gate5s 9eauty Cuts LLC. he set up shop in a +>4-square-foot corner room of the
coup!e5s home an% ,e'an to 'et it rea%y for ,usiness. The room con.enient!y ha% a %oor to
the outsi%e pro.i%in' customers %irect access to the shop. 9efore she opene% the %oors to the
,usiness# Gate pai% /)#100 to ha.e the carpet rep!ace% with a ti!e f!oor. he a!so pai% /1#)00
to ha.e the room painte% with .i,rant co!ors an% /1-0 to ha.e the room rewire% for
appropriate !i'htin'. Gate ran an a% in the !oca! newspaper an% officia!!y opene% her shop on
2anuary )4# )010. 9y the en% of the year# Gate5s 9eauty Cuts LLC 'enerate% /40#000 of net
income ,efore consi%erin' the home office %e%uction. The awyers incurre% the fo!!owin'
home-re!ate% expen%itures %urin' )010<
/4#)00 of rea! property taxes.
/)#000 for homeowner5s insurance.
/)#400 for e!ectricity.
/1#-00 for 'as an% other uti!ities.
They %etermine% %epreciation expense for their entire house was /8#+00.
A!so# on 4arch )# Gate was a,!e to fina!!y se!! her one-,e%room 4anhattan
con%ominium for /48>#000. he purchase% the con%o# which she ha% !i.e% in for six years
prior to her marria'e# for /)0-#000.
Gate owns a .acation home in 4yrt!e 9each# outh Caro!ina. he purchase% the home
se.era! years a'o# !ar'e!y as an in.estment opportunity. To he!p co.er the expenses of
maintainin' the home# 2ames an% Gate %eci%e% to rent the home out. They rente% the home
for a tota! of 101 %ays at fair mar"et .a!ue :this inc!u%e% ei'ht %ays that they rente% the home
to 2ames5s ,rother 2ac";. 7n a%%ition to the 101 %ays# Gate a!!owe% a 'oo% frien% an%
customer# C!air# to stay in the home for ha!f-price for two %ays. 2ames an% Gate staye% in the
home for six %ays for a romantic 'etaway an% another three %ays in or%er to %o some repair
an% maintenance wor" on the home. The renta! re.enues from the home in )010 were
/1>#400. The awyers incurre% the fo!!owin' expenses associate% with the home.
/?#100 of interest expense.
/+#400 of rea! property taxes.
/1#?00 for homeowner5s insurance.
/1#)00 for e!ectricity.
/1#100 for 'as# other uti!ities# an% !an%scapin'.
/-#)00 for %epreciation.
!e"#ired$ Fetermine the awyer5s taxa,!e income for )010. Fisre'ar% se!f-emp!oyment
taxes for Gate an% %isre'ar% the phase-out of itemi=e% %e%uctions. Assume the coup!e pai%
/4#400 in state income taxes an% fi!es a Coint return. The awyers use the metho% of
a!!ocatin' expenses to the renta! that minimi=es their overall taxable income for ,')'.
14-4?
>ames and Date have taxable income of +))-,&,'. 7ee the analysis below.
,otal income
>amess 7alary +)'','''
Dates 7chedule 3 income before
home office deduction
/','''
=ome!office deduction (for 4H8* (6,./,* 7ee 0ote 4 below for computation
Ient revenue )6,/''
Iental expenses (for 4H8* (),,''&* ax court method allows more total
deductions for year (+K.- more in
deductions*< 7ee 0ote ? below for
computation
Hain on sale of principal residence
after exclusion
,.,''' +/-6,''' A ,'&,''' F +,-.,''' gain
minus ,&',''' exclusion
$1& ,otal income +)L),'&.
(,* #oving expenses (,,,''*
(.* A34 +)&6,6&. ()*O (,*
8temi9ed deductions:
7tate income taxes (/,/''*
Ieal property taxes on principal
residence
(.,LKL* +/,,'' A &'/ (deducted as home office
expense* F +.,LKL
Ieal property taxes on
vacationErental home
(,,/&K* +.,/'' A K/)(deducted as rental
expense* F+,,/&K
=ome mortgage interest expense on
principal residence
()L,6KL* +)K,,'' A ,,.'/ (deducted as home
office expense* F +)L,6KL
=ome mortgage interest expense on
vacationErental home
(L,&6
,*
+K,)'' A ,,&)6 (deducted as rental
expense* F +L,&6,
(/* otal itemi9ed deductions (./,'..* 7tandard deduction for #F> is +)),/''
O +),''' (non!itemi9er property tax*, so
>ames and Date deduct itemi9ed
deductions.
(&* Gersonal and dependency
exemptions
(-,.''* +.,L&' x , F +-,.''
(L* otal from 4H8 deductions (/),...* (/* O (&*
,axa-le income $117,.20 (.* O (L*
14--0
+ote A: =ome office deduction computation
1ome 5ffice De6uction
,ype
$A&
Amount
$!&
5ffice 7
$%84'%,200
for in6irect&
$A& x $!&
1ome office
Expense
0ew flooring 5irect +,,)'' )''; +,,)''
0ew paint for office 5irect ),,'' )''; ),,''
0ew office lighting 5irect L&' )''; L&'
Ieal property taxes 8ndirect /,,'' ),; &'/
=ome interest expenseV 8ndirect )K,,'' ),; ,,.'/
"tilities 8ndirect .,K'' ),; /L6
=omeowners insurance 8ndirect ,,''' ),; ,/'
5epreciation 8ndirect -,.'' ),; 6-L
otal expenses +/',&&' $8,%42
Votal interest expense for the year is computed as follows:
First loan: +,/',''' @ -; x W of a year F +6,/''.
7econd loan: +,/',''' of initial ac%uisition debt plus +,',''' of refinanced loan to improve
home plus +)'',''' of home e%uity debt e%uals +.L',''' of %ualifying debt (interest on
+)',''' of the +.-',''' loan is not deductible*. +.L',''' x L; @ W F +)',6''.
otal interest expense F +)K,,'' (+6,/'' from loan ) O +)',6'' from loan ,*.
+ote !: Iental expenses: he 7awyers used the rental home as follows: Iental days: )')
(K6 rental to unrelated parties at fair market value O . maintenance*< Gersonal days: )L
days (L vacation days O 6 rented to brother O , rented at less than fair market value*.
?ecause personal use of )L is more than the greater of ()* )& days or (,*)'; of the number
of rental days ()'.)*, their residence %ualifies as property with significant personal and
significant rental use (mixed use or vacation home*Rthis means deductions are limited to
gross rental income. ?ecause the ax 3ourt method allows them to deduct +K.- more
deductions overall (rental O personal taxes and interest*, they use the ax 3ourt method to
determine their deductions from the rental.
/ental 1ome Expense Allocation
Allocation met0o6 to
rental use
Expense Amount ,ier
4/8 met0o6
$101'117&
,ax ourt
met0o6
$101'%(. tier 1
101'117 ot0er&
8nterest +K,)'' ) +-,6&L +,,&)6
Ieal estate taxes .,/'' ) ,,K.& K/)
,otal tier 1 expenses $12,.00 1 $10,791 $%,4.9
Jlectricity ),,'' , ),'.L ),'.L
HasEother utilities and landscaping ),L'' , ),.6) ),.6)
8nsurance ),K'' , ),L/' ),L/'
,otal tier 2 expenses $4,700 2 $4,0.7 $4,0.7
5epreciation (tier .* &,,'' % /,/6K /,/6K
otal Jxpenses on property +,,,/''
14--1
+et income from rental 4/8
met0o6
,ax ourt
met0o6
Iental receipts +)6,/'' +)6,/''
Cess tier ) expenses ()',-K)* (.,/&K*
8ncome after tier ) expenses -,L'K )/,K/)
Cess tier , expenses (/,'&-* (/,'&-*
8ncome after tier , expenses .,&&, )',66/
Cess: tier . expenses (.,&&,* (/,/6K*
,axa-le rental income $0 $(,%9.
5eductible personal use expenses
(interest and property taxes*
+),-'K +K,'/)
5eductible rental expenses (sum of
tier ) , ,, and . expenses* (for 4H8*
)6,/'' 12,00.
5epreciation expense carried over to
next year
K.- '
otal deductions associated with
property (for and from*
+,',)'K +,),'/L
14--)

Solutions Manual: Tax Consequences of Home Ownership

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Chapter 14 - Tax Consequences of Home Ownership

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