28.

CHAPTER 3
Compute 2015 taxable income in each of the following independent situations.
a. Drew and Meg, ages 40 and 41 respectively, are married and file a joint return. In addition to four dependent children, they have AGI of $65,000 and itemized
deductions of $15,000.
AGI

$65,000
(15,000)

Less: Itemized deductions

Personal and dependency exemptions (6 $4,000)
Taxable income

(24,000)
$26,000

b. Sybil, age 40, is single and supports her dependent parents, who live with her. Sybil also supports her grandfather, who lives in a nursing home. She has AGI of
$80,000 and itemized deductions of $8,000.
AGI
Less: Standard deduction (head of household)
Personal and dependency exemptions (4 $4,000)
Taxable income

$80,000
(9,250)
(16,000)
$54,750

c. Scott, age 49, is a surviving spouse. His household includes two unmarried stepsons who qualify as his dependents. He has AGI of $75,000 and itemized deductions
of $10,100.
AGI

$75,000
(12,600)

Less: Standard deduction (surviving spouse)

Personal and dependency exemptions (3 $4,000)
Taxable income

(12,000)
$50,400

d. Amelia, age 33, is an abandoned spouse and maintains a household for her three dependent children. She has AGI of $58,000 and itemized deductions of $9,500.
AGI

$58,000
(9,500)

Less: Itemized deductions

Personal and dependency exemptions (4 $4,000)
Taxable income

(16,000)
$32,500

e. Dale, age 42, is divorced but maintains the home in which he and his daughter, Jill, live. Jill is single and qualifies as Dales dependent. Dale has AGI of $64,000 and
itemized deductions of $9,900.
AGI
$64,000
Less: Itemized deductions
(9,900)
Personal and dependency exemptions (2 $4,000)
(8,000)
Taxable income
$46,100
29.

(LO 1, 8)
Compute Emilys 2015 taxable income on the basis of the following information. Her filing status is single.
Salary

$85,000

Interest income from bonds issued by Xerox

1,100

Alimony payments received

Contribution to traditional IRA

6,000
5,500

Gift from parents

25,000

Capital gain from stock investment, held for 7 months

2,000

Amount lost in football office betting pool

500

Number of potential dependents (two cousins, who live in Canada)

Age

40

Salary
Interest on bonds
Alimony received
Capital gain
IRA contribution
AGI
Standard deduction
Personal and dependency exemptions (1 $4,000)
Taxable income

$85,000
1,100
6,000
2,000
(5,500)
$88,600
(6,300)
(4,000)
$78,300

The alimony payments and bond interest are taxable. The gift is a nontaxable exclusion. The $2,000 of the capital gain is taxable. Net gambling losses are
not deductible. Cousins do not meet the relationship test.

30.
Compute Aidens 2015 taxable income on the basis of the following information. Aiden is married but has not seen or heard from his wife for over three
years.
Salary
$80,000
Interest on bonds issued by City of Boston
3,000

Interest on CD issued by Wells Fargo Bank

Cash dividend received on Chevron common stock
Life insurance proceeds paid due to the death of Aunt Margie (Aiden was the designated beneficiary of the policy)
Inheritance received on death of Aunt Margie
Jackson (a cousin) repaid a loan Aiden made to him in 2012 (no interest was provided for)
Itemized deductions (state income tax, property taxes on residence, interest on home mortgage, charitable contributions)
Number of dependents (children, ages 17 and 18; mother-in-law, age 60)

2,000
2,000
200,000
100,000
5,000
9,700
3

Age

43

Salary
Interest on CD
Dividend
AGI
Itemized deductions
Personal and dependency exemptions (4 $4,000)
Taxable income

$80,000
2,000
2,200
$84,200
(9,700)
(16,000)
$58,500

The interest ($3,000) on the bonds is not taxable. Excluded from gross income are the life insurance proceeds ($200,000) and the inheritance ($100,000).
The loan repayment ($5,000) is a nontaxable return of capital. Aiden chose to itemize his deductions from AGI ($9,700) because it provided a greater
deduction than did head of household (as an abandoned spouse; $9,250).

31.
a.

Determine the amount of the 2015 standard deduction allowed in the following independent situations. In each case, assume that the taxpayer is claimed as another
persons dependent.
Curtis, age 18, has income as follows: $700 interest from a certificate of deposit and $6,100 from repairing cars.
$6,300. Although $6,100 (earned income) + $350 = $6,450, the amount allowed cannot exceed the standard deduction available in 2015 for single taxpayers.

b.

Mattie, age 18, has income as follows: $600 cash dividends from a stock investment and $4,700 from handling a paper route.
$5,050. $4,700 (earned income) + $350.

c.

Mel, age 16, has income as follows: $675 interest on a bank savings account and $800 for painting a neighbors fence.
$1,150. The greater of $1,050 or $1,150 [$800 (earned income) + $350].

d.

Lucy, age 15, has income as follows: $400 cash dividends from a stock investment and $500 from grooming pets.
$1,050. The greater of $1,050 or $850 [$500 (earned income) + $350].

e.

Sarah, age 67 and a widow, has income as follows: $500 from a bank savings account and $3,200 from babysitting.
$5,100. $3,200 (earned income) + $350 + $1,550 (additional standard deduction).

32.

j.

(LO 4)
Taxpayers son has gross income of $7,000.
QC. Cannot be QR due to the gross income test.
Taxpayers niece has gross income of $3,000.
B.
Taxpayers uncle lives with him.
QR. An uncle cannot be a QC.
Taxpayers daughter is age 25 and disabled
B.
Taxpayers daughter is age 18 but does not live with him. Her gross income is $8,000.
N. Cannot be a QC due to the abode test. Cannot be a QR due to the gross income test.
Taxpayers cousin does not live with her.
N.
Taxpayers brother does not live with her.
QR.
Taxpayers sister lives with him. She is age 17 and has dropped out of school.
B.
Taxpayers older nephew is age 23 and a full-time student.
QR. A qualifying child cannot be older than the taxpayer.
Taxpayers grandson lives with her. His gross income is $7,000.
QC. Cannot be a QR due to the gross income test.

33.

(LO 3, 4) Determine the number of personal and dependency exemptions in each of the following independent situations.

a.
b.
c.
d.
e.
f.
g.
h.
i.

a.

Leo and Amanda (ages 48 and 46, respectively) are husband and wife and furnish more than 50% of the support of their two children, Elton (age 18) and Trista (age 24).
During the year, Elton earns $4,500 providing transportation for elderly persons with disabilities, and Trista receives a $5,000 scholarship for tuition at the law school
she attends.
Four. Two personal and two dependency exemptions. Elton is a qualifying child, so his gross income does not matter. Trista is not a qualifying childalthough a fulltime student, she is not under age 24. However, Trista falls within the qualifying relative category. She passes the gross income test because the tuition portion of a
scholarship is nontaxable.

b.

c.

d.
34.

Audrey (age 45) is divorced this year. She maintains a household in which she, her ex-husband, Clint, and his mother, Olive, live. Audrey furnishes more than 50% of
the households support. Olive is age 91 and blind.
Two. One personal and one dependency exemption. Clint cannot qualify as a member of
Audrys household in the year of the divorce. Olive meets the relationship test.
Crystal, age 45, furnishes more than 50% of the support of her married son, Andy (age 18), and his wife, Paige (age 19), who live with her. During the year, Andy
earned $8,000 from a part-time job. All parties live in Iowa (a common law state).
Three. One personal and two dependency exemptions. Because Andy is a qualified child, he is not subject to the gross income test. Paige meets the gross income
requirements of a qualifying relative.
Assume the same facts as in (c), except that all parties live in Washington (a community property state).
Two. One personal and one dependency exemption. As a qualifying child, Andy is still immune from the gross income test. In a community property situation, however,
Paige is treated as having $4,000 in gross income. Thus, she does not meet the gross income test and cannot be a qualifying relative.

a.

Determine the number of personal and dependency exemptions in each of the following independent situations.
Reginald, a U.S. citizen and resident, contributes 100% of the support of his parents, who are citizens of Canada and live there.
Three. The parents qualify as dependents under the Mexico/Canada exception.

b.

Pablo, a U.S. citizen and resident, contributes 100% of the support of his parents, who are citizens of Panama. Pablos father is a resident of Panama, and his mother is a
legal resident of the United States.
Two. Pablos father does not qualify because he is a citizen and resident of Panama; as a resident of the United States, Pablos mother does qualify.

c.
35.
a.

b.

c.

d.

36.

Gretchen, a U.S. citizen and resident, contributes 100% of the support of her parents, who are U.S. citizens but are residents of Germany.
Three. The parents qualify because they are U.S. citizens.
Determine how many personal and dependency exemptions are available in each of the following independent situations. Specify whether any such exemptions would
come under the qualifying child or the qualifying relative category.
Andy maintains a household that includes a cousin (age 12), a niece (age 18), and a son (age 26). All are full-time students. Andy furnishes all of their support.
Four. The niece is in the qualifying child category. The cousin and son are not, due to the relationship and age tests. They both fall within the qualifying relative
category.
Jackie provides all of the support of a family friends son (age 20) who lives with her. She also furnishes most of the support of her stepmother, who does not live with
her.
Three. Both persons fall within the qualifying relative category. The stepmother meets the relationship test, and the family friends son is a member of the taxpayers
household.
Raul, a U.S. citizen, lives in Costa Rica. Rauls household includes his friend Helena, who is age 19 and a citizen of Costa Rica. Raul provides all of Helenas support.
One. Helena is not a qualifying child under the exception to the citizenship or residency test. Raul is not her adoptive father.
Karen maintains a household that includes her ex-husband, her mother-inlaw, and her brother-in-law (age 23 and not a full-time student). Karen provides more than half
of all of their support. Karen is single and was divorced last year.
Four. Two fall within the qualifying relative category, and it is assumed that each meets the gross income test. The mother- and brother-in-law satisfy the relationship
test. Although the ex-husband is a member of the household, he can qualify except in the year of the divorce. The brother-in-laws age and non-student status have no
bearing on the dependency issue.
Jenny, age 14, lives in a household with her father, uncle, and grandmother. The household is maintained by the uncle. The parties, all of whom file their own Federal
income tax returns, report AGI as follows: father ($30,000), uncle ($50,000), and grandmother ($40,000).

a.

Who is eligible to claim Jenny as a dependent on a Federal income tax return?

Jenny is a qualifying child as to all three parties. Therefore, the father, uncle, and grandmother are eligible to claim her as a dependent.

b.

Which of Jennys relatives takes precedence in claiming the exemption? Explain.

In this tiebreaker situation, the father (as parent) takes preference. If the father forgoes the exemption, the uncle is next in order of preference, due to a higher AGI.
38.

(LO 4, 9) Wesley and Myrtle (ages 90 and 88, respectively) live in an assisted care facility and for years 2015 and 2016 received their support from the following
sources.
Percentage of Support
Social Security benefits
16%
Son
20
Niece
29
Cousin
12
Brother
11
Family friend (not related)
12

Who is eligible to claim the Federal income tax dependency exemptions under a multiple support agreement?
a.
Son, niece, and brother. The cousin and the family friend do not meet the relationship test.
Must Wesley and Myrtle be claimed as dependents by the same person(s) for both tax years? Explain.
b.
No. The eligible parties can rotate the exemptions as they choose.
Who, if anyone, can claim an itemized deduction for paying the medical expenses of Wesley and Myrtle?
c.
If the eligible person who is awarded the exemption also pays the medical expenses, that person can claim them.
39. (LO 5) In each of the following independent situations, determine Winstons filing status. Winston is not married.
Winston lives alone, but he maintains a household in which his parents live. The mother qualifies as Winstons dependent, but the father does not.
a.
Winston qualifies for head-of-household filing status as long as one parent is his dependent.

Winston lives alone, but he maintains a household in which his married daughter, Karin, lives. Both Karin and her husband (Winstons son-in-law) qualify as Winstons
dependents.
b.
Winston must use single filing status. Except in the case of parents, head-of-household status requires that the dependent be a member of the
taxpayers household.
Winston maintains a household in which he and a family friend, Ward, live. Ward qualifies as Winstons dependent.
c.
The dependent must meet the relationship test. Therefore, Winston must use single filing status.
Winston maintains a household in which he and his mother-in-law live. Winstons wife died last year.
d.
Winston can qualify for head of household if the mother-in-law is his dependent. He does not meet the requirements of a surviving spouse
because a mother-in-law is not a child.
Same as (d), except that Winstons wife disappeared (i.e., she did not die) two years ago.
e.
Because Winston is still married, he cannot use head-of-household filing status. (He does not satisfy the requirements of an abandoned
spousea mother-in-law is not a child). Consequently, Winston must use married filing separately filing status.
40.

(LO 4, 5) Christopher died in 2013 and is survived by his wife, Chloe, and their 18year-old son, Dylan. Chloe is the executor of Christophers estate and maintains
the household in which she and Dylan live. All of their support is furnished by Chloe. Dylan saves his earnings. Dylan reports the following information.
Year
Earnings
Student?
2013
5,000
Yes
2014
7,000
No
2015
6,000
Yes
What is Chloes Federal income tax filing status for:
a.
For 2013, Chloe should file a joint return. Because she is the executor of Christophers estate, she can consent on his behalf to file jointly.
Being under 19 years of age, her son is a qualifying child. Thus, she can claim three exemptionstwo personal and one dependency.
b.
For 2014, Chloe must file as single. She is not a surviving spouse because she cannot claim Dylan as a dependent. Dylan is not a qualifying
child (due to the age test) and is not a qualifying relative (due to the gross income test).
c.
For 2015, Chloe is a surviving spouse. She can claim Dylan as a dependent. Dylan is a qualifying childalthough not under age 19, he is a
full-time student. As a qualifying child, he is not subject to the gross income test.

41.

(LO 3, 4, 5) Nadia died in 2014 and is survived by her husband, Jerold (age 44); her married son, Travis (age 22); and her daughter-in-law, Macy (age 18). Jerold
is the executor of his wifes estate. He maintains the household where he, Travis, and Macy live, and Jerold furnished all of their support. During 2014 and 2015,
Travis is a full-time student, while Macy earns $7,000 each year from a parttime job. Travis and Macy do not file jointly during either year.

What is Jerolds Federal income tax filing status for 2014 and 2015 if all parties reside in:
Idaho (a community property state)?
a.
For 2014, Jerold can file a joint return. As executor of Nadias estate, he can issue a consent on her behalf. For 2015, Jerold can qualify as a
surviving spouse. Travis is a qualifying child due to his student status, and Macy is a qualifying relativeher gross income of $3,500 (50%
$7,000) meets the gross income test. Thus, Jerold has three exemptionsone personal and two dependency.
Kansas (a common law state)?
b.
The answer as to filing status does not change: joint return for 2014 and surviving spouse for 2015. Kansas is a common law state, so all of
the $7,000 Macy earns is assigned to her. Travis is a qualifying child. Macy will not be a dependent under the qualifying relative category
because of the gross income test. Thus, Jerold will have two exemptions.
43.

(LO 1, 2, 3, 4, 5, 6) Using the Tax Rate Schedules, compute the 2015 tax liability for Charlotte. Charlotte (age 40) is a surviving spouse and provides all of the
support of her four minor children, who live with her. Charlotte also maintains the household in which her parents live, and she furnished 60% of their support.
Besides interest on City of Miami bonds in the amount of $5,500, Charlottes father received $2,400 from a part-time job. Charlotte earns an $80,000 salary, a
short-term capital loss of $2,000, and a cash prize of $4,000 at a church raffle. Charlotte reports itemized deductions of $10,500.
Salary
Short-term capital loss
Cash prize
AGI
Less: Personal and dependency exemptions (7 $4,000)
Standard deduction
Taxable income
Tax on $41,400 using surviving spouse rate schedule:
$1,845.00 + 15%($41,400 $18,450) = $5,287.50.
The father does not fail the gross income test because tax-exempt income is not counted.

44.

$80,000
(2,000)
4,000
$82,000
(28,000)
(12,600)
$41,400

(LO 1, 2, 3, 4, 5, 6, 8) Use the Tax Rate Schedules to compute Morgans 2015 Federal income tax liability. Morgan (age 45) is single and provides more than 50%
of the support of Rosalyn (a family friend, age 36), Flo (a niece, age 18), and Jerold (a nephew, age 18). Both Rosalyn and Flo live with Morgan, but Jerold (a
citizen of France) lives in Canada. Morgan earns a $95,000 salary, contributes $5,000 to a traditional IRA, and receives sales proceeds of $15,000 for an RV that
cost $60,000 and was used only for vacations. She has $8,200 in itemized deductions.
Gross income
Contribution to traditional IRA
AGI
Less: Personal and dependency exemptions (4 $4,000)
Standard deduction
Taxable income
Tax on $64,750 using head-of-household rate schedule:
$6,872.50 + 25%($64,750 $50,200) = $10,510.00.

$95,000
(5,000)
$90,000
(16,000)
(9,250)
$64,750

Although Rosalyn does not meet the relationship test, she is a member of Morgans household. Jerold and Flo meet the relationship test. Although Jerold is not a U.S.
citizen or a resident, he is a resident of Canada.

CHAPTER 4
21. Bigham Corporation, an accrual basis calendar year taxpayer, sells its services under 12-month, and 24-month contracts. The corporation provides services
to each customer every month. On July 1, 2015, Bigham sold the following customer contracts: and Determine the income to be recognized in taxable
income in 2015 and 2016.
Length of Contract
Total Proceeds
12 months

14,000
Length of Contract
24,000
12 months
24 months

24 months

2015 Income
a.
b.

2016 Income
c.
d.

Revenue Procedure 200434 permits an accrual basis taxpayer to defer recognition of income for advance payments for services, goods and a few other items to be
earned after the end of the tax year of receipt. The portion of the advance payment that relates to services performed in the tax year of receipt is included in gross
income in the tax year of receipt, matching what is reported in the taxpayer's financial statements for that year. The portion of the advance payment that relates to
services to be performed after the tax year of receipt is included in gross income in the subsequent tax year.
Revenue Procedure 200434 does not apply to prepaid rent or prepaid interest. Advance payments for these items are always taxed in the year of receipt.
Length of Contract

2015 Income

12 months
24 months

2016 Income

a. $14,000 6/12 = $7,000

b. $24,000 6/24= $6,000

c. $14,000 6/12 = $7,000

d. $24,000 18/24 = $18,000

Note that for the 24-month contracts, Bigham will only report $12,000 on its 2016 financial statements. The remaining $6,000 is reported on Bighams 2017
financial statements. Rev.Proc. 200434 does not allow for deferral beyond the year subsequent to the year the advance payment was received.
22.

Simba and Zola are married but file separate returns. Simba received $80,000 of salary and $1,200 of taxable dividends on stock he purchased in his name
and paid from the salary that he earned since the marriage. Zola collected $900 in taxable interest on certificate of deposit that she inherited from her aunt.
Compute Zolas gross income under two assumptions as to the state of residency of the couple. If an amount is zero, enter $0.
Idaho (Community Property State)
a.
b.
c.

Dividends
Interest
Salary

South Carolina (Common Law State)

d.
e.
f.

Under a community property system, all property is deemed either to be separately owned by the spouse or to belong to the marital community. Property may be held
separately by a spouse if it was acquired before marriage or received by gift or inheritance following marriage. Otherwise, any property is deemed to be community
property. For Federal tax purposes, each spouse is taxed on one-half of the income from property belonging to the community. The laws of Texas, Louisiana,
Wisconsin, and Idaho distinguish between separate property and the income it produces. In these states, the income from separate property belongs to the community.
Accordingly, for Federal income tax purposes, each spouse is taxed on one-half of the income. In the remaining community property states, separate property produces
separate income that the owner-spouse must report on his or her Federal income tax return.
In all community property states, income from personal services (e.g., salaries, wages, and income from a professional partnership) is generally treated as if
one-half is earned by each spouse.
Idaho
(Community Property State)
Dividends a.
b. $ 900
c. $40,000

600

South Carolina
(Common Law State)
d. $

e. $900
f. $ 0

Interest
Salary

Note that the stock is a community asset because it was created with community funds (i.e., Simbas salary).

23.

Casper and Cecile are divorced this year. As part of the divorce settlement, Casper transferred stock to Cecile. Casper purchased the stock for $25,000, and
it had a market value of $43,000 on the date of the transfer. Cecile sold the stock for $40,000 a month after receiving it. In addition Casper is required to pay
Cecile $1,500 a month in alimony

24.

. He made five payments to her during the year. What are the tax consequences for Casper and Cecile regarding these transactions?

Alimony and separate maintenance payments are deductible by the party making the payments and are includible in the gross income of the party receiving the
payments. Thus, income is shifted from the income earner to the income beneficiary, who is better able to pay the tax on the amount received.
A transfer of property other than cash to a former spouse under a divorce decree or agreement is not a taxable event. The transferor is not entitled to a deduction and
does not recognize gain or loss on the transfer. The transferee does not recognize income and has a cost basis equal to the transferors basis.
How much gain or loss does Casper recognize on the transfer of the stock?
a.
Casper is not required to recognize gain on the transfer of the stock.

Does Casper receive a deduction for the $7,500 alimony paid?

b.

Yes. Casper may deduct the $7,500 of alimony paid.

How much income does Cecile have from the $7,500 alimony received?
c.

Cecile has $7,500 of income from the alimony received.

When Cecile sells the stock, how much does she report?
d.

25.

Cecile has a realized and recognized capital gain of $15,000 ($40,000 sales price $25,000 carryover basis) when she sells the stock.

Elizabeth made the following interest-free loans during the year. Assume that tax avoidance is not a principal purpose of any of the loans. Assume that the
relevant Federal rate is 5% and that the loans were outstanding for the last six months of the year.
Borrower
Amount
Borrowers Net Investment Income
Purpose of Loan
Richard
5,000
800
Gift
Woody
8,000
600
Purchase Stock
Irene
105,000
-0Purchase Residence

If interest is charged on the loan but is less than the Federal rate, the imputed interest is the difference between the amount that would have been charged at the Federal
rate and the amount actually charged.
What are the effects of the imputed interest rules on these transactions? Compute Elizabeths gross income from each loan:
The imputed interest rules apply to the following types of below-market loans:
1.

Richard: Gift loans (made out of love, affection, or generosity).

2.

Woody: Compensation-related loans (employer loans to employees).

3.

Irene: Corporation-shareholder loans (a corporations loans to its shareholders).

No interest is imputed on total outstanding gift loans of $10,000 or less between individuals, unless the loan proceeds are used to purchase incomeproducing property. This exemption eliminates immaterial amounts that do not result in apparent shifts of income. However, if the proceeds of such a loan
are used to purchase income-producing property, other limitations apply instead.
On loans of $100,000 or less between individuals, the imputed interest cannot exceed the borrowers net investment income for the year (gross income from
all investments less the related expenses). Thus, the income imputed to the lender is limited to the borrowers net investment income. In addition, if the
borrowers net investment income for the year does not exceed $1,000, no interest is imputed on loans of $100,000 or less. However, these limitations for
loans of $100,000 or less do not apply if a principal purpose of a loan is tax avoidance.
As with gift loans, there is a $10,000 exemption for compensation-related loans and corporation shareholder loans. However, the $10,000 exception does
not apply if tax avoidance is one of the principal purposes of a loan. This vague tax avoidance standard makes practically all compensation related and
corporation-shareholder loans suspect. Nevertheless, the $10,000 exception should apply when an employees borrowing was necessitated by personal
needs (e.g., to meet unexpected expenses) rather than tax considerations.
a.
In this example, Richard is not subject to the imputed interest rules because the $10,000 exception applies.
b.

The $10,000 exception does not apply to the loan to Woody because the proceeds were used to purchase income-producing assets. However,
under the $100,000 exception, the imputed interest is limited to Woodys investment income ($600). However, the $1,000 exception also applies
to this loan; therefore, no interest is imputed.

c.

None of the exceptions apply to the loan to Irene because the loan was for more than $100,000. Therefore, Elizabeth must recognize $2,625 as
interest income. $105,000 5% 6/12 = $2,625.

37.

(LO 2) Drake Appliance Company, an accrual basis taxpayer, sells home appliances and service contracts. Determine the effect of each of the following
transactions on the companys 2015 gross income assuming that the company uses any available options to defer its taxes.
In December 2014, the company received a $1,200 advance payment from a customer for an appliance that Drake special ordered from the manufacturer. The appliance
did not arrive from the manufacturer until January 2015, and Drake immediately delivered it to the customer. The sale was reported in 2015 for financial accounting
purposes.
a.
The $1,200 is included in the 2015 gross income. The advance payment received in 2014 for goods delivered in 2015 qualifies for deferral
because the company satisfied the tax and financial accounting conformity requirement.
In October 2015, the company sold a 6-month service contract for $240. The company also sold a 36-month service contract for $1,260 in July 2015.
b.
For the sale of the six-month service contract, $120 is included in 2015 gross income ($240 3/6 = $120). The advance payment for services
qualifies for proration over the life of the contract because all of the income will be earned by the end of the tax year following the year of
receipt.
Drake must include in 2015 gross income $210 ($1,260 6/36). Drake would include in 2016 gross income $1,050 ($1,260 $210), the balance
on the contract sold in 2015 for services that would not all be performed by the end of the tax year of receipt. That is, the portion of the advance
payment that relates to services to be performed after the tax year of receipt is included in gross income in the tax year following the tax year of
receipt of the advance payment.

On December 31, 2015, the company sold an appliance for $1,200. The company received$500cash anda notefromthe customer for $700and $260interest,to be paid at
the rate of $40 a month for 24 months. Because of the customers poor credit record, the fair market value of the note was only $600. The cost of the
appliancewas$750.
c.

The company must include $1,200 in gross receipts and can deduct the cost of the appliance, $750, in arriving at gross income of $450. The fair
market value of the note is not relevant for purposes of determining the accrual method taxpayers gross income. The interest of $260 will be
taxed as it accrues over the 24-month life of the contract.

38.

(LO 2, 5) Freda is a cash basis taxpayer. In 2015, she negotiated her salary for 2016. Her employer offered to pay her $21,000 per month in 2016 for a total of
$252,000. Freda countered that she would accept $10,000 each month for the 12 months in 2016 and the remaining $132,000 in January 2017. The employer
accepted Fredas terms for 2016 and 2017.
Did Freda actually or constructively receive $252,000 in 2016?
a.
No. Actual receipt applies to the $120,000 ($10,000 12 months) she received in 2016. The $132,000 deferred income is not constructively
received in 2016 because under the actual contract terms, she did not have the right to receive the income in 2016. The constructive receipt
doctrine cannot change actual events to what might have been done.

What could explain Fredas willingness to spread her salary over a longer period of time?
b.

Freda may have expected to be in a lower marginal tax bracket in 2017. She also benefited by not having to pay the tax on the income shifted
into 2017 until she filed her 2017 income tax return or made payments on estimated taxes for 2017.

In December 2016, after Freda had earned the right to collect the $132,000 in 2017, the employer offered $133,000 to Freda at that time, rather than $132,000 in
January 2017. The employer wanted to make the early payment so as to deduct the expense in 2016. Freda rejected the employers offer. Was Freda in constructive
receipt of the income in 2016? Explain.
c.

Yes. The $132,000 actually received in 2017 was constructively received in 2016 because it was made available to her in that year.

49.

(LO 4) Indicate whether the imputed interest rules should apply in the following situations. Assume that all of the loans were made at the beginning of the tax year
unless otherwise indicated.
Mike loaned his sister $90,000 to buy a new home. Mike did not charge interest on the loan. The Federal rate was 5%. Mikes sister had $900 of investment income for
the year.
a.
This loan is a gift loan between individuals that is eligible for the $100,000 exception. Although Mikes sister has $900 of investment income,
interest is not imputed under this exception if the borrowers net investment income is not greater than $1,000. So the imputed amount is $0.

Sams employer maintains an emergency loan fund for its employees. During the year, Sams wife was very ill, and he incurred unusually large medical expenses. He
borrowed $8,500 from his employers emergency loan fund for six months. The Federal rate was 5.5%. Sam and his wife had no investment income for the year.
b.

This loan is an employer-employee loan for not greater than $10,000. Sam did not use the funds to buy investments, and there appears to be no
tax avoidance motive. Thus, no interest is imputed.

Jody borrowed $25,000 from her controlled corporation for six months. She used the funds to pay her daughters college tuition. The corporation charged Jody 4%
interest. The Federal rate was 5%. Jody had $3,500 of investment income for the year.
c.
Interest is imputed on this loan. The $100,000 exception is not available on corporation shareholder loans. The imputed interest would be
calculated as follows:
$25,000 (5% 4%) 1/2 = $125

Kait loaned her son, Jake, $60,000 for six months. Jake used the $60,000 to pay off college loans. The Federal rate was 5%, and Kait did not charge Jake any interest.
Jake had dividend and interest income of $2,100 for the tax year.
d.

The loan from Kait to Jake is classified as a gift loan between individuals that is eligible for the $100,000 exception. So the imputed interest
income for the six months is calculated as follows:
$60,000 5% 1/2 = $1,500
Under the $100,000 exception, the imputed interest is limited to Jakes net investment income of $2,100. So in this case, the limit has no effect
on the amount of imputed interest.

51.

(LO 4) Pam retires after 28 years of service with her employer. She is 66 years old and has contributed $42,000 to her employers qualified pension fund. She
elects to receive her retirement benefits as an annuity of $3,000 per month for the remainder of her life.

Assume that Pam retires in June 2015 and collects six annuity payments this year. What is her gross income from the annuity payments in the first year?
a.
Cost (her investment) = $42,000

Employees investment
Number of anticipated payments
[Exhibit 4.2]

$42,000
210

Collections in 2015 (6 payments $3,000)

Exclusion for capital recovery ($200 6 payments)
Include in gross income

= $200 exclusion per payment

$18,000
(1,200)
$16,800

The simplified method is used to calculate the annuity exclusion percentage because this is a qualified retirement plan distribution.
Assume that Pam lives 25 years after retiring. What is her gross income from the annuity payments in the twenty-fourth year?
b.
Pam will have recovered her investment as a return of capital prior to the twenty-fourth year (i.e., 17 years and 6 months). Thus, all annuity payments received in
the twenty-fourth year
($36,000) are includible in her gross income.
$3,000 12 payments = $36,000
Assume that Pam dies after collecting 160 payments. She collected eight payments in the year of her death. What are Pams gross income and deductions from the
annuity contract in the year of her death?
c.
Investment in the contract
$42,000
Total amount collected (160 $3,000 = $480,000)
Less: Capital recovered ($200 exclusion 160 payments)
(32,000)
Unrecovered cost (loss in the final year return)
$10,000
Income from collections in final year: ($24,000 collected
8 $200 = $1,600 exclusion) =

$22,400

56.
(LO 4) Melissa, who is 70 years old, is unmarried and has no dependents. Her annual income consists of a taxable pension of $17,000, $14,000 in Social
Security benefits, and $3,000 of dividend income. She does not itemize her deductions. She is in the 15% marginal income tax bracket. She is considering getting a parttime job that would pay her $5,000 a year.
WhatwouldbeMelissasafter-taxincomefromthepart-timejob,considering Social Security and Medicare tax (7.65%) as well as Federal income tax on the earnings of
$5,000?
a. Melissa will be subject to a 15% income tax rate and 7.65% Social Security and Medicare tax rate on the $17,000 in earned income. Also, the additional $5,000
income will increase Social Security benefits subject to income tax. Her modified AGI before the additional $5,000 was $20,000. Therefore, her
taxable Social Security benefits would be calculated as follows:
50%[$20,000 + 50%($14,000) $25,000] = $1,000
With the additional income of $5,000 from the part-time job, her taxable Social Security benefits would be as follows:
50%[$25,000 + 50%($14,000) $25,000] = $3,500
So the part-time job would result in an increase in taxable Social Security benefits of $2,500 ($3,500 $1,000).
Melissas after-tax income from her part-time job would be:
Salary
Less: Federal income tax ($5,000 15%)
FICA tax ($5,000 .0765)
Increased taxable Social Security benefits ($2,500 15%)
After-tax income from part-time job

$5,000
(750)
(383)
(375)
$3,492

What would be the effective tax rate (increase in tax/increase in income) on the additional income from the part-time job?
b.
Her effective tax rate would be 30.16% [($5,000 $3,492) $5,000].

CHAPTER 5
11. (LO 2)
Ted works for Azure Motors, an automobile dealership. All employees can buy a car at the companys cost plus 2%. The company does not
charge employees the $300 dealer preparation fee that nonemployees must pay. Ted purchased an automobile for $29,580 ($29,000$580). The companys cost
was $29,000. The price for a nonemployee would have been $33,900 ($33,600$300 preparation fee). What is Teds gross income from the purchase of the
automobile?
The discount on the price of the automobile of $4,600 ($33,600 $29,000) is a qualified employee discount. The discount can be excluded from Teds gross income
because the price he paid was above the employers cost. However, Ted must include in gross income 80% of the dealer preparation fee, a service, of $300, which is
$240 ($300 80%). The maximum qualified employee discount that can be excluded for a service is 20%.

28

(LO 2) Determine the gross income of the beneficiaries in the following cases:

Justins employer was downsizing and offered employees an amount equal to one years salary if the employee would voluntarily retire.
a.
The payments received for not working must be included in Justins gross income because he experienced an increase in wealth when the payment was
received (although he may experience a decrease in future income).
Trina contracted a disease and was unable to work for six months. Because of her dire circumstances, her employer paid her one-half of her regular salary while she
was away from work.
b.
The payments received by Trina must be included in her gross income. The payments were not gifts, although they were made because of her dire
circumstances, because the Internal Revenue Code specifically provides that employers cannot be considered donors to their employees.

Coral Corporation collected $1 million on a key person life insurance policy when its chief executive died. The corporation had paid the premiums on the policy of
$77,000, which were not deductible by the corporation.
c.

The life insurance proceeds are excluded from Coral Corporations gross income. The corporation collected the proceeds as the beneficiary of the policy
upon the death of the insured.

Juan collected $40,000 on a life insurance policy when his wife, Leona, died in 2014. The insurance policy was provided by Leonas employer, and the premiums were
excluded from Leonas gross income as group term life insurance. In 2015, Juan collected the $3,500 accrued salary owed to Leona at the time of her death.
d.

30.

The life insurance proceeds of $40,000 are excluded from Juans gross income. He collected the proceeds as the beneficiary of the policy upon the death of
the insured. The fact that the corporation paid the premiums and the premiums were excluded from Leonas gross income does not affect the tax treatment
of the proceeds. The accrued salary must be included in Juans gross income because it would have been taxable to Juans wife if she had collected it
(income in respect of a decedent).

(LO 2) What is the taxpayers gross income in each of the following situations?

Darrin received a salary of $50,000 in 2015 from his employer, Green Construction.
a.
$50,000 salary.
In July 2015, Green gave Darrin an all-expense-paid trip to Las Vegas (value of $3,000) for exceeding his sales quota.
b.

$3,000, the value of the trip.

Megan received $10,000 from her employer to help her pay medical expenses not covered by insurance.
c.

The $10,000 as compensation, unless this is paid under a nondiscriminatory medical reimbursement plan available to other employees.

Blake received $15,000 from his deceased wifes employer to help him in his time of greatest need.
d.

The $15,000 is an excluded gift because it was paid based on Blakes need.

Clint collected $50,000 as the beneficiary of a group term life insurance policy when his wife died. The premiums on the policy were paid by his deceased wifes
employer.
e.

31.

Zero. Life insurance proceeds paid to the beneficiary upon death of the insured are excluded from gross income.

(LO 2) Donald was killed in an accident while he was on the job in 2015. Darlene, Donalds wife, received several payments as a result of Donalds death. What
is Darlenes gross income from the items listed below
a. Donalds employer paid Darlene an amount equal to Donalds three months salary ($60,000), which is what the employer does for all widows and widowers of
deceased employees.
b. Donald had $20,000 in accrued salary that was paid to Darlene.
c. Donalds employer had provided Donald with group term life insurance of $480,000 (twice his annual salary), which was payable to his widow in a lump sum.
Premiums on this policy totaling $12,500 had been included in Donalds gross income under 79.
d. Donald had purchased a life insurance policy (premiums totaled $250,000) that paid $600,000 in the event of accidental death. The proceeds were payable to
Darlene, who elected to receive installment payments as an annuity of $30,000 each year for a 25-year period. She received her first installment this year.

Darlenes gross income from the receipts is $86,000.

Amount Gross
Received Income
a.

Employer payments, not excluded as gift. The fact that

$ 60,000 60,000
the payment is part of company policy provides the earmarks of compensation rather than a gift.

b.

Accrued salary, earned before death.

c.

Group term life insurance proceeds.

$ 20,000 $20,000
$480,000 0

d.

Annuity proceeds
Less: Recovery of capital
($600,000*/$750,000**) $30,000

$ 30,000
24,000

$ 6,000
$86,000

*Investment in contract: nontaxable $600,000 insurance proceeds.

**Expected return: $30,000 25 years.

32.

(LO 2) Sally was an all-state soccer player during her junior and senior years in high school. She accepted an athletic scholarship from State University. The
scholarship provided the following:
Tuition and fees
15,000
Housing and meals
6,000
Books and supplies
1,500
Transportation
1,200

a. Determine the effect of the scholarship on Sallys gross income.

a.
The $16,500 received for tuition, fees, books, and supplies can be excluded from Sallys gross income as a scholarship. The $6,000 received for
room and board and the $1,200 received for transportation must be included in her gross income. The athletic scholarship is considered a
payment to further the recipients education and is not compensation for services.
b. Sallys brother, Willy, was not a gifted athlete, but he received $8,000 from their fathers employer as a scholarship during the year. The employer grants the children
of all executives a scholarship equal to one-half of annual tuition, fees, books, and supplies. Willy also received a $6,000 scholarship (to be used for tuition) as the
winner of an essay contest related to bioengineering, his intended field of study. Determine the effect of the scholarships on Willys and his fathers gross income.
b.

34.

The $8,000 scholarship is additional compensation to Willys father. The fact that the scholarships are awarded only to the children of
executives indicates that the employer is not simply making payments to assist the student seeking his or her education, but rather to compensate
an employee. However, the $6,000 scholarship received as a contest winner is excluded from gross income. Although contest winnings are
generally subject to tax, the exception is when the prize is a scholarship.

(LO 2) Adrian was awarded an academic scholarship to State University for the 20152016 academic year. He received $6,500 in August and $7,200 in
December 2015. Adrian had enough personal savings to pay all expenses as they came due. Adrians expenditures for the relevant period were as follows:

Tuition, August 2015

3,700

Tuition, January 2016

3,750

Room and Board

August-December 2015

2,800

January-May 2016

2,500

Books and educational supplies

August-December 2015

1,000

January-May 2016

1,200

Determine the effect on Adrians gross income for 2015 and 2016
Adrian received a total of $13,700 and spent $9,650 ($3,700 + $3,750 + $1,000 + $1,200) on tuition, books, and supplies. The amount received for room and board is
not excludible from gross income. Therefore, he must include $4,050 ($13,700 $9,650) in gross income. When he received the money in 2015, Adrians total
expenses for the period covered by the scholarship were not known. Therefore, he is allowed to defer reporting the income until 2016, when all the uncertainty is
resolved.
35. (LO 2) Leigh sued an overzealous bill collector and received the following settlement:
Damages to her automobile that the collector attempted to repossess
3,300
Physical damage to her arm caused by the collector
15,000
Loss of income while her arm was healing
6,000
Punitive damages
80,000
What effect does the settlement have on Leighs gross income?
a.
Leigh must include in gross income the punitive damages of $80,000. The other amounts ($15,000 and $6,000) may be excluded as arising out of
the physical personal injury, except the $3,300 amount received for damage to her automobile. This amount is a nontaxable recovery of capital
(i.e., it reduces her basis for the automobile by $3,300).
Assume that Leigh also collected $25,000 of damages for slander to her personal reputation caused by the bill collector misrepresenting the facts to Leighs employer
and other creditors. Is this $25,000 included in Leighs gross income? Explain.
b.

36.

The $25,000 is included in Leighs gross income because it did not arise out of a physical personal injury.

(LO 2) Determine the effect on gross income in each of the following cases:

Eloise received $150,000 in settlement of a sex discrimination case against her former employer.
a.
The settlement in the sex discrimination case did not arise out of physical personal injury or sickness. Therefore, the $150,000 is included in
Eloises gross income.
Nell received $10,000 for damages to her personal reputation. She also received $40,000 in punitive damages.
b.

The damages to Nells personal reputation are not for physical personal injury or sickness. Therefore, Nell must include the $10,000 in her gross
income. She must also include the $40,000 punitive damages in her gross income.

Orange Corporation, an accrual basis taxpayer, received $50,000 from a lawsuit filed against its auditor who overcharged for services rendered in a previous year.
c.

The damages of $50,000 are included in Orange Corporations gross income under the tax benefit rule, assuming the company received tax
benefit from deducting the audit fees in a previous year.

Beth received $10,000 in compensatory damages and $30,000 in punitive damages in a lawsuit she filed against a tanning parlor for severe burns she received from
using its tanning equipment.
d.

The compensatory damages of $10,000 for the physical personal injury are not included in Beths gross income, but the punitive damages of
$30,000 must be included in her gross income.

Joanne received compensatory damages of $75,000 and punitive damages of $300,000 from a cosmetic surgeon who botched her nose job.
e.

42.

Because the compensatory damages of $75,000 arose from a physical personal injury, they are excluded from Joannes gross income. The
punitive damages of $300,000 are included in her gross income.

(LO 2) Does the taxpayer recognize gross income in the following situations?

Ava is a filing clerk at a large insurance company. She is permitted to leave the premises for lunch, but she usually eats in the companys cafeteria because it is quick
and she is on a tight schedule. On average, she pays $2 for a lunch that would cost $12 at a restaurant. However, if the prices in the cafeteria were not so low and the
food was not so delicious, she would probably bring her lunch at a cost of $3 per day.
a.
It appears that Avas meals are not provided for the convenience of the employer, but rather as a convenience for the employee. Thus, this is a
taxable fringe benefit. Therefore, Ava is required to include in gross income the difference between the amount she paid for the meals, $2, and
the amount she would be required to pay of $12 to an unrelated restaurant. A comparison to the poorer quality of the self-prepared lunch is not a
valid measure of the benefit she actually received.

Scott is an executive for an international corporation located in New York City. Often he works late, taking telephone calls from the companys European branch. Scott
often stays in a company-owned condominium when he has a late-night work session. The condominium is across the street from the company office.
b.

Scott is not required to include anything in gross income for the use of the condominium. The lodging is for the convenience of the employer.
Also, because of the close proximity of the condominium to the office, the condominium is considered to be on the employers business premises
according to the Tax Court.

Ira recently moved to take a job. For the first month on the new job, Ira was searching for a home to purchase or rent. During this time, his employer permitted Ira to
live in an apartment the company maintains for customers during the buying season. The month that Ira occupied the apartment was not during the buying season, and
the apartment would not otherwise have been occupied.
c.
Apparently Ira is not being provided the housing for the convenience of his employer. However, the use of the apartment should qualify as a noadditional-cost service because the apartment would otherwise be vacant.

CHAPTER 6
39. (LO 3)
Trevor, a friend of yours from high school, works as a server at the ST Cafe. He asks you to help him prepare his Federal income tax return.
When you inquire about why his bank deposits substantially exceed his tip income, he confides to you that he is a bookie on the side. Trevor then provides you
with the following documented income and expenses for the year:
Tip Income
Gambling income
Gambling expenses
Payouts to winners
Employee compensation
Bribe to police officer who is aware of Trevors bookie activity

16,000
52,000
29,000
8,000
7,500

How will these items affect Trevors AGI (ignore the impact of self-employment taxes)?
A. The effect of the illegal gambling business on Trevors AGI is as follows:
Gross income
Deductible expenses:
Salaries
Payouts to winners
Increase in AGI

$52,000
$ 8,000
29,000

(37,000)
$15,000

The bribe to police of $7,500 is not deductible because this expense violates public policy.
Trevor also must include the tip income of $16,000 in his gross income.
His taxable income (ignore the impact of self-employment taxes)?
B. Trevors taxable income also increases by $15,000.
41.

(LO 3) Nancy, the owner of a very successful hotel chain in the Southeast, is exploring the possibility of expanding the chain into a city in the Northeast.
She incurs $35,000 of expenses associated with this investigation. Based on the regulatory environment for hotels in the city, she decides not to expand.
During the year, she also investigates opening a restaurant that will be part of a national restaurant chain. Her expenses for this are $53,000. The restaurant
begins operations on September 1. Determine the amount that Nancy can deduct in the current year for investigating these two businesses.

Even though Nancy decides not to pursue the expansion of her hotel chain into another city, the investigation expenses of $35,000 are deductible in the current year.
Because Nancy is in the hotel business, all investigation expenses associated with the hotel business are deductible in the year paid or incurred. Because Nancy was not
in the restaurant business, she can deduct only part of these investigation expenses. Of the $53,000, an amount of $2,000 [$5,000 $3,000 (reduction for excess over
$50,000)] can be immediately expensed. The balance of $51,000 ($53,000 $2,000) is amortized over a period of 180 months at the rate of $283 per month ($51,000
180) commencing in September (the month the business is started). Consequently, the total deduction for the year is $35,000 for the hotel investigation + $3,132
[$2,000 + ($283 4 months)] for the restaurant investment, or a total of $38,132.
44.

(LO 3) Alex, who is single, conducts an activity in 2015 that is appropriately classified as a hobby. The activity produces the following revenues and expenses:

Revenue
Property taxes
Materials and supplies
Utilities
Advertising
Insurance
Depreciation

18,000
3,000
4,500
2,000
5,000
750
4,000

Without regard to this activity, Alexs AGI is $42,000. Determine the amount of income Alex must report, the amount of the expenses he is permitted to deduct, and his
taxable income.

Alex must report the $18,000 as revenues. All of the property taxes of $3,000 can be deducted. Because the remaining expenses of $16,250 exceed the balance of
$15,000 ($18,000 revenues $3,000 property taxes), the $15,000 is deductible as follows:
Materials and supplies
Utilities
Advertising
Insurance
Depreciation (because depreciation is sequenced
last, only $2,750 of the $4,000 is eligible)
Total deductible expenses

$ 4,500
2,000
5,000
750
2,750
$15,000

These expenses of $15,000 are classified as miscellaneous itemized deductions and will be subject to the 2%-of-AGI floor. Consequently, $1,200 [($42,000 + $18,000)
2%] of these expenses is disallowed.
Other AGI
Revenues from hobby
Less: Expenses
Property taxes
Miscellaneous itemized
deduction ($15,000 $1,200)
Reportable net income from hobby
Less: Personal exemption
Taxable income

45.

$42,000
$18,000
(3,000)
(13,800)
1,200
(4,000)
$39,200

(LO 3) Samantha, an executive, has AGI of $100,000 before considering income or loss from her miniature horse business. Her outside income comes from prizes
for winning horse shows, stud fees, and sales of yearlings. Samanthas home is on 20 acres, half of which she uses for the horse activity (i.e., stables, paddocks,
fences, tack houses, and other related improvements).
Samanthas office in her home is 10% of the square footage of the house. She uses the office exclusively for maintaining files and records on the horse activities.
Her books show the following income and expenses for the current year:

Income from fees, prizes, and sales

Expenses Entry fees
Feed and veterinary bills
Supplies

$22,000
1,000
4,000
900

Publications and dues

Travel to horse shows (no meals)
Salaries and wages of employees
Depreciation Horse equipment
Horse farm improvements
On 10% of personal residence
Total home mortgage interest
Total property taxes on home
Total property taxes on horse farm improvements

500
2,300
8,000
$3,000
7,000
1,000

11,000
24,000
2,200
800

The mortgage interest is only on her home because the horse farm improvements are not mortgaged.

What are Samanthas tax consequences if the miniature horse activity is a hobby?
a. If the miniature horse activity is held to be a hobby, Samanthas deductions associated with the hobby may not exceed her gross income from the activity.
Income
Deduct:

Balance
Deduct:

$22,000
Mortgage interest (10% $24,000)
Property taxes on horse farm improvements
Property taxes on home (10% $2,200)

$2,400
800
220

(3,420)
$18,580

Other expenses
Entry fees
Feed and veterinary bills
Supplies
Publications and dues
Travel
Salary and wages

$1,000
4,000
900
500
2,300
8,000

Balance

(16,700)
$ 1,880

Depreciation:
On horse equipment
On horse farm improvements
On home (10% office portion)
Total
Limited to:
Net Income

$ 3,000
7,000
1,000
$11,000
(1,880)
$ 0

The items are handled as follows:

AGI

$100,000

Plus: Horse farm income

22,000

New AGI

$122,000

Itemized deductions:
Interest and taxes on horse farm (hobby portion)
Interest and taxes on home ($26,200 $2,620)
Other expenses and depreciation of hobby ($16,700 +

$ 3,420
23,580

$27,000

$1,880)
Less: 2% of AGI ($122,000)

$18,580
(2,440)

$16,140

Note that the deductions of the miniature horse operation are $19,560 ($3,420 + $16,140), of which $3,420 were deductible anyway. The net increase in taxable
income is:
Income
$22,000
Otherwise nondeductible expenses
(16,140)
Net increase in taxable income
$ 5,860
If it is a business?
b. If the miniature horse activity is classified as a business, Samantha will be able to deduct $9,120 for AGI as follows:
Remainder of income after other expenses and before amounts
that affect basis (depreciation) (see part a. above)

$ 1,880
Less: Depreciation (11,000)
Deduction for AGI ($ 9,120)

In addition, Samantha can deduct the remaining property taxes and mortgage interest of
$23,580 as an itemized deduction. The net effect is as follows:
Loss on horse farm
Add: Otherwise deductible taxes and interest

($9,120)
3,420

Net decrease is taxable income

($5,700)

Contrast this decrease of $5,700 with the increase of $5,860 in part a. The $11,560 difference is due to the difference between hobby and business treatment.

47.

(LO 3) Adelene, who lives in a winter resort area, rented her personal residence for 14 days while she was visiting Brussels. Rent income was $5,000. Related
expenses for the year were as follows:

Real property taxes

Mortgage interest
Utilities
Insurance
Repairs
Depreciation

$ 3,800
7,500
3,700
2,500
2,100
15,000

Determine the effect on Adelenes AGI.

Because the house was rented for less than 15 days, the rental income of $5,000 is excluded from Adelenes gross income. The only expenses that can be deducted in
this case are the real property taxes of $3,800 and the mortgage interest of $7,500. These expenses are classified as itemized deductions (i.e., deductions from AGI).
Therefore, there is no effect on AGI.

48.

(LO 3) During the year (not a leap year), Anna rented her vacation home for 30 days, used it personally for 20 days, and left it vacant for 315 days. She had the
following income and expenses:
Rent income
Expenses Real estate taxes
Interest on mortgage
Utilities
Repairs
Roof replacement (a capital expenditure)
Depreciation

$ 7,000
2,500
9,000
2,400
1,000
12,000
7,500

Compute Annas net rent income or loss and the amounts she can itemize on her tax return, using the courts approach to allocating property taxes and interest.
a.
Gross income
$7,000
Deduct: Taxes and interest (30/365 $11,500)
(945)
Remainder to apply to rental operating expenses and depreciation $6,055
Utilities
and
repairs [30/50 ($2,400 + $1,000)]
(2,040)
Remainder
$4,015
Depreciation (30/50 $7,500 = $4,500, limited to remainder)
(4,015)
Net rental income
$ 0
She can itemize $10,555 of property taxes and mortgage interest ($11,500 total less $945 allocated to rental). Thus, under the courts approach,
Anna has no net rental income and has an itemized deduction of $10,555.
The roof replacement of $12,000 is a capital expenditure, and the related depreciation is included in the $7,500 of depreciation.
How would your answer in part (a) differ using the IRSs method of allocating property taxes and interest?
b.

Gross income
Deduct: Taxes and interest (30/50 $11,500)
Remainder to apply to rental operating expenses
and depreciation
Utilities and repairs [30/50 ($2,400 + $1,000)
= $2,040, limited to remainder]
Net rental income

$7,000
(6,900)
$ 100
(100)
$ 0

Anna can deduct the remaining taxes and interest of $4,600 ($11,500 less rental allocation of $6,900) as itemized deductions. Under the IRSs
approach, she has no net rental income and has an itemized deduction of $4,600.
49.

(LO 3) How would your answer to Problem 48 differ if Anna had rented the house for 87 days and had used it personally for 13 days?

Because Anna used it for fewer than 15 days, it is classified as rental property.
Percentage of use
Gross income
Expenses:

Rental
87%

Personal
13%

$ 7,000

$ 0

Interest and taxes ($9,000 + $2,500)

Utilities and repairs ($2,400 + $1,000)
Depreciation ($7,500)
Total expenses
Net income (loss)

$10,005

$1,495
2,958
442
6,525
$19,488
($12,488)

975
$2,912
$ 0

Anna could deduct $325 ($2,500 13%) of property taxes as itemized deductions and take a rental loss deduction for AGI of $12,488. The mortgage
interest of $1,170 ($9,000 13%) is not deductible as an itemized deduction because it is not qualified residence interest.
The roof replacement of $12,000 is a capital expenditure, and the related depreciation is included in the depreciation of $7,500.

50.

(LO 1, 3)

Chee, single, age 40, had the following income and expenses during 2015:

Income
Salary
Rental of vacation home (rented 60 days, used personally 60 days, vacant 245 days)
Municipal bond interest
Dividend from General Electric
Expenses Interest on home mortgage
Interest on vacation home
Interest on loan used to buy municipal bonds
Property tax on home
Property tax on vacation home
State income tax
State sales tax
Charitable contributions
Tax return preparation fee
Utilities and maintenance on vacation home
Depreciation on rental 50% of vacation home

$43,000
4,000
2,000
400
8,400
4,758
3,100
$2,200
1,098
3,300
900
1,100
300
2,600
3,500

Calculate Chees taxable income for the year before personal exemptions. If Chee has any options, choose the method that maximizes his deductions.
Income (Note 1):
Salary
Dividend
Rental of vacation home (Note 2)
Adjusted gross income
Itemized deductions:
State income taxes (greater than sales tax; Note 3)
Property tax on home
Interest on home mortgage
Interest and property taxes on vacation home (Note 2)
Charitable contributions
Tax return preparation fee (Note 4)
Taxable income before personal exemption

$43,000
400
0
$43,400

$3,300
2,200
8,400
4,893
1,100
0

(19,893)
$23,507

Notes
(1)

The municipal bond interest of $2,000 is excludible from gross income, and the interest expense of $3,100 on the loan to buy municipal bonds is not
deductible.

(2)

Rental income
Less: Taxes and interest (60/365 $5,856)
Remainder
Less: Utilities and maintenance (1/2 $2,600)
Remainder
Less: Depreciation ($3,500, limited to $1,737)
Net income from vacation home

$4,000
(963)
$3,037
(1,300)
$1,737
(1,737)
$ 0

Note that $4,893 ($5,856 total $963 vacation home portion) of property taxes and mortgage interest on the vacation home are itemized deductions.
(3)

(4)

At the time of publication, the option to deduct the greater of state income tax or sales tax had not been extended to 2015. Whether extended or not, the
results in this problem are the same.

Tax preparation fees are reduced by 2% of AGI (in this case, 2% of AGI exceeds $300).